The rise of Lehman Brothers

Lehman Brothers was established in 1850 when Henry Lehman and his brothers started up a shop which sold to local farmers (Harvard, 2012) and from these humble beginnings Lehman rose to become America’s 4^th largest investment bank. Lehman’s rise in the 21^st century originated from a change in strategy. This was driven by the Federal Reserve slashing interest rates to 1% (Displacement: stage one of financial crisis). Following this Lehman moved through stage two (credit expansion) and stage three (bubble/mania) of financial crisis.

Lehman Brothers logo (Google Images, 2013)

Traditionally Lehman had pursued a low risk strategy which involved originating and purchasing assets to sell them on while not investing their own capital or holding assets on their balance sheet.  In the early 2000s the bank decided to change to an aggressive, higher risk strategy which involved using their own capital to buy assets and then storing these assets. Management at Lehman believed they were missing out on the advantages of the bullish market that many of their competitors were exploiting (Valukas, 2010). Although this high risk strategy was not uncommon among investment banks, it proved especially risky for Lehman as they had a small equity base and high leverage (Valukas, 2010).

As the boom (stage two of crisis) progressed Lehman invested heavily in property, leveraged loans and the mortgage market including the sub-prime market. The aim of this strategy was high revenue growth which was achieved by an increase in the bank’s balance sheet and risk. 

The crisis then progressed into stage three and a bubble began to form as the economy expanded. The market reacted positively to Lehman’s new aggressive growth strategy, with share price increasing steadily to peak in February 2007 at $85.80 (Bebchuk et al, 2009) and analysts at the major credit rating agencies such as Moody’s and Standard & Poor’s  giving Lehman positive investment grade ratings.

When the sub-prime crisis set in, Lehman believed that by pursuing a counter-cyclical strategy they could increase their advantage over competitors. At this time the economy had moved to stage four of the crisis: distress, but behaviour at Lehman still displayed signs of a stage three crisis for example mania and irrational exuberance*. Lehman had pursued this counter-cyclical strategy before during the downturn of 2001-2002 and it had proved successful, leading to an increased market share, so they continued their aggressive capital destructive strategy when many other banks were raising and hoarding capital (Cohan, 2012). This pursuit of market domination was what ultimately led to the downfall of Lehman.

Graphs illustrating the aggressive growth strategy at Lehman: First graph showing the increase in asset base and the second showing increasing net revenue

(Both graphs composed using data cited in Valukas, 2010)

Irrational Exuberance: “Unsustainable investor enthusiasm that drives asset prices up to levels that aren’t supported by fundamentals” (Investopedia, 2013)

Bibliography

1.      Bebchuk et al . (2009). The wages of failure: executive compensation at Bear Sterns and Lehman 2000-2008. Harvard Law School : Discussion Paper. 657 (1), 1-28. (Available at http://www.law.harvard.edu/programs/olin_center/papers/pdf/Bebchuk_657.pdf)

2.      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

3.      Craig, S. et al (2008) AIG, Lehman Shock Hits World Markets. The Wall Street Journal, 16 Sept. Available at: http://online.wsj.com/article/SB122152314746339697.html

4.      Harvard Business School. (2012) History of Lehman Brothers.  .Available: http://www.library.hbs.edu/hc/lehman/history.html. Last accessed 3rd Feb 2013.

5.      Investopedia. (2012). Irrational Exuberance  Available: http://www.investopedia.com/terms/i/irrationalexuberance.asp#axzz2K9e2BRip. Last accessed 6th Feb 2013.

6.      Valukas, A. ( 2010) Lehman Brothers Holding Inc. Chapter 11 Proceedings Examiner Report. Jenner & Block, Volumes: 1-9