Lehman Brothers & The Credit Crunch

Investment banking is inherently risky. Their over-riding purpose is to chase profit. To do so, they weigh up all of their possible opportunities and all of their possible outcomes in a hope of predicting their best gamble. In the face of the largest economic crash since the 1930s, investment opportunities were limited and the inherent flaws of every firm were brought to the fore. With the benefit of hindsight, it is clear that the ambitious decisions taken as part of Lehman Brothers’ operating model, were misguided. In accordance with Zingales (2008), their foray into subprime mortgaging with high leverage was their undoing.

Valukas (2010) stated that these choices together with the global recession brought the downfall of Lehman. Therefore, their demise was a consequence rather than a cause of the recession. The high leverage model left them exposed when the recession brought volatile conditions. Markets had already been on their way down for about a year before September 2008, Lehman exacerbated this so what was to come was worse than ever predicted. DOW Jones dropped 504 points as a result of Lehman’s bankruptcy and AIG were being forced into collapse as well. From this perspective, is it possible to call Lehman “too big to fail”? Perhaps it was, as another company’s existence was based on Lehman’s fortunes.

Businesses across the globe, both big and small, were directly affected by the shockwaves Lehman sent through the market. Either, there were indirect effects, such as money flow between firms halting or, direct problems for institutions who had a close working relationship with the bank. Bad debt securities that had passed onto the Fed, led to a week long period when they had to freeze redemptions as there were worries that their reserves couldn’t cope with the demand. The Fed also pumped excessive amounts of money into the economy for years afterwards in the form of a stimulus package from early 2009 to combat this. Their aim was to continue economic growth and ease the country out of a recession. Jordan (2010) and Whelan (2010) cite SunCal Cos as an example of firms that were directly affected by Lehman. A land developer and home builder based in California whose primary lender was Lehman, ran into debts in and around $230million. They managed to survive and are still operating today. However, outside USA, as far afield as Israel, a 3D graphics development company called Orad Hi-Tec Systems witnessed their stocks lose value, Tsipori (2010). Lehman was their largest shareholder and had been the underwriter for their IPO held in 1999. This was an obvious outcome.

However, it can be said that Lehman was a wakeup call to the banking sector. Richard Wolff, a journalist for The Guardian (2011) indicates that Europe felt threatened afterwards and the situation encouraged European countries to bail out their banks no matter the cost because they all believed it was better than the alternative. Lehman’s demise forced the market to be reassessed as there were clear problems, Zingales (2008). Market regulations were tightened in an attempt to increase transparency and tackle the complacency that can come with large, sustained profits.

Overall, I believe that the government followed the right course of action in the Lehman saga. A view reinforced with the discovery of corruption at the top and fraudulent records. The government had to show that they were prepared to let a bank fail. The government couldn’t afford to continue to act like a generous uncle. They had to re-incentivise a sector that had become negligent and refused to learn from the past - Enron, an American energy provider had applied an accounting gimmick similar to Repo 105 on their reports to transfer liability and subsequently failed in late 2001. In any case, Lehman was accepting bankruptcy. When they realised they were losing alarming sums of money from mortgages, instead of acting immediately and confronting their mistake head on, they hid it on their balance sheet in the hope that they could fool another bank into purchasing them and burdening them with debt. For Richard Fuld to initiate a very aggressive strategy for expansion, he maintained an even more passive one to stop bankruptcy.

This is the price of capitalism. Only the most organised, profitable and competitive companies survive and grow. Those who can’t make sense of the markets, embrace the competition or maintain the confidence of clients fail. And they deserve to fail!

Too Big To Fail?

The Wall Street Journal’s (2008) opinion was that Lehman Brothers was treated harshly by the Fed. The government always had the option to provide Lehman with a loan. The Federal Reserve had provided funds for mortgage providers Fannie Mae and Freddie Mac in the week previous to Lehman’s bankruptcy. They even supplied financial support to the insurers American International Group (AIG) the day following Lehman’s collapse. AIG were pressing for a loan and as the Lehman situation had distorted the market with more volatility, the government gave in reluctantly. Many commentators at the time claimed that the government and the Fed had no other option as the effects of AIG’s collapse would be all encompassing. These institutions were categorised by the government as “too big to fail”, whilst Lehman was not.

Graph taken from CNBC indicating AIG's falling share price and the amount of government it received and dates paid. Total was $137.8billion.

The US economy, like many other economies across the globe, is dependent upon the financial stability of certain institutions. These are viewed as integral parts of the economic system because of their connections to other banks, businesses and governments via contracts, loans and insurances, as defined by Joines (2010). If this select group were to fail, many others would crash along with them and in turn, the economy would struggle to ever recover. If their failure could be prevented, the government would step in and save them with the use of tax payers’ money. There were numerous financial institutions that gained this tag over the 2008-2009 period.

AIG was one such company given this tag because they guaranteed the debt of multiple corporations and many mortgages, which was customary as a result of the Subprime Mortgage Crisis. The New York Times newspaper that was published on September 16^th reflected that AIG’s failure would have caused significant write-downs in value of all the companies that had bonds insured by them. Roger Altman, a former Treasury officer, was reported in the New York Times, saying that because of the span of their reach, the world over was genuinely scared by the thought of AIG’s collapse. Andrew Clark, writing for The Guardian, highlighted these fears as UK retailers like Boots, Argos and Sainsbury’s would be devalued as AIG provided a substantial portion of their insurance.

Simultaneously in the UK, Northern Rock was undergoing a nationalisation themselves. Like Lehman, they too had got caught up in the mortgage market. One of their attractions was the 125% house value mortgages they were offering, which coincidentally accounted for the majority of their repossessions. The National Audit Office summarised that they were trying to maintain their assets of over £100billion, with short-term loans. Treasury announced they were backing Northern Rock, spread panic amongst depositors who began to “run the bank.”  Administration was considered as the search for buyers was unsuccessful but eventually the Treasury themselves took over Northern Rock because the potential “hardship” that the public could have faced was viewed as too extreme.

Why was Lehman not saved whilst AIG was? To this day there is a debate as to whether Lehman Brothers was too big to fail and whether it should, ultimately, have been bailed out. Opposition Democrats, like Christopher Dodd, criticised the government for being inconsistent. The Fed released a statement that they believed the market could handle the disruption caused by an investment bank, but held the view that AIG’s downfall would “lead to substantially higher borrowing costs and reduced household wealth”. It confirmed that the government were willing to let a bank fail, and what would stop them from doing the same again? It was a method of re-incentivising the sector again, to remain prudent, as there was no back-up plan otherwise. Vince Cable, Economics minister of the UK Liberal Democrat Party believed that “the US government had drawn a line in the sand.”

My own opinion is that the US government were trying to make an example of Lehman. It was a political decision. Votes were the main motive. Elections were scheduled a few months later and the Republican Party wanted to be re-elected. They couldn’t be shown to the public as being weak and bowing to the pressure that big business put on them (of course, this was undermined the following day). The taxpayers had already seen their own money that they worked hard for being used to rescue Fannie Mae and Freddie Mac and the government didn’t want to risk any more. Multi-million corporations had already gained a reputation for dismissing and belittling the every-man in the street. If the government were going to help a company, who as it would turn out were blatantly lying about their funds, it would create a very bad image for all involved.

The Final Days

From the Summer of 2008 onwards, Lehman could do very little to contest their slide into bankruptcy. A public offering launched on June 12^th could only garner $6billion, which was some way short of the aid Lehman needed. By the end of the week on Friday 12^th September, it had become clear to the public that this gradual decline had quickly developed into an overwhelming debt burden that Lehman could no longer handle themselves. At this point, the US Government called a meeting of the major Wall Street firms in an attempt to negotiate some sort of deal between all of the firms to save Lehman from collapse.

 

Lehman Brothers share price, taken from The Financial Times using Thomson Datastream. The stock price can be used to indicate firm performance.

It was always a possibility that the government themselves would come to the rescue themselves with a Federal Reserve bail-out if no agreement could be reached between Lehman and any other possible buyers. However, in this series of meetings across the 12^th to 14^th September, Henry Paulson, the US Secretary of the Treasury, stated and reiterated that a government loan would not be forthcoming. Valukas (2010) indicates that there were substantial moral objections within the Federal Reserve System and government as to the consequences of funding Lehman and it was also thought that the reported reserves within Lehman were too low to avoid collapse. Their perception was that any loan proposal would just stave off the inevitable.

 

The official Treasury photograph of Henry Paulson.

 

Initially there was interest in providing funds. Aidikoff, Uhl & Bakhtiari, have quoted the two main suitors on that weekend as Bank of America, who had bought Merill Lynch only months before, and Barclays Bank, UK. Andrew Clark reported a story for The Guardian newspaper that Bob Diamond, president of Barclays, had tried to get business tycoon Warren Buffett involved with the deal. Buffett had previously injected a $5billion cash boost into Goldman Sachs to ease them through the financial crisis. However, neither that deal nor Bank of America could finalise a take-over. Barclays buyout was dead in the water as it was blocked by the UK’s Financial Services Authority. In all reality, it was unlikely that any suitor would have took on the burden of Lehman as their problems were more far reaching than they disclosed.

As it was Lehman Brothers filed bankruptcy papers in the early hours of Monday, September 15^th 2008. The Wall Street Journal indicated in their issue the next day that liquidation was perhaps a no worse scenario than being bought and gutted by another bank. Once liquidation had begun, the bank was segregated into good and bad parts and put up for sale. The Guardian newspaper reported a week later that Barclays had purchased the North American division of Lehman’s business whilst Japanese brokers Nomura agreed a deal to take on Lehman’s equities across Europe, the Middle East and Pacific Asia.