Liquidity Risk Management Case Study: Lehman Brothers

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Between 2003 and 2004 Lehman Brothers acquired five mortgage lenders including the subprime originator BNC Mortgage LLC and Alt- A mortgage originator Aurora Loan Services. During the house price bubble, these acquisitions contributed to Lehman achieving record revenues and becoming the fastest growing investment bank or asset management company by revenue. In 2007 it surpassed Bear Stearns in becoming the largest underwriter for mortgage-backed securities. It retained a significant portion of these securities on its books amounting to $85 billion or around four times its equity. Due to this growth, its share price reached an all time high of $86 in February 2007.

On March 13 2007 the stock market suffered its largest one-day drop in five years amidst fears that the growing number of defaults in the subprime mortgage market, to which Lehman was significantly exposed, would affect its profitability. However, on March 14 2007, Lehman reported a record in revenue generation and profits for its first fiscal quarter claiming that the growing defaults would not significantly impact its earnings as losses were being effectively controlled.

However as delinquencies in the subprime market continued which also led to the collapse of two Bears Stearns hedge funds and a sharp decline in Lehman’s share value, the bank announced on 22nd August 2007 that it would be closing down its subprime mortgage originator BNC Mortgage which eliminated 1200 jobs. It also closed down its Alt-A originator offices in a number of states. However, as the subprime crisis continued it continued to actively generate mortgages through its other mortgage lending acquisitions as well as continued to underwrite and issue mortgage-backed securities.

On 13th December 2007 Lehman reported record net income for the year of $4.2 billion and revenue of $19.3 billion due to a temporary recovery in the fixed income market and what appeared to be promising gains in global equity markets. However it remained highly leveraged with a leverage ratio (Assets/ Equity) of 31 to 1 making it very vulnerable to a deteriorating market situation. Lehman failed to avail the opportunity to cut down its large positions in risky assets at this time on the premise that financial markets would eventually recover.

On 17th January 2008 as defaults continued to rise and house prices continued to decline Lehman announced that it would stop originating mortgages through its wholesale channels.

17th March 2008 saw Lehman’s share price declined sharply by more than 48% following the collapse of Bear Stearns and the Federal-government backed takeover by JP Morgan Chase & Co. on 16th March 2008 which raised concerns in the market whether other investment banks, in particular Lehman, would meet the same fate. There were reports that on that day South Asian Bank DBS Group Holding Limited instructed its traders not to work with Lehman. These instructions were later withdrawn.

Better than expected reported profits for the first fiscal quarter on 18th March 2008 caused Lehman share prices to rise regaining the value lost the previous day. On 1st April 2008, it also announced that it had raised $4 billion in preferred stock which could be converted to common stock at a 32% premium to its current value. These events help to restore investors’ confidence to an extent, in Lehman brothers.

On 15th April 2008 Lehman’s CEO Richard Fuld told investors that he believed that the worst of the crisis had passed but that the financial environment would remain challenging for some time to come.

In May 2008, Lehman’s share price continued to fall on reports that its hedge fund managers questioned it first quarter results on the belief that mortgage assets had not been valued correctly. On 16th May 2008 it trimmed an additional 5% of its workforce, i.e. 1,400 job cuts.

On 9th June 2008 Lehman announced its first quarterly loss of $3 billion since becoming a public company after its spin-off from American Express, as a result of losing around 73% of its value due to the worsening credit crisis. To counter this loss, Lehman announced that it had sold $6billion in stock to strengthen its capital position, increased its liquidity to $45 billion, reduced its assets by $147 billion decreasing its exposure to residential and commercial mortgages by 20%. All of this had resulted in a lower leverage ratio of 25 to 1. In addition, on 12th June 2008 its CFO, Erin Callan was removed and the president and COO , Joseph Gregory stepped down and was replaced by Herbert McDade.

On 19 August 2008 Lehman’s share price fell by around 13% due to reports that 3-quarter results would reveal significant write down in its assets and that it was looking for buyers for its investment management business.

On 22nd August 2008 its stock price recovered some of its value on news that was the state-controlled Korean Development Bank was considering buying it. Further on 29th August reports also indicated that Lehman planned to cut an additional 6% of its workforce amounting to 1500 jobs prior to the deadline of its third-quarter results. On 2nd September 2008 news reports suggested that KDB would purchase a 25% stake in Lehman.

On 8th September 2008, the share price for Lehman fell sharply on reports that the talks with KDB had been put talks on hold due to rapidly declining values of global equity markets, lack of backing from KDBs regulators and difficulty in finding partners for the deal. Also, Lehman itself had difficulty attracting new investors and therefore struggled to raise new capital.

When news reports on 9th September indicated that the talks had ended the 45% fall in Lehman’s stock price pushed the S&P 500 and Dow Jones down. This was exacerbated when the US government announced that it would not bail out Lehman as it had done Bear Stearns if the situation became critical. Credit Default Swaps, default insurance for Lehman’s debt increased significantly, a reverse indicator of how the markets perceived Lehman’s financial strength. This resulted in a run on the bank with hedge fund clients pulling out, lines of credit being withdrawn, great margin/ collateral calls and trades being canceled.

On 10th September 2008 in its third quarter results, it reported a loss of $3.2 billion as a result of asset write-downs amounting to $5.6 billion. In order to build up investor confidence, it also announced that it planned to spin off its commercial real estate assets and a major stake of its asset management unit, Neuberger Berman. However, as a result of the announcement, its stock price declined a further 7%. Moody’s also announced that it would review Lehman’s ratings and that it would have to downgrade the entity if it could not find a strong buyer.

On 11-12th September 2008 Lehman’s stock declined a further 42% as it struggled to find a buyer. Through the efforts for the US Treasury and Federal Reserve who urged the Wall Street CEOs to come up with a solution for Lehman, Bank of American and Barclays comes forward as potential buyers. By the week’s end, Lehman has only $1 billion in cash. In the event that a deal did not materialize therefore there was possibility that it could lead to an emergency liquidation of its assets.

13th-14th September 2008 Wall Street leaders continued to meet with regulators over the weekend to come up with a possible solution. The two potential buyers wanted the government to provide a backstop guarantee as it had done for JP Morgan in the case of Bear Stearns. However the government insisted that it would not provide assistance this time. Barclays bank ended its bid when the US regulators assistance was not forthcoming and when its deal was vetoed by the Bank of England and the UK’s Financial Services Authority. Bank of America also withdrew its bid. The latter diverted its focus to acquisition negotiations with another investment bank, Merrill Lynch, which it subsequently acquired in an emergency deal the following day.

On 15th September 2008, due to the failure of negotiations and no change in the US government’s position regarding the possibility of a bailout, Lehman filed for bankruptcy protection. With $639 billion in assets, it was the largest bankruptcy filing in US history causing the Dow Jones to suffer its largest drop in a single day since 11th September 2001. The bankruptcy led to a loss of over $46 billion of Lehman’s market value.

On 22nd-23rd September 2008, the bankruptcy court approved the sale of Lehman’s brokerage holding to Barclays and its Asian pacific franchise to Nomura Holdings Inc. The latter also announced plans to acquired Lehman holdings in Europe and Middle East which it completed in October 2008.