I found this
joke online and thought I should share it!
Lehman
Brothers and George Bush:
U.S. (Former)
President George W. Bush: I am saddened to hear about the demise of Lehman
Brothers. My thoughts go out to their mother as losing one son is hard but
losing two is no doubt a tragedy
Below I have
included a couple of interesting videos. The first shows Sky News reporting on
when news of the bankruptcy first broke and the second shows a recruitment
video for Lehman Brothers from 1999. This video gives us an insight into the
culture at Lehman.
In my blog I have explored how Lehman Brothers moved
through Kindelberger’s (1989) stages of financial crisis as well as the reasons
behind the failure of Lehman Brothers. These reasons include, but are
definitely not limited to, risk management, irrational exuberance/arrogant
culture at Lehman, financial innovation (including repo 105 transactions) and
finally regulation. Lehman had a number of firm specific variables that
contributed to its failure, these variables led to Lehman’s business model being
inherently flawed and unsustainable. In addition to these firm specific
variables there were economy wide factors that played a role in Lehman’s
downfall. These economy-wide variables include the rise of financial innovation
and the role of regulation in the economy. The impact of Lehman’s failure on
the global economy was vast; it set off a chain of events that led
to the world experiencing a deep global recession the worst since
the Great Depression. The great crisis of 2007 saw U.S. foreclosures spike (see
graph below) and it is estimated that in the U.K around 3.7 million people have
been made redundant since the beginning of the recession, that represents a huge one in seven of all employees (Sky News, 2013). Without a doubt Lehman
has left a scar on the global financial landscape.
(Graph showing spike in foreclosures,
The Economist, 2007)
I feel in order to protect the world from another global
crisis we need to introduce a comprehensive regulatory framework that governs
all financial institutions whose well-being has an impact on the financial
stability of the economy. Only time will tell whether the new measures
implemented will be enough to prevent another Great Crash.
I hope you have found my blog as useful and interesting as I
have found researching Lehman Brothers. In this blog it has not been possible
to explore every detail of Lehman’s bankruptcy but if you ever want to find out
more I recommend reading the report of Anton R. Valukas who was the examiner in
the bankruptcy proceedings of Lehman Brothers Holdings Inc. The link to his
nine volume report is shown below.
Kindleberger, C.P. Manias, Panics and Crashes:
A History of Financial Crises, rev. ed. Basic Books, New York, 1989.
Sky News (2013) Financial Crisis Led To 3.7 Million Job Losses.
[online] Available at:
http://news.sky.com/story/1054212/financial-crisis-led-to-3-7-million-job-losses
[Accessed: 24 Feb 2013].
The Economist (2007) The hammer drops. [online] Available
at: http://www.economist.com/node/9905451 [Accessed: 24 Feb 2013].
Valukas, A. (2010) LEHMAN
BROTHERS HOLDINGS INC. CHAPTER 11 PROCEEDINGS EXAMINER REPORT.Jenner & Block, Volumes: 1-9.
Regulatory reform in the post Lehman world:
Have there been moves towards a safer financial system?
Under
intense public pressure governments around the world have sought to introduce
regulation to prevent a large scale financial crisis occurring again. On July
10th 2010 the U.S. government introduced the Dodd-Frank Wall Street Reform and Consumer Protection Act. This
law, which stretches to 2,319 pages, is wide-ranging in its scope. It creates a
new Consumer Financial Protection Agency
which has the role of monitoring the complex financial instruments within
the financial system and educating investors on these instruments (Hallman,
2012). To try and regulate financial institutions deemed ‘too big to fail’
Dodd-Frank created the Financial Stability Oversight Council which has the
power to take control of failing banks and unwind them. In addition, Dodd-Frank
provided shareholders with a “say-on-pay” vote and restricted remuneration in
financial institutions that received government funds.
(Obama signing Dodd-Frank: Google Images, 2013)
The
Dodd-Frank reform sounds impressive with such a wide scope of reform but little
has been done to implement Dodd-Frank which implies the regulators might have
bitten off more than they can chew. The reform has also (as expected) come up
against huge opposition from Wall Street for example in quarters one and two of
2012 the American Banker Association spent $4.6m to lobby on topics including
Dodd-Frank (Hallman, 2012). In
the UK the Bank of England established a Financial Policy Committee in 2011 and
there are calls for extra taxes on bank bonuses (FT, 2013). The EU has
introduced the European Systemic Risk Board.
At an international level the Financial Stability Board has
introduced principles for sound compensation practices (Financial Stability Forum,
2009) and there has been the creation of Basel III. Basel III stresses the importance of capital including building
up counter- cyclical capital buffers and maintaining higher levels of capital within the financial institutions The Basel Committee has also increased the
number of principles for good bank corporate governance from 8 to 14 (Basel
Committee, 2010).
The
question remains whether these regulations will be fully enforced, will they be
held in place in times of rapid growth and whether they are really enough to
protect the stability of the global financial system.
Bibliography
1.Hallman, B. (2012) Four Years After Lehman, U.S.
Banks Fight Reform. [online] Available at:
http://www.huffingtonpost.com/2012/09/15/lehman-brothers-collapse_n_1885489.html
[Accessed: 23 Feb 2013].
2.Bis.org
(2013) Basel Committee - BIS. [online] Available at: http://www.bis.org/list/bcbs/index.htm
[Accessed: 23 Feb 2013].
3.Financial
Times (2013)Labour demands extra tax on
bank bonuses - FT.com. [online] Available at:
http://www.ft.com/cms/s/0/14e7f0c8-6a42-11e2-a3db-00144feab49a.html#axzz2LuGscvlW
[Accessed: 25 Feb 2013].
4.Financialstabilityboard.org
(2013) Financial Stability Board. [online] Available at:
http://www.financialstabilityboard.org/ [Accessed: 23 Feb 2013].
Prior
to the collapse of Lehman the government failed to regulate several key
areas of the financial system. The
government did not introduce measures that would have curbed risk taking, reined in the use of derivatives and increased disclosure within the system. These
failures helped contribute to the collapse of Lehman and the wider financial
crisis. As well as failing as chief regulator of Lehman the SEC (Securities and
Exchange Commission) discovered that Lehman had excluded many important risk
factors from their risk tests but failed to act (Valukas, 2010).Lehman was also allowed to operate repo 105 transactions without disclosing the true nature of
the repos and was able to exceed many of its risk limits without
disclosing this fact.
Why was pre-collapse regulation so weak?
(Google Images, 2013: Fat cat banker
having his shoes polished by a member of the senate)
One view why regulation was so weak
is regulatory capture. Regulatory capture can be defined as “The process by which regulatory agencies
eventually come to be dominated by the very industries they were charged with
regulating” (Investopedia, 2013)
One method of regulatory capture is lobbying which aims to
influence decision makers. Wall Street spends an extortionate amount on
lobbying government for example it is estimated that $3.28bn was spent lobbying in 2012
(Lobbying Database, 2012). Stigler (1971) found that regulated institutions
frequently pressurised regulators to modify regulations. An example of regulatory capture occurred when politicians blocked attempts to reform the
government sponsored enterprises such as Fannie Mae and Freddie Mac (Dowd, 2009)
even though many admitted that the enterprises were major players in the
financial crisis. In addition, financial institutions can exert pressure
through political campaign contributions which also allows them to exert
considerable influence.
So what could the government do?
Stricter
governmental disclosure rules could have curbed excessive risk taking at
Lehman. In addition, compensation packages in place in the financial sector
have been accused of encouraging risk taking and short termism e.g. at Lehman
compensation was often based solely on revenue (Valukas, 2010) . The government
could introduce measures to regulate executive compensation, insisting it be
based on a number of risk factors that are in line with the health of the
financial system. Another piece of legislation could be introduced to regulate the creation and
trading of complex financial instruments.
Bibliography
Dowd, K (2009) ‘Moral Hazard and the
Financial Crisis’,Cato Journal29(1): 142-6
Investopedia.com (2012) Regulatory
Capture Definition | Investopedia. [online] Available at:
http://www.investopedia.com/terms/r/regulatory-capture.asp#axzz2LeTwzYVa
[Accessed: 23 Feb 2013]Opensecrets.org (2012) Lobbying
Database | Open Secrets. [online] Available at:
http://www.opensecrets.org/lobby/index.php [Accessed: 23 Feb 2013].
Stigler, G.J. 1971. "Theory of Economic
Regulation." Bell Journal of Economics and Management Science 2 (Spring):
3-21
Valukas, A. (2010) LEHMAN BROTHERS HOLDINGS
INC. CHAPTER 11 PROCEEDINGS EXAMINER REPORT. Jenner & Block,
Volumes: 1-9.
After the collapse of Lehman what has become known as the
great panic of 2008 ensued (Clark, 2009). Kindleberger (1989) describes this
panic as the final stage of a financial crisis. On the day Lehman filed for
bankruptcy a record number of 8bn share were exchanged (Clark, 2009). Lehman had
been considered by many as too big to fail so its collapse triggered a crisis
of confidence in the economy. The fall of Lehman has been described as an “earthquake” and as a “heart attack” in the financial markets,
some also postulated that after Lehman the economy was just one financial
institution away from a global financial meltdown (FT, 2009). Not long after
the announcement of Lehman’s bankruptcy, Bernake (Chairman of the Federal
Reserve) made his famous statement “we
may not have an economy on Monday” (Thomas & Hirsh, 2009).
(Google Images, 2013 : Lehman employs lining
up to hear the news of their future)
After Lehman’s demise the world's economy spiraled, global
trade froze and panic came with the announcement that some money market funds were heavily invested in Lehman bonds. This led to investors rushing to withdraw their money from
money market funds (CNN, 2008). In order to prevent the panic causing further damage
Bernake assured investors that all their money would be guaranteed. In the
following days the Treasury and Federal Reserve pumped trillions of dollars in
to try to support the ailing financial system (NY Times, 2012).
Many had assumed that the government would intervene and stabilize Lehman to avoid it collapsing. Executives at Lehman claim they warned key
government figures such as the Treasury Secretary Henry Paulson and the
chairman of the Federal Reserve Ben Bernake of the contagion effect Lehman
could have on world markets. They claimed that letting Lehman fail would be to
“unleash the forces of evil on the global markets” (Clark, 2009).
Leaders in government maintained that they could do nothing
to prevent the failure of Lehman but it has been argued that the U.S. government could
have intervened in the interbank money markets, putting guarantees in place to
allow short term funding for Lehman. In addition, the U.S. government could have provided
guarantees against future losses to Barclays, who expressed interest in buying Lehman. Financial institutions who had run into difficulty before Lehman and many that ran into difficultly after Lehman were bailed out for example Bear Sterns in March 2008. This inconsistency in
bailout policy further introduced uncertainty into the economy.
So why didn't the U.S.
government bailout Lehman?
There are several possible explanations of why the government
let Lehman fail, some of which point to conspiracy theories among government
and senior figures in the financial services sector but here I will discuss
what I believe are the most plausible theories. Number one is that the
government wanted to stress to the financial sector that there existed
consequences for risky actions. Cassidy (2010) states that
“Many people suspect Paulson and Bernanke let Lehman go bankrupt to
re-establish the principle that irresponsible behaviour would be punished”.
Another possible reason behind the Federal Reserve’s refusal to bailout Lehman is public opinion. The U.S. government was under increasing pressure concerning
the use of public funds to bail out large financial institutions. The public
was angered that for many years the banks had privatised the gains but now the
losses were being socialised. Henry Paulson, Secretary of the Treasury, said “I am being called Mr Bailout. I can’t do it again” (Nocera, 2009).
(Bailout Money: Google Images, 2013)
In the next
post I will discuss the role of regulation in Lehman’s demise as well as
looking at regulatory reforms post Lehman.
Bibliography
1.CASSIDY, J. (2010).How markets fail: the logic of
economic calamities. New York, Picador.
2.Clark, A. (2009)
How the collapse of Lehman Brothers pushed capitalism to the brink. Guardian,
4 Sept. Available at:
http://www.guardian.co.uk/business/2009/sep/04/lehman-brothers-aftershocks-28-days
3.Financial Times Video (2009) Sep 14: Part 2 - The Lehman
aftershock - markets - FT.com. [online] Available at: http://video.ft.com/v/63078044001/Sep-14-Part-2-The-Lehman-aftershock
[Accessed: 23 Feb 2013].
4.Kindleberger, C.P. Manias, Panics and Crashes:
A History of Financial Crises, rev. ed. Basic Books, New York, 1989.
5.Money.cnn.com (2008) Monday Meltdown: How Lehman's fall created
a global panic - Dec. 15, 2008. [online] Available at:
http://money.cnn.com/2008/12/15/news/economy/monday.meltdown.fortune/index.htm
[Accessed: 23 Feb 2013].
6.Nocera,
J (2009) The New York Times Lehman Had to Die So Global Finance Could Live.
[online] Available at:
http://www.nytimes.com/2009/09/12/business/12nocera.html?pagewanted=all
[Accessed: 23 Feb 2013].
7.Thomas, E., & Hirsh, M. (2009).
Paulson's complaint. Newsweek, May 25. Available at http:// www.highbeam.com/doc/IGl-200187807.html.
Retrieved on February 19,2013
8.Topics.nytimes.com (2008) Lehman Brothers Holdings Inc. News -
The New York Times. [online] Available at:
http://topics.nytimes.com/top/news/business/companies/lehman_brothers_holdings_inc/index.html
[Accessed: 23 Feb 2013].
“the
act of creating and then popularising new financial instruments as well as new
financial technologies, institutions and markets. It includes institutional,
product and process innovation”
(FT, 2013)
Financial innovation represents both as an
economy wide and firm specific factor in Lehman’s demise as the use of complex
financial instruments destabilised Lehman’s business model. From the late
1990s/early 2000s onwards the use of financial innovative products such as CDOs
and CDSs (see end for definitions) ballooned across the economy and Reuters
estimates that the CDO market peaked at $534.2bn in 2006 which was almost an 800%
increase on the 2000 figure (NY Times, 2011).
(Henry Paulson U.S. secretary of the treasury)
Lehman used these products excessively as
financial innovation played a large part in Lehman’s aggressive growth
strategy. An example of this excessive use occurred in 2006 when financial
instruments made up 45% of total assets (Lehman Brother Inc, 2006). In particular Lehman was
heavily invested in CDOs and CDSs and in 2008 held $614.6m equity securities in
CDOs (Lehman Brother Inc., 2008). These CDOs lost a huge proportion of their
value when confidence faltered in the market.
In addition to CDOs and CDSs Lehman used a
financially innovative product to indulge in some very creative accounting
practices to reduce their balance sheet. Lehman’s strategy had increased the
risk and leverage of the firm substantially. In 2008, after the near collapse
of Bear Sterns, the attention of the markets turned to Lehman and its future
viability. Lehman needed market confidence to survive, especially to lend in
the interbank markets, so management devised a strategy to reduce their assets
and ,in turn, their leverage ratio. Much of Lehman's balance sheet was made up of illiquid assets that were difficult to sell so they turned to financial innovation and used what were
termed ‘repo 105’ transactions.
Lehman used repo105 transactions to move assets off balance
sheet and decrease the leverage ratio before the end of the quarter. Repo 105
transactions were similar to other repos used to gain short term financing but
instead of being reported as a loan they were accounted for as a sale which allowed Lehman to move the assets off balance sheet (Valukas, 2010). Lehman could count these repos as sales
because “the value of the securities Lehman pledged in Repo 105 transactions
were worth 105 per cent of the cash it received” (De la Merced and Werdigier,
2010). Repo 105 actions were a type of “window dressing” of Lehman’s reports.
This
simple illustration shows how Lehman used repo 105:
The repo 105 transactions used were
never publicly disclosed, the financial regulators didn't discover them and
Lehman’s auditors Ernst & Young also failed to disclose them. Through repo
105 transactions Lehman was able to decrease its leverage; the decrease in
leverage is shown in the graph below.
(Composed from Valukas Report, 2010)
CDO – “An
investment-grade security backed by a pool of bonds, loans and other assets.
CDOs do not specialise in one type of debt but are often non-mortgage loans or
bonds” (Investopedia, 2013)
CDS – “A
swap designed to transfer the credit exposure of fixed income products between
parties” (Investopedia, 2013)
Bibliography
1.De la Merced, M. and Werdigier, J. (2010) The
Origins of Lehman’s ‘Repo 105’. The New York Times. Available at: http://dealbook.nytimes.com/2010/03/12/the-british-origins-of-lehmans-accounting-gimmick/.
2.Financial Times. (2013).Financial Innovation.Available:
http://lexicon.ft.com/Term?term=financial-innovation. Last accessed 17th
February 2013.
3.Investopedia.
(2013).Collateralized Debt
Obligations.Available:
http://www.investopedia.com/terms/c/cdo.asp#axzz2LA9o5psS. Last accessed 17th
February 2013.
4.Investopedia.
(2013).Credit Default Swaps.Available:
http://www.investopedia.com/terms/c/creditdefaultswap.asp#axzz2LA9o5psS. Last
accessed 17th February 2013.
6.Lehman Brothers Holdings Inc., 2008. Second
Quarter 10-Q ending May 31, 2008,New
York: Lehman Brothers Inc.
7.The
New York Times. (2011).Collateralized
Debt Obligations.Available:
http://topics.nytimes.com/topics/reference/timestopics/subjects/c/collateralized-debt-obligations/index.html.
Last accessed 17th February 2013.
8.Valukas,
A. (2010) LEHMAN BROTHERS HOLDINGS INC. CHAPTER 11 PROCEEDINGS EXAMINER REPORT.Jenner & Block, Volumes: 1-9.
A wide variety of factors contributed to the downfall of Lehman, these include firm specific factors
such as an inherently flawed and unsustainable business model as well as
economy wide factors.
One
central factor was risk and in particular risk management. When Lehman changed
to an aggressive growth strategy the amount of risk skyrocketed but managers at
Lehman disregarded nearly all risk controls. An employee at Lehman summed up
Lehman’s view on risk with the following quote:
“the majority of the trading
business’s focus is on revenues, with balance sheet, risk limit, capital or
cost implications being a secondary concern”
(Valukas, 2010:52)
An
example of the complete disregard of risk limits at Lehman occurred in 2007
when Lehman increased their risk appetite limit several times throughout the
year from $2.3bn to $4bn (Valukas, 2010). Lehman explained this rise as a
change in calculation but it seems unlikely that such a large rise was down to
a calculation change. As well as disregarding risk limits Lehman ignored the
advice of some of their risk management team as well as external risk
specialists. One of those who communicated their concerns was Lehman’s Chief
Risk Officer Madelyn Antoncic who was subsequently reassigned (*FCIR, 2011).
Another
factor that played a role was irrational exuberance (see post 1 for definition)
and arrogance among Lehman’s employees. Senior staff at Lehman believed Lehman
was infallible. This arrogance is displayed in emails from late 2007 between
two top executives Fuld and Goldfarb when Fuld describes the firm’s position:
“I agree we need some help – but the
Bros always wins!!” (Cohan, 2012)
This
arrogant persona led to Fuld, once nicknamed the Gorilla of Wall Street, being
demonised post Lehman’s collapse (see picture below). He was named on the '25
people to blame for the financial crisis' list by Times magazine (2009) and is
described in press as greedy and a symbol of failure (Freeman, 2011).
(The Demon Fuld: Google Images, 2013)
In my next post I will examine the
role of financial innovation, balance sheet manipulation and disclosure in Lehman’s collapse.
*FCIR: Financial Crisis Inquiry Report
Bibliography
1.Cohan, W. (2012).Lehman E-Mails Show Wall Street
Arrogance Led to the Fall.Available:
http://www.bloomberg.com/news/2012-05-06/lehman-e-mails-show-wall-street-arrogance-led-to-the-fall.html.
Last accessed 3rd Feb 2013.
2.Financial Crisis Inquiry Report
(FCIR), 2011
3.Freeman, J. (2009).Banking On a Rescue.Available:
http://online.wsj.com/article/SB10001424052970204251404574342350506568022.html.
Last accessed 12th Feb 2013.
4.Sender, H et al. (2008).Broken brothers: How brinkmanship
was not enough to save Lehman.Available:
http://www.ft.com/cms/s/0/d9792572-8358-11dd-907e-000077b07658.html#axzz2KizR1ukN.
Last accessed 12th Feb 2013.
5.Time Lists. (2009).25 People to Blame for the
Financial Crisis.Available:
http://www.time.com/time/specials/packages/article/0,28804,1877351_1878509_1878508,00.html.
Last accessed 12th Feb 2013.
6.Valukas, A. (2010) LEHMAN
BROTHERS HOLDINGS INC. CHAPTER 11 PROCEEDINGS EXAMINER REPORT.Jenner & Block, Volumes: 1-9.