The Lehman Brothers Collapse. Who, Why, How and Its Long- Effects on Securities Markets - Term Paper Example

? The Lehman Brothers Collapse Who, Why, How and Its Long-term Effects on Securities Markets By: Submitted The Lehman Brothers Collapse Introduction The Lehman Brothers Collapse during the 2008-09, period is believed to be a very significant as well as interesting topic in the field of Finance as it illustrates the financial blunders committed by the management of the company alongside its long term effects on securities markets. Consequently, the Lehman Brothers Collapse is considered to be one of the most disastrous failures in the history of the financial world. The primary reason being the fact that Lehman Brothers demolished greatest quantity of capital in the shortest span of time. There are a few terms which need to be defined before proceeding further. Security markets are the markets where securities of different types are bought and sold with reference to demand and supply. Mortgage markets involve dealings of loans on housing, business and industrial real estates. The markets in which corporations raise new capital by issuing common stock are referred to as primary markets. Secondary markets on the other hand are the ones where formerly issued securities are bought and sold among the investors, with no direct involvement of the corporations. Leverage is usually referred to borrowing. Stockholders are those who buy shares of a company, thereby gaining the rights of votes, earning dividends and profits. In a dramatic manner, Lehman Brothers underwent the largest bankruptcy in the history of United States, with its stocks plummeting drastically, customers opting their way out and assets being heavily undervalued by the official credit rating groups of that time. Lehman Brothers was mutually established by the three brothers, Henry Lehman, Emanuel Lehman and Mayer Lehman. Since its foundation, it was considered to be a very reputable institution in which people used to place immense amount of trust. With the passage of time, the popularity of the firm increased tremendously and it became one of the most reliable financial service companies in the United States, with the launch of its various subsidiaries such as Aurora Loan Services, Crossroad Groups, etc. Since 1993, the company was being led by Richard S. Fuld, Jr, who can be construed as a typical traditional leader with a top down command and control approach. He used to be very daunting in his demeanour and often commanded respect and devotion from his employees on the basis of power. He had a large management team along with him comprising of senior managers and board of directors who always aided him in forming corporate level policies, core business strategies and decision making. Up till 2007, the firm did reasonably well as far as the monetary records are concerned. The company even reported a staggering $4.2 billion profit in the year 2007. However, the consequences of following a superficial policy based on narrow scope and risky business were soon revealed when the company suffered the biggest financial turmoil of USA’s history which also triggered the late 2000’s recession. The responsibility of this crisis which resulted in the destruction of one of the most established names in the world of international finance lies directly on the management team of Lehman Brothers which consisted of several heavyweights, led by a very impolite and fiery Chairman and CEO, Richard S. Fuld, Jr. Article Summaries Onaran and Scinta (2008) state that the fourth biggest investment bank of the United States surrendered to the subprime mortgage catastrophe it had initially facilitated to develop in the midst of the largest bankruptcy in history. The old and respectable firm, Lehman Brothers Holding Inc, which had even survived the Great Depression, reported a bankruptcy petition in the US Bankruptcy Court. It had to lose 94 percent of its market worth during this tumultuous year. The filing of the biggest bankruptcy case ever was led by bankruptcy legal representative Harvey Miller. Within hours, the shares of the company dropped tremendously by 92%. It is believed that in case of liquidation, Lehman’s shareholders might get 60 cents for a dollar. The reporting has been done by Lehman’s holding company, exclusive of its subsidiaries. Lehman owes more than $157 billion to its 10 major unprotected creditors including Tokyo based Auzoro Bank Ltd, Mizuho Corporate Bank Ltd as well as several others. On the other hand, liabilities to bondholders amount up to $155 billion. Meanwhile, Lehman Brothers assets are recorded to be $639 billion. However, due to lack of commitment from the US government, the two potential acquirers, Barclays and Bank of America Corp. pulled out from overtaking the ill-fated bank. The chief financial officer of the company, Ian Lowitt said that unsteadiness in the security and mortgage markets aggravated the firm’s conditions, thereby causing irrecoverable issues of liquidity that led to inconceivable economic circumstances. The sudden downfall of Lehman Brothers has been reported by Mollenkamp et al. (2008), throwing light on how the collapse came about. The US government acted in a rather cold manner in the case of Lehman Brothers, as it declined to offer any protection to Barclays and Bank of America Corp, the two potential purchasers of the bank. In the meantime, Lehman Brothers has aptly stated that its Chapter 11 filing does not incorporate any of its subsidiaries or broker-dealers, who will carry on their operations in a regular manner. As far as customers are concerned, Lehman said that it is up to them whether they persist to trade or take any other action in connection with their accounts. The filing has been undertaken by Lehman to safeguard its assets and capitalize on value. In addition to it, Lehman intends to file several other proposals to make payments and other benefits to its thousands of employees. However, staff at the Lehman entities in the United Kingdom who reported for liquidation will not be entertained. This credit crunch which engulfed Lehman Brothers along with several other banks was initiated last year with an abrupt dip in the housing prices. The New York Stock Exchange has been designing possibilities to reallocate the 200 blue chip shares that Lehman’s expert division trades. In the scenario of Lehman getting liquidated, the exchange will reassign the shares to any of the remaining expert divisions. The Lehman collapse is also attributed to the Credit Default Swaps (CDS), agreements between two stakeholders that serve as cover against debt defaults. Lehman Brothers was a hefty purchaser and supplier of CDS and got indulged into contracts with several other companies. This swapping process generated a chain reaction that drowned everyone into mystification. The causes of the Lehman crisis have been explored by Siegel (2009), expounding the reasons behind the most turbulent bankruptcy in the history of United States. The primary reason of this crisis lies in the mortgage whirl of the 2000’s. During the boom of the housing sector, several financial organizations were deeply engrossed in the real estate market. These financial institutions and the credit rating groups got so stimulated by the apparent gains that they did not comprehend that the housing market was in a big bubble. Consequently, they intensely underrated the risk associated with subprime mortgage. In the case of Lehman Brothers, Richard Fuld, was responsible for this as he was blindly drawn into the lofty expected profits associated with the measure of financing the real estate market. In this manner, he and several other CEOs of financial institutions could not maintain power over risk and leverage. The Federal Reserve is also believed to be accountable for this crisis as it also fell short in recognizing the threats brought about by the build up of highly leveraged subprime securities in major financial institutions. The demise of the Lehman Brothers proved disastrous for all kinds of financial markets. Having seen the fate of a very trustworthy firm such as Lehman Brothers, people started to shift from private firms to more secure Treasury bills. This phenomenon hampered the entire chain of financial processes, affecting securities markets, mortgage markets, primary markets as well as secondary markets; leading to record highs in risk premiums. These tremors ultimately resulted in the late 2000’s recession. Though the Federal Reserve is criticized for its failure to foresee the crisis, it should also be credited for the manner in which it handled the crisis by liberally providing capital to the banking system. It has to be said that these measures prevented the crisis from turning into a Great Depression of the 1930’s. Berman and Knight (2009) evaluate the mistakes committed by the Lehman Brothers and provide lessons that can be learnt from them. Financial Leverage involves investing the funds from loans to obtain greater rate of returns, with the disparity in rates being called spread. Investment banks such as Lehman Brothers were known for making profits with the help of this spread. Lehman Brothers got excessively leveraged as it borrowed huge amount of money in order to invest in Mortgage base securities (MBS). When it became known that the value of the MBSs was much less than anticipated, the MBSs turned out to be futile and the spread of Lehman Brothers turned negative. The Debt to Equity ratio which shows the relative amount of debt and equity of a firm, is supposed to be 10 to 1 for financial institutions such as banks. However, in the case of Lehman Brothers, this ratio varied from 30 to 1 to 60 to 1. This signifies the narrow margin of safety within which the bank was operating. A slight increase in this ratio led to bankruptcy for Lehman. The unbalanced bonus scheme also played its role in the downhill slide of Lehman Brothers. Under this scheme, employees were bestowed with bonuses when the company did well; however, when the company performed poorly, employees were not penalized. Roubini (2009) analyzes the Lehman crisis after a year of its occurrence, illustrating the aftershocks of the calamitous event as well. In his work, he explains the important role that derivatives play in the economy. Communication mediums from derivatives to economy comprise of business credit lines, which are determined by the performance of Credit Default Swaps (CDS). It does not seem that the bigger banks of today have learnt anything from the Lehman crisis as the leverage ratio of international banks has jumped to around 50 in the United States and Europe. In order to offset the effects of the Lehman disaster, three policies must be enacted upon. Firstly, the development of Resolution Authority for methodically important organizations is the need of the hour. In order to not default on their deposits or derivative contracts, LFI (Large Financial Institutions) must uphold a capital pillow adequately good enough to keep its credit default swap price beneath a threshold height. Secondly, Macro-Prudential Regulatory Structure is vital to ensure the stability of not just the individual financial institutions but the stability of the entire financial system. Such a framework can eliminate the inequities existing in the financial system, thereby leading to a sound and safe economic environment. Finally, in order to reduce the liquidity mismatch, which mainly results when liquidity in securities markets fades away; systemic risk must be curtailed since it can even pervade through borders to infect the global financial world. Synthesis The Lehman Brothers collapse is a major event in the history of global finance, which affected the world in a rather violent manner. MBSs, CDS and Collateralized Debt Obligations (CDOs), which are primarily asset based securities issued in relation to debt obligations, all played a part in bringing about one of the most unfortunate happenings of the century. In this fashion, the Lehman Brothers downfall paved way for a chain of reactions that gave birth to the 2007-09 recession, the aftershocks of which are felt even today. This event proved to be a learning lesson for financial institutions and commercial banks all over the globe, teaching them not to underestimate risk in a market. It made them realize that they should not blindly follow a path which superficially seems to be a profitable one. Instead, prudence and caution is necessary in the assessment of markets such as that of real estate. A market thriving in a bubble should not be considered to a perpetually profitable one. Therefore, the role of finance officers, CEOS as well as the Federal Reserve Bank becomes all the more important in evaluating the effectiveness of the markets and coming up with an accurate forecast of the economic scenario. The rebound effects of MBSs and CDOs have also provided a lesson not only to financial institutions but also to people in general about being vigilant in matters of debt obligations. The analysis of the article summaries of the previous section not only helps in comprehending the blunders committed by the Lehman Brothers but also in understanding the causes and long-term effects of this tragedy. At the time when Lehman Brothers fell prey to the subprime mortgage crisis and filed a report to the US Court of Bankruptcy, it owed around a total of $313 billion to its creditors and bondholders. Moreover, due to lack of promises from the US government, neither Barclays nor Bank of America Corp were prepared to overtake the bank, thereby leaving it in a peculiar situation. Lehman’s reason for filing was to shield its assets which were worth $639 billion at that time. Though it also attempted to protect the interests of its employees but it did not succeed in that to a great extent. Besides, Lehman’s involvement in a large number of Credit Default Swaps (CDS) contracts further confounded the problems for the troubled firm. The investment banks, particularly Lehman Brothers were not able to foresee the perils that lay ahead in the housing sector. Richard Fuld, CEO of Lehman Brothers got fascinated by the apparent profitability portrayed by the real estate market and as a result, underestimated the mortgage risks and invested heavily in the housing sector, without maintaining any control over risk and leverage. Consequently, the inevitable occurred and the firm got overleveraged with its debt ratio reaching an incredible high of 60 to 1. The balance sheet of the company too transformed in a drastic manner. The fraudulent bonus mechanism was also culpable as it promoted a rather selfish attitude among the employees of the company. The consumers lost confidence in the whole financial system and started to invest in rather safe Treasury Securities. This led to the subprime mortgage crisis which in turn triggered the Recession of the late 2000’s. Unfortunately, it seems that the banks and other financial institutions have not learnt much from the devastating impact of Lehman Brothers’ collapse on the securities markets, as even today, high leverage is common among banks of US and UK. The effects of Lehman Brothers collapse can be subsided by coming up with a Resolution Authority, developing a cushion of funds, forming a Macro-Prudential Regulatory Structure to stabilize the financial system in an all round manner and reducing systemic risk. Apart from all these technical measures, improvement in overall management in financial institutions can play a vital role in harmonizing the system and alleviating the negative consequences of the Lehman collapse. References Berman, K and Knight, J. (2009) Lehman's Three Big Mistakes. Harvard Business Review Accessed from: http://blogs.hbr.org/financial-intelligence/2009/09/lessons-from-lehman.html [Accessed 19 February, 2012] Mollenkamp, C., Susanne, C., Serena, NG. and Lucchetti, A. (2008). Lehman Files for Bankruptcy, Merrill Sold, AIG Seeks Cash. The Wall Street Journal. Accessed from: http://online.wsj.com/article/SB122145492097035549.html[Accessed 19 February, 2012] Onaran, Y and Scinta, C. (2008). Lehman Files Biggest Bankruptcy Case as Suitors Balk (Update4). Bloomberg. Accessed from: http://www.bloomberg.com/apps/news?sid=awh5hRyXkvs4&pid=newsarchive[Accessed 19 February, 2012] Roubini, N. (2009). The Lehman Anniversary. Forbes Magazine. Accessed from: http://www.forbes.com/2009/09/16/lehman-brothers-anniversary-derivatives- counterparties-opinions-columnists-nouriel-roubini.html[Accessed 19 February, 2012] Siegel, JJ. (2009). The Lehman Crisis: An Unhappy Anniversary. BusinessWeek. Accessed from: http://www.businessweek.com/investor/content/sep2009/pi20090918_770685.htm [Accessed 19 February, 2012] Read More