Group 25

International Finance (MAF 760)

Lehman Brothers and Bear Stearns. Why they collapse?

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Shaheen
Ijaz
Singh
Ahmed Khan

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Contribution of Group 25
Omar Shaheen
Muhammed Usman Ijaz
Gulsheer Singh
Qadeer Ahmed Khan

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Unit Title: International Finance

Assignment Title: Lehman Brothers and Bear Stearns. Why did

Group assignment 1
they collapse?
Lecturer:
Dr. Sohel Azad

Tutor:

Dr. Sohel Azad

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Omar
Muhammad Usman
Gulsheer
Qadeer

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Omar Shaheen

1|Page

Group 25

International Finance (MAF 760)

Lehman Brothers and Bear Stearns. Why they collapse?

PLAGIARISM AND COLLUSION

Plagiarism occurs when a student passes off as the students own work, or copies without acknowledgement as to its
authorship, the work of another person. Collusion occurs when a student obtains the agreement of another person for a
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may be reproduced and/or communicated for the purpose of detecting plagiarism and collusion.

DECLARATION
I certify that the attached work is entirely my own (or, where submitted to meet the requirements of an
approved group assignment, is the work of the group), except where material quoted or paraphrased is
acknowledged in the text. I also certify that it has not been submitted for assessment in any other unit or
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SIGNED:

Members of Group 25
Omar
Usman
Gulsheer
Qadeer

DATE:

22/09/2014

An assignment will not be accepted for assessment if the declaration appearing above has not been signed by the
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Assessors comments - see over page

2|Page

Group 25

International Finance (MAF 760)

Lehman Brothers and Bear Stearns. Why they collapse?

Assessors Comments:

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3|Page

Group 25

International Finance (MAF 760)

Lehman Brothers and Bear Stearns. Why they collapse?

EXECUTIVE SUMMARY:
Coupled with the economic collapse of the housing market the biggest government
intervention in American history has led to a thorough reorganization of the investment
banking industry, culminating in the failure of the United States in 2008 two major
investment banks: Lehman Brothers and Bear Stearns.
The reports talks about the both companies with respect to their business dealings and what
kind of business they were into. The report starts with the brief history about both companies,
from their foundation to their demise. What happened to them afterwards?
Main focus of the report is on the reasons for their respective collapse and what caused them.
Both companies were the major financial players in the industry and with their collapse not
only US economy was hurt but the ripples were left worldwide. Lehman Brothers and Bear
Stearns were international banks, as their market was beyond US.
In the analysis part, report discusses in-depth analysis of their different financial ratios and
leverage ratio. Further, the report looks at the housing market situation during last 100 years
with respect to their prices and at the same time comparing those with economic situation
such as interest rates and mortgage capacity of the population. Management style of the both
companies was influential as well, and other control to consider was the US government as
regulations were not actively monitored.
Companies made decisions which played important role for their demise, it is currently hard
to answer who was exactly responsible for the failure but in the end burden was suffered by
investors.

4|Page

Group 25

International Finance (MAF 760)

Lehman Brothers and Bear Stearns. Why they collapse?

INTRODUCTION:
An introduction about companies.
In year 1844, Henry Lehman started the trading company named as H. Lehman which mainly
traded in the cotton and in the later year 1850, firm changed its name to Lehman Brothers as
Henrys brothers joined the business. After the demise of Henry, remaining brothers changed
focused the business from cotton trading to commodity trading and brokerage operations. In
the subsequent years, company went through difficult times, mergers and divestments before
in the year 1994, its initial public offering where it was named as Lehman Brother Holdings
Inc. Before declaring bankruptcy in 2008, Lehman Brothers, the fourth largest investment
bank in the United States and at that time it was dealing in the areas such as investment
banking, asset operations and fixed, research, investment management, private equity and
private banking. Lehman filed for Chapter 11 bankruptcy protection on 15th September, 2008
and this filling is one of the largest in the history of United States. Lehmans bankruptcy
played an important role in unfolding the financial crisis which affected the whole world.
Looking the financial reports of the year 2008, it can found that assets of the company were
approximately around $600-700 billion but it still collapsed.
Bear Stearns was founded by Joseph Bear, Robert Stearns and Harold Mayer as an equity
trading company in the year 1923. In the subsequent years, the company went through Wall
Street crash but managed to hold itself till the year 2008. Bear Stearns was mainly dealing
with financial services, investment banking and investment management. At the time of it
demise in year 2008, it was one of the largest investment bank based in the New York. Bear
Stearns was not only based in New York, it had global reach as well such as 12 different
countries and employed around 15,500 people worldwide. Bear Stearns was one of the most
reputed companies in the financial sector, as admired by its current and potential employees.
Near it demise, the company had total asset worth $400billion as compared to net equity of
$11.1 billion. Major of the asset based securities were related to subprime mortgages, as the
housing market fell most of the hedge fund lost their respective values. With the liquidity
near to zero, the Federal Reserve Bank of New York agreed to provide Bear Stearns with
loan of $25billion but market conditions were against them. On the 16 th March, 2008 JP
Morgan Chase agreed to buy Bear Stearns for $2 per share which was later raised to $10 per
share when shareholder disagreed.
5|Page

Group 25

International Finance (MAF 760)

Lehman Brothers and Bear Stearns. Why they collapse?

REASONS FOR COLLAPSE OF LEHMAN BROTHERS AND BEAR

STEARNS:
Reasons have been divided into two main categories, for better understanding, such as firm
culture & upper management and financial characteristics.
FIRM CULTURE AND UPPER MANAGEMENT:
Both Bear Steams and Lehman Brothers had firm cultures that valued excessive risk-taking,
and senior leadership failed to head key warning signs that could have helped prevent failure
or mitigate damage. In 2005-06 Lehman was one the largest underwriter of the real estate
loans in the US economy whereas in 2007 there were many cases filed against the company
that the loans were made to the borrowers on no reasonable grounds. It was proved that there
was mismanagement within the company and the borrowers who could not even afford to pay
back were provided with loans which were mostly invested in the household sector,
subsequently US economy started to experience a sharp downfall in the real estate sector and
Lehman announced a $2.5 billion write down due to the investments made in real estate.
Total losses of the company in 2008 rose to $6.5 billion which made the company stuck in a
difficult position. Overall the culture was aggressive and overconfident; such when the hedge
funds of Bear Stearns were near collapse instead of controlling them they increased the
leverage in order to cover the losses.
Bear Stearns was known for its highly aggressive hiring decisions and strategy making
decisions. Alan "Ace" Greenberg, former Chairman of Bear Steams, said, "If somebody with
an MBA degree applies for a job, we will certainly not hold it against them, but we are really
looking for people with PSD degrees," meaning poor, smart, and with a deep desire to
become very rich (Kensil et al, 2012). Deep desire of becoming rich and aggressive culture
led the Bear Stearns to reply mostly on the volatile bond market for their revenue. Failure can
also be linked to the poor decisions made by the superior management as they were living
lavish lives without any care for the companies. Some of the high executives were later found
out to no or little knowledge of the position they held, thus leading to poor decisions
regarding risk strategies and no contingency plan for crisis.

6|Page

Group 25

International Finance (MAF 760)

Lehman Brothers and Bear Stearns. Why they collapse?

FINANCIAL CHARACTERISTICS:
The idea of Lehman Brothers of providing loans to the borrowers was good as the prices of
the land were rising constantly and it would maximize their profits but they did not take into
account the negative side, what would happen if the prices of the assets decrease. This was
exactly that happened during 2007-08, The leverage of Lehman Brothers rose to 44 times
from 20 in 2007 where as a normal bank would have a leverage of about 12 times. On the day
of bankruptcy Lehman Bros had $600 million worth of assets but the main reason that added
to its financial crisis was that it lacked liquidity. On the other hand, Bear Stearns had a
leverage ratio of nearly 36 per cent. As the markets began to fall both companies finances
became weak, other banks and the people started to lose faith in the companies. A point to
argue here is that other financial bank such as Morgan Stanley, Merrill Lynch and Goldman
Sachs had higher leverage ratio as well when compared with the Lehman Brothers and Bear
Stearns. Those banks, beside Lehman brothers and Bear Stearns, were in control of their
leverage ratios, as they had more liquid assets which they could convert quickly.
Bears had significant risk in the area of market derivatives. According Kensil et al (2012),
during the year 2006 Bear derivate position was $8.7trillio and by the 2007 it had grown to
$13.4 trillion. As the subprime mortgage borrowers started defaulting thus started a chain
reaction for the company, such as raising rumours that company cannot make payments
(liquidity concerns) which lead to unwinding of derivatives trade with Bear.
Both companies maintained its own VAR model numbers for each portfolio of assets and this
affected the risk management structure. VAR model employed historical data thus not
capturing the true volatility of the asset values. These exercises by the company clearly
violated the Basel 2 standards and allowed them to use the most favourable conditions for
calculating its capital charges. In addition, companies failed to comply with Basel 2 failed to
emphasize asset prices to calculate capital requirements. Majority of the Investment Banks in
the United States pressured the Securities Exchange Commission (SEC) to replete the void
created by the Gramm-Leach-Bliley Act of 1999. This was done to digress from the
European Union regulations. The SEC thus created the Consolidated Supervised Entity (CSE)
program, a voluntary supervision package for the brokers. The CSE employed 3 regulations
from Basel 2 and allowed the rest of the monitoring to be done by SEC. The CSE also
allowed exemption from the net capital rule. This then allowed the investment bank to
calculate the capital requirement using the alternative method in Basel 2. Bear Sterns and
7|Page

Group 25

International Finance (MAF 760)

Lehman Brothers and Bear Stearns. Why they collapse?

Lehman Brothers enjoyed this involvement of the CSE program as the altered calculations
led to lower capital requirements. When the acquisition commenced the debt to equity ratio
of this bank was 33:1. The new calculations however still allowed the bank to hold only 10%
of the capital as a cushion. Bear Stearns and Lehman Brothers used loopholes and outright
tricks delay the markdowns instead of choosing to comply with Basel 2 standards. Such
behaviour shows complete disregard of financial system.

8|Page

Group 25

International Finance (MAF 760)

Lehman Brothers and Bear Stearns. Why they collapse?

ANALYSIS:
Our analysis is based on three major factors that we think were important for this study.
Housing prices and interest rates
Lack of transparency and government regulations (internal and external)
Ratio analysis
All the three major factors are discussed below in detail.
In the figure 1 (Appendices), according to Zingales, it can be seen that price after 1997 show
constant increase and that increase is steep. This was due to low interest rates, as between
January 2002 and January 2004 the average 3 month T-Bill rate was 1.3% as compared to 6.1%
averaged in the previous forty years (Zingales, p 3). According to Shiller (2008), a survey in
2005 of San Francisco home buyers, it was found that mean expected price to increase over
the next ten years was expected to be at 14% per year while the median was at 9% per year.
This eventually led to home owners finding it hard to pay their mortgages as their home
equity increases. On the other hand, at the same time mortgage options available were
increasing such as interest only and negative amortization. These options allow purchaser to
buy houses at which they could not endure the mortgage payments in connection with their
ability to refinance it continuously at high price. According to Zingales, interest only
mortgages share was at 0% in 2001 and in the year 2008 it has increased to 37.80%. Lending
standards declined especially in the areas such has home prices were high and while at the
same time competition among lenders increased.
In the past companies could not influence the rating agencies as they only had few securities
to buy. With the influence of collateralised debt obligation (CDO), major bank were buying
different and hundreds of these rating in a single year, thus allowing to them look for the best
rating in the market. Sometimes even produced their own rating with very high risks with the
rating of AAA at lowest possible cost involved, even around 2008, Standard & Poor provided
CDO evaluation manual. This allowed them to be more famous then the AAA corporate
securities even though they had the highest risk. According to Zingales, these AAA rated
asset backed securities had average spread of 32 basis point. High constraints in the
regulations allowed very demand for these products, two major Government Sponsored
Entities (GSE) Fannie Mae and Freddie Mac were encouraged to invest in these securities.
9|Page

Group 25

International Finance (MAF 760)

Lehman Brothers and Bear Stearns. Why they collapse?

Department of Housing and Urban Development (HUD) set out performance benchmarks for
the two GSE and those could only be completed by arbitrage opportunity such as issue AAA
rated debt and invest in the AAA rate asset backed securities. Lartey describes the CDO as
very complex financial product which was based on the very complex risk ratings and
complex mathematical models. As the property prices crashed, repossession and arrears went
up like vertical cliff Lehman got caught in the middle of this and was forced to write down
$10.5 billion worth of investments during the first three quarter of 2008 (Kensil et al. 2012,
pp 63).
Another issue was the usage of the accounting system, as there is argument of using fair
value accounting played part in the failure. There is three different way to determine the price
values, first one is the market prices, second is illiquid market data and third is entity
estimated prices. The system was designed to be clearer but it had it drawbacks. With the
progress of time, as the general market become less liquid entities moved to the entity
estimated model which was not much developed. It can be seen in the figure 2 (Appendices)
that Level 1 assets of the both companies were decreasing while there is significant increase
in the level 2 and level 3 assets thus leading back to the liquidity problems as elaborated in
the reasons.
Zingales (2008, pp 11) states that lack of transparency in the major market is one of the
contribution problem, credit default swaps grew at alarming rate during the last ten years,
almost from zero to $44 trillion.
Lartey (2012) states chief executive of Lehman was overconfidence in his management style
and at the same time employees were paid high salaries and bonuses which were more than
half of what the company earned.
Glass-Stegall Act of 1933 is an important factor to be considered here, according to the Act
in United States Banks had to maintain their commercial and investment activities separately
until in the late 1980s when the Act was abolished. Merger of commercial and investment
banking led to rise of unethical actions. Consider this, in order to compete with the other
commercial banks and at the same time maintaining the investment portfolio was leading to
decision more focused on one then the other. If one side is making loss, decisions were made
to cover the loss from the other side with utilizing high amount of leverage thus higher risk.

10 | P a g e

Group 25

International Finance (MAF 760)

Lehman Brothers and Bear Stearns. Why they collapse?

Auditors of the companies were blamed as well, as it is auditors duty to perform audit in
such a way and give assurance as well that financial statements are free of any misstatements
whether it is error of fraud. There has been mixed views about this as it is very difficult for
auditor to review each and every transaction to find fraud. In the case of Lehman Brothers
and Bears Stearns it would have been impossible to review their each and every transaction
during a respective financial year.

Lehman Brothers (amount in Billions)

Bears Stearns (amount in Billions)

Year

2002

2003

2004

2005

2006

2007

2002

2003

2004

2005

2006

2007

Revenue

16.8

17.3

21.3

32.4

Income

1.7

2.4

3.3

46.7

59

6.9

7.4

8.4

11.6

16.6

16.2

4.2

0.8

1.1

1.3

1.4

Assets

260.3

312.1

357.2

Asset

0.065

0.055

0.06

410.1

503.5

691.1

184.9

212.3

256

292.6

350.4

395.4

0.079

0.093

0.085

0.037

0.035

0.033

0.04

0.047

0.041

0.4%

0.5%

0.7%

0.8%

0.8%

0.6%

0.4%

0.5%

0.5%

0.5%

0.6%

0.0%

turnover
Return on
asset
Equity
Return on

8.9

13.2

14.9

16.8

19.2

22.5

6.4

7.5

10.8

12.1

11.8

11.2%

12.9%

16.1%

19.6%

20.8%

18.7%

12.5%

14.7%

14.4%

13.0%

16.5%

0.0%

equity

Azadinamin states in his research paper, during the years from 2002 to 2007, revenue of both
companies showed constant increase such as Lehman Brothers has revenue of $16.8 billion in
year 2002 as compared to year 2007 revenue was $59 billion, on the other hand Bears Stearns
has revenue of $6.9billion. Looking at the income aspect, both companies showed steady
grow from the year 2002 till year 2007 and in 2007, Bears Stearns records zero income.
Assets of both companies show increase from year 2002 to year 2007, asset turnover and
return on asset show steady increase as well and in the year 2007, Bears Stearns shows zero
percentage return on asset as company did not had any income. During the years 2002,
leverage of Lehman has been around 20 per cent but while near 2007 leverage ratio has
peaked to near 44 per cent. Bear Stearns is one of Wall Street's highest leveraged companies.
Throughout its history is innovative and creative, and sometimes led them to take some risk
positions. The company's management is called concentrated in a few long-term strategic
planning opportunities for direct return. To the end of 2007 the balance sheet of Bear Stearns
shows $ 395 billion in assets and $ 11.1 billion in equity. The leverage ratio of the company
was around 36 to 1. Lehman had massive asset base but at the same time where the liquidity
was very low, as all the cash was tied with investments but wasnt actually in hand.
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Group 25

International Finance (MAF 760)

Lehman Brothers and Bear Stearns. Why they collapse?

At the international level, collapse of these could be felt very hard. The demise of Lehman
resulted in the loss of 70% of $48 billion of receivables from derivatives that could otherwise
have been relaxed and as much as $75 billion in value was destroyed (Lartey, pp 16). In
England $160million Lehman products were bought by investors, in Hong Kong 43000
individuals had bought mini bonds issued by Lehman valued approximately at $1.8billion
and pension funds such as New Yorks state Teachers retirement fund also incurred huge
loss. Some of the hedge funds around the globe were frozen when Lehman bankruptcy was
declared.

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Group 25

International Finance (MAF 760)

Lehman Brothers and Bear Stearns. Why they collapse?

CONCLUSION:
International Banking experienced enormous changes all economic and market in the past
few years. Recent regulatory and competition in the banking sector, has forced many
investment banks sided pursuit of economic growth, industry, region and other financial
institutions have traditionally fall, such as commercial banks. This exposed the banks to take
more risk, often leads to a crisis. Lehman Brothers and Bear Stearns have a reaction on the
subprime crisis and other economic activity, has taken some previous decisions on the
management of both investment banks is a problem, although they declined in the business
judgment rule.
While majority of both banks failures were from within the companys own operations,
many questions arose as to whether the interaction between the banks and the
Government agencies that regulated and monitored Lehman and Bear contributed to the
collapse. Many analysts believed the bankruptcy of both banks had set off a panic that would
end up by threatening not only the U.S. financial system but also the entire global financial
system. The fact is that, these questions are currently hard to answer, among other reasons
because there is very little exact knowledge about what exactly happened to both of the
investment banks. Eventually Bear Stearns was purchased by JP Morgan Chase for it nominal
level while Lehman Brothers could not be saved as it filed for it Chapter 11 bankruptcy, later
North American division was purchased by Barclays Plc. and Nomura Holdings agreed to
buy Asian division and other divisions were just shut down.

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Group 25

International Finance (MAF 760)

Lehman Brothers and Bear Stearns. Why they collapse?

REFERENCES:
Azadinamin, A 2013, The Bankruptcy of Lehman Brothers: Cause of Failure &
Recommendations Going Forward, THE BANKRUPTCY OF LEHMAN BROTHERS, Swiss
Management Center (SMC) University, pp 1-15.
Lartey, R 2012, What caused the collapse of Lehman Brothers?, Running head: Failure of
Lehman Brothers, SMC University Switzerland, pp 1-26.
Zingales, L 2008, Cause and Effects of the Lehman Brothers Bankruptcy, University of
Chicago Business School, pp2-26.
Shiller, Robert J., 2005, Irrational Exuberance, Princeton University Press 2nd edition.
Shiller, Robert J., 2008, The Subprime Solution: How Today's Global Financial Crisis
Happened, and What to Do about It, Princeton University Press.
Kensil, S. & Margraf, K. 2012, The Advantage of Failing First: Bear Stearns v. Lehman
Brothers, Journal of Applied Finance- No.2, pp 60-76
FURTHER READING:
Grove, H, & Cook, T 2013, 'Lehman Brothers and Bear Stearns: Any Financial and
Corporate Governance Differences?', Amity Global Business Review, 8, pp. 112-130.
Hintze, J 2009, 'One Year After Bear's Collapse JP Morgan Reaping Benefits. (cover
story)', Securities Industry News, 21, 6, pp. 1-20, Business Source Complete, EBSCOhost,
viewed 10 September 2014.
Haas, R, & Horen, N 2012, 'International Shock Transmission after the Lehman Brothers
Collapse: Evidence from Syndicated Lending', American Economic Review, 102, 3, pp. 231237, Business Source Complete, EBSCOhost, viewed 9 September 2014.

14 | P a g e

Group 25

International Finance (MAF 760)

Lehman Brothers and Bear Stearns. Why they collapse?

Kensil, S, & Margraf, K 2012, 'The Advantage of Failing First: Bear Stearns v. Lehman
Brothers', Journal Of Applied Finance, 22, 2, pp. 60-76, Business Source Complete,
EBSCOhost, viewed 12 September 2014.
Duong, B 2009, 'Lehman in retrospect', Institute Of Public Affairs Review, 61, 3, p. 59,
MasterFILE Premier, EBSCOhost, viewed 1 September 2014.
Rosato, JF 2011, 'DOWN THE ROAD TO PERDITION: HOW THE FLAWS OF BASEL II
LED

TO

THE

COLLAPSE

OF

BEAR

STEARNS

AND

LEHMAN

BROTHERS', Connecticut Insurance Law Journal, 17, 2, pp. 475-500, Legal Source,
EBSCOhost, viewed 15 September 2014.

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Group 25

International Finance (MAF 760)

Lehman Brothers and Bear Stearns. Why they collapse?

APPENDIX:
Figure 1:

Figure 2:

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Group 25

International Finance (MAF 760)

Lehman Brothers and Bear Stearns. Why they collapse?

(Image from Kensil et al. 2012, pp65)

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