Here's How Lehman Should Have Gone Down

In September 2008, Lehman Brothers' bankruptcy roiled markets worldwide, with catastrophic results. Credit markets froze, and the S&P 500 lost 40% before the year was out. Could this happen again? In a paper released yesterday, the FDIC prepared a case study in which regulators manage Lehman's failure with the tools and mandate they have under the Dodd-Frank Act on financial reform. Here's how things might have gone.

Will they, won't they?
What happened
: In July, Treasury Secretary Hank Paulson told Lehman CEO Dick Fuld that the bank would receive no federal assistance. However, Fuld claims that Paulson never ruled this out. The government certainly sent mixed signals concerning the possibility of assistance: As late as Sept. 10 -- five days prior to the bankruptcy filing -- the Federal Reserve Bank of New York was using a presentation that discussed the option of federal financial support for Lehman.

Lehman executives and board members believed that the government would ultimately step in to help the bank -- and so did the senior management of other top Wall Street firms.

How it could have gone: In the spring of 2008, the FDIC meets with Lehman, along with the SEC and the Federal Reserve. Regulators quash any hint of ambiguity by firmly asserting that:

  • No rescue will be forthcoming;
  • Lehman has a July deadline to sell itself or raise adequate capital.
  • Failing that, the alternative to a sale or an capital raising is receivership (i.e., the government takes responsibility for the firm and oversees its resolution). Shareholders should expect to be wiped out under this scenario.

The following tables show two timeline of events leading up to Lehman's bankruptcy -- first what actually happened, and then a hypothetical "Dodd-Frank" timeline:

Actual events

March

Near collapse of Bear Stearns, before it is acquired by JPMorgan Chase (NYSE: JPM  )

Lehman holds discussions with Warren Buffett concerning a strategic investment by Berkshire Hathaway (NYSE: BRK-B  ) . Talks end without a result.

June

Korean bank KDB is the only potential strategic investor left

July

Rumors that Lehman is "done" become widespread.

September

Sept. 10: Lehman pre-announces Q3 earnings and a restructuring plan in which it hives off its commercial real estate assets.

Sept. 15: Lehman Brothers files for bankruptcy, causing significant disruption in markets worldwide.

Alternative scenario under Dodd-Frank

March-July

The FDIC establishes an on-site presence at Lehman to perform due diligence.

FDIC and other regulators hold joint meeting to inform Lehman that there will no bailout or assistance.

FDIC starts planning for a sale.

FDIC identifies and values 'problem' assets that could block an acquisition, in order to determine the best way to structure the sale.

August-September

Lehman is unable to sell itself. The FDIC starts to market Lehman to potential acquirers. Potential buyers are invited to submit bids that are consistent with the deal structure.

The FDIC evaluates bids.

Source: FDIC, Examiner's Report – Lehman Brothers Holdings.

The acquisition
What happened
: Barclays purchased Lehman's North American activities post-bankruptcy against the backdrop of chaotic global markets. Given these conditions and the timing, it was impossible for Lehman to realize full value on the sale of its assets.

How it could have gone: Lehman Brothers is placed in receivership, but Barclays is able to purchase the entire company, with a loss-sharing agreement on problem assets identified by the FDIC. This is the same sort of arrangement that the FDIC typically puts together in the context of a failed commercial banks. Consistent with the planned deal structure, Lehman's assets and certain liabilities are transferred to Barclays, with limited disruption to financial markets. Lehman obtains better bids for its assets, and creditors recover a higher proportion of what they are owed.  

Messy and expensive
What happened
: Lehman's estate sued Barclays, claiming it structured the sale agreement in a manner that produced "an immediate and enormous windfall profit." Lehman's bankruptcy fees to law firms, consultants, and other advisors topped $1 billion, including at least $370 million to restructuring firm Alvarez & Marsal. The bankruptcy became the costliest in U.S. history

How it could have gone: The sale takes place in an orderly, transparent manner, reducing any risk of litigation. Fees for professional services are much lower.

Too big to fail: Alive and well in America
Sheila Bair, the head of the FDIC, is one of the few regulators who has advanced the notion that "too-big-to-fail" institutions should be broken up. Regulators now have the authority to require banks to do so under Dodd-Frank. Should it happen? Yes. Will it happen? No.

With Bair entering her last few weeks at the head of the FDIC, I don't see anyone taking up her banner to push for banks to break themselves up. Citigroup (NYSE: C  ) , JPMorgan Chase, and Bank of America (NYSE: BAC  ) must be breathing a sigh of relief. Taxpayers, on the other hand, should be sorry to see her go.

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Fool contributor Alex Dumortier, CFA has no beneficial interest in any of the stocks mentioned in this article. You can follow him on Twitter. Berkshire Hathaway is a Motley Fool Inside Value selection. Berkshire Hathaway is a Motley Fool Stock Advisor pick. The Fool owns shares of Bank of America, Berkshire Hathaway, and JPMorgan Chase &. Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.


Read/Post Comments (5) | Recommend This Article (9)

Comments from our Foolish Readers

Help us keep this a respectfully Foolish area! This is a place for our readers to discuss, debate, and learn more about the Foolish investing topic you read about above. Help us keep it clean and safe. If you believe a comment is abusive or otherwise violates our Fool's Rules, please report it via the Report this Comment Report this Comment icon found on every comment.

  • Report this Comment On April 19, 2011, at 5:58 PM, xetn wrote:

    This article is backwards; it should be "How the rest of the banks should have gone down". Answer, they all should have failed. No bailouts period.

    Now look at the mess the country is in: swimming in debt, big banks getting bigger and the taxpayers footing the bill. (Of course, we can't overlook GM and Chrysler, or AIG). That is the purpose of bankruptcy. You pay the price for excessive risk-taking.

  • Report this Comment On April 19, 2011, at 6:17 PM, jlacroix wrote:

    excellent response, xetn!

  • Report this Comment On April 19, 2011, at 6:35 PM, rd80 wrote:

    I see no reason to expect that the FDIC scenario would be any less disruptive than the actual scenario.

    To think otherwise assumes no glitches in the Dodd-Frank process. For example, who eats the losses if, as was the case in Lehman, the 'problem assets' overwhelm the situation? And how would sorting that out be any different than bankruptcy - a proven and well established process?

  • Report this Comment On April 19, 2011, at 9:20 PM, ynotc wrote:

    Dodd Frank would have the same effect. Once the FDIC steps in all of the investors will panic and dump the shares effectively bankrupting the company and liquidating any capital.

  • Report this Comment On April 20, 2011, at 11:24 AM, 4thand80 wrote:

    Dodd-Frank would probably make the markets worse off than without it. Presumably no bailouts would have been offered to Merrill, Goldman, Morgan, etc either. As soon and the FDIC steps in at Lehman, investors will dump everything bankrupting the company and trigger massive CDS payouts written by the other banks and large drops in illquid assets like CLOs causing immense pressure on other banks. Similiar fates for MS, GS, and ML would materialize shortly after causing an even worse situation. Do you really think the government would have the resources available to deal with 4 or 5 banks circling the drain at the same time? Also the other banks not in dire trouble (CS, DB, etc) would be unable to handle the extra funding capacity from large hedge funds and effectively force them to sell assets and deleverage to meet margin. Fatally crippled markets would follow as credit becomes non-existant.

    No mention of how Dodd-Frank would have handled this though.

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