On September 15, 2008, Lehman Brothers filed for bankruptcy. With $639 billion in assets and $619 billion in debt, Lehman's bankruptcy filing was the largest in history, as its assets far surpassed those of previous bankrupt giants such as WorldCom and Enron. Lehman was the fourth-largest U.S. investment bank at the time of its collapse, with 25,000 employees worldwide. Lehman's demise also made it the largest victim, of the U.S. subprime mortgage-induced financial crisis that swept through global financial markets in 2008. Lehman's collapse was a seminal event that greatly intensified the 2008 crisis and contributed to the erosion of close to $10 trillion in market capitalization from global equity markets in October 2008, the biggest monthly decline on record at the time. (For more information on the subprime meltdown, read Who Is To Blame For The Subprime Crisis?)

History of Lehman Brothers

With a special focus on recognizing the potential of promising industries and helping finance the expansion of these enterprises, Lehman Brothers played an important part in the financial and commercial history of the United States for more than 150 years. The history of the firm offers an inside look at the emergence and growth of American industry and technology as well as the establishment of the modern corporation.Laying the Foundation

In 1844, Henry Lehman immigrated from Rimpar, Germany, to Montgomery, Alabama where he established a small shop selling groceries, dry goods, and utensils to the local cotton farmers. By 1850, his two brothers, Emanuel and Mayer, had joined him in the business, and they named it Lehman Brothers. After Henry Lehman's death in 1855 at the age of 33, the two younger brothers headed the firm for the next four decades. During their tenure, only family members—sons, brothers, and cousins—were permitted as partners. This was a policy that continued until the 1920s.

Soon after its founding, Lehman Brothers evolved from a general merchandising business to a commodities broker that bought and sold cotton for the planters living in and around Montgomery, Alabama. "King Cotton" dominated the economy of the southern United States in the 1850s. As the business grew, a brief partnership was formed with cotton merchant John Wesley Durr to build a cotton storage warehouse, enabling Lehman Brothers to engage in larger sales and trades. A New York office was opened in 1858, giving the firm a stronger presence in the commodities trading business as well as a foothold in the financial community.Enlarge Image

With much of its operations tied to the southern economy, Lehman Brothers did not escape the hardship of the Civil War. The firm was rebuilt after the war, concentrating its operations in the New York office. In 1870, Lehman Brothers spearheaded the formation of the New York Cotton Exchange, the first commodities futures trading venture. Mayer Lehman was appointed to its first board of directors. As Lehman Brothers' commodities sales and trading business grew to include other goods, the company also helped to establish the Coffee Exchange and the Petroleum Exchange.

Because of its Southern heritage and Northern connections, Lehman Brothers was designated to be the Alabama government's fiscal agent to help sell the state's bonds in 1867. This was no simple assignment, given the credit rating of the Southern states at that time. The firm was also assigned to service the state's debts, interest payments, and other obligations, beginning a long tradition in municipal finance.Building the Financial Firm

The rapid development of the railroads helped transform the country from an agrarian to an industrial economy in the years following the Civil War. The boom in railroad construction resulted in tremendous activity on Wall Street, as companies turned to financial markets to raise funds for expansion. Kuhn, Loeb & Co., which merged with Lehman Brothers nearly a century later, was one of the leading financial advisors and underwriters to the railroad industry. The firm was engaged in the financing of the Chicago and North Western Railroad, the Pennsylvania Railroad, the Baltimore & Ohio, and the Great Northern, along with the reorganization of the Union Pacific.

Railroad bonds were a milestone in the developing capital markets. To raise the huge amount of money needed to fund the industry's expansion, underwriters began reaching beyond their traditional sources of financing. Bonds were structured at affordable prices and sold to individual investors, bringing masses of first-time investors into the market. Noting this trend, Lehman Brothers expanded its commodities business to include the sales and trading of securities. In 1887 the firm became a member of the New York Stock Exchange, marking the evolution of Lehman Brothers from a commodities business to a merchant-banking firm. The New York office provided the presence to build a securities trading business, and Lehman Brothers aggressively pursued this area. The firm was also becoming more involved in financial advisory, which provided the foundation for developing the underwriting business in the early 1900s.

For a 20-year period beginning in 1906, Emanuel's son, Philip Lehman, and Henry Goldman, the dominant partner in the firm of Goldman, Sachs, formed an alliance to fund the emerging retail industry. The two firms jointly underwrote securities issues for some of the most famous names in the retailing industry, including Sears, Roebuck & Co.; F.W. Woolworth Co.; May Department Stores; Gimbel Brothers, Inc.; and R.H. Macy & Co.

Robert Lehman, Philip's son, became a partner in the firm during the 1920s and quickly moved into the leadership role. Robert Lehman led the firm from 1925 until his death in 1969, a period of significant growth for the firm. His business philosophy centered on his belief that consumption, not production, would determine America's future prosperity. To that end, he steered the firm to back emerging industries geared toward mass consumption. His commitment to identifying growth industries led the firm to become active in the financing of airlines and motion picture companies as well as continuing Lehman Brothers' substantial support of the retailing industry.Supporting Emerging Industries

Lehman Brothers was an early backer of the entertainment business, advising on the consolidation of the Keith-Albee and Orpheum theaters in the 1920s. This merger created the nation's largest vaudeville circuit, with more than 700 theaters and a seating capacity of 1.5 million. As the motion picture industry developed in the 1930s, Lehman Brothers helped fund Radio-Keith-Orpheum (RKO), Paramount Pictures, and 20th Century Fox.

The firm was also interested in the growth of the communications industry in the 1930s, underwriting the first public offering of the leading televised company at that time, Allan B. Dumont Laboratories. In addition, the firm helped fund the Radio Corporation of America (RCA).

The Depression made it difficult even for strong companies to raise capital during the 1930s. To help mediate risk and encourage investment, Lehman Brothers was one of the first firms to devise a new method of financing known as the private placement. These loans between blue-chip borrowers and private lenders included strict safeguards and restrictions for lender safety, enabling borrowers to raise needed capital and lenders to receive an appropriate return with a tolerable level of risk. Innovative at the time, the private placement is a standard financing technique today.

The first half of the twentieth century was also an era of immense expansion in the oil industry. Lehman Brothers became involved, financing Murphy Oil and the TransCanada pipeline, as well as supporting the oil service business of Halliburton and the development of Kerr-McGee's oil and gas exploration and production business.The Electronic Age

Economic expansion in the 1950s was driven by the arrival of electronic and computer technology. Lehman Brothers quickly sought investment opportunities in these areas, helping to launch Litton Industries as well as underwriting Digital Equipment Corporation’s first public offering.

In the 1960s the firm greatly expanded its capital markets trading capabilities, particularly in commercial paper. This led to the firm's designation as an official dealer for U.S. Treasuries. In the 1960s and 1970s, when many U.S. companies began to expand internationally, Lehman Brothers inrceased its global presence as well, opening offices in Europe and Asia. The firm’s international stature was further enhanced in 1977 through the merger with the distinguished investment bank, Kuhn, Loeb & Co.

As significant advances in electronic technology and computer science contributed to economic expansion during the 1970s, Lehman Brothers sought opportunities in applied science and technology. Among their new investments were future industry leaders such as QUALCOMM, a developer of digital wireless communication systems, and Loral Corporation, a manufacturer of defense electronics.

In the 1980s, financial advisory centered on mergers and acquisitions as major corporations moved to expand both domestically and internationally. Lehman Brothers

acted as an advisor on several large U.S. and cross-border transactions, including Bendix/Allied, Chrysler/American Motors, General Foods/Philip Morris, and Genentech/Hoffman-LaRoche

Establishing New Directions

The development of personal computers and the elements that made them user-friendly gave rise to a field of related industries in the 1980s, ranging from microprocessors to video games. The fast pace of high-tech research and development enabled tiny start-up ventures with expertise in design, programming, and engineering to become major international corporations seemingly overnight. Lehman Brothers bought into these new markets by backing companies like Intel, the company that introduced the world’s first microprocessor, raising funds to expand its business to meet the demands of the nascent personal computer market.

Advanced research techniques developed during the mid-1980s helped create a new healthcare industry—biotechnology. Lehman Brothers was very active in assisting many new companies in this industry, such as Cetus, obtain the capital base necessary to fund research and development.

In 1984, Lehman Brothers was acquired by American Express and merged with its retail brokerage Shearson to form Shearson Lehman Brothers. American Express began to divest its financial services by business lines in 1992 and eventually, in 1993, the firm was spun off and once again became known solely as Lehman Brothers. In 2000, Lehman celebrated its 150th anniversary. The company's World Trade Center offices were destroyed by the 2001 terrorist attacks, and eventually it moved into its new global headquarters in midtown Manhattan in 2002. Lehman Brothers became entangled in the subprime mortgage lending crisis, which led to its demise in 2008. On September 15, Lehman Brothers Holdings Inc. filed a Chapter 11 bankruptcy petition in federal court. The company's assets were subsequently sold to several other firms, including Barclays Bank, PLC and Nomura Holdings, Inc.

The Prime CulpritIn 2003 and 2004, with the U.S. housing boom (read, bubble) well under way, Lehman acquired five mortgage lenders, including subprime lender BNC Mortgage and Aurora Loan Services, which specialized in Alt-A loans (made to borrowers without full documentation). Lehman's acquisitions at first seemed prescient; record revenues from Lehman's real estate businesses enabled revenues in the capital markets unit to surge 56% from 2004 to 2006, a faster rate of growth than other businesses in investment banking or asset management. The firm securitized $146 billion of mortgages in 2006, a 10% increase from 2005. Lehman reported record profits every year from 2005 to 2007. In 2007, the firm reported net income of a record $4.2 billion on revenue of $19.3 billion. (Check out the answer to our frequently asked question What is a subprime mortgage? to learn more about these loans.)

Lehman's Colossal Miscalculation

In February 2007, the stock reached a record $86.18, giving Lehman a market capitalization of close to $60 billion. However, by the first quarter of 2007, cracks in the U.S. housing market were already becoming apparent as defaults on subprime mortgages rose to a seven-year high. On March 14, 2007, a day after the stock had its biggest one-day drop in five years on concerns that rising defaults would affect Lehman's profitability, the firm reported record revenues and profit for its fiscal first quarter. In the post-earnings conference call, Lehman's chief financial officer (CFO) said that the risks posed by rising home delinquencies were well contained and would have little impact on the firm's earnings. He also said that he did not foresee problems in the subprime market spreading to the rest of the housing market or hurting the U.S. economy.

The Beginning of the EndAs the credit crisis erupted in August 2007 with the failure of two Bear Stearns hedge funds, Lehman's stock fell sharply. During that month, the company eliminated 2,500 mortgage-related jobs and shut down its BNC unit. In addition, it also closed offices of Alt-A lender Aurora in three states. Even as the correction in the U.S. housing market gained momentum, Lehman continued to be a major player in the mortgage market. In 2007, Lehman underwrote more mortgage-backed securities than any other firm, accumulating an $85-billion portfolio, or four times its shareholders' equity. In the fourth quarter of 2007, Lehman's stock rebounded, as global equity markets reached new highs and prices for fixed-income assets staged a temporary rebound. However, the firm did not take the opportunity to trim its massive mortgage portfolio, which in retrospect, would turn out to be its last chance. (Read more in Dissecting The Bear Stearns Hedge Fund Collapse.)

Hurtling Toward FailureLehman's high degree of leverage - the ratio of total assets to shareholders equity - was 31 in 2007, and its huge portfolio of mortgage securities made it increasingly vulnerable to deteriorating market conditions. On March 17, 2008, following the near-collapse of Bear Stearns - the second-largest underwriter of mortgage-backed securities - Lehman shares fell as much as 48% on concern it would be the next Wall Street firm to fail. Confidence in the company returned to some extent in April, after it raised $4 billion through an issue of preferred stock that was convertible into Lehman shares at a 32% premium to its price at the time. However, the stock resumed its decline as hedge fund managers began questioning the valuation of Lehman's mortgage portfolio.

On June 9, Lehman announced a second-quarter loss of $2.8 billion, its first loss since being spun off by American Express, and reported that it had raised another $6 billion from investors. The firm also said that it had boosted its liquidity pool to an estimated $45 billion, decreased gross assets by $147 billion, reduced its exposure to residential and commercial mortgages by 20%, and cut down leverage from a factor of 32 to about 25. (Read Hedge Fund Failures Illuminate Leverage Pitfalls to learn more about the double-edged sword of leverage.)

Too Little, Too Late

However, these measures were perceived as being too little, too late. Over the summer, Lehman's management made unsuccessful overtures to a number of potential partners. The stock plunged 77% in the first week of September 2008, amid plummeting equity markets worldwide, as investors questioned CEO Richard Fuld's plan to keep the firm independent by selling part of its asset management unit and spinning off commercial real estate assets. Hopes that the Korea Development Bank would take a stake in Lehman were dashed on September 9, as the state-owned South Korean bank put talks on hold.

The news was a deathblow to Lehman, leading to a 45% plunge in the stock and a 66% spike in credit-default swaps on the company's debt. The company's hedge fund clients began pulling out, while its short-term creditors cut credit lines. On September 10, Lehman pre-announced dismal fiscal third-quarter results that underscored the fragility of its financial position. The firm reported a loss of $3.9 billion, including a write-down of $5.6 billion, and also announced a sweeping strategic restructuring of its businesses. The same day, Moody's Investor Service announced that it was reviewing Lehman's credit ratings, and also said that Lehman would have to sell a majority stake to a strategic partner in order to avoid a rating downgrade. These developments led to a 42% plunge in the stock on September 11.

With only $1 billion left in cash by the end of that week, Lehman was quickly running out of time. Last-ditch efforts over the weekend of September 13 between Lehman, Barclays PLC and Bank of America, aimed at facilitating a takeover of Lehman, were unsuccessful. On Monday September 15, Lehman declared bankruptcy, resulting in the stock plunging 93% from its previous close on September 12.

ConclusionLehman's collapse roiled global financial markets for weeks, given the size of the company and its status as a major player in the U.S. and internationally. Many questioned the U.S. government's decision to let Lehman fail, as compared to its tacit support for Bear Stearns (which was acquired by JPMorgan Chase) in March 2008. Lehman's bankruptcy led to more than $46 billion of its market value being wiped out. Its collapse also served as the catalyst for the purchase of Merrill Lynch by Bank of America in an emergency deal that was also announced on September 15.