Business Failure Analysis - Lehman Brothers Bankruptcy - Case Study Example

Business Failure Analysis

Lehman Brothers Bankruptcy

Introduction to the case with evidence

Survival of organizations today increasingly depends on their capability to adapt quickly and to undergo effectively various internal and external changes. Financial and economic crises are referred to the extreme form of change, whereas the company has a limited set of alternatives: either bankruptcy or successful adaptation and transformation (Appelbaum, 2012). The recent sub-prime crisis of 2008-2009 has become a threat to many different organizations, especially those operating in banking and financial services industry. Unexpectedly, many financial institutions and banks needed bailout money in order to survive and not be liquidated (Appelbaum, 2012). While such crisis conditions have been mainly created by the external factors, management was responsible for overcoming crisis event by adopting adequate decisions and finding timely solutions. The case of Lehman Brothers is a case when management failed to management to foresee, recognize and take reactive measures on time to manage the crisis lead to the company’s bankruptcy and massive negative economic consequences for many smaller players in the banking industry. This paper aims to provide a more detailed multi-level root cause analysis of Lehman’s business failure.

Lehman Brothers and its business failure

Lehman Brothers was one of the largest investment banks that was founded back in the 1850 (Winford, 2013). Over its 150-years old history the bank has undergone numerous downturns and recessions becoming the largest underwriter of US mortgage bonds (Johnson and Mamun, 2012). However, in September 2008, the bank filed for liquidation, reporting huge financial losses in the sub-prime mortgage market (Appelbaum, 2012). The failure and eventual bankruptcy of Lehman Brothers incurred significant losses for its creditors and equity holders. According to Fleming & Sarkar (2014), Creditors filed around $1.2 trillion of claims against the Lehman estate. In fact, the failure of Lehman Brothers in 2008 has turned out into the largest bankruptcy in the history of US. The failure of the bank employing more than 25,000 employees around the world with assets and liabilities of $639 billion and $ 613 billion, respectively, contributed negatively to the global economic recession (Paulson, 2010; Lowenstein, 2010). What is more interesting in the case of failure of one of the bank giants in the US was unexpectedness of Lehman’s collapse. In the first quarter of 2008, when all major financial institutions reported substantial losses from write-downs in real estate market, Lehman Brothers reported profits (Williams, 2010).

A systematic multi-level root cause analysis (1500)

While aiming to analyse the root causes of Lehman Brothers’ failure in 2008, it is important to adopt a systematic multi-level root cause analysis, with a strong focus made on such critical aspects as company’s strategy, corporate culture, structure, etc.

Strategy at Lehman Brothers

While for its investors, regulatory bodies and other key groups of stakeholders the investment bank had a well-polished corporate strategy, the interviews with the former employees of Lehman Brothers have shown some critical aspects and gaps in this area. More specifically, there were identified four major aspects: (1) lack of clarity of the firm’s strategy; (2) desire to grow bigger faster; (3) goal to grow to $150per share; and (4) maniacal desire to be the best (Winford, 2013).

As it has been revealed in the empirical study carried out by Winford (2013), the employees of Lehman Brother lacked clarity and consistency of the company’s business strategy in the last years of the company’s existence. Many employees were doubtful about the firm’s overall strategic direction and goal pursued by the company (Winford, 2013). Meanwhile, the company had a clearly defined growth strategy and ambition to be the largest investment bank. As some of the former employees explained: “Lehman Brothers always wanted to be a big investment bank…and never had the balance sheet to do it” (cited in Winford, 2013). The management of Lehman Brothers cultivated the idea that the company’s stock should reach $150 despite the adverse changes in external environment. Furthermore, the company was pushing hard to outperform its key competitors – JP Morgan and Goldman Sachs. As many former employees of Lehman Brothers stated, the “firm’s strategy was simply to beat Goldman Sachs” (Winford, 2013: 64).

Based on these statements it is possible to suggest that the ambitions and inspirations of Lehman Brothers’ leaders were quite egoistic and narrow. The ambitions of bank executives were not backed up by realistic plans and long-term sustainable strategy, rather were driven by unhealthy spirit of competition.

Organizational structure

The choice of organizational structure predetermines the ways the employees and management interact with each other, what communication systems are used and the extent to which company can adapt to external changes and market fluctuations. The research indicates that organizational structure of Lehman Brothers was decentralized, autonomous structure with flat hierarchy. The investment bank adopted decentralized organizational structure, whereas business operations were run by business units with minimal intrusion of top management for large transactions. While this type of structure enabled the bank to adapt to changes and local environments more effectively, it prevented Lehman Brothers rom effective and balanced decision-making process destructed by isolated parts of organization. In addition to this problem, structure of Lehman Brothers provided individual contributors with relatively high autonomy and freedom to make their own decisions (Winford, 2013). This structure made the decision-making process at Lehman Brothers more fragmented and less coordinated, raising thus potential conflicts and misunderstandings among divisions.

Inadequate systems and risk management processes

Lehman Brothers has managed to grow significantly its balance sheet since 2006, making up its investment portfolio comprised of long-term investments funded through short-term borrowing (Hines et al., 2011). Company’s assets were comprised of significant shares of commercial and residential mortgage-back securities. Even though by 2007 the residential mortgage-backed securities began to illustrate the signs for concerns, the management of Lehman Brothers continued its aggressive investment into these risky and doubtful assets (Hines et al., 2011). In result of these risky investments, the company faced with the challenge of selling assets as their liquidity has been substantially lowered.

Some experts believe that this mismanagement of Lehman Brothers’ assets indicated on the firm’s poor risk management strategy. The company had inadequate systems in place that also might have contributed to the banks’ balance sheet mismanagement. As some of the employees reported: “There was a huge push to grow and take more and more risks…and they were left warehousing an enormous amount of assets” (Winford, 2013: 68). Obviously, this risk taking strategy was closely interrelated to the firm’s strategy of high stocks and growth ambitions. Focus on risky projects and innovation of new profitable but doubtful products made the company to get into its own financial trap. As some researchers later concluded, the company’s management “was paved with an increased appetite for risk in pursuit of increased revenues” (Hines et al., 2011: 40). People were encouraged and financially motivated to generate firm’s profits despite the macroeconomic risks imposed with these decisions. The company’s decentralized structure enabled the firm to focus on monitoring and managing risks at micro level but posed barriers on evaluating the deals in the context of accumulated, aggregate risks (Winford, 2013).

Even though Lehman Brothers had risk management committee, many experts and researchers believed that its role and influence were negligible (Winford, 2013). Madelyn Antonic, who was a chief risk officer in Lehman Brothers until 2007 was dismissed as the management was not keen to understand better the firm’s risk position. Madelyn Antonic was replaced by an employee from finance department, who was looking for the opportunities of internal promotion and who probably has readily closed eyes on some critical issues (Winford, 2013). In fact, when Madelyn Antonic left the company in 2007, a centralized, sophisticated risk management function at Lehman Brothers also disappeared.

Culture and Leadership

The organizational culture of Lehman Brothers during the last years of bank’s existence was characterized by such features as: aggressiveness, arrogance, competitiveness, and invincibility (Winford, 2013). Throughout the whole organization employees of Lehman Brothers were competing internally with other employees and divisions, neglecting by such powerful HR tools as team-work, collaboration and cooperation. While some employees argue that collaboration was more common at the level of individual business units, there was no or limited signs of collaboration and team work at the upper level of Lehman Brothers (Winford, 2013). As it has been already mentioned the culture was promoting risk-taking behavior, whereas employees enjoyed greater autonomy and freedom to make decentralized decisions. What is also important to mention is that at the macro level, systems of Lehman Brothers did not impose a requirement to monitor or track the risk positions of Lehman’s business units during the last three years prior to bank’ bankruptcy (Winford, 2013).

Leadership and culture in the Lehman Brothers both were well aligned with the firm’s profitability and growth plans. The leaders placed a strong focus on taking market share from key competitors. In 2006, the instruments for achieving the above discussed strategic goals were mainly associated with the commercial real estate. However, leaders of the bank failed to predict and evaluate the risk profile of these assets neglecting by some common risk management tools and mitigation measures (Winford, 2013).

Failure to analyse the market trends and foresee potential scenarios

Lehman Brothers being a company with the strong perception of being “too large to fail” has proved to be ill-prepared to predict and to foresee potential internal and external threats. As Boedihardjo (2009) explained, the management of Lehman Brothers developed its real estate investment plan based only on an assumption that the housing market will grow continuously. Thus, having no alternative scenarios of potential bubble the management of Lehman Brothers failed to detect the threats at early stages and therefore, to undertake some effective prevention measures (Appelbaum, 2012). If Lehman Brothers had effective detection measures in place supported by effective internal communication and early warning systems, the company’s business failure could be prevented and the overall damage could be limited (Appelbaum, 2012). However, the management of the company could not even assume the firm’s vulnerability to the industry trends and market manipulations.

Accounting and reporting manipulations

However, in addition to professional negligence and excessive risk taking culture, there were some concerns related to the ethical aspects of decision making processes at Lehman Brothers over the past few years of the bank’s existence. Hines at al. (2011) suggested that in order to maintain the confidence of investors Lehman executives allegedly mislead investors by leveraging ratios. According to Hines et al. (2011), management of Lehman Brothers performed the so called Repo 105 transactions whereas the company intentionally used its cash secured from collaterized borrowings to retire other collaterized borrowings. Thus, for instance, in May 2008, the company received $51 billion of financing, which secured the firm’s assets from financial reports and eliminated the loan (Hines et al., 2011). Meanwhile, it also paid off $51 billion of other short-term loans that enabled the company to reduce its net leverage ratios by 9-13% and gross leverage ratio by 5-8% during the period from 2007-2008. This practice helped the company to present more sustainable financial position of the bank than it was in reality. It is also interesting to note that these Repo 105 transactions were not disclosed in the reports to the SEC or in Lehman’s financial reports (Hines et al., 2011). Thus, the company intentionally used accounting manipulations in order to mislead its existing and potential investors and regulatory bodies. Unethical behavior and excessive arrogance of the Lehman Brothers top executives disguised the bank’s actual financial problems and contributed greatly to its overall business failure.

Turnaround or exit strategy

As it has been already mentioned in the introductory section of the report, crises and adverse changes in external environment are inevitable elements of business. While all companies to different extents face with various challenges threatening not only their market shares but their overall existence, some businesses manage to survive and turn crises into the opportunities. Still, many companies fail to adapt and adequately respond to changes and end up with business failure and bankruptcy. The case study of Lehman Brothers indicates that the even though all financial and banking institutions have faced with the challenges posed by real estate and mortgage crises of 2008, the company could avoid the bankruptcy and to retain business on the surface. If the executives of Lehman Brothers did not manipulate the financial reporting information in order to mislead investors and did not reinvest assets into doubtful and risky portfolios comprised of mortgage and real-estate products, the consequences of the failure might have been not so dramatic. The management of the bank should have predicted and foresee the potential risks and take relevant measures in order to protect its investors and shareholders. If the company’s management had developed strong transformational and visionary aspects of its strategy and organizational culture, it might have a positive impact on the overall firm’s performance during crisis. As Stevens and Buechler (2013) explained, Lehman Brothers failed to provide sufficient guidance to its employees on how to act in uncertain and difficult situations (Stevens and Buechler, 2013). Employees were not managing and taking risks responsibly. Therefore, as part of the turnaround strategy, Lehman Brothers had to adopt a sufficient risk management strategy and to reconsider its overall approach to profit generation. Instead of dismissing the head of risk management division, the company’s management had to empower the person responsible for risk management to adopt organization-wide risk management sessions, trainings, systems and processes. In addition to the management actions, the Board of the Lehman Brothers also should have taken more proactive approach in directing and monitoring its executives. By addressing all of the above discussed issues and problems, Lehman Brothers would still incur significant financial losses but might not go bankrupt.

Conclusion

Lehman Brothers was one of the largest investment banks that was founded back in the 1850. However, in September 2008, the bank filed for liquidation, reporting huge financial losses in the sub-prime mortgage market (Appelbaum, 2012). In order to analyse the potential causes of the failure of such a big giant in the banking industry, which was too large to fail, there was carried out a more detailed analysis of the firm’s strategy, structure, culture and leadership. While the bank had a relatively unclear strategy in terms of corporate vision and strategic aspirations, it was obvious that fast growth and ambitions to grow to $150per share were the top priorities of management’s agendas. However, the ambitions of bank executives were not backed up by realistic plans and long-term sustainable strategy and finally, suffered fiasco in 2008. The organizational structure of Lehman Brothers was decentralized, autonomous structure with flat hierarchy. The investment bank adopted decentralized organizational structure, whereas business operations were run by business units with minimal intrusion of top management for large transactions. While this type of structure enabled the bank to adapt to changes and local environments more effectively, it prevented Lehman Brothers rom effective and balanced decision-making process destructed by isolated parts of organization. In addition to these issues and concerns, the company had significant problems with risk management. Being driven by greediness for profitability, the company’s culture and structure stimulated manager and employees to take risky decisions and undertake risky projects. Focus on risky projects and innovation of new profitable but doubtful products made the company to get into its own financial trap. Dismissal of chief risk manager Madelyn Antonic in 2007 also served as a contribution to the bank’s failure and unpreparedness to manage and mitigate external and internal risks. In addition to all of the above outlined aspects, it also has been revealed that the management of Lehman Brothers intentionally violated the ethical code of conduct, manipulating by the accounting and financial reporting information. The company used Repo 105 transactions in order to maintain investor’s confidence by handling its collaterised assets and liabilities and leveraging its ratios. The case study of Lehman Brothers indicates that the even though all financial and banking institutions have faced with the challenges posed by real estate and mortgage crises of 2008, the company could avoid the bankruptcy and to retain business on the surface. While it is possible to claim that Lehman Brothers has become a “victim” of external housing bubble effect, it is also possible to state that the bank’s failure could be prevented if the company had clearly defined sustainable strategy, collaborative teamwork, organizational culture cultivating sustainable innovation, adequate risk taking strategies and socially responsible management.