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The Bankruptcy of Lehman Brothers: Causes of Failure & Recommendations Going Forward

Amirsaleh Azadinamin

Doctorate of Finance Candidate

March 6, 2012

Electronic copy available at:

THE BANKRUPTCY OF LEHMAN BROTHERS Abstract This paper looks at the failure of Lehman Brothers as the biggest bankruptcy case in the US history and the events that followed. The first part of the paper reviews factors that led to the failure and consequently the bankruptcy event. Some of the causes leading to the crisis, namely the market for Credit Default Swaps (CDOs), misrepresentation of financial statement, complex structure of the company, low standards, and unethical behavior of top managers are reviewed in the paper as the essential causes. In misrepresentation of financial statements there is an extra emphasis on the misuse of the Repo 105 procedure and how Lehman used it to make its financial statements appear healthier than what they were in actuality. Many also suggest that the misrepresentation by the top managers also violated the Sarbanes-Oxley Act. The second part of the paper reviews whether the failure could have been prevented before the crisis was spiraled out of control with devastating consequences. Numerous analyses and their conclusion suggest that there were many signs suggesting the coming of a crisis, but numerous people, whether analyst, auditors, or even employees, failed to recognize them or deliberately turned a blind eye to the warning signs. The most prominent sign is mentioned as the net negative cash flows that Lehman was running three years prior to the crisis despite healthy looking balance

sheets as well as income statements. The last part of the paper offers solutions for going forward and ways to avoid another failure of a giant financial institution. As for solutions going forward, paper recommends companies to abandon dubious and wrongful accounting practices in order to attain unattainable targets as well as using new methods to assess the health of the organization.

Electronic copy available at:

THE BANKRUPTCY OF LEHMAN BROTHERS The Biggest Bankruptcy in the US History The failure of Lehman Brothers in 2008 was the largest case of bankruptcy in US history. But the failure was the beginning of a series of events that were yet to be unfolded. The news and negative effects of the bankruptcy rippled through the market. The Dow Jones

Industrial Average declined by more than 500 points by the end of the trading session of the day (Mamun & Johnson, 2012). Tremendous research has been done on the failure of Lehman Brothers including the causes of failures and whether it could have been prevented. A devastating report in March 2010 recounted in minute detail the practices carried out by Lehman Brothers, an institution founded in 1850 that declared bankruptcy on September 15, 2008. Notably, the executives were accused of gross negligence in their duty of disclosure (Morin & Muax, 2011, p. 38). This also sheds light on unethical practices that were either directly exercised by top managers or were supervised under their watch. Also, many blame accounting standards and techniques and how they are used to portray financial statements as not what they are, but how management wants them to portray. These practices leave open windows of opportunities for those whose intentions are to misuse their position, whether it is for personal reasons or short-term gains of the organization. In case of the Lehman it seems that it was more of the latter. Lehman failed to disclose various transactions in the notes to their financial statements. This may be due to negligence of accountants and auditors that leads many to argue for the reexamination of Generally Accepted Accounting Standards (Jeffers, 2010). Many also blame the techniques that are currently used to predict firms financial distress. The numerous bankruptcies and financial difficulties that US banks went through in 2008, including the events that analysts failed to predict, indicated shortcomings in financial analysis techniques (Morin & Maux, 2011). This will also be discussed throughout the paper.

THE BANKRUPTCY OF LEHMAN BROTHERS Causes of the Failure There is no single cause that led to the failure of Lehman Brothers. There were numerous causes and agents that led to the disaster, including greedy Wall Street traders, the debt load of American households, the Feds action, rating agencies, and last but not least, the

deregulation (Morin and Maux, 2011). These factors were responsible for the crisis of credit and not solely the failure of Lehman Brothers. Still, the market of Credit Default Swaps was one of the biggest factors dedicating to the catastrophe, if not the biggest one as Lehman was heavily involved in that market. In explaining the sub-prime market, Morin and Maux (2011) explain that sub-prime loans refer to inferior quality (sub) real estate loans whose higher risk of payment
default is countered by the bank with a higher interest rate. These mortgage loans, granted at variable

rates, were extended to American households with modest incomes (p. 41). Morin and Maux (2011) also discuss Lehmans involvement in that particular market as well as how Lehman caused erosion in that market at the same time: The bank is accused of having sold Collateralized Debt Obligations (CDOs) to its clients and taking short positions that effectively eroded the value of these securities. In doing so, Goldman Sachs also helped other clients to short the mortgage bond market, and triggered the plunge of the subprime market. Rumors of collusion between banks soon followed (p. 41). In a separate report and a SWAT analysis done by Datamonitor (2008), the significant exposure of Lehman to sub-prime mortgage is explained as a threat for the organization and criticized: Investments in the sub-prime mortgages and mortgage backed securities are at risk of being written off amid a crisis in the US sub-prime mortgage market. Much of that sub-

THE BANKRUPTCY OF LEHMAN BROTHERS prime debt was repackaged as collateralized debt obligations (CDOs) and mortgagebacked securities and was sold in the wholesale market. Many of the hedge funds and investment vehicles invested heavily in these securities and are finding them illiquid due to the defaults in the mortgage market (p. 7). As one might guess by now, the crisis was triggered and snowballed by what is now known as the subprime crisis starting in the summer of 2007. As it was mentioned the subprime crisis triggered the crisis in the American financial sphere, but it was soon spread to larger financial centers, even scattering to nonfinancial institutions. The rise in key interest rates by American Federal Reserve along with the dissipation of demand for real property fuelled an increase in defaults on mortgage payments, leading to insolvency. Subsequently, these failures caused a chain reaction on the markets. The failure also spread over all securitization vehicles, in which they are designed to allow a company or a bank holding assets with little liquidity to group them together and sell them to a specialized entity that is created for the same purpose (Morin and Maux, 2011). Securitization therefore enables an organization to dispose of assets while immediately obtaining capital in exchange, a process which represents a new means of financing for these entities. Credit then becomes liquid; however, if it is based on a poor risk, someone will eventually have to pay the piper (p. 41). In return and to prevent further disaster, the US government quickly responded to the disaster and proposed a rescue plan for the banks. In early 2010, when the crisis seemed to be dampen and there were cautious optimisms and positive signs from the American banks, attention was shifted toward the accountability of the executives of one of the institutions being

THE BANKRUPTCY OF LEHMAN BROTHERS at the center of the crisis. Morin and Maux (2011) explain the method that this unethical behavior was taking place: On March 12, 2010, a 2,200 page inquiry report prepared by legal expert Anton R.Valukas revealed the extensive use of accounting manipulations that might have largely contributed to the collapse of Lehman Brothers, which went bankrupt on September 15, 2008. This report sheds light on the systematic use of a balance sheet window-dressing technique called Repo 105, which let Lehman remove roughly $50 billion in commitments from its balance sheet in June 2008, and artificially reduce its net debt level by wagering on the collateralized loan market (p. 42). As it was mentioned the negative cash flows that Lehman was running prior to the bankruptcy also cause Lehman not to be able to meet its at-the-time-current obligations. Lehman was also unable to maintain confidence because a series of business conditions had left it with heavy concentration of illiquid assets with declining values that mostly included residential and commercial real estate. Morin and Maux (2011) state that legal experts believed that Lehman executives deliberately manipulated information in statements. In addition, the auditors, Ernst & Young, purposely closed their eyes to these balance sheet manipulations as early as 2000s. They believed that Lehman significantly used Repo 105, and failed to disclose it to the government, to the rating agencies, to its investors, and to its own board of directors, and all in a while the auditors were aware of the situation. Morin and Maux (2011) state that although Repo 105 was in line with American accounting standards, its purpose was to deceive and they used techniques to reduce its reported leverage substantially. The schemes Lehman allegedly carried out using REPO 105 therefore had a significant impact on its balance sheet by undervaluing its liabilities. The income statement was

THE BANKRUPTCY OF LEHMAN BROTHERS also affected, but to a lesser extent: financing costs were undervalued given that Lehman did not recognize these REPO transactions as loans. However, with respect to the cash flows involved in these transactions, inflows and outflows of funds are the same regardless of the accounting method used (p. 42). What Is Repo 105? Jeffers (2011) explains repo as repurchase agreement (repo) that has historically been used by companies to manage their short term cash. But in the Lehman case, these transactions took an unusual spin that were intended to make Lehmans balance sheet look healthier that what they really appeared to be. The traditional agreements normally involve an investment banking firm giving a counterparty highly liquid securities in exchange for cash. These are accounted for as loans with collateral. In case the investment banking firm is not capable of paying, the lender will sell the collateral for his money to be reimbursed. The cash received by the company is normally repaid at a later date plus a small amount

of interest (normally 2 percent) to get the securities back. Additionally these transactions would generally be accounted for as financing arrangements. To maintain its stellar reputation, Lehman engaged in this common arrangement but instead of utilizing the normal practices, Lehman employed creative but deceitful accounting practices known as Repo 105. Essentially, Repo 105 is an aggressive and deceitful accounting offbalance sheet device which was used to temporarily remove securities and troubled liabilities from Lehmans balance sheet while reporting its quarterly financial results to the public. These transactions were recorded as sales rather than as loans (Jeffers, 2011, p. 46).

THE BANKRUPTCY OF LEHMAN BROTHERS How Lehman Used Repo 105 Even though repo 105 is a legal procedure, Lehman used it as follows, according to Wilchins and DaSilva (2010). First, they bought government bonds from another bank using its Lehman Brothers Special Financing Unit in the United States. Just before the end of the quarter, the US unit transferred bonds to London affiliate, knows as Lehman Brothers International. Then, the London affiliate gave assets to its counterparty and received cash and agreed to buy the assets back at a later time at a higher price, at least 105 percent of the price. The money that was received was used to cover and pay off a large amount of the liabilities. The reduction in assets and liabilities showed healthier quarterly financial statements and corresponding ratios, appearing much better to regulators, investors, and the general public. At the beginning of the next quarter and with healthy-looking statements, Lehman went on to borrow more at other lending institutions. Only then, Lehman repurchased the securities from the London affiliate at 105 percent of the original price. Having done so, the financial statements would have gone back to the previous inferior position. Did Lehman Violate the Sarbans-Oxely Act? Kourabi et al., (2011) explains that the Sarbanes-Oxley Act was enacted into law in 2002 and in response to the collapse of Enron and WorldCom, following the discovery of many accounting scandals. The Act is designed to restore investors confidence, to enhance the reliability and accuracy of the financial reporting, to improve the corporate governance system, to improve the content and timeliness of the disclosure requirements, to strengthen the role of the independent directors, and to improve the internal control practices and procedures (p. 43).

THE BANKRUPTCY OF LEHMAN BROTHERS Jeffers (2011) notes that even though repo 105 is a legal procedure, but if the procedure is used to taint the fair financial position of the company with the full knowledge of CFOs and CEOs, the executives are subject to severe financial penalties and imprisonments. In the case of Lehman, the executives were fully aware that the Repo 105 was being used to mislead the statements. From all accounts, it appeared that the senior management knew of the Repo 105 transactions and nevertheless, they certified the accuracy of the statements knowing that they were inappropriate. As a result, these executives were fully aware that the financial statements were misleading and did not fairly present the true position of the company (p. 53). Hence, those Lehman executives were subjected to criminal and financial liability. With top managers being fully aware, an accounting scandal was in the making and the Sarbanes-Oxley Act was violated. Complex Structure Steinberg and Snowdon (2009) blame the Lehman bankruptcy on the complex structure of the organization along with numerous other issues leading to the bankruptcy. Lehman Brothers was conducting business in global scope having about 3000 legal entities which made the situation incredibly complicated. Any organization that experiences exponential growth on the same scale as Lehman must have a similar degree of complexity. The complexity dedicated to the expansion and growth, and the expansion and growth contributed to the complexity. It works both ways as one would not be materialized with the absence of the other. Prevention Morin and Maux (2011) analyze the financial statements of 2005 to 2007 in order to establish whether the failure of Lehman Brothers could have been predicted. In doing so, they mention that most analysis are centered on balance sheet that portrays the financial structure of

THE BANKRUPTCY OF LEHMAN BROTHERS the company and the state of its solvency/liquidity. Income statements are also of great importance. However, the statements of cash flows are mostly ignored by analysts. The statement of cash flows, which illustrates a companys capacity to transform its results into


cash, has been virtually ignored by analysts, who tend to focus instead on the balance sheet and the income statement (p. 40). The question in the Lehman Brothers case remains: beyond the lies that were generally hidden by the top management, how could investors or auditors not detect such warning signs? Morin and Maux (2011) examine financial statements over the three years leading to the bankruptcy to show that such warning signs were indeed detectable. The reason that the bankruptcy was failed to be detected was that the statement of cash flows were not given equal weighs in comparison to other financial statements. Although Lehman Brothers had $7.286 billion in cash and cash equivalents on November 30, 2007, an analysis of its statement of cash flows signals major dysfunctions in working capital management. This is particularly striking for the financial instruments: over a three-year period, they generated net negative cash flows of $161.657 billion (p. 40). The shortcoming in predicating a disaster by analysis is so clear that many may believe that analysts either did not just understand the statements or were blinded by the superficial performance. It is also possible that holding to the minimum of standards, they simply turned a blind eye to the warning signs. In any event, having negative cash flows must have rang a bell about the horrible health of the organization, and it must have hinted analysts about the superficiality of the balance sheet and income statement. Furthermore, Morin and Maux (2011) drew a conclusion that the 2005-2007 statements of cash flow of Lehman Brothers were reliable predictors of the coming bankruptcy. They

THE BANKRUPTCY OF LEHMAN BROTHERS mention the following signs of distress to be completely detectable in Lehmans financial statements. 1. Chronic inability to generate cash from operating activities (p. 52). 2. Massive and systematic investment in working capital items and even more intensive investments in financial tools and instruments. 3. Systematic use of external financing to offset operating deficits, in which it mainly included long-term debt. 4. Steady deterioration of cash flows over three years leading to the crisis.


Steinberg and Snowdon (2009), members of the Lehman tax department, maintain that they were also aware of the trouble ahead. Early in 2008, they anticipated and started planning that they were going record net operating losses for US tax purposes for the 2008 taxable year. Steinberg and Snowdon (2009) note that they were focused on providing tax advice for the disposition of assets, deleveraging of the balance sheet and in structuring potential capital transactions while also attempting to ensure the preservation of the historic and current tax attributes such as foreign tax credit and tax net operating loss carry forwards of the company. There were various signs of disaster looming in the near future even though the tax team was kept in the dark about the dire situation. Since they did not know the depth of the trouble the question in their mind was if Lehman was to be absorbed by another financial institution, or perhaps mass layoffs, but no thoughts on filing for bankruptcy. However, due to unethical use of accounting standards, Lehman posted net positive results and growth between 2005 and 2007. This may be the only reason these signs of distress were not visible in the income statement. Analysts made recommendations and predictions based on Lehmans estimated earnings
per share. They therefore had their eyes riveted to the statement of income, which may explain why Lehmans cash flow situation did not cause any apparent concern (Morin and Maux, 2011, p. 52).

THE BANKRUPTCY OF LEHMAN BROTHERS However, when the analysis is made based on the statements of cash flow, the financial deterioration of the company is completely visible. The analysis signals major dysfunction in working capital management. This is particularly striking for the financial instruments which generated, over a three-year period, net negative cash flows of $161.657 billion (p. 52). What is surprising is that the systematic payment of dividends that went on despite sizable cash deficits was completely unnoticed by the auditors in assessing financial statements. What is even more shocking is the financing of the dividends that was done through long-term loans, which by itself indicates a dysfunctional cash management.


All these finding, can bring one to a conclusive result, that the failure of Lehman could have been predicted and prevented. Recommendations Going Forward One can learn many lessons from a failure, especially when the failure is the biggest of an institution in the US history. Modifying accounting practices and adding new methods of predicting the disaster are two are two lessons to be named. Caplan et al., (2010) examined the failure of Lehman and have suggested a few recommendations for going forward. Avoiding Unachievable Business Strategy Caplan et al., (2010) mention that in 2006, Lehman made a deliberate decision in pursuing a higher-growth business strategy. To achieve their goal they switched from a low-risk brokerage model to capital-intensive banking model that required them to buy assets and store them as opposed to acquiring assets to primarily moving them to a third party. Having to keep the assets internalized the risk and returns of the investments. The mismatch between short-term debt and long-term, illiquid investments required Lehman to continuously roll over its debt, creating significant business risk. Lehman

THE BANKRUPTCY OF LEHMAN BROTHERS borrowed hundreds of billions of dollars on a daily basis. Since market confidence in a companys viability and debt-servicing ability is critical for it to access funds of this magnitude, it was imperative for Lehman to maintain good credit ratings (p. 24). In order to pursue this high growth trend they had no other option but to aggressively target a high growth rate in revenues. But they also had to target an even faster growth in its balance sheet and total capital base. This unreachable target led them to hold $700 billion in


assets in 2007 on equity of $25 billion with $675 billion in liabilities (Caplan et al., 2010). This unfeasible strategy at the time also brought along higher risk because most of assets were long term and highly illiquid. Commercial real estate, private equity, and leveraged loans were just to name a few. As the subprime crisis unfolded Lehman had to act quickly, and that meant liquidating a vast amount of its illiquid assets in housing mortgages. Negative perception of the market caused the assets to be bought as even a lower price. Looking back at the events unfolding and the strategy that Lehman chose, one may conclude that pursuing the company strategy at any cost was absolutely wrong. There is a cost to any strategy and Lehman must have forgone its high-growth strategy if its cost outweighed the benefits and was deemed as unfeasible at the time. Elimination of Dubious Accounting Practices by Holding High Ethical Standards When achieving the planned strategy of high growth seemed unattainable for Lehman, top managers decided to use dubious or perhaps corrupt accounting practices to reach the goal. Using Repo 105 in its unordinary way was only one of the many wrongful practices used in Lehman for showing healthier financial statements. Even though as it was mentioned the Repo 105 is a legal procedure, but Lehman used it in an unusual and unethical way to acquire new loans by showing healthier than actual statements. Accounting standards open the way for

THE BANKRUPTCY OF LEHMAN BROTHERS unethical managers to take advantage of these standards and practice them according to their unethical behavior. Accounting standards must be modified to impede the unethical and wrongful practices that could jeopardize peoples wealth.


Caplan et al., (2010) suggest that substance must be taken into consideration over form, in which the fairness and the health of the organization must be judged based on the substance of the statements and not simply the ratios inferred from them. Auditing standards state that the auditors judgment should be based on whether, among other considerations, (1) the accounting principles selected and applied have general acceptance, (2) the accounting principles are appropriate under the circumstances, and (3) the financial statements, including the related notes, are informative about matters that may affect their use, understanding, and interpretation (p. 27-28). This may put an emphasis on the going concern factor in accounting measurements. The going concern states the health of the company in the long-run and whether the company will survive in the long run, regardless of the current financial position. Adhariani and Masyitoh (2010) state that going concern is one of the main decision making factors in assessing financial decisions. The research done by Adhariani and Masyitoh (2010) shows that certain ratios and numbers such as liquidity, profitability, and cash flow that are concluded from financial statements are not significant to influence the issuance of audit opinion. They determine solvability as the most significant factor. Going concern is an extremely interesting issue to discuss. Investors, creditors and also government are extremely interested in identifying the financial position of the company, and one of factors brought to their consideration is the auditors opinion.

THE BANKRUPTCY OF LEHMAN BROTHERS Opinion relevant to going concern is a red alert that financial failure in the company comes to exist (p. 27).


Even though financial ratios are very useful in predicting the failure and success rates of any company to maintain its going concern in the future, they are not sole indicators of the health of the company. As for the corporate culture that was completely stepped over in Lehman, Caplan et al., (2010) mention that the need for an ethical culture is perhaps greatest when an unplanned event occurs (p. 29). Having to hold higher standards, individuals will hold a course of action representing the policy of the organization. Although the specific financial instruments that Lehman used to manage its financial statements apply primarily to the financial services industry, the events at Lehman provide lessons about corporate governance that apply to all organizations. First, all parties with meaningful roles in the financial reporting process shouldnt apply accounting rules with the intent to obfuscate the economic substance of transactions. As a corollary to this rule, if the transaction has no economic substance but serves only to window-dress the financial statements, its proper disclosure will eliminate any incentive to engage in the transaction (p. 29). In the case of Lehman Brothers, one can see that some of the auditors, accountants, and top managers failed to practice high ethical standards, even though they might have practiced the minimum required to be shielded from legal actions. Alternative Theoretical and practical financial distress prediction models Morin and Maux (2011) dispute the methods that are currently being used by analysts for predicting financial distress. Instead, they state that the Altman financial distress prediction



model can provide a clearer and more complete picture, and they provide quantitative evidence to prove it. They conclude that Lehmans coefficient was well below 1.81, which is Altman models threshold of financial distress. It is worth noting that Lehmans average coefficient over three years leading to the failure was 0.0897 which supports the observation. Altman formula demonstrates that the ratios of internally generated funds to total debt and the return on equity (ROE) are better predictors of financial distress than the liquidity ratios. The main advantage of discriminant analysis is that it can deal with several variables that define the complete profile of a firm rather than simply analyzing one factor (p. 44). In inferring to his conclusion, Altman grouped 22 independent variables into 5 groups: liquidity, profitability, lever effect, solvency, and activity ratios, and in studies done by Altman himself, it has been a great indicator of financial distress. Altman looked at the relevance of the ratios and their correlation. The integration of these five variables in a single equation yielded the greatest success rate for predicting financial distress (p. 44). Concluding Remarks The failure of Lehman Brothers was contributed to numerous factors that went in parallel to contribute to the biggest bankruptcy in the US history. They went hand in hands because no single factor could have brought this disaster by itself. Dubious and doubtful accounting practices could not be possibly practiced in the long run if not for low ethical standards held by top managers as well as the auditors. It seems as if auditors mainly tried to shield themselves from legal action just by executing the minimum requirements expected from them. The Repo 105 procedure is nothing but an ordinary and legal practice for short-term financing that was taken out of its context by unethical accounting practices in order to please investors and lenders. The complex structure of Lehman also provided a window of opportunity



for the same unethical managers to abuse the trust that was placed in them, the organization, and management by investors and shareholders. It can also be concluded that the Sarbanes-Oxley Act was violated because top managers deliberately tainted the financial statements to falsely show the health of the company to be better than what it really was at the time. Once these managers were incapable of reaching their growth and expansion rate they had to inflate their financial statements to keep the appearance of a company with high rate of growth. For Lehman, the mistake lay in putting too much faith in an outmoded culture and failing to see how its very strength undermined the business. For companies that confidently set out to change their cultures, the Lehman experience offers a lesson about the nature of corporate culture itselfit can be much stronger, more deeply embedded, and far less malleable (Greenfield, 2010, p. 36). The main signal of deficiency in the organization came from the net negative statements of cash flows, nevertheless, auditors failed to recognize the lack of correlation between the statements of cash flow with balance sheet and income statements. Auditors failed to recognize that the net negative statements of cash flows reflected the financial standing of the company. This highlights yet another conclusion that is drawn from the paper. The current analytical and rating methods have sufficient shortcomings and the case of Lehman is prominent evidence. Studies show that the Altmans z-score test may be complementary in predicting the crisis in the making. At the end, Lehmans failure had an impact beyond expectations. The consequences did not just leave its negative print on the economy but also on the society with the lost confidence in institutions and corporate culture. As Greenfield (2010) mentions, one must wonder when businesses and their executives will realize that their activities can significantly impact the very

THE BANKRUPTCY OF LEHMAN BROTHERS fabric of human society (p. 54). In any event, holding higher standards and ethical culture by auditors, managers, and rating agencies are essential in avoiding this sort of disaster. References


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THE BANKRUPTCY OF LEHMAN BROTHERS Verleun, M., Georgakopoulos, G., Sotiropoulos, I., & Vasileiou, K. Z. (2011). The SarbanesOxley Act and Accounting Quality: A Comprehensive Examination. International Journal Of Economics & Finance, 3(5), 49-64. doi:10.5539/ijef.v3n5p49 Wilchins, Dan & DaSilva, Silvio (2010). Graphic: How Repo 105 Worked,