Lehman Brothers

A Case Study of the Lehman Brothers Bankruptcy

When the investment bank Lehman Brothers fell on 15 September 2008, it was the largest
bankruptcy ever, and it still is. The bank had assets of $639 billion, which is about as much as
the five subsequently largest bankruptcies combined. The size of the bankruptcy could also be
described as more than one and a half time the gross domestic product of Sweden in 2009.
(Investopedia Staff, 2010)
This report aims to establish an overview of the financial risks included in Lehman Brothers’
business, how they were neglected and finally led to their bankruptcy. Furthermore, to analyse
the risks and give a recommendation of a more sustainable risk approach.

Background

The foundation for Lehman Brothers was laid by the German immigrant Henry Lehman and his
brothers in the 1850s. For the first decades the company traded cotton, but in the beginning of
the 20th century it started with banking and securities trading, eventually becoming an
investment bank. Investing and doing business in growing sectors of the 20th century as well as
going global and acquiring other firms, Lehman Brothers expanded and became one of the
world’s largest investment banks. (Historical Resources, 2010)
Modern investment banks like Lehman are complex institutions with advanced and opaque
structures, with daily transactions of several billion of dollars. The main business areas of
Lehman before the collapse was typical investment banking as well as equities, fixed income,
capital markets and investment management. Their investment banking business provided
financial services such as mergers and acquisitions, underwritings and issuing securities. In the
other business lines, the equity part of Lehman invested in equity around the world while the
fixed income, capital markets and investment management parts concerned various services
and wealth management. Their main revenues came from fees derived from the size of the
transactions or services provided. (Lehman Brothers 2007 Annual Report, 2008).

Risks in Investment Banking

Due to the nature of investment banking there will always be a trade of between risk and
potential profit. How prone one is towards risk is essentially a complex strategical decision,
where risk contra profit must be carefully balanced to satisfy all the company’s stakeholders,
both in short and long term. In the beginning of the 21th century the economy was blooming
and as always, the growth seemed to last forever. The stability in the economy motivated a
higher risk taking in order to make bigger profits. Likewise, several investment banks exposed
themselves to extremely high risks and generated record profits annually. Lehman Brothers, for
instance, had a net income of $4.2 billion during 2007, which was an all-time-high for the bank.
However, only one year later Lehman Brothers was forced into bankruptcy due to failure in
managing risks.Before the bankruptcy, Lehman Brothers’ risk management department had
identified five specific risks inherent in their business. (Lehman Brothers 2007 Annual Report,
2008).

• Market risk represents the potential unfavourable change in the value of a portfolio of
financial instruments due to changes in market rates, prices and volatilities.
• Credit risk represents the possibility that a counterparty or obligor will be unable or
unwilling to honor its contractual obligations to Lehman Brothers.
• Liquidity risk is the risk that Lehman brothers are unable to meet their payment
obligations, borrow funds in the market at a good price on a regular basis, to fund actual
or proposed commitments or to liquidate assets.
• Operational risk is the risk of loss resulting from inadequate or failed internal processes,
people and systems, or from external events.
• Reputational risk concerns the risk of losing confidence from the customers, public and
the government due to unfortunate decisions about client selection and the conduct of
their business.

In summary, the market, credit, liquidity, operational and reputational risks constituted the
total risk in Lehman Brothers business (Lehman Brothers Annual Report, 2007). In order for
successful and sustainable investment banking they must be carefully managed and balanced.
On the other hand, if treated with disrespect they could have disastrous consequences and
destroying whole companies.

From Boom Years to Crisis

Investment banking is extremely competitive. Lehman Brothers was the fourth largest
American investment bank and aimed to become the biggest. In order to overtake its rivals,
Lehman Brothers pursuit an annual growth in revenues of 15 %. In support of the revenue
growth they targeted an even faster growth in total capital base, which was projected at 15 %
per year. In order to achieve these expansion goals Lehman’s management made major
changes in its business strategy. They altered from a lower risk brokerage model to a higher
risk, more capital-intensive investment banking model. Instead of making money from
transactions, they shifted towards making money on long-term investments. Lehman’s
management primarily focused on expanding three specific areas of principal investment:
commercial real estate (real estate used for generating profit, like offices), leveraged loans
(loans for leverage buyouts) and private equity. (Bankruptcy Report No.08‐13555, 2008)
Lehman Brothers were also heavily involved in different kinds of subprime loans and
mortgages. Subprime loans were loans to people which were considered financially risky and
were issued without or with little security. Because of the risk in these loans, they had higher
interest rates. Subprime loans had become popular and widespread because of a long period of
low interest rates in the wake of the September 11 attacks and the big housing bubble
followed. There were also government initiatives that encouraged banks to issue loans so that
even financially weak people could buy houses. (Norberg, 2009)

Lehman Brothers, as well as the other leading investment banks, made big profits from
subprime loans as long as credit defaults were at normal rates. The model was to originate
loans and turn them into securities, which means splitting many loans into tiny pieces and
mixing them to even out the credit risk. The securities, called Residential Mortgage Backed
Securities, were sold to investors to make money for the bank. Although the loans were
considered risky, the securities were considered and rated to be almost as safe as state
obligations. This was primarily because the loan takers were considered independent and due
to ever rising real estate prices. (Norberg, 2009, Bankruptcy Report No.08‐13555, 2008)

However, the bubble of cheap loans and skyrocketing real estate prices burst in 2006. When
the interest rate started to climb an increasing number, obligors started to default which meant
a significant loss in revenues and a severe increase in liquidity risk. The investors realized that
the securities had more risk than assumed and started to avoid them, while the rating institutes
started to downgrade them. This meant that Lehman Brothers was stuck with unsellable assets
with constantly falling values. Another consequence of climbing interest rate was that the
demand for commercial real estate fell along with the prices. This meant further problems for
Lehman Brothers, as they had to write-down their quite recently acquired commercial real
estate assets. (Bankruptcy Report No.08‐13555, 2008)

As many of the investment banks were facing trouble, the credit market uncertainty grew
which meant increased loan costs on the whole market, a so called credit crunch. This made
their leveraged loans assets difficult to sell. As all of this sums up, Lehman had three business
areas, subprime loans, commercial real estate and leveraged loans, with assets they couldn't
sell, assets with steadily decreasing market-values. (Bankruptcy Report No.08‐13555, 2008)

In the beginning of 2008 Lehman Brothers made a quarterly loss of over $2.5 billion, mostly
concentrated in the mentioned areas (Lehman Brothers First Quarterly Report, Lehman
Brothers Second Quarterly Report 2008). The fact that Lehman Brothers were losing money
combined with their high debts and a balance sheet filled with weak, illiquid assets had
disastrous consequences for the banks reputation. Lenders and other interdependent parties
successively lost confidence in the bank which lead to increasing capital costs and difficulties in
getting short-term funding to maintain liquidity.
Lehman Brothers announced a quarterly loss of $3.9 billion in September 2008 (Lehman
Brothers Second Quarterly Report, 2008). Even though Lehman Brothers had managed to sell
some of their assets during the year in order to decrease risk and get liquidity, the market
didn't believe in Lehman Brothers and the firm became unable to borrow enough money for
their daily operations (Bankruptcy Report No.08‐13555, 2008).
It became clear that few other options than bankruptcy were possible. Lehman negotiated with
other banks about a sale during the weekend of 12-14 September, but no settlements were
reached. Due to their reckless behaviour and disregard of risk awareness, the US government
had lost confidence in the bank and chose not to intervene in the inevitable end of Lehman
Brothers. When Monday came, September 15 2008, Lehman Brothers had to file for
bankruptcy. An era of 158 years had ended; the largest bankruptcy in history was a fact, and
what in the beginning was a credit crunch turned into a full-blown financial chaos.

The Strategical Failures

There were several strategical mistakes that eventually led the bank into bankruptcy. When
Lehman started to focus more on long-term investments instead of brokerage, it consumed
significantly more capital than before. Considering Lehman Brother’s small equity base this
meant a drastically increase in liquidity risk. (Bankruptcy Report No.08‐13555, 2008) This
created a vicious cycle that in return made it much more difficult for the bank to borrow capital
and to hedge risks. By not carefully investigating and acknowledging the capital demands of the
new business line, Lehman Brothers exposed themselves to liquidity risks which could have
been avoided. An alternative, more risk aware approach would have been to advance slowly in
the new lines. And as the company learns the fundamentals of the business and thereby the
inherent risk as well, successively expand in size.
Lehman Brothers continued to pursuit their aggressive growth strategy despite the financial
crisis. They believed that the subprime crisis would not spread onto other market and to global
economy. Consequently, they believed that instead of reducing risk as their rivals did, there was
an opportunity to take market shares and improve profits. These actions lead to severe
increase in credit risk and operational risk due to an enlarged market risk. In the end a relatively
manageable risk and loss became significantly larger and struck Lehman twice as hard. A more
rational, risk minimizing approach would have been to execute a more thorough market
analysis before making such an important strategically decision. The analysis would probably
have led to some alarming conclusions that would have intimidated the management to go in
another direction. (Bankruptcy Report No.08‐13555, 2008)
The liquidity risks and losses of income were amplified by Lehman Brothers capital structure
and leverage ratio. (Bankruptcy Report No.08‐13555, 2008) The leverage ratio is defined as
total assets divided by shareholders equity. Using leveraged finance is like walking on stilts
when picking apples. As long as you keep your balance, you will be able to get more apples, but
it will hurt more if you fall. In finance, as long as return on total assets is greater than the capital
costs the leverage ratio generates a positive leverage effect, which speaks for a high leverage
ratio. However, if the return on total assets is smaller than the capital cost, the leverage will
make losses substantially larger. So, a high leverage ratio involves a high risk.
The previous leverage regulation made it possible for investment banks to have a ratio of 12 to
1. However, due to a rule change in 2004 they were enabled to enlarge their leverage ratios up
to 40 to 1.( Niall Ferguson, 2008,) Lehman Brothers took advantage of this and in only two years
of time they increased their leverage ratio from 24.4 to 30.7 (Lehman Brothers Annual Report,
2007).
In real figures, of Lehman Brothers’ total assets of $ 691 billion only $ 22.5 billion was
shareholder’s equity, which meant that $ 668.5 billion were liabilities. With such a high leverage
ratio, a negative return on total assets of 4 % would be greater than the whole shareholders’
equity. The target leverage ratio is a trade-off between risk and feasible earnings. However, one
must conclude that Lehman Brothers leverage ratio was way too high and in the future one
must undermine the shareholders growth demand in order to find a more risk aware ratio. One
way to better control the leverage ratio could be to adapt it more flexible after the conjuncture
cycles. In practice this would mean that during stable economic times one should use a higher
leverage ratio. When the conditions start to shifts the management should successively lower
the ratio to effectively hedge the leverage risk. Another, more regulatory approach, would be
to restore the old leverage restrictions. The successes or impact of such credit regulations is of
course hard to determine. However, one cannot deny the force behind a leverage ratio of 30 to
1. From delivering new record profits each year, Lehman Brothers found themselves losing $5
billion dollars in only 6 months, quickly destroying the shareholders equity.

Exceeding the Risk Limits

When analyzing Lehman Brothers risk management one can conclude that Lehman’s
management countless times exceeded their own risk limits, ultimately exceeding their risk
polices by margins of 70% as to commercial real estate and by 100% as to leverage loans.
(Bankruptcy Report No.08‐13555, 2008) One explanation of this rather dangerous behaviour is
the compensation system. In order to attract and keep the sharpest minds in the industry,
investment banks normally rewarded their most revenue generating employees with big
monetary bonuses.
However, the bonus incentives are asymmetric. If the firm’s results are negative, it loses its
accumulated capital, whilst the staff only loses its future payments and gets to keep old
bonuses. This situation creates the risk of moral hazard. Traditionally, investments are a trade-
off between risk and potential profit. However, since bankers at most can lose their job, they
may take excessive risk in order to get bigger bonuses. This creates at situation where the
bankers act without any feeling of risk. In the case of Lehman Brothers, the staff and
management made a fortune during the good years when the firm made record profits, profits
that were possible due to high risk taking with high leverage and exposure to then profitable
loaning and real estate affairs. For example, Richard Fuld, the CEO of Lehman Brothers who had
ruled the bank for 16 years when it collapsed, made approximately $350 million during the 00's,
even after the stock had crashed. Astronomic salaries bred the greed and short-sighted thinking
in management that made them blind to what the result would be if the worst-case scenarios
really happened. A big part of the bonuses is paid as stocks in the company, so the incentives
are only partly asymmetric. Of course, running the bank into bankruptcy is unbeneficial and
tragic for everyone in the company, but it seems short-term thinking overpowered long-term
thinking.
Besides exceeding their own risk limits they choose actively not to include their new business,
real estate and leverage loans in their stress test simulations. (Bankruptcy Report No.08‐13555,
2008) Consequently, Lehman’s management did not have a regular and systematic way of
estimating the potential losses of these large and illiquid. They motivated this conduct by a
false believe that these new business areas were small in comparison with their old ones and
that the potential profits far exceeded the possible risks. This clearly demonstrates unnecessary
high operational risk taking and could effectively been reduce by a humbler and more
professional mindset.