Lehman Brothers: The Collapse of a Financial Giant

Lehman Brothers’ stock was selling at $86 a share in February 2007, giving the company a market capitalizationMarket CapitalizationMarket Capitalization (Market Cap) is the most recent market value of a company’s outstanding shares. Market Cap is equal to the current share price multiplied by the number of shares outstanding. The investing community often uses the market capitalization value to rank companies of nearly $60 billion. For the year, the company reported a new record high in net income, over $4 billion. In January 2008, Lehman Brothers was the fourth-largest investment bank in the U.S.

In March, immediately after Bear Stearns (the second-largest holder of mortgage-backed securitiesMortgage-Backed Security (MBS)A Mortgage-backed Security (MBS) is a debt security that is collateralized by a mortgage or a collection of mortgages. An MBS is an asset-backed security that is traded on the secondary market, and that enables investors to profit from the mortgage business, right behind Lehman Brothers) almost collapsed, Lehman stock dropped by almost 50%. In June, the company reported a quarterly loss of $2.8 billion, its first quarterly loss since being spun off from American Express way back in 1994.

By the end of 2008, Lehman Brothers Holdings Inc. had vanished from the investment banking landscape, the largest corporate bankruptcy filing (with $619 billion in debt) in U.S. history.

Summary: 

• Lehman Brothers began in the mid-19^th century – 1844, to be precise – as a general store. Henry Lehman was responsible for the first incarnation of the business; his brothers (Mayer and Emanuel) joined the business in 1850, laying the groundwork for what would become a financial industry powerhouse.
• The 1990s were a time of great power and financial success for Lehman Brothers; the repeal of the Glass-Steagall Act allowed the company to engage in both commercial and investment banking services, a move that would ultimately lead to its downfall.
• Lehman’s ultimate end came as a result of being utterly overwhelmed by mortgage-backed securities (MBS) that were mostly backed with subprime loans, many of which went into default.

The Beginnings of Lehman Brothers

Lehman Brothers began in the mid-nineteenth century, 1844 to be exact. It was started in Montgomery, Alabama by Henry Lehman, an immigrant from Germany. From being a dry-goods and general store, Henry’s brothers – Mayer and Emanuel – joined him, giving birth to Lehman Brothers in 1850. During the 1850s, Lehman began to become a major commodities trading company, specializing in the key cotton market.

The company’s shift from commodity trading to investment banking began in 1906 when it partnered with Goldman Sachs on an IPO. Between 1906 and 1926, Lehman was involved in underwriting nearly a hundred new equity issues, including those of such notable companies as F.W. Woolworth, Studebaker, and Macy’s department stores.

The history of Lehman Brothers mirrors how investment banking’s changed and developed in the United States’ economy. The company managed to pursue and even thrive through major national upheavals such as the Civil War, both world wars, and the stock market crash of 1929 and the resulting Great DepressionThe Great DepressionThe Great Depression was a worldwide economic depression that took place from the late 1920s through the 1930s. For decades, debates went on about what caused the economic catastrophe, and economists remain split over a number of different schools of thought.. Going through a myriad of changes, spin-offs, and mergers, the company developed into a commodities brokerage and ultimately into one of the largest investment banks in the world.

Success in the 1990s

Lehman Brothers was acquired by Shearson/American Express in 1984 for a reported $360 million. American Express owned Lehman Brothers from 1984 to 1994, at which time it spun the company off via an initial public offering (IPO), which attracted more than $3 billion in new capital. The repeal of the Glass-Steagall ActGlass-Steagall ActThe Glass-Steagall Act, also known as the Banking Act of 1933, is a piece of legislation that separated investment and commercial banking. The Act came as an emergency response to the massive bank failures during the Great Depression, as it was thought that speculation by commercial banks had contributed to the crash – which previously prevented banks from simultaneously conducting investment and commercial banking business – enabled Lehman Brothers to expand greatly by offering both services.

Lehman Brothers prevailed after the horrors of 9/11 and continued as a dominant force in the investment banking industry. By 2007, Lehman had grown to become the fourth-largest investment banking firm in the country. Much of its growth and profitability came from huge investments in mortgage-backed securities (MBS). Ironically, those very same investments ultimately led to the company’s downfall.

The Housing Market and Subprime Loans

Lehman Brothers was deeply invested in mortgage-backed securities (MBSs) by the time the mid-2000s rolled around. The housing boom led to an overabundance of both MBSs and collateral debt obligations (CDOs)Collateralized Debt Obligation (CDO)A Collateralized Debt Obligation (CDO) is a synthetic investment product that represents different loans bundled together and sold by the lender in the market. The holder of the collateralized debt obligation can, in theory, collect the borrowed amount from the original borrower at the end of the loan period. being created and, by 2007, Lehman was the largest holder of MBS.

The icing on the cake for Lehman Brothers was its deep dive into loan origination in 2003. The company acquired a number of lenders, several of whom focused on providing the subprime loans that the U.S. government had been pushing since the turn of the century. Their huge investments in MBS, many of which were teeming with subprime mortgage loans, is what caused the demise of Lehman Brothers.

The Housing Market Crash

The incredibly risky and haphazardly structured subprime loan bundles were overwhelming the market by 2007 and into 2008. In reality, the earliest stages of the crash begun as early as 2006. All it took was a slowdown in the housing market for defaults on mortgage loans to grow in numbers. The massive number of subprime mortgages simply could not be sustained.

However, Lehman Brothers continued to deepen their investment in the housing market and mortgages, buying up a massive piece of the real estate marketplace, with a 2007 receipt for more than $100 billion in mortgage-backed securities and assets.

Competition and Failure

Lehman Brothers’ biggest competitor – Bear Stearns – went down in flames first. A Federal Reserve-backed deal enabled J.P. Morgan Chase to buy out the company in 2008. The deal, though, made Lehman’s future uncertain.

Lehman was already in a weakened state after depending on repos for daily funding. The company sought to boost market confidence through equity fundraising in the early summer of 2008. However, the move proved less reassuring when, in September, Lehman reported an anticipated third-quarter loss of nearly $4 billion. On top of this, it reported a $5.6 billion loss in toxic asset write-downs.

The End of Lehman Brothers

Lehman’s stock plummeted some 77% in the first seven days of September 2008. Richard Fuld – the CEO at the time – attempted to save face in front of investors and keep the doors open by using multiple tactics, including a spin-off of the company’s commercial real estate assets.

Investors saw Lehman for what it was: a sinking ship. The clear signal that investors were running came with the swelling of credit default swaps on Lehman’s debt, as well as with the backtracking of major hedge fund investors.

The final straw dropped by September 15 when, after attempted buyout rescue deals by both Bank of America and Barclays fell through. Lehman Brothers was forced to file for bankruptcy, an act that sent the company’s stock plummeting a final 93%. When it was all over, Lehman Brothers – with its $619 billion in debts – was the largest corporate bankruptcy filing in U.S. history.

Following the bankruptcy filing, Barclays and Nomura Holdings eventually acquired the bulk of Lehman’s investment banking and trading operations. Barclays additionally picked up Lehman’s New York headquarters building.

Lehman’s collapse was a major contributor to the domino effect of multiple financial disasters that eventually became the Global Financial Crisis of 20082008-2009 Global Financial CrisisThe Global Financial Crisis of 2008-2009 refers to the massive financial crisis the world faced from 2008 to 2009. The financial crisis took its toll on individuals and institutions around the globe, with millions of American being deeply impacted. Financial institutions started to sink, many were absorbed by larger entities, and the US Government was forced to offer bailouts. Many in the industry still wonder why Lehman was allowed to fail, rather than being rescued by the U.S. federal government like so many other banks were. One reason often put forward is simply the massive size of Lehman’s debt and the woeful inability of its assets to begin to cover it.

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