As
stage four of the financial crisis (distress) progressed, Lehman’s management realised
that the crisis was more severe than they had previously thought. The counter cyclical strategy pursued had
cost Lehman a huge share price decrease (shown in graph 1) and massive losses.
Many
rumours circulated about Lehman’s financial health and the interbank market
froze, reluctant to lend. This lack of confidence resulted in Lehman not
securing the vital funds it needed for daily operations. On the 15th
of September 2008 Lehman Brothers filed for chapter 11 bankruptcy protection.
This became the largest corporate bankruptcy in the U.S history with $639
billion in assets, the great ‘Wall Street Titan’ had fallen (Craig et al, 2008).
If
you have an hour to spare and want to learn more about the end of Lehman
Brothers the film below entitled “The Last Days of Lehman Brothers” provides a
good overview of the run up to Lehman’s bankruptcy.
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 4th largest investment bank. Lehman’s rise in the 21st
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
A
financial crisis is “a disturbance to financial markets, associated
typically with falling asset prices and insolvency among debtors and
intermediaries, which spreads through the financial system, disrupting the
market’s capacity to allocate capital”
(Portes & Swoboda, 1987: p10)
Throughout history
there have been numerous financial crises that vary in strength and
location. The most notable financial crises include the great depression in the US (1929), the oil crisis in 1973, the Asian
financial crisis (1997), the bursting of the dot com bubble (2001), the financial
crisis of 2007-2010 and most recently the European debt crisis (2010).
In a financial crisis the economy goes through a series of stages, Kindleberger (1989) defined these
stages as follows:
Stage 1: Displacement: Displacement occurs when there is an
outside shock to the economic system which modifies the outlook of the economy
·In
the case of the 2007-2009 financial crisis the shock was the slashing of short term interest rates to 1% by the
Federal Reserve- aimed at stimulating growth in the sluggish economy
Stage 2: Boom/Credit
Expansion: These low
interest rates stimulated a boom in housing as mortgages were cheaper to attain.
This boom increased house prices and construction rates raised to satisfy
demand
Stage 3: Bubble/Mania: A large proportion of the population became involved in the
housing boom and segments of the population usually not included become
involved, for example, sub-prime mortgage holders.This led to speculation for profits
and rationality gave way to irrationality and mania
Stage 4: Distress: In the US interest rates began to
rise, leading to a fall in house prices and many sub-prime mortgage holders
were unable to meet repayments. At this stage the bubble begins to unravel
Stage 5: Crash and Panic: System unstable and close to
crashing. Panic was triggered by the failure of many financial institutions for
example that of Lehman Brothers in 2008
The graph
below illustrates the movement in the
interest rate in the US between January 2000 and January 2010. The fall in
interest rates as described in Stage 1 is evident as is the rise described in
Stage 4.
In my blog I am going to explore the rise and fall of Lehman
Brothers. I believe the rise and fall of Lehman mirrors the rise and
fall of the global economy and illustrates the five stages of a financial
crisis. I will research Lehman Brothers and aim to define:
·How Lehman Brothers moves through the
stages of the crisis
·The reasons behind the failure of
Lehman Brothers
·How this failure is connected to the
economy
·The impact of Lehman’s failure on the
economy If you are interested in learning more about the causes of the most recent financial crisis (2007-2009) the video below provides a short summary of what went wrong.
Bibliography
1.Kindleberger, C.P. Manias, Panics and Crashes:
A History of Financial Crises, rev. ed. Basic Books, New York, 1989.
2.Portes, R. and Swoboda, A. (1987)
"Anatomy of Financial Crises." From Threats to International
Financial Stability, pp. 10-58. New York: Cambridge University Press, 1987.
3.Trading Economics. (2013).United States Interest Rates.Available:
http://www.tradingeconomics.com/united-states/interest-rate. Last accessed 4th
Feb 2013.
