lehman, financial crisis 2008, and more

Lehman's history

Lehman Brothers was founded in 1850, and became an important trader in cotton during those times. Later it focused on trading and brokering of commodities. The firm dealt with great depression, and came out having survived. The business of venture capital and underwriting of capital issues was steady and successful in the subsequent years. By 1975, Lehman had became a prominent investment banker for the American businesses. 

American Express acquired Lehman in 1984 for $360 m to form Shearson Lehman American Express. In 1988, the firm merged with EF Hutton stock brokerage to form Shearson Lehman Hutton Inc. 

Before the initial public offering, the banking and brokerage operations were divested of, and retail brokerage and asset management business was sold by American Express. Lehman Brothers Holdings Inc. became a publicly traded firm in 1994 with Richard Fuld as its CEO. His 14-year stint as CEO had to end with filing for bankruptcy on 15 September 2008. Before that, the firm fended off rumors of cash crunch due to the collapse of Long Term Capital Management in 1998 as fake news. By 2007, Lehman had posted record revenues, earnings, and earnings per share for four consecutive years. Fuld became a hero after leading the firm to post 14 consecutive years of profits after it had reported a loss of $102 m in 1993. Little did the market know of the amount of leverage used to drive returns on equity. The asset management business was revived in 2003. In 2007, Lehman had revenues of over $19 b and posted record high earnings of $4.2 b. 

Perhaps things would be fine had it not ventured into the lower grade mortgage lending business. Of course it was lucrative, and seemed like a good idea at that time. The Alt-A mortgage, considered lower than prime but better than subprime, began after Lehman acquired Aurora Loan Services in 1997. Later in 2000, BNC Mortgage LLC was acquired, and Lehman became a subprime mortgage lender. These lower grade, higher risk mortgage lending operations had a stunning growth story: Lending in 2003 was $18.2 b; in 2004, it was $40 b; and in 2006, both Alt-A and subprime loans comprised more than $40 b per month. Quite naturally, Lehman started 2007 with too much of risky assets supported by too little of equity. Any good year with this capital structure would yield enormously high earnings for common shareholders; and it did, in 2007 of about $4.2 b. Any bad year would be of enormous losses. And a very bad year, would let the course to bankruptcy; and it did in 2008. 

2008 operations

The winding down of BNC subprime operations in August 2007 perhaps came a little too late. Consider this: Lehman posted profits of $489 m in the first quarter of 2008. Citigroup posted losses of $5.1 b, and Merrill Lynch had $1.97 b losses. In the second quarter though Lehman reported record losses of $2.8 b which came after a very long time. Revenues for the quarter ended May 2008 were $6.240 b, and interest costs alone were $6.908 b. It had $6.513 b of cash available for operations. Total assets were $639.432 b, of which $13 b was cash deposits mainly with the regulatory authorities. In effect, its net operating assets were: Financial instruments and securities of $269 b; Collateralized agreements of $294 b; and receivables of $42 b; totaling $605 b. You couldn't do much with property and equipment ($4 b), intangible assets ($4 b), and other assets ($5.8 b). During the quarter, Lehman lost $17.899 b of cash from operations which was made good by debt.

In June 2008, Lehman raised $4 b of common stock at $28 per share, and $2 b of non-cumulative preferred stock carrying 8.75% coupon, which had a mandatory convertible clause. Apparently, this capital raising was not good enough because its statement of financial position as of May 2018 looked like this: Assets ($639.432 b) financed by common equity ($19.283 b), preferred stock ($6.993 b), and debt and other payables ($613.156 b). Just 3% common equity meant that asset losses of only 3% would wipe out entire equity; a very vulnerable situation to be in.

The auditor's report dated July 2008 based on their review of May 2008 (quarter) operations, and the report dated January 2008 based on their audit of November 2007 (year) operations, expressed unqualified opinions on the financial statements. There wasn't a note on Lehman's going concern issues.

Lehman reported Tier1 capital ratio of 10.7% and risk-weighted capital ratio of 16.1% as of May 2008. This wasn't reflective of the risks that the firm was up against. As long as property prices remained high it was fine. If prices were to fall, Lehman would need cash to make good on margins to its lenders. When prices came crashing, the firm would need significant amounts of cash on short notice. Inability of the original individual mortgage borrowers also had a role to play which had cascading effects on property prices and consequently on the bundled mortgage assets prices; there was a reason they were called subprime.

Lehman stock prices started falling, and the subsequent downgrades on Lehman by the rating agencies meant its derivative contracts demanded billions of dollars in collateral. By 9 September 2008, Lehman was worth only $6 b while it began 2008 with a market capitalization of over $35 b.

source: wsj

Nevertheless, here's the thing: If the markets trusted on Lehman's ability to recoup, even if it were to take a long time, it would have been ok. However, it was not to happen. Lehman lost on its credibility to raise short term cash, and there was no other choice. 

No bail out

Even the government turned the other way. It would rescue Fannie Mae and Freddy Mac; both firms had owned or guaranteed about $6 t of the total $12 t US mortgage market. It bailed out AIG. It also facilitated the $50 b Merrill Lynch buyout by Bank of America. But not Bear Stearns and Lehman. The first to go was Bear Stearns when the government let JPMorgan Chase buy Bear Stearns for $2 per share. Warren Buffett bailed out Goldman Sachs by investing in its $5 b preferred stock carrying 10%, which helped boost the firm's credibility and made its capital raising easier. All the firms that survived were beneficiaries of the government's $700 b troubled assets relief program bailout. 

Of course, the government thought Korea Development Bank would rescue Lehman. When it did not, the stock price crashed below $8 per share. It also hoped that Barclays would buyout Lehman which did not happen thanks to the veto of the UK regulators. 

Then the bankruptcy was made inevitable; 15 September 2008 and Lehman became part of the history being the largest bankruptcy of all time.

The S&P-500 fell more than 4.5% (source: Yahoo finance) on the day, and so did the Dow Jones which fell from 11421 to 10917.

Bankruptcy meant $0 stock prices, and this is how they panned out.

Subsequent to the filing, Barclays bought selected US assets for $1.29 b, and Nomura bought Lehman's Asia operations for $225 m, and parts of European operations for nought ($2 nominal). 

What if

I sometimes wonder what would have happened to Lehman and the financial markets if the US government had bailed it out. That is to supply cash and fill liquidity, and own equity until Lehman was able to get back on its feet. When asset prices and markets recovered, as they did, Lehman would repay its debt (equity) back to the government, and either remain a privately held firm or issue shares to public to operate as a listed entity. Alas, it wasn't to be. And we have a number of lessons to learn. 

Lessons that markets don't learn

The first and foremost is never to be at the mercy of someone else. This position of weakness is almost always caused by excessive leverage compared to own capital. The second is never to trust the governments to come and support during desperate times even while they choose to discriminate. The third is never to be in a business that is mainly dependent upon hope, greed, and the greater fool; most likely, the business itself would end up being one such fool eventually. Lehman, along with other firms that fell, unfortunately did not have the time to learn these lessons. Yet, I hope that those firms that did survive have learned. But then, don't we know that what we learn from history is that we don't learn from history?