Lehman Brothers: leverage, mortgages and the largest US bankruptcy

The situation

In the early hours of Monday 15 September 2008, Lehman Brothers Holdings filed for bankruptcy in New York. The firm was the fourth-largest investment bank in the United States and employed about 25,000 people. Its filing listed roughly $639 billion of assets, which made it the largest bankruptcy in US history. Benzinga gives debts of $619 billion; another summary gives $613 billion, so the sources differ slightly on that number.

Ten months before, Lehman had closed its 2007 financial year with record profits. The Irish Times, reporting on the court-appointed examiner’s findings, says Lehman announced record 2007 earnings of about $4 billion in January 2008, and that within eight months the profits and the firm were gone. The company’s net income for the year was reported as $4.2 billion on net revenues of $19.3 billion, in a case study that summarises the examiner’s report.

By the weekend of 13 and 14 September, the question was no longer whether Lehman was in trouble. According to the examiner’s findings, on Friday 12 September the bank had less than $2 billion of assets it could convert to cash quickly and lacked the cash to open for business on Monday. A rescue by the British bank Barclays failed on Sunday. Treasury Secretary Henry Paulson, according to an academic review of the episode, reportedly ruled out public money. Lehman filed at 1:45 a.m. on Monday.

The central puzzle is how a firm that reported record profits in January could be insolvent, or very close to it, by September. The sources give several answers: heavy bets on property, a balance sheet funded by short-term borrowing, an accounting device that made it look less leveraged, and a loss of trust from lenders. They disagree on how much of this was foreseeable and whether the authorities could have prevented it.

Background

A firm with a long history

Lehman began as a dry-goods business in Montgomery, Alabama, in 1844, according to Benzinga. By 2008 it was one of the five big independent US investment banks, firms that advised on deals, traded securities and arranged finance but did not take ordinary customer deposits. The Financial Crisis Inquiry Commission (FCIC) names Lehman among the investment banks that packaged mortgage loans into residential mortgage-backed securities, and notes that a lender called First Alliance sold loans to Lehman.

Taking on more risk, 2006 and 2007

The FCIC describes a shift in Lehman’s approach in 2006 and 2007 as competitors grew. Michael Gelband, the head of fixed income, and Madelyn Antoncic, the chief risk officer, warned against taking on too much risk amid “growing pressure to compete aggressively against other investment banks”. Antoncic was moved aside to a policy role, and in her words, as the FCIC quotes her, “At the senior level, they were trying to push so hard that the wheels started to come off.” Gelband left, and Lehman officials put it down to philosophical differences.

The examiner’s report, according to the Irish Times, found that Lehman raised its firm-wide risk limit three times in the year after late 2006. Antoncic opposed the rise from $2.3 billion to $3.3 billion and was overruled; by the end of 2007 the limit stood at $4 billion. The stress tests left out the riskiest holdings, which were real estate investments, private equity and leveraged loans.

Archstone and commercial property

One of the largest bets was the purchase of the apartment group Archstone-Smith. According to the case study that summarises the examiner’s report, Lehman and Tishman Speyer agreed in May 2007 to buy it for about $22.2 billion including debt, and the deal closed on 5 October 2007 at $60.75 per share. Lehman’s original exposure was about $11.5 billion and was cut to about $5.4 billion by selling down at or near closing. The Irish Times adds that a $2.3 billion bridge loan for the Archstone deal was left out of risk calculations, even though including it would have pushed the firm past its limit.

The same summary says Lehman’s commercial real estate exposure, leaving out assets held for sale, stood at about $90 billion before falling to about $71 billion at the end of May 2008 and about $54 billion by late summer. The FCIC reports that by the end of 2007 Lehman’s holdings of commercial and residential real estate and related securities were nearly double the level of two years before and more than four times its total equity.

The industry

Leverage and thin capital

Investment banks of this period earned profits by borrowing heavily and investing the proceeds. The FCIC says that the five big firms operated with “extraordinarily thin capital”, so that a small fall in asset values could wipe them out. The case study puts Lehman’s total assets at about $691 billion at the end of November 2007 against stockholders’ equity of about $22.5 billion, a gross leverage ratio of 30.7 times. The Irish Times says Lehman had only $25 billion in capital, far less of a buffer than rivals such as Goldman Sachs. The two capital figures differ and the sources do not explain why.

Funding through short-term borrowing

Much of this borrowing was overnight. The FCIC describes the repo market, in which a firm sells securities with a promise to buy them back the next day, as a multitrillion-dollar part of the shadow banking system. If lenders refuse to roll over their lending, the borrower has to find cash at once or sell assets, probably at a loss. That is a bank run in market form, and the examiner’s report concluded that Lehman failed in part because it lost the confidence of lenders and counterparties and had too little liquidity.

Pressure to cut leverage

From 2007, according to the examiner, market observers pressed the investment banks to reduce leverage, and a ratings downgrade would have had immediate costs. By mid-2007 much of Lehman’s inventory was hard to sell without large losses. The Irish Times reports that Bear Stearns nearly collapsed in March 2008, and Lehman stepped up its use of one accounting technique after that.

Regulation

Regulators involved included the SEC and the Federal Reserve Bank of New York. The examiner’s account of the liquidity pool shows how loose the rules were: there was no consistent definition of liquidity. The SEC used a 24-hour test, a Lehman officer referred to a five-day standard, and the Federal Reserve Bank of New York reviewed assets case by case. The Fed’s New York bank subtracted pledged assets from the pool in its own calculations, while Lehman kept counting them.

The decision

Lehman’s leaders faced a choice in 2007 and the first half of 2008 that was not framed as one choice. Each option below is drawn from what the sources describe, and they overlap.

Option 1: cut risk and raise capital early

The sources show that Lehman did try to deleverage. The case study reports that in January 2008 chief executive Richard Fuld ordered a firm-wide reduction aimed at roughly halving commercial real estate, residential and leveraged loan positions. Commercial real estate exposure did fall, to about $54 billion. But the examiner found that much of the inventory was hard to sell without large losses. The Irish Times reports that the firm chose to accumulate illiquid assets, including residential and commercial real estate, whose values were falling.

Option 2: look less leveraged without being so

The option the examiner says Lehman took was to use an accounting device known as Repo 105. In ordinary repo, assets are lent against cash and stay on the balance sheet. Under Repo 105, the transaction was recorded as a sale, so assets left the balance sheet just before the quarter ended and returned afterwards. The effect was to reduce reported leverage at the moment investors and rating agencies looked. The examiner’s testimony says that Lehman did this rather than reduce leverage through sales, and that it paid a premium for the transactions.

Option 3: find a buyer or a partner

The third path was a rescue. The case study says that Korea Development Bank talks ended on 9 September, and the share price closed at $7.79 that day, down roughly 45 per cent. Fuld had hoped Bank of America would buy the firm, according to Benzinga, but Bank of America bought Merrill Lynch instead. That left Barclays as the main candidate over the weekend of 13 and 14 September.

What they did

Repo 105, from 2001 to 2008

The Irish Times says Lehman used the technique from 2001 and stepped it up after March 2008. HousingWire adds that use rose sharply toward the end of 2007, even though some staff were concerned. The examiner gives the quarter-end volumes as $38.6 billion in the fourth quarter of 2007, $49.1 billion in the first quarter of 2008 and $50.38 billion in the second quarter. Executives called it a “gimmick” and “window dressing”, and one of them, Martin Kelly, said there was “no substance to the transactions”. Bart McDade wrote in April 2008 that it was “another drug we r on”, as HousingWire quotes the email. The case study says the second-quarter use lowered reported net leverage to 12.1 times from 13.9 times.

Lehman could not find a US law firm to give a legal opinion that the transactions were true sales, and it used the London firm Linklaters instead, according to the Irish Times and The Economist’s coverage. Linklaters said it was not aware of any facts that would justify criticism of its opinions. The examiner’s testimony says Lehman’s auditor, Ernst and Young, knew of the Repo 105 policy and did not object to its omission from public filings. Ernst and Young maintains that Lehman’s reporting complied with accounting principles.

The liquidity pool

Lehman told investors it held a pool of liquid assets that would cover 12 months of expected outflows in a stressed environment. It reported pool sizes of $34 billion at the end of the first quarter of 2008, $45 billion at the end of the second and $42 billion at the end of the third. On 9 June it announced a $45 billion pool, its largest ever. By summer, the examiner says, Lehman was counting assets deposited or pledged to clearing banks. In June 2008 Citibank required a $2 billion “comfort deposit” and Lehman posted $5 billion of collateral to JPMorgan, and Lehman kept counting both. The examiner records that regulators knew of the encumbrances; the SEC and the Federal Reserve disagreed internally with their inclusion but did not require changes to public reporting.

Spring and summer 2008: results and market confidence

According to the case study, Lehman reported first-quarter net earnings of $489 million on 18 March 2008, and its shares rose almost 50 per cent to $46.49. On 9 June it said it expected a second-quarter loss of $2.8 billion, and the shares fell to about $30. After management changes in mid-June, they fell to $22.70.

The weekend, 12 to 14 September 2008

Laurence Ball’s review of the Federal Reserve’s role says that Paulson took charge of the negotiations in New York on 12 September. On 14 September the Barclays deal collapsed, and officials pushed for the holding company to file. The filing came at 1:45 a.m. on Monday 15 September. The broker-dealer subsidiary stayed open with support from the Fed’s Primary Dealer Credit Facility and was partly acquired by Barclays on 18 September. Ball reports that Paulson was said to have ruled out aid, saying “I can’t be Mr. Bailout”.

What happened

Markets and the wider system

The Dow Jones Industrial Average closed at 10,917.51 on 15 September after falling more than 500 points. The S&P 500 closed at 1,192.69, its lowest close in nearly three years, according to Benzinga. The same report notes that three of the five largest US investment banks had failed or been bought since the spring, that Merrill Lynch was being sold to Bank of America, and that the government was set to take control of AIG the next day. In his 2010 testimony to the FCIC, as the Star Tribune reports, Federal Reserve chairman Ben Bernanke said he believed the failure would be catastrophic for the US financial system and economy.

What the examiner found

The examiner, Anton Valukas of the law firm Jenner and Block, published his report on 11 March 2010. It ran to about 2,200 pages in nine volumes, drawing on more than five million documents and over 250 informal interviews. The Irish Times says it concluded that Lehman and some affiliates were insolvent at various points in 2008, depending on the measure. It said responsibility was shared, and that executive conduct ranged from serious but non-culpable errors of judgment at one end to balance sheet manipulation that could support legal claims at the other. The Economist’s account says Valukas found no legitimate business reason for Repo 105 and believed Ernst and Young had a case to answer. He found “colourable claims” against Fuld and three finance chiefs, Chris O’Meara, Erin Callan and Ian Lowitt, over allegedly misleading quarterly reports. Fuld said he was unaware of the Repo 105 transactions.

Other views

The Federal Reserve: nothing could be done

Bernanke told the FCIC on 3 September 2010 that the idea that the Fed could have saved Lehman was a myth. The Star Tribune reports him saying that Lehman did not have enough collateral to borrow from the Fed, that it faced a modern form of bank run, and that regulators concluded over the weekend of 13 and 14 September that failure was “essentially certain in either case”. He also said he should have been more direct in his earlier congressional testimony.

An economist: the Fed could have lent

Laurence Ball of Johns Hopkins University, in a 2016 working paper for the National Bureau of Economic Research, argued that the stated reason was not the real one. He found that the Fed had the authority to rescue Lehman, that the paper trail shows no analysis of whether Lehman’s collateral was adequate, and that political considerations mattered. His estimates put reported assets at about $600 billion and equity at $28 billion at the end of August, with about $60 billion of assets of doubtful value and outside estimates of overvaluation of $15 billion to $30 billion. On those numbers adjusted equity ranged from about negative $2 billion to positive $13 billion, so Lehman was near the line of insolvency. He found at least $131 billion of collateral eligible for the Fed’s lending facility against an estimated need of about $88 billion in the likely case. The Fed, according to his account, applied a “Friday criterion”, limiting the broker-dealer to collateral it held on 12 September. The paper says officials’ claims that Lehman was insolvent were not backed by a balance-sheet analysis. This is one economist’s reading, and Bernanke did not publicly provide the shortfall figure the FCIC asked for.

The examiner: shared responsibility

The examiner did not find that regulators or auditors could necessarily have prevented the collapse, according to his testimony. He described responsibility as spread across executives, lawyers and auditors, each relying on someone else. He also said the growth strategy and risk management showed “serious but non-culpable errors of business judgment”, which The Economist reported, as distinct from the Repo 105 conduct.

Limits of the evidence

Several key numbers come from summaries of the examiner’s report rather than the report itself, which could not be opened for this case. Asset and debt totals at filing vary by source. Fuld has denied knowing about Repo 105, and Ernst and Young and Linklaters deny wrongdoing, so many of the claims discussed above are findings of a court-appointed examiner, not court rulings.

Reading it through a framework

Leverage and risk of ruin

A firm that holds assets worth 30 times its equity is ruined by a fall of about 3 per cent in their value. The case study gives Lehman a ratio of 30.7 times at the end of 2007, and the FCIC says its property holdings were more than four times equity. Reported equity of $28 billion on $600 billion of assets in August 2008 left room for little more than 5 per cent of error in valuations, before counting the $60 billion that Ball calls questionable. The framework shows why Repo 105 mattered: the ratio was the number that rating agencies and lenders watched, so improving the reported figure by $50 billion of quarter-end removals bought time rather than safety.

Principal-agent and governance

Risk managers, auditors and regulators are meant to check the people who benefit from taking risk. At Lehman the chief risk officer was overruled and then moved aside, the stress tests left out the riskiest holdings, and the auditor did not object to the omission of Repo 105 from public filings. Regulators saw the pledged assets in the liquidity pool but did not change what Lehman told the market. Each safeguard existed on paper. The examiner’s observation that each party relied on another is a textbook description of diffused accountability.

Since then

The Fed’s account of why it let Lehman fail has remained contested. Ball’s 2016 paper is the most detailed academic challenge found for this case, and it argues that Bernanke first raised the collateral explanation on 7 October 2008. The FCIC report and the examiner’s report remain the main public records. The sources opened for this case do not cover the progress of the bankruptcy estate, the repayment to creditors or later changes to leverage and liquidity rules, so none of those are described here.

What to take from it

• A thin layer of capital under a very large balance sheet means a small valuation error can end the firm, so leverage matters as much as profit.
• Funding that must be renewed daily makes confidence a business input, and confidence can vanish in a weekend.
• Reported ratios can be shaped at the reporting date, so readers should ask how a figure behaves between quarter-ends.
• Risk controls that can be overruled by the people they constrain do not work as controls, as the Antoncic episode shows.
• After a failure, explanations differ: the Fed said it could not lend, an economist says it could, and the examiner says responsibility was shared, so readers should compare the evidence each side offers.

Questions to think about

1. When Lehman faced falling property values in 2007, what could a board have done to reduce risk without triggering the loss of confidence it feared?
2. Should an accounting treatment that is allowed but not disclosed be treated as misleading? Where would you draw the line?
3. If you were Paulson on 13 September 2008, what would you need to know before refusing public support, and what would you worry about afterwards?
4. How should a regulator define liquidity so that a firm cannot count pledged assets?

Concepts at work

This case draws on financial leverage, liquidity risk and the principal-agent problem. Explore them in Insights.

Written from the public sources listed below. Figures are as those sources report them.