It took more than 150 years to build the Lehman Brothers franchise from its humble beginnings as an Alabama general store1 and only a few weeks for the firm to collapse.
On September 15, 2008, the Lehman group parent holding company, Lehman Brothers Holdings Inc. (“LBHI”), filed for bankruptcy protection,2 setting into motion the largest corporate failure in US history.3 As recently as May 31, 2008, the firm had reported itself solvent, with consolidated assets of $639 billion against liabilities of $613 billion.4 Even as late as the day before filing, the Lehman estate’s unaudited balance sheets for LBHI and its affiliates indicated that the entire firm had $626 billion of assets against just $560 billion of liabilities, with LBHI itself holding $209 billion of assets and only $189 billion of liabilities.5 Nevertheless, LBHI and its affiliates6 seem to have had little choice but to file for Chapter 11 protection.
Lehman faced a severe liquidity crisis, which regulators and market participants had increasingly feared would befall the firm after the near failure of The Bear Stearns
Companies, Inc. (“Bear Stearns”) in March 2008, which itself suffered from a run before being acquired by JPMorgan.7 Lehman’s court-appointed bankruptcy examiner (the
“Examiner”) explained the rationale behind this fear, noting that “[f]inancial institutions such as Lehman ha[d] a relatively greater risk of failure due to a lack of liquidity, as
compared to a risk of failure due to the value of their liabilities exceeding the fair value of their assets.”8 Lehman management, however, downplayed the firm’s liquidity risk and
“told the rating agencies that it was focused on building its ‘liquidity fortress.’”9
In the end, the fortress was breached. Describing the firm’s final days, Lehman’s CFO reported that “cash and collateral were being tied up by [its] clearing banks ... [and] cash had drained very quickly over the last three days of the previous week.”10 The market believed that the current value of the firm’s liabilities exceeded the value of its assets or soon would. While former Lehman CEO Richard Fuld has argued that fears over
Lehman’s solvency were unwarranted,11 the Examiner uncovered evidence to suggest otherwise, concluding that at least some of Lehman’s assets might have been
unreasonably valued, without regard to fire sale considerations.12
Lehman made significant missteps in the years leading up to its bankruptcy, although the firm was not alone in embracing high leverage and risky strategies. “Excessive
leverage was a pervasive problem” among financial institutions, according to former Federal Deposit Insurance Corporation (“FDIC”) Chairman Sheila Bair.13 Indeed, in
concluding that “[i]n the years leading up to the crisis, too many financial institutions ...
borrowed to the hilt,” the Financial Crisis Inquiry Commission (“FCIC”) emphasized that
“as of 2007, the five major investment banks were operating with extraordinarily thin capital,” leading to leverage ratios as high as 40:1.14
Chief among Lehman’s missteps was an overly aggressive growth strategy that,
beginning in 2006, led it to commit an increasing amount of capital to commercial real estate, leveraged loans, and illiquid private equity investments.15 This plan proved exceedingly risky given the firm’s high leverage and small equity cushion.16 When the market for certain assets targeted for increased investment began to show signs of weakness in 2007, Lehman management decided to “double-down” so as to take advantage of “substantial opportunities.”17 The Examiner found that even as its competitors were shedding risk, Lehman saw an “opportunity to pick up ground and improve its competitive position.”18 Seizing this opportunity proved costly, nearly
doubling the reported value of Lehman’s commercial real estate assets from $28.9 billion at the end of 2006 to $55.2 billion at the end of 2007.19 Not only did the firm’s
commercial real estate portfolio account for a large portion of the company’s reported losses,20 but it also fueled concerns among possible suitors over future write-downs.
Lehman explored a number of options to secure at least a partial survival of the firm. By the summer of 2008, management began contemplating a spin-off of the firm’s
problematic commercial real estate exposure into an entity labeled SpinCo, relieving Lehman’s balance sheet of worrisome assets and reducing the need for continued
markdowns.21 Lehman would need to ensure that SpinCo was a viable standalone entity and infuse it with equity equivalent to at least 20 to 25 percent of the value of the
transferred assets.22 By September 2008, Lehman hoped to obtain this equity by selling 51 percent of its investment management division for $2.5 billion, issuing $3 billion of equity directly and raising over $2 billion from a third-party investor.23 Lehman was ultimately unable to carry out this plan quickly enough to avoid bankruptcy. Even absent time constraints, Treasury Secretary Henry Paulson, JPMorgan CEO Jamie Dimon, and Berkshire Hathaway CEO Warren Buffett, among others, were highly skeptical of the spin-off.24 In its final months, Lehman also borrowed from the Fed in order to access needed liquidity. The firm had as much as $18 billion outstanding under the Fed’s single- tranche open market operations in June 2008, as well as a $45 billion loan from the
Primary Dealer Credit Facility near the time of its bankruptcy.25
Lehman also explored the possibility of entering into a strategic partnership or, as its situation grew more dire, selling itself to a competitor. Lehman contacted, among others, (1) Warren Buffett, who demanded better terms than Lehman was willing to offer in March 2008 and dismissed Lehman’s SpinCo proposal around September 2008;26 (2) Korea Development Bank, which had expressed interest in a $6 billion investment in
“Clean Lehman” (i.e., Lehman without SpinCo) as late as August 31, 2008, but failed to reach an agreement with Lehman owing to significant valuation differences and rapidly deteriorating market conditions;27 and (3) MetLife, which passed on an investment on
August 20, 2008, because it already had substantial commercial real estate exposure.28 Lehman’s most promising potential buyers were Bank of America Corporation (“Bank of America”) and Barclays PLC (“Barclays”). Lehman held two rounds of discussions with Bank of America, first proposing a merger between the two firms’ investment banks that would have given control over the combined entity to Lehman.29 Then, in early
September 2008, fearing “that Lehman could become a serious problem,” Secretary
Paulson began pressuring Bank of America to buy Lehman.30 Bank of America ultimately refused, as CEO Ken Lewis believed that the deal would yield little strategic benefit. Bank of America’s due diligence team concluded that Lehman’s commercial real estate
positions were overvalued. It “had uncovered approximately $65–67 billion worth of Lehman assets that ... it did not want at any price,” and was unwilling to pursue a deal without government assistance, which was not forthcoming.31
Barclays expressed greater interest and, indeed, ultimately purchased Lehman’s US and Canadian investment banking and capital markets businesses in bankruptcy.32 Barclays was unable to consummate a deal prior to the bankruptcy filing because its UK regulator, the Financial Services Authority (“FSA”), refused to waive the requirement that a
guaranty by Barclays of Lehman’s obligations prior to the closing of the transaction (as demanded by the Federal Reserve Bank of New York, “FRBNY”) garner the prior approval of Barclays shareholders.33 Had the requirement been waived, Barclays would have
purchased Lehman’s operating subsidiaries for approximately $3 billion and would have guaranteed Lehman’s debt.34 Notably, however, Barclays would not have assumed any of the commercial real estate assets that Lehman planned to transfer to SpinCo.35 Thus, even had the envisioned transaction been consummated, the remaining Lehman entities would have retained the highly problematic commercial real estate exposure, although they might have succeeded in avoiding a bankruptcy filing. The Fed had great difficulty determining whether or not Lehman was solvent over “Lehman weekend,” due to these commercial real estate assets that Lehman valued at $50 billion but a valuation that others disputed.36 Reportedly, certain staff members at the FRBNY had determined that Lehman was solvent, while other senior government officials had reached the opposite conclusion. The fact that these assets could not be valued, contributed to the Fed’s unwillingness to lend to Lehman.37
As a result LBHI was left with no choice but to file for bankruptcy. Because LBHI was so critical to Lehman’s operations and functioned as “the central banker for the Lehman entities,”38 its filing caused key subsidiaries to seek similar protection. Although
apparently solvent, such subsidiaries lacked the liquidity to function without LBHI’s support. On the same day as LBHI filed under Chapter 11, its European broker-dealer subsidiary, Lehman Brothers International (Europe) (“LBIE”), was placed into
administration.39 While LBIE’s balance sheet then implied that it had nearly $17 billion in equity ($49.5 billion in net assets against only $32.6 billion in net liabilities), it was
forced to seek administrative protection because “LBHI managed substantially all of the material cash resources of the Lehman Group centrally,” and “LBIE was informed by
LBHI that it would no longer be in a position to make payments to or for LBIE.”40 Four days later, LBHI’s US broker-dealer, Lehman Brothers Inc. (“LBI”), was placed into liquidation proceedings under the Securities Investor Protection Act of 1970 (“SIPA”).41 Despite reporting more than $3 billion in excess capital at the end of August 2008 and generally being in compliance with regulatory requirements, LBI was forced to wind down because “it was a foregone conclusion that [it could] not survive as an independent
entity.”42 By the beginning of October, fifteen LBHI subsidiaries filed for Chapter 11 in the United States, and in the end, more than twenty would do so.43
Lehman’s Chapter 11 filings provoked heated dispute,44 particularly over the
contentious issue of whether and to what degree LBHI’s affiliated US debtors would be
“substantively consolidated” with LBHI. An equitable remedy that recognizes debtors as one combined entity, “substantive consolidation” “pools all assets and liabilities of ...
subsidiaries into their parent and treats all claims against the subsidiaries as transferred to the parent.”45 The remedy also “eliminates the intercorporate liabilities of the
consolidated entities,”46 an important aspect of the Lehman case due to the vast array of intercompany and guarantee claims filed.47 The estate’s initial plan in April 201048
rejected substantive consolidation and instead “recognize[d] the corporate integrity of each Debtor,”49 splitting creditors into two opposed groups, those that favored
substantive consolidation (the Ad Hoc Group) and those that opposed it (the Non- Consolidation Group), each of which produced its own favored counterplan.50 After protracted wrangling by the parties over successive plans,51 a so-called Modified Third Amended Plan52 was finally confirmed on December 6, 2011, following a creditor vote53 and became effective on March 6, 2012, enabling Lehman to emerge from bankruptcy.54 Distributions commenced on April 17, 2012, with a disbursement of approximately $22.5 billion to creditors.55
The Modified Third Amended Plan supports the core conclusion of this book: direct exposure to Lehman entities filing for bankruptcy in the United States did not destabilize significant Lehman counterparties, either in the immediate aftermath of the Lehman shock or subsequently. The estimated magnitude of unsecured third-party exposure to LBHI and its US debtor affiliates was between about $150 billion and $250 billion.56 To be sure, such figures are large. Nevertheless, in light of the fact that such exposures were distributed across a large number of individuals and institutions—only a small fraction of which were of systemic importance—such sums would likely have been manageable in the aftermath of the LBHI filing, even assuming that these parties were to recover nothing of their exposures.
Moreover some creditors believed that they would recover—and in fact did recover—a considerable portion of certain claims well before a plan was even proposed. By
September 2009, claims against Lehman Brothers Special Financing Inc. (“LBSF”), guaranteed by LBHI, were trading at roughly forty cents on the dollar, a price around which Morgan Stanley sold a $1.3 billion claim that month.57 Further, even if unlikely to receive forty cents on the dollar, most other creditors still had good reason to expect
nonzero recoveries, given that the estate had substantial assets. The extent of these assets is underscored by the Initial Plan, which indicated that as of the end of 2009, on an
undiscounted basis, LBHI and its US affiliates would yield approximately $66 billion to creditors after an orderly liquidation.58 With the estate then projecting about $370 billion in allowable claims,59 such a liquidation would have yielded an average recovery of nearly 18 percent. As of March 2014, allowed claims were reduced to $303.6 billion60 and
Lehman’s unsecured creditors had received a total of $86.0 billion, representing a
realized recovery of more than 28 percent.61 As of September 2015, distributions totaled
$144 billion, amounting to a 35 percent recovery for unsecured general creditors. 62 Given the expectation of substantial recoveries, which were borne out in fact, the exposure of counterparties is further diminished in importance. These findings tend to undermine the
“too interconnected to fail” hypothesis.63
Other researchers have been unable to find a significant correlation between Lehman’s bankruptcy and the failure of other interconnected financial institutions, rejecting the idea that Lehman’s downfall led to a cascade of bankruptcies through asset
interconnections.64 Some scholars have argued that connectedness did play an important role during Lehman’s bankruptcy.65 However, the importance of Lehman’s connectedness was limited to the internal connectedness among Lehman entities (i.e., Lehman
subsidiaries were connected to each other). While the connectedness of Lehman entities potentially played an important role in Lehman’s demise, this is entirely separate from the issue of Lehman’s connectedness to other firms, which is really the connectedness that would matter for systemic risk.