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Transcript of Lehman Brothers and the global recession of sub prime mortgage
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³Letting Lehman fail basically brought the entire world capital market down´-
--Professor Paul Krugman
Introduction:
³Whilst financial innovation and securitisation have brought real benefits and allowed
for risk dispersion through the system, it has come at a cost´ (John McFall quoted in a press
release to accompany publication of the UK treasury committee inquiry ³Financial Stability
and Transparency´
As a result of such innovations over the past three decades the world has witnessed
over a 100 significant banking crises, no other industry in history has a parallel flair of
privatising gains and socialising losses. It could be said that to a certain extent it is the result
of this extensive innovation and securitisation that Lehman Brothers, the powerful investment
bank that had braved through several storms collapsed marking the darkest hour of the
financial crisis of 2008. The focal point of this paper is to analyse how and why the business
model of Lehman Brothers changed from 1997 to 2007. To further this discussion we will
also look at the long term and short term causes for the biggest bankruptcy in the U.S.
history.
Brief History:
Lehman Brothers originated as a family owned dry good business in 1947 from
Alabama. As the U.S. economy grew with the passage of time, through diversification the
firm also took giant strides and grew alongside it. Over the years it went through a number of
challenges and came out at the top such as the railroad bankruptcy of the 1800s to the great
depression of the 1930s and made its way through the two most devastating wars in the
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history of this planet. Through a range of mergers and accusations in 1970¶s it became the 4th
largest investment bank. The downturn of the 1980¶s severely damaged the company
financially and internally, this led to it being bought by the American express in 1984. The
newly formed company followed the Lehman legacy of rapid growth and reached to a new
height through various accusations along side with the boom of the late 1980s. But as all
good things come to an end due to severe capital shortages American express decided to
dissociate from its banking and brokerage operations, spinning out Lehman Brothers Holding
Inc. in 1994. This entity was known as Lehman Brothers the independent global financial
power house we knew.
Lehman Business Model:
³Intermediation ± taking in deposits and making loans ± which was their traditional
function, is no longer the name of the game. Commercial banks have become investment
banks and are increasingly tempted into proprietary trading ± that is, betting their own capital
at the casino. The trend can be explained by the internationalisation of finance and the
consequent break up of closed shops´ (Erturk. I and Solari. S, 2008)
The reinvention of old school merchant banking in the 1990s encouraged Lehman
Brothers to operate in its own account trading, in derivatives underwriting equity, mergers
and acquisitions advice, asset management and private wealth management.
But the traditional banking practices were not enough to sustain the profits as they
started to erode, as the U.S. investment banking turnover by over 21% in a single year
leading to massive redundancies and executive compensation in the top investment banks.
The financial innovation in securitizations markets were proving to be quiet profitable and
desirable as it generated constant high profit levels these became the main sources for
Lehman Brothers net revenues. These securitization derivatives such as Collateralized Debt
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Obligations and Credit Debt Swaps provided more trading opportunities, as banks started to
off load their risks in form of mortgage backed securities from their books and vice versa by
buying such securities in order to generate constant and long term revenue / profits. The main
objective of Dick Fuld who held the reins of Lehman Brothers Inc. from 1994 to 2008 was to
expand the companies trading arm and to overtake companies such as Morgan and Stanley,
Merrill and Goldman Sachs.
According to ³the vertical integration strategy´ (Levine. J, 2007) in 1997 bought
Harbourton Mortgage Investment Corporation, the firm specialized in buying and servicing
federal housing administration loans renaming it Aurora Loan Services Inc. since then
Lehman rapidly grew its operations in mortgage including servicing organically and by
means of a range of acquisition such as BNC Mortgage Inc., Finance America Inc, (both sub-
prime wholesale lenders) and SIB Mortgage Corporation (an alt A wholesaler). The aim of
these acquisitions was to protect and leverage the returns from the underwriting and
securitizing desks that purchased and securitised the bulk of the sub-prime alt-A loans.
In June 1998 Lehman Brothers started a subsidiary company Lehman Re Ltd. to
underwrite insurance and reinsurance risks, its main purpose was to bridge the gap between
the insurance industry and the investment banking industry while capitalizing on the
convergence of the markets. Lehman RE Ltd. provided customised services and products
such as finite and structured financial solutions; property catastrophe reinsurance and trade
credit insurance. (Goch, L. 1st august, 1999)
Lehman had also expanded into the commercial real estate which is considered to be
more risky then the residential real estate. The year 2006 witnessed a 10% increase from
2005 in securitised mortgages at $146 billion.
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The period 2004 to 2006 witnessed record revenues from the real estate operation and
an increase of 56% profit from the capital markets unit. Revenues for the company were
primarily generated by the three main segments, capital markets, investment management and
investment banking. The fact to the matter is that it was the capital market segment that
established the high and the low of the corporation, but as most of the activities were
conducted off balance sheet it was hard to pass a judgement on the contribution and
exposures from the reported accounts.
Proven irresponsible as it is another reason that encouraged or some would argue
forced Lehman to move into such risky market as the subprime and change its business
dynamics was the shareholder pressure to compete with the return of the rival investment
banks.
³In many cases, pressure on finding dynamic new executives comes from
shareholders, particularly new ones whose primary concern - unlike the charitable
foundations which used to dominate the banking sector - is profitability.´(Retail Banker
International, October 2003)
The revenue and profits were at all time high and the shareholders were happy, the
operations were functional and the corporation was the largest underwriter of commercial real
estate. Lehman Brother was at the top of its game with every one following its lead. Levine
describes the scenario in ³the vertical-integration strategy´ as ³ following the lead and
success of Lehman and Bear, other large Wall Street broker-dealers have begun acquiring
mortgage banking businesses as part of their own strategies of vertical integration in the
mortgage sector.´ If this was the case the multibillion dollar bankruptcy question is why the
investment banking giant collapsed and became an ultimate example of failure in the history
of Wall Street.
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Seeds of Crises:
It was during the real estate boom that the seeds for the recent financial crisis
the so called ³credit crunch´ were sewn. It can be easily seen in the figure (Shiller, 2005)
below the abnormal and rapid increase in the house prices which is at an average of 12.4%
per year from March 1997 to June 2006. The reason for this can be easily understood and
linked to the extraordinary low interest rates. During the real estate boom the default rates
dropped as all mortgage holders work hard to pay off their debt when the value of their home
equity increases in order to secure such asset. Not only that but with availability of innovative
mortgage services such as the investment banking firms like Lehman brothers investing in the
sub-prime market access in securing mortgages is a lot easier as the lending standards are
low in such favourable conditions.
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These mortgages were pooled together sliced and diced to form tranches
which were considered quite safe. All the mathematical models used in justifying these
activities were based on past records which do not go back as far as the last default problem
in the great depression. Nor did they take into account the fall in the lending standard. As
Rajan et al. (2008) show, a default model fitted in low securitization period breaks down in a
high securitization regime in a ³systematic´ and ³predictable´ way. These tranches were used
as commodities in the financial market and according to Nadauld and Sherlund (2008) in
their sample of 1,257 mortgage securitization deal 128 belonged to Lehman alone. Due to the
dispersion and distribution of collateralized debt obligation major investment banks such as
Lehman Brothers purchased hundreds of such tranches.
The article ³spreading the muck´ (The Economist, May 2007) argues that good times
can¶t last forever it suggests that due to such favourable conditions and availability of credit
the investment banks have become a little complacent and have rushed headlong into the U.S.
subprime lending. A European central banker expresses his views on the matter by saying
³With all the sophistication of their risk-management systems, a whole series of the most
powerful institutions in finance went ahead and made the classic errors of not watching credit
quality and overshooting.´ He also says that in their talent for complex financial innovation
balancing collateral and leverage the investment banks may back fire on them ± as well as on
the industry at large
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Over the last decade the number of Credit Default Swaps (CDS) grew and from zero
it reached $44 trillion, which is twice the size of the U.S stock market. This rapid increase in
Credit Debt Swaps among the investment banks lead to a lack of transparency in the industry.
Due to this it was difficult to understand who owned what not to mention the complex nature
of these repackaged portfolios is such that a minute variable in the predicted rate of default
may cause the value of some trenches to fluctuate from 50 cent to a dollar to zero. By the end
of 2007 Lehman Brothers had over $60 billion invested in commercial real estate which
exposed it to subprime mortgage risk as it could not subsidise it if need be not only that but it
was threaten by the collateralised debt obligation and credit default swaps as well. With the
crash of the property prices as predicted the repossessions increased eventually it declaring a
$6.5 billion loss in 2008.
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Risk of losing Share Holders:
The purpose of investment is to get return on the investment in the form of yield. The
bankers at Lehman Brothers in order to retain their shareholders started invest in high risk
tranches as risk is directly proportional in relation to yield. As far as its hedge funds were
considered they were demanded to hold only high rated securities in order to satisfy their
regulatory requirements and boost their yields. Managers of such hedge funds were well
aware of the gamble they took in investing in high rated securities but were unable to resist it
in order to retain investors in the intense competition of yield hungry customers. Another
aspect that encouraged Lehman to take such measures was the fact that all its competitors
were conducting the same activities all over the industry and if the strategy failed than every
investment bank would be in the same situation. Hence reducing the reputational costs and
may also force bailouts from the governments.
It can also be argued that the decision of taking on risky debts were a simple matter of
unethical behaviour.
Heads I Win, Tails You Lose:
The mentality of Lehman Brothers and other investment banks could not be phrased
better then the above heading taken from ³Moral Hazard and the Financial Crisis´ by Kevin
Dowd. The idea behind the irresponsible management of investment by Lehman Brothers is
argued to be its unethical behaviour towards it. The reason for such laxed approach is the
immunity from the consequences of investment. According to Peston (2008)
³Thus, if a private-equity firm or hedge fund generates a capital gain of £1bn ± and in the
boom conditions of the past few years, that wasn¶t usual ± the partners in the relevant fund
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would trouser 20 percent, or £200m. But if there was a loss of £1bn, well only the backer
would lose´
Investors are inspired by the good returns. With such compensational packages banks
like Lehman brothers use their talent and take risk on such funds especially when none of
their own funds are on the line but potential of creating colossal bonuses for themselves. The
mentioned unethical and irresponsible behaviour can be easily proven as it is accepted by
Richard S. Fuld Jr., the chief executive of Lehman Brothers himself. The passage stated is
highlights a small part of the conversation between congressman Henry Waxman and Richard
Fuld at the congressional hearing on October 6 th 2008(Dowd, 2009)
The congressman said to Fuld, ³you made all this money by taking risks with other
people¶s money. The system worked for you, but it didn¶t seem to work for the rest of the
country and the tax payers, who now have to pay $700 billion to bail out our economy.´ In
response fuld replied ³I take full responsibility for the decisions I made and the actions I
took.´
What he actually meant was that his action may have lead to the down fall of Lehman
Brothers but he did not do so knowingly so he is not to be blamed for the consequences. But
when the sensitive matter of his own came up, his remuneration he supported the
compensation system that had paid him about $350 million between 2000 and 2007.
According to him ³we had compensation committee that spent a tremendous amount of time
making sure that the interests of the executives were aligned with shareholders.´
Among all of these cases the executives in question always sneak out and get away
with it by claiming that it wasn¶t their fault, but never do they try to justify themselves by
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saying that they were doing what they always did and happen to be caught in a terriable
storm.
The above table shows the total cash inflow for the CEO and other executives apart
from their salaries.
Holdup Model:
³The problem with having innovation and ideas at the centre of your business as
opposed to, say automobiles is that your capital is made up of people rather than physical
inventory. Your assets walk out the door at the end of every day. And there is no copyright or
patent protection available to ensure that employees cannot take their ideas and talents to
another firm and start competing with you. This is especially easy on Wall Street because
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changing job often doesn¶t mean uprooting your family and leaving your friends. It simply
means walking across the street´ (Sanford, 1996)
The idea behind the holdup model is to gain leverage on an entity. Occasionally the
high bonuses, share options and the businesses practices are bargained by derivatives
managers in investment banks in exchange for their continuous services as they may have an
option to switch to a rival firm. The managers can use this offer to gain leverage over their
executives to gain certain luxuries and liberties. As the executives would never want the
firms secret to be disclosed to its rivals nor would they want a qualified derivative manager to
leave them when he/she was generating decent profits allowing the firm to gain clients.
This may also be the case in Lehman Brothers as the managers may not want top
executives to disrupt their business activity and conduction of risky operations in exchange
for high return for the executives.
High Leverage and Short Term Debt Financing:
Lehman financial policy is a vital element and catalyst in its demise. It utilised a high
leveraging strategy by taking excessive debt in order to increase its return in the market. But
the leveraged multiplied the losses as soon as the housing market took the long for told
cyclical downturn. According to regulation a commercial bank is not allowed to leverage its
equity more than 15 to 1, the magnitude of this problem was such that by the time the crisis
started the leverage ratio for Lehman Brothers was more than 30 to1 as can be seen in the
financial accounts below.
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Attempt were made to control the instability created by the high leverage by using
short term debt, as shown in the statement it financed more than 50% of the company¶s assets
at the start of the crises. Not only did Lehman take short term loan but it used this debt in
falsifying the company accounts. These short term loan are known as repos are commonly
used by firms for day to day use, where borrowers temporarily exchange their assets with
cash. According to the Valukas report Lehman used these repos to exchange its assets
temporarily which were securities inventories in exchange for cash, hence shifting its
leverage off balance sheet improving its financial conditions for its quarterly reports, by
showing these transactions as sales and not loans.
These short term loan when on low interest can prove to be quiet favourable, but
when the risk of default increases it is hard to access them. even the slightest hint of
insolvency would make the lender hesitant in renewing the loan and these speculations can be
easily turn into the truth if a few lenders step back from lending to the company same was the
case with Lehman. With uncertainty in the market for Lehman Brothers the interbank lending
stopped resulting in a cease in the cash supply of the industry and as banks rely on funds and
on each other as they are complexly interconnected due to the securitisations process Lehman
became the domino of the industry knocking every other investment bank into turmoil.
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Bailout:
The credit crisis erupted in the august of 2007 with the failure of two Bear Stearns
hedge funds as a result of which the stock for Lehman fell sharply. This was due to the fact
that Lehman was an even bigger underwriter of property than Bear Stearns and with Bear
Stearns in trouble the confidence in the survival of Lehman Brothers collapsed. Lehman
fought the speculation for about a year in which its stocks rebounded and reached new highs.
But with it high leverage and uncertainty in the market it credit supply dried up. The state
owned South Korean bank, a potential stake holder put the talks on a halt. This served as the
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final blow to the existence of Lehman Brothers after being denied bailout from the
government of the United States and Barclays Capital. It declared bankruptcy on sep 15th
2008.
Conclusion:
The collapse of Lehman Brothers is due to a number of reason ranging from the
irresponsible decisions and compensation taken by the senior executives to the favourable
market encouraging it to move into subprime mortgage. It is also due to the yield hungry
consumers and the different internal models such as the hold up. It can be blamed at the
industry as well which is cyclical in nature and also the United States government which did
bail out AIG and Bear Stearns. But the obvious short term reasons are the commercial real
estate, the high leverage and the uncertainty which pulled the life like supply of credit from
the once existing investment banking giant.
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9. Nadauld, Taylor D. And Shane M. Sherlund, 2008, ³ The Role of
Securitisation process in the expansion of subprime credit´, Ohio state
working paper.
10. Peston, R. (2008) ³We lose in greed game´ Blog posted on the BBC website
(28th march)
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11. Rajan,U,A. Seru, V.Vig, 2008, ³The Failure of Models that Predict Failure:
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st the Wharton School, University of Pensylvania.
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