The rise and fall of Lehman Brothers
Lehman Brothers, Lehman Brothers Holdings Inc, was one of five most powerful global financial services firms in US. Its legendary had never failed to appeal elites at that time engaging in financial area, and even today, the rise of Lehman Brothers is still one of the required lessons in business schools all over the world. Majored in Economics, I am also interested in how Lehman Brothers built their business empire. In the rest of my paper, I will discuss the rise and fall of Lehman Brothers and the impact it had on the global economy.
In 1844, a young man from Germany moved to US and started his own business, a cloth shop named Henry Lehman. After three years of running his business, his brother, Emanuel Lehman came to US to assist him and the name of the cloth shop was changed to H. Lehman and Bro. Three years later, his youngest brother, Mayer Lehman, also moved to US thus the name of the shop, Lehman Brothers. In the 1850s, the cotton industry was prosperous in US and cotton was of high price. As the social recognition of cotton’s value is formed, cotton became a way of trading, in another word, a commodity money. Lehman Brothers also received a large amount of cotton paid by their customers, which motivated them to move their business to New York city, the biggest cotton trading center in US. After Lehman Brothers gained their first barrel of gold in trading cotton, they started their first investment in coffee industry which paid them a satisfying profit. As the railroad was being built in US, Lehman Brothers started buying bonds of railway company and that the transition from running real economic industries to investment. In 1925, Robert Lehman, the grandson of Emanuel Lehman took control of the company and introduced a new managing system: management board was no longer only selected from family members. This system provided Lehman Brothers with more elites with whose help the company grew in an incredible speed and finished its transition to an investment bank. In 1969 when Robert Lehman died, there were no man from Lehman family in the manage board of Lehman Brothers. In the following years, the firm faced its failure in the market due to the disagreement in the manage board, and the firm was later purchased by American Express. In 1994, American Express made a decision to separate the firm as an independent investment bank and named it Lehman Brothers Holdings Inc. After the establishment of Lehman brothers Holdings Inc., the bank was not accepted by the market because it was risky to invest in a new bank. This situation continued until 1999, when Lehman Brothers decided to invest on substandard loan which was known as a combination of high rate of risk and high rate of return. At the beginning of involving in substandard loan, Lehman Brothers successfully made billions of dollars in less than six years and reached its career’s peak in 2006 when the nominal profit was over 4 billion dollars. However, the peak was shortly ended by the total collapse of the firm hence the opening of the economic crisis in 2008.
At the beginning of 2000, real estate developed rapidly in the US and the price of the house had increased by 100% from 2000 to 2006. In normal cases, the increase of price level, also known as inflation, is a sign of the positive growth of economy. However, things were different in 2000, during which the Web Bubble in the US broke and caused a recession. Also, in 2001, the US faced one of the saddest dates in her history, 9/11 terrorist attacks. In order to stimulate the economy, Fed decided to lower the interest rate which encouraged people to purchase instead of to save and encouraged companies to borrow from banks and invest on the economy. As a result, more and more people decided to purchase realty because the drop of interest rate made the house cheaper. After the demand curve was shifted upward, the intersection point of demand curve and supply curve made upward as well, thus the increase in the price level of realty goods. As the house became more expensive, there were more demand of the loan from banks simply because people could not afford the house by themselves any longer. This circle finally went to the most critical point, the bank. Usually, banks should assess customers and make sure about the certainty of income before they lend money to them. However, the huge profit in the loanable funds market made most banks break their rules and start loaning to anyone who asked for the loan, and this kind of loan was named substandard loan. The risk of providing substandard loan was inevitable and this motivated banks to apply three methods. First, banks will take lenders’ house as mortgage. Second, the interest rate of substandard loan was much higher than regular loans, in other words, it was usury. Third, banks assigned the debt to the investment bank, Lehman Brothers who later sold the debt to bonds investors by separating the debt into multiple pieces and combining each piece with other financial goods and services like stock or other kinds of bonds. Lehman Brothers believed that this movement guaranteed the risk for individual investors could be lowered because the risk was carried by more people. The straw that broke the camel’s back was the rating agencies, Standard & Poor’s, Moody’s Investors Service and Fitch Ratings, who all gave the combination AAA rate, little rate of risk and high rate of return. Because of the rating, many people invest their money on Lehman Brothers, including banks, pension funds, etc. With the confidence of this combination went higher and higher, people started to borrow to invest on it and Lehman Brothers provided a 32-time leverage to them. When people invest one dollar in a 32-time leverage, they would get 32 dollars’ return if the combination worked out or, they would lose 1 dollar and Lehman Brothers would lose 31 dollars if it did not. But due to the AAA rating, there were more and more decided to purchase the leverage. In order to avoid the risk of paying 31 times the money, Lehman Brothers bought insurance from AIG to protect the combination.
Finally, a chain reaction was formed. Because the combination was so popular, Lehman Brothers demand more debts from banks; banks, therefore, provided more substandard loans because there was zero risk in doing so as long as someone else, Lehman Brothers, was responsible for the risk. In the fall 2006, the chain reaction went to its peak. Everyone was purchasing realties because there was no limitation in loaning and the price of realty kept rising. However, the rise was temporary, and it started to fall when it reached a level where consumers could no longer afford even with the help of loans. After the price of realties started falling, those who purchased high-price realty could not pay their loans and they gave realties to banks as mortgages. Banks, then, gave realties to Lehman Brothers. However, the flow stopped right here in Lehman Brothers because Lehman Brothers were not able to sell those realties due to the fall of price. As a result, all of the investors who purchased the combination lost their money. Unfortunately, thanks to the 32-time leverage, Lehman Brothers lost 31 times amount of money that investors lost.
To pay the 31 times amount of money, Lehman Brothers and AIG, the insurance company, made their biggest effort but ended up as a failure. The Substandard Loan Crisis led to the bankrupt of Lehman Brothers while AIG was saved by US government. After the Lehman Brothers Holding Inc announced its bankrupt, a financial crisis started and impacted banks all over the world, causing investors withdrawing their funds and finally, the economic crisis started in 2008.

Yu Liu