The Collapse of Lehman Brothers – Lessons Learned: Corporate Governance and Ethics.

The Collapse of Lehman Brothers – Lessons Learned: Corporate Governance and Ethics. 


Executive summary. 3

Introduction. 3

Financial situation and background. 4

Discussion. 6

Conclusion. 15

Reference. 16

Appendix. 18


Executive summary

This essay discusses about the collapse of Lehman Brothers in 2008, from the perspective of corporate governance and ethics. It first gives some background about the collapse and analyze financial situation of the company before the incident happened. It reveals unethical or misleading financial or accounting practices in the company. Then we provide problem determination and lesson learned from a corporate governance perspective. That is what government, financial institutions and companies can do to have better control in the future.

Introduction

Lehman Brothers was a company with a long and interesting history. It was founded in 1850 as a family business, by three brothers who immigrated to the US, and started as a shop, which later entered trading with cotton. During the more than 150 years existence the company became the fourth largest financial firm in the world. Before announcing bankruptcy on 15th of September 2008, they were providing full range of financial services. (See Exhibit 7)

Lehman Brothers was tangled after the sub-prime mortgage disasters happened. The firm accumulated a very large commercial real estate portfolio. Lehman was also very highly leveraged and was taking no steps to get borrowing under control.

On September 7th 2008, after the Government rescued Freddie Mac and Fannie Mae and Lehman announced a large third quarter loss three days later, the bank began to have pronounced liquidity problems. A large New York clearing bank asked the firm to provide more collateral to protect any daylight open position that may arise. Credit rating agencies threatened to downgrade the company unless some reasonable plan was announced that would restore capital and stabilize funding. Lehman had no such plan. That weekend, after exhausting private sector solutions, the government made it clear that no public money would flow to Lehman. Lehman Brothers Holdings, Inc. filed for bankruptcy. (Ryback, 2010) (See Exhibit 8)

Financial situation and background

Let’s step back and investigate the financial situation of Lehman Brothers before it collapsed.

 

On April 1, 2008, two weeks after the government arranged the sale of Bear Stearns (Bear), Lehman Brothers (Lehman) announced that it had raised $4 billion of new capital in the form of convertible preferred shares. (Yalman Onaran, 2009). On the news, Lehman’s stock rose 18% to $44.34, an increase of 18% from the prior day’s closing price (see Exhibit 1).

Lehman’s traditional strength was in fixed income. In 1995, over 55% of the firm’s revenues came from this area. By 2007 the proportion had fallen to 39% of the firm’s total, but fixed income remained the dominant business (see Exhibit 2). Fixed income securities made up 59% of the securities on its balance sheet at year end 2007 (see Exhibit 3), and Lehman was among the perennial leaders in fixed income underwriting (see Exhibit 4). The firm’s particular area of expertise and focus was in mortgage related securities. The first part of the strategy worked well, and Lehman had built dominant leadership positions in underwriting mortgage backed securities (see Exhibit 5), and by year-end 2007 mortgaged-related securities and loans accounted for 28% of the firm’s total assets, larger than any other asset class. (Rose, Ahuja, 2011)

By the end of 2007, Lehman held $79 billion dollars of mortgage related assets on its balance sheet at year end, approximately half of which was commercial and half residential, and $5.3 billion was sub-prime. The firm’s Level III assets – those for which there was no traded market from which to derived valuations, requiring that they be “marked to model” according to the US accounting rule FAS 157 – increased by $6.5 billion during the quarter, to $38.9 billion, and represented 6% of Lehman’s total assets and 170% of shareholder equity (see Exhibit 6). The firm’s leverage ratio at year-end, its assets divided by shareholder equity, was about 30.7 times. (Rose, Ahuja, 2011)

In May 21 2008, Lehman stock closed down 6% to $39.56 per share that day

On June 2, 2008, Standard & Poor’s announced that it was downgrading the credit ratings of Lehman Brothers and Merrill Lynch to A from A+ and Morgan Stanley to A+ from AA-.. (Michael Patterson, 2008)

In June 2008 Lehman shocked investors by reporting its first ever quarterly loss. Fitch, lowered Lehman’s long term debt rating to A+ from AA-, and Moody’s lowered its outlook for the firm to negative (Rose, Ahuja, 2011)

On September 7th, after the Government rescued Freddie Mac and Fannie Mae and Lehman announced a large third quarter loss three days later, the bank began to have pronounced liquidity problems. That weekend, after exhausting private sector solutions, the government made it clear that no public money would flow to Lehman. Lehman Brothers Holdings, Inc. filed for bankruptcy. (Ryback, 2010)

Discussion

Analyze and describe the motivation of the company’s mangers that allowed or created misleading financial statements or engaged in unethical practices in order to influence the company’s stock price.

There are lots of examples we can pull out from different references. We are going to illustrate couple examples of what Lehman did unethically.

On May 21 2008, David Einhorn, the co-founder and President of hedge fund Greenlight Capital, raised questions about Lehman and announced that his firm had a short position in Lehman’s stock. He went into greater detail about his view that its equity was overvalued. (David Einhorn, 2008) Among Einhorn’s most significant concerns about Lehman’s financial conditions were:

CDOs For the first time Lehman had disclosed a position of $6.5 billion of CDO exposure, which they had apparently been carrying for some time. Lehman’s exposure was revealed in a footnote to a table in the 10-Q; a similar table in the earnings release on March 18 did not carry the footnote or reference CDOs.
Write-downs Lehman had taken a $200 million write down on the value of its CDOs in the quarter, which. Einhorn was also troubled by a gain of $722 million in the value of the equity related Level III assets. Real Estate Investment Trust called Archstone-Smith, had been written down by an undisclosed amount.
Accounting error In the earnings release on March 18, Lehman valued its Level III assets at $38.9 billion, after taking a write down of $875 million. In the first quarter 10-Q filed on April 8, the end of the quarter value of Level III assets was $40.2 billion, not the $38.9 billion CFO had reported on the earnings call. In addition, the loss of $875 million reported on the call had become a gain of $228 million, a swing of $1.1 billion.

Einhorn said that in his call with Lehman Brother’s CFO, Callan. She denied all these problems had occurred. On the other hand Einhorn was criticized back by Lehman for selectively using and misconstruing information, as well as by Wall Street analysts. (Louise Story, 2008)

 

In general we had assumed that the collapse of Lehman in September 2008 was the consequence of a fatal combination of intricate accounting rules, complex derivatives, greed, excessive leverage and the complacency of rating agencies. It was also the trigger for a chain reaction across other financial institutions which suffered from the panic and liquidity freeze that followed. (Arturo Bris, 2010)

The report shows similarities between the collapses of Enron in 2001 and Lehman Brothers in 2008. Lehman’s pre-pay transaction is the Repo 105, a fascinating term that fools analysts and investors. Lehman Brothers managed to reduce leverage on the right-hand side of the balance sheet and, at the same time, reduce assets (some of them undesirable) on the left-hand side. Repo 105 transactions doubled between late 2006 and May 2008, were known inside the company, exceeded the firm’s self-imposed limits and typically happened at the end of each quarter, when financial information had to be released.

Magically, Lehman Brothers used repos reportedly for financing reasons, but accounted for them as asset disposals. In that way (with no transfer of the underlying security), Lehman circumvented the two problems mentioned and used the repo proceeds to reduce its leverage right before the disclosure period. These repo proceeds amounted to about $50 billion by September 2008

Problem is it failed to disclose this. And because of the legal constraints in the US on the treatment of repo transactions as asset disposals, Lehman Brothers engineered them through its UK subsidiary. They were clearly used as leverage-reducing transactions because otherwise Lehman could have secured short-term financing at much lower rates — a repo 105 implies a cost of financing of five percent, plus interest! In short Lehman Brother use prepays to hide leverage. (Arturo Bris, 2010)

Lessons Learned: what and how corporate governance measures can be done to have better control in the future.

The global financial crisis has revealed the need to rethink fundamentally how financial systems are regulated.  There was an increased innovation in structured finance products, willingness by lenders to take excessive risks, low interest rate and obscure financial engineering. (Colander, 2008) The majority of economists thus failed to warn policy makers about the threatening system crisis. (Siborurema 2010)

There were not enough regulations that decreased the risk taking in Lehman Brothers. One mechanism behind the crisis is that Lehman Brothers and other financial institutions did not have incentives enough to avoid system-risks since the US government previously always had taken a large share of the costs when an institution important to the system had been close to failing. (Siborurema 2010)

There is not sufficient risk management by Lehman Brothers. A guideline for the maximum leverage ratio of a Wall Street stock dealer was 20 to 1. That value is said to be fine when the company’s assets consist of commercial papers, bonds and shares that are relatively easy-valued because they are more liquid. Though, this ratio is far too high when the asset mix includes for example investments in real estate, as in the case of Lehman Brothers. In November 2007, the leverage ratio of Lehman Brothers was 30.7 to 1. (Siborurema 2010)

The American banking regulation system was divided in two parts before the crisis. Commercial banks were regulated by the US Federal Government but investment banks are not regulated. One example of this is that commercial banks have an accepted maximum leverage ratio of 10 to 1 while there is no limit for investment banks.  Lehman Brothers was an investment bank and did therefore not have as hard regulations as commercial banks. (Siborurema 2010).

The American government did not have enough insight in the complex network between Lehman Brothers and other financial institutes worldwide. The lack of understanding makes it hard to provide a good legal framework. (Siborurema 2010)

To show more of holy grand details, the literature “Grant Kirkpatrick. (2009)The corporate Governance Lessons from the Financial Crisis”, examines macroeconomic and structural conditions and shortcomings in corporate governance at the company level. Corporate governance enhancements often followed failures that highlighted areas of particular concern. It is therefore natural for the Steering Group to examine the situation in the banking sector and assess the main lessons for corporate governance in general. (Grant Kirkpatrick, 2009)

Topic Points
The corporate governance dimension While the post-2000 environment demanded the most out of corporate governance arrangements, evidence points to severe weaknesses. Risk models failed due to technical assumptions, but the corporate governance dimension of the problem was how their information was used in the organization. Attention has focused on internal controls related to financial reporting, but not enough on the broader context of risk management. The financial turmoil has revealed severe shortcomings in risk management practices as reviewed and evaluated by the Senior Supervisors Group
The Senior Supervisors draw conclusions: CDO exposure far exceeded the firms understanding of the inherent risks (SEC 2008)Understanding and control over potential balance sheet growth and liquidity needs was limitedA comprehensive, co-coordinated approach by management to assessing firm-wide risk exposures proved to be successful as did more active controls over the consolidated balance sheet, liquidity, and capital

 

Warning signs and Stress testing. Warning signs for liquidity risk which were clear during the first quarter of 2007 should have been respected. (House of Commons, 2008). Stress testing and related scenario analysis has shown numerous deficiencies at a number of banks. Stress testing has been insufficiently consistent or comprehensive in some banks. Some have taken on high levels of risk by following the letter rather than the intent of regulations
Transmission of risk information Transmission of risk information has to be through effective channels, a clear corporate governance issue. A failure to transmit information can be due a silo approach to risk management. Lower prestige and status of risk management staff vis-àvis traders also played an important role (KPMG, 2008)
Remuneration and incentive systems: strong incentivesto take risk Remuneration and incentive systems have played a key role in influencing financial institutions sensitivity to shocks and causing the development of unsustainable balance sheet positions. Remuneration has to be aligned with the longer term interests of the company and its shareholders. Executive remuneration has been less analyzed and discussed. More investigation is required to determine the actual situation and the corporate governance implications of remuneration schemes.
Incentive systems at lower levels have favored risk taking and outsized bets Remuneration problems also exist at the sales and trading function level. Incentive structures need to balance various interests. Financial targets against which compensation is assessed should be measured on a risk-adjusted Basis, which is more difficult if the internal cost of funds do not take account of risk. (Heller, 2008) Incentive systems at sub-executive level are also a concern for non- financial companies.Basel II enables regulators to impose additional capital charges for incentive structures that encourage risky behavior.
Risk policy is a clear duty of the board Deficiencies in risk management and distorted incentive systems point to deficient board oversight.  Financial companies are not unique in this regard even though the macroeconomic impacts of poor risk management are arguably more important.
Does the board obtain relevant information? In the wake of the financial crisis many boards of financial enterprises have been quite active, but why not before? Reports have not so far dealt in much depth with the role and performance of the boards. (Institute of International Finance, 2008) There appears to be a need to re-emphasize the respective roles of the CEO and the board in the risk management process. A survey of European banks indicates that risk management is not deeply embedded in the organization, a clear corporate governance weakness. Risk management information was not always appropriate or available to the board. With an appropriate mandate, CROs can potentially provide a strong internal voice for risk management
Board composition The composition of risk committees is also an important issue. The quality of board members is a particular concern, but fit and proper person tests often do not fully address the issue of competence. Even though board competence is difficult to judge by outsiders, it is often asserted that bank boards’ lack banking and financial experience. (Guerra and Thal-Larsen, 2008) Some banks report difficulties in recruiting non-executive directors with recent “high level” financial expertise in order to staff their risk and audit committees. Supervisory boards of state owned banks have often not been capable of responding to a changing business model. (Sachverständigenrat, 2008) (Hau et al., 2009)
General implications for boards In some instances the question of independent directors might have been pushed too far. The boards’ access to information is key. Disclosure of material information on foreseeable risk factors as good practice
Rating agencies: misleading but also misused by some The importance of promoting the provision of third party analysis put CRAs under considerable commercial pressure. CRAs assigned high ratings to complex structured sub-prime debt based on inadequate historical data and in some cases flawed models. Often CRAs were involved in advising on how to structure the instrument so as to obtain a desired rating, posing serious conflicts of interest. It is also important to improve how ratings are used. (UBS, 2008)
Disclosure and accounting standards: important gaps Research suggests that the readability of risk disclosures is difficult and that there are no generally accepted risk management accounting principles. (van Manen, 2009) The misuse of off-balance sheet entities has posed problems. Accounting standards have been put to the test concerning fair value of assets which either trade in thin markets or in no markets at all.
The regulatory framework Supervisory, regulatory and enforcement authorities are key in ensuring sound corporate governance. Deficiencies in terms of adequate supervisory staff resources need to be addressed

Conclusion

This literature discusses how Lehman Brother, one of the largest investment banks in America in 2008, collapsed after the sub-prime mortgage crisis in 2007. The financial situations, reports and statements of the company was illustrated and analyzed. We show couple examples of what unethical financial reporting and accounting practices Lehman had been doing.

Lehman did make lots of risky hedges and leverages to yield exceptions profits. It also over leveraged on sub prime mortgages related securities. At the same time they are using unethical accounting and financial reporting tricks to hide their leverages to investors.

There once sub prime mortgages crisis triggered, Lehman Brother got impacted and closed down. After Lehman Brother closed down, world wide financial crisis happened. Financial markets in the whole world are affected deeply.

This literature has done some investigation and lessons learned; pulling strategies and suggestions from different references that if there is better corporate governance, regulations and risk management framework, similar tragedies might not happened. Even if it happened, it would be handled more gracefully. The literature finally enumerates and tabulates different dimensions, measures, strategies and regulations about corporate governance and corporate ethics that would help to have better control in the future.

Reference

1. Artuto Bris. (2010). The Lehman Brothers Case. A corporate Governance failure, not a failure of financial markets.

2. David Colander. (2008). The Financial Crisis and the Systemic Failure of Academic Economics.

3. David Einhorn. (2008). “Private Profits and Socialized Risk,” speech before Grant’s Spring Investment Conference, April 8, 2008

4. Grant Kirkpatrick. (2009). The corporate Governance Lessons From The Financial Crisis. Financial Market Trends, OECD 2008.

5. Guerrera, F. and P. Thal-Larsen. (2008), “Gone by the Board: why the directors of big banks failed to spot credit risks”, Financial Times, 26 June.

6. Hau, H., J. Steinbrecher and M. Thum. (2009), Board (in)competence and the subprime crisis,

7. Heller, D. (2008). “Three ways to reform bank bonuses”, Financial Times, 3 February

8. House of Commons Treasury Committee. (2008). The run on the Rock, Volume 1 and II, London.

9. Institute of International Finance. (2008). Final Report of the IIF Committee on Market Best Practices: Principles of Conduct and Best Practice Recommendations, Washington, D.C

10. KPMG. (2008). Audit committees put risk management at the top of their agendas.

11. Ladipo, D. et al. (2008). Board profile, structure and practice in large European banks, Nestor Advisors, London.

12. Michael Patterson. (2008). “U.S. Stocks Drop, Led by Financials; Wachovia, Lehman Retreat,” June 2, 2008, Bloomberg.com, accessed January 2009.

13. Clayton S. Rose, Anand Ahuja. (2011). Before the Fall: Lehman Brothers, Harvard Business Review 0-309-093

14. Ryback. (2010). Leman Brothers: Too Big To Fail. Toronto Leadership Center

15. Sachverständigenrat. (2008). Das deutsche Finanzsystem: Effizienz steigern – Stabilität erhöhen, Wiesbaden.

16. Securities and Exchange Commission. (2008). SEC’s Oversight of Bear Stearns and Related Entities, Report No 446-A.

17. Siborurema. (2010). Economic Crisis Breakdown of Communication. The Case of Lehman Brothers. Deusto University

18. Louise Story. (2008). “Lehman Being Besieged By Investor Betting Against It,” June 4, 2008, The New York Times, via Factiva, accessed January 9, 2009

19. UBS. (2008), Shareholder Report on UBS’s Write-Downs, company website.

20. Van Manen, J. and Jod de Groot. (2009). “Business risk reporting”, to be published in: The Handbook of International Corporate Governance, Kogan Page.

21. Yalman Onaran. (2008). “Lehman Sells $4 Billion Shares to Help Calm Investors,” Bloomberg.com, April 1, 2008, accessed January 2009.

Appendix

Exhibit 7 – Financial Crisis Timeline

Exhibit 8 – Lehman Brother Stock trend

Eric Tse, Richmond Hill, Toronto
Tse and Tse Consulting -Security, Identity Access Management, Solution Architect, Consulting
http://tsetseconsulting.webs.com/index.html
https://tsetseconsulting.wordpress.com/
http://erictse2.blogspot.com/

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