Lehman Brother\'s Scandal in 1980\'s

Lehman Brother's Scandal In 1980's

Lehman Brothers was one of the most important and old banks in the United States, with its history going back to the 1840s. However, 'greed' began to seriously take over during the 80s and the company began to speculate on the rising Wall Street and NYSE, going into leverage buy-outs and junk bonds. Many consider that the Lehman Brothers gurus were, alongside Drexler, one of the investment banks that stimulated the economic growth of the United States during the 80s. Others, on the other hand, see Lehman Brothers as the prototype of easily made and usually immoral money and as illegal beneficiaries of inside trading and inside information.

The book, written as an excellent piece of documentary, covers the period from July 1983 to April 1984, up to the firm's takeover by Shearson/American Express. It is both a stimulating political story, with two adversaries fighting for glory and money and bringing the company's failure in the end, but, at the same time, it does an excellent job of covering key business issues and of describing and explaining some of the economic mechanisms that were behind financial transactions during the rise of the Wall Street current.

The main idea from the course as it appears in the book is related to bonds. As we know from the textbook, bonds are generally used in order to raise capital. Previous to the 80s, bonds were generally rated according to the company's reputability and companies which were known to have difficulties in making payments were listed as junk companies, with bonds that were generally never purchased and which did not help the respective companies from entering bankruptcy.

However, with Lehman Brothers, a new era began. Lehman Brothers invested heavily in junk bonds, with the general idea in mind that the price that could be obtained in time for junk bonds (the coupon or the interest rate) was enough to compensate the risk that the company was undertaking.

This was not too far from the truth and Lehman Brothers made a fortune. However, soon after that, it began to use junk bonds in order to finance leverage by-outs. This was a much more difficult and dangerous enterprise. The principle was rather simple and we will refer to it further below. Anyhow, leverage buy-outs simply meant that you could purchase a company's shares on debt alone (except for a small 5-10% of the total price) and then make an extraordinary profit by selling the company's assets bit by bit.

2. In order to exemplify one of the financial transactions in the book, we will be using a leverage buyout (LBO) and describe the mechanisms that make it reasonable and have turned it into a success in the 80s.

Lehman Brothers, through its intermediaries, wants to make a deal from buying and then selling a company, profiting from the differences between the company's real value and the fact that its assets are under evaluated on the stock exchange. As such, it chooses a company, usually one where the stockholders can be easier to convince than others.

The two parties facing each other are Lehman Brothers and the raided company's management. The reason for this is quite simple: it is more than sure that, in the case Lehman manages the buyout, the former management will no longer have a place to work in. The stockholders do not enter the equation, but do negotiate the price of their shares.

The interesting aspect is the way Lehman can come up with a sum large enough to cover all of the stockholders' financial demands. Leverage buyout! It may use junk bonds issuing (bonds at high interest rate) and then cover up the loan from the profits made in the deal.

Negotiations with each important stockholder in part are commenced and continue at an incredible pressure. The problem for each stockholder in part is when to sell. If they sell too soon, then they will not benefit from the subsequent new offer that Lehman is most likely to come up with if it is refused. If they sell too late, Lehman will already have a majority and will no longer need the shares from other stockholders. In an obvious minority, they will need to sell at a much lower price.

The management, who is facing a job loss situation, need to come up with different investment plans and convince the stockholders that it is better to stick with the current team and attack future possible businesses than sell right away. As I have said, for Lehman, pressure comes from the profit it will later make: if it has to raise the price offer too much, then the profit will be lower and it will not cover the debt that Lehman has to return, plus the interest rate.

Of course, inside information and inside trading is quite useful, because this will tell you how much more you have to offer before you convince the stockholders that they have to sell. As such, many of the important financial characters of the 80s served some time in prison on this account. Although it was not the case for people at Lehman Brothers, it nevertheless became a victim of its own maneuvers.