Big, but Still Failed—The Collapse of Lehman BrothersLEHMAN BROTHERS Once 4th Biggest Investment Bank Fortune: Most Admired Securities Firm in 2007 American Dream of Over 150 Years History Survived all the crises: 1929, 1987, 1998, 2000Bankruptcy Protection: Sep 15, 2008Outline Backgrounds Causes of Lehman’s Bankruptcyu External environmentu Internal mechanismsl Derivative Abuse: CDO CDSl High-leverage strategyl Operation risksl Other reasons Lessons About Lehman BrothersuFounded in 1850uInvestment banking, equity and fixed-income sales and trading, research, investment management, private equity, and private bankinguSpecialized in fixed-income securities: Lehman Aggregate Bond Indexl About 40% revenue from 2000 to 2007uAggressively expanded businessBackground Causes LessonsLEHMAN BROTHERSIn Millions of USD In Millions of USDSource: Google FinanceBackground Causes LessonsLEHMAN BROTHERS Lehman underestimated the subprime crisis of 2007u Continued mad expansion in 2007u Great liquidity problems in 2008 Final struggle of Lehman Brothersu Issued securities to collect 14 billion dollars u Tried to find strategic investorsu Turned down by U.S. Government on Sep 12u Filed for Chapter 11 on Sep 15Jan: Emergencyinterest rate cutJuly: Met BOAMar: Bear Stearns acquired by J P Morgan Apr: 4 b convertible stock; Stock +18%Jun: Met KDBAug: MetMetLifeSep 10: Barclays offered Aug: Remet KDBSep 12: Declinedby US GovernmentSep: Bought by Barclays and NomuraMar: Stock drop 20%Jun: 2.8bquarterly LossSep 25: File forChapter 11LEHMAN BROTHERSU.S. subprime mortgage crisisSoil: U.S. financial marketSeed: U.S. MBS market Catalyst: U.S. housing bubblethe biggest and most important external environmentBackground Causes: External Environment Lessons The Soil: the U.S. financial marketu Liberalization l Liberalization of interest rate and businessesl Break the boundary between banking and securities industry l Mixed operation as a trendu Securitization l The process to securitize the poor-liquidity asset through FEl Solved the root vulnerability of the banksLEHMAN BROTHERS Background Causes: External Environment Lessons The Seed: the U.S. MBS marketu MBS (Mortgage Backed Securities): l Structured financial products with primary securitizationl The housing mortgages as the underlying assetsu MBS market l Fannie Mae and Freddie Mac l Ginnie Mael Private MBS marketBackground Causes: External Environment LessonsLEHMAN BROTHERS The Catalyst: the U.S. housing bubbleBackground Causes: External Environment LessonsLEHMAN BROTHERSu Boom to Bubble – Federal Fund RatelExtremely loose monetary policy since 2001lThe low interest rate policy started to reverse since Jun 2004 The Catalyst: the U.S. housing bubbleBackground Causes: External Environment LessonsLEHMAN BROTHERSu Boom to Bubble – Housing PricelLow mortgage rate and real estate market grew fastlHouse prices stopped rising in the summer of 2005lBegan falling sharply in 2007 The Catalyst: the U.S. housing bubbleBackground Causes: External Environment LessonsLEHMAN BROTHERSu Boom to Bubble – crisis beganExhibit 5. Annual Existing House Price ChangelHousing financial institutions expanded rapidlylHousing loan and subprime mortgage increased a lot lsubprime mortgage crisisLEHMAN BROTHERSExhibit 6. Supreme MBS Securitization At the end of the boom, the face value/ value =10Exhibit 8. Relationships of CDO and CDSLEHMAN BROTHERSSoaring subprime default rates triggered the collapse of the MBS and CDO market.Lehman Brothers exposed lot to CDO bankruptcy when price decline for 3%-4% Consequence of Lehman’s high leverageu Lehman’s accumulated real estate couldn’t get sold and began to depreciateu Lehman’s ability to sell mortgage and securitize them was damaged due to subprime crisis, then Lehman had to keep lots of mortgage-related risks on its own balance sheetBackground Causes: High Leverage LessonsLEHMAN BROTHERSHigh leverage Vulnerability towards CrisisLarge loansLow equity Final Bankruptcyu Firm Culture: Individual Authority of Richard S. FuldlRemarkable historic achievements lCharismatic leadership styleu Risk Control: Institutional FailureBackground Causes: Operational Risk LessonsLEHMAN BROTHERSu Dependence of RM DepartmentlRisk committee leader: Fuldl Incentive mechanismu Low effectiveness of VaRl Limitations of the concept itself and statistical methodslLack of review and check for model’s initial parameters uToo fast growth in unfamiliar areas and too centralized businessuFair value measurement affected the financial statements uWhen market is in prosperity, the implementation of the fair value accounting standards will indirectly lead to asset prices too high or too low.uSpecial market situation sped up the bankruptcyuMarket panicuOpponents’ termination of Lehman s businessuHuge impact brought by the short sideBackground Causes: Other Reasons LessonsLEHMAN BROTHERSLEHMAN BROTHERS For Chinese government, it should strengthen the supervision of financial markets in order to decrease the market risk For an individual company, it is important to strengthen internal controls to decrease the Moral Hazard Problem and operation risku An independence status of the risk management department focusing on identification and response of risk, and aligning the risk with the goal of the companyu A variety of qualitative and quantitative analysis methods to be used to measure the riskGovernmentGuide financial derivatives innovation Information disclosureReduce Asymmetric Information problemBackground Causes: Other Reasons LessonsLEHMAN BROTHERS Reasonable business structure and business diversification are very important to an individual company. Improving the deleveraging process of Chinese financial institutions.u High leverage, high potential risku Deleverage process may increase liquidity shortageu Absorb and expand the equity capital until it can support the balance sheetsOver concentrated in the high risk financial derivativesLack of response to the crisisBankruptcy in economic crisisBackground Causes: Other Reasons LessonsThank You for Your Attention!And Happy New Year!