Where do we Start?
As we start the new year, I want to look back at the story of the fourth-largest investment bank in America. The bank's name was Lehman Brothers Holdings Inc. After the subprime fallout of 2008; it went from one of the most influential global financial services firms to a defunct business in months. How does a 158-year-old successful business meet its end in a matter of months?
In 1844, a young German Jewish immigrant, Henry Lehman, found himself in the cattle country of Montgomery, Alabama, where he opened a dry-goods store, "H. Lehman." Within six years, he invited his brothers, Emanual and Mayer, to join him. The company's name was updated to "Lehman Brothers."
Alabama was a primary cotton-producing State, and the three brothers began to routinely accept raw cotton as payment for merchandise, eventually starting a second business trading in cotton.
As a result, their second business grew to become the most significant part of their commodities trading/brokerage operations.
Moving on Up
By 1858, the center of cotton trading had shifted from the South to New York City, where commission houses were based. Lehman opened its first branch office at 119 Liberty Street, and 32-year-old Emanuel relocated there to run the office.
Within four years of facing difficulties due to the Civil War, the firm teamed up with a cotton merchant named John Durr to form Lehman, Durr & Co. Hence, the firm's headquarters became located in New York City. The brothers also helped found the New York Cotton Exchange in 1870, where Emanuel sat on the board of governors until 1884. The firm continued to grow in the emerging market for railroad bonds, ultimately leading them to the financial-advisory business.
All in the Family
As the Lehman Brothers started to get a reputation for being sound business people to work with, they started their underwriting business in 1899. The brothers underwrote its first public offering, the preferred and common stock of the International Steam Pump Company. Furthermore, within the next six years, Emanuel's son Philip Lehman directed the firm to partner with Goldman Sachs & Co. to bring the General Cigar Co. to market, followed closely by Sears, Roebuck, and Company. Among other giant companies were F.W. Woolworth Company, May Department Stores Company, Gimbel Brothers, Inc., R.H. Macy & Company, The Studebaker Corporation, B.F. Goodrich Co. and Endicott Johnson Corporation.
In 1925, Philip Lehman retired and handed the company over to his son Bobbie Lehman. Along with Bobbie, several new non-family members joined the executive team. During the depression era, they focused more on venture capital (new up-and-coming companies) instead then participate in the failing equities business.
As a result, In the 1930s, Lehman underwrote the initial public offering of the first television manufacturer, DuMont Laboratories, and helped fund the Radio Corporation of America (RCA). It also helped finance the rapidly growing oil industry, including Halliburton and Kerr-McGee. In the 1950s, Lehman underwrote the IPO of Digital Equipment Corporation. Later, it arranged the acquisition of Digital by Compaq.
Not, all in the Family
In 1969, Bobby Lehman died, leaving no heir of the Lehman family to manage the partners. Furthermore, the firm had many financial constraints due to the economic issues of the 1970s. By 1972, the firm was facing hard times, and in 1973, Pete Peterson, chairman and chief executive officer of the Bell & Howell Corporation, was brought in to save the firm.
Under Peterson's leadership as chairman and CEO, the firm acquired Abraham & Co. in 1975. Two years later merged with Kuhn, Loeb & Co. (another family business started by a family in the mid-1800s.) to form Lehman Brothers, Kuhn Loeb Inc., the country's fourth-largest investment bank, behind Salomon Brothers, Goldman Sachs, and First Boston. Peterson led the firm from significant operating losses to five consecutive years of record profits with a return on equity among the highest in the investment-banking industry.
In 1983 there was a power struggle between Peterson and now Co-CEO Lewis Glucksman (former trader at Lehman), and Glucksman won. He forced more competition in the management ranks and ultimately destroyed the culture. Consequently, he sold the investment banking business to Shearson/American Express, an American Express-owned securities company, to form Shearson Lehman/American Express. The total transaction was worth $360M in 1984.
Go Go 90s
The mid-80s and the 90s were an intense time for leveraged buyouts of big companies. See the movie Wall Street for more insight. Shearson Lehman was on the front end of many large buyouts. For example, In 1989, Shearson backed F. Ross Johnson's management team in its attempted management buyout of RJR Nabisco but was ultimately outbid by private equity firm Kohlberg Kravis Roberts, who Drexel Burnham Lambert backed. As a result, executives were fired and replaced often.
As new management teams came and went, the need for large revenue deals was always the focus. In 2003 the company was one of ten firms that simultaneously entered into a settlement with the U.S. Securities and Exchange Commission (SEC), the Office of the New York State Attorney General, and various other securities regulators. The issue was undue influence over each firm's research analysts by its investment-banking divisions. The firms had improperly associated analyst compensation with the firms' investment-banking revenues and promised favorable, market-moving research coverage in exchange for underwriting opportunities. In other words, if the analysts received the right amount of money (compensation), they would ensure the research would support the sale for the investment bank. Everyone was happy, except when the deal was bad for investors.
An $80 million settlement was assigned to Lehman, and structural reforms included a complete separation of investment banking departments from research departments. No analyst compensation, directly or indirectly, from investment-banking revenues and the provision of free, independent, third-party research to the firm's clients would be allowed. Meanwhile, new forms of income would need to replace the old M&A opportunities.
A few More
Lehman was one of the first Wall Street firms to move into the mortgage origination business. In 1997, Lehman bought a Colorado-based lender, Aurora Loan Services, an Alt-A lender. In 2000, Lehman purchased West Coast subprime mortgage lender BNC Mortgage LLC to expand their mortgage origination pipeline. Therefore, Lehman quickly became a force in the subprime market. By 2003 Lehman made $18.2 billion in loans and ranked third in lending. In 2004, this number topped $40 billion.
Moreover, in 2006, Aurora and BNC were lending almost $50 billion per month. By 2008, Lehman had assets of $680 billion supported by only $22.5 billion of firm capital. From an equity position, it's risky commercial real estate holdings were thirty times greater than capital. In such a highly leveraged structure, a 3 to 5 percent decline in real estate values would wipe out all money within the company.
The management-approved practice was a repurchase agreement that temporarily removed securities from the company's balance sheet to hide the massive imbalance of the company's finances. However, unlike typical repurchase agreements, these deals were described by Lehman as the outright sale of securities. They created a misleading picture of the firm's financial condition in late 2007 and 2008 to protect the firm.
Fire Sale
In August 2007, the executives at Lehman knew that the subprime business was a failed venture. The firm closed its subprime lender, BNC Mortgage, eliminating 1,200 positions in 23 locations, and took an after-tax charge of $25 million and a $27 million reduction in goodwill.
Moreover, in 2008, Lehman faced an unprecedented loss to the continuing subprime mortgage crisis. Lehman's loss resulted from having held on to significant positions in subprime and other lower-rated mortgage tranches when securitizing the underlying mortgages. In ordinary speak, they couldn't sell the lower-rated (junk) bonds they held on subprime. In the first half of 2008 alone, Lehman's stock lost 73% of its value as the credit market tightened.
In August of 2008, the Lehman executives movement was rapid. New faces came in, so the investment community could see Lehman was still a viable company to do business with. However, on September 9, Lehman's shares plunged 45% to $7.79 after a significant merger opportunity was put on hold. Investor confidence continued to erode as Lehman's stock lost roughly half its value and pushed the S&P 500 down 3.4%. On September 11, 2008, Lehman was reportedly looking for a buyer, and the word leaked out. As a result, its stock price dropped another 40 percent.
What's Next?
On Saturday, September 13, 2008, Lehman filed for bankruptcy; on September 17, 2008, the New York Stock Exchange delisted Lehman Brothers. September 16, 2008, Barclays PLC announced that they would acquire a "stripped clean" portion of Lehman for $1.75 billion (mostly the Lehman office building in New York).
Manhattan court bankruptcy Judge James Peck, after a 7-hour hearing, ruled:
"I have to approve this transaction because it is the only available transaction. Lehman Brothers became a victim, in effect, the only true icon to fall in a tsunami that has befallen the credit markets. This is the most meaningful bankruptcy hearing I've ever sat through. It can never be deemed a precedent for future cases. It's hard for me to imagine a similar emergency."
Lehman's bankruptcy was the largest failure of an investment bank since Drexel Burnham Lambert collapsed in 1990. It is a harbinger for all systems. They start with integrity and good intent, but when success is not enough, it starts to get perverted, and the system is no longer a guide rail but an impediment to overcome; we begin to see problems.
Everything comes to an end, and what you do with this information to inform your present matters most. What are you going to create this new year?
