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Lehman Brothers Case Study

The collapse of Lehman Brothers in September 2008 was a pivotal event in the global financial crisis, resulting from excessive risk-taking, poor risk management, and regulatory failures. The firm's bankruptcy, the largest in U.S. history, highlighted significant ethical lapses and misrepresentation by its executives, leading to widespread economic repercussions. This case serves as a cautionary tale underscoring the need for stronger regulatory oversight, improved risk management, and enhanced transparency in financial practices.

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0% found this document useful (0 votes)
147 views8 pages

Lehman Brothers Case Study

The collapse of Lehman Brothers in September 2008 was a pivotal event in the global financial crisis, resulting from excessive risk-taking, poor risk management, and regulatory failures. The firm's bankruptcy, the largest in U.S. history, highlighted significant ethical lapses and misrepresentation by its executives, leading to widespread economic repercussions. This case serves as a cautionary tale underscoring the need for stronger regulatory oversight, improved risk management, and enhanced transparency in financial practices.

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honey jade riego
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© © All Rights Reserved
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Executive Summary

The collapse of Lehman brothers on September 15, 2008, marked one of the most
significant financial failures in history, triggering a global financial crisis. Lehman brothers, a
major investment bank, had heavily invested in subprime mortgage-backed securities. As the
housing market crashed, these assets lost value, leading to severe financial losses.

Despite efforts to secure a bailout or a merger, no viable solution was reached, and the
firm filed for bankruptcy with over $600 billion in assets, making it the largest bankruptcy in u.s.
history. The failure of Lehman brothers resulted in a loss of investor confidence, a stock market
crash, and severe economic repercussions worldwide.

The collapse highlighted major weaknesses in financial regulation, risk management, and
corporate governance. In response, governments and financial institutions implemented stricter
policies, including the Dodd-frank act, to prevent similar crises in the future. The Lehman
brothers case remains a cautionary tale of excessive risk-taking and lack of oversight in financial
markets.

Introduction

Lehman brothers was a global financial services firm that played a major role in the
history of American finance. Founded in 1850 by Henry Lehman, a German immigrant, and his
two brothers, Emanuel and Mayer, in Montgomery, Alabama, the company initially started as a
small dry goods store. By the late 19th century, the brothers transitioned into the financial
industry, becoming brokers and later establishing a full-fledged investment banking business.
Over the years, Lehman brothers grew into one of the most influential investment banks in the
world, with its headquarters in New York City.

By the 20th century, Lehman brothers was a major player in financial markets, offering a
range of services, including investment banking, securities trading, and asset management. It was
involved in raising capital for businesses, advising corporations on mergers and acquisitions, and
trading stocks and bonds. Lehman brothers had a reputation for innovation in financial products,
such as mortgage-backed securities, and was deeply involved in the global financial markets.

However, it was Lehman brothers' downfall that brought it into the global spotlight. In
the years leading up to its bankruptcy, Lehman brothers had taken on significant risks,
particularly through investments in subprime mortgages—home loans given to borrowers with
poor credit histories. During the housing boom in the early 2000s, Lehman became heavily
involved in the mortgage market, bundling these risky loans into securities and selling them to
investors. The firm also used high levels of debt to finance its operations, which made it
vulnerable when the housing bubble burst.

In 2008, as the global financial crisis worsened, Lehman brothers found itself unable to
cover its losses from its risky investments. In September of that year, with no viable options for a
bailout, the firm filed for bankruptcy, marking the largest bankruptcy filing in U.S. history at the
time. Lehman brothers' collapse sent shockwaves through the global financial system, causing a
chain reaction that led to massive losses for other financial institutions, a sharp decline in stock
markets, and a credit freeze that severely impacted the global economy. This event is widely seen
as one of the key triggers of the 2008 financial crisis, also known as the great recession.

The fall of Lehman brothers raised important questions about the role of financial
institutions in the economy, the risks of excessive leverage, and the need for greater regulatory
oversight in the financial sector. Many have argued that the failure of Lehman brothers
highlighted flaws in risk management practices, corporate governance, and the lack of proper
regulation of complex financial products. The bankruptcy left thousands of employees jobless
and caused widespread economic damage, affecting millions of individuals and businesses
worldwide.

Lehman brothers' story serves as a cautionary tale about the dangers of unchecked risk-
taking, financial speculation, and the potential consequences of a systemic collapse in the global
financial system

Background of the Study

The collapse of Lehman brothers was not due to a singular ethical failure by one
individual, but rather the result of numerous missteps by various parties. The downfall can be
attributed to three main factors:

I. Deception and lack of transparency of chief executive officer Richard Fuld


II. Financial misrepresentation and fraud by chief financial officer Erin Callan
III. Professional negligence and a breach of ethical duty in auditing by Ernst &
Young.

Deception and lack of transparency

When the housing market began to decline in 2007, Fuld adhered to a highly leveraged
and aggressive business model, failing to recognize the impending crisis that others anticipated.
While some competitors acted to mitigate risk, Fuld doubled down on mortgage-backed
securities, thereby increasing Lehman brothers’ exposure to danger without acknowledging
potential consequences. He missed a crucial opportunity to address the bank’s financial
instability and heavy reliance on risky loans, instead promoting an image of stability to investors.
Had he been upfront, alternative solutions could have emerged, providing banks like Barclays
and bank of America with time to consider acquisitions and potentially rescue Lehman brothers.
Additionally, while initial transparency would have presented challenges, it could have garnered
support from major investors and the public, facilitating recovery efforts. Ultimately, Fuld’s
insistence on portraying an overly optimistic outlook hampered the possibility of mitigating
losses, leading to Lehman brothers' downfall.

Financial misrepresentation and fraud

The second ethical violation involved Callan’s approval of transferring assets from
Lehman brothers to Hudson castle, an illusory subsidiary, which misrepresented the company's
financial health. This maneuver, known as Repo 105, aimed to create a false image of stability
for stakeholders, highlighting systemic issues within the organization. Investigations revealed
that the primary intent of Repo 105 was not tax benefits but to create a deceptive façade of
security over two consecutive quarters. Had the executive team properly managed these
challenges, they could have used this tactic temporarily while strategizing, but they chose to
mislead shareholders instead. A transparent disclosure of finances would likely have fostered
greater trust and facilitated the acquisition of necessary support for recovery.

Professional negligence and a breach of ethical duty in auditing

Ernst & Young, as the sole third-party observer of activities at Lehman brothers,
neglected to disclose significant efforts by executive leadership to hide financial troubles, raising
concerns of gross negligence and a failure in corporate responsibility. This oversight is
particularly concerning for a firm that is expected to adhere to ethical standards as certified
public accountants. The decision to overlook unethical conduct, potentially motivated by the
lucrative nature of their client, reflects an alarming disregard for principles akin to prior
accounting scandals, such as Enron. By failing to certify the accuracy and reliability of financial
information, Ernst & Young not only misled shareholders but also undermined the broader
industry and the integrity of accounting professionals.

Literature Review

The Lehman brothers scandal, culminating in the bankruptcy of the 158-year-old investment
bank in 2008, remains one of the most significant events in global financial history. The event
not only marked the end of one of the largest investment banks but also acted as a catalyst for the
global financial crisis of 2007–2008. Scholars and analysts have since extensively studied the
causes, consequences, and impacts of the Lehman brothers scandal. This literature review
summarizes key research and perspectives regarding the scandal.

1. The cause of Lehman brothers' collapse


The collapse of Lehman brothers can be traced to a variety of interconnected factors.
Research suggests that the root causes include:
 Excessive Risk-Taking And Leverage: Lehman brothers engaged in significant
risk-taking, including massive investments in subprime mortgage-backed
securities (MBS). The company’s use of leverage (borrowed money) to fund these
investments exacerbated its financial instability (Acharya & Richardson, 2009).
 Failure In Risk Management: Critics argue that the bank's risk management
framework was inadequate, with a lack of proper oversight regarding the growing
risk exposure in mortgage-related assets (Sorkin, 2009).
 Regulatory Failures: research highlights that both Lehman and the regulatory
authorities failed to identify and mitigate the risks associated with the bank’s
operations. The securities and exchange commission (SEC) and other regulatory
bodies did not take sufficient action to rein in the excesses in the financial sector
(Brunner Meier, 2009).
2. The role of Lehman brothers in the global financial crisis
Lehman’s bankruptcy is often seen as a defining moment in the 2008 financial crisis.
Researchers emphasize the bank’s role in triggering systemic shockwaves across the
global financial system:
 Liquidity Crisis: The sudden collapse of Lehman brothers caused a liquidity
freeze in the global banking system. Many financial institutions faced difficulty
borrowing funds due to the lack of confidence in financial assets and
counterparties (Gorton, 2009).
 Contagion Effect: Scholars argue that Lehman’s bankruptcy spread uncertainty
throughout the financial system, leading to the failure of other major institutions
such as AIG, Bear Stearns, and Merrill Lynch (Kindleberger & Caliber, 2011).
 Investor Panic and Confidence Loss: Lehman’s failure instigated a chain reaction,
severely impacting global financial markets and investor confidence, resulting in
massive declines in stock markets and the collapse of many financial institutions
(Mian & Sufi, 2011).
3. The role of credit rating agencies
Another significant aspect of the scandal was the role of credit rating agencies
such as Moody’s, S&P, and Fitch. Research reveals that these agencies failed to properly
assess the risk associated with Lehman brothers’ mortgage-backed securities and other
assets:
 Misleading Ratings: Several studies suggest that the rating agencies misled
investors by giving top ratings to risky MBS, contributing to the overvaluation of
assets held by Lehman and other financial institutions (White, 2010).
 Conflict Of Interest: Scholars argue that rating agencies had conflicts of interest
because they were paid by the firms whose securities they rated. This dynamic led
to biased and inaccurate ratings, which exacerbated the financial crisis (Jorion,
2010).

Methodology

This document examines the methodology employed by Lehman brothers, a prominent


investment bank, prior to its collapse in 2008. We'll delve into its investment strategies, risk
management practices, and key decisions that contributed to its downfall.

Lehman brothers' methodology was primarily focused on leveraging its extensive


network and expertise in global markets. They deployed a range of strategies, including:

 Investment Banking: Underwriting and advising on mergers, acquisitions, and debt and
equity offerings.
 Trading: Engaging in proprietary and client-driven trading of securities, derivatives, and
commodities.
 Investment Management: Managing assets for institutional and individual clients through
mutual funds, hedge funds, and private equity investments. Lehman brothers was known
for its aggressive risk-taking and its focus on short-term profits, which proved to be a
major factor in its downfall. Their reliance on highly leveraged transactions, particularly
in the mortgage-backed securities market, left them vulnerable to the housing market
crash in 2008. This ultimately resulted in their bankruptcy, demonstrating the potential
risks associated with uncontrolled risk appetite and unsustainable business practices.

Analysis

Lehman brothers’ was the fourth-largest bank in us history once, but 2008 witnessed the
failure of it and out of this failure arose a global financial crisis. It is found that the firm was
engaged in unethical accounting practices which resulted in the manipulation of financial data in
addition to the main problem of the liquidity issues which were covered by the Repo 105
transaction tool almost all the time. All these terrible facts prove to us the imperativeness of the
ais in financial reporting, risk management, and compliance with regulations.

1. Identifying the problem


The focus was mainly on the way of Lehman brothers' booking in the Repo 105,
which was a repurchase agreement hidden by an asset sale and at the same time it should
have been a tool to decrease their leverage on a temporary basis, as a phantom sale, and
hence, they misrepresented their position to the investors.
2. The root causes:
 Weak internal control in AIS
 Lack of transparency in financial reporting
 Regulatory and auditor negligence
3. Major AIS failures:
 Misclassification of the transactions
 Ineffective internal control
 Weak oversight by external auditors

Conclusion and Recommendation

The collapse of Lehman Brothers serves as a cautionary tale about the dangers of ethical
lapses in corporate governance, financial management, and auditing. The combination of Richard
Fuld’s deception and lack of transparency, Erin Callan’s financial misrepresentation and fraud,
and Ernst & Young’s professional negligence in auditing created a perfect storm of unethical
behavior that led to Lehman’s ultimate downfall. The failure to act ethically and transparently at
key moments not only had catastrophic consequences for the firm itself but also reverberated
across global financial markets, contributing to the global financial crisis of 2008.

Each of these factors demonstrates the critical importance of ethical leadership,


transparency, and integrity in both financial management and external auditing. Had the
individuals involved acted responsibly and in accordance with ethical principles, it is
conceivable that Lehman Brothers might have been able to navigate the crisis with a significantly
different outcome. The ethical violations and lapses in judgment that occurred at Lehman
Brothers ultimately highlight the broader systemic risks that arise when financial institutions
prioritize short-term gains over long-term stability and accountability.

This study highlights the need for :


1. Stronger Regulatory Oversight: Implement stricter capital requirements and risk
assessments for financial institutions.
2. Improved Risk Management: Encourage banks to conduct rigorous stress testing and
liquidity management.
3. Enhanced Transparency: Require greater disclosure of financial activities and risk
exposure.
4. Government Intervention Strategies: Develop contingency plans to handle potential
failures of major financial institutions.
5. Financial Literacy: Educate investors and policymakers on the risks associated with
complex financial instruments.

The lessons learned from Lehman Brothers’ downfall should serve as a foundation for
reforming corporate governance, financial regulation, and auditing practices to ensure that such
failures do not happen again.
References:

Investopedia. (n.d.). Lehman Brothers. Retrieved from


https://www.investopedia.com/terms/l/lehman-brothers.asp
Encyclopedia Britannica. (n.d.). Bankruptcy of Lehman Brothers. Retrieved from
https://www.britannica.com/event/bankruptcy-of-Lehman-Brothers
Schwarcz, S. L. (2012). The bankruptcy of Lehman Brothers: Causes of failure &
recommendations going forward. ResearchGate. Retrieved from
https://www.researchgate.net/publication/230687440_The_Bankruptcy_of_Lehman_Brothers_C
auses_of_Failure_Recommendations_Going_Forward
Seven Pillars Institute. (n.d.). Lehman Brothers Bankruptcy - Financial Ethics. Retrieved from
https://sevenpillarsinstitute.org/case-studies/the-dearth-of-ethics-and-the-death-of-lehman-
brothers/
Brunnermeier, M. K. (2009). Deciphering the Liquidity and Credit Crunch 2007–2008. Journal
of Economic Perspectives, 23(1), 77-100. Retrieved from https://doi.org/10.1257/jep.23.1.77
Gorton, G. (2009). The Subprime Panic. The Economic Review, 31(1), 1-28.
Jorion, P. (2010). Financial Risk Manager Handbook. John Wiley & Sons.
Kindleberger, C. P., & Aliber, R. Z. (2011). Manias, Panics, and Crashes: A History of Financial
Crises (6th ed.). Palgrave Macmillan.
Mian, A., & Sufi, A. (2011). Household Leverage and the Recession of 2007 to 2009. Journal of
Economic Perspectives, 25(1), 77-98. Retrieved from https://doi.org/10.1257/jep.25.1.77
Sorkin, A. R. (2009). Too Big to Fail: The Inside Story of How Wall Street and Washington
Fought to Save the Financial System—and Themselves. Viking Press.
White, L. J. (2010). The Credit Rating Agencies: A Walk on the Wild Side. Journal of Economic
Perspectives, 24(2), 157-176. Retrieved from https://doi.org/10.1257/jep.24.2.157
Bell, S. (2010). The causes and effects of the Lehman Brothers bankruptcy. University of
Arkansas. Retrieved
from https://scholarworks.uark.edu/cgi/viewcontent.cgi?article=1090&context=finnuht
Guynn, R. D. (2010). The financial crisis and the collapse of financial firms. Journal of Financial
Crises, 1(1), 1-34. Yale University. Retrieved
from https://elischolar.library.yale.edu/cgi/viewcontent.cgi?article=1001&context=journal-of-
financial-crises
The Lehman Brothers Collapse: A Case
Study in Unethical Practices

GROUP 5

Dela Cruz, Bench


De Los Reyes, Arvel
Duria, John Benedict
Mansilungan, Keren Cesiah
Marvida, Michaela
Narvato, Donnabel
Rago, Justine Mae
Riego, Honey Jade O.
Tatlonghari, Jay Mark

February 24, 2025

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