Financial Accounting Study Case About Lehman’s Brother

Lehman Brothers had humble origins, tracing its roots back to a small general store that was founded by German immigrant Henry Lehman in Montgomery, Alabama, in 1844. In 1850, Henry Lehman and his brothers, Emanuel and Mayer, founded Lehman Brothers.

While the firm prospered over the following decades as the U.S. economy grew into an international powerhouse, Lehman had to contend with plenty of challenges over the years. Lehman survived them all – the railroad bankruptcies of the 1800s, the Great Depression of the 1930s, two world wars, a capital shortage when it was spun off by American Express in 1994, and the Long Term Capital Management collapse and Russian debt default of 1998. However, despite its ability to survive past disasters, the collapse of the U.S. housing market ultimately brought Lehman Brothers to its knees, as its headlong rush into the subprime mortgage market proved to be a disastrous step.

Background and Company’s Growth

On September 15, 2008, Lehman Brothers filed for bankruptcy. With $639 billion in assets and $619 billion in debt, Lehman’s bankruptcy filing was the largest in history, as its assets far surpassed those of previous bankrupt giants such as WorldCom and Enron. Lehman was the fourth-largest U.S. investment bank at the time of its collapse, with 25,000 employees worldwide. Lehman’s demise also made it the largest victim, of the U.S. subprime mortgage-induced financial crisis that swept through global

financial markets in 2008. Lehman’s collapse was a seminal event that greatly intensified the 2008 crisis and contributed to the erosion of close to $10 trillion inmarket capitalization from global equity markets in October 2008, the biggest monthly decline on record at the time. 
You may be interested in: High Degree of Operating Leverage.

Exposure to the mortgage market
Lehman borrowed significant amounts to fund its investing in the years leading to its bankruptcy in 2008, a process known as leveraging or gearing. A significant portion of this investing was in housing-related assets, making it vulnerable to a downturn in that market. One measure of this risk-taking was its leverage ratio, a measure of the ratio of assets to owner’s equity, which increased from approximately 24:1 in 2003 to 31:1 by 2007. While generating tremendous profits during the boom, this vulnerable position meant that just a 3–4% decline in the value of its assets would entirely eliminate its book value or equity. Investment banks such as Lehman were not subject to the same regulations applied to depository banks to restrict their risk-taking. In August 2007, Lehman closed its subprime lender, BNC Mortgage, eliminating 1,200 positions in 23 locations, and took a $25-million after-tax charge and a $27-million reduction in goodwill. The firm said that poor market conditions in the mortgage space “necessitated a substantial reduction in its resources and capacity in the subprime space.

No.| Case / Problems| Recommendation/ Solution|
1| Leverage – technique to multiply gains and losses. This has been done by the Lehman’s brothers, In other words, for every £1 of cash and other readily available capital, it would lend £12. In2004, Lehman’s leverage was running at 20. Later, it rose past the twenties and thirties before peaking at an incredible 44 in 2007.| Financial leverage offers many advantages for a firm to move forward. But like most things, there are some limitations that come with financial leverage as well. It seems that financial leverage is a good idea for a company when interest rates are low. But it is important to use financial leverage in moderation to avoid some of these limitations.The more debt in the capital structure of the firm, the greater the financial risk to the lender. This results in higher average interest rates to be paid and restrictions on the corporation. Common stockholders

may become concerned and drive down the price of the stock.| 2| Lehman was an upturned pyramid balanced on a small sliver of cash. Although it had a massive asset base (and equally impressive liabilities), Lehman didn’t have enough in the way of liquidity. In other words, it lacked ready cash and other easily sold assets.| Those who cannot afford the mortgages reset to prime rate will lose houses that they should not have had in the first place, and will be back to the start. They might be offered a mortgage at a reduced rate, but for a longer time. The government might subsidize the reduced value of this mortgage.| 3| Lehman had over $60 billion invested in commercial real estate (CRE) and was very big in subprime mortgages (loans to risky homebuyers). Also, it had huge exposure to innovative yet arcane investments such as collateralised debt obligations (CDO) and credit default swaps (CDS).| Reset the interest rate on sub prime mortgages to the prime rate at the time of the mortgages or at the current prime rate, depending upon which is lower. This will stop foreclosures, and the value of the mortgages will recover to reasonable values.

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