BOSTON UNIVERSITY FINANCIAL MONEY, MARKETS, & INSTITUTIONS AD 712 Professor: Dr.

John Sullivan Facilitator: San Chee

THE LEHMAN BROTHERS CARTEL: TOO BIG TO FAIL?

AALAA MILAGRO May 29, 2011
ABSTRACT
Lehman Brothers and the Too Big to Fail concept can only be understood by understanding the broader scope of the financial crisis itself. In doing so, we must distinguish the triggers, the events leading up to the global financial system breakdown, versus the vulnerabilities, the structural regulatory and supervision weaknesses that amplified the crisis. Actionable balance sheet manipulation, non-culpable errors of business judgment(Bernanke, 2010), and Lehmans Repo 105 rule contributed a level of financial engineering that allowed the Shadow Banking System to grow into a toxic global problem. This paper will examine the public and private sector vulnerabilities and triggers of the global financial system, shadow banking and its role in leading to the failure of Lehman Brothers. At its apex, Too Big to Fail was the culmination of private sector arrangements and lack of public sector regulations created a problem that became greater than America alone.

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TABLE OF CONTENTS
INTRODUCTION Pg. 3 PRIVATE SECTOR VULNERABILITIES Pg. 4 PUBLIC SECTOR VULNERABILITIES... Pg. 5 SOCIAL TRIGGERS. Pg. 7 LEHMAN BROTHER .. Pg. 8 Repo 105 & Balance Sheet Manipulation Lehman & Corporate Social Responsibility Too Big To Fail CONCLUSION.... Pg. 15 BIBLIOGRAPHY. ..Pg. 17

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INTRODUCTION Lehman Brothers and the Too Big to Fail concept can only be understood by understanding the broader scope of the financial crisis itself. In doing so, we must distinguish the triggers, the events leading up to the global financial system breakdown, versus the vulnerabilities, the structural regulatory and supervision weaknesses that amplified the crisis. Actionable balance sheet manipulation, non-culpable errors of business judgment(Bernanke, 2010)1, and Lehmans Repo 105 rule contributed a level of financial engineering that allowed the Shadow Banking System to grow into a toxic global problem and ultimately the fall of Lehman. Vulnerabilities increase the effects of the triggers. Subprime mortgage losses were large but not large enough to account for a global financial crisis. Prior to the crisis, Shadow Banks, financial entities other than conventional financial institutions like Lehman Brothers & Countrywide Financial, Inc., began playing a major role in global finance. As the shadow banking system grew they became more dependent on short-term wholesale funding. Reliance on short-term uninsured funds made Shadow Banks subject to runs similar to the banking system prior to the development of deposit insurance. When the Subprime mortgage market problems became well known, the providers of short-term funds retreated from Shadow Banks, disrupting the shortterm money market. This paper will examine the role of public and private sector vulnerabilities and triggers of the global financial system, shadow banking and its contribution leading to the failure of Lehman Brothers. Too Big to Fail was the culmination of private sector arrangements and lack of public sector regulations creating a problem that became greater than America alone.
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PRIVATE SECTOR VULNERABILITIES The key vulnerabilities of the U.S. banking system were a product of private sector arrangements. An overdependence on short-term funding, poor risk management, excessive leverage, misuse of derivative instruments, and the mismanagement of mortgage securitization process allowed the U.S. Banking system to become over-exposed to systemic risks. The worldwide scramble to appropriate wealth through 'financial manipulation' is the driving force behind this crisis. It is also the source of economic turmoil and social devastation. In the words of renowned currency speculator and billionaire George Soros (who made $1.6 billion of speculative gains in the dramatic crash of the British pound in 1992), 'extending the market mechanism to all domains has the potential of destroying society'. (Chossudovsky,M., 1998) 2 Investment banks, hedge funds, monolines, conduits, Special Investment Vehicles (SIVs) and money market funds, all non-depository banks, made up the Shadow Banking System. Because of their non-depository status, Shadow Banks were not subject to the same regulations as traditional commercial lending institutions. Lehman Brothers, an investment bank, served as the intermediary between investors and lenders. They exchanged funds from the investors to participating organizations, gaining profits from fees or from the difference in rates offered between the investor and borrower. The excess would then be deposited and Lehman would supply collateral to those guaranteeing the deposits. Initially, shadow banking collateral was limited to Treasury securities, Fannie Mae and Freddie Mac debt, and federally insured certificates of deposit. However, demand for collateral began to exceed the supply allowing securities to supplement the gaps. With the assistance of Ernst & Young (Financial Accounting Firm & Lehmans auditors), J.P. Morgan Chase
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(Investor), and Citibank (Investor), Lehman was able to engineer financial statements that

supported their lapse in moral judgment through loopholes via the absence of regulation for nontraditional banks. The growth in banking sector balance sheets along with measurement omissions and shifting scrutiny all played their part in the development and transmission of todays credit crisis. Such growth in lending would not have been possible without the emergence of what has become known as the shadow banking system. (Davies, 2009)3 The financial systems systemic risk threshold allowed for investment banks to build upon the high risk, high leverage model spawned by confidence and maintained by trust.

PUBLIC SECTOR VULNERABLILITIES With the development of innovative new products within the investment banking sector such as repurchase agreements, (a Lehman tool of choice), specific interbank loans, contingency funding and similar products created a market dependency on the shadow banking system. In early 2007, asset-backed commercial paper conduits, in structured investment vehicles, in auction-rate preferred securities, tender option bonds and variable rate demand notes, had a combined asset size of roughly $2.2 trillion. Assets financed overnight in tri-party repo grew to $2.5 trillion. Assets held in hedge funds grew to roughly $1.8 trillion. The combined balance sheets of the then five major investment banks totaled $4 trillion. In comparison, the total assets of the top five bank holding companies in the United States at that point were just over $6 trillion, and total assets of the entire banking system were about $10 trillion. (Geitner, 2009) 4 As early as 2005, Lehman Brothers initially did not include leveraged loan commitments and illiquidity on balance sheet submissions. Time would eventually expose that Lehman maintained approximately $700 billion of assets, and
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corresponding liabilities, on capital of approximately $25 billion. (Valukas, 2010)5 This was equivalent to almost 10% of the U.S. debt by 2008. The U.S. Government, SEC and Central Bank System were inadequately structured to handle the rapid growth of the non-traditional banking industry. Certain leniencies, like limited data reporting revealing risk positions and an optional monitoring agreement offered by the SEC, gave organizations like Lehman Brothers the opportunity to take advantage of an ineffective use of existing authorities. This was just one example of the lack of poor executive leadership, monitoring, and implementation. Statutory gaps in the framework were apparent and with Geithner and Bernanke serving on the Board of the FOMC together, they share responsibility for the overall architecture of the model that would eventually expose how allowing the leadership chose to be at the expense of global expansion. Relaxing the regulations for insurance underwriting serves as another perfect example in the governments continued efforts to sacrifice the benefits of foreign investments for solvency and measuring systemic risks. Arguably, the Graham Leach Bliley Act of 1999, which eliminated the parameters of the Glass-Steagel Act and allowed for more liberal underwriting methodologies carry their weight as well in contributing to the Lehman Brothers collapse. The bubble had been inflated by increasingly lenient lending standards, which in turn allowed under-qualified households to borrow excessive amounts of money on residential mortgages that could not be repaid unless housing prices continued to rise. These mortgages were often bundled into residential mortgagebacked securities that were blessed with excessively optimistic (high) ratings by credit rating agencies and sold to insufficiently cautious investors.(White, L., 2010)6 In September 2008, investors lost faith in the quality of the securitized loans, withdrew their money from the shadow
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banking system, and instead invested in short-term government treasuries. This withdrawal of

funds was the 21st century equivalent of a bank run from the Depression era, except that the scared parties were large investors rather than the ordinary individual depositors of the Depression. (Doren, 2010) SOCIAL TRIGGERS OF THE FINANCIAL CRISIS & LEHMANS ROLE There were several social triggers that contributed to the collapse of Lehman Brothers instigating a global panic, and the collapse of the Nations fourth largest investment firm, leading to the financial crisis as a whole. The private sectors development of mortgage backed securities (MBS) was backed by non-conforming loans that offered enhancements for evaluating credit. This sector remained small for some time however, investment banks developed new ways of securitizing sub-prime mortgages by repackaging them into Collateralized Debt Obligations (CDO), (sometimes with other asset backed securities), and then dividing the cash flows into different tranches to appeal to different classes of investors with different tolerances for risk. (Bailey, et al., 2008)7 Questionable accounting, complex assets built on subprime mortgages in a market whose values were instable and inflated, highly leveraged positions, intricate and devastating connections w/balance sheets across the global financial world. Contracting credit, layoffs, job losses, (Bailey, et al., 2008)8 and a rise in foreclosures were just some of the many circumstances that aided in exposing Lehmans over collateralized debt issues. Lehman Brothers had six months from the date of Bear Stearns fire sale to find a long-term solution to its menagerie of problems. They were plagued by deficient capital, liquidity drain, and deteriorating confidence from the market. This combination of corporate toxicity within a publicly traded financial entity, had a survival rate of slim to none. Bear Stearns was the first firm to prove Too Big to Fail to be true when for the first time in history, the government
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provided $30 Billion in last minute financial aid and fire sale assistance of the organizations devalued stock at a rate of $2 per share/$240Million to JP Morgan Chase. $20 Million of the $30Million offered in Federal support was to cover illiquid mortgage backed securities. With six months to strategize, Lehmans senior executives under the leadership of Dick Fuld, continued to allow an already difficult problem to manage grow into a global collapse whose magnitude could not have been foreseen. LEHMAN BROTHERS: BACKGROUND After 150 year in business and success in the consumer market, the firm joined the S&P100 Index where stock prices rose to new highs hitting of $100 per share. The early part of the 21st Century marked the beginning of unprecedented growth for investment firms, global expansion, and Lehman Brothers. The investment banking firm became the first to underwrite corporate debt virtually via the internet. These strategic moves created allowed Lehman to capitalize on a large piece of the foreign investment markets including Tel-Aviv, London, Mumbai, Tokyo, Canada, and Manhattan with some due to large mergers and acquisitions. By 2002 they executed the largest financial services IPO in history for Citi-Group, and the largest European leveraged buyout in history for KKR & Wendel Investissement. Lehman Brothers then acquired Lincoln Capital Managements fixed income accounts. (Anonymous, 2008) Within five short years, Lehman Brothers hoisted themselves into the spotlight as being a leader in capital markets and IPOs, with a growth record of $175 Billion dollars. REPO 105 & BALANCE SHEET MANIPULATION Repurchasing agreements is a tool used by non-financial institutions to raise money by
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utilizing assets to collateralize short-term loans. Statement of Financial Accounting Standards

(SFAS 1040) issued by the Financial Accounting Standards Board (FASB) revised their standards in 2001 in a way that benefitted the banks. This proved to be yet another regulatory loophole that was able to be manipulated to benefit the foreign investment and exchange market. Typically, these commitments were viewed as temporary due to their short-term nature and allowing for assets to remain on the banks balance sheet. Removing some loans from the balance sheet boosted the amount of capital banks held against their remaining assets, making them appear financially stronger than if loans were still on the balance sheet.(Griffiths, 2010) A recent 2,200 page report and analysis conducted by Anton Valukas revealed Lehman Brothers excessive use of the REPO 105 methodology. With this tool they were able to give the impression of a robust balance sheet with minimum leveraged debt and remain within the law having these packages underwritten in London; it is believed that in London it was easier to get the collateralized debt signed off on. At its peak, Lehman was able to remove $50.4B in assets from a 2008 balance sheet. Lehman produced a manufactured reduction in leveraged ratio, a primary indicator of a banks assets versus capital ratio as a result.

As a buyer and seller of Credit Default Swaps (CDS), Lehman held an estimated one million derivatives with 8000 different firms between 2003-2008. This insurance for debt securities was unregulated with no central clearing house, privately negotiated between buyers and sellers, and dominated by major global debtors with limited public disclosures. (.) Lehman while within the law abused the use of Repo 105 beyond that of their peers excluding AIG. In the examiners report he defines Lehmans use of Repo 105 as colorable. Valukas report defines colorable as one where a potential litigant could have a claim for recovery.

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Here is how the report says the Repo 105 worked: In an ordinary repo, Lehman raised cash by selling assets and then promising to buy them back several days later. Those moves were treated as financings and the assets remained on the balance sheet. But under its Repo 105 move in which the assets were 105% or more of cashaccounting rules permitted the transaction to be treated as a sale so the assets could be removed from the balance sheet. As a result, Lehmans balance sheet appeared $50 billion smaller. And using Repo 105, Lehman reported net leverage of 12.1 at the end of the second quarter 2008. Without 105, Lehmans leverage would have been 13.9. Lehmans own accounting personnel described Repo 105 transactions as an accounting gimmick and a lazy way of managing the balance sheet as opposed to legitimately meeting balance sheet targets at quarter end. Lehman used Repo 105 to reduce balance sheet at the quarter end. In 2008, Lehman knew that net leverage numbers were critical to the rating agencies and to counter-party confidence. Its ability to deleverage by selling assets was severely limited by the illiquidity and depressed prices of the assets it had accumulated.(Valukas, 2010) Corkery, 2010)) LEHMAN & CORPORATE SOCIAL RESPONSIBILTY At the root of Lehmans problems, management systems failed to govern. Additionally, they experienced a breakdown in five interconnected areas: Incentives: the risk versus reward factor; assessing personal gains based on pecuniary and nonpecuniary returns; From executive management on down, there were great financial bonus associated with the types of gains Lehman Brothers were reporting. Managers made decisions that exemplified greed and incompetence. It is managements responsibility to ensure a high level of integrity and judgment that corresponds with the organization. Because Lehmans management encouraged the use of repurchasing agreements, later termed Repo 105, employees on all levels had the incentive to get deals packaged, sold and moved only to worry about the consequences when that time came. Bernanke was aware of this balance sheet manipulation and had a similar attitude. By doing nothing, the Central Bank implied these practices were
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allowable. The Nation was benefitting, banks were thriving, and economy seemed sound. Lehman Brothers management was a complex cartel of accomplished executive leadership that developed a powerful combination of powerful, sometimes misguided incentives; inadequate control and risk management systems; misleading accounting; low quality human capital in terms of integrity and/or competence all wrapped up in a culture that failed to provide a sensible guide for managerial behavior. (Brown, 2008) Control & IT: the boundaries on behavior and how information is acquired and exchanged; from 2001-2007, beginning with LehmanLive-their virtual global trading platform- exponential growth was experienced for Lehman and the subprime lending market as a whole. This was attributed to the internet. Virtual exchanges of information decreased the amount of time and boundaries that was traditionally required to complete a transaction. These advances in technology increased foreign market investments, consumer trust, and confidence in the derivatives market globally. Internal and external communications were required to change as well. The pressure on financial Public Relations to maintain trust and confidence among stakeholders including employees, customers, and policy makers is high. Internally, Lehman Brothers practiced omitting true liabilities and debt while skewing the results of their actual performance. Stakeholders were given a false sense of security in the firm. Quarterly and annual earnings alluded to the public a company with long-term stability. Internally you have to keep employees informed of breaking developments without getting overly focused on responding to the rumor of the minute. Externally, you need to be balance the need to be responsive to the medias deadlines with the

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and effectuate. (Brown, 2008)

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reality that complicated business decisions take time to research, think through, properly disclose

Accounting: leadership choices on principles for calculating gains and losses versus GAAP gains and losses; Lehman exercised loose accounting measures prior to the dawn of the financial crisis which we now know resulted in a failure. Repo 105 was not accepted under the U.S. Law Standards. Innovation and global expansion however, created a pathway for Lehman under the aegis of an opinion letter under British law. This was not without the help of auditors Ernst Young and the government externally. It was not unusual for Repo transactions within investment banks to fund daily operations. This was a common characteristic of the non-financial institutions that dealt with a high risk, high leverage business model. These transactions are typically accounted for as financings or sales while meeting SFAS 140 regulations. In exchange for sales of government backed securities or other high quality assets Lehman would receive cash. These transactions had the primary purpose of dumping bad assets lacking accuracy. SFAS 140 required documentation from Lehmans Repo 105 transactions as sales rather than financings. Recent claims suggest Ernst Young had a professional, moral, and ethical responsibility to disclose these transactions ($38.6B by November 30, 2008). In the words of William Black, University of Missouri financial expert, Bad data leads to bad decisions. (Trumbull, 2010) Human Capital: luring a caliber of employees that can creatively develop innovative uses for existing products; and Culture: group think and an organizations view and implementation of corporate social responsibilities. The interconnectedness between these two is unique in the rise and fall of Lehman Brothers. An important aspect to the rebuilding of Shearon, Lehman, Hutton after the 1984 demise

name, Lehman Brothers. The new team concentrated on becoming less dependent on fixed-

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and sale to American Express, under the leadership of Dick Fuld, was to restore the companys

income trading and more on investment banking. Fuld took the lessons learned from previous Lehman losses by establishing relationships between capital markets and banking. This was different from the human behavioral culture of the past, opposing an embracing team work sharing model. By 2006 profits under Fulds leadership had risen 800% totaling $4.6 billion in earnings. One of the most important elements of Fulds plan to develop a culture teamwork at Lehman Bro. has been to link compensation to the overall performance of the firm through equity awards. (Wharton, 2007) Fuld was noted as saying that by establishing a culture built on teamwork lead to the best decisions for the firm as a whole, and paying employees in stock aided in reinforcing the culture. As a leader, Lehmans Captain followed four keys to leadership. 1.) Understand the business, make it safe for people to buy-in by doing your homework and limit surprises. 2.) Pick a strategy and stick to it, unless your wrong, ignore the press and let the rumors die. 3.) Leverage team work and reconfigure the I mentality to a WE mentality. Claiming all successes was considered destructive and counter- productive to the growth of the organization. 4.) Surround yourself with the best possible. If you want to run an A firm, B people cant get it done. (Wharton, 2007) Culturally, Dick Fuld contributed to Lehmans greatest advances and abysmal losses. He seemed to have lost his keys. TOO BIG TO FAIL? A Too Big to Fail firm is one whose size complexity, inter-connectedness, and critical functions are such that, should the firm go unexpectedly into liquidation, the rest of the

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2010)

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financial system and the economy would face severe adverse consequences. (Bernanke,

The Too Big To Fail (TBTF) policy was first introduced in 1984 just after the Continental Illinois Crisis. In 1991, this policy was eliminated by the Federal Deposit Insurance Corporation Improvement Act (FDICIA). Early 2008, Bear Stearns the 5th largest investment bank in the U.S, and AIG, both non-financial institutions, through TARP funding, received financial assistance of a critical injection from the Treasury and FRBNY. The TBTF policy is in fact at work in the financial crisis. Since, these large financial organizations have been receiving special treatment and support in order to stabilize the global market place. So why wasnt Lehman Brothers thrown a life vest like Bear Stearns? Lehman Brothers did not have to fail. Their leadership ignored all of the warning signs that preceded their filing for bankruptcy on September 15, 2008. LEHMAN BROTHERS 4th Largest Investment Banking Firm in U.S Bond Trading Powerhouse MBS as primary holdings $5.3 B in debt obligations vs. $2.3 B in income. 98.8% devaluation in stock. Higher rate of insolvency Potential investors in place (HSBC, BlackRock, Blackstone) No FED Funding Leadership was affected by misdirected intentions of stature, pride & value to the U.S. Financial System BEAR STEARNS 5th Largest Investment Banking Firm in U.S Bond Trading Powerhouse MBS as primary holdings w/$834 M in debt in debt obligations vs. $327 M in income. 89% devaluation of stock. Lower rate of insolvency Confirmed investor in place (J.P. Morgan Chase) $29 Billion in guarantees w/FED funding for investor Leadership showed creative flexibility and as an investment firm held less in toxic MBS assets than Lehman.

Policymakers simply did not have the same incentives to save Lehman and assume the responsibility of their toxic asset holdings. Between July September 2008, liquidity availability grew stressful for the firm to continue daily operations. Enticing organizations to assume the

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risks was difficult as well. In the short-term, saving Bear Stearns vs. Lehman will be debated for decades to come. Systemic risks needed stabilizing and reserves for long-term injections/stimulus funding were going to be required by the FED; leaving an uneven playing field. CONCLUSION The root cause of bad decision making resides in the nexus of culture, incentives, control and measurement, accountings and human capital. When those elements are out of alignment, particularly in competitive industries, really bad things happen. (Shalman, 2010) Banks depend on trust, and trust in turn is greatly strengthened by effective regulation and enforcement of well-designed rules. Banking customers and money market participants must be certain that banks and financial institutions will behave honestly; if they do not they will be penalized. ( M it t n i k , N e l l, P l a t e n, S e m m l e r , & C h a p p e , 2 0 0 9 ) Ineffective or ill-designed rules and regulations, on the other hand, will not support trust, may permit unfair and dishonest practices, but worst of all, may not prevent the build-up of excessive risk. When such risk comes home to roost, a lot of businesses and consumers that had nothing to do with the decisions to take on that risk will end up paying a heavy price. ( M it t n i k , N e l l , P l a t e n, S e m m l e r , & C h a p p e , 2 0 0 9 ) Lehman Brothers management made choices that did not benefit the primary and secondary stakeholders; they lost their money and abused their trust. This is not the first time in history companies have gone from a team model to a narcissistic one. It is however, the first time of this magnitude in a global marketplace. Regulators, government, and management should take notes because if history proves the U.S. Banking System correct, it will happen again.

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