Essay ACCT 6350 Lehman Case And Questions

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Lehman on the Brink of Bankruptcy
Lehman Brothers was founded in the mid-19th century as a cotton trading company. The latest entity (Lehman Brothers Holdings Inc) emerged from a spin-off from American Express in 1994. This company grew quickly and for fiscal year 2007, the company reported record income of over $4 billion on revenue of over $60 billion. In early 2008, Lehman’s stock was trading in the mid-sixties with a market capitalization of over $30 billion. Over the next eight months, Lehman’s stock lost 95 percent of its value and was trading around $4 by September 12th, 2008. Three days later, Lehman filed for bankruptcy protection. By some measures, Lehman was the largest company to fail in U.S. history.

In March 2010, Lehman’s Bankruptcy Examiner, Anton Valukas, issued a 2,200 page report that outlined the reasons for the Lehman bankruptcy.1 The Examiner’s Report also provides insight into how Lehman’s deteriorating financial position led to allegedly misleading financial reporting practices, including a type of collateralized short-term borrowing arrangement that Lehman dubbed “Repo 105.” The Examiner’s Report includes interviews with key Lehman personnel and provides accounting students a rare “inside” look at the mechanics and dynamics of aggressive accounting practices when carried out by a large and sophisticated company. In December 2010, the Attorney General for the State of New York filed a lawsuit against Lehman’s auditors, Ernst and Young LLP (hereafter E&Y).2 In April 2011, Valukas testified before a subcommittee of the U.S. Senate Committee on Banking, Housing & Urban Affairs, in a hearing on the role of the accounting profession in preventing another financial crisis.3 This case summarizes information from these sources. COMPANY BACKGROUND
Originally, Lehman’s business model was that of a brokerage firm and underwriter. In that role, Lehman acted as an agent, marketing securities and acquiring assets on behalf of third parties. In 2006, Lehman’s management and Board of Directors decided to increase the firm’s risk profile and pursue a higher growth strategy. Thereafter, Lehman acquired assets for its own investments, hence internalizing the risk and returns of those investments. That is, Lehman transformed itself from a “moving” business in which it held securities only for a short time period, to a “storage” business in which it managed securities over a much longer period (Valukas 2010, Volume 1, p. 43).

According to a senior Lehman executive, the company pursued an aggressive 13 percent growth rate in revenues (Valukas 2010, Volume 1, pp. 61-62). This business strategy was high-risk in light of Lehman’s low equity and high leverage. The increased risk was borne by Lehman’s investment in long-term assets, primarily commercial real estate, leveraged loans and illiquid private equity with high growth potential. When the sub-prime mortgage crisis hit the U.S. in 2006, Lehman undertook an aggressive strategy of “doubling down” rather than pulling-back and diversifying. By doing so, it violated its own internal controls on risk management. Lehman increased its holdings in these long-term, illiquid, high-risk investments from $87 billion in 2006 to $175 billion at the end of the first quarter of 2008 (Valukas 2010, Volume 1, p. 57). These newer investments increased Lehman’s business risk in several ways. First, these assets were difficult to liquidate in an economic downturn, primarily because a ready market did not exist and they could only be sold at steep losses. Second, many lenders steeply discount the collateral value of illiquid assets, making them less valuable as collateral against borrowings. Finally, there was no feasible way to hedge these assets.

In order to finance these long-term investments, Lehman needed to borrow billions of dollars. In late 2007, the company held assets of $700 billion on equity of $25 billion, with $675 billion of