Lehman Brothers' risk management failures and the 2008 collapse

Lehman Brothers and Risk Management

The collapse of Lehman Brothers in 2008 stemmed from the bank\'s over-leveraging in the run-up to its bankruptcy. In other words, the bank had adopted a risky strategy of borrowing to the hilt during the housing/mortgage market boom. So long as the boom was underway, Lehman profited. When the boom became a bust, the bank\'s investment in mortgage-backed securities imploded. As Harris (2013) observes, Lehman\'s financial risk profile and risk management processes and policies were no different from Goldman Sachs\' -- a bank which weathered the 2008 crisis far better than its investment banking rival. The main difference in the two banks was located in the area of corporate governance. Nonetheless, risk management strategies played a direct role in Lehman\'s undoing. This paper will discuss several aspects of risk management with regard to financial services.

Factors Contributing to the Fall

The main factors that contributed to Lehman\'s financial failure were its five acquisitions of mortgage lenders -- one of which (BNC) was engaged primarily in subprime lending, and the other of which (Aurora) loaned to borrowers who had no documentation of actual net worth or income (Greenfield, 2010). While these acquisitions appeared to be intelligent moves in the middle of the housing boom (as the firm\'s profits rose significantly), when the housing bubble burst massive defaults on subprime loans resulted, triggering a wave of panic in the mortgage-backed securities sector. Lehman had securitized nearly $150 billion worth of risky mortgages in 2006 alone -- and instead of selling these securities in the form of collateralized debt obligations (CDOs) or credit defaul swaps (CDSs), it had retained them and in fact purchased more from other banks (Nilakantan, 2010). Selling the derivatives packages was meant to be a form of insurance for the banks -- but instead they were time bombs that grew far out of proportion to the hedge that they were meant to be (Nilakantan, 2010). In short, speculative trading in insurance against defaults led to another bubble in the insurance derivatives themselves: as Vo (2015) notes, by 2007 \"CDS had became the dominant credit market...already 20 times larger than its size in 2000 and was three times exceeding the U.S. GDP, with a notional outstanding value of $57 trillions\" (p. 207). The gargantuan size of this sudden market should have been a red flag for Lehman\'s traders and management -- it had all the earmarks of a bubble -- a classic pump \'n\' dump. Yet Lehman failed to realize what it was amassing more and more of, thinking prices would continue to go up instead of realizing the floor was falling out beneath them.

In 2007, when defaults on sub-prime loans began to rise significantly, Lehman\'s CFO told investors that risks associated with the growing defaults would have a minimal impact on the firm. This obtuseness on the part of management was a major factor in Lehman\'s downfall. As Harris notes, risk management is crucial in the financial services market -- yet it \"is but one function within the broader role of effective corporate governance. Corporate governance encompasses all of the significant functions of the organization as it interacts with its stakeholders\" (Harris, 2013, p. 88). It was the corporate governance of Lehman that promoted turning a blind eye to what investors felt could be a substantial threat.

Before 2007 was out, Lehman\'s blindness began to be felt by management and the firm was compelled to close both BNC and Aurora. However, the bank continued underwriting mortgage-backed securities (MBSs) and loading its portfolio with them -- to the extent that its portfolio of MBSs amounted to 4x the equity of the firm\'s investors. Even when Lehman had the opportunity to unwind its MBS position with the rebound in the market at the end of 2007, it failed to act and the toxic loans bundled into the derivatives packages remained on the books: this was a colossal failure of risk management that stemmed from a lack of corporate guidance (Chang, Duke, Hsieh, 2011).

To manage these types of risks in the future, firms should be cognizant of what exactly they are buying (CDSs were not exactly known for being transparent). They should also take the necessary steps to ensure that portfolios are properly hedged. The greed that allowed Lehman to become over-leveraged with far too great a position in mortgage-backed securities was its ruin. Management should promote a culture of responsibility rather than rewarding a culture of greed through bonuses and incentives (Greenfield, 2010).

High-Risk Investments

The sufficiency of risk management techniques used by financial institutions today with respect to high-risk investments such as mortgage-backed securities is difficult to determine because since the collapse of the global markets in 2008, the world\'s central banks have essentially taken the ultimate backstop position -- essentially promising to prop up the market place through the purchasing of bonds. This has occurred in the U.S., the EU, Japan and elsewhere: it is the policy of quantitative easing (QE) and it has essentially led to a new bubble in the stock market and in the bond market, which some predict will soon burst (Lima et al., 2016).

Risk management techniques that could be used today, such as hedging practices and properly weighted portfolios that limit risk could be sufficient practices -- however, the climate of expectation in which traders simply \"front-run\" the Fed and base transactions on the likelihood of a rate increase does not help to promote a culture of risk management. In a top-down system in which the Fed sets the tone for the rest of the industry, the Fed\'s own lack of transparency and highly-loaded books do not make a compelling case for risk aversion as far as other firms are concerned (Chang et al., 2011). Thus, while the strategies of risk management, hedging, and balancing portfolios should be sufficient, the overall climate of the industry appears toxic and thus places a question on the effectiveness of any hedge should the market\'s bubble burst (Lima et al., 2016).

Management\'s Role

Management\'s role within a financial investment firm for establishing proper risk management procedures includes financial reporting to shareholders of how accounts are being managed, attendant risks involved, and rationales for future steps along with a description of a portfolio\'s performance to date. To this end financial reports must be accurate -- which, in the case of Lehman, they were not (Greenfield, 2010). Consequences that should be enacted when financial firm management fails to perform their fiduciary obligation to investors would come from the Securities and Exchange Commission (SEC), which can revoke a firm\'s license to broker trades on account of misleading financial reports. Such a revocation can come swiftly on the heels of firm\'s lack of transparency or misleading information to investors. Fines do not seem to carry much weight with large firms that make billions in profits annually (Greenfield, 2010).

Foreign Markets

The impact to the performance of foreign markets, considering the recent debt crisis within the EURO zone necessitates a proper hedge to one\'s exposure to foreign investments. Such a hedge could take a number of approaches -- precious metals, FX, derivatives, or bonds -- and a proper, balanced allocation should be achieved so that negative risk can be established. As Vo (2015) points out, diversification is the tried and true method of responsible risk management and in foreign markets is as applicable as in domestic markets.