The collapse of Lehman Brothers one year ago this week has us asking ourselves what principles of financial intelligence we can learn from Lehman’s failure. The financial crisis that engulfed Wall Street and the economy in general, after all, provides a good backdrop for some important lessons.

1. Too much leverage
The basic concept of financial leverage is taking the proceeds of a loan and investing that money to receive a higher rate of return. The difference in the rates (the interest rate of the loan and interest rate earned on the investment) is called the spread.

Businesses, such as banks, borrow money from others through deposits or loans and pay a fixed interest rate on the debt. Then they take that borrowed money and invest it, expecting, of course, to get a higher return. At a traditional bank, deposits are paid 1-2 percent interest rates and the money is then loaned out at 5-20 percent interest rates. It’s easy to see how commercial banks make money — they will be profitable as long as there is a nice spread.

Lehman Brothers was overleveraged. They borrowed money in order to invest in mortgage-backed securities (MBS) (as well as a variety of other investments). In the case of the MBSs, when it was revealed that the assets used as collateral for those mortgage-backed securities were worth a lot less than they thought, the MBSs became worthless and Lehman Brothers’ spread went from positive to negative. In balance sheet terms, they started with a balance sheet in which they owned more than they owed. They ended up with a balance sheet in which they owed more than they owned. That’s never good, and Lehman Brothers went bankrupt.

2. Risky debt-to-equity ratios
Debt-to-equity ratios tell you how much debt a company has for every dollar of equity. The calculation is easy: divide total liabilities by shareholders’ equity (both found on the balance sheet). In the case of commercial banks, the FDIC likes to see a debt-to-equity ratio of about 10 to 1, meaning for every dollar of equity, the bank has $10 of debt. With that level of debt to equity, a bank can weather the storm of a loss due to bad loans or a shrinking interest spread.

Investment banks, however, are not regulated by the FDIC. Their debt-to-equity ratios tend to be much higher. Lehman Brothers, for example, had, at various times, debt-to-equity ratios of 30-60 to 1. If a firm is running at $60 of debt for every $1 of equity, their cushion is dangerously small. Any drop in the value of the assets underlying their investments, or in their spread, pushes the firm to bankruptcy. This was the case for Lehman.

3. Upside-only compensation schemes
Another factor that spelled disaster for Lehman Brothers was the bonus system that compensated people for generating stellar returns. In general, the investment banks set up plans that paid a bonus when the firm performs well. But when the firm did poorly, employees weren’t asked to give any money back. The plan rewarded risk taking for high returns but did not punish for low returns or losses. There was no personal downside to taking risk.

Our two cents on the bigger picture
Taken together, the bias to use high levels of financial leverage to increase returns, combined with risky debt-to-equity ratios and upside-only bonuses, was a recipe for disaster. In hindsight, it’s easy to see how this happened. The Wall Street banks were designed in multiple ways to take risk. Somehow, the system needs to match the risk with the potential rewards.

Author: Karen Berman & Joe Knight @ HBP