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Working Paper Series

Fall of Lehman Brothers – reasons why the failure could not be stopped

Arif Ahmed

South Asian Management Technologies Foundation

August, 2011

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Contents

Abstract ............................................................................................................................................ 3

Background ....................................................................................................................................... 4

Genesis of the Problem .................................................................................................................... 5

The Abettors of Failure ..................................................................................................................... 9

Controls that failed ......................................................................................................................... 12

Preventing another Lehman ........................................................................................................... 16

Conclusion ...................................................................................................................................... 19

Reference ....................................................................................................................................... 22

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Abstract

Failure of Lehman Brothers marks an important point of modern economic history. In a matter

of eight months a successful and respected financial institution filed for bankruptcy creating a

ripple effect across the banking world spread over various political boundaries. This paper

examines the genesis of the risk and finds that it was well within the limits of executives and

management of Lehman Brother to stop the complete annihilation. It was possible to sustain

despite suffering serious damages if Lehman Brothers did not blindly believed that their next

action will be met by success. A classic example of gamblers fallacy, Lehman Brother underlined

that nobody is invincible to economic reality. The article identifies the controls that could have

prevented the fall and suggests a tool to evaluate chances of capital erosion.

Keyword: Lehman Brothers, Repo 105, Comfort deposits, Liquidity, Valuation, Lehman Breach

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Unit 10 Research Paper

Causes behind failure of Lehman and could that have been prevented

Background

On January 29, 2008, Lehman Brothers Holdings Inc. (Lehman) reported record revenues of

nearly $60 billion and record earnings in excess of $4 billion for its fiscal year ending November

30, 2007. During January 2008, Lehman’s stock traded as high as $65.73 per share and averaged

in the high to mid‐fifties, implying a market capitalisation of over $30 billion. Less than eight

months later, on September 12, 2008, Lehman’s stock closed under $4, a decline of nearly 95%

from its January 2008 value. On September 15, 2008, Lehman moved for the largest bankruptcy

proceeding ever filed (McDonald & Robinson, 2009).

The failure busted a myth about “too big to fail” that was prevalent among the banking

community (Sorkin, 2009). It also busted another myth that it is only the deposit banks that are

liable to fail and not investment bankers (House of Commons, 2010).

The sub-prime crisis may be a name that has been ascribed to the singularly most important

reason behind the fall, but it is the climax. The real story lies in the unchained incentive to

violate cardinal principles of risk management–matching risk exposure with risk appetite. This

has been violated time and again by large corporations be in banking sector or otherwise. The

fall of Lehman Brothers emphasised the absoluteness of economic justice and exposed how

susceptible are banking corporations interlinked across political boundaries.

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Lehman’s financial plight, and the consequences to Lehman’s creditors and shareholders,

underlined the danger of investment bank business model which rewarded excessive risk taking

and leverage (Skalak, Golden, Clayton, & Pill, 2011). It also highlights failure of Government

agencies that should have better anticipated and mitigated the outcome.

Genesis of the Problem1

Lehman’s business model was not anything out of the book. A large number investment banks

at various points of time have followed some variation of a high‐risk, high‐leverage model based

on confidence of counterparties to sustain. Lehman maintained approximately $700 billion of

assets, and corresponding liabilities, on capital of approximately $25 billion (Swedberg, 2010).

But the assets were predominantly long‐term, while the liabilities were largely short‐term – a

classic case of asset liability mismatch. Lehman funded itself through the short‐term repo

markets and had to keep borrowing large sums of money in those markets on a daily basis to be

able to open for business. Confidence of counterparties was critical and the moment such repo

counterparties lost confidence in Lehman and declined to roll over its daily funding, Lehman was

unable to fund itself and continue to operate.

In 2006, Lehman decided to embark upon an aggressive growth strategy to take on significantly

greater risk and simultaneously to substantially increase leverage on its capital (Schapiro, 2010).

In 2007, as the sub‐prime residential mortgage business progressed from problem to crisis,

Lehman was slow to recognise that the problem will spill over on commercial real estate and

other business lines. Instead of pulling back, Lehman fell victim to the Gamblers fallacy (Bellos,

2010) and made the conscious decision to increase exposure hoping to profit from a

1 The chronological details have been drawn from volume 1 of the Report of Anton R. Valukas, examiner in the case

of Lehman Brothers Holding Inc., at United States Bankruptcy Court, Southern District of New York.

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counter‐cyclical strategy. In order to accommodate the additional exposure, Lehman repeatedly

exceeded its own internal risk limits and controls by significant margins.

Near collapse of Bear Stearns in March 2008 pointed out that Lehman’s growth strategy has not

only been misplaced but has put its’ survival was in jeopardy. The markets were shaken by

Bear’s demise, and Lehman was widely considered to be the next bank that might fail.

Confidence was eroding and Lehman pursued a number of strategies to avoid failure and

maintain confidence, including reporting misleading picture of its financial condition.

One of the ways to maintain investor and counterparty confidence was to get favourable ratings

from the principal rating agencies to. Lehman understood that while the rating agencies looked

at many things in the rating process, net leverage and liquidity numbers were of critical

importance (Gardner & Mills, 1994). Lehman required favourable net leverage position to

maintain its ratings and investor confidence. Lehman announced a quarterly loss of $2.8 billion

at end of the second quarter of 2008 (Ward, 2010). This was the result of a combination of

write‐downs on assets, sales of assets at losses, decreasing revenues, and losses on hedges.

Following a crafted strategy, Lehman underplayed the loss by claiming that it had

1. Significantly reduced its net leverage ratio to less than 12.5,

2. Reduced the net assets on its balance sheet by $60 billion, and

3. A strong and robust liquidity pool.

Lehman did not disclose was that the balance sheet was designed using an innovative

accounting device known as “Repo 105” to manage its balance sheet (Kass-Shraibman &

Sampath, 2011). This accounting device temporarily removed approximately $50 billion of

assets from the balance sheet at the end of the first and second quarters of 2008. In an ordinary

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repo cash is raised by selling assets with a simultaneous obligation to repurchase them the next

day or several days later and such transactions are accounted for as financing with the assets

remaining on the balance sheet of the issuer. In a Repo 105 transaction, since the assets were

105% or more of the cash received, accounting rules permitted the transactions to be treated as

sales rather than financings and the assets could be removed from the balance sheet (Albrecht,

Albrecht, Albrecht, & Zimbelman, 2009). Lehman Brothers used this accounting rule to its

advantage and reported net leverage was 12.1 at the end of the second quarter of 2008, while

the net leverage would have 13.9 if they were treated as ordinary repo transaction (Syke, 2010).

Since Lehman used Repo 105 for no reason other than to reduce balance sheet at the

quarter‐end, this was not a Repo 105 transaction in substance and should not have been

accorded the special accounting treatment. Effectively instead of selling assets at a loss, Repo

105 transaction achieved reduction of assets without having a negative impact on equity and

consequently on leverage ratios. The only purpose or motive for [Repo 105] transactions was

reduction in the balance sheet and that there was no substance to the transactions.

Lehman did not disclose its large scale use of Repo 105 to the Government, rating agencies,

investors, or even to its own Board of Directors. Lehman’s auditors, Ernst & Young, were aware

of but did not question Lehman’s use and nondisclosure of the Repo 105 accounting

transactions (Davies, 2010).

In mid‐March 2008, after near collapse of Bear Stearns, teams of Government monitors from

the Securities and Exchange Commission (“SEC”) and the Federal Reserve Bank of New York

(“FRBNY”) were stationed at Lehman, to monitor its’ financial condition with particular focus on

liquidity (Congressional Oversight Panel, 2010).

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Lehman publicly asserted throughout 2008 that it had a liquidity pool sufficient to weather any

foreseeable economic downturn, but did not publicly acknowledge that by June 2008 significant

components of its reported liquidity pool had become difficult to monetise. Even on September

10, 2008, Lehman publicly announced that its liquidity pool was approximately $40 billion

though but a substantial portion of that total was either encumbered or otherwise illiquid. From

June on, Lehman continued to include in its liquidity reports substantial amounts of cash and

securities which it had placed as “comfort” deposits with various clearing banks (National

commission on the causes of the financial and economic crisis in the United States, 2011).

Technically Lehman could recall those deposits but if they would have done so, their ability to

continue its usual clearing business would have been in doubt. By August, substantial amounts

of “comfort” deposits had actually become pledges which Lehman could not have withdrawn.

By September 12, two days after it publicly reported a $41 billion liquidity pool, the pool

actually contained less than $2 billion of readily monetisable assets.

Earlier, on June 9, 2008, Lehman pre‐announced its second quarter results and reported a loss

of $2.8 billion, its first ever loss since going public in 1994. Despite that announcement, Lehman

was able to raise $6 billion of new capital in a public offering on June 12, 2008. But Lehman

knew that new capital was not enough against the liquidity crisis it was facing.

On September 10, 2008, Lehman announced that it was projecting a $3.9 billion loss for the

third quarter of 2008. Although Lehman had explored options of selling out but had no buyer

(Wiliams, 2010) and only announced survival plan they had was to spin off troubled assets into a

separate entity. By the close of trading on September 12, 2008, Lehman’s stock price had

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declined to $3.65 per share, a 94% drop from the $62.19 January 2, 2008 price (New York

magazine, 2008).

It appeared by early September 14 that a deal had been reached with Barclays which would

save Lehman from collapse. But later that day, the deal fell apart when the parties learned that

the Financial Services Authority (“FSA”), the United Kingdom’s bank regulator, refused to waive

U.K. shareholder‐approval requirements and the deal fell through (Posner, 2010). Lehman no

longer had sufficient liquidity even to fund its daily operations and on September 15, 2008, at

1:45 a.m., Lehman filed for Chapter 11 bankruptcy protection (Paul, 2010).

The Dow Jones index plunged 504 points on September 15. On September 16, AIG was on the

verge of collapse and the Government intervened with a financial bailout package that

ultimately cost about $182 billion (Carter, Clegg, Komberger, & Schweitzer, 2011). On

September 16, 2008, the Primary Fund, a $62 billion money market fund, announced that –

because of the loss it suffered on its exposure to Lehman and its share price had fallen to less

than $1 per share. On October 3, 2008, Congress passed a $700 billion Troubled Asset Relief

Program (“TARP”) rescue package (Janda, Berry, & Goldman, 2009).

The Abettors of Failure

Lehman failed because it was unable to retain the confidence of its lenders and

counterparties which was prompted by the insufficient liquidity it had to meet its current

obligations. Lehman was unable to maintain confidence because a series of business decisions

that had led to heavy concentrations of illiquid assets with deteriorating values like residential

and commercial real estate. Confidence was further eroded when it became public that

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attempts to form strategic partnerships to bolster its stability had failed. There also was

contribution of reported losses of $2.8 billion in second quarter 2008 and $3.9 billion in third

quarter 2008, without news of any definitive survival plan.

The business decisions that brought Lehman to its crisis may be, with the advantage of

hindsight, be termed as erroneous but they were well within normal business judgment rule –

however faulted that might have been. There could have been alternative responses, but the

response provided was also legitimate. But the decision not to disclose the effects of those

judgments and taking shelter behind accounting rulebook was certainly improper action of

senior officers overseeing and certifying misleading financial statements. Questions of

professional misconduct are also raised against Lehman’s external auditor Ernst & Young

primarily for its failure to question and challenge improper or inadequate disclosures in those

financial statements (Davies, 2010).

Research findings (Allen & Peristiani, 2004) demonstrate that the market responds to

the potential for conflicts of interest as commercial bank advisors provide lending to acquirers

in return for merger advisory fees. The advisor’s implicit (or explicit) promise to provide credit is

viewed as a potential conflict of interest by the market and weakens any perceived profits

resulting from merger advisory fees; i.e., losses on future loan commitments (as well as related

adverse reputational effects) may more than offset merger advisory fees. Lehman Brothers

failure was not pointed out by analysts till the crisis had sunk in deep.

A banking panic is a systemic event because the banking system cannot honour

commitments and is insolvent. Unlike the historical banking panics of the 19th and early 20th

centuries, the current banking panic is a wholesale panic, not a retail panic. In the earlier

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episodes, depositors ran to their banks and demanded cash in exchange for their deposit

accounts. Unable to meet those demands, the banking system became insolvent. The current

panic involved financial firms stifling other financial firms by not renewing sale and repurchase

agreements (repo) or increasing the repo margin, forcing massive deleveraging, and resulting in

the banking system being insolvent. Subprime related products were shocked by the decline in

housing prices, but the location of these risks was not known. Worried that their banks were not

solvent, and concerned about the liquidity of their collateral, repo depositors increased repo

haircuts, essentially demanding more equity financing of the collateral. Banks could not get

enough new investment though the sale of equity or new debt, and decided to sell assets, since

they could not suspend convertibility. Earlier episodes have many features in common with the

current crisis, and examination of history can help understand the current situation and guide

thoughts about reform of bank regulation. New regulation can facilitate the functioning of the

shadow banking system, making it less vulnerable to panic (Gorton,2009).

The subprime lending crisis demonstrated that regulators will extend their safety net to

support large companies that have close links to major financial institutions. In view the large

liquidity support for major securities firm, market participants now believe that the federal

safety net will be used to support any company whose failure could threaten the stability of

financial market. Consequently it is reasonable to expect that safety net subsidies will be

extended into the commercial sector if commercial firms are allowed to establish large-scale

baking operations (Wilmarth, 2008).

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Controls that failed2

The major areas where controls failed in Lehman Brother include the following:

1. Business and Risk Management: Majority of decisions that Lehman Brothers took were

not out of ordinary. However there was a gross failure in terms of relating the decisions

to their risk bearing capacity. Further financial reports were camouflaged to deceive

investors. In 2006, Lehman adopted a more aggressive business strategy by increasing its

investments in potentially highly profitable lines of business that carried much more risk

than Lehman’s traditional investment banking activities (Baker, 2010). Through the first

half of 2007, Lehman focused on committing its own capital in commercial real estate

(“CRE”), leveraged lending, and private equity like investments (Schapiro, 2010). These

investments were considerably riskier for Lehman than its other business lines because

they were acquiring potentially illiquid assets that it might be unable to sell in a

downturn. Lehman shifted from focusing almost exclusively on the “moving” business –

a business strategy of originating assets primarily for securitisation or syndication and

distribution to others – to the “storage” business – which entailed making longer‐term

investments using Lehman’s own balance sheet. However, Lehman’s management

informed the Board, clearly and on more than one occasion, that it was taking increased

business risk in order to grow the firm aggressively. The board was also informed that

the increased business risk is causing higher risk usage metrics and ultimately firm‐wide

risk limit overages. The fact that market conditions after July 2007 were hampering the

firm’s liquidity was also conveyed to the board.

2 The description of various internal management functions have been drawn from volume 2-5 of the Report of

Anton R. Valukas, examiner in the case of Lehman Brothers Holding Inc., at United States Bankruptcy Court,

Southern District of New York.

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2. Valuation: Lehman Brothers evidently did not follow proper valuation procedures and

some valuations were unreasonable for the purpose of solvency analysis (Bruemmer &

Sandler, 2008). This increase in Lehman’s net assets was primarily caused by

accumulation of potentially illiquid assets which were not highly liquid especially during

a downturn. By one measure, Lehman’s holdings of these illiquid assets increased from

$86.9 billion at the end of the fourth quarter of 2006 to $174.6 billion at the end of the

first quarter of 2008. Under GAAP, Lehman was required to report the value of its

financial inventory at fair value. However from beginning in the first quarter of 2007,

Lehman adopted SFAS 157, which established the fair value of an asset as the price that

would be received in an orderly hypothetical sale of the asset (Carmichael & Graham,

2011). As the level of market activity declined in late 2007 and 2008 the valuation inputs

became less observable and some of the assets of Lehman became increasingly less

liquid. Lehman progressively relied on its judgment to determine the fair value of such

assets. In light of the dislocation of the markets and its impact on the information

available to determine the market price of an asset, investors, analysts and the media

focused on Lehman’s mark‐to‐market valuations. The Office of the Chief Accountant,

Divison of Corporate Finance (2010) highlighted the lack of confidence in Lehman’s

valuations was also evident in the demands for collateral made by Lehman’s clearing

banks throughout 2008 to secure risks they assumed in connection with clearing and

settling Lehman’s tripartite and currency trades, and other extensions of credit. The

uncertainly as to the fair value of Lehman’s assets also played a role in the negotiations

between Bank of America and Lehman regarding a potential acquisition of Lehman by

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Bank of America. Bank of America put together a diligence team at some point around

September 10 or 11, 2008, and it became quickly apparent to them that, without

substantial government assistance, the deal would not be beneficial to Bank of America.

The sticking point for Bank of America was huge difference in Lehman’s valuation of its

assets (Wiliams, 2010).

3. Repo 105: The way this financial tool was used was indeed fraudulent in nature and

Lehman Brothers focused on form over substance. In late 2007 and 2008, Lehman

employed off‐balance sheet devices known as “Repo 105” and “Repo 108” transactions,

to temporarily remove securities inventory from its balance sheet, usually for a period of

seven to ten days, and to create a materially misleading picture of the firm’s financial

condition. Repo 105 transactions were nearly identical to standard repurchase and

resale (“repo”) transactions that any investment banks use to obtain short‐term

financing. However there was a critical modification. Lehman accounted for Repo 105

transactions as “sales” as opposed to financing transactions based upon providing

greater collateral or higher than normal haircut (Albrecht, Albrecht, Albrecht, &

Zimbelman, 2009). By describing the Repo 105 transaction as a “sale,” Lehman removed

the inventory from its balance sheet. Lehman regularly increased its use of Repo 105

transactions in the days prior to reporting periods to reduce net leverage and balance

sheet. Lehman’s periodic reports did not disclose the cash borrowing from the Repo 105

transaction – i.e., although Lehman had in effect borrowed tens of billions of dollars in

these transactions, Lehman did not disclose the known obligation to repay the debt.

Lehman used the cash from the Repo 105 transaction to pay down other liabilities,

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thereby reducing both the total liabilities and the total assets reported on its balance

sheet and lowering its leverage ratios. Thus, Lehman’s Repo 105 practice consisted of a

two‐step process: (1) undertaking Repo 105 transactions followed by (2) the use of Repo

105 cash borrowings to pay down liabilities and reducing leverage. A few days after the

new quarter began, Lehman would borrow the necessary funds to repay the cash

borrowing plus interest, repurchase the securities, and restore the assets to its balance

sheet. Lehman never publicly disclosed its use of Repo 105 transactions, the accounting

treatment for these transactions, considerable escalation of its total Repo 105 usage, or

the material impact these transactions had on the firm’s publicly reported net leverage

ratio (Syke, 2010).

4. Misstatement: In addition to its material omissions, Lehman misrepresented in its

financial statements that the firm treated all repo transactions as financing transactions

–not sales – for financial reporting purposes. Starting in mid‐2007, Lehman faced a crisis

as market observers began demanding that investment banks reduce their leverage. The

inability to reduce leverage could lead to a ratings downgrade, which would have had an

immediate, tangible monetary impact on Lehman In mid‐to‐late 2007 (Wiliams, 2010).

Top Lehman executives from across the firm felt pressure to reduce the firm’s leverage

for quarterly and annual reports. By January 2008, Lehman ordered a firm‐wide

deleveraging strategy, hoping to reduce the firm’s positions in commercial and

residential real estate and leveraged loans in particular by half. Selling inventory,

however, proved difficult in late 2007 and into 2008 because, starting in mid‐2007, many

of Lehman’s inventory positions were difficult to sell without incurring substantial losses.

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Moreover, selling sticky inventory at reduced prices could have led to a loss of market

confidence in Lehman’s valuations for inventory remaining on the firm’s balance sheet

since emergency sale pricing would reveal the valuation errors (Office of the Chief

Accountant, Divison of Corporate Finance, 2010). In light of these factors, Lehman relied

at an increasing pace on Repo 105 transactions in late 2007 and early 2008. Research

findings indicate that banking ties increase analysts’ reluctance to reveal negative news,

and that reform efforts must carefully consider the incentives of affiliated and

unaffiliated analysts to initiate coverage and convey the results of their research

(O.Brien, McNichols, & Lin, 2005)

Preventing another Lehman

Could fall of Lehman Brothers been avoided or another recurrence prevented? On a

scenario divorced from the circumstances under which Lehman operated, it can definitely be

claimed that such accidents are avoidable. Lehman did not follow the prudent path of financial

management and corporate governance, though according to their corporate governance

guideline they were committed to industry best practices (Yong, 2009). The question lies

whether such organisations are structurally equipped to do so. The faculty of risk management

have grown in importance because actual results are not always the expected action (Vaughan,

1982). The advantage of working in an uncertain decision horizon is that one is free to interpret

the future since however low may be the chances of an optimist occurrences, there still is a

chance of it occurring. The only judgement that can be questioned is whether there was

adequate risk absorption capability before embarking on a strategy that has a low probability of

occurrence.

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In the specific case of Lehman Brothers, the gradual slipping into the danger zone could

have been spotted and arrested by enforcing any of the following mechanisms.

1. Risk Appetite: The risk exposure and risk appetite is required to be in a ratio

reflecting the risk attitude of the institution. Change in the attitude is a strategic

issue and is to be decided by management and not executive. In case of Lehman,

evidently these were decided by executives and as a lag feature to accommodate

a decision to use Repo 105 for financing the balance sheet. In fact, collapse of

Lehman Brothers lead to a reassessment of risk exposure arising from the credit

default swaps (ASEAN Studies Centre: Institute of Southeast Asian Studies, 2008).

2. Stress Testing: Stress test for extreme values would have alerted Lehman about

the point of breakdown, an activity that Lehman paid scant attention to

(Schapiro, 2010). Reporting of the breakdown point and close observance of its

progress towards that could have resulted into evasive action being taken earlier.

Failure of Lehman Brothers underlined the importance of newer stress testing

approaches including testing for destruction (Kemp, 2011).

3. Capital adequacy: Asset exposure especially that of risky assets needs to be

complemented by adequate capital (McNeil, Frey, & Embrechts, 2005). Though

Lehman raised capital during the crisis those were to accommodate the risky

assets already on the balance sheet and not for future assets. Capital adequacy is

also to be computed for off-balance sheet assets using a credit conversion factor

(Carmichael & Rosenfield, Accountants’ Handbook: Special Industries and Special

Topic, 2003).

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4. Liquidity Management: An honest maturity profile statement would have shown

alarming duration gap for Lehman (Carrel, 2010). Either this was not done or

overlooked by the concerned executives. Lehman also contradicted view of

analysts who pointed this out. Whenever long terms assets are funded by short

term sources, the duration gap analysis will raise alarm to highlight up the

danger. Risk based management system should include analysis of duration gap

(Asan Development Bank, 1999).

5. Fair valuation and asset recognition under IFRS: International financial reporting

standards require fair valuation of financial assets which are held for trading

(Dick & Missioner-Piera, 2010). Fair valuation takes into consideration impact of

illiquid market especially in cases of banks (Congressional Oversight Panel, 2009).

This valuation is supposed to be driven by market situation and perception of

management. In addition, as asset is recognised only when the reporting entity

has right to its future benefits including cash flows (Epstein & Jermakowicz,

2010). The cash which was actually a substitute for a repo was not to be regarded

as asset of Lehman under the definition of the accounting standards. However

Lehman chose to stick to the legal definition of ownership and reported those as

their assets.

6. Corporate Governance: Finally a proper corporate governance plan that would

have highlighted the fraudulent activities of Lehman was completely absent (Sun,

Stewart, & Pollard, 2011). The decisions at were taken more to ward off short

term problem at the cost of long term stability – an issue closely related with

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shareholders interest. However, in Lehman Brothers people, including

institutional investors, were all busy to protect their own interest and left the

corporate interest aside. An industry specific conceptualisation of corporate

social responsibility (CSR) needs to take into account the defining characteristics

of an industry as well as social perception of the industry. In banking, CSR is

affected by the nature of the product. Governmental influence gives banking CSR

a special dimension. Banks need to develop special strategies which would show

that they take account of wider societal concerns which arise from their business

activity (Decker, 2004). Universal banks aided and abetted violations of corporate

governance rules and federal securities laws by officers of Enron and WorldCom.

Bank officials also repeatedly disregarded risk management policies established

by their own banks indicate that GLBA’s current regulatory framework is not

adequate to control the promotional pressures, conflicts of interest and risk-

taking incentives that are generated by the commingling of commercial and

investment banking. A comprehensive reform of the supervisory system for

universal banks is urgently needed and must become a top priority for Congress

and financial regulators (Wilmarth, 2007).

Proper articulation and observance of these controls could have prevented the fall of

Lehman Brothers. However, it cannot be assured that another Lehman Brother would not

happen and that is where proper risk management practice plays a critical role.

Conclusion

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In banking, the business sources money from promoters in form of capital and

depositors or from others sources. These are utilised to lend money or to invest in securities or

in investment banking assets. Thus if an asset become non income and cash inflow generative,

the promoters are supposed to bear the loss. If the bank is undercapitalised for its lending and

investment pattern – the depositors take the hit – that is when bankruptcy settles in.

Finance allows designing tools that can decide on holding of low risk and high risk assets.

One of the ways would be to look at the maximum possible loss that the asset portfolio is

expected to run into. The point of crossing over from the safe zone to the danger zone can be

computed as the difference between the following two:

1. Summation of the present value of the expected realisable future value of the assets

carried in the balance sheet and present value of future expected cash inflow from the

assets, and

2. Summation of the present value of the expected future liquidation value of the liabilities

(excluding capital) carried in the balance sheet and present value of future expected

cash outflow against those liabilities and management cost.

The difference will be divided by the realisable value of the capital of the corporation. Let us

call this point “Lehman Breach”. If the result is less than 1 we have crossed the danger point.

This point onwards will hurt the investors in capital of the corporation. This is where a capital

infusion will be required to keep the corporation healthy. Unfortunately, unless this infusion

comes in very quickly, the investors will sell out and book the loss, making the present realisable

value of capital go down rapidly.

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If the Lehman Breach value is less than zero, the breach will also hurt other parties

represented by the liabilities of the corporation. This is usually a one way road to irrevocable

bankruptcy unless the Government comes into rescue directly or through some intermediaries.

The higher the Lehman Breach value, greater is the capability of the corporation to accept risk.

What would be worrying is that organised crime groups are increasingly targeting

legitimate business and committing economic crimes (Marine, 2006). Failure of Lehman was an

act of error of judgement and, at the worst, a failure of corporate governance. In the event such

events start forming a part of criminal activity, the existing control mechanisms which are

designed to tackle bonafide errors, may be found incompetent.

Each panic teaches us something new and this accumulating experience should in time

enable us to prolong the interval of recurrence if not eventually to prevent the recurrence

entirely, just as epidemics of disease, formerly thought inevitable, are now prevented

(Marburg, 1908). It is for us to apply the lessons judiciously.

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