Origins
Lehman Brothers was founded in 1850 in Montgomery, Alabama, by three German-Jewish immigrant brothers who began as cotton traders before expanding into banking. Over more than 150 years, the firm evolved from a commodities house into one of the world’s most prestigious investment banks. By the 2000s, under CEO Richard “Dick” Fuld, Lehman had transformed into an aggressive trading-oriented operation that relied heavily on borrowed money to amplify returns.
The firm’s business model was characterized by leverage ratios that reached as high as 30-to-1, meaning it borrowed $30 for every $1 of its own capital. This strategy worked spectacularly during good times but left the firm fatally exposed when asset values declined. Unlike traditional banks, Lehman had no depositors; instead, it relied on short-term funding from the repo market, where lenders could refuse to roll over loans at any moment.
Structure & Function
Lehman functioned as a major player in the origination, underwriting, and trading of mortgage-backed securities. The firm’s distinctive vulnerability was its exposure to commercial and residential real estate during the housing bubble. By 2008, Lehman held a massive portfolio of real estate assets that were rapidly declining in value.
To maintain the appearance of financial health, Lehman utilized a controversial accounting maneuver known as “Repo 105.” This technique allowed the firm to book temporary repurchase agreements as outright “sales” of assets at the end of each quarter. This enabled Lehman to hide up to $50 billion in debt from its public balance sheet, artificially lowering its reported leverage. Internally, executives referred to these maneuvers as a “drug” the firm used to maintain its credibility in the market.
Historical Significance
The bankruptcy of Lehman Brothers in September 2008 is widely regarded as the most critical event of the 2008 financial crisis. The U.S. government’s decision to let the firm fail, after previously rescuing Bear Stearns, shattered the market’s assumption that all systemically important banks would be saved. The resulting “unprecedented loss of investor confidence” caused global credit markets to freeze instantly.
Lehman’s fall had a profound contagion effect, triggering a run on the Reserve Primary Fund and forcing the government to nationalize the insurance giant AIG a few days later. The failure proved that the firm was too interconnected to fail safely, necessitating the $700 billion TARP bailout to prevent a total systemic collapse. Its collapse remains the largest bankruptcy in history and a definitive lesson in the dangers of hidden leverage.
Key Developments
- 1850: Founding of the firm in Montgomery, Alabama.
- 1994: Dick Fuld becomes CEO.
- c. 2000: Transitions into an aggressive trading-oriented business model.
- 2003: Begins using Repo 105 to hide billions in debt from its balance sheet.
- c. 2004: SEC ruling allows Lehman and other investment banks to determine their own capital levels, leading to soaring leverage.
- 2007: Internal warnings about the “meltdown” for subprime lenders are largely ignored by senior leadership.
- 2007 (December): Firm increases its use of Repo 105 to hide a $38-billion spike in debt.
- 2008 (March): Bear Stearns collapse increases pressure on Lehman as the most vulnerable remaining bank.
- 2008 (June): Reports a second-quarter loss of $2.8 billion; Fuld fires his president and CFO.
- 2008 (September 10): Reports a third-quarter loss of $3.9 billion after massive real estate write-downs.
- 2008 (September 15): Files for bankruptcy after a failure to find a buyer or secure a government bailout.
- 2008 (September): The failure triggers a run on money market funds and a global freeze in interbank lending.
- 2010: The Valukas Report exposes the firm’s systematic use of “Repo 105” to mislead the public.