Financial Crisis of 2007-2008, Lax Regulations or something Else - Essay Example

?Introduction The financial crisis of 2007-2008 is now termed as the global financial crisis due to the sheer size with which the crisis damaged and collapsed the financial and economic system of the world. Starting as a subprime mortgage crisis it soon converted into a full blown financial crisis with multiple failures of large banks and financial institutions. Institutions like Lehman Brothers, Citibank, HSBC and many other global financial houses simply crumbled to the unwinding financial crisis. Though the exact causes of the crisis may not be easier to explore and understand however, lax regulations are considered as the major cause of the crisis. Over the period of time, financial services industry went through extensive de-regulation with many institutions taking benefits of such lax regulations. Changes in regulations resulted into a shift in orientation and business strategies of the financial institutions. The focus clearly shifted towards managing short term performance rather than ensuring long term survival of the organization.( Allen & Snyder, 2009) Regulations alone however, cannot be termed as the reason for the financial crisis as there were multiple factors at play. Though lax regulations played their part but the changes in business strategies, changes in accounting standards, loose monitoring from the supervisory authorities, efficient market hypothesis as well as other factors were can be evaluated for their possible impact on the crisis. In this part of the paper, it will be argued that lax regulations were not the only reason for the financial crisis which emerged during 2007-2008. Financial Crisis of 2007-2008, Lax Regulations or something Else Financial crisis of 2007-2008 is considered as one of the worst economic and financial crisis since great depression of 1930s. The sheer size and intensity of the crisis has made it global because not only the developed countries were affected by the crisis but also the other developing countries were subject to crisis also. Besides creating the threat of the complete collapse of the leading financial institutions of the world, it also resulted into governments intervening by bailing out the financial institutions as well as other organizations. The crisis resulted into economic chaos but also resulted into significant political as well as social issue also. The after effects of the financial crisis forced many developed countries to actually enter into strict austerity measures to deal with the growing public debt and fiscal deficit issues.( Aalbers, 2009) How Crisis Started The overall immediate cause of the financial crisis was the bursting of housing bubble in US wherein subprime mortgage holders started to default on their repayments. Over the period of time, US financial institutions started to lend to those borrowers who were technically not eligible to obtain the loans owing to their bad credit history and other factors. However, such borrowers also offered opportunity to earn higher returns as financial institutions attempted to profit from higher risks. Due to inflows from Russian as well as Asian financial crisis, financial institutions were left with excessive liquidity to offload in developed capital markets of US and UK. In order to utilize excess funds and banking on the lax regulations, financial institutions in US started to lend to borrowers with adverse credit history. This was accompanied by the boom in the construction sector of the economy also and financial institutions along with construction companies attempted to benefit from this. Housing bubble however, started to burst simultaneously at other developed markets also. Not only US suffered from the same but countries like UK also witnessed the cooling off of housing market and increasing rates of defaults on housing portfolio. Further, the crashing of the bubble created a contagion effect on other sectors of the economy also. As a result of this crisis and resulting tightening of credit by the financial institutions, other related industries such as automobiles also started to suffer due to lack of consumer credit. The subprime mortgage crisis therefore caused a severe economic downturn as other sectors of the economy also started to witness downturns. What started as a subprime mortgage crisis therefore created much larger consequences for the economies of developed countries? (Majid, & Kassim, 2009) The overall size of the crisis and the impact it had on the whole economy started a debate as to how the crisis happened and what are the underlying factors causing such serious damage to the economy of developed countries. Over the period of time, different factors have been outlined which might have contributed to the overall crisis however biggest reason cited was the lax regulations. It is important to note however, that there are multiple factors at play which resulted into the financial crisis. The factors at micro as well as at the macro level played together to result into serious economic consequences for the developed countries. However, it is critical to first look into the way capitalism changed over the period of time and how as a economic system it created the opportunities of high risk for the financial institutions to adapt risky business policies. Capitalism and Crisis It is argued that capitalism is inherently a faulty economic system and goes through a systematic crisis every now and then. In order to overcome the crisis emerging due to institutional capitalism it is important to actually make radical changes in the system itself to avert the crisis. Historically, capitalism has gone through many changes and neoliberal tendencies started to take their place. A shift towards neoliberal ideology gradually resulted into introduction of more market based economic policies. Governments and supervisory institutions gradually adapted lax monetary policies to create easy money and keep interests rates at relatively lower level in order to continue to stimulate the demand in the economy.(Papava, 2010) It is also argued that the third and more recent shift into the capitalist system resulted into what is called asset bubbles. This phenomenon resulted due to increase in profits over wages and thus created a pool of investable funds and offered financial institutions an opportunity to lend such funds by taking higher level of risks. Further, a comparison between the wages as well as profits indicates that the profits rapidly increased as neoliberal economic policies were adapted. Higher level of profits earned by the financial institutions therefore further prompted them to take on higher level of risks and thus making lending policies which were not conservative in nature. The current financial crisis has also been dubbed as the systematic crisis because of the inherent faults into the financial capitalism. The wider level of inequality caused by the financial capitalism produced the pricing bubbles with the inherent tendency to burst and created significant political change. The financial crisis therefore is considered as the mere part of the much deeper crisis at hand faced by the capitalism itself. Lax Regulations It has been argued that certain regulations were changed or modified in order to allow more space to financial institutions. The regulations put forward under the Basel Accord actually encouraged the use of unconventional banking practices and hence allowed banks to be more creative in designing their business strategies while at the same time ignoring the risk management aspect of such business policies. (Baber, 2013) Various regulations were put in place to broaden the lending powers of the financial institutions while at the same time increasing the depositor insurance. Credit unions were allowed to take checkable deposits thus creating an alternative channel for the depositors to place their deposits at the high cost. Further innovations resulted into keeping the financial derivatives market deregulated thus further worsening the situation which ignored the double edged sword nature of the financial derivatives.( Andrew, 2009) In United Kingdom, the tripartite arrangement between the Treasury, Bank of England and Financial Services Authority failed to provide the results. It was pointed out that FSA lacked the required skills and willingness to audit complex financial products developed over the period of time. The separation of powers of these institutions actually weakened the supervisory role of these institutions as they were slow in responding to the overall rapid changes taking place in the market. (Buttimer, 2011) Financial Innovation Recently, there have been consistent changes in the regulatory environment to allow financial institutions to operate on their own. US and UK during 1980s systematically engaged into free market policies and started to de-regularize many industries including that of the financial services industry. However, due to de-regulated environment, there was a rapid change in the financial innovation with many complex and innovative financial products were introduced in the market. (Trimbath, 2009) Financial derivatives emerged as one of the most used financial products in the market. The rapid innovation in financial product development however was not matched up by the regulations. The overall regulatory response to the financial innovation was relatively slow which helped financial institutions to continue to accumulate bad credit and engage into short term policies while ignoring the long term sustainability of their organizations.( Lo,2009) Securitization emerged as one of the preferred methods for the financial managers to actually share the risk. Through the process of securitization, financial institutions started to issue debt obligations backed up by the mortgage portfolios taken under the subprime mortgage loans. The overall idea was to recoup the lost liquidity by issuing bonds and matching the cash flows of both the mortgage loans and obligations taken under the securitization.( Bondt, 2010) The mass scale defaults by the subprime lenders drained the liquidity out of the financial institutions as they were entitled to repay their obligations taken under the disguise of financial securitization. Financial innovation therefore resulted into significant change in the way financial institutions actually pursued their business policies. The overall marketing and selling of these products, the role of institutional investors played an important role in ensuring that the overall business model of the financial institutions change radically.( Jain,2009) Housing Bubbles There has been a consistent increase in the housing prices in developed markets and more specifically in United States. The average housing prices from 1997 to 2006 increased by more than 100% thus providing a chance to the homeowners to not only take advantage of their higher home equity but also increased the size of the loans given for the purpose of purchasing a mortgage. In 1963, the average price of a new home sold in US was $19,300 which increased to $313,0001 before finally declining in value after the crisis emerged. This unrealistically high increase in the value of the homes further encouraged financial institutions to accumulate collaterals with inflated prices. A similar trend seem to emerge in UK too wherein since 1983, housing prices in UK increased by 428% whereas prices in London increased by more than 500% till 2012. Suc a high level of increase in prices clearly indicates towards the creation of a housing price bubble forcing banks and financial institutions to actually rely on inflated collaterals with their intrinsic values much lower than their market values.( Hall, 2009) As a result of this pricing bubble in housing market, two important phenomenon started to emerge. Firstly, consumers started to refinance their mortgages at the relatively lower interest rates whereas secondly consumers also financed their other spending by taking second mortgages. The loans which were supposed to be used for the purpose of mortgage and housing development were actually used to finance the consumer spending thus reducing the loan to collateral values for financial institutions.( Borio, 2008)  Source : http://monevator.com/historical-uk-house-prices/ Role of Rating Agencies The overall ratings business is dominated by three large rating agencies in the world i.e. S&P, Moody’s and Fitch. The role of rating agencies were further consolidated and recognized through the Basel Accords and Banks were specifically asked to give due weightage to the risk ratings assigned by these agencies to various debt obligations. The role of rating agencies have been criticized because of their inability to specifically put risk on the complex financial instruments. Historically, these rating agencies only developed expertise in rating sovereign debt as well as the range of corporate sector entities. However, as the overall complexity of the financial instruments increased, the models prepared by these rating agencies failed to predict the probabilities of defaults associated with the complex financial products. The lack of information was also one of the reasons which rating agencies failed to incorporate into their models while providing ratings for the borrowers. The availability of information to the loan orginators and the financial institutions was not available to the rating agencies therefore the overall models of the rating. Further, the heterogeneous nature of the underlying assets posed the similar problem of understanding the real characteristics as well as the risks associated with each of the asset.( Mazumder, & Ahmad,2010) Conclusion Lax regulations were not the only reason for the financial crisis of 2007-2008 but there are different and multiple factors at play which resulted into the crisis. Excessive liquidity at the global level, supervisory structure, housing price bubbles, the very nature of capitalism and other factors contributed into culmination of these crises. Rapid financial innovation as well as the rating agencies and lack of regulatory authorities to match with the pace of financial innovation are also some of the reasons for the same. Over the period of time, both US and UK engaged into market based economic policies which allowed financial institutions to bring in fundamental change in their business models and focused on taking more risks. Rating agencies also failed to appropriately assign the risks to the complex financial products developed as a result of the de-regulation of the financial services industry. Part-II Introduction The Bankruptcy of Lehman Brothers was the largest corporate bankruptcy in the history of United States. With debts over $600 billion, Lehman Brothers filed for the Chapter 11 bankruptcy and created shock waves in the global financial institutions. Before its bankruptcy, it was the 4th largest financial services institutions in US having business interests in investment banking, equity, fixed income trading and sales as well as other allied businesses. Over the period of time, it has emerged as one of the most respected institutions in the world with over 25000 staff all over the globe. In 2008, Lehman Brothers filed for its bankruptcy after a massive level of reduction in its stock values, mass exodus of its clients as well as devaluation of its overall assets by the rating agencies. What was once one of the most promising business organizations within the financial services industry became an overnight failure and kick started the more painful process of financial crisis of 2007-2008. It is believed that the real beginning of the financial crisis started with the bankruptcy of Lehman Brothers as it caused several issues of trust of the public in the ability of financial institutions to deal with their money. There have been many reasons for the bankruptcy of the firm however, it is also suggested that the business model followed by Lehman Brother was relatively risky and caused its demise at the start of the global financial crisis. Lehman Brothers and its Bankruptcy Just few months before the bankruptcy of the firm, the stock market capitalization of Lehman Brothers reached approximately $60 billion thus making it one of the best financial institutions in the market. The housing boom which just preceded the crisis enticed the firm to acquire new mortgage lenders and shifted its focus on further expanding its mortgage lending portfolio. It also became one of the leading underwriters of the mortgage backed securities giving it access to one of the fastest growing market niches in the financial services industry. Federal Reserve, owing to the declining stock market in 2000s, decreased the interest rates in order to boost the market. However, a reduction in the interest rates also made it relatively easier for borrowers to afford the inexpensive mortgages. As a result of this, many conventional and conservative financial institutions also jumped into this opportunity to serve the growing needs of the market for new homes. With the increase in demand for new homes, prices also started to increase and thus a pricing bubble started to emerge in the early 2000. However, by 2006, the overall rates of default started to increase and financial institutions including Lehman Brothers started to pursue the aggressive policy of securitizing their mortgage portfolios based upon the belief that by doing so they will be able to reduce the risk or maintain it at the acceptable level. However, these toxic mortgages created further losses for the Banks and Lehman Brothers was one of the worst affected in the market. Lehman Brothers Business Lehman Brothers was primarily an investment bank serving institutional, high net-worth and corporate clients. The primary business of the firm was offering financial services however, it was also engaged into other businesses which formed only 10% of its overall business. The overall range of services offered by the firm including raising capital for the firms, direct placements, corporate finance, advisory services, private placements, sale and trading of securities as well as range of other services. Apparently, the firm’s major business activities, as disclosed in its reports submitted to Securities and Exchange Commission suggested that it is actively involved in the research and development as well as the underwriting and distribution of the debt and other financial securities on the behalf of its customers. It is important to note that a boom in the housing market in US prompted the firm to extensively take risk into the mortgage portfolio. Despite the collapse of Bears Stern, firm continued to expand its mortgage portfolio by underwriting mortgage based securities. This practice of the firm continues to ensure that it receives an steady flow of clients wanting to do business with the firm. Apart from this, Lehman Brothers was extensively engaged into the naked short selling and was accused of having no accountability for failure. Excessive use of short selling and the resulting decline in the stock values of the short sold stocks resulted into significant strain on the liquidity of the firm. Since Lehman Brothers was also engaged into sale and purchase of securities therefore short selling was a natural part of its overall business model as one of the revenue generating streams for the firm. It is also important to note that Lehman Brothers extensively engaged into the marketing and sell of CDOs. The rapid financial innovation which took place over the period of time forced financial services organizations like Lehman Brothers to develop and extensively market new financial products. The Collateralized Debt Obligations were extensively marketed and sold by the Lehman Brothers to provide other financial institutions an underwriting cover to insure themselves against the defaults.( Valukas, 2013)  It is critical to note that high level of exposure in CDOs was backed up by the highly inflated credit ratings assigned to them. Before their write-downs, most of the CDOs were rated AAA thus rating agencies failed to comprehensively outline various risks involved in such debt obligations and the given ratings failed to provide true and fair picture of the nature of such securities. Most of the CDO issues were not only over-valued but Lehman continued to underwrite its subprime mortgage portfolio by issuing more CDOs. The following table indicates that % of defaults of CDOs as of Dec 2008 and suggests that approximately 25% of the CDO portfolio of Lehman Brothers defaulted as of that date. Though the overall rate of default of Lehman’s CDOs was relatively low however, given the size of the portfolio as well as losses suffered in other businesses, Lehman was not able to sustain the losses and hence filed for the bankruptcy under Chapter 11. Source: http://www.hks.harvard.edu/m-rcbg/students/dunlop/2009-CDOmeltdown.pdf It is suggested that the Lehman’s focus on earning short term and investing into more risky securities such as CDO were primarily driven by the way it tailored its business model. It clearly deviated from its original business model and attempted to venture into more risky investments causing its demise. Accounting Practices It has been observed that accounting practices followed by Lehman Brothers were such that they made financials of the firm more attractive than they actually were. The cosmetic accounting treatments adapted by the firm resulted into the potential hiding of the actual information material to the investors and therefore created an entirely different financial picture of the organization. The reporting of the financing derivatives as well as the use of special purpose vehicles used to hide the financial transactions presented a rosy picture of the firm. The very business model of the firm was such that it misrepresented its financial statements in order to offer much favorable picture to its shareholders.( Czarniawska, 2012) The use of Repo 105 transactions especially at the end of the financial year by the firm were aimed at actually presenting a more favorable picture of the firm’s financial position. Further, a smaller firm was created in order to off-load certain toxic transactions in order to keep the books of the firm relatively clean and again to provide investors a more favorable position to deal with in the market. Executive Compensation Due to shift in focus on achieving short term results, the overall compensation in Lehman Brothers was linked with the performance. Better short term performance was duly recognized with higher level of compensation and better monetary benefits for traders and executives involved in day to day activities of the firm. It was the nature of the firm’s model that the employee focused was on achieving better short term performance in order to earn higher compensation. In order to improve the performance for better compensation, Lehman’s executives started to take higher risks and ventured into businesses which were traditionally risky in nature. Over $400 million were paid to the CEO of the firm in terms of pay, bonuses and other compensation benefits just before the start of the financial crisis. Later bankruptcy documents suggested excessively high level of compensation for the executives who were rewarded simply because they continued to take on higher levels of risks and failed to offer a viable strategy to counter with the adverse impacts of this strategy.( Appelbaum, Keller, Alvarez,& Bedard, 2012) Though the compensation of the top executives of the firm were known and disclosed in financial statements of the firm however, the outsize level of compensation paid to other officers and executives of the firm was not revealed in any of its documents. Excessive Leverage As discussed above, the compensation of the executives was linked with their ability to earn higher returns. As a result of this, Lehman as a firm extensively engaged into seeking excessive leverage and acquiring toxic debt which resulted into its demise. It is critical to note that due to rule changes by the SEC, there was an industry wide shift in the practice of keeping the excessive leverage at the relatively lower level. Lehman Brothers, along with other players in the market continued to focus on keeping this ratio low however, the method adapted by the firm was considered relatively risky and dubious in nature.( Rapp, 2009) In order to keep the excessive leverage at acceptable levels, it engaged into what is called Repo 105 transactions. Repo 105 transactions are considered as accounting maneuvers wherein the short term loans acquired by the financial institutions are recorded as sales. As a result of this, Lehman was able to keep its net leverage ratio at relatively acceptable level while showing Repo 105 transactions as sales. The cash obtained through Repo 105 were used to repay the debt and it appeared that Lehman continued to use this practice in order to keep its debt levels at relatively low level.( Hines, Kreuze, & Langsam, 2011) Neither regulatory authorities nor general public and investors were able to smear as to what accounting practices were used by Lehman Brothers. Though it is suggested that the firm’s auditors knew about this practice however, it failed to properly disclose this fact and turned a blind eye towards the controversial accounting practices continued for years. Source: http://www.hks.harvard.edu/m-rcbg/students/dunlop/2009-CDOmeltdown.pdf The above figure indicates the overall quality of the CDOs underwritten by various financial institutions. It indicates the percentage of subprime portion of the total underwriting and points out that Lehman Brothers excessively booked the subprime loans and CDOs and its ratio was relatively on the higher side. Due to this higher ratio that these firms were forced to take on higher write-downs on their portfolios and resultantly suffered extensive losses over the period of time.( Katherine, 2009)  The above graph also suggests the extent to which Lehman Brothers was engaged into the excessive risk taking without realizing as to how its overall strategies may result into sever losses for it in the future. Could the Crisis been Averted? The above discussion suggests that the firm actively pursued a business model which offered it short term benefits. The clear focus of the firm was on ensuring that the short term performance remains at the acceptable level. Further, the lack of accountability for taking excessive risks, use of controversial accounting principles as well as the compensation of the executives actually allowed the employees to continue to engage into risky business ventures. Considering the overall shifts which taken place at the industry wide level globally, it may be relatively difficult to suggest that the collapse could have been avoided if firm followed a relatively different model. Other competitor firms such as Berkshire Hathaway continued to perform well even during the financial crisis and outperformed the market in different segments. The success of Berkshire therefore clearly suggests that a more focused and conservative business model might have resulted into averting the collapse of Lehman Brothers.( O'Connell, 2010) The business model adapted by the firm was relatively risky and contained inherent risks which were shared at the industry wide level. Due to linkages in the financial services industry with each other, the failure of one firm also has an impact on others. The excessive use of leverage and innovative financial products in order to earn higher level of returns clearly were the major causes of the failure of Lehman Brothers. It is also important to note that Lehman Brothers continued to expand itself at the global level and expanded its overall base of products and services offered. It gradually drifted from its original business of selling and buying securities and offering advisory services. The consolidation which took place at the industry wide level forced Lehman Brothers to acquire businesses which were not directly related with the firm or the firm did not enjoyed the relative competitive advantage into the same. As such its entire focus was on the accumulation of toxic debt through mortgage portfolio and it continued to underwrite or hedge its toxic portfolio with CDOs and other innovative financial products. The overall collapse of the firm could have been averted if it would have followed a more conservative business model with focus on managing niche segments of the industry. However, its decline was so fast that it was even unable to take advantage of bailout package offered by US government. 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