Lessons from Lehman Brothers' Collapse

In February 2007, with a stock price of $86 a share, Lehman Brothers had a market capitalization of over $60 billion. The annual net profit for the corporation was above $4 billion, setting a new record. As of the beginning of 2008, Lehman Brothers ranked as the fourth biggest investment bank in the United States.

Lehman Brothers shares plunged by over half in March after the near-collapse of Bear Stearns, the second-largest holder of mortgage-backed securities. The corporation posted its first quarterly loss since being split off from American Express in 1994, a total of $2.8 billion in June. Lehman Brothers Holdings Inc., the biggest corporate bankruptcy filing in U.S. history (with $619 billion in debt), disappeared from investment banking by year's end of 2008.

Lehman Brothers' Early Years

The origins of Lehman Brothers may be traced back to the nineteenth century, namely, to 1844. A German immigrant named Henry Lehman founded the organisation in Montgomery, Alabama. Henry's brothers, Mayer and Emanuel, joined him in 1850 to form Lehman Brothers from their dry goods and general shop. In the 1850s, Lehman became a significant player in the cotton market and expanded into other commodities trading.

When it teamed with Goldman Sachs on an initial public offering in 1906, the business transitioned from commodities dealing to investment banking. Lehman underwrote approximately a hundred new stock offerings between 1906 and 1926, including those of household names like F.W. Woolworth, Studebaker, and Macy's.

Lehman Brothers' past reflects the evolution of investment banking in the American economy. The corporation persisted and even prospered despite terrible national disruptions like the Civil War, World Wars, the stock market collapse of 1929, and the subsequent Great Depression. The original firm started as a commodities brokerage but has since undergone several transformations to become one of the world's biggest investment banks.

The 1990s' Success

It was stated that Shearson/American Express paid $360 million to purchase Lehman Brothers in 1984. From 1984 to 1994, American Express was the sole owner of Lehman Brothers. At that time, the firm was "spun off" via an IPO that brought in over $3 billion. Lehman Brothers were allowed to grow rapidly after the repeal of the Glass-Steagall Act, which prohibited banks from engaging in investment and commercial banking activity simultaneously.

Despite the tragedy of September 11, 2001, Lehman Brothers recovered and regained its position as a market leader in investment banking. To the point that it was the fourth biggest investment bank in the United States in 2007, Lehman Brothers saw tremendous growth. Massive investments in mortgage-backed securities were crucial to its expansion and financial success (MBS). The company's demise may be traced back to its investments, which is ironic in retrospect.

How does Bankruptcy Affect You Now?

The failure of Lehman Brothers signalled the start of the 2008 financial crisis and subsequent recession. Because the millennial generation was just starting in their careers, they were particularly hard hit. Millennials were the hardest hit by rising unemployment rates, which rose from 9.9% in May 2007 to a record 19.5% in April 2010. Unemployment was 8.8% between the ages of 25 and 54 and 7.0% between 55 and older. Even though millennial unemployment had fallen to 8.9% by December 2017, the damage had already been done.

The reasons for Lehman's Failure

Lehman brothers' debt and bankruptcy had below mentioned major causes:

• Risk: The bank had taken on too much risk without the ability to raise capital quickly. Technically, its $639 billion in assets exceeded its $613 billion in debt in 2008. However, selling the assets proved difficult. Lehman Brothers were unable to sell them to raise sufficient funds. It went bankrupt because of a cash flow problem.

• Culture: Management encouraged taking unnecessary risks. According to Lehman's chief risk officer, upper management ignored many of her risk-management strategies. Top executives believed their company was too sophisticated to fail and wanted to stay ahead of competitors who used similar high-risk strategies.

• Regulator's Inaction: The Securities and Exchange Commission and other authorities did nothing. Even though the SEC was aware that Lehman Brothers was taking on too much risk as early as 2007, it never demanded that Lehman take any action. 5 Furthermore, it did not openly notify rating agencies that the bank had exceeded its permitted level of risk.

Case Study

What were the consequences of the Lehman brothers' debt and bankruptcy? Streamline the timeline. 

The failure of Lehman Brothers shook the financial markets. The Dow Jones Industrial Average fell 504.48 points, the most in seven years, to its lowest level in seven years. Losses continued until the Dow closed at 6,594.44 on March 5, 2009. It had fallen 53% since its peak of 14,164.53 on October 10, 2007. Investors flocked to the relative safety of US Treasury bonds, driving up prices.

Investors knew that the financial institutions that owned Lehman's bonds were in jeopardy due to the company's bankruptcy. On September 16, 2008, the Reserve Primary money market fund "broke the buck." This meant that its shares, normally worth at least $1, were worth $0.97. Investors lost faith in the money market fund after it disclosed losses of $785 million in Lehman's commercial paper.

On September 17, 2008, the collapse began to spread. Investors withdrew a record $196 billion from money market accounts. If the run had continued, businesses would have been unable to obtain funding for ongoing operations. Within a few weeks, the economy would have collapsed. Shippers, for example, would not have had the funds to deliver food to supermarkets.

On September 18, 2008, Paulson and Bernanke met with congressional leaders to warn them that a credit market crisis was only a few days away. The Treasury Department would be able to buy stock in troubled banks due to its $700 billion bailout request. This was the quickest way to defrost the frozen financial system by injecting capital.

On September 29, 2008, Congress rejected the proposal. As a result, the Dow fell 777.68 points, the most in a single day until 2018.

Relevant case details

The following are relevant facts (assumptions are labelled) about the case:

• Repurchase Agreements were a standard method of financing for Lehman Brothers.

• Leverage ratios rise when a financial firm uses repurchase agreements because they are a liability.

• In some circumstances, buyback agreements may be removed from a company's balance sheet thanks to a loophole in financial accounting rules.

• During reporting periods, Lehman Brothers would (legally) remove loans related to buyback agreements from its balance sheet to deceive investors by lowering leverage (assumption).

• Lehman Brothers' buyback agreement tricks were a secret from investors. The company's stock price at Lehman Brothers may have been affected if investors had known (assumption).

• This dishonest method was not used by any other banks (assumption).

Conclusion

The failure of Lehman Brothers played a significant role in the chain reaction of other financial disasters that eventually led to the 2008 Global Financial Crisis. Many in the industry are still perplexed as to why the American federal government did not save Lehman, as it did so many other banks, but instead allowed it to fail. One common argument is that Lehman's debt is simply too large for its assets to even begin to repay.