The fall of Lehman Brothers

#21

What?

Collapse of Lehman Brothers, a financial services firm, in the 2008 financial crisis

Related Concepts

• Subprime mortgage crisis
• Mortgage-backed security (MBS) 
• Collateralized debt obligation (CDO)
• Too big to fail

Timeline of events

• In 2004, amidst the housing bubble, Lehman acquired five mortgage lenders and dealt with loans without documenting the numbers
• Lehman's real estate business enabled revenues in the capital markets unit to surge 56% from 2004 to 2006
• In 2007, the firm announced $4.2 billion in net income on $19.3 billion in revenue
• When Lehman's stock price reached a record $86.18 per share, giving it a market capitalization of nearly $60 billion, defaults on subprime mortgages began to rise to a seven-year high
• Things started going downhill from then on
• On June 7, 2008, Lehman announced a Q2 (2nd quarter) loss of $2.8 billion
• Lehman's stock plunged by 45% while the firm's debt saw a 66% increase in credit-default swaps
• Lehman Brothers filed for bankruptcy on September 15, 2008, with $639 billion in assets and $619 billion in debt

Impact

• A company that had been alive for more than a century and a half was forced to file for bankruptcy, the largest bankruptcy filing in US history
• The failure of the fourth-largest investment bank in the US had severe ramifications for the global economy
• The bankruptcy triggered a 4.5% one-day drop in the Dow Jones Industrial Average (DJIA)

Aftermath

• President Bush announced a $700 billion bail-out plan to help salvage the remaining pieces of the financial sector
• The Dodd-Frank Act was implemented to help increase financial regulation

Related Movies

Too big to fail, The big short

Notes

Subprime mortgage crisis:

• Occurred when banks sold too many mortgages to feed the demand for mortgage-backed securities sold through the secondary market
• When the Federal Reserve increased the rate, it resulted in increased mortgage interest rates which in turn caused home prices to plummet, and borrowers to default on their loans

Mortgage-backed security (MBS):

• An investment similar to a bond 
• Constitutes a bundle of home loans bought from the banks that issued them
• Put simply, they are shares of a home loan sold to investors
• Working:
• A bank lends a borrower the money to buy a house and collects monthly payments on the loan
• This loan, one of many, is then sold to a larger bank 
• This bank ties the loans together into a mortgage-backed security and issues shares aka tranches (French for "slices") to investors
• Investors collect the dividends in the form of monthly mortgage payments

Collateralized debt obligations (CDOs):

• In the above working of an MBS, the shares or tranches can be repackaged and resold as other securities aka CDOs 

Too big to fail:

• A financial organization so massive to the global economy that the central bank must prevent it from going bankrupt

Concept: Poison Pill

#20

What?

• Counter to Greenmail
• Defense strategy used by a target firm to prevent a hostile takeover by another company via diluting its shares

Concept

• Poison pill: something that's difficult to swallow or accept
• Allows existing shareholders to purchase additional shares at a discount and thus diluting the ownership interest of the hostile party
• This process raises the acquisition costs thereby deterring takeover attempts

Origin

• Devised by Wachtell, Lipton, Rosen, and Katz (legal firm in NY)
• Been around since the 1980s 
• Spies used to carry poison pills to avoid being questioned by their enemies when captured

Types

• Flip-in, flip-over (among others)
• Flip-in is more commonly followed

Flip-in Strategy

• Allows shareholders (except for the acquirer) to purchase additional shares at a discount before the takeover is finalized
• Though purchasing additional shares provides shareholders with instantaneous profits, the practice dilutes the shares already purchased by the acquiring company
• Provisions of flip-in usually in the company's bylaws or charter itself

Flip-over Strategy

• Allows stockholders of the target company to purchase the shares of the acquiring company at a deeply discounted price if the hostile takeover attempt is successful
• A target company shareholder may dilute equity by buying the stock of its acquirer at a two-for-one rate
• The acquirer may thus avoid the acquisition in the case it perceives a dilution of shares after the acquisition

Examples

• 2012: Netflix (NFLX) announced a shareholder rights plan after investor Carl Icahn acquired a 10% stake
• Any new acquisition of 10% or more, any Netflix merger, sales, or transfer of more than 50% of assets would enable existing shareholders to purchase two shares for the price of one
• Icahn criticized this move as "an example of poor corporate governance"
• Netflix shares soared to $304 by July 2011
• The poison pill would allow the stock to reach a price of $350 per share
• July 2018: Papa John’s (PZZA) adopted a poison pill to prevent ousted founder John Schnatter (30% stakeholder) from acquiring the company
• The company enforced a Limited Duration Stockholders Rights plan aka the wolf-pack provision, which doubled the share price for those who tried to buy a large stake (31% or more for Schnatter and 15% for others) without the board's approval
• It thus deterred Schnatter from a hostile takeover

Disadvantages

• Stock values become so diluted that even shareholders need to purchase new shares just to keep even
• Institutional investors are discouraged from buying into corporations that have aggressive defenses
• Ineffective managers can stay in place through poison pills, else VCs might buy the firm and improve its value with better managing staff

Example

• In 2008, Microsoft offered Yahoo! shareholders $31 per share at a 62% premium
• They pulled out after Yahoo! launched a poison pill
• Yahoo's share price took a nosedive leading its Head Jerry Pinto to step down

Concept: Greenmail

#19

What?

• Blackmail + Greenbacks (US Dollars)
• Refers to when a raiding company holding a large chunk of stock forces the target company to buy it back at a premium to avoid a hostile takeover
• The target company is coerced into making a greenmail payment as a defensive measure to stop the takeover bid
• Aka bon voyage bonus

Concept

• A rise in corporate mergers during the 1980s led to the inception of greenmail
• Corporate raiders would initiate takeover bids with no intention of seeing it through
• Critics see greenmail as a predatory practice much like extortion
• Some instead see it as a free-market solution to shareholder conflicts

Examples

• James Goldsmith earned more than $90 million from the Goodyear Tire and Rubber Company in the 1980s (see notes for the full story)
• Occidental Petroleum paid $194 million greenmail to David Murdock in 1984
• David Murdock owned a 5% stake in the company and was a member of its board of directors after the company acquired IBP, Inc.
• Murdock owned 19% of IBP as well
• Disputes between Murdock and the CEO Armand Hammer led to a greenmail payment to Murdock of $40 per share
• Share price in the market was only $28.75
• Wall Street, the 1987 film, portrays greenmail tactics
• Fellow corporate raider Sir Larry Wildman refers to Gordon Gekko as "a two-bit pirate and a greenmailer"

Measures put in place

• Federal and state regulations act as deterrents
• Internal Revenue Service (IRS) introduced an excise tax of 50% on greenmail profits in 1987
• Companies introduced defence mechanisms such as poison pills to prevent investors from making hostile takeover bids
• Anti-greenmail provision (a special clause in a firm's corporate charter) prevents the board of directors from approving greenmail payments

Notes

What happened with James Goldsmith:

Sir James Goldsmith was a notorious corporate raider in the 1980s, minting millions via his orchestration of 2 high-profile greenmail campaigns. One was against St. Regis Paper Company from which he earned $51 million. The other venture that earned him $93 million in only 2 months was the Goodyear Tire and Rubber Company.

When Goldsmith acquired 8.6% stake in St. Regis and threatened a takeover, the company was coerced into repurchasing the shares bought at $35.50 by Goldsmith at a hefty premium of $52 per share. After suffering this loss in 1984, St. Regis fell prey to Rupert Murdoch, after which they sought refuge in Champion International,. agreeing to a takeover at $1.84 billion. Murdoch too received remuneration when he sold his 5.6% stake in St. Regis to the Champion.

In October 1986, Goldsmith purchased 11.5% stake in Goodyear at $42 per share while simultaneously planning a takeover of the company. He filed the takeover with the Securities and Exchange Commission (SEC), after which he proposed to sell off all assets of the company except its tire business. Facing obvious resistance from the Goodyear executives, Goldsmith then offered to resell his shares at $49.50 each. Goodyear lost $2.9billion in this transaction by buying back 40 million shares at $50 each. Unfortunately, Goodyear's stock price plunged to $42 after the buyback.