Causes of Financial Crisis of 2007-2010, Analysis of the Fall of Lehman Brothers - Essay Example

?The Financial Crisis This study aims at presenting the major causes of financial crisis of 2007 along with a comprehensive analysis of the fall of Lehman Brothers, with strong reference to financial crisis. The financial crisis of 2007-2010 is considered as the greatest crisis after the great depression. In September 2007, the US Department of Labor had released their jobs report which stated that not only there are no growths in the jobs rate, but also 4000 people had already lost their jobs by then due to the business environment. In the year 2007, the analysts already started warning the investors that in USA that the market was on the verge of a severe credit crunch. Lehman Brother’s was one of the major victims of this crisis, and its bankruptcy acted as a catalyst in such a situation. The decline of Lehman Brothers started with the abolition of the Glass-Steagall Act. This is considered as one of the legislative acts which influenced the financial institutional structure of US. This was a seminal event that intensified the financial crisis of 2008. About $10 trillion eroded away from the equity market in 2008 after the bankruptcy event of Lehman Brothers, which was recorded to be the biggest decline of all times. Answer a: Financial Crisis of 2007-2010 The financial crisis of 2007-2010 is considered as one of the worst financial crisis after the Great Depression of 1930s (Coggan, 2007; Minsky, 1992). In this section, the discussion would be specifically on such causes that led to financial crunch Right from lax regulation, housing bubble, credit rating given by the agencies, to subprime mortgage lending, pay structure of the management and board, and easy credit facilities, are considered to be the major causes of financial crisis. In this study each aspect will be identified, and flaws in every situation would be evaluated, so as to discuss the grounds for the downfall major financial institutions in the second section. Lax regulation The Glass-Steagall Act, which is generally referred to in case of deregulation has no such role in financial crisis. It was an expression involving the whole Banking Act of 1933, which mainly limited securities activities associated with commercial banks, and affiliation aspects between securities firms and commercial banks. However, Gramm-Leach Bliley Act of 1999, also known as Financial Modernization Act, was an abolished part of Glass-Steagall Act of 1993 acted as a force in minimizing the gap between the traditional commercial banking institutions and the modern risky investment banks. It allowed the banks to associate with each other and engage into underwriting activities and security deals (Baily, and Elliott, 2009; The Financial Crisis Inquiry Commission, 2011). The Commodity Future Modernization Act which was passed in 2000, allowed over the counter derivatives to become self-regulating. Derivative was designed to be a tool that hedged risk associated with investment in securities market. However, this soon turned into a speculative tool (Federal Reserve Bank of San Francisco, 2012; (Duhigg, 2008). The banks sell the loans to the investment banks, which combine different types of loans such as home loan, car loan, education loan, etc into a complex derivative instrument, called Collateralized Debt Obligations (CDOs), and further sell them in the market to the investors. The borrower of the loans when paid the loan back, the money went straight to the investors. The Sub-prime loans were also popular because it was a high interest loan taken by those who could not afford it. The return and risk of any CDO investor was dependent on the various tranches. The securitization food chain is stated below. Figure 1: Securitisation Food Chain The Credit Default Swaps (CDS) allowed the investors to invest in certain corporations without feeling the heat of direct equity exposure, as can be seen in Figure 1. By 2008 it was found that the outstanding associated with CDS was around $40 trillion, and the over the counter derivative outstanding amount was around $683 trillion in June 2008 (Flaaten, 2009; Balakrishnan, 2008). Warren Buffet addressed this as to be the financial weapon designed for mass destruction (Forbes, 2008). Figure 2: Outstanding Credit Default Swaps Source: (FSA, 2009) Housing Bubble The house prices increased considerably escalating the demand of houses in US. The price of the houses outpaced the income growth during the phase of housing bubble (Schmuecker, 2011). In the year 2008, Case Shiller home price index revealed that the housing price drop in the year 2008 was the greatest decrease that was seen. This resulted in the subprime crisis which got created due to the Alt-A collateralized debt, credit, other mortgages, and hedge funds. It badly affected the industry as construction of new houses was nearly stopped (The Economist, 2009; Barker, 2004). Leverage Lax Regulation in banking industry encouraged innovation, which added to reckless credit escalation, bets on the price of assets and excessive leverage. This increased the vulnerability of bursting the housing bubble and leading to economic downturn. The consumers started taking advantage of the escalating housing prices by acquiring the home equity loans that almost doubled from around $627 billion in the year 201 to about $1,428 billion in the year 2005 (Belka, 2010). The housing mortgage debt increased at an average of 73 percent in 2008, compared to 46 percent in 1990s. The household debt percentage against the annual disposable personal income was around 127 percent in the year 2007 in comparison to 77 percent in the year 1990 (Connelly, et al., 2010). Sub-prime Lending The loans which are extended to the subprime borrowers do not satisfy the major guidelines of the loans are generally termed as the subprime loan (Balckburn, 2008). This is because extending loan to these borrowers might be risky, as their credit ratings were low (Labaton, 2008). The underwriting regulation and standards were relaxed by mortgage lenders because of the cut throat competition in the market and the accessibility of the creditworthy borrowers (Morgenson, 2010). However, the subprime mortgage crisis resulted because these subprime mortgage borrowers failed to pay back their loans and the banks were not getting investors to sell-off those mortgage assets and get back their money (Duhigg, 2008). Freddie Mac and Fannie Mae were the government enterprises that were created to support the mortgage backed securities (MBS) in the secondary market. The guaranteed 40 percent MBS of USA. During 2004-2007 they became the biggest buyer of Alt-A mortgage and subprime loans. The total exposure was of around $1 trillion, which even multiplied the cost of financial collapse. Another cause of crisis was the NINJA loans, which were extended to the borrowers who have no income, no asset and no job. In case of most of the loans, the borrower has to show a solid proof of regular income, while a NINJA loan ignores them. It was also considered to be a type of subprime loan. Limited Liability and Business Cycle All the major investment banks had converted themselves from partnership to corporation limiting their liabilities, so they invested people’s money aggressively in risky investments. No one was accountable for that money as the investment banks were not liable to pay. However if business cycle is studied then it can be understood that recurring and fluctuating are part of this cycle. There are five major stages in a business cycle such as expansion, peak, recession, trough, and recovery. This means that recession is bound to come after peak stage, which happened in the case of financial crisis. Easy Credit Facilities The low rate of interest made the credit facilities more accessible to the American consumers, and they increased their borrowings without any second thoughts. In the year 2000, the target rate of the fed fund was 6.5 percent (Olin, 2012; Max, 2004). This directed towards growing demand of the assets and the scheme was to amplify the price of those assets for diminishing the rate of interest (Bernanke, 2005). The terms and conditions based on which the borrowers received loans were easy and verification of the relevant documents in order to validate the creditworthiness was not given any attention. “They are too big to fail” – Banks’ Belief Major Banks like Lehman Brothers has become so huge due to their complex structure that the government had the notion that they are too big to fail. The top executives in these banks also believed that banks of such massive size will surely get assistance from government in case of contingencies. However, the scenario and the notion changed during Lehman’s bankruptcy. Bear Stearns was bought by Morgan Chase, but the Federal Reserve did not guarantee the obligations of Lehman for Barclays to acquire it. This was because of the abnormally large structure of the company, which made the process complex and increased its risk exposure (McDonald, and Robinson, 2009). Repo Market Repo is the short-term instruments for lending. The securities sold by the dealers to the investors with a guarantee to buy it back at a same price along with premium are what take place in Repo market. The premium size is depended on perceived risk. The short-term funds that were there in the shadowing banking system were supported by securities mortgages, which collapsed, so the collateral that backed the repos were being withdrawn by the cash lenders (McKitrick, 2011; Pozsar, Adrian, Ashcraft, and Boesky, 2012). Lehman Brothers also funded themselves from the Repo market, but the lenders could not trust the sustainably of the firm, and pulled out cash. Bonus Structure and Compensation Offered to Bankers Spectacular Collapse of the banks, where executives are paid for their performance has raised questions that link risk and executive pay. In a research report by Thomas Philippon and Ariell Reshef, they have mentioned that in the year 2000, the wages of the executives has increased by 40 percent, the qualification remaining the same (Fox, 2009). The executives in the banks were offered stock or equity options in order to eliminate short-termism. The pay level of the executive has increased dramatically compared to the non-executives (The Independent, 2009). According to Standard & Poor 500, the average total pay of the CEOs has increased from $850,000 in the year 1970, to 10.5 million during 2008, as can be seen in Figure 2. Figure 2: Rise in Pay Source: (Faulkender, Kadyrzhanova, Prabhala, and Senbet, 2010) The escalation of pay of the executives has led to an increase in inefficient practice of wealth transfer. Figure 3 clearly explains how increasing pay and bonus can increase risk and add to financial crisis. Raja (2008) has suggested that bonus is issued to hide the trailing risk, which was linked to the subprime mortgages. Raja (2008) considers these bonuses to be alpha and says there are ways through which alpha is generated, such as ability of the investment managers to identify the undervalued assets, from activism, or from financial entrepreneurship. Figure 3: Interrelationship between Pay and Risk Source: (Faulkender, Kadyrzhanova, Prabhala, and Senbet, 2010) Credit Rating Agencies These credit rating agencies are now under scanner because of giving money safe credit ratings to the CDOs and MBS transactions of the banks which were based on the subprime mortgage loans. High rating given by these agencies encouraged the investors to fund the securities, which in turn funded the housing bubble in USA (Morgenson, 2010; (Valukas, 2010). It was estimated that around $3.2 trillion loans were given to the homeowners on the basis of undocumented income and bad credit. These mortgages received high credit ratings from the credit rating agencies (Whalen, 2007). They converted the F-rated securities to A-rated, which reveals that if these agencies has not given AAA ratings to securities and investments, then demand for those specific investments would have been low, and many banks could be saved from bankruptcy (Wright, and Mukherji, 1999). Conclusion Every business cycle goes through different stages, which affect the economic condition of the global market aggressively. The financial crisis of 2007-2010 was the result of the recession stage of the business cycle which usually comes after the peak stage. The indications of the peak stage were the causes such as housing bubble, heavy investment of the investment banks in sub-prime mortgage based loans. The top level company managers received exquisite pays which were not taken back due to limited liability policies. On top of that lax regulation by the government, mismanagement by board of directors, fraud practices by credit rating agencies, and speculative activities by other financial firms led the economy towards the next stage of business cycle. Answer b: Collapse of Lehman Brothers Lehman Brothers: Introduction Lehman Brothers could have been saved if it followed a less risky business model with low level of leverage. The pace of Lehman’s investment in real estate industry was extremely fast and risky (Whalen, 2007). This was partly because of external causes such as bursting of housing bubble and failure of subprime loan market, but also due to internal reasons such as huge and abnormally complex structure of the bank, greed of the CEO and management team to earn supernormal profits and aggressive investment business model of the company (Farrell, 2007). The bankruptcy of Lehman escalated the pace of financial crisis leading it towards recession. In this section the discussion on Lehman’s business cycle towards its insolvency would be done. Growth of Lehman Brothers after 2002 Lehman Brothers continued to grow throughout 20th century and it expanded to various areas in the financial sector. In the year 1977, the bank merged with an investment bank, called Kuhn, Loeb & Co. and kept growing. In the year 1984, it acquired American Express Company. Figure 4, shows the steady growth of Lehman in terms of net revenue. However, after 2007, there was a sharp fall because it was becoming difficult for Lehman to procure funds as working capital. Leverage has led to profitability in the capital market after 2002, as can be seen in Figure 4. Lehman was successful in maintaining a balance sheet over $1 trillion. Figure 4: Net Revenue of Lehman Brothers Capital Market Capital market is segregated into three divisions such as research, trading and sales. This lies within the investment bank. Lehman made money in capital market by charging for the research reports that they made for selling or purchasing investment securities. The clients were usually institutional and they invested large amounts in the capital market, so the research reports by Lehman was of great importance for them. Investment Banking The investment banking functions of Lehman comprised of 20 percent of the revenue of the company in 2007. This segment was incredibly important for growth of the firm (Goldstein, 2007). This sector of the bank was split into two segments, merger and acquisition segment and corporate finance. Around 45 percent of the revenue of Lehman was generated from the underwriting activities of the investment banking division, as can be seen in Table 1. Investment Management Since investment management business is generally fee based, so it offers good returns. Lehman generated good and steady returns, though the total number of transactions has lessened (Lehman Brothers, 2008). This initiative was to raise investment management revenues in line with the revenue percent. The investment management division of Lehman consisted of two parts, namely private investment management and asset management (Onaran, 2008). Table 1: Net revenue Source: (Sharma, 2012) Business Model of Lehman Brothers The business model of Lehman Brothers was structured to take high risk and high leverage. Just earlier to the bankruptcy, the bank had around $700 billion of asset of which around 3.5 percent was equity (Maux, and Morin, 2011; Lehman Brothers, 2008). They borrowed about billions of funds from the repo market and paid it back on an everyday basis in order to be in business. However, the counterparties were not confident of their sustainability and they withdrew money. It had a detrimental effect on the reputation and confidence of Lehman Brothers (Jensen, 1986). Lehman Brothers had around 3000 legal entities around the world, which made its organisational structure complex. The management team had the intention of implementing high-growth strategies (Jeffers, 2011). In order to do this, they shifted from the low-risk brokerage model to risky capital-intensive investment banking model. Based on this model, Lehman Brothers had to first buy and accumulate in contract to the other model, where they bought and transferred the risk to the third party. The complex structure of the bank created managerial problems. Lowered the ethical standards, and manipulated financial statements (Holmstrom, 1979). Richard Fuld was the CEO of Lehman Brothers since 1994 till 2008. He received around a half billion dollar during a span of 15 years of his service, as a CEO of Lehman. In 2007, he received a total compensation of $22,030,534. Though he was praised to have handled the initial subprime crisis well, but it was said that he underestimated the housing bubble, and its effect on Lehman’s mortgage bond underwriting business. He is also blamed for not completing many proposed deals, which could have saved the company from bankruptcy. The management team was under the sole control of the CEO and board of directors which were absolutely risk hungry and lacked expertise in the banking industry. Comparative Analysis Lehman Brothers was among the top four banks of USA. In can be said the Lehman was a more profitable organization than its competitors such as Morgan Stanley and Merrill Lynch. Due to the size of Lehman, it was mainly focused towards trading and fixed-income sales. It drove more of its revenue from fixed-income sales, and securities trading than any of its competitors. Moreover, the reliance of the bank on the capital market has drove Lehman toward being the top investment banks. This means that the company generated revenue compared to the per unit risk, than its competitors, as can be seen in Table 2. Table 2: Comparison to Competitors Source: (Sharma, 2012) It derived more revenue in trading than its peers, and it also made more progress in diversifying its business than its peers, as evident from the Q2 2007 reports. The net income of the bank increased by 27 percent, in spite of a decrease in 14 percent drop stimulated by subprime in the trading division, as can be seen in Table 3. Table 3: Sales and Trading Revenues Source: (Sidel, Berman, and Kelly, 2008) As can be seen in Table 4, the gross leverage and the net assets of Lehman compared to its peer group was towards the higher end in 2007. Even after a minimal decline, it crept back to the high end, which signaled high risk. Leverage position of the major banks can be even assessed from Figure 5. Table 4: Leverage Position of Top Five Financial Institutions Source: (Callen, 2008) Figure 5: Leverage Position of the Major Banks Cause of Collapse Payment Structure of Executives and CEO According to Bebchuk, Cohen, and Spanmann (2008), the wealth and compensation of the top executives in Lehman Brother and Bear Stearns were also considered as the major reason for collapse, , as can be seen in Appendix 2. The compensation of the top five firms which includes Lehman cashed out handsome performance based compensation and bonus during the span of 2000-2008, as can be seen in Appendix 1. However, when these firms collapsed, these were not taken back from them. The estimated cash flow of the top executives of Lehman and Bear Stearns was $1 billion and $1.4 billion respectively. The CEO of Lehman held options of $106 million, and stocks of $195 million according to the proxy statement of Lehman. They were given equity stocks of the company, so that they have interest in the profitability of the company. This excessive amount of bonus and compensation for the performance did prove disastrous for the shareholders of the company. Leverage Ratio Leverage allows the financial institution to escalate or diminish their gain or loses through investment beyond what is possible through direct investments. Excessive leverage by the banks has led to financial crisis. The leverage ratio is a tool to measure the leverage position of the company and comment on the requirements related to capital adequacy. Identification of leverage ratio can assist in formulating measures for risk of extreme leverage. The leverage ratio as can be seen from the extract of annual report, in Table 5, was highest in the year 2007. Table 5: Extract of Annual Report with Leverage Ratio of Lehman Brothers Source: (Lehman Brothers, 2008) Off-Balance Sheet Exposure of Lehman Brothers Lehman Brothers was exposed to the risk of off-balance sheet in order to hide the extent of risk it was into because of its investments, even seven year before its collapse. It was found that Linklaters, one of the magic circle law practices assisted Lehman in implementing questionable accounting practices that hid $50 billion of their debts. They allowed manipulation of balance sheet for Lehman in order to keep the investors in dark (Montgomery, 2011). Failure of Lehman could have been avoided: Discussion Lehman Brothers prepared for its own peril when it changed its business model from less risky or an aggressive and highly risk prone investment model. It invested in various forms of real estate investments such as hotels, housing, commercial property to sub-prime loans. Generating supernormal profit and expanding abnormally led to its downfall, which if avoided could have saved the bank easily (Onaran, 2008). The financial statement revealed facts and figures generated from creative accounting. Even the credit rating agencies gave good credit ratings for these banks just before its bankruptcy (Fama, and Jensen, 1983; Forbes, 2008). The independent auditors such as Ernst and Young overlooked the misstatements of the bank, and on the credit rating agencies (Jensen, 1986; Godfrey, Hodgson, and Holmes, 2003). Probably the actual credit rating and right accounting practices would have revealed the threat Lehman was associated with. At that time risk was still small and assistance could be received (Dutta, Caplan, and Lawson, 2010). Highly improved tools could be implemented then, to improve their transparency, and inform the market regarding their risk exposure (Eisenberg, 2008). Barclays was the only one who had the capacity to acquire Lehman, but they could not guarantee the trading obligations of Lehman Brothers that was required in order to sign the merger agreement and the closing (Krugman, 2009; Perry, 2008). The treasury department did not have the authority to guarantee such an obligation, but the Federal Reserve had and they did not do it (Alchian, Demsetz, 1972; Bebchuk, Cohen, and Spamann, 2010). Conclusion Lehman Brothers was one of four majors banks of USA, which investors considered would never fail because it was too big to incur losses. Lehman grew considerably because of its merger and acquisition strategies, and it became a large and complex organisation. However, it considerably dealt in subprime and mortgage backed loans. Lehman faced problems due to the housing bubble, and also failed because the firm did not have enough working capital to manage its daily operations. Lehman Brothers cannot be considered a scapegoat though the fall of Lehman was due to the affect of few internal factors and majorly external factors because the banks and its activities were thorough in relation to such external occurrences. However, it could have been avoided if Lehman retained it less risk and less profit business model with minor alterations. A drastic high investment and high profit business model led to its downfall. Lehman’s downfall further deepened the financial crisis and spread to massive destructive, which otherwise could have been controlled or avoided (Labaton, 2008). Though Bear Stearns was in a riskier position than Lehman, but it was acquired by Morgan Chase, but Lehman was not fortunate to receive that support from Barclays. References Alchian, A. A., Demsetz, H., 1972. Production, information costs, and economic organization. American economic review, LXII, 5, pp. 777–95. Baily, M. N., and Elliott, D. J., 2009. 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Chapter 11 proceedings examiner report: Volume 3. [pdf] Available at: [Accessed 26 March 2013]. Whalen, C. J., 2007. The US credit crunch of 2007: A minsky moment. Public policy brief, 92, p. 5-24. Wright, P., and Mukherji, A., 1999. Inside the firm: Socioeconomic versus agency perspectives on firm competitiveness. Journal of socio-economics, 28, pp. 295–307. Raja, R. (2008). Bankers’ pay is deeply flawed. Financial times comment & analysis, [online] Available at: < http://www.ft.com/intl/cms/s/0/18895dea-be06-11dc-8bc9-0000779fd2ac.html> [Accessed 9 April 2013]. Appendices Appendix 1 Appendix 2 Read More