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The Collapse of Lehman Brothers

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On September 15, 2008, Lehman Brothers filed for bankruptcy. With $639 billion in assets and $619 billion in debt, Lehman’s bankruptcy filing was the largest in history, as its assets far surpassed those of previous bankrupt giants such as WorldCom and Enron. Lehman was the fourth-largest U. S. investment bank at the time of its collapse, with 25,000 employees worldwide. Lehman’s demise also made it the largest victim, of the U. S. subprime mortgage-induced financial crisis that swept through global financial markets in 2008.

Lehman’s collapse was a seminal event that greatly intensified the 2008 crisis and contributed to the erosion of close to $10 trillion in market capitalization from global equity markets in October 2008, the biggest monthly decline on record at the time.

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Еhe collapse of the U. S. ousing market ultimately brought Lehman Brothers to its knees, as its headlong rush into the subprime mortgage market proved to be a disastrous step The modem Lehman Brothers (with distant origin in a dry goods business that was begun in Alabama in 1847) assumed the functions of an investment bank some 50 years later (e.

g. , McDonald & Robinson, 2009; Tibman, 2009). In 1994, it was spun off from American Express, and Richard Fuld, who had joined Lehman in 1969, was appointed its President and CEO. Lehman did well under Fuld’s leadership, and by 2006, it had some $700 billion in assets and liabilities and around $25 billion in capital.

Its assets were mainly long term and its liabilities short term. It financed itself by borrowing from tens of billions of dollars to hundreds of billion dollars on a daily basis in the short-term repo market. As any investment bank, Lehman was as a consequence highly dependent on confidence One reason why Lehman would later go bankrupt has to do with the fact that anyone who was perceived as a threat by Fuld was quickly eliminated ­ including a number of critics who early on realized that Lehman was headed for serious trouble (McDonald & Robinson, 2009; Tibman, 2009).

It should also be noted that Fuld’s personal experience was mainly as a bond trader and that he had little technical understanding of such new financial instru­ ments as CDOs, credit default swaps (CDSs), and the like (e. g. , McDonald & Robinson, 2009, pp. 91, 234-236) Lehman was one of the leaders in the production of securitized mortgages and also owned two mortgage firms, BNC in California and Aurora Loan Services in Colorado. 6 According to The Wall Street Journal, “Lehman established itself [in the mid-I 990s] as a leader in the market for subprime­ mortgage-backed securities.

It built a staff of experts who had worked at other securities firms and established relationships with subprime-mortgage lenders” (Hudson, 2007). In 2005 and 2006, Lehman was the largest producer of securities based on subprime mortgages. By 2007, more than a dozen lawsuits had been initiated against Lehman on the ground that it had improperly made borrowers take on loans they could not afford. “Anything to make the deal work,” as one of Lehman’s former mortgage underwriters put it (Hudson, 2007). As soon as the subprime crisis erupted, Lehman started to suffer losses.

Lehman’s affairs, however, its fall had mainly to do with a dramatic change of strategy that took place in some other areas than the subprime market and that was initiated in 2006 (Valukas, 2010). 7 From 2006 till mid-2007, Lehman followed a very aggressive new strategy that consisted in using its own capital to expand in commercial real estate, private equity, and leveraged lending. Fuld did not believe that the problems in the subprime mortgage market would spread; he also thought that the problems in this market provided Lehman with an opportunity to aggressively advance when its competitors were pulling back.

Lehman’s so-called countercyclical strategy was terminated by mid-2007, as its losses and illiquid assets were beginning to get out of control. Neither during the last quarter of 2007 nor during the first quarter of 2008, however, did Lehman attempt to raise equity or sell of assets. During this period, it also used an accounting trick to remove some $50 billion from its books (“Repo lOS”). By this time, Lehman’s dependence on the short-term repo market had also increased dramatically and was nearly 26% of its liabilities or twice that of peer banks (Valukas, 2010, p. 407). Despite all of these failures, Fuld insists that it was rumors and short selling that brought down Lehman, not its huge losses in a deteriorating economy and his own failure to deal with this. “Ultimately what happened to Lehman Brothers,” Fuld (2008b, p. 8) would later say when he testified at Congress, “was caused by a lack of confidence. ” While it seems that Fuld believed that Lehman could weather any storms it faced during the spring and summer of 2008, investors were getting increasingly nervous.

While many banks had declared heavy losses and write-downs, Lehman was not one of them. In fact, Lehman declared a profit of several hundred million dollars for the first quarter of 2008. The three major rating agencies responded by applauding Lehman’s performance, something they would do till the very end. 9 Still, rumors were strong that Lehman was covering up its losses. Some investors also started to look for information on their own, and what they found made them suspicious.

One of these was David Einhorn, the head of a hedge fund called Greenlight Capital. At a conference for investors in ApriL Einhorn gave a speech in which he argued that investment banks were dangerous for a number of reasons. For one thing, he said, they used half of their revenue for compensation – something that means that its employees had a very strong incentive to increase the leverage of their firm. He ended his speech with a full-blown attack on Lehman. If you calculate its leverage properly, he said, it was 44: 1.

This means, he explained, that if the assets of Lehman fell by 1 %, the firm would have lost almost half of its equity. The consequences of this were dramatic: “suddenly, 44 times leverage becomes 80 times leverage and confidence is lost” (Einhorn, 2008a, p. 9). Einhorn also tried to estimate Lehman’s losses. He did this by looking very carefully at various categories of assets, in which Lehman had invested and which had fallen in value.

Cite this The Collapse of Lehman Brothers

The Collapse of Lehman Brothers. (2016, Dec 25). Retrieved from https://graduateway.com/the-collapse-of-lehman-brothers/

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