The collapse of the Lehman Brothers is the story of the end of a 158-year-old institution, synonymous with the 2008 financial crisis. The collapse of Lehman Brothers in 2008 sent shockwaves through the entire global banking and financial system when the price bubble in the U.S. housing market tied to the subprime mortgage market suddenly burst. Lehman Brothers Holdings Inc. was founded in 1847 by Henry and Mayer Lehman (Lioudis, 2021). They started a small shop in Montgomery, Alabama, to sell groceries, local cotton farmers, utensils, and other commodities. They joined the Cotton exchange and later the New York exchange market to expand their business and boost their liquidity. Lehman was one of the first firms to move into the mortgage origination business, beginning in 1997. By 2003 it ranked third in lending to financial entities and was the fourth largest investment bank in the U.S before bankruptcy. The essay’s focus is to analyze the causes of the collapse of Lehman Brothers and its impact on stakeholders and the financial sector.
Timeline of the Collapse of Lehman Brothers
The decline in the mortgage market in 2007 precipitated the collapse of the Lehman Brothers. In August 2007, the firm closed its subprime lender, BNC Mortgage, eliminating 1,200 jobs in 23 locations (Sraders, 2018). Lehman took an after-tax charge of 25 million dollars and a 27-million-dollar reduction (Ball, 2018). By 2008, the subprime mortgage issue was blooming into a crisis as Bear Stearns had fallen and liquidity was scarce and growing tighter. Lehman had been particularly vulnerable; they had many low-quality mortgages left unused when creating mortgage-backed securities. On June 9, 2008, Lehman announced a quarterly loss of 2.8 billion dollars and was forced to sell off 6 billion dollars in assets (Lioudis, 2021). Lehman’s stock dropped, announcing it would cut a percentage of its workforce before the third quarter reporting deadline.
There were attempts to buy the bank by the state-controlled Korea Development Bank, Bank of America, and Barclays bank, but efforts to bail out the company failed. On September 10, Lehman announced a loss of 3.9 billion dollars and intended to sell off even more highly lucrative assets (Lioudis, 2021). The federal government approved the company’s emergency liquidation after filing for bankruptcy leading to the end of the investment banker. Lehman’s bankruptcy filing was the largest in U.S. history, sending an already distressed market into incredible volatility, which spread to the real estate and money markets.
Causes of Collapse
The actions that led to the collapse of the Lehman Brothers include a flawed risk-return relationship, bad accounting practices, and loose risk management strategies. Lehman merged and bought numerous commercial and investment banks to compete with commercial banks with significant influence. Lehman’s unethical practices exposed them to multiple risks, ultimately resulting in their bankruptcy. The bank had taken on excessive risk without having the ability to raise cash quickly. By 2008, Lehman had assets of 680 billion dollars, supported by only 22.5 billion dollars of firm capital (Ball, 2018). With that leverage, a 3% decline in real estate values would wipe out all capital (Lioudis, 2021). In addition, the assets were difficult to sell in an already volatile mortgage market; thus, the failure to raise sufficient funds to ensure the company was a going concern led to its liquidation.
Another factor that led to the collapse of the Lehman Brothers was their bad accounting treatment of financial transactions. The company employed fraudulent accounting practices such as window dressing and disregarding business governance practices. In collaboration with their auditors, Lehman Brothers management manipulated the company’s financial statements before releasing the information to the public. The manipulated financial statements showed favorable results for the business and misled investors. In addition, Lehman used a repurchase agreement to alter the financial information to their advantage (Amadeo, 2020). Before its collapse, Lehman had used the repurchase agreements to hide 50 million dollars, including the previous year’s losses (Ball, 2018). Window dressing and repurchase transactions are legal in the U.S. as financial institutions and banks employ them. However, the transactions should be transparent and benefit the stakeholders.
Lehman continued this strategy by utilizing one of its specialized entities in the U.S. to purchase government bonds from another bank. This particular Lehman entity transfers these bonds to its London-based affiliates before the preset settlement deadlines or the end of the quarter. These fraudulent practices developed a false image regarding the company’s financial statements as there was no liquidity, a factor that led to its collapse.
Lehman Brothers’ collapse can be attributed to its internal culture based on loose risk management policies and strategies. Unaware of the hidden risks, Lehman Brothers decided to invest big in collateralized debt obligations (CDOs). CDOs are riskier than bank deposits as they amalgamate different loans. In 2008, Lehman suffered heavy losses amounting to 3% of its short-term assets from the CDO’s balance sheet. Half of Lehman’s CDOs, estimated at $431 billion, had experienced defaults by November 2008 (Ball, 2018). Borrowers began to lose confidence and began to call back their loans. Lehman’s creditors were able to quickly recover their money due to Lehman’s constant reliance on short-term loans. However, with its high propensity to borrow, the company had borrowed more than it could pay back, leading to its financial crisis.
The company executives hoped the federal government would step in with other systemically important financial institutions, as they did with Bear Stearns, to save the company. Bear Stearns, another financial institution, had been bailed out by regulators as it had threatened to default on its obligation. The spreads on Lehman’s debt’s credit default swaps (CDS) were a good indicator of this perception. The CDS spreads were relatively constant during the summer of 2008, even though Lehman’s poor financial situation was publicly known. They did not surge until the week before Lehman filed for bankruptcy which was too late to recoup investments.
Impact and Recommendations
The company liquidation led to job losses, a reduction in asset prices, and a global financial crisis that spread worldwide. Lehman’s bankruptcy devastated significant U.S. stock indexes, especially the Dow market, as it wiped investments worth billions. Lehman Brothers had a sizable workforce working worldwide; thus, its collapse led to the loss of 25,000 jobs (Sraders, 2018). The employees had substantial investments in the firm’s stock; thus, the fall in its stock price negatively impacted their investments. Investors and creditors suffered a similar fate as the liquidation led to the loss of assets. The company’s bankruptcy disrupted financial services in numerous financial institutions associated with the firm worldwide. In addition, there were multiple bankruptcy proceedings recorded after Lehman’s collapse.
The analysis of Lehman’s post-bankruptcy revealed how risk management strategies and accounting standards played a significant role in its fall. It exposed flaws in regulatory authorities’ monitoring and oversight as they could not predict the tragedy. Regulatory bodies displayed a lack of capacity in effectively auditing the financial statements of Lehman Brothers. The recommendations to prevent another failure of financial institutions entail implementing strong corporate governance structures, robust risk management policies, and constant, effective monitoring and supervision of financial institutions.
Regulators would be more equipped to spot financial institution misconduct if they were familiar with the fundamentals of accounting, the creation, analysis, and auditing of financial statements. The collapse of the Lehman Brothers led to the Dodd-Frank Act of 2010, designed to give regulators greater authority to intervene when a crucial financial institution is in distress. Skeel (2018), the Act states that if the treasury, the federal government, and Federal Deposit Insurance Corporation (FDIC) agree that a financial institution is in danger of default, a receivership overseen by the FDCI can commence. The law covers financial institutions, including commercial banking companies, holding companies, and subsidiaries.
Conclusion
Lehman Brothers’ collapse severely impacted the global banking system and the financial system as a whole. Large sums of money were lost by firms and people who invested in Lehman Brothers and associated enterprises. The decline of the financial institution was precipitated by its flawed risk-return relationship, bad accounting practices, and loose risk management strategies. These strategies led to intermittent liquidity issues; thus, banks withdrew their credit lines and services, exacerbating the financial situation to liquidation. The financial crisis primarily affected the world’s stock markets, investors, and firm personnel through significant losses, liquidations, and job losses. The aftermath of the financial disaster was the implementation of regulations that intervene in financial issues to prevent catastrophic losses.
References
Amadeo, K. (2020). How the 2008 Lehman Brothers collapse affects you today. The Balance.
Ball, L. M. (2018). The fed and Lehman Brothers: Setting the record straight on a financial disaster. Cambridge University Press.
Lioudis, N. (2021). The Collapse of Lehman Brothers: A case study. Investopedia.
Skeel, D. (2018). History credits Lehman Brothers’ collapse for the 2008 financial crisis. Here’s why that narrative is wrong. Brookings.
Sraders, A. (2018). The Lehman Brothers collapse and how it’s changed the economy today. The Street. Web.