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Lehman Brothers Collapse

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Lehman Brothers Collapse

Executive Summary

The following report discusses and analyzes the events leading up to the failure of Lehman Brothers as well as outcomes and repercussions of one of the largest bankruptcy cases to date. The first part of this paper describes the primary factors that contributed to the ultimate demise of Lehman Brothers. The main factors that lead to the crisis include, but are not limited to; the misrepresentation of financial statements, a complete lack of internal control, accounting as well as management collusion, managerial fraud, increased moral hazard, and the overpayment of executives within the firm. Misrepresentation of the financial statements and the misuse of accounting practices was the main reason for the Collapse of Lehman Brothers. It was said that upper management violated the Sarbanes-Oxley Act through the use of questionable and unethical accounting practices, more specifically through the use of Repo 105 transactions. The second part of this paper addresses the underlying causes and issues relative to the study of financial ethics. This paper also addresses those who were involved as well as affected by the events that took place in the Lehman Brothers scandal. After evaluating the reasons for Lehman Brothers failure, the report discusses possible courses of action to take in order to avoid a similar situation. Detailed solutions to eliminate internal fraud and collusion for this case have been documented in the following pages as well. The most effective method for reducing these problems is increasing awareness of unethical practices and promoting an ethically-centralized work environment. The end of the paper finishes with the current outcome and general overview of the financial position of, one of the largest financial institutions in the United States, Lehman Brothers.

Introduction
Lehman Brothers bank filed for bankruptcy on September 15, 2008. At the time, Lehman Brothers was the 4th largest investment bank in the world. When Lehman Brothers submitted its Chapter 11 bankruptcy filing, it employed over 25,000 people worldwide and held $639 billion in assets. However, the $619 billion in debt that the company held was too much for the firm to stay above water. To date, the Lehman brother bankruptcy remains the largest in history. The following report will take a deeper look into what caused the collapse, explain its overall impact and explore the possible remedies for the problem.
Facts & Catalyst
To fully understand the catalysts that led to the downfall of Lehman Brothers, it is important to understand the setting in which it took place. The main events that contributed to the Lehman Brothers bankruptcy occurred between 2004 and 2008. During this time, individuals and organizations alike played key roles in causing, allowing or perpetuating the risky practices at Lehman. These players included: top executives and directors at Lehman Brothers, the SEC, Ernst & Young – Lehman’s accounting firm, and several others.
The major catalyst that paved the way for Lehman’s actions was a series of decisions by the Securities and Exchange Commission in 2004. During this year, the SEC reduced the capital requirements of investment banks which allowed for greater debt to equity ratios, also known as leveraging. According to the New York Times, “the banks agreed to submit to supervision of their holding companies by the agency” in exchange for the lowered capital requirements (Labaton). Although, this increased supervision by the SEC would appear to minimize the risk of fraud, it was the real starting point for unstable business practices.
With the change of the capital requirement for investment banks, Lehman Brother’s debt to equity ratio rose by 39% in the 4 years following the SEC’s decision. By the year 2007, Lehman Brothers had a leverage ratio of 31:1. This meant that for every $31 that Lehman spent, $30 of those dollars were financed with debt, while only $1 was actually coming out of Lehman’s assets. This increased leverage basically allowed Lehman Brothers to do more business with less of their own money. This strategy has the potential to be very lucrative for a firm when market conditions are good, which is why Lehman brothers was able to report record gains from 2004 until 2007.
The downside of leverage is that it can be especially devastating during times of economic contraction. When a firm is leveraged at a ratio of 30:1, a mere 3.3% drop in the value of the firm’s assets will result in insolvency and the equity of the firm is wiped out (Cause and Effects, YouTube). This is exactly what happened to Lehman when the housing bubble burst.
This housing market decline was especially concerning for Lehman due to the fact that mortgage backed securities comprised much of Lehman’s assets. Additionally, many of these mortgages were classified as “sub-prime”, meaning the “borrower [has] a larger-than-average risk of defaulting on the loan” (“Subprime Mortgage”, Investopedia.com). With such a large debt ratio and a very high default risk associated with many of Lehman’s investments, it is easy to see the pressures that they faced.
This pressure to continue reporting financial gains was what led to the true fraud at Lehman brothers. In order to cover up the massive losses that Lehman was facing, and restore investor confidence, Lehman began to cover up their losses through a scheme called “Repo 105” transactions. This involved shipping the debt to a different firm in the weeks before the financial reports were published. These kinds of “repo” deals are frequently used within the banking industry. The difference between Lehman Brothers and other banks however, is that Lehman chose to categorize these transactions as sales (income) instead of loans (liabilities). This strategy falsely raised the value of the firm, reduced their debt for a very short, albeit critical, timeframe and gave investors the illusion of a healthy firm.
Underlying Issues/Causes
The 2008 collapse of financial giant, Lehman Brothers is attributed to several underlying factors. Many of which are directly related to credit crisis of that year however, there was a multitude of unethical actions taken by the firm and associates that largely contributed to the demise of the company. These actions include: increased moral hazard, misrepresentation of financial statements, accounting as well as management collusion, managerial fraud, overpayment of executives within the firm, and a complete lack of internal control. At the time, investment banks did not have to follow the same rules regarding risk and Lehman Brothers took full advantage of this through high-risk borrowing practices. They increased their leverage ratio through the purchase of housing-related assets and mortgage-backed securities. These investments are high risk due to their dependence on the housing market. With many of their assets and investments pegged to the market, substantial losses were incurred when the sub-prime mortgage crisis hit, severely decreasing the value of the company’s assets. Lehman Brothers took excessive risks in the belief that they were too big to fail. Unfortunately for them, the U.S. government did not employ any plan to intervene with the financial troubles that faced them. Although it was deemed legal by the generally accepted accounting principles, Repo 105 was an accounting technique used to move almost $50 billion from the company’s balance sheet in order to reduce their total debt and look financially stable in the eyes of investors. The idea being that their current assets still exceed current liabilities. Lehman Brothers failed to disclose the extent at which they were using this technique to the public, as well as to some or all of its own board members. The undervaluing of the liabilities within the company is a purposely employed fraud tactic that allowed the company to continue day to day operations without being caught. However, this required participation from several parties in order for it to continue. The use of Repo transactions were made possible by the collusion of management and accounting departments alike. Not only were the accountants at Lehman Brothers participating in the scheme, but the external auditors were facilitating it as well. Ernst and Young, the firm’s auditing partner, allowed the transactions and positively reported the firm’s accounting practices prior to the company’s collapse. External auditors are supposed to be a form of regulation for companies but in this case, they acted as the opposite and aided the company in misrepresentation by looking the other way. It is possible that these practices were hidden from some executives however; it is extremely unlikely that they were hidden from all of them. At some point, some executives had to be aware of what was going on yet nothing was done about it. In relation to the fraud triangle, it is evident that Richard Fuld, head of Lehman Brothers, was pressured to allow the company to deceive investors and the public in order to keep the historic company afloat. It is likely that he rationalized these tactics with the belief that Lehman Brothers would eventually generate profits and recuperate the money needed to fund the company’s liabilities that had been hidden through the use of the Repo 105 technique. Additionally, executive pay at Lehman Brothers had increased every year for 8 years prior to the firm’s bankruptcy filing. This was an unethical practice as even through the company’s negative profit quarters, the executive’s pay was continually increased. It is the board’s job to oversee auditing practices and in turn, the accounting practices within the firm however; this was not apparent and showed a complete lack of internal control.
Stakeholders/Costs
Lehman is the biggest investment bank to collapse since 1990, when Drexel Burnham Lambert filed for bankruptcy amid a collapse in the junk bond market. Based on assets, Lehman also far surpasses WorldCom as the largest U.S. bankruptcy ever (Gasparino 2008). When such a large investment bank goes bankrupt there are many stakeholders. You have to think about the employees, clients whom invested with Lehman Brothers, companies that Lehman Brothers has invested in and any creditors that Lehman Brothers might owe.
Since Lehman Brothers had such a large debt they began to look at which of their assets were going to be sold to raise capital. Of all the assets they had, the largest and most valuable was the firm's entire investment management division. This included its Neuberger & Berman asset management unit as well as stakes in hedge funds and private equity funds (Gasparino 2008). The decision whether or not to sell had to be made as soon as possible. It’s no surprise that customers are often reluctant to trade with dealers whose parent companies are in bankruptcy, so the longer Lehman waits to sell its broker-dealer unit, the less valuable it will be. Lehman also discussed liquidating a number of other companies in which it had owned stakes of 10 percent or more. These companies include Imperial Sugar Co , Lpath Inc, Derma Services, Flagstone Reinsurance, GLG Partners, Ronco Corp , Pacific Energy Partners, Blount International , Pemstar Inc and TransMontaigne Inc (CNBC 2008).
Lehman Brothers had massive amounts of debt, if not paid back to the creditors it could potentially bankrupt them as well. Lehman Brothers owed Citibank and Bank of New York Mellon about $138 billion, which during the bankruptcy filings both banks were named as trustees equaling the debt in the form of senior Lehman bonds. Among Lehman's other unsecured creditors are Japanese banks Aozora Bank, Mizuho Financial Group Inc, Shinsei Bank and UFJ Bank. France's BNP Paribas is also on Lehman's list of its 30 largest unsecured creditors. The firm said that as of May 31, it owed about $110.5 billion on account of senior unsecured notes, $12.6 billion on account of subordinated unsecured notes, and $5 billion on account of junior subordinated notes (CNBC 2008).
Lastly, the employees were heavily affected by the bankruptcy. Lehman Brothers had over 26,000 employees; a lot of them lost their jobs along with their retirement plans. During my research I found an article that describes the scenery at their Headquarters in midtown Manhattan on the day the bankruptcy was announced. The article described men dressed in suits coming and going, while other employees entered the building with what appeared to be empty duffel bags, then left with them full (CNBC 2008). It goes on to talk about a number of people staying through the night to finish cleaning out their offices.
Possible Courses of Action
Misrepresentation of Financial Statements
The unethical actions of upper-level management are the largest factors leading to the bankruptcy of the Lehman Brothers. Although Repo 105s are legal accounting practices upper management used them in a misleading way to temporarily improve the financial position of the company. When a company has internal fraud being committed by upper management it is normally extremely hard to catch and prevent. The most important measure that any business can use to avoid fraudulent acts and future litigation is providing a strong ethical environment and standards that all employees must follow. In addition to having high ethical standards being imposed on employees, the company should promote a “confidential whistle blowing hotline that personnel can access when they believe unethical acts are being committed (Goldmann, 2009).” If there is a strong culture based around high ethical standards in a company, then the employees should have increased awareness towards questionable or unordinary practices that occur around them
Accounting & Managerial Collusion
The use of Repo 105 transactions was never made public in order for the Lehman Brothers to maintain their image as a profitable company. To prevent misrepresentation of the financial statements outside auditors or external financial reporting experts must be hired. These individuals will be given the task of analyzing the financials at physical locations unannounced, so that fraudsters are unaware of when they will be audited. Unfortunately the SEC was investigating Lehman Brothers on site and they still couldn’t find any discrepancies and the external auditors looked the other way. All financial statements must be monitored when a company is in question for unethical behavior or fraud. The fact that Lehman Brothers had negative cash flows for three years leading up to their failure and still had a positive outlook on their balance sheet and income statement should have raised flags, but it went unnoticed. So, it would be in the best interest of companies to “establish a competent and independent audit committee that is extensively trained to recognize and screen for anomalous patterns that could indicate fraud (Goldmann, 2009).”
Another reason that upper-level management misrepresented their financial position was the immense amount of pressure being forced on them to make the company look profitable in order to reach company benchmarks. To reduce the rationalizations towards committing fraud Lehman Brothers should have adjusted the companies goals as the economy and their financial position changed. Setting goals for managers to achieve is beneficial, but if they are seemingly unattainable then managers are almost forced to commit unethical or questionable practices.
Executive Payment
Achieving business strategies and reaching financial goals is ingrained in the culture of all successful companies and compensation comes along with each success. The executives of Lehman Brothers were grossly overpaid and compensated during the last 8 years of operations. Questionable and unethical practices were committed by managers due to the lucrative compensations being given out by the company. To avoid this problem Lehman Brothers should have avoided the excessive performance based compensation and reduced the amounts being awarded to managers.
Internal Control
Due to a lack of internal control, the managers and accountants were able to distort the financial position of Lehman Brothers. When a company uses Repo transactions designated as sales and not loans, the board should be informed and they should make sure that the accounting method is being used properly. Authorizing the use of questionable methods should be approved by several upper-level management personnel in some written form before they are carried out. Regular internal audits and surprise audits will also help prevent fraud from happening. If the audits are consistent and all transactions are continuously monitored there is no chance for fraudsters to rework the financial statements of Lehman Brothers and alter their financial position.
In addition to the increased monetary compensation awarded to managers, they could have provided other benefits for reaching specific benchmarks. For example, they could have given them extra days off during the year to spend with family and friends. The problem with monetary compensation whether it is through stock options or cash, is that the person receiving it will do anything to maintain that additional income. The short term performance becomes more important than the long term position of the company. If the company creates a highly ethical culture, a strong prevention environment, and combines that with attainable goals, the thought of committing fraud should not become an option for employees.
Outcomes
“Lehman Brothers was probably the biggest loser in the financial meltdown of 2008” (dailybell.com). However their collapse was an event whose repercussions extended far beyond its executives, investors and creditors. Financial markets were agitated for weeks, considering the size and standing as a major player in the world’s economy. Many wondered why the U.S. government decided to let Lehman fail while they chose to support several other companies in the same industry such as Bear Stearns. So what were the outcomes of this decision by the U.S. government? The collapse of Lehman Brothers and their announcement of a Chapter 11 bankruptcy on Monday, September 15th had several financial, controversial, and legal effects on the world.
The financial aftermath of the collapse was visibly enormous with extreme market turmoil. Lehman’s Bankruptcy, the largest corporate bankruptcy in history, led to more than $46 billion of its market value being wiped out in a matter of days. The Dow Jones Industrial average dropped 1.1 trillion and the S&P hit a 13 year low. All hedge funds invested in Lehman assets were frozen. The Fed cut interest rates to 0%. Global Trade halted and unemployment ballooned. Its collapse also served as the catalyst for the purchase of Merrill Lynch by Bank of America in an emergency deal. Federal Reserve's Open Market Committee, which sets interest rates and regulates the money supply, announced it would print an additional $40 billion a month, and use it to buy mortgage backed securities from Fannie Mae and Freddie Mac, the quasi-governmental patronage factories whose finances were so bad that the federal government had to take them over in the wake of the Lehman Brothers collapse. The global market as a whole crashed.
Lehman Brothers remains embroiled in controversy after managing to conceal from the outside world a multi-billion-dollar mess. An audit of the pay of top executives revealed that while Lehman Brothers was going bankrupt, the management had received steep increases in salary and bonuses. The assessment of performance bonuses for executives in a bankrupt company made little sense. Lehman’s executives carried out “materially misleading” accounting tricks that hid billions of dollars in debt from regulators. Many Wall Street critics wonder what the New York branch of the Federal Reserve knew about the scheming. “It also emerges that the NY Fed, and thus Timothy Geithner, were at a minimum massively derelict in the performance of their duties, and may well be culpable in aiding and abetting Lehman in accounting fraud and Sarbox violations,” writes Smith, referring to the Sarbanes-Oxley Act of 2002. “We need to demand an immediate release of the e-mails, phone records, and meeting notes from the NY Fed and key Lehman principals regarding the NY Fed’s review of Lehman’s solvency”(allgov.com).
A Lehman Brothers class action suit has been filed on behalf of investors who purchased Lehman Preferred Series “J” stock shares issued between February 5, 2008 and September 15, 2008 (aboutlawsuits.com). The lawsuit was filed in the U.S. District Court in Manhattan by institutional investors Forgel Capital Management. The investigation of Lehman brothers found that, similar to what Enron had done prior to its collapse, they had moved some bad debt from its books to small subsidiary corporations in order to give the appearance that the company was in better financial health. One of the major legal actions following the collapse was written in the Dodd Frank Wall Street Reform and Consumer Protection Act. This was Congress' response to the crisis.
Conclusion
The Collapse of Lehman Brothers was the biggest financial failure in the history of the United States. Not only did its collapse cripple the retirement funds of its stockholders, but Lehman’s bankruptcy also shook the entire global economy. The extreme performance pressures combined with the oversights of many key players in this case led to some of the most notorious acts of fraud in the history of the investment world. While the collapse of Lehman brothers cannot be undone, it is clear that incorporating various anti-fraud practices could have made a considerable difference in the outcome. Utilizing surprise audits, a whistleblower hotline, a zero tolerance policy for fraudulent behaviors and encouraging a culture with high ethical standards might have even saved the firm. Lehman Brothers remains an excellent example of the severe consequences a firm can suffer without effective ethical controls.

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