The Collapse of Lehman Brothers: A Case Study

Lehman Brothers was the fourth-largest investment bank in the U.S. employing 25,000 people worldwide when it collapsed. It had $639 billion in assets and $613 billion in liabilities. The bank became a symbol of the excesses of the 2008 financial crisis, engulfed by the subprime meltdown that swept through financial markets and cost as much as $10 trillion in lost economic output, according to some estimates.

The bank filed for bankruptcy on Sept. 15, 2008. Hundreds of employees, mostly dressed in business suits, left the bank’s offices with boxes in their hands. It was a somber reminder that nothing is forever—even in the richness of the financial and investment world. So what led to its demise In this article, we examine the events that led to the collapse of Lehman Brothers.

Key Takeaways

• Lehman Brothers began as a dry-goods store, branched off into commodities trading and brokerage services, and eventually became an investment bank.
• The firm survived many challenges but was brought down by the collapse of the subprime mortgage market.
• Lehman first got into mortgage-backed securities in the early 2000s before acquiring five mortgage lenders.
• The firm posted multiple, consecutive losses and its share price dropped.
• Lehman filed for bankruptcy on Sept. 15, 2008, with $639 billion in assets and $619 billion in debt.

Lehman Brothers History

Lehman Brothers had humble origins, tracing its roots to a general store founded by German brothers Henry, Emanuel, and Mayer Lehman in Montgomery, Alabama, in 1844. Farmers paid for their goods with cotton, which led the company into the cotton trade. The brothers expanded the scope of the business into commodities trading and brokerage services. The firm then began investment banking activities in 1899.

The firm prospered over the following decades as the U.S. economy grew into an international powerhouse. But Lehman faced plenty of challenges over the years. The company survived the railroad bankruptcies of the 1800s, the Great Depression, two world wars, a capital shortage when it was spun off by American Express (AXP) in 1994 in an initial public offering (IPO), and the Long Term Capital Management collapse and Russian debt default of 1998.

Despite its ability to survive past disasters, the collapse of the U.S. housing market ultimately brought Lehman to its knees, as its headlong rush into the subprime mortgage market proved to be a disastrous step.

The Prime Culprit

The company branched into mortgage-backed securities (MBSs) and collateral debt obligations (CDOs) along with many other financial firms. With the U.S. housing bubble well underway, Lehman acquired five mortgage lenders along with BNC Mortgage and Aurora Loan Services in 2003 and 2004, which specialized in Alt-A loans. These loans were made to borrowers without full documentation.

Lehman’s acquisitions seemed prescient at first. Its real estate business enabled revenues in the capital markets unit to surge 56% from 2004 to 2006. The firm securitized $146 billion in mortgages in 2006—a 10% increase from 2005. Lehman reported record profits every year from 2005 to 2007. In 2007, it announced $4.2 billion in net income on $19.3 billion in revenue.

The Colossal Miscalculation

In February 2007, Lehman’s stock price reached a record $86.18 per share, giving it a market capitalization of nearly $60 billion. But by the first quarter of 2007, cracks in the U.S. housing market were already becoming apparent. Defaults on subprime mortgages began to rise 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. Following the earnings report, Lehman said the risks posed by rising home delinquencies were well contained and would have little impact on the firm’s earnings.

The Beginning of the End

Lehman’s stock fell sharply as the credit crisis erupted in August 2007 with the failure of two Bear Stearns hedge funds. During that month, the company eliminated 1,200 mortgage-related jobs and shut down its BNC unit. It also suspended wholesale and correspondent lending activities by its Alt-A lender Aurora. 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 MBSs than any other firm, accumulating an $85 billion portfolio—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 would turn out to be its last chance.

Hurling Toward Failure

In 2007, Lehman’s high degree of leverage was 31, while its large mortgage securities portfolio made it highly susceptible to deteriorating market conditions. On March 17, 2008, its shares plummeted nearly 48% due to concerns that it would be the next firm to fail following Bear Stearns’ near-collapse,

By April, after an issue of preferred stock—which was convertible into Lehman shares at a 32% premium to its concurrent price—yielded $4 billion, confidence in the firm returned somewhat. However, the stock resumed its decline as hedge fund managers began to question the valuation of Lehman’s mortgage portfolio.

On June 7, 2008, Lehman announced a second-quarter loss of $2.8 billion, its first loss since it was spun off by American Express, and reported that it raised another $6 billion from investors on June 9. According to author David P. Belmont:

“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 percent, and cut down leverage from a factor of 32 to about 25.”

Too Little, Too Late

Over the summer, Lehman’s management made unsuccessful overtures to potential partners. The stock plunged 77% in the first week of September 2008, as investors questioned chief executive officer (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 Sept. 9, as the state-owned South Korean bank put talks on hold.

The devastating news led to a 45% drop in Lehman’s stock, and credit-default swaps on the firm’s debt rose to a record high of 610 basis points. Hedge fund clients began abandoning the company, with short-term creditors following suit. Lehman’s fragile financial position was best exemplified by the pitiful results of its Sept. 10 fiscal third-quarter report.

Facing a $3.9 billion loss, which included a $5.6 billion write-down, the firm announced an extensive strategic corporate restructuring effort. Moody’s also announced a review of Lehman’s credit ratings, and it found that the only way for Lehman to avoid a rating downgrade would be to sell a majority stake to a strategic partner. By Sept. 11, the stock suffered another massive plunge (42%) due to these developments.

With its cash dwindling by the end of that week, Lehman was quickly running out of time. Over the weekend of Sept. 13, Lehman, Barclays, and Bank of America (BAC) made a last-ditch effort to facilitate a takeover of the former, but were unsuccessful. On Monday, Sept. 15, Lehman declared bankruptcy, resulting in the stock plunging 93% from its previous close on Sept. 12.

Note

Lehman’s stock plunged 93% between the close of trading on Sept. 12, 2008, and the day it declared bankruptcy.

Where are They Now?

Fuld runs Matrix Private Capital Group, which he founded in 2016. The company manages assets for high-net-worth individuals (HNWIs), family offices, and institutions. He reportedly sold an apartment in New York City for $25.9 million as well as a collection of drawings for $13.5 million.

In the years following the collapse, Fuld acknowledged the mistakes the bank made though he remained critical of the government for mandating that Lehman Brothers file for bankruptcy while bailing out others. In 2010, he told the Financial Crisis Inquiry Commission the bank had adequate capital reserves and a solid business at the time of its bankruptcy.

Erin Callan (now Erin Montella) became chief financial officer (CFO) at the age of 41. However, she was fired in June 2008 due to the company’s situation and following suspicions she leaked information to the press. Her LinkedIn profile lists her as an advisor at Matrix Investment Holdings. Other stints include six months serving as head of hedge fund coverage for Credit Suisse and co-founding a non-profit that provides paid maternity leave to mothers. In 2016, Montella published Full Circle: A Memoir of Leaning in Too Far and the Journey Back about her experiences in the financial world.

What Was the Major Cause of the 2008 Financial Crisis?

There were several factors that led to the 2008 financial crisis. The primary cause was the bursting of the housing bubble, which was fueled by subprime mortgage lending or high-risk loans to borrowers who had very poor credit histories. Banks packaged these loans and sold them to investors who were hungry for high returns. These lax lending standards and loose financial regulations led to the collapse of the housing market, which had a ripple effect throughout the economy.

Which Banks Failed in 2008?

Several major banks failed in 2008. These firms included Lehman Brothers, which filed for bankruptcy in September 2008 after the federal government refused to bail it out, and Washington Mutual, which also collapsed in that same month.

What Does It Mean to be Too Big to Fail?

The term too big to fail is often used to describe companies or firms that so important to a nation’s economy that their collapse would lead to a significant amount of damage. The term is commonly used to describe very large banks and financial firms, and was frequently used during the 2008 financial crisis. The U.S. government ended up bailing out several major banks when the crisis hit because they were too big to fail, including Bank of America and JPMorgan Chase.

The Bottom Line

Lehman’s collapse roiled global financial markets for weeks, given its size and status in the U.S. and globally. At its peak, Lehman had a market value of nearly $46 billion, which was wiped out in the months leading up to its bankruptcy.

Many questioned the decision to allow Lehman to fail, compared with the government’s tacit support for Bear Stearns, which was acquired by JPMorgan Chase (JPM) in March 2008. Bank of America was in talks to buy Lehman but backed away after the government refused to help with its most troubled assets. Instead, Bank of America announced it would buy Merrill Lynch on the same day Lehman filed for bankruptcy.