Group25_MAF760

Group 25

International Internatio nal Finance (MAF 760) Lehman Brothers and Bear Stearns. Why they collapse?

Assignment Coversheet Faculty of Business and Law Student ID:

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213443624 213352554 213065326 213325063 Shaheen Ijaz Singh Ahmed Khan

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Contribution of Group 25 Omar Shaheen Muhammed Usman Ijaz Gulsheer Singh Qadeer Ahmed Khan

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First Name:

Omar Muhammad Usman Gulsheer Qadeer

Burwood, Vic. 3125

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Unit Title: International Finance Assignment Title: Lehman Brothers and Bear Stearns. Why did

Group assignment 1 they collapse? Lecturer: Dr. Sohel Azad

Tutor:

Dr. Sohel Azad

If this assignment has been completed by a group or team: 1. Each student in the group must complete and sign a separate coversheet. 2. The assignment will be returned to the student in the group nominated below.* This assignment was completed in a group or team: YES Number in group or team: This assignment should be returned to the student named on this coversheet: YES *Assignment to be returned to:

ON-Line submission, submission, this coversheet must be completed and submitted with your assignment. Submission is taken as your having signed it.

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Unit Code: MAF760 Assignment Number:

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Omar Shaheen

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Group 25

International Finance (MAF 760) Lehman Brothers and Bear Stearns. Why they collapse?

PLAGIARISM AND COLLUSION Plagiarism occurs when a student passes off as the student’s own work, or copies without acknowledgement as to its authorship, the work of another person. Collusion occurs when a student obtains the agreement of another person for a fraudulent purpose with the intent of obtaining an advantage in submitting an assignment or other work. Work submitted may be reproduced and/or communicated for the purpose of detecting plagiarism and collusion.

DECLARATION I certify that the attached work is entirely my own (or, where submitted to meet the requirements of an approved group assignment, is the work of the group), except where material quoted or paraphrased is acknowledged in the text. I also certify that it has not been submitted for assessment in any other unit or course. SIGNED:

Members of Group 25 Omar Usman Gulsheer Qadeer

DATE:

22/09/2014

An assignment will not be accepted for assessment if the declaration appearing above has not been signed by the author. If the assessment task involves group work, marks will be allocated only to students in the group who have completed and submitted a copy of this form. If you are unable to sign this form, please contact a member of the teaching team for the unit to discuss the issues that prevent you from doing so.

You are advised to retain a copy of your work until the original has been assessed a nd collected by you. Assessor’s comments - see over page

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Final mark for this assignment:

Assessor’s Comments:

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’s Name:

Signature:

Date:

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EXECUTIVE SUMMARY: Coupled with the economic collapse of the housing market the biggest government intervention in American history has led to a thorough reorganization of the investment banking industry, culminating in the failure of the United States in 2008 two major investment banks: Lehman Brothers and Bear Stearns. The reports talks about the both companies with respect to their business dealings and what kind of business they were into. The report starts with the brief history about both companies, from their foundation to their demise. What happened to them afterwards? Main focus of the report is on the reasons for their respective collapse and what caused them. Both companies were the major financial players in the industry and with their collapse not only US economy was hurt but the ripples were left worldwide. Lehman Brothers and Bear Stearns were international banks, as their market was beyond US. In the analysis part, report discusses in-depth analysis of their different financial ratios and leverage ratio. Further, the report looks at the housing market situation during last 100 years with respect to their prices and at the same time comparing those with economic situation such as interest rates and mortgage capacity of the population. Management style of the both companies was influential as well, and other control to consider was the US government as regulations were not actively monitored. Companies made decisions which played important role for their demise, it is currently hard to answer who was exactly responsible for the failure but in the end burden was suffered by investors.

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INTRODUCTION: An introduction about companies. In year 1844, Henry Lehman started the trading company named as H. Lehman which mainly traded in the cotton and in the later year 1850, firm changed its name to Lehman Brothers as Henry‟s brothers joined the business. After the demise of Henry, remaining b rothers changed

focused the business from cotton trading to commodity trading and brokerage operations. In the subsequent years, company went through difficult times, mergers and divestments before in the year 1994, its initial public offering where it was named as Lehman Brother Holdings Inc. Before declaring bankruptcy in 2008, Lehman Brothers, the fourth largest investment bank in the United States and at that time it was dealing in the areas such as investment banking, asset operations and fixed, research, investment management, private equity and private banking. Lehman filed for Chapter 11 bankruptcy protection on 15th September, 2008 and this filling is one of the largest in the history of United States. Lehman‟s bankruptcy

played an important role in unfolding the financial crisis which affected the whole world. Looking the financial reports of the year 2008, it can found that assets of the company were approximately around $600-700 billion but it still collapsed. Bear Stearns was founded by Joseph Bear, Robert Stearns and Harold Mayer as an equity trading company in the year 1923. In the subsequent years, the company went through Wall Street crash but managed to hold itself till the year 2008. Bear Stearns was mainly dealing with financial services, investment banking and investment management. At the time of it demise in year 2008, it was one of the largest investment bank based in the New York. Bear Stearns was not only based in New York, it had global reach as well such as 12 different countries and employed around 15,500 people worldwide. Bear Stearns was one of the most reputed companies in the financial sector, as admired by its current and potential employees. Near it demise, the company had total asset worth $400billion as compared to net equity of $11.1 billion. Major of the asset based securities were related to subprime mortgages, as the housing market fell most of the hedge fund lost their respective values. With the liquidity near to zero, the Federal Reserve Bank of New York agreed to provide Bear Stearns with loan of $25billion but market conditions were against them. On the 16th March, 2008 JP Morgan Chase agreed to buy Bear Stearns for $2 per share which was later raised to $10 per share when shareholder disagreed. 5|Page

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R EASONS FOR COLLAPSE OF LEHMAN BROTHERS AND BEAR STEARNS: Reasons have been divided into two main categories, for better understanding, such as firm culture & upper management and financial characteristics. FIRM CULTURE AND UPPER MANAGEMENT:

Both Bear Steams and Lehman Brothers had firm cultures that valued excessive risk-taking, and senior leadership failed to head key warning signs that could have helped prevent failure or mitigate damage. In 2005-06 Lehman was one the largest underwriter of the real estate loans in the US economy whereas in 2007 there were many cases filed against the company that the loans were made to the borrowers on no reasonable grounds. It was proved that there was mismanagement within the company and the borrowers who could not even afford to pay back were provided with loans which were mostly invested in the household sector, subsequently US economy started to experience a sharp downfall in the real estate sector and Lehman announced a $2.5 billion write down due to the investments made in real estate. Total losses of the company in 2008 rose to $6.5 billion which made the company stuck in a difficult position. Overall the culture was aggressive and overconfident; such when the hedge funds of Bear Stearns were near collapse instead of controlling them they increased the leverage in order to cover the losses. Bear Stearns was known for its highly aggressive hiring decisions and strategy making decisions. Alan "Ace" Greenberg, former Chairman of Bear Steams, said, "If somebody with an MBA degree applies for a job, we will certainly not hold it against them, but we are really looking for people with PSD degrees," meaning poor, smart, and with a deep desire to become very rich (Kensil et al, 2012). Deep desire of becoming rich and aggressive culture led the Bear Stearns to reply mostly on the volatile bond market for their revenue. Failure can also be linked to the poor decisions made by the superior management as they were living lavish lives without any care for the companies. Some of the high executives were later found out to no or little knowledge of the position they held, thus leading to poor decisions regarding risk strategies and no contingency plan for crisis.

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FINANCIAL CHARACTERISTICS:

The idea of Lehman Brothers of providing loans to the borrowers was good as the prices of the land were rising constantly and it would maximize their profits but they did not take into account the negative side, what would happen if the prices of the assets decrease. This was exactly that happened during 2007-08, The leverage of Lehman Brothers rose to 44 times from 20 in 2007 where as a normal bank would have a leverage of about 12 times. On the day of bankruptcy Lehman Bros had $600 million worth of assets but the main reason that added to its financial crisis was that it lacked liquidity. On the other hand, Bear Stearns had a leverage ratio of nearly 36 per cent. As the markets began to fall both companies finances became weak, other banks and the people started to lose faith in the companies. A point to argue here is that other financial bank such as Morgan Stanley, Merrill Lynch and Goldman Sachs had higher leverage ratio as well when compared with the Lehman Brothers and Bear Stearns. Those banks, beside Lehman brothers and Bear Stearns, were in control of their leverage ratios, as they had more liquid assets which they could convert quickly. Bear‟s had significant risk in the area of market derivatives. According Kensil et al (2012),

during the year 2006 Bear derivate position was $8.7trillio and by the 2007 it had grown to $13.4 trillion. As the subprime mortgage borrowers started defaulting thus started a chain reaction for the company, such as raising rumours that company cannot make payments (liquidity concerns) which lead to unwinding of derivatives trade with Bear. Both companies maintained its own VAR model numbers for each portfolio of assets and this affected the risk management structure. VAR model employed historical data thus not capturing the true volatility of the asset values. These exercises by the company clearly violated the Basel 2 standards and allowed them to use the most favourable conditions for calculating its capital charges. In addition, companies failed to comply with Basel 2 failed to emphasize asset prices to calculate capital requirements. Majority of the Investment Banks in the United States pressured the Securities Exchange Commission (SEC) to replete the void created by the Gramm-Leach-Bliley Act of 1999. This was done to digress from the European Union regulations. The SEC thus created the Consolidated Supervised Entity (CSE) program, a voluntary supervision package for the brokers. The CSE employed 3 regulations from Basel 2 and allowed the rest of the monitoring to be done by SEC. The CSE also allowed exemption from the net capital rule. This then allowed the investment bank to calculate the capital requirement using the alternative method in Basel 2. Bear Sterns and 7|Page

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Lehman Brothers enjoyed this involvement of the CSE program as the altered calculations led to lower capital requirements. When the acquisition commenced the debt to equity ratio of this bank was 33:1. The new calculations however still allowed the bank to hold only 10% of the capital as a cushion. Bear Stearns and Lehman Brothers used loopholes and outright tricks delay the markdowns instead of choosing to comply with Basel 2 standards. Such behaviour shows complete disregard of financial system.

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ANALYSIS: Our analysis is based on three major factors that we think were important for this study. 

Housing prices and interest rates



Lack of transparency and government regulations (internal and external)



Ratio analysis

All the three major factors are discussed below in detail. In the figure 1 (Appendices), according to Zingales, it can be seen that price after 1997 show constant increase and that increase is steep. This was due to low interest rates, as between January 2002 and January 2004 the average 3 month T-Bill rate was 1.3% as compared to 6.1% averaged in the previous forty years (Zingales, p 3). According to Shiller (2008), a survey in 2005 of San Francisco home buyers, it was found that mean expected price to increase over the next ten years was expected to be at 14% per year while the median was at 9% per year. This eventually led to home owners finding it hard to pay their mortgages as their home equity increases. On the other hand, at the same time mortgage options available were increasing such as interest only and negative amortization. These options allow purchaser to buy houses at which they could not endure the mortgage payments in connection with their ability to refinance it continuously at high price. According to Zingales, interest only mortgage‟s share was at 0% in 2001 and in the year 2008 it has increased to 37.80%. Lending

standards declined especially in the areas such has home prices were high and while at the same time competition among lenders increased. In the past companies could not influence the rating agencies as they only had few securities to buy. With the influence of collateralised debt obligation (CDO), major bank were buying different and hundreds of these rating in a single year, thus allowing to them look for the best rating in the market. Sometimes even produced their own rating with very high risks with the rating of AAA at lowest possible cost involved, even around 2008, Standard & Poor provided CDO evaluation manual. This allowed them to be more famous then the AAA corporate securities even though they had the highest risk. According to Zingales, these AAA rated asset backed securities had average spread of 32 basis point. High constraints in the regulations allowed very demand for these products, two major Government Sponsored Entities (GSE) Fannie Mae and Freddie Mac were encouraged to invest in these securities. 9|Page

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Department of Housing and Urban Development (HUD) set out performance benchmarks for the two GSE and those could only be completed by arbitrage opportunity such as issue AAA rated debt and invest in the AAA rate asset backed securities. Lartey describes the CDO as very complex financial product which was based on the very complex risk ratings and complex mathematical models. As the property prices crashed, repossession and arrears went up like vertical cliff Lehman got caught in the middle of this and was forced to write down $10.5 billion worth of investments during the first three quarter of 2008 (Kensil et al. 2012, pp 63). Another issue was the usage of the accounting system, as there is argument of using fair value accounting played part in the failure. There is three different way to determine the price values, first one is the market prices, second is illiquid market data and third is entity estimated prices. The system was designed to be clearer but it had it drawbacks. With the progress of time, as the general market become less liquid entities moved to the entity estimated model which was not much developed. It can be seen in the figure 2 (Appendices) that Level 1 assets of the both companies were decreasing while there is significant increase in the level 2 and level 3 assets thus leading back to the liquidity problems as elaborated in the reasons. Zingales (2008, pp 11) states that lack of transparency in the major market is one of the contribution problem, credit default swaps grew at alarming rate during the last ten years, almost from zero to $44 trillion. Lartey (2012) states chief executive of Lehman was overconfidence in his management style and at the same time employees were paid high salaries and bonuses which were more than half of what the company earned. Glass-Stegall Act of 1933 is an important factor to be considered here, according to the Act in United States Banks had to maintain their commercial and investment activities separately until in the late 1980s when the Act was abolished. Merger of commercial and investment banking led to rise of unethical actions. Consider this, in order to compete with the other commercial banks and at the same time maintaining the investment portfolio was leading to decision more focused on one then the other. If one side is making loss, decisions were made to cover the loss from the other side with utilizing high amount of leverage thus higher risk.

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Auditors of the companies were blamed as well, as it is auditor‟s duty to perform audit in

such a way and give assurance as well that financial statements are free of any misstatements whether it is error of fraud. There has been mixed views about this as it is very difficult for auditor to review each and every transaction to find fraud. In the case of Lehman Brothers and Bears Stearns it would have been impossible to review their each and every transaction during a respective financial year.

Lehman Brothers (amount in Billions)

Bears Stearns (amount in Billions)

Year

2002

2003

2004

2005

2006

2007

2002

2003

2004

2005

2006

2007

Revenue

16.8

17.3

21.3

32.4

46.7

59

6.9

7.4

8.4

11.6

16.6

16.2

Income

1

1.7

2.4

3.3

4

4.2

0.8

1.1

1.3

1.4

2

0

Assets

260.3

312.1

357.2

410.1

503.5

691.1

184.9

212.3

256

292.6

350.4

395.4

Asset

0.065

0.055

0.06

0.079

0.093

0.085

0.037

0.035

0.033

0.04

0.047

0.041

0.4%

0.5%

0.7%

0.8%

0.8%

0.6%

0.4%

0.5%

0.5%

0.5%

0.6%

0.0%

8.9

13.2

14.9

16.8

19.2

22.5

6.4

7.5

9

10.8

12.1

11.8

11.2%

12.9%

16.1%

19.6%

20.8%

18.7%

12.5%

14.7%

14.4%

13.0%

16.5%

0.0%

turnover Return on asset Equity Return on equity

Azadinamin states in his research paper, during the years from 2002 to 2007, revenue of both companies showed constant increase such as Lehman Brothers has revenue of $16.8 billion in year 2002 as compared to year 2007 revenue was $59 billion, on the other hand Bears Stearns has revenue of $6.9billion. Looking at the income aspect, both companies showed steady grow from the year 2002 till year 2007 and in 2007, Bears Stearns records zero income. Assets of both companies show increase from year 2002 to year 2007, asset turnover and return on asset show steady increase as well and in the year 2007, Bears Stearns shows zero percentage return on asset as company did not had any income. During the years 2002, leverage of Lehman has been around 20 per cent but while near 2007 leverage ratio has peaked to near 44 per cent. Bear Stearns is one of Wall Street's highest leveraged companies. Throughout its history is innovative and creative, and sometimes led them to take some risk positions. The company's management is called concentrated in a few long-term strategic planning opportunities for direct return. To the end of 2007 the balance sheet of Bear Stearns shows $ 395 billion in assets and $ 11.1 billion in equity. The leverage ratio of the company was around 36 to 1. Lehman had massive asset base but at the same time where the liquidity was very low, as all the cash was tied with investments but wasn‟t actually in hand.

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At the international level, collapse of these could be felt very hard. The demise of Lehman resulted in the loss of 70% of $48 billion of receivables from derivatives that could otherwise have been relaxed and as much as $75 billion in value was destroyed (Lartey, pp 16). In England $160million Lehman products were bought by investors, in Hong Kong 43000 individuals had bought mini bonds issued by Lehman valued approximately at $1.8billion and pension funds such as New York‟s state Teachers‟ retirement fund also incurred huge

loss. Some of the hedge funds around the globe were frozen when Lehman bankruptcy was declared.

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CONCLUSION: International Banking experienced enormous changes all economic and market in the past few years. Recent regulatory and competition in the banking sector, has forced many investment banks sided pursuit of economic growth, industry, region and other financial institutions have traditionally fall, such as commercial banks. This exposed the banks to take more risk, often leads to a crisis. Lehman Brothers and Bear Stearns have a reaction on the subprime crisis and other economic activity, has taken some previous decisions on the management of both investment banks is a problem, although they declined in the business judgment rule. While majority of both banks failures were from within the company‟s own operations,

many questions arose as to whether the interaction between the banks and the Government agencies that regulated and monitored Lehman and Bear contributed to the collapse. Many analysts believed the bankruptcy of both banks had set off a panic that would end up by threatening not only the U.S. financial system but also the entire global financial system. The fact is that, these questions are currently hard to answer, among other reasons because there is very little exact knowledge about what exactly happened to both of the investment banks. Eventually Bear Stearns was purchased by JP Morgan Chase for it nominal level while Lehman Brothers could not be saved as it filed for it Chapter 11 bankruptcy, later North American division was purchased by Barclays Plc. and Nomura Holdings agreed to buy Asian division and other divisions were just shut down.

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R EFERENCES: Azadinamin, A 2013, „The Bankruptcy of Lehman Brothers: Cause of Failure & Recommendations Going Forward‟, THE BANKRUPTCY OF LEHMAN BROTHERS , Swiss

Management Center (SMC) University, pp 1-15. Lartey, R 2012, „What caused the collapse of Lehman Brothers?‟, Running head: Failure of Lehman Brothers, SMC University Switzerland, pp 1-26. Zingales, L 2008, „Cause and Effects of the Lehman Brothers Bankruptcy‟, University of

Chicago Business School, pp2-26. Shiller, Robert J., 2005, “Irrational Exuberance”, Princeton University Press 2nd edition.

Shiller, Robert J., 2008,

The Subprime Solution: How Today's Global Financial Crisis

“

Happened, and What to Do about It”, Princeton University Press. Kensil, S. & Margraf, K. 2012, „ The Advantage of Failing First: Bear Stearns v. Lehman Brothers‟, Journal of Applied Finance- No.2, pp 60-76 FURTHER READING:

Grove, H, & Cook, T 2013, 'Lehman Brothers and Bear Stearns: Any Financial and Corporate Governance Differences?', Amity Global Business Review, 8, pp. 112-130. Hintze, J 2009, 'One Year After Bear's Collapse JP Morgan Reaping Benefits. (cover story)', Securities Industry News, 21, 6, pp. 1-20, Business Source Complete, EBSCOhost , viewed 10 September 2014. Haas, R, & Horen, N 2012, 'International Shock Transmission after the Lehman Brothers Collapse: Evidence from Syndicated Lending', American Economic Review, 102, 3, pp. 231237, Business Source Complete, EBSCOhost , viewed 9 September 2014.

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Kensil, S, & Margraf, K 2012, 'The Advantage of Failing First: Bear Stearns v. Lehman Brothers', Journal Of Applied Finance, 22, 2, pp. 60-76, Business Source Complete, EBSCOhost , viewed 12 September 2014. Duong, B 2009, 'Lehman in retrospect', Institute Of Public Affairs Review, 61, 3, p. 59, MasterFILE Premier, EBSCO host , viewed 1 September 2014. Rosato, JF 2011, 'DOWN THE ROAD TO PERDITION: HOW THE FLAWS OF BASEL II LED

TO

THE

COLLAPSE

OF

BEAR

STEARNS

AND

LEHMAN

BROTHERS', Connecticut Insurance Law Journal , 17, 2, pp. 475-500, Legal Source, EBSCOhost , viewed 15 September 2014.

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APPENDIX: Figure 1:

Figure 2:

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(Image from Kensil et al. 2012, pp65)

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Group25_MAF760

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