Greed and Glory on Wall Street

Contents: 

1. Introduction. Brief overview of the case
2. Lehman Brothers main characteristics. What they deal with.
3. History of creation and growth
4. Beginning of the financial problems
5. Huge loss on mortgages and its influence
6. Bankruptcy case
7. Last attempts to save Lehman
8. Possible reasons
9. Where the debt comes from?
10. Illegal part
11. Conclusion

 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 
 

    The Global Economic and Financial Crisis changed the world of money in a dramatic way. A lot of banks collapsed, thousands of firms experienced black-outs, small businesses were forced to leave markets, and even world-famous corporations had to struggle to survive. One weekend inside of one single building on Wall Street had enough power to influence the future of the whole planet.

    The United States’ economic and financial positions literally have exploded from the inside during only one weekend. The two tragic events had happened at the same time. The first is the purchase of the investment bank Merrill Lynch by the Bank of America. The firm was acquired under distressed circumstances during the 2008 Financial Crisis, at which point the largest bank in New-York merged its global banking and wealth management division with the newly acquired firm to form a separate entity (Auletta, n/d). The second hit is filing for bankruptcy of the Lehman Brothers who had not found support from the government or any other financial institution to be saved and to continue operations. Representatives from Federal Reserve explained their choice by the decision not to put taxpayer’s money at risk in order only to prevent Lehman’s collapse. Merrill was the nation’s largest brokerage force and its name was known in towns across America while Lehman’s main customers were mostly big companies and highly-developed corporations. After the fall of the two giants on the Wall Street the world’s money indexes went down, a lot of investments simply burned out, and the overall circumstances in the market got worse either. Basically, Lehman bankruptcy forced market to reassess the risk. However, this case had a greater impact on money market funds.

    The following case is the largest bankruptcy filing in the US history which led to the dramatic consequences. September 15, 2008 was the crucial day for the investment bank called the Lehman Brothers.

    Lehman Brothers Holdings Inc. was a global financial-services firm with a list of additional activities and services, such as investment banking, research and trading, private equity and investment management. It was a primary dealer of the US Treasury Securities Market. The headquarters were located in New-York, London and Tokyo, the most influential financial capitals of the world. Primary subsidiaries were also very strong and included companies such as Aurora Loan Services, SIB Mortgage Corporation, Lehman Brothers Bank, and Eagle Energy Partners. (Geisst, 2001).

    The firm “Lehman Brothers” as a dry-goods store was founded in 1850 upon the connection of the three brothers: Henry, Emanuel and Mayer Lehman. In the 1850s one of the most important crops in the US was cotton, and the start-up business was trying to develop by accepting raw cotton form customers as payment for merchandise, because the main clients were local farmers. They were not able to offer something else in exchange. Brothers didn’t decline the possibility for barter in order not to lose customers. After a certain period the shop faced new problems – how to value numerous goods which they were getting as a payment, and how not to lose money on reselling them. This is how the idea of goods exchange appeared. The brothers accepted cotton from their clients to resell it again later. In other words they were having a kind of double-business by receiving profits from selling goods in their shop plus an additional profit from operations with the cotton received. (Geisst, 2001).

    A business would have remained local if not the Civil War between the South and the North. The entire business was concentrated on the agricultural southern part which suffered from the war the most. Therefore, Lehmans decided to gain profit from selling cotton in the northern part of the USA.  Within a few years “Lehman Brothers” became a second business trading in cotton, eventually becoming a very significant power in the market. After the death of Henry, two brothers continued operations. In 1858 the center of cotton trading had shifted from the Southern Part of the US to New-York which could offer more opportunities. During this year “Lehman Brothers” opened their first brunch in New-York, but because of a civil war in 1862 they had to cooperate with a cotton merchant John Durr to form Lehman, Durr & Co in order to save family business. (Geisst, 2001).

    In the 1860-1880s USA experienced fast development of railways construction. America for the very short period have become an industrial country from an agricultural one, getting the ability of fast transportations of people and various goods throughout the long distances as the main advantage. In order to get additional cash for building new railroads, companies were borrowing money by issuing bonds. Lehman Brothers understood that a lot of brokers in New-York made huge profits out of selling those debt papers. Eventually it had become the main argument for the business to step up into the New-York stock exchange and to become active participants of it. Lehman became a member of the Coffee Exchange in 1883 and a member of the New York Stock Exchange in 1887 (Geisst, 2001).

    One of the key persons in the Lehman Brothers was Herbert Henry Lehman, an uncle of the three brothers. He started working in the bank in 1908, a lot earlier than Robert Lehman, but then he quitted to politics. In the 1920s he had become a close friend of Franklin Roosevelt, the only American president who was elected three times in a row. Herbert Lehman was a candidate for the position of New-York major, but he lost the elections. In 1932 when Franklin Roosevelt had become a president, Herbert Lehman was automatically elected for the position of the New-York’s major; because everybody knew that he was a close friend of the new president. (Geisst, 2001).  In this case, Robert Lehman did not have to worry about possible decrease in the number of clients. Herbert Lehman was an active politician; he was elected as a member of the Senate and remained on this position until 1957. Curious fact, that before the election of Herbert the budget deficit was more than $100 million, but upon his retirement budget surplus was around $80 million. (Auletta, n/d).

    During the Great Depression the company survived the crisis by focusing on venture capital. Until 1924 the firm was a clear family business, M. Hancock became the first non-family member to join the firm. In 1927 C. Gutman and Paul Mazur also joined “Lehman” (Geisst, 2001). In 1928 the firm changed location to the now famous One William Street address.

    Robert Lehman died in 1969, leaving only one family member to control the whole business. The firm had already been involved not only into the issuance of stocks and bonds but also tried on a role of a consultant for large corporations’ mergers and acquisitions. For example, Lehman Brothers were consulting the merging contract between the two largest companies, the owners of circuses all over the United States – Keith-Albee and Orpheum Theatres. New holding has united more than 700 circuses in the US with the total number of seats available for more than 1,5 million people. Managers were sure that the industry of entertainment was the golden flow of money. At the same time, together with strong headwinds from the difficult economic environment, the company was facing hard times.  In 1973 they brought in Pete Peterson, CEO of the Bell&Howell Corporation (Geisst, 2001). Under his leadership the firm acquired Abraham & Co. in 1975, and two years later merged with Kuhn, Loeb & Co., the country’s fourth-largest investment bank. (Shirkhedkar, 2007). In 1984 Lehman was acquired by Shearson/American Express, as American Express-owned Securities Company focused on brokerage. On May 11, the combined companies became Shearson Lehman/American Express. In 1988, another merger with E.F. Hutton happened. (Geisst, 2001).

    During the period from 1983 to 1990, Shearson Lehman was aggressive in building its leveraged finance business in the model of rival Drexel Burnham Lambert. In 1993 American Express began to divest itself of its banking and brokerage operations. In 1994 it gave away Lehman Brothers Kuhn Loeb in an initial public offering, as Lehman Brothers Holdings Inc. (McDonald, 2009).

    In 2001 the firm acquired the private-client services business of Cowen & Co., and later in 2003, aggressively re-entered the asset-management business, which it has exited in 1989. (Geisst, 2001). Beginning with $2 billion in assets under management, the firm acquired the Crossroads Group, the fixed-income division of Lincoln Capital Management and Neuberger Barman. At the 2008 ALB China Law Awards, Lehman Brothers was crowned as Debt Market Deal of the Year and Equity Market Deal of the Year. The business managed to survive under the terrorist attack on the 11^th of September 2001. In 2003 the company was one of the ten firms which simultaneously entered into a settlement with the US Securities and Exchange Commission. (McDonald, 2009).

    So at the overall level of the company was quite stable and trustworthy. However, success is not permanent and the company was not able to overcome the subprime mortgage crisis. In August 2007, the firm closed its subprime lender, BNC Mortgage, eliminating 1,200 positions in 23 locations, and took an after-tax charge of $25 million and a $27 million reduction in goodwill. (Sorkin, 2008).

    The fall of the Lehman Brothers was as fast as its rise. In fact, it had two causes: firstly, the Lehmans had invested a large part of their money into mortgages, which in future will become the main reason for the world’s financial and economic crisis. The second reason is lack of government financial support even though a lot of companies were purchasing these mortgages. Net income of the bank increased until $4 billion (Paulson, 2008). In comparison, in 2005 this number was much lower - $3.26 billion (Paulson, 2008). The data on the bank’s inflow of money overcame the bravest forecasts of analysts. However, in summer 2007 brokers from Wall Street were in a chain of rumors that the bank’s financial statements are overvalued and not more than just a fake. People used to tell that the real debts from the operation with notorious mortgages were hidden. June 9, 2008 the Lehman Brothers announced an additional emission of stock worth $5 million in order to attract new investors (Shirkhedkar, 2007). In prior to the stock placement the rating agency Standard&Poors had decreased the bank’s rating. In a few days the bank had published reports that a lot of people were shocked with. The investors started selling a stock of Lehman.

    In 2008, Lehman faces a huge loss due to the continuing mortgage crisis. Huge losses accrued in lower-rated mortgage-backed securities throughout 2008. In the second fiscal quarter Lehman stock lost 73% of its value as the credit market continued to tighten. On August 22, 2008, shares in Lehman closed up to 5% (16% for the week) on reports that the state-controlled Korea Development Bank was considering buying Lehman (Shirkhedkar, 2007). August 25, 2008 the Lehman Brothers started to sell its actives worth $40 billion together with stock and plant assets. Moreover, the company Neuberger Berman was also under sale. The situation culminated on September 9, 2008, when Lehman’s shares plunged 45% to $7.79, after it was reported that the state-run South Korean firm had put talks on hold. The US government did not announce any plans to assist. On September 10, 2008, Lehman announced a loss of $3.9 billion and their intent to sell off a majority stake in their investment-management business, which includes Neuberger Berman. The stock slid 7% that day. (Paulson, 2008).

    On September 14, 2008, The New York Times reported that Barclays refused to sigh an agreement to purchase all or part of the Lehman Brothers and a deal to rescue the bank from liquidation collapsed (Auletta, n/d). Leaders at the Wall Street banks continued to meet later that day to prevent the bank’s rapid failure.

    On September 12, 13, 2008 in newspapers and magazines people were assuming that the government won’t let the Lehmans to go down. Two days after September 15, 2008 Lehman Brothers announces filing for Chapter 11 bankruptcy protection citing bank debt of $613 billion, $155 billion in bond debt, and assets worth $639 billion (Paulson, 2008). Nevertheless, it was further announced that subsidiaries would continue to operate as they used to.

    On Tuesday, September 16, 2008, Barclays Plc announced that they will acquire a part of Lehman for $1.75 billion, including most of Lehman’s North America operations (Sorkin, 2008). On September 20, this transaction was approved by US Bankruptcy Judge James Peck (BBC, 2008). On September 17, the New-York stock exchange delisted Lehman Brothers.

    After five days, Nomura Holdings, Inc. agreed to acquire Lehman Brothers' franchise in the Asia Pacific region including Japan, Hong Kong and Australia. The following day, Nomura announced its intentions to acquire Lehman Brothers' investment banking and equities businesses in Europe and the Middle East. A few weeks later the deal became legally effective on Monday, October 13. In 2007, non-US subsidiaries of Lehman Brothers were responsible for over 50% of global revenue produced. (McDonald, 2009)

    During the weekend Wall Street eliminated the two financial giants – the Lehman Brothers who filed for bankruptcy and Merrill Lynch which was sold to the Bank of America. Investors were shocked with these facts and according to their opinion the financial crisis was in its culmination. Some experts see the reason in the activities of financial institutions that decided not to save Lehman but helped to the more reliable in their opinion Merrill Lynch.

    Crisis and bankruptcy are not simultaneous for companies, so we can emphasize some vital reasons which led to such an outcome for Lehman in particular and for Wall Street in the whole. Mortgage related investments, consisted of billion of dollars, went bad in 2008. The Fed reduced interest rates in hope to control any economic damage. This change led to higher demand for this type of loans. Homeowners took an advantage of the cheap rate and refinance their present mortgages. When everybody had used the emerging situation for their personal benefit, they all suddenly appeared to be worse off.  Following the interest rate, banks decided to force the financial system to resell mortgage backed securities. From this time, people experience influence of so-called toxic mortgages (unsafe securities) and nightmare mortgages (payments cut in half). In the whole, the rate of default was still increasing. As a result of this crisis, Lehman Brothers suffered a huge decrease in the stock price, but they were not lucky enough to attract somebody to save their financial position. The company was trying to search for buyers, but was unsuccessful in thus either. As the last attempt they sold $6 billion of the assets, however, the value had already gone down. The next step was selling of investment-management business, including Neuberger Berman. With no buyers or Treasury bailout and with the stock price continuously falling down the Lehman Brothers had no other choice except to file for bankruptcy.  (Zingales, 2008)

    Another interesting fact or question is why did the bank have so enormous debt? The problem’s roots are in the Lehman Brothers financial policy. First of all, they had massive exposure to property derivatives. Derivatives are the securities whose price is dependent upon or derived from one or more underlying assets. In a more simple language these are investments that are tied to the value of properties like houses or mortgages. Secondly, the Lehman was operating with leveraged assets. While commercial banal are regulated and cannot leverage their equity more than 15 to 1, this bank had a leverage of more than 30 to 1 (Zingales, 2008). Basically what happened is Lehman took their assets secured by them loans, and then invested these loans in the property derivatives. So when the investments lost value Lehman had to pay high interest payments on the money they borrowed. This closed chain led to the cash shortage.

    The results of the professional independent audit were shocking for the ex-management team. The head managers were accused of being involved into risky financial operation and of fabricating the outstanding financial information. Moreover, personal auditing team of the Lehman Brothers – Ernst& Young – also was accused of falsifying the results of an annual verification (Steinberg, 2010). A situation with the Ernst & Young for the Lehman Brothers is the same as with the Arthur Andersen for the Enron Corporation. The auditing firm had an incentive to hide real information because being paid. If the real data would have come out everyone would be worse off. The company would lose the points in the stock exchange, and the audit firm would lose the major client and a “large number of zeroes”-contract.

    Wall Street suffered a lot during these two days when it lost two financial giants. We can’t actually blame people or government for it. Events of September 2008 is the tragic evidence of how far and deep the financial crisis has spread and that nobody is protected from the downfall, no matter if it is a small shop on the corner or financial giant like the Lehman Brothers.

      
 
 
 
 
 
 
 
 
 

References 
 

Auletta, Ken. (n/d). Greed and Glory on Wall Street: The Fall of the House of Lehman. Random House. 

BBC. (Sept 20, 2008) Judge approves $1.3bn Lehman deal. BBC News. Retrieved March 21, 2010 from: http://news.bbc.co.uk/2/hi/7626624.stm  

Geisst, Charles R.(2001) The Last Partnerships: Inside the Great Wall Street Dynasties. McGraw-Hill. 

McDonald, Lawrence, G. (Jul 2009). A Colossal Failure of Common Sense: The Inside Story of the Collapse of Lehman Brothers. Crown Business. 

Paulson, Henry. (Sep 15, 2008). Lehman Brothers Files for Bankruptcy, Scrambles to Sell Key Business. Retrieved March 21, 2010 from:

http://www.cnbc.com/id/26708143/Lehman_Brothers_Files_For_Bankruptcy_Scrambles_to_Sell_Key_Business 

Shirkhedkar, Jayant. (2007). Saving Lehman, One person at a time. McGraw-Hill. 

Sorkin, Andrew Ross. (Sept 14, 2008). Lehman Files for Bankruptcy; Merrill Is Sold. Retrieved March 20, 2010 from: http://www.nytimes.com/2008/09/15/business/15lehman.html?pagewanted=all  

Steinberg, Julie. (March 12, 2010) Ernst & Young’s Lehman Fallout. Fins.Retrieved March 20, 2010 from: http://www.fins.com/Finance/Articles/SB126841170848760949/Calculating-Ernst-Young-s-Lehman-Fallout 

Zingales, Luigi. (October, 2008). Causes and Effects of the Lehman Brothers Bankruptcy. United States House of Representatives. Retrieved March 20, 2010 from: http://www.scribd.com/doc/11096014/Causes-and-Effects-of-the-Lehman-Brothers-Bankruptcy