Problems that Lehman Brothers Faced - Case Study Example

Lehman Brothers A Case Study of the Problems they Faced Name of Student: Student No: Date: Name of Supervisor: Table of Contents Lehman Brothers 1 A Case Study of the Problems they Faced 1 Issues 4 Conclusion and Recommendations 15 Table of Figures Figure 1: Interdependencies between Lehman Brothers and other entities. Source: PricewaterhouseCoopers, 2009. 3 Figure 2: What event had the most significant impact on the industry in 2008? Source: SIFMA, 2008 4 Figure 3: Global Presence of Lehman Brothers. Source: PricewaterhouseCoopers, 2009. 5 Figure 4: Organisational structure and decision making. Source: Goh & Madani, 2012 9 Introduction The significance of the bankruptcy of Lehman Brothers is the global footprint it left behind. There were literally thousands of participants in the financial market directly affected by their collapse. Furthermore, it caused a domino effect due to various cross-border and cross-organisational interdependency. The Lehmnan liquidation caused over seventy five separate and distinct bankruptcy proceedings (PricewaterhouseCoopers, 2009). The interdependency of this firm with others in the industry and how they are interrelated is illustrated in Figure 1. Figure 1: Interdependencies between Lehman Brothers and other entities. Source: PricewaterhouseCoopers, 2009. The collapse of Lehman brothers is viewed by many as a defining moment in financial circles. This is illustrated by the results of a survey conducted by SIFMA in 2008 that asked respondents to list the most significant event of 2008: Figure 2: What event had the most significant impact on the industry in 2008? Source: SIFMA, 2008 This report seeks to ascertain what exactly caused this catastrophic collapse and how they could have been avoided or solved. The issues will be examined in detail and recommendations made. Issues The effect of the bankruptcy of Lehman Brothers was exacerbated by the intricate nature of its global legal framework. There were several Lehman Brothers entities worldwide as illustrated in Figure 3. These entities did not file for bankruptcy as one. On September 15th 2008, LBHI filed for bankruptcy and caused global chaos which began with Lehman Brothers International (Europe) filing for administration the same morning. This was followed by appointment of a SIPC trustee for Lehman Brothers Inc on 19th September, 2009. The impact on clients and colleagues was exposure by several Lehman Brothers bodies located in different jurisdictions which had differing bankruptcy and insolvency legislation, contractual protection and remedies (Pricewaterhouse, 2009). Figure 3: Global Presence of Lehman Brothers. Source: PricewaterhouseCoopers, 2009. Lehman Brothers conducted a risk management assessment in 2006 that outlined the strengths and weaknesses of the firm. The conclusion reached was the Lehman, while having a considerable credit strength, which gave it a stable A1 rating, it was also hindered by opacity in risk disclosures as well as an industry wide reluctance by securities organisations to give guidance on their risk exposures (FOIA Confidential, 2006). A core competency in the securities industry that is also a driver for critical rating is management of risk. The characteristics of this risk are difficult to disseminate in a timely and transparent way to clients of these firms because of the fluid nature of the industry. Moody’s ratings are a direct judgement on the risk control culture and capabilities perpetrated by management, predominantly in the financial sector (Global Securities Firms Industry, 2005). The Risk Management Assessment done on Lehman Brothers would inflate this judgement through evaluation of the risk management practises of the firm in the context of the financial sector framework. This is achieved by locating such management as pertains to standards and best practises. In the year 2006, FOIA Confidential found that the key attributes held by Lehman Brothers were that: They show an extremely disciplined and holistic approach for the determination of risk appetite. This begins with stating the financial targets on the whole and what the minimum achievable objectives are. This method has led to a rational set of limits and a risk philosophy that is conservative. There is a thriving robust culture of individual excellence as well as playing on a team perceived at every level of the organisation. Forestalling a ‘star’ system for traders means that management can look beyond numbers as a factor in risk management and probe the intent behind trades in the books. The system of risk is incorporated across businesses and stems from growth that is organic. This homogeny in analysis and design lends advantage to Lehman Brothers as pertains to aggregation and risk breakdown. These are both crucial to successful risk-taking actions. There is a strong reliance in the firm on a ‘second-level’ structure of governance composed of sets of committees; this structure is advantageous for taking care of ex-post position risk and anticipatory commitment as well as risks brought about by transactions. There is a comprehensive assortment of risk measures. Managers of risk utilise an amalgamation of overall qualitative evaluations and refined quantitative metrics based on statistics or non-parametric in character. These include scenarios and stress-tests. However, even in 2006, the FOIA Confidential identified areas of concern. These were: The willingness exhibited by the firm to take large concentrated position in investments that were not liquid. The firm’s tangible equity as of November 30th 2005 consisted of 303% total notional amount of off-balance sheet commitments and contingencies. The risks contained in these positions is not reflected in the notional amounts especially as there is hedging and selling down of positions, however this percentage represents some of the highest of the five major US broke dealers, second only to Merrill Lynch. This shows how aggressive Lehman is in generation of revenue from new sources. Lehman belatedly began to attempt a break-in in the top hedge fund service provider ranks. This is a source of temptation to management to assume additional operational exposures when mitigating risk in dealings with second-tier hedge funds. There is relative dearth of diversification from the basic mortgage/fixed-income and credit trading portfolios. The firm has displayed steadiness in the dynamic interest rate environment in the past, but this narrow concentration is a potential source of compound losses should the scenario arise (as it did) of fast rising interest rates and a drop in housing values in the US. Lehman’s public risk disclosures have poor quality and extremely restricted in scope. While being opaque in risk disclosures is a characteristic of the industry, Lehman’s annual report takes only four brief pages to describe risk in 2005 (Global Securities Firms Industry, 2005). There is no integrated operational-risk framework and this hinders assessment and dealing with the gaps that exist in the firm’s process. The lack of a dedicated Risk Committee of the Lehman board is a characteristic common to 5 of the main US securities firms which differs markedly from large banks. This is a risk management framework weakness that applies to the industry as a whole according to Moody’s. In 2007/2008 there was a global crisis precipitated by the collapse or bailout by governments of a large number of financial institutions. This failure led to a global freeze of credit markets prompting intervention by governments. There were some macroeconomic factors such as loose monetary policies that were fundamental to what happened and affected all organisations (Taylor, 2009), although some were affected more than others. Brunnermeier (2009) claims that a number of recent studies have attributed the degree to which firms were affected by the crisis to risk management and financing policies. These policies stem from the corporate board vs. shareholders ability to trade-off (Kashyap et al, 2008) and therefore the implication is that a firm’s performance during this period was ultimately dependent upon corporate governance. This is illustrated in Figure 4 below: Figure 4: Organisational structure and decision making. Source: Goh & Madani, 2012 The question arises as to whether this risk could have been anticipated. The CAMELS Rating System is one instrument that can be used to determine this. This system started life as the Uniform Financial Institutions Rating System (UFIRS) in 1979. This system was implemented in US banking institutions initially but was followed by global implementation as recommended by the US Federal Reserve (Epstein and Martin, 2003; Bauer et al, 1998). This system was abbreviated universally as CAMEL due to its five assessment areas. These are Capital, Asset quality, Management, Earnings and Liquidity ratios (Cox & Cox, 2006). This system analyses the banking system through its balance sheet and profit and loss statements which covers the firm’s dynamic aspect (Deyoung et al, 2001). The economic situations of banks (and other financial institutions) is more dynamic than ever before and this change is reflected in the new globalised financial system. Consequently, there has been a change in the supervisory authorities’ system of approach and assessment with focus shifting to means of overcoming and managing risk (Doumpos & Zopounidis, 2009). Due to this new scenario, it was necessary for the US Federal Researve and the Comptroller of the Currency to add a further assessment known as market risk, with the initial S (Hafer, 2005) which modified CAMEL to CAMELS with a supplemental assessment system scale which ranged from 1 or optimum, to 5 which was the worst for risk management (Broz, 1997). Gaillard (2009) gives the ratios utilised to produce results while evaluation of the situation (Jeffery & Thomas, 2002) of Lehman Brothers used are: Capital Adequacy Ratio This is an important index that can save the institution from potential risks in addition to being essential for decision-making when it comes to growth (Shelagh, 2005) as well as charting the future. This index resulted from Basil (Kose et al, 2000) and for Lehman to have capital adequacy, the ratio needed to be higher than 8%. This indicates that the total amount of capital is 8% more than the risk-weighted assets. CAR = (TIER I + TIER II) / RISK-WEIGHTED ASSETS. Results from Lehman brothers show: 2005 CAR= (16,794 TIER I + 3,407 TIER II) / 221,434 WEIGHTED = 9.123% 2006 CAR= (19,191 TIER I + 5,881 TIER II) / 287,021 WEIGHTED = 8.735% 2007 CAR= (22,491 TIER I + 7,645 TIER II) / 414,638 WEIGHTED = 7.268% Where: Tier I is the basic and own capital including common and preferred stocks, minority rights in subsidiaries and convertible bonds. Tier II is supplementary capital. Tier I needs to comprise 50% of the total amount of numerator and the higher the index value, the better the institution’s capital adequacy (Christopoulous et al, 2011). Asset Quality Ratio This is based on assessing quality of assets through evaluation of the portfolio credit risk. The capability of the bank to identify, quantify, observe and control credit risks is also evaluated while noting any provisions made for bad and doubtful claims. (Total Non-Performing Loans>90 Days – Provisions) / Total Loans Results from Lehman showed: 2005 (1,255 NON-PERFORMING - 649 PROVISIONS) / 21,643 LOANS= 0.027986 2006 (2,054 NON-PERFORMING - 1,119 PROVISIONS) / 27,971 LOANS= 0.033433 2007 (4,073 NON-PERFORMING - 1,731 PROVISIONS) / 43,277 LOANS= 0.054115 Basil II defines total non-performing loans over ninety days as a significant marker in loan repayment. Provisions consist of reserve capital slated to compensate for losses coming from already provisioned delayed loans. The lower this index is, the more precise are the banks provisions and therefore the higher the quality and dependability of its portfolios(Christopoulous et al, 2011). Management Quality Ratio Management is the backbone of decision making which ensures smooth running of the organisational risks and exercises control. It is therefore important to have proper management that complies with regulations in order for the bank to run smoothly. Management Expenses/ Sales Lehman Brothers had the following results: 2005 7,929 / 32,420 = 0.244571 2006 9,536 / 46,709 = 0.204158 2007 10,599 / 59,003 = 0.179635 Management expenses encompass bank operating expenses while sales comprise all interest expenses and other charges stemming from the bank’s profit and loss account. Good management is indicated by a low ratio (Christopoulous et al, 2011). Earnings Ratio Earnings are the main source of capital and they are analysed against interest rate policies and provisions adequacy. Strong profits indicate that the bank is able to support current and future endeavours, absorb losses, increase financing and pay dividends. Evaluation of earnings not only covers amount and tendency to profit but also the quality and duration. iv. ROA = Net Profits/Total Assets the higher the ratio, the more efficient the firm but adequate levels are between values of 1-2.5%. v. ROE = Net Profits/Own Capital When this ratio is high, it indicates that the bank is using its own capital efficiently. Lehman brothers posted the following results; 2005 ROA = 3,260 NET PROFITS / 410,063 TOTAL ASSETS= 0.00795 ROE = 3,260 NET PROFITS / 16,794 OWN ASSETS= 0.194117 2006 ROA = 4,007 NET PROFITS / 503,545 TOTAL ASSETS= 0.007958 ROE = 4,007 NET PROFITS / 19,191 OWN ASSETS= 0.208796 2007 ROA = 4,192 NET PROFITS / 691,063 TOTAL ASSETS= 0.006066 ROE = 4,192 NET PROFITS / 22,490 OWN ASSETS= 0.186394 (Christopoulous et al, 2011). Liquidity Ratios Evaluation of liquidity takes into account the existing liquidity status as it pertains to liabilities undertaken. It also evaluates how well the bank deals with alterations in financial resources and market conditions which change rapid asset liquidation with minimum losses. vi. Loans to Total Deposits (L1) = Total Loans/ Total Deposits This ratio examines the extent to which deposits are retained for the purpose of loan issuance and its attendant implication in the banks dependence on interbank markets. When this ratio is low, the bank’s liquidity status is good. Should the value be less than 1 this indicates that the loan is secure because deposits are adequate to cover them. vii. Circulating Assets to Total Assets (L2) = Circulating Assets/ Total Assets This ratio enables the bank to be aware of how extensive their liability is which is covered by assets that are not directly available. The higher this number, the better its liquidity. Lehman Brothers had the following results: L1 L2 2005 21,643 / 44,975 = 0.481223 2005 179,362 / 410,063 = 0.437401082 2006 27,971 / 58,609 = 0.477248 2006 230,175 / 503,545 = 0.457109097 2007 43,277 / 86,346 = 0.501204 2007 313,103 / 691,063 = 0.4530744669 (Christopoulous et al, 2011). Sensitivity to Market Ratio This parameter measures the extent to which the possible fluctuations of interest rates, exchange rates for foreign currency, purchase of products and selling prices will impact on the bank’s bottom line and its asset value. viii. Total Securities to Total Assets = Total Securities/Total Assets Lehman Brothers posted: 2005 140,743/ 410,063 = 0.343222870 2006 225,196 / 503,545 = 0.44722120 2007 301,234 / 691,063 = 0.43589947 The lower the value of this ratio, the better because it indicates an appropriate response to market risks. A high value indicates that the bank’s portfolio is vulnerable to market risks (Christopoulous et al, 2011). Inferring from the combined rating assessment above, the indication is that the bank’s best years were 2005 and 2006 but that the situation became distinctly worse in 2007. it had bad credits and an apathetic management that seemed unable to turn back the tide. The management was also not compliant with regulations from supervisory authorities and followed inadequate risk management approaches. Conclusion and Recommendations Matters arising from the Lehman’s Brothers collapse is an ongoing challenge to the finance sector. It has led to identification and implementation of risk mitigation measures in order to minimize a future return to this crisis according to PricewaterhouseCoopers (2009). The intricate and fluid nature of regulation in the industry also needs to be addressed. Stakeholders must continue to deal with the challenges that emerged including enumerating, summating, scrutinizing and exposure of market, credit and liquidity risks. There should also be more emphasis on scrutinizing selection and monitoring of derivative and other counterparties as well as the risks found in contractual agreements and regulation. It would also be wise for investors to insure their assets. References Bauer, P.W., Berger, A.N., Ferrier, G.D. & Humphrey, D.B. (1998). Consistency conditions for regulatory analysis of financial institutions: A comparison of frontier efficiency methods, Journal of Economics and Business, Vol. 50, 85–114. Broz, L. (1997). The International Origins of the Federal Reserve System. Cornell University Press. Brunnermeier, M. (20090. Deciphering the liquidity and credit crunch 2007-2008. J. Econ. Perspect. 23, 77–100. Christopolous, A.G., Mylonakis, J., Diktapanidis, P. (2009). Could Lehman Brothers’ Collapse Be Anticipated? An Examination Using CAMELS Rating System. International Business Research Vol. 4, No. 2; April 2011 Cox, D. & Cox, M. (2006). The Mathematics of Banking and Finance. 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