DAMODARAM SANJIVAYYA NATIONAL

LAW UNIVERSITY,
VISAKHAPATNAM, A.P., INDIA

PROJECT TITLE

Lehman Brothers and Goldman Sach Case Study

SUBJECT

NAME OF THE FACULTY

NameRoll Number: -

CONTENTS
1

OBJECTIVE, RESEARCH METHODOLOGY

Chapterisation
1. Introduction
2. Lehman Brothers Case Study
A. History and Facts
B. Ethical Issue Examined
C. Wrongs done by Company
3. Goldman Sach Case Study
A. Players
B. Instrument
C. Events
D. Transactions
E. Outcome
F. Analysis of Ethical Issue
4. Foreign Institutional Investment
5. Conclusion
6. Bibliography

OBJECTIVE
The primary aim and objective is to grasp knowledge about both cases and understand the both
case and make a comperative analysis
RESEARCH METHODOLOGY
This project is totally a doctrinal research methodology i.e. material is taken from many sources
like books, journal and another means of sources. Many cases are collected from the online
journal and the judgments are from the sites of any concerning courts.

Introduction
3

Bankruptcy is a legal status of a person or other entity that cannot repay the debts it owes to
creditors. In most jurisdictions, bankruptcy is imposed by a court order, often initiated by the
debtor.
Bankruptcy is not the only legal status that an insolvent person or other entity may have, and the
term bankruptcy is therefore not a synonym for insolvency. In some countries, including the
United Kingdom, bankruptcy is limited to individuals, and other forms of insolvency
proceedings (such as liquidation and administration) are applied to companies. In the United
States, bankruptcy is applied more broadly to formal insolvency proceedings.
There have been people there have been debtors and creditors. Moreover, as long as there have
been debtors and creditors there have been debtors who have not been able to pay their debts.
Throughout history, however, there has been very little in the way of organized bankruptcy
proceedings to straighten out the mess left when debts go unpaid and the lender wants his
money back or at least something in return for the lost funds.
Problems created because of bad debts and bad debtors create huge problems for economies.
The simple fact is that any modern economy, as well as most of those economies that have
existed throughout history, require a sound system that encourages loans and takes steps to
assure repayment of those loans. Money is required to expand a business, buy a tractor, or to
build a house.
In Ancient Greece, bankruptcy did not exist. If a man owed and he could not pay, he and his
wife, children or servants were forced into "debt slavery", until the creditor recouped losses
through their physical labour. Many city-states in ancient Greece limited debt slavery to a period
of five years; debt slaves had protection of life and limb, which regular slaves did not enjoy.
However, servants of the debtor could be retained beyond that deadline by the creditor and were
often forced to serve their new lord for a lifetime, usually under significantly harsher conditions.
An exception to this rule was Athens, which by the laws of Solon forbade enslavement for debt;
as a consequence, most Athenian slaves were foreigners (Greek or otherwise).

Lehman Brothers Case Study

4

History and facts

In the mid-1800s, Henry, Emanuel, and Mayer Lehman emigrated from Germany, to
Montgomery, Alabama, where, in 1844, they established a small shop selling groceries to the
local cotton farmers. Since the farmers often paid their bills in cotton, the brothers soon found
that their business relied as much on selling cotton as dry goods. Deciding to focus on trading
cotton, in 1858 the brothers established a New York office and were instrumental in setting up
the New York Cotton Exchange. The brothers also began trading other commodities, as well as
helping companies raise capital in the bond and equity markets. In 1887, Lehman Brothers
became a member of the New York Stock Exchange, establishing the company in securities
trading and providing a foundation for the underwriting business.1
In the early 1900s, Lehman Brothers developed its banking practice by helping to intermediate
funding for the emerging group of retail, industrial, and transportation giants that were founded
during this period. Robert Lehman, a grandson of Emanuel Lehman, took over the firm in 1925
and led the company until his death. During Robert Lehmans tenure, Lehman Brothers became
a well-known investment bank, working with leading U.S. and international companies in
underwriting securities offerings, providing financial advice, and helping in mergers and
acquisitions. Lehman was organized as a partnership and was privately owned and family
controlled until Robert Lehmans death in 1969; he was the last of the Lehman family to work
at the firm.2
Ethical Issue Examined
In August 2007, Lehman announced that it would close BNC Mortgage, its main subprime
origination platform and its Korean mortgage business. It also suspended its wholesale and
correspondent lending activities at its Aurora Loan Services subsidiary. Yet, in October 2007, it
acquired the Archstone Real Estate Investment Trust, the largest residential REIT in the U.S.,
amid concerns from rating agencies and investors that it was overpaying for the deal.
Lehmans long-term assets were being funded by short-term debt (e.g., repo agreements and
commercial paper) and Lehman borrowed billions of dollars each day in the overnight
1Site referred: - http://investopedia.com/articles/economics/09/lehman-brothers-collapse.asp
2 Ibid
5

wholesale funding markets in order to operate. By early 2008, other institutions were less likely
to accept Lehman securities as collateral (or, alternatively, demanded more collateral for a given
level of financing, thereby eroding Lehmans ability to continue to carry out its short-term
obligations).3
Following the near collapse of Bear Stearns in March 2008, precipitated by a liquidity crisis,
rumors circulated that Lehman would be the next bank to go under. As Lehmans perceived
financial position worsened, it faced a higher cost of credit. Some lenders withdrew from the
firm, refusing to roll over its repos, others demanded bigger haircuts (discounts), and still others
refused to accept all but a narrow type of collateral, refusing Lehmans real-estate-related assets
and rendering them even more ineffective.
For example, between June and August 2008, Lehman delivered an additional $9.7 billion to
J.P.
Morgan Chase to support its securities clearing and triparty services (wherein it acted as agent
for
Lehmans repo transactions). Also, uncomfortable with the collateralized debt obligations
(CDOs) that Lehman delivered, J.P. Morgan requested additional collateral, but would only
accept cash
At the end of its 2007 fiscal year, Lehman Brothers held $111 billion in commercial or
residential realestate-related assets and securities, more than double the $52 billion that it held at
the end of 2006, and more than four times its equity. Increasingly, rating agencies and investors
expressed concerns regarding these types of assets due to the illiquidity of the market for them
and to the substantial losses that other firms experienced in these categories. The constant
revaluation by Lehman Brothers of these types of assets would contribute to significant writeoffs throughout 2008.
Wrongs done by Company
During much of the late 1990s and into the early 2000s many emerging-markets
and

commodity-rich

3 Ibid
6

countries experienced large current account surpluses and sought safe assets to
invest

in,

traditionally

sovereign and government agency debt. At the same time, there was significant
growth

in

institutional

cash pools, such as pensions, money market funds, and hedge funds, which also
demanded

these

safe

assets. As demand for these safe assets outstripped supply, a global savings glut
resulted.
During the same period, booming U.S. housing prices and low interest rates
combined

to

create

an

exuberant mortgage market. Mortgage-backed securities (MBS), whereby investors

purchased

the

right

to a stream of payments fuelled by a pool of underlying mortgages, became very

popular.

As

U.S.

housing

and mortgages had traditionally been considered stable investments, and because
at

this

time

mostly

lower risk prime mortgages were used, many of these MBS received high
investment-grade

ratings.

Prior to 2003, the market in MBS had been dominated by the governmentsponsored

entities,

the

Federal

National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage
Corporation
(Freddie Mac), and also enjoyed an implied governmental guarantee. 4
In response to the savings glut, banks became more involved in producing MBS. As
demand

continued,

banks combined MBS with other types of asset-backed securities (ABS), such as
those

based

on

credit

card receivables, auto loans and student loans, to sell them as a new type of bondlike

security

called

collateralized debt obligations (CDOs). Payments under the CDOs were to be made
out

of

the

flow

4 Site refrred:
-http://topics.nytimes.com/top/news/business/companies/lehman_brothers_holdings_inc/index.htm
7

of

repayment from the underlying MBS and ABS making up the CDO. Again, because
of

the

mortgages

underlying the CDOs, many received investment-grade ratings.

CDOs proved very popular and were aggressively sold to investors in all the worlds
major

markets.

By

2007, CDOs had become a significant portion of the ABS market. To meet the
demand

for

MBS

and

CDOs, banks began pooling not just prime mortgages but also riskier subprime
loans

and

greater

portion of the securities underlying CDOs became MBS, and then subprime MBS.
Over

time,

lenders

loosened underwriting standards in order to increase the quantity of subprime

mortgages

that

could

be

pooled. As they became common, CDOs and other structured debt were routinely
used
repo transactions.

as

collateral

for

CDOs were termed structured instruments because they were divided into different
tranches

based

on

the timing of payments and the payment priority given the holder of a particular
tranche

(higher-rated

tranches were guaranteed payment before lower rated tranches). Creating

tranches

allowed

investors

to

choose at what level of risk to invest and allowed investment firms to create
investment-grade

tranches

from even sub-prime mortgages. Lehmans troubles were due in part to the fact
that

it

retained

some

of

the low-rated tranches of the CDOs it generated, and these tranches were the first
to

get

when the housing market cooled.

into
6

5 Ibid
6 Site referred: http://money.cnn.com/2008/07/02/news/companies/lehman_sloan_boyd.fortune/index2.htm.
8

trouble

Goldman Sach Case Study

The players
The central players in the Goldman Sachs ABACUS deal in 2007 include the following:

Goldman, Sachs & Co. A prominent global investment banking and securities firm
founded in 1869 and located in the heart of Wall Street. Goldmans credo is they bring
together people, capital and ideas to produce solutions and results for [their] clients by
playing a number of roles: financial advisor, lender, investor and asset manager. Among
other things, Goldman has become known for its advisory services and proprietary
trading.

The Securities and Exchange Commision (SEC). A federal agency that acts as the
primary enforcer of federal securities laws and regulates the securities industry, the
nations stock exchanges, and other electronic securities markets in the United States.
The SEC has the authority to bring civil enforcement actions against individuals or
companies alleged to have violated the securities law.7

Paulson & Co. A New York-based hedge fund founded in 1994 by John A. Paulson. At
the time of the case, Paulson was known for his pessimistic outlook of the mortgage
industry. He bet against the ABACUS CDO and netted approximately $1 billion in doing
so.8

ACA Management. A former well-known manager of collateralized debt obligations

(CDOs) in the financial markets. ACA was chosen as the Portfolio Selection Agent by
Goldman, Sachs & Co. for the 2007 ABACUS deal in an effort to lend credibility for
marketing purposes. It is estimated that ACA lost approximately $900 million due to its
position in the ABACUS deal. Its parent company, ACA Capital, fell under financial

7 Blankfein, L. (2009). To Avoid Crises, We Need More Transparency. The Financial Times
8 Ibid
9

distress and eventually failed in late 2007. The firm is currently operating as a run-off
financial guaranty insurance company.

IKB Deutsche Industriebank AG (IKB). A bank based in Dusseldorf, Germany, that

specializes in lending to small and medium-sized companies. IKB was bailed out in
August 2007 because of the massive losses it sustained from the subprime market
meltdown. The SEC asserts that IKB was on the wrong side of the Goldman ABACUS
CDO deal, resulting in losses estimated at $150 million. IKB was a valuable client of
Goldman Sachs and had invested in several of Goldmans CDOs prior to 2007.9

The instruments
The following three highly complex financial instruments were leveraged by Goldman and
Paulson & Co. during the 2007 ABACUS CDO deal. Typically, investors who buy or sell these
types of products are considered highly sophisticated. However, some wonder if the instruments
are too complex for such investors to fully understand their potential downside risks.

Residential Mortgage-Backed Securities (RMBS). Residential mortgage-backed

securities are commonly issued bonds that are backed by pools of residential real estate
mortgages. The RMBS related to The SEC vs. Goldman Sachs case were comprised of
subprime mortgages.10

Synthetic CDOs. Collateralized debt obligations are a type of security whose value and
payments are derived from a portfolio of underlying (fixed-income) assets. CDO
securities are split into different risk classes, or tranches, whereby senior tranches are
considered the safest. Interest and principal payments are made in order of seniority.
Thus, junior tranches offer higher coupon payments (and interest rates) or lower prices to
compensate for additional default risk. A synthetic CDO is similar to a traditional cash
CDO. The primary difference between the two is that a synthetic CDO does not own the

9Carney, J. (2009). Is Warren Buffett's Investment in Goldman Sachs the Future of Wall Street? Retrieved
November 3, 2009, from Business Insider: www.businessinsider.com
10 Goldman Sachs History. (n.d.). Retrieved November 1, 2009, from Funding Universe:
http:www.fundinguniverse.com/company-histories/The-Goldman-Sachs-Group-Inc-Company-History.html

10

underlying assets. Alternatively, synthetic CDOs gain credit exposure to a portfolio of

fixed-income assets through the use of credit default swaps. The risk of loss on synthetic
CDOs is divided into tranches just like traditional (cash) CDOs.11

Credit Default Swap (CDS). Credit default swaps are a form of insurance policies and
function similarly. CDSs are agreements between buyers who desire some form of debt
default protection and sellers that provide a buyer with a nominal payoff in the event of
credit default. Buyers of CDSs pay a series of fee premiums similar to an insurance
policy for the protection. CDSs can be used as a way to hedge default risk for those
who own bonds, or they can be used as a way to speculate (commonly referred to as
naked credit default swaps) on debt issues and the creditworthiness of other entities
without having to hold their bonds.

The events
Considered by many economists to be the worst financial crisis since the Great Depression, the
financial crisis of 2007 was primarily the consequence of a liquidity shortfall in the U.S. banking
system. One early indicator that a financial crisis was imminent was the collapse of the
subprime mortgage market.12
Subprime, by definition, means less than prime, and in the mortgage industry, subprime loans
are considered to be one of the riskiest classes of credit. Subprime borrowers are those who
typically do not qualify for conventional financing and are characterized by undesirable financial
metrics such as low credit scores, high debt-to-income ratios, and limited net worth. During the
early-to-mid 2000s, subprime borrowers were able to obtain financing rather easily due to the
abundance of credit available at historically low costs and lax mortgage underwriting standards.
Borrowers gorged on the seemingly infinite stream of easy, cheap debt. Many borrowers then
used the loans to buy houses. As demand for homes skyrocketed, housing prices began to
(artificially) inflate and deviate from their true underlying values, effectively creating a bubble.13
11 Ibid
12 Ibid
13 Ibid
11

Approximately 80% of U.S. mortgages issued to subprime borrowers during this time were
adjustable-rate mortgages (ARMs). In mid-2006, home prices in the U.S. peaked and
subsequently began a rapid decline. Increasing interest rates were a significant contributing
factor to the house price decline. In addition, teaser rates on subprime ARMs were beginning
to reset at prevailing higher interest rates. As the economy contracted, subprime borrowers were
unable to refinance their freshly adjusted high-rate mortgages into conventional fixed-rate
mortgages. The result was an increase in delinquencies, defaults, and eventually foreclosures.
The effects of the subprime market meltdown were devastating and far-reaching. As many of the
subprime mortgages were pooled together after origination and re-sold as packaged securities,
numerous economic sectors regardless of size were adversely impacted by the subprime
fallout.14
The transactions
While other elements of The SEC vs. Goldman Sachs case (such as the parties involved, the
financial instruments leveraged, and the events that took place) are fairly clear, the actual
information (or lack thereof) communicated between parties involved is in dispute. Facts of the
case that all parties have agreed upon include:15

Goldman was approached by John Paulson of Paulson & Co. to assemble a synthetic
CDO, dubbed ABACUS 2007-AC1, in exchange for a $15 million fee.

Goldman brought in an outside asset manager (ACA Capital) to aid in the selection of
collateral that was to comprise ABACUS. In the end, it consisted primarily of subprime
mortgage securities.

Goldman sold ABACUS to German-based bank IKB.

Paulson effectively shorted ABACUS by entering into credit default swaps to buy
protection on specific layers of the CDO (the senior tranches).

14 Reynolds, A. (2008). "Wall Street" No Longer Exists. Retrieved November 2, 2009, from Wall Street
Journal: http://online.wsj.com/article/SB122212959612065505.html
15 Ibid
12

The CDO ultimately failed as a result of the subprime market meltdown. In the end, John
Paulson netted approximately $1 billion, IKB lost approximately $150 million, ACA
Capital lost approximately $900 million, and Goldman lost approximately $100 million
(which was partially offset by the $15 million fee it received from Paulson & Co.).

The disagreements between the parties center on the information Goldman provided to the
parties on the other side of the transaction and on the sales strategies Goldman employed to
close the deal.16
In short, the SEC alleged that Goldman made materially misleading statements and omissions in
connection with the ABACUS CDO placement. The SEC charged that Goldmans marketing
materials for ABACUS conveyed that ACA Management, an independent third party with
experience analyzing RMBS credit risk, selected the reference portfolio of the RMBS underlying
the CDO. In fact John Paulson (who, unbeknownst to IKB, had a direct adverse economic
interest in the instrument) played a significant role in the portfolio selection. Additionally, the
SEC alleged that Goldmans salesman for ABACUS, Fabrice Tourre, misled ACA into believing
that Paulson had invested hundreds of millions of dollars in the equity of ABACUS. Tourre
further said that Paulsons interests in the collateral selection process were aligned with ACAs
when in reality their interests sharply conflicted.
Goldman has defended itself, telling the SEC its allegations were based on the benefit of perfect
hindsight. Short-sellers, Goldman contended, were a routine part of synthetic CDO structures
such as ABACUS. It was common practice not to disclose the identity of the short side to the
long side. Regarding the selection process of the CDO collateral, Goldman argued that the
portfolio ACA selected with Paulsons input had the same characteristicsand experienced
virtually the same poor performance as other similarly structured CDOs. Goldman further tried
to justify its position as an unbiased intermediary by noting that it kept a portion of the CDO on
its books and ended up losing approximately $85 million (net of a $15 million structure fee).
Critics maintain Goldman was simply unable (not due to a lack of trying) to shed its position in
time to avoid incurring any losses.17
16 Ibid
17 Ibid
13

The outcome
Goldman was fined $550 million and eventually conceded saying that, The marketing materials
for the ABACUS 2007-ACI transaction contained incomplete information. In particular, it was a
mistake for the Goldman marketing materials to state that the reference portfolio was selected
by CA.18

Foreign Institutional Investment

Economies like India, which offer relatively higher growth than the developed economies, have
gain favour among investors as attractive investment destinations for foreign institutional
investors (FIIs). Investors are optimistic on India and sentiments are favourable following
governments announcement of a series of reform measures in recent months.
According to a poll conducted by Bank of America Merrill Lynch (BofA-ML) recently, in which
50 investors participated, India was the most favourite equity market for the global investors for
the year 2015 at 43 per cent, followed by China at 26 per cent. The global investment bank is of
the view that India remains to be in a structural bull market.
India is poised to become the second biggest ecosystem option after the US in the next two years
on account of the on-going high growth rates. Several technology based start-ups have received
over US$ 2.3 billion in funding since 2010, while over 70 private equity (PE) and venture capital
(VC) funds remain active in the segment.
FIIs net investments in Indian equities and debt have touched record highs in the past financial
year, backed by expectations of an economic recovery, falling interest rates and improving
earnings outlook. FIIs have invested a net of US$ 89.5 billion in 2014-15 expected to be their
highest investment in any fiscal year. Of this, a huge amountUS$ 57.2 billionwas invested
in debt and it is their record investment in the asset class, while equities absorbed US$ 32.3
billion.

18 Westfall, C. (2009). Investment Bank Transition Not an Easy One. Retrieved November 4, 2009, from
KPMG Insiders: http://www.kpmginsiders.com/display_analysis.asp?cs_id=228341
14

India continues to be a preferred market for foreign investors. India-focused offshore equity
funds contributed US$ 0.5 billion, whereas India-focused ETFs added a much higher US$ 1.2
billion of the total net inflows of about US$ 1.7 billion into the India-focused offshore funds and
ETFs during the quarter ended June 2015.
India companies signed merger and acquisition (M&A) deals worth US$ 31.16 billion in
January-November 2015. The total M&A transaction value for the month of November 2015 was
US$ 2.97 billion involving a total of 47 transactions.
In Private Equity, a total of 91 deals worth disclosed value of US$ 1.43 billion were reported in
November 2015.

Conclusion
India is being viewed as a potential opportunity by investors, with the economy having the
capacity to grow tremendously. Buoyed by strong support from the government, FII investments
have been strong and are expected to continue to improve going forward. "FIIs are flocking
towards Indian bonds as the confidence level of central bank and the government is at one of the
highest levels and benign commodity prices have added confidence," said Rahul Goswami, Chief
Investment Officer for fixed income at ICICI Pru Mutual fund. "India is among the few markets
where interest rates are expected to drop with fair visibility, which would attract flow from FIIs"
said Arvind Sethi, MD & CEO, TATA Asset Management.
A PricewaterhouseCoopers India report based on a survey of 40 PE firm partners has projected
that the country has the potential to get PE funding of US$ 40 billion by 2025. Future PE
investments would be driven by Indias consumption story, realistic valuations, competitive
businesses, growing private entrepreneurship, among other factors, as per the report,

Bibliography
15

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17