FINANCIAL MANAGEMENT

Case Study: The Collapse of Lehman Brothers

Written by Group 3:

Alyssa Bella K.
Mutiara Maknun
Muhammad Winarno A.

MASTER OF MANAGEMENT
FACULTY OF ECONOMICS AND BUSINESS
UNIVERSITAS GADJAH MADA
YOGYAKARTA
2019
Introduction
Lehman Brothers was initially founded in 1844 by 23-year-old Henry Lehman. Lehman
Brothers, later became Lehman Brothers Holding Inc., becomes independent through a public
stock offering and its common stock begins trading on the New York & Pacific stock exchanges
in 1994. Before filing for bankruptcy in 2008, Lehman Brothers was the fourth largest Wall
Street investment bank in the United States (behind Goldman Sachs, Morgan Stanley, and
Merrill Lynch), doing business in investment banking, equity, and fixed-income sales and
trading (especially US Treasury securities), research, investment management, private equity,
and private banking (Naegeli, 2014).
On September 15, 2008, Lehman filed out Chapter 11 bankruptcy, after 164 years of
operation. One of the main cause of the bankruptcy was the climax of the subprime mortgage
crisis which started in 2007. The messed up condition is caused by the high default risk of
subprime mortgage. A subprime mortgage is a housing loan that’s granted to borrowers with
impaired credit history (Amadeo, 2018). According to the Federal Deposit Insurance
Corporation (2015) these borrowers have been delinquent, bankrupt, or have low credit scores
and/or low income.

Discussion
On January 29, 2008, Lehman reported record revenues of nearly $60 billion and record
earnings in excess of $4 billion for its fiscal year ending November 30, 2007 (Ahmed, 2011).
Lehman was feeling confidence on itself, especially because during 2007 the US economy
started to get ill due to the effects of the subprime crisis. Even though its leverage ratio kept on
increasing as shown on table 1, Lehman still has the confidence to keep actively involved in
the mortgage market. Lehman confidence boost even more because during January 2008,
Lehman’s stock traded as high as $65.73 per share. It also success on raising $4 billion through
the sale of some of its preferred stock on April 2008.
Table 1. Lehman Brothers Leverage Ratio
Year 1st Quarter of 2008 2007 2006 2005 2004 2003

Leverage Ratio 31.7 × 30.7 × 26.2 × 24.4 × 23.9 × 23.7 ×

Lehman started to get worried when on June 9, 2008, it pre‐announced its second
quarter results and reported a loss of $2.8 billion. It started to look for someone to buy it ever
since. Even though it announce its first ever loss since going public in 1994, Lehman was
success on raising $6 billion of new capital in a public offering on June 12, 2008 (Ahmed,
2011).
Richard Fuld, CEO of Lehman, called Lazard, the largest independent investment bank
in the world, to advise it on August 2008. Fuld started negotiating to offload $30 billion in
several illiquid assets and commercial mortgage securities (Singh, 2018). Reportedly, Temasek,
HSBC, Korean Development Bank and several other Chinese banks looked upon the
prospective deal. But all the discussions failed which led to the sentiment turning catastrophic
over Lehman Brothers’ ‘going concern’ status.
On September 10, 2008, Lehman announced that it was projecting a $3.9 billion loss
for the third quarter of 2008. In the same day, its stock dropped to $6.93. On the next day,
Lehman failed to have the deal with Bank of America after it became quickly apparent to Bank
of America that, without substantial government assistance—since The US Federal Reserve
refused to guarantee certain liabilities of Lehman and thought that it was too big to save—the
deal would not be beneficial to Bank of America. In the same day, the stock dropped even more
to $3.65 (Ahmed, 2011). On Saturday, September 13, The US Federal officials called an
emergency meeting with the Chiefs of Wall Street and the Securities and Exchange
Commission to discuss any potential solution which can pull out Lehman Brothers from the
crisis. The CEOs of big investment banks such as Goldman Sachs, JP Morgan Chase, Morgan
Stanley, Citigroup, and Wells Fargo were struggling with their own complications, that’s why
they refused to take a piece of Lehman Brothers.
It appeared by early September 14 that a deal had been reached with Barclays which
would save Lehman from collapse. But later that day, the deal fell apart when the parties
learned that the Financial Services Authority, the United Kingdom’s bank regulator, refused to
waive U.K. shareholder‐approval requirements and the deal fell through. Lehman no longer
had sufficient liquidity even to fund its daily operations and on September 15, 2008, at 1:45
a.m., Lehman filed for Chapter 11 bankruptcy protection (Ahmed, 2011).
Prior to filing for chapter 11 bankruptcy, the fall of Lehman begun when there was a
decreasing U.S. Federal Rate nearly up to 1% in 2003. This decreasing interest rates had cause
Lehman Brothers to lend more aggressively in the housing markets, which led to the real estate
prices rallying. However, seeing the prime market for home loan failed to increase Lehman’s
credit growth, it started lending to subprime borrowers which was in fact, subjected to poor
credit history.
However, in 2004, there was an increasing rates that made the cost of funds for lending
institution increased. This is in line with a declining demand in housing market. Witnessing
this phenomenon, the subprime borrowers started defaulting on their payments due to fear of
the house payment cost would outweigh its true value in the future. Consequently, in August
2007, Lehman Brothers were forced to shut down its mortgage lending unit BNC and eliminate
other 2500 related jobs.
Furthermore, some analysts argue that there were at least three parties which
significantly contribute to the subprime crisis and fall of Lehman Brothers:
Lehman Brothers - while housing market has started its downward journey in 2007,
Lehman didn’t scale down its activity in the mortgage market. It kept underwriting MBS and
by the time its rival, Bear Stearns collapse due to excessive exposure to mortgage market, it
triggered a 48% plunge in Lehman’s stocks. Furthermore, in 2007, Lehman failed to write
down all its toxic assets, not like Citigroup and Goldman Sachs, which earlier realized a better
value when the crisis intensified. On the other hand, Lehman incentive structure, which given
the employees parts of its stocks as bonuses, has driven the employees to ignore higher leverage
in exchange of good revenues report and higher stock price. In addition, Lehman decided to
invest even more in the MBS due to the relaxation of leverage by SEC that trigger even more
losses. Analysts further blamed the use of Value at Risks metrics by Lehman Brothers as bad
management policy due to its inconsistency in probability of risk and maximum loss during
normal and abnormal condition.
The U.S. Federal Government - Henry Paulson has been blamed for not giving
Lehman Brothers a chance to be bailed out by the Fed days before the filing of chapter 11.
Henry bravely refused to admit the accusation, saying that he had urged Lehman Brothers to
find investors who wanted to invest at Lehman’s toxic asset, however, none of the effort had
been fruitful. Besides, in 2003, the U.S. government had to rely on money market to find its
war on Iraq rather than its own reserves. This means that the government would not be able to
raise funds for its long term investment. It occured to the analysts that the Fed has lost control
over its own economy, when the fall of Lehman brothers had caused the U.S. a systemic
problem and put the global economy in crisis. Dr. A. Tony Prasetiantono (2008) also argued
opposite political position might be the reason of bailed out delay. He elaborated that Henry
Paulson along with Goldman Sachs were known for their support in the John McCain’s
campaign, while Lehman Brothers chose to support the opposite party, which was Hillary
Clinton and Barack Obama.
 Ernst and Young and JP Morgan - In 2010, two years after the collapse of Lehman
Brothers, Ernst and Young was accused by the New York Supreme Court for facilitating a
massive accounting fraud and sought a $150 million in fees between 2001 and 2008 (Freifeld,
2010). On the other hand, ABC News (2010) from Australia reported that JP Morgan has
purportedly holding all Lehman Brothers’ assets as a potential offset against any claims JP
Morgan have had against Lehan.

Recommendation
As mentioned earlier that many parties are involved and to be blamed for Lehman Brothers
collapse, there might be some actions Lehman Brothers and The Fed could do to prevent the
disaster. From Lehman point of view, they could have done:
1. Risk appetite: according to ISO 31000, risk appetite means “Amount and type of risk that
an organization is prepared to pursue, retain or take.” In 2006, Lehman changed their risk
management in which increased the risk appetite limit to $3.5 billion in September2007.
Figure 1. Average Monthly Risk Usage Total Firm

In January 2008, the executive committee increased the risk appetite limit to $4
billion, and based on the new calculation, the overage was eliminated. Had the pre-2006
calculation been used, the level would have been set at $2.46 billion (Examiner Report,
Vol 8., Appendix 10). In fact, collapse of Lehman Brothers leads to a reassessment of
risk exposure arising from the credit default swaps (ASEAN Studies Centre: Institute of
Southeast Asian Studies, 2008).
2. Stress Testing: Stress test for extreme values would have alerted Lehman about the point
of breakdown, an activity that Lehman paid scant attention to (Schapiro, 2010). Although
Lehman’s stress tests included several that were designed to simulate a significant
downturn in the mortgage and real estate markets, it did not run stress scenarios that
simulated a widespread mortgage crash as happened. “No one could have predicted a
downturn of the magnitude and scale that occurred; it had never happened before, such a
downturn without a precipitating economic event. This time, the housing crash was the
precipitating event.” (Lehman’s Managing Director, Madelyn Antoncic, FCIC Staff
Interview.) This mean that failure of Lehman Brothers underlined the importance of newer
stress testing approaches including testing for destruction (Kemp, 2011).
3. Corporate Governance: a proper corporate governance plan that would have highlighted
the fraudulent activities of Lehman was completely absent (Sun, Stewart, & Pollard, 2011).
There are moral hazards happening in Lehman Brothers’ case, such as Repo 105. A
comprehensive reform of the supervisory system for universal banks is urgently needed
and must become a top priority for Congress and financial regulators (Wilmarth, 2007).
 While, from The Fed point of view, they should have saved Lehman Brothers.
Other financial institutions, such as Bear Stearns and AIG, also experienced crises in
2008 and surely would have failed if not for emergency loans from the US Federal
Reserve. The aftermath of Lehman Brothers’ collapse was huge in fact, over an
estimated 6 million jobs were lost, unemployment rose 10%, the Dow Jones Industrial
Average dropped an astounding 5,000 points, according to ABC News, as well as an
international ripple effect that devastated economies in countries like Latvia, Hungary,
and Lithuania. Even Pakistan sought a bailout after the crisis from the International
Monetary Fund (IMF), and Iceland faced a crisis when officials announced the
government had no funds to prop up major banks in the country. Thus, The Fed should
have saved Lehman Brothers.

Conclusion
The main cause of Lehman Brothers Collapse is due to Subprime Mortgage Crisis in 2008.
Moreover, there are several other factors affecting why Lehman bankruptcy, such as decreasing
Fed Rate which start the crisis, moral hazard by Lehman Brothers and Ernst & Young. On top
of that, The Fed did not save Lehman from bankruptcy like they did to Bear Stearns and AIG.
Thus, there are some possible actions Lehman should have done to avoid the bankruptcy such
as risk appetite management, new stress testing and corporate governance. While The Fed
should have saved Lehman to prevent further impact of the crisis.

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