In 2007, the Lehman Brothers board supported managements decision to take on increasing levels of risk. Did the Lehman Brothers Board of Directors fulfill their

Let me see if I understand this,” said the Lehman Brothers board member, “Areyou directing us to put Lehman into bankruptcy?”2 After this question, there wassilence on the speakerphone. Christopher Cox, the Chairman of the U.S. Securities and Exchange Commission, didn’t answer the Lehman board member’s ques- tion. It was Sunday, September 14, 2008, and the board of directors of Lehman Brothers was meeting, for the fourth time that weekend, in emergency session. (Exhibit A pres- ents a brief biography of the members of Lehman Brothers’ board of directors; Exhibit B presents a timeline of the events and Exhibit C lists the cast of characters presented in this case.)

How had it come to this? Just that week, on Tuesday, September 9th, the board’s Finance and Risk Committee had met and Lehman Brothers management had assured the committee that Lehman Brothers had $42 billion in liquidity.3 Now, five days later, Lehman had a liquidity problem.4

There were a number of urgent questions that the board of directors had to untan- gle, and untangle quickly. First, how serious was the liquidity problem? Second, what were the board’s fiduciary obligations and responsibilities in a moment like this? Third, what options did the board have available? Finally, and most critically, what was the board going to do?

There was not much time left.

U.S. HOUSING MARKET COLLAPSES

After a long run-up, U.S. home prices peaked in the summer of 2005.5 During the boom, housing prices greatly exceeded their long-run trend of price appreciation. There were some who warned of looming problems, but these warnings were largely ignored.6 One particularly attractive market during the boom was the market for sub- prime mortgages. These mortgages, targeting borrowers who were traditionally poor credit risks, were extremely lucrative (in the short-run) to the companies that issued and serviced these mortgage loans. Subprime mortgages charged higher interest rates on the loan, and generated larger fees than conventional mortgages. This made lenders highly motivated to originate such mortgages. Further, as long as housing prices

Lehman Brothers: Crisis in Corporate Governance 123

Lehman Brothers: Crisis in Corporate Governance1

Randall D. Harris, California State University, Stanislaus

Copyright © 2012 by the Case Research Journal and by Randall D. Harris

“

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124 Case Research Journal • Volume 32 • Issue 1 • Winter 2012

increased, subprime borrowers could always refinance the mortgage or sell the property if they got into trouble. In 2007, the subprime mortgage market in the U.S. was valued at $1.2 trillion, a 600% increase from 20017, and 82% of the debt was rated AAA.8

Once housing prices peaked the game was over. By February of 2007, the market for subprime mortgages had collapsed.9 Although subprime mortgages were a relatively small part of the overall U.S. mortgage market, these mortgages had been widely secu- ritized in the form of mortgage backed securities, or MBS. Subprime mortgages were bought by lenders, pooled into a large bundle, sliced into various pieces, or tranches, and then sold. Vendors of these securities had found an enthusiastic global market of buyers.10 Investors were widely drawn to these securities for their above average yield and the deceptively low foreclosure rate on the underlying subprime mortgages.11 Unfortunately, underwriting standards for the subprime mortgages that backed these MBS securities had deteriorated considerably during the boom.12

As prices on houses began to drop, and the default rate on subprime mortgages began to rise, the dilemma for investors became acute. No one was sure exactly who had exposure to the resulting toxic (e.g. worthless or near-worthless) assets. Subprime mort- gages had been securitized into numerous investment vehicles, including MBS, and the issuers themselves were often unable to quickly identify where potential problems might exist. “There were genuine fears about the locations of subprime risk concentrations among counterparties,” said one researcher.13 It was this tremendous uncertainty that contributed to a growing sense of panic in the markets. As the panic spread, it infected the repo market, the short-term collateralized credit market that was the lifeblood of the global banking system. Once the crisis reached the repo market, events rapidly began to spiral out of control.14

Lehman Brothers takes on Risk

Lehman Brothers funded its daily operations in the overnight repo market. Lehman Brothers, founded in 1850 and based in New York City, was the fourth largest invest- ment bank in the United States in 2008.15 Holding approximately $650 billion to $700 billion of assets on its balance sheet, much of it tied to the subprime market, Lehman needed billions of dollars from the repo market each day in order to be able to open for business.16 Funded like other New York investment banks, Lehman Brothers’ business model was not unique; all of the other investment banks at that time followed some variation of a high-risk, high leverage model that required daily market borrowing, and most critically, the confidence of lenders.17 Lehman borrowed short-term (often overnight) and lent longer-term. This business model meant that its survival was tied daily to the confidence of its overnight lenders. (Exhibit D shows selected quarterly financial information for Lehman Brothers from August 31, 2007 to August 31, 2008.)

In 2006, Lehman Brothers had made a conscious decision to embark on an aggres- sive growth strategy, and had deliberately focused on the subprime and commercial real estate markets.18 This strategy was fully endorsed by Lehman’s board of directors.19 Lehman borrowed heavily to make increasingly risky loans, taking its leverage ratio up to 30 times its underlying stockholder’s equity.20 As the sub-prime market collapsed in 2007, Lehman was slow to recognize the depth and severity of the crisis and what it would eventually do to the commercial real estate market and its other lines of business. Rather than pull back, the company decided to “double down” on its bets, hoping to make enormous profits from buying into the declining housing market.21 As it did so,

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Lehman Brothers: Crisis in Corporate Governance 125

Lehman significantly exceeded prudent risk management and many of its own internal controls.22

The bet on a housing market recovery proved to be wrong. By April of 2007, New Century Financial Corporation, the U.S.‘s second largest subprime lender, filed for bankruptcy. Even then, most did not recognize that the situation would worsen dramat- ically. Indeed, U. S. Treasury Secretary Henry “Hank” Paulson commented at the time that problems in the subprime mortgage market were “largely contained.”23 By August of that year Lehman Brothers began to reduce its exposure to the subprime mortgage market. Lehman closed its subprime mortgage unit, BNC Mortgage, and booked an after-tax charge of $25 million and a goodwill write-down of $27 million. 1,200 peo- ple lost their jobs.24 Even though Lehman had closed its subprime unit however, the company retained many of these types of loans on its books.

The Pressure Increases

The U. S. Federal Reserve, seeing the increasing level of market distress, began cutting the U.S. discount rate. On Friday, August 17, 2007, the Federal Reserve cut the dis- count rate by 50 basis points, and expanded its lending from overnight to 30 days. Despite the Federal Reserve’s efforts to ease market pressures, losses on mortgage-backed securities began to spread quickly to all of the major investment banks, and particular- ly to the firms Bear Sterns, Lehman Brothers and Merrill Lynch.

Bear Sterns was the first to go out of business. On Monday, March 17, 2008, Bear agreed to be acquired by the bank JP Morgan Chase for $2/share, later amended to $10/share.25 In this deal, the Federal Reserve agreed to take the first $30 billion in loss- es on toxic Bear Sterns assets. The stock market reacted badly to news of this “merger.” The stock of Lehman Brothers dropped 48% that day, only to recover to down 19% by the end of trading. Lehman Brothers was widely expected to be the next investment bank to fail.26 Also on that day, the Federal Reserve opened the discount window to all of the primary dealers on Wall Street, an unprecedented act designed to stem the increasing panic and liquidity bottlenecks in the credit markets. (Exhibit E shows Lehman Brothers daily closing stock price from Friday, January 12, 2007 to Friday, September 12, 2008.)

U.S. government officials, including Treasury Secretary Henry Paulson, New York Federal Reserve President Timothy Geithner, and Securities and Exchange Commissioner Christopher Cox, were strongly criticized for their role in the Bear Sterns merger with JP Morgan Chase. The criticism from elected government officials in Washington, D.C. in particular, was vicious. The Bear Sterns experience solidified the opinion of key government officials that they could not afford to be seen as bailing out any more investment banks. “I can’t be Mr. Bailout,” said Secretary Paulson.27

By summer of 2008, all of the remaining major investment banks in New York were in distress. Losses on the mortgage-backed asset portfolios of the investment banks were mounting almost daily. Losses were particularly acute for Lehman Brothers. Lehman had booked a $2.8 billion loss for the second quarter of 2008. In an effort to improve the firm’s liquidity, bankers inside Lehman turned souring real-estate investments into highly-rated commercial paper, which they then used as collateral for cash. These secu- rities, called Fenway commercial paper, were dubbed as “goat poo” by bank insiders.28 The Fenway commercial paper, named for Fenway Funding LLC (a subsidiary of finance company Fenway Capital), allowed Lehman to finance longer-term assets such as real estate loans with loans from investors such as money-market funds.29 The Fenway

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126 Case Research Journal • Volume 32 • Issue 1 • Winter 2012

commercial paper was tied, among other things, to loans that Lehman had made for a project in California’s Mojave Desert.30 Lehman used the Fenway commercial paper to help keep itself afloat in the summer of 2008.

Looking for a merger to save the company, Lehman Brothers approached the bank Morgan Stanley. These talks quickly stalled. In desperation, Richard “Dick” Fuld, the Chairman of the Board and Chief Executive Officer of Lehman Brothers, told his attor- ney to approach Bank of America about a deal.

After several weeks of phone calls and haggling, Dick Fuld met with Ken Lewis, the CEO of Bank of America, at the offices of the New York Federal Reserve on Monday, July 21, 2008. This meeting was arranged by Henry Paulson and Timothy Geithner.31 Several days after this meeting, Lewis called Fuld and told him that Bank of America wasn’t interested, though he left the door open for further discussion. Other possible bidders for Lehman included the Korea Development Bank and the British bank Barclays, but negotiations between these firms and Lehman also stalled, restarted and stalled.

Matters were spiraling quickly out of control. To make matters worse, the problems were not confined to the New York investment banks, and in fact appeared to be spread- ing. One area of particular concern was the two GSEs (Government Sponsored Enterprises) Fannie Mae and Freddie Mac, whose distress was becoming unmistakable. As the largest issuers of mortgage backed securities in the United States, the collapse of one or both of these entities was simply unthinkable. On Friday, September 5, 2008, with the assistance of the U.S. Federal Reserve, Freddie Mac and Fannie Mae were placed into government receivership. The CEOs of both companies were fired, and the common shareholders of both firms effectively held worthless shares. Support for the failed institutions exceeded $100 billion each.32 The stock market reacted negatively, and speculation regarding which banking institution would next fail intensified.

THINGS GET UGLY: WEEK OF SEPTEMBER 8TH

After the close of trading on Monday, September 8th, Korea Development Bank pub- licly announced that they were withdrawing from bidding on Lehman Brothers. By 2 a.m. the next morning, every wire service in the world was reporting the news.33 Lehman’s stock plummeted at the open of trading on Tuesday and kept diving. Secretary Paulson recalled:

I returned to my office to find that once again all hell was breaking loose. Dow Jones Newswire was reporting that Lehman’s talks with KDB (Korea Development Bank) had fallen through. The firm’s shares were plunging and credit spreads widening-they would top 400 basis points by day’s end. But I didn’t need a Bloomberg terminal to tell me what was happening. Once more we had a big financial institution under assault, and no clear solution in sight. If Lehman didn’t find a buyer soon, it would go down.34

Lehman shares hit $7.79 per share at the close of trading that day, a 45% drop. Furious negotiations ensued between the Federal Reserve, the U.S. Treasury Department, JP Morgan Chase, and Citigroup over the fate of Lehman Brothers. At one point during the day, Tim Geithner called Secretary Paulson, and Paulson asked him if he thought he could hold things together through the close of trading on Friday. Geithner replied that he thought so, but only if the markets believed that the govern- ment was working on a solution to Lehman. “I’ll lean on Ken Lewis (CEO of Bank of

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America),” Paulson said. “Maybe at the right price Bank of America will be willing to do something.”35

Finance and Risk Committee Meeting36

The Finance and Risk Committee of Lehman Brother’s Board of Directors met in per- son at 10 a.m. on Tuesday, September 9th. Present for the meeting were Mr. Kaufman (Chair), Ms. Evans, Mr. Akers, Mr. Berlind and Mr. Hernandez. After approval of the minutes, Paolo Tonucci, Lehman Brothers’ treasurer, reviewed the firm’s liquidity and capital condition, and also presented a summary of general market conditions. Mr. Tonucci said, “ . . . long-term debt market conditions had worsened in the quarter, with the market essentially shut down.” Short-term debt markets were also challenging, he said, with investors being averse to funding debt that wasn’t easily used as collateral with the European Central Bank or the U.S. Federal Reserve. With regard to Lehman’s cur- rent situation, Mr. Tonucci said that:

. . . the firm was generally able to maintain its liquidity . . . primarily as a result of the deleveraging of its balance sheet . . . the firm’s liquidity pool at the end of the third quar- ter was $42 billion (versus $45 billion at the end of the second quarter).

Mr. Tonucci went on to tell the committee that the firm had reduced its leverage ratios over the last several quarters (See Exhibit D), and had also reduced its exposure to a number of less liquid assets. He then briefly touched on the recent downgrades to the firm’s credit ratings.

The committee had a number of questions for Lehman management, addressing among other things, access to funding sources for the firm, the Federal Reserve’s pri- mary dealer facility, and the status of the commercial paper market. After some further discussion, Mr. Kaufman (Chair) introduced a resolution to reduce the firm’s annual dividend to $0.05 per share (from $0.60 per share in 2007), stating that this was “an efficient way to preserve capital.” The resolution passed unanimously, and the commit- tee then excused Lehman management and met in private session.

Lehman Liquidity Crisis

The next day, Wednesday, September 10th, newspapers were reporting the increasing fear in New York that Lehman Brothers might fail.37 Confidence, so critical for Lehman’s daily operations, was quickly being lost. There were reports to management from Lehman’s trading floor that hedge funds were pulling their money out of the com- pany. Lehman’s largest shareholder, GLG Partners, began to reduce the amount of busi- ness that it did with the firm.38 Under pressure from U.S. government officials, Bank of America CEO Ken Lewis agreed to send a team to begin due diligence on a possible deal for the company. After markets had closed, Lehman prematurely announced a $3.9 billion loss for the third quarter of 2008, as well as a recapitalization plan for the firm.39

Wall Street hated the proposed Lehman Brothers recapitalization plan. It simply wasn’t enough.40 Lehman CEO Dick Fuld, who had been working the phones that week, reached out to Bob Diamond, the CEO of Barclays Capital, on Thursday, September 11th. Rebuffed by Diamond, Fuld called Tim Geithner. After a call from Geithner, Diamond began negotiations with the U.S. government regarding a possible acquisition of Lehman. Although Diamond and Fuld talked later that day, Dick Fuld’s role in the negotiations effectively ended at that point.41 U.S. government officials, who

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hoped to start a competition to acquire the firm, now had two firms engaged in nego- tiations for Lehman Brothers.

After markets closed on Thursday, September 11th, Lehman Treasurer Paolo Tonucci panicked. “We’ve got a real problem,” he said to co-workers. “JP Morgan is pulling another $5 billion in collateral from us! I just got off the phone with Jane Buyers Russo (head of JP Morgan’s broker-dealer unit). She says that we need to wire it by tomorrow. And she might pull another $10 billion by the weekend.” Lehman had pledged Fenway commercial paper as collateral to JP Morgan, and JP Morgan now sus- pected that the notes were “worth practically nothing as collateral.” JP Morgan demand- ed cash from Lehman to replace these notes and other collateral, and they wanted their money the next day. Lehman posted the money on Friday, but it was essentially the last $5 billion of cash that the firm had readily available.

By the close of trading on Friday, September 12th, it was clear that Lehman Brothers was in trouble. A secret meeting, “The Big One” according to Lloyd Blankfein, CEO of Goldman Sachs, was convened at 6 p.m. that evening at the offices of the New York Federal Reserve.45 Representatives from most of the major banks and investment banks in New York were in attendance. Lehman CEO Dick Fuld was not invited.46 The meet- ing ended without any meaningful resolution or plan of action, but with an agreement to reconvene over the weekend.

WEEKEND OF SEPTEMBER 13-14

Negotiations over the fate of Lehman Brothers began early on the morning of Saturday, September 13th. Just after 7 a.m., Secretary Paulson called Ken Lewis about Bank of America acquiring Lehman Brothers. Lewis reported that, after a closer inspection of Lehman’s books, his bankers believed that there was at least $40 billion in bad assets on Lehman’s books, and possibly much, much more. Paulson believed at this point that Lewis didn’t really want to buy Lehman, but scheduled an appointment with Bank of America for later in the morning.47 Paulson, suspecting that Bank of America might balk, was on the phone by 8 a.m. with Barclays, a United Kingdom—based bank, about acquiring Lehman. Barclay’s bankers were even more pessimistic about Lehman’s assets than Bank of America, estimating that at least $52 billion of Lehman’s balance sheet was bad. While all this was going on, representatives from Lehman Brothers were waiting upstairs, on the 7th floor of the Federal Reserve building in New York, wondering about their fate.48

Shortly before 11 a.m., Secretary Paulson, Tim Geithner, and other government rep- resentatives met with bankers and lawyers from Bank of America. The mood for the meeting was chilly, with personal animosity between Secretary Paulson and several of the Bank of America representatives barely contained.49 Trying to break the tension, Geithner asked the Bank of America group, “So what’s the latest?”50 In clear terms, the Bank of America team told the U.S. Treasury Secretary that they were not interested in buying Lehman Brothers unless the government was willing to help backstop the trans- action. Paulson recounts:

. . . after poring over Lehman’s books, Bank of America now believed that to get a deal done it would need to unload between $65 billion and $70 billion of bad Lehman assets. Bank of America had identified, in addition to $33 billion of soured commercial mort- gages and real estate, another $17 billion of residential mortgage-back securities on Lehman’s books that it considered to be problematic. In addition, its due-diligence team

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had also raised questions about other Lehman assets, including high-yield loans and asset-backed securities for loans on cars and mobile homes, as well as some private-equi- ty holdings. The likely losses on all these bad assets, they estimated, would wipe out Lehman’s equity of $28.4 billion.

We asked if they (Bank of America) would be willing to finance any of the assets they wanted to leave behind or take more losses. They said no.51

As the meeting wore down, it was clear that the U.S. government was unwilling to backstop the Lehman-Bank of America deal any further. “Not one penny will come from the government,” said Paulson. However, Secretary Paulson wanted to keep Bank of America in the hunt in order to possibly leverage a Barclays bid for the company.53

Board of Directors Conference Call54

The first Lehman board meeting of the weekend was a conference call at noon on Saturday, September 13th. Dick Fuld reported to the board on the status of negotia- tions. “There is no resolution yet with respect to Bank of America, but it seems to be a game of chicken between Bank of America, on the one hand, and the Federal Reserve and Treasury, on the other hand,” he said. Fuld also updated the board on the negotia- tions between Lehman and Barclays Bank, but said that “Barclays would prefer not to assume . . . (Lehman’s) commercial real estate assets.”

Thomas Russo, Lehman’s Chief Legal Officer, then reported to the board on the meeting that had been held at the Federal Reserve on Friday. He told the board that he didn’t even know about the meeting until 5 p.m., and that the Federal Reserve had expressed concerns to him about the systemic risk that Lehman Brothers posed to the financial markets. Russo reported on the various negotiations that were occurring, all with the express intent that any solution would not involve federal money. Further, “the Federal Reserve believes that any bankruptcy filing (by Lehman) would be extremely disruptive . . .” he said.

The Lehman board had a lot of questions for management at that point. How do we spin off the commercial real estate assets? Are other financial institutions going to provide the equity that Lehman needs to spin off the commercial real estate? How would a spin-off work if Lehman does a deal with Bank of America?

The discussion then shifted to the negotiations with Bank of America. What kind of price would Bank of America be willing to pay? Someone pointed out that it should be emphasized to the Federal Reserve that a Lehman bankruptcy would be a systemic risk. After further discussion of this and additional discussion about funding employee health care costs in the event of a bankruptcy filing, the meeting adjourned.

The Board Reconvenes55

The board reconvened via conference call at 5 p.m. on Saturday. Dick Fuld reported to the board on the structure of a potential deal with Barclays. Barclays would buy the operating subsidiaries of the corporation for $3 billion, and Lehman shareholders would retain all of the commercial real estate assets. “Under the proposed structure, a consor- tium of financial institutions would provide new debt financing to Lehman (estimated at $40 billion), with the preferred and common equity remaining at Lehman Brothers,” Fuld said. Further, the deal was contingent upon the approval of the U.K. Financial Services Authority (FSA), because of Lehman’s significant London operations.

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“Is this a real offer?” said a board member. “What about the financing? What are the terms?” said another. After some discussion, Lehman management summarized the pro- posed structure of the deal as Barclays gets the “good” bank and Lehman shareholders get the “bad bank.” Another board member wanted to know about the status of discus- sions with Bank of America. “Phone calls to Bank of America’s Chief Executive Officer and to its General Counsel have not been returned,” was the reply. Lehman is “over a barrel” said a board member, frustrated with the status of negotiations. The board dis- cussed using the systemic risk of a Lehman failure being a source of negotiating lever- age. After further discussion regarding getting the FSAs approval of the Barclays deal and a number of other matters, the board meeting adjourned.

Sunday Morning Breakdown

New York Fed President Geithner was on the phone by 7:15 a.m. Sunday morning, September 14th. He talked to Bob Diamond, CEO of Barclays Capital, regarding their possible acquisition of Lehman. Barclays had a working proposal on the table to com- plete the acquisition. Diamond, who had left the Fed building at 4 a.m. to join a board meeting conference call, reported to Geithner that he was having trouble with his London-based regulators, and specifically the UK’s Financial Services Authority (FSA). Not only were UK regulators concerned about the due diligence on Lehman and the potential losses from a merger with Barclays, but they were also increasingly concerned about the stability of their own financial system. When Secretary Paulson joined Geithner in his office at 8 a.m., Paulson recalled, “We were beside ourselves. This was the first time we were hearing the FSA might not support the deal.”56

Nevertheless, the government team decided to present the proposed deal to the now- reassembled group of CEOs downstairs at the New York Federal Reserve Building in lower Manhattan at 10 a.m. At this meeting, led by Secretary Paulson, Tim Geithner, and Securities and Exchange Commissioner Chris Cox, they announced that the U.S. Government had “good news: there was an offer on the table for Lehman Brothers.”57 Barclays Bank, they said, would acquire Lehman, and what was needed from the CEOs present was $30 billion in financing for a “bad bank”58. This “bad bank” would guaran- tee the assets that Barclays had refused to acquire as part of their deal for Lehman Brothers. Negotiations then ensued among the CEOs to raise the needed capital amongst the New York banks to support the “bad bank” deal.

By late Sunday morning, Secretary Paulson was reasonably confident that he had a deal to save Lehman well under way. The New York CEOs had reached agreement on $30 billion in capital to fund Lehman’s “bad bank.” In the meantime, however, there had been intense and hurried negotiations with UK regulators. Tim Geithner had numerous conversations with London, and the UK side had expressed reservations regarding what was occurring in New York. Further, and to a great extent, they felt out of the loop. To smooth the waters, Secretary Paulson decided to call Alistair Darling, Britain’s Chancellor of the Exchequer. Unfortunately, the Chancellor was unwilling to aid the U.S government with Lehman. “We are very concerned over here,” he said. “Lehman has a significant business in the U.K., and we have real concerns as to whether it is adequately capitalized.”59

“He’s not going to do it,” Paulson told Geithner. “He said he didn’t want to import our cancer.”60 The government team assembled in Geithner’s office was stunned, and multiple, frantic conversations broke out. Geithner sat for a moment, and then after some reflection said, “Okay. Let’s go to Plan B.”61 The government group discussed what

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to do next. After some discussion, the decision was made to begin preparing Lehman for bankruptcy. “At that moment, I did not have time for regret, recriminations, or sec- ond-guessing,” recalled Paulson.62 The meeting broke up, and the government team pre- pared to relate the news to the group of banking CEOs downstairs.

The CEOs were stunned, angry. “But we have the money!” said one banker.63 “The British screwed us,” Paulson said.64 A general feeling of being blindsided permeated the room. After some time, the discussion moved to mechanisms for unwinding Lehman positions, a daunting task even under good circumstances. Talk also touched on mech- anisms for dealing with the next bank failure, possibly an emergency fund with a capi- talization of at least $100 billion.

Sunday Evening Board Meeting65

After considerable delay, the Lehman board convened, in person, at 5 p.m. on Sunday evening. Thomas Russo gave an update to the board on the status of negotiations. “While (we) believed that we had reached a deal with Barclays . . . the FAS said that it would not grant Barclays the needed exemption from certain capital rules,” he said. As

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