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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References:

1. Bebchuk, A. Lucian. and Cohen, Alma. ( 22 November 2009) ³ The Wage

Failure: executive compensation at Bear Stearns and Lehman 2000 ± 2008´(

Working Draft)

2. Dowd, Kevin. (winter 2009) ³Moral Hazard and the Financial Crisis´, ³Cato

Journal´ (Vol. 29, no. 1)

3. Ertuk, Ismail. and Solari, Stefano. (1st September 2007), ³Banks as

Continuous Reinvention ,́ ( The New Political Economy)(12:3,369-388)

4. Ertuk, Ismail. , Engelen, Ewald. , Froud, Julie. , Leaver, Adam. and Williams,

Karel.(November 2008), ³Financial Innovation: frame, conjuncture and

bricolage´ ( CRESC working paper series, working paper no. 59)

5. Godechot, Oliver. ³ Hold-Up in finance: the conditions of possibility for high

bonuses in the financial industry´

6. Haldane, G. Andrew. (April 2009) ³Rethinking the Financial network´

Speech delivered at the Financial Student Association, Amsterdam.

7. Goch, Lynna. (1st august 1999), ³ Tailored to suit´ ( Best Review Property ±

casualty insurance edition. BRPC)

8. Minsky, P. Hyman. (may 1992) ³ The Financial Instability Hypothesis´

working paper No. 74, ( hand book of radical political economy)

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:

distance, incentice and defaults´, University of Chicago working paper

12. Sanford, C. 1996, 2 Managing the Transformation of Corporate Culture: Risk

and Rewards´ in 1996 ± 1997 Musser ± Schoemaker Leadership lectureseries

st the Wharton School, University of Pensylvania.

13. ³Shareholders Instil Profit Motive At Major Banks´, Retail banker

international, Ret Bin (31st October 2003)

14. Shiller, Robert J., 2005 ³ irrational Exuberance´, Princeton university press

2nd edition

15. ³A Special Report on the International Banking´ the Economist ( 19th May

2007)

16. Zingales, Luigi. (6th October, 2008) ³Testimony of Luigi Zingales on causes

and effects of the Lehman brothers bankruptcy´ before the Committee on

Oversight and Government Reform, United States House of Representatives.

Lehman Brothers and the global recession of sub prime mortgage

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