Lehman Brothers Bankruptcy & the associated risks
Lehman Brothers, Inc., the fourth-largest U.S. investment bank filed chapter 11 protection on Sep 15, 2008, marking the initiation of the largest bankruptcy in U.S. history.
The direct cause of the bankruptcy was its inability to cover its debt position through selloffs of assets. As of May 31, 2008, the company declared a total of 639 billion in assets and $613 billion in debts.
However, due to various difficulties to secure funding, with only $6 billion in cash and equivalents, Lehman Brothers collapsed without the federal government employing measures, like what they did to Bear Stearns by facilitating J.P. Morgan Chase’s purchase, to save it.
The changing point of the once ‘too big to fail’ investment bank started in 2006 when the bank began to develop massive businesses in commercial real estate, leveraged loans, and private equity – businesses that had higher capital inputs, riskier in returns, and more illiquid than Lehman brothers’ traditional businesses.
Apart from its prime culprit – their significant exposure to the U.S. real estate and subprime mortgage markets, the essay will discuss the following: a) company culture of excessive risk-taking and management level omission of risk limit; b) Leverage concerns; c) regulatory absence.
II. Real estate exposure and subprime mortgage crisis
Starting 2006, Lehman Brothers adopted the new business strategy to target the real estate market to capitalize on its experience in the sector. In contrast to moving their acquired asset through securitization to a third party, the bank now chose to retain the assets as their investment on books, hoping to gain greater profits.
This movement included the expansion to commercial real estate, high-yield loans, and private equity businesses. At the same time, the company, despite its experienced team of risk management that performed stress testing in various scenarios, failed to simulate the widespread mortgage crash as happened.
The Chief risk officer Antoncic said “No one could have predicted a downturn of the magnitude and scale that occurred; it had never happened before, such a downturn without a precipitating economic event. This time, the housing crash was the precipitating event.” (Wiggins and Metrick, 2014)
Although Lehman Brothers was not the only big banks that sought a high leverage level, it had more illiquid assets than the rest of its peers, causing it difficult to identify sufficient assets to provide as collateral needed for borrowings, and in hindsight, unable to turn them into cash quickly enough when needed.
III. Omission of risk limit
In 2006, with the adoption of a new business strategy, it was found that Lehman started to disregard its risk management conduct by breaching many of its own risk management rules, accelerating risk metrics, and became more disregarded in their risk procedures.
From 2004 to 2008, the company increased the company-wide risk appetite limit – the integrated risk measure in Lehman for both credit risk and market risk monitoring – from $1.8 billion to $4 billion. The escalation was, with no surprise, starting from 2006 where the risk appetite limit jumped to $3.5 billion in 2007 and $4 billion in 2008.
Had the original pace been maintained, the risk limit would have been set at $2.5 billion in 2008 (Anton, 2010).
In addition, numerous independent risk limits were repeatedly breached: concentration limits on its leveraged loan and commercial real estate business, risk limits regarding principal investments, single transaction limits on leveraged loans, and single transaction limits in the leveraged lease bridge loans and commercial real estate areas. (Anton, 2010).
One single case that stood out representing the most outsized example of Lehman’s disregard to risk limits was the purchase of Archstone REIT with Tishman Speyer, valued at approx. $22 billion.
The deal had several breaches in both debt risk limit level and equity funding limit level. The result was a near $800 million overflow of its risk appetite to its risk limit of $3.5 billion in 2007.
Nevertheless, as the company sought a new strategy and increased its illiquid asset portion, they never included these investments in its stress test calculation. It was also reported that key risk personnel were excluded from key decisions regarding the discussion of new business strategy. (Anton, 2010)
IV. Leverage concerns and book manipulating
Lehman Brothers, with its peers, were facing a high leverage ratio in mid-2007. Experts called for a deleverage action for the investment banks. However, as a result of the worsening subprime mortgage market, the illiquid assets of Lehman, which doubled from $52 billion to $111 billion, became hard-to-sell. These assets were having difficulty at being priced at an acceptable range for Lehman.
And Lehman was reluctant to sell such assets at a discounted price because it would take losses on these investments, and it would further call into question the value of its remaining assets of similar type, and eventually push Lehman to mark them down, recognizing additional losses. In addition, the use of “Repo 105” to manage its balance sheet and leverage ratio was later proved to be a temporary measure to remove up to $50 billion of assets on a quarter-end basis – purely manipulative action on managing books and its presentation in public financial information. Lastly, Lehman was reluctant to also sell their tier 1 assets at a discount such as their Neuberger Berman subsidiary.
V. Regulatory Absence
The SEC, Lehman Brothers’ primary regulator, was held responsible for not taking preventive or corrective action pursuant to its authority prior to the Lehman bankruptcy. It was reported that the SEC knew about Lehman’s exceeding its own risk control limits, and the fact that Lehman reported illiquid assets in the liquidity pool.
Lehman Brothers were probably one of the most involved investment banks in producing MBS. And it became the most profitable product at the time. With demand continued, more sophisticated products were constructed based on MBS and other ABS. The combination of these products was eventually turned into CDO or collateralized debt obligations where payments were to be made from the flow of repayment from the underlying MBS and ABS making up the CDO.
Not long after the creation of CDO, the CDO-squared – CDO of CDOs – were created to further deepen the complexity and level of securitization of the debt obligations. And These CDOs went into trouble when the housing market cooled down. As banks tried to hedge the risk from potential default from the CDOs, the risk quickly spread to the credit sector, eventually causing a catastrophic financial crisis in 2008.
Lehman Brothers Bankruptcy Written by Zihan Liu
Edited by Jimei Shen
Lehman Brothers Bankruptcy
Statement of Anton R. Valukas, Examiner, Lehman Brothers Bankruptcy before the Committee on Financial Services United States House of Representatives regarding “Public Policy Issues Raised by the Report of the Lehman Bankruptcy Examiner”
Sec.gov. 2021. [online] Available at: <https://www.sec.gov/Archives/edgar/data/806085/000110465908045115/a08-18147_110q.htm> [Accessed 24 May 2021].
Wiggins, R. and Metrick, A., 2014. The Lehman Brothers Bankruptcy B: Risk Limits and Stress Tests. SSRN Electronic Journal.
Wiggins, R. and Metrick, A., 2014. The Lehman Brothers Bankruptcy C: Managing the Balance Sheet Through the Use of Repo 105. SSRN Electronic Journal. Wiggins, R., Piontek, T. and Metrick, A., 2014. The Lehman Brothers Bankruptcy A: Overview. SSRN Electronic Journal.
Lehman Brothers Bankruptcy