Finance

Lehman Brothers

Lehman Brothers

On September 15,2008 gave us the reminded that nothing is forever even in the richness of the investment and financial world when hundreds of employees dressed in suits were seen carrying boxes in their hands and coming out of the famous investment bank the Lehman Brothers. In 2003-2004 the US housing bubble was doing very well which led the Lehman Brothers to acquire five mortgage lenders along with BNC Mortgage and Aurora Loan Services which specialized in ALT-A loans (these loans were given to the borrowers without full documentation). They recorded tremendous profits from the real estate business.

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On March 14, 2007, the stock had its biggest drop in five years after which there was concern regarding the Lehman Brothers financial health but they said that it would have little impact on the firm’s earnings. As the credit crisis erupted in August 2007 the stock prices of the Lehman Brothers fell sharply. In early September of 2008, they faced a loss of $3.9 billion and Moody’s Investor Service announced that the chances to prevent a downgrade were only by selling a majority stake to a strategic partner. With only $1 billion left in cash, they were running out of time. A takeover by the Bank of America or Barclays did not work out and ultimately on September 15, they declared bankruptcy.

Background of Lehman Brothers:

Lehman Brothers were established in 1844 in Montgomery, Alabama by Henry Lehman who was an immigrant from Germany. It was just a dry good and general store, soon his brothers Mayer and Emanuel joined him which gave birth to Lehman Brothers in 1850. They became a major commodity trading company that specialized in the key cotton market and shifted to New York. The shift took place from commodity trading got investment banking in 1906 when they partnered with Goldman Sachs on an IPO. Between 1906 and 1926 they were involved in a number of IPOs.

The firm prospered over the years as the economy of the US became an international powerhouse. They survived through The Great Depression, two world wars, a capital shortage when it was spun off by the American Express in 1994 in an IPO, the long-term capital management, and the Russian debt default in 1998. Despite surviving through such tough times, the subprime mortgage crisis ultimately brought the Lehman Brothers to their knees.

Causes of Lehman’s Bankruptcy:

  • Risk: The bank had taken too much risk without having the ability to raise cash quickly. They had $639 billion worth of assets which was more than enough to cover the liabilities of $613 billion in 2008 however the assets were difficult to sell. The cash flow problem was one of the reasons for its bankruptcy.
  • Culture: The management was rewarded for excessive risk-taking. The chief risk officer said that much of her advice on risk management strategies were ignored. The senior management thought that they were too smart to fail and wanted to stay ahead of the competitors and thus used high-risk strategies.
  • Overconfidence: Lehman brothers relied on complicated financial products that were based on quick real estate growth just as the real estate market started declining. Their revenue grew by 130% between 2000-2006 which was due to the success of the mortgage-backed securities. In March 2006 the Lehman Brothers bought heavily into commercial real estate and risky loans. Instead of selling them right away, they kept them in their books. The management thought keeping them would bring them considerable profits but the real estate market started to decline.
  • Regular inaction: As early as 2007 the Securities and Exchange Commission and other regulators knew the Lehman Brothers were taking on too much risk but did not do anything about it. The regulator also did not publicly disclose to the rating agencies that the bank had exceeded the risk limits.

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How the US Government Tried to Save Lehman Brothers?

US Treasury secretary Hank Paulson and Federal Reserve chairman Ben Bernanke grew extremely concerned over the potential bankruptcy of the Lehman Brothers in march 2008. This concern came after the Federal reserve had rescued the investment bank, Bear Stearns. Which made them think the Lehman Brothers would be next. The potential buyers were Bank of America and British Barclays.

Also, they were warned that neither the treasury nor the Federal Reserve could help them with funds as they were an investment bank so the government could not nationalize it like it did with other government enterprises, and for a similar reason no federal regulator could take it over. The Lehman Brothers did not have enough assets to secure a loan from the Federal Reserve.

Bank of America wanted the government to cover $65-$70 billion in anticipated losses but the govt denied it. The next few days were spent finding funding for the investment bank but the Bank of America backed out. The next day Barclays Bank also backed out since the British regulators did not approve of the deal.

Present Scenario:

The Lehman Brothers bankruptcy kicked off the 2008 financial crisis and the recession followed. As the millennial generation were entering the workforce and were heavily impacted. Unemployment rates rose for men from 9.9% in May 2007 to 19.5% in April 2010. Although the employment rate had fallen to 8.9% by December 2017 the damage had already been done. The one positive impact is that the millennial generation was higher educated than in the past generation.

Lehman Brothers bankruptcy also set the stage for the Dodd-Frank Wall Street Reform Act. The act established the Financial Stability Oversight Council which identifies risks that affects the entire financial industry. The council would turn over the firm that became too big to the Federal Reserve for closer supervision.

Final thoughts:

Lehman Brothers collapse roiled global financial markets for weeks given its size and status in the US market. At its peak, it had a market value of $46 billion but was wiped out within months before they declared bankrupt. Bank of America was had been in talks to buy Lehman but backed out because the government refused to help them out with the troubled assets. The same day Lehman Brothers filed for bankruptcy the Bank of America announced it would buy Merrill Lynch.

Author -Sanjana Rau

About the author- Started my journey of self even when the odds were against me, keen observation, a cool temper, and sports worked the best for me.

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