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April 4, 2012

Overview

Lehman Brothers was founded in 1850 by two cotton brokers in Montgomery, Ala. The firm moved to New York City after the Civil War and grew into one of Wall Street’s investment giants. On Sept. 14, 2008, the investment bank announced that it would file for liquidation after huge losses in the mortgage market and a loss of investor confidence crippled it and it was unable to find a buyer.

Its collapse sent global financial markets into a panic and brought credit markets worldwide to the edge of a meltdown. Within days, the Treasury Department and Federal Reserve as well as governments around the world embarked on what became multi-trillion dollar efforts to keep the financial system from collapsing. Wall Street’s remaining investment banks sold themselves to bigger entities or converted into bank holding companies to secure federal protection. Job losses soared as the recession that had begun in late 2007 turned into the steepest downturn since the Great Depression.

In the years that followed, the term a “Lehman moment’' entered the vocabulary of governments and investors as a shorthand for a financial event with explosive and unpredictable consequences, and the ghost of Lehman hovered over discussions of topics from regulatory reform in the United States to the handling of the Greek government’s debt.

Lehman’s leaders argued after its collapse that it could have survived if the firm had been given the kind of support used later to keep its competitors alive. But as more detail emerged about Lehman’s road to ruin, it became a symbol for the way debt, deception and self-delusion had created the biggest boom and bust cycle in nearly a century.

Suits and Studies

In March 2010, a 2,200-page document laid out in new and startling detail how Lehman used accounting sleight of hand to conceal the bad investments that led to its undoing. The report, compiled by an examiner for the bank, concluded that, among other things, the firm’s demise was the result of bad mortgage holdings and, less directly, demands by rivals like JPMorgan Chase and Citigroup, that the foundering bank post collateral against loans it desperately needed.

Lehman also used a small company — its “alter ego,” in the words of a former Lehman trader — to shift investments off its books. The relationship raised new questions about the extent to which Lehman obscured its financial condition before it plunged into bankruptcy.

In May 2010, Lehman Brothers Holdings and a group of unsecured creditors filed a lawsuit against JPMorgan Chase for more than $5 billion, saying it siphoned billions of dollars of Lehman assets, thus hastening its bankruptcy.

Almost two years later, JPMorgan was sued for $20 million by the Commodities Futures Trading Commission, which charged that it had overextended credit to Lehman by allowing Lehman to overvalue its holdings by counting client funds as its own. The bank settled the matter and agreed to pay a fine of approximately $20 million.

In December 2010, New York Attorney General Andrew M. Cuomo sued Ernst & Young, accusing the accounting firm of helping its client Lehman Brothers “engage in a massive accounting fraud” by misleading investors about the investment bank’s financial health.

In March 2012, Lehman Brothers emerged from bankruptcy, becoming a liquidating company whose primary business in the years to come will be paying back its creditors and investors.

Lehman will start distributing what it expects to be a total of about $65 billion to creditors. The first group of payments to creditors is expected to be at least $10 billion.

A History That Included Close Calls

Lehman’s slow collapse began as the mortgage market crisis unfolded in the summer of 2007, when its stock began a steady fall from a peak of $82 a share. The fears were based on the fact that the firm was a major player in the market for subprime and prime mortgages, and that as the smallest of the major Wall Street firms, it faced a greater risk that big losses could be fatal.

The bank’s demise set off tremors throughout the financial system. The uncertainty surrounding its transactions with banks and hedge funds exacerbated a crisis of confidence. That contributed to credit markets freezing, forcing governments around the globe to take steps to try to calm panicked markets.

As the crisis deepened in 2007 and early 2008, the storied investment bank defied expectations more than once, just it had many times before, as in 1998, when it seemed to teeter after a worldwide currency crisis, only to rebound strongly.

Lehman managed to avoid the fate of Bear Stearns, the other of Wall Street’s small fry, which was bought by JP Morgan Chase at a bargain basement price under the threat of bankruptcy in March 2008. But by summer of 2008, the rollercoaster ride started to have more downs than ups. A series of write-offs was accompanied by new offerings to seek capital to bolster its finances.

Lehman also fought a running battle with short sellers. The company accused them of spreading rumors to drive down the stock’s price; Lehman’s critics responded by questioning whether the firm had come clean about the true size of its losses. As time passed and losses mounted, an increasing number of investors sided with the critics.

On June 9, 2008, Lehman announced a second-quarter loss of $2.8 billion, far higher than analysts had expected. The company said it would seek to raise $6 billion in fresh capital from investors. But those efforts faltered, and the situation grew more dire after the government on Sept. 8 announced a takeover of Fannie Mae and Freddie Mac. Lehman’s stock plunged as the markets wondered whether the move to save those mortgage giants made it less likely that Lehman might be bailed out.

On Sept. 10, the investment bank said that it would spin off a majority of its remaining commercial real estate holdings into a new public company. And it confirmed plans to sell a majority of its investment management division in a move expected to generate $3 billion. It also announced an expected loss of $3.9 billion, or $5.92 a share, in the third quarter after $5.6 billion in write-downs.

Bankrupt With No Bailout in Sight

By the weekend of Sept. 13-14, it was clear that it was do or die for Lehman. The Treasury had made clear that no bailout would be forthcoming. Federal officials encouraged other institutions to buy Lehman, but by the end of the weekend the two main suitors, Barclays and Bank of America, had both said no.

Lehman filed for bankruptcy Sept. 15. One day later, Barclays said it would buy Lehman’s United States capital markets division for $1.75 billion, a bargain price. Nomura Holdings of Japan agreed to buy many of Lehman’s assets in Europe, the Middle East and Asia. Lehman also said it would sell much of its money management business, including its prized Neuberger Berman asset management unit, to Bain Capital and Hellman & Friedman for $2.15 billion.

Lehman’s demise set off tremors throughout the financial system. The uncertainty surrounding its transactions with banks and hedge funds exacerbated a crisis of confidence. That contributed to credit markets freezing, forcing governments around the globe to take steps to try to calm panicked markets.

On Oct. 5, Richard S. Fuld Jr., Lehman’s chief executive, testified before a Congressional panel that while he took full responsibility for the debacle, he believed all his decisions “were both prudent and and appropriate” given the information at the time.

Negligence and Accounting Tricks

In March 2010, Anton R. Valukas, an examiner for the bank, laid out for the first time what his report characterized as “materially misleading” accounting gimmicks that Lehman used to mask the perilous state of its finances. Lehman used what amounted to financial engineering to temporarily shuffle $50 billion of troubled assets off its books in the months before its collapse in September 2008 to conceal its dependence on leverage, or borrowed money.

Senior Lehman executives, as well as the bank’s accountants at Ernst & Young, were aware of the moves, according to Mr. Valukas, the chairman of the law firm Jenner & Block and a former federal prosecutor, who filed the report in connection with Lehman’s bankruptcy case.

Mr. Fuld certified the misleading accounts, the report said, which called him “at least grossly negligent.” The report also stated that Henry M. Paulson Jr., who was then the Treasury secretary, warned Mr. Fuld that Lehman might fail unless it stabilized its finances or found a buyer.

The report drew no conclusions as to whether Lehman executives violated securities laws. But it did suggest that enough evidence exists for potential civil claims. Lehman executives are already defendants in civil suits, but have not been charged with any criminal wrongdoing.

The New York Times reported in April 2010 that a firm called Hudson Castle played a crucial, behind-the-scenes role at Lehman, shifting investments off its books. While Hudson Castle appeared to be an independent business, it was deeply entwined with the bank. For years, its board was controlled by Lehman, which owned a quarter of the firm. It was also stocked with former Lehman employees, but none of this was disclosed.

Entities like Hudson Castle are part of a vast financial system that operates in the shadows of Wall Street, largely beyond the reach of banking regulators. These entities enable banks to exchange investments for cash to finance their operations and, at times, make their finances look stronger than they are.

A section of the examiner’s report said that a transaction transferred $2 billion in assets from C.M.E. Group, which operates the Chicago and New York mercantile exchanges. The assets were collateral and clearing deposits held by C.M.E. and linked to Lehman’s futures and options contracts — proprietary trades that Goldman, Barclays, and another firm, DRW Trading, would take on along with the collateral transfer in question.

The transfer resulted in what the report said was “a loss to Lehman exceeding $1.2 billion.” Mr. Valukas concluded that “an argument can be made that the transfers at issue were fraudulent transfers avoidable” under bankruptcy law.

In its lawsuit, Lehman Brothers Holdings accused JPMorgan of extracting billions of dollars in collateral for loans prior to Lehman’s bankruptcy by threatening to deprive the bank of services vital to its broker-dealer business.

New York State v. Ernst & Young

The New York attorney general in December 2010 sued Ernst & Young, accusing it of helping Lehman to mislead investors. Ernst & Young, Lehman’s longtime outside auditor, certified the financial statements of Lehman from 2001 until the firm’s bankruptcy filing in September 2008. The lawsuit focuses on the accounting firm’s approval of a much-criticized accounting maneuver employed by Lehman that allowed it to remove debt from its balance sheet.

The controversial transactions involved “the surreptitious removal of tens of billions of dollars of securities from Lehman’s balance sheet in order to create a false impression of Lehman’s liquidity, thereby defrauding the investing public,” the complaint said.

The lawsuit seeks the return of the entirety of fees that Ernst & Young collected for work performed for Lehman from 2001 to 2008, exceeding $150 million, plus investor damages and equitable relief, the lawsuit said.

The lawsuit focuses on an accounting maneuver known inside Lehman as Repo 105. This tactic temporarily removed as much as $50 billion of assets from its balance sheet to give the appearance that the firm had reduced its debt levels. It often did this just before the end of a financial quarter, the lawsuit said.

Shareholder Lawsuits Against Lehman Officials

The company has been protected from litigation since it filed for Chapter 11 bankruptcy in 2008. But investors have filed several lawsuits against former Lehman officials founded on accusations that the bank’s senior executives and directors lied about its financial state.

In August 2011, former officials of Lehman Brothers, including Richard S. Fuld Jr., its former chief executive, agreed to pay $90 million to settle a shareholder lawsuit that accused them of misleading investors about the investment bank’s health in the months leading up to its collapse.

In a court filing in the Federal Bankruptcy Court in Manhattan, 13 Lehman executives and directors asked a judge to release insurance proceeds that would pay for the settlement. The potential settlement, which would be the largest to date of a lawsuit against Lehman’s top officials, would not affect the status of any outstanding government investigations of the company and its management.

If the bankruptcy judge were to agree with the Lehman officials’ request and release the insurance proceeds to settle this lawsuit, Mr. Fuld and his former colleagues would not have to bear any personal expense in resolving the case. They would also neither admit nor deny wrongdoing. Meanwhile, other litigants are scrambling to settle cases with Lehman before the company’s insurance coffers are empty.

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