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The Bankruptcy of Lehman Brothers: Causes of Failure & Recommendations Going Forward

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This paper looks at the failure of Lehman Brothers as the biggest bankruptcy case in the US history and the events that followed. The first part of the paper reviews factors that led to the failure and consequently the bankruptcy event. Some of the causes leading to the crisis, namely the market for Credit Default Swaps (CDOs), misrepresentation of financial statement, complex structure of the company, low standards, and unethical behavior of top managers are reviewed in the paper as the essential causes. In misrepresentation of financial statements there is an extra emphasis on the misuse of the Repo 105 procedure and how Lehman used it to make its financial statements appear healthier than what they were in actuality. Many also suggest that the misrepresentation by the top managers also violated the Sarbanes-Oxley Act. The second part of the paper reviews whether the failure could have been prevented before the crisis was spiraled out of control with devastating consequences. Numerous analyses and their conclusion suggest that there were many signs suggesting the coming of a crisis, but numerous people, whether analyst, auditors, or even employees, failed to recognize them or deliberately turned a blind eye to the warning signs. The most prominent sign is mentioned as the net negative cash flows that Lehman was running three years prior to the crisis despite healthy looking balance sheets as well as income statements. The last part of the paper offers solutions for going forward and ways to avoid another failure of a giant financial institution. As for solutions going forward, paper recommends companies to abandon dubious and wrongful accounting practices in order to attain unattainable targets as well as using new methods to assess the health of the organization.
Electronic copy available at: http://ssrn.com/abstract=2016892
THE BANKRUPTCY OF LEHMAN BROTHERS 1
The Bankruptcy of Lehman Brothers: Causes of
Failure & Recommendations Going Forward
Amirsaleh Azadinamin
Doctorate of Finance Candidate
March 6, 2012
Electronic copy available at: http://ssrn.com/abstract=2016892
THE BANKRUPTCY OF LEHMAN BROTHERS 2
Abstract
This paper looks at the failure of Lehman Brothers as the biggest bankruptcy case in the US
history and the events that followed. The first part of the paper reviews factors that led to the
failure and consequently the bankruptcy event. Some of the causes leading to the crisis, namely
the market for Credit Default Swaps (CDOs), misrepresentation of financial statement, complex
structure of the company, low standards, and unethical behavior of top managers are reviewed
in the paper as the essential causes. In misrepresentation of financial statements there is an extra
emphasis on the misuse of the Repo 105 procedure and how Lehman used it to make its
financial statements appear healthier than what they were in actuality. Many also suggest that
the misrepresentation by the top managers also violated the Sarbanes-Oxley Act. The second
part of the paper reviews whether the failure could have been prevented before the crisis was
spiraled out of control with devastating consequences. Numerous analyses and their conclusion
suggest that there were many signs suggesting the coming of a crisis, but numerous people,
whether analyst, auditors, or even employees, failed to recognize them or deliberately turned a
blind eye to the warning signs. The most prominent sign is mentioned as the net negative cash
flows that Lehman was running three years prior to the crisis despite healthy looking balance
sheets as well as income statements. The last part of the paper offers solutions for going forward
and ways to avoid another failure of a giant financial institution. As for solutions going
forward, paper recommends companies to abandon dubious and wrongful accounting practices
in order to attain unattainable targets as well as using new methods to assess the health of the
organization.
THE BANKRUPTCY OF LEHMAN BROTHERS 3
The Biggest Bankruptcy in the US History
The failure of Lehman Brothers in 2008 was the largest case of bankruptcy in US
history. But the failure was the beginning of a series of events that were yet to be unfolded. The
news and negative effects of the bankruptcy rippled through the market. The Dow Jones
Industrial Average declined by more than 500 points by the end of the trading session of the day
(Mamun & Johnson, 2012). Tremendous research has been done on the failure of Lehman
Brothers including the causes of failures and whether it could have been prevented. A
devastating report in March 2010 “recounted in minute detail the practices carried out by
Lehman Brothers, an institution founded in 1850 that declared bankruptcy on September 15,
2008. Notably, the executives were accused of “gross negligence” in their duty of disclosure”
(Morin & Muax, 2011, p. 38).
This also sheds light on unethical practices that were either
directly exercised by top managers or were supervised under their watch. Also, many blame
accounting standards and techniques and how they are used to portray financial statements as
not what they are, but how management wants them to portray. These practices leave open
windows of opportunities for those whose intentions are to misuse their position, whether it is
for personal reasons or short-term gains of the organization. In case of the Lehman it seems that
it was more of the latter. Lehman failed to disclose various transactions in the notes to their
financial statements. This may be due to negligence of accountants and auditors that leads many
to argue for the reexamination of Generally Accepted Accounting Standards (Jeffers, 2010).
Many also blame the techniques that are currently used to predict firms’ financial distress. The
numerous bankruptcies and financial difficulties that US banks went through in 2008, including
the events that analysts failed to predict, indicated shortcomings in financial analysis techniques
(Morin & Maux, 2011). This will also be discussed throughout the paper.
THE BANKRUPTCY OF LEHMAN BROTHERS 4
Causes of the Failure
There is no single cause that led to the failure of Lehman Brothers. There were
numerous causes and agents that led to the disaster, including greedy Wall Street traders, the
debt load of American households, the Fed’s action, rating agencies, and last but not least, the
deregulation (Morin and Maux, 2011). These factors were responsible for the crisis of credit and
not solely the failure of Lehman Brothers. Still, the market of Credit Default Swaps was one of
the biggest factors dedicating to the catastrophe, if not the biggest one as Lehman was heavily
involved in that market. In explaining the sub-prime market, Morin and Maux (2011) explain
that sub-prime loans
“refer to inferior quality (sub) real estate loans whose higher risk of payment
default is countered by the bank with a higher interest rate
. These mortgage loans, granted at variable
rates, were extended to American households with modest incomes” (p. 41). Morin and Maux
(2011) also discuss Lehman’s involvement in that particular market as well as how Lehman
caused erosion in that market at the same time:
The bank is accused of having sold Collateralized Debt Obligations (CDOs) to its
clients and taking short positions that effectively eroded the value of these securities. In
doing so, Goldman Sachs also helped other clients to short the mortgage bond market,
and triggered the plunge of the subprime market. Rumors of collusion between banks
soon followed (p. 41).
In a separate report and a SWAT analysis done by Datamonitor (2008), the significant
exposure of Lehman to sub-prime mortgage is explained as a threat for the organization and
criticized:
Investments in the sub-prime mortgages and mortgage backed securities are at risk of
being written off amid a crisis in the US sub-prime mortgage market. Much of that sub-
THE BANKRUPTCY OF LEHMAN BROTHERS 5
prime debt was repackaged as collateralized debt obligations (CDO’s) and mortgage-
backed securities and was sold in the wholesale market. Many of the hedge funds and
investment vehicles invested heavily in these securities and are finding them illiquid due
to the defaults in the mortgage market (p. 7).
As one might guess by now, the crisis was triggered and snowballed by what is now
known as the “subprime crisis” starting in the summer of 2007. As it was mentioned the
subprime crisis triggered the crisis in the American financial sphere, but it was soon spread to
larger financial centers, even scattering to nonfinancial institutions. The rise in key interest rates
by American Federal Reserve along with the dissipation of demand for real property fuelled an
increase in defaults on mortgage payments, leading to insolvency. Subsequently, these failures
caused a chain reaction on the markets. The failure also spread over all securitization vehicles,
in which they are designed to allow a company or a bank holding assets with little liquidity to
group them together and sell them to a specialized entity that is created for the same purpose
(Morin and Maux, 2011).
Securitization therefore enables an organization to dispose of assets while immediately
obtaining capital in exchange, a process which represents a new means of financing for
these entities. Credit then becomes liquid; however, if it is based on a poor risk,
someone will eventually have to pay the piper (p. 41).
In return and to prevent further disaster, the US government quickly responded to the
disaster and proposed a rescue plan for the banks. In early 2010, when the crisis seemed to be
dampen and there were cautious optimisms and positive signs from the American banks,
attention was shifted toward the accountability of the executives of one of the institutions being
THE BANKRUPTCY OF LEHMAN BROTHERS 6
at the center of the crisis. Morin and Maux (2011) explain the method that this unethical
behavior was taking place:
On March 12, 2010, a 2,200 page inquiry report prepared by legal expert Anton
R.Valukas revealed the extensive use of accounting manipulations that might have
largely contributed to the collapse of Lehman Brothers, which went bankrupt on
September 15, 2008. This report sheds light on the systematic use of a balance sheet
window-dressing technique called Repo 105, which let Lehman remove roughly $50
billion in commitments from its balance sheet in June 2008, and artificially reduce its
net debt level by wagering on the collateralized loan market (p. 42).
As it was mentioned the negative cash flows that Lehman was running prior to the
bankruptcy also cause Lehman not to be able to meet its at-the-time-current obligations.
Lehman was also unable to maintain confidence because a series of business conditions had left
it with heavy concentration of illiquid assets with declining values that mostly included
residential and commercial real estate. Morin and Maux (2011) state that legal experts believed
that Lehman executives deliberately manipulated information in statements. In addition, the
auditors, Ernst & Young, purposely closed their eyes to these balance sheet manipulations as
early as 2000s. They believed that Lehman significantly used Repo 105, and failed to disclose it
to the government, to the rating agencies, to its investors, and to its own board of directors, and
all in a while the auditors were aware of the situation. Morin and Maux (2011) state that
although Repo 105 was in line with American accounting standards, its purpose was to deceive
and they used techniques to reduce its reported leverage substantially.
The schemes Lehman allegedly carried out using REPO 105 therefore had a significant
impact on its balance sheet by undervaluing its liabilities. The income statement was
THE BANKRUPTCY OF LEHMAN BROTHERS 7
also affected, but to a lesser extent: financing costs were undervalued given that Lehman
did not recognize these REPO transactions as loans. However, with respect to the cash
flows involved in these transactions, inflows and outflows of funds are the same
regardless of the accounting method used (p. 42).
What Is Repo 105?
Jeffers (2011) explains repo as repurchase agreement (repo) that has historically been
used by companies to manage their short term cash. But in the Lehman case, these transactions
took an unusual spin that were intended to make Lehman’s balance sheet look healthier that
what they really appeared to be. The traditional agreements normally involve an investment
banking firm giving a counterparty highly liquid securities in exchange for cash. These are
accounted for as loans with collateral. In case the investment banking firm is not capable of
paying, the lender will sell the collateral for his money to be reimbursed.
The cash received by the company is normally repaid at a later date plus a small amount
of interest (normally 2 percent) to get the securities back. Additionally these transactions
would generally be accounted for as financing arrangements. To maintain its stellar
reputation, Lehman engaged in this common arrangement but instead of utilizing the
normal practices, Lehman employed creative but deceitful accounting practices known
as Repo 105. Essentially, Repo 105 is an aggressive and deceitful accounting off-
balance sheet device which was used to temporarily remove securities and troubled
liabilities from Lehman’s balance sheet while reporting its quarterly financial results to
the public. These transactions were recorded as sales rather than as loans (Jeffers, 2011,
p. 46).
THE BANKRUPTCY OF LEHMAN BROTHERS 8
How Lehman Used Repo 105
Even though repo 105 is a legal procedure, Lehman used it as follows, according to
Wilchins and DaSilva (2010). First, they bought government bonds from another bank using its
Lehman Brothers Special Financing Unit in the United States. Just before the end of the quarter,
the US unit transferred bonds to London affiliate, knows as Lehman Brothers International.
Then, the London affiliate gave assets to its counterparty and received cash and agreed to buy
the assets back at a later time at a higher price, at least 105 percent of the price. The money that
was received was used to cover and pay off a large amount of the liabilities. The reduction in
assets and liabilities showed healthier quarterly financial statements and corresponding ratios,
appearing much better to regulators, investors, and the general public. At the beginning of the
next quarter and with healthy-looking statements, Lehman went on to borrow more at other
lending institutions. Only then, Lehman repurchased the securities from the London affiliate at
105 percent of the original price. Having done so, the financial statements would have gone
back to the previous inferior position.
Did Lehman Violate the Sarbans-Oxely Act?
Kourabi et al., (2011) explains that the Sarbanes-Oxley Act was enacted into law in
2002 and in response to the collapse of Enron and WorldCom, following the discovery of many
accounting scandals.
The Act is designed to restore investors’ confidence, to enhance the reliability and
accuracy of the financial reporting, to improve the corporate governance system, to
improve the content and timeliness of the disclosure requirements, to strengthen the role
of the independent directors, and to improve the internal control practices and
procedures (p. 43).
THE BANKRUPTCY OF LEHMAN BROTHERS 9
Jeffers (2011) notes that even though repo 105 is a legal procedure, but if the procedure
is used to taint the fair financial position of the company with the full knowledge of CFOs and
CEOs, the executives are subject to severe financial penalties and imprisonments. In the case of
Lehman, the executives were fully aware that the Repo 105 was being used to mislead the
statements. From all accounts, it appeared that the senior management knew of the Repo 105
transactions and nevertheless, they certified the accuracy of the statements knowing that they
were inappropriate. “As a result, these executives were fully aware that the financial statements
were misleading and did not fairly present the true position of the company” (p. 53). Hence,
those Lehman executives were subjected to criminal and financial liability. With top managers
being fully aware, an accounting scandal was in the making and the Sarbanes-Oxley Act was
violated.
Complex Structure
Steinberg and Snowdon (2009) blame the Lehman bankruptcy on the complex structure
of the organization along with numerous other issues leading to the bankruptcy. Lehman
Brothers was conducting business in global scope having about 3000 legal entities which made
the situation incredibly complicated. Any organization that experiences exponential growth on
the same scale as Lehman must have a similar degree of complexity. The complexity dedicated
to the expansion and growth, and the expansion and growth contributed to the complexity. It
works both ways as one would not be materialized with the absence of the other.
Prevention
Morin and Maux (2011) analyze the financial statements of 2005 to 2007 in order to
establish whether the failure of Lehman Brothers could have been predicted. In doing so, they
mention that most analysis are centered on balance sheet that portrays the financial structure of
THE BANKRUPTCY OF LEHMAN BROTHERS 10
the company and the state of its solvency/liquidity. Income statements are also of great
importance. However, the statements of cash flows are mostly ignored by analysts. “The
statement of cash flows, which illustrates a company‘s capacity to transform its results into
cash, has been virtually ignored by analysts, who tend to focus instead on the balance sheet and
the income statement”
(p. 40).
The question in the Lehman Brothers’ case remains: beyond the
lies that were generally hidden by the top management, how could investors or auditors not
detect such warning signs? Morin and Maux (2011) examine financial statements over the three
years leading to the bankruptcy to show that such warning signs were indeed detectable. The
reason that the bankruptcy was failed to be detected was that the statement of cash flows were
not given equal weighs in comparison to other financial statements.
Although Lehman Brothers had $7.286 billion in cash and cash equivalents on
November 30, 2007, an analysis of its statement of cash flows signals major
dysfunctions in working capital management. This is particularly striking for the
financial instruments: over a three-year period, they generated net negative cash flows of
$161.657 billion (p. 40).
The shortcoming in predicating a disaster by analysis is so clear that many may believe
that analysts either did not just understand the statements or were blinded by the superficial
performance. It is also possible that holding to the minimum of standards, they simply turned a
blind eye to the warning signs. In any event, having negative cash flows must have rang a bell
about the horrible health of the organization, and it must have hinted analysts about the
superficiality of the balance sheet and income statement.
Furthermore, Morin and Maux (2011) drew a conclusion that the 2005-2007 statements
of cash flow of Lehman Brothers were reliable predictors of the coming bankruptcy. They
THE BANKRUPTCY OF LEHMAN BROTHERS 11
mention the following signs of distress to be completely detectable in Lehman’s financial
statements.
1. “Chronic inability to generate cash from operating activities” (p. 52).
2. Massive and systematic investment in working capital items and even more intensive
investments in financial tools and instruments.
3. Systematic use of external financing to offset operating deficits, in which it mainly
included long-term debt.
4. Steady deterioration of cash flows over three years leading to the crisis.
Steinberg and Snowdon (2009), members of the Lehman tax department, maintain that they
were also aware of the trouble ahead. Early in 2008, they anticipated and started planning that
they were going record net operating losses for US tax purposes for the 2008 taxable year.
Steinberg and Snowdon (2009) note that they were focused on providing tax advice for the
disposition of assets, deleveraging of the balance sheet and in structuring potential capital
transactions while also attempting to ensure the preservation of the historic and current tax
attributes such as foreign tax credit and tax net operating loss carry forwards of the company.
There were various signs of disaster looming in the near future even though the tax team was
kept in the dark about the dire situation. Since they did not know the depth of the trouble the
question in their mind was if Lehman was to be absorbed by another financial institution, or
perhaps mass layoffs, but no thoughts on filing for bankruptcy. However, due to unethical use
of accounting standards, Lehman posted net positive results and growth between 2005 and
2007. This may be the only reason these signs of distress were not visible in the income
statement. “
Analysts made recommendations and predictions based on Lehman‘s estimated earnings
per share. They therefore had their eyes riveted to the statement of income, which may explain why
Lehman‘s cash flow situation did not cause any apparent concern” (Morin and Maux, 2011, p. 52).
THE BANKRUPTCY OF LEHMAN BROTHERS 12
However, when the analysis is made based on the statements of cash flow, the financial
deterioration of the company is completely visible. The “analysis signals major dysfunction in
working capital management. This is particularly striking for the financial instruments which
generated, over a three-year period, net negative cash flows of $161.657 billion” (p. 52). What
is surprising is that the systematic payment of dividends that went on despite sizable cash
deficits was completely unnoticed by the auditors in assessing financial statements. What is
even more shocking is the financing of the dividends that was done through long-term loans,
which by itself indicates a dysfunctional cash management.
All these finding, can bring one to a conclusive result, that the failure of Lehman could have
been predicted and prevented.
Recommendations Going Forward
One can learn many lessons from a failure, especially when the failure is the biggest of
an institution in the US history. Modifying accounting practices and adding new methods of
predicting the disaster are two are two lessons to be named. Caplan et al., (2010) examined the
failure of Lehman and have suggested a few recommendations for going forward.
Avoiding Unachievable Business Strategy
Caplan et al., (2010) mention that in 2006, Lehman made a deliberate decision in
pursuing a higher-growth business strategy. To achieve their goal they switched from a low-risk
brokerage model to capital-intensive banking model that required them to buy assets and store
them as opposed to acquiring assets to primarily moving them to a third party. Having to keep
the assets internalized the risk and returns of the investments.
The mismatch between short-term debt and long-term, illiquid investments required
Lehman to continuously roll over its debt, creating significant business risk. Lehman
THE BANKRUPTCY OF LEHMAN BROTHERS 13
borrowed hundreds of billions of dollars on a daily basis. Since market confidence in a
company’s viability and debt-servicing ability is critical for it to access funds of this
magnitude, it was imperative for Lehman to maintain good credit ratings (p. 24).
In order to pursue this high growth trend they had no other option but to aggressively
target a high growth rate in revenues. But they also had to target an even faster growth in its
balance sheet and total capital base. This unreachable target led them to hold $700 billion in
assets in 2007 on equity of $25 billion with $675 billion in liabilities (Caplan et al., 2010). This
unfeasible strategy at the time also brought along higher risk because most of assets were long
term and highly illiquid. Commercial real estate, private equity, and leveraged loans were just to
name a few. As the subprime crisis unfolded Lehman had to act quickly, and that meant
liquidating a vast amount of its illiquid assets in housing mortgages. Negative perception of the
market caused the assets to be bought as even a lower price. Looking back at the events
unfolding and the strategy that Lehman chose, one may conclude that pursuing the company
strategy at any cost was absolutely wrong. There is a cost to any strategy and Lehman must
have forgone its high-growth strategy if its cost outweighed the benefits and was deemed as
unfeasible at the time.
Elimination of Dubious Accounting Practices by Holding High Ethical Standards
When achieving the planned strategy of high growth seemed unattainable for Lehman,
top managers decided to use dubious or perhaps corrupt accounting practices to reach the goal.
Using Repo 105 in its unordinary way was only one of the many wrongful practices used in
Lehman for showing healthier financial statements. Even though as it was mentioned the Repo
105 is a legal procedure, but Lehman used it in an unusual and unethical way to acquire new
loans by showing healthier than actual statements. Accounting standards open the way for
THE BANKRUPTCY OF LEHMAN BROTHERS 14
unethical managers to take advantage of these standards and practice them according to their
unethical behavior. Accounting standards must be modified to impede the unethical and
wrongful practices that could jeopardize peoples’ wealth.
Caplan et al., (2010) suggest that substance must be taken into consideration over form,
in which the fairness and the health of the organization must be judged based on the substance
of the statements and not simply the ratios inferred from them.
Auditing standards state that the auditor’s judgment should be based on whether, among
other considerations, (1) the accounting principles selected and applied have general
acceptance, (2) the accounting principles are appropriate under the circumstances, and
(3) the financial statements, including the related notes, are informative about matters
that may affect their use, understanding, and interpretation (p. 27-28).
This may put an emphasis on the going concern factor in accounting measurements. The
going concern states the health of the company in the long-run and whether the company will
survive in the long run, regardless of the current financial position. Adhariani and Masyitoh
(2010) state that going concern is one of the main decision making factors in assessing financial
decisions. The research done by Adhariani and Masyitoh (2010) shows that certain ratios and
numbers such as liquidity, profitability, and cash flow that are concluded from financial
statements are not significant to influence the issuance of audit opinion. They determine
solvability as the most significant factor.
Going concern is an extremely interesting issue to discuss. Investors, creditors and also
government are extremely interested in identifying the financial position of the
company, and one of factors brought to their consideration is the auditor’s opinion.
THE BANKRUPTCY OF LEHMAN BROTHERS 15
Opinion relevant to going concern is a red alert that financial failure in the company
comes to exist (p. 27).
Even though financial ratios are very useful in predicting the failure and success rates of
any company to maintain its going concern in the future, they are not sole indicators of the
health of the company.
As for the corporate culture that was completely stepped over in Lehman, Caplan et al.,
(2010) mention that the need for “an ethical culture is perhaps greatest when an unplanned event
occurs” (p. 29). Having to hold higher standards, individuals will hold a course of action
representing the policy of the organization.
Although the specific financial instruments that Lehman used to manage its financial
statements apply primarily to the financial services industry, the events at Lehman
provide lessons about corporate governance that apply to all organizations. First, all
parties with meaningful roles in the financial reporting process shouldn’t apply
accounting rules with the intent to obfuscate the economic substance of transactions. As
a corollary to this rule, if the transaction has no economic substance but serves only to
window-dress the financial statements, its proper disclosure will eliminate any incentive
to engage in the transaction (p. 29).
In the case of Lehman Brothers, one can see that some of the auditors, accountants, and
top managers failed to practice high ethical standards, even though they might have practiced
the minimum required to be shielded from legal actions.
Alternative Theoretical and practical financial distress prediction models
Morin and Maux (2011) dispute the methods that are currently being used by analysts
for predicting financial distress. Instead, they state that the Altman financial distress prediction
THE BANKRUPTCY OF LEHMAN BROTHERS 16
model can provide a clearer and more complete picture, and they provide quantitative evidence
to prove it. They conclude that Lehman’s coefficient was well below 1.81, which is Altman
model’s threshold of financial distress. It is worth noting that Lehman’s average coefficient over
three years leading to the failure was 0.0897 which supports the observation. Altman formula
demonstrates that the ratios of internally generated funds to total debt and the return on equity
(ROE) are better predictors of financial distress than the liquidity ratios. “The main advantage
of discriminant analysis is that it can deal with several variables that define the complete profile
of a firm rather than simply analyzing one factor” (p. 44). In inferring to his conclusion, Altman
grouped 22 independent variables into 5 groups: liquidity, profitability, lever effect, solvency,
and activity ratios, and in studies done by Altman himself, it has been a great indicator of
financial distress. “Altman looked at the relevance of the ratios and their correlation. The
integration of these five variables in a single equation yielded the greatest success rate for
predicting financial distress” (p. 44).
Concluding Remarks
The failure of Lehman Brothers was contributed to numerous factors that went in
parallel to contribute to the biggest bankruptcy in the US history. They went hand in hands
because no single factor could have brought this disaster by itself. Dubious and doubtful
accounting practices could not be possibly practiced in the long run if not for low ethical
standards held by top managers as well as the auditors. It seems as if auditors mainly tried to
shield themselves from legal action just by executing the minimum requirements expected from
them. The Repo 105 procedure is nothing but an ordinary and legal practice for short-term
financing that was taken out of its context by unethical accounting practices in order to please
investors and lenders. The complex structure of Lehman also provided a window of opportunity
THE BANKRUPTCY OF LEHMAN BROTHERS 17
for the same unethical managers to abuse the trust that was placed in them, the organization, and
management by investors and shareholders. It can also be concluded that the Sarbanes-Oxley
Act was violated because top managers deliberately tainted the financial statements to falsely
show the health of the company to be better than what it really was at the time. Once these
managers were incapable of reaching their growth and expansion rate they had to inflate their
financial statements to keep the appearance of a company with high rate of growth.
For Lehman, the mistake lay in putting too much faith in an outmoded culture and
failing to see how its very strength undermined the business. For companies that
confidently set out to change their cultures, the Lehman experience offers a lesson about
the nature of corporate culture itself—it can be much stronger, more deeply embedded,
and far less malleable (Greenfield, 2010, p. 36).
The main signal of deficiency in the organization came from the net negative statements
of cash flows, nevertheless, auditors failed to recognize the lack of correlation between the
statements of cash flow with balance sheet and income statements. Auditors failed to recognize
that the net negative statements of cash flows reflected the financial standing of the company.
This highlights yet another conclusion that is drawn from the paper. The current analytical and
rating methods have sufficient shortcomings and the case of Lehman is prominent evidence.
Studies show that the Altman’s z-score test may be complementary in predicting the crisis in the
making.
At the end, Lehman’s failure had an impact beyond expectations. The consequences did
not just leave its negative print on the economy but also on the society with the lost confidence
in institutions and corporate culture. As Greenfield (2010) mentions, “one must wonder when
businesses and their executives will realize that their activities can significantly impact the very
THE BANKRUPTCY OF LEHMAN BROTHERS 18
fabric of human society” (p. 54). In any event, holding higher standards and ethical culture by
auditors, managers, and rating agencies are essential in avoiding this sort of disaster.
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Wilchins, Dan & DaSilva, Silvio (2010). Graphic: How “Repo 105” Worked,
blogs.reuters.com/reutersdealzone/2010/03/12/graphic-how-repo-105-worked/
... Traditionally, the bank would manage its short-term cash using repurchase agreements. However, in 2007, the transactions took an unusual spin that made the balance sheet look healthier (Azadinamin, 2013). It was, therefore, an accounting gimmick that allowed Lehman to classify short-term loans as a sale. ...
... The repo transactions are not illegal, but Lehman tailored them in a manner that effectively overstated its financial position. The senior executives were fully aware of the transactions' impacts but did not disclose them in the annual reports (Azadinamin, 2013). It misled the users of the statements by misrepresenting the true position of the bank. ...
... It misled the users of the statements by misrepresenting the true position of the bank. Therefore, the bank violated the Sarbanes-Oxley Act, aiming to restore investor confidence (Azadinamin, 2013). The law requires firms to improve the quality of their financial statements by providing all the information relevant to users. ...
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This study assessed the failure of the Lehman brothers. The aim was to evaluate the causes of Lehman's bankruptcy and determine the strategies that could prevent bankruptcy in the banking sector going forward. Findings indicated a close relationship between regulations and the actions of management. In particular, the failure of Lehman showed that regulation and supervision are critical to the success and continuity of the banking sector. The analysis also showed that the demise of Lehman was a result of complex factors. These included unethical management practices, deregulation, excessive risk-taking, poor corporate governance structure, fraud, and lack of a robust ethics code. Keywords: Derivatives, Hedging, Subprime Mortgage, Bankruptcy.
... Our examination in particular concerns the credit component, also known as CVA. While the collapse of Lehman Brothers [3] is likely the most ill-famed credit event in popular culture, credit events are anything but a rare occurrence in finance. The credit crisis of 2007 and collapse of Lehman Brothers in 2008 brought to attention systemic risks in the financial markets and the need for better modelling of risks. ...
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A critical problem in the financial world deals with the management of risk, from regulatory risk to portfolio risk. Many such problems involve the analysis of securities modelled by complex dynamics that cannot be captured analytically, and hence rely on numerical techniques that simulate the stochastic nature of the underlying variables. These techniques may be computationally difficult or demanding. Hence, improving these methods offers a variety of opportunities for quantum algorithms. In this work, we study the problem of Credit Valuation Adjustments (CVAs) which have significant importance in the valuation of derivative portfolios. We propose quantum algorithms that accelerate statistical sampling processes to approximate the CVA under different measures of dispersion, using known techniques in Quantum Monte Carlo (QMC) and analyse the conditions under which we may employ these techniques.
... The reduction in assets and liabilities created the impression that the Lehman financial statements were much better. When the reporting period finished, the bank repurchased the securities and its financial statements went back to the previous inferior position (Azadinamin 2013;Hines et al. 2011;Jeffers 2011). ...
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Every financial crisis triggers some regulatory and supervisory changes related to the ensuing threats. These regulations usually address specific types of risks and reduce them but do not protect the entire system from another crisis. The aim of this study was to develop a conceptual framework of financial system resilience based on the theoretical approach of complex system theory and its explanation of these systems' self-adaptation. Our analysis embraces the time since the 2008+ financial crisis in the United States. We argue that the digitalization of financial markets may contribute to the greater safety of the banking sector. We adopted blockchain technology for the pattern of self-modification mechanisms of the financial system. The main findings highlight that the blockchain technology incorporated into the system approach and applied to financial regulation and supervision can significantly improve the safety of the financial markets.
... E&Y didn't even look at whether the volume of Repo 105 transactions was material to Lehman's balance sheet and net leverage ratio. E&Y personnel claimed that they only agreed to the accounting treatment applied to the transactions, but didn't actually look at the transactions themselves, their overall impact on the financial statements, and the real reason why they were used [24]. ...
... Failure of proprietorship and partnership involves pushing the economy downwards but loss is restricted to only a few owners of these businesses. When it comes to the corporation, where public investment is part of the organization, investors and potential investors have the right to know about any ongoing concerns of the businesses (Azadinamin 2012). Moreover, Ejaz et al. (2020) suggested that globalisation, high communication technology and advent of multinational companies generate an important influence in reducing international investment blockades. ...
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This study investigated the financial signals that have been ignored or have failed to be controlled by J. Crew Inc. from 2013 until 2019. Exploratory research is carried out with the help of secondary data which was collected from the downloaded formal documents submitted by J. Crew Inc. to the Securities Exchange Commission (SEC). Researchers analyzed these documents and prepared statements on vertical income statement, vertical balance sheet, horizontal income statement, horizontal balance sheet, trend analysis of income statement, and trend analysis of balance sheet, as well as ratio analysis on liquidity, long-term solvency, profitability, and turnover ratios with the help of excel. This paper has identified total of 15 alarming signs that companies either ignored, could not control, or did not act with alertness towards to stop the business being taken out of hands. In this research paper, the establishment of J. Crew Inc. was presented in four sections: Crew Retail Stores, Crew Factory Stores, Crew Mercantile Stores, and Crew Madewell Stores. The results of this study show that it was not the COVID-19 pandemic that pushed this retail giant into bankruptcy, but numerous reasons and financial turbulences. J. Crew's financial performance gave plenty of alarming signals that the showed the company was not on track, but these were ignored by the company. Right from net profit, operating expenses, total revenue, goodwill, return on assets, liquidity, and solvency, all 15 indicators were not meeting the industry ideal standard for a continuous period of 5 years. Whether or not the organization can rebuild and contend in a post-pandemic world, is not yet clear.
... Almilia (2006) concluded that the results showed that the financial ratios from the income statement, balance sheet and cash flow statement have a significant influence in predicting financial distress. Azadinamin (2013) in his study entitled "The Bankruptcy of Lehman Brothers: Causes of Failure & Recommendations Going Forward" concluded that the negative cash flow during the three years was the main reason for the bankruptcy of Lehman Brothers. Altman (1968) used financial ratios in his bankruptcy prediction model to produce an early warning system for the companies. ...
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Purpose- With the bankruptcy of many large companies in recent years especially after the global financial crisis in 2008, the attention to bankruptcy prediction models has increased dramatically. The aim of this study is to examine the financial soundness of the companies listed in the mobile telecommunication sector in the Kuwait stock exchange (KSE). Methodology- Many bankruptcy models were developed as an early warning systems for any distress a company might face. This paper uses one of the most common models, Altman Z-score model, to examine the likelihood of bankruptcy and the financial soundness of mobile telecommunication companies listed in Kuwait stock exchange market during the period from 2013 to 2016. Findings- The results showed that out of the three companies operating in Kuwait, only one of them had a healthy financial position while the other two companies are facing financial distress. Conclusion- The study found that mobile telecommunication companies in Kuwait are facing the risk of bankruptcy due to their negative working capital which makes them vulnerable to any unexpected short-term obligations. As a result, these companies should work to reduce the gap between their current assets and current liabilities
... One of the fundamental ones of those was the failure of the trust system in banking. The fall of the giants like Lehman Brothers [2] and the cessation of the Fannie Maes and Freddie Macs [3] of the world simply eroded the concept that 'banks can be trusted with public money'. The crisis warrants the question: how can trust be reborn into financial systems? ...
... Nevertheless, many companies experiencing financial distress can be rehabilitated for the benefit of bondholders, stockholders, and society. Related to the bankruptcy suffered by Lehman Brothers, Azadinamin (2013) concluded that the signs of bankruptcy can be detected from the financial statements, including: ...
Article
This study aims to identify suitable financial distress prediction model for companies in Indonesia. The population and samples used in this study are listed companies with the data range from 2006 to 2015. Samples were selected in a purposive manner at some stage. The first stage of study was choosing a company with negative earnings for two consecutive periods in the study period with total assets of around IDR1 trillion to IDR5 trillion. For a comparison, the researcher chose companies with positive earnings by the same criteria. As independent variables other than using financial ratios, variable corporate governance with ownership structure and macro-economic variables were also used as representation of conditions faced by companies in Indonesia. Analysis method used in this study was Binary Logistic Regression Analysis. The research found financial distress prediction influences by: Working Capital to Total Assets; Current Ratio; Book value of equity to total liabilities; Total Debt to Total Assets; EBIT to Current Liabilities; and Institutional Ownership.
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This study presents empirical evidence on the effect of the Sarbanes-Oxley Act (SOX) of 2002 on the corporate value and performance. The study analyzed the financial data of 117 public companies listed in Standard & Poor's (S&P) 500 Index, and which were the only companies listed in this index during the period 2000-2008, after excluding other financial companies due to their characteristics which made them unfit for the study. It was concluded that SOX has a significant negative effect on the corporate value, and no impact on corporate performance.
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This paper investigates the impact of the Sarbanes-Oxley (SOX) Act on the quality of financial statement information. Where other papers have only investigated the short-term effects of SOX, this paper takes a longer post-SOX period. A distinction is also made between technology and non-technology based firms. Earnings management, conservatism and value relevance measures were used in order to examine the impact of SOX on accounting quality. A significant increase was found on both the earnings management and value relevance measures, which was persistent over a four-year post-SOX period. On the contrary, a slight increase in conservatism was observed, however these results are not significant. Moreover, the technology based firms score worse on the earnings management measure, thus, the separate investigation between technology and non-technology based firms has revealed interesting information which would otherwise have stayed undetected.
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The failure of Lehman Brothers in 2008 was the largest bankruptcy in US history. Financial markets did not respond well to the news of this bankruptcy filing as the Dow Jones Industrial Average (DJIA) declined by more than 500 points by the end of the trading session that day. We identify key dates surrounding the final months of Lehman Brothers’ existence and study the wealth effects experienced by shareholders of other financial institutions’ stocks. At one of the first signs of trouble for the 158 year old investment bank, we find that when Lehman Brothers announced their first quarterly loss, the stocks of depository institutions and primary dealers declined. Ultimately, on 15 September 2008 when Lehman Brothers filed for bankruptcy, the stocks of banks and primary dealers declined by −2.90% and −6.00%, respectively, and were the biggest losers that day. We also study how the size of the depository institutions may have played a role in the adverse effects they experienced surrounding Lehman's troubles. We present evidence that it was primarily large banks, savings and loans and brokerage firms who were impacted the most.
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Lehman Brothers made many disastrous business bets that could have been avoided. Hope Greenfield, who served as Chief Talent Officer at Lehman Brothers for 7 years, offers a deeper look at the culture that allowed the disaster to occur. Beyond faulty risk models and stereotypes about greedy Wall Streeters, Greenfield shows that the Lehman story illustrates the truth of a little-remarked phenomenon of organizational development: the very attributes of a corporate culture that underlie a company's success often carry the seeds of destruction.
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Going concern is one of essential things for user to make a financial decision. This research is aim to explore factors that caused the issuance of going concern audit report by auditor. This research adds two new variables, audit size and audit committee, besides the other factors that cause auditor issue a going concern audit report. This research uses a Regression Logistic Analysis to determine the relationship of each variable (liquidity, solvability, profitability, cash flow, audit firm size, and audit committee) to going concern audit report. Different from previous researches, the results of this research show that liquidity, profitability, cash flow, and audit committee are not significant to influence the issuance of audit opinion. Audit size has a more significant relationship to audit opinion, while solvability is the most significant factor.
Managing the bankruptcy of Lehman Brothers
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