7 things You Need to Know to Simply Understand Lehman Brothers Collapse
- 5 April 2020 | 1707 Views | By Abhinav Mishra
Collapse of Lehman Brothers is arguably known as the triggering moment for when the world went into the financial crisis was in 2008, those who were in the market then would still remember it. A lot of people lost their jobs, savings were swallowed by the markets, and the government seemed helpless to many. Unprecedented massive collapse of the banking system also resulted in several companies wiping off their profits along with reserves and surplus.
In this article, we are going to talk about the company which led to the great fall of 2008 – Lehman Brothers.
Lehman Brothers was started as a small general store by Henry Lehman in Montgomery, Alabama in 1844. When Henry’s brothers, Mayer and Emanuel, joined him in 1850, Lehman Brothers was founded. In the initial days, the company sold dry goods and did cotton trade. In the early 1900s, Lehman Brothers started intermediating funding for the retail, industrial, and transportation giants that were emerging at the time. Later, the business expanded into brokerage services and commodities trading. Lehman Brothers also helped establish the Coffee and the Petroleum Exchanges. The company grew like anything in the coming century and also survived the Great Depression of 1930 and two world wars.
In the year 1994, the company became public and it grew even stronger from that point. So, the question arises, what happened 12 years back which changed everything for the company? Before we get to that, you need to know that the company was the fourth-largest investment bank in the US. It had over 25000 employees all over the world and was running for more than 150 years.
The US market by then
The company did not fall overnight and the financial crises did not start with them. Bankers in the USA had figured out a very lucrative business of buying up the US mortgages of poor Americans (known as subprime which is a loan given to someone who has a poor credit score) and then selling them on as risk-free assets(mortgage backed securities) by packaging them with better quality mortgages.
The interest rate was raised by the US central bank in 2006 which made many American homeowners default. This led to the fall in house prices and it was then clear that there are considerable losses in the system. Though it was a fact that there are losses in the system, it was unclear where the toxic securities are and whose balance sheet is getting impacted with these poor loans.
Banks also started charging a high interest rate against the loans given to the institutions and other banks. This phase was known as the credit crunch phase. The crunch turned into a panic state when everyone more or less stopped lending money.
So was the fall because of the Subprime? No, the subprime merely revealed the underlying fragility of the system. The entire banking system in the west was catastrophically illiquid and undercapitalized. Even the entire Europe had the same story. As per experts, if the companies had more robust balance sheets, there would still have been a crisis but it would have not been on the scale that people saw in September 2008.
Path to failure – 2005 to 2008
Coming to Lehman Brothers, the company securitized $146 billion of mortgages in 2006. A 10% increase from 2005 and the company reported profit from 2005 to 2007 every quarter. In 2007, the company reported a net income of $4.2 billion with the total revenue of 19.3 billion. In the February of 2017, the stocks of the company reached a record of $86.18 with a market capitalization of more than $60 billion. The scene changed within a quarter, cracks in the US housing market were apparent. Lehman Brothers profitability became questionable for the first time on 14 March 2007, when the US market recorded the biggest single day fall in 5 years.
On March 17, 2008, the firm’s shares plummeted nearly 48% due to concerns that Lehman would be the next Wall Street firm to fail following Bear Stearns’ near-collapse. Bear Stearns, a large investment bank was rescued in 2007. In April, a preferred stock option was issued that yielded $4 billion and brought little confidence in the company but the stock price was continuously declining over the concern of valuation of Lehman’s mortgage portfolio.
On June 7, the company announced a loss of $2.8 billion and that they have raised another $6 billion from investors. These measures, as per experts, came in too late. The stock plunged 77% in the first week of September 2008, as investors questioned CEO Richard Fuld’s plan to keep the firm independent by selling part of its asset management vertical and spinning off some commercial real estate assets.
Losses Start to Mount
The news of fresh investment from the Korean Development bank was dashed on September 9 and Lehman’s stock dropped by 45%. By the end of that week, the company had only $1 billion cash and had already reported a $3.9 billion loss. Over the weekend, many big companies tried to take over the company but no attempt was successful and on Monday, September 15, Lehman declared bankruptcy.
The most shocking thing about Lehman Brothers filing bankruptcy is that it came less than a year after the bank had posted its biggest profits ever, and after repeated assurances by the bank’s chief executives that liquidity levels were high, that its leverage was manageable, and that the bank’s overall finances were looking good.
Why did the company fail?
There are many reasons for the collapse of the firm but the primary reasons are lack of trust, shaky funding, and poor long term investments.
The primary cause is the company’s overzealous lending during the housing bubble from 2003 to 2004. They acquired 5 lending firms that focused on subprime lending, the firm was over-leveraged and the value of its mortgage portfolio was no longer compelling. The other main reason was that the Fed did not come to rescue the firm given that it was one of the biggest investment banks in the country.
Third, the lies by its CEO Richard Fuld. Most big organizations had already foreseen the US housing market going south and they started reducing their leverage while Lehman continued increasing their asset portfolio. Even when it was clear that the Fuld strategy was not working, he did not take the responsibility and admitted his error. He kept on painting a rosy picture of a bank’s financial health until the very end when the situation reached a point of no turn back.
Fuld was painting a false rosy picture of the bank’s health and chose to lie but the banks’ financial reports would have shown a clear picture. To fool the shareholders, CFO Erin Callan also gave approval of Lehman’s assets to be siphoned away into Hudson Castle. Post collapse, it was confirmed that the siphoning of Lehman assets to Hudson Castle was not done for tax benefits. It was done to create the illusion that Lehman Brothers was financially stable and secure.
How did Lehman Brothers cause the financial crises and what was the impact?
Though there were other factors that contributed to the economic turmoil, the triggering point was Lehman’s failure which unleashed the floodgates of widespread recession. People and investors lost trust in the financial system post Lehman collapse. The general public who had placed so much trust in Lehman and when they saw the fallout of one of the most successful companies they became skeptical of the economy altogether. The collapse made people believe the whole economic system could blow up.
Over an estimated 6 million people lost their jobs, unemployment rose to an all time high of 10%. The Dow Jones Industrial Average (DJIA) dropped an astounding 5,000 points which never happened before that. The ripple effect devastated economies in countries like Hungary, Latvia, Lithuania, and the European Union. Pakistan asked for a bailout after the crisis from the International Monetary Fund (IMF), and Iceland had no funds to prop up major banks in the country which led to its crisis.
The collapse of Lehman Brothers contributed to the global equity markets losing close to $10 trillion in the market capitalization in October 2008.
Did Lehman Brothers’ clients lose money?
The brokerage customers of Lehman Brothers did not lose money. Five years from when the firm filed bankruptcy, the customers received their money in 2013. Clients of Lehman US broker dealer received 100% of their claims with the banks’ London based affiliate and parent company.
The system which was put in place to protect customers’ property worked even though there were complexities and numerous legal challenges. Brokerage clients including hedge funds and pension funds received more than $100 billion.
Around 110,000 Lehman’s former retail clients were paid in full a few months post the collapse, the total amount mounting to $92 billion. Creditors of Lehman’s European arm had received all of their money with interest.
The failure of Lehman Brothers was the most unfortunate event in the history of the US finance industry. It killed the general public illusion that some companies were too big to fail. The main lesson from the collapse of Lehman Brothers is that accountability and transparency are very important, regardless of how dire the circumstances may seem.