Lehman Brothers and Risk Management

Lehman Brothers and Risk Management

This report examines the Lehman Brothers collapse and discusses issues of investment bank risk management. The report considers factors which contributed to Lehman's failure, from financial engineering as practiced by CEO Richard Fuld and other executives to lax auditing by Ernst & Young to the influence of an industry characterized by excessive risk-taking. In particular, the report focuses on the presence of inherent conflicts of interest, as well as the existence of multiple instances of moral hazards and principal-agency conflicts.

This report discusses the findings of the Lehman Brothers bankruptcy examiner and considers other analyses as well. A survey of the literature shows the investment banking industry has long been vulnerable to the risk management challenges that led to Lehman Brothers' bankruptcy. Motivated by greed and enabled by lax government regulation and ineffective corporate governance, Lehman gambled heavily on the performance of the subprime mortgage industry. The company, dominated by Fuld, condoned unacceptable levels of risk-taking and promoted questionable business practices. Like many of its competitors, Lehman operated with compensation programs that conflicted with risk management objectives of the company.

Nowhere was this conflict more evident than in the failure of investment banking powerhouse Lehman Brothers. Skewed compensation packages provided the motive, while lax accounting and government oversight created the opportunity for Lehman to self-destruct.

Discussion

"In this way, unbeknownst to the investing public, ratings agencies, Government regulators, and Lehman's Board of Directors, Lehman reverse engineered the firm's net leverage ratio for public consumption" (as quoted in Wall Street Journal, 2010). So goes the damning report issued by U.S. bankruptcy-court examiner Anton Valukas blaming Lehman Brothers senior executives and auditor Ernst & Young for their roles in precipitating the largest bankruptcy in U.S. history and the worst financial crisis since the Great Depression (Spector, Craig, and Lattman, 2010).

Analysts and business leaders have argued that Lehman's downfall was the result of bad decision-making, bad luck and bad timing. This report argues that the company's downfall was equally the result of ethical failures by CEO Richard Fuld and Lehman senior executives. Motivated by greed and arrogance, Lehman made a series of disastrous business moves into the subprime mortgage industry, gambles that were compounded by overuse of leverage.

Analysis shows that an industry-wide climate condoning excessive risk-taking existed. Lehman's approach to overuse of leverage was hardly unique among Wall Street investment banks. At the time of Lehman's failure when it scaled its leverage up from the industry standard 20 to 1 to 30 to 1, Morgan Stanley's leverage was also 30.0 times, Goldman Sachs was 24.3 times and Merrill Lynch's was 44.1 times (Hutchinson, 2008).

As its financial condition deteriorated, Lehman tried to prevent disaster by providing misleading information to the investment community. Lehman executives' financial misconduct was aided and abetted by questionable behavior on the part of auditor Ernst & Young, which issued an unqualified opinion of Lehman's financial statements.

In developments that stunned the financial world, Lehman Brothers was shown to have lied about its financial condition to cover its impending collapse. Ultimately, bankruptcy proceedings and lawsuits were the final chapter in the 158-year history of the then fourth largest U.S. investment bank. Lehman's collapse was widely seen as having intensified the 2008 financial crisis, contributing to the erosion of nearly $10 trillion in market capitalization from global markets in October 2008.

Lehman Brothers had its humble beginnings in 1850 in Montgomery, AL, founded by German immigrants Henry, Emmanuel, and Mayer Lehman. The firm prospered in the following decades, growing into an international powerhouse. Lehman Brothers survived the railroad bankruptcies of the late 1800s, the Great Depression of the 1930s, as well as two world wars and being spun off by American Express in 1994 with a capital shortage (Investopedia, 2009). It did not, however, survive the subprime mortgage meltdown and the freewheeling risk-taking culture built by its former CEO Richard S. Fuld Jr.

Preferring to be known as Dick, Richard Fuld, born in New York in 1946, graduated from the University of Colorado in 1969, then joined Lehman Brothers. Fuld advanced through the ranks, taking over as CEO in 1994. From 1994 to 2007, the company's market capitalization increased from $2 billion to $45 billion. The firm's share price went from $5 to $86, yielding an average annual return of 24.6%. At the same time the company grew to more than 28,000 employees with more than 60 offices in 28 countries. By 2006, Lehman Brothers was the number one underwriter of securities backed by sub-prime mortgages. The man presiding over this spectacular growth was Richard Fuld (Oliver and Goodwin, 2010).

It was reported that Fuld received nearly half a billion dollars in total compensation between 1993 and 2007, by which time he was chairman of the board of directors and CEO. As recently as March, 2008, less than six months before the company's bankruptcy filing, Fuld was awarded a $22 million bonus for 2007 performance (Plumb and Wilchins, 2008). Lehman Brothers staff shared in the rewards as well, receiving a disproportionately high percentage of their pay in Lehman stock and options. At the time the company went public, Lehman employees owned 4% of the company, then worth $60 million. As of 2006 employees owned about 30% of the firm, worth about $11 billion, at least on paper (Oliver and Goodwin, 2010).

Fueling this growth was a corporate culture rife with greed and recklessness. Later investigations showed that Lehman Brothers executives took more and more risks in their quest for greater profits, ignoring those few brave employees who advised caution. The unrestrained greed and recklessness would lead to dramatic and painful consequences.