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Pursuing a High Risk Business Model: The Case of Lehman Brothers

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DOI: 10.2139/ssrn.2717666

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 Pursuing a High Risk Business Model: The Case of Lehman Brothers

Karikari Amoa-Gyarteng

Ghana Baptist University College

January 18, 2016

Abstract:

Lehman Brothers’ bankruptcy was the largest in the history of the United States. It contributed in part to the 2007-2008 Global Financial Crisis.
Lehman Brothers, as enumerated in this paper, was principally responsible for its own collapse with the hugely risky investments it undertook
which led to the accumulation of toxic assets. With its huge size and ability to manipulate financial reports, it engaged in the use of Repo
transactions to hide its rather high leverage from the prying eyes of regulators, investors and lenders. This paper analyzes the events leading up to
the colossal failure of the bank and suggests that tight regulations and accounting standards with no gray areas are the measures needed to contain
the pursuit of high risk business models by greedy CEO’s.

Keywords: Bankruptcy, Leverage, Risk, Subprime, Repo 105

1.0 Introduction

Lehman Brothers was founded by Henry Lehman in 1844 and collapsed under the leadership of Richard Fuld in 2008. The impact of the collapse

was felt across the entire financial system. The significance of it is demonstrated in Appendix 1 which shows respondent answers to a survey of the

U.S Securities and Financial Markets Association (2008). Over 60% of respondents viewed the collapse of Lehman Brothers as the event that had

the most significant impact on the financial system in 2008. Prior to the bank’s collapse, it was the fourth largest investment bank with an employee

Electronic copy available at: http://ssrn.com/abstract=2717666

size of 25,000 (Wiggins et al., 2014).

Lehman Brothers had a worldwide presence as depicted in Appendix 2. The bank’s global nature meant that its bankruptcy was going to have a

rippling chaotic effect globally (PWC, 2009). As a result of Lehman Brothers’ presence across many financial centers of the world and for the fact

that it was one of the biggest investment banks at the time it filed for bankruptcy, Story and White (2008) posit that the bank’s collapse threatened

the entire global financial market industry.

1.1 History and Background of Lehman Brothers.

The roots of Lehman Brothers’ were planted by Henry Lehman, Emmanuel Lehman and Mayer Lehman in the mid 1800’s when they established a

groceries store that catered to the needs of cotton farmers. After a while, they moved into cotton selling. The brothers also engaged in trading of

other commodities and raising funds on the bond and equity markets for companies. It was not until the early 1900’s that Lehman Brothers

developed and became well established in the banking industry. Their core competency was intermediating capital for big companies in the then

fledgling retail and industrial sectors of the economy. Lehman Brothers grew in the investment banking arena by underwriting securities and

providing financial advice under the leadership of Robert Lehman, grandson of Emmanuel Lehman. Robert Lehman died in 1969.

After the appointment of a new Chief Executive Officer, the firm became a complex international bank having operations in investment banking,

client services and capital market (Wiggins et al., 2014). According to Estrada (2011), Lehman Brothers’ business spanned the following:

a. Advising and Structuring transactions

b. Originating loans

c. Providing investment management and advisory services

d. Making financial instrument products available on the market, thereby serving as an issuer and also as an intermediary

Electronic copy available at: http://ssrn.com/abstract=2717666

 e. Providing underwriting services

According to Estrada (2011), the capital markets division constituted 64% of the core business of Lehman Brothers. The division, as of August

2008, had reported assets of $586 billion. The investment banking division, according to Estrada (2011) made up 20% of the business. The

investment management division that engaged in providing investment advice to highly resourceful clients and institutions constituted 16% of

Lehman Brother’s business (Estrada, 2011). The division had $277 billion in assets. In 1984, profits tumbled and Lehman Brothers was sold to

American Express (Fineman and Onaran, 2008). However, after a decade, American Express pulled off from Lehman Brothers. Wiggins et al.

(2014) explain that owing to deregulation within the financial industry such as the 1999 repeal of the Glass Steagal Act, Lehman Brothers expanded

its portfolio to include risky products. As expressed by Wiggins et al. (2014), the investment in risky products inter alia saw a growth of 13% in

revenues between 2000 and 2006. The firm’s stock price appreciated and this led to a market capitalization appreciation of 340% between the

periods captured above. This is illustrated in appendix 3.

Lehman Brothers, between 2003 to 2007 was a major underwriter and loan originator such that it acquired BNC Mortgage and other mortgage

companies. When the housing market was perceived to have reached its zenith, Lehman acquired assets and stored them as though they were the

firm’s own investments. This meant that the firm was taking on more risk and liquidity was declining. According to Wiggins et al. (2014), at the end

of 2007 even though Lehman Brothers’ had closed BNC Mortgage, it held $111 billion in real estate assets compared to $52 billion in 2006. It had

equity that was just about 25% of its real estate assets. To improve on its leverage and liquidity, it engaged in Repo 105 transactions and decided in

August 2008 to put $50 billion dollars of its real estate assets that had now become toxic assets into a publicly traded corporation so that the firm

will remain strong. This did not materialize. Lehman also failed to find a financial partner, and was unable to fund its operations for the ensuing

month (Wiggins et al., 2014). It was therefore left with no option than to file for chapter II Bankruptcy.
2.0 Risky Investment Practices Adopted by Lehman

The nature of investment banking is to trade risk in the hopes of making a profit (Feng and Fredrikson, 2010). As is stated by Feng and Fredrickson

(2010), the beginning of the 21st century presented opportunities in the U.S economy such that many firms such as investment banks took higher

risk and anticipated higher profits. The thinking behind this strategy was that the economic stability was going to last. Lehman Brothers recorded a

net income of $4.2 billion in 2007 which was the highest for the firm (Feng and Fredrickson, 2010).

Lehman Brothers operated under an internally coded five risk business areas. The risk areas included

a) Market risk: The possibility that the value of the portfolio will diminish owing to fluctuations in market rates.

b) Credit risk: The likelihood of an obligor falling to meet its obligations to the bank.

c) Operational risk: The possibility of incurring risk coming out of bad internal processes or external events

d) Reputational risk: The risk of attracting a negative perception from the public on their operations.

e) Liquidity risk: The possibility that the bank will not be able to meet its short term obligations.

From the internally diagnosed risk areas, it is safe to say that Lehman Brothers was not totally oblivious of the consequences of investing in

subprime mortgages, which in effect locked up their working capital and rendered the bank illiquid. Subprime loans involved giving loans to

financially risky individuals or entities in anticipation of higher returns. According to Feng and Fredrickson (2010), Lehman Brothers and a host of

competitors profited from giving subprime loans because the default rates were normal. Norberg (2009) explains that when banks give subprime

loans, they mitigate their risk by turning the loans into securities which are then bought by investors. The securities are almost risk free. Feng and

Fredrickson (2010) posit that when interest rates started to rise in 2006, obligors started to default and liquidity risk was then not only a possibility

but a reality. Investors started to stay away from the securities and left Lehman Brothers with a lot of toxic assets on its hands.
Aside facing a crisis in the subprime mortgage arena, demand for commercial real estate also tumbled as prices ascended. This ensured that Lehman

was hit hard and was compelled to write down on their commercial real estate assets. As a result of the troubles that many investment banks went

through in the immediate period before the Lehman bankruptcy, the phenomenon commonly referred to as credit crunch emerged because of

increased loan cost (Feng and Fredrickson, 2010). Lehman Brothers, for their inability to sell their assets reported a $2.5 billion loss in the first

quarter of 2008 followed by another loss of $3.9 billion in September 2008. Whilst the bank was fast losing money, it was also losing investor

confidence and hence could not attract partners neither could it borrow to finance their operations. The only option open to Lehman was bankruptcy

as the United States government was not willing to offer bail out.

3.0 What Caused the Failure of Lehman Brothers?

What started the failure of Lehman Brothers has severally been catalogued. Boedihardjo (2009) attributes the precipitation of the crisis to a model

that was developed by a group of academics that convinced the then Chief Executive Officer to invest in the real estate market. They had developed

a model that showed that the bank will always make profits if it invested in real estate. What followed was that the bank in the next five years

borrowed heavily to invest in the housing market. According to Boedihardjo (2009), this strategy worked and catapulted Lehman Brothers to

become the fourth largest investment bank in the world.

Out of a desire to gain unbridled profits from the housing market, the bank acquired five mortgage lenders, including Aurora Loan Services and

BNC Mortgage based in Colorado and California respectively. However Latifi (2012), asserts that acquiring BNC Mortgage Company and Aurora

Loan Services was the sounding of Lehman’s death knell as the duo had excessively granted loans to borrowers who did not meet the requirements.

When real estate prices began to rise and many obligors could not meet their obligations, Lehman Brothers suffered gargantuan loses.

Even though, Lehman Brothers suffered losses, it continued its strategy of putting money in long term investments. This therefore skyrocketed its
liquidity risk. According to Feng and Fredrickson (2010), the bank was convinced that the subprime crisis was not contagious and that it was not

going to affect other markets. It pushed on with its strategy, lending itself to additional credit, liquidity and operational risk.

Feng and Fredrickson (2010) report that Lehman’s capital structure was tilted heavily to debt. The bank had taken advantage of a new 2004 banking

regulation that permitted banks to push their leverage ratios up to 40:1. It increased its leverage ratio to 30.7:1. In 2007, the bank recorded $691

billion in assets, $688.5 billion in liabilities and only $22.5 billion in shareholder equity (Lehman Brothers Annual Report, 2007). This meant that

the bank financed almost 97% of its assets with debts and other liabilities which was very risky especially in times when revenue levels had

plummeted.

When Lehman’s borrowers started to call back the loans they had extended the bank, it was put into trouble as liquidity had suffered a nose dive

under the acquisition of assets that were not turning into cash at an appreciable rate inter alia. Their credit rating had also been downgraded

significantly, leading to a loss of investor confidence and a difficulty to borrow. External events such as the collapse of Bear Stearns in the 1st

quarter of 2008 also negatively affected investor and lender confidence in investment banks such as Lehman Brothers. As reported by Estrada

(2011), Lehman Brothers’ stock devalued by 73% in the first half of 2008. Measures that the bank took to curb an imminent collapse included

cutting down its workforce and initiating an unsuccessful effort to sell off troubled assets to the Korea Development Bank. It also announced

attempts to detach itself from its subprime commercial real estate assets. It attempted as well, a deal with Barclays but it fell through on the back of

tight UK regulations. Lehman Brothers then activated the only option available to it on September 15, 2008: Bankruptcy.

4.0 Corporate Governance Issues

Lehman Brothers at the height of its operations had 3000 legal entities globally (Steinberg et al., 2009). This depicts a complex organization that
required effective monitoring from a well composed and capable board of directors. However, the Lehman Brothers Board of Directors consisted of

ten members with an average age of 68.4 years (Tothova, 2013). Four out of the ten were over seventy five years old and only two out of the entire

group had any financial service industry experience. It goes without saying that the board was very ineffective. The Majority of them had

experiences that were totally tangential to the experience needed to guide an investment bank as huge as Lehman Brothers. Their experience ranged

from theatre to the military. One board member was the director of Weight Watchers International. Lehman Brothers as a consequence had

managerial lapses that contributed in no small way to its collapse.

The Chief Executive Officer is described by former associates as a Wall Street mogul who ruled the firm with an iron fist. According to McDonald

(2009) who functioned as a vice president of the bank, Lehman had very well educated sub managers that were afraid to relate with decision

makers. Criticism of the aggressive growth strategy of upper echelons was rejected with alacrity and according to McDonald (2009), managers who

were skeptical and concerned about the excessive leverage the bank was carrying could not speak out for fear of victimization. Only a selected

executive committee of the CEO had the power to make decisions. The bank actively promoted a culture of greed and promoted managers that had

an attitude of aggression (Greenfield, 2009). These managers originated large deals with the anticipation of huge bonuses and not for the interest of

clients. Lehman’s corporate culture in the assessment of Latifi (2012) was a risk oriented one filled with a non-interaction between the board and

management and a lack of accountability and transparency.

5.0 Resorting to Fraud

Lehman Brothers employed several tactics to stay afloat (or to be seen as financially stable) when the firm noticed that its financial situation was

going awry. Some were legal, but others, such as the use of the accounting technique Repo 105 were not. Liu and Schaefer (2011) define Repo 105

as a temporary transfer of assets, primarily fixed income or equity securities, to another entity for cash. The agreement is that the entity transferring
the assets repurchases them at a specified future date. At the said date, the entity that received cash repays with interest and the transferred assets are

returned.

These agreements, as attested to by Liu and Schaefer (2011) are wholly legitimate for the purposes of addressing short term liquidity challenges.

With an estimated Repo market of $12 trillion, banks regularly resort to the use of Repos to borrow cash from firms with excess liquidity (Liu and

Schaefer, 2011). The collateral that is put at stake is financial assets which serve as a buffer in the event of a default. Usually in Repo transactions,

the transferred assets remain on the banks’ balance sheet and its balanced by recording the cash received as a liability (Liu and Schaeffer, 2011).

What made Lehman Brothers’ Repo 105 fraudulent was the fact that they recorded the transactions as sales to shore up dwindling revenue. Cash

received from the transaction was also recorded as a liability. Valukas (2010) attributes to Repo 105, the reason for which Lehman Brothers was

able to remove a $50billion obligation from its balance sheet in June 2008. The resulting effect was that its debt stock was artificially reduced.

Latifi (2012) contends that large firms usually use its small subsidiaries to initiate fraud as regulators generally find difficulties digging through the

complexities that large firms provide to get to the activities of subsidiaries. This is exactly the case of Lehman Brothers as it used Hudson Castle to

manipulate some transactions off its balance sheet. Hudson Castle is described by Latifi (2012) as a company whose board was wholly controlled by

Lehman. Most staff of Hudson Castle were also former employees of Lehman Brothers. Before the decline of Lehman Brothers, Husdon Castle had

created four distinct legal entities primarily to borrow money and pass it on to Lehman Brothers as loans through Repo transactions. Another firm

that operated as a conduit for Lehman Brothers to access loans was Fenway (Dash and Story, 2010).

Hallman (2010) describes a typical Repo transaction involving Lehman Brothers as follows:

1. Lehman Brothers’ European entity transfers $105 million or $108 million worth of securities to a counterparty
 2. Lehman Brothers will receive $100 million in cash

3. Lehman will utilize the money to pay off other short term obligations

4. Lehman will then go ahead and report low satisfying leverage figures so that its ratings will be high together with a heightened investor

confidence

5. Days after the quarter has ended, Lehman Brothers would settle the loan and take back its collateral

Liu and Schaefer (2011) buttress the characterization of such arrangements as over collateralized as Lehman many times put up either $105 million

or $108 million for a $100 million Repo transaction. According to Liu and Schaefer (2011), accounting standards that existed at the time treated

Repo transactions two fold.

a) In Repo transactions that were financing transactions, the securities remained on the borrower’s balance sheet and cash was treated as a

liability.

b) In a Repo transaction that was considered a sale, no cash liability was created and the collateralized assets were removed from the balance

sheet till such a time that the repurchase had taken place.

The accounting standard that existed at the time lent itself to manipulation. SFAS 140 ( para 218) stated that in a Repo transaction,

“ the transferor’s right to repurchase is not assured unless it is protected by obtaining collateral sufficient to fund substantially all of the cost of

purchasing identical replacement securities during the term of the contract so that it has received the means to replace the assets even if the

transferee defaults.

Judgment is needed to interpret the term substantially all and other aspects of the criterion that the terms of a repurchase agreement do not

maintain effective control over the transferred asset. However, arrangements to repurchase or lend readily obtainable securities, typically fall with

as much as 98% collateralization for entities that agree to repurchase or as little as 102% overcollateralization for securities lenders typically fall

clearly within that guideline. The Board believes that other collateral arrangements typically fall well outside that guideline”.
Liu and Schaeffer (2011) contend that in spite of the above statements, no accounting standard specifies 105% collateralization as a sale. However,

the accounting rule was prone to manipulation. Lehman Brothers, therefore, took advantage and set its collateral at 105% with the idea that it would

be accepted as a sale. Lehman Brothers used the cash from Repo deals to reduce liabilities with a view of portraying a good financial picture and

achieve better leverage ratios. Lehman Brothers failed to disclose details of its Repo 105 “sales” which is indicative of the fact that the bank had

premeditated concealing facts and according to Jeffers (2011), failure to disclose a fact in a transaction can be interpreted as perpetrating fraud.

6.0 Involvement of Ernst & Young

Ernst & Young was the accounting firm that oversaw the auditing of Lehman Brothers’ financial reports. To the extent that the firm practically

stood by and approved Lehman’s quarterly reports (Freifield, 2015), the auditing firm aided and abetted the fraud that Lehman Brothers perpetrated.

Ernst & Young was accused of issuing an unmeritorious opinion on Lehman Brothers’ financial reports (Mahon, 2015). The auditing firm was sued

for $105 million for working for and abetting Lehman’s deception of the public, investors and regulators. The case ended with a $99 million

payment to investors despite the courts declaring that they could not be held liable for the collapse of Lehman Brothers.

7.0 Code of Ethics at Lehman Brothers

Stevens (2009) defines code of ethics as statements that enforce the major philosophical principles in companies and serve as policy documents to

guide all stakeholders in the execution of their responsibilities. It states the do’s and don’ts of the organization and it can serve as a moderator of

behavior in firms if effectively implemented (Stevens, 2009). Castaldo et al.(2009) contend that codes are measures for organizations to keep faith

with customer expectations through the ethical consumerism concept. Codes as noted by Stevens and Buechler (2013), can only function effectively
if communicated organization wide; anything short and they become relics only tangential to the firm’s vision.

Ethical codes are widely accepted and they find importance in about fifty three percent of the world’s largest companies (Kaptein, 2004). However,

Mathews (1987) found that firms emphasized employee misconduct and illegal activities to the detriment of product quality, safety and

environment. Mathews (1987) findings are buttressed by Snell and Herndon (2000) who conclude that codes are primarily focused on corporate

self-defense. Ultimately codes can enhance a firm’s reputation and elicit kinder treatment from regulators in the event of transgressions (Kaptein

and Schwartz, 2008).

Lehman Brothers’ executives knew the importance of a code of ethics. The question of whether or not they abided by them fully was answered on

September, 2008 when they filed for bankruptcy. Lehman Brothers’ code outlined the expected behavior of employees. The firm also had an

internal code of conduct and all employees were enjoined to go by the firm’s corporate ethical values. The code of ethics emphasized strong client

relations. In the view of Stevens and Buechler (2013), some aspects of Lehman’s code such as the part that states that ‘ Ethical business practices

are the product of more than a fear of legal ramifications’ are mind stretching and visionary. Aspects of the code, however, were too laced in

legalese. Stevens (1996) has it that the Lehman code of ethics was written by legal officers and it focused mainly on protecting the firm.

The generality of the code is difficult to decipher for the employee looking for answers in gray situations. It overemphasized behaviors that could

lead to a violation of the law and Stevens and Buechler (2013) explain that core issues like mitigation of risk were not central. The code also

captured the need for employees to aggressively pursue profits for the firm but was mute on ethics to consider in that pursuit. Mathews (1996) and

Stevens (1994) maintain that the Lehman code was too generic and it lacked transformational language. The downsides of the code aside,

executives at Lehman broke some core values contained in it. In part, the code stated that Lehman aims to have “Full, Fair, Accurate, Timely and
Understandable Disclosure”. This was however not the case in the firm’s Repo Transactions. In summary, Lehman’s code of ethics had some

visionary aspects (Stevens and Buechler, 2013) but overall, it was a generic code that was not sufficient to provide clear ethical guidance to

employees.

8.0 The Lehman Bankruptcy, Could It Have Been Prevented?

The impact of booms and busts has become more contagious across the world as there is more interconnectedness in the global financial space. One

crisis in a financial organization, especially a big one such as Lehman Brothers, was always going to find expression in the global financial system.

It is therefore imperative that big financial firms are not allowed to fail. The Lehman failure unfolded whilst the US government looked on.

McDonald (2009) concludes that Lehman Brothers was just put to sleep as the government was not prepared to step in with bail out money as it had

done for other financial institutions.

The US Treasury, however, claimed that Lehman Brothers did not have enough collateral to serve as guarantees. Some analysts and political

watchers also believed at the time that what happened to Lehman Brothers was a necessary evil to purge the financial system. Brown (2009)

contends that sometimes it takes a crisis for people to agree to set up an international architecture to regulate the financial industry. In the words of

Latifi (2012), Lehman brothers was made a sacrificial lamb to curb moral hazard and prevent the public purse being set as bail out money.

However, it did not have to come to the point where Lehman Brothers will fall into financial distress and seek governmental intervention. There

were a number of internal measures it could have taken to prevent such a disaster from ever rearing its head. The bank took so much risk in the real

estate market. The fact that they invested heavily in subprime mortgages meant they had locked up capital and it was going to suffer when interest

rates began to rise and mortgage takers could not pay back. In essence, they had ballooned their liquidity and credit risk. They also took on so much
leverage risk and encouraged, to its own detriment, employees to aggressively seek returns for the firm. Consequently, the activities of such

employees only helped Lehman to acquire more risk. If only it had divested its interest and mitigated its risk whilst still pursuing profitable

ventures, Lehman Brothers could still be around today.

Managerial problems and a breakdown of corporate governance also did not help matters. The CEO had too much power and the board was an

inefficient one filled with unqualified non industry players. Corporate governance structures should have been put on the front burner so that

decision making was not left to a select few. If that had happened, the firm would not have been so resolute in taking on risky ventures and it would

not have resorted to accounting fraud to stay healthy in the eyes of the public.

9.0 Conclusion and Recommendation

The Lehman Brothers rise and fall should be a prominent case study for bankers and regulators across the world. The unbridled aggression to take

unmitigated risks which brought initial success could be held responsible for the eventual decline and bankruptcy of the firm. The fact that Lehman

Brothers resorted to the use of Repo 105 transactions and push to conceal financial facts only goes to confirm the likelihood of many a distressed

firm taking the easy and cheap but fraudulent way out. Regulators should always be one step ahead.

In the case of Lehman Brothers, the gray area in the then prevailing accounting standard did not help matters. It afforded the firm the leeway to over

collateralize in Repo transactions with the view of recording those transactions as sales. Such oversights should not happen. In effect, banking

regulation should always be stringent. With the repeal of the Glass Steagal Act, commercial banks can now underwrite securities and investment

banks can also have commercial banking divisions. This makes their operations more complex and therefore it calls for tighter regulation.
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Case Study 2014-3A-V1

Appendices

Appendix 1-- Respondent Answers to a Survey of the U.S Securities and Financial Markets
Association (2008).
0% 20% 40% 60% 80%

The collapse of Lehman Brothers

The passage of the $700 billion

Troubled Asset Relief Program

Fannie Mae and Freddie

Mac being placed into
conservatorship

The takeover of Bear Stearns by

JPMorganChase

The U.S. government rescue of AIG

Source: SIMFA (2008)

 Appendix 2—Worldwide Presence of Lehman Brothers

The impact of Lehman Brothers’ bankruptcy was intensified because of the entity's globalized legal structure.

Lehman
Brothers Lehman
Canada Inc. Lehman
Lehman Brothers Brothers
Holdings Inc. Brothers
Limited
Lehman Brothers International
Lehman Lehman Lehman
Special (Europe) Ltd.
Brothers Inc. Brothers Brothers
Financing
Commodity Holdings
Services Lehman Japan
Brothers
Middle East Lehman Brothers
Hong Kong

Many clients and

counterparties found
themselves exposed to
Lehman
multiple Lehman Brothers
Brothers
entities in various legal Australia
jurisdictions with different Holding
bankruptcy and insolvency
laws and contractual
protections and remedies.

Source: PricewaterhouseCoopers’ Financial

Services Institute (FSI) (2009)
 Apendix3 - Market Capitalization of Lehman Brothers Holdings between 1994-
2008 (in $billions)

Source: CRSP Data

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