Bankruptcy in Lehman Brothers - Case Study Example

Bankruptcy in Lehman Brothers Lehman Brothers, a 150 year old global investment bank shocked many people world wide, when the organization declared bankruptcy in September 2008.The firm, which was the fourth largest investment bank in the United States employed over 27,000 people by the time of bankruptcy. Their core businesses involved trading fixed income assets, research, investment management and private equity. In this regard, the firm provided financial services to corporations, governments, institutions and wealthy individuals globally. The collapse of Lehman Brothers has put the huge work force out of work, wiping out billions of dollars in personal net worth, and an estimated $600 billion loss in stock market value worldwide (Jenny, 2008, pp 43-45). The US treasury did not bailout the bank from collapse. This is because all government bailouts are normally bankrolled by taxpayers and administrators must limit the financial burden placed on them. Due to the effect of raising global inflation, the tax payers are definitely on the receiving end and increasing bills could strain them (Bernard 2008, pp 21-22). The effect of the government’s failure to bail out Lehman Brother’s resulted in the pulling out of banks that had initially expressed interest to buy out the firm. Consequently, unprecedented fall in share prices occurred not only in the United States but in the whole world. Before bankruptcy of Lehman Brothers, the government nationalized Fannie Mae and Freddie Mac, a conglomerate of huge lenders that own or guarantee around $6 trillion of the $12 trillion US mortgage of market. In addition the treasury also facilitated the JP Morgan buyout of the Bear Stearns in March. Lehman Brothers bankruptcy therefore came at a time the exchequer was already strained. However, there is a limit to an extent of which the government can go to bailout troubled firms because it also have limited funds. Lehman had very small direct contact with ordinary home owners and retail markets; hence the treasury decided that Lehman bankruptcy could not cause economic meltdown, as could have happened if Fannie and Freddie went under (Kulikowski, 2009, p 26). The bankruptcy of the financial institution has affected many people economically and morally across the world. The immediate loss of jobs and investments in the bank further shattered people’s faith of investing in banking institutions world wide.4000 employees of the London staff of Lehman Brothers were all laid off. In the US, the jobs of about 10,000 employees on the firm are at risk. In Hong Kong, Kulikowski (2009, p 23) notes that angry investors of Lehman Brothers held violent protests and demanded the repayment of their investments allied to the collapsed US bank. Thousands of investors have lost their life time savings after investing in Lehman Brothers Bonds and are demanding assistance from banks to help them regain their investments. Most investors had selected schemes like mutual funds and saving schemes in banks which in turn invested in Lehman’s Brothers owing to its remarkable investment history. People from all walks of life are complaining that the banks which sold them the bonds did not inform them on the possible risks involved in the investments which subsequently led to loss of their life time savings. Millions of people around the world will be indirectly or directly affected by the collapse. Most banks and pension funds have investments directly with Lehman or with firms that have traded with it. Unraveling these complex arrangements could take the stakeholders’ months and that will continue to pack financial markets. These factors will combine to deepen the credit crunch (McDonald, and Robinson, 2009, pp 45-47). The collapse of the bank has highlighted serious management malpractices, in the giant firm, which has had an impressive performance during its 150 year history. Since it was founded in 1844, Lehman Brothers has played a vital role in recognizing the potential of upcoming enterprises, by helping in their financing and expansion. Founded in 1844 by a German immigrant Henry Lehman and his two brothers Emanuel and Mayer, the firm grew from a small shop selling groceries and dry goods into the present day investment bank (McDonald, and Robinson, 2009, pp 15-16). The firm was a family business which was headed by Henry in its formative years. Upon his death in 1855, Mayer and Emanuel took over and managed it in the following years. During this period, only family members were permitted as partners, a tradition that continued up to date (Bernard, 2008, p 40).Lehman Brothers transformed from general merchandising business to a commodity broker specializing in cotton trade for the cotton planters in Montgomery, Alabama in the 1850s. Brisk growth in the cotton trade prompted the firm to enter into partnership with cotton merchant John Wesley Durr. In the partnership, Lehman brothers built storage warehouse, a development that necessitated it to engage in larger sales (Schack, 1950, pp 25-29). In 1858, the firm opened office in New York, a move that enhanced its foothold in commodity trading business and exposed it to the financial community in New York. During the American civil war, the firm suffered greatly because its major business was concentrated in the Southern States. However, after the war was over, the firm was rebuilt and it shifted its focus to New York. In 1870, New York Cotton Exchange was established, under the stewardship of Lehman Brothers (Schack, 1950, p26). Subsequently, growth in commodity sales increased and resulted in inclusion of other goods, such as coffee and petroleum products. Following these developments, the firm established Coffee Exchange and Petroleum Exchange. Lehman Brothers as noted by Schack (1950, p 29), entered in the financial market business in 1867, when it was appointed to be Alabama government fiscal agent. In the 1880s, rapid expansion of railway network in the United States helped to accelerate the rate of industrialization, from an economy that heavily relied on agriculture. Consequently the demand for financial services increased due to the tremendous expansion in the railway network. Lehman Brothers took advantage of this development whereby it started dealing in sales and trading of securities, besides its commodity portfolio. The firm according to McDonald and Robinson (2009, p 31), became a member of the New York Stock Exchange market in 1887, transforming from a commodities business to a banking firm. In addition, Lehman Brothers started providing financial advisory services, which later developed to underwriting business. Under leadership of Philip Lehman, son to Emanuel, the firm in partnership with Goldman Sachs started an association to fund the rising retail industry in 1906.The two firms underwrote securities for some of the most prominent retailers, such as Sears, Roeback and Co, Woolworth Co, Gimbel Brothers and many others(Schack, 1950, p 23). Under Robert Lehman tenure from1925 to 1969, the firm witnessed substantial growth, by initiating policies which encouraged the firm to fund up-coming industries, geared towards mass consumption. It was during this period that the American market was severely hit by the great depression. In this period, Robert Lehman believed that consumption, rather than production, held the future for the Americas economic prosperity. This business philosophy and commitment led the firm into increasing its funding to airlines, motion picture companies, in addition to the retailing industry (Schack, 1950, p 31). In the entertainment industry, Lehman brothers offered financial backup and advisory services to budding enterprises such as Keith-Albee and Orpheum theatres in 1920s.Rapid growth of the entertainment industry continued and later developed into motion pictures in 1930s.In this regard, Lehman Brothers funded a number of these firms, such as Paramount Pictures, and 20th Century Fox. In addition, the firm ventured in communication industry, whereby it underwrote the public offering of television companies, such as Allan B. Dumont Laboratories and Radio Corporation of America (Kulikowski, 2009, p 102). During 1930s, the global economy was hit by unprecedented crisis which resulted from the great depression. Consequently, it became difficult and risky for financial institutions to provide capital in order to encourage investments. Lehman Brothers successfully devised a financing method known as the private placement, which spurred new investments, by minimizing risks to the lenders (Bernard, 2008, pp 67-73). This development ensured that the firm remained competitive in the financial market, expanding its economic portfolio, which allowed it to engage in financing petroleum industry, such as Murphy oil and the Trans Canada pipeline. In addition, the rapidly growing oil industry in the mid 20th century increased demand of capital for expansion, in which Lehman Brothers supported firms such as Halliburton and Kerr-McGee's oil. This expanded gas exploration and production business in the United States, which was witnessing increased demand of energy in the growing industries (Jenny, 2008, p 34). The arrival of electronic and computer technology played a great role in accelerating economic growth in the 1950s, and Lehman brothers seized investment opportunity in electronics industry. In particular, it funded the launching of Litton industries and Digital Equipment Corporation. In addition, the firm expanded in capital markets trade, a feat that resulted in the firm being designated as the official dealer for the U.S. Treasuries (McDonald and Robinson, 2009, p 31). Between 1960s and 1970s, the firm ventured in the international market, where it opened offices in Europe and Asia. In addition, it enhanced its international image by merging with Kuhn, Loeb & Co an international investment bank. The growth in electronic industry according to McDonald and Robinson (2009, p 84), continued significantly from 1970s and Lehman Brothers expanded their investments in applied science and technology. In this regard, it funded firms such as QUALCOMM, a firm specializing in development of digital wireless communication systems, and Loral Corporation, a manufacturer of defence electronics. These firms later became market leaders in their areas of specialization. Development of computer technology intensified from 1980s, when demand for user friendly applications, such as microprocessors and video games increased sharply. Consequently, many small ventures with expertise in design, programming and engineering emerged to become big international corporations. According to Bernard (2008, p 45), Lehman Brothers invested into these new markets, by funding a number of companies such as Intel, which introduced the first microprocessor in the world. Intel has grown by leaps and bounds into a leading global corporation, specializing in provision of personal computers in the world. Moreover the development of new research technology such as biotechnology in 1980s provided new investment opportunities for the Lehman Brothers to finance the upcoming investors in the industry. Biotechnology has proved to be a very attractive field particularly in the health and agricultural fields. The firm was actively involved in funding emerging companies in the industry, to finance research and development of the biotechnological products. Equally important, the firm provided advisory services to multinational companies, particularly when the need to expand into the international and domestic market became the norm. In this respect, major corporations merged in order to increase their market share and reduce the expenses in launching their products and services in the market (Bernard, 2008, pp 43-49). Bankruptcy of Lehman Brothers resulted when the firm invested in subprime mortgage market back in 2001.During this period, housing boom in the US prompted the firm to borrow billions of dollars in order to invest in the housing market. The investment proved a success initially until the housing market crashed in 2007. Consequently, the firm made a heavy loss of $613 billion and by mid September, 2008, the firm was declared bankrupt. The bankruptcy of the firm exposed serious flaws in its decision to invest with subprime borrowers (McDonald, and Robinson, 2009, pp 200-208). Historically, the firm has been making profits by financing sectors which promote mass consumption. Though this was the case in the housing sector, proper risk assessment was not accorded necessary attention. Collapse of housing market, was caused by the inability of the borrowers to repay their loans, as a result of rising inflation and limited money in circulation. Shortage of enough money in circulation in the US economy was caused by the American involvement in two costly wars in the Afghanistan and Iraq. Consequently, the government borrowed heavily in the domestic market. In addition, raising costs in fuel increased the rate of inflation and the cost of living shot up (Kulikowski, 2009, p 100). Though these incidents occurred gradually, the top management of the Lehman Brothers did not heed the risk assessment reports presented by the risks experts. As a result, proper risk mitigation measures were not implemented and the firm suffered great loss, which led to its collapse (McDonald, and Robinson, 2009, p 283). The great depression that affected the US market in the 1930s did not bring down the firm owing to astute management and innovativeness of the firms leadership. However, this contrasted sharply with how the most recent managers dealt with the impending financial crisis (Jenny, 2008, pp 43-44). Bibliography 1. Bernard, B, 2008, Greed and Glory on Wall Street: The Fall of the House of Lehman. New York: Random House. 2. Jenny, A, 2008, Struggling Lehman: Dismissal of 1,500 Employees Inevitable, Economic Journal vol. 14, no 3, pp 42-44. 3. Kulikowski, L, 2009, Mortgage Portfolio Severed by Lehman Brothers: The Future of American Housing, vol. 3, pp 97-109. 4. McDonald, L.G. and Robinson, P, 2009 A Colossal Failure of Common Sense: The Inside Story of the Collapse of Lehman Brothers. New York: Crown Publishers. 5. Schack, J, 1950, Lehman Brothers: Centennial - Lehman Brothers 1850 - 1950. New York: Spiral Press. Read More