Lehman Brothers, RIP

The anniversary of its bankruptcy, 14 September 2008

Christie’s auctions off the Lehman Brothers sign, September 2013

Thirteen years ago today, on 14 September 2008, Lehman Brothers filed for bankruptcy. Those of you who have seen the film Too Big to Fail will know the story of Lehman’s attempted rescue and its ultimate failure. The 158-year-old investment banking firm ran out of funding and was unable to find a buyer, and so had to file for bankruptcy and be liquidated. Everything Lehman owned had to go, including the Lehman Brothers (European) headquarters sign, which was auctioned off at Christie’s for a second time on the fifth anniversary of the firm’s failure.

Viewed from today’s perspective, two years into the continuing covid crisis, Lehman’s bankruptcy might seem like a bit of arcane financial history for many of you. But it was a very big deal at the time and I would argue that it changed the course of financial history. The financial markets went into free fall after Lehman filed for bankruptcy, putting an end to any wishful thinking that the US government might have finally gotten things under control following the nationalization of Fannie Mae and Freddie Mac. On the same day that Lehman failed, Merrill was sold to BofA and AIG was only days away from collapse. It looked like things could not get any worse, but they did. Bank share prices continued to fall, the global financial system came close to shutting down, the Fed guaranteed all outstanding money market fund obligations, the Treasury bailed out the US auto industry and the overall US stock market fell another 45% from the time of the Lehman filing. Lehman’s bankruptcy did not cause these events, but it sure didn’t help.

[If you would like to learn more about the Lehman bankruptcy, as reported in real time, read here. And if you would like a refresher on the timeline of major events during the global financial crisis (2007-9), read here.]

But what are we to make of the Lehman bankruptcy today, 13 years on? To my knowledge, the definitive history of this period has not yet been written, and perhaps it never will be, although Adam Tooze’s book Crashed, published in 2018 and reviewed here, comes pretty close. (I read Crashed and loved it. And now Professor Tooze has just published another excellent book on the covid crisis, Shutdown, reviewed here.) We all have our own perspectives on the Lehman bankruptcy, some more informed than others, but all of them reflect our personal experiences and biases and all are subject to fair challenge (including mine). Here are some of my observations on the Lehman bankruptcy, with the benefit of hindsight:

Risk management matters. Yes, this seems like a statement of the obvious, especially viewed from our vantage point today. But it wasn’t so obvious in the “go go” days leading up to the collapse of the US mortgage market, when highly leveraged “risk on” investment banking firms like Lehman were minting money and generating high returns on equity, and making their senior executives rich along the way. In its long and storied history, Lehman had survived many financial crises, including several world wars and the Great Depression, but more recently it came close to failing on several occasions, including during the Russian debt default in 1998, just ten years prior to its ultimate bankruptcy and liquidation. In the run-up to the global financial crisis of 2007+, Lehman took on very large exposures to the residential and commercial real estate market as well as the ABS and high yield bond markets, and it did so on the back of a very low capital base with excessive amounts of short-term capital markets funding. Lehman didn’t cause the collapse of the US mortgage market, but it was a big player in the riskiest segments of the market and the firm was not prepared for the perhaps inevitable volatility and financial carnage that ensued.

What goes up can also come down. Leverage works both ways: when times are good it magnifies ROE (return on equity) and when times are bad it magnifies losses. Lehman experienced both the highs and lows of leverage on multiple occasions prior to and during the financial crisis. During a difficult 2007, Lehman still reported ROE of about 21% (25% return on tangible equity), but ROA (return on total assets) for the year was only 0.7%. At year-end 2007, Lehman Brothers reported balance sheet leverage of about 30x (total assets/total shareholders equity). This is a capitalization ratio (equity/assets) of just over 3%, and almost certainly understated significantly Lehman’s true leverage (including off-balance sheet exposures and net of year-end accounting window dressing). My understanding is that Lehman was in fact levered in excess of 40x (2.5% equity) at the time it failed. This sort of leverage may be appropriate for a very low risk financial institution, but not for an investment bank and certainly not a high-risk firm like Lehman. At year-end 2007, Lehman reported total assets of $691bn, of which about $300bn was held in the form of financial instruments, a large portion of which was in mortgages, commercial real estate and junk bonds. Lehman’s total shareholder’s equity at the time was only $22bn, including $4bn of intangible assets. Suffice it to say that it didn’t take much of a loss in asset value to wipe out all or most of Lehman’s equity, and this is exactly what happened during 2008.

Share prices are not infallible estimates of value. Many finance students seem to believe as a matter of almost religious faith that publicly traded share prices are always reliable estimates of intrinsic value. But even if this were true (which it is not), it is also true that “stuff happens” and values change, sometimes very quickly. At the end of 2006, Lehman’s share price closed the year at $156, giving the firm an implied equity market value of $83bn. During the first half of 2007, however, Lehman’s share price fell 75% and by September the shares were worthless. The stock market may or may not have reflected a reasonable view about Lehman’s financial prospects at year-end 2006, but in any event Lehmans’ prospects, or the market’s view of Lehman’s prospects, changed quickly. As I said above, “stuff happens and values change, sometimes very quickly”. Indeed.

Firms go broke when they run out of cash, not shareholders equity. Many solvent non-financial corporations operate with negative equity and do so successfully for years on end. Look at Boeing for example. (OK, Boeing has been effectively bailed out a few times, but still….) But financial institutions are different, and banks like Lehman which generate losses in excess of book equity (or regulatory capital) are quickly put out of their misery, by regulators or by the capital markets. And this generally happens before the banks become balance sheet insolvent, leaving depositors or other funding sources in the lurch and taxpayers potentially on the hook. It is highly likely that Lehman was in fact insolvent from a balance sheet perspective at some point before it failed in September 2008, and this was the view expressed at the time by Treasury Secretary Hank Paulson and others. I don’t know if Paulson was correct on this point, but his view was certainly consistent with the collapse of Lehman’s stock price during 2007. But what killed Lehman was not just excessive leverage, falling asset values and its collapsing share price, but also a lack of liquidity in the funding markets. Lehman had $691bn of total assets at year-end 2007, which were funded with just $22bn of shareholders equity plus $123bn of long-term debt. The balance of Lehman’s financing requirements came from short-term debt and other sources of generally reliable trade finance (eg repo), much of which dried up during the financial crisis. Prior to its bankruptcy, Lehman reportedly was rolling over $200bn of funding on an overnight basis. When Lehman’s trading and funding counter-parties stopped doing business with the firm, Lehman’s liquidity dried up. And when this happened, Lehman was bust, whatever the condition of its balance sheet.

Culture matters. During its 158-year history, Lehman went from being a family controlled company (1850-1969), to a private partnership (1969-1984), to a subsidiary of American Express (1984-1994), to a publicly traded company with a large employee ownership (1994-2008). During the 1980s and 90s, Lehman and most of its investment banking peers went from from being managed by investment bankers (eg Pete Peterson) to being run by traders (Lew Glucksman and Dick Fuld). And once these firms went public, they were no longer constrained by the limited amounts of the partners’ private capital but were now able to take more risk and play for much higher stakes with large amounts of OPM (Other People’s Money). This is in essence the story of modern US investment banking and it was the story of Lehman. And the resulting (and contributing) changes in investment banking cultures contributed materially to the events that played out during the 2007-9 period.

Should Lehman have been bailed out? I think it is fair to say that the US government’s failure to bail out Lehman was inconsistent with the precedent established with the previous bailout of Bear Stearns, which was sold to JP Morgan in March 2008, with $30bn of Fed support. And I think it is probably also fair to say that the government’s failure to bail out Lehman likely accelerated and prolonged the continuing financial crisis. But Lehman (like Bear) was never a critical part of the US investment banking landscape, let alone the broader US banking or financial services industry, and I would be hard pressed to say that the absence of either of these two firms has made much of a difference in the competitive dynamics of the investment banking business, let alone the US financial system. I don’t know if the US government was right to let Lehman fail, but I tend to think it was. As Hank Paulson famously said at the time (with more than a bit of irony, given his own investment banking background), “moral hazard matters”. And Lehman always struck me as one of the poster children for demonstrated moral hazard in investment banking, although not nearly as extreme a case as my old employer, Deutsche Bank. Like Lehman, too many investment banks have for too long run their businesses with a “heads we (the banks) win and tails you (the public) lose” strategy. For the good of the investment banking business, and our financial system, one of these big investment banking firms probably had to fail, and I suppose it might as well have been Lehman (and Bear before it) given the vulnerable position they put themselves into.

In summary: Investment banking today is a much more staid and sustainable business than it was during the “go go” years of the 1980s, 1990s and early 2000s and in my view this is generally a good thing. It says a lot, I think, that the top US investment bank today is probably JP Morgan, which wasn’t really in the business back in the early 1980s. (JPM was then a US commercial bank, although it did have a big investment banking business outside the US, particularly in London.) Although it too has changed much over the years, JPM has generally managed its investment banking business in a more conservative and responsible manner than its principal competitors, contributing to its long-term stability and its success. As I said above, culture matters, particularly in tough times. And I believe the folks at JPM, Goldman Sachs and Morgan Stanley would all agree.

In memoriam, Lehman Brothers & Co, 1850-2008