What goes up but never comes down?
Lehman Brothers filed for bankruptcy on September 15, 2008. Hundreds of employees, mostly dressed in business suits, left the bank's offices one by one with boxes in their hands. It was a somber reminder that nothing is forever—even in the richness of the financial and investment world.
At the time of its collapse, Lehman was the fourth-largest investment bank in the United States with 25,000 employees worldwide. The bank became a symbol of the excesses of the 2007-08 Financial Crisis, engulfed by the subprime meltdown that swept through financial markets and cost an estimated $10 trillion in lost economic output.
Lehman Brothers History
Lehman Brothers had humble origins, tracing its roots to a general store founded by German brothers Henry, Emanuel, and Mayer Lehman in Montgomery, Alabama, in 1844. Farmers paid for their goods with cotton, which led the company into the cotton trade. After Henry died, the other Lehman brothers expanded the scope of the business into commodities trading and brokerage services.
The firm prospered over the following decades as the U.S. economy grew into an international powerhouse. But Lehman faces plenty of challenges over the years. The company survived the railroad bankruptcies of the 1800s, the Great Depression, two world wars, a capital shortage when it was spun off by American Express in 1994 in an initial public offering, and the Long Term Capital Management collapse and Russian debt default of 1998.
Despite its ability to survive past disasters, the collapse of the U.S. housing market ultimately brought Lehman to its knees, as its headlong rush into the subprime mortgage market proved to be a disastrous step.
The Prime Culprit
The company, along with many other financial firms, branched into mortgage-backed securities and collateral debt obligations. In 2003 and 2004, with the U.S. housing bubble well underway, Lehman acquired five mortgage lenders along with BNC Mortgage and Aurora Loan Services, which specialized in Alt-A (ninja) loans. These loans were made to borrowers without full documentation.
At first, Lehman's acquisitions seemed prescient. Lehman's real estate business enabled revenues in the capital markets unit to surge 56% from 2004 to 2006. The firm securitized $146 billion of mortgages in 2006—a 10% increase from 2005. Lehman reported record profits every year from 2005 to 2007. In 2007, it announced $4.2 billion in net income on $19.3 billion in revenue.
The Colossal Miscalculation
In February 2007, Lehman's stock price reached a record $86.18 per share, giving it a market capitalization of nearly $60 billion. But by the first quarter of 2007, cracks in the U.S. housing market were already becoming apparent. Defaults on subprime mortgages began to rise to a seven-year high. On March 14, 2007, a day after the stock had its biggest one-day drop in five years on concerns that rising defaults would affect Lehman's profitability; the firm reported record revenues and profit for its fiscal first quarter. Following the earnings report, Lehman said the risks posed by rising home delinquencies were well contained and would have little impact on the firm's earnings.
The Beginning of the End
Lehman's stock fell sharply as the credit crisis erupted in August 2007 with the failure of two Bear Stearns hedge funds. During that month, the company eliminated 1,200 mortgage-related jobs and shut down its BNC unit. It also closed the offices of Alt-A lender Aurora in three states. Even as the correction in the U.S. housing market gained momentum, Lehman continued to be a major player in the mortgage market.
In 2007, Lehman underwrote more mortgage-backed securities than any other firm, accumulating an $85 billion portfolio, or four times its shareholders' equity. In the fourth quarter of 2007, Lehman's stock rebounded, as global equity markets reached new highs and prices for fixed-income assets staged a temporary rebound. However, the firm did not take the opportunity to trim its massive mortgage portfolio, which in retrospect, would turn out to be its last chance.
Hurling Toward Failure
In 2007, Lehman's high degree of leverage was 31, while its large mortgage securities portfolio made it highly susceptible to the deteriorating market conditions. On March 17, 2008, due to concerns that Lehman would be the next Wall Street firm to fail following Bear Stearns' near-collapse, its shares plummeted nearly 48%.
By April, after an issue of preferred stock—which was convertible into Lehman shares at a 32% premium to its concurrent price—yielded $4 billion, confidence in the firm returned somewhat. However, the stock resumed its decline as hedge fund managers began to question the valuation of Lehman's mortgage portfolio.
On June 7, 2008, Lehman announced a second-quarter loss of $2.8 billion, its first loss since it was spun off by American Express, and reported that it raised another $6 billion from investors by June 12.
According to David P. Belmont, "The firm also said it 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."
Too Little, Too Late
These measures were perceived as being too little, too late. Over the summer, Lehman's management made unsuccessful overtures to a number of potential partners. The stock plunged 77% in the first week of September 2008, amid plummeting equity markets worldwide, as investors questioned CEO Richard Fuld's plan to keep the firm independent by selling part of its asset management unit and spinning off commercial real estate assets. Hopes that the Korea Development Bank would take a stake in Lehman were dashed on September 9, as the state-owned South Korean bank put talks on hold.
The devastating news leads to a 45% drop in Lehman's stock, along with the firm's debt suffering a 66% increase in credit-default swaps. Hedge fund clients began abandoning the company, with short-term creditors the following suit. Lehman's fragile financial position was best emphasized by the pitiful results of its September 10 fiscal third-quarter report.
Facing a $3.9 billion loss, which included a $5.6 billion write-down, the firm announced an extensive strategic corporate restructuring effort. Moody's Investor Service also announced that it was reviewing Lehman's credit ratings, and it found that the only way for Lehman to avoid a rating downgrade would be to sell a majority stake to a strategic partner. By September 11, the stock had suffered another massive plunge (42%) due to these developments.
With only $1 billion left in cash by the end of that week, Lehman was quickly running out of time. Over the weekend of September 13, Lehman, Barclays, and Bank of America made a last-ditch effort to facilitate a takeover of the former, but they were ultimately unsuccessful. On Monday, September 15, Lehman declared bankruptcy, resulting in the stock plunging 93% from its previous close on September 12.
Too Little, Too Late
The Bottom Line
Lehman's collapse roiled global financial markets for weeks, given its size and status in the U.S. and globally. At its peak, Lehman had a market value of nearly $46 billion, which was wiped out in the months leading up to its bankruptcy.
The government let Lehman fail yet provided tacit support for Bear Stearns, which was acquired by JPMorgan Chase in March 2008. Bank of America had been in talks to buy Lehman but backed away after the government refused to help with Lehman's most troubled assets. Instead, Bank of America announced it would buy Merrill Lynch on the same day Lehman filed for bankruptcy.
The legendary investor Jim Rogers once said: ‘If you bail out every investment bank that gets in trouble, that's not capitalism, that's socialism for the rich.’ Every investment bank without Lehman however... Please stand corrected Jim... And next time – who knows?...
Pride goeth before the fall:
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