Harvard Business School Case Study Series #3
The Rise and Fall of Lehman Brothers
Please read pages 1-10 of the case study.
Your presentation should address the aspects below:
Brief Introduction: Provide a
ief overview of the case study
Question 1: Describe the general funding model of Lehman Brothers.
Question 2: What was the focus of Lehman Brothers growth strategy?
Question 3: What happened to Lehman Brothers risk limits as it pursued its growth
strategy?
NB: All presentations must begin with a slide depicting the case study title and group
member names, while the final slide must be a reference list slide.
In addressing the above questions, you need to:
1. Identify the key issues depicted in the case study related to the identified
questions above.
2. Draw from the
oader literature to a
ive at your answer.
For further details of the assessment, please refer to the assessment 3 schedule in VU
Collaborate.
This case study addresses the following learning outcomes:
• LO1: Analyse the operations of Australian and global financial systems.
• LO2: Integrate conceptual and practical understandings of financial institutions
in order to analyse the manner in which they operate.
• LO4: Analyse knowledge of commercial bank functions in order to understand
their impact on the flow of funds.
• LO5: Work collaboratively in teams while exhibiting individual responsibility
and accountability.
In May 2015, Dick Fuld, former CEO of the Wall Street investment bank Lehman Brothers (Lehman) spoke to a room full of investors in midtown Manhattan. It was the first time Fuld had spoken publicly about the September 2008 bankruptcy and subsequent liquidation of his firm. In his speech Fuld offered a list of factors that he believed contributed to Lehman’s demise. Refe
ing to the events of the time as a “perfect storm,” he argued that the government’s agenda to increase home ownership was one key driver. “There was very little regulation or market supervision,” Fuld explained. And, while admitting that market conditions in 2008 were worse than he realized at the time, Fuld also argued that Lehman was never in fact bankrupt. “When Lehman was mandated into bankruptcy, we said our equity capital was $28 billion. Second, we had a Tier 1 capital ratio of 11 percent. Third, Lehman had unencumbered collateral of $127 billion.” Fuld defended the risk management culture of the firm and hinted that there was a hidden agenda behind Lehman’s being forced to file chapter 11.2
With nearly $700 billion in assets, Lehman was the largest U.S. bankruptcy in history, exceeding the value of the next five largest combined. (See Exhibit 1 for a list of the largest U.S. bankruptcies.) In 2007, Lehman achieved record earnings of over $4 billion on revenues of $60 billion.3 By September 2008 the fourth-largest investment bank in the world was bankrupt. As CBS News’ Steve Kroft remarked, “it’s hard to overstate the enormity of the 2008 collapse of Lehman Brothers XXXXXXXXXX,000 employees lost their jobs; millions of investors lost all or almost all of their money; and it triggered a chain reaction that produced the worst financial crisis and economic downturn in 70 years.”4
How could a successful investment bank with a long and storied history effectively disappear overnight? Some investors blamed Fuld himself, an executive who had built his career on taking significant risks. Others believed that there was enough blame to go around: a weak board of directors, a firm culture that rewarded risk, questionable accounting policies, never-before-seen levels of market volatility, and the high-leverage business model employed by investment banks.
In 2009 Anton R. Valukas was named as the court-appointed examiner to conduct a review of the events leading up to Lehman’s Chapter 11 filing and to determine if there were significant grounds to
This document is authorized for use only by Omesh Khatri in (BEO2000) Financial Institutions and Monetary Theory - C at Victoria University, 2021.
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ing criminal charges against anyone involved. The SEC explored
inging its own civil case, and in 2010, the State of New York sued Lehman’s auditors, Ernst & Young.
What caused Lehman to fail? Why did things seem to go so wrong so quickly for the firm? Were there warning signs the market missed? Was reckless or even criminal behavior on the part of Lehman’s leadership a factor? Dick Fuld commented in 2015, “It’s very easy to look back XXXXXXXXXXThere is no ‘if’ or ‘woulda coulda shoulda’ XXXXXXXXXXYou can only make a decision at any specific time with the best information that you think you have.”5
The U.S. Financial Services Industry
Banks functioned as middle men, matching the savings of individuals, corporations, and other organizations with individuals, corporations, and other organizations seeking funding in the form of debt or equity. At traditional banks, these savings were largely in the form of deposits; depositors placed money in checking or savings accounts or in CDs (certificates of deposit, also known as time deposits), and the bank in turn lent that money. These deposits, up to $250,000 per depositor, per bank as of 2017, were insured by the Federal Deposit Insurance Corporation (FDIC). The FDIC was created by the 1933 Banking Act in the aftermath of the Great Depression. It functioned as an independent agency of the U.S. federal government, and all insured banks were examined and supervised by the FDIC “for operational safety and soundness.”6 Banks paid premiums to support the deposit insurance fund, but it was backed by the U.S. Treasury. Henry “Hank” Paulson was named Secretary of the Treasury in 2006. Before being named Secretary, Paulson had been CEO of Goldman Sachs.
The Glass-Steagall Act, a piece of the 1933 Banking Act, separated banks into commercial banks and investment banks. Commercial banks, which took deposits and made loans, were required to limit securities-related income to 10% of their total income. Investment banks were to focus on securities-related activities and could not take deposits. In 1999, Glass-Steagall was largely repealed by the Gramm–Leach–Bliley Act (GLBA).7
Investment Banks
Twenty-first-century investment banks took deposits and made loans, like traditional banks, but also underwrote financial transactions (acting as intermediaries between securities issuers and investors); performed a wide variety of advisory functions (advising companies on financial strategy such as mergers and acquisitions, restructurings, and capital raising); and functioned as
oker-dealers (buying and selling securities on clients’ behalf). Many investment banks also owned investment management operations, investing assets on behalf of third-party individuals and institutions.
U.S. investment banking net revenues totaled $36.6 billion in 2007, and global net revenues totaled $90.2 billion.8 The products and services offered by investment banks had evolved over time, and in recent years a number of newer businesses had grown in importance for investment banks. Two of these were securitization and principal investing.
SecuritizationSecuritization involved pooling a group of assets in order to create a single or series of debt and/or equity securities. A special-purpose vehicle (SPV), a stand-alone legal entity, would be created to purchase these assets and then issue securities. A loan originator could sell a pool of assets to an SPV. The SPV would fund the purchase of these assets by issuing one or more tradeable debt securities (e.g., bonds) to an underwriter in exchange for cash. The underwriter in turn sold those securities to investors. Securitized mortgages were refe
ed to as mortgage-backed securities (MBS), and other securitized assets were known as asset-backed securities (ABS).9
This document is authorized for use only by Omesh Khatri in (BEO2000) Financial Institutions and Monetary Theory - C at Victoria University, 2021.
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The first MBS were issued in 1970,10 with the Government National Mortgage Association (Ginnie Mae), an agency of the U.S. Department of Housing and U
an Development (HUD), functioning as the underwriter. Fannie Mae and Freddie Mac, government-sponsored enterprises (GSEs), entered the securitization market soon after. By creating a secondary market in mortgages, these agencies provided increased liquidity and freed up capital for mortgage originators, enhancing their ability to originate mortgages and furthering the agencies’ goal of increased home ownership. Over time MBS structures grew more complex. In 1983, Fannie Mae issued the first collateralized mortgage obligations (CMO); these separated the SPV payment streams into different debt tranches with varying risk profiles and risk ratings.11 Issuance of mortgage-related securities in the United States totaled $2 trillion in 2006, up from approximately $600 billion in XXXXXXXXXX
Investment banks served as underwriters for securitization transactions, collecting a fee for this role. Generally, the more complex the securitization structure, the greater the banks’ fees. By serving as the middle man on these transactions, banks also assumed risk. In the event that the underwriter was unable to sell the securitized assets, it would be stuck holding them.
Principal investingMany investment banks were increasingly focused on principal investments. Principal investments entailed buying assets with a bank’s own capital and holding those assets on its balance sheet before selling them, ideally for a profit. Principal investments were focused on both short-term trading and longer-term investment positions and varied in their liquidity. At Goldman Sachs, a leading investment bank, 2007 revenues from principal investing and trading activities made up 65% of net revenues, compared with investment banking, which contributed only 16% of net revenues.13
RegulationCommercial and investment banks were subject to supervision and examination by numerous regulators. Entities registered as
oker-dealers, derivatives dealers, or investment advisers were regulated by the SEC as well as self-regulatory organizations, including the Financial Industry Regulatory Authority (FINRA), the New York Stock Exchange (NYSE), and other national securities exchanges. Additionally, each U.S. state had its own securities administrators that regulated entities operating within that state.
Banks were overseen by several regulators. State-chartered banks and trust companies that belonged to the Federal Reserve System were regulated by the Board of Governors of the Federal Reserve; all other state-chartered banks were regulated by the FDIC. The Office of the Comptroller of the Cu
ency (OCC) regulated “National” and “N.A.” banks. The Office of Thrift Supervision (OTS) regulated federally chartered and state-chartered savings banks and savings and loans associations.a
a The OTS was dissolved in 2011.
CompensationProfessionals at investment banks were compensated with a base salary and a year-end bonus (payable in both cash and company stock). The size of an individual banker’s bonus was generally a function of market performance, the performance of the banker’s division and group relative to the rest of the bank, and the performance of