Business Failure of Lehman Brothers - Case Study Example

Introduction

Business, collapse, often is a result of single or multiple causes that gradually choke the business, more so in a financial sense, resulting in its inability to continue with its operations. While failure of small businesses usually arise from poor choices of such fundamental units as market understanding, financing, poor customer strategy, among others, failure of established businesses tend to emerge from managerial discourses that fail to exploit the prospects of the business in the contemporary market. Khelil (2014) while analysing the many faces of entrepreneurial failure, explores three pertinent theories associated with the same namely the voluntarist approach that rejects the notion that environmental factors play a role in business failure, the deterministic approach that associates business failure with environmental factors and emotive approach that assigns the same to varying degrees of motivation, commitment and aspiration. Notwithstanding whether then associated forces act singly or in collaboration with other structural aspects of the business, venture failures of large companies have everything to do with management decisions, especially its objectivity to understanding and adjusting to market dynamics. To that end, this paper attempts to put to perspective the different aspects that characterize the failure of Lehman Brothers, once the forth-largest investment bank in the U.S.

Company background

Lehman Brothers traces its roots back to a small grocer shop established in Montgomery, Alabama in 1844 by Henry Lehman, a German immigrant. His two brothers would later join him in 1850, prompting the change of the business name to Lehman Brothers. Soon after its establishment, the business grew faster and embarked on general merchandising and commodity brokerage to cotton farmers of Alabama. With its rapid growth, the business soon entered into a partnership with John Wesley Durr to build a cotton storage warehouse, and subsequently the establishment of an office in New York to establish a stronger presence of the business and facilitate its financial undertakings. After setbacks of the civil war, the firm emerged stronger and managed to establish the New York Cotton Exchange in 1870. The firm would prosper in the subsequent decades as the U.S. economy grew to becoming an international powerhouse.

However, Mosman (2009) reports that the road to its success was not that rosy since it had to contend with numerous challenges. For instance, the railroad bankruptcy of 1800s, the Great depression of the 1930s, the two world wars, a capital shortage following the decision to bypass it by the American Express Company in 1994, the collapse of the Long Term Capital Management as well as the 1998 Russian debt default, all of which it navigated successfully. However, the company’s decision to rush into the U.S. subprime mortgage market followed by the subsequent collapse of the same in during the 2007-08 economic crises finally brought it to its knees. Brinkman (2011) reports that the U.S. housing boom of 2003-04 saw the acquisition of five mortgage lenders by Lehman Brothers, including BNC Mortgage and Aurora Loan Services that at first enhanced the performance of the company.

In fact, between 2004 and 2006, the company’s recorded a 56 percent growth in its capital market units, a rate that was far much better than any recorded in the investment banking or asset management market. In 2006, the firm securitized $146 billion dollars’ worth of mortgages, representing a 10 percent growth from the 2005 figures (Fabozzi, Martellini and Priaulet, 2006). The company also reported profits from the years 2005 through 2007, with a final income of $4.2 billion in 2007. However, the company’s colossal miscalculation would be its failure to accurately assess the cracks that began to appear in the housing market in the first quarter of 2007. A poor assessment of the market a day after it registered its biggest drop in five years, the company CFO still believed that the company was in a good position to curb the effects of delinquencies resulting from the increased defaults.

Lehman’s road to collapse: the contributing factors

With the eruption of the credit crisis in August 2007 that saw the failure of two Bear Sterns hedge funds, Lehman’s stocks dipped significantly. A series of event would follow that mark the company’s slippery slope into closure. Foremost, during the same month, Lehman decided to eliminate 2500 mortgage related jobs and subsequently shut down its BNC unit (). With the correction of the housing market gaining momentum in the final quarter of 2007, Lehman continued to be an integral player in the market. In the same year, statistics show that it underwrote more mortgaged-backed securities than any firm in the market, accumulating a portfolio equivalent to $85 billion, a figure that was four times its shareholder’s equity. The effect of this, according to Berman and Knight (2009), is that Lehman ended up being extensively leveraged, which in the language of bookkeeping implies that they ended up owing lenders more than the value of what they owned. Essentially, in the case of mortgage-backed securities, whatever the company used as collateral proved to be worth a lot less than many thought, the securities became worthless and the company spiraled from positive statements to negative ones.

As at 2007, the company had a high debt-to-equity ratio, a figure that, simply put, tells the amount of debt a company has against every dollar of equity. Bell and Hindmoor (2015) report that the company’s debt-to-equity ratio stood at 31 in the same year, and the huge portfolio of mortgage securities made it increasingly susceptible to a deterioration in market conditions. In fact, between the periods of August 2007 and March 2008, the company was running a debt-to-equity ratio of 30-60 to 1, implying a dangerously small cushion. The near-collapse of Bern Sterns (the second-largest underwriter of mortgaged-backed securities in the U.S.) in March 2008 resulted in a slump in the shares of Lehman Brothers by nearly 48 percent, driving fears in the market that its collapse was imminent. Calm returned briefly for the company following its sale of preferred stock in April of 2008, managing to raise $4 billion and their subsequent conversion to company shares at a premium of 32 percent. However, this breath of life was short-lived as hedge fund managers began to question the valuation of the firm’s mortgage portfolio, prompting resumption of the decline of its stocks.

In June 2008, the company announced a loss of $2.8 billion, its first since the spun off by American Express, yet had managed to raise $6 billion from investors. In a bid to halt its slide down the slippery slope, Belmont (2011) reports that the company took a number of corrective actions that include a boost to its liquidity pool by $45 billion. Secondly, the firm reduce its gross assets by $147 billion, cut its exposure to residential and commercial mortgages by nearly 20 percent and reduced its leverage to 25 from a factor of 32. However, these overtures proved to be too little too late. Belmont notes that despite the numerous actions, the company’s stocks plummeted by 77 percent in the first week of September 2008 following a downward spiral in equity markets globally. Furthermore, with markets under strain, hopes of the firm survival took another turn to the worst when a state-owned Korean bank halted talks concerning a possible stake purchase. The news sent the company to its deathbed, at least technically.

Another factor that contributed to the company’s failure relates to its upside-only compensation schemes that rewarded people with stellar returns whenever the company performed well, but failed to incorporate a mechanism through which the same people would give back to the company in the event of a poor run. Essentially, the plan rewarded risk-taking with high returns but exacted no punishment for poor returns. Any investment environment that lacks a personal downside to risk-taking is by default flawed, and Lehman learnt this the hard way. Taken together, three pertinent issues emerge as the contributing factors to the collapse of the firm. First, the company’s bias towards high levels of financial leverage in a bid to increase its returns left it exposed to market dynamics. Secondly, the risky debt-to0equity ratios that it failed to tame at the onset of the crisis proved to be detrimental to its survival prospects. Finally, the upside-only bonuses preferred by the company made it difficult to draw back funds in the event of poor performance.

However, even as we discuss the prospects of the mentioned factors being the ultimate catalysts to the failure of the firm, also worth exploring is the extent to which regulators’ complicity contributed to the erratic trade and investment decisions made by the firm prior to the collapse. To begin with, regulators of financial institutions, despite being fully aware that pooling of risky mortgages into low-risk securities have the potential of extreme consequences especially when the risks associated with each loan are correlated, went along and bought the idea that property market in the U.S. would appreciate and depreciate independent of each other (Great Britain, 2010: 20). The notion of independence proved wrong and the property market embarked on a nationwide slump somewhere in 2006. The period prior to the onset of the crises saw an increase in irresponsible mortgage lending within the U.S. Many institutions doled out subprime loans to borrowers with questionable or poor credit histories, who in turn struggled to pay or defaulted on the payments.

Secondly, regulators failed to alert market participants of the dangers of the pooled mortgages that upon establishment were used as back up plans to securities termed collateralized debt obligations, CDOs, which were essentially sliced into trenches depending on their degree of susceptibility to default. The mistake, according to ABC, was that the triple-A credit ratings assigned to the CDOs by such agencies as Moody duped investors into believing that they were safer. As it turned out, the banks that created the CDOs actually financed, and hence had control over the agencies, which made them particularly generous in their assessment of the CDOs. The pertinent question regarding this relates to where the regulators were when banks and other financial institutions infiltrated agencies designed to assess financial products sent to the market.

Noteworthy though is that the appeal of these investment portfolios, the securitized products, emanates from the fact that they appeared to be safer and at the same time offered higher returns at a time when interest rates were low in the global market. Within the economic experts fraternity, many still disagree on whether the low interest rates were the results of mistakes by the central bankers or largely the result of broader shifts in the global economy. Regarding the plausibility of a mistake of the central bank, Ciro (2016: 51) argues that the existence of a parallel banking system that was largely unregulated and operated outside the usual regulatory and supervisory framework essentially handicapped the regulators, resulting in runaway practices. He further argues that regulators were unable to make “meaningful assessment of the potential of potential fallout from a major default such as Lehman Brothers.” Defenders of the feds on the other hand argue that the emergence of a saving glut, more so in emerging economies such as China, pumped capital into the American-government bonds thereby driving down interest rates.

A point to note is that the low interest rates were an incentive for banks, hedge fund managers and other investors with interest in riskier assets with comparatively higher returns. The low interests thus proved profitable for such institutions to secure funds through loans and use the extra cash gained to enhance their investment based on the assumption that the returns would exceed the cost of borrowing. In fact, the Great Moderation offered a low volatility that inherently increased the appeal for the same towards leveraging (Taylor and Baily, 2014: 73). Generally, low, unstable interest rates tend to force investors to re-think their decisions before investing. However, when the rates are low and stable, the confidence increases since the risks or borrowing are generally lower, a perfect condition for the purchase of long-term, high-yield securities. The latter is what happened in the property market prior to the collapse, and regulators failed to instigate corrective measures for the runaway boom.

The blame, however, seems to lie squarely on the Fed and other regulators. Central banks could have done more to address the emergent situations. The Fed, it appears, made no specific attempt to manage the housing bubble just as the European Central Bank did virtually nothing to curb the credit surge in the region, believing rather wrongly and inadvertently, that current account balances did not have much influence on the monetary union. Hetzel (2010: 167-168) notes that bankers in the U.S. and around the European Union believe that higher interest rates would have achieved little in as far as managing the housing and credit boom. Perhaps this could be true. However, they had other alternative regulatory tools that would have been very effectual. For instance, lowering loan-to-value ratios of mortgages, or demanding that banks establish some peripheral capital would have had far-reaching and beneficial consequences.

Management lessons from the collapse

The collapse of Lehman Brothers for obvious reasons has elicited extensive discussion regarding actions, from either within the firm or from external sources that would have saved the institution. While it is apparent that human irresponsibility coupled with the impacts of external mechanisms beyond the company’s control may have resulted in the collapse, the sure thing is that the firm’s management played a role in its ultimate failure. While causation is a complex matter and finance is an intricate system with extensive interconnections, absurd management decisions and discourses contributed immensely to Lehman’s failure (Williams, 2010). To begin with, the company had bad modelling assumptions that any sane management would have realized in time to save the day. For instance, the company assumed that the value of residential real estate neve tank, derivatives market is always liquid and the notion that managing risks associated with short borrowing and long lending is an easy affair (Ritholz, 2015). If the company’s management had paid attention to these elements, the company would not have travelled the path of failure.

Secondly, the company extensively utilized the repo 105 (or repurchase) transactions that made its leverage ratios look much more sensible to investors than they actually are. Philips (2010) defines the term as transactions used by an institution to borrow cash on a short-term basis, and often entail raising cash by lending out high quality assets such as treasury bills for a short period, and using the proceeds to fund operations. In the case of Lehman, the firm regularly sold short-term repurchase agreements, in the process creating an impression of the presence of cash in its balance sheets, thus offsetting, or rather concealing, its huge debts. Obviously, the management had powers to address this issue before it spiraled into the crises that it eventually became, yet it opted to do nothing. Instead, the firm continued to operate on the resultant guise, that it was less leveraged. To understand the grand sham for what it is, once the company had released its quarterly earnings, it would then reverse all the repurchase agreements, which would in turn drain the cash off the company’s balance sheet. The actions thereof represent a perfect example of how not to do business.

In addition to the human errors characterized by poor approaches to business, many analysts have taken note of the fact that while the federal government bailed out most companies e.g. the American International Group, Goldman Sachs and Morgan Stanley, the fact that Lehman Brothers never benefitted from such is questionable. The issues of politics being at play in reaching a decision not to bail out Lehman remain one of the pragmatic arguments. Sorkin (2013) notes that the U.S. governed was “hardly predisposed to participating in the bailout of Lehman, despite assertions that it was prepared to help.” Part of the reason for the failure to bail out Lehman stems from a conviction in Wall Street at the time that its collapse would not pose a systemic risk in the market, yet it is now clear that the same has resulted in the government doing more to prop up the economy than it otherwise would have done.

Finally, the collapse also revealed the need to have exceptional regulatory oversight in the financial sector. Essentially, the existence of a well-functioning financial sector implies proper functioning of all the remaining sectors of an economy. A housing bubble in the U.S. and parts of Europe was the major precursor to the crisis, and the pain thereof would spread globally in the guise of mortgage-backed securities facilitated by shoddy regulations that could not keep pace with the evolution in the financial sector, let alone being effective and efficient. Stewart and Eavis (2014) term the collapse as the culmination of a lack of authority to bail it. The pertinent question to this include whether the company had enough solid assets to back a loan from the Fed and disparities in the valuation of the firm’s assets, especially liquid assets. Technically, Lehman appeared to be solvent, hence did not need a bailout, but instead was simply suffering from what analysts termed a ‘bank run’. The latter proved to be a poor assessment, adding more doubt to the willingness of the establishment to bailout the firm, hence the argument of politics being at play.

Conclusion

The failure of businesses is largely a factor of several forces, interacting or acting solely, and range from poor management and business decision-making to external factors that are beyond the control of the business. The collapse of Lehman Brothers as has been broached earlier appears to be a factor of both human and external effects. The company adopted ambiguous and deceptive operation techniques that portrayed it superficially as performing while in real sense it was in deep trouble. For instance, its management despite being fully aware of the dangers of its flawed modelling assumptions still perpetuated them in the business, making its collapse imminent. However, in as much as poor decision making on the side of the management might have triggered the collapse, other external factors such as the lack of comprehensive regulatory mechanisms offered room for the perpetuation of erratic business behaviors in the market. For instance, the Fed and other European regulators failed to instigate pragmatic measures to curb the effects of the Great Moderation, not forgetting that its very existence is questionable. That notwithstanding, the collapse of Lehman offers numerous lessons regarding potentially beneficial strategies through which markets and businesses can avoid or escape the grasp of failure. Key among them is adoption of good business practices, especially regarding investment decisions and bookkeeping, the essence of government bailout, among others.