Comparative analysis of Bear Stearns and Lehman Brothers. Bear Stearns and Lehman Brothers were two lucky financial institutions that were lucky to bear the great depression of 1929. At the beginning of the twenty first century these two institutions, having bravely fought what is regarded as the biggest financial crisis in America's history, collapsed. This essay is an attempt at dissecting the factors that were truly responsible for causing the collapse of these financial institutions. A number of factors will be discussed in detail starting from the corrupt and inefficient financial managers who engaged in unethical and highly risky practices that resulted in millions of investors' dollars going to waste. The collapse of American housing market and its impact on the operations of these two institutions will be discussed. This essay will examine how unsafe and unregulated investment in the risky collateralized debt obligations (CDOs) exposed Bear Stearns and Lehman Brothers to the unstable real estate market. The ethical dimension of managerial decisions will also come under scrutiny and it will be explained how the managers of these financial institutions engaged in corrupt and highly unethical behavior. The essay will also highlight key lessons that emerge from a detailed analysis of the performance of the two investment banks. Recommendations for financial managers will also be provided at the end. These recommendations will serve to highlight the key factors the executives and managers must keep in sight while managing everyday organizational activities. This essay will finish off with a conclusion that sums up all the important points that came under discussion in the essay.
Historical analysis of the Investment Banks
Bear Stearns
Bear Stearns was founded in 1923 as an equity trading house by Robert Stearns, Joseph Bear and Harold Mayer. The three partners invested an initial working capital of only $500,000 in the company. The company remained intact during the Great Depression of 1929. Bear Stearns countered the adverse climate of 1920's and 1930's, successfully seeing off the stock market crash that resulted in the bankruptcy of many large financial players. The strength of the financial well being of Bear Stearns can be gauged by the fact that at a time when other banks were failing in dozens, it was able to pay bonuses to its customers. With the passage of time the company grew on a consistent basis and it became a publicly traded company in 1985. The coming years saw the company growing internationally and establishing international offices in Tokyo, London and Beijing among a number of other major cities across the globe. The bank started providing a range of complex services including assisting organizations in mergers and acquisitions activities as well as indulging in corporate finance, fixed income sales and assisting organizations in institutional activities. In 2002, at a time when other American companies were running in considerable losses, Bear Stearns became the only company to report profits in the first quarter. This was also the time when the organizational focus started to shift in favor of the housing industry, which merely in a period of five years would spelt doom on this eighty year old financial institution. Before being hit by the subprime crisis in 2007 Bear Stearns was nominated as Fortune's magazine "America's Most Admired Securities Firm" in 2005. Bear Stearns had its offices in almost all the major cities of USA including New York, Los Angeles, San Francisco, Denver, Houston, Dallas, Chicago, and Irvine by 2007 (Ferrell, Fraedrich and Ferrell).
Lehman Brothers
Lehman Brothers was founded by three German immigrants, Henry Lehman, Emanuel Lehman and Mayer Lehman in the middle of the nineteenth century. The main business of Lehman Brothers business was offering brokerage services for the buyers and sellers of the cotton crop. In the concluding decades of nineteenth century Lehman Brothers swiftly expanded their business to include start trading in various other commodities such as coffee, wheat, sugar and petroleum products. As their business started to flourish the Lehman Brothers soon transformed from brokerage services to merchant banking and by 1887 their company was trading on the New York Stock Exchange. During the early years of the twentieth century the second generation of Lehman family focused its attention entirely on the investment banking industry by cutting its ties to the cotton industry. Like Bear Stearns, the Lehman Brothers easily sailed through the famous stock market crash of 1929. In the years to follow the company diversified its business portfolio and started advising and financing various businesses including well renowned companies such as Sears, B.F. Goodrich, Digital Equipment, Campbell Soup and Halliburton. The company opened up its first international office in 1960 and by 1998 the Lehman Brothers had joined the revered S&P 100 Index. One of the most significant breakthroughs in organization's history came in 2000 when its stock price rose to $100 per share. Throughout its history the organization successfully sailed through many ups and downs commonly associated with the volatile investment banking industry but the strategic blunder in terms of investment in the RMBS proved too costly as it finally led to the collapse of this celebrated financial institution.
The collapse of Investment Banks
The collapse of Bear Stearns
The collapse of two Bear Stearns hedge funds, the Bear Stearns High-Grade Structured Credit Fund and the Bear Stearns High-Grade Structured Credit Enhanced Leveraged Fund in July 2007 proved to be the final nail in the coffin of Bear Stearns (Waggoner). Before going into the detail of the operating mechanism of the two Bear Stearns hedge funds it is important to first describe what a hedge fund exactly is (Kennon). A hedge fund is a rather belligerently managed portfolio of investments where the fund manager makes investments in stocks, mutual funds bonds, startups, real estate, collectibles, gold and any area of the market where there are chances of high returns at low risks (Vikas Agarwal).
Modus operandi of Bear Stearns hedge funds
The two Bear Stearns hedge funds were basically subprime hedge funds. The investment methodology according to which the two Bear Stearns hedge funds operated is elaborated as follows:
The hedge fund managers purchased Collateralized Debt Obligations (CDOs) from the money obtained by investors since the CDOs pay an interest rate higher than the cost of borrowing (Fabozzi). The CDOs are managed by a separate legal entity the Special Purpose Vehicle (SPV) which purchases different types of assets for example asset backed securities, bank loans, emerging market bonds and then issue new bonds backed by these securities. In case of Bear Stearns the hedge funds were backed by residential mortgage backed securities (RMBS) (Fabozzi, Davis and Choudhry).
The Bear Stearns hedge fund managers subsequently borrowed more money from various financial institutions in order to buy more CDOs (Klaassen and Eeghen). The basic underlying assumption behind borrowing money to buy CDOs was that since the CDOs pay an interest rate pay an interest rate which is higher than the cost of borrowing so every unit of leverage that is added into the framework will lead to greater expected rate of return (Fabozzi).
The credit default swaps were also purchased by the hedge fund managers in order to get insurance against the overall increase in risk because of the use of leverage (Fabozzi, Davis and Choudhry). A credit default swap can simply be defined as the option to swap a credit asset for cash in case a default occurs (Smithson). The buyer of the credit default swap purchases credit risk protection on a reference asset for example in case of Bear Stearns hedge funds the reference asset will be the residential mortgage backed securities (RMBS). In case a credit event occurs during the tenure of credit swap term the seller will make a payment to the buyer but, in case the credit event does not occur the seller will not make any payment to the buyer (Tavakoli).
The return on hedge fund can be calculated as subtracting the cost of borrowing leverage and the cost of obtaining credit risk protection from the return on CDOs (Madura). In the hedge fund terminology this return is known as the "positive carry".
Factors leading to the collapse of Bear Stearns hedge funds
Different critics and analysts came forward with different reasons for the spectacular collapse of the two Bear Stearns's two large hedge funds. Some of the main factors that played the most important role in bringing about the demise of the decades old financial enterprise are listed as below.
Unstable nature of subprime debt: The unstable nature of the subprime debt was the most single most important fact leading to the collapse of the Bear Stearns hedge funds. In 2007 as the American housing market began to collapse and the subprime borrowers started defaulting in enormous numbers the CDOs owned by Bear Stearns also collapsed since they were linked to the subprime mortgages (DePamphilis). The collapse of the American housing market was triggered by increased defaults from home owners, which automatically resulted in the decrease in market value of the bonds which derived their value from these homes. In order to explain in detail the linkage between the tragic demise of the American housing sector and the failure of the two Bear Stearns hedge funds it is first important to describe the concept of subprime mortgage. The term subprime refers to the increased risk associated with the borrowers to whom the loan is given; since these loans are given to customers who normally have a poor credit history hence these loans are highly risky. These loans charge high rates of interest from the prospective borrowers based on their poor credit history. The subprime loans are normally given to customers who do not qualify for a mortgage from a conventional lender such as a bank. From the lender's point of view which in this case was the Bear Stearns bank as long as the house prices continued to increase the risk of incurring losses on a mortgage was low. In a market with soaring house prices the home mortgages are referred to as the low risk, high yielding instruments, unfortunately this was not the case with the American market which witnessed a steep decline in the price of houses which led to the collapse of the subprime mortgage market (Hamilton). As the property prices declined people were no longer able to refinance their homes nor were they able to pay off their mortgages by selling their homes. By late 2006 the situation of the American subprime mortgage deteriorated to the extent that every eighth subprime mortgage one was in default (Strachman). In 2007 almost 1.5 million Americans lost their homes. In an extremely synchronized chain of events the terrible collapse of the housing market led to the defaults in mortgage payments which in turn led to decrease in the value of the subprime mortgages subsequently followed by the decrease in the value of subprime mortgage backed CDOs. The two infamous Bear Stearns hedge funds having heavily invested in the sub-prime backed CDOs also collapsed with the collapse of these CDOs. The collapse in the subprime mortgage market can be attributed to a definite lack of understanding on part of the two hedge fund managers in exactly estimating the risk associated with the mortgage market. While the credit default swap was apparently employed to counter the risk associated with the subprime mortgages the Bear Stearns hedge fund managers apparently failed to understand the total level of risk associated with the mortgage market. The main issue which then emerges was not a lack of credit default swaps but it was the proverbial collapse of the real estate and mortgage bond markets that caught the Bear Stearns management unassuming and hit them hard without providing them a chance of recovery. The Bear Stearns hedge fund managers assumed normal real estate market conditions for entering into credit default swaps but failed to make a contingency plan in case the entire real estate sector collapsed. This lack of contingency planning and foresight hit the organization hard ultimately resulting in the collapse of 85 years old financial institution.
Self centered nature of the top management: In the month of July 2007 when the hedge fund crisis was threatening to destroy the very foundations of Bear Stearns, the CEO Jimmy Cayne spent ten out of total twenty one workdays out of the office; during this time he was mostly spotted playing bridge and golf with his friends. Jimmy Cayne was also very fond of using private jets and helicopters; he owned a large fleet of private aircrafts, all paid through company's account. The attitude of the Bear Stearns top executive showed that he and his team were indifferent to the plight of investors, many of whom had their entire life earning at stake. Just when stocks were at an all time low in March 2008 Jimmy Cayne bought himself a 6,000 square footage $28.24 million (E18m) home. This self centered approach of the CEO shows he was clearly more concerned about his personal well being rather than worrying about the most affected party in this entire crisis; the investors.
Ignoring the threat posed by Liquidity Risk: The top management of Bear Stearns committed the strategic blunder of ignoring liquidity risk which in the end proved to be very costly for the organization. Liquidity risk is defined as the risk that arises when a financial institution is not in possession of enough liquid assets when obligations become due (Gildersleeve). Liquid assets include assets which can be turned into cash at rather a short notice such as cash, marketable securities and accounts receivable (Nakajima). As the American housing market collapsed the creditors from whom Bear Stearns had borrowed money to invest in CDOs become increasingly irritable. These lenders had taken mortgage backed, subprime bonds as a collateral on loans. The lenders now started asking Bear Stearns to give further money on these loans as the collateral (the subprime bonds) had witnessed an enormous decrease in value. This situation could have very well been avoided if the fund managers did not borrow huge amounts of money to invest in the CDOs (Stein). While this strategy may have resulted in fewer returns for the investment bank due to low amount of leverage, it could have played a role in preventing the collapse of the entire financial institution. In hindsight, giving up a modest portion of potential returns could have saved millions of investor dollars.
Selling Inappropriate Products to Clients: Bear Stearns hedge fund managers Ralph R. Cioffi and Matthew M. Tannin misrepresented the health of funds to investors and lenders. They had futile hopes that the hedge funds' bleak prospects would dramatically change and that somehow they would be able to retain the funds to their former glory. Prosecutors built their case against the two hedge fund managers on the basis of some emails sent by the two in the spring of 2007. The messages communicated through emails clearly prove that both the hedge fund managers Ralph R. Cioffi and Matthew M. Tannin were unsure of the future funds when they were portraying an upbeat picture to investors regarding the health of funds. At the judicial inquiry conducted into the case Ralph R. Cioffi and Matthew M. Tannin were accused of not disclosing the true state of the funds to their investors when in reality they were very well aware of the direction towards which the hedge funds were moving. Later investigation into the case revealed that both Cioffi and Tannin were aware that their funds were headed to the garbage heap but they deliberately held this information from becoming public. As late as March 2007, Ralph R. Cioffi continued to bring investors into the fund despite telling to one colleague that he was sick to his stomach over the hedge funds performance. It was in this very month that Ralph R. Cioffi removed $2 million of his own money from one of the funds since he was aware of the direction in which the hedge funds were headed. This then proves to be a case of where the hedge fund managers made a mockery of ethical norms and principles.
Exceeding risk limits: The two hedge funds of Bear Stearns, High-Grade Structured Credit Fund and the High-Grade Structured Credit Enhanced Leveraged Fund, had borrowed heavily to invest in securities known as collateralized debt obligations (CDOs). This heavy borrowing when analyzed in greater detail reveals that the mandated risk limits were greatly stretched when it comes to Bear Stearns borrowing for investment in the CDOs. This heavy borrowing came back to haunt the investment bank at a later point in time when the bank was not able to payback its investors, despite selling off organizational assets in order to raise additional cash.
Loss of clients' confidence: Bear Stearns ultimately failed because the company's investors no longer believed the organization could repay its loans. The company's financial position worsened to the extent that it was unable to pay off its short-term, overnight loans. Bear Stearns had a number of complex agreements with other banks, investment houses and corporations, as the organization's financial position worsened these large investors ultimately concluded that Bear Stearns was unable to fulfill its financial commitments. In this way the organization lost its hard built credibility among its clients all due to the greedy practices of its top level management.
Failure in carefully monitoring traders' activities: The two hedge funds at Bear Stearns were not properly monitored; top level management allowed the managers of the hedge funds to engage in highly risky investments. The lack of check and balance on traders activities resulted in huge losses for the investors.
Failure in carrying out Scenario Analysis testing: A fundamental mistake committed by Bear Stearns fund managers' was their failure in accurately forecasting how the subprime bond market would behave under problematic situations. They never used the highly regarded forewarning system of scenario analysis that looks predicts how a financial institution will behave under a certain event or a combination of events. For example the financial managers can use scenario analysis technique to determine the impact of stock market crash on organizational operations (Lam).
Failure in protecting hedge funds from Event Risk: The fund managers also committed the blunder of not protecting themselves from event risk. Event risk is defined as the risk of loss to an organization that arises from events that maybe unlikely but in case they occur they may produce serious impact on overall functioning of the organization (Lam). These unlikely events may occur in the form of fraud, market dislocations, natural or man made disasters, system failures among a number of other unexpected events (Gitman and Joehnk). Bear Stearns was exposed to this risk when the financial managers failed to plan the consequences produced on the overall functioning of the organization in case the real estate prices go down dramatically. The sorry end for the investment bank could have been avoided had the management used effective planning and management techniques for running the organization in case an unexpected event occurs.
The collapse of Lehman Brothers
Lehman Brothers along with other large investment banks became the central players in the financial derivatives market that surfaced in the later part of the twentieth century. Derivatives are defined as financial instruments that derive their value from some underlying asset. The underlying asset can be a stock, bond or any commodity such as gold, oil copper etc. It is the fluctuation in the price of the underlying asset that determines the value of the derivative instrument. The most important characteristic that signify derivative products is that they are highly leveraged instruments. The main culprit that played a significant role in the collapse of both Bear Stearns and Lehman Brothers, the collateralized debt obligation (CDO) emerged as a new breed of exotic derivative products in the middle of 1990s. Major players in these securities were the institutional investors; the individual investors on the other hand completely avoided these securities because of their complex nature (Francois Trahan). The derivative market was in full boom during the 1990s and the Lehman Brothers reaped great benefits out of this mushrooming market. The main derivative product that was being sought by Lehman Brothers in this period was the residential mortgage backed securities (RMBS). Lehman Brothers stakes in the RMBS grew to the extent that by 2004 the organization possessed more RMBS than any other entity. The high demand for RMBS caused the mortgage creators to aggressively extend loans to people; the rules for giving out loans were relaxed so much so that even people with a bad credit history and insufficient income were now able to get loan. These mostly first time buyers with a not so good credit history were known as the 'subprime borrowers' (Brooks and Dunn). All was going well for Lehman Brothers until the housing market in the United States started to collapse. Housing prices increased rapidly from 1995 to 2005 giving the perception that RMBS were perhaps an invincible derivative security that can never give negative returns. This perception was seriously challenged when by late 2007 housing prices began to tumble. The structure of RMBS was faced a questionable future when by 2008 the housing prices declined by more than 20% in many residential markets. Prime residential markets witnessing sharpest increase over the previous few years including the Las Vegas and South Florida real estate markets were the worst sufferers where the property prices declined by more than 50%. Falling housing prices meant that many of the sub-prime borrowers were now in a seriously upside down position with the price of their residential property less than the total unpaid balance of their mortgages (Hardaway). This ultimately resulted in a lot of borrowers defaulting on their loans and this trend eventually led to undercutting the market for RMBS. Large institutional investors, government agencies and other financial institutions having huge ownership stakes in the RMBS started panicking as the market for RMBS started to tumble. The RMBS markets were practically labeled as being 'frozen' in many areas meaning that in those markets these securities could not be sold at any price. By the end of 2007, Lehman Brothers held $90 billion worth of RMBS that were now being categorized as 'toxic assets' (William J. Baumol). Another factor that made a huge contribution to the collapse of Lehman Brothers was the increased presence of the company in the leveraged loan market where it supplied loans to companies which needed debt to buy off other companies.
Unethical practices were the norm of the day at Lehman Brothers. At a time when the company made an application asking to get government aid the executives were busy taking home millions of dollars in profits, an action that ultimately caused huge public outcry. Many financial analysts also accused the firm of engaging in unethical behavior in its transactions with 'First Alliance Mortgage' a company that was renowned for its predatory lending practices. On September 14th, 2008 Lehman Brothers filed for Chapter 11 Bankruptcy left with a magnanimous $613 billion in debt. After filing for bankruptcy the company's shares fell almost 90% to 21 cents per share (Ferrell, Fraedrich and Ferrell). This translated into huge losses for many of Lehman Brothers investors who witnessed the value of their stock reducing to nothing. Lehman Brothers was finally purchased by Barclay PLC for $1.75 million (Dufries). The company's shares had lost 73% of their value by August 2008. The fall of Lehman Brothers produced severe impact on businesses across the world; this negative impact is expected to be felt by businesses in the long term future (Bonnick).
Important lessons for financial managers
Lessons to be learnt from the Bear Stearns financial collapse
In order to avoid future such incidents financial managers need to learn key lessons from the collapse of Bear Stearns, an investment bank that was considered invincible for the colossal nature of its operations and for its huge trading volumes. Some of these key lessons are:
Accurately predict how a particular market would behave: It is the responsibility of managers of a financial institution to foresee in advance the behavior of a particular market under extreme circumstances. Stress testing techniques should be carried out to observe the level of stress a particular firm can sustain, for example stress tests can be carried out to check that if stock market crashes by 50% what would be the impact on company's performance. The failure to apply correct risk mitigation techniques was the factor that ultimately brought down the 85 year old financial institution.
Listen to unconventional wisdom: It is important for financial institutions to listen to alternative point of views. At a time when the American real estate prices were at their peak, Yale professor Robert Shiller, New York University professor Nouriel Roubini, and renowned hedge fund manager Jeremy Grantham were telling people that the real estate prices were like insane bubbles which may burst at any time. No one was ready to listen to their views at that time; it was much later that their forewarnings proved true with the dramatic collapse of American housing market that also resulted in the collapse of many large financial institutions. Listening to unconventional views thus broadens financial managers' understanding of the events occurring around them and helps them in seeing the larger picture.
Carry out a proper macroeconomic research: It is the job of financial institutions' hedge fund managers to do a thorough research of the macroeconomic environment surrounding the organization. This research will help them observe if any changes in the economic, legal, political environment is adversely affecting the company. Accurately predicting the economic environment in which managerial decisions are taken is crucial to the success of an organization. Decisions such as expanding capacity when the economy is moving towards recession can have dire consequences for an organization as was witnessed in the case of Bear Stearns.
Lessons to be learnt from the Lehman Brothers financial collapse
The collapse of Lehman Brothers provide some eye opening lessons for the financial institutions in general and investment banks in particular. Some of the most important factors that can be learnt from the collapse of Lehman Brothers are described as follows:
Monitor traders carefully: Financial institutions normally regard high performing traders as untouchables and do not subject their activities to the same level of scrutiny as is legally required. It is important for the financial institutions to realize that all their traders particularly those making high profits should be held accountable for all their activities (Chincarini).
Separation of front, middle and back end of the office: The front, middle and back offices of every financial institution are tasked to perform a certain set of activities, as long as they stick to performing their desired roles organizational activities run smoothly (Porter, Glauber and Healey). The task of the front end of an investment institution is to take up positions in the market while the people in the middle end of the office monitor risks while those in the back end of the office are tasked with record keeping and accounting. Some of the worst derivative disasters occurred because of the functions of these three different dimensions of an organization was not kept separate (Eggers and Moumen). Most importantly traders in the front end of the office can manipulate those at the back office if the activities of these two offices are not kept separate.
Restrain from blindly trusting financial models: Some of the largest reported losses in financial institutions occurred because of the blunder committed on part of the financial managers in blindly trusting various models and computer programs (Grossman and Livingstone). These managers mistakenly believed that these models can never report false results. Financial managers should be well aware that whenever large profits are reported by using simple trading strategies there is some underlying fault with the financial model in use.
Carefully defining and appreciating the risk limits: It is the responsibility of top management of an organization to carefully define a risk limit and then ensure that proper procedures exist within the organization for making sure that risk limits are obeyed (Knapp). The risk limits should be setup for organizational employees working at the board level and for the employees working at the front, middle and back end of the organization. It is of utmost importance to an organization that appropriate risk limits are developed in case derivatives are used by an organization. It is a widely witnessed trend in financial institutions that without proper practices in place for monitoring of derivative traders, hedgers and arbitrageurs assume the role of being speculators.
Equal treatment to be meted out to employees in terms of enforcement of risk limits: Financial organizations must ensure risk limits are enforced for all employees working in an organization. In many organizations, top management is tempted to ignore violation of risk limits by particular employees who are making huge profits for the organization (Eggers and Moumen). This management approach assumes a very short sighted approach focusing only on short term gains. This management approach leads to the development of an organizational culture where risk limits are not taken seriously; this management attitude paves the way for huge disaster for the organization in the long run (Tellis, Kuo and Tanner). The penalties for exceeding risk limits thus, should be as great when profit as is the case when losses otherwise the traders making losses would be enticed to increase their bets in the hope that eventually the losses would turn into huge profits and they would be forgiven for their mistakes.
Benefits of Diversification: Financial institutions must take note of the tremendous benefits of diversification. In many financial institutions it is a normally accepted practice to increase trader's volume in case the particular employee appears to be good at predicting a market variable. This practice should be avoided at all costs since the benefits of diversification are huge and it is unlikely that a particular can be so good that for him/her these benefits are lost for the sake of investing heavily in just one market variable.
The demise of the giants
Bear Stearns
Bear Stearns management pumped $1.6bn (£800m) into the funds but it was not able to stop the funds and the organization from collapsing. The funds had borrowed so much money that they could not afford to payback their investors. As a last resort the organization also tried selling assets in order to raise additional cash which was then pumped into the funds but, it all proved futile. The subprime crisis which started somewhere in early 2007 produced such a devastating impact on the organization that by the month September Bear Stearns saw the collapse of its two famed hedge funds (Chincarini). The last quarter of 2007 posed another sorry picture for the organization when the third quarter profits were reported to decrease by 61%. The Federal Reserve tried saving the organization but even its help could not protect the organization. At the end JP Morgan agreed to buy the company at about $2 per share which after intense negotiation was settled at $10 per share. Merely a few years ago the investment bank's shares were trading in the stock market at $ 133.20 per share, the dramatic fall in share price depicts the terrible fall from grace the financial institution along with its management had to face (Ferrell, Fraedrich and Ferrell).
Lehman Brothers
The demise of Lehman Brothers occurred in 2008 when on September 14th, 2008 the organization filed for Chapter 11 bankruptcy. The bankruptcy of Lehman Brothers triggered the financial panic ever seen in America's history. Staying true to the notion that panics are contagious, financial analysts and monitors were shocked to observe that within days many other large financial institutions also collapsed (Arthur MacEwan). The collapse of Lehman Brothers, regarded as a proverbial Wall Street brand, also produced its negative impact on the real economy of the USA. The two main indicators that depict the health of the economy of a country i.e. the real GDP and the monthly job losses suffered badly due to the dramatic collapse of Lehman Brothers (Tellis, Kuo and Tanner).
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Figure : Monthly job losses 2008-2009 ()
Figure : Change in real GDP 2008-2008 ()
Conclusion
The use of derivative products by the two investment banking giants, Bear Stearns and Lehman Brothers were not the only reason for their collapse, there were a number of other reasons as well prominent among them was lack of empathy shown on part of the management at a time when many investors were losing their hard earned money. The use of the derivative products by decision makers at Bear Stearns and Lehman Brothers resulted in enormously increasing the risk factor for their respective organizations. Careful observation of the factors reveals that unfair use of derivative instruments was extremely unfair for the stakeholders who were made to believe that the investment bank managers were using their funds within the prescribed risk limits. Another big ethical issue that arises from the discussion on the two investment banks was the level of transparency associated with the use of complex financial instruments in making profits for the customers. Deceptive means for luring customers may be used by financial managers if the potential purchaser of a particular financial instrument is not able to understand the level of risk associated with the use of the instrument. The two banks examined in the above case no doubt pushed the limits of legitimate risk taking along with engaging in the use of fraud and manipulation tactics to deceive stakeholders. The lesson to be learned from the colossal demise of the two leaders in investment banking, Bear Stearns and Lehman Brother, is not to combine leverage and greed. Financial institutions in particular those using derivative instruments need to start looking beyond short term gains and start understanding the importance of long term growth and productivity. The Board of Directors (BOD) and CEOs of financial institutions need to develop their business model on lines that balance market opportunity with risk. Through ethical compliance programs and visionary leadership a number of ethical risks can be avoided. The common case of lower level managers using manipulative and deceptive tactics to create profits is the most important kind of ethical risk that can be avoided by a change in leadership philosophy.
