The Lehman Brothers Meltdown

question 98

Essay

The Lehman Brothers Meltdown
Even though regulations are needed to promote appropriate business practices, they may also produce a false sense of security. Regulatory agencies often are coopted by those they are supposed to be regulating due to an inherent conflict of interest. The objectivity of regulators can be skewed by the prospect of future employment in the firms they are responsible for policing. No matter how extensive, regulations are likely to fail to achieve their intended purpose in the absence of effective regulators.

Consider the 2008 credit crisis that shook Wall Street to its core. On September 15, 2008, Lehman Brothers Holdings announced that it had filed for bankruptcy. Lehman's board of directors decided to opt for court protection after attempts to find a buyer for the entire firm collapsed. With assets of $639 billion and liabilities of $613 billion, Lehman is the largest bankruptcy in history in terms of assets. The next biggest bankruptcies were WorldCom and Enron, with $126 billion and $81 billion in assets, respectively.
In the months leading up to Lehman's demise, there were widespread suspicions that the book value of the firm's assets far exceeded their true market value and that a revaluation of these assets was needed. However, little was known about Lehman's aggressive use of repurchase agreements or repos. Repos are widely used short-term financing contracts in which one party agrees to sell securities to another party (a so-called counterparty), with the obligation to buy them back, often the next day. Because the transactions are so short-term in nature, the securities serving as collateral continue to be shown on the borrower's balance sheet. The cash received as a result of the repo would increase the borrower's cash balances and be offset by a liability reflecting the obligation to repay the loan. Consequently, the borrower's balance sheet would not change as a result of the short-term loan.
In early 2010, a report compiled by bank examiners indicated how Lehman manipulated its financial statements, with government regulators, the investing public, credit rating agencies, and Lehman's board of directors being totally unaware of the accounting tricks. Lehman departed from common accounting practices by booking these repos as sales of securities rather than as short-term loans. By treating the repos as a sale of securities (rather than a loan), the securities serving as collateral for the repo were removed from the books, and the proceeds generated by the repo were booked as if they had been used to pay off an equivalent amount of liabilities. The resulting reduction in liabilities gave the appearance that the firm was less levered than it actually was despite the firm's continuing obligation to buy back the securities. Since the repos were undertaken just prior to the end of a calendar quarter, their financial statements looked better than they actually were.

The firm's outside auditing firm, Ernst & Young, was aware of the moves but continued to pronounce the firm's financial statements to be in accordance with generally accepted accounting principles. The SEC, the recipient of the firm's annual and quarterly financial statements, failed to catch the ruse. In the weeks before the firm's demise, the Federal Reserve had embedded its own experts within the firm and they too failed to uncover Lehman's accounting chicanery. Passed in 2002, Sarbanes-Oxley, which had been billed as legislation that would prevent any recurrence of Enron-style accounting tricks, also failed to prevent Lehman from "cooking its books." As required by the Sarbanes-Oxley Act, Richard S. Fuld, Lehman's chief executive at the time, certified the accuracy of the firm's financial statements submitted to the SEC.
When all else failed, market forces uncovered the charade. It was the much maligned "short-seller" who uncovered Lehman's scam. Although not understanding the extent to which the firm's financial statements were inaccurate, speculators borrowed Lehman stock and sold it in anticipation of buying it back at a lower price and returning it to its original owners. In doing so, they effectively forced the long-insolvent firm into bankruptcy. Without short-sellers forcing the issue, it is unclear how long Lehman could have continued the sham.
Case Study Short Essay Examination Questions
A Federal Judge Reprimands Hedge Funds in their Effort to Control CSX
Investors seeking to influence a firm's decision making often try to accumulate voting shares. Such investors may attempt to acquire shares without attracting the attention of other investors, who could bid up the price of the shares and make it increasingly expensive to accumulate the stock. To avoid alerting other investors, certain derivative contracts called "cash settled equity swaps" allegedly have been used to gain access indirectly to a firm's voting shares without having to satisfy 13(D) prenotification requirements.
Using an investment bank as a counterparty, a hedge fund could enter into a contract obligating the investment bank to give dividends paid on and any appreciation of the stock of a target firm to the hedge fund in exchange for an interest payment made by the hedge fund. The amount of the interest paid is usually based on the London Interbank Offer Rate (LIBOR) plus a markup reflecting the perceived risk of the underlying stock. The investment bank usually hedges or defrays risk associated with its obligation to the hedge fund by buying stock in the target firm. In some equity swaps, the hedge fund has the right to purchase the underlying shares from the counterparty.
Upon taking possession of the shares, the hedge fund would disclose ownership of the shares. Since the hedge fund does not actually own the shares prior to taking possession, it does not have the right to vote the shares and technically does not have to disclose ownership under Section 13(D). However, to gain significant influence, the hedge fund can choose to take possession of these shares immediately prior to a board election or a proxy contest. To avoid the appearance of collusion, many investment banks have refused to deliver shares under these circumstances or to vote in proxy contests.
In an effort to surprise a firm's board, several hedge funds may act together by each buying up to 4.9 percent of the voting shares of a target firm, without signing any agreement to act in concert. Each fund could also enter into an equity swap for up to 4.9 percent of the target firm's shares. The funds together could effectively gain control of a combined 19.6 percent of the firm's stock (i.e., each fund would own 4.9 percent of the target firm's shares and have the right to acquire via an equity swap another 4.9 percent). The hedge funds could subsequently vote their shares in the same way with neither fund disclosing their ownership stakes until immediately before an election.
The Children's Investment Fund (TCI), a large European hedge fund, acquired 4.1 percent of the voting shares of CSX, the third largest U.S. railroad in 2007. In April 2008, TCI submitted its own candidates for the CSX board of directors' election to be held in June of that year. CSX accused TCI and another hedge fund, 3G Capital Partners, of violating disclosure laws by coordinating their accumulation of CSX shares through cash-financed equity swap agreements. The two hedge funds owned outright a combined 8.1 percent of CSX stock and had access to an additional 11.5 percent of CSX shares through cash-settled equity swaps.
In June 2008, the SEC ruled in favor of the hedge funds, arguing that cash-settled equity swaps do not convey voting rights to the swap party over shares acquired by its counterparty to hedge their equity swaps. Shortly after the SEC's ruling, a federal judge concluded that the two hedge funds had deliberately avoided the intent of the disclosure laws. However, the federal ruling came after the board election and could not reverse the results in which TCI was able to elect a number of directors to the CSX board. Nevertheless, the ruling by the federal court established a strong precedent limiting future efforts to use equity swaps as a means of circumventing federal disclosure requirements.
Discussion Questions
1. Do you agree or disagree with the federal court's ruling? Defend your position.
2. What criteria might have been used to prove collusion between TCI and 3G in the absence of signed agreements to coordinate their efforts to accumulate CSX voting shares?
Case Study Short Essay Examination Questions
Google Thwarted in Proposed Advertising Deal with Chief Rival Yahoo!
A proposal that gave Yahoo! an alternative to selling itself to Microsoft was killed in the face of opposition by U.S. government antitrust regulators. The deal called for Google to place ads alongside some of Yahoo!'s search results. Google and Yahoo! would share in the revenues generated by this arrangement. The deal was supposed to bring Yahoo! $250 million to $450 million in incremental cash flow in the first full year of the agreement. The deal was especially important to Yahoo!, due to the continued erosion in the firm's profitability and share of the online search market.
The Justice Department argued that the alliance would have limited competition for online advertising, resulting in higher fees charged to online advertisers. The regulatory agency further alleged that the arrangement would make Yahoo! more reliant on Google's already superior search capability and reduce Yahoo!'s efforts to invest in its own online search business. The regulators feared this would limit innovation in the online search industry.
On November 6, 2008, Google and Yahoo! announced the cessation of efforts to implement an advertising alliance. Google expressed concern that continuing the effort would result in a protracted legal battle and risked damaging lucrative relationships with their advertising partners.
The Justice Department's threat to block the proposal is a sign that Google can expect increased scrutiny in the future. High-tech markets often lend themselves to becoming "natural monopolies" in markets in which special factors foster market dominance by a single firm. Examples include Intel's domination of the microchip business, as economies of scale create huge barriers to entry for new competitors; Microsoft's preeminent market share in PC operating systems and related application software, due to its large installed customer base; and Google's dominance of Internet search, resulting from its demonstrably superior online search capability.
Discussion Questions
1. In what way might the Justice Department's actions result in increased concentration in the online search business in the future?
2. What are the arguments for and against regulators permitting "natural monopolies"?
BHP Billiton and Rio Tinto Blocked by Regulators in an International Iron Ore Joint Venture
The revival in demand for raw materials in many emerging economies fueled interest in takeovers and joint ventures in the global mining and energy sectors in 2009 and 2010. BHP Billiton (BHP) and Rio Tinto (Rio), two global mining powerhouses, had hoped to reap huge cost savings by combining their Australian iron ore mining operations when they announced their JV in mid-2009. However, after more than a year of regulatory review, BHP and Rio announced in late 2010 that they would withdraw their plans to form an iron ore JV corporation valued at $116 billion after regulators in a number of countries indicated that they would not approve the proposal due to antitrust concerns.
BHP and Rio, headquartered in Australia, are the world's largest producers of iron ore, an input critical to the production of steel. Together, these two firms control about one-third of the global iron ore output. The estimated annual synergies from combining mining and distribution operations of the two firms were estimated to be $10 billion. The synergies would come from combining BHP's more productive mining capacity with Rio's more efficient distribution infrastructure, enabling both firms to eliminate duplicate staff and redundant overhead and BHP to transport its ore to coastal ports more cheaply.
The proposal faced intense opposition from the outset from steel producers and antitrust regulators. The greatest opposition came from China, which argued that the combination would concentrate pricing power further in the hands of the top iron ore producers. China imports about 50 million tons of iron ore monthly, largely from Australia, due to its relatively close proximity.
The European Commission, the Australian Competition and Consumer Commission, the Japan Fair Trade Commission, the Korea Fair Trade Commission, and the German Federal Cartel Office all advised the two firms that their proposal would not be approved in its current form. While some regulators indicated that they would be willing to consider the JV if certain divestitures and other "remedies" were made to alleviate concerns about excessive pricing power, others such as Germany said they would not approve the proposal under any circumstances.
Discussion Questions
1. A "remedy" to antitrust regulators is any measure that would limit the ability of parties in a business combination from achieving what is viewed as excessive market or pricing power. What remedies do you believe could have been put in place by the regulators that might have been acceptable to both Rio and BHP? Be specific.
2. Why do you believe the antitrust regulators were successful in this instance but so unsuccessful limiting the powers of cartels such as the Organization of Petroleum Exporting Countries (OPEC), which currently controls more than 40 percent of the world's oil production?
Case Study Short Essay Examination Questions
Justice Department Approves Maytag/Whirlpool Combination
Despite Resulting Increase in Concentration
When announced in late 2005, many analysts believed that the $1.7 billion transaction would face heated anti-trust regulatory opposition. The proposed bid was approved despite the combined firms' dominant market share of the U.S. major appliance market. The combined companies would control an estimated 72 percent of the washer market, 81 percent of the gas dryer market, 74 percent of electric dryers, and 31 percent of refrigerators. Analysts believed that the combined firms would be required to divest certain Maytag product lines to receive approval. Recognizing the potential difficulty in getting regulatory approval, the Whirlpool/Maytag contract allowed Whirlpool (the acquirer) to withdraw from the contract by paying a "reverse breakup" fee of $120 million to Maytag (the target). Breakup fees are normally paid by targets to acquirers if they choose to withdraw from the contract.
U.S. regulators tended to view the market as global in nature. When the appliance market is defined in a global sense, the combined firms' share drops to about one fourth of the previously mentioned levels. The number and diversity of foreign manufacturers offered a wide array of alternatives for consumers. Moreover, there are few barriers to entry for these manufacturers wishing to do business in the United States. Many of Whirlpool's independent retail outlets wrote letters supporting the proposal to acquire Maytag as a means of sustaining financially weakened companies. Regulators also viewed the preservation of jobs as an important consideration in its favorable ruling.
-What is anti-trust policy and why is it important?

---

Definitions:

Diaphragm of Stethoscope

The diaphragm of a stethoscope is the flat, disc-shaped part used to listen to higher frequency sounds in the body, such as breath, bowel, and heart sounds.

Auscultating

The act of listening to the internal sounds of the body, typically with a stethoscope, as part of a medical examination.

Deep, Rapid Breaths

A pattern of breathing that is both deeper and faster than normal, often a sign of distress, excitement, or physical exertion.

Tactile Fremitus

A vibration felt on the chest wall during speech, which can indicate abnormalities in or around the lungs.