Managing Hedge Fund Risk and Financing: Adapting to a New Era

The Importance of Integrated Risk Management: Lehman Brothers International (LBIE)

Lehman Brothers International is a good case study of how operational, counterparty, and market risks can combine to create losses for hedge funds. In particular, the hedge funds that had the operational capability to know rapidly what their exposures were to LBIE and to take proactive action to withdraw excess funds, to find alternative sources of short security positions and leverage, to know the extent to which their securities were rehypothecated, to cancel trading agreements and to novate portfolios to new prime brokers before Lehman collapsed avoided the losses and the protracted recovery procedures that followed.

Lehman Brothers was founded in Montgomery, Alabama, by German immigrants Henry, Emanuel and Mayer Lehman in 1850—and prospered over the following decades as the U.S. economy grew. The collapse of the U.S. housing market ultimately brought Lehman Brothers to its knees, as its headlong rush into the subprime mortgage market proved to be a disastrous step. In 2007, Lehman underwrote more mortgage-backed securities than any other firm, accumulating an US$85-billion portfolio, or four times its shareholders' equity.

As the credit crisis erupted in August 2007 with the failure of two Bear Stearns hedge funds, Lehman's stock fell sharply. 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 ...