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The Dearth of Ethics and the Death of Lehman Brothers

Many believe the beginning of the end for Lehman Brothers was when Washington repealed the Glass-
Steagall Act. This landmark legislation from the Great Depression separated the interests of commercial
and investment banks, preventing them from competing against each other (2) and protecting their
balance sheets by allowing each sector to focus on the business and transactions that it did best. For
investment banks, that typically meant highly liquid, asset-light portfolios, leaving commercial banks to
handle capital-intensive portfolios, including real estate or corporate investments. Additionally, the act
insulated the economy from mass collapse in the event of one sector’s failure by preventing the other
from being dragged down in tow. But in 1999, President Clinton signed the Gramm-Leach-Bliley Act into
law, allowing commercial and investment banks to compete head-to-head for the first time in 60 years
(2). The arms race that ensued would prove disastrous for Lehman Brothers, the financial community, and
the global economy at large.

With the repeal of Glass-Steagall, Lehman Brothers became a key player in the United States
housing boom. From 2004 to 2006, Lehman Brothers experienced a 56 percent surge in revenues from
real estate businesses alone (1). The firm recognized profits from 2005 to 2006, and in 2007 it reported a
record net income of $4.2 billion on revenues of $19.3 billion. In the same year, Lehman Brothers’ stock
reached an all-time high of $86.18 per share, giving it a market capitalization close to $60 billion (1). This
proved exceptional to the surrounding climate, however, and the housing market began to show signs of
a pending bubble burst.

In March 2007, the stock market experienced its biggest single-day plunge in five years, while the
number of mortgage defaults simultaneously rose to the highest percentage in almost a decade. Bear
Stearns, Lehman Brothers’ most comparable Wall Street rival, experienced the total failure of two hedge
funds in August. Despite rapidly deteriorating marketing conditions, Lehman Brothers continued writing
mortgage-backed securities and touting its financial strength to the press and shareholders while decrying
the notion that domestic and global economies were in danger. Meanwhile, its operations were reckless,
as illustrated by its $11.9 billion in tangible equity and $308.5 billion in tangible assets on balance sheets
in 2003 that yielded a leverage ratio of 26 to 1. Four years later, its $20 billion in tangible equity and $782
billion in tangible assets sent its leverage ratio skyrocketing to 39 to 1 (4). Even with storms brewing in
every direction, Lehman Brothers failed to trim its portfolio of high-risk, illiquid assets, and when crisis
erupted in 2007, Lehman Brothers had missed its chance. Instead of acknowledging this misstep,
executives took internal action to preserve a rosy façade.
 By means of deliberate accounting sleight-of-hand, concealment, and communication of
misleading information, until 2008 Lehman Brothers maintained the appearance of underdog success to
the investment community. The primary means by which Lehman Brothers disguised its distress was
through implementation of what was known to insiders as “Repo 105.” This legal but shady accounting
device helped create favorable net leverage and liquidity measures on the balance sheet, which was key
for credit rating agencies and consumer confidence. By utilizing Repo 105, Lehman Brothers raised cash
by selling assets to a behind-the-scenes phantom company called Hudson Castle, which appeared to be
an independently run organization but was actually controlled by Lehman Brothers executives. In
accordance with Repo 105 terms, assets were sold to Hudson Castle and repurchased between one and
three days later (3). Because the assets were valued at 105 percent of the cash received, GAPP accounting
rules allowed the transactions to be treated as sales, thus removing the assets from Lehman Brothers’
balance sheet altogether.

Under the direction of Chief Financial Officer Erin Callan and the certification of Chief Executive
Officer Richard S. Fuld, Jr., Lehman Brothers applied this technique at the end of the first and second fiscal
quarters of 2008 to transfer a combined total of $100 billion, amending its leverage ratio from 13.9 to a
far more favorable 12.1. Thanks to creative accounting and clever public relations, Lehman Brothers was
able to report a positive view of its net leverage, including a $60 billion reduction in net assets on the
balance sheets and a deep liquidity pool. Each of these quarterly balance sheet spins was intended to
offset the effect of announcing — for the first time in years — a loss of $2.8 billion from write-downs on
assets, decreased revenues, and losses on hedges (1). Application of Repo 105 allowed Lehman Brothers
to avoid having to report selling assets at a loss.

During the bankruptcy investigation, the company’s global finance controller admitted that,
“there was no substance to [Repo 105] transactions (5).” Fuld, Callan, and their respective teams
concealed the use of this tactic from ratings agencies, investors, and the board of directors. The one party
in on the scheme was Ernst & Young, Lehman Brothers’ audit firm, which failed to alert either internal or
external parties to the manipulation that was taking place, even when explicitly questioned. They could
not maintain the illusion for long, however, and in September 2008, Lehman Brothers’ situation finally
came to a head.

On September 10, 2008, just three months after reporting second-quarter successes, Lehman
Brothers announced that its supposedly robust liquidity amounted to approximately $40 billion, but only
$2 billion constituted assets that could be readily monetized. The remainder was tied up on so-called
“comfort deposits” with various clearing banks, and though the firm technically had the right to recall said
deposits, the validity of Lehnman Brothers’ work with these institutions was questionable at best (2). By
August, the deposits had been converted into actual pledges.

A few months prior, Fuld began coming to terms with Lehman Brothers’ negative outlook. In a
last-ditch effort, he made a public offering that yielded $6 billion in new capital for the firm. However, by
the by the time third fiscal quarter financial statements were due, Lehman Brothers was projecting
additional losses of $3.9 billion. Its stock price had plummeted to $3.65 per share, a 94 percent decrease
from January 2008. Fuld announced a plan to spin off the majority of the company’s real estate holdings
into a new public company, but there were no prospective buyers (Holdings, Inc.). On Sept. 13, the United
States Treasury made it clear that Lehman Brothers would not be the recipient of bailout money. Instead,
a number of financial institutions, including Barclays and Bank of America, were being encouraged to
acquire the faltering company, invigorate it with much-needed capital, and bring it back from the edge of
collapse (3). Each potential acquiror declined. On Sept. 15, 2008, Fuld admitted defeat and finally heeded
private advice from Treasury Secretary Henry Paulson, Jr. At 1:45 a.m., he filed for Chapter 11 bankruptcy
protection, just before the opening of Asian markets (1).

In the days following the largest bankruptcy filing in United States history, the American market
experienced a shock unlike any it had felt since the Great Depression. When the domestic stock market
opened on Sept. 15, the Dow Jones dropped 504 points. The following day, Barclays agreed to buy Lehman
Brothers’ United States capital markets division for the bargain price of $1.75 billion. Meanwhile,
insurance giant AIG was on the verge of total collapse, forcing the federal government to step in with a
financial bailout package that ultimately cost $182 billion (3). On Sept. 16, the Primary Fund announced
that due to its Lehman Brothers exposure, its price had plummeted to less than $1 per share. The ripple
effect of Lehman Brothers’ failure was widespread, giving rise to a confidence crisis in global banks and
hedge funds. Credit markets froze, forcing international governments to step in and attempt to ease
concerns. Domestically, this resulted in the controversial passage of the Trouble Asset Relief Program, a
$700 billion federal rescue aid package, on Oct. 3, 2008 (5).

Finally, Ernst & Young, the only third party privy to the happenings at Lehman Brothers, failed to reveal
the extensive steps taken by executive leadership to conceal financial problems. As a firm of certified
public accountants expected to honor and uphold an industry-wide code of ethics, Ernst & Young may be
accused of being responsible for gross negligence and lack of corporate responsibility. Why would such a
highly respected organization risk its own reputation and turn a blind eye on behavior that is clearly
unethical? Obviously Lehman Brothers was a sizeable (and presumably lucrative) client of the firm. But
past scandals involving questionable accounting observances, such as Enron, have demonstrated firsthand
that inaction is as equally reprehensible as direct involvement in the scheme itself. More than just a
paycheck was at risk, and failure to act successfully discredited Ernst & Young on the basis of ethical and
industry standards.

As an accounting firm, Ernst & Young is charged with certifying that companies deliver accurate
and reliable information to shareholders. In this regard, Ernst & Young failed completely, as executives
were aware of behind-the-scenes bookkeeping and the extent to which it was occurring. In this situation,
concern for ethical behavior was of minimal or nonexistent concern. Therefore, the company’s
shareholders were deliberately deceived for the purpose of preserving a paycheck, and in that regard, the
team of accountants who chose not to act disappointed more than just their company; they let down the
entire industry and each of the right-minded professionals within it.

The story of Lehman Brothers’ demise is unfortunate, and not just because its collapse meant the
end of a Wall Street institution. The real tragedy lies in the lack of ethical behavior of its executives and
professional advisors. They made conscious decisions to deceive and manipulate, and the consequences
proved too dire to preserve the historic investment bank’s existence. The perennial lesson of the Lehman
Brothers case is that no matter how dire the circumstances may appear, transparency and accountability
are paramount. Right action up front may sting initially, but as history has repeatedly shown, gross
unethical business practices rarely endure in the long term. A global financial crisis such as that of 2008
may not be prevented from happening again. What can be improved, in large measure through ethics
education, is how corporations behave. Wall Street should take note of the case of Lehman Brothers to
ensure history does not find a way to repeat itself.

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Sumber : Case Study: The Collapse of Lehman Brothers.” Investopedia.com. 2 Apr. 2009. Web. 26 Nov.
2011.