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On September 15, 2008, Lehman Brothers filed for bankruptcy. With $639 billion in assets and $619
billion in debt, Lehman's bankruptcy filing was the largest in history, as its assets far surpassed those of
previous bankrupt giants such as WorldCom and Enron. Lehman was the fourth-largest U.S. investment
bank at the time of its collapse, with 25,000 employees worldwide. Lehman's demise also made it the
largest victim, of the U.S. subprime mortgage-induced financial crisis that swept through global financial
markets in 2008. Lehman's collapse was a seminal event that greatly intensified the 2008 crisis and
contributed to the erosion of close to $10 trillion in market capitalization from global equity markets in
October 2008, the biggest monthly decline on record at the time. (For more information on the subprime
meltdown, read r




 
Ñ


 


Lehman Brothers had humble origins, tracing its roots back to a small general store that was founded by
German immigrant Henry Lehman inMontgomery, Alabama, in 1844. In 1850, Henry Lehman and his
brothers, Emanuel and Mayer, founded Lehman Brothers.

While the firm prospered over the following decades as the U.S. economy grew into an international
powerhouse, Lehman had to contend with plenty of challenges over the years. Lehman survived them all
± the railroad bankruptcies of the 1800s, the Great Depression of the 1930s, two world wars, a capital
shortage when it was spun off by American Express in 1994, and the Long Term Capital
Management collapse and Russian debt default of 1998. However, despite its ability to survive past
disasters, the collapse of theU.S. housing market ultimately brought Lehman Brothers to its knees, as its
headlong rush into the subprime mortgage market proved to be a disastrous step. (To learn more about
previous financial disasters, be sure to check out our 
 


.Ñ

c 
In 2003 and 2004, with the U.S. housing boom (read, bubbleÑ well under way, Lehmanacquired five
mortgage lenders, including subprime lender BNC Mortgage and Aurora Loan Services, which
specialized in Alt-A loans (made to borrowers without full documentationÑ. Lehman's acquisitions at first
seemed prescient; record revenues from Lehman's real estate businesses enabled revenues in the
capital markets unit to surge 56% from 2004 to 2006, a faster rate of growth than other businesses in
investment banking or asset management. 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, the firm
reported net income of a record $4.2 billion on revenue of $19.3 billion. (Check out the answer to our
frequently asked question r 


 to learn more about these loans.Ñ

 
c 


  
In February 2007, the stock reached a record $86.18, giving Lehman a market capitalizationof close to
$60 billion. However, by the first quarter of 2007, cracks in the U.S. housing market were already
becoming apparent as defaults on subprime mortgages rose 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. In the post-
earnings conference call, Lehman's chief financial officer (CFOÑ said that the risks posed by rising home
delinquencies were well contained and would have little impact on the firm's earnings. He also said that
he did not foresee problems in the subprime market spreading to the rest of the housing market or hurting
the U.S. economy.



As the credit crisis erupted in August 2007 with the failure of two Bear Stearns hedge funds, Lehman's
stock fell sharply. During that month, the company eliminated 2,500 mortgage-related jobs and shut down
its BNC unit. In addition, it also closed 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. (Read more in r



 




.Ñ

 
   
Lehman's high degree of leverage - the ratio of total assets to shareholders equity - was 31 in 2007, and
its huge portfolio of mortgage securities made it increasingly vulnerable to deteriorating market
conditions. On March 17, 2008, following the near-collapse of Bear Stearns - the second-largest
underwriter of mortgage-backed securities - Lehman shares fell as much as 48% on concern it would be
the next Wall Street firm to fail. Confidence in the company returned to some extent in April, after it raised
$4 billion through an issue of preferred stock that was convertible into Lehman shares at a 32% premium
to its price at the time. However, the stock resumed its decline as hedge fund managers began
questioning the valuation of Lehman's mortgage portfolio.

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. (Read 


 



 to learn more about the
double-edged sword of leverage.Ñ

 
 
However, 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 news was a deathblow to Lehman, leading to a 45% plunge in the stock and a 66% spike in credit-
default swaps on the company's debt. The company's hedge fund clients began pulling out, while its
short-term creditors cut credit lines. On September 10, Lehman pre-announced dismal fiscal third-quarter
results that underscored the fragility of its financial position. The firm reported a loss of $3.9 billion,
including a write-down of $5.6 billion, and also announced a sweeping strategic restructuring of its
businesses. The same day, Moody's Investor Service announced that it was reviewing Lehman's credit
ratings, and also said that Lehman would have to sell a majority stake to a strategic partner in order to
avoid a rating downgrade. These developments led to a 42% plunge in the stock on September 11.

With only $1 billion left in cash by the end of that week, Lehman was quickly running out of time. Last-
ditch efforts over the weekend of September 13 between Lehman, Barclays PLC and Bank of America,
aimed at facilitating a takeover of Lehman, were unsuccessful. On Monday September 15, Lehman
declared bankruptcy, resulting in the stock plunging 93% from its previous close on September 12.
c 

Lehman's collapse roiled global financial markets for weeks, given the size of the company and its status
as a major player in the U.S. and internationally. Many questioned the U.S. government's decision to let
Lehman fail, as compared to its tacit support for Bear Stearns (which was acquired by JPMorgan ChaseÑ
in March 2008. Lehman's bankruptcy 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. (To learn more about the financial crisis,
read 
 !"#

$%Ñ

When the Wall Street evangelists started preaching "no bailout for you" before the collapse of British bank
Northern Rock, they hardly knew that history would ultimately have the last laugh. With the onset of the
global credit crunch and the fall of Northern Rock, August 2007 turned out to be just the starting point for
big financial landslides. Since then, we have seen many big names rise, fall, and fall even more. In this
article, we'll recap how the financial crisis of 2007-08 unfolded. (For further reading, see r





 
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Like all previous cycles of booms and busts, the seeds of the subprime meltdown were sown during
unusual times. In 2001, the U.S.economy experienced a mild, short-livedrecession. Although the
economy nicely withstood terrorist attacks, the bust of thedotcom bubble, and accounting scandals, the
fear of recession really preoccupied everybody's minds. (Keep learning about bubbles in r )

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To keep recession away, the Federal Reservelowered the Federal funds rate 11 times - from 6.5% in May
2000 to 1.75% in December 2001 - creating a flood of liquidity in the economy. Cheap money, once out of
the bottle, always looks to be taken for a ride. It found easy prey in restless bankers - and even more
restless borrowers who had no income, no job and no assets. These subprime borrowers wanted to
realize their life's dream of acquiring a home. For them, holding the hands of a willing banker was a new
ray of hope. More home loans, more home buyers, more appreciation in home prices. It wasn't long
before things started to move just as the cheap money wanted them to.

This environment of easy credit and the upward spiral of home prices made investments in higher yielding
subprime mortgages look like a new rush for gold. The Fed continued slashing interest rates,
emboldened, perhaps, by continued low inflation despite lower interest rates. In June 2003, the Fed
lowered interest rates to 1%, the lowest rate in 45 years. The whole financial market started resembling a
candy shop where everything was selling at a huge discount and without any down payment. "Lick your
candy now and pay for it later" - the entire subprime mortgage market seemed to encourage those with a
sweet tooth for have-it-now investments. Unfortunately, no one was there to warn about the tummy aches
that would follow. (For more reading on the subprime mortgage market, see ourSubprime
Mortgages special feature.Ñ

But the bankers thought that it just wasn't enough to lend the candies lying on their shelves. They decided
to repackage candy loans into collateralized debt obligations (CDOsÑ and pass on the debt to another
candy shop. Hurrah! Soon a big secondary market for originating and distributing subprime loans
developed. To make things merrier, in October 2004, theSecurities Exchange Commission (SECÑ relaxed
the net capital requirement for five investment banks - Goldman Sachs (NYSE:GSÑ, Merrill Lynch
(NYSE:MERÑ, Lehman Brothers, Bear Stearns and Morgan Stanley (NYSE:MSÑ - which freed them
to leverage up to 30-times or even 40-times their initial investment. Everybody was on a sugar high,
feeling as if the cavities were never going to come.



But, every good item has a bad side, and several of these factors started to emerge alongside one
another. The trouble started when the interest rates started rising and home ownership reached a
saturation point. From June 30, 2004, onward, the Fed started raising rates so much that by June 2006,
the Federal funds rate had reached 5.25% (which remained unchanged until August 2007Ñ.

r



There were early signs of distress: by 2004, U.S. homeownership had peaked at 70%; no one was
interested in buying or eating more candy. Then, during the last quarter of 2005, home prices started to
fall, which led to a 40% decline in the U.S. Home Construction Index during 2006. Not only were new
homes being affected, but many subprime borrowers now could not withstand the higher interest rates
and they started defaulting on their loans.

This caused 2007 to start with bad news from multiple sources. Every month, one subprime lender or
another was filing for bankruptcy. During February and March 2007, more than 25 subprime lenders filed
for bankruptcy, which was enough to start the tide. In April, well-known New Century Financial also filed
for bankruptcy.





Problems in the subprime market began hitting the news, raising more people's curiosity. Horror stories
started to leak out.

According to 2007 news reports, financial firms and hedge funds owned more than $1 trillion in securities
backed by these now-failing subprime mortgages - enough to start a global financial tsunami if more
subprime borrowers started defaulting. By June, Bear Stearns stopped redemptions in two of its hedge
funds and Merrill Lynch seized $800 million in assets from two Bear Stearns hedge funds. But even this
large move was only a small affair in comparison to what was to happen in the months ahead.

-
 !!" 
 


It became apparent in August 2007 that the financial market could not solve the subprime crisis on its
own and the problems spread beyond the United State's borders. The interbank market froze completely,
largely due to prevailing fear of the unknown amidst banks. Northern Rock, a British bank, had to
approach the Bank of England for emergency funding due to a liquidity problem. By that time, central
banks and governments around the world had started coming together to prevent further financial
catastrophe.

 
 ( 


The subprime crisis's unique issues called for both conventional and unconventional methods, which
were employed by governments worldwide. In a unanimous move, central banks of several countries
resorted to coordinated action to provide liquidity support to financial institutions. The idea was to put the
interbank market back on its feet.

The Fed started slashing the discount rate as well as the funds rate, but bad news continued to pour in
from all sides. Lehman Brothers filed for bankruptcy, Indymac bank collapsed, Bear Stearns was acquired
by JP Morgan Chase (NYSE:JPMÑ, Merrill Lynch was sold to Bank of America, and Fannie Mae and
Freddie Mac were put under the control of the U.S. federal government.

By October 2008, the Federal funds rate and the discount rate were reduced to 1% and 1.75%,
respectively. Central banks in England, China, Canada, Sweden, Switzerland and theEuropean Central
Bank (ECBÑ also resorted to rate cuts to aid the world economy. But rate cuts and liquidity support in itself
were not enough to stop such a widespread financial meltdown.

The U.S. government then came out with National Economic Stabilization Act of 2008, which created a
corpus of $700 billion to purchase distressed assets, especially mortgage-backed securities. Different
governments came out with their own versions of bailout packages, government guarantees and outright
nationalization.

c

c-- 

The financial crisis of 2007-08 has taught us that the confidence of the financial market, once shattered,
can't be quickly restored. In an interconnected world, a seeming liquidity crisis can very quickly turn into a
solvency crisis for financial institutions, a balance of payment crisis for sovereign countries and a full-
blown crisis of confidence for the entire world. But the silver lining is that, after every crisis in the past,
markets have come out strong to forge new beginnings.
„





 









 

 

 



 
 

 


 


  

 







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» Understand the reasons that led to the subprime crisis in the US and its impact on financial institutions.

» Analyze the aggressive strategies that Lehman Brothers followed in the mortgage business.

» Study the role of leadership at Lehman Brothers behind the company's rise and subsequent collapse.

» Appreciate the significance of risk management and the drawbacks of excessive leverage.

» Examine the innovations in financial instruments primarily derivatives.

» Analyze the consequences of lack of supervision on OTC derivatives and mortgage lending mechanism in the US.

» Debate on the role played by the US policy makers for adopting liberal credit driven economic growth policy that
eventually led to the subprime crisis.

c

Page No.

Introduction 1

The Subprime Crisis 2

The Fall of Lehman 5

Fuld - Victim or Culprit? 10

What Went Wrong? 11

The Fed's Decision? 13

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èowever, on September 10, 2008, Lehman again reported a net loss of US$ 3.9 billion (after provisioning for US$ 5.6
billion in write-downs) for the third quarter ending August 2008 (Refer to Exhibit I for the financial highlights of
Lehman Brothers between 2003 and 2007). To turn around its operations, the bank announced a restructuring plan
that intended to sell a majority stake in its investment management business (Refer to Exhibit II for the business
segments of Lehman Brothers). The plan also included spinning off a majority of its remaining commercial real estate
holdings that had gone bad, into a new public limited company.

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rhile many analysts attributed different reasons for the collapse of Lehman, most of them agreed that the then
ongoing subprime crisis was a root cause. Analysts claimed that the move by JP Morgan Chase (JP Morgan)7 to
freeze Lehman's assets days before the bank filed for bankruptcy was one of the factors responsible for Lehman's
collapse.

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Analysts felt that Fuld was riding high on his success and was aggressively conducting business to attain the top slot
in the investment banking business...
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Industry experts blamed the subprime crisis and the resultant collapse of Lehman Brothers on the global
macroeconomic imbalance that the US had created. The US economy had a savings rate close to zero in 2007.
Experts opined that with the huge fiscal deficit and balance of payment deficit the US had, the US dollar (dollar)
would have depreciated unless it was a global currency...


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ƒ The wider index closed down 4.7 per cent at 1,192.96 points
ƒ Dow Jones Industrial Average was down 4.4 per cent lower at 10,917.51 points
ƒ Nasdaq Composite index fell 3.6 per cent to 2,179.91 points

Impacts
'
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medit]% -..

Impacts from the Crisis on Key Wealth Measures

Between June 2007 and November 2008, Americans lost more than a quarter of their net worth. By early
November 2008, a broad U.S. stock index, the S&P 500, was down 45 percent from its 2007 high.
Housing prices had dropped 20% from their 2006 peak, with futures markets signaling a 30-35% potential
drop. Total home equity in the United States, which was valued at $13 trillion at its peak in 2006, had
dropped to $8.8 trillion by mid-2008 and was still falling in late 2008. Total retirement assets, Americans'
second-largest household asset, dropped by 22 percent, from $10.3 trillion in 2006 to $8 trillion in mid-
2008. During the same period, savings and investment assets (apart from retirement savingsÑ lost $1.2
trillion and pension assets lost $1.3 trillion. Taken together, these losses total a staggering $8.3
m181]
trillion. Members of USA minority groups received a disproportionate number of subprime mortgages,
and so have experienced a disproportionate level of the resultingforeclosures.m182]m183]m184]
medit]   / 
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FDIC Graph - U.S. Bank & Thrift Profitability By Quarter

The crisis began to affect the financial sector in February 2007, when HSBC, the world's largest (2008Ñ
bank, wrote down its holdings of subprime-related MBS by $10.5 billion, the first major subprime related
m185]
loss to be reported. During 2007, at least 100 mortgage companies either shut down, suspended
m186]
operations or were sold. Top management has not escaped unscathed, as the CEOs of Merrill
m187]
Lynch and Citigroup resigned within a week of each other in late 2007. As the crisis deepened, more
and more financial firms either merged, or announced that they were negotiating seeking merger
m188]
partners.

During 2007, the crisis caused panic in financial markets and encouraged investors to take their money
out of risky mortgage bonds and shaky equities and put it intocommodities as "stores of
m189]
value". Financial speculation in commodity futures following the collapse of the financial derivatives
markets has contributed to the world food price crisis and oil price increases due to a "commodities
super-cycle."m190]m191] Financial speculators seeking quick returns have removed trillions of dollars from
equities and mortgage bonds, some of which has been invested into food and raw materials.m192]

Mortgage defaults and provisions for future defaults caused profits at the 8533 USA depository
institutions insured by the FDIC to decline from $35.2 billion in 2006 Q4 to $646 million in the same
quarter a year later, a decline of 98%. 2007 Q4 saw the worst bank and thrift quarterly performance since
1990. In all of 2007, insured depository institutions earned approximately $100 billion, down 31% from a
record profit of $145 billion in 2006. Profits declined from $35.6 billion in 2007 Q1 to $19.3 billion in 2008
Q1, a decline of 46%.m193]m194]
medit]   / 
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The TED spread ± an indicator of credit risk ± increased dramatically during September 2008.



 
,












As of August 2008, financial firms around the globe have written down their holdings of subprime related
securities by US$501 billion.m195] The IMF estimates that financial institutions around the globe will
eventually have to write off $1.5 trillion of their holdings of subprime MBSs. About $750 billion in such
losses had been recognized as of November 2008. These losses have wiped out much of the capital of
the world banking system. Banks headquartered in nations that have signed the Basel Accords must
have so many cents of capital for every dollar of credit extended to consumers and businesses. Thus the
massive reduction in bank capital just described has reduced the credit available to businesses and
m196]
households.

When Lehman Brothers and other important financial institutions failed in September 2008, the crisis hit a
m197]
key point. During a two day period in September 2008, $150 billion were withdrawn from USA money
funds. The average two day outflow had been $5 billion. In effect, the money market was subject to
a bank run. The money market had been a key source of credit for banks (CDsÑ and nonfinancial firms
(commercial paperÑ. The TED spread (see graph aboveÑ, a measure of the risk of interbank lending,
quadrupled shortly after the Lehman failure. This credit freeze brought the global financial system to the
brink of collapse. The response of the USA Federal Reserve, theEuropean Central Bank, and other
central banks was immediate and dramatic. During the last quarter of 2008, these central banks
purchased US$2.5 trillion of government debt and troubled private assets from banks. This was the
largest liquidity injection into the credit market, and the largest monetary policy action, in world history.
The governments of European nations and the USA also raised the capital of their national banking
systems by $1.5 trillion, by purchasing newly issued preferred stock in their major banks. m196]

However, some economists state that Third-World economies, such as the Brazilian and Chinese ones,
will not suffer as much as those from more developed countries.m198]

The International Monetary Fund estimated that large U.S. and European banks lost more than $1 trillion
on toxic assets and from bad loans from January 2007 to September 2009. These losses are expected to
top $2.8 trillion from 2007-10. U.S. banks losses were forecast to hit $1 trillion and European bank losses
will reach $1.6 trillion. The IMF estimated that U.S. banks were about 60 percent through their losses, but
British and eurozone banks only 40 percent.m199]