Mike’s Monday Blog
I’m sure the last thing you want to read is something discussing COVID-19; I know I certainly fall into that category. It’s been a hectic couple of weeks to say the least, but we won’t be discussing that in this week’s blog. To put a lid on it however, my views have not changed since then, even with the markets going further in the red. If you are interested in reading that piece, click here.
Throughout client calls and meetings since the outbreak, questions have been asked on whether it's accurate equating what's happening now to the 2008 financial crisis. I wanted to re-share a previous post (and old college essay) on the 2008 crisis, and the investment bank Lehman Brothers, so you can understand the differences between a fundamental financial/monetary issues versus a viral outbreak. Although the two may seem similar on the face of it, they are quite different when it comes down to brass tacks. I hope you enjoy.
September 15, 2008 marked the largest bankruptcy filing in United States history (Investopedia, 2008). The fourth largest investment bank at the time, Lehman Brothers Holdings, Inc., filed for Chapter 11 bankruptcy. This solidified people’s beliefs that the state of the U.S. economy was in true turmoil. However, before the firm collapsed in dramatic fashion, it was one of the most respected and well-known banks on Wall Street.
Three German immigrant brothers founded Lehman Brothers: Henry, Emanuel, and Mayer Lehman in Montgomery, Alabama in 1844 (H.B.S., 2012). Initially designed as a general merchandising business, it was later morphed into a commodities broker that specialized in the buying and selling of cotton. In the year 1858, Lehman Brothers opened its first New York office for the purpose of gaining a larger presence in the financial community (H.B.S., 2012). Following the end of the Civil War, Lehman moved its headquarters to New York City and became heavily involved in the commodities business. In the early 1900’s, underwritings for initial public offerings became a larger part of their business. In 1906, Lehman partnered with Goldman Sachs to help take Sears, Roebuck and Company public.
In May of 1925, Robert Lehman took over the firm and successfully guided them through the Great Depression by focusing more so on venture capital projects and less so on the equity markets (Wikipedia, 2015).
Jumping into the 1980’s, Lehman Brothers (and other financial institutions) gravitated towards the age of computers and information technology. Lehman, in particular, backed companies such as Intel and became engrained in the technological advancement of personal computers. With the introduction of computers for their everyday operations, the firm moved deeper into financial markets by trying to profit off the daily fluctuations. Their trading operations expanded and became a greater importance to their revenue stream. In 1984 the massive credit card company, American Express, bought Lehman Brothers. However, their cohesiveness ended when American Express separated from the firm, and Lehman once again became an independent operation (H.B.S., 2012).
Richard (Dick) Fuld, Jr. became CEO of Lehman Brothers in 1994. A hard-nose, strict, win-at-all-costs personality drove Lehman into projects and areas where the potential returns were very lucrative (but also risky in the long run). Mr. Fuld wanted to “eviscerate the competition” at all costs. One Lehman secretary described Fuld’s behavior as repulsive. She said Dick would never acknowledge her when she said good morning and rarely gave people of lower rank any attention.
Lehman at the time was a very respectable firm on Wall Street, but the likes of Goldman Sachs, Morgan Stanley and Bear Stearns were slightly larger operations in comparison. During the 1990’s and early 2000’s, Lehman Brothers’ bond index was perhaps the best there was. It was equivalent to the Dow Jones Industrial Average for stocks (H.B.S., 2012). However, Dick wanted more from the firm, and by 2005, Lehman was the largest underwriter of subprime mortgage-backed securities (Stewart, 2009). Fuld’s competitiveness inevitably got the best of him. In the end of September 2008, he was the scapegoat for the American people and everything that was wrong with Wall Street’s unrelenting greed. The mortgage crisis was well and truly underway, and the resulting impact it had on the global economy is something we have never seen prior to its occurrence, and hopefully, something we will never see again.
Lehman Brothers’ 2005 and 2006 fiscal year earnings were record breaking. Their heavily weighted investments in the housing market were paying off handsomely. Collateralized Debt Obligations (CDO’s) were a type of security where mortgage issuers would bundle different types of mortgages from all across the country and sell them to different investment banks and other institutions. During this time, the regulatory agencies were extremely lax when it came to governing the issuance of mortgages. It was so bad that issuers of mortgages would not even require applicants to disclose their annual income. Mortgage issuers would often give the option for what would later be called ‘teaser rates’. This was sneaky on the issuer’s side because they would entice those who couldn’t usually afford a larger home with a surprisingly low interest rate. The issuer would then bundle the assortment of mortgages into a security and sell it to Wall Street firms for a premium, in effect making a double profit on the mortgages they issued. However, the mortgage’s teaser rates grew larger and the required payments per month began to increase accordingly. Most homebuyers were naïve and did not give themselves enough of a buffer in terms of their affordability. They would buy more expensive homes and have difficulty making the payments if/when their interest rate rose. This practice created a huge demand for homebuyers and the housing market was booming.
In the world of finance, the number one thing you need to control is risk. Having protection from downside risk is a massive part of what smart investing is all about. Credit Default Swaps (CDS) were created to hedge (taking an opposite position to reduce exposure and risk) against the possibility of homeowners failing to pay their mortgages. Essentially, a CDS bets against the mortgages in a CDO.
During the next year, in 2007, the Dow Jones Industrial Average (DJIA) peaked at 14,093 and housing prices were at an all-time high. Everything seemed to be going so well, and then suddenly took a turn for the worst.
Cracks began appearing in the monthly housing numbers beginning in the summer of 2007. By March of 2008, the investment bank Bear Stearns was in trouble. The firm was too highly levered (investing with borrowed money) in the housing market. The government had to step in with a $29 billion bailout for their troubled assets. The U.S. government also assisted in the merger of two investment bank titans: JP Morgan Chase and the troubled Bear Stearns (Stewart, 2009). Investors were assured that issues with mortgage-backed securities were now contained and no other firms faced the same debacle. Lehman Brothers reiterated this on their quarterly conference call on March 14, 2008. They stated that they weren’t as highly levered as the other investment banks in the housing markets. Later that year, in September, the mortgage agencies Fannie Mae and Freddie Mac were in trouble. The government had to inject $200 billion in capital to help keep the two private companies from going under. This solidified investor’s previous suspicions that there was legitimate systemic risk in the housing market. The stocks of the financial companies were declining at a steady clip since the Bear Stearns situation in March, but once the Fannie and Freddie situation became known to the public, investors knew the entire housing market was in serious disarray. Panic engulfed the market and investors were dumping everything that involved mortgage-backed securities. Lehman, Goldman, Morgan Stanley and Merrill all experienced enormous volumes of selling for weeks on end.
After the markets closed on Friday September 12, all of the executives of the major banks, Hank Paulson (the Secretary of the Treasury), Tim Geithner (President of the New York Federal Reserve), and Ben Bernanke (Chairman of the Federal Reserve) gathered at the New York Federal Reserve just around the block from the New York Stock Exchange (Stewart, 2009). Their mission was to save Lehman Brothers from bankruptcy, and the world from a global financial meltdown. They had until the opening bell at 9:30 on Monday morning to devise a plan to tackle this behemoth of an issue. Lehman Brothers had the nominal value of all of their assets on their balance sheet valued at $640 billion. With that being said, the company had a leverage ratio of over 30:1. This means that for every dollar they actually possessed, they borrowed thirty dollars on credit. The main issue with this is that the value their mortgage-backed securities were rapidly becoming worthless and the amount they were truly losing was amplified thirty times.
All the while, Lehman’s CEO Dick Fuld was confident that the assembled group would come up with a solution in which Lehman would either be bought out by another firm, or would be the recipient of a government bailout. Amazingly, Fuld had multiple opportunities to remedy their situation in the winter/spring of 2008, but thought that Lehman was ‘too big to fail’. “He had had months to find a buyer and hadn’t done so” (Stewart, 2009). The British bank Barclays were Lehman’s last hope, but the British government would not accept the merger due to the amount of debt from Lehman’s balance sheet that would have to be absorbed by the British taxpayers.
Throughout the weekend, the assembled men tried everything they could, but to no avail. On late Sunday night, September 14, 2008 (on my birthday no-less), Lehman Brothers Holdings, Inc. filed for Chapter 11 bankruptcy. This was an utter embarrassment, personally, for CEO Dick Fuld. To have multiple opportunities to sell the companies when the stock price was in the $40’s and to now have the stock literally trading for pennies on the dollar was a hard thing to swallow to say the least.
There were three large legal issues throughout the fall of Lehman Brothers. First was the security interest. Security interest is the interest in the collateral, whether it is personal property, fixtures, or accounts (Cengage). “It gives the creditor added protection that the debt will be paid, and if it is not, they can exercise remedies with regard to their collateral” (Cengage). Lehman Brothers did not live up to their agreements with their creditors. They piled the amount they owed to creditors onto their balance sheet with seemingly no thought of the potential for a downturn in their investments. This all comes back to protecting or hedging your investments from downside risk. The result of this was that once they filed their Chapter 11, all of the firm’s doors would be locked and all of the remaining assets would be seized (for the creditors) the next day. Employees had only a few hours to go into their office(s) and gather their personal belongings.
The second legal issue slightly ties into the third issue, which is of course the involuntary bankruptcy itself, and the fiduciary duty Lehman’s executives (and particularly Fuld) had to the company’s shareholders. Somehow, throughout their record-breaking quarters and large executive bonuses and compensations, they forgot that they work for the shareholders and not the other way around. They untruthfully reinforced their optimism with regards to their leverage ratio, which can be considered fraud. Their ratio was well over 30:1 while they knowingly and falsely claimed that their competitors had much higher debt. Goldman Sachs, for example, were levered less than 20:1 and protected themselves from the potential of such a downturn, which is partly the reason why they are still in existence today.
With regards to the five paths of a firm’s legal strategy, Lehman Brothers is without doubt classified under stage one: Avoidance. Their legal department was rarely involved in their managerial decisions, and the negative implications that came with their final decision. For stage one: avoidance, “Legal counsel serves primarily in an emergency role… Avoidance behavior is not strategy, but a cost-cutting measure” (Bird, 2008). Lehman’s lawyers were seldom used throughout the infamous weekend. The representing lawyers only had a worthwhile role when the firm had to file the bankruptcy on Sunday night.
Lehman Brothers was one of the most respected financial institutions in the world. They had billions and billions of dollars under management and were quite successful. The breadth of their investments was impressive and their portfolios were well diversified. This was of course before they dove head first into the subprime mortgage-backed security market. All the large financial companies had their hands in the mortgage market, but Lehman overextended their exposure and got burned at the worst possible time. One could write another six plus pages as to what Lehman Brothers could have done differently, but the main points are (1) keeping the amount of leverage to a workable level (2) being truthful when discussing their bad situation (3) if Dick Fuld did what was best for the shareholders.
Their legal strategy could have been better as well. Lehman could have used their legal team a lot more in all areas of their business. Due to their stage one position, anything could have been better as opposed to how they really utilized their legal department. Simply asking what kinds of implications are involved in a particular project and how that would affect their long-term operations would have saved a lot of time, money, lost jobs, and perhaps prevented a near global collapse of the financial markets. Lehman’s collapse should set a precedent for future companies that are contemplating or implemented policies that do not fully utilize legal strategy. Although it is a cost-saving measure in the short-term, the long-term negative ramifications far outweigh the money initially saved; Lehman Brothers found this out the hard way and will never get a second chance.
I want to extend a big thank you for taking the time and reading my weekly blog. If you have any questions or would like to schedule a sit-down meeting to discuss more of your financial future, please contact me at 610-374-6249 x114 or visit my website mlistmeier.wradvisors.com
- "Case Study: The Collapse of Lehman Brothers." Investopedia. N.p., 30 Oct. 2008. Web. 22 Nov. 2015.
- "Chapter 31 - Bankruptcy." Business Law. N.p.: n.p., n.d. N. pag. Cengage.com. Web. 2 Dec. 2015.
- "Lehman Brothers Collection." History of Lehman Brothers. Harvard Business School, 2012. Web. 22 Nov. 2015.
- Stewart, James B. "Eight Days - The New Yorker." The New Yorker. N.p., 21 Sept. 2009. Web. 23 Nov. 2015.
- Photo credit - https://unsplash.com/s/photos/stock-market
This is meant for educational purposes only. It should not be considered investment advice, nor does it constitute a recommendation to take a particular course of action. Please consult with a financial professional regarding your personal situation prior to making any financial related decisions. (03/20)