Chapter 4 Data Analysis 4.1 The case study analysis of Lehman Brothers 4.1.1. Lehman Brothers - historical background information Lehman Brothers was founded in 1850 in Montgomery, Alabama, by the brothers Henry, Emmanuel and Mayer Lehman. The brothers - sons of the lower franconian cattle merchant Abraham Löw Lehmann - emigrated 1844-1850 from Rimpar near Würzburg to the USA. Prior to the establishment of Lehman Brothers, in 1844, Henry Lehman opened a general retail store in Alabama. His brother Emanuel joined the business in 1848. The business was soon shifted into a cotton trade company. From this, the banking activity developed(McDonald & Patrick 2010). After the American Civil War the business was relocated to New York. 1977 Lehman Brothers merged with Kuhn, Loeb & Co. and changed its name temporarily to Lehman Brothers Kuhn Loeb & Co. In 1984, Lehman Brothers was bought by American Express and merged with Shearson and in 1988 with E.F. Hutton &Co. In 1993, American Express sold the well-developed company to the Travelers Group. The Travelers Group parted from the investment banking, and in 1994 it became an independent company again under the name Lehman Brothers and went public. In recent years, until to the insolvency the independent company was able to consolidate its market position in the competition. On 15September 2008, the U.S. investment bank Lehman Brothers collapsed - and triggered a devastating chain reaction(Spiegel Online 2011). 4.1.2. The failed business model of Lehman Brothers 1 2 3 It was 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. Due to the collapse, consumer confidence shattered during a time of uncertainty, and later on, a number of questionable moves came to light. This analysis will proceed in two parts: First, a recapitulation of the series of events leading to Lehman Brothers’ failure, then the identification of several choices made by its management team and how the results led to the bank’s final downfall(Lieven 2009). On 29 January 2008, Lehman Brothers Holdings Inc. presented profits of $4 billion for the accounting year 2007 which was a record. The business model seemed successful. 1 http://gallery.hd.org/_exhibits/money/_more2008/_more09/bankruptcy-failure-collapse-of-Lehman- Brothers-US-investment-bank-20080915-worldwide-first-few-days-of-news-headlines-and-images- mainly-from-UK-perspective-10-DHD.jpg http://static.guim.co.uk/sys-images/Guardian/About/General/2012/4/12/1334269125617/Lehman- Brothers--008.jpg 2 http://static.guim.co.uk/sys-images/Guardian/About/General/2012/4/12/1334269125617/Lehman- Brothers--008.jpg 3 http://static.guim.co.uk/sys-images/Business/Pix/pictures/2010/3/12/1268355047409/Lehman- Brothers--001.jpg In January Lehman shares reached a value of 65.73 dollars. The stock market valued the company $30 billion. About eight months later, on 12 September 2008, the share price was less than $4. On 15 September Lehman filed for creditor protection. It was recorded as the largest bankruptcy of U.S. economic history. The business model failed(Zingales 2008). Many think the beginning of the fall for Lehman Brothers was when Washington repealed the Glass-Steagall Act(Casserley, Macdonald & Härle 2009). This legislation from the Great Depression which broke out in 1929, divided the interests of commercial and investment banks, preventing them from competition among each other and taking care of their balance sheets by letting these sectors focus on business and transactions that they can do best. For investment banks, that characteristically meant to be highly liquid, asset-light portfolios, letting commercial banks to handle capital- intensive portfolios, such as real estate or corporate finance. In addition, the act protected the economy from a domino effect in the case of one division’s breakdown. In 1999, the law was repealed by former US President Bill Clinton(Crawford 2011). The following opportunities for the market would prove to be catastrophic for Lehman Brothers, the financial sector, and the worlds' economy. With the repeal of the Glass-Steagall Act (Crawford 2011), Lehman Brothers became an important actor in the US housing boom. From 2004 to 2006, the revenues from real estate businesses increased by 56 percent. The profits increased and the company achieved a record net income of $4.2 billion on revenues of $19.3 billion. Lehman Brothers’ stock reached an all-time high of $86.18 per share. Market capitalization reached almost $60 billion. Anyway, the real estate market started to show signs of a bubble burst(Quiring et al. 2013). In March 2007, the economy faced its biggest one-day stock market plunge since the burst of the Dotcom bubble, and the number of mortgage defaults reached highest percentage for almost 10 years. Conditions quickly deteriorated, but LehmanBrothers still traded mortgage-backed securities while the domestic and global economies were instable. Meanwhile, its operations were out of control. Its $11.9 billion in tangible equity and $308.5 billion in tangible assets on balance sheets in 2003 yielded a leverage ratio of 26 to 1. In 2007, its $20 billion in tangible equity and $782 billion in tangible assets made its leverage ratio exorbitantly increase to 39 to 1. Even when the collapse occurred most likely, Lehman Brothers didn't react by trimming its portfolio of high-risk, illiquid assets. Instead of acknowledging this error, executives attempted more likely to preserve a bright pretense(Mildner 2012). By means of creative accounting, covering up the real situation, and misleading information, until 2008 Lehman Brothers claimed that their business operations were still successful(Der Spiegel 2010). The primary means by which Lehman Brothers concealed its misery was through the utilization of questionable accounting tools which helped to create positive net leverage and liquidity measures on the balance sheet. These are the key figures by which rating agencies among others evaluate a company and which help to gain confidence of the markets. By using those tools, Lehman Brothers raised cash by selling assets to a ghost company called Hudson Castle, which appeared to be independent but indeed was controlled by Lehman Brothers. In accordance with the accounting tools used, assets were sold to the said company and repurchased a couple of days later(Südwest Presse 2010). By this method, the transactions were treated as sales, thus removing the assets from Lehman Brothers’ balance sheet. Lehman Brothers utilized this technique among other things to transfer a combined total of $100 billion, changing its leverage ratio from 13.9 to a more desirable 12.1. In that way, Lehman Brothers reported a positive image of its net leverage, including a deep liquidity pool. Each of the balance sheet published at the end of the first two quarters in 2008 were intended to equalize a loss of $2.8 billion from write-downs on assets, decreased revenues, and losses on hedges (Mildner 2012). Thereby, Lehman Brothers was able to avoid having to report selling assets at a loss. Due to investigations after the collapse, Lehman Brothers' global finance controller added that, “there was no substance to these transactions”(Knapp 2013, p. 31). The financial executives hid these actions from rating agencies, investors, and other stakeholder. The only other actor that was aware of these issues was Ernst & Young, financial auditor of Lehman Brothers, which screwed up to inform all participants to the manipulation that was going on(DiePresse.com 2012). In September 2008, Lehman Brothers’ situation came to the top. A few weeks before, the CFO, began to make correction with the firms’ negative position. He tried to yield $6 billion in new capital by making a public offer. However, fiscal quarter financial statements 3/2008 had to be presented, in which Lehman Brothers released additional losses of $3.9 billion. Its stock price had dropped 94% since the beginning of 2008 to $3.65 per share. On 13 September, the United States Treasury announced that Lehman Brothers will not be rescued(Lieven 2009). Barclays and Bank of America as well as other financial institutions, tried to take over the instable company, with the goal to strengthen it with fresh money, and save it from the collapse. None of the banks endorsed this step. On Sept. 15, 2008, the CEO couldn't deny the disastrous situation anymore and filed for bankruptcy protection(Spiegel Online 2011). In the days following the largest bankruptcy since the Great Depression, the market was shocked. The Dow Jones fell by 504 points when the stock market opened. Lehman Brothers’ United States capital markets division was taken over by Barclays' Bank for the price of $1.75 billion. Later, the insurance company AIG had to be rescued from the collapse forcing the government to react with a rescue operation that cost $182 billion(Quiring et al. 2013). On Sept. 16, the Lehman price per share had collapsed to less than $1. The collapse of Lehman Brothers was devastating and led to a confidence crisis in global financial sector. Credit markets came to a standstill(Steinmann 2013); governments all over the world had to react and try to take away the fear. With $613 billion debt, the Lehman collapse was the first bankruptcy of the crisis of that size - and is until today the largest one in the history of the banking sector. Lehman followed its high risk strategy until the end and whitewashed the books in many ways. Due to several investigations against the bank, a lot of details came up that showed what the business model really looked like. It was characterized by Sprave (2009)as :- - No separation of commercial and investment banking o Since former US President Bill Clinton repealed the Glass-Steagall Act in 1999 - Ignore and hide risks o Showing profits, hiding losses, o Leverage ratio (debt burden) exceedingly high, and o Liquidity other age.