Lehman Brothers Case Study (Final)1 PDF

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Complete study of the demise of Lehman Brothers during the 2008 crisis....

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LEHMAN BROTHERS CASE STUDY

By Robert-Louis Jennings-Blanchet 6093945 Mads Axel Johansen 6097447 Bruno Minarrieta 6090819 Andres Obando 6090855

FIN 6446

1 –Fai l ur eAnal ysi s................................................................................................................................2 1.1 – Lehman Brothers’ Failure: Major Factors...........................................................................................2 1.2. – Who Stood to Benefit From the Implosion?......................................................................................3 1.3. – Lehman Brothers Vs Long Term Capital Management......................................................................4 1.4. – What Could Have Been Done Differently?........................................................................................4 2 –Risk Management................................................................................................................................4 2.1. – Lehman Brothers’ Risk Management................................................................................................4 2.2. – Lehman Brothers’ Risk Management Model Evaluation...................................................................5 2.3. – The “Repo 105” Scheme....................................................................................................................5 3 –Liquidity Crisis and Business Model of Investment Banks..............................................................6 3.1. – The Importance of Liquidity..............................................................................................................6 3.2. – Liquidity Analysis Alternatives for Liquidity Problems.....................................................................6 3.3. – Lessons Learned: Reflecting on the Investment Banks’ Business Model...........................................7 3.4. – Sustainability of “Pure-Play” Investment Banks................................................................................8 4 –Systemic Banking Crisis and Regulation...........................................................................................8 4.1. – Systemic Banking Crisis and Banking Contagion..............................................................................8 4.2. – The Fire-Wall.....................................................................................................................................8 5 –Feder alBai l outandPubl i cPol i cy..............................................................................................10 5.1. – Federal Bailout................................................................................................................................10 5.2. – Public Policy....................................................................................................................................12 6 –Financial Analysis..............................................................................................................................13 6.1. – Income Statement............................................................................................................................13 6.2. – Statement of Financial Condition....................................................................................................14 6.3. – Cash Flow Statement.......................................................................................................................15 6.4. – Financial Ratios...............................................................................................................................16 6.5. – Altman Z-Score Analysis.................................................................................................................17 6.6. – Conclusions.....................................................................................................................................17

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1 –Failure Analysis 1.1 – Lehman Brothers’ Failure: Major Factors The demise of Lehman Brothers (hereinafter LB) was the largest bankruptcy in U.S. history with a total of pre-filling assets of $691.1 billion, which is more than the next five bankruptcies on the list combined (Exhibit 1). There were multiple factors which contributed to the failure of LB. The two most fundamental were the company’s “high risk, high reward” culture and the overconfidence they had in their own abilities based on past performance. In the early 2000’s LB experienced exceptional growth relative to its closest competitors, from 2002 to 2005 LB increased their staff by 75% from 11,090 to 22,919 compared to their four closest competitors, which on average reduced their staff by 7.75% in the same period. The company was also able to increase its revenue by 138% through this period relative to an industry average of 51.5% (Exhibit 2). Based on the company’s strong prior performance, especially being able to grow in the market downturn in 2001-2002, the management in LB had the belief that they would be able to cope with any situation and continued to apply the strong growth strategy and disregarding their risk management policies and quantitative metrics. This belief was also strongly supported by the company’s CEO Dick Fuld, which had an aggressive strategy for the growth of the company’s international and equity business. LB was divided into three different segments; Capital Markets, Investment Banking and Investment Management. To continue this growth strategy, Lehman first invested in BNC Mortgage in 2000, which was a large originator of subprime mortgages in the United States and later acquired the whole company in 2004. Lehman had also founded Aurora in 1997, which was the largest issuer of the risky Alt-A loans, where there were less stringent requirements and higher loan-to-value ratios. These companies enabled LB to expand its securitization business, which contributed to more than 50% of the company’s revenue growth between 2001 to 2005. The Capital Markets segment was LB’s main source of revenue (Exhibit 3). It accounted for 84.96% of the company’s total gross revenue in 2005 and included the securitization business and equity investment. This revenue increased by $24.352 billion from 2005 to 2007, an 88.41% increase, indicating LB’s strong focus on growing its securitization business. The business model was able to produce high profits when the real estate values continued to increase, but in 2007 the market began showing weakness as delinquency rates began increasing. Even with the sign of a weakened market Lehman continued their growth strategy and purchased ArchestoneSmith for $22 billion, which was a REIT and one of the largest apartment owners in the United States. The company began experiencing the downturn in securitization market in the fourth quarter of 2007, as the company’s sale of commercial mortgages dropped from $15 billion in the prior quarter to $1.5 billion, leaving the company with an increased concentration of illiquid assets on the balance sheet. 2

Exhibit 4 shows the value of LB’s asset held in 2006 and 2007, and it can be seen how the company’s assets held in real estate increased dramatically in the one-year period. The holding of mortgage backed securities increased by more than $30 billion compared to the prior year, which was a 54.36% increase. One of the reasons for this increase was the company’s declining sales within the securitization business, as mentioned earlier. Also, the real estate held for sale increased by approximately 133% in only one year, which was a clear sign of the weakening of the real estate market and that more homeowners were beginning to default their loans, forcing LB to repossess the property and attempting to sell it themselves. As most investment banks Lehman Brother’s balance sheet was dominated by short-term liabilities and financed with long-term assets. This financing model required the business to be able to access the short-term markets and borrow large amounts of money to fund its assets, which required the market to maintain confidence in the company and the rating agencies to continue to give them a high credit rating. If the credit rating agencies were to downgrade the company it would increase the cost of debt and it could limit the company’s access to capital. In the first quarter of 2007, Lehman adopted SFAS 157, known as the Fair Value Rule, which required asset valued using different methods. SFAS 157 classified assets into three different categories, Level I, II and III. Level I assets were the most liquid and were based on market value. Level III assets were the most illiquid and the valuation was based on the management’s best estimate as it was difficult to get a market value. According to LB’s 2007 10-K statement, the company used two approaches for valuing Level III assets, which were income approach and cost approach. The income approach is based on the present value of future cash flows, while the cost approach bases its value on the replacement cost. Exhibit 5 shows the total value and weight of each level as of November 30, 2007. The Level III assets were valued at $41.979 billion and accounted for 14.42% of the total. The problem, which contributed to LB’S downturn, was that the company valued these assets at an unrealistic level, which hurt the company dramatically when creditors began losing faith in the valuation and asking for increased collaterals, forcing the company to file for chapter 11. 1.2. – Who Stood to Benefit From the Implosion? Multiple investors such as Warren Buffet, Bank of America and a Korean Development Bank looked at either investing in or acquiring the company, but all these deals fell apart. This was mainly due to the poor management and unwillingness to correctly value the company’s assets, which would have forced them to increase their write-downs. As mentioned, LB ended up filing for Chapter 11, which Barclays managed to take advantage of, as LB’S negotiation power decreased. Barclays purchased the company’s North American investment bank and capital markets operations for only $1.75 billion,

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excluding the illiquid real estate assets from the deal. With this deal, Barclays managed to firmly establish itself in the United States and is now the seventh-largest American investment bank based on revenue. 1.3. – Lehman Brothers Vs Long Term Capital Management Long-Term Capital Management (hereinafter LTCM) was a hedge fund created in 1993 by a former bond trader from Solomon Brothers. The notable piece about LTCM is that its primary shareholders were two Nobel laureates, Robert Merton and Myron Scholes. LTCM claimed they had a significantly better statistical model for realizing higher gains related to bonds. Due to the reputations of the founders and principal shareholders, LTCM received a lot of interest from investors, mainly banks and financial institutions. In its first two years, LTCM had a return on equity of 43% and 41%, respectively. They also received $7 billion in investment capital. LTCM typically made relative-value trades, in which a long position in a certain instrument is offset by a short position in another instrument of similar characteristics. These trades tend to offer lower returns and thus leverage had to be used to magnify the gains. However, leverage is both a magnifier of gains and losses. The phenomenon of leverage is what ultimately brought down LTCM. Due to the numerous investments made by various banks and financial institutions, LTCM was the focal point that could bring down the system, similar to how AIG could have brought down the system in 2008. The main difference between LTCM and LB, was the way in which the government choose to deal with each case. For LTCM the government decided to provide a bailout as it was seen that they could potentially bring down or significantly affect the rest of the system. Due to the sheer speed of the 2008 financial crisis, the government thought they had created a moral hazard by bailing out Bear Stearns. Because of this, the Fed felt it was important that the market saved a financial institution. LB ultimately was not bought out by its rivals and thus had to file for bankruptcy. 1.4. – What Could Have Been Done Differently? LB could have taken two different approaches that could have enabled it to avoid its fate. They could have taken a more conservative approach throughout the mid-2000’s and run the company in a healthier manner, but this was not in the company’s DNA. The other way would have been a more proactive approach, reducing risk exposure and listening to the warning signals, such as the real estate market weakening and their competitors filing for bankruptcy, closing down parts of their company and suffering large loses. The issue was with LB’S management unwillingness to accept the company’s situation. Many companies were interested in LB and the even received an offer to purchase 25% of the equity stake, which would have helped the company meeting its financial obligations. However, they were not willing to accept what they saw as low prices for the company’s assets. 2 –Risk Management 2.1. – Lehman Brothers’ Risk Management

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Instead of managing risk LB saw risk as an equivalent of return and embraced it. The company had risk management policies and quantitative metrics in place, but through the overconfidence of their executives and the focus on growth, the company decided not to listen to the warning signals. In a meeting between the finance and risk departments in January 2008, management suggested increasing the risk limits from $3.5 billion to $4.0 billion. This limit had already been increased two years before from $2.3 billion. As mentioned above, the company’s primary growth in revenue was from securitization and, therefore, they also decided to exceed its limits on commercial real estate and leveraged loans by over 70%. In 2007 the company ended up firing the Chief Risk Officer due to opposing views which signified the company’s management of risk. Lehman Brother, as many other banks, also had a stress test in place, which focused on different aspects of the banking risks in case of a hypothetical downturn. The company updated their stress test model at the beginning of 2008, excluding some of their riskiest assets, and after running 13 scenarios, the worst outcome was a $3.2 billion loss. This solidified the company’s lack of internal control when it came to risk management during the crisis. LB had all the right tools in place to help them manage risk but decided not to use them. 2.2. – Lehman Brothers’ Risk Management Model Evaluation LB was able to achieve a tremendous growth through the market downturn in 2001 and 2002 as the company continued with an aggressive strategy instead of taking a more conservative approach, as their competitors did. The company increased its market cap by 132% from 2002 to 2005, which was strongly fueled by its risk seeking approach, compared to the company’s closest competitors that only grew 53.5% in the same period (Exhibit 2). The company also began to increase its exposure to the popular securitization business with the acquisition of BNC Mortgage in 2004 and being one of the primary Alt-A providers. The approach continued to work for the company as it reported record earnings of $4 billion in 2007 on a $60 billion dollars’ revenue. Based on this timeline the company would be perceived as a highly risky company, but nothing abnormal compared to other investment banks within the same industry also trying to take advantage of the rapid market growth in the early 2000’s. The company’s stock also grew from approximately $35 at the beginning of January 2002 to approximately $85 by the end of 2007. By then, the company’s private equity portfolio consisted of 41% of real estate related assets, which would at this point be seen as an unnecessary risk, needing a dramatic reallocation of assets to bring it to a reasonable level. 2.3. – The “Repo 105” Scheme With LB downgrade in credit rating and continuous need for financing their long-term assets, the company attempted to reduce its overall risk profile. In order to do this, the company did what they internally called “Repo 105,” which was an accounting scheme using repurchase agreements. LB entered 5

into agreements with European banks where they would sell assets and agree to repurchase them at a fixed date in the future. When the value of the assets was at least 105% of the cash received it would be treated as a sale and LB could use the cash to bring down its overall debt. Exhibit 6 shows how the company’s cash and cash equivalents sharply increased, by 65.83%, between 2006 and 2007, which these “Repo 105” contributed to. This maneuver enabled LB to appear less risky, as the company reported a net leverage ratio of 12.1x for the second quarter of 2008, where in reality the true net leverage ratio was at least 13.9x. By having a lower leverage, the company could access capital at lower interest rates. This was necessary as it had to pay back the banks in Europe while continuing to finance its growing balance sheet of illiquid assets. Exhibit 7 shows how LB’s interest expenses had been rapidly increasing over the most recent years from $17.79 billion in 2005 to 39.746 billion in 2007, which is a 123.42% increase. 3 –Liquidity Crisis and Business Model of Investment Banks 3.1. – The Importance of Liquidity The financial crisis was, in part, caused by liquidity problems. Mortgage and mortgage-backed securities started to fail, credit markets froze and banks stopped lending one another. Investment Banks were unable to turn their assets into cash and, without other banks to rely upon for cash needs, they started to fail to answer their liability holders’ claims, resulting in a widespread liquidity crisis. The role of sufficient liquidity is to make sure that banks can meet their financial obligations when they become due. It is of paramount importance given that without it, banks could miss out on loan requests and investment opportunities, while falling into solvency problems, which can lead to reputational damage or even bankruptcy. 3.2. – Liquidity Analysis Alternatives for Liquidity Problems As seen in the financial analysis at the end of this report, LB’s balance sheet was vastly dominated by long-term investments and short-term funding with an average current ratio of 0.13, which made them extremely dependent on the credit market and vulnerable to liquidity risks. Once the counterparts denied LB their daily borrowings, they were unable to operate. This situation could have been avoided at the early stages, or at least softened, if they had started to sell troubled assets instead of moving forward with their so-called “growth strategy”, which forced them to override their risk limits. Another key aspect of LB’s liquidity problems was the sky-high leverage ratios that the company had been maintaining for years after the crisis. The importance of this lies on the amplifier effect that it has on the consequences of the other risks the company has to face. As the worst possible scenarios came true in terms of market, credit, liquidity, operational and reputational risks, the leverage made the fall inevitable. The financial analysis shows that by the end of 2007, LB had a financial leverage ratio of

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almost 31x, more than twice the value required by US regulations, which means that roughly 3% of the company’s assets were financed by shareholder’s equity. A more flexible leverage level could have helped lower the damage made by the poor performance of the mortgage-backed securities and the decrease in the housing prices. They tried to make their way into reducing the financial leverage by issuing preferred stocks in 2008, but such flexibility couldn’t be achieved overnight. Before LB suffered the effects of the crisis, they should have tried to raise capital gradually and reduce liabilities, aiming for a low and sustainable leverage ratio. Even though it could’ve affected the profitability of the company, they would’ve done a better job at managing the risk. Another measure that could’ve made the situation less severe was to stop issuing bad quality loans and securitizing the...