INTRODUCTION

Goldman Sachs Group, Morgan Stanley, Merrill Lynch (now as Subsidiary of Bank of America), Lehman Brothers and Bear Steams (sold to JPMorgan Chase) were the world top five investment banks in United States. They were the key players in the financial markets and make significant contribution to the economics. But when they failed, the consequences would also be extremely fatal. The 158 years old Lehman Brothers Holdings Inc. filed for Chapter 11 bankruptcy on Sunday 1:45am, September 15, 2008 (“Wikipedia: Lehman Brothers”, July 15, 2013). With a total assets of $639 billion and $619 billion in debts, Lehman Brothers’ bankruptcy filing became the largest in history, It’s assets far surpassed those of previous bankrupt giants such as WorldCom and Enron (“IInvestopedia: Case Study", April 02, 2009). The collapse of the Lehman Brothers is contagious and even triggered the Global Financial Crisis.

LEHMAN BROTHERS HISTORY

Three brothers – Henry Lehman, Emanuel Lehman and Mayer Lehman in 1850, founded Lehman Brothers. Started as a normal dry-goods store, the brothers grew the business by buying and selling cotton to planters living in and around Montgomery, Alabama ("History of Lehman Brothers", n.d). Eventually the brothers built a cotton storage warehouse together with a cotton merchant John Wesley Durr in a brief partnership form. Thereafter in 1858, an office in New York was opened to fulfill the needs of the growing sales and trades.

After Civic War, Lehman Brothers who already have a strong pressure in the cotton commodities trading moved their headquarters to New York City. They also did a part in financing Alabama's reconstruction. In 1870, Lehman Brothers together with a group of cotton merchants and traders founded the New York Cotton Exchange, which is still in operating today. Lehman brothers also start to deal with emerging market for railroad bonds and the financial advising industry ("Wikipedia: Lehman Brothers", July 15, 2013).

In 1877, Lehman Brothers become a member of the New York Stock Exchange and gradually become a merchant-banking company. From then on, Lehman Brothers focused on securities trading and financial advisory, which provided the foundation for developing the underwriting business in the early 1900s ("History of Lehman Brothers", n.d).

In 1906, Lehman Brothers form an alliance with Goldman Sachs & Co. and introduce the General Cigar Co. to the market. Lehman & Goldman continued to underwrite new securities issues over the next two decades, which included F.W. Woolworth Company, Gimbel Brothers (Gimbels), May Department Stores, Company, R.H. Macy & Company (Macy’s) and Sears, Roebuck & Company. Beside the retail industry, Lehman Brothers also underwrote the initial public offering for the communication industry – DuMont Laboratories; and computer technology industry – Digital Equipment Corporation ("History of Lehman Brothers", n.d & "Wikipedia: Lehman Brothers", July 15, 2013).

Lehman Brothers introduced “private placement”, a new financing method to aid the capital crisis caused by the Great Depression in the 1930s. Private placement financing has become a standard financing method today ("History of Lehman Brothers", n.d.).

In the 1960s, Lehman Brothers become an official dealer for the U.S. Treasuries. Lehman Brothers further expanded its business internationally with offices in Asia and Europe. Kuhn, Loeb & Co, the country’s fourth largest investment bank at that time merged with Lehman Brothers, to create Lehman Brothers, Kuhn, Loeb Inc. in 1977. This further enhanced Lehman Brothers achievement globally. Lehman Brothers financing advisory business became more focused on mergers and acquisitions.

An American Express owned Securities Company, Shearson/American Express acquired Lehman Brothers, Kuhn, Loeb Inc. in 1984 to form Shearson Lehman/Lehman Brothers. In 1988, the firm merged with E.F. Hutton & Co. and was renamed as Shearson Lehman Hutton, Inc. After the many mergers, Lehman Brothers eventually become solely again when American Express began to divest its retail brokerage and investment banking business. In 1993 Shearson was sold to Primerica and in 1993 Lehman Brothers become independent and named as Lehman Brothers Holdings Incorporated ("Wikipedia: Lehman Brothers", July 15, 2013).

Lehman Brothers continued its investment banking and institutional business for almost fifteen years after independence and survive through many downsides including the 1997 Asian Financial Crisis and September 11, 2001 terrorist attacks was finally destroyed by the U.S. Subprime Mortgage Crisis in 2008 ("Wikipedia: Lehman Brothers", July 15, 2013).

RICHARD S. FULD JR.

Richard "Dick" Severin Fuld, Jr. (born April 26, 1946) also known as Dick Fuld or the Gorilla of Wall Street was ranked by TIME magazine as one of the “25 People to Blame for the Finance Crisis”, number 9 on CNN “Ten Most Wanted: Culprits of Collapse” and first place on CONDE NAST PORTFOLIO (now known as Upstart Business Journal) “Worst American CEOs of All Time” ("Wikipedia: Richard S. Fuld, Jr.", June 28, 2013).

Dick Fuld joined Lehman Brothers in 1969 as a commercial-paper trader after his pilot career in the U.S. Air Force. He was an ambitions man and studied part-time for his New York University’s MBA during his early years in Lehman Brothers. In 1982, Dick Fuld became a supervisor with 22 managers under him in both the fixed-income and the equities divisions. At that time, his division generated two-thirds of Lehman Brothers’ profits (“Richard S. Fuld Jr. 1946— Biography”, n.d.).

By 1984, Dick Fuld was promoted to the Vice Chairman and 1990 the President and Co-CEO of Shearson/Lehman Brothers. After spun-off from American Express in 1994, Dick Fuld became the Chairman and Chief Executive Officer of Lehman Brothers Holdings Inc. until the shocking demise in September 2008.

Under his leadership, the company return on equity rose from 3 percent to 14 percent in just two years (1994-1996). Dick Fuld was aggressive, he desired for bigger profits therefore decided to change the firm's strategy. He focused on investment banking (mergers and acquisitions) and equities that generated much higher margin compare to fixed-income. In order to make such changes, Dick Fuld needed to recruit more people of related profession and provided them with the best remuneration package. In 1997, out of the $48 million additional remuneration for new recruits, only 5% was allocating to the fixed income division. And this was definitely a right move as it brought Lehman Brothers fourteen straight years of profits.

At Lehman Brothers, turnover was very low. The employees loved the company as Lehman Brothers furnished them with amazing compensation package. "If you join us, we promise to make you rich - perhaps seriously rich." This was the message by Dick Fuld to the new recruits of Lehman Brothers (“Richard S. Fuld Jr. 1946— Biography”, n.d.). Beside the basic monthly salaries, Dick Fuld rewarded employees with Lehman Brother shares, which can only be access five years later. Some employees objected the requirements of waiting five years but most others accepted as Lehman Brothers share price was increasing everyday. It was believed that Lehman Brothers was packed with self-made millionaires. Lehman Brothers not only brought wealth to the employees, Dick Fuld also earned himself a total compensation near to half a billion dollars ($483,800,000) from 1993 to 2007 ("CEO Richard …", February 22, 2009).

CAUSE OF FAILURE

There were a several factors that contributed to the Lehman Brothers demise. What really happen? Who to blame?

COMPANY CULTURE

Although the subprime crisis ended the glories history of Lehman Brothers, its company culture should be the starting point of this disaster. The Lehman Brothers’ risk-oriented corporate culture leaded the company to pursue an aggressive growth strategy. Risk has no limits in Lehman Brothers. Margins were their mean concern ("Investopedia: Case Study", April 02, 2009).

The management got engaged in subprime market lending activities and make tremendous profits as the applicable interest rate was higher than the conventional loans and also had additionally higher origination and other fees. The risk involved in subprime lending relatively high but when any employees tried to question or show concern of the issues, they were dismissed. Eventually no one question. Making profit became the employer’s number one mission.

Employees who performed excessive risks or questionable deals were rewarded like heroes when there was financial gain. Managers who made careless business mistakes and poor judgment were still highly paid. Such system affected the employees’ moral. As Richard "Dick" Severin Fuld, Jr., the CEO of Lehman Brothers does not welcomed bad news (“Wharton, Lehman's Demise and Repo 105...”, September 09, 2009), employees started to cut corners or cheat their way through to be successful in the company. Unethical acts being to spread in Lehman Brothers.

During the early stage of the subprime crisis, the talented Lehman Brothers professionals came out with a brilliance idea. Over the last few decades, accountants have been using this same trick and magically remove unattractive assets from the balance sheets (“Norris Floyd, Demystify the Lehman Shell Game”, April 01, 2010). This common trick was called Repos, or repurchase agreements. According to Financial Accounting Standards Board (FASB), Repos transaction should be classified as liability on the balance sheet. But Lehman Brothers classified them as sales legally. How can this be done legally? Lehman Brothers found a loophole in the financial standards, which allowed Repos as sales – “if the securities securing the transaction were worth significantly more than the loan, that could be a sale” (“Norris Floyd, Demystify the Lehman Shell Game”, April 01, 2010).

SUBPRIME MORTGAGE CRISIS (LEVERAGE)

The U.S. Subprime Mortgage Crisis was definitely the prime culprit of Lehman’s collapse. Lehman Brothers was engaged in a highly leveraged style investment strategy, which made it vulnerable to market changes. In the early 2000s, U.S. property & housing prices went up tremendously. Lehman Brothers saw the opportunity in this market and began aggressively borrowed huge amount of fund to invest in real estates mortgage market.

According to Investopedia: Case Study (April 02, 2009), Lehman acquired five mortgage lenders, including subprime lender BNC Mortgage and Aurora Loan Services, which specialized in Alt-A loans (made to borrowers without full documentation). During the good years, Lehman Brothers make tremendous profit and increasing their leverage ratio (a measure of the ratio of assets to owners equity) from 20 to 1 to an unbelievable peak of 44 to 1 (“D’Arcy Cliff, Why Lehman Brothers collapsed”, September 14, 2009).

In 2007 when the United States housing prices start to decline, Dick Fuld stubbornly refused to admit the mistake and also said “he did not foresee problems in the subprime market spreading to the rest of the housing market or hurting the U.S. economy” ("Investopedia: Case Study", April 02, 2009). Credit Crisis in August 2007 was a nightmare to Lehman Brothers causing its shares to drop massively and the closure of its subprime lender, BNC Mortgage. 1,200 people lost their jobs. The year ended with $85 billion mortgage-backed securities, which is four times its shareholders’ equity. These $85 billion portfolio included investment in commercial real estate (CRE), collateralized debt obligations (CDO) and credit default swaps (CDS).

As a result from the subprime mortgage crisis, Lehman Brothers shares dropped from $82 to less than a dollar in September 2008.

UNSUCCESSFUL BAILOUT

The last resort to save Lehman Brothers was to sell it to potential investors. Warren Buffett, Korea Development Bank, Bank of America and Barclay Bank all show interested in acquired Lehman Brothers. First, Dick Fuld and Warren Buffet did not managed to close the deal in March 2008 due to some kind of miscommunication over a phone conversation. And in August 2008, Dick Fuld rejected Korea Development Bank $5 billion offer as Dick Fuld felt the offer was too low. At that time Dick Fuld optimistically believed there were still Bank of America and Barclay Bank or even the U.S. government. But unfortunately he was wrong and too late to come to sense. On September 12, 2008 evening, Bank of America decided not to acquire Lehman Brothers and turn to consider acquiring Merrill Lynch (“Warner Craig, The Last Days of Lehman Brothers”, September 09, 2009 & “Field Abigail, Lehman Report: …”, March 2010).

Hopes from Barclays Bank arrived on Sunday morning, September 13, 2009 but the happiness was short-lived. The U.S. government demanded Barclays to guarantee all Lehman’s debts but according to British laws, the company needs to seek approval from their shareholders and it can only be done by Tuesday September 13, 2008. As British government refused to make exception for this deal and the U.S. government would not support Lehman for even two days. The only options left for the Lehman Brothers was to declare bankruptcy. This ended the 158 years old company (“Warner Craig, The Last Days of Lehman Brothers”, September 09, 2009 & “Field Abigail, Lehman Report: …”, March 2010).

ETHICAL ISSUES / REPO 105

In March 2010, bankruptcy court examiners report revealed Lehman Brothers “Repo 105” Scandal. Repo 105 is an accounting technique that disguised short-term loan as sales and the proceeds can be used to offset debts (“Wikipedia: Repo 105”, February 23, 2013).

Surprisingly, Lehman Brothers had been using this dubious accounting practice to dress up their balance sheet and fooled everyone since 2007. According to the examiner’s report, Lehman Brothers had temporarily erased $50 billion of tonic assets off the balance sheets in 2008 and made Lehman Brothers look healthier on paper.

The use of Repo 105 was not disclose to the public, government and rating agencies. Even Dick Fuld denied knowledge of the use of Repo 105 in Lehman Brothers balance sheet. But that is impossible as evidence shown Dick Fuld was simply lying. Therefore Lehman Brothers was believed to use the beauty of Repo 105 and intentionally manipulate their balance sheet to mislead investor that the company was not overleveraged (“Heide B. Malhotra, Epoch Times:…”, April 14, 2010).

Ernst & Young who was Lehman’s external auditors from 2001 to 2008 was sued for accounting fraud related to Repo 105 and the collapse of Lehman Brothers in December 2010. The examiner’s report pointed out that Ernst and Young chose to remain silent even they were aware of the use of Repo 105 in Lehman’s balance sheet. But Ernst & Young said that the Repo transactions were accounted for in line with Generally Accepted Accounting Principles (“EY (company)”, August 15, 2013). This accounting loophole saved Dick Fuld and Ernst & Young from any legal responsibility.

Lehman Brothers, the failed investment bank, stands accused of misleading investors, regulators and other users of their financial statements due to its use of Repo 105 transactions to temporarily improve its leverage position at financial reporting period ends.

But what are Repo 105 transactions? In simple terms, assets are sold typically just before a reporting period end for 5% less than their current balance sheet value with an agreement to buy them back shortly after the period end for the amount borrowed plus interest. The difference between the cash received and the asset values is known as the ‘haircut’. The cash received is used to either pay down debt or improve the net debt position specifically to make period end figures look better.

As Lehman did not technically have sufficient cash at the period end to repurchase the assets, due to the 5% haircut, then US GAAP regards it as having lost control of the assets and requires the assets to be removed from the balance sheet and replaced with the cash. This was the case even though the bank’s own staff regarded Repo 105 as little more than an accounting gimmick.

PREVENTATIVE MEASURES Firstly in any form of business, diversification the risk is important. Yet Lehman Brothers chose to put all their majority of their funds into one single investment – the Subprime Mortgage market. Hence when the mortgage market plummeted, so did Lehman Brothers.

Secondly, Lehman Brothers balance sheet was a mess, thanks to Repo. To eliminate future used of Repo 105 by other companies, the Financial Accounting Standards Board introduced a new rule – “FAS 166, replaces the 98%-102% test with one designed to get at the intent behind a repurchase agreement. The new rule looks at whether a transaction truly involves a transfer of risk and reward. If it does not, the agreement is deemed a loan and the assets stay on the borrower's balance sheet” (“Knowledge@Wharton, Lehman's Demise and Repo 105: …”, March 31, 2010).

More stringent policies was also introduced by International Financial Reporting Standards, SEC, the Basel Accord et al.

CONCLUSIONS

Monday, 15 September 2008, it was a date many people will remember especially the 26,000 former employees of Lehman Brothers who lost their jobs. Dow Jones dropped 504 points, which is one of its largest drops. Merrill Lynch was brought over by Bank of America. Investors and companies around the world who have direct connection with Lehman Brothers lost almost all their money. The collapse of Lehman Brothers trembled the financial markets and economies worldwide.