The Demise Of Lehman Brothers
Many regard September 15, 2008 as one of the worst days in Wall Street’s history. Merrill Lynch was sold to Bank of America to avoid bankruptcy and after unsuccessfully finding a buyer; investment bank Lehman Brothers filed for the largest bankruptcy in US history. These two events helped trigger the biggest economic downturn since the Great Depression of 1929. Wall Street had collapsed and failed the American people; it was day one of the Great Recession.
The Great Recession and Lehman Brothers
Preceding the collapse were the “housing bubble” and “subprime mortgage crisis”. Over the past ten years, real estate prices were increasing at an unsustainable rate but unfortunately; consumers were under the illusion that the growth would continue. While this was occurring, financial markets found their new “baby”, CDOs. These CDOs, or collateralized debt obligations, are asset-backed securities; in this instance the assets were mortgages. These CDOs successfully drove the economy until they began to default; and before investors, banks and insurance companies understood what was happening, it was too late.
Thousands actors spanning from individuals to large corporations had a hand in causing the Great Recession. Unfortunately many did not expect the bubble to burst, but some did see it on the horizon, including Lehman Brothers and other corporations. Did these big businesses try and help avoid the collapse? Shockingly, no, not all of them did. What these businesses lacked were a core set of principles, ideology, or set of ethics. These corporations also completely disregarded their stakeholders. The ethical theory of deontology is based on a set of rules or duties that an individual actor must abide by. Large corporations also have a duty to account for their stakeholders. This isn’t a law or regulation, but it ignoring your stakeholders is both unethical and a terrible business practice (Enron is a perfect example why this is true). If Lehman Brothers, successfully adopted a deontological ideology regarding their stakeholders and business practices, they would have been able to make more sustainable business decisions that would have allowed them to navigate through the subprime mortgage crisis and potentially avoid bankruptcy.
How Poor Regulation and Market Forces Affected Lehman
Roughly a month after Lehman Brothers filled for bankruptcy and economy collapsed; the United States House of Representatives and Committee on Oversight and Government Reform held a set of hearings to understand what had happened. Luigi Zingales, testified on the causes and effects of Lehman’s bankruptcy. Zingales found three main factors to the collapse: bad regulatory policies, a lack of transparency and market complacency.
Regarding the issue of market complacency Zingales cites the rise of real estate prices – the housing bubble – and a deterioration of lending standards. Not only were the quality of mortgages declining, but also banks were lending in bulk; causing “low documentation mortgages [growing] from 29% to 51% [from 2001-2006]” (Zingales, 4). Another issue was only a small number of banks were issuing massive amounts of these mortgage-backed securities. This “changed the fundamental nature of the relationship between credit rating agencies and investment banks” (Zingales, 5). Now investment banks had much more power over these credit agencies and were able to shop their securities around until they received a AAA rating, when in reality the security should have been rated much lower.
One of the largest problem regulators failed to recognize was banks were able to severely manipulate their accounting records. In the United States, “banks are allowed to allocate zero capital to loans hedged by credit default swaps (CDS)”. What this means is that banks were allowed to incorrectly record loans as assets, also falsely driving up their capital leverage. This then put great pressures on credit rating agencies. What regulators did not realize was that, the market pressures lead credit agencies to market better ratings for a profit. For example, “Moody’s revenues from structured finance ratings increased from $100 million in 1998 to more than $800 million in 2006” (Zingales, 9). Also firms were able to use the fair value accounting practices for their mortgage-back securities (MBS) as long as they were for sale. There are three levels of how fair value accounting principles for securities. Because MBS are so hard to value, individual firms were forced to use Level 3 accounting for the securities, allowing the firms to estimate the fair value of the their own securities. Firms drastically overvalued their MSBs. This would not have been an issue if the market for CDSs was stable, but in the ten years leading to the Great Recession, “the market for credit default swaps grew unregulated from almost zero to more than $44 trillion” (Zingales, 11). Clearly there was a need for reform.
Lehman Brothers’ Dysfunctional Board
David Larker and Brian Tayan, recently investigated Lehman Brothers Board of Directions in an attempt to further understand the business’s bankruptcy. As Larker and Tayan conducted their research they compared Lehman’s board to Goldman Sachs. Both companies’ boards were structured similarly but Lehman filed for bankruptcy and Goldman successfully made it through the financial crisis, Larker and Tayan were motivated to find why Lehman failed.
On the outside, Larker and Tayan found nothing out of the ordinary with Lehman’s Board. It consisted of 10 directors, the average age was 68 (slightly higher than the average), the directors had diverse backgrounds and there was a mix of current and former CEOs from both the for profit and non-profit sectors (Larker, 1). One of the main findings from the study was Lehman Brothers directors “had a notable absence of financial service expertise” (Larker, 1). This was quite surprising considering Lehman is a financial service entity. Secondly, there were no current CEOs of a major public corporation, a characteristic of many boards of directors. Another interesting finding was that the two individuals representing the non-profit sector were a former actress and theatre producer. Finally, Larker examined how the board of directors interacted and worked together. Larker found that in 2008, the finance and risk committee only met twice, the audit committee 7 times, but the compensation committee an astounding 8 times (Larker, 3). This raises the question of if Lehman’s Board of Directors had the right intentions for the business. As clearly the numbers point to a slight disregard of business activities, and a strong focus on themselves.
Representative Henry Waxman spoke upon the Lehman Brothers bankruptcy on October 6, 2008. Waxman states that, “Lehman’s fall triggered the credit freeze that is choking our economy” (Waxman, 1) causing the congress to pay out $700 billion rescue package to save Wall Street. Waxman was part of a Committee that researched the bankruptcy in depth, citing many emails and heavily criticized Lehman CEO Dick Fuld. Waxman quoted two emails written Lehman executives in the past year. The first was after executive Neuburger Berman made a recommendation for top management to forgo bonuses in an attempt to cut costs and send a strong message to investors and stakeholders. George Walker, Berman’s boss responded, “Sorry team. I’m not sure what’s in the water at 605 Third Avenue today… I’m embarrassed and apologize” (Waxman, 2). Clearly if executives are mocking initiatives to cut costs and promote a stakeholder ideology, there is an underlying issue within the business. Waxman also quotes an email, requesting executives receive a $20 million bonus four days before the company filed for bankruptcy. Clearly Lehman had internal issues dealing with greed and over compensation of their executives. Finally, Waxman states that Fuld takes no responsibility for what transpired at Lehman, and that the culture within Lehman allowed individuals to have no accountability for their actions or failures. Fuld and his other coworkers, sucked their business dry of money as they drove the company, Wall Street and the American economy into the ground. And as taxpayers are stuck with a $700 billion bill to fund, Fuld successfully walked away from Lehman “earn[ing] over $500 million” (Waxman, 3)
Lehman’s Lack of Ethics
As stated above, Lehman clearly had a disregard for their stakeholders. Their executives were greedy leading them to making poor business decisions. Also market pressures lead Lehman down a path to failure, but Lehman was not alone as the market was able to take down the entire financial sector. What Lehman lacked was a core set of rules, and a strong ideology. I believe what the company lacked was an ideology that promoted the welfare of their stakeholders. Who are these stakeholders? In Lehman’s case it is their investors, insurers, credit agencies, government, employees, smaller mortgage lenders, home buyers and even the general population because the massive implications of their demise. I originally struggled in selecting a certain ethical theory, and I came down to consequentialism or deontology, which are ironically polar opposites. Under consequentialism, actors select “choices increase the Good” or bring a better consequence (Alexander). As opposed to deontology which is “focused moral rules and principles as ways of guiding behavior” (Gaus). I chose deontology because in business you do not know the potential consequences of decision until potentially years after the decision is made. Where as with deontology, the corporation can adopt a set of principals to abide by and allow the decisions to take care of themselves, as they cannot control the consequences. Ideally, Lehman’s Board of Directors would have focused this ideology decades ago that would help them navigate through these economic downturns. But unfortunately Lehman was sucked into the market deficiencies and was overwhelmed by greed within the top executives.
Ultimately, there was not much that could have been done to save the economy from the downturn we have experienced over the last five years. But, what is unfortunate was that Lehman Brothers could have potentially avoided their bankruptcy if the company had a stronger central focus on their stakeholders. If they were able to avoid this bankruptcy, the impact of the recession may have been significantly less and the $700 billion recovery bill may never have been needed. Lehman itself has a duty consider to their stakeholders in order to be sustainable. But clearly, executives within the company disregarded this duty as they continually received high bonuses, and had several risky business practices. At the height of their problems Lehman only had $3.30 of equity for every $100 of loans, so “a mere 3.3% drop in the value of assets wipes out the entire value of equity and makes the company insolvent” (Zingales, 12). But little did Fuld and Lehman know, the company would become insolvent, file for bankruptcy, and bring down the entire American economy.
Alexander, Larry. “Deontological Ethics.” (Stanford Encyclopedia of Philosophy). Stanford Encyclopedia of Philosophy, 21 Nov. 2007. Web. 17 Nov. 2013.
Gaus GF , . What is deontology? part two: Reasons to act. Journal of Value Inquiry, 35(2)
Larcker, David, and Brian Tayan. “Lehman Brothers: Peeking Under the Board Facade.” Rock Center for Corporate Governance at Stanford University Closer Look Series: Topics, Issues and Controversies in Corporate Governance No. CGRP-03 (2010).
Zingales, Luigi. “Causes and effects of the Lehman Brothers bankruptcy.” Committee on Oversight and Government Reform US House of Representatives (2008).