The History of Lehman Brothers
The History of Lehman Brothers
The History of Lehman Brothers
On June 9, Lehman announced a second-quarter loss of $2.8 billion, its first loss since
being spun off by American Express, and reported that it had raised another $6 billion from
investors. The firm also said that it had 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.
led to more than $46 billion of its market value being wiped out. Its collapse also served as
the catalyst for the purchase of Merrill Lynch by Bank of America in an emergency deal that
was also announced on September 15.
In recent days, there have been thousands of articles written about the collapse of Lehman
Brothers. Some blame chief executive Dick 'the Gorilla' Fuld for his overconfidence and failure
to recognise that Lehman faced a momentous crisis. Arguably, Fuld's battle to salvage something
for Lehman's suffering shareholders eventually cost them every cent.
Some commentators blame Bank of America for ending takeover talks with Lehman in favour of
buying its larger rival Merrill Lynch for $50 billion the following day. Other pundits blame
Barclays for refusing to buy Lehman without US government backing, in the form of emergency
funding.
However, I have come up with three very simple reasons why Lehman was doomed to fail. Here
they are...
The three Ls that killed Lehman:
1. Leverage
During the good times, the best way to enhance your returns is to 'gear up' by borrowing money
to invest in assets which are rising in value. This enables you to 'leverage' (magnify) your
returns, which is particularly useful when interest rates are low. However, leverage cuts both
ways, as it also magnifies your losses when asset prices fall. (Witness the recent return of
negative equity to the UK property market.)
A sensibly run retail bank would have leverage of, say, 12 times. In other words, for every 1 of
cash and other readily available capital, it would lend 12. In 2004, Lehman's leverage was
running at 20. Later, it rose past the twenties and thirties before peaking at an incredible 44 in
2007.
Thus, Lehman was leveraged 44 to 1 when asset prices began heading south. Think of it this
way: it's a bit like someone on a wage of 10,000 buying a house using a 440,000 mortgage. If
property prices started to slide, or interest rates moved up, then this borrower would be doomed.
Thanks to its sky-high leverage, Lehman was in a similar pickle.
2. Liquidity
Most businesses fail not because of lack of profits but because of cash-flow problems. Like all
banks, Lehman was an upturned pyramid balanced on a small sliver of cash. Although it had a
massive asset base (and equally impressive liabilities), Lehman didn't have enough in the way of
liquidity. In other words, it lacked ready cash and other easily sold assets.
As markets fell, other banks started to worry about Lehman's shaky finances, so they moved to
protect their own interests by pulling Lehman's lines of credit. This meant that Lehman was
losing liquidity fast, which is a dangerous state for any bank. Only six months earlier, in March
2008, Lehman rival Bear Stearns faced a similar loss of liquidity before JPMorgan Chase rode to
its rescue.
Believing that Lehman did not have enough liquidity at hand, other banks refused to trade with
it. Once a bank loses market confidence, it loses everything. Being unable to trade meant that
Lehman and its business ceased to exist in other banks' eyes.
3. Losses
After the terrorist attacks of 11 September 2001, US interest rates plummeted, causing a fiveyear boom in domestic and commercial property prices. This boom ended in 2006 and US
housing prices have since fallen for three years in a row.
Lehman was heavily exposed to the US real-estate market, having been the largest underwriter of
property loans in 2007. By the end of that year, Lehman had over $60 billion invested in
commercial real estate (CRE) and was very big in subprime mortgages (loans to risky
homebuyers). Also, it had huge exposure to innovative yet arcane investments such as
collateralised debt obligations (CDO) and credit default swaps (CDS).
As property prices crashed and repossessions and arrears sky-rocketed, Lehman was caught in a
perfect storm. In its third-quarter results, Lehman announced a $2.5 billion write-down due to its
exposure to commercial real estate. Lehman's total announced losses in 2008 came to $6.5
billion, but there was far more 'toxic waste' waiting to be unearthed.
In summary...
Lehman once employed 28,000 people across the world, including 5,000 in London. At their
peak, its shares traded at $85, but they are now roughly 10. Lehman's remains were shared out
between Barclays, which bought its US broking arm, and Japanese giant Nomura, which bought
its European and Asian assets. These firms, plus number-one investment bank Goldman Sachs,
have profited most from picking over the bones of Lehman's businesses.
In short, Lehman Brothers -- a company with a 158-year history, including 14 years as an NYSElisted giant -- failed simply because it took on too much risk in a booming market. In the end, its
move from the safety of corporate finance and M&A (mergers and acquisitions) income into the
risky world of proprietary trading proved to be its downfall.
The lesson here is that any firm, no matter how big and powerful, can be dashed to pieces on the
rocks of leverage, liquidity and losses!