The failure of Lehman Brothers Holdings, the world's fourth largest bank, shook the world's markets and cost investors billions of dollars (Schwartz, 2016). On Monday, September 15, 2008, Lehman Brothers filed for bankruptcy in the United States Bankruptcy Court in New York. This was the most dramatic action since the start of the 2007-2009 financial crisis (Schwartz, 2016). The question is, how did such a massive organization disintegrate during the initial part of the depression? The collapse has had a devastating impact on people, the United States, and the global economy as a whole. Many estimate the bankruptcy to be the largest in history. The biggest monthly decline was seen in the year, 2008 and financial crisis sweeping though global markets. Its assets worth $639 billion, $619 billion in debt and huge wage bill attributed to 25000 employees was just but one of the reasons for the swift collapse of the firm (McDonald, 2016). The beginning of Lehman’s mortgage and credit problems contributed to this record loss. This was contributed by the reckless investment move of holding on these mortgages for too long or even worse the assets were maybe not of their market. It was one of the most dramatic events that dawned the reality of the United States (Schwartz, 2016).
In the seven days prior to the Lehman’s bankruptcy, equity underwriting clients experienced an abnormal return ranging at -5 % on average and within the same week, the said companies suffered an aggregate risk of $ 23 Billion (Schwartz, 2016). The big mystery was that the companies affected were not big and they were financially inhibited, while other big clients were not affected. These values were significantly higher than those for firms that offered equity underwriting services. A red light to this bankruptcy was that no client groups with bigger financial standing was affected but rather small firms were severely affected
Lehman played a significant role in shaping the financial set up of the US for over 150 years. Its history and the growth of the company reflect the gradual development, challenges and successes of the American technology, industry and Modern Corporation. According to (Yale, 2014), the foundation of the company can be drawn back to 1840s where Henry Lehman. The business evolved from a general shop to broking of cotton for the farmers. At that time in the United States ‘King Cotton’ was very dominant in the economy. Henry died in 1855 and the leadership of the business was held by the younger brothers for decades. Until 1920s, the Lehman Brothers was a family business handled by sons, brothers and cousins. In 1924, John M. Hancock partnered with the Lehman Brothers. He was the first non-family member to be engaged in the business. Later on Monroe C. Gutman then Paul Mazur and others followed. Robert Lehman led the firm from 1925 and this period was characterized by immense growth in the firm. He geared support of retailing, financing airlines and this contributed to significant growth of the company. It was one the first firms to develop a method of funding known as private placement. In 1969 Robert Lehman died and since then no family member has led in the business.
Lehman’s Brothers sought investment opportunities in the fast growing computer and electronic technology fields. In the 20th century the Lehman’s engaged in financing Murphy Oil and other oil companies and services (Auletta, 2006). During these times the oil industry was immensely developing. As time went by, the firm opened offices in Europe and Asia. The Brothers acted as advisors on several large U.S. transactions. Avenues like design, programming and engineering took the lead and the brothers backed up these businesses. An example is Intel, whereby Lehman raised funds to expand in order to meet the huge demand. In 2000 the Lehman Brothers turned 150 years. In 2001, the company’s World Trade Center was destroyed by terrorists and this prompted the transition to new headquarters in Manhattan, (Lehman 2007). Lehman got involved in subprime lending crisis that led to its collapse in 2008. Its assets were then sold to other businesses for instance Barclays Bank. At one level the answer is evident that huge losses suffered from the crush of the real estate sector would immensely impact the business. Financial institutions lost trust in Lehman thereby leading to a precipitating liquidity crisis.
The question at hand would be why did the Federal Reserve avoid bailing the company?
Inside the Federal RB, time was running out and the fate of the World’s largest investment bank was at the mercy of the Federal Reserve. Despite the imminent risk to the global economies the Fed failed to bail out Lehman. Federal Reserve gave differing opinions on the reason for the action. The main reason was because the fed argued that the bank was in too deep of a hole to be rescued by the government. Ben Bernanke, the Fed Chairman at the time said the risky real estate investments entered by Lehman was too much for him and he had no legal capacity to authorize it rescue. However, different opinions have been regenerated since then with most economists arguing that bailing out Lehman would lead to allocation of money that would have saved Americans billions of dollars.
Consequence of the Lehman’s default
The world economy faced a terrific times during the 2007-2008 financial turmoil of the United States. The banking sector, insurance company, the loans and savings and mortgage lenders suffered immensely. Economies abroad got soaked in the mess including Germany, Japan, China, Europe as well as other countries. The turmoil began with mortgage dealers who mortgaged but were unfair to the borrowers, (Schwartz 2009). Subprime mortgages were unsophisticated as some mortgages were even lent to disqualified mortgage holders. In 2001, U.S economy experienced a short recession contributed by terrorist attacks. To restore back the condition, the Federal Reserve dropped the federal funds rate by 11% which promoted liquidity in the economy. Cheap money, more mortgage and more lending characterized the economy. Bankers, insurance houses and mortgage companies thought it ‘wise’ to pass debt to another with a clogged eye on the future. By the time 2007, financial institutions froze being characterized by the bankruptcy of Lehman Brothers, (Taylor, 2008). In 2008 Federal Funds rate was reduced 1% and discounts reduced to 1.75%.
Irresponsibility in the Lehman Brothers was seen through their downfall. Trust was lost in all sectors and questions were raised on the viability of the counterparts. Vulnerability and broken links displayed the failures in finances. Gambling with borrowed money and relying on credit-risk protection was no guarantee to success (Taylor, 2008).
Risky Debt to Equity Ratio is another contributory factor to the down fall. The fact that investment banks are not regulated by FDIC, their debt-equity ratio tends to be extremely high. The regulators who slept on their jobs for mishandling the crisis and failure to play their oversight role paid the price of their irresponsibility. They let the Lehman go bankrupt and this brought the economy of the United States to a sinking point that recuperating would take years. High approval of mortgages led to increase I the prices of housing and eventually devaluation of financial instruments. Bankruptcy by many institutions led to impossibility to borrow money and eventually to decrease in houses prices among other extreme impacts.
Too much leverage was given to the company. The concept of financial leverage is to take the money allocated through loans and then investing the money to get higher returns. The difference in the rates i.e. the difference between the interest rate of the loan and interest rate from investment. Principally, the Lehman Brothers did not follow this rule of thumb. They were overleveraged because they had borrowed money and used it to invest on mortgage backed securities (Lehman Brothers Holdings Inc, 2007). Thereafter, it was revealed that the assets used as collateral were not valuable enough to cover the loan.
Upside only compensation schemes
It is estimated that the average loss of income in each U.S household is approximately $5800. This is measured from 2008 to 2009 whereby slow economic growth became the trend. The Federal government response to mitigate the crisis through the Troubled Relief Program resulted to a cost of $73 billion that is a huge burden on the taxpayers. This is according to the estimation Congressional Budget Office made in 2008 (Friedman, 2011). The U.S lost approximately $3.4 trillion on real estate from July 2008 to March 2009.5
The collapse of the Lehman brothers serves as a lesson that no organization is too big to fail. Lehman was a deeply rooted company that has lasted over decades but collapsed in the long run. This displays a clear message that mistakes, ignorance, selfish needs among other factors can bring down any organization be it small or huge.
Literature Review
This section reviews the empirical and theoretical literature on the bankruptcy of the Lehman Brothers Holding.
Theoretical Framework on Market Efficiency
This literature framework can be explained through theory of market efficiency. The empirical analysis analyses the different literature in a bid to answer the question: How efficient was the market during this crisis? Based on market efficiency theory, the eventual collapse of Lehman Brothers would be avoided. More so, the overall market would have evaluated the danger and averted. According to Friedman (2011), 24 days before the bankruptcy news, results of stocks had significantly dropped. This analysis supports the semi strong market theory; which essentially suggests that the market would have substantial information on the imminent collapse of Lehman Brothers.
More so, it would appear that brokerage firms would be affected negatively by the collapse of Lehman. However, the theory of market efficiency did not hold as documented in various literature sources. During its collapse, the company has bad debts amounting to $ 60 billion. With a debt of this capacity, you would expect the stock market to come crushing down. Katie (2013) seeks to explain the impacts of Lehman’s collapse and at most importantly explain the reason why the Federal Reserve failed to bail out Lehman. On examining the impact of the Lehman’s collapse, the literature identifies serious repercussions caused to its stakeholders. To begin with, the collapse in fact imposed material losses to its customers. In fact, the similarity between these firms was that they had hired Lehman to be its agent in equity underwriting. Findings show that the companies that used Lehman as its underwriter for the period leading to its collapse suffered significant negative abnormal returns.
Bankruptcy Theory
The dominant theory of bankruptcy is known as the Creditors Bargain theory whereby scholars argue that bankruptcy is only limited to solving problems caused by a huge number of creditors. The two factors that hold this theory are illiquidity and debt overhang or presence of a huge number of uncoordinated creditors. Based on this theory, it is evident that Lehman Brothers was meant for bankruptcy.
The literature review seeks to answer the question on whether the Lehman Brother bankruptcy impacted the global market. Secondly, the question on the significance of the information surrounding the crisis. Before the collapse of Lehman brothers, Bear Stern had been faced out through bankruptcy but it was rescued by The Fed. This served as a warning to investment banks; especially those that relied on subprime mortgage. The whole fracas behind the collapse of the firm was due to the soaring U.S. markets. Interest rates increased gradually thereby weakening the strength of the dollar. Eventually, indebted home owners faced financial turmoil thereby sparking foreclosure. The foreclosure caused immense panic leading to huge drops in the value of real estate.
Therefore, when Lehman collapsed, the biggest losers were fixed interest rate dealers who heavily invested in securities directly or indirectly linked to the sub-prime mortgage market. The subsequent rippling effect was huge thereby exposing interconnected markets (Braga & Vincelette, 2006). A quick reminder is that AIG had invested in swaps controlled by the Lehman brothers company. Its impact was felt in Wall Street as the Dow Jones Industrial average dropped by a whopping 500 points; the worst score only bettered by 9/11.
In addition, this theory partially answers the question on why the Fed failed to bail out Lehman. Initially, the government has saved the likes of American International group, the Bank of America, Citigroup, Goldman Sachs and Morgan Stanley. A review by Katie (2013) explains that the decision was more of a policy and political decision rather than a legal decision. The reason tabled was that the problem faced by other firms was more of a liquidity problem while Lehman’s problems were purely solvency problems. Legally, the government was not allowed to bail out bankrupt company because the encumbered obligations could not be collaterized by assets owned by Lehman’s brokerage subsidiary.
Theory on the Value of Investment Banking Relationships
Extensive theoretical and empirical literature has examined ways in which underwriting between investment banks can enhance value for both sides. To begin with, the first part of the review involves the writings by Friedman (2011). This article examines the long standing question on whether organizations derives its value from investment bank relationships or does its collapse affect industrial firms that have receive underwriting and advisory service from the Lehman Brothers. The scholarly theoretical framework of Investment Banking relationships is that firms derive value fellow investment banks (John, 2008). This did not seem to be the case during Lehman’s bankruptcy. Equity underwriting appear to be extremely valuable for client firms and an equal measure is expected to be reciprocated to the company monitoring the underwriting process. In this case however, the rupture of existing relationship was damaging to both the client firms and the Lehman Brothers. Another impact of the bankruptcy was the upsurge in the number of creditor claims due to the overwhelming panic by the market. The creditor claims ranged from debt to over the counter derivatives.
To add on, after its bankruptcy, cross-border lending declined sharply and therefore banks had to write down some of the subprime assets in order to re-finance the large chunk of long term debt held. Financial institutions experiences sharp decline in their market to book ratio; which ultimately transmitted this shock across nation by curtailing their lending to clients abroad (Auletta, 2006).
Conclusion
The paper covers the impact of the 2007/2008 recession and how it contributed to the collapse of Lehman; a financial empire that had survived over 150 years of recessions and depression. The introduction covers the background of the crisis and it impacts on micro and macro-economic environment. More so, the literature entails the theoretical framework and empirical analysis of the problem in question. We can conclude that the Lehman Brothers was not only crushed by sub-prime mortgage crisis but also by the decision by the Federal government to let it crush through bankruptcy.
References
Auletta, Ken. (2006.) Greed and Glory on Wall Street: The Fall of House of Lehman, Random House, NY
Braga, C. A. P., & Vincelette, G. A. (2011). Sovereign debt and the financial crisis: Will this time be different?. Washington, D.C: World Bank.
Cross-border Banking in Europe: Implications for Financial Stability and Macroeconomic Policies. (2011). London: Centre for Economic Policy Research.
Friedman, J. (2011). What caused the financial crisis. Philadelphia: University of Pennsylvania Press
John B. Taylor (2008) The Financial Crisis and the Policy Responses: An Empirical Analysis of What Went Wrong, November. p9
Katie, J. (2013). Why Banks Fail: A Case Study of Northern Rock, Lehman brothers, and Union Bank of Switzerland (UBS)?. Munich: GRIN Verlag GmbH.
Lehman Brothers Holdings Inc. (2007). Form 10-K for fiscal year ended November 30, 2007.
McDonald, O. (2016). Lehman Brothers: A crisis of value.
Schwartz H. (2009). Subprime Nation. Ithaca, NY: Cornell Univ. Press. 258 pp9
Yale program on financial stability case study (2014). 2014october 1, 2014;The Lehman Brothers Bankruptcy A:1 Overview
