THE COLLAPSE OF

THE LEHMAN
BROTHERS
 OVERVIEW

a) Reasons for the collapse of the Lehman Brothers

b) Contagion effect of the collapse of the Lehman Brothers to
the governance of corporation in the world.
c) Possible violation of principles of corporate governance
d) Corporate governance structure, mechanism and procedures
that would have saved Lehman Brothers
e) The collapse of the U.S. housing market

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 a) Reasons for the collapse of the Lehman Brothers

▰ Risky lending practices (extension of subprime mortgages): Subprime mortgages

are loans extended to customers who would otherwise not be accepted for
credit due to their poor credit score.
▻ The main justification for extending these loans was that although these
credits were very risky, the rising prices of mortgages could compensate
for any loss through remortgaging in the event of default.
▻ This indicated that Lehman Brothers had no idea that the subprime
mortgage market could eventually crash.

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Reasons for the collapse of the Lehman Brothers

▰ Deficient management of risk:

▻ Inaccurate projections into the nearest future and poor
counter strategies when market conditions changed.
▻ A proper analysis of the credit risk and market risk would have
informed the firm of the need to lower their commitments in
subprime loans, reduce defaults and better position itself to be
protected from huge loss.

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Reasons for the collapse of the Lehman Brothers

▰ The collapse of the Bear Stearns hedge funds in august 2007: This is said
to have resulted in a sharp Lehman’s stock fall as much as 48% on
concern that it would be the next.
▰ Failure to take advantage of her stock rebound during the last quarter of
2007 by trimming its massive mortgage portfolio: This was at a time
when the global equity markets reached new highs and prices for fixed-
income assets staged a temporary rebound. This in retrospect would
turn out to be its last change.

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 Reasons for the collapse of the Lehman Brothers

▰ Excessive borrowing: This resulted in high leverages which partly

accounted for the bankruptcy of Lehman Brothers. Its leverage ratio by
2007 was a whopping 31:1.
▻ This high leverage compounded the liquidity problem
▰ Reported quarterly losses: On 9thJune 2008, the firm announced a second
quarter loss of $2.8 billion since its IPO and later a third quarter loss $3.9
billion. As a result, the firm’s stock was dropping sharply in value.
▰ Excessive dependence on credit ratings by investors: Reported loss of $3.9
billion including a write-down of $ 5.6 billion
▻ Moody’s Investor Service announced that it was reviewing Lehman’s
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credit ratings and also said that Lehman would have to sell a majority
 Reasons for the collapse of the Lehman Brothers

▰ The news of failed possible takeover of the firm by Korea Development Bank:
The news that South Korean bank had put talks on hold regarding a possible
takeover of the firm was a deathblow to Lehman leading to a 45% plunge in
the stock and a 66% spike in credit-default swaps on the company’s debt. As
a result, the company’s hedge fund clients began pulling out, while its short-
term creditors cut credit lines.
▰ The refusal of the US Government to bail out the Firm and a failed takeover
between Lehman, Barclays PLC and Bank of America: Theses were key events
that set the tone for Lehman’s eventual collapse.

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Contagion effect of the collapse of the Lehman Brothers to
the governance of corporation in the world.

▰ The collapse of Lehman Brothers and the wake of financial crisis of 2008-09
pushed to the top of the agenda a number of questions about key functions of
corporate governance, particularly in the areas of risk management and executive
compensation.
▰ The G20 has recognized that one of the causes of the financial crisis was the poorly
designed executive compensation packages that lead to excessive risk taking.
▰ Lehman bankruptcy resulted in multilateral and national corporate governance
reform efforts identified specific areas of corporate governance requiring reform. In
particular, the reform efforts focused on:

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 Contagion effect of the collapse of the Lehman Brothers to
the governance of corporation in the world.

▰ Positioning risk management as a key board responsibility:

▻ Risk management procedures designed for boom times may not be suitable
for recessionary periods and vice versa.
▻ Differing economic conditions require different management responses. It
has become clear that in some institutions risk oversight has become
technical and fragmented, managed more on a product or a division basis and
not on an enterprise basis.
▻ As a consequence in some organisations risk management had little effect on
board decisions. Risk managers were often separated from management and
strategy. This had to change and new ways of thinking about risk at board
level needed to be developed. 9
 Contagion effect of the collapse of the Lehman Brothers to
the governance of corporation in the world.

▰ Encouraging remuneration practices that balance risk and long-term performance

criteria.
▻ Strong international consensus about the role of pay practices in creating
counter-productive incentives and excessive risk-taking, a number of
jurisdictions responded rapidly by putting in place restrictions on executive
compensation at financial institutions.
▻ Compensation incentives should be based on performance and should be
aligned with shareholder interests and long-term, firm-wide profitability,
taking into account overall risk and the cost of capital.

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Contagion effect of the collapse of the Lehman Brothers to the
governance of corporation in the world.

▰ Role of institutional shareholders: Institutional investors come under the spotlight to

a considerable degree with criticism that they have not exercised their ownership
duties diligently following the Lehman collapse.
▰ Role of the non-executive director (NED): The role of the NED in ensuring good
corporate governance came under sharp focus following the collapse of Lehman
Brothers. Certain areas required further review for example,
▻ Understanding the culture within a company was found to be critical for NEDs
as executive directors will operate with a host of unspoken assumptions and
the culture within a company will impact the company’s risk profile, and;
▻ Challenging data sources in areas such as risk management and
compensation. There is a growing market expectation that NEDs will question
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whether existing board information sources are sufficiently varied and
Contagion effect of the collapse of the Lehman Brothers to
the governance of corporation in the world.

▰ Additional corporate governance issues: While the boards are primarily

responsible for the weaknesses and failures of risk management and incentive
systems, other aspects of the corporate governance framework also play a role.
These include credit rating agencies (CRA), regulatory frameworks and
disclosures. In each case though, boards and companies can use their own
powers to overcome the evident weaknesses,
▰ Rating agencies: These can mislead but also can be misused by some. In regard
to the collapse of Lehman Brothers, CRAs assigned high ratings to complex
structured subprime debt based on inadequate historical data and in some cases
flawed models. As investors realised this, they lost confidence in ratings and
securitized products more generally
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Contagion effect of the collapse of the Lehman Brothers to
the governance of corporation in the world.

▰ Disclosure improvements: That good corporate governance requires high

standards of both financial and non financial disclosure.
▰ The International Auditing and Assurance Standards Board (IAASB) has
considered the lessons learned from this bankruptcy and, where necessary has
enhanced the guidance for audits of valuations of complex or illiquid financial
products and related disclosures.
▰ The regulatory framework: Good corporate governance requires appropriate
supervisory, regulatory and enforcement authorities. The experience after the
collapse of Lehman has broadly confirmed their importance.

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Possible violation of principles of corporate governance

▰ Disclosure and transparency: The governance of the Lehman Brothers was not
adequately transparent to its shareholders and other relevant stakeholders and
market participants. The financial reports were always covered up for investors.
▰ Board oversight of risk: The board did not possess a comprehensive
understanding of their institutions’ risk profile hence judged inappropriately.
▻ They placed excessive reliance on internal advice and did not arm
themselves with external, potentially contrary opinions.
▻ Majority of decisions that Lehman Brothers took were not out of ordinary.
However there was a gross failure in terms of relating the decisions to their
risk bearing capacity.
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Possible violation of principles of corporate governance

▰ Remuneration and alignment of incentive structures: Good governance practice

requires that boards should strive to align executive and board remuneration with
the longer-term interests of the company and its shareholders.
▻ However, the Lehman executives were seen to “reach for short-term yield” at
the expense of long-term firm stability and value.
▻ In some cases, the relatively high proportion of variable pay comprising
remuneration packages required the firm to issue bonuses even when the
business was not profitable.
▰ Shareholder engagement: According to good corporate governance practice,
shareholders have a number of basic rights and obligations. These include the
right to make key corporate decisions, and the right to obtain information about
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the company in order to inform their decision making and prevent management
Possible violation of principles of corporate governance

▰ Shareholder engagement: According to good corporate governance practice,

shareholders have a number of basic rights and obligations.
▻ These include the right to make key corporate decisions, and the right to
obtain information about the company in order to inform their decision
making and prevent management from taking decisions that are contrary to
their interests. This was however not the case with Lehman Brothers.

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Corporate governance structure, mechanism and
procedures that would have saved Lehman Brothers

▰ Board composition: A good corporate governance structure requires ensuring

effective leadership by the board chairman and the CEO, appointing experienced
non executive directors (NEDs), and assigning key tasks to board committees
composed of a majority of NEDs.
▰ The board committees must relate to key areas of the organization including
risk management, auditing, remuneration, and nomination.
▰ The board risk committee should have been responsible for risk governance and
should have ensured that the organisation develops and executes a
comprehensive and robust system of risk management.
▰ The Lehman board put more emphasis on maximizing returns without realizing
that risks and returns are directly related.
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Corporate governance structure, mechanism and
procedures that would have saved Lehman Brothers

▰ Board competence: It was very important for the Lehman board to be well
equipped with banking and financial experience. The board should have their
performance evaluated and be held accountable to appropriate stakeholders.
▰ Rotation of Lehman Brothers’ External Auditors. It is evident that Lehman Brothers
had appointed Ernst and Young as their auditor since 2001 till the time the
institution collapsed, this leads to the issue of self-review by the auditor and thus
this compromises the audit opinion the auditor is likely to give.

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Corporate governance structure, mechanism and
procedures that would have saved Lehman Brothers

▰ Monitoring by Regulatory bodies: Effective and constant monitoring by regulatory

bodies could have also prevented Lehman Brothers’ bankruptcy. The firm was
said to have increased its Repos 105 transactions few days prior to the reporting
period and borrowed to buy back immediately after the reporting period. A critical
audit of quarterly financial statements could have revealed the unethical
treatments of Repos 105 and the quality of the Firm’s mortgage portfolio. The
inability of the regulatory bodies to detect this indicated that proper auditing was
not done.

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The collapse of the U.S. housing market.

▰ The United States housing bubble was a real estate bubble affecting over half of
the U.S. states. Housing prices peaked in early 2006, started to decline in 2006
and 2007, and reached new lows in 2012.
▰ The collapse certainly didn't happen overnight, but loud rumblings started to
occur as subprime mortgages, those made to consumers with less than perfect
credit became 20% of the market in
▰ Pools of mortgages used for investments were defaulting, and institutions such
as Lehman Brothers and Bear Sterns that underwrote, owned and sold many such
investments saw drops in value so great they not only had to shut their doors but
also brought down others.

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