Lehman Brothers Controversy: Analyzing The Causes Of The Bankruptcy

My Annotated bibliography that I created for the research essay.(These are the sources which should be used for the research essay).

The Rise and Fall of Lehman Brothers

Lehman Brothers Holdings Inc. was one of the largest investment banks in the Unites States of America, up to the year 2008. The company, a global provider of financial services, was only behind Goldman Sachs, Merrill Lynch and Morgan Stanley, as far as the competition in the Wall Street was concerned. The company was founded in the year 1850 in Alabama and had its headquarters in New York City, United States. The company provided various financial services worldwide, which included fixed income sales, trading, investment banking, equity, private banking and so on. On 15^th September, 2008, the company filed for bankruptcy (ABC News 2018). The company had been in operations for approximately 158 years when it became defunct in 2008 itself. The company had filed under Chapter 11 Bankruptcy Protection, owing to the exodus of all its clients, the disastrous crash in the stock market and devaluation of all its assets by the credit rating companies (Wolff 2018). The company’s mortgage crisis is considered to be primarily responsible for the fall of the Lehman dynasty. This massive scandal was one of the largest of its kind and this can also be said to be the beginning of the global financial crisis that plagued the world in the 2000s (Fleming and Sarkar 2014). The question arises as to what or who was actually responsible for the downfall of the Lehman Brothers. The following essay takes a critical and analytical look at the Lehman Brothers controversy.

The Lehman Brothers, before its fall, had been one of the strongest and most powerful names, not just on Wall Street, but also across the globe. As the economy of the United States grew over the decades since its establishment, the company prospered and continued to grow for a period of nearly 150 years. It would not be an understatement to call the company an international powerhouse. Yet, this is not to say that the company did not face severe challenges over the years. However, the company managed to stand tall amidst several odds which included the railroad bankruptcy in the 1800s, two World Wars, the Great Depression in the 1930s, the capital shortage by American Express Co. in 1994, the Russian Debt Default of 1998s and the Long Term Capital Management collapse. Despite having survived all these obstacles and potential dealbreakers, the company finally succumbed to the fall of the housing market in the United States, which proved to the disastrous for the company. It is thus important to study, what exactly went wrong at the Lehman Brothers (International Business Times 2018).

In the years 2003 – 2004, the United States housing market was expanding at a rapid rate and was expected to grow steadily for the next few years. Sensing an opportunity for good investment, the Lehman Brothers acquired around five mortgages, which included the subprime lender BNC mortgage and also the Aurora Loan Services. The investment seemed quite sound and fail proof at the time. The real estate business of the company experienced a surge of nearly 56 % between the years 2004 and 2006 (Lioudis 2018). This rate was quite impressive and assuring, as compared to that of any other company in asset management and investment banking. In the year, the company secured mortgages worth 146 billion US dollars, which was a 10 per cent increase from the year 2005.  Until the year 2007, the company registered high profits and had a net income of approximately 4.2 billion dollars and revenues worth 193 billion dollars. In 2007 in February, the stocks had reached nearly 86 dollars, which endowed the company with a market capitalization worth 60 billion dollars. However, by the middle of 2007, the foundations of the US housing market was beginning to shift and cracks were beginning to appear (Wiggins, Piontek and Metrick 2014). In March of 2007, the stock market witnessed one of the biggest drops in the last five years, which is expected to have had an impact on the profitability of Lehman Brothers. The management of the company claimed that despite the sudden shifts in the stock market, the delinquencies had been taken care of and no impact would be felt on the earnings of the firm.

The Company's Expansion in the Housing Market

This was the beginning of the end for Lehman Brothers. The credit crisis began in 2007 and resulted in the failure of a number of hedge funds. At this time, the stock market for the Lehman Brothers crashed. Additionally, the company was forced to shut down the BNC mortgage unit and also terminate nearly 2500 employees who were employed in the mortgage related jobs. However, at this point, the company had managed to retain its position as a top player as far as the mortgage market was concerned (Dumontax and Pop 2013). By the end of 2007, the company had almost recovered from the initial shock and was beginning to regain its footing. It can be argued that the company’s high leverage degrees were predominantly responsible for the company’s ultimate failure. In the year 2007, the ratio of the assets of the company to the shareholders’ equity was 31. Moreover, the number of mortgage securities which had been exposed during the previous quarters of the fiscal year rendered the company vulnerable to the rapidly deteriorating conditions of the market. By March 2008, the market shares of the Lehman Brothers had fallen by almost 48 per cent. At this point, it could be predicted that the next firm on Wall Street to fall would be Lehman Brothers. Despite the numerous hurdles, the company managed to keep standing and even improved its positioning in April by raising nearly 4 billion dollars in profits (Del Giovane, Nobili and Signoretti 2013). Nevertheless, the value of their sticks began to decline rapidly since the managers in charge of hedge funds were now beginning to question the valuation of the Lehman Brothers’ mortgage portfolio.

Throughout 2008, the company attempted to fight off losses and devaluation by selling its assets, issuing stick and also reducing costs. There were massive subprime or low rated mortgage loans which the company found nearly impossible to pay off. When these loans were rendered illiquid, the company had lost its ability to pay the creditors back. At one point, the company was stuck in a rut and could not issue stock nor raise cash through credit. In other words, the company was descending into a quicksand of debt, which was impossible to recover from.  Meanwhile, the housing prices were beginning to fall, owing to the declining market conditions and the tendency of the home buyers to remain on the safe side. However, no measure could suffice or make up for the damage that had already been done. The stocks had plunged to a miserable 77 per cent by September 2008, while the equity markets around the world were plummeting. By this time, the CEO, Richard Fuld’s plans to keep the company independent were also beginning to fall apart. Around this time, the company incurred losses amounting to almost 4 billion dollars. In order to counter it, the company attempted to completely revamp and restructure its organization. However, such measures proved to be feeble attempts to recover. By the end of the first week of September, the once magnanimous Lehman Brothers had only about one billion dollars left in cash in its savings.

The Credit Crisis and the Impacts on Lehman Brothers

It must be remembered that the Lehman Brothers was one of the largest financial companies in the world, and suchdeplorable conditions within the company were beginning to affect the overall financial system across the globe. As a result, liquidation of the firm remained the only possibility. In September of 2008, the Federal Reserve Bank of New York met to discuss the future of the investment banks of the United States. The meeting concluded with the decision to liquefy the bank assets since that would help in stabilizing the markets. Finally, on 15^th September, the company was declared bankrupt (Ball 2016). The repercussions were felt in the United States and across the world. For instance, on the same day, the stocks of the Daw Jones fell by nearly 500 points (Leaven and Valencia 2013).

There are a few things which went wrong at the company, which caused it to hurtle towards its downfall (Harvard Business Review 2018). One factor was excess leverage. The main concept related to financial leverage involves taking a loan and investing of that money in order to attain higher rates of returns. Usually, investment banks borrow money in the form of loans or deposits and then pay a fixed rate of interest on the money borrowed. This money is then invested in order to get better returns on it. However, in the case of Lehman Brothers, the company was overleveraged. The company had taken huge loans in order to invest them in MBSs or Mortgage Backed Securities. However, it turned out that the mortgage backed securities were worth much less than it was actually perceived. The debt to equity ratios of the company was risky, which led to its failure (Fernandez and Wigger 2016). The debt to equity ratio of the company would determine the amount of debt a company has for every dollar in the equity. Investment banks like Lehman Banks usually have high ratios. For instance, the debt to equity ratio for the Lehman Brothers was often 30 – 60 to 1. However, the sudden drop in the value of the assets led to a shift in the ratio which eventually led to bankruptcy.

Another major factor that was responsible for the downfall of the Lehman Brothers was the compensation or bonus system that had been implemented. The system provided compensations to the people for having generated stellar returns. In other words, the company paid a bonus when the firm managed to perform well. Yet, when the employees failed to perform well, they were not penalized or punished for the same. Since the employees literally had nothing to lose, they were not motivated or committed to their work. The lack of buyers was another major factor in this case (Prestley and Jones 2014). In the cases of Washington Mutual, Wachovia or even Bear Stearns, the lack of buyers and customers was responsible for troubles and crises. Yet, these companies managed to garner support and acquired more buyers, whereas Lehman did not (Kensil and Margraf 2015). When it comes to Lehman Brothers, the Bank of America had been interested but they preferred to go with Merrill Lynch instead. In short, no firm had the prime motive to save the company and were more focused on their own profits. Acquisition had been the only remaining alternative to liquefaction; yet, the lack of interested buyers proved to be detrimental for the company. The balance sheet of the company was a disaster in disguise. Due to a lack of interested buyers, the Federal Reserve Bank of New York decided to provide the bank with an emergency loan but backed out last minute due to the poor balance sheet. The company was declared incapable of having enough collateral for back up (Duygan Bump et al. 2013). The Federal Reserve could easily have provided an emergency loan, yet it chose not to. This is because it was assumed that the bank would sustain a major loss when the bank would eventually collapse in the long run (Stewart and Eavis 2014). Moreover, the general public would not accept the move on the part of the Federal Bank to help Lehman Brothers. The customers and citizens of the United States were getting quite impatient with the overall financial industry. If the Federal Reserve stepped in to help such a bank, it would have a negative impact. In short, the collateral at stake was too much, which led to the Federal Reserve to allow the bank to fail (Mensah 2015).

High Leverage and Vulnerability to Market Conditions

According to certain critics, it was the supreme rule of Fuld which led the bank to its downfall. The bank was completely under the monopoly of Fuld for more than 18 years. A book published by a previous employee of the bank revealed that Fuld was extremely insecure about his position and was intolerant towards individuals below him who were more talented than him. According to accounts of the ex employees of the company, Fuld wanted to be the emperor of the company and followed a bureaucratic leadership style which ended up costing him the company (Stein 2013). Also, it can be said that the board members were backdated and belonged to a different generation. Most of the board members of the bank were above the age of 70, which meant that they belonged to a different period in finances altogether. These board members were not receptive to the new changes and trends in the banking industry and watched silently, as the dynasty came crashing down (Stevens and Buechler 2013). In retrospect, it can be asserted that the fall of Lehman Brothers was not simply due to deteriorating financial conditions, but also due to political factors. As mentioned above, it was politics which determined whom to save and whom to fail during the Lehman fiasco. For instance, the Federal Reserve attempted to save institutions which would be systematically important in the long run, and unfortunately, Lehman Brothers did not fall under this category (Cline and Gagnon 2013).

It must be ascertained that there was no one single cause that led to the failure of the Lehman Brothers. For a firm founded in 1850 to collapse all of a sudden in 2008, there must have been several triggers and forces which resulted in the downfall. Following the scandal, reports were published in the year 2010 which detailed every minute aspect of the business and scrutinized all the myriad activities of the executives. It was around this time that the executives were blamed for gross negligence and even unethical practices (Stevens and Buechler 2013). In fact, a large number of executives of the company were misusing their position in order to acquire short term gains which proved to be detrimental for the company. The extreme greed of the traders on Wall Street, the actions of the Federal Reserve, the credit rating agencies, the mounting debts of the American households and deregulation were just some of the things that went wrong at the bank. Out of these, the credit default swaps or the subprime mortgage loans were the biggest factors which led to the ultimate catastrophe (Kim, Koo and Park 2013). The subprime crisis of the year 2007, as it is now known, was what snowballed into a larger disaster in 2008. The subprime crisis initially began in the financial spheres of America, but eventually spread like a virus to the non – financial institutions as well. Eventually, this had a sort of chain reaction in the market. With its massive investments in the market, the Lehman Brothers had caused erosion in the subprime US housing market, which was looked down upon by both the Federal Reserve and the other investment banks. The US government did take measures to counter the disaster and the attention was slowly shifting towards one particular organization that was deemed to be partially responsible for the fiasco. This is also probably why the Federal Reserve refused to come to the rescue of the bank in 2008.

The Company's Attempts to Recover from Losses

Prior to its downfall, the Lehman Brothers was running on negative cash flows. As a result, the company was neither able to pay back its loans nor was it able to live up to its obligations. The company was also unable to maintain a level of confidence, which was triggered by business and market conditions. This is because the market at present was concentrated and saturated with illiquid assets which were declining in terms of value. In order to push this factor under the rugs, the accountants and executives at the company deliberately came up with carefully manipulated statements which showed otherwise. Moreover, the Lehman Brothers had been using the Repo 105, which is a kind of repurchase agreement that aids organizations in manipulating financial statements (Jones and Prestley 2013). However, this was done secretly and the company had failed to mention that to its own board of directors, let alone the investors, the rating agencies, the government or even the Federal Reserve. Yet, the auditors were perfectly aware of the situation and the consequences of such an act (Wiggins, Bennett and Metrick 2014).

Despite the disaster that was Lehman Brothers, there are some lessons to be learnt from the fiasco (Srivastava 2018). For instance, investors need to seriously take into account the price paid for stocks. It was the global financial crisis and ensuing panic which caused the stocks to plummet in the year 2008. Yet, if Lehman Brothers had not used Repo 105, they would have been able to avoid such a scene. While the Repo 105 is not illegal, it violated the Sarbanes Oxley Act of 2002, because the financial statements which had been manipulated were misleading and did not reveal the actual status of the company (Wiggins and Metrick 2014). As a result, the company ended up losing the goodwill of the investors. Secondly, it is extremely important for a financial organization to have a well defined structure within the company. After the company declared bankruptcy, the extremely intricate and complex structure of the organization was blamed (Gambacorta and Mistrulli 2014).  By 2008, the Lehman Brothers were conducting operations across the globe and had more than three thousand legal entities. All of these made the organizational structure extremely complicated. As a matter of fact, such complexity is unavoidable as a company expands and grows in terms of scope and business. Some critics are however of the opinion, that such a disaster could have prevented. A careful analysis of the financial statements of Lehman Brothers would reveal the misleading facts and figures in the financial statements (Adu Gyamfi 2016). The statement containing cash flows that would have highlighted the inability of the company to convert its results into cash had been strategically ignored by the top management.

Conclusion:

it can be said that the Lehman Brothers Holdings Inc. which had been founded in the year 1850 came crashing down in 2008 owing to a number of factors. The above essay highlights the role of the US housing market, the nonchalance on the part of the company’s auditors and executives, the greedy traders on Wall Street, the inability of Americans to invest in real estate and the miscalculation on the part of the Federal Reserve in the collapse of the mogul (Chevapatrakul and Tee 2014). It is unfortunate that the auditors and top management were solely focused on short term gains and failed to account for the warning signs that were right in front of them. Having examined what exactly went wrong at the company, it is suffice to say that the top management of the company was majorly at fault for the collapse. Faulty leadership and failure to take into account warnings signs are what led the company to its failure (Hurley and Hurley 2015). By the end, the company had lost the faith and goodwill of its investors, creditors, the government and even its client. As a result, not a single hand came to rescue the company while it was drowning. The collapse of the Lehman Brothers was one of the largest in the history of financial organizations around the world – an incident whose repercussions were felt for years after it happened.

The Inevitable End of Lehman Brothers

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