The Collapse of Lehman Brothers
Lehman Brothers was viewed as one of the titans on Wall Street and was the fourth biggest investment bank in the United States at the time of its bankruptcy. However, the company itself had much humbler origins. Lehman was founded in Montgomery, Alabama in 1844 as a general store run by three German immigrants, Henry, Emanuel and Mayer Lehman. This quiet general store evolved into one of the biggest banks in the United States and had survived through various wars and market panics over its 164 year history. Then suddenly over one weekend Lehman stopped existing all together filing for bankruptcy on September 15th 2008.
It is astonishing to look at Lehman’s size and core statistics at the time of its bankruptcy. Lehman had listed assets of $639 billion versus $619 in liabilities leaving the company with only $20 billion in equity. This means that at the time of its bankruptcy Lehman had about 31 times more debt than equity to fund its assets. Furthermore, the Lehman bankruptcy was the largest ever easily surpassing companies such as WorldCom and Enron in terms of the amount of assets it had. Lehman’s collapse had a major impact on global financial markets as it contributed to a decline of about $10 trillion in market capitalization from global equity markets in October 2008. This drop was the largest decline of any month ever up to that point.
In many ways the Lehman bankruptcy served as a watershed moment for financial institutions around the world. Since its collapse the Dodd Frank act was passed in hopes of reigning in the banks and limiting the risk they can take. On an international level Basel III was launched raising the mandatory levels of tier 1 capital ratios for all banks, with even higher rates for “systematically important” banks. Much of this regulation can trace its origins to the aftermath of the financial crisis and the collapse of Lehman.
The causes of Lehman’s collapse are fairly straightforward and well known. Lehman bet big on the US housing and real estate markets and when these markets turned sour in 2008 it came at the worst time for Lehman. This is because the downturn in the housing market led to a significant decrease in the value of Lehman’s assets as well as a collapse of the mortgage and subprime mortgage markets. These losses quickly drained Lehman’s capital reserves to the point where it could no longer support itself. Eventually, Lehman’s final option was to try to sell itself to Barclay’s and when this fell through the company declared for bankruptcy. Once Lehman entered bankruptcy it was the official end to the company since laws regarding the bankruptcy filings of financial institutions are different from regular companies in that they cannot re-emerge from bankruptcy.
However, the underlying causes for Lehman’s collapse are in many ways less obvious. These issues arose from the culture at Lehman brother as well as the shortcomings of their CEO Richard Fuld. Since its spinoff from American Express in 1994 Lehman had established a culture of corporate greed and poor governance. The company itself encouraged taking outsized risks, as well as instituting poor risk procedures. This risk taking culture started at the top with their CEO, Dick Fuld, who was appropriately, nicknamed “the gorilla” for his uncompromising style. In many ways the culture of Lehman placed the emphasis on short term gain and prosperity without focusing on things such as risk and sustainability. It was this culture which eventually led to Lehman’s collapse and the wave of financial destruction which arose from it.
As the housing bubble was developing in the early part of 2003 Lehman took full advantage of rising asset prices by entering into the mortgage origination business. During 2003 and 2004 Lehman acquired five mortgage lenders including the subprime lender BNC Mortgage and Aurora Loan Service, a company which specialized in making loans without full documentation, a predatory practice which has since been persecuted by the government. These types of businesses had significantly higher risk profiles than typical mortgage lenders. However, during the good times they also were far more profitable.
In the years prior to Lehman’s collapse the company posted some of its strongest financial results. In 2007 Lehman securitized $146 billion in mortgages, a 10% increase from 2006. These securitization and real estate endeavors led to Lehman posting record profits each year from 2005- 2007 during the buildup in the financial crisis. This culminated in 2007 when Lehman posted net income of $4.2 billion on revenues of $19.3 billion. Clearly during the boom years business was good for Lehman. But, prudence and forward thinking were not instilled in the employees or as part of the culture itself because Lehman did very little to hedge its risk to real-estate and housing prices. Instead a system was put in place where Lehman’s employees were paid extraordinarily high salaries and bonuses which were based upon their performance that year. In fact, more than half of what Lehman made in pretax profit was paid out to its employees. This bonus structure motivated employees to value short term performance over long term performance as it would provide them with immediate benefits. This led to continued outsized risk taking because for the employees there was the same downside, losing their job, if a bet went bad, but unlimited upside based upon the amount of risk they took. However, the biggest poster boy of this culture of risk taking was Dick Fuld who earned more than $310 million in-between 2000 and 2007 or just over $44 million a year. With this type of personal financial upside for all members of the company it is no surprise that Lehman focused on the short term over the long term and looked to capitalize as much as possible on the housing bubble.
Another flaw which permeated throughout Lehman, and specifically Fuld, was one of hubris and arrogance. It is understood that Fuld would fire, or eliminate many of the people in Lehman who posed a threat to him or questioned his strategy. This disincentive to stand up to Fuld, led to one track thinking throughout the company. This led to a lack of checks and balances which empowered Fuld to take outsized risks with the company and mold it in his own specific image. This is a prime example of bad corporate governance in that one member of the company has outsized power. In an ideal situation there would be a collaboration of voices focusing on both short and long term goals to help plan for Lehman’s future. This poor corporate governance is a problem which falls on the board of trustees who should have been managing Fuld and the company better as well as Fuld himself for being more open to new ideas.
The main cause behind the collapse of Lehman though was Dick Fuld. Fuld was an overly stubborn individual who in many ways was unfit to lead Lehman into the future. One of the most revealing insights into Fuld’s persona and psyche was revealed while he was charged to talk in front of congress. When being questioned by congress Fuld made this quote.
“I wake up every single night thinking, ‘What could I have done differently? What could I have said? What should I have done.’ And I have searched myself every single night. And I come back to this: at the time I made those decisions, I made those decisions with the information that I had. I can look right at you and say, this is a pain that will stay with me for the rest of my life…”
Looking at the above quote it appears as though Fuld was sympathetic and did the best job he could. However, on closer examination his words appear to be very hollow. To begin with Fuld appeared overly defiant when talking to congress by most reports. To begin with, Fuld was only willing to accept limited blame for the collapse of Lehman instead blaming issues such as “false rumors” about the firm’s solvency, uncontrollable market forces, and a refusal by the US government to come to the rescue.
Looking at those three explanations above it is obvious that Fuld was trying to pass the buck on the collapse of Lehman. To address his first point about rumors about a liquidity crisis, Lehman was looking to sell itself because it had essentially run out of cash and could not secure more short term funding from its creditors. That is a solvency issue, without rumors. His second point of “uncontrollable” market forces is equally delusional. He is obviously discussing the downturn in the housing and real estate markets. However, this is inherently his own fault due to his poor risk management and over exposure to the housing market. So even though he could not control the market itself it was his responsibility to control his firm’s exposure to housing rpices which he did a poor job of. Finally Fuld blames the government for not bailing out Lehman. In this instance he is claiming it is the government’s fault for not risking tax payer money versus his own for running the company into the ground. This final point is by far the most puzzling. It shows that Fuld was out of touch with reality and how highly he thought of himself that he could not possibly be wrong.
Even though Fuld’s arrogance was on display during his time in front of congress, looking at his historical actions it is obvious that his arrogance was seeping into his business decisions, specifically those involving Lehman’s bet on housing and real estate prices. To begin with, Fuld came through the ranks as a bond trader. He never had the technical understanding of the complex mortgaged backed securities and other securitized products. However, the biggest issue with Fuld, and Lehman centers on their bet on the housing and real estate markets. Fuld, who eliminated those who opposed him, managed to guide Lehman into the real estate and housing bubble at its peak, while failing to witness the signs that the market was heading for a correction.
Much of this trouble began to materialize in 2007. For example, on March 14th 2007, Lehman saw its biggest drop in stock price in five years as default rates were rising across the country and analysts believed that this would hurt Lehman’s profitability. However, on the company’s next conference call, their CFO stated that the risks posed by the housing market were contained and pose little financial threat to the company. Furthermore, he stated that he did not see risks in the subprime market hurting the rest of the housing market or the U.S. economy as a whole. This statement is obviously comical in nature looking at it in hindsight but it does show just how off-track the senior leadership at Lehman was.
There were plenty of other clues to what was coming that Fuld and his team continued to ignore as they plowed the company’s resources into the housing and real-estate sectors. For example, the ratings agencies warned the real estate industry that underwriting standards had become too relaxed and rental growth projections were too robust. Then in April 2007 Moody’s said it was going to adjust its ratings to reflect the fact that lending practices had become too risky. However, these warnings were ignored by the company and Fuld, because they did not want the punch bowl to be taken away from them.
Furthermore, Fuld was stubborn even as the financial crisis was happening. He refused to change the course and direction of Lehman Brothers even as it became obvious that the landscape around him was drastically changing. For example, Lehman underwrote more MBS’s in 2007 than any other company, and accumulated an $85 billion portfolio, which was four times its equity. Even as the market had slight upticks, Fuld and the team at Lehman refused to divest its mortgage and real-estate portfolios. They refused to do this because they did not want to sell into a down market even though all of their competitors were doing exactly that. However, what the real problem was was that Lehman was not taking an honest look at the true value of their real estate portfolio, and was unwilling to accept the losses as its value had decreased significantly. This of course would have led to people losing their bonuses and maybe their jobs which would have been a suboptimal option for the company in the short term.
In conclusion the collapse of Lehman Brothers is one built upon hubris, arrogance, and a corporate philosophy that focused on the short term. The majority of the blame for this corporate culture falls on the shoulders of the company’s CEO of thirteen years, Dick Fuld. His refusal to acknowledge that he could be wrong, and desire to trample all those who opposed him led Lehman down their quick path of decline from record high profits in 2007 to bankruptcy in 2008.
Clark, Andrew. “Defiant Dick Fuld blames false rumours and the Fed for collapse of Lehman.” Guardian. 01 2010: n. page. Web. 11 Nov. 2012. <http://www.guardian.co.uk/business/2010/sep/01
Pristin, Terry. “Risky Real Estate Deals Helped Doom Lehman.” cnbc.com. CNBC, 17 2008. Web. 09 Nov 2012. <http://www.cnbc.com/id/26758811>.
Siris, Peter. “Explaining the fall of Lehman Brothers.” NewYork daily News. 13 2008: n. page. Web. 11 Nov. 2012. <http://articles.nydailynews.com/2008-09-13/news/17907151_1_lehman-brothers-fannie-and-freddie-freddie-mac>.
Sorkin, Andrew Ross. “Lehman Files for Bankruptcy; Merrill Is Sold .” NewYork Times. 14 2008: n. page. Web. 11 Nov. 2012.
- Paper 2 the collapse of Lehman (bizgovsoc4.wordpress.com)
- Judge Tosses Key Claims in Lehman Executive Class Action – Bloomberg (bloomberg.com)