Introduction

Ethics is a system of moral principles. They affect how people make decisions and lead
their lives. The term is derived from the Greek word ethos which can mean custom, habit,
character or disposition. Ethics is concerned with what is good or right in human interaction. In
brief, ethics is considered as the moral standard by which people judge behavior. (Colley, J.,
Doyle, J., Logan, G. & Stettinius, W. , 2003).
Ethical issue is a problem or situation that requires a person or organization to choose
between alternatives that must be evaluated as right or wrong.
In the 21st century, every industry is facing ethical issues and of course the banking
industry. At its simplest, banking can be defined as the business conducted or services offered by
bank. In other words, banking is a business activity of accepting or safeguarding money owned
by others individuals and entities, and then lending out this money in order to make a profit. The
banking activities these days have been widened which include issuance of debit or credit card,
providing safe custody of valuable items, lockers, ATM services and online transfer of funds
across the country. (Business Dictionary, 2016)
Financial institutions have become very complex in the way they operate with the various
products and services they offer. The transactions regarding the money are relevant from a moral
and an ethical perspective. Banks are the official intermediaries of money, we need to look at
how they handle money and what they do with it. Crime, pollution, corruption, violation of
human rights, threats to human life, totalitarian regimes, and all sorts of wrong-doing need and
use money every year. Financial institutions play a key role in the supply and movement of
elsewhere.
The Subprime Mortgage Crisis is an ongoing real estate crisis and financial crisis
triggered by a dramatic rise in mortgage delinquencies and foreclosures. In the United States, the
crisis had major adverse consequences for banks and financial markets around the globe. (US
News, 2008)

On 15th September 2008, Lehman Brothers files for bankruptcy-court protection due to
subprime mortgage crisis. Lehman was the fourth-largest U.S. investment bank at the time of its
collapse, with 25,000 employees worldwide. Lehman Brothers was founded by German
immigrant Henry Lehman in Montgomery, Alabama in 1844, as a drygoods store. In 1850, Henry
Lehman and his brothers, Emanuel and Mayer, founded Lehman Brothers. (Lehman Brothers,
2016)
The federal government did not employ extraordinary measures to save Lehman.
Lehman's collapse was a seminal event in the history in financial crisis that began in the U.S.
subprime mortgage industry in 2007. The crisis resulted in significant and wide losses to the
economy. (Lehman Brothers, 2016)
Lehmans collapse was because of its significant exposure to the U.S. subprime mortgage
and real estate markets. When these markets began to slow down, they sparked a retraction in the
shadow banking system for short-term loans as concerns about unknown exposures to
securitized subprime mortgages spread to other types of assets. Lehman was an investment
banks, it relied on these short-term markets to raise billions of dollars each day. Definitely,
Lehman was unable to secure its funding. (Lehman Brothers, 2016)
The purpose of this report is to examine and analyze the ethical and/or corporate
governance issues in banking and we are going to discuss the subprime mortgage crisis of case
Lehman Brother in year 2008. (Lehman Brothers, 2016)

Key Issues and Problem

There are some main issues highlighted which lead to bankruptcy of Lehman Brother in 2008.
1. High Risk Business Model
During 2003 and 2004 (Housing Bubble Period), Lehman Brother has adopted high risk
business model by expanding its business especially investment banking by acquiring 5
mortgage lender such as subprime lender BNC Mortgage and Aurora Loan service which is
specialize in Alt-A loan. (Lehman Brothers, 2016)
Subprime mortgage is type of loan that granted to individual who has low credit rating
and not qualified for conventional mortgage. (Business Dictionary, 2016) Due to the bank is
lending money to those low credit rating people, they need to bear high of borrower may default.
Thus , they will impose much higher interest rate than a conventional mortgage .Alt-A loan is a
loan made to people who have high income, good credit rating but have difficult to provide their
income or asset documentation. . (Business Dictionary, 2016) Therefore they do not provide full
documentation when they apply for Alt-A loan. Hence, both services are harmful and unethical if
the customers default the payment.
Besides, Lehman had packed those subprime mortgage into a financial asset, named
collateralized debt obligation (CDO) which is structured financial product backed by a pool of
loan and sell to investors. . (Business Dictionary, 2016) Bank will sell the loan or credit card to
investment bank , and subsequently pool and slice them to form CDO. Investor will get interest
from investor provided that the borrower of the loan make the installment in timely basis. If the
underlying loan go bad or default , the bank transfer much of the risk to the investor ,typically is
large pension fund or hedge fund. Thus, it is a toxic for investor and company.
2. Unforeseen Event: Burst of Housing Bubble In 2007
Unfortunately, there is an unforeseen event where cracks in the U.S. housing market in first
quarter of 2007. It is due to the housing estate bubble burst, and borrower cannot make payment
for their subprime loan. (Housing Bubble, 2016)

After Housing bubble burst, Lehman faced another unforeseen event where credit crisis
erupted in August 2007 and March 2008 with the failure of two Bear Stearns hedge funds.
Hence, Lehmans stock fell sharply. Thus, the company had to eliminate 2500 mortgage-related
job, shut down BNC units and closed down offices of Alt-A lender in 3 states. (Lehman
Brothers, 2016) Due to the above unforeseen circumstances, management of Lehman cannot
adjust their strategies timely and slowly leading bankruptcy in September 15, 2008.
3. Liquidity and Leverage Problem in 2008
Lehman faced liquidity problem even though it has huge asset based which is
$639billions of asset. Those assets are not ready cash and not easily sold assets. Most of them are
the properties which arise from subprime mortgage. In addition, they adopted high degree of
leverage (the ratio of total assets to total shareholder equity). Lehman leveraged 33 to 1 when the
price of asset dropping dramatically. (Lehman Brothers, 2016)
On September 6, 2008, Lehmans hedge fund clients began pulling out and short-term
creditors cut credit lines due to Lehmans low credit rating. On September 10, firm announced a
sweeping strategic restructuring of its businesses but this further led to a 42% plunge in the stock
on September 11. With only $1 billion left in cash, Lehman cannot restructuring its business.
Nonetheless, Barclays PLC and Bank of America Corp. (BAC), aimed at takeover of Lehman,
were unsuccessful. Hence, Lehman declared bankruptcy due to liquidity and leverage problem.
4. Fraud in Financial Statement
In March 2010, the court held that Lehman executives regularly used cosmetic
accounting gimmicks to reduce its balance sheet. The gimmick was known as a "Repo 105." In
an ordinary repo transaction, Lehman would raise cash by selling assets with a promise to buy
them back later. It's a common form of short-term financing. Due to it was a financing rather
than a sale, the assets remained on Lehman's balance sheet. However, Lehman treated the
transaction as a genuine sale and took the risky assets off its books. This had cause misleading in
overall leverage ratio of Lehman from 13.9 to 12.1, failing to give actual financial picture of
Lehman. (US News, 2008)

Reasoning and Analysis

i.

Reason why acted unethical

We have identified why Lehman Brothers has acted unethically as the following reasons:
1. Poor Internal Control and Risk Management Strategies
Lehman Brother has failed in monitoring the risk they will be faced in the future such as
credit risk (risk of default payment) and liquidity risk (Risk of failure paying debt). First,
Lehman adopted Value at Risk system and this is merely model based on mathematical
assumption without considering the volatility of market conditions.(Risk Management of
Lehman, 2010) Hence, due to vigorous market condition in 2008, Lehman failed to respond to
high credit and liquidity risk.
Second, after the crash of subprime in 2007, Lehman's chief financial officer (CFO) said
that he did not foresee risks posed by rising home delinquencies

in the subprime

market spreading to the housing market or hurting the U.S. economy. Hence, we can see that
Lehman failed to determine the likelihood and significance of the market risk in 2007 and failed
to take corrective action to safeguard companys high housing asset. Ultimately, Lehman
collapsed later. (Lehman Brothers, 2016)
Thirdly, the problem became worst when Lehman continued to be a major player in the
mortgage market ignoring high business failure risk. In 2007, Lehman underwrote
more mortgage-backed securities than other firm, accumulating $85 billion portfolio, or four
times shareholders' equity. However, this turns out to be last chance to maintain high share prices
and drop tremendously thereafter. (Lehman Brothers, 2016)
By applying Kolhberg preconventional level, it states that people make decision based on
avoiding punishment and ultimately based on self-interest. Apparently, CFO of Lehman Brothers
act in Kolhberg preconventional level to act on his self-interest by avoiding punishment of
dropping share prices in short term, so he tend to achieve his short term goals instantly by
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ignoring the assessment of risks in the long term success and implement sound internal control
system which add more cost to company in short term.
2. Poor Corporate Governance Arrangement
First, Lehman's CEO, Mr Richard Fuld is in dominant position influencing all the
decision of the company. His colleagues nicknamed him "Gorilla" because of his imposing
stature on the firm as nobody not even "outsiders" dared challenge his ideas, policies and
decisions. (FoxBusiness, 2015) Thus, investors not dare to challenge his risky idea on
adopting high subprime and Alt-A loan which are the harmful products to investors as he is
dominant.
Second, there is no appropriate audit committee and risk committee in the board to
oversee the internal control and risks of Lehman, leading the firms failed to employ efficient
strategies to face the credit risk and liquidity risk.
Lastly, there is lack of non-executive director in the board of Lehman to scrutiny the
performance of CEO who massively trading company in a risky way. Hence, there is no
oversight body to oversee the executive directors in order to maximize shareholders wealth.
Thus, CEO had acted opportunism to increase share price in the short term in 2007 by
underwriting more mortgage instead of acting long term interest to restructure the company.
In brief, poor corporate governance is the reason that led Lehman to bankrupt in 2008.
According to egoism, CEO and Lehmans governance is acted within their self-interest as
they might save cost on developing sound corporate governance and focus more on profitable
activities. Thus, there is high chance for Lehmans CEO acted on his self-interest and
unethically towards investors, increasing the total agency cost.
3. Maximising Shareholder Wealth by Creating False Information In Financial Health
Year 2008 was the financial crisis was course the growing of the housing market in USA.
According to Hudson 2007 mentioned that Lehman Brothers acquired 5 mortgage lenders
and became msrket leader in the production securitized mortgage by trying to cut profit from
this feasible investment.(Latifi, n.d.)However Aurora Loan Services in Colorado and BNC
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Mortgage in California had excessively lent Alt-Loans to unqualified borrowers without full
documentation and inflate their debt was Lehmans adverse step.
Besides that, the highest grade of Collateralized Debt Obligations (CDO) more
attractive to the investor. According to David Lis formula CDO can make positive impact
and widely ignored risk in the financial market. (Forslund, 2012) Lehman Brothers borrowed
money which allowed them to invest more in the CDO to maximise the investment bank
profit. Investment banks will higher their leverage if the leverage allowed sharply increased
meant earn more profit. Lehman Brothers was the bank which earns much high leverage in
year 2004.(Hantoft, 2012)
One of the ethical issues is consequential views of ethics. Lehman brother define
good by consequences. We can see that Lehman Brothers proceeded with high profit margin
in 2007 that only concern about his short-term financial health (outcome) and wastes it in
consideration on communication well with investor.
The report found that there was the inaccurate picture of the financial condition
composed by Lehman Brothers by using a Repo 105accounting strategy, the auditor of Ernst
and Young knew it but didnt question. Repo 105 was an accounting trick which company
proceed from said sale to reduce its liabilities by classifies the short-term loan as a sale. The
report also mentions that Lehman Brothers manipulate that Statement of Financial Position to
keep rating Agency approval. This ethical issue was egoism. Egoism was called big man
thinking which the well-being of each individual affected by the action and focuses only on
individual self-interest. Lehman Brothers was focuses on individual self-interest by
maximizing shareholder wealth and using those accounting trick.
4. Increasing competitive, investors confidence and globalization
Lehman had invested heavily in securities tied to the US sub-prime mortgage market
where demand is high and supply is low. First, US government was promoted Sub-prime
mortgages as a way for target lower-income families to own their homes. Second, real estate
brokers all over the US were making fast money selling mortgage products without worrying
about if and how these would be honoured.

Third, Lehman was chosen to offer alt-a loan and Collateralized Debt Obligations (CDO)
that other investment bank dint dare to offer as the default rate is very high. Due to other
investment bank dint offer sub-prime mortgage, Alt-A loan and CDO, Lehman Brothers are
differentiate from its competitor which offering normal investment services, reducing the
competitiveness. Hence, Lehman Brother able earn a lot of profits and increase investors
confidence, thus increasing the chance of globalization to become market leader in global
although they offer unethical products to public.
According to egoism which focus only on individual self-interest. Lehman Brother offer
three types of harmful service in order to increase competitiveness and globalization which
focus on well-being by itself without considering the long term impact of unethical action such
as global economic recession and high unemployment.
5. Maximizing Stakeholders Welfare
According to utilitarianism, it is a form of consequences of an act, which must benefit the greater
number of people. (Colley, J., Doyle, J., Logan, G. & Stettinius, W., 2003). In 2003 and 2004,
when U.S. housing boom was well under way, Lehman acquired five mortgage lenders which
lent to people with low credit or high debt loads and without complete documentation (US
Legal). Initially, this mortgage has brought good consequence to all people in United States
which including upper, middle as well as working class of people.
Normal mortgage application will require consumer provide all income and asset
documentation to determine mortgage qualification. After that, bank officer will review the
documentation has been submitted, measure that no documentation is missing as well as all
necessary and latest information is obtained. However, Lehman Company has eliminated those
necessary procedures which including require complete documentation and strictly check on the
fact. By doing so, many people can easily obtain a mortgage from Lehman Company. In fact,
many people is able to purchase house with a mortgage obligation, even working class can also
have their own house. It caused peoples standard of living has been increased. All class of
citizens are happy to enjoy a house
Second, the demand of land property will increase, hence the property developers will be
happy as they can earn more profit by supply or build more of it. Besides, property developer no
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more applies target costing method in design the housing development project strictly. They
might provide more high quality with well design land property for customer. On the other hand,
property developer can also considered about development of rural welfare in United Stated.
This is because of rural people also qualified for applying and obtaining the mortgage, reducing
the poverty gap between rural and urban.
Third, the property company would like to employed more agent during housing boom
was well under way. More job opportunity is provided to United States people. At the same
time, more people will work as a property agent; no matter it is a part time or full time job which
enables people to earn more income. Lehman Brothers also provide a lot of job opportunity to
citizens as increase of workload of mortgage. All the employees, trade union and community
will be happy as they get their jobs.
Fourthly, Government will be happy as the economy of United States has grown because
increasing in purchasing power of citizen with high overall gross domestic product (GDP) and
reducing in unemployment rate. Lastly, shareholders, directors and employees of Lehman are
happy as company is profitable with high yield of return to all stakeholders.
ii. The impact of unethical services offered by Lehman
1. Economic issue Great Recession arose (U.S. News, 2008)
The collapse of Lehman brother gave a big impact to global economic such as recession
began in December of 2007 to June of 2009. Second, US and global unemployment rate increase
from 5% to 9.5%. Thirdly, GDP of every country shrink. Furthermore, economic growth in Asia
and pacific dropped from 8% (2007) to 5.1% in 2008. Lastly, the value of the real estate
depreciated tremendously after the collapse of Lehman.

2. Social issue
First, increase in the level of poverty is reflected in developing countries. Poverty rate
of Bangladesh and Philippines have increased by nearly 4% between 2008 and 2010.
According to recent estimates by the United Nations Department of Economic and Social
Affairs (UNDESA), the poverty line of US$ 1.25 a day grew by 14 million between 2008 and
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2009 (United Nations, 2009). Therefore, poor is getting poorer after occurrence of financial
crisis in 2008.
Next, global financial crises has given rise to human right crisis as public feel
unsatisfied when poverty, thus they protest For instance, people in Africa protest against
desperate social and economic situation and sharp increase in living cost. (Amnesty
International, 2009) According to non-consequential views of ethics, Lehman has not acted
distributive and procedural justice when they issued harmful products to public, leading to
negative consequences of economic recession after bankrupt.
3. Legal Issue
After the collapse of Lehman, Dodd-Frank Act, which represents the principal political
response to the banking crisis, is converted into detailed rules that traders and C.E.O.s
have to follow such as book a detail account to investors.(Cassidy,J., 2013) Next,
legislature also forced employer of banking industries to implemented clawback
provisions in employment contracts, forcing employers

give back some employees

remuneration if they go beyond the firms risk guidelines and generate big losses, thus
safeguard human rights. (Cassidy,J., 2013)
iii. Recommendation
Banking Industries can take Lehman Brothers failure as a model by not undertaking a lot
of harmful services such as high default risk of subprime, Alt-A and CDO. Besides, the leverage
level of bank should not maintain at 20: 1 (asset: equity) to avoid overflow of unmovable assets.
Thirdly, a sound internal control and corporate governance should implement according
to UK Corporate Governance Code 2012 and Sarbanes Oxley Act 2002 to avoid falsifying of
financial statement and agency problem. Lastly, banks should focus on ethical by having at least
Kolhberg level 4 (rule-follower) and above and provide more corporate social responsibility to
society such as Maybank donate $20,000 to New Straits Times School Pocket Money Fund on
2015. (Maybank, 2015)

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Conclusion
In the movie of Despicable Me, Lehman Brothers was described as Bank of Evil as it
offered harmful products such as subprime mortgage, Alt-A and CDO which subsequently cause
great economic loss to the global world, leading the poverty rate and GDP rate become adverse.
Hence, in the report, we have discussed some key issues and problems that caused Lehman
Brother collapse such as high risk business model, unforeseen events, liquidity and leverage
problem and fraud in financial statements.
In the second part of assignment, we have discuss on the reason why Lehman act
unethical to the public as there are poor internal control and risk management strategies, poor
corporate governance, maximize shareholders wealth, increase competitiveness and maximize
stakeholders welfare. The effect of acting unethical has led to bankruptcy in 2008 which arises
economic issues, social issue and legal issues. Therefore, we provide some recommendation to
other banking industries, so that they wont repeat the unethical act like Lehman Brothers.
In this assignment, we have learnt a lot of things include the background of financial
crisis in 2008. We have grasped why subprime crisis can affect the global economy and the
disadvantages of Alt-A and CDO to the banking industries. In addition, we also master how to
apply ethics theory in the case study and also know that a sound corporate governance is vital to
an organization.
Nonetheless, we have familiar that cooperation is important to complete the assignment
by dividing the work equally effectively and efficiently. Lastly, we are able to learn how to
manage the time well and complete it without any delay.
(3476 words)

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