Thursday, September 18, 2008

The Fall of Lehman Brothers

Lehman Brothers, one of the world’s most respected investment banks and America’s fourth largest, with a history that dates back more than 150 years, has filed for bankruptcy. To put things in perspective, this mighty financial institution arranged for funding of the American Railroad company in the 1860s, rode out the Great Depression and funded the oil rush of the 1930s; even in 2007, it was ranked the most ‘Most admired Financial Securities Firm’ by Fortune magazine.

The sub-prime crisis has had a bigger impact than what the global financial services industry had dared to imagine. After 5 years of low interest rates and heady growth, it seemed unlikely that suddenly everything would come to a crunching halt. But business cycles, consumer demand and investor confidence are far more fickle than what the Big Daddies of Finance had foreseen. Investment in sub-prime real estate loans and repackaged debt has pulled some of the world’s biggest and most respected financial firms into terminal tailspins. Let us talk about the three things that people talk about in any unfortunate situation: what caused it, what can we learn from it and the possible future outcomes.

Causes

Though I am not completely aware of Lehman’s trading positions (and probably we never will know), there is a strong chance that Lehman had taken leveraged positions in financial markets, i.e. borrowed (at low rates of interest) and used the borrowings to purchase huge positions in financial assets like securitized bonds. So, say with an own capital of $8, they bought risky assets of $100 (roughly 11 times leverage). The borrowings usually would have low interest payouts, so Lehman had the chance to make disproportionate profits on own capital when markets moved in their favour. Taking the given example forward, let us say they borrowed $92 at 4%. Now, their open position of $100 moves favourably to $120. They will get to keep the balance ($16.32) after paying out interest of $3.68 (4% of $92). Return on investment (ROI): 16.32 on an investment of 8, which works out to be a heartbeat-skipping 204%.

But all this happens if the market moves in their favour. The situation becomes disproportionately risky when the market moves against them. If the market moves to 90, not only is their own capital wiped out by the mark-to-market (MTM) losses, they will either have to sell their positions or borrow a further $3.68 to pay out the lenders. Unfortunately, Lehman was stuck with illiquid positions that it could not sell in a hurry and nor did it find any suitors or lenders to bail it out.

The problem was three-fold: As part of its market-leading debt repackaging business, for the last couple of years, Lehman underwrote or bought large tracts of mortgage-backed securities. These bets would turn sour in 2007, but at the time they were bought, this would have been difficult to predict, so no one can blame them for it. In any case, everybody and his brother-in-law was into mortgaged backed securitized debt in the early years of this century, so they just followed the Wall Street herd. As is common knowledge now, the cataclysmic downturn in the American realty sector in the latter half of 2007 led to higher than expected defaults in mortgages and these securitized bonds lost value quickly, thereby making them illiquid and hitting Wall Street’s big boys with massive mark-to-market (MTM) losses. To make matters worse, Lehman would have taken highly leveraged risky positions to maximise return on invested capital, so when MTM losses hit, they would have virtually wiped out Lehman’s liquid reserves and perhaps even their owned capital. The second, related problem would have been that Lehman’s risk managers could not correctly predict the probability of extreme downward market movements, thereby undercapitalizing the firm’s positions.

The situation still might not have been so bad, had Lehman got funding when the losses became imminent. Its attempts to shore up capital in the last month and find a buyer in the last week before bankruptcy was a case of too little, too late. It is unlikely that the top management of a mighty financial services behemoth that hires some of the brightest human beings in the planet was not aware or did not understand the magnitude of their misfortune; probably they went into denial, as all human beings tend to do, when they were hit with bad news, or perhaps, as some news reports have speculated, Lehman’s CEO Richard Fuld was too arrogant to admit that they had screwed up big time and go around begging for money. As some correspondents have indicated, half-humourously, schadenfreude might have played a role in Lehman not getting any suitors within the Wall Street community.

What We Can Learn From It

The lesson is simple: more effective risk management. Investment banking is a high-risk, high-return business, because firms take on leveraged positions; sometimes the size of the leverage is multiplied manifold by margin trading in derivative markets, where the nominal could run into mind-boggling billion dollar figures, whereas actual capital invested may be a couple of million. So investment banks need good risk managers who can temper the greed with fear. People should be moved between trading and risk management, so that there is better understanding between these units; for this to happen, rewards have to be shared generously with the ‘spoilsports who say no to everything’, as the risk managers are often branded. In any case, rewards, even for traders, should be based on risk-adjusted returns (which take into account the relative risk of the position in terms of variance or Value at Risk) rather than absolute return on capital.

Possible Future Outcomes

Though there might still be bombs waiting to detonate in Lehman’s books, I believe that it would still make a fantastic buy for any financial services firm. Lehman has brilliant people. It is known for its financial innovations, perhaps a tad ironically, in the debt capital space. It also has a good corporate finance practice (Equities, M&A) and it is a globally renowned player in derivatives trading. It would propel a general banking and financial services firm like Barclays or HSBC into the top league in the prestigious, high margin, investment banking space and bring into its fold some very smart traders, at a ‘never-before-and-never-again’ price. But liquidity is tight all around, and we still do not know the size of ‘toxic assets’ in Lehman’s books, so perhaps potential suitors have stayed away. If the court appointed receiver does not sell off the firm piecemeal to buyers, Lehman might still come back to life from this near-death experience; in fact, in my view, it can become a supremely profitable firm again. At some point in time, the housing sector will pick up; the foreclosed assets that are behind Lehman’s mortgaged-backed securities will turn profitable and Lehman’s traders will once again be able to demonstrate their virtuosity in the world’s leading fixed income and derivative markets bringing back the multi-million dollar bonuses. Following the maxim ‘That which does not kill you makes you stronger’, Lehman will, additionally, have better risk control mechanisms, having learnt a lesson from this traumatic event.

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