Lehman Brothers Bankruptcy

Executive Summary

In the year of 2008, as a victim of the U.S. subprime mortgage crisis, Lehman went bankruptcy. Lehman Brothers Holdings Inc. had existed more than 160 years and was U.S. fourth-largest investment bank at the time of its collapse.

As the first company went bankruptcy on Wall Street, Lehman's collapse has been seen as a seminal event that greatly intensified the 2008 crisis and caused the evaporation of close to $10 trillion in market capitalization from global equity markets, the biggest monthly decline on record at the time. Later, people found out Lehman was suspected of repurchasing and forum shopping in foreign market. The crafty Lehman bankers found a fault in the international accounting standards system — the intersection of British law and American accounting standards. Bankers started using this omission to beautify financial report by repo 105.

Lehman along with other financial institutions experienced a golden time from 1990 to early 2008. However, due to concentrated business in housing mortgage, unusually high leverage, over-optimistically management and excessive anxiety attitude to the market, it soon became a victim in the crisis. 

This tragedy may cause the concern of regulators. There are ways that related institutional intermediaries might follow to avoid such failures. First, further improve the accounting standards in accordance with changes in the business. Second, the regulators in different countries should consider more in the global environment. Third, strengthen companies’ accounting information disclosure system.

Repurchase Transaction

A repurchase agreement is the sale of assets together with an agreement for the seller to buy back the securities at a later date.^[1] The assets mostly are fixed income and equity securities. There are few characters of a repurchase agreement. First, it is a temporary transaction. Second, the transaction happens for a short time during which market price of these asset does not fluctuate much. Third, the transaction highly secured through collaterals. Those collaterals often are Treasury-bills, have same book vales as loan and may not involve physical transfer.^[2] Base on the three points above, the transaction will not cause much interest cost.

Repo Structure

The structure of the repo contract shown as below:

On the value date:

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[pic 8]

The repo seller (FI 1) sells their securities (usually over collateralized) to the buyer (FI 2), and the buyer gives the money (cash) to the seller.

At maturity:

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The seller repurchases the same amount of securities, and pays the cash plus repo interest.

In the 1990s, during the golden time of banks and financial institutions, Lehman shot up as the fourth-largest investment bank in the U.S.^[3] Soon the 2007-08 financial crisis happened. Lehman as a specialist in selling MBS and RBS, experienced a dramatic asset shrink. To maintain a positive credit rating, Lehman started to use repo transactions to beautify its financial reports. The leverage ratios pulled down by the securities sold to counterparties. From those actions, we can assume that the substance of those transactions is a short-term loan to finance the temporary working capital need.