Analysis of Lehman Brothers Holdings Inc - Case Study Example

The Case Study of Lehman Brothers Holdings Inc. The Lehman Brothers filed for the largest Chapter 11 bankruptcy protection in the history of the US on September 15, 2008 (Knapp 23). The move by the firm caused a number of concerns from stakeholders in the entire banking industry as well as the international community. The company had turned to relying on Repo 105 system to manage its balance sheet as an alternative to the reduction of its reported net leverage. Such a move followed the company’s overburdening with illiquid assets, which it could not sell. The acquisition of illiquid assets by the firm was also the cause of an investigation regarding the valuation and liquidity ratios of the company. As much as the risk decisions of the business fell within the business judgment rule that did not result in colorable claims, many experts considered them as retrospective. Others reviewed the decisions that the company made as being out of poor judgment (Knapp 23). There is a need for the financial institution regulators eliminate the gaps in their regulatory activities that permit enormous, complex, and interconnected institutions to run without supervision in the future. Introduction Many corporate institutions fail not only because of the lack of profits, but also because of problems in their cash flow. The operations of the fourth-largest investment bank, Lehman Brothers came to a halt in 2008 while the company had share prices trading at $86.18 that dropped to $4. The business had over 25000 workers across the globe by the time of its bankruptcy (Knapp 24). As a result, the Bankruptcy Court in New York’s South district ordered for the appointment of an examiner in the company’s case. The company’s case was the largest in the history of the nation because it had more than $700 billion in assets and more than $600 billion in debts. The case overtook the previous records of firms such as Enron and WorldCom. A collapse in the housing market of the U.S. economy brought down the corporation because it had previously rushed into the subprime mortgage market, which was extensively affected by the recession. In the 2005-06 period, Lehman Brothers was the biggest producer of subprime-based mortgage securities. There were more than a dozen lawsuits filed against the company in 2007 with an allegation that the business institution had lured and compelled borrowers to take on unaffordable loans. The company’s collapse also made it the biggest victim financial crisis induced by subprime mortgage issues in the US, and caused the crisis to move through global markets. The collapse was also a decisive event that intensified the 2008 economic crisis and eroded more than $10 trillion from world equity markets (Knapp 24). The organization’s top three counterparties at the time were J.P Morgan, Deutsche, and UBS. However, many critics considered the counterparties and particularly J.P Morgan as being risky for LBI. Much of the concern between the two firms related to the fact that Lehman Brothers had prevented a merger between Chase Manhattan Bank and J.P Morgan from ever attaining the expected synergies. Lehman Brothers was a party to three of the most common forms of transactions, namely: foreign exchange derivatives interest rate swaps, as well as credit default swaps. However, the confidence of customers continued to fall as the firm saw its share prices fall by half (Knapp 27). In 2008, the company realized an unprecedented loss because of continued subprime mortgage crisis. The loss alluded to the fact that the enterprise held subprime mortgages and other mortgages with low ratings by the time of the crisis. This work analyzes the case of Lehman Brothers with a consideration for the decisions the company took and its subsequent fall. The paper categorizes the analysis into four sections, namely: the key players in the case, background information, key facts and questions and the lessons learned from the litigation. Key Players in the Case This section of the report contains a discussion of the key stakeholders in the situation, which includes the client, the accountant, and the third parties. For this case, the client was Lehman Brothers. The company had close to $700 in assets at the time it failed (Knapp 30). Such a fact makes the company the biggest bankruptcy case in the nation’s history. The business had worked out a number of activities before it settled into the finance industry. For instance, the company started and operated as a cotton dealer because of booming business in the industry. However, the company moved on and tried a mixture of merchandise trade before it settled finally in the mortgage insurance industry (Knapp 30). Lehman flourished financially because its line of business mushroomed with derivative markets in the 1990s and beyond. The company grew more active in the market for residential mortgage-backed securities (RMBS) than it had done before. At that time, there were many RMBS because of the involvement of the government agencies, investment banks, and brokerage firms’ participation in the business. The trade involved a securitization process in which the company bought as many residential mortgages from mortgage companies, banks, and other entities. After the purchase, the company would pool them and sell their ownership rights in pools to other institutions (Knapp 30). The second player in the case was E&Y Company, who was the accountant, in this case, who audited the accounts of Lehman Brothers from 2004-2008. At that time, the company used the Repo 105 accounting method. The adopted approach targeted to reduce the leverage ratios of the enterprise because the significant figures would attract the attention of the stakeholders. In the spring of 2010, the shocking revelation concerning the bankruptcy of the company caused the DJIA to plunge over 500 points within a few hours. Such a case was a precursor to a series of events that followed and resulted from the adopted accounting method that management of Lehman had proposed. One such action was the appointment of a bankruptcy examiner by a court in the southern district of New York to investigate the case (Knapp 30). The examiner released a 2,200-page report that summarized his findings. The examiner had reviewed more than 20 million documents and more than 20 million e-mails for which his team spent $38 million. The massive report documented the circumstances as well as the events that resulted in the collapse of the collapse and all the parties that the examiner believed had the civil liabilities regarding the case. The report prompted an outcry from the public because it suggested that the officials of Lehman had used multibillion-dollar systems to cover up their financial records. The third player in the case was the third parties were institutions that participated in the case as well as those that the case affected. In the 2003-2004 period, Lehman Brothers acquired five mortgage lenders that included BNC Mortgage that was a subprime lender and Aurora Loan Services that was an Alt-A loans specialist. Alt-A loan specialization means that Aurora Loan Services would obtain loans without to borrowers without the use of full documentation (Knapp 34). The associate corporations would help Lehman Brothers to run smoothly in the housing boom era. At first, the acquisition by the company of the two others paid off well because the company realized a growth in its profits. Background Information on the Case An increase in the demand for RMBS resulted in the rise of aggressiveness of mortgage originators in their extension of loans to individuals who had previously found it hard to access them. The cause of their failure in the past attributed to their poor credit worthiness, poor history, and other terms. Most customers were first-time homeowners, which the mortgage terms call subprime mortgage holders. Most of the mortgage originators did not have much consideration for the risks posed in the proses because they wanted to sell their loans downstream and transfer the risks to the purchasers (Knapp 34). The most critical factor that underlies the health of the market for housing business was the sharp decline in the market prices for houses. Initially, the steady rise in the housing prices of the country had minimized the perception of risk factors in the business. However, the turnaround meant that there was an increase in the mortgage defaults, which would be dangerous for institutions such Lehman because they owned significant amounts of the securities. The events leading to the latter happening would mean something like what happened to the Lehman Brothers. Housing prices reached their peak in the US in 2006 and by late 2007, they had begun tumbling such that there was a decline of 20% in mid-2008 (Knapp 34). There was an even sharper fall in markets such as South Florida and Las Vegas that initially had the highest rise in prices. For instance, the market prices dropped by more than 50%. The fall in prices of housing in the country caused an increasing number of homeowners in the country to be upside down. Such a statement means that the market prices for the homes they owned were lower than the remaining portions of the mortgage loans (Knapp 34). In fact, by early 2008, an approximated 9 million Americans had a negative equity of their homes, which resulted in a sharp decline in mortgage defaults and foreclosures. It was not along that the sharp fall in the housing prices reduced the market prices for RMBS Knapp 34). Government agencies, investment banks, and large institutional investors that had ownership interests in RMBS found the value of their securities spiraling downwards. It was even sure that the prices would continue falling and in some cases, the markets for such securities froze. At that condition, the securities did not attract sales at any prices. As such, Lehman Brothers was among the affected institutions because it owned considerably large amounts of such securities. There arose interest by financial analysis concerning the leverage ratios for the company, which made the CEO, Richard Fuld to call for a company-wide deleveraging method. The CEO noted that the company needed to reduce the leverage ratios and attract the confidence of market investors and lenders. As a result, the companys management chose to use an unconventional method that would reduce the leverage ratio of the institution. The company adopted the Repo 105 transactions near the end of each quarterly reporting period (Knapp 34). The third party financial statements did not cause a problem because the method omitted Repo 105 transactions from the company’s accounts. Therefore, such parties did not realize that the company altered the ratios deliberately to hide the enormous leverage ratios that would compromise its reputation to the stakeholders. After the declaration of the company’s bankruptcy, there was appointed an examiner that would investigate the case and determine the cause of the problem. For this example, Lehman’s bankruptcy examiner determined the cause of the problem and noted that the company did the Repo 105 procedures purposefully because of its reputation. Essential Facts, Question, and Related Discussion Key Fact: E&Y Did Not Play a Critical Part in the Failure of the Company Key Question: Do Auditors Have a Responsibility to Determine Whether Significant Transactions of a Client Are Accounting-Motivated? Before ascertaining the role of E&Y in the case, there is a need to review the standards for consulting services set by AICPA. The standards require that the company respond to the needs of the client in a professional way. For this case, there was no need for E&Y to object the adopted method that the company had chosen. A second consideration is the fact that Lehman had kept substantial information hidden from its auditor. However, there is a need to review the duties and standards of auditing set by AICPA, as well. For this case, the rules place E&Y in the prime position of accepting liability for the outcomes of the audit process. Such a case would mean that the auditor was to blame for collaborating with its client to corrupt the results of the reports given to the public. However, there are questions that need meditation before ascertaining the liability of E&Y in the case. The first issue concerns whether Lehman’s board understood the risks associated with the use of Repo 105. The second issue concerns whether the same board knew the level to which the chosen method altered the leverage ratios. The third question still relates to the board, this time concerning its decision to raise the allowable risk celling without considering the effects and failing to monitor the progress of its adoption. The answers to three questions may find some levels of blame on the auditing firm. For this case, the auditor was to advise the client concerning the right moves for the first two questions. As much as some people may suggested that the company kept some information hidden from the auditor, there is an understanding that the purpose of the auditor was finding faults in the accounting system. For the remaining two questions, the give the auditor with no escape route out of liability because they happened while the auditor worked for Lehman. In any case, the auditor should have advised the client against such moves. Such an argument means that auditors have a responsibility to determine whether significant transactions of a customer are accounting-motivated. The argument still points to the fact that E&Y could have helped the company out of the jeopardy that followed the poor choices. The help could have inclined the company to the appreciation that accounting practices should not perceive the interests of one party only. It also means that the best practices should incorporate the interest of all the concerned parties. Lessons from the Case The Lehman case gives important lessons for both business managers and account auditors. For the former party, there is a need that they weigh the decisions made before implementing them. For instance, Lehman progressed from one mistake to another consistently to the last one that caused its failure. The first mistake that the company made concerned its investment decisions in the subprime mortgages. The decisions pushed the firm into winning the trust of many clients and caused the next wrong choice. For this case, the next choice concerned the business’ move to adopt the use of Repo 105 accounting method and keep it hidden from the auditors. The auditors noticed foul play in the accounting system of the company and chose to keep quiet. Therefore, the case is a mockery of wrong corporate decisions. Conclusion This work has analyzed the case of Lehman Brothers in four categories. The background of the case provided much information concerning the simulators to the failure of the company. As such, the source of the failure was the drop in the market prices for houses in the US, which eroded the subprime mortgages that Lehman held. The company then chose to adopt the Repo 105 accounting method that hides its problems for a short period, which latter caused its downfall. Another part was the stakeholders of the case for which the report identified E&Y as the auditor and Lehman was the client. The case also involved other stakeholders. Another element was the most critical question from the case, which resulted in the conclusion that both the firms management and its auditors were to blame.   Works Cited Knapp, Michael. Contemporary Auditing. Cengage Learning, 2015. Print. Read More