Quora Answer: What was the Biggest Weakness of Lehman Brothers?

The following is my answer to a Quora question: “What was the biggest weakness of Lehman Brothers?”

It is very difficult to identify their biggest weakness.  On the surface, the obvious answer is over leveraging, but that does not actually answer the question.  That is stating the obvious without addressing the underlying psychology of the management that brought them to this.

Rather, the collapse of Lehman Brothers is a study in how the seeds to disaster are often laid much earlier.  It is a fact that well into the housing bubble, Lehman Brothers went on a spending spree, acquiring five mortgage lenders in 2003 and 2004.  These included subprime lenders BNC Mortgage and Aurora Loan Services.  Both of them specialised in loans made to borrowers without full documentation.  These were loans where the actual documentation was never established, the identities of the borrowers were never verified, or loans made under less than ideal, sometimes, illegal circumstances.

I am quite certain that an investment bank the size of Lehman Brothers, at that time the fifth largest in the US, was quite aware that the housing boom was a bubble, and that bubble would burst.  Instead, they went all in, and brought the lenders, increasing their exposure exponentially.  This was borne out of greed, the short-term gain, over longer-term, sustainable market growth.  What exacerbated this was that as the bubble expanded, Lehman’s profits surged almost 60%, from 2004 to 2006.  They further securitised another US$146 billion of mortgages in 2006, which was a 10% growth, meaning they further increased their exposure, leveraging that debt.  All the way until 2007, the eve of the crisis, they reported record profits.  In 2007, that reported net income was US$4.2 billion, from US$19.3 billion in revenue.  This was not earned from actual repayment of debt, which was negligible, but from the inflation of the security.  Its leverage was a factor of 31 then.

In February 2007, on the back of the years of perceived growth, the stock reached a record US$86.18.  This meant that Lehman Brothers’ market capitalisation was almost US$60 billion.  This was when there were indications that the bubble was collapsing.  Defaults on the subprime loans began to rise, but it was a steady rise, not a spike.  However, by this time, it was a seven-year high.  This should have been a sign to pare back exposure, and any sane person would have,

On 14^th March 2007, Lehman Brothers reported the record revenues and profit for its fiscal first quarter.  This was just a day after their stock recorded its biggest one-day drop in over five years.  The market was getting concerned about the rising defaults, and Lehman Brothers’ exposure.  It is recorded that the management saw little impact in the rising debt delinquency, and their CFO then, Erin Callan Montella, said she did not expect any contagion from the subprime market to the rest of the American economy.  She was gone in three months.  By that time, Lehman Brothers had underwritten further mortgage securities, until her portfolio stood at US$85 billion.

Lehman Brothers was not doomed then.  In the final quarter of that year, the market rebounded because of the global equities market.  In line with this, Lehman Brothers’ stock also rebounded, and this would have been an excellent time to trim their loan portfolio, raising investor confidence and reducing exposure.  They elected not to do that.

Bear Stearns was the 2^nd largest underwriter of mortgage-backed securities.  On 13^th March, Bear Stearns had less than US$3 billion on hand.  On 17^th March, Lehman Brothers’ shares fell 48%, because it had the same vulnerability.  However, it managed to raise US$4 billion in April, allaying some market concerns.  This was done through the issuance of preference shares that were convertible at a 32% premium to its price.  However, fund managers remained unconvinced, and the share price continued a steady decline.

On the 09^th June, Lehman Brothers announced a US$2.8 billion second quarter loss, but reported that it had raised another US$6 billion from investors.  It has also taken other measures such as boosting its liquidity pool by just over US$40 billion, decreasing gross assets by US$147 billion, reducing its exposure to mortgages by 20%, cutting leverage from a factor of 32 to 25.  This was all too late.

In that time, Richard Severin Fuld Jr., CEO, attempted to boost investor confidence in the stock by seeking potential partners to buy into the main company.  However, he still hoped to keep it independent.  He sold part of the asset management arm, and spun off commercial real estate assets.  But the stock still fell by 77% in that first week.  On the 09^th June, the last viable potential investor, Korea Development Bank, declined to continue talks to take a stake in the bank.  This was the death knell, and market confidence evaporated.  Stock price plunged a further 45%, and credit defaults soared by almost 70%.  Hedge fund clients cut ties, and credit lines were cut.

On the 10^th September, Lehman Brothers pre-announced third-quarter results which were dismal, and highlighted their fragile credit position.  Their reported loss was US$3.9 billion, with US$5.6 billion asset write-down.  Moody’s announced it was reviewing Lehman Brothers’ credit rating, making it too expensive for them to borrow.  On 11^th September, the stock plunged 42%.

At the end of the week, Lehman Brothers only has US$1 billion cash on hand.  There were talks over the weekend with Barclays and Bank of America for a potential takeover, but it was unsuccessful.  Part of that failure had much to do with the fact that Richard Fuld was not well-liked, and he had made enemies.  This is from a direct source who was involved in part of those negotiations.  On the Monday, the 15^th of September, Lehman Brothers declared bankruptcy. Their stock plunged 03% from its previous close, Friday, 12^th September.

As can be seen, it was a series of misreading of the market that brought them low.  It was not a sudden bankruptcy.  In fact, investment bankers were speculating that Lehman Brothers would file bankruptcy months beforehand because their exposure to the market was unsustainable.  This was a collective failure of their management team, and their risk management.  Could we say it was greed?  Was it hubris?  Was it collective loss of perspective?  It was a combination of this and more.  Underlying all this is how American capitalism works.  There is an emphasis on creating short-term profits to justify executive compensation, and not long-term stockholder value.  It was this constant pursuit of short-term growth that lead Lehman Brothers down the rabbit hole.  They will not be the last, because that underlying culture has still not been addressed.