Introduction: (Background)
The Lehmen Brothers was created when Henry Lehmen migrated from a small town in Germany called Rimpar to Montgomery Alabama. The business centred around trading dry goods, groceries, and utensils. Henry Lehmen’s two brothers, Emanuel and Mayer, joined the business in 1850. When the brothers joined Henry, The business’s name was change to Lehmen Brothers. Five years later, Henry Lehmen died because he suffered from the yellow fever. Emanuel and Mayer Lehmen continued in the business. The two brothers managed the business for forty years. Later on, the company moved from trading dry goods, groceries, and utensils to trading of cotton. The Lehmen Brothers merged with a cotton farmer named John Wesley Durr. The merger boosted their performance as they were competing with the top players in the cotton market. The lehmen brothers continued by establishing a huge warehouse, which ended up developing the business. Nonetheless, Lehmen Brothers developed a reputation in the financial sector when they established an office in New York in 1858. The establishment of the office in new york shows the evolution of Lehmen Brothers. In 1861, the civil war started in the United States. The civil war disrupted Lehmen Brother’s progress because it destroyed both the economy and the crops (which are in the south). When the war ended, the Lehmen Brothers continued to develop and became a commodity broker in cotton. By 1870, the Lehmen Brothers was one of the significant players in the foundation of New York Cotton Exchange and the first commodities futures trading venture. Moreover, the Lehmen Brothers also became an important player in the Coffee Exchange and Petroleum Exchange. As time passed, the last family member left the company. In 1994, Lehmen Brothers went public through an initial public offering. When the Lehmen Brothers joined the New York Stock Exchange, they shifted from trading cotton to merchant banking. At the time, Richard Fuld was the CEO of Lehmen Brothers. Lehmen Brothers were taking excessive risk to gain great returns. Lehmen Brothers established themselves in Wall-street. The Lehman Brothers nature of business was to ease the fund flow from suppliers of funds to users of funds, ergo Lehmen Brothers is considered an intermediary between investors and business. Some of the services that the Lehmen Brothers provide are advisory services, management of assets, investments and equity, giving loans, and trading financial instruments and securities. The Lehmen Brothers’ operations are classified into three categories. The three categories are capital management, investment banking, and investment management. In this paper we will discuss how Lehman Brothers the company that survived the cicil war and two world war collapsed.
The core problem
There are many causes that lead Lehman Brother to collapse. The major cause of their collapse is
the subprime mortgages. Housing boom was in full constrain during the mid-2000s, and Lehman
brothers like numerous other firms, were getting to be increasingly intensely included in
issuing mortgage-backed securities, MBSs, and collateral obligation commitments, or CBOs.
However Lehman took it to the another level between 2003 and 2004 by amplifying into loan
originating – obtaining, among three other loan specialists, BNC Contract and Aurora Loan
Services- both of which specialized in subprime loans. The reason that permit Lehman Brother to
extend these loan that they said that as long as the subprime mortgages is very risky and it might
default, increasing prices of mortgages will repay for any losses through remortgages. Mortgages
market stated to crash in 2006, because of adjustable interest rate. Customers were mixed by the
opportunity to own houses despite their low credit scores offered at first. However, these
borrowers were challenged with many difficulties when rates were becomes higher. Borrowers’
capability to refund their loans were challenged because the floating rates were relatively
higher than rates they were paying before on their loans. Lehman Brother took benefits of the
high returns of the subprime mortgage market, securitized the subprime mortgages portfolio
and sold them to hedge fund and investment bank who thought they could benefit from high
returns. At the end of year 2007, the firm began net income is nearly $4.2 billion. However, in
the last quarter of 2007, the stock price value increases to $86.18, and the total market cap of
$60 billion. Suddenly, the unexpected crash happened and the mortgages price began to
decrease. The higher interest rate resulted in a huge default, and with the low prices of housing,
Lehman Brother made vary high losses in the world. The Firm’s problems were associated by
the loss of trust from investors including investment banks and hedge funds. Another
cause that lead Lehman Brothers to collapse is the inefficient management and inability to make precise prediction into long term investment. Lehman Brothers expected that the
mortgage prices will increase or remain the same, however it is decreased. The bankruptcy of
Lehman Brother is due to the excessive borrowing resulting in high leverages. The high
leverages has a pressure on the firms liquidity and with the default of subprime mortgages, the
liquidity problem has raised. Lehman Brothers raised preferred stock that is worth $4 billion to
lower the leverage and boost confidence in the firm. As investor confidence was built, it was
short, and hence the stock price began to decline again when the valuation of the firm’s
mortgage portfolio was asked by hedge funds. The high leverage and its negative impact, and
the stock price caused to Lehman Brother collapse. Lehman Brothers decided to use Repos105
and Repos108 transactions, which caused the bankruptcy of the firm. Repos105 indicate that
the money they get is less than the assets being sold with 5%, while Repos108 denoted that the
cash they received is less than the assets being sold with 8%. There were many symptoms during the time that Lehman Brothers were operating, the symptoms could be seen outside the firm and in the firm’s financial statements. The first symptom could be detected on the 21st of February, 2003 when Warren Buffet who is an american investor and speaker wrote to his shareholder saying “”In our view, however, derivatives are financial weapons of mass destruction, carrying dangers that, while now latent, are potentially lethal.” Hence, Buffet sensed the danger of mortgage-backed securities and other derivatives. The second symptom was in June 2004. Housing Prices were off the charts, so the Federal Reserve Chairman started raising interest rates to slow the market. Two years later, the interest rate reached 5.25%. As the rates increased, demand decreased thus the home prices fell. People started to default because their homes were worth less than what they were paying, they could not put their homes up for sale, and they could not pay the mortgages because of the increased interest rates. The third symptom was when Dr. Raghuram Rajan was chief economist at the World Bank in 2005. He presented a paper entitled, “Has Financial Development Made the World Riskier?”. Rajan’s research stated that many big banks were holding derivatives to increase their profit margins. He alerted, “The inter-bank market could freeze up, and one could well have a full-blown financial crisis.” Everyone did not take Dr. Raghuram Rajan words seriously. The fourth symptom was in December 2005 when the Yield curve Inverted. On July 17, 2006, the yield curve gravely inverted. The ten year note yielded 5.06 %, which is less than the three month bill at 5.11%. The five symptom was the fact that home prices fell for the first time in eleven years in September 25, 2006. The sixth symptom was the slowing demand of housing which decreased home permits by 28% in November 2006. Symptoms from Lehman Brother’s financial statements in the years 2005 to 2007 showed not only “Chronic inability to generate cash from operating activities”, but also massive and systematic investment in working capital items and even more concentrated investments in financial tools and instruments. Moreover, the financial statement shows systematic use of external financing to offset operating deficits, in which it mainly included long-term debt. A major indicator is the steady deterioration of cash flows over three years leading to the crisis.
The last chance for Lehman Brothers to survive was to be bailed out by the US government. The US government, fed, saved a struggling firm by arranging for it to be acquired. The firm that was saved is Bear Stearns. However, the fed refused to help out Lehman Brothers.
Why Bear and not Lehman?
Bear Stearns company is an investment bank and brokerage firm. The firm was deeply focused on the subprime mortgages. On March 2008, Bearn Stearns failed because of the financial crises and recession. The government, Federal Reserve Bank of New York, interfered and bailed out Bear Stearns from the financial crises that they were going threw. The Fed provided emergency financing to Bear Stearns because they wanted to stay away from the risks that would occur if such company would collapse. Afterwards, Bear Stearns was sold to JP Morgan Chase for $10 per share. The interference of the Fed to save Bear Stearns had ripple effects. The most dangerous effect that resulted was the over confidence of both investors and companies that the Fed will aid big investment banks if they were in trouble. The new belief that big investment firms were too big to fail encouraged the companies to take higher risk. In the same year, Lehman Brothers went threw what Bear Stearns went threw. Investors believed that the Fed will help as they did with Bear Stearns. Nevertheless, little did they know that the same thing does not apply to Lehman Brothers. The Lehman Brothers was in a bad situation, whereby their liabilities exceeds their assets (includes relestate) which is in fact full of bad mortgages. The Fed looked for alternatives to save the Lehman Brothers, however the losses were severe to the extent that any borrowings will not save them and buyer repelled from the numbers that they saw. Furthermore, the Fed did not want to fuel the idea that some companies are too big to fail. The economy at that time was not in a good state because of the subprime mortgages, so many other financial institutions may fail and ask for the Fed’s help. Unlike Bear Stearns, Lehman Brothers used Repo 105. The use of Repo 105 decreased Lehman Brothers’ liabilities by fifty billion and reduced leverage. Lehman Brothers practiced some form window dressing to improve their financial statements and make it appealing by trying to reflect a higher profit. As for the Fed, rescuing the Lehman Brothers would not have stopped the financial crises. The rescue would just decrease both the collateral damage and the panic.
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There are numerous factors that caused the demise of Lehmen Brothers.
1- Repeal of the Glass-Steagall Act
After the great depression that occurred in 1930 and continued to 1933, the Glass-Steagall Act came to existence. The Glass-Steagall Act states that commercial banks and investment banks should be separate entities. In 1999, the Glass-Steagall Act was changed. After the change, commercial banks are able to do some activities that were done by the investment banks. Hence, many commercial banks have merged with investment banks. The Lehman Brothers has acquired numerous investment and commercial banks to go head to head with commercial banks that has a high leveraged position. The immoral merging activities by Lehman introduced them to plenty of risk.
2- Subprime mortgages
The Fed has decreased the 6% interest rate to 1%, hence people started borrowing. The banks gave the borrowers loans with adjustable rates. Later on, interest rates increased. Thus, people were not able to pay back their loans. This affected Lehman Brothers greatly, whereby they suffered huge losses. Moreover, the prices of the houses has drastically declined even though they were expected to remain the same or increase. Subprime mortgages was one of the major causes of Lehman Brothers’ demise.
3-Liquidity crisis
Lehman Brother’s incapability to meet short term debt was one of the reasons that they failed. The Lehman Brothers had strong asset based, however they were having irregular liquidity issues. As a result, most banks withdrew their services and credit lines to Lehman Brothers. The market confidence is being lost. Since Lehman wasted the confidence level of lenders and customers, the bank became unattractive in the eyes of investors. To manage this challenge, Lehman Brothers decided to decrease their gross asset base $147 billion to increase their liquidity position$45 billion. However, Their strategy about liquidity redemption saw the mitigation in their commercial mortgage exposure by 20% and leverage from a factor of 32 to approximately 25.
Collateralized Debt obligation and Derivative crisis.
Lehman Brothers wanted to increase their opportunities in the real estate market, before the collapse they were notified to have compromised into sundry critical and not needed investments (Murphy, 2008). Residential Whole Loans (RWL’s) are residential mortgages that is usually traded and pooled during the process of securitization and consequently metamorphose into Residential-Mortgaged Backed Securities (RMBS) (Lartey, 2012). At May 2008, Lehman’s unified market value of RWL’s was $8.3 billion between its subsidiaries. However, Lehman did not have a strong product control process to deem for residential whole loans connected together with misstatement in assets support intensivement their positions. As at the time of filling their bankruptcy, Lehman had in its books an estimated notional derivative to the tune of $35 trillion in their portfolio (Kimberly, 2011) and held over 900,000 derivative positions globally (Valukas, 2010). These derivatives were credit default swaps; clearly, the property costs break down in the financial market through the global economic crisis driving to repossession of assets, Lehman wrote its credit default swaps (CDS) by $2.5 billion. As a result, 50% of Lehman’s CDOs evaluated at $431 billion had experienced defaults in the midst period 2006 and 2007. Financial experts and analyst debate that the turn down in the worth of CDOs significantly participated to the collapse of Lehman Brothers.
Leveraging, Lehman’s high borrowing attitude to finance their assets suffered from high leverage position. In 2007, Lehman’s leverage ratio has raised from 20 in 2004 to 44 to 1 shareholders’ equity. By inclusion, Lehman would lend $44 which was too peak to a normal leverage ratio to maintain for every $1 of cash and other available financial resources. The outcome of the global financial crisis that witness prices sliping connected with increased interest rates, Lehman’s financial position was negatively impacted them to their bankruptcy.
Complex Capital Structure
Lehman Brothers was beard with problems apropos capital structure, as a result of having to conquer with directing business in over 3,000 different legal entities. As obstacles grow due to their expansion strategy climaxing into a big growth. The growth was called to have share in to the high degree of capital structure complexity. Many of financial analysts specified this incident as a possible factor that contributed to the failure of Lehman.
Unsuccessful bail-out and takeover attempts.
Narrativizing the previous events about their liquidation, Lehman Brothers attempted a number of measures to rescue their operations. Because of their ineffective effort to dispose of some of their subsidiaries, a requirement by the enormous losses filed in 2008. The company announced losses of $2.8 billion which speeded the elimination of $6 billion worth of their assets due to the low rated mortgage tranches in their subprime position at their second financial quarter solo. The government announced not to help any financial crisis that emerged Lehman situation was worse. Lehman Brothers notified a possible takeover transaction with the Bank of America and Barclays bank, In their achievement to turn-around the future of Lehman after the government’s announcement. These take-over plan did not succeed to shape while the UK financial service authority and the Bank of England was supposed to have elected the deal to save Lehman from collapse; thus , the federal regulators in the US also withstanded a possible participation of the Bank of America in their seek for a possible take-over. Thoughtless lending practices, sighted as a hazard cutback technique.Extreme reliance on credit ratings by investors. An broad sight of markets, feigning they could auto edit themselves and an deficient estimation of the risks of deregulation, command to softer rules and regulatory violation.The blast of complicated financial products, jointly with derivatives, with shortage of liquidity and different danger features that were not clear or comprehensive. Acute stimulants and asymmetric replace designs bear up dispensable risk-taking.
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