Wall Street Crime and Punishment: When Lehman Brothers Collapsed And The Economy Followed

Does crime pay?

Wall Street Crime and Punishment is a weekly series by Benzinga's Phil Hall chronicling the bankers, brokers and financial ne’er-do-wells whose ambition and greed take them in the wrong direction.

The newly terminated employees from Lehman Brothers slowly marched in groups of fours and sixes from the elevators of their towering glass skyscraper through the building’s lobby and onto Manhattan’s Seventh Avenue, swaying a slow, numb procession, shell-shocked warriors moving from one battleground to another.

Their workspace possessions — framed photographs, plaques, knick-knacks, small plants and folders overflowing with papers — were clustered together in a haphazard manner and hurriedly put into cardboard boxes and plastic bags collected from lunch deliveries.

The ebb and flow of Seventh Avenue’s pedestrian traffic barely noticed this flotsam cast into the open air, and few in the Lehman Brothers refugee stream seemed cognizant of the noise and commotion that midtown Manhattan had to offer. They were still too shocked to comprehend what occurred.

Despite the C-suite’s Micawber-worthy hope of something better on the way, there was no white knight to save Lehman Brothers and the workers knew the firm’s demise had no longer become a case of “if” but “when.”

But what they could not wrap their minds around was the “how”: Lehman Brothers was supposed to be indestructible, like Egypt’s pyramids and China’s Great Wall, standing forever as a testament to man’s genius. It was supposed to be a corporate story without an ending, and certainly not one as ignoble and humiliating for those whose careers were quickly stuffed into flimsy boxes and tacky bags.

But Lehman Brothers did fall, shattering in the self-immolation of cupidity and stupidity. And when it crashed, its collapse resonated around the world.

When Cotton Was King: The Lehman Brothers odyssey did not begin amid Manhattan’s concrete canyons, but rather in the dusty confines of Alabama’s capital city of Montgomery in 1844, when a young German-Jewish immigrant named Hayum Lehmann arrived with limited English skills and limitless energy. Reinventing himself as Henry Lehman, he managed to save enough funds to open a dry goods shop in 1847. His siblings Emanuel and Mayer joined him in Alabama, both adapting the Lehman surname to enable the new Lehman Brothers brand.

The enterprising trio found their way into the South’s lucrative cotton business, initially by serving as cotton factors who coordinated the sale of the valuable cash crop on behalf of planters and later as traders of the profitable commodity.

Henry Lehman only enjoyed the early rewards of this endeavor — he died from yellow fever in 1855 at the age of 33 — but Emanuel and Mayer grew the business further, taking advantage of enslaved labor to solidify their financial foundation.

Emanuel relocated to New York City in 1858 when the rumblings of a war between the states forced the relocation of the majority of U.S. cotton trading to the North. When war finally broke out in 1861, the Lehmans teamed with a cotton merchant named John Durr who helped circumvent the Northern efforts to halt cotton sales from the secessionist Southern states.

In the aftermath of the Civil War, Lehman Brothers moved its headquarters to New York City, leaving the Southern-based operations under the control of Benjamin Newgass, the brother of Mayer’s wife Babette. While the Lehmans offered input with the creation of the New York Cotton Exchange in 1870, they eventually looked beyond that commodity and expanded into investment banking.

Over the decades, Lehman Brothers was responsible for enabling a parade of promising corporations to become publicly-traded, beginning with International Steam Pump Company in 1899 and later followed by Sears, Roebuck and Company, F.W. Woolworth Company, May Department Stores Company, Gimbel Brothers, Inc., R.H. Macy & Company, The Studebaker Corporation, the B.F. Goodrich Co., Radio Corporation of America (RCA) and Digital Equipment Corporation.

The company underwent leadership changes over the years, with the Lehman family eventually losing control of the reins. A 1984 to 1994 union with American Express Company AXP that was later joined by E.F. Hutton nearly erased Lehman Brothers’ distinctive personality, but it managed to emerge by the end of the 20th century as one of the most powerful and influential U.S. financial services firms.

Mayer and Emanuel Lehman; no photograph or portrait of Henry Lehman is known to exist.

The Loan Wolf: In 1997, Lehman acquired Aurora Loan Services, a Littleton, Colorado-based mortgage lender specializing in Alt-A loans. Alt-A occupied the ground between the prime and subprime loans, and the mortgages originated by this company would be packaged into mortgage-backed securities for sale in the secondary market.

Lehman Brothers justified this acquisition, its first in the mortgage space, based on dramatic shifts in federal housing policy. The Clinton administration, particularly its Department of Housing and Urban Development under the stewardship of Andrew Cuomo — an attorney who never worked a day in the private sector housing or mortgage industries and was the son of New York Gov. Mario Cuomo — decided it was in the national interest to expand the U.S. homeownership rate, particularly among minority communities who had historically been denied access to homeownership opportunities due to redlining policies.

While Alt-A loans became more popular, subprime mortgages gained even greater popularity and Lehman Brothers latched on to this by purchasing an ownership stake in Irvine, California-based subprime lender BNC Mortgage in 2000; a complete takeover of the company happened three years later.

Lehman Brothers theorized it was on the right track with nonprime mortgages — after all, the dot-com bubble burst in 2000 appeared to erase the potential that digital technology start-ups offered. And with the federal government actively encouraging more people to buy homes, nonprime vehicles helped speed borrowers who would be shut out of homeownership into the American dream.

By 2004, the U.S. homeownership rate reached a historic peak of 69.2%; 10 years earlier, it had been 64%. However, this rapid growth came at a cost: loan quantity trumped quality, as too many mortgages were approved for borrowers who did not meet the underwriting guidelines needed for the origination of prime mortgages and did not fully comprehend the complex machinery of the subprime documents they were signing.

At first, it was a joyous boom time. The combined forces of Aurora Loan Services and BNC Mortgage generated approximately $50 billion per month in nonprime mortgage originations in 2006.

Related Link: The complete Wall Street Crime and Punishment series

The Foreclosure Hole: In March 2007, relatively few people noticed when the Ohio Housing Finance Agency issued $100 million in taxable municipal bonds to help 1,000 families with the refinancing of their toxic mortgages.

“We were the first state housing finance agency to roll out a refi product,” recalled Douglas A. Garver, the agency’s then-executive director, in a 2011 interview with the housing industry news resource MortgageOrb. “There was no product for us to duplicate — we were on our own in that regard.”

The bond sale was the first acknowledgment that the excessive origination of nonprime mortgages was creating more problems than solutions. Sloppy underwriting in many of the nonprime mortgages resulted in too-risky home loans being shoved into mortgage-backed securities that were rubber-stamped with credit rating agencies’ seals of approval. Wall Street juiced up its sales mechanism for these securities and investors couldn’t get enough of them.

In February 2007, Lehman's stock price peaked at $86.18 per share, resulting in a market capitalization of roughly $60 billion. The following month, the stock went into its greatest free-fall in five years as news of increasing defaults on nonprime mortgages began to circulate.

The company’s leadership, particularly Chief Financial Officer Erin Callan, insisted the risks created by mortgage delinquencies were contained and there was nothing to worry about.

At first, calm took hold and both Wall Street and the federal government tried to pooh-pooh concerns that the housing market was in peril. Then in August 2007, a pair of Bear Stearns hedge funds failed and the resonance reached Lehman Brother, which could no longer pretend all was copacetic. BNC Mortgage was abruptly shuttered, Aurora shut down several of its offices across the country and 1,200 jobs in the company’s mortgage operations were axed.

The initial thought was that the situation would correct itself. After all, Lehman Brothers’ $110 billion mortgage-backed securities portfolio was the nation’s largest and the prevailing logic was the company’s size guaranteed safety, and failure was not an option. But that portfolio was also about four times the firm’s shareholder’s equity.

Even worse, the over-leveraged company was dependent on a strong economy. As 2007 transitioned into 2008, economic conditions deteriorated as the housing bubble slowly began to pop. Lehman Brothers’ shares sank by nearly 48% on March 17, 2008, amid fears that it could not maintain its equilibrium with an oversized and problematic mortgage-backed securities portfolio.

The company’s peril brought in U.S. Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben Bernanke who expressed their fears to Lehman Brothers President Richard Fuld that he was facing a potential bankruptcy the federal government could not avert.

Richard Fuld at the 2008 World Economic Forum in Davos, Switzerland.

Bear Stearns avoided that fate by attracting JPMorgan Chase & Co. JPM as a buyer and Paulson reached out to Bank of America Corp BAC and Barclays PLC BCS to consider buying Lehman Brothers, but neither was willing to make an acquisition without government assistance and Paulson was powerless to funnel federal dollars to that endeavor. The Fed couldn’t help since Lehman Brothers did not fall under its regulation.

On June 7, 2008, Lehman announced a second-quarter loss of $2.8 billion, its first negative quarterly performance in 14 years. Although it raised $6 billion from investors within a week, that barely helped. An unlikely outreach for help was dispatched to the Korea Development Bank, but South Korea’s government was unwilling to get involved.

The company’s third-quarter loss of $3.9 billion, which included a $5.6 billion write-down, proved to be the start of its death knell despite efforts by Fuld to improvise mitigation, including the spinoff of the company’s commercial real estate assets.

Lehman Brothers’ stock tumbled by 42% on Sept. 11, 2008. Four days later, the company declared bankruptcy while holding $619 billion in debt.

It was the largest bankruptcy filing in U.S. history, a feat that was never topped.

On the day Lehman Brothers declared bankruptcy, its stock crashed by 93% from its previous close. A domino effect of that announcement was the cratering of the Dow Jones Industrial Average by 504.48 points, its greatest drop in seven years. Lehman Brothers’ collapse has been cited as the starting point of the economic bedlam that gave rise to the Great Recession.

Who’s To Blame? In the aftermath of the collapse, bankruptcy court examiner Anton Valukus uncovered an accounting scheme dubbed by the company’s insiders as “Repo 105” that perverted the common repo transaction — raising cash through the sale of an asset with the promise of a buyback later — by intentionally misidentifying the transaction as a permanent sale and thus removing the risky assets from its books. During the first half of 2008, the company’s Repo 105 scheme slashed its balance sheet by $50 billion and shrank its leverage ratio from 13.9 to 12.1.

Ernst & Young LLP, the company’s external accounting firm, was sued by then-New York Attorney General Eric Schneiderman for enabling Lehman Brothers to deceive investors. Ernst & Young paid a $10 million settlement. Schneiderman’s lawsuit was the only action taken by a law enforcement authority in connection with Lehman Brother’s downfall.

Although ex-president Fuld was brought before a congressional hearing and chastised for the $485 million in salary, bonuses and options that he earned between 2000 and 2007, he never faced criminal or civil charges. He began a consulting firm for high-net-worth clients and would not speak publicly about what transpired until he gave a speech at a financial conference in 2015 where he absolved the now-defunct company of blame and pointed to Washington as the culprit.

“Regardless of what you heard of Lehman Brothers’ risk management, I had 27,000 risk managers, because they all owned a piece of the firm,” he said, adding “the government pushed for non-qualified homeownership. The government clearly wanted everybody to fulfill their view of the American dream.”

After Lehman Brothers declared bankruptcy, Nomura Holdings Inc NMR crafted a deal to buy Lehman Brothers' franchise in the Asia Pacific region for $225 million. Barclays agreed to a deal to purchase Lehman Brothers’ U.S. capital markets division at $1.75 billion; the British bank also acquired the Seventh Avenue headquarters, formerly home to some of the 25,000 Lehman Brothers employees who lost their jobs.

When Lehman Brothers failed and its workforce was ordered to leave their offices, some went into local bars to tranquilize their sorrow with beer bottles and cocktail glasses. Others hailed cabs and rode away, lost in their thoughts amid the miasma of Manhattan’s traffic.

And others found their way down into the city’s subways, waiting amid the humid swelter of the underground stations for a train to take them somewhere better. It would be a very long and crowded ride: by the time the Lehman Brothers-fueled Great Recession abated, more than 8 million people lost their jobs.

Photos: Lehman Brothers headquarters in 2006 by Sachab; Lehman Brothers headstone by FutureAtlas.com, both via Flickr Creative Commons.