In an unprecedented move that rocked the financial industry to its core, on Sept. 15, 2008, Lehman Brothers filed for Chapter 11 bankruptcy protection. Not only was it the largest bankruptcy case in United States history, but it also came after repeated assurances from the company’s chief executives that finances were healthy, liquidity levels were high, and leverage was manageable. The implosion of this Wall Street institution shattered consumer confidence during a time of fragility, and in the aftermath of its collapse, a number of questionable decisions came to light. This analysis will proceed in two parts: First, a recap of the series of events leading to Lehman Brothers’ failure, followed by the identification of several dubious choices made by its executive management team and how the consequences led to the bank’s ultimate demise.
History and Facts
Many believe the beginning of the end for Lehman Brothers was when Washington repealed the Glass-Steagall Act. This landmark legislation from the Great Depression separated the interests of commercial and investment banks, preventing them from competing against each other (2) and protecting their balance sheets by allowing each sector to focus on the business and transactions that it did best. For investment banks, that typically meant highly liquid, asset-light portfolios, leaving commercial banks to handle capital-intensive portfolios, including real estate or corporate investments. Additionally, the act insulated the economy from mass collapse in the event of one sector’s failure by preventing the other from being dragged down in tow. But in 1999, President Clinton signed the Gramm-Leach-Bliley Act into law, allowing commercial and investment banks to compete head-to-head for the first time in 60 years (2). The arms race that ensued would prove disastrous for Lehman Brothers, the financial community, and the global economy at large.
With the repeal of Glass-Steagall, Lehman Brothers became a key player in the United States housing boom. From 2004 to 2006, Lehman Brothers experienced a 56 percent surge in revenues from real estate businesses alone (1). The firm recognized profits from 2005 to 2006, and in 2007 it reported a record net income of $4.2 billion on revenues of $19.3 billion. In the same year, Lehman Brothers’ stock reached an all-time high of $86.18 per share, giving it a market capitalization close to $60 billion (1). This proved exceptional to the surrounding climate, however, and the housing market began to show signs of a pending bubble burst.
In March 2007, the stock market experienced its biggest single-day plunge in five years, while the number of mortgage defaults simultaneously rose to the highest percentage in almost a decade. Bear Stearns, Lehman Brothers’ most comparable Wall Street rival, experienced the total failure of two hedge funds in August. Despite rapidly deteriorating marketing conditions, Lehman Brothers continued writing mortgage-backed securities and touting its financial strength to the press and shareholders while decrying the notion that domestic and global economies were in danger. Meanwhile, its operations were reckless, as illustrated by its $11.9 billion in tangible equity and $308.5 billion in tangible assets on balance sheets in 2003 that yielded a leverage ratio of 26 to 1. Four years later, its $20 billion in tangible equity and $782 billion in tangible assets sent its leverage ratio skyrocketing to 39 to 1 (4). Even with storms brewing in every direction, Lehman Brothers failed to trim its portfolio of high-risk, illiquid assets, and when crisis erupted in 2007, Lehman Brothers had missed its chance. Instead of acknowledging this misstep, executives took internal action to preserve a rosy façade.
By means of deliberate accounting sleight-of-hand, concealment, and communication of misleading information, until 2008 Lehman Brothers maintained the appearance of underdog success to the investment community. The primary means by which Lehman Brothers disguised its distress was through implementation of what was known to insiders as “Repo 105.” This legal but shady accounting device helped create favorable net leverage and liquidity measures on the balance sheet, which was key for credit rating agencies and consumer confidence. By utilizing Repo 105, Lehman Brothers raised cash by selling assets to a behind-the-scenes phantom company called Hudson Castle, which appeared to be an independently run organization but was actually controlled by Lehman Brothers executives. In accordance with Repo 105 terms, assets were sold to Hudson Castle and repurchased between one and three days later (3). Because the assets were valued at 105 percent of the cash received, GAPP accounting rules allowed the transactions to be treated as sales, thus removing the assets from Lehman Brothers’ balance sheet altogether.
Under the direction of Chief Financial Officer Erin Callan and the certification of Chief Executive Officer Richard S. Fuld, Jr., Lehman Brothers applied this technique at the end of the first and second fiscal quarters of 2008 to transfer a combined total of $100 billion, amending its leverage ratio from 13.9 to a far more favorable 12.1. Thanks to creative accounting and clever public relations, Lehman Brothers was able to report a positive view of its net leverage, including a $60 billion reduction in net assets on the balance sheets and a deep liquidity pool. Each of these quarterly balance sheet spins was intended to offset the effect of announcing — for the first time in years — a loss of $2.8 billion from write-downs on assets, decreased revenues, and losses on hedges (1). Application of Repo 105 allowed Lehman Brothers to avoid having to report selling assets at a loss.
During the bankruptcy investigation, the company’s global finance controller admitted that, “there was no substance to [Repo 105] transactions (5).” Fuld, Callan, and their respective teams concealed the use of this tactic from ratings agencies, investors, and the board of directors. The one party in on the scheme was Ernst & Young, Lehman Brothers’ audit firm, which failed to alert either internal or external parties to the manipulation that was taking place, even when explicitly questioned. They could not maintain the illusion for long, however, and in September 2008, Lehman Brothers’ situation finally came to a head.
On September 10, 2008, just three months after reporting second-quarter successes, Lehman Brothers announced that its supposedly robust liquidity amounted to approximately $40 billion, but only $2 billion constituted assets that could be readily monetized. The remainder was tied up on so-called “comfort deposits” with various clearing banks, and though the firm technically had the right to recall said deposits, the validity of Lehnman Brothers’ work with these institutions was questionable at best (2). By August, the deposits had been converted into actual pledges.
A few months prior, Fuld began coming to terms with Lehman Brothers’ negative outlook. In a last-ditch effort, he made a public offering that yielded $6 billion in new capital for the firm. However, by the by the time third fiscal quarter financial statements were due, Lehman Brothers was projecting additional losses of $3.9 billion. Its stock price had plummeted to $3.65 per share, a 94 percent decrease from January 2008. Fuld announced a plan to spin off the majority of the company’s real estate holdings into a new public company, but there were no prospective buyers (Holdings, Inc.). On Sept. 13, the United States Treasury made it clear that Lehman Brothers would not be the recipient of bailout money. Instead, a number of financial institutions, including Barclays and Bank of America, were being encouraged to acquire the faltering company, invigorate it with much-needed capital, and bring it back from the edge of collapse (3). Each potential acquiror declined. On Sept. 15, 2008, Fuld admitted defeat and finally heeded private advice from Treasury Secretary Henry Paulson, Jr. At 1:45 a.m., he filed for Chapter 11 bankruptcy protection, just before the opening of Asian markets (1).
In the days following the largest bankruptcy filing in United States history, the American market experienced a shock unlike any it had felt since the Great Depression. When the domestic stock market opened on Sept. 15, the Dow Jones dropped 504 points. The following day, Barclays agreed to buy Lehman Brothers’ United States capital markets division for the bargain price of $1.75 billion. Meanwhile, insurance giant AIG was on the verge of total collapse, forcing the federal government to step in with a financial bailout package that ultimately cost $182 billion (3). On Sept. 16, the Primary Fund announced that due to its Lehman Brothers exposure, its price had plummeted to less than $1 per share. The ripple effect of Lehman Brothers’ failure was widespread, giving rise to a confidence crisis in global banks and hedge funds. Credit markets froze, forcing international governments to step in and attempt to ease concerns. Domestically, this resulted in the controversial passage of the Trouble Asset Relief Program, a $700 billion federal rescue aid package, on Oct. 3, 2008 (5).
Ethical Issues Examined
So what went wrong? The collapse of Lehman Brothers was not the result of a single lapse in ethical judgment committed by one misguided employee. It would have been nearly impossible for an isolated incident to bring the Wall Street giant to its knees, especially after it successfully withstood so many historical trials.
Instead its demise was the cumulative effect of a number of missteps perpetrated by several individuals and parties. These offenses can be categorized into three acts: Lies told by Chief Executive Officer Richard Fuld; concealment endorsed by Chief Financial Officer Erin Callan; and negligence on behalf of Ernst & Young.
1. When the housing marketing began faltering in 2007, Fuld was entrenched in a highly aggressive and leveraged business model, not unlike many other Wall Street players at the time. Unlike the competitors, a few of whom had the foresight to identify the pending collapse and evaluate possible consequences of mortgage defaults, Fuld did not rethink his strategy. Instead he proceeded into mortgage-backed security investments, continuously increasing Lehman Brothers’ asset portfolio to one of unreasonably high risk given market conditions. In short, he was obstinate, but when the time came to recognize his error, he did not assume responsibility or admit wrongdoing. Fuld had an opportunity in 2007 to voice concerns about his bank’s short-term financial health and its heavy involvement in risky loans, and he squandered it in favor of communicating to investors and Wall Street that no foreseeable concerns existed. Had he been truthful, more competitive solutions — along with the benefit of time — would have been available, likely helping prevent or minimize the financial hemorrhage that loomed on the horizon. For example, commercial banks, such as Barclays and Bank of America, which were approached for a snap acquisition decision, would have had more time to evaluate whether the move would complement their long-term strategies. They also would have had more time and opportunity to resuscitate Lehman Brothers than they did a few quarters down the road.
Additionally, while the immediate effects of admitting a shaky outlook would have been negative, two repercussions must be considered. First, large capital investors would have been appreciative of the transparency, and after getting past the initial shock, they would have taken action to get the bank back on track. Second, had the general public — including the federal government — been aware of the situation and the actionable measures being taken to rectify it, more intellectual and financial aid would have been available to minimize losses and potentially avoid total collapse. This was not the case, however, and by choosing to paint an unrealistically optimistic picture of Lehman Brothers’ financial situation, Fuld forfeited the opportunity to take advantage of various solutions that would have cut the company’s losses. Had he acted more prudently, Lehman Brothers’ story may have ended differently.
2. The second ethical lapse, which was perhaps the most premeditated and fundamentally wrong, was Callan’s approval of siphoning assets away from Lehman Brothers accounts and into Hudson Castle, the phantom subsidiary created for the benefit of its parent company’s balance sheet. This blatant misrepresentation of financial health, perpetrated through the employment of Repo 105, was an attempt to grossly manipulate the bank’s many stakeholders and also clearly indicative of a much bigger problem. Even more telling is the fact that this technique was used in two consecutive quarters.
Various documents examining the collapse of Lehman Brothers, including congressional testimonies and investigative reports, confirm that the purpose of Repo 105 was not to diminish earnings for tax benefits or similar effects. Instead, moving assets away from the balance sheet was intended to create the illusion of a company that was stable and secure. Had Lehman Brothers’ executive team been capable of managing the issue, this tactic would have been a temporary stay until reorganizational measures were taken and accurate statement releases could be resumed. Instead, for six consecutive months, the bank’s leverage was so dangerously high that it had no choice but to intentionally mislead its shareholders if it hoped to maintain any semblance of confidence in its operation. As with Fuld’s decision to lie about the company’s state of affairs, Lehman Brothers would have been better served by fully and accurately disclosing the details of its finances. With the benefit of credibility and time to strategize, the likelihood of receiving much-needed aid would have been far greater.
3. Finally, Ernst & Young, the only third party privy to the happenings at Lehman Brothers, failed to reveal the extensive steps taken by executive leadership to conceal financial problems. As a firm of certified public accountants expected to honor and uphold an industry-wide code of ethics, Ernst & Young may be accused of being responsible for gross negligence and lack of corporate responsibility. Why would such a highly respected organization risk its own reputation and turn a blind eye on behavior that is clearly unethical? Obviously Lehman Brothers was a sizeable (and presumably lucrative) client of the firm. But past scandals involving questionable accounting observances, such as Enron, have demonstrated firsthand that inaction is as equally reprehensible as direct involvement in the scheme itself. More than just a paycheck was at risk, and failure to act successfully discredited Ernst & Young on the basis of ethical and industry standards.
As an accounting firm, Ernst & Young is charged with certifying that companies deliver accurate and reliable information to shareholders. In this regard, Ernst & Young failed completely, as executives were aware of behind-the-scenes bookkeeping and the extent to which it was occurring. In this situation, concern for ethical behavior was of minimal or nonexistent concern. Therefore, the company’s shareholders were deliberately deceived for the purpose of preserving a paycheck, and in that regard, the team of accountants who chose not to act disappointed more than just their company; they let down the entire industry and each of the right-minded professionals within it.
The story of Lehman Brothers’ demise is unfortunate, and not just because its collapse meant the end of a Wall Street institution. The real tragedy lies in the lack of ethical behavior of its executives and professional advisors. They made conscious decisions to deceive and manipulate, and the consequences proved too dire to preserve the historic investment bank’s existence. The perennial lesson of the Lehman Brothers case is that no matter how dire the circumstances may appear, transparency and accountability are paramount. Right action up front may sting initially, but as history has repeatedly shown, gross unethical business practices rarely endure in the long term. A global financial crisis such as that of 2008 may not be prevented from happening again. What can be improved, in large measure through ethics education, is how corporations behave. Wall Street should take note of the case of Lehman Brothers to ensure history does not find a way to repeat itself.
BY: ASHLEIGH MONTGOMERY
1. “Case Study: The Collapse of Lehman Brothers.” Investopedia.com. 2 Apr. 2009. Web. 26 Nov. 2011. <http://investopedia.com/articles/economics/09/lehman-brothers-collapse.asp>.
2. Leynse, James. “Three Lessons of the Lehman Brothers Collapse.” Time.com. 15 Sept. 2009. Web. 26 Nov. 2011. <http://www.time.com/business/article/0,8599,1923197,00.htm>.
3. Lubben, Stephen. “Lehman Brothers Holdings, Inc.” New York Times. 26 Aug. 2011. Web. 24 Nov. 2011. <http://topics.nytimes.com/top/news/business/companies/lehman_brothers_holdings_inc/index.htm>.
4. Sloan, Allan, and Roddy Boyd. “How Lehman Lost Its Way.” CNN Money. 2 July 2008. Web. 24 Nov. 2011. <http://money.cnn.com/2008/07/02/news/companies/lehman_sloan_boyd.fortune/index2.htm>.
5. Valukas, Anton R. Volume 1 Report of Anton R. Valukas, Examiner. 08-13555 (JMP). Vol. 1.
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