The Lehman Brothers Bankruptcy: Causes, Consequences, And Ethical Implications

Background

Questions:

1. Explain what led to their downfall, the relevant ethical issues and the response from the Government?

2. Explain how corporations overcome this problem and also ensure the management behaves responsibly, ethically whilst maintaining corporate profitability?

The Lehman Brothers bank was counted as the fourth largest investment bank of US. But on Sept 15, 2008 the bank filed bankruptcy which is the largest bankruptcy filed in the world history. In this bankruptcy the Lehman assets exceeded from the earlier bankrupt giants like WorldCom and Enron. Lehman was having around 25000 staff all over the world (Valukas, 2010).

Lehman filed its bankruptcy with assets valuing $639 billion and debt of 619$ billion. The major reason why Lehman came to its knees was the US housing market collapse. The Lehman step towards subprime mortgage market showed to be an unfortunate step. Between the years 2006 and 2007 Lehman was enjoying the leading position of producing securities on the basis of subprime mortgage. But the way and procedure that Lehman used on forcing burrowers to take loans that they could not afford were illegal because of which in 2007 thousands of lawsuits were charged against the bank (Richard, 2011).

The Lehman collapse made it the largest victim of US subprime mortgage stimulating financial crisis. The major reason for Lehman’s bankruptcy was that it was enjoying lead position in low rated and subprime mortgages

The Lehman’s decision in mortgage market proved to be risky as the Bank burrowed huge amounts in funding its investments. These investments made by Lehman were proved by analysts to be risky and unnecessary. The investigators found insufficient data in evaluating the Bank’s commercial portfolio in its second and third quarters of 2008.

The US housing market was on boom in the year 2003 and 2004 and in this period Lehman purchased five mortgage lenders. The major of them were Aurora Loan services and BNC mortgage. BNC mortgage is a leading subprime lender and Aurora specializes in providing Alt-A loans which allowed burrowers to give loans without documentations.

These acquisitions of Lehman initially proved to be profitable as the revenues in capital market increased to 56% from 2004 to 2006   .This growth proved to be the fastest growth than any other businesses into investment banking. From 2005 the bank was gaining profit till 2007 and the net income of the bank was recorded to be 4.2$ billion by the year 2007 (Richard, 2011).

In the starting time of 2007, the US housing market was getting cracks and the defaults made on subprime mortgage were becoming apparent. In the first quarter of 2007 the stock values has a biggest drop in the five years and raised the concerned that the rising defaults will tarnish the Lehman’s profitability. Despite of the alarming indications of loss the CFO of Lehman did not took necessary steps and said that the risk arising from housing market will have no impact on the Bank’s earning. He also indicated that the problems of the subprime market will not spread to the rest of the housing market and will not hurt the US economy. This miscalculation of Lehman’s CFO proved to be very harmful for the US economy and led to the bankruptcy of Lehman (Richard, 2011).

Causes of Lehman Brothers’ Bankruptcy

The management of Lehman did not gave respect to its stakeholders. The top executives of Lehman were greedy, running behind profit making because of which they started making poor or one sided business decisions. The external pressure from the market especially from US housing market led not only the downfall of Lehman but also the entire US financial sector (Andrew, 2013).

The reason given by Andrew (2013) why Lehman unlike other banking sectors was not able to cope up with the crisis was the poor ethical practices, lack of core set of rules and strong ideology which promotes the welfare of the Lehman’s stakeholders. The stakeholders are the investors, insurers, government, Lehman staff, burrowers, lenders who were badly affected by the unethical decisions made by the Lehman.

According to Betsy (2013), in Lehman’s ethical story deontology suits best because in a business decision no one is fully aware of its consequences in the initial years. But the Lehman Bank could have adopted set or ethical rules and policies which the business operations could have abide in the initial years. These ethical rules will automatically take care of the decisions as these rules cannot control the consequences of these decisions. Thus the company or the top executives could have taken ethical decisions in starting which would have save the bank from bankruptcy.

Also the Board of directors should have focused on taking ethical decisions and ethical theory decades ago   which could have safeguard and navigated the bank from economic downturns. But unfortunately the Lehman Bank was not able to handle the economic crisis as it was deep into the market deficiencies and top executives were besieged by greed (Betsy, 2013).

The Government of all countries is always involved in maintaining financial stability. This is done by providing direct help to the successful financial firms in their bad times. The government takes rescuing actions to provide financial stability in the markets, providing support in making mortgage finance available and protecting the taxpayers from paying excessive loans (Brian).

The government has supported or rescued Fannie Mae and Freddie Mac but did not chose to help the Lehman Brothers. Instead the government made Lehman brothers to file bankruptcy. However on the very next day of filing bankruptcy government granted AIG an emergency loan of 85$ billion in exchange of 80% of company warrants.

The reason why government decided to intervene in AIG bankruptcy and not in Lehman because the bankruptcy of AIG will mark a systemic risk in the country’s financial system whereas the Lehman bankruptcy will not affect the financial system.

The Lehman collapse has threatened not only the global capitalism but also the huge multinational global banks. After this collapse the government has bailed out those banks who started demanding dominant influence over the government. Government has burrowed huge amounts in funding these bailouts of big banks and also raised the national debts so as to reduce the private debts of these big banks.

Conclusion

Lehman Brothers could have saved itself from bankruptcy by focusing on their stakeholders. The top executives and board of directors disregarded the duty of safeguarding the interest of stakeholders as they were largely involved in achieving high bonuses.

Consequences

References

Andrew. Nov 18, 2013. The demise of Lehman Brothers. “B-ethics”. Available at https://bizgovsoc8.wordpress.com/2013/11/18/the-demise-of-lehman-brothers/

Betsy Stevens.2013. An Analysis of the Lehman brothers code of ethics and the role it played in the firm. “Journal of leadership, accountability and ethics vol. 10(1)” Available at https://www.na-businesspress.com/JLAE/StevensB_Web10_1_.pdf

Brian Perry. Credit crisis: Government response. Available at https://www.investopedia.com/university/credit-crisis/credit-crisis6.asp

Richard Wolf. Dec, 2011. Lehman Brothers: financially and morally bankrupt. Available at https://www.theguardian.com/commentisfree/cifamerica/2011/dec/12/lehman-brothers-bankrupt

Valukas, A. R. March, 2010. Lehman Brothers Examiner’s Report, Vol 1&2. Available at SMC Blackboard Learning Resource.

The Agency problem is faced by many corporations and it is one of the major concerns of shareholders. Explain how corporations overcome this problem and also ensure the management behaves responsibly, ethically whilst maintaining corporate profitability.

The agency problem arises when there is a mismatch between the owner of the firm and the management of the firm i.e. when the owner of the firm is not the one who is managing it. The agency problem arises due to the relationship between the shareholders and the management of the firm. When the management goal differs from the goals of the firm, then the owner of the firm has to invest cost on solving the agency problems. The other reasons for agency problem are the conflict of interest which arises between the creditor, shareholder and management as they have different goals (Timothy, 2014) For instance the management and the stakeholders of a company have different or conflicting ideas for managing or running the company.

The corporations are dealing with agency problem by monitoring the performance and using the incentives as cited by Timothy (2014).

1. Paying Incentives: Incentive schemes are used to reward the individual on their quality of work. Incentives schemes are in the form of bonus pay and team based incentive pay. The method of paying incentive or giving performance based incentive is used all across the globe in dealing with agency problem. According to Bloom et al (2012) with the use of performance incentive in almost 17 countries with firms around 6000 have gain heterogeneity and solved the issues of agency problem.

2. Division of Labor: The corporate can reduce the agency problem by reducing their reliance on labor division. The employer or the owner has the right to sell his firm to the workers so as to improve their incentives. In other sense the agency problem can be alleviated by turning the agents into residual claimants. This will work best when the agent is wealthy but in most of the cases the agent is not that much wealthy that the amount he is able to pay does not matches with the amount the principal want to sell his asset. Most of us will think that the agent can borrow money but this is not practically right as there will agency problems at the time of repaying the loans. Thus the banks will replace the employer at the time of agency problems.

The corporations are trying to minimize the agency problem by following three types of mechanisms where the interest and objectives of managers and shareholders are aligned. With these mechanisms the problems of management entrenchment and monitoring is overcome (Maria, 1999):

1. Encouraging managers to align their interest with those of shareholders to bring efficient management. The managers are encouraged by incentive plans, stock option plans etc.

2. Protecting and strengthening the shareholder rights by providing them more incentive and right of monitoring the management. With this approach the rights of investors are enhanced by providing them legal protection from the expropriation from the managers.

3. Using indirect corporate controls like take-over.

Thus from the various methods discussed above the best method for solving agency problem is the performance base pay or Economic Value Added measure which will benefit both the shareholders and the management and will solve their agency problem too (Maria, 1999).

References

Timothy J. Besely, Maitreesh Ghatak. Jan, 2014. Solving agency problems: intrinsic motivation, incentives and productivity. “London school of economics.” Available at https://thred.devecon.org/papers/2014/2014-001_Ghatak_Solving_Agency_Problems.pdf

Maria Maher, Thomas Anderson. 1999. Corporate governance: effects on firm performance and economic growth. “Organization for Economic co-operation and development”. Available at https://www.ecgi.org/research/accession/cgeu.pdf