DEFINITION of Lehman Formula
Lehman Brothers developed the Lehman Formula, also known as the Lehman Scale Formula, in the 1960s while raising capital for corporate clients.
BREAKING DOWN Lehman Formula
The original structure of the Lehman Formula is a 5-4-3-2-1 ladder, as follows:
- 5% of the first million dollars involved in the transaction
- 4% of the second million
- 3% of the third million
- 2% of the fourth million
- 1% of everything thereafter (above $4 million)
Today, because of inflation, investment bankers often seek some multiple of the original Lehman Formula, such as the double Lehman Formula:
- 10% of the first million dollars involved in the transaction
- 8% of the second million
- 6% of the third million
- 4% of the fourth million
- 2% of everything thereafter (above $4 million)
A Brief History of Lehman Brothers
Lehman Brothers was previously considered one of the major players in the global banking and financial services industries; however, on September 15, 2008 the firm declared bankruptcy, largely due to its exposure to subprime mortgages. Lehman Brothers also had a reputation for short selling in the market.
A subprime mortgage is a type of mortgage that is normally issued by a lending institution to borrowers with relatively poor credit ratings. These borrowers will generally not receive conventional mortgages, given their larger-than-average risk of default. Due to this risk, lenders will often charge higher interest on subprime mortgages.
Lenders began issuing NINJA loans, a step beyond subprime mortgages, to people with no income, no job and no assets. Many issuers also required no down payment for these mortgages. When the housing market began to decline, many found their home values lower than the mortgage they owed as interest rates associated with these loans (called "teaser rates”) were variable, meaning they started low and ballooned over time, making it very hard to pay down the principle of the mortgage. These loan structures resulted in a domino effect of defaults.
The bankruptcy of Lehman Brothers was one of the largest bankruptcy filings in U.S. history. Although the stock market was in modest decline prior to these events, the Lehman bankruptcy, coupled with the prior collapse of Bear Stearns significantly depressed the major U.S. indexes in late September and early October 2008. After the fall of Lehman Brothers, the public became more knowledgeable about the forthcoming credit crisis and the recession of the late 2000s.