Did the accounting treatment of financial instruments contribute to the collapse of Lehman Brothers?

Table of contents

List of figures

List of tables

1. Introduction

2. Company background

3. The case of one of the world’s leading investment banks - Lehman Brothers Holding Inc
3.1. Before the beginning
3.2. The boom and the bust
3.3. Reasons for the financial bankruptcy and moral hazard
3.4. The accounting treatment of the Repurchase agreement Repo
3.5. The impact of Lehman Brothers’ collapse at the global level

4. Could Lehman’s failure have been avoided?
4.1. The role of the corporate governance and the audit practices
4.2. Analyzing the case of Lehman by using CAMELS ratios

5. Conclusion

Bibliography

List of figures

- Figure 1. The process of Repo 105 transactions

List of tables

- Table 1. The usage of Repo 105 and its impact on the net leverage
- Table 2. CAR
- Table 3. Assets Ratios
- Table 4.Senstivity Ratios

1. Introduction

On September 15th’ 2008 at 1:45 am, the fourth largest investment bank Lehman Brothers filed for bankruptcy and nearly caused a meltdown of the USA financial system. Nine months earlier, Lehman had started the year with a market capitalization of over $30 billion.^[1]

Prior to its bankruptcy Lehman Brothers decided to follow a new, very aggressive growth strategy - to increase its risk profile. This increase was borne by the Lehman’s investment in long-term assets such as commercial real estate and leveraged loans with high growth potential. In order to finance these long-term investments, Lehman needed to use a short-term debt, since the long-term was not accessible for them. This huge mismatch between short-term debt and long-term illiquid assets increased the firm’s business risk to a much higher level than the normal for the investment banking sector.

During the same period, the economic situation in the USA worsened - many of the investment banks faced huge depreciation of assets, as a consequence of the housing bubble. To handle with the economic situation and to manage the mismatch between short-term debt and long-term illiquid assets, Lehman Brothers had no other choice but to reduce its exposure and leverage. In order to reduce its reported leverage ratios, Lehman developed and engaged in Repo 105 transactions.

Repos (explained as repurchase agreements) have been used by companies to finance their security position by transferring securities as collateral for short-term borrowings of cash. But in the case of the investment bank Lehman Brothers, the Repos 105 were used to make their financial statement to look healthier than what it was in the reality. It was a clever, but at the same time a very risky accounting trick, in order to mislead the investors, the outstanding institutions, and the government. But was it successful?

The main issue of this working paper is whether the accounting treatment of the Repurchase agreement 105 contributed to the collapse of Lehman Brothers. It was questioned how the Repos were used and the following effects over Lehman’s financial stability.

While seeking for an appropriate solution of the main issue, the paper goes through the historical fluctuations of the financial system, from the 1950s till 2006 (two years before the Lehman’s bankruptcy). Further, the paper reviews some causes that may have led to the collapse of the investment bank. Finally, the global impact of the collapse has been summarized and possible preventions from future crisis have been proposed by the author.

2. Company background

In 1844, a Jewish emigrant from Germany, Henry Lehman established a small shop selling dry goods, groceries to the local cotton farmers in Montgomery, Alabama. A few years later, in 1850, his brothers Emanuel and Mayor joined him in the business, naming it Lehman Brothers and holding an inventory of groceries, hardware and clothing, catering for the local farmers. After the death of Henry Lehman, the business was headed by the both young brothers for next four decades. The Emanuel’s and Mayor’s store witnessed the cotton boom in the middle of 1800s, also called “King Cotton”, which dominated the economy of the southern United States. As the business grew, a partnership with the cotton merchant John Wesley Durr was formed to build a cotton storage warehouse, permitting them to become more profitable. As the cotton market continued to develop, Lehman Brothers opened a New York office to better fulfill its role from general store to cotton and commodity trader. As their business started to expand into new commodities such as coffee, sugar and even petroleum, so they did their first steps into the American financial markets.

In 1870, Lehman became a member of the New York Cotton Exchange and in 1878 a member of the New York Stock Exchange enabling them an exclusive access to buy and sell securities on the trading floor. In addition to the commodities trading, Lehman Brothers underwrote Initial Public Offering for companies. Before the World War it joined with Goldman Sachs in underwriting many new issues, the best known of which was for Sears, Roebuck and Co.

After the Great Depression in 1930s and the passing of the Glass-Steagall act, the Lehman Brothers became purely an investment bank. Through the merger with the investment bank Kuhn Loeb & Co. in 1971, they became the fourth largest investment bank in the USA. In 1984 the Lehman Brothers was sold to the American Express and ten years later the firm was spun off as a public company and assuming its original name Lehman Brothers Holding Inc. It remains one of the Wall Street best-known and oldest investment banking firms, increasing its revenues significantly from approximately three billion dollars to the nineteen billion dollars during the period 1994-2008. After the reveal of the Act in 1999 and less than a decade after the financial crisis hit the US banks and spread across the world, Lehman Brothers became entangled in the crisis which led to its collapse in the autumn of 2008.

On 15th of September 2008 Lehman Brothers Holding Inc. filled a Chapter 11 bankruptcy petition in the federal court. The investment banking company faced a lot of difficulties during its existence among them were the Great Depression of the 1930s, two world wars, a capital shortage when it was spun off by the American Express in 1994, the long term capital management collapse and the Russian debt default of 1998. And Lehman Brothers survived all of them, but the subprime mortgage crisis of 2007 brought them to their meltdown.

Lehman Brothers was one of the leading investment banking companies, specialized in three segments: capital markets, investments management and investment banking. The company operated primary in debt and equity underwriting, mergers and acquisition advice, and global finance. The Lehman Brothers had offices in Europe, US and Asia, with more than 25,000 employees worldwide. It was headquartered in New York City, New York. The auditor of the Lehman Brothers Holding Inc. was Ernst &Young.^[2]

The company recorded revenues of $19,257 million in the fiscal year ended November 2007, an increase of 9.5% over 2006 - $17,583 million. The operating profit of the company was $6,013 million in the fiscal year 2007, an increase of 1.8% over 2006. The net profit was $4,192 million in the fiscal year 2007, an increase of 4.6% over 2006 - $4,007 million. ^[3]

Apart from the Enron’s bankruptcy in the late 2001 and the WorldCom’s collapse in 2000, the failure of Lehman Brothers was described as the largest unit financial institution to have collapsed with assets worth $639 billion and $619 billion in debt.^[4] Prior to the declaring of bankruptcy Lehman Brothers suffered huge losses and the company’s stock lost 95% of value and was traded around $4 by September 12, 2008.^[5]

Lehman's collapse was a seminal event that greatly escalated the 2008 crisis and contributed to the erosion of close to $10 trillion in market capitalization from global equity markets in October 2008, the biggest monthly decline on record at the time.^[6]

3. The case of one of the world’s leading investment banks - Lehman Brothers Holding Inc.

3.1. Before the beginning

The financial services sector of the US economy has been growing since 1950. As compared to 2.8 percent in 1950 and 4.9 percent in 1980 the financial services sector contributed 8.3 percent to the US GDP at its peak in 2006.^[7] The growth of the finance is related with two main activities: asset management and the provision of the household credit, accompanied with the growth of the financial contracts and claims, including bonds, derivatives, mutual fund shares and stocks.

Enormous growth in the household credits was estimated, from 48 percent of GDP in 1980 to 99 percent of GDP in 2007 and especially during the housing boom between 2000 and 2006.^[8]

One reason for this was the new group of economic actors which was involved in the bubble: people with lower level of income, who were able for the first time to buy a house, thanks to subprime and low-grade mortgages. Compared to the traditional economic actors, these new ones could only make their payments on one condition and this was that the housing market kept going up.

The US housing bubble was the most visible effect of the credit bubble triggered by the large increases in the capital inflows from China. These capital surpluses were caused by consuming and investing less and saving more. The savings were loaned to the USA, which caused the fall of the interest rates and encouraged the domestic lending, especially in the high-risk mortgages. Over time, investors lowered the return they required for risky investments, as they may have mistakenly assumed that the world had become safer. Or maybe they have acted irrationally?

Yet another reason for the growth of the household credit was the securitization. Instead of banks holding consumer or mortgage loans on their balance sheets, these loans were packaged into mortgage-backed securities. As a result, more than the half of the outstanding single-family mortgages was securitized. By August 2007 the amount of subprime mortgages was estimated at $2 trillion.^[9]

Securitization went hand in hand with the shadow banking, in which the key functions of the traditional banking were led by the non-financial entities. Like banks these entities issue short-term, liquid claims and hold long-term, riskier and less-liquid assets. The shadow banking enabled the supply of the credit to a wider set of households. The non-traditional banking assisted in the spreading the risk across the financial system, but on the other hand reduced its stability. Examples of the institutions that belong to this modern banking system are investment banks, mortgage brokers, hedge funds, investments vehicles. The shift from the traditional banking to the modern banking brought the idea that a bank that is conservative and displays prudence in its acts has been replaced by a bank as a profit-making outfit, not so different from the ordinary firm, seeking for higher revenues and profits.

The whole securitization process would have gone smoothly only in the case the house prices were always going up, but in the case the market turned down, the borrowers would have to foreclose and the mortgage-backed securities would register as a loss or a worthless piece of paper. This is actually what happened in the 2007, when the decline of US housing market started to make an enormously impact on the financial system.

If these mortgages have been of the traditional type (not securitized), there would have been foreclosures and many local banks would have suffered great losses. Instead of this a huge number of mortgages were securitized, which brought a plenty of damages to the financial system of the US economy. If these securities were transparent, the investors at the end of the chain would have to take their losses and that would have been all. But this is not what actually happened. Instead, all the trouble spread across the other parts of the financial system: the interbank lending started to freeze up.

3.2. The boom and the bust

In financial circles, the period between 2007 and 2010 is best known for the economic recession that rocked the American economy to its core foundation. According to the World Bank, the economic recession hit USA and the world at large in three phases: the first phase was characterized by the U.S.-subprime-mortgage-finance catastrophe. The second phase of the recession was mainly related to the Lehman Brothers’ collapse. Finally, the final phase of the crisis was characterized, mainly, by the worldwide economic recession. It represented one of those rare moments in history when a crisis had originated from the developed rather than the developing world.

In early 2007 it became obvious that home prices were falling and more and more households with subprime loans were unable to make their mortgage payments. Over the year 2007 the collapse of the housing bubble and the shutdown of subprime lending as well as high leverage, inadequate capital, and short-term funding from repo markets and lack of liquidity led to the losses for many financial institutions and the collapse of the financial entities such as Bear Stearns and Lehman Brothers.

In August 2007 Lehman Brothers closed its own subprime lending arm, BNC Mortgage, cutting 1,000 jobs and claiming $25 million after-tax charge. Nevertheless Lehman continued to underwrite $16.5 billion of new mortgage-backed securities.

In the fall of 2007, the financial sector faced a lot of difficulties, billions of dollars in mortgage-related losses on loans, securities, and derivatives, with no end in sight. Some large investment banks and insurance companies experienced massive losses - Merrill Lynch, Citigroup and AIG - related to the subprime mortgage market. The Security and Exchange Commission failed in supervising by allowing them to take too much risk into investing in mortgage-backed securities.

As a result, one of the leading financial institutions - Bear Stearns - collapsed in the US. In March 2008, the failure of the investment bank was caused by its high leverage, its exposure to the risky mortgage-backed securities and its usage of short-term funding. The mortgage securitization was one of the most profitable divisions, generating 46% of the company’s total revenue. The Bear Stearns was one of the top-three underwriters of mortgage-backed securities from 2000 to 2007. In May 2006 the bank had lost three million dollars related with the default on mortgages. The government considered investment banking company too interconnected to fail and in March 2008 Bear Stearns was purchased by the JP Morgan. It was the first time in the history of the USA that FED (Federal Reserve) carried rescue measures to save a failing investment bank.

After the failure of Bear Stearns the economic condition continued to worsen as the prices in the real estate industry continued to fall. The next bank, which was on the edge of collapse, was the fourth largest investment bank in the United States - Lehman Brothers.

3.3. Reasons for the financial bankruptcy and moral hazard

There are numerous of causes that led to the one of the largest bankruptcies in the US history.

First, an intentional overloading of the financial market with subprime mortgage-backed securities. An example of this practice were the Fannie Mae and the Freddie Mac entities. Established back in the late 1930s, as government-sponsored enterprises, these two companies had the initiative to increase homeownership among all the Americans. Ever since then, they were giving loans to moderate and low-income borrowers without concerning lending standards and risk of default. In 1968, Fannie Mae and Freddie Mac went private. This led to the change of the entities’s policy - instead of following the government’s goal, they turned into chasing a continuously increasing profit. The two entities lowered the credit quality standards of the mortgages they securitized. They made the bad mortgages into bad securities. As long as they could resell a mortgage to the secondary market (investment banks for example), they really didn’t care that much about the quality of the mortgages. The securitization diversified the housing risk among different financial institutions. Fannie and Freddie reported that only 0.3% of their loans were subprime when the actual number was 18%.^[10]

This behavior created the wellspring of toxic assets for greedy banks like Lehman Brothers to serve them to their clients. The investment bank specialized in the mortgage securitization, which implies that the firm used credit derivatives to spread its financial risk. These derivatives were designed in such way that that tens of thousands of mortgages were placed in pools to spread out the risk and then divided into slices, known as tranches, based on quality.

Second, the style of leading of Lehman Brothers’ CEO and Chairman Richard Fuld can be seen as an aggressive and competitive. Lehman’s focus was on the maximizing profits rather than responsible leading. Even in the wake of the coming decline in the sub-prime market, Lehman Brothers continued to underwrite mortgage-backed securities and to maintain a portfolio of these assets on their balance sheet.

The pride of Fuld led to rejection of several offers by investors to buy Lehman Brothers. Between March and September 2008, before the collapse of the investment bank, there were several attempts for Lehman to be purchased by Morgan Stanley, Goldman Sachs and Bank of America. The CEO was in the opinion that he will never sell Lehman Brothers Holding Inc. The US Treasury Secretary Henry Paulson made the comment “Dick is no condition to make any decisions... He is in denial”^[11]. Perhaps if the Fuld wasn’t that pride, the bankruptcy wouldn’t have been undertaken. How costly pride can be?

Third, less regulatory environment permitted investment banks like Lehman Brothers and Bearing Stearns to engage in risk-taking strategies. Security and Exchange Commission made the decision to allow the investment banks to self-regulate 2004 Consolidated Supervised Entities program. The CSE program put the regulations in the hands of the bankers.

Fourth, there was no government funding. The government wasn’t willing to use taxpayer money to bail out private companies, as it creates a moral hazard. Moral Hazard is a term used in the banking cycles to describe the intention of the bankers to make bad loans on en expectation that in case of troubles they will be bailed out by the Federal Reserve. The US Treasury Secretary Henry Paulson’s morals hazard aversion had prevented Lehman Brothers from purchasing of government bailout. Rescuing Lehman would not have prevented the financial crisis, most likely it would have only reduced the degree of panic and the amount of collateral damage to the global economy.

Fifth, there was no potential buyer of the Lehman Brothers, since the purchase was not an attractive one - all bank’s assets have lost their value during the mortgage crisis. The Bank of America bought Merrill Lynch instead and no other American financial institution was willing to buy. At the end of the “Lehman weekend” the only visible buyer was the British bank Barclays, but to make the purchase Barclays needed a shareholder vote, which would have taken several weeks.

[...]

^[1] Caplan, Dennis, Dutta, Saurav and Marcinko, David, 2012, Lehman on the Brink of Bankruptcy: A Case about Aggressive Application of Accounting Standards, Vol. 27, No. 2, p.441.

^[2] Datamonitor, Lehman Brothers Holding Inc, Company Profile, p.4.

^[3] Lehman Brothers, Annual Report 2007, Financial Highlights.

^[4] Investopedia, Case Study: The Collapse of Lehman Brothers.

^[5] Caplan, Dennis, Dutta, Saurav and Marcinko, David, 2012, Lehman on the Brink of Bankruptcy: A Case about Aggressive Application of Accounting Standards, Vol. 27, No. 2, p.441.

^[6] Investopedia, Case Study: The Collapse of Lehman Brothers.

^[7] Greenwood, R. and Scharfstein, D, 2013, The growth of finance, Journal of Economic Perspectives, 27(2), p.3

^[8] Greenwood, R. and Scharfstein, D, 2013, The growth of finance, Journal of Economic Perspectives, 27(2), p.5

^[9] Schwedberg, Richard, The Structure of Confidence and the Collapse of Lehman Brothers in: Lounsbury, Michael and Hirsch, Paul, 2010, Markets on Trial: The Economic Sociology of the U.S. Financial Crisis: Part A, Volume 30A, p.79.

^[10] Calabria, Mark, 2011, Fannie, Freddie, and the Subprime Mortgage Market, Cato Institute Briefing Papers, No.120.

^[11] Sorkin, Andrew, 2009, Too Big to Fail The Inside Story of How Wall Street and Washington Fought to Save the Financial System from Crisis - and Lost, Viking