2. About Lehman brothers …
Lehman Brothers Holdings Inc. was a global financial services firm founded in 1847.
Before filing for bankruptcy in 2008, Lehman was the fourth-largest investment bank in the
United States (behind Goldman Sachs, Morgan Stanley, and Merrill), with about 25,000
employees worldwide. It was doing business in investment banking, equity and fixed-income
sales and trading (especially U.S. Treasury securities), research, investment
management, private equity, and private banking Lehman was operational for 158 years from
its founding in 1850 until 2008.
3. Lehman brothers History…
Lehman Brothers began in the mid-nineteenth century, 1844 to be exact. It was started in
Montgomery, Alabama by Henry Lehman, an immigrant from Germany. From being a dry-goods
and general store, Henry’s brothers – Mayer and Emanuel – joined him, giving birth to Lehman
Brothers in 1850. During the 1850s, Lehman began to become a major commodities trading
company, specializing in the key cotton market.
The company’s shift from commodity trading to investment banking began in 1906 when it
partnered with Goldman Sachs on an IPO. Between 1906 and 1926,
Lehman was involved in underwriting nearly a hundred new equity issues, including those of such
notable companies as F.W. Woolworth, Studebaker, and Macy’s department stores.
4. The history of Lehman Brothers mirrors how investment banking’s changed and
developed in the United States’ economy. The company managed to pursue and even
thrive through major national upheavals such as the Civil War, both world wars, and
the stock market crash of 1929 and the resulting Great Depression. Going through a
myriad of changes, spin-offs, and mergers, the company developed into a
commodities brokerage and ultimately into one of the largest investment banks in the
world.
That was till on September 15, 2008, when it filled for the largest bankruptcy in
US History, involving more than US$639 billion in assets.
Lehman brothers History…
5. Definitions
Mortgage: It is a loan taken from bank to buy a house. It is an agreement between homebuyers
and banks. The homebuyer agrees to payback money to the bank over time. The payback will be
the principal amount plus interest. Till such time, the ‘house’ remains as lien with the borrower.
Mortgage Backed Security (MBS): All mortgages bought by investment banks are clubbed
together, and a MBS is formed. What is MBS? It is a financial instrument whose assets are ‘loan
agreements’. Why it is called an asset? Because loans generate income inform of ‘monthly
payments’ – which the borrowers regularly pays to bank.
Subprime mortgage: Those Mortgage Backed Securities whose borrower’s risk profile is too low
7. Involvement of Investment Banks
There are two types of banks which are involved. First, are the retail banks which lends
money to the borrowers. Second, type is the investment banks to whom, the retail banks
eventually sell the loans.
An investment bank is a financial services company or corporate division that engages in
advisory-based financial transactions on behalf of individuals, corporations, and
governments.
In traditional banking, there are only two agencies dealing with loans – borrower and lender
(homebuyer and retail bank). But since year 2000’s, a third party got involved – investment
banks.
8. Involvement of Investment Banks
These investment banks started buying the “mortgage agreements” from the retail banks.
This way, they became entitled to receive the monthly payments from the borrowers.
The role of retail banks became substantially marginalised. Their responsibility was limited to
issuance of loan only. After this step, their job was to sell the loans to investment banks.
Period.
Henceforth, it was investment banks who became the holder of the mortgage agreements.
Why retail banks sold the loans? Because this way, their balance sheet had zero liability,
and only cash asset (received from investment bank).
Why investment banks bought loans? To use them as Mortgage Backed Security (MBS)
which could promise 5-6% fixed returns.
10. Demand on MBS
Till loans were issued to credit worthy borrowers, mortgage backed security market
flourished. It was a perfect investment vehicle for matured economies (like USA, UK,
Australia etc). The demand for MBS skyrocketed.
To feed the rising demand, MBS needed more mortgages. But the problem was, credit
worthy borrowers in America are only limited.
In this scenario, the retail banks tweaked their lending criteria. They started issuing loans
to even not so credit worthy borrowers. But they charged higher interest rates on
such loans.
Then a stage came when demand of MBS further grew. Retail and commercial banks,
wanted to match the pace. Hence, they started issuing loans without even verifying the
credentials of the borrowers.
This way, list of borrowers were rising at a desired pace.
11. Collateralised Debt Obligations (CDO’s)
When retail banks started issuing loans to less credit worthy borrowers, investment banks
knew the risk. They could gauge that these borrowers have high chance of defaulting. The
overall credit ratings of MBS’s were dangerously low (like B+, CCC and below).
Hence, what they did was to create another investment vehicle called CDO’s. These CDO’s
had a mix of mortgage backed securities:
Prime mortgages (Credit Rating A to AAA)
Subprime mortgages (Credit Rating A- and below).
This helped them to hide the so called “subprime mortgages” under the blanket of
prime mortgages.
Moreover, the buyers of CDO’s were not common men. They were purchased mainly by
hedge funds, investment banks themselves, pension funds etc.
12. Real Estate Bubble
As more people were becoming eligible for the mortgage, the demand for homes started
increasing. More people had money (borrowed) to buy a new home.
This created a price bubble in the real estate sector. The price of residential properties
only went up.
For the MBS market, The risk of loss here was only when the borrowers fail to make
payments (loan default). this was not a problem, why? Because the property which was used
as a collateral – could be sold to make up for the loss.
This assumption was not wrong – but it remained true only till the property prices was only
moving upward.
13. Real Estate Bubble
There were two agencies whose contribution could not be underestimated in the rise of
subprime mortgage.
The credit rating agencies (Moody, S&P, Fitch etc) gave AAA ratings to most of MBS’s –
even when loans were issued to subprime borrowers.
Credit default swaps are basically insurance cover for the MBS. They protected the MBS
against any loss in revenue due to ‘loan defaults’ or ‘prepayments’. As the MBS’s were
insured, investors had that false sense of protection.
In 2008-09, majority borrowers were defaulting on loans. The insurance companies (Like
American International Group, Inc. (AIG) ) could not cover this urgency. They also declared
themselves as bankrupt.
14. Real Estate Bubble
In those times, even those people who had no source of income were getting loans to buy
home. These people had near zero capability to payback the mortgage, but they still took the
loan. Why?
Their logic was, as the price of homes were only going up, they can use it to their advantage.
Example: Take a $100,000 loan, and buy a home. After few months sell the home for
$102,000. Use the sale proceeds to pay back the loan, and pocket the balance as profit.
People were taking mortgages to do trading of real estate properties. To help such
borrowers, banks offered incentives. The loans had lower monthly payments for the first few
months.
15. Bursting the Bubble
A stage was reached in the US housing market where the borrowers started defaulting on
their loans. Why the default? Because it was inevitable. How?
The cause was subprime mortgages. The loans were issued to people who had little
capability to payback the loan. Hence, they eventually could not afford the ‘monthly
payments’ – and their property went for foreclosure.
At a point in 2007-2008, there were more houses on sale than there were buyers for it.
This triggered a steady price fall. The housing bubble bursted.
16. Bursting the Bubble
When financial institutions saw this trend of falling prices, they became defensive. They
stopped buying shares of ‘subprime mortgage backed security’.
As a result, the share price of MBS’s started to fall steeply. This eventually started to reflect
on the wall street.
Who were these big investors? They were investment banks like Lehman Brothers, Bear
Sterns etc.
This way the earnings of investment banks (MBS’s) stopped, and eventually they had
to declare themselves as bankrupt.
17. The Crisis Arrival
The panic first spread across common Americans, and then across the world. The stock
market crashed, and the credit market froze.
Loans became almost impossible to get. The economies across the world became cash
starved. In absence of sufficient liquidity, growth rates became negative.
Due to negative sentiments, public spending was also falling. This eventually led to the
recession.
18. The Crisis Main Elements
Bad Loans: The root cause of the crisis was “bad loans”. Had the retail banks checked
themselves from issuing bad loans, subprime mortgage backed securities based CDO’s
would have never been born.
Why retail banks issued bad loans? Because they knew that, the responsibility of bad loans
will not be on them (it will be on investment banks). Their risk of loss was almost zero.
Moreover, there was demand for subprime mortgages, and they also fetched higher interest
rates for the banks
Investment Banks: Formation of CDO with subprime mortgages was their first mistake.
Their second mistake (which also amounts to crime), is hiding the true credit rating of the
CDO’s and MBS’s.
19. The Crisis Main Elements
Insurance Companies: Insurance cannot be sold to anyone. Like a cancer patient will not
be able to buy a health insurance, similarly an unhealthy CDO’s should not have got the
protection of Credit Default Swaps.
Bailout: USA’s economy is huge. It is so big that, even a small change here effects the
economies around the globe. On top of this, in modern economy, banks just cannot fail. Too
many people are dependent, on even basic functions of banks. Hence, at the back of the
mind, the banks knew that US congress will eventually bail them out.
20. The Crisis Main Elements
Congress & SEC: First it was US congress who restricted the powers of SEC over
regulation of MBS, CDO’s and Credit Default Swaps. The Department of Justice (DOJ) also
kept quite seeing the wrongdoings by congress and SEC.
People: It will not be wrong to say that common people also contributed to the mess of
subprime mortgage. People who knew that they will not be able to pay the ‘monthly
payments’ of the mortgage, should not have taken the loan in first place. Their greed for easy
money made the matter worse.
21. Lehman Brothers Bankruptcy
The bankruptcy of Lehman Brothers on September 15, 2008 was the climax of the subprime
mortgage crisis. After the financial services firm was notified of a pending credit downgrade due
to its heavy position in subprime mortgages, the Federal Reserve summoned several banks to
negotiate financing for its reorganization.
These discussions failed, and Lehman filed a Chapter 11 petition that remains the largest
bankruptcy filing in U.S. history, involving more than US$600 billion in assets.
The bankruptcy triggered a 4.5% one-day drop in the Dow Jones Industrial Average, then
the largest decline since the September 11, 2001 attacks.
22. Lehman Brothers Bankruptcy
At the time of its collapse, Lehman was the fourth-largest investment bank in the United States
with 25,000 employees worldwide. It had $639 billion in assets and $613 billion in liabilities. The
bank became a symbol of the excesses of the 2007-08 Financial Crisis, engulfed by
the subprime meltdown that swept through financial markets and cost an estimated $10 trillion
in lost economic output.
The bankruptcy triggered a 4.5% one-day drop in the Dow Jones Industrial Average, then
the largest decline since the September 11, 2001 attacks.
23. Lehman Brothers Bankruptcy
The company, along with many other financial firms, branched into mortgage-backed securities
and collateral debt obligations. In 2003 and 2004, with the U.S. housing bubble well under
way, Lehman acquired five mortgage lenders along with BNC Mortgage and Aurora Loan
Services, which specialized in Alt-A loans. These loans were made to borrowers without full
documentation.
At first, Lehman's acquisitions seemed prescient. Lehman's real estate business enabled
revenues in the capital markets unit to surge 56% from 2004 to 2006. The firm securitized $146
billion of mortgages in 2006—a 10% increase from 2005. Lehman reported record profits every
year from 2005 to 2007. In 2007, it announced $4.2 billion in net income on $19.3 billion in
revenue.
25. Lehman’s Bankruptcy Causes
Lehman’s bankruptcy had four underlying causes:
1-Risk:
The bank had taken on too much risk without a corresponding ability to raise cash quickly. In
2008, it had $639 billion in assets, technically more than enough to cover its $613 billion in
debt. However, the assets were difficult to sell.5 As a result, Lehman Brothers couldn’t sell
them to raise sufficient funds. That cash flow problem is what led to its bankruptcy only 7
billion dollar cash
26. Lehman’s Bankruptcy Causes
Lehman’s bankruptcy had four underlying causes:
2-Culture:
Management rewarded excessive risk-taking. Lehman’s chief risk officer said that top
management ignored many of her risk-management strategies.5 Top managers wanted to
stay ahead of competitors that also used high-risk strategies, and they also thought the
company was too smart to fail. At this time lehman brothers was proud owner of thousands of
people mortgages in amount of 76 billion dollars. At end of 2007 the held 5.2 billion dollar
worth of subprime mortgages.
27. Lehman’s Bankruptcy Causes
Lehman’s bankruptcy had four underlying causes:
3- Overconfidence :
The firm relied on complicated financial products based on quick real estate growth just as
the real estate market began to decline.
Between 2000-2006, its revenue grew 130% thanks to early successes with mortgage-
backed securities, In 2003-2004, Lehman Brothers bought five mortgage lenders, which
allowed it to originate and underwrite subprime loans, increasing its profitability. In March
2006, Lehman bought heavily into commercial real estate and risky loans and instead of
selling them right away, it kept them on its books. Management thought it would make more
money owning these assets but its timing couldn’t have been worse, as real estate prices
were falling.in 2007 lehman brothers reported record profits over 4 billion dollars. There
revenue reached 60 billion dollar. There stock price reached 86 dollar. That was the peak of
lehman brothers.
28. Lehman’s Bankruptcy Causes
Lehman’s bankruptcy had four underlying causes:
4-Regulator Inaction:
The Securities and Exchange Commission and other regulators didn’t take action. As early
as 2007, the SEC knew Lehman Brothers was taking on too much risk, but the agency never
required Lehman to do anything about it. It also didn’t publicly disclose to rating agencies that
the bank had exceeded risk limits
29. Lehman’s Bankruptcy Causes
Lehman’s bankruptcy had four underlying causes:
4-Regulator Inaction:
The Securities and Exchange Commission and other regulators didn’t take action. As early
as 2007, the SEC knew Lehman Brothers was taking on too much risk, but the agency never
required Lehman to do anything about it. It also didn’t publicly disclose to rating agencies that
the bank had exceeded risk limits
30. Corporate Governance
Corporate governance is the system of rules, practices, and processes by which a firm is
directed and controlled. Corporate governance essentially involves balancing the interests of
a company's many stakeholders, such as shareholders, senior management executives,
customers, suppliers, financiers, the government, and the community.
Since corporate governance also provides the framework for attaining a company's
objectives, it encompasses practically every sphere of management, from action plans and
internal controls to performance measurement and corporate disclosure.
The financial crisis revealed severe shortcomings in corporate governance. When
most needed, existing standards failed to provide the checks and balances that
companies need in order to cultivate sound business practices.
31. Corporate Governance
The financial crisis of 2007–2009 which devastated global capital management is often
partly attributed to bad corporate governance. For example, the OECD Steering Committee
on Corporate Governance argues that ‘the financial crisis can to an important extent be
attributed to failures and weaknesses in corporate governance.
The standard story appears to be that weak boards tolerated the rise of a culture of greed
and excessive pay, which led financial executives to take the risks that ultimately caused the
financial crisis .
32. The Crisis Global Effect
Lehman was brought down by its overexposure to financial products based on sub-
prime (poor quality) housing mortgages. Its crash is seen as the event that set off the
financial crisis in the US, leading to the worst global economic slowdown since the great
depression of the 1930
The global economy was growing rapidly before 2008. Compound annual growth rate
(CAGR) of world GDP between 1997 and 2007 was 3.4%. This has come down to 2.5% in
the period between 2008 and 2018. While the financial crisis started in the developed world,
it is the rest of the world that has suffered more in the post-crisis era. This can be seen from
the bigger reversal of GDP growth trajectory — in BRICS (Brazil, Russia, India, China and
South Africa) and rest of the world. The Organization for Economic Cooperation and
Development (OECD) countries, which includes developed economies, were not growing at
a very high pace even before the crisis.
33. The Crisis Global Effect
Economies worldwide slowed during this period since credit tightened and international trade
declined. Housing markets suffered and unemployment soared, resulting in evictions and
foreclosures. Several businesses failed.
The effects of the crisis spread to developing countries, primarily through declines in trade
and commodity prices and reduced access to credit, as lower demand in developed
countries hurt the export sectors and slowed growth in developing countries.
The financial crisis that hit the world economy in 2008-2009 has transformed the lives of
many individuals and families, even in advanced countries, where millions of people fell, or
are at risk of falling, into poverty and exclusion.
34. The Crisis Global Effect
In all, the Great Recession led to a loss of more than $2 trillion in global economic
growth, or a drop of nearly 4 percent, between the pre-recession peak in the second quarter
of 2008 and the low hit in the first quarter of 2009, according to Moody's Analytics.