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Lehman Brothers History

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The Collapse of Lehman Brothers: A Case Study

Lehman Brothers filed for bankruptcy on September 15, 2008. Hundreds of employees, mostly dressed in business suits, left the bank's offices one by one with boxes in their hands. It was a somber reminder that nothing is forever—even in the richness of the financial and investment world.

At the time of its collapse, Lehman was the fourth-largest investment bank in the United States with 25,000 employees worldwide. It had $639 billion in assets and $613 billion in liabilities. The bank became a symbol of the excesses of the 2007-08 Financial Crisis, engulfed by the subprime meltdown that swept through financial markets and cost an estimated $10 trillion in lost economic output.

In this article, we examine the events that led to the collapse of Lehman Brothers.

Key Takeaways

• Lehman Brothers had humble beginnings as a dry-goods store, but eventually branched off into commodities trading and brokerage services.
• The firm survived many challenges but was eventually brought down by the collapse of the subprime mortgage market.
• Lehman first got into mortgage-backed securities in the early 2000s before acquiring five mortgage lenders.
• The firm posted multiple, consecutive losses and its share price dropped.
• Lehman filed for bankruptcy on September 15, 2008, with $639 billion in assets and $619 billion in debt.

Lehman Brothers had humble origins, tracing its roots to a general store founded by German brothers Henry, Emanuel and Mayer Lehman in Montgomery, Alabama, in 1844. Farmers paid for their goods with cotton, which led the company into the cotton trade. After Henry died, the other Lehman brothers expanded the scope of the business into  commodities  trading and  brokerage services .

The firm prospered over the following decades as the U.S. economy grew into an international powerhouse. But Lehman faced plenty of challenges over the years. The company survived the railroad bankruptcies of the 1800s, the Great Depression , two world wars, a capital shortage when it was spun off by American Express ( AXP ) in 1994 in an initial public offering, and the Long Term Capital Management collapse and Russian debt default of 1998.

Despite its ability to survive past disasters, the collapse of the U.S. housing market ultimately brought Lehman to its knees, as its headlong rush into the subprime mortgage market proved to be a disastrous step.

The company, along with many other financial firms, branched into mortgage-backed securities and collateral debt obligations . In 2003 and 2004, with the U.S. housing bubble well under way, Lehman acquired five mortgage lenders along with BNC Mortgage and Aurora Loan Services, which specialized in Alt-A loans. These loans were made to borrowers without full documentation.  

At first, Lehman's acquisitions seemed prescient. Lehman's real estate business enabled revenues in the capital markets unit to surge 56% from 2004 to 2006. The firm securitized $146 billion of mortgages in 2006—a 10% increase from 2005. Lehman reported record profits every year from 2005 to 2007. In 2007, it announced $4.2 billion in net income on $19.3 billion in revenue.  

In February 2007, Lehman's stock price reached a record $86.18 per share, giving it a market capitalization of nearly $60 billion.   But by the first quarter of 2007, cracks in the U.S. housing market were already becoming apparent. Defaults on subprime mortgages began to rise to a seven-year high. On March 14, 2007, a day after the stock had its biggest one-day drop in five years on concerns that rising defaults would affect Lehman's profitability, the firm reported record revenues and profit for its fiscal first quarter. Following the earnings report, Lehman said the risks posed by rising home delinquencies were well contained and would have little impact on the firm's earnings.  

Lehman's stock fell sharply as the credit crisis erupted in August 2007 with the failure of two Bear Stearns hedge funds. During that month, the company eliminated 1,200 mortgage-related jobs and shut down its BNC unit.   It also closed offices of Alt-A lender Aurora in three states. Even as the correction in the U.S. housing market gained momentum, Lehman continued to be a major player in the mortgage market.

In 2007, Lehman underwrote more mortgage-backed securities than any other firm, accumulating an $85 billion portfolio, or four times its shareholders' equity . In the fourth quarter of 2007, Lehman's stock rebounded, as global equity markets reached new highs and prices for fixed-income assets staged a temporary rebound . However, the firm did not take the opportunity to trim its massive mortgage portfolio, which in retrospect, would turn out to be its last chance.  

In 2007, Lehman's high degree of leverage was 31, while its large mortgage securities portfolio made it highly susceptible to the deteriorating market conditions. On March 17, 2008, due to concerns that Lehman would be the next Wall Street firm to fail following Bear Stearns' near-collapse, its shares plummeted nearly 48%.  

By April, after an issue of preferred stock —which was convertible into Lehman shares at a 32% premium to its concurrent price—yielded $4 billion, confidence in the firm returned somewhat.   However, the stock resumed its decline as hedge fund managers began to question the valuation of Lehman's mortgage portfolio.

On June 7, 2008, Lehman announced a second-quarter loss of $2.8 billion, its first loss since it was spun off by American Express, and reported that it raised another $6 billion from investors by June 12.   According to David P. Belmont, "The firm also said it boosted its liquidity pool to an estimated $45 billion, decreased gross assets by $147 billion, reduced its exposure to residential and commercial mortgages by 20%, and cut down leverage from a factor of 32 to about 25."  

These measures were perceived as being too little, too late. Over the summer, Lehman's management made unsuccessful overtures to a number of potential partners. The stock plunged 77% in the first week of September 2008, amid plummeting equity markets worldwide, as investors questioned CEO Richard Fuld's plan to keep the firm independent by selling part of its asset management unit and spinning off commercial real estate assets. Hopes that the Korea Development Bank would take a stake in Lehman were dashed on September 9, as the state-owned South Korean bank put talks on hold.  

The devastating news lead to a 45% drop in Lehman's stock, along with the firm's debt suffering a 66% increase in credit-default swaps .   Hedge fund clients began abandoning the company, with short-term creditors following suit. Lehman's fragile financial position was best emphasized by the pitiful results of its September 10 fiscal third-quarter report.  

Facing a $3.9 billion loss, which included a $5.6 billion write-down , the firm announced an extensive strategic corporate restructuring effort. Moody's Investor Service also announced that it was reviewing Lehman's credit ratings , and it found that the only way for Lehman to avoid a rating downgrade would be to sell a majority stake to a strategic partner. By September 11, the stock had suffered another massive plunge (42%) due to these developments.  

With only $1 billion left in cash by the end of that week, Lehman was quickly running out of time. Over the weekend of September 13, Lehman, Barclays, and Bank of America ( BAC ) made a last-ditch effort to facilitate a takeover of the former, but they were ultimately unsuccessful.   On Monday, September 15, Lehman declared bankruptcy, resulting in the stock plunging 93% from its previous close on September 12.

Lehman stock plunged 93% between the close of trading on September 12, 2008, and the day it declared bankruptcy.

Former chair and CEO Richard Fuld runs Matrix Private Capital Group, which he founded in 2016. The company manages assets for high-net worth individuals, family offices and institutions. He reportedly sold an apartment in New York City for $25.9 million as well as a collection of drawings for $13.5 million.

In years following the collapse, Fuld acknowledged the mistakes the bank made though he remained critical of the government for mandating that Lehman Brothers file for bankruptcy while bailing out others. In 2010, he told the Financial Crisis Inquiry Commission the bank had adequate capital reserves and a solid business at the time of its bankruptcy.

Erin Callan (now Erin Montella) became chief financial officer at the age of 41 and resigned in June 2008 following suspicions she had leaked information to the press. Her LinkedIN profile lists her as an advisor at Matrix Investment Holdings. Other stints include six months serving as head of hedge fund coverage for Credit Suisse and co-founding a non-profit that provides paid maternity leave to mothers. In 2016, Montella published an autobiography, Full Circle: A Memoir of Leaning in Too Far and the Journey Back , about her experiences in the financial world.

Lehman's collapse roiled global financial markets for weeks, given its size and status in the U.S. and globally. At its peak, Lehman had a market value of nearly $46 billion, which was wiped out in the months leading up to its bankruptcy.

Many questioned the decision to allow Lehman to fail, compared with the government's tacit support for Bear Stearns, which was acquired by JPMorgan Chase ( JPM ) in March 2008. Bank of America had been in talks to buy Lehman, but backed away after the government refused to help with Lehman's most troubled assets. Instead, Bank of America announced it would buy Merrill Lynch on the same day Lehman filed for bankruptcy.

Yale School of Management. " The Lehman Brothers Bankruptcy: An Overview ."

Yale School of Management. " The Lehman Brothers Bankruptcy A: Overview ," Page 3.

Yale School of Management. " The Lehman Brothers Bankruptcy A: Overview ," Pages 3-5.

International Journal of Accounting Research. " What Caused the Failure of Lehman Brothers? Could it have been Prevented? How? Recommendations for Going Forward ," Page 1.

Hong Kong Institute of Bankers. " Bank Asset and Liability Management ." John Wiley & Sons, 2018.

United States District Court Southern District of New York. " Lehman Brothers Equity/Debt Securities Litigation, 08 Civ. 5523 (LAK) ," Page 51.

David P. Belmont. " Managing Hedge Fund Risk and Financing: Adapting to a New Era ," Pages 72-73. Jon Wiley & Sons (Asia), 2011.

Claudio Scardovi. " Restructuring and Innovation in Banking, " Page 18. Springer, 2016.

Matrix Private Capital Group. " About Us ."

Richard Fuld. " Written Statement Of Richard S. Fuld, Jr. Before The Financial Crisis Inquiry Commission ," Page 8.

Rosalind Z. Wiggins, Thomas Piontek and Andrew Metrick. " The Lehman Brothers Bankruptcy A: Overview ," Page 8. Yale Program on Financial Stability Case Study, October 2014.

LinkedIn. " Erin Callan Montella ."

Erin Callan Montella. " Full Circle: A Memoir of Leaning in Too Far and the Journey Back ." Triple M Press, 2016.

Rosalind Z. Wiggins, Thomas Piontek and Andrew Metrick. " The Lehman Brothers Bankruptcy A: Overview ," Pages 11, 20 and 21. Yale Program on Financial Stability Case Study, October 2014.

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Lehman’s Demise and Repo 105: No Accounting for Deception

March 31, 2010 • 10 min read.

The collapse of Lehman Brothers in September 2008 is widely seen as the trigger for the financial crisis, spreading panic that brought lending to a halt. Now a 2,200-page report says that prior to the collapse, the investment bank's executives went to extraordinary lengths to conceal the risks they had taken. While Lehman's huge indebtedness and other mistakes have been well documented, the $30 million study by Anton Valukas, assigned by the bankruptcy court, contains a number of surprises and new insights, several Wharton faculty members say.

• Finance & Accounting

The collapse of Lehman Brothers in September 2008 is widely seen as the trigger for the financial crisis, spreading panic that brought lending to a halt. Now a 2,200-page report says that prior to the collapse — the largest bankruptcy in U.S. history — the investment bank’s executives went to extraordinary lengths to conceal the risks they had taken. A new term describing how Lehman converted securities and other assets into cash has entered the financial vocabulary: “Repo 105.”

While Lehman’s huge indebtedness and other mistakes have been well documented, the $30 million study by Anton Valukas, assigned by the bankruptcy court, contains a number of surprises and new insights, several Wharton faculty members say.

Among the report’s most disturbing revelations, according to Wharton finance professor Richard J. Herring , is the picture of Lehman’s accountants at Ernst & Young. “Their main role was to help the firm misrepresent its actual position to the public,” Herring says, noting that reforms after the Enron collapse of 2001 have apparently failed to make accountants the watchdogs they should be.

“It was clearly a dodge…. to circumvent the rules, to try to move things off the balance sheet,” says Wharton accounting professor professor Brian J. Bushee , referring to Lehman’s Repo 105 transactions. “Usually, in these kinds of situations I try to find some silver lining for the company, to say that there are some legitimate reasons to do this…. But it clearly was to get assets off the balance sheet.”

The use of outside entities to remove risks from a company’s books is common and can be perfectly legal. And, as Wharton finance professor Jeremy J. Siegel points out, “window dressing” to make the books look better for a quarterly or annual report is a widespread practice that also can be perfectly legal. Companies, for example, often rush to lay off workers or get rid of poor-performing units or investments, so they won’t mar the next financial report. “That’s been going on for 50 years,” Siegel says. Bushee notes, however, that Lehman’s maneuvers were more extreme than any he has seen since the Enron collapse.

Wharton finance professor professor Franklin Allen suggests that the other firms participating in Lehman’s Repo 105 transactions must have known the whole purpose was to deceive. “I thought Repo 105 was absolutely remarkable – that Ernst & Young signed off on that. All of this was simply an artifice, to deceive people.” According to Siegel, the report confirms earlier evidence that Lehman’s chief problem was excessive borrowing, or over-leverage. He argues that it strengthens the case for tougher restrictions on borrowing.

A Twist on a Standard Financing Method

In his report, Valukas, chairman of the law firm Jenner & Block, says that Lehman disregarded its own risk controls “on a regular basis,” even as troubles in the real estate and credit markets put the firm in an increasingly perilous situation. The report slams Ernst & Young for failing to alert the board of directors, despite a warning of accounting irregularities from a Lehman vice president. The auditing firm has denied doing anything wrong, blaming Lehman’s problems on market conditions.

Much of Lehman’s problem involved huge holdings of securities based on subprime mortgages and other risky debt. As the market for these securities deteriorated in 2008, Lehman began to suffer huge losses and a plunging stock price. Ratings firms downgraded many of its holdings, and other firms like JPMorgan Chase and Citigroup demanded more collateral on loans, making it harder for Lehman to borrow. The firm filed for bankruptcy on September 15, 2008.

Prior to the bankruptcy, Lehman worked hard to make its financial condition look better than it was, the Valukas report says. A key step was to move $50 billion of assets off its books to conceal its heavy borrowing, or leverage. The Repo 105 maneuver used to accomplish that was a twist on a standard financing method known as a repurchase agreement. Lehman first used Repo 105 in 2001 and became dependent on it in the months before the bankruptcy.

Repos, as they are called, are used to convert securities and other assets into cash needed for a firm’s various activities, such as trading. “There are a number of different kinds, but the basic idea is you sell the security to somebody and they give you cash, and then you agree to repurchase it the next day at a fixed price,” Allen says.

In a standard repo transaction, a firm like Lehman sells assets to another firm, agreeing to buy them back at a slightly higher price after a short period, sometimes just overnight. Essentially, this is a short-term loan using the assets as collateral. Because the term is so brief, there is little risk the collateral will lose value. The lender – the firm purchasing the assets – therefore demands a very low interest rate. With a sequence of repo transactions, a firm can borrow more cheaply than it could with one long-term agreement that would put the lender at greater risk.

Under standard accounting rules, ordinary repo transactions are considered loans, and the assets remain on the firm’s books, Bushee says. But Lehman found a way around the negotiations so it could count the transaction as a sale that removed the assets from its books, often just before the end of the quarterly financial reporting period, according to the Valukas report. The move temporarily made the firm’s debt levels appear lower than they really were. About $39 billion was removed from the balance sheet at the end of the fourth quarter of 2007, $49 billion at the end of the first quarter of 2008 and $50 billion at the end of the next quarter, according to the report.

Bushee says Repo 105 has its roots in a rule called FAS 140, approved by the Financial Accounting Standards Board in 2000. It modified earlier rules that allow companies to “securitize” debts such as mortgages, bundling them into packages and selling bond-like shares to investors. “This is the rule that basically created the securitization industry,” he notes.

FAS 140 allowed the pooled securities to be moved off the issuing firm’s balance sheet, protecting investors who bought the securities in case the issuer ran into trouble later. The issuer’s creditors, for example, cannot go after these securities if the issuer goes bankrupt, he says.

Because repurchase agreements were really loans, not sales, they did not fit the rule’s intent, Bushee states. So the rule contained a provision saying the assets involved would remain on the firm’s books so long as the firm agreed to buy them back for a price between 98% and 102% of what it had received for them. If the repurchase price fell outside that narrow band, the transaction would be counted as a sale, not a loan, and the securities would not be reported on the firm’s balance sheet until they were bought back.

This provided the opening for Lehman. By agreeing to buy the assets back for 105% of their sales price, the firm could book them as a sale and remove them from the books. But the move was misleading, as Lehman also entered into a forward contract giving it the right to buy the assets back, Bushee says. The forward contract would be on Lehman’s books, but at a value near zero. “It’s very similar to what Enron did with their transactions. It’s called ’round-tripping.'” Enron, the huge Houston energy company, went bankrupt in 2001 in one of the best-known examples of accounting deception.

Lehman’s use of Repo 105 was clearly intended to deceive, the Vakulas report concludes. One executive email cited in the report described the program as just “window dressing.” But the company, which had international operations, managed to get a legal opinion from a British law firm saying the technique was legal.

The Financial Accounting Standards Board moved last year to close the loophole that Lehman is accused of using, Bushee says. A new rule, FAS 166, replaces the 98%-102% test with one designed to get at the intent behind a repurchase agreement. The new rule, just taking effect now, looks at whether a transaction truly involves a transfer of risk and reward. If it does not, the agreement is deemed a loan and the assets stay on the borrower’s balance sheet.

The Vakulas report has led some experts to renew calls for reforms in accounting firms, a topic that has not been front-and-center in recent debates over financial regulation. Herring argues that as long as accounting firms are paid by the companies they audit, there will be an incentive to dress up the client’s appearance. “There is really a structural problem in the attitude of accountants.” He says it may be worthwhile to consider a solution, proposed by some of the industry’s critics, to tax firms to pay for auditing and have the Securities and Exchange Commission assign the work and pay for it.

The Valukas report also shows the need for better risk-management assessments by firm’s boards of directors, Herring says. “Every time they reached a line, there should have been a risk-management committee on the board that at least knew about it.” Lehman’s ability to get a favorable legal opinion in England when it could not in the U.S. underscores the need for a “consistent set” of international accounting rules, he adds.

Siegel argues that the report also confirms that credit-rating agencies like Moody’s and Standard & Poor’s must bear a large share of the blame for troubles at Lehman and other firms. By granting triple-A ratings to risky securities backed by mortgages and other assets, the ratings agencies made it easy for the firms to satisfy government capital requirements, he says. In effect, the raters enabled the excessive leverage that proved a disaster when those securities’ prices fell to pennies on the dollar. Regulators “were being bamboozled, counting as safe capital investments that were nowhere near safe.”

Some financial industry critics argue that big firms like Lehman be broken up to eliminate the problem of companies being deemed “too big to fail.” But Siegel believes stricter capital requirements are a better solution, because capping the size of U.S. firms would cripple their ability to compete with mega-firms overseas.

While the report sheds light on Lehman’s inner workings as the crisis brewed, it has not settled the debate over whether the government was right to let Lehman go under. Many experts believe bankruptcy is the appropriate outcome for firms that take on too much risk. But in this case, many feel Lehman was so big that its collapse threw markets into turmoil, making the crisis worse than it would have been if the government had propped Lehman up, as it did with a number of other firms.

Allen says regulators made the right call in letting Lehman fail, given what they knew at the time. But with hindsight he’s not so sure it was the best decision. “I don’t think anybody anticipated that it would cause this tremendous stress in the financial system, which then caused this tremendous recession in the world economy.”

Allen, Siegel and Herring say regulators need a better system for an orderly dismantling of big financial firms that run into trouble, much as the Federal Deposit Insurance Corp. does with ordinary banks. The financial reform bill introduced in the Senate by Democrat Christopher J. Dodd provides for that. “I think the Dodd bill has a resolution mechanism that would allow the firm to go bust without causing the kind of disruption that we had,” Allen says. “So, hopefully, next time it can be done better. But whether anyone will have the courage to do that, I’m not sure.”

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The Dearth of Ethics and the Death of Lehman Brothers

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.

Three Wrongs

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

Works Cited

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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