Lehman Brothers

A fall from grace.

The Lehman Brothers was an investment bank that grew into the fourth-largest investment banking firm in the US. Along its journey, it was tested by many pivotal events, but its fate was ultimately decided by the subprime mortgage crisis in 2008.

10 of the current largest investment banks :

  1. JPMorgan Chase
  2. Goldman Sachs
  3. Bank of America & BofA Securities
  4. Morgan Stanley
  5. Citigroup
  6. UBS
  7. Credit-Suisse
  8. Deutsche Bank
  9. HSBC
  10. Barclays

Investment Banks generate money through service fees, unlike traditional retail and commercial banks through deposits and lending. 

Some of the services investment banks provide are financial advice, creating and selling securities, brokerage, and financial underwriting procedures for high-profile businesses and governmental organizations.

Lehman Brothers were too invested in the creation of mortgage-backed securities and collateral debt obligations, which were deemed safe investments during the time of the housing boom.

Eventually, debt payments became more susceptible to the correcting housing market, causing many borrowers to default, significantly impacting creditors, investors, and intermediate companies.

History of Lehman Brothers

The origin of Lehman Brothers was, at the start, a general store founded by 3 German brothers, HenryEmanuel, and Mayer Lehman, in Montgomery, Alabama, in 1844.

As agricultural plots of land surrounded the store, many of their customers were farmers and accepted products to be paid for in cotton.

Henry Lehman, the initial founder, died in 1855, passing more responsibility to his brother for the future of the business. They expanded the business into commodities and brokerage services, providing their services in the familiar cotton market.

They later converted into investment banking when partnering with Goldman Sachs in 1906.

In 1984, it was acquired by Shearson/American Express at a value of $360 million, until 1994, when Lehman was made an independent company from American Express after they failed to achieve their financial conglomerate vision. 

LB accumulated more than $3 billion in capital from its initial public offering (IPO). LB survived many catastrophic events before being claimed by the subprime mortgage crisis, including:

  • Railroad bankruptcies (the 1800s)
  • Two world wars
  • Great depression
  • American Express spin-off
  • Long-term capital management collapse
  • Russian debt default (1998)
  • 9/11 - World Trade Centre Terrorist Attacks

Steps towards Lehman Brothers climax

LB was heavily invested in mortgage-backed securities (MBSs) and collateral debt obligations (CDOs) during the mid-2000.

The housing boom stimulated the market for these investment products, with the sales of CDOs increasing 8-fold, from $30 billion in 2003 to $225 billion in 2006.

LB had acquired various other lending institutions to increase its debt operations, with many of these acquired firms that have a history of issuing subprime loans.

MBS

MBS is a pool of mortgage debt transformed into single security by investment banks.

Credit rating agencies assess the credit risk of the MBS and assign it a credit rating according to the underlying borrowers.

MBS pays interest to the investors as opposed to the bank. The bank sells the individual mortgages that collectively make up the MBS to investment institutions for them to securitize. 

The securitization of mortgage bonds enables banks to become an intermediary between home buyers and the investment industry. 

The bank can sell these mortgages to investment banks at a discount for inclusion in MBS interest payments. The sale of mortgages replenishes the available funds for banks to issue more loans.

CDO

CDOs are further packaged investment products composed of multiple pools of debt containing various cash-flow generating assets, including MBS, corporate bonds, auto loans, credit card loans, etc. 

wallet car

The debt is organized into "tranches" (groups) following the credit ratings, with each tranche making up a percentage of the CDO.  

Therefore, CDOs consist of both high and low-risk bonds, balancing risk and yield.

Subprime bonds

Subprime bonds refer to the condition of bonds issued to individuals looking to purchase a home or other high-valued products with a below-average credit score.

As there are increased risks of subprime borrowers defaulting, interest rates are higher than prime bonds for contingencies. 

However, adjustable-rate mortgages (ARM) were made more attractive by fixing low-interest rates at the beginning of issuance and resetting to higher rates at intervals on future specified dates. 

mortgage rate

However, this was no hindrance as buyers intended to refinance the debtor by selling the property at a higher price, gaining some profit in the process.

With the housing market in high demand, low credit earners wanted to be involved in the action, and subprime bonds allowed them.

NINJA loans, a name derived from the eligible bond criteria "no income, no job, and no assets," brought extreme risks as no down payments or proof of income were necessary to qualify for the loan.

The name ironically plays on how these loans were incorporated into CDO and MBS with low transparency due to the negligence of lenders and credit rating agencies.

The collapse of Lehman Brothers

Lehman Brothers' was growing with the prevalence of subprime bonds, revealing continuously higher revenues each year, surging 56% from 2004 to 2006.

Accompanied by intermittent increases in bond securitization products, $146 billion worth of mortgages were securitized in 2006 - a 10% increase from the previous year.

During the first quarter of 2007, the adversities began to surface in the housing market when the default rate increased to a seven-year high.

The severity of the subprime bond defaults increased when Bear Stearns, a major competitor to LB, started to feel the pressure in March 2007.

The underwriting of their investment products proved to be extensive to mitigate risks from the subprime bond market, signaling market turmoil.

Questions were directed towards LB on whether they could withstand the turbulent markets, which they reassured will have little effect due to their well-structured bond products. 

They recorded a high revenue in the first fiscal quarter of 2007, reassuring the markets and investors.

The price of homes began to decline with less demand, spawning home buyers in a position of possessing a mortgage with no down payment, worth more than the home bought. The method of refinancing vanished when the house market dove.

Adjustable-rate mortgages increased interest payments rapidly after resetting, making mortgage payments less affordable to maintain, and facilitating the default of subprime bonds.  

bankrupt

On 15th September 2008, Lehman Brothers acknowledged they were too entangled with subprime bonds and could not manage their $619 billion debt, officially declaring bankruptcy.

LB owned $639 billion in assets, a sufficient amount to pay off its debt. However, it was difficult to sell these assets to provide liquid funds, as most of them were associated with the falling real estate market.

Lehman's strategy was high-risk, high-reward to succeed against its competition. The heavy buying of commercial real estate and risky loans accelerated at the height of the housing market but was never sustainable long-term when the market corrected.

The Security and Exchanges Commission (SEC) failed to intervene earlier; unaware LB had taken on too much risk. Credit rating agencies were unaware of their exceeding risks.

Government Intervention of Lehman Brothers

On 18th September 2008, the government discussed potential bailout schemes to restabilize the markets.

Troubled Asset Relief Program (TARP) was the first drafted recovery plan of $1 trillion to purchase toxic debt to prevent a total financial calamity.

Congress stalled the plan until it had been adjusted to provide $700 billion in support and was renamed the "Emergency Economic Stabilization Act of 2008".

Additionally to the relief program, the government bought shares of the failing companies to help finance their recovery and later sold them, accumulating some profit.

Mergers deals were financed; for example, the Fed provided a $12.9 billion bridge loan, to be paid back with interest, for the merger between Bear Stearns and JPMorgan Chase.

The government saved many jobs and the value of the dollar from depreciating.

Many financial institutions involved in this bailout scheme included:

Why was LB not bailed out?

Such as Bear Stearns, the US Treasury Secretary, Hank Paulson, advised LB to find a buyer, with Bank of America and British Barclays both being interested parties.

signature

However, they were informed that the US Treasury and Federal Reserve would not be able to aid in government funding. The "Emergency Economic Stabilization Act of 2008" had not been passed by congress either to provide some relief.

LB was an investment bank and therefore was exempt from funding. However, Goldman Sachs and Morgan Stanley bypassed policies by converting investment banks into bank-holding companies to qualify for some form of funding.

A loan by the Fed wasn't applicable as LB failed to provide sufficient liquid assets.

Bank of America and Barclays had pulled out of the deal as it would have endured too much risk for either company.

The debt and illiquid assets LB had accumulated were too large, being the primary reason it could not be resurrected by the government and led to its filing for bankruptcy. 

How this affected the world economy

Post bankruptcy, companies that owned Lehman bonds were targets as investors knew the debt was likely to default.

The following day the Reserve Primary money market fund, with a net asset value of $1, had dropped to $0.97, phrased by a colloquial term "breaking the buck."

Since the market fund contributed to the purchase of Lehman's commercial paper, which accounted for 1.5% of the fund portfolio, it caused a loss of $785 million.

Investors became less confident in the money market, which led to an exodus away from corporate bonds and to more secure treasury bonds.

On 17th September 2008, $144.5 billion was withdrawn from money market accounts compared to the usual weekly $7 billion transactions. This degraded the net asset value to $0.96, forcing the market to liquidate caused by the panic selling of assets.

The continuation would have caused businesses to fall as daily operations could not be financed through loans, causing a catastrophic sequence of job losses and foreclosures.

The impact was widespread as much of Europe and Asia had invested in United States MBS. LB was also an established issuer of short-term corporate bonds worldwide, causing international instability.

Consumer spending was down, and borrowing rates rose. In addition, US exports were low affecting jobs overseas as supplies and services were disrupted.

Hence the government needed to intervene and inject liquidity into the US market and restore confidence.

Who is to blame?

Creditors

Mortgage lenders were the immediate culprit as they issued debt to people considered high risk.

The incentive for lending to high-risk borrowers was the economy was in a relatively stable state, with low-interest rates, resulting in high demand for real estate.

As the return on investment was low, banks were looking to profit more by lending to riskier clients.

Homebuyers

The purchases made by naive housing venturers made the mistake of taking on more risk than they could withstand.

Mortgages with no down payments and low rates offered by lenders were appealing but at the mercy of house prices, as borrowers could profit primarily by refinancing as the value of houses increased.

The drop in demand eventually cast a shadow over them.

Investment Banks

The secondary mortgage markets made it easier for debt to be transferred between lenders and freed up more liquidity for more mortgages to be issued.

Investment banks created a high demand for loans as their business model created debt securities to sell to investors.

The securitization of mortgages into CDOs further added to the problem as risky loans were distributed throughout the security.

Rating Agencies

Agencies and underwriters were criticized as they should have been able to foresee potential risks of subprime bonds with occurring defaults. Sooner acknowledgment could have softened the economic downfall.

A conflict of interest was displayed as investment banks paid fees to credit rating agencies for rating their CDO products. Therefore there was pressure for agencies to please, to maintain business and good relations.

A high demand would have also flooded agencies with intensive work, instigating corners being cut and leniency for faster processing.

Hedge funds

Hedge Fund strategies to capitalize on the housing boom included credit arbitrage. It involved leveraged positions to purchase larger volumes of CDOs to gain greater returns and, in turn, fueled lower subprime interest rates.

Credit default swaps hedged the CDOs.

The leveraged positions provided volatility in the market, resulting in a more intense downfall.

Overall it was a joint effort.

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Researched and authored by Rohan Hirani | Linkedin

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