Sample Cause and Effect Essay on Business Management: The Collapse of Lehman Brothers

EssayCause and Effect Essay
Nov 30, 2021

The collapse of Lehman Brothers was a significant event that many management researchers and experts have studied due to its consequences. The company was a powerhouse in the financial service industry and had international partners. This competitive position allowed Lehman Brothers to exponentially grow and become an influential factor in the global economy. However, the company indulged in various unethical and greedy practices that led to a bankruptcy announcement on September 15, 2008, and created a downtrend in the global financial market. The collapse of Lehman Brothers was due to government legislation, management malpractice, aggressive business strategies, and overall neglect of the company’s financial condition which eventually led to bankruptcy and global financial losses.

Lehman Brothers Background

Lehman Brothers started as a dry-goods store in Alabama during the 1850s. One of the brothers, Henry Lehman, established the general store business which became the foundation of the company’s rise to the trade industry. Henry’s brothers, Mayer and Emanuel Lehman, later joined him and expanded the company to the financial service industry. In 1858, the company established a Lehman Brothers branch in New York City. Lehman Brothers engaged in the cotton trade and commodities industry and found success despite the economic and social effects of the Civil War. During this time, Lehman Brothers created various ventures, such as the New York Cotton Exchange, Cocoa Exchange, and New York Petroleum Exchange. These ventures along with their active participation in the financing sector contributed to Lehman Brothers’ early success.

Around the late 1880s, the next generation of Lehmans took over Lehman Brothers. Philip Lehmans, Emanuel Lehman’s son, became the head of the company. During this time, Lehman Brothers became a member of the New York Stock Exchange and engaged in the investment banking industry. Lehman Brothers acquired influential partners like Goldman Sachs which led to securities ventures like General Cigar Company, Inc. and Sears, and Roebuck & Co. Lehman Brothers’ venture in the securities industry signaled its exponential growth in the financial industry. With this, the company shifted its focus from commodity trading to financial services.

In 1925, Robert Lehman became Lehman Brothers’ head. Under his leadership, the company supported various industries. It supported aviation companies, such as Aviation Corporate and Transcontinental & Western Air. The two companies later became American Airlines, Inc and Trans World Airlines, Inc., respectively. The company also supported the motion picture industry, which most businessmen perceived as risky investment options. Lehman Brothers aided in the establishment of Radio-Keith-Orpheum Corporation, Paramount Pictures, and Twentieth-Century Fox Fil Corporation. Additionally, Lehman Brothers supported the oil, electronics, and automotive industries. The company aided in the growth of companies such as TransCanada Pipelines Ltd., Penzoil Company, Haliburton Oil Well Cementing Company, Kerr, McGee Oil Industries, Inc, International Business Machines, Digital Equipment Corporation, Loral Electronics Corporation, Litton Industries, Hertz Corporation, and Ford Motor Company. This extensive list showcases the influence that Lehman Brothers had on various industries and the growth of top competitors.

In the following years, Lehman Brothers experienced changes in leadership, financial challenges, and business mergers. The financial challenges that the company experienced led to the business mergers and Lehman Brothers’ financial service expansion. In 1977, the company merged with Kuhn, Loeb & Co. which produced the fourth-largest investment bank in the US at the time. Along with its financial service expansion, the company invested in tech companies like Cetus and Intel. Despite the success of the tech industry, Lehman Brothers experienced a decrease in profits due to Lew Glucksman’s preference for trading which divided the company’s trading and investment banking departments. In the 1990s, Richard Fuld bought Lehman Brothers and became the company’s CEO. Fuld’s leadership allowed Lehman Brothers to double its size and become a top player in the financial service industry. However, due to various ethical and management issues, Fuld announced Lehman Brothers’ bankruptcy in 2008.

Causes of Lehman Brothers’ Collapse

The collapse of Lehman Brothers was due to the accumulating results of business malpractices. According to Mawutor (2014), the collapse was due to the Glass-Steagall Act repeal, unethical practices, liquidity crisis, collateralized debt obligation, derivative crisis, leveraging, complex capital structure, and unsuccessful take over attempts. These factors are the major issues that led to the collapse of the financial service powerhouse. Additionally, Morin and Maux (2011) stated that the bankruptcy was due to greedy wall street trades, American household debts, government action, rating agencies, and deregulation of securities (as cited in Azadinamin, 2012). These additional causes are the implications and root factors that comprise the major issues. It is also important to note that experts conclude that the collapse was due to the combination of the causes and not of a single factor.

Glass-Steagal Act Repeal

The Glass-Steagall Act was a law that took effect in 1933. It separated the operations of commercial banks from investment banks. The legislation of the act was the government’s attempt to avoid conflict of interest between the two industries and companies that engage in both businesses. However, the Gramm-Leach-Bily Act took effect in 1999 which allowed commercial banks to engage in investment banking operations (Mawutor, 2014). Lehman Brothers saw this opportunity to merge with various commercial and investment banks to retain their competitive position (Valukas, 2008, as cited in Maluwor, 2014). The company engaged in aggressive and unethical tactics to successfully merge with other businesses. Financial analysts concluded that Lehman Brothers’ aggressive tactics led to unethical merging practices in the financial industry (Mawutor, 2014). The unethical practices made the company vulnerable to various issues which contributed to its negative reputation and bankruptcy.

Unethical Management Practices

Lehman Brothers’ unethical practices were not only present in their merger tactics but also in their management. Lehman Brothers engaged in dubious mechanics, unethical accounting practices, and disregard of corporate governance practices (Caplan et al., 2012, as cited in Maluwor, 2014). Among these factors, the company’s unethical accounting practices contributed greatly to the public’s and investors’ declining confidence towards Lehman Brothers. The company manipulated its financial statements to attract investors and other partners. It utilized Repo 105 to fabricate balance sheets and record loans as sales (Jeffers, 2011, as cited in Azadinamin, 20141). This form of corporate crime allowed the company to show that it has a healthy financial condition despite its high leverage ratio and declining profits.

The company’s unethical practices also included a bonus system that resulted in massive losses. According to Berman & Knight (2009), Lehman Brothers compensated its employees with large bonuses when the company performs well which promoted risk-taking. However, when the company performed poorly, the employees do not incur losses. This led employees to take risks without the fear of financial losses. Additionally, Lehman Brothers had the practice of issuing excessive bonuses to their senior managers (Murphy, 2008, as cited in Maluwor, 2014). Various report media stated that Richard Fuld paid himself a total of $300 million through salary and bonuses while senior managers and employees received a total of around $480 million in bonuses. It is important to note that these transactions occurred during the period when Lehman Brothers is experiencing financial issues.

Liquidity Crisis

Lehman Brothers engaged in various transactions that included borrowing and loaning money from other companies. This led the company to have liquidity problems years prior to its bankruptcy announcement (Maluwor, 2014). There was also the issue of the company’s practice of manipulating financial statements and liquidity pools. Since Lehman Brothers is experiencing a liquidity crisis, commercial and other banks refrained from transacting with the company and withdrew their Lehman-related operations (D’Arcy, 2009, as cited in Maluwor, 2014). With the majority of banks withdrawing their operations; investors and customers also avoided transactions with Lehman Brothers. The mistrust towards the company greatly contributed to its bankruptcy and collapse.

Derivative Crisis and Leveraging

Lehman Brothers actively sold securities to companies that required them to heavily borrow money. The company invested in Residential Whole Loans, Collateralized Debt Obligations, and other derivatives which increased Lehman Brothers’ volatility. According to Murphy (2008), Lehman Brothers had a lack of a product control process which contributed to their collapse (as cited in Maluwor, 2014). Aside from this, the company had a high leverage ratio which resulted in a financial condition where the company cannot maintain its operations. In 2007, Lehman Brothers had a leverage ratio of 44 to 1 which was difficult to maintain. When the value of securities and derivatives declined, this resulted in Lehman Brothers owning a negative portfolio. This led to the company’s bankruptcy as well as defaults for the securities that it has sold.

Complex Capital Structure

Lehman Brothers’ aggressive business practices involved financing companies. This resulted in Lehman Brothers having multiple subsidiaries and partners that rely on the company for funding. With this, the company develops a complex capital structure that became a possible factor for its collapse (Maluwor, 2014).  According to CFA Institute, capital structure is a company’s combined debt and equity which it then uses as capital. A complex capital structure can lead to unpaid and unpayable debts that a company may fail to address. With Lehman Brothers’ declining financial condition and unethical practices, the company may not have the capability to settle its debts which contributed to the collapse.

Government Actions Against Lehman Brothers

Government actions were perhaps one of the greater contributors to the collapse of Lehman Brothers. Before its bankruptcy announcement, the company attempted to salvage itself by selling the major shares of its subsidiaries and even selling the company to other financial institutions. However, the US government strongly stated that it will not help Lehman Brothers nor will it assist in a financial crisis that results from the company’s actions (Anderson, 2009, as cited in Maluwor, 2014). Lehman Brothers attempted to sell itself to the Bank of America and Barclays Bank, however, the Bank of England vetoed the deal (Caplan et al., 2012, as cited in Maluwor, 2014). These government actions against the company were the result of their unethical practices and led to the company’s failure in avoiding bankruptcy.

Effects of Lehman Brothers’ Collapse

Loss of Jobs and Investor Money

The collapse of Lehman Brothers led to massive losses for its partners. These partners included the company’s employees, investors, shareholders, and directors. The company had more than 3000 legal entities that employed thousands of employees and had different investors. The collapse resulted in more than 26,000 individuals losing their jobs and financial assets. A CNBC article reported that Lehman Brothers employees experienced depression, debt, and loss of life savings due to the collapse. Aside from its effects on the employees, the collapse led investors to suffer great financial losses. Lehman Brothers had a negative portfolio and investors had no way of acquiring their investments nor the securities that the company has sold.

Global Financial Losses

Aside from its employees and internal partners, the collapse resulted in the financial losses of the company’s global partners and subsidiaries. The US real estate industry experienced a $46 billion decline in its market value. The Federal Agricultural Corporation lost $48 million due to an unpaid Lehman Brothers debt. The Constellation Energy Company experienced a decrease in stock price which eventually led Mid America Energy to acquire the company. Japanese financial institutions lost a total of $2.4 billion due to the Lehman Brothers collapse. Royal Bank of Scotland Group faced claims between $1.5 billion and $1.8 billion due to a Lehman Brothers guarantee. A German bank lost 500,000 euros from the collapse. Lastly, an England hedge fund lost $12 million (Maurna, 2008; Emily, 2008; Kirchfield & Simmons, 2008; Spector, 2009; as cited in Maluwor, 2014). These financial losses resulted in a global financial crisis that included credit freezes, stock market declines, and debt crises. Additionally, Birkhanov (2011) stated that Lehman Brothers’ collapse resulted in a negative shock to capital liquidity, the underperformance of non-financial companies, the popularity of sovereign spreads, and a global recession. These effects showed that Lehman Brothers played an integral role in the global economy and its collapse inevitably resulted in a global financial crisis.

The Lehman Moment

The Lehman Moment is a term that management experts use to refer to the Lehman Brothers’ bankruptcy announcement which then caused a global financial crisis. This was the moment that the company admitted to its negative financial portfolio which affected its subsidiaries and partners. The Lehman Moment was the consequence of the different causes of the collapse and the starting point of the financial crisis. During this moment, employees lost their jobs and the company’s partners experienced financial losses. Additionally, since Lehman Brothers sold securities and derivatives, these products lost their value which turned into losses for other companies. The Lehman Moment was an integral event in a poorly performing global economy that led to the global financial crisis.

Ways Lehman Brothers Could Have Avoided Bankruptcy

Addressing Its High Leverage Ratio

Lehman Brothers had an unhealthy leverage ratio years before its bankruptcy. This is due to the company’s aggressive borrowing and investment in securities, especially mortgage-backed securities. In 2007, the company had $700 billion in assets and $675 billion in liabilities. This results in equity of $25 billion and a high leverage ratio. If the company decided to properly manage its high leverage ratio, it could have potentially avoided bankruptcy or reduced its debts. Lehman Brothers could have engaged in less risky investments and developed plans to address its unhealthy leverage ratio.

Ethical Responsibility

Lehman Brothers engaged in unethical business practices through the manipulation of financial statements and its senior management’s excessive bonuses. Financial analysts stated that the company’s financial statements prior to the year of bankruptcy showed signs of vulnerability and performance decline. This indicates that the company was aware of its financial condition and vulnerability but chose to ignore it. Lehman Brothers falsified financial reports to attract investors and continued giving excessive bonuses to employees. If the company exercised ethical responsibility through transparency, it could have acquired help from various financial institutions and perhaps the US government. Ethical responsibility would have also allowed Lehman Brothers to quickly recognize its financial condition and develop strategies to avoid bankruptcy. The company’s disregard of ethical responsibility and other management principles led to its poor reputation and collapse.

Conclusion

Lehman Brothers was a financial service powerhouse that played an integral role in the global economy. However, due to government legislation, management malpractice, aggressive business strategies, and neglect of a company’s financial condition led to the 2008 bankruptcy announcement and global financial losses. The Lehman Moment became a world-changing event that resulted in massive financial losses due to a single company’s actions. Lehman Brothers’ lack of corporate social responsibility and other fundamental business principles made it vulnerable to the issues that caused its collapse. The Lehman Moment showcased a company’s influence in the global economy as well as the consequences of poor management practices.

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