The Financial Crises and the Collapse of the Lehman Brothers - ABD - Essay Example

The Financial Crises and the Collapse of the Lehman Brothers - ABD Question A The recent financial crisis of 2007-10 has been one of the greatest banking crises that have occurred in a century. However, this does not imply that financial crisis of 1929 & 1933 were any less severe but what sets the recent financial crisis apart was that it had affected the economies and many different countries together due to the increased interconnectedness within the global economy. The core of this crisis cannot be restricted to the interplay between the macro indicators and the developments in the financial market through a series of financial innovations. The role of governments and that of economic theories had an equal amount of role to play in the control and monitoring function and the predictive ability and risk measurement respectively. The study of such indicators helps to understand and appreciate the importance of non financial factors as a cause of the recent financial crisis that shook the entire world (Kotz, 2009). The aftermath of the great financial crisis helps us to reflect upon the shocks experienced by the policy landscape and government policies and greed of bankers and the plight of the taxpayers. This has brought to focus, the need for enhancement of the role of the government in regulating and controlling the systems of the market from the inadequacies and the excesses. Also linked with these issues is the problem with moral hazards. The role of moral hazard has been identified to be central to the causes of the recent crisis and the learning from the controversy that can be drawn (Engelen et al., 2008). A moral hazard can be clearly defined as the responsibility of one party towards the interest of the other but where the interests of the former attain priority. For example, a person sells a financial product to the other but chooses only those funds for sale which provide him with the highest bonuses but might not hold any interest of the buyer. The risks associated with it are mutually borne by the seller and the buyer. The subprime was a typical example for the moral hazard theory where gains and social losses were privatized (Godechot, 2008). Financial risk management failures were caused primarily due to the ignorance of the systematic interaction between the different risk elements of the process. There were modeling errors that were based on the assumption of normal markets and ignored abnormal market situations. Such practice made the financial risk management system more prone to crisis rather than being less exposed. Credit default swaps and collateralized debt obligations are two instruments that were completely untrue representations of the marked to market model of price valuations (Pozsar et al., 2012). When the senior management gets out of control, the organizations experience the end of accountability. Company officials that are paid highest of the salaries have left it to luck for any large failure that is faced by the companies. The staring examples in the context can be the management at Goldman Sachs and Citigroup. These officials believe that lack of accountability is only a natural outcome of bad business decisions and a consequence of having to live within the free markets. Political legitimacy of the markets comes at stake in the scenario. Even if the senior management ends their responsibility and the risk management system fails completely, stakeholders should ideally question the system and practice. However, in reality, limited liability has marked the end of corporate governance. Hence we see why stricter rules and heavier penalties do not seem to work (Dowd, 2009). The financial crisis of 2007-09 has also been analyzed form the point of view of failures in the theories of renowned economists. The flaw in the modern economic theory of Keynesian multiplier by Keynes has failed owing to the inability of the framework to bridge the gap between the classical economic theory and the economic reality. It has been argued that the Keynesian multiplier is supported by the substitution of the national income or the cause by the investment or the effect and these in turn yielded the rise and fall of both consumption and investment in equal proportions. Had this been the case, then there would have been no cause for balance between consumption and savings at all (Montgomerie and Williams, 2009). The crisis emerged owing to rise in investment demand while consumptions did not rise in the same proportion. Such theories have led to inappropriate assumptions and conclusions about economic movements (Davar, 2011). The failure of market economics was also assisted by studies where the role of government and that of the regulatory division have been highlighted. The global regulatory standards have largely failed to identify and respond to the big changes in the financial markets which have also been in charge of creation of complexity within markets causing a rise in the risk throughout the system. In times of economic instability, such risks tend to higher up. Studies identified that companies that were deemed to be too big to fail needed greater regulatory control and supervision post the crisis through an improved market discipline (HM Treasury, 2009; Fergusen, 2009). The consolidation within the banking system had gone up to high levels. The companies however remained competitive. The level of competition had not gone so far to have complete elimination of competition within markets. This implied that banks were still very much risk prone in terms of pursuing economies of scale, leverages and to take risky projects. Bank failures have also been accused to have been caused by systematic economic risk. This is because the banks are linked with high levels of monetary transactions within the economy taken as a whole. Hence it is irrational to assume that banks and such companies marked by high levels of competition within their industry are too big to fail even in the event of excessive and unregulated leverages (Fergusen, 2009) The regulators of the financial markets are organized as per a notional basis where these institutions act as representatives of the interests of the financial sector in general. The act of these regulators tries to protect the national interests of the financial sector, however, the financial interplays have a global effect. The regulation within the financial markets is geographically endogenous, nevertheless, such regulation has come about to be extremely weak and footloose. The financial sector is responsible for creation of jobs and is environment friendly yet the regulators try to provide a more liberal framework for financial activities with a view to retain the players within the financial domain and sustain them. Such high competition has weakened the financial regulation making them more relaxed and laid back. The Sarbanes Oxley Act came about as a process reversal in financial regulation. It was a guideline and response towards the issue of corporate governance, reporting and accounting scandals. It has however proved little material information value for the protection of the investors. In a study by Froud et al., (2009), it has been argued that the concept of social innovation or the innovation of extended financial products with a view to extend credit facilities to a larger section of the market as the case of securitization during the financial crisis, should ideally include certain constraints on financial through the process of social innovation. It is believed that the regulation is necessary to bring about such regulation because in the absence of regulations, easy availability of credit increased the dependence on credit and over reliance tightens constraints on income earned. It has been deemed necessary because private enterprises have the ability to undertake such social innovations as per management discretion as an additional way of sourcing finance. In a scenario where only few businesses appear to be socially responsible, such innovations call for regulations because the markets are a sphere filled with profit seeking and attempts for decision making by the management without any social competition. In a similar study, Blackburn, (2008) viewed that the growing financialization of property led to unregulated and uncontrolled demand for sovereign reallocation of funds. This in turn led to increased intermediation by the financial intermediaries and hence firms and banks could take advantage of the asymmetry in information and imbalances in power. Bebchuk, Cohen and Spamann, (2009) studied the financial crisis causes from the point of view of pay checks of the top executives of the failing companies during the financial crisis. They believed that high pay checks allowed the top executives to take up high risks and this in turn was one of the reasons that was responsible for the great financial crisis. In their study, they reported that the top executives of Lehman Brothers and Bear Sterns had drawn out significant amount of cash from 2000-2008 through share sale and bonuses of compensation received as a part of performance incentives. Such amount did not leave them financially unstable during the beginning of the crisis which allowed for high risk taking incentive. It is suggested that in order to reduce such impacts, legislation as well as the regulators should allow for fixing of such incentives (Rajan, 2008). The Warwick Commission Report, (2009) has identified that the cause of the recent financial crisis cannot be simply the banks who can be held responsible for underestimating their risks and throwing in toxic assets into the market. There is a much larger area of concern within the micro and the macro environment which can be held responsible for the crisis. It has been identified within the report that inefficient and inappropriate allocation of risks has been held responsible for the financial crisis. Such risk allocation disparity can be viewed within the mismanagement of liquidity among the insurance companies who were forced to sell their illiquid assets to get some short run liquidity which in turn caused prices of such illiquid instruments to fall. As for the regulation, Warwick Commission Report, (2009) has identified that financial player were identified to be independent of each other and regulation assumed that risk could be controlled and measured through banks alone. The internal risk models have to assume that financial intermediaries are dependent on each other and therefore highly interlinked for which risks have to be calculated for the interconnected roles and not simply through a combined value at risk measure. The developments that have been described and discussed above have reflected upon important causes that can potentially shape the future approach towards capital regulation, liquidity, remuneration, rating agencies and economic theories (Wolf, 2008). These are important for financial institutions as well as government, analysts and policy makers in all countries across the world irrespective of the fact that they operate nationally or internationally. These issues also help to appreciate that cross border banking activities have concerns over their operations that need focus (The Turner Review, 2009). In addition to this, managers who did benefit from the incentive and bonus scheme of attractive compensation packages within the company could have been used to pay the bonuses by clawing back into business in the event of losses and increasing bonus pool every time from which employees could be paid out annually. The case appeared to be deeply flawed and this called for a complete revamping of the incentive system (Rajan. 2008) The regulatory norms and monitoring soundness were questioned over the national level. The limited liability of the business management reduced the risk aversion among the large players, the assumption that firms were too large to fail was too loosely held and increased regulation is sought in larger companies which are also too large to defraud. The crisis was largely global in nature. This also came after the world had undergone significant amount of globalization and integration. The crisis brought to the forefront, the fault lines that lay within the global supervision and regulation activity. The crisis also demolished quite a few assumptions of the efficient market hypothesis and the Keynesian theory and established that it is perfectly possible for markets to act irrationally in the absence of liquidity. The arguments also highlighted that financial markets are not independent and are rather much dependent post liberalization. This together leads to assume that individual rationality cannot guarantee a combined rationality and thus the snowballing effect of the crisis was realized (Minsky, 1992; Whalen, 2007). Question B The Lehman fate and the global financial crisis has been a lesson for one and all and is a tale that speaks the story of excess leverage, complex financial innovations, inappropriate salary and incentive schemes, and a broad macroeconomic imbalance situation (Krugman, 2009; Ahiakpor, 2003). The story has a flip side where the tale also speaks of caution of regulatory faults, monitoring and control failure by the government, flawed economic theory, information asymmetry and power imbalances, inadequacy in risk management tools and improper spreading of risks in portfolio. When Lehman Brothers filed bankruptcy in September 2008, the debts outstanding were estimated to be close to $613 billion (From Case Pack). It was the biggest bankruptcy in the history of United Stated and the sparks were felt throughout the world. Lehman’s collapse set the tone for the breakdown of the near breakdown of the international financial system. The collapse of Lehman Brothers raised questions over the decision of government over Bear Sterns acquisition. It provided speculation on the issue of remuneration of employees who were considered to be the elite. Companies set aside a huge amount of up to 40-50% of the company revenues as comp ratio or a pay restricted for the use of their top employees (From Case Pack). Fuld has been estimated to have cashed in about $310 to $500 million in 8 years spanning 2000 to 2008 and also being the pivot of all kinds of inappropriate financial innovations and trade decisions that have cause Lehman’s bankruptcy (From Case Pack). Financial and non financial reasons behind the collapse Lehman Brothers strategy for the year 2006-07 was to use up more of balance sheet in order to raise investments which included the increase in risks for the proprietary capital. Such risks came in the form of huge amount of debt commitments that could not be financed out of equity that was actually retained for Lehman. Such high risk exposures helped the company to bag larger deals and the management took up high risks with a view o higher profits as per their discretion. Such deals also build longer term relationships with the clients of Lehman Brothers. On the non financial aspect, the management of Lehman Brothers was equipped with the entitlement of making such large deals under the Delaware law. It was also observed that the risk management framework within the company was not very strong and evidence of high business in 2006 supports the argument that major decision making power vested with the high officials with disregard to risk assessment results (Valukas, 2010). While discussing the issue of unsuitable spreading of risk within the portfolio, Lehman Brothers also had a lot of concentrated risk exposure in the real estate markets. It has been discussed above that inappropriate allocation of risky assets has been a cause for the financial crisis. Lehman officers entered into real estate investments after January 2007 when the real estate market was providing signals of contagion. The company though that such risk would be managed and over capitalized on their real estate investments. Lehman Brothers had taken double exposure than their risk appetite permitted them to. The evidence talks about the lack of regulatory control on such high risk exposures where the limits to transaction and exposures were ignored. Lehman brother grew to be quite a large firm and it was deemed to be one of those which were too big to fail. However, the lack of regulation on exposures made it overlook an evident and warned credit bubble. The internal risk control measure was inadequate in predicting the riskiness of the business or even controlling business decisions of the top management (Borio, 2008). By the end of 2007, Lehman Brothers had amassed over twice the amount of capital it had in 2006 and more than four times the amount of risk it could legally take. In 2008, the valuation of Lehman’s debt was put at $ 10 million which came to $ 3 million on an annual basis and this was much higher than contemporaries like Merrill Lynch at $241000 and Goldman Sachs at $ 165000 (London Stock Exchange, 2008). It was concluded that Lehman was the next big worry after the buyout of Bear Sterns. The leverage positions for companies like Goldman Sachs, Lehman Brothers and AIG went as high as 40: 1 during the crisis (From Case pack). This meant that for each $40 for an asset, the company had only $1 to cover up for the asset in the event of a loss. In case the losses were incurred for up to 3%, these companies would get completely wiped out. Lehman Brothers was operating with a leverage ratio of 30:1 in the year 2007 (Zonebourse, 2007) and 44: 1 in 2008. The rise has been astonishing as the leverage ratio stood at 24:1 in 2003. Lehman’s real estate exposure helped it raise revenues within the capital market units by 56% within a span of 2 years to 2006 (Zonebourse, 2006). The company had securitized about $146 billion in 2006 which was a 10% rise over 2005. Profits were reported throughout 2005 till the year 2007 when the revenues rose to $19.3 billion and profits were at $4.2 million (Zonebourse, 2007). The US housing market appeared to be dwindling in the beginning of 2007 when the stocks of Lehman Brothers stood at $86.18 which provided it with a market capitalization of a record $60 billion (Zonebourse, 2007). With the crash of Bear Sterns, the company saw two of its derivative assets collapsing. However, the CFO at Lehman Brothers was unable to see any mushrooming impact of the housing delinquency spreading to the rest of America. The failure of Bear Sterns initiated the run on funds by Lehman brothers. These derivatives were also interlinked with counterparty and derivative instruments of other commercial financial establishments. The company also experiences a run on its massive OTC derivative deals where a run on the instruments played a significant role in the severity of its complete collapse (The financial crisis inquiry commission, 2011). The Federal government had tried various ways of bailing out and recuing Lehman but was unable to find any private company that would want to buy out such huge debts. The concerns that also contributed towards the complete failure an absence of revival for Lehman brothers also included concerns over moral hazard and political reactions. Moral hazard was strongly linked with the top management and the exposure decisions taken at Lehman Brothers. The consideration for the risks associated with the losses and potential failure of investment due to overexposed portfolio was completely undermined over the issue of making private profits for the concern and thereby gaining high compensation and incentives. The consideration for highly skewed portfolio towards housing assets was also eliminated on the personal discretion of company officials. This also exposed the weakness within the risk management team in the company which was unable to have any control over the decisions of the top management and the risk assessment division appeared to be compliance rather than a lawful and compulsive activity in investment decisions (Woodford, 2003). The role of the government fell short of what it is expected to deliver. The government failed to assess the impact of failure while the Federal Reserve was not legally able to undertake the decision of recuing Lehman Brothers. Political counterparts at the State government anticipated the impact of Lehman Brother’s failure to be limited to the nation and would be manageable as anticipated by participant of the market. These together after the rescue of Goldman Sachs and Bear Sterns had together brought the financial meltdown to the global level. The collapse of Lehman Brothers was a demonstration of the fact that it had brought together, a collapse of four other large investment banking concerns. The cause behind such a huge collapse was the inadequacy of the regulatory supervision pretty largely. The regulatory oversight failed to detect and challenge the huge leverage positions that were evident over the years beginning 2002. The credit rating agencies as well as the government were deeply flawed in their regulatory oversight and believed in the phrase ‘too big to fail’ true by every word without giving any thought. The effect of huge debt on large companies was completely overlooked due to the size of the company (From Case Pack). The second prime cause has been claimed to be cause behind the failure of Lehman brothers has been high riskiness of trading activities which comprises of securitizations and OTC dealing of derivative instruments. The huge leverage sought in the housing asset created and unprecedented bubble and is the third major financial cause behind the failure of Lehman brothers. Lastly, over-reliance on short term funds helped the company to sustain and present short term results. However, the profits that appeared until 2007 were backed by an extremely weak leveraged position with almost no asset backing (Walras, 2005). An important part of failure at Lehman Brothers is also attributed to the lack or absence of any corporate governance which included the risk management division largely. The collapse also brought to focus the compensation schemes and incentive measures that were exercised by Lehman Brothers for their top executives. Another staring and alarming gap was the limited liability issue which when combined with the compensation and incentive benefits gave enough reason to the company’s management to overlook the risks associated with a business deal and make investments purely for the motive of profits. Any consideration for riskiness and limits on exposure was thereby eliminated (Walker, 2006). It is being argued that the crisis is not a mark of market failure caused by deregulation. However, in reality, the case has a different viewpoint. The crisis was born from the ashes of a highly distorted market of the financial world. The financial markets that were highly concentrated excessively leveraged and thrived on spurious theories pertaining to risk management. Among these, the issue of moral hazard has also been primary and critical to the forthcoming of the financial crisis. 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