Syndicate Assignment: case study: Letting go of Lehman Brothers

1.0 Introduction

On 15th September 2008, when the investment bank Lehman Brother fell was the largest
bankruptcy ever in the history. The bank had assets nearly $639 billion, the Lehman bank
business areas before the collapse was investments banking, equities, capital markets and
investment management (Lehman Brothers, 2007, annual report; 2008). Due to competition
from other investment banks, Lehman Brothers decided to change from lower risk brokerage
to higher risk, they focused on making long –term investment. They were also involved in
different types of Subprime loans and Mortgages, these loans were issued to people who
had little security and this led to higher interest rates. The government also encouraged
banks to issue loans so that even financially weak people could buy houses. However,
things changed when cheap loans and real estate prices burst in 2006. Interest rates started
to become very high and led to default which meant then a lot of loss in revenue and severe
increase in Liquidity risk. Prices of real estate also fell and assets lost value (Bankruptcy
report, 2008). In the beginning of 2008, Lehman Brothers started losing millions of money
with their high debts and their balance sheet filled with weak, illiquid assets. Lenders and
other parties lost confidence in the bank increasing capital costs and made it hard for the
bank to get short-term funding to maintain Liquidity (Lehman Brothers second quarterly
report, 2008). They tried to negotiate with other banks for sale but no settlements were
made, therefore due to their disregard of risk awareness, the US government had lost
confidence in the bank and chose not to intervene in the inevitable end of Lehman Brothers.

There are things that need to be considered when a major financial firm assumes to be “too
big to fail” the government needs to nationalise the company in order to limit its effects on
other firms and also to protect the system. This has been the debate over whether the US
government action to let the Lehman Brothers fail was justified or it was the best thing to do
to avoid financial institutions creating a problem called “moral hazard”. Many financial
institutions, investment banks in particular, issued large amounts of debt during 2004–2007,
and invested the proceeds in mortgage-backed securities (MBS), essentially betting that
house prices would continue to rise, and those households would continue to make their
mortgage payments. Borrowing at a lower interest rate and investing the proceeds at a
higher interest rate is a form of financial leverage .During 2008, three of the largest U.S.
investment banks either went bankrupt like Lehman Brothers or were sold at fire sale prices
to other banks Bear Stearns and Merrill Lynch. These failures augmented the instability in
the global financial system.

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2.0 Do you believe that the U.S. government treated some financial institutions
differently during the crisis? Was that appropriate?

The US government’s decision could have been based on many past factors and their
financial policies which are not disclosed to common man. From a lay man’s point of view,
after reading the case study, it is very easy to say that the government’s decision was biased
in some way, as the Federal Reserve had bailed out two groups before Lehmann and then
AIG two days after. But, I do not think they were biased or acted differently with different
institutions. The government had to look into the interests of the country and to keep the
economy going rather than help one or two companies. In the case of Lehmann brothers,
The United States government was right in principle not to save Lehman Brothers from
bankruptcy as they acted too late. The government should have forced the industry to
address the financial pressures that were simmering for over a year before the Lehman
Brothers crisis, through legal and taxation pressures if necessary. By the time of the Lehman
Brothers crisis the industry participants were concerned exclusively in safeguarding the
future of their own businesses. AIG's collapse would be the beginning of the entire world's
economic system unravelling. Lehmann Brothers is nowhere near as significant an
institution. Also, Lehmann brothers approached the government at a very late stage, when
the stock markets in Russia had dropped a lot because of their problem. As with Lehman,
the funding of the U.S. government is largely via short-term means, namely, short-term
securities and current cash flows from taxes. Hence, the government is exposed to a
potential cash flow squeeze in several ways. Companies like AIG, Fannie Mae and Freddie
Mac is believed to have had collateral and showed great promise of paying back the Federal
Reserve in the future that’s why they received bailout while they were not very sure about
the Lehman Brothers. The government also expected companies such as Bank of America
and Barclays to buy parts of Lehman Brothers company therefore they did not step in.
Analysts view the Lehman Brother’s fall as a good way to show the government how to deal
with issues of financial crisis, Lehman Brothers were also known to take larger risks which
led the company to fail(Eiteman, D. K., Daly, K., Rath, S Stonehill, A. I, and Moffett, M. H,
2010).

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3.0 Many experts argue that when the government bails out a private financial
institution it creates a problem called “moral hazard,” meaning that if the institution
knows it will be saved, it actually has an incentive to take on more risk, not less. What
do you think?

“Moral hazard” applies to the fact that Lehman Brothers decided to push the limits by taking
higher risks. We presume that the government may have let the Lehman brothers to fall in
order for other institutions to learn the lesson and to avoid the same mistakes in future.
“Moral hazard was the central of the problems of 2007- 2008 global credit crisis. Bailout had
most definitely heightened over the years, especially since the 1998 case of long term
capital management. Fannie Mae and Freddie Mac being allowed to set up as private –
sector profit seeking companies that benefited from implicit guarantee caused moral hazard.
But with Lehman Brothers down fall was a way to draw the line. Federal Reserve Chairman
Ben Bernanke countered that charge, saying it was impossible for the Fed to rescue Lehman
Brothers from bankruptcy in 2008 because the Wall Street firm lacked sufficient collateral to
secure a loan. Asked how the Lehman case differed from that of American International
Group Inc. (AIG), which received $182 billion in taxpayer aid, Bernanke said there was a
fundamental difference.

Letting Lehman go down was a well-intentioned attempt to draw the line under moral hazard.
The problem was that it merely showed that moral hazard had already grown too great.
Within days, it was obvious that the financial system was on the brink of total collapse, and
so there was no alternative but to re-inject yet more moral hazard into the system, by making
it clear to the other systemically important big banks that they would not be allowed to fail.
Normally moral hazard cleanses itself during a crisis, because investors lose a lot of money
and know to behave differently in future. This time, despite such a damaging crisis, moral
hazard is even greater coming out that it was going in. Avoiding bailouts earlier in the
process might have stopped moral hazard growing too great. By the time Lehman’s turn
came, it was too late.

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4.0. Do you think that the U.S. government should have allowed Lehman Brothers to
fail?

Lehman Brother was allowed to collapse because Lehman bankruptcy was an economic
disaster, that US taxpayers must honour in full all the debts of all the banks, however, the
problem that followed from Lehman did not just stem from the fact that the government was
not honouring Lehman’s debts. Therefore, the decision to allow Lehman Brothers to fail is a
double-edged sword. It was an uncontrolled bankruptcy of an investment bank in the world
where the official line was still that everything was under control, it was like a massive
domino effect on not only U.S market but all over the world markets. According to the
statistics, during the first six months of 2008, Lehman’s stock value decreased approximately
by 73%, which also led to 1,500 employees becoming unemployed. As a result of a steadily
declining market value, U.S. investor confidence diminished causing the S&P 500 and the
Dow Jones drop sharply in September 2008.

If the U.S. government had assisted Lehman, investors’ confidence across the world may
not have faltered as it did which in turn would not have negatively impacted the world
markets. On the other hand, who would pay the cost for such a massive bailout if the
government had assisted Lehman? AIG has received $85 billion from U.S. government as
federal assistance, unfortunately, some individual in AIG’s upper management awarding
themselves with bonuses and vacations after the bailout. It was believed that Lehman
Brothers was hardly to fail because it was big investment bank with long history, after AIG’s
discretionary spending of the government loan; the government was trying to make a signal
for out of Lehman Brothers by letting it collapse. Making such signal out of a large company
will make other large corporations to operate responsibly and ethically. The collapse of
Lehman was good to the extent it signalled very clearly to market participants the magnitude
of losses throughout the financial sector. If Lehman Brothers did not have such a
consequential impact on the global economy, then the government should have allowed the
giant corporation to fail. (Eiteman, D. K., Daly, K., Rath, S Stonehill, A. I, and Moffett, M. H,
2010)

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5.0 Conclusion:

There were several strategic mistakes that eventually led the Lehman bank into bankruptcy.
When Lehman started to focus more on long-term investments instead of brokerage, it
consumed significantly more capital than before. Considering Lehman Brother’s small equity
base this meant a drastically increase in liquidity risk. This created a vicious cycle that in
return made it much more difficult for the bank to borrow capital and to hedge
risks(Bankruptcy Report, 2008) .Lehman’s management exceeded their own risk limits, If the
firm’s results are negative, it loses its accumulated capital, whilst the staff only loses its
future payments and gets to keep old bonuses. This situation creates the risk of moral
hazard. Investments are a trade-off between risk and potential profit. However, since
bankers at most can lose their job, they may take excessive risk in order to get bigger
bonuses. This creates a situation where the bankers act without any feeling of risk. In the
case of Lehman Brothers, the staff and management made a fortune during the good years
when the firm made record profits, profits that were possible due to high risk taking with high
leverage and exposure to then profitable loaning and real estate affairs. These days there is
mortgage crisis in United States due to decline in prices of real-estates. As a result, housing
loans made by the bank to people with little support made these loans very risky, and when
interest rates were raised by these banks, these borrowers could no more repay Lehman.
This led to huge losses for Lehman. It caused $60 billion loss in bad real estate loans for
Lehman Brothers. One of the main reasons for its downfall was its poor relations with top
banks of United States. They refused to do business with Lehman due to over-confidence of
its CEO over the Lehman financial assets. And after big debt of $639 billion, when Lehman
asked Barclays and Bank of America for acquisition, they simply rejected the offer.

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6.0 Reference

Eiteman, D. K., Daly, K., Rath, S Stonehill, A. I, and Moffett, M. H, 2010 Multinational
Business Finance, Pearson Education Australia

Fox, Justin. "The Bailout's Biggest Flaw." Time 28 Sept. 2009: 44. Academic OneFile. Web.
6 Mar. 2011.

Historical Recources (2010), History of Lehman Brothers,

Lehman Brothers (2008), Lehman Brothers 2007 Annual Report

Lehman Brothers First Quarter Report, 2008

Lehman Brothers Second Quarter Report, 2008

http://www.investopedia.com/articles/economics/09/lehman-brothers-collapse.asp

http://www.huffingtonpost.com/2009/05/11/glass-steagall-act-the-se_n_201557.html