The collapse of Lehman Brothers

German immigrants to the US set up Lehman Brothers in 1850. Capitalizing on cotton's high market value, the brothers who owned the firm, accepted raw cotton from customers as payment for merchandise. They then started trading in cotton. Within a few years, this business grew to become the most significant part of the operation. Lehman gradually evolved into a repected investment bank. Managment problems and internal tensions led to the firm being sold to Shearson, an American Express-backed electronic transaction company, in 1984, for $360 million. In 1993, under newly appointed CEO, Harvey Golub, American Express began to divest itself of its banking and brokerage operations. In 1994, it spun off Lehman Brothers Kuhn Loeb as Lehman Brothers Holdings, Inc. through an IPO.
Lehman performed quite well under CEO Richard S. Fuld, Jr.. In 2001, the firm acquired the private-client services, or (PCS), business of Cowen & Co. In 2003, Lehman aggressively re-entered the asset-management business, which it had exited in 1989. Beginning with $2 billion in assets under management, the firm acquired the Crossroads Group, the fixed-income division of Lincoln Capital Management and Neuberger Berman These businesses, together with the PCS business and Lehman's private-equity business, comprised the Investment Management Division. This division generated approximately $3.1 billion in net revenue and almost $800 million in pre-tax income in 2007. Prior to going bankrupt, Lehman had in excess of $275 billion in assets under management. Altogether, since going public in 1994, the firm had increased net revenues from $2.73 billion to $19.2 billion and had increased employee headcount from 8,500 to almost 28,600.

In August 2007, Lehman closed its subprime lender, BNC Mortgage, and took an after-tax charge of $25 million and a $27 million reduction in goodwill. The problems only aggravated in 2008 Lehman faced an unprecedented loss, since it had held on to large positions in subprime and other lower-rated mortgage tranches when securitizing the underlying mortgages. In the second quarter, Lehman reported losses of $2.8 billion and was forced to sell off $6 billion in assets. In the first half of 2008, Lehman stock lost 73% of its value as the credit market continued to tighten.

On August 22, 2008, shares in Lehman closed up 5% (16% for the week) on reports that the state-controlled Korea Development Bank (KDB) was considering buying the bank. But the gains quickly disappeared on reports KDB was facing difficulties in getting the approval of regulators and in attracting partners for the deal. It culminated on September 9, when Lehman's shares plunged 45% to $7.79, after it was reported that KDB had put talks on hold.

Investor confidence continued to erode as Lehman's stock lost roughly half its value and pushed the S&P 500 down 3.4% on September 9. The Dow Jones lost 300 points the same day on investors' concerns about the security of the bank. The next day, Lehman announced a loss of $3.9 billion and indicated it would to sell off a majority stake in the investment-management business, which included Neuberger Berman. The stock slid seven percent that day. Market rumours were strong that Lehman was reportedly searching for a buyer as its stock price dropped another 40 percent on September 11, 2008.

On Saturday September 13, 2008, Tim Geithner, the president of the Federal Reserve Bank of New York called a meeting to discuss the future of Lehman. Lehman reported that it had been in talks with Bank of America and Barclays for the company's possible sale. However, both Barclays and Bank of America ultimately declined to purchase the entire company.

The International Swaps and Derivatives Association (ISDA) arranged an exceptional trading session on Sunday, September 14, 2008, to allow market participants to offset positions in various derivatives.

In New York, shortly before 1 a.m. the next morning, Lehman announced it would file for Chapter 11 bankruptcy protection citing bank debt of $613 billion, $155 billion in bond debt, and assets worth $639 billion. It further announced that its subsidiaries would continue to operate as normal. A group of Wall Street firms agreed to provide capital and financial assistance for the bank's orderly liquidation. The Federal Reserve, in turn, agreed to a swap of lower-quality assets in exchange for loans and other assistance from the government.

On September 16, 2008, Barclays announced it would acquire a "stripped clean" portion of Lehman for $1.75 billion, including most of Lehman's North America operations. On September 20, the transaction was approved. On September 17, 2008, the New York Stock Exchange delisted Lehman Brothers.

Nomura, Japan's top brokerage firm, agreed to buy the Asian division of Lehman for $225 million and parts of the European division for a nominal fee of $2. It would not take on any trading assets or liabilities in the European units. Nomura decided to acquire only Lehman's employees in the regions, and not its stocks, bonds or other assets.

Did the US government make a big blunder, by not bailing out Lehman? After all, following the bankruptcy there were major upheavals in the financial markets. By October, it was evident that the credit markets had seized up. Companies found it difficult to raise working capital. Trade finance was becoming scarce. Investment decisions were postponed, industrial production shrank and world trade collapsed. By the end of 2008, the world economy was shrinking for the first time since World War II. G7 economies contracted at an annualised rate of 8.4% in the first quarter of 2009.

Former US Treasury secretary, Hank Paulson and Tim Giethner, the incumbent one recently justified their actions stating that the regulators did not have sufficient authority to do a quick bailout. The Fed had tried to broker a deal, but no buyer could be found for Lehman. Barclays which showed interest did not get approval from UK regulators. Bank of America, a potential bidder had already paired up with Merrill.

The collapse of Lehman had some unintended consequences. As Niall Ferguson mentioned[1], Paulson might have taken the right decision without being fully aware: “By showing Americans and particularly their legislators in Congress, just what could happen if even the fourth largest investment bank failed, he created what had hitherto been lacking: the political will for a wholesale bailout of the financial system” If Lehman had been bailed out, there would have been a hue and cry in congress. The TARP bailout would never have been possible. In that case, Citigroup, a bank three times bigger than Lehman would have collapsed.

An editorial in the Financial Times was more emphatic[2], that the US authorities had been right to allow Lehman Brothers to fail. “They could not know how awful it would prove to be and when it comes to saving failing companies, governments should err on the side of inaction. Capitalism relies on the discipline provided by the lure of wealth and the fear of bankruptcy.”

[1] Financial Times, September 15, 2009.
[2] Financial Times, September 14, 2009.