This September marks the fifth anniversary of Lehman Brothers’ bankruptcy. While US markets have posted a stronger than expected year, full recovery has been slow since the “too big to fail” 2008 financial crisis. Robert W. Kolb takes a look back at Lehman Brothers’ decline in the following excerpt from The Financial Crisis of Our Time.
There really were Lehman brothers, two German immigrants who settled in Alabama in the middle of the nineteenth century, got their start by running a general store, and moved into cotton trading. After the Civil War, they moved their business to New York, entered the financial advisory industry, and the firm joined the New York Stock Exchange in 1887. Active in the investment banking business since the late 1880s, Lehman went through a series of mergers and divestitures, both as an acquiring firm and as a target. For a while, it was part of American Express, but it went public in the mid-1990s and was an independent company until its demise in 2008.
Lehman focused much of its real estate securitization activity in commercial real estate and was widely admired for its strategy in that area. But Lehman was also a big player in residential real estate, carrying as much as $25 billion in residential mortgages of highly questionable value as the end neared. Like other players on Wall Street, Lehman used extremely high leverage to earn profits of $4 billion in 2006. Following the collapse of Bear, Lehman possessed all the information one can imagine about the seriousness of the problems it faced. By June 2008, the public too received the message, if they did not already have it: Lehman posted a quarterly loss of $2.8 billion. At a time when other firms were scrambling to unload assets and secure partners, Lehman’s CEO Richard Fuld still was insisting that Lehman can “go it alone.”
As summer wore on and fall approached, the crisis deepened and Lehman’s prospects deteriorated. Despite Fuld’s proud go-it-alone stance, Lehman was seeking a merger partner in the summer and was scouring the Middle East and Asia for investment funds. Ironically, in hindsight, Lehman even tried to sell itself to AIG. In the summer, Lehman proposed to the Federal Reserve that Lehman could transform itself into a bank holding company subject to regulation by the Federal Reserve, a transformation that would allow Lehman to borrow from the Federal Reserve. However, the Fed rejected this plan. Later, Treasury Secretary Paulson explained this decision by saying that Lehman lacked good assets to deposit as collateral and that the federal government lacked the powers to offer Lehman support.
By September, matters were clearly worsening rapidly. Shortly after Labor Day, other Wall Street firms began to demand additional collateral for loans they had extended to Lehman. On September 9, the Korea Development Bank announced conclusively that it would not be investing in Lehman, and Lehman’s stock fell a further 37% on the news.
Realizing its desperate straits, Lehman intensified discussions with Barclays and Bank of America, seeking to be acquired. A key question in such matters turned on whether the Federal Reserve would offer guarantees to limit the potential losses of acquirers. Both Barclays and Bank of America were clearly looking for such a guarantee to make an acquisition palatable.
The Fed faced the following question: Is Lehman too big to fail, given current market conditions? After all, Lehman was bigger than Bear, and market conditions were worse in September than they had been in March, when the Fed put itself on the hook for $30 billion to get the Bear deal done. The Fed certainly had its hands full at the moment, that week of September 8–12, as Merrill Lynch, a much larger firm, was under simultaneous pressure. Also, the shares of Washington Mutual contributed to the stress by falling 30% that Wednesday and another 21% the next day, while AIG tottered on the brink of collapse. By September 11, a Thursday, Lehman’s survival depended on whether the Fed would guarantee some of its assets to help get a deal done, and Lehman was trying to limp to the weekend, when it would try to finalize a deal. The Wall Street Journal reported on September 12 that Lehman had experienced $10 billion in paper losses in 2008, had a market capitalization of $2.86 billion, and was holding a bonus pool of $3 billion, more than its entire market capitalization.
The weekend brought resolution, and it was not a victory. On Saturday night, the Fed refused to offer support for a Lehman deal, and Barclays and Bank of America abandoned their talks to acquire Lehman, proving that their pleas for Fed assistance were not mere bargaining ploys. Lehman had no alternatives remaining, and it filed for the largest bankruptcy in US history on September 15, 2008, ending its more than 150-year history.
The collapse of Lehman led almost immediately to bitter recriminations. Had the Fed and Treasury erred in not finding a way to save Lehman? Was the government trying to send a message of market discipline to show that some firms were not too big to fail? Could Lehman have done a better job for itself by acting more aggressively and wisely to restructure its miserable finances as the magnitude of the crisis developed? All these issues would attract much attention in time, but the market and public policy analysts had little leisure to reflect on these broader issues that were now of historical concern, for other larger shoes were already threatening to drop the same weekend.
Robert W. Kolb is Professor of Finance and Frank W. Considine Chair of Applied Ethics at Loyola University Chicago. He has been professor of finance at the University of Florida, Emory University, the University of Miami, and the University of Colorado, and has published more than 20 books, including The Financial Crisis of Our Time, Lessons from the Financial Crisis: Causes, Consequences, and Our Economic Future and Futures, Options, and Swaps.
Image credit: Richard S. Fuld, Jr. January 2007 by the World Resources Institute Staff. Creative commons license via Wikimedia Commons.