During the height of the 2008 credit crunch, Lehman Brothers, led by CEO Dick Fuld, was not bailed out by the government. Instead, it was allowed to fail and become the largest bankruptcy in history.
How did this 150-year old firm that survived the Civil War and the Great Depression fail?
The short answer is, the firm was obsessed with growth so it chased returns with little regard for prudent risk management.
Their business model during the 2000’s economic growth period relied upon:
- Excessive leverage (40 to 1): a couple percent drop in asset prices renders the firm’s balance sheet without equity.
- Being the largest securitizer of sub-prime real estate mortgages.
- The overnight repo market to fund daily operations.
- Accounting gimmicks such as Repo 105 to make the balance sheet look good for quarterly reporting.
- Unrealistic modeling with faulty assumptions such as real estate prices only go up and the overnight repo market is always liquid.
- Believing “this time is different” and not preparing for the inevitable market cycle to reverse course.
- Retaining ownership in some securities they created to increase their profits.
- Incorrectly believing they would get a bailout from the government like Bear Sterns (after rejecting a bailout from Warren Buffett before late 2008).
What lesson can individual investors learn from this?
Be wary of investments requiring excessive leverage and market conditions remaining the same in perpetuity.