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Northwest Christian UniversityWriting 123Frankie J NyquistJune 30 2019AbstractLehman Brothers triggered a global Essay
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Nov 26th, 2019

Northwest Christian UniversityWriting 123Frankie J NyquistJune 30 2019AbstractLehman Brothers triggered a global Essay

Northwest Christian UniversityWriting 123Frankie J. NyquistJune 30, 2019AbstractLehman Brothers triggered a global economic recession when filed bankruptcy on September 15, 2008 that could have been avoided if it had an established culture of ethical behavior and policies for corporate sustainability. Deregulation took place in the early 2000s and economists argued that markets would self-regulate based on the natural laws of supply and demand. Proponents of deregulation argued that it would make it easier for the average consumer to borrow money to buy houses, after all wasn’t that the American dream? Financial institutions were able to sell loans to investors, which made Wall Street enormous profits in the housing boom.

Institutions took excessive risk and had little actual liquid assets on the books to cover debts. Creative accounting practices like Repo 105 hid the problems under the direction of corporate executives and traders made huge bonuses. The crisis could have been avoided with internal polices of sustainability and proper risk management. The lack of oversight and ethics made many financial institutions unstable that were thought to be too big to fail until one did.

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Keywords: Corporate Sustainability, Economics, Lehman Brothers Bankruptcy, RecessionLessons Learned from the Lehman Brothers BankruptcyAt the time Lehman Brothers filed bankruptcy on September 15, 2008 it was the fourth largest financial institution is the US. Its failure triggered the global recession and nearly caused the economic system to collapse. The firm was under the leadership of CEO Richard Fuld, and he was the longest-tenured CEO on Wall Street. Lehman Brothers along with many other investment firms began to expand its offerings after the 1999 repeal of the Glass-Steagall Act, which had barred affiliations between commercial banks and investment banks and their activities. Lehman Brothers bankruptcy is the largest in in history when many thought it was too large to fail until it did. The markets panicked and significant stock market sell-off took place that had negative effects on banks, savings and loans, primary dealers and brokerage firms. The collapse caused distrust in the banking system as a result of widespread corruption and subprime lending. The bankruptcy has forced accounting standards to change and large corporations to keep more funds held in assets. The corporate culture of taking high risks and lavish reward at Lehman Brothers none the less effected the way they did business. Deregulation in investment banking from 1999 through 2004 allowed investment banks to engage in hedge fund trading and take more risk. Proponents of deregulation argued that derivates mitigated risk and that deregulation would allow more Americans to buy homes. Investment banks could bundle mortgages with other loans and debts into collateralized debt obligations (CDOs) which they sold to investors. Mortgage originators could sell loans on secondary markets to investors, so they did not hold loans to maturity like banks had done in the past. Rating agencies gave many CDOs AAA ratings when the loans included were for overvalued properties with borrowers who could have trouble repaying the loans after the rates adjusted. Subprime lending often led to predatory lending where consumers were given loans they could never possibly repay. Often these loans were adjustable rate mortgages that had an introductory teaser rate for a period then increase. Properties were being appraised for significantly more than they were worth because the demand was high. The increase in demand for property drove up real estate prices to record highs from 2004 through 2006 and it created an asset bubble. Mortgage lenders and appraiser’s compensation was based on quantity of loans not quality so they gave loans to borrowers who could not reasonably repay them. Since the lender knew the loans were being sold as hedge funds in secondary markets they did not carry the risk and would be rewarded based on the sales they made. HR Magazine said that The troubled mortgage operations and investment banks also have strong cultures, but they are cultures characterized by rampant individualism, little attention or oversight from supervisors, and huge rewards for successful performance. Those values generate tremendous pressure to maximize individual performance and payouts, often by taking outsize risks and biding failures. (Cascio & Cappelli, 2009, p. 46) At the individual level of loan officer or investment broker, people pushed limits on prudent individual transactions. The common factor motivating subprime lending and inaccurate balance sheets was major financial incentives to meet and exceed company and individual performance targets. Performance-based pay that creates pressures to make riskier decisions. Insufficient attention to ethics, inadequate reporting and disclosure, insufficient development programs and poor alignment of pay and performance. The lending and compensation ecosystem from appraisers to brokers is compensation based on loan origination, so it was corporate culture to push loans through regardless of whether borrower had the ability to repay. Additionally, there was a lack of checks and balances on loan origination that created a culture where loans were funded even if the property was over appraised and sold for more than it was actually worth. During the height of the housing market investment banks saw record growth and huge profits. Lehman Brothers was considered the most aggressive and successful firms. Lehman Brothers had a solid reputation and it was one of the oldest banks on Wall Street. Lehman Brothers took on more risk in 2006 because of the high yields when the market began to decline when other investors had shied away from them. When the Federal Reserve raised its rates adjustable mortgage interest rates skyrocketed. The housing market began to decline, and as adjustable rates started to hit owners they could no longer sell the property for what they owed if it was bought at peak times because the property was worth less than they owed. Many lenders faced difficulty when the housing market started to sour in 2008 along with Lehman Brothers and some even received government assistance. Federal Home Loan Mortgage Corporation (Freddie Mac), Federal National Mortgage Association (Fannie Mae) and Bear Stearns and many other large financial institutions received government assistance when they were in trouble and many assumed that Lehman Brothers would also be bailed out. Government officials argued that the assistance they had given other companies were small in comparison to the Lehman Brothers capital deficit and were unable to help them. According to Fed Chair Ben Bernanke, Treasury secretary Henry Paulson, and Timothy Geithner, president of the Federal Reserve Bank of New York, other firms like Bear Stearns and AIG had collateral that covered the bailout, while Lehman did not” (Sraders, 2018). It was also an election year and many Americans did not want to see Wall Street greed bailed out so there was much political debate on whether the government should step in and help or let them fail and in the end the government let Lehman Brothers go bankrupt. When Lehman Brothers declared bankruptcy, it had an adverse effect on the global economy and almost collapsed the economic system. An article on the failure of Lehman Brothers and its impact on other financial institutions explains: “Financial institution consolidations and failures were all too common between 2006 and 2008. Countrywide Home Loans, Bear Stearns, Washington Mutual, Wachovia, AIG and Merrill Lynch are just a few financial institutions that experienced significant difficulties and restructuring in the past few years. But it was the failure of Lehman Brothers that proved to be decisive during the US Great Recession that lasted from December 2007 until June 2009” (Johnson & Mamun, 2012). Many investors on a global level had purchased investments that included subprime mortgages and they did not understand the risk. When Lehman Brothers failed, investors were left with nothing. Since the investments were highly rated, many investors did not truly understand the risk they were taking. Countries like Iceland had a complete collapse of its financial system after the markets experienced significant losses, resulting in the loss of many jobs in the public and private sector. Lehman Brothers accounting methods strategically disguised problems from investors and regulators. In 2007, Lehman posted record high net revenues, net income and earnings per common share. Their revenues were, for a fourth consecutive year and the highest volume of trade on the London Stock Exchange. The financial statements were being manipulated using an accounting loophole called Repo 105. Lehman Brothers moved over fifty billion dollars in debt before quarterly reporting and then moved it back on to the balance sheet. The transactions were not included in the notes of the financial statement. They used the loop hole to manipulate the leverage ratio so they were acceptable, but the information was not accurate. An analysis of the bankruptcy in the American Journal of business stated The failure of Lehman reminds us that financial reporting must remain transparent, allowing users to make informed decisions with confidence (Hines, Kreuze, Langsam, 2011, p. 46). Lehman executives took on more risk and ignored its own risk models and excluded some assets from their risk analyses. Lehman Brothers took risks that more cautious banks shied away from”it borrowed more and more money because of a false sense of security. By Aug.2007, Lehman Brothers was borrowing up to $44 for every dollar it owned; it’s called leveraging. Most of their competitors like Goldman Sachs and Morgan Stanley had a leverage ratio in the 20s or low 30s. Lehman’s was significantly higher. While leverage multiplies profits when prices go up it also multiplies losses if prices fall. Legal review of its balance sheet shows accounting misuses to make the company appear to have less debt. Journal of Legal, Ethical and Regulatory Issues said:At that time, the repurchase agreements could count as a sale rather than debt under Generally Accepted Accounting Principles; thus, Lehman understated their financial difficulties. Both the accounting principles, possible violations of U.S. securities law, and the conflict that results are examined. The authors conclude that as long as the conflict exists between what is expected of auditors (under accounting standards and GAAP) and the regulators and the law, Lehman-type events will continue to be likely (Jones, Presley, 2013). Some employees of Lehman Brothers raised concerns prior to the bankruptcy. As stated in the bankruptcy examiners report Lehman’s former global financial controller, Martin Kelly, raised concerns about the propriety of the Repo 105 program with two of Lehman’s chief financial officers, who served consecutively. Kelly first expressed his concerns to CFO Erin Callan, who served from December 2007 until mid-2008. (Examiner’s Report, 2010, Vol. 3, p. 930). Martin Kelly had concerns about the size of Lehman’s Repo 105 program as evidenced by the volume of compared to its competitors. From an accounting perspective, the firm’s Repo 105 usage spike at quarter-end, during Lehman’s reporting periods. Lehman Brothers was not following corporate governance guidelines and issues were reported internally and auditors failed to address the repo 105. A case about aggressive application of accounting standards explains Repo 105 was a more expensive source of financing compared to ordinary repo agreements because of the opportunity cost of the increased collateral, as well as transaction costs incurred by channeling these transactions through Lehman’s British subsidiary (Caplan, Dutta, and Marcinko, 2012).Lehman Brothers Bankruptcy could have been avoided if prudent risks were taken with a focus on sustainability instead of profitability. Accounting for corporations should be standard so that there is financial transparency. It’s questionable if Wall Street has learned its lesson from the failure of Lehman Brothers and whether corporations have renewed focus on ethical accounting and sustainability. The accounting practices that were being used by Lehman Brothers were addressed by accounting regulators so that they could no longer be used to manipulate balance sheets. The CPA Journal explained Financial Accounting Standards Advisory Council’s (FASB) view on repo 105:In April 2011, FASB issued ASU 2011-03, Transfers and Servicing (Topic 860): Reconsideration of Effective Control for Repurchase Agreements, to deal with the Repo 105/108 issue. It eliminated the criterion of whether the transferor can repurchase the assets on the agreed-upon terms from the assessment of effective control. This also eliminated the related guidance concerning having enough cash to redeem substantially all of the securities in the initial agreement, as well as the “substantially all” bright-line definition used by Lehman (Hartwell, 2016, p. 33).There are several corporate practices that could have been done to prevent the financial crisis caused by Lehman Brothers bankruptcy. The culture of investment bankers needs to change from the top down. Many executives led companies to make as much money as possible with out considering how sustainable it is long term. If Lehman Brothers had reserved capital instead of paying out huge bonuses and taking more risk, it would have been much more fiscally solvent and able to survive. It is understandable the employees should be compensated for their work and that there should be cap on the amount of bonuses CEOs and corporate executives make. When Lehman Brothers filed bankruptcy over twenty-five thousand employees lost their jobs and many individuals and governments lost complete investment portfolios. It seems Wall Street executives including Dick Fuld, CEO of Lehman Brothers did not consider the morality and consequences of their actions. Corporate sustainability and risk management policies should have clear thresholds and ratios. Corporate sustainability aims to create long-term value through the implementation of a business strategy that focuses on the social, environmental, ethical, cultural, and economic way of doing business. Financial accounting should be transparent and regulated so that investors can clearly understand what the risks are. After the failure the government created the Consumer Financial Protection Bureau (CFBP) to help protect consumers against predatory lenders and unfair banking practices. CFPB aims to improves financial documents so that they clearly list the payment amounts and terms in easy to understand language so the borrowers understand loans. The guidelines create greater transparency though the inclusion of a three-page Loan Estimate that explains to buyers if they face a balloon payment or a potential increase in their mortgage rate as well as a Closing Disclosure that more user-friendly.It has been over ten years since the collapse of Lehman Brothers and the global recession and in hind sight there have been some changes made since financial crisis. Many corporations now have corporate sustainability and social responsibility policies. The culture of compensation has shaped the way business is done and an article in the Economic Times states Should students be taught differently now that it’s all too well-known that greedy alumni from prestigious schools were as much responsible as any other factor in the collapse of firms like Lehman Brothers? (Binoy, 2009). Compensation of executives in financial services industry is still not regulated in America. Top executives of insolvent companies like Dick Fuld have walked away with their personal fortunes intact. The Security Exchange Commission (SEC) is the government regulator that oversees publicly traded companies and has yet to bring charges to anyone at Lehman Brothers. In conclusion, if Lehman Brothers had established corporate sustainability and ethics regarding the risks it took, it could have avoided bankruptcy. Lehman Brothers’ collapse caused economic turmoil around the globe and one of the lessons learned from the fourth largest lender is that deregulation left institutions vulnerable to greed and malpractice. Government oversight has become necessary to ensure financial institutions do not take excessive risks and over compensate executives. The CFPB has changed lending guidelines have changed to be more consumer friendly and prevents banks from giving creditors loans that they cannot reasonably repay. In addition, the has made loan documents easier to understand. ReferencesBinoy, Prabhakar. (2009). Moral of the crisis story? IIMs say ethics. (ET Cetera). The Economic Times, p. The Economic Times, Oct 22, 2009.Caplan, Dennis H., Dutta, Saurav K., & Marcinko, David J. (2012). Lehman on the brink of bankruptcy: A case about aggressive application of accounting standards. (Instructional Resources) (Lehman Brothers Holdings Inc.) (Report). Issues in Accounting Education, 27(2), 441-459.Cascio, Wayne F., & Cappelli, Peter. (2009). Lessons from the financial services crisis: Danger lies where questionable ethics intersect with company and individual incentives. (Performance Management) (Company overview). HRMagazine, 54(1), 46.Hartwell, C. (2016). How Lehman Brothers and MF Global’s misuse of repurchase agreements reformed accounting standards. The CPA Journal, 86(8), 32-35.Hines, Charles, Kreuze, Jerry, & Langsam, Sheldon. (2011). An analysis of Lehman Brothers bankruptcy and Repo 105 transactions. (Report). American Journal of Business, 26(1), 40-49.Examiner’s Report (2010), Report of Anton R. Valukas, Examiner, United States Bankruptcy Court, Southern District of New York, United States Bankruptcy Court, New York, NY.Johnson, M., & Mamun, A. (2012). The failure of Lehman Brothers and its impact on other financial institutions. Applied Financial Economics, 22(5), 375-385.Jones, B., & Presley, T. (2013). Law and accounting: Did Lehman brothers use of Repo 105 transactions violate accounting and legal rules? Journal of Legal, Ethical and Regulatory Issues, 16(2), 55-91.Sraders, A. (Sep12, 2018). The Lehman Brothers collapse and how it’s changed the economy today. Retrieved from

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