Financial Crisis and Lehman Brother Collapse - Essay Example

PART A The global financial crisis hit the Western nations significantly between the years 2007 and Most people argue that these global financial crises were caused by poor processes and poor systems that were used by the financial sector of organizations and entities. However, it is also possible that other elements and aspects outside the financial sector also contributed in various ways and forms to the credit crunch as it is known. This section of the paper examines the fundamental research question: was the world of finance the only sector that was responsible for the global financial crises of 2007 – 2010 or not? To this end, the paper will critically evaluate all the factors responsible for the global financial crisis and identify whether there were factors that were only related to the financial sector or not. The paper will therefore conclude on whether the financial sector was solely responsible or not Financial Retail Products and the Profit Motive Prior to the financial crisis of 2007, it was believed that mass marketing of retail financial products in high income countries after the early 1980s was safe (Froud, Johal, Montgomerie, & Williams, 2010). This was a general belief that this constituted the democratization of finance and ownership in modern Capitalist society. This is because poor people and middle class persons who could not normally afford to own some kinds of properties could acquire properties through the acquisition of various financial products and services. The supporters of this school of thought believed that it was a shared framework that enabled all people in the society to own what they wanted to own. “Mainstream finance represented financial innovation in circular and technological terms as that which perfected the market.” (Engelen, Erturk, Froud, Leaver, & Williams, 2008, p. 4). This means that the growth of technology and the enhancement of the financial sector led to the growth and expansion of the debt systems and debt structures (Froud J. , Johal, Montgomerie, & Williams, 2009). This grew the trend of financial intermediation and created more financial retail products. However, this process gave way for the evils of exploitation by numerous financial intermediaries (Froud, Johal, Montgomerie, & Williams, 2010). This created a major problem that fed into the system of the credit crunch. “Empirical evidence of the United States shows that extension of credit and asset ownership in an unequal society is self defeating because it does not abolish the tyranny of exploitation and earned income, and it indeed tightens the vice in so far as low income individuals and households accumulate debts but not assets” (Bebuch, Cohen, & Sparmann, 2009, p. 1422) This indicates that the abundance of financial retail products on the US and international markets induced spending. They forced people particularly the poor to get into debt and this induced their spending habits. However, these poor people made little or no effort to gain any assets that could help keep the economy growing and thriving. Thus, there was the massive privatization of the acquisition of profits based on rationality and rationalization of the quests for more avenues and the increase of sales amongst these financial intermediaries (Buiter, 2008). However, as financial intermediation increased and more people were roped into the debt system, there were socially inefficient principles and regulations that caused people to borrow and continue to borrow. Another aspect of this huge appetite for borrowing was the fact that more money was injected into the US economy through international financial intermediation which caused capital from nations like China, UAE and others to be injected into the US economy which caused Americans to get access to more money to borrow to fund their habits of consumerism (Buiter, 2008). Dowd identifies the profit motive of these financial intermediaries to be a moral hazard. This is because these financial intermediaries sought to create markets and continue selling their financial products (Dowd, 2009). Poor Management of Risks in the Financial Sector The management of risk amongst the key players of the financial sector was also poor. The management of risks, particularly, systematic risks were poor amongst banks and other entities. The French bank, Societe General was given numerous awards for having the best methods and systems for checking and assessing risks, but a 31 year old trader was charged for taking billions of dollars from the bank to indulge in high risk trading which came with serious issues for the bank (Blackburn, 2008). The lack of proper risk appraisal and analysis led to a situation where the poor and the less advantaged began to default in their sub-prime mortgages and this was as high as 30% (Blackburn, 2008). The domino effect was that the defaults meant that large mortgage brokerages could not thrive and they all failed. The banks therefore proposed money to the financial system and this created a higher impaired base for major banks. “The turmoil is best seen as a natural result of a prolonged period of generalized and aggressive risk-taking which happened to leave the subprime market at its lowest levels.” (Borio, 2008, p. 251) This implies that the financial imbalances in good times caused too many investments to be made and this led to serious problems and issues that affected the entire markets. Also, it was pervasive for most financial entities to tie their transfers of certain derivatives and assets to remuneration (Godechot, 2010). This means that the professionals and staff members of these financial entities gained more money as they sold derivatives, thus, they continued to make transfers and this led to the creation of a major system for providing loans to vulnerable and sensitive segments of the population. Executive Compensation and Self Review of Remuneration Some authorities believe that the global financial crisis was largely linked to the compensation structures that induced risk-taking and encouraged organizations to pursue unnecessary risks that could have been avoided. Studies of Lehman Brothers indicate that the top 5 executives cashed out large sums of compensation during the 2000 and 2008 period (Bebuch, Cohen, & Sparmann, 2009). They cashed out large amounts of bonuses in return for high risks that brought revenues. Compensation tied to results meant that managers and executives were prone to taking high risks and this automatically created lower levels of care and sensitivity to the realities of cutting down risks and maintaining appropriate levels of care and controls. Instead of these executives focusing on the going concern of their businesses, they were motivated to seek excessive leveraging and expand to take risks in high ventures and processes (HM Treasury, 2009). These business executives and directors focused on wholesale funding and sought to acquire risky products that enabled them to meet their targets and created major problems and issues for the entire organization. Poor Accounting Practices and the Lack of Prudential Regulations Disclosure became affected and influenced in the high risk firms where executive compensation was high and there was the need to maintain public confidence. This is because most of these firms had to present favorable and positive financial statements that will maintain the public’s confidence in them in order to remain solvent. The lack of strong and firm laws that would compel directors to present consistent financial statements led to a system and a situation where faulty and misleading financial statements were turned in. This culminated in the presentation of inappropriate financial statements that deceived the public and created false images and views which caused the crisis to deepen. Due to this, there was a lack of transparency and this led to major off balance sheet financing which presented misleading information and kept the bad system going (Buiter, 2008). Rating Agencies Most investor decisions were based on the ratings of respected institutions like Moody’s and Standard & Poors. These entities had used various tools and methods that worked significantly for decades. However, in the early 2000s, their approach was not realistic and it provided misleading views about investments and returns and this caused the financial crisis to subsist and thrive (Buiter, 2008). Many of the rating agencies and processes were poor and the researchers were also biased due to incentives and other personal motivations (Montgomerie & Williams, 2009). This created a system where wrong information was presented and the rating agencies failed to use systems that were robust enough to analyze and detect issues and matters. Thus, a lot of assets were in bad situations and in bad shape, but they provided a positive image that was generally misleading and could not be relied upon since they did not present the actual image of the markets (Pozar, Adrian, Ashcraft, & Boesky, 2012). Macroeconomic Factors The fundamental macroeconomic system used by these firms included the Keynesian multiplier based system that sought to improve national income through effective investments that was meant to provide yield (Davar, 2011). This system was based on some assumptions that were not honored during the period of the financial crisis and this created a process of imbalance that was felt throughout the nations. The excessive global liquidity created by the Central Banks of the nations in the Western world contributed to this issue (Buiter, 2008). This is because nations in the West like the United States and the United Kingdom was involved in two major wars and this created major challenges to the global economy. The changes in the global order also caused new and high-saving nations like China to enter the global order and this led to a system whereby these nations injected more money into the US economy which fueled the consumerism of the American people without creating real assets (Buiter, 2008). Other authorities identify that the financial crisis was due to poor political leadership. This is because the political leadership of the time showed a strong desire to protect their interest by supporting their favored businesses and entities. They therefore created favorable rules and regulations that kept huge corporate entities to thrive and grow in order to satisfy the elite and this turned out to be detrimental to the poor and the middle class who had acquired loans for their upkeep (Caulkin, Folkman, & Francis, 2010). The macroeconomic circumstances facilitated the housing bubble since there was access to easy and available credit and scant regulations which caused the people to get trillions of dollars of risky mortgages (Financial Crisis Enquiry Commission, 2011). This kind of liberal system was based on the belief that in the long run, things will improve significant, and this never happened, hence, the credit system and cycle failed and a bubble occurred (Kotz, 2009). Failure to attain economic equilibrium led to the creation of economic instability due to unregulated bankers and other financial intermediaries (Whalen, 2007). Additionally, global issues like macro-economic imbalances coupled with financial innovation created major problems and issues in the global order (Financial Services Authority, 2009). The injection of more money and funding from overseas fueled the trend of consumerism and global financial markets created issues relating to cross-border banks that helped to raise funds into a market that was fueled by greed and consumerism (Financial Services Authority, 2009). Conclusion From the study conducted so far, it is apparent that the global financial crisis was centrally perpetrated by the financial sectors of the nations. This is because the financial sector’s lapses and issues were core and fundamental in the events that led up to the crisis. This include the poor regulation of banks and the offering loans as well as the proliferation of financial intermediary firms that sought to increase consumerism and sell financial products, many of which were interest-bearing loans given to people in the different social and economic classes of the western world. However, the position of the financial sector cannot be over-emphasized. There were other issues and problems that came up which contributed to the global financial crisis. First of all, greed of business executives and directors in organizations like major entities that played significant roles in the global financial system. This includes directors of entities like Lehman Brothers and others that had directors who were paid on the basis of their performance. These directors took high and excessive risks that led to major issues and problems for various stakeholders. Secondly, the poor rating services by various “independent” rating agencies were not free of biases and inappropriateness. This continued to mislead the economy. On the other hand, it must be stated that the biggest non-financial impact on the global economic order that contributed to the global financial crisis are poor and undisciplined macroeconomic structures in the leading economies of the world. The poor controls by the ruling elite and poor macroeconomic processes contributed significantly to the global financial crisis. PART B This section will discuss and provide an insight into the financial and non-financial reasons why Lehman Brothers collapsed. This will provide an illustration and insight into the actual impact of the credit crunch and the global financial crisis that occurred and how it affected numerous entities and organizations. Lehman Brothers went public in the year 1994 and it was meant to provide financial intermediary services (Valukas, 2010). The company provided financial statements that had very high levels of liquidity and leveraging. In terms of relevance, the leverage of Lehman Brothers was consistent over the years. However, for the purpose of this discussion, the sharp change that occurred and the details that occurred in the period will be analyzed from a financial perspective. Operational and Going Concern Factors Generally, speaking, Lehman Brothers was set up to operate as a financial intermediary firm. To this end, they borrowed significant amounts of money and invested it with the hope of leveraging their funds. They invested heavily in the estate industry and bought a lot of houses. Most of Lehman Brothers’ operations was funded by individual investors who invested in the firm and Lehman Brothers gave home loans and other mortgages to people who were expected to pay back. Thus, a lot of people bought homes and this increased their expectations of interests. This is because it was widely believed that assets like homes were foolproof and would always earn major returns, irrespective of the economic conditions. And where a borrower defaulted, there was the tendency to sell the building and raise funds from the sale. Lehman Brothers need to maintain a good leveraging because that was the only way they could maintain and retain investor confidence. Thus, they consistently maintained high return on assets which showed a leverage ratio of 24:1 in 2003 and this consistently increased to 31:1 in 2007 (Lipton & Kennie, 2012). This was a period of tremendous property booms and a lot of people were able to acquire assets and pay their interests without issues. However, in 2007 when the financial crisis occurred and there was a major trend towards defaulting in paying for mortgages, the whole industry had a major issue. This is because up to 30% of mortgage holders in the United States either lost their jobs or they were going through difficult times and could not pay off their mortgages. In effect, the whole industry became choked and the interest expected by firms like Lehman Brothers and their investors fell short. Significantly, the asset worth that was held by Lehman Brothers fell sharply and they could not continue operating and carrying out their activities (Ciro, 2011). Therefore, Lehman Brothers could not continue making profits and there was the need for them to go through some rather difficult decisions. Disclosing this was obviously going to reduce the goodwill enjoyed by Lehman Brothers so they resorted to different circumstances and approaches. Financial Position Lehman Brothers Holdings Inc reported a record revenue of $60 billion in January 2008 (McDonald & Robinson, 2010). This was an increase of about $4 billion from the previous year’s revenue which was also very high (McDonald & Robinson, 2010). The stock price for Lehman Brother’s share was $65.73 (Williams, 2010). This made Lehman Brothers’ shares one of the most valuable and the most expensive on the markets at that time. However, in less than eight months, there was a collapse and a plummeting of the Lehman Brothers shares from this level to about $4. This was a 95% fall in the value of their shares and it is mainly because of a number of issues and discoveries that were made in-between the period (Williams, 2010). Lehman Brothers applied for a Chapter 11 Petition bankruptcy protection. Financially, Lehman Brothers was operating with high assets and low liabilities. From their 2007/08 financial statement, Lehman Brothers had assets worth $700 billion and liabilities worth $25 billion (Tibman, 2012). This shows clearly that Lehman’s brothers had a lot of assets and its trading position was imbalanced. This is because from a layman’s point of view, a firm with liabilities that is worth under 4% of its assets is too good to be true. Hence, there was a reasonable suspicion on the grounds that the firm was trading in a way and manner that could be questioned on several grounds and in several ways. From a financial perspective though, the firm’s assets had to be real, they had to exist and they had to be acquired in a transaction that was acceptable under financial accounting rules like the International Financial Reporting Standards (IFRS). However, most of the estimations included long-term estimates that were to be gained on the basis of projections made in 2006 and 2007, before the world realized that there was a global meltdown. Therefore, these estimations were made on assumptions and rules that were somewhat subjective, rather than objective in outlook. On the other hand, Lehman Brothers’ liabilities were short-term in nature and they were to be paid off almost immediately (Tibman, 2012). The assets included hundreds of millions of products that were on markets that were risky and opened to the changes and modifications in the processes and systems that were extremely volatile. Lehman Brother’s survival as a going concern was dependent on investor confidence. This is because most of their assets were contributed by investors who bought various financial products through Lehman Brothers. Therefore, it is apparent that Lehman Brothers could not afford to show them the realities of affairs and businesses. They had to continue to present financial statements that were good and were of a nature that could boost their businesses and affairs in a positive way and manner. When the global financial crisis hit Lehman Brothers, they had to resort to more aggressive trading strategies and processes. They did not recognize the changes and differences that had come up as a result of the global financial crisis. Hence, they continued to use methods and systems that proved to be dangerous and less productive to counter the cycle of the financial crisis on their operations and affairs. This leaked into their affairs and destroyed their financial processes and their financial reporting systems and procedures. When Bear Stearns collapsed in mid-2008, there were questions that were raised about Lehman Brothers and their survival capabilities. Lehman Brothers had to present a positive image of their financial position and assure the general public that they were going to remain liquid and productive into the foreseeable future. They therefore use an accounting technique known as Repo 105. Repo 105 is a process where the account is manipulated through a short-term repurchase agreement which is recorded in the financial statement as Sales (Hollander, 2011). In other words, they signed agreements with some third parties and made them pose as people with real assets and they recorded it on their financial statements as sales. This was to ensure that they could convince the public that their trading position was favorable and there was a lot of positive things going on within the firm. The cash obtained through the sales is recorded against the firm’s debts and this cancels out the debts and maintains a temporary leverage which reflects in the firm’s financial statements. In the case of Lehman Brothers, they were able to sell their assets which were at this time worthless due to the financial crises and this enabled them to find people who posed as people who bought their assets. The effect was that Lehman Brothers was seen as healthy and they were able to continue presenting a positive image of their firm through the mid-2008. However, in truth, there was no substance of those transactions and processes since they were no real and no cash was realized. This reflected the issue of executive greed and the need for executives like directors and managers to prove that the firm is well structured when it is not. The Lehman Brothers case was a textbook example of a situation where firms had to indulge in off-balance sheet financing in order to present a favorable image of their firm. This is because the directors had targets and they had a conflict of interest by trying to present a positive image of themselves when things were so bad and they could not do much about it. There was a lot of manipulation of the financial statements and due to the challenges of the external business environment and the collapse of other similar entities, there was the need for proper checks and balances in the business environment. Therefore, the Security and Exchange Commission and Federal Reserve Bank of New York took residency in Lehman Brothers as a method of checking the system to prevent wrongful accounting practices (Ferrell & Fraedrich, 2010). The authorities and their task force conducted various forms of investigations to analyze and evaluate the financial statements. They identified that many of the deposits that were made to cancel the debts were actual pledges (MacEwan & Miller, 2012). Through the strict analysis of the financial statements of Lehman Brothers, it was identified that the firm inflated various assets. Eventually, the financial statements of Lehman Brothers was redrawn and this led to the presentation of a loss of $39 billion and there were no buyers for their options due to the financial crisis and the problems that came with other similar entities that folded up in the same period (Tibman, 2012). Eventually, the share of Lehman Brothers declined to $3.65 and this was a slip from the January value of $62.19 (Scott, Schultz, & Taylor, 2010). This showed that financially, the firm had been hit by the global financial crisis and they had reacted poorly by trying to set up a system of covering up these issues through various inappropriate financial reporting techniques and systems. Conclusion Lehman Brothers was first of all affected by the macroeconomic conditions of the property markets. This is because the high rates of default in paying for mortgages created a major situation that they could not deal with. And since they had invested heavily in the property markets, they were severely affected by the defaulting mortgage holders. Lehman Brothers, being a financial intermediary had used an extremely aggressive approach to sell financial products to consumers who should not have gotten access to certain forms of credit. This is because they sought to expand into the markets and also provide high levels of services to consumers from less affluent backgrounds. So they contributed to accelerating the financial crisis by making debts accessible to people who were not supposed to get those debts in the first place. Then when it became apparent that things were bad, Lehman Brothers did not take realistic and reasonable steps in dealing with the case and issues. Rather, they tried to cover up due to the greed of their executives and this led to the presentation of falsified financial statements which created major problems and issues for them. They used various off-balance sheet financing methods which was illegal and when it was discovered and the whole situation was made public, Lehman Brothers’ investors lost confidence in them and the firm collapsed significantly and sharply within a considerably short period of time. Bibliography Bebuch, L. A., Cohen, A., & Sparmann, H. (2009). The Wages of Failure: Extreme Compensation at Bear Stearns and Lehman 2000 - 2008. Working Draft , 1 - 19. Blackburn, R. (2008). The Subprime Crisis. New Left Review , 63-106. Borio, C. (. (2008). The Financial Turmoil of 2007 - ?: A Preliminary Assessment of Some Policy Considerations. BIS Working Paper , 251-260. Buiter, W. H. (2008). Lessons from the North Atlantic Financial Crisis. Conference Paper: Columbia Business School , 231-249. 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Uncontrolled Risk: Lehman Brothers and How Systematic Risk can Stilly Bury Alive, the World of Finance. New York: Meholtra Hill. Read More