Risk Management: An Analysis of the Failure of Lehman Brothers

This report provides a comprehensive analysis of the Lehman Brothers case study, focusing on the financial risks that led to the firm's collapse. It delves into the use of financial models, such as the Repo 105 model, and how these contributed to underestimating and mispricing risks. The report examines the various financial interdependencies and the impact of globalization, highlighting the specific reasons behind Lehman Brothers' failure, including the lack of a buyer, balance sheet issues, and political factors. Furthermore, it explores the strategies and safeguards that companies can implement to mitigate model risks and prevent similar crises, such as limiting personal guarantees, restructuring business models, transferring risk, and performing thorough risk analyses. The analysis emphasizes the importance of differentiating between uncertainty and risk in the risk management process, offering valuable insights into financial stability and risk mitigation.

Running head: RISK MANAGEMENT
Risk management
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Introduction
Financial models are widely criticized for underestimating and therefore mispricing the
risk prior to the crisis. Statistical pricing and risk forecasting models played an important part in
the build up to the current crisis. The essay has highlighted the case of Lehmann Brothers of
USA. The firm had to face a number of different difficulties during its course of business and
was successful in achieving its goals. The company survived every possible disruptions
including the Great Depression of 1930’s, bankruptcies of the 1800’s, capital shortage, two
world wars and the debt default of Russia. But every business had its end as the company got
stuck in the collapse of the US housing sector. The failure of the company was due to a number
of different reasons that took a toll on its survival.
Financial Risks involved
Over the time the market prices lose the connection with the basic ideas. This leads to the
collapse in the prices of the products and services and in turn increases the perceived risks
subsequently. The following process is reinforced by the external changes in the behavior of the
participants of the market. For example the margin requirements during times of financial
turmoil can lead to the fall in the prices of the goods and services. Globalization has brought in a
number of financial interdependencies among the different kind of organizations especially
banks, financial institutions and other companies that transacts money. However such
organizations are prone to risks as too many interdependencies can lead to defaults and failures
exactly in the case of Lehman Brothers1.
1 Elliott, M., Golub, B. and Jackson, M.O., 2014. Financial networks and contagion. The
American economic review, 104(10), pp.3115-3153.

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Financial modeling is the task involved in the setting up of a model that revolves around
the financial decision making situation. Repo 105 model can be used as the model to determine
the failure of Lehman Brothers. The following model is referred too as an accounting trick in
which the company classifies a short term loan as a sale and accordingly uses the cash proceeds
from the sale in order to reduce the liabilities of the company. The sudden collapse of the
mentioned financial firm in the month of September 2008 is seen as the trigger for financial
crisis that put an end to the lending activities. However a new report says that the officers of
Lehmann Brothers intentionally concealed the facts about the risks that they had taken from the
market in an extraordinary manner. Such concealing activities made up a new financial term
named Repo 105. The firm had appointed different accountants and financial experts to make
sure that they present a false image of their position to the people. The management of the
company wanted to make the borrowings from the market look not to be borrowing so much
money, rather it used a special technique to avoid this particular rule. It invested in repo deals
where it took slightly less cash than the net worth of the particular asset.
This gap allowed the management of Lehman to record the transaction as it had been a
original sale of the bond. However it agreed upon repurchasing the bond within a week or two.
However Lehman did not repurchased the bond and used the technique of Repo 105 to move to
$50 billion off of its own balance sheet. Moreover the management of the company also did not
mention the use of the following technique to the government and the rating agencies. It also did
not disclose the facts to the board members as well as the investors and thus created a huge gap
of communication between the concerned parties and the management of the organization. The
main task was allocated to the accounting firm named Ernst and Young who was in charge to

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maintain the accounting department of the firm2. The company was aware of the use of Repo 105
by the mentioned organization but failed to keep a proper check on the amount of use by the
following bank. The company did not approved the use of the financial model nbut rather used
them for making the auditing purpose easier.
The range of relevant safeguards that can be put in place to mitigate model risks
Taking the example of the failure of Lehmann Brothers the companies are now adapting
new strategies to make sure that they have a proper safeguard policy in place which will be
helpful to prevent them from possible model failures. The businesses face different risks but can
reduce the risks and their personal liability by means of specific risk reduction measures. These
risk reduction measures involves the development of the products, creation of new and
innovative products, upgrading the old products and many more as such.
1. Limiting the Personal Guarantees- The owner of the business or the company must
protect the personal assets of the company and limit the number of personal guarantees
that are issued as collateral for the different financial uses of the company like obliging
the different financial payments and obliging the performance bonds of the company. The
Organizations have the ability to procure the bonds or the equivalent protection without
the use of a personal guarantee at the time when the bonds are not guaranteed statutorily.
2 Kidwell, D.S., Blackwell, D.W., Sias, R.W. and Whidbee, D.A., 2016. Financial institutions,
markets, and money. John Wiley & Sons.

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2. Business Structure- The business structure must be transformed from a single ownership
in which one of the person is directly liable for business operations to a corporation or a
limited liability company where the owner have a very limited power.
3. Transferring Risk- The risks of the company must be passed on to insurance companies
and other parties with much higher benefits. These helps to reduce the financial risks
especially in cases of fire, theft and damage to the products or the manufacturing units.
4. Perform a risk analysis- The performance of a risk analysis must be based on the
evaluation of the risky activities and the likelihood of the impact occurring and the
different benefits on the risky activities. The organizations must also avoid risks by not
carrying out undertaking the tasks that are deemed to be risky.
5. Transfer the risk- The most important task of the management of the organization is to
transfer the risk of the task that have a high chance of frequent occurrence and the risky
activities must be assigned to be solved or tackled by other companies which are experts
in their own fields3.
6. Reduce risk- The risk involved in the failure of the product and warranty claims are
implemented in the form of a quality assurance program. The risks can be reduced by
development of a system to report the feedbacks of the customers and accordingly
identify all the existing problems.
3 Pleune, T., 2017. Operational Risk Management. In Commercial Banking Risk
Management (pp. 121-134). Palgrave Macmillan US.

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7. Reduce risk of surprises- Risk of Surprises can be reduced by keeping an exact figure
of the records and by implementing effective controls. It can also be reduced by putting
in place a system that can limit the usage of the particular actions and the amount they
spend. It can also evaluate the controls and reporting system by comparing the control
process and the actual profit and performance of the system4.
8. Reduce financial risk- The reduction of the financial risk of the organization is another
main task of the management of the business organization. The management must reduce
the outstanding balances and must determine the credit liabilities of the organization5.
The management must also implement the credit and the payment standards and ask for
the payments of the consumers of the companies or ask for payment from the consumers
who are generally prone to miss the standards required in the industry6.
9. Reduce other financial risks- The other financial risks include reducing or paying the
full amount of the outstanding loans. The growth rate must be controlled in such a way
that the company has the capability to manage its finance easily and can finance
internally. If the company is unable to pay off the loans they tend to replace the short
4 Wiggins, R.Z. and Metrick, A., 2014. The Lehman Brothers Bankruptcy B: Risk Limits and
Stress Tests.
5 Meunier, P.P. and Bakker, A., 2016. How to turn uncertainties of operational risk capital into
opportunities from a risk management perspective.
6 Fleming, M. and Sarkar, A., 2014. The failure resolution of Lehman Brothers, Federal Reserve
Bank of New York. Econ Policy Rev. March, 31.

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term credit with the long period credit loans. According to Stephen and Peter (2014) The
differentiation between uncertainty and risk has been the fundamental concept in the risk
management process even in the present day. The economic factors and the uncertainty
and risk that exist in today’s world are analyzed in this part7.
Reasons behind the failure of Lehman Brothers
The following paper has discussed about the reasons behind the failure of the Lehman
brothers in the market8. The paper analyses the reasons as well as the possible tasks that could
have prevented the organization from failure9. Some of the original reasons behind the failure of
the Lehman Brothers were as follows,
1. There Was No Buyer
The most key problem was the absence of a proper buyer for the products in the market.
There were other such institutions which faced similar crisis situations. The most notable among
them were organizations like Bear Sterns, Washington Mutual, Merill Lynch and Wachovia. But
these companies had a stark difference with Lehman Brothers as these companies were not
declared bankrupt and they survived the initial scare of being bankrupted. However Bank of
America showed some interest in buying Lehman Brothers but instead opted out for Merill
7 Fleming, M. and Sarkar, A., 2014. The failure resolution of Lehman Brothers, Federal Reserve
Bank of New York. Econ Policy Rev. March, 31.
8 Mensah, J.M.K., 2015. The failure of Lehman Brothers: causes, preventive measures and
recommendations. Browser Download This Paper
9

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Lynch. In another development Barclays tried to buy the company but backed up after the
balking from the British Regulators10.
This is one of the most important points as because the U.S regulators of the mentioned
financial institution believed that a deal or an agreement could be reached upon which would
help the organization to sail on the turbulent waters in the market. However the management of
Lehman was reluctant and never wanted to save the firm11. Another option to save it was
acquisition which was also not practiced by the organization. Finalizing the deal with Barclays
was almost done but it got screwed up by the interference of the British regulators. If the British
regulators allowed the acquisition to proceed, then no debate topics could have been present
now.
2. Its Balance Sheet Was a Disaster
The absence of potential buyers meant the only possible way to save the institution was the
support of an emergency loan to help the institution stand up tall in the crisis moment. However
the Federal Reserve refused to grant the loan as because they estimated that Lehman did not have
the strong collateral to repay back the loan and it would bring in additional misery for the
10 Acharya, V.V., Pedersen, L.H., Philippon, T. and Richardson, M., 2017. Measuring systemic
risk. The Review of Financial Studies, 30(1), pp.2-47.
11 Harris, R., 2013. Warning Signs Prior to the Financial Crisis of 2008: A Comparative
Analysis. Journal of Management & Engineering Integration, 6(1), p.88.

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Federal Reserve. Thus the Federal Reserve was wise enough to not grant the loan as its
calculations showed that Federal Reserve would be open to a significant loss while trying to
revive an organization that would fail the either way.
3. There Was No Political Palatability for Bailouts
There was no politically desirable option for the organization as because the common
people were becoming utterly impatient about the financial company. The idea about the
reserve or any other institutions will come forward and save the firm were considered void
by the people. The loss of the company was considered to be insignificant with the presence
of a proper acquirer.
4. Its Failure Wouldn't Directly Affect Average Americans
The time when it came to AIG, no other reasons mattered. The company was bailed on the
day when it failed to generate the amount needed to survive in the market. It also failed to have
any buyer and the annual balance sheet also was in a mess. The losses were significant and it
failed to stand up which resulted in its closure. The politics that existed in the field were quite
different from the other companies in the market12. The failure of the mentioned financial
institution would directly and indirectly affect the institutional investors and the ones who had
acquired the shares of the company. However on the other hand failure of AIG would directly
affect the Americans.
12 CHENG, I.H., Hong, H. and Scheinkman, J.A., 2015. Yesterday's heroes: compensation and
risk at financial firms. The Journal of Finance, 70(2), pp.839-879.

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After the failure of the Lehman Brothers the other financial institutions of the world
realized the problems and had to undergo a sea of change to meet the new challenges in the
market. Standing in such a tough time the failure of one or more organizations could be
devastating for the economy of U.S.A.
The impact of the bankruptcy has been analyzed widely. The different studies related to
the bankruptcy have provided solid evidence to the effect of such an event and the impact of the
same on the stock markets. Some other studies also assessed the failure of the financial
institution in the Chinese stock market and concluded that the impact was very much
insignificant. While analyzing the impact of the bankruptcy of Lehman Brothers on the
structure of ISE-100 benchmark showed a increase in the deviation on the following benchmark
that is ISE-100. CNN New York estimated that the failure of the mentioned financial institution
was one of the major sources that led to the worst performances of large markets across the
globe. New York Dow Jones closed 504 points below or 4.4% below the average which was the
largest fall in the last seven years, while NASDAQ on the other hand dropped by 3.6% which
was the largest fall since 20003. Even the European stock market suffered as a result of such a
large failure o0f a financial institution which had its roots all over the world. The FTSE index of
London fell by 3.92% and the Paris CAC fell by 3.78% which was by far the worst performance
of these stock indexes.
The sudden fall in the price of the shares of the company spelt doom for many investors and
there was a sudden crash in the economic system of the country13. The indicators of a healthy
13 Rajan, U., Seru, A. and Vig, V., 2015. The failure of models that predict failure: Distance,
incentives, and defaults. Journal of Financial Economics, 115(2), pp.237-260.

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economy like modern living, purchasing power and other factors were clearly violated. The
bankruptcy of the financial institution that is mentioned here has had dire effects on the investors
and the other parties that were concerned with the following. The day after the firm declared
itself bankrupt the reserve fund minimum average value stood at just $1, an incident referred to
as “breaking the buck”14. This was mainly because the amount held US$785 million in the
organizations securities held in securities of debts on the day before the organization filed for
bankruptcy. The US Securities and Exchange Commission on May 5, 2009, filed a suit against
Reserve Management Company Inc., its Chairman, Vice Chairman and President, and Reserve
Partners, Inc., and alleged their failure to provide important documents in times of need
including investors, the Fund's board of trustees, and the rating agencies and as a result submitted
a lawsuit for financial bankruptcy. The suit was capable to enforce the fund to increase the
distribution of the remaining assets of the funds15. The reserve fund was clear of different fraud
charges that were imposed on them but on the other hand, Reserve Partners, Inc and Reserve
Management Company, Inc were found guilty of committing illegal transactions with Lehmann
Brothers. The investigating court however ordered the remaining assets of the organization to be
distributed among the shareholders of the business16.
14 Rajan, U., Seru, A. and Vig, V., 2015. The failure of models that predict failure: Distance,
incentives, and defaults. Journal of Financial Economics, 115(2), pp.237-260.
15 Sornette, D., 2017. Why stock markets crash: critical events in complex financial systems.
Princeton University Press.
16 Fleming, M.J. and Sarkar, A., 2014. The failure resolution of Lehman Brothers.

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There are several models for forecasting the financial bankruptcy of the banks over the years.
But the negative factor lies in the fact about the short time for the stakeholders to change the
particular situation in the market. The final model includes the expectations from the market and
the sector variables. The variables are statistically tested and the problems are assessed the
recommendations are provided to improve the particular situation. The following research has
identified the existence of the financial distress that exists in more than 96% of the companies
that went bankrupt. The paper by (sun et al. 2016) has discussed about the particular hypothesis
that exists within the structure and the main causes that leads to the failure of the models17.
In a similar incident the then CEO and the president of the federal agricultural mortgage
corporation, pointed out that that the third part of the company quarter in the year 2008 earnings
conference would have to abide by the rules of the statutory guidelines and provide a hefty sum
of US $52.4 million in the company debt as a result of the bankruptcy18. The mentioned company
has also used the $22 billion hedge funds in the form of assets to ensure the safety the trading
and borrowings. The acquisition of the mentioned company’s business in London by the
responsible organization behind the probe of the bankruptcy by the US holding company resulted
in the freezing up of the accounts of Lehman.
17 Sun, J., Li, H., Huang, Q.H. and He, K.Y., 2014. Predicting financial distress and corporate
failure: A review from the state-of-the-art definitions, modeling, sampling, and featuring
approaches. Knowledge-Based Systems, 57, pp.41-56.
18 Lehner, O.M., 2014. Finance, risk and accounting perspectives.

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The failure of the hedge funds to carry out the burden of bankruptcy showed the over
dependence on the management of Lehmann Brothers19. Thus it can be assessed that taking
decisions of investment must be done carefully and it should not be based on only confidence
and trust on the business and the management. The decisions rather must be based on the
performance of the business and the investments that have been done in the business in the past,
present and the future. However in cases like the one mentioned in the assignment decisions
must not and should not be taken just based on past performances of the investments done. There
are instances on the global front where hugely successful business have reaped huge revenue on
the investments but have failed in the long run20. Similarly the person or an organization must
think a thousand times, analyze the situation and the market, analyze the performance of the
business, should have a clear and transparent idea on the future course of business and most
importantly must have a provision of backup in case of the business failure.
19 Bingham, N.H. and Kiesel, R., 2013. Risk-neutral valuation: Pricing and hedging of financial
derivatives. Springer Science & Business Media.
20 Gehrig, T. and Haas, M., 2016. Anomalous Trading Prior to Lehman Brothers' Failure

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Bibliography
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risk. The Review of Financial Studies, 30(1), pp.2-47.
Bingham, N.H. and Kiesel, R., 2013. Risk-neutral valuation: Pricing and hedging of financial
derivatives. Springer Science & Business Media.
CHENG, I.H., Hong, H. and Scheinkman, J.A., 2015. Yesterday's heroes: compensation and risk
at financial firms. The Journal of Finance, 70(2), pp.839-879.
Elliott, M., Golub, B. and Jackson, M.O., 2014. Financial networks and contagion. The American
economic review, 104(10), pp.3115-3153.
Fleming, M. and Sarkar, A., 2014. The failure resolution of Lehman Brothers, Federal Reserve
Bank of New York. Econ Policy Rev. March, 31. ()
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Gehrig, T. and Haas, M., 2016. Anomalous Trading Prior to Lehman Brothers' Failure.
Haimes, Y.Y., 2015. Risk modeling, assessment, and management. John Wiley & Sons.
Harris, R., 2013. Warning Signs Prior to the Financial Crisis of 2008: A Comparative
Analysis. Journal of Management & Engineering Integration, 6(1), p.88.
Kidwell, D.S., Blackwell, D.W., Sias, R.W. and Whidbee, D.A., 2016. Financial institutions,
markets, and money. John Wiley & Sons.

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recommendations. Browser Download This Paper.
Meunier, P.P. and Bakker, A., 2016. How to turn uncertainties of operational risk capital into
opportunities from a risk management perspective.
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Pleune, T., 2017. Operational Risk Management. In Commercial Banking Risk Management (pp.
121-134). Palgrave Macmillan US.
Rajan, U., Seru, A. and Vig, V., 2015. The failure of models that predict failure: Distance,
incentives, and defaults. Journal of Financial Economics, 115(2), pp.237-260.
Sornette, D., 2017. Why stock markets crash: critical events in complex financial systems.
Princeton University Press.

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Sun, J., Li, H., Huang, Q.H. and He, K.Y., 2014. Predicting financial distress and corporate
failure: A review from the state-of-the-art definitions, modeling, sampling, and featuring
approaches. Knowledge-Based Systems, 57, pp.41-56.
Wiggins, R.Z. and Metrick, A., 2014. The Lehman Brothers Bankruptcy B: Risk Limits and
Stress Tests.