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Lehman – A Case of Strategic Risk

Journal 34: Cass-Capco Institute Paper Series on Risk

Patrick McConnell

The bankruptcy of Lehman Brothers in 2008 was a critical event in the Global Financial Crisis, exposing serious fault-lines in the structure of global financial markets and leading to widespread economic disruption. But how did Lehman, a company of over 150 years’ experience in commodities markets, reach such a precarious position? The underlying reason for the failure goes back to a change in corporate strategy in 2006 in which Lehman decided to shift from a “moving” or securitization business to a “storage’ business, with the firm making and holding longer-term, riskier investments.

This “strategic positioning” was fully endorsed by the board, although certain senior risk management executives had expressed concerns about the extent of the change to the firm’s “risk appetite.” Using the official report into the firm’s bankruptcy, this paper describes how Lehman over-extended itself in its “strategic execution,” failing to put in the place the proper governance structures needed to man-age, arguably, the greatest risk to any firm, “strategic risk.” To prevent similar failures in future, there is a demonstrable need for banking regulators, especially of “significantly important” banks, to address such critical deficiencies in corporate governance and strategic risk management.

Like the assassination of Archduke Franz Ferdinand in 1914 (which led to the outbreak of the First World War), the bankruptcy of Lehman Brothers in September 2008 had ramifications far beyond the narrow confines of the event itself. The liquidation of Lehman did not cause the global financial crisis (GFC) but the firm’s failure exposed serious faultlines in the structure of the global financial markets where a cat’s cradle of opaque and complex interconnections collapsed like a house of cards when Lehman was removed.

Lehman’s bankruptcy was large but its cause was not unusual; in essence, the firm just could not pay its debts to its creditors. The proximate cause of the insolvency was that the firm was overly exposed to the commercial property market and was sitting on a large warehouse of securities, so-called Collateralised Debt Obligations (CDOs), the value of which were falling rapidly as a result of agency downgrades [Valukas (2010)]. Much of the commentary on Lehman’s bankruptcy concentrates on hypotheticals, such as what would have happened if the U.S. Federal Reserve Bank had not “allowed” Lehman to fail and instead arranged a shotgun marriage with another bank, as happened earlier in the year with Bear Stearns [FCIC (2011)]. But at the time, the Fed was not able/willing to save Lehman and the rest is history [Tibman (2009); Valukas (2010)].

This paper does not look at the frantic activities in months leading to Lehman’s bankruptcy, which are well covered elsewhere [Tibman (2009); Valukas (2010)], but instead asks the question: how did a firm that had been trading successfully for over 150 years come to a point where it was so catastrophically insolvent? The board and management were experienced in the businesses in which Lehman operated and therefore should not have been caught out so completely by the events in the credit markets in 2007 and 2008. The paper argues that the events can be traced back to a decision in 2006 to radically change the strategic direction of the firm and that there was a failure to manage the risks in that change of strategy. In short, the firm failed to properly manage its “strategic risks.”


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