The Lehman Brother’s Bankruptcy: a Test of Market Efficiency

Allied Academies International Conference page 43 THE LEHMAN BROTHER’S BANKRUPTCY: A TEST OF MARKET EFFICIENCY Christine Pichardo, Longwood University Frank Bacon, Longwood University ABSTRACT This study tests the market efficiency theory by examining the effect of the Lehman Brothers bankruptcy on several brokerage firms, as well as the overall market. It would suggest that these brokerage firms would occur negative stock prices following the announcement of the Lehman Bankruptcy. For this study, I analyzed 15 firms’ stock price’s risk adjusted rate of return before and after September 15, 2008, some with larger assets in Lehman than others.

Results show stock prices dropping approximately 24 days prior to the announcement and continuing to drop for several weeks. This supports the semi-strong market theory; which suggest that the market anticipated the collapse of Lehman. INTRODUCTION When Lehman Brothers collapsed, they had about $60 billion in toxic bad debts, and had assets of $639 billion against debts of $613 billion; making it the largest investment bank to collapse since the 1990’s. With a bankruptcy of this capacity, you would expect the stock market to take some sort of hit.

This study examines the market’s reaction to this event by analyzing the risk adjusted return of selected brokerage firms’ stock prices around the event date of September 15, 2008. LITERATURE REVIEW The concern for Lehman Brothers started as early as March, with the collapse of Bear Sterns. The recent collapse of large investment banks are the result of the sub prime mortgage crisis, which actually started about a year ago. That’s when the first signs that the soaring U. S. housing market was weakening.

Interest rates began to increase, the economy weakened, which turned indebted homeowners into financial turmoil sparking foreclosures and rapid drops in house prices. Lehman Brothers were considered one of Wall Street’s biggest dealers in fixed-interest trading and were heavily invested in securities linked to the sub-prime mortgage market. They lost $14 billion in the past 18 months after being forced to take huge write downs on the value of those investments; which ultimately lead them to file for bankruptcy. When Lehman collapsed, it sent a rippling affect across the globe, exposing how interconnected nternational markets have become. One of the largest companies affected were AIG, who backed a majority of credit default swaps by Lehman Brothers. So, when Lehman collapsed, AIG and many other banks, firms and individuals felt the pain. Proceedings of the Academy of Accounting and Financial Studies, Volume 14, Number 1 New Orleans, 2009 page 44 Allied Academies International Conference September 15, 2008 has been proclaimed Wall Street’s worst day in seven years. The Dow Jones Industrial average lost more than 500 points, more than 4%, which is the steepest fall since the day after the September 11th attacks.

DATA AND METHODOLOGY This study includes 15 investment firms, about 9 with a significant stake in Lehman, and 6 others. The purpose of this study was to see how fast and how much of an impact the bankruptcy of one of the largest investment firms affected the stock prices of those 15 firms. I analyzed the 15 firm’s prices, and the corresponding Standard & Poor’s 500 Index (S&P 500) from 180 days before the event date of September 15, 2008 and 30 days after. To test the affect of the bankruptcy on the 15 firms stock prices, and to test the semi-strong market efficiency theory; I used the following hypothesis.

H10: The risk adjusted return of the stock price of the sample of investment firms is not significantly affected by this type of information on the event date. H11: The risk adjusted return of the stock price of the sample of investment firms is significantly negatively affected by this type of information on the event date. H20: The risk adjusted return of the stock price of the sample of the investment firms is not significantly affected by this type of information around the event date as defined by the event period.

H21: The risk adjusted return of the stock price of the sample of investment firms is significantly negatively affected around the event date as defined by the event period This study uses the standard risk adjusted event study methodology to test the stock market’s response to the Lehman Brothers Bankruptcy on September 15, 2008. Using Yahoo Finance, I found the historical stock prices for the 15 firms and the S&P 500 index during the event study period. The event study period involved 180 days prior to the event and 30 days after, using day 0 as the event date.

Using those prices, I calculated the holding period returns for the companies (R) and the corresponding S&P 500 index (Rm) for each day using the formula: Current daily stock return= (current day close price – previous day close price) previous day close price Current daily index return= (S&P current close- S&P previous close) S&P previous close A regression analysis was then performed using the actual daily return of each company (dependent variable) and the corresponding S&P500 index daily return (independent variable) over the pre-event period day -180 to -31 period prior to the event period of day –30 to day +30) to obtain the alpha (the intercept) and the beta (standardized coefficient). Table 1 shows alphas and betas for each firm. New Orleans, 2009 Proceedings of the Academy of Accounting and Financial Studies, Volume 14, Number 1 Allied Academies International Conference Table 1 Alpha’s and Beta’s of Sample Firms Firm FSLBX FSVBX SHRAX YCVTX EKNGX IMEIX SLCVX QVGIX PSEFX VFINX BX C JPM BRO GS Alpha -14. 585314 -4. 318129 -23. 0695 -4. 098515 1. 190605 -4. 68900 -6. 69768 2. 196207 -4. 72506 169. 7731 -5. 853405 -9. 375442 27. 97969 17. 96228 -60. 47504 Beta . 052077 . 007655 . 097596 . 013841 . 002005 . 037221 . 015906 . 009090 . 010639 -. 039547 . 0174029 . 0232386 . 0098513 . 0010140 . 0176874 page 45 In order to get the normal expected returns, the risk-adjusted method was used. The expected return for each stock, for each day of the event period from -30 to +30, was calculated as: E(R) = alpha + Beta x (Rm), where Rm is the return on the market (S&P 500 index). Then, the Excess return (ER) was calculated as the Actual Return (R) minus the Expected Return E(R).

Average Excess Returns (AER) were calculated (for each day from -30 to +30) by averaging the excess returns for all the firms for given day: AER = Sum of Excess Return for given day / n, where n = number of firms in sample (15). Also, daily cumulative average excess returns or Cars was calculated by adding the AERs for each day from -30 to +30. The graph of CAER was plotted for the event period day -30 to day +30. QUANTITATIVE TESTS AND RESULTS Did the market react to the Lehman Brother Bankruptcy? Was the information surrounding the event significant? If the information surrounding the event suggests new, significant information Proceedings of the Academy of Accounting and Financial Studies, Volume 14, Number 1 New Orleans, 2009 page 46 Allied Academies International Conference hen we would expect the average excess daily returns as shown in Exhibit 1 to be significantly different from 0 and differ from the cumulative average excess returns. If a significant risk adjusted difference is observed, then this information did significantly impact the firm’s stock price, as hypothesized. To statistically test for a difference in the risk adjusted daily average excess returns and the cumulative average excess daily returns (day -30 to +30), a paired t-test was used. The result of these tests supports the alternative hypotheses H11 and H21, and concludes that the risk adjusted return of the stock price of the sample firms is indeed significantly negatively affected around and on the event date.

How efficient was the market to this information? Does it support the weak, semi-strong or strong form of market efficiency theory? To test for this, I used the CAER (cumulative average excess return) to see if it was significantly different from zero and analyzed the graph between time and CAER. As shown in exhibit 2, there is evidence that the adjusted rate of return on stock prices began to decline approximately 24 days before the event date. This confirms the semi-strong market efficiency theory, and proves the market anticipated the bankruptcy with the negative decline in stock prices. EXHIBIT 1: Time vs. Average Expected Return New Orleans, 2009

Proceedings of the Academy of Accounting and Financial Studies, Volume 14, Number 1 Allied Academies International Conference page 47 EXHIBIT 2: Time vs. Cumulative Average Excess Returns CONCLUSIONS This study examined the effect of the Lehman Brothers bankruptcy on stock prices’ risk adjusted rate of return for 15 selected brokerage firms, with 9 having larger assets in Lehman. Statistical tests proved that the bankruptcy had indeed a negative impact on the risk adjusted rate of return for the 15 firms stock prices. Results show stock returns beginning to drop about 24 days or so prior to the event, which could also be exaggerated due to the economic crisis around that time.

However, the stock prices did significantly negatively fall around the event date, which supports the semi-strong market efficiency theory. Months after the event, there has continued to be a ripple effect in the market. Besides Lehman Brothers, other investment firms have been affected; among several others, Merrill Lynch was taken over by Bank of America and AIG had to be bailed out by the fed. The impact of the credit crisis is still being felt months later. REFERENCES Dolan, Karen. “Lehman, AIG, Merrill: Which Funds Are Most Affected? ” Morningstar, inc. 15. September 2008. 17 October 2008. http://news. morningstar. com/articlenet/article. aspx? d=253125#hide Fama, E. F. (1970). “Efficient Capital Markets: A Review of Theory and Empirical Work. ” Journal of Finance, Volume 25 (May), 383-417. http://stuwww. uvt. nl/fat/files/library/Fama,%20Eugene%20F. %20%20Efficient%20Capital%20Markets,%20A%20Review%20of%20Theory%20and%20Empirical%20Wor k%20(1970). pdf Graeme Wearden, David Teather, and Jill Treanor. “Banking crisis: Lehman Brothers files for bankruptcy protection. ” Guardian. co. uk. 15 September 2008. 5 December 2008. http://www. guardian. co. uk/business/2008/sep/15/lehmanbrothers. creditcrunch Henderson, Marshall D. and Bacon, Frank. “Stock Market Efficiency and the 9/11 Terrorist Attack. ”

Proceedings of the Academy of Accounting and Financial Studies, Volume 14, Number 1 New Orleans, 2009 page 48 http://www. finance. yahoo. com http://www. investopedia. com Madura, Jeff. Financial Markets and Institutions. 8th Edition. 2008 Allied Academies International Conference Maich, Steve. “Edge of Disaster: Fall of Lehman Brothers and Merrill Lynch”. Macleans. 2008. 5 December 2008. http://vnweb. hwwilsonweb. com. proxy. longwood. edu/hww/results/getResults. jhtml? _DARGS=/hww/results /results_common. jhtml. 20#record_2 Ross, Westerfield, and Jaffe. Corporate Finance. 8th Edition. 2008 New Orleans, 2009 Proceedings of the Academy of Accounting and Financial Studies, Volume 14, Number 1