Collapse of Lehman Brothers - Dissertation Example

?Running Head: Global Financial Crisis & Lehman Brothers Global Financial Crisis & Lehman Brothers [Institute’s TABLE OF CONTENTS TABLE OF CONTENTS 2 INTRODUCTION 3 FINANCIAL CRISIS OF 2007-2010 4 Causes of Financial Crisis 4 Government Intervention & Crisis 5 COLLAPSE OF LEHMAN BROTHERS’ BUSINESS MODEL 6 Timeline 6 Causes & Factors 10 CONCLUSION 15 REFERENCES 17 APPENDICES 20 INTRODUCTION During the last few decades, human race has witnessed huge developments and advancements around the globe (Mishkin, pp. 7-9, 1992); however, at the same time, countries have confronted enormous crises especially during the last two decades that have changed various processes globally. Specifically, corporate world is one of the major components of human society that has confronted a lot during the last few years (Wheelock & Wilson, pp. 127-138, 2000). It is an observation that the last depression phase of 1930s resulted in huge number of adverse impacts around the world (Brain, pp. 321-327, 1999); however, the current financial crisis on global level seems to be having far more reaching effects on the developed, as well as developing parts of the world. In particular, the world witnessed running down of the US economy during mid of the year 2007 and then the crisis subsequently hit different parts of the world due to lack of liquidity available in the US banking system as well as crumple of various huge financial organizations. In addition, financial experts (Bono, pp. 1-34, 2008) have indicated adverse role of government as well that caused the global financial crisis and that is still resulting in adverse impact globally. In this regard, today, a huge number of economies around the world are still confronting the viral effects of the global financial crisis due to their dependence on processes of US economy (Davies & Green, pp. 10-18, 2008). Debate and discussion regarding different aspects of financial industry is not a new practice (Zhang, pp. 23-30, 1995). After every financial crisis, it is an observation that financial experts argue and discuss the role of authorities and government to avoid any crisis in the future. Such debates were observable in the year 2001 after collapse of Enron (Amel et al., 2493-2519, 2004), as well as in the year 2004 at the time of WorldCom tragedy, and in the year 2008 with the collapse of Lehman Brothers. Interestingly, experts have indicated that accounting frauds and government scandals are some of the most common underlying reasons that exist behind every financial crisis (Goldsmith, pp. 8-11, 2009). In particular, this paper is an attempt in the same series of debates and discussions that will include analysis of different aspects of global financial crisis while going through the collapse of Lehman brothers that enable a critical understanding of realistic factors that caused such crisis globally. FINANCIAL CRISIS OF 2007-2010 Causes of Financial Crisis As earlier mentioned in the introduction, shortage of liquidity in the US financial system became the first cause that triggered the roots to derive recent financial crisis in the United States. Subsequently, it affected other economies of the world as well by beginning with the collapses of different financial institutions, as well as investment banks in developed parts of the world that automatically affected developing nations. Analysis (Bebchuk et al., p. 31, 2009) has identified that investment banks, financial institutions were two of the main backbones of the US economy, and their bankruptcies gave a heavy blow to the country as collapse of even one stakeholder resulted in huge punch on the overall market. In the month of August 2008, the liquidity crisis hit the then leading investment bank, Lehman Brothers, and studies (Davies & Green pp. 56-60, 2008) have pointed out the adverse role of certain newspapers that rumored about dishonoring of Lehman Brothers’ financial commitments by few banks. Such rumors initiated the process of financial crisis, as there were witnessing of huge queues at the banks where depositors were expecting their bankruptcies, and such rumor resulted in an adverse effect on whole running of the US financial market. In such a circumstance, shortage of liquidity became the major reason of a crisis as banks were maintaining liquid cash in accordance with regular withdrawals. In order to save the day and limit further cash withdrawals, the Federal Bank straight away broadcasted its assurance for withdrawals up to US$100,000. Experts (Bebchuk et al., pp. 31, 2009) believe that such an immediate action by the Federal Bank was very effective in restoring the daily processes of banking system in the country. Although such decision was effective for individual payments, however, it resulted in a panic situation in the interbank processes of the country as banks with excess liquidity began to consider banks with less liquidity with suspicion, which began to signal chances of a liquidity crunch in the system (Taylor, pp.42-45, 1999). In the result, in a span of only 72 hours, Lehman Brothers surrendered by filing its bankruptcy due to its inability of make few payments of its major clients. Contrary to anticipations, the Federal Bank decided to give a lesson to the financial industry by not saving Lehman Brothers from the crisis. However, while setting an example for the financial institutions, the Federal Bank was unable to understand the situation that went worse as all the stakeholders in connection with Lehman Brothers suffered due to its bankruptcy and there were arguments regarding ineffective role of the Federal Bank in the situation of a collapse in the future. Behind the micro causes of recent financial crisis, rupture of real-estate industry was the larger picture that created bubbles in the US economy. In particular, stakeholders were expecting ample returns from the mortgages; however, the real-estate market did not rise and stakeholders confronted huge losses that accelerated the process of financial crisis in the country (Lungu, pp. 65-78, 2008). Extra optimism of financial institutions and provision of new financial products to masses was also another imperative cause that disrupted the US economy. Government Intervention & Crisis However, along with other causes, financial experts have blamed the US government equally for the global financial crisis that affected millions of people around the world. In particular, experts believe that the government was unable to play its essential and important role in balancing and maintaining different processes of the financial industry. In addition, permission of the government to allow financial organizations to lend money without any credibility was another fault that was dismantling the US economy gradually (Portes, pp. 20-59, 2009), and in brief, government initiated the subprime crisis with its inappropriate and inaccurate decisions. In addition, as the financial organizations were unable to make investments in the real-estate industry, it was feasible for them to begin selling sub-prime mortgages. Alternatively, the banks offered new options to mortgagee for acquiring a mortgage on 0% down payment and in case of reduction in the prices, default on the mortgage (Sen pp. 10-37, 2008). The utilization of such instinctively remedial financial products is another indication of the apathetic attitude and adverse role of the government that was not interested in intervening in the process personally to save the financial systems. Rather, it sat back while allowing financial institutions to make their decision, which subsequently caused huge financial crisis. Besides ineffective micro policies, the government’s role at macro level was not appropriate as well. The unnecessary utilization of financial leverage by the government was another imperative underlying reason of the financial crisis. In particular, experts believe that low interest rates was a major factor that created an environment of low investment and that did not attract the anticipated number of investors, thus, lack of confidence in the corporate world. Moreover, while the government was able to keep stability in the economic environment on macro level, it did not show interest in getting involved on micro-level that indicated its optimism regarding the intrinsic financial risks (Sen, pp. 1-8, 2008). In the result, on one side, the financial system was gradually loosening due to lack of intervention of the government on micro-level, and on the other hand, inefficient macro policies did not bring adequate investors in the country, thus, gradual destabilization of the US economy. In this regard, such inefficient intervention of the government caused further issues for the financial institutions and investment banks as they were not only suffering from defaults but were confronting lesser investments. COLLAPSE OF LEHMAN BROTHERS’ BUSINESS MODEL Timeline The paper has already included description that Lehman Brothers was one of the major financial institutions that collapsed during the current global financial crisis and first part of the paper identified few specific reasons behind the Lehman Brothers’ collapse. This section of the paper will briefly list and discuss short timeline of such collapse. In particular, during the last two weeks of August 2007, Lehman Brothers announced its preparation to close down its subprime mortgage facilities that indicated cutting down of approximately a thousand jobs (Valukas, pp. 1-239, 2010). During the month of September, the company made few changes in its directors and Erin Callan became the Chief Financial Officer. In December, the company showed annual earnings of roughly four billion dollars. In January 2008, Lehman Brothers shared its hesitance regarding creating mortgages while using wholesale canals due to identification of few weak spots in real-estate market (Valukas, pp. 1-239, 2010). The month of March witnessed collapse and bailing out of Bear Stearns and experts began to inquire regarding possibility of further collapses. During the same month, corporate world began to hear rumors about few banks asking its customers to stop working with Lehman Brothers that weakened its position adversely (Valukas, pp. 1-239, 2010). However, Lehman Brothers declared earnings of approximately five hundred million dollars for its first quarter that was an optimistic indication of its successful operations. Subsequently, during the month of April (Valukas, pp. 1-239, 2010), the company announced increment of four billion dollars in its capital. However, suddenly, in May 2008, there was once again cutting down of additional 1400 employees (Valukas, pp. 1-239, 2010), and consequently, reports of the second quarter showed losses of three billion dollars. Further, there were two more replacements in the positions of CFO and COO during the month of June 2008 (Valukas, pp. 1-239, 2010). Contrary to rumors and losses, Korean Development Bank indicated its interest in acquiring twenty-five percent shares of Lehman Brothers in September 2008. Unfortunately, the talks were not successful and during the same month, Lehman Brothers confronted fifty-two percent falling in the stock market. The month of September (Valukas, pp. 1-239, 2010) came out to be very unfortunate for Lehman Brothers as the company indicated another loss of approximately four billion dollars during the third quarter. Finally, on “September 15, 2008, Lehman Brothers filed a Chapter 11 bankruptcy petition in U.S. Bankruptcy Court with debts of 619 billion dollars” (Valukas, pp. 1-239, 2010) and the 158-year old organization collapsed. Appendix 1 – Annual Transactions & Issue Size (Gerbino, 2011) Interesting thing to notice is there was still profit during the first quarter of Lehman Brothers that filed bankruptcy in the fourth quarter, which indicates that no one would have anticipate collapse of Lehman Brothers. However, at the same time, this showed ineffective policies of the company, as well as the regulatory authorities that a firm announcing profits in the first quarter end up with bankruptcy in the fourth quarter (Viney, pp. 50-77, 2009). Analysis has indicated that Lehman Brothers’ bankruptcy was the biggest of all the bankruptcies in the history as Lehman even exceeded the range of Enron, WorldCom, etc. In this regard, collapse of Lehman Brothers did not close down a single company; however, it brought disaster for thousands of families globally. At the time of failure, the company was having roughly 25,000 workforces (Valukas, pp. 1-239, 2010) in different parts of the globe that were the foremost victims of the bankruptcy. In the result, collapse of Lehman Brothers came out to be a triggering event that exaggerated impact of financial crisis and turned US financial crisis into a global financial crisis, biggest in the history and that resulted in rapid increment in the rate of unemployment in the United States, as well as globally. Appendix 2 – Unemployment Rate from 2000-2010 (IMF, 2011) This huge financial institution, Lehman Brother had a modest beginning as in the year 1844 (Altman, 589-609, 1968); Henry Lehman came into the United States from Germany and began a general store. Subsequently, in the year 1850, Henry Lehman (Amel & Rhoades, 17-27, 1989) established Lehman Brothers with his brothers and then the organization continued to flourish. During this journey from a small general store (Kamin, pp. 1-10, 1999) to fourth top investment banking institution, Lehman Brothers confronted and survived in various crises from the Great Depression of 1930s and two World Wars (Berger & Humphrey, pp. 541-600, 1992). In addition, the firm survived from railroad bankruptcies of 1800s (Ohlson, pp. 109-131, 1980), as well as the Russian default of late 1990s (Kolari et al., 361-387, 2002). However, unfortunately, failure of housing market of the United States eventually resulted in collapse of this great firm that survived a number of disasters but came to its knees on September 15, 2008 (Bono pp. 1-34, 2008). Appendix 3 – Daily Transactions & Interest Rates (Afonso et al., 2010) Until now, this section described and discussed timeline of Lehman Brothers’ collapse in a brief manner that gives an idea as how the firm collapsed after a series of different events and incidents. The following section will discuss different causes and factors and will mainly focus on ‘WHY’ aspect of the collapse. Before that, in order to summarize the understanding of ‘how’ aspect of Lehman Brothers’ failure, the abovementioned figure (Appendix 2) will be very effective in acquiring comprehensive knowledge about it. In particular, the figure indicates scenario of the Federal Bank funds market from January 2007 until November 2008. One can clearly see four different stages that indicate significant phases in the funds market. Lehman Brothers is visible on the third from left, which indicates the amount of daily transactions that will be helpful in understanding how the firm collapsed. In addition to it, when it comes to liquidity in the financial markets, inter-banking lending is the most common and instant resource. As discussed in earlier section of the paper, inter-bank lending became suspicious, which is one of the major reasons that inclined Lehman Brothers to fail and file bankruptcy. In brief, the ‘how’ aspect of Lehman Brothers’ collapse is somehow similar to the causes and factors of global financial crisis. Thus, it will be inappropriate to replicate the same discussion in this section, one of the major reasons that this section included brief but specific timeline that would have enabled an understanding of different decisions and processes that resulted in the collapse of Lehman Brothers. Causes & Factors Although Lehman Brothers filed bankruptcy on September 15, 2008, the causes and factors go back to the year 2003 and 2004 (Aragon et al., 1-41, 2009) when the housing industry of the United States was on a boom and the company obtained five mortgage lenders. Analysis has indicated that such a step was the foremost wrong decision as some of these lenders were involved in lending without complete credentials that became the major reason of bankruptcy in the end. Although Lehman’s operations with these lenders did not result in any problematic outcomes and Lehman even came out to be one of the fastest growing firms in financial community. However, in the year 2006 (Goddard et al., 1911-35, 2007), Lehman Brothers securitized its mortgages worth approximately 145 billion dollars that was roughly ten percent increase from the previous year. Still, until 2007, the company announced profits in its balance sheets that kept Lehman Brothers on the A-rating (Aragon et al., 1-41, 2009). During the first quarter of 2007, Lehman Brothers enjoyed capitalization of approximately sixty billion dollars due to its high stock record of $86.18. However, housing market of the United States began to show signs of breakage as defaults on mortgages made a record high rate after seven years (Aragon et al., 1-41, 2009), which affected Lehman Brothers’ position significantly. However, reports have indicated that even after such indications, Lehman Brothers’ CFO was unsuccessful in identifying potential risks that later became the reason of company’s collapse, as in March 2007 (Buiter, pp. 1-78, 2008), CFO clearly indicated that U.S. housing market was going through a turmoil; however, Lehman Brothers did not see any risks for itself. Appendix 4 – Write-downs of Lehman Brothers (Standard & Poors, pp. 1-6, 2008) Furthermore, another reason evident from different reports is underwriting of Lehman Brothers on a huge level, as during the year 2007, Lehman Brothers was the firm underwriting highest number of mortgage securities resulting in creation of portfolio worth eighty-five billion dollars that was approximately three to four times greater than equity of its stakeholders. Another mistake that Lehman Brothers made was in the fourth quarter when there was observation of new higher prices of fixed-income assets in the global equity market; however, still, Lehman Brothers did not take advantage from the prospect that would have enabled it to avoid its collapse the following year. Appendix 5 - Highest Peak in September 2008 when Lehman Brothers filed bankruptcy (Bank of England, 15, 2009) In this regard, Lehman Brothers missed the opportunity and reports indicated ratio of 1:31 (total assets to shareholders’ equity) in the year 2007 (Buiter, pp. 1-78, 2008), which indicates huge vulnerability of the firm in midst of worsening conditions of the U.S. housing market, and thus, this was one evident cause of Lehman Brothers’ collapse in the year 2008. Besides careless underwriting of Lehman, after the bailout of Bear Stearns, Lehman Brothers was the next in line and thus, experts believe that if there would have to have any its collapse, it was evidently Lehman. As earlier discussed in the paper, Lehman Brothers took an effective step by increasing capital by four billion dollars that played a significant role in bringing confidence back in the company. However, once again, Lehman Brothers still did not reduce its portfolio’s accumulation that later became the reason of controversies regarding validity of Lehman’s valuation. Appendix 6 – Exposures of Lehman Brothers to Problematic Assets (Standard & Poors, pp. 1-6, 2008) Furthermore, analysis of different reports (Buiter, pp. 1-78, 2008) has identified another imperative reason that could have played an adverse role in increasing chances of Lehman Brothers’ collapse. In particular, it is an understanding that short selling could have been that one reason. It has been an observation that during a 1-month phase when there was a bar on short selling, Lehman Brothers’ condition was adequately stable. However, as the ban took off, there was intensification in the market and that resulted in further decline in Lehman’s share prices. Appendix 7 – Falling of Lehman Brothers’ Share from Jan Peak to Sep Fall (Samvit, 2011) In the result, finally, Lehman Brothers was out of cash with only one billion dollars left in hand. Even then, management put efforts to rescue the 158-year old company by arranging talks with Bank of America, Barclays, etc; however, none was successful (Buiter, pp. 1-78, 2008). On the final day, Lehman ended up filing bankruptcy that resulted in reduction of its stock by ninety-three percent. Interestingly, at the time of bankruptcy, it is an observation that the firm had considerable amount of liquidity in excess, which indicates that Lehman would have able to survive for a week; however, it filed bankruptcy. This indicates that shortage of liquidity as usually experts indicates was not the ultimate cause of Lehman Brothers’ collapse. However, one can state that there was a total failure in confidence of customers, client, shareholders, creditors, as well as management of the Lehman Brothers itself, which subsequently caused bankruptcy. CONCLUSION To summarize, mid 2007 witnessed beginning of the crisis in the US economy that suffered due to lack of liquidity in the financial industry that resulted in failure of a number of financial institutions, such as that of Lehman Brothers. In addition, inappropriate bailout packages of the government for to-be-bankrupt organizations were another ineffective step that caused the crisis. In conclusion, it is evident from abovementioned discussion and debate that recent financial crisis on global level was an outcome of inappropriate decisions of financial institutions, as well as of the government that resulted in adverse impact on millions of lives globally. Although the world is still confronting effects of the collapses of financial industry, however, the crisis brings a lesson for the financial institutions, as well as the regulatory authorities to re-evaluate the inherent risks and eliminate factors that caused financial crisis on such a huge global level. In addition, the crisis is a lesson for individual stakeholders as well to be more conscious about the financial processes and their personal portfolios. In this regard, there is now an urgent need of mutual efforts from financial institutions, government, organizations, and individuals to allow an effective and quick recovery from the financial crisis. Additionally, government will have to play an efficient and crucial role in re-evaluating its macro and micro policies while introducing new mechanisms, and at the same time, bringing confidence in the financial community regarding the new replacements. It is after this global financial crisis that huge institutions, such as IMF, G8, World Bank, etc are emphasizing on the importance of tough financial parameters, in order to avoid any such disaster in the future. In particular, after the crisis, compliance has been enjoying huge significance in the financial industry. Compliance is one of the proficient ways that will ensure implementation and observance of the regulations and that will be very effective in evading similar crises. One of the major reasons of such an importance of compliance is argument of experts who indicate that regulatory authorities spent millions of pounds on the regulation of financial markets globally; however, a very lesser percentage of the same if spent on compliance will resolve a number of issues. REFERENCES Afonso, G., Kovner, A., Schoar, A. 2010. “What happened to US Interbank Lending in the Financial Crisis? VOX. 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APPENDICES Appendix 1 – Annual Transactions & Issue Size Appendix 2 – Unemployment Rate from 2000-2010 Appendix 3 – Daily Transactions & Interest Rates (Afonso et al., 2010) Appendix 4 – Write-downs of Lehman Brothers Appendix 5 - Highest Peak in September 2008 when Lehman Brothers filed bankruptcy Appendix 6 – Exposures of Lehman Brothers to Problematic Assets Read More