Looking back on one of the most tumultuous years in American financial history, it is interesting to consider that one year ago, the largest investment banks on Wall Street were quickly crumbling before our eyes or on the brink of collapse. The fall of Lehman Brothers was especially shocking to the financial system, intensifying the fear that other investment banks would follow suit.
"You had this situation where these banks like Lehman created this massive systemic risk and the system failed," said Lawrence McDonald, a former Lehman vice president. "You could make a very good case that Lehman was one giant domino."
The company's collapse was the largest bankruptcy in American history. At the time, Lehman held $639 billion in assets and employed 25,000 people.
A corporation of modest beginnings, Lehman was first a general store in Montgomery, Ala., established in 1844 by German immigrants. Soon after opening, the store expanded into the more profitable cotton brokerage business. Following the Civil War, the corporation moved its headquarters to Manhattan, New York and began underwriting public offerings of stock. Eventually, Lehman Brothers became one of Wall Street's largest investment banks, having a market capitalization of around $50 billion at its height.
Sept. 16, 2008, Lehman struck a deal with Barclays PLC, an international financial services provider based in the United Kingdom. Barclays then agreed to purchase Lehman's U.S. capital markets division for a mere $1.75 billion.
"This is a once in a lifetime opportunity for Barclays," Barclays President Robert Diamond, Jr. said of the acquisition. The vibrant screens surrounding the former Lehman Brothers headquarters in Manhattan - which previously glowed in Lehman green - now shine in Barclays blue.
Economics Prof. Edwin Burton called the deal a "gold mine" for Barclays, which allowed it to expand its business into the United States by acquiring an already established investment bank at a fire-sale price. The deal included Lehman's midtown Manhattan headquarters and two data centers valued at $1.5 billion. In other words, Barclays paid only $250 million for Lehman's actual business unit.
Grace Ng, a Barclays analyst and University alumna, put this figure into perspective by comparing it to New York Yankee Alex Rodriguez' salary. Rodriguez, who holds a $275 million contract with the baseball team, was more valuable than Lehman Brothers at the time of the sale - ignoring the value of Lehman's real estate.
The demise of this financial juggernaut and others like it can be traced back to the mortgage-backed securities market. An MBS is a financial security that is based upon an underlying pool of mortgages, Burton explained. In the early 1970s, investment banks realized that there was an opportunity for immense profits if they could buy consumer mortgages from commercial banks, pool the mortgages together, break the pool up into pieces and then sell the pieces to investors. The commercial banks also benefited greatly from this deal because they made a small profit on the sale of the mortgages. All the default risk now fell upon the investment banks after purchasing the mortgages. The investment banks benefited from the creation of MBS because they could make profits by selling the securities to investors. They thus created a new market that grew to include trillions of dollars of mortgage-backed securities.
Lehman ran into trouble when the true risk of mortgage-backed securities came under scrutiny. During summer 2007, the housing bubble burst; sub-prime loans began to default. Investors started to fear that the mortgage-backed securities were riskier than the rating agencies originally believed.
Vadim Elenev, an analyst at Cornerstone Research and University alumnus, speculated that the agencies were biased toward rating the securities as having less risk than might have been true. Investment banks pay rating agencies to assess the risk of securities that the banks later sell to the public. Moreover, the rating agencies run the risk of losing customers if the customers are unhappy with the ratings of the securities. Because of this possibility, the rating agencies were given incentives to rate securities as less risky so that they could continue to receive business from their customers.
As the fear that mortgage-backed securities would default increased, the market value of these securities decreased. According to Investopedia.com, a Forbes Inc. subsidiary, Lehman Brothers held an $85 billion portfolio of mortgage-backed securities at the peak of the market. Lehman wrote down billions of dollars worth and value in its MBS portfolio because of the decrease in market value of these securities. The massive losses that Lehman incurred from the write-downs caused lenders to fear that Lehman was insolvent. The lenders then refused to loan money to Lehman, causing opportunities for short-term financing to dry up. Without available credit, Lehman could not obtain enough money to meet its debt obligations. Entering the weekend of Sept. 13, Lehman only held $1 billion in cash. Lehman would not survive the weekend if it could not find a buyer.
Former Lehman CEO Richard Fuld, Jr. scrambled to find a company that would take a stake in the firm and save it from bankruptcy. By Sept. 15, however, Lehman had no choice but to file for bankruptcy - and that's when Barclays stepped in.
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