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The crisis that swept across the world's financial system from 2007 to 2009 caused many casualties. Some of the financial institutions were merged; some were sold while others were declared bankrupt. Lehman Brothers Holdings Inc. fell victim of this crisis and was declared bankrupt on 15th September 2008. The crash shocked the world's financial system.
In this paper, the causes and impact of Lehman's fall is exposed. The bankruptcy report revealed the fraudulent and manipulative practices that went on in the financial system. Neglect of regulatory responsibility of government and other parties is ingredient to the collapse of Lehman is discussed. Some sober lessons from Lehman's collapse are proffered so that corrective measures can be taken against future crisis.
The world witnessed one of the greatest upheavals in its financial system between 2007 and 2008 1 leading to the crashing of many financial institutions and affecting a large spectrum of investors, particularly in the US. This crisis was preceded by a credit bubble which started about year 2001 when the traditional banks and the "shadow banks" developed high profit propensity in their business. Within that period the housing bubble also came into play (Swedberg 2009) However by 2007 the housing market began to suffer setback which spread to the whole financial system bringing down one of the big US mortgage banks.
As the days went by other financial institutions began to show cracks in their businesses especially those that were neck deep in the housing business. Many of the institutions especially small finance houses went bankruptcy, some merged. On March 16, a major investment bank Bear Stearns was bought by JP Morgan Chase so as to save it from bankruptcy. After the fall of Bear Stearns, the housing market continued to decline affecting many more securities including Lehman Brothers Holdings Inc.
THE COLLAPSE OF LEHMAN BROTHERS
Rechard swedberg provided a detailed account on the listing of Lehman Brothers Inc. He said that Lehman Brothers started life as a dry goods business in Alabama in 1844 and later metamorphosed in to becoming an investment bank in 1994, running deep into the new financial market and becoming a leader in the sub prime securitization market. It owned two mortgage firms, BNC in California an Aurora Loan services in Colorado. Lehman's foundation began to show visible signs of cracking when the housing market contained to decline in 2007 and Lehman got struck with mortgage bonds and it could no longer service. To salvage the situation, Lehman went into the commercial real estate business which unfortunately landed it into more bad debts. After the fall of Bear Stearns on March 16, 2008. The position of Lehman became worsened by the drastic fall of its shares and its collapse became imminent. There were many attempts to sell Lehman before the collapse particularly by Warren Buffett, Morgan Stanly, Goldman Sachs and Bank of America but they were turned down. The last hope to buy Lehman came from korea Development Bank on September 10, but that hope later disappeared.
The weekend of September 13-14, which preceded the bankruptcy filing, saw series of meetings held to decide the fate of Lehman. Hopes initially were high that the state would come to the rescue as it would not such a big financial house to collapse. Examples of such state intervention in the past, on Bear Stearns, Freddie Mac and Fennie Mac ( Swedberg 2009) raised that hope. Unfortunately many personalities were against a bailout, including Bus and the Presidential Candidates Obama and McCain and Nancy Pelosi, the speaker of the House. During that weekend, there were last minute attempts to sell Lehman to Bank of America or Barclays Bank but they ended in futility. Harry Miller, Lehman's bankruptcy lawyer was asked to arrange for the bankruptcy and which he did and made public on Monday, September 15. Miller who did not favour the bankruptcy filing said that Lehman's collapse would have disabling effect on the global financial system.
This paper examines the Lehman Brother's bankruptcy report and other information sources regarding the Investment bank's collapse to determine why such a high rated organization could collapse. The work is considered under the following: Impact of Lehman' fall; Causes of Lehman's fall; Highlights of the Court proceedings, and Lessons to be learnt from the collapse.
CAUSES OF THE FALL
Many views have been adduced as to the man's causes of Lehman's collapse. First is the subprime mortgage crisis. Lehman adopted a new business strategy, in 2006 of investing into commercial real estate (CRE) which generated higher profit but with high risk equity-like investments where illiquid assets which are usually different to sell in crisis period. Lehman intensified that strategy even in the face of the mortgage crisis through its subsidiaries, BNC mortgage Inc. and Aurora Loan services. Lehman felt that the mortgage crisis would not spread further than it had done. And even if the crisis continued, it would adopt its previous successful strategy of continuing its business in a depressed market (Valukas 2010), unfortunately that strategy was a wrong conception of the severity of the mortgage crisis and its damaging effect (846) on Lehman's other businesses. (Valukas 2010). Another cause of Layman's problem was its disregard of the warnings by its risk management officers to reconsider its business growth strategy of continuous acquisition of risky and illiquid investments and pay regard to the risk policies and risk limits of the company. The examiners report stated that Layman had a well established risk management personnel it would relied of regarding issues of sound business discussions (Valukas 2010). The report also stated that similar working was given by the office of Thrift supervision and Mordy's Investor Services but they were not heeded to. Although Layman's management and board were receiving stress tests report on monthly basis but they excluded reports on the commercial real estate investments. Its private equity investments and leveraged loan commitment.
Therefore It could not detect the losses being incurred in those business not detect the mounting illiquid investment burden. Another cause of Lehman's failure was the flagrant abuse of its balance sheet regulatory limit. And to avoid the penalties of the credit rating agencies, Lehman introduced the Repo 105 transaction's strategy which allows it to remove some assets temporarily off the balance sheet shortly before the reporting periods thereby reducing its net leverage. Table 1 shows the effect of the use of the Repo 105 at the fourth quarter ended of the 2007, first quarter ended of 2008 and second ended of 2008.
Table 1: The Effect of Repo 105 Usage on the Net Leverages.
Repo 105 usage
Reported net leverage
Net leverage without Repo 105
Source: Valuka's report on Lehman Brothers Holdings Inc., of the bankruptcy proceedings at United States bankruptcy court Southern District of New York.
The actions of the auditing firm, Ernst & Young in the affairs of Lehman's business was depressingly sad. The auditors could not warn on the damages of Repo 105 even after one of the Lehman's senior officers alerted her of the inappropriateness of Repo 105. Another cause of failure was that the auditors did not employ the fraud detection tools to alert the management and the board early enough that Lehman was running into bankruptcy. An analysis of 2007 and 2008 Lehman's financial statement as shown below revealed a very high propensity to bankruptcy.
2.1 TOOLS AND TECHNIQUE OF FINANCIAL STATEMENT ANALYSIS
Lehman brother's 2007 and 2008 financial statement would be analyzed to identify the financial strength and weakness of Lehman brother filing bankruptcy. This would be achieved through establishing a proper relationship between the variable s of the balance sheet and income statement. Various techniques and tools are implored in analyzing financial statement. However, only Altman Z-Score bankruptcy model and ratio analysis would be used in this work.
2.1.1 ALTMAN Z-SCORE BANKRUPTCY PREDICTION MODE
The Altman Z-Score which uses statistical techniques to predict a company's probability of failure was propounded by Edward Altman in the early 60's . this was achieved using five financial ratios in multiple discriminant analysis; using eight variables from company's financial statement (creditguru 2010). Table 1 below shows the variables obtained from Lehman brothers consolidated financial statement for the year 2008 and 2007 respectively. The Altman Z-Score proposed the following interpretations:
Z-Score above 3.0 - the company is considered save base on the financial figures only.
Z-Score between 2.7 and 2.99 - the company should be on alert and exercise caution.
Z-Score between 1.8 and 2.7 - a good chance of the company going bankruptcy within two years of operations from the date of financial figures given.
Z-Score below 1.81 - highly probability of bankruptcy.
Table 2: values obtained from Lehman brothers unaudited consolidated financial statements three months ended 31st march 2007 and 2008.
In million, except share data
Income Before Tax
Using Altman Z-Score equation;
Z-Score = 1.2(working capital/total assets) + 1.4 (retained earning/total assets) + 3.3 (income before tax/total assets) + 0.6 (total equity/total liabilities) + 1.0 (total revenues/total assets) -------------------------------------------------------- equation 1.
Now, for the year 2008
Working capital = current assets - current liabilities
= 269,400 - 384,731
Total assets = 639,432
Retained earning = 16,901
Income before tax = 3,424
Total equity = 26,276
Total revenues = 18,610
Total liabilities = 613,159
Substituting in equation. -------------------------------------------------------1
Z-Score2008 = 1.2(-115,331/639,432) + 1.4(16,901/639,432) +
3.3(3,424/639,432) + 0.6(26,276/613,159) +
= 1.2(-0.18) + 1.4(0.03) + 3.3(0.01) + 0.6(0.04) + 1.0(0.03)
= -0.22 + 0.04 + 0.03 + 0.02 + 0.03
= - 0.1
ïœ Z-Score 2008 = -0.1
Now, for the year 2007
Working capital = current assets - current liabilities
= 313,129 - 435,714
Total assets = 691,065
Retained earning = 19,698
Income before tax = 3,578
Total equity = 22,490
Total revenues = 29,374
Total liabilities = 668,573
Putting in the equation --------------1
Z-Score2007 = 1.2(-122,585/691,065) + 1.4(19,698/691,065) +
3.3(3,578/691,065) + 0.6(22,490/668,573) +
= 1.2(-0.18) + 1.4(0.03) + 3.3(0.01) + 0.6(0.03) + 1.0(0.04)
= -0.22 + 0.04 + 0.03 + 0.02 + 0.04
= - 0.09
ïœ Z-Score 2007 = -0.09
Technically, the test result in each case for the two years (2007 & 2008) financial statements of Lehman brothers indicates that Z-Score 2008 & 2007 obtained are less than 1.8. This practically shows that there exists high probability of bankruptcy ever before Lehman filed chapter 11 bankruptcy on September 15, 2008.
2.1.2. FINANCIAL STATEMENT RATIO ANALYSIS
The financial Ratio analysis is the use of variables or data obtained from financial statement to provide a basis for comparison. This financial tool will be used to evaluate the overall financial conditions of Lehman. Financial ratios enable shareholders, stockholder or even potential investors to gauge the viability, liabilities and future performance of the company. If proper implored this should have helped the owners of Lehman brothers to identify and quantify the strength and weakness, evaluate its financial position and understand the risk it may be facing in the near future. Amongst several financial ratios available the under listed which includes Liquidity ratio, Profitability ratio and Leverage ratio would be utilized for the purpose of this work to analysis two years financial statement of Lehman.
Table 3: Variables obtained from the Lehman Brothers financial statement as at 2007 and 2008 financial year.
In million, except share data
Total Current Assets
For the period of March ended 2007
Current Ratio = 313129/435714 = 0.7187 * 100 = 71.87%
Quick Ratio = 12743/435714 = 0.0239 * 100 = 2.93%
Working capital Ratio = 313129 - 435714 = -122585
For the period of March ended 2008
Current Ratio = 269409/384731 = 0.7003 * 100 = 70.03%
Quick Ratio = 13031/384731 = 0.0339 * 100 = 3.39%
Working capital Ratio = 269409 - 384731 = -115322
Table 4: The result Analysis of liquidity ratios for the period 2007 and 2008
current assets - current liabilities
current assets / current liabilities
Cash/ current liabilities
The computed result of the liquidity ratio from Lehman financial statement before the bankruptcy filing in 2008 as shown in table 4; above indicates that the working capital ratio is less than one in each case. This reflects the increase in the current liabilities and high burden of debt financing. Also the debt maturity of Lehman will be difficult to meet due to the decrease incurrent ratio within the period under review.
2.1.4 Profitability Ratio
Table 5: Variables obtained from the Lehman Brothers financial statement as at 2007 and 2008 financial year.
In million, except share data
Now, for the period of March ended 2007
Profit ratio = 19647/29374 =0.6689 * 100 = 66.89%
Net Profit ratio = 2385/29374 = 0.0812 * 100 = 8.12%
Asset revenue ratio = 2385/691065 = 0.0035 * 100 = 0.35%
Net Equity revenue = 2385/22490 = 0.1061 * 100 = 10.61%
Also, for the period of March ended 2008
Profit ratio = 17405/18610 =0.9353 * 100 = 93.53%
Net Profit ratio = 2408/18610 = 0.1294 * 100 = 12.94%
Asset revenue ratio = 2408/639432 = 0.0038 * 100 = 0.38%
Net Equity revenue = 17405/26276 = 0.6624 * 100 = 66.24%
Table 6: The result Analysis of Profitability ratios for the period 2007 and 2008
Total Profit /sales
Net profit ratio
Net Profit/Total asset
Net Equity Revenue Ratio
Net Profit/Net Equity
2.1.5 Leverage Ratio
For the year 2007;
Liabilities / Asset Ratio = 668573/691065 =0.9675 * 100 = 96.75%
Equity / asset Ratio = 22490/691065 = 0.0326 * 100 = 3.26%
Liabilities / Equity = 668573/22490 = 29.73 * 100 = 2972.8%
Now, for the year 2008;
Liabilities / Asset Ratio = 613156/689432 = 0.8894 * 100 = 88.94%
Equity / asset Ratio = 26276/689432 = 0.0382 * 100 = 3.82%
Liabilities / Equity = 613156/26276 = 23.34 * 100 = 2333.53%
Table 7: The result Analysis of leverage ratios for the period 2007 and 2008
Liabilities / Asset Ratio
Total Liabilities / Total Asset
Equity / asset Ratio
Total Equity / Asset
Liabilities / Equity
Liabilities / Equity
Source of Data: Income statement and Balance Sheet, Lehman Brothers: SEC Form 10-Q 2008 and 2007 Financial Statement. See Exhibit 1 on the Appendix Below
EFFECTS OF LEHMAN'S FALL
Effects of Lehman's bankruptcy were considered the largest ever in US history with the sum of $613 billion at stake. Lehman also had up to eighty subsidiaries suggesting that the effect of the fall was going to spread across the globe. This substantiated by the volume of claims, numbering up to 20,000 which were filed against Lehman bankruptcy court. The collapse spread over to Japan, Scotland, Iceland, England, HongKong and many other countries. For example the loss by Japan's banks and insurance companies was said to be in the magnitude of $2.4 billion. Table3 shows the effect of Lehman's fall on Asian's stock performance.
Table 3: Before & after Lehman Brothers bankruptcy - Asian Stock Performance.
Lowest after 12-Sep-08
Source: Japan Securities Depository Center, Inc.
Another effect of Lehman's collapse was the fear of disintegration of the whole financial system leading to withdrawal of up to $400 billion by nervous investors. To stem the tide some financial activities such as the money repo and interbank markets were frozen. This fear also led to the loan were getting to difficult to obtain car loan, student loan and industrial drive to rescue the remaining investment banks and A/G whose collapse was imminent. For example Goldman Sachs and Morgan Stanly status were changed from investment banks to bank holding companies (Swedberg 2009) to enable the two banks have access to Fed's lending facilities. The implementation of the Troubled Asset Relief Program (TARP) with an injection of $700 billion to rescue the whole financial system was an aftermath of the Lehman's fall and it was meant as Paulson said to restore confidence within the financial system.
4.0 LESSONS LEARNT FROM LEHMAN'S COLLAPSE
The collapse of Lehman brothers and the global disruptions it brought with it was unimaginable. Many people could not believe that such age-old firm that had survived numerous great shocks such as two world wars, with the great depression and with numerous subsidiaries world wide and dealing in hundreds of billions of dollars could crash. But the great lesson learnt is that no organization is too big to collapse. Unless a business organization obeys the rule of business, its existence could be shaky. The management and leadership assessment of Fuld, Lehman's Chief Executive Officer was not very impressive. He was said to have very strict autocratic management style and brutal in dealing with threats.
Fuld's knowledge of modern financial instrument such as collaterized debt obligations (CDO) and credit default swaps (CDS) is said to be limited having the background of bond trading. This limitation could explain why his handling of the crisis situation Lehman found itself was clumsy and unprofessional. For example his investing deeply in commercial real estate when the housing market was dwindling was due to lack of insight and his inability to relate the financial crisis with the downturn in the housing market. Also when it was apparent that Lehman' collapse could not be avoided, Fuld defied an advice by Paulson, secretary of the Treasury, to find a buyer for Lehman. He did not appreciation the seriousness of the crisis Lehman was into, (Swedberg 2009).
The Lehman's brankruptcy report revealed that Lehman had adequate risk management structure which indeed warned both the management and the Board, through its regular report, of the dangers embedded in some of Lehman's investment but those warnings were ignored probably due to the uncompromising leadership style of Fuld and the lesson here is that the views and expertise of non- management staff in any organization should be respected. The role of oversight and regulatory agencies particularly SEC in Lehman's business performance was subjected to much criticism. Paulson, Treasury Secretary; Bernanke Fed Chairman; Geithner' President of the Federal reserve Bank of Ney York (FRBNY) and Cox, SEC chairman were heads of the various agencies when Lehman was going through the crisis. Each of the heads had some role to play on the affairs of lehman and were said to be concerned about its future and if it went bankruptcy they were worried what affect it would have on the US economy. The concern was intensified after Bear Stearns hit the rock. These heads opened regular lines of communication. The SEC and FRBNY stationed their staff at Leheman to Monitor its state of affairs. At some point Lehman was advised to seek for a buyer to save her from bankruptcy.
However fuld was reluctant to sell Lehman at the time. Most critism went to SEC which had the primary regulatory responsibility over Lehman. SEC was said not to have carried out that responsibility adequately. Instead it left Lehman to operate unauspiciously. SEC know that Lehman was operating beyond its risk control limits. It also knew that Lehman was manipulating its balance sheet so as to lower its leverage and give the impression of a healthy organization. Yet SEC took no definitive action (Valukas 2010). Another area where Lehman deceived the public was in its liquidity situation, tha is its ability to meet shortterm obligatios. For example, just three months before the bankruptcy announcement Lehman declared publicly that its liquidity pool was $45 billion and on th 10th September, 2008, five days before the bankruptcy , it declared that it had $41 billion in liquidity. But by 12th September when through assessment was carried out it was found that Lehman has about &1.4 billion liquidity which was not even enough to transact a day operation.
The sad thing was that SEC did not know this true situation about Lehman because its enforcement was weak. The lesson learnt in this experience with Lehman is that regulatory and supervisory agencies charge with the responsibility of enforcing certain laws or policies should not shrink in their duties because such negligence could cause huge losses to individuals and even to an entire nation.
Lehman,s fraudulent and misleading tendencies were brought to the fir at the bankruptcy proceedings. For example in the stress-testing exercise which Lehman was required to maintain so that its level of risk-taking would be periodically evaluated Lehman, in subjection itself to the test excluded its high risky commercial real.
5.0 EXAMINATION OF LEHMAN' COLLAPSE
After Lehman collapse and the declaration of bankruptcy by Hary Miller, Lehman's bankruptcy lawyer on 15th September, 2008 the US trustee was directed by the US Bankruptcy Court for the Southern District of New York to appoint an Examiner to look at the circumstances surrounding the collapse of Lehman. Anton R. Valukas was appointed as the Examiner on 19th January, 2009.
The task no doubt was daunting considering the size and complexity of the Lehman's organization. The examiner started with data collection and carefully selected materials which would help in the inquiry. Materials collected and reviewed were said to be equivalent to 34 million pages, which were converted electronically, (Valukas 2010). The reviews were carried out by contract attorney and professionals.
The Examiner's report of the difficulties encountered in accessing the p6 most relevant systems which were held by Barclays and the non-standardized form of Lehman's system call for sympathy and commendation, (Valukas 2010). At the end the 2209 pages of the bankruptcy report presents a masterpiece and an excellent reference material for the financial system.
The process of interviewing the witnesses was informal excluding all the oath taking and transcription which has the disadvantage of the witness not being open or cooperative. The witness was also given prior notice of the topics to be considered at the court so that the witness would have enough time to reflect on the topic and be fully grounded on the issues. About 250 witnesses were interviewed during the proceedings, (Valukas 2010). The examiner expressed satisfaction at the level of cooperation received from government and other parties especially with SEC.
The bankruptcy proceeding with its 2209 pages report to determine why Lehman collapsed was really a humbling experience. The stories have brought out clearly the flaws in the financial system. Most prominent in those flaws were the flagrant abuse of the financial system rules for the pursuit of high profits, culminating in the contrivance of unending financial innovations. Some of the innovations lacked transparency giving rise to manipulations and outright deception. Lehman's fall could not have been prevented because it stretched its business operation beyond the realms of sanity. Its misjudgment of the downward slide of the housing market thereby accumulating high illiquid assets; its introduction of the palliative and self-serving repo 105 model for the manipulation of its balance sheet and the unethical and uncooperative postures of Fuld, Lehman CEO, all portent failure for the 158 year-old conglomerate.
Although the decision not to rescue Lehman was considered a big mistake, the lesson learnt by collapse would guide the government and other regulatory bodies to infuse more sanity and introduce better monitoring procedures in the system. Besides the remaining banks that survived the turmoil would now be prepared to operate by the rule having seen the consequences of bad business. It is hoped that confidence which was eroded during the crisis would be restored and the tightening of the measures to forestall any future disruptions in the financial system would not be too hard as to strangle the general economic activities in the US and globally.