Study Behind The Fall Of Lehman Brothers Finance Essay - Free Essay Example

Sample details Pages: 4 Words: 1146 Downloads: 3 Date added: 2017/06/26 Category Finance Essay Type Research paper Did you like this example? Introduction Lehman Brothers, the Americas fourth-largest investment bank, declared the largest bankruptcy in the United States history on 15 September 2008. The fall of Lehman Brothers rattled the global market and led to a great drop in the United States stock market the day after the announcement and ultimately, the financial tsunami. Lehman Brothers had successfully survived many economic crises, like railroad bankruptcies of the 1800s, the Great Depression in the 1930s and the collapse of Long-Term Capital Management in the 1900s in its 158 years of history. So what made it collapsed? Reasons of the Bankruptcy Low Liquidity The basic reason for Lehman Brothers bankruptcy was the lack of liquidity. Lehman Brothers had total debts of US$613 billion against total assets of US$639 billion when it bankrupted. Its total assets were seemingly enough to cover the debts, however the liquidity pool was far below from the total. Few days before the filing of the bankruptcy, it publicly reported a US$41 billion liquidity pool but with a significant portion which was difficult to monetize or illiquid. For example, substantial amounts of cash and securities which were placed as deposits with various banks for its usual clearing business and had become actual pledges were included in the pool to achieve and report a better liquidity and maintain the market confidence. Lehman Brothers actual liquidity pool contained less than US$2 billion of readily monetizable assets. The lack of liquidity made it impossible to repay the short term debts and go bankruptcy without choice. High Leverage Lehman B rothers bankruptcy was also a result of its high-risk and aggressive leverage policy. It usually had a leverage of more than 30 to 1 (i.e. US$3.30 of equity for every US$100 loans) while commercial banks are regulated to leverage its equity no more than 15 to 1. When it bankrupted, the leverage ratio was slightly reduced to approximately 24 with a capital of around US$26 billion and the total liabilities of more than US$600 billion. Its high debt-to-equity ratio implied how seriously it relied on the use of debt to supplement investments. Issuing bonds can finance the long term investments. However, for a large part, Lehman Brothers funded itself through the short term repo markets and borrowed money in the markets to be able to operate daily businesses. Lehman Brothers leverage policy put itself at high risk of instant shortage of funds. When the repo markets lose confidence in Lehman Brothers and refused to lend, Lehman Brothers would fail to repay the previous debts and fund its daily operations. It became the real situation of Lehman Brothers when it went bankruptcy. Confidence in Lehman Brothers was eroding following the sub-prime residential mortgage crisis in 2007 and the near collapse of Bear Stearns in early 2008. It was widely considered to be the next bank which might fall. Huge Losses In addition to the liquidity and leverage problems, the huge losses resulting from the sub-prime residential mortgage crisis also played an important role in Lehman Brothers bankruptcy. For a number of years prior to the crisis, low interest rates and large inflows of foreign funds created easy credit conditions in the United States. Easy credit encouraged the demand for housing, which drove house prices higher. With a belief in long term trend of rising housing prices, subprime and adjustable-rate mortgages became more popular. However, when the adjustable-rate mortgages began to reset at higher rates and the housing market started to decline after the peak, refinancing became more difficult and mortgage delinquencies and foreclosures rose dramatically. Lehman Brothers held on to large positions in subprime and lower-rated mortgage-backed securities. Huge accumulated losses of approximately US$60 billion with a combination of write-downs on assets, sales of assets at losses and losses on hedges were resulted from the continuing mortgage delinquencies and foreclosures. The market generally believed that the reported losses might be underestimated and further provisions had to be made for the depreciation of the value of the mortgage-linked assets. The uncertainties discouraged potential investors to take over Lehman Brothers and Lehman Brothers could only go bankrupt. Don’t waste time! Our writers will create an original "Study Behind The Fall Of Lehman Brothers Finance Essay" essay for you Create order Belief in Accounting The bankruptcy of Lehman Brothers shocked the market. Few months before the bankruptcy when it reported a quarterly loss, it was still trying to cushion the bad news by trumpeting its strong liquidity position and the decline in its leverage ratio. Neither its quarterly reports nor annual reports mentioned the risk of being bankrupt though it finally did. The general public believed that Lehman Brothers did not truly present its financial status in its financial statements and such belief was recently supported by a report of the causes of the bankruptcy made by a court-appointed examiner. It was discovered that Lehman Brothers made use of an accounting device called Repo 105 to paint a misleading picture of its financial condition. Lehman Brothers entered repurchase (repo) agreements at the end of a financial quarter to raise cash by collateralizing assets with an obligation to repurchase them at a small premium the day or several days after the year-end. The cash raised was th en used to pay down the debt. By nature, it was a short term financing and had no effect on the overall leverage. However, Lehman Brothers took the advantage of an accounting rule called SFAS140 and recorded the transactions as sales of assets. The collateralized assets were taken away from the balance sheet and the obligation to buy back the assets was not shown either. Such way of treatment helped Lehman Brothers to reduce the balance sheet and report a better leverage at the quarter-end. With limited access to Lehman Brothers financial information, investors were definitely misled by this material window dressing action. Lehman Brothers, apparently, was not moral to its investors, so as Lehman Brothers auditor, Ernst Young, who was supposed to give a true and fair view on its accounting and disclose anything material to investors. The accounting gimmick put the trustworthiness of accounting in doubt. And what the Financial Accounting Standards Board did to save the banks a nd financial systems from the crisis made people further question the role of accounting. The Board changed the accounting rules to allow the banks close to bankruptcy to report high profits even though their financial position remained unhealthy in reality. Accounting is a means to provide quantitative financial information that helps users in making better business decisions. It provides a fairly good account of the past economic activities of company and a picture of the present and future. It tells the performance and earning power as well as the financial position in terms of resources availability (assets) and obligations (liabilities) of a company. It provides reliable financial information, however it has its limitations. It does not provide non-financial information such as behavioral and socio-economic which may influence the decision-making. To conclude, we could believe in accounting but we should not rely on accounting without taking other information in consideratio n when making a decision.