Lehman Brothers Holdings Inc - Associated Risks, Losses, and their Impact - Example

of the of the Number Lehman Brothers Holdings Inc. Contents Contents 2 Introduction 3 2. Discussion 32.1. The Problem 3 2.2. Associated Risks 4 2.3. Associated Losses and their Impact 5 2.4. Addressing the Problem 6 3. Conclusion 7 Works Cited 8 1. Introduction Lehman Brothers Holdings Inc. was a well-known global financial services company with its headquarters in New York, United States. Prior to 2008, Lehman Brothers used to be the 4th largest investment bank, only after giant financial enterprises such as Goldman Sachs, Morgan Stanley, and Merrill Lynch. The company was associated with business related to investment banking, sale of equity and fixed income products and private equity, trading of U.S. Treasury securities, investment management as well as private banking. In spite of such well established operations of the company with $639 billion in assets, the financial crisis of 2008, combined with many other factors, brought the bank on the verge of bankruptcy, and subsequently the financial institution reported a collapse on September, 2008. The case of Lehman Brothers’ bankruptcy was the biggest in the history of the United States. The paper will analyze the root cause of the problem that drove Lehman Brothers to collapse, associated risks, impact of associated losses as well as possible solutions of the concerned problem. 2. Discussion 2.1. The Problem The business model of Lehman Brothers was not an exceptional one. Lehman Brothers was incorporated as a risk oriented business structure like multiple investment banks that are formed with a highly leveraged business structure. Lehman Brothers used to maintain an asset base of $700 billion but most of those assets were long term in nature whereas the debts were short term. Such imbalance in asset-liability and Lehman Brothers ignorance for correcting such disparity was the initiation of the problem which had led the investment bank to collapse. In 2006, Lehman Brothers decided to incorporate an aggressive growth strategy for amplifying its bottom line which required the company to adopt a highly levered capital structure rather than funding itself through short term repo-rates. When the sub-prime residential mortgage business in 2007 approached towards crisis, Lehman Brothers failed to recognize the spillover effect of such problem into commercial real estates. Hence, instead of pulling back all its money from this drowning sector, Lehman Brothers kept on increasing their exposure with a hope to gain huge profit from counter-cyclical strategy. For the requirement of additional exposure, Lehman exceeded their own internal risk taking capacities in repeated manner. When Bear Stearns collapsed by adopting a similar business strategy in March 2008, it became an alarming situation for Lehman Brothers as well, as many financial analysts had figured out Lehman Brothers to be the next investment bank to collapse (Christopoulos, John Mylonakis and Pavlos Diktapanidis). Instead of rectifying its own strategies, Lehman Brothers implemented various deceptive strategies such as reporting of faulty financial statements and making unethical relationships with rating agencies to obtain a decent rating in order to avoid failure. When such activities became prominent, investors’ confidence gradually eroded. Hence, when Lehman Brothers presented a defective leverage ratio of less than 12.5 and reduced net asset of $60 billion in their balance sheet due to liquidation of assets, their auditor Ernst & Young did not raise any question. Even in the first week of September 2008, the company declared that they had managed a liquidity pool of $40 billion, a substantial part of which was either overburdened or illiquid (MacEwan and Miller 485). In the meantime, the stock price of the company experienced a drop of 94%. A combining effect of all these factors led Lehman Brothers to collapse. 2.2. Associated Risks Several credit and market risks were associated with the bankruptcy of Lehman Brothers. Credit risk arises when the borrower relies on a future cash flow for paying the existing debt. If the borrower fails to receive the expected amount, it will lead the lender to the verge of credit risk due to inability of the borrower to repay. Market risk is a systematic one that the investors experience as a result of turmoil in financial market. The financial crisis of 2008 which was ignited by the collapse of Lehman Brothers led the market to experience both the kinds of risks. The business decisions made by Lehman Brothers way before 2008 showed that one of the major reasons behind the company’s demise was its propensity to take decision beyond its risk bearing capacity. In 2006, the business strategy adopted by the company was much aggressive as compared to the bank’s traditional investment banking behaviors. Consequently, Lehman Brothers failed to meet its short term obligations, in-spite of having a huge asset base. Liquidity problem became prominent and as a result of broken market confident most of the private banks started withdrawing their credit lines to Lehman Brothers. In order to strengthen its liquidity base, Lehman Brothers sold its assets of $147 billion, but such strategy further resulted in a decline of 20% in the commercial mortgage exposure. Such liquidity crunch combining with the previous loans of Lehman Brothers taken for the requirement of aggressive expansion had driven the financial intermediary to be exposed to a credit risk (Presley and Bryce Jones, “Lehman Brothers: The Case Against Self-Regulation”). High borrowing attitude of Lehman led the investment bank to a highly leveraged position, confirming the high riskiness of its capital structure. In 2007, the leverage ratio of Lehman Brothers became 44:1 which indicated that for $1 of cash requirement the company would have to lend $44. Such huge debt component in the capital structure and Lehman Brothers approach of publishing decisive financial statements soon resulted in broken investors’ confidence and let the investment banking institution exposed to market risk (“Lehman Brothers’ Bankruptcy”). 2.3. Associated Losses and their Impact The bankruptcy of Lehman Brothers exposed hardship in operations of a number of organizations in the United States and the world as well. The failure of Lehman Brothers caused depreciation of price of commercial real estates in the United States. A 70% quench from $48 billion of receivables from derivatives. In terms of market value, it had suffered from a shrink of $46 billion. Being the most trusted broker of the US, Lehman Brothers was responsible for more than 1000 hedge funds (Baba and Frank, “From turmoil to crisis: Dislocations in the FX swap market before and after the failure of Lehman Brothers”). Hence, the foreign exchange derivatives market became tranquilizing immediate after the incident happened. A number of institutions suffered due to their exposure to Lehman Brothers in terms of home loans. For instance, the demise of Lehman Brothers resulted in writing off of Federal Home Loan Mortgage Corporation’s contract of $400 million and the $48 million debt of Federal Agricultural Corporation. The US’s leading energy producer Constellation Energy’s stock price was slashed by 56% in New York Stock Exchange because of its trading relationship with Lehman Brothers. Coming to the international context, the global economy was not entirely vindicated from the adverse effect of Lehman Brother’s bankruptcy. The Japanese Banks and Insurance Companies reported a loss of 249 billion yen (translating in US currency, it came close to $2.4 billion) with respect to their relation with Lehman Brothers in terms of unsecured guarantee. For the same reason, Royal Bank of Scotland encountered a loss of $1.8 billion. Approximately 5600 investors from England suffered huge amount of losses because of their total investment of $160 million in the structured products sold by Lehman Brothers. A state owned bank from Germany lost 500,000 Euros whereas at the same time $12 million of hedging fund of England remained un-squared off as a result of Lehman Brother’s bankruptcy (Baba and Frank). Such severe consequences of Lehman Brother’s collapse was considered to be synonymous with financial crisis and wealth destruction that had accounted for more than 6 million of job losses in global economy. 75 distinct bankruptcies were preceded by the collapse of Lehman Brothers. Many small firms had to shut down their operations as a result of crunches in investible funds. The confidence of general public broke due to massive job cuts and lessening in disposable income and subsequently, the stock exchanges also crashed (Sandretto, 426). 2.4. Addressing the Problem In order to take preventive measures to control from another Lehman Brothers incident to occur, it is important to identify the areas where restrictions should be incorporated. In depth, examination had shown that the risk attitude of the financial institutions should be calculative in nature while taking exposure in market (Schapiro, 258). Failure of Lehman Brothers has justified the requirement of stress testing as well where the asset liability portfolios of different financial institutions are evaluated in different financial situations. One of the main reasons for Lehman Brothers to collapse was the institution’s decision to raise capital and include risky assets in its balance sheet, beyond the limits as stipulated by capital adequacy ratio. Hence, the exposure of risky assets raised and maintained by the financial institutions should also be required to comply with the ideal capital adequacy ratio (Fleming and Asani Sarkar). The financial statements of Lehman Brothers have shown alarming situation regarding liquidity crunch well in advance. However, the chief executives neglected such trepidations and they also indulged into producing decisive financial statements to mislead general investors which in turn directed Lehman Brothers to bankruptcy (Kwaku and Mensah Mawutor). Therefore, liquidity management and fair valuation of assets are also of utmost importance in order to prevent the financial systems to collapse. Lehman Brothers prioritized their own interest rather than the corporate interests which had created conflict of interest by violating corporate governance. Strong corporate governance should also be incorporated in order to control fraudulent activities (Addo, 296). 3. Conclusion The recent competitions among commercial banks let the banks to adopt more risky approaches. However, such behavior has dragged the banks on the verge of bankruptcy, disrupting the equilibrium of financial systems. Hence, the banking system should incorporate preventive measures in terms of unethical practices and risky investment exposures. The role of external auditors should also be more effective and transparent in order to control dubious financial practices of private institutions. All such efforts will lead the baking and financial institutions to take a more sustainable attitude towards their business expansion so that the global economy does not need to experience another case of Lehman Brothers. Works Cited “Lehman Brothers’ Bankruptcy”. PwC.com. 7 April 2009. Web. 14 February 2015. Addo, A. H. The 2008 Financial Crisis: The Death of an Ideology. Pittsburgh: Dorrance Publishing, 2010. Print. Baba, Naohiko and Frank Packerb. “From turmoil to crisis: Dislocations in the FX swap market before and after the failure of Lehman Brothers”. Journal of International Money and Finance 28.8: 1350-1374. Print. Christopoulos, Apostolos., John Mylonakis and Pavlos Diktapanidis. “Could Lehman Brothers’ Collapse Be Anticipated? An Examination Using CAMELS Rating System”. International Business Research 4.2: 1913: 2050. Print. Fleming, Michael. and Asani Sarkar. “The Failure Resolution of Lehman Brothers”. Federal Reserve Bank of New York 2.1 (2014): 2-18. Print. Kwaku, John. and Mensah Mawutor. “The Failure of Lehman Brothers: Causes, Preventive Measures and Recommendations”. Research Journal of Finance and Accounting 5.4 (2014): 85-89. Print. MacEwan, Arthur. and John A. Miller. Economic Collapse, Economic Change: Getting to the Roots of the Crisis. Armong: M.E. Sharpe, 2011. Print. Presley, Theresa. and Bryce Jones. “Lehman Brothers: The Case Against Self-Regulation”. Journal of Leadership, Accountability and Ethics 11.2 (2014): 11-22. Print. Sandretto, Michael. Cases in Financial Reporting. London: Cengage Learning, 2011. Print. Schapiro, Mary. L. Lehman Brothers Examiners Report: Congressional Testimony. Darby: DIANE Publishing, 2010. Print. Read More