International Business Analysis - Financial Crisis of 2007-2010 - Coursework Example

International Business Analysis Table of Contents Financial crisis of 2007 Causes 3 Financial innovation 3 Economic policies 3 Taxes and Subsidies 4 Too big to fail concept 5 Liquidity 5 Asset quality and leverage amount 6 Executive compensation structure 6 Role played by rating agencies 7 Governance 7 Collapse of Lehman Brothers in 2008 7 Financial innovation 8 Economic policies 8 Taxes and subsidies 9 End of “Too Big To Fail” notion 9 Leveraging the financial position 10 Liquidity crisis 10 Executive compensation structure 11 Woes of rating agencies 11 Practicing corporate governance 12 Reference list 13 Financial crisis of 2007-2010: Causes The origination of the financial crisis did not happen in one day. A critical analysis suggests that the crisis developed as a layered process and several economic, financial and ethical factors can be considered responsible for the same. The crisis essentially developed in the financial system of developed nations such as the US and countries in Europe but it had serious implication on the global economic development (Shahrokhi, 2011). The crisis initiated with derivatives and mortgages and culminated in global recession and slowdown of economic development. The crisis was determined to be one of the worst crises since the great depression of 1930s (Choi, 2013). The paper examines all the financial and non-financial factors that played an important role in unfolding the systematic crisis. Financial innovation The financial crisis of 2007 initiated with the rise of credit boom and housing bubble along with other underlying factors such as issuance of CDOs (collateralized debt obligation) and selling of derivatives (Choi, 2013). A study by authors such as Reinhart and Rogoff (2008) suggested that hyperactive financial innovation and deregulation in financial sector played a crucial role in the crisis. Prior to discussing role of financial innovation in the crisis of 2007, it is important to define financial innovation briefly. Financial innovation has been defined as “the act of creating and then popularising new financial instruments as well as new financial technologies, institutions and markets. It includes institutional, product and process innovation” (Financial Times, 2015). The financial innovation involves development of shadow banking, online and phone banking and products such as derivatives, currency mortgages and securitised assets (Financial Times, 2015). Financial liberalisation by means of innovation resulted in crisis because it tends to transfer risk of banks and institutions to investors that were generated by means of excessive borrowing and leverage. Additionally, portfolio diversification led to risk distribution in various other non-financial sectors (Choi, 2013; Kim, Koo and Park, 2013). Economic policies The great depression of 1930s and stock market crash of 1929 resulted in proposition of the Banking Act of 1933 was proposed. This act is also known as Glass-Steagall Act, named after the then senators of the continental US. The act in essence prescribed regulations that spoke of interbank control system and restricted investment banking from mixing with commercial banking activities. The role of commercial banks was restricted to creation of secured loans and undertaking deposits while investment banks largely operated in the market. Furthermore, this act provided retail banks to guarantee and trade only in government bonds. The enactment of Glass-Steagall Act brought stabilization in the finance market and economy of the US for an extensive period (Benston, 1990). However, it was repealed and replaced in 1999 by the Gramm-Leach-Bliley Act while citing old fashioned nature of the act. The Gramm-Leach-Bliley Act allowed ownership of both retail and investment banking sectors to various holding organisations such as Merrill Lynch, Lehman Brothers, AIG and others (Federal Reserve, 2013). The GLB act relaxed the prescribed norms of Glass-Steagall and merged risky and non-risky components of banking sectors and thereby contributing indirectly towards the crisis. The other enactments that further contributed in the crisis are New Community Reinvestment Act, 1995 and Commodity Futures Modernization Act, 2000, which relaxed the mortgage securitisation process and deregulated over-the-counter financial derivatives respectively (Boz and Mendoza, 2014). Taxes and Subsidies The housing bubble of the US has played a vital role in the onset of the financial crisis. Consequently, the first tax factor that was scrutinised post crisis was tax treatment provided for residential housing. In most countries including the US, the tax returns to owner occupied housing that include imputed rent and other capital gains (price appreciation of property) is lightly taxed. In addition to the low tax, certain costs such as interest rate are often considered under deductibles. Tax relief earned from mortgage interest has positive role in building up housing debts and in this regard, there are evidences which suggests that favourable tax treatment with respect to home ownership tend to have high proportion of housing mortgages. Contrastingly, when significant reduction was undertaken in mortgage interest relief, the UK and the US observed drastic decline in mortgage with respect to home value (Alworth and Arachi, 2010). Additional studies suggest that in the US, implicit subsidies from government increased significantly for systematically important banks during and before the crisis. Such subsidies were availed by investment banks as well (IMF, 2014). According to a study by Statista (2015), Bank of America received maximum subsidies amounting to $45 billion followed by ING, JP Morgan, Citi Group and other investment banks. Too big to fail concept Failure is not unusual among business organisation and such failures mainly have significant consequences on shareholders and extensive stakeholders. However, such failure was hardly anticipated for the banking sector in the US prior to the crisis. The concept of TBTF applies largely on banking and other financial institutions. Kaufman (2013 p. 217) defined a TBTF organisation as “a large complex firm that is perceived to require either or both special regulation to discourage failure while alive and/or a special resolution regime when dead in which governments can intervene and not have the insolvent firm resolved through the usual resolution (bankruptcy) processes that apply to other firms in the same industry, at least with respect to allocating losses”. The financial crisis reveals that most of the large financial institutions are closely connected to one another by means of financial contracts, credit guarantees and short term loans. The potential collapse of a significantly big corporation has consequences on dependent firms and the economy and therefore is often committed by governments to commit in situations similar to bankruptcy. Being complex and well connected, the scope of failure of such banks is generally ignored and the TBTF notion enhances their risk appetite. The Federal deposit insurance was determined as a government guarantee that increases risk appetite of the US banks (Wheelock, 2012). Liquidity Large scale financial liquidity from global perspective was determined to be significantly responsible for accumulated financial vulnerabilities prior to the crisis. On the basis of liquidity, significant argument has been undertaken with respect to monetary easing in various advanced economies such as the US. Prior to the crisis and after enactment of GLB act, monetary, fiscal and regulatory policies became significantly discretionary and unpredictable (Mishkin, 2011). Between 2003 and 2005, the interest rates were dropped significantly by the Fed compared to previous decades and thereby credit expansion was promoted. Interestingly, during this period the Fed fund rates were dropped below the prevailing inflation rate in the country. As a result, liquidity increased tremendously in the economy and consumers had greater disposable income. High level of disposable income made consumers invest significantly in mortgaged properties and stock market (Taylor, 2014). Liquidity cannot be considered as a direct influence in the financial crisis but in absence of excessive liquidity, the situation would not have worsened as consumers would not have had the purchasing power. The monetary policy not only increased liquidity but low interest rates lured consumers in purchasing properties on mortgage. In many occasions, consumers not only bought one house but two while mortgaging the first property. The globalisation linked several economies in one thread as a result, liquidity in the US economy attracted foreign banks and investor. Thereby, it affected the global financial system (Mishkin, 2011; Taylor, 2014). Asset quality and leverage amount The financial crisis unveiled noteworthy weakness in the banking regulation and one of the key challenges therein was determined to be risk level of banks’ assets. Risk weighted assets are considered essential for banks because it helps in determining a firm’s risk exposure in terms of risk based capital ratios. Financial innovation diverted banks’ attention from quality of assets to increased risk taking. For equity investors, risk weighted assets (RWA) is treated as a crucial measure of credibility as high quality RWA implies greater stability and protection against risk and failure. It was determined from studies that between 2007 and 2008, the quality of RWA in most banks was in their worst condition. Additionally, the capital structure of most US bank holding companies witnessed drastic changes in RWA and general asset quantity while rise in debt was observed. At the time of crisis, most financial institutions were highly levered resulting to low risk absorbency and collapse (Das and Sy, 2012). Executive compensation structure It has been often been argued by different researchers that excessive risk taking among executives was induced by distorted compensation structure. Most of the standard pay arrangements are focussed on rewards and short term gains (Cooper and Kish, 2014). Many studies criticised compensation package of CEOs for incentivizing risk taking capabilities that allowed executives to sell greater number of CDOs to every individual than ever. Analysis revealed that between 2000 and 2008, bankers earned compensation in wage, stocks and options in huge amount. Furthermore, it was observed that the compensation was no where related to performance of an individual or the organisation (Dong, 2009; Victoravich, Xu and Gan, 2012). Performance was measured only in terms of more and more creation and selling of CDOs. Payment of excessive compensation is not directly associated with the financial crisis but it does have an invisible impact on the motivational level of executives and CEOs. Comparative studies suggest that generally compensation of bank CEO is relatively less than non-bank CEO but recently, the situation has reversed for most investment banks. Additionally, compensation structure of majority of CEOs highlighted significant proportion of bonus and performance oriented pay (Victoravich, Xu and Gan, 2012). Role played by rating agencies In financing, one of the chief issues faced by banks is whether lenders will pay back. Similar issue is faced by investors while investing in shares and debentures issued by banks in order to determine the prospective level of return. Therefore, credit rating agencies are responsible for establishing credit worthiness of lenders as well as borrowers. Credit rating agencies are significantly responsible for filling asymmetrical information gap. Three largest credit rating agencies S&P, Moody’s and Fitch group was accused of manipulating rating of bonds and overrating the same. In most cases, these agencies rated poor quality bonds as investment grade. Followed by this, most of the overrated bonds were sold to investors even though their underlying values were equivalent to zero. Banks leveraged their financial position to trade such CDOs consistently and thereby reached on the verge of bankruptcy (White, 2010). Governance Good governance is essential for healthy functioning of a business organisation and lack of governance was determined to be one of the essential factors responsible for the unfolding of the crisis. It was gathered that poor risk management at various financial corporation was a result of lack of governance and transparency. Corporate governance shares a strong yet invisible relationship with stakeholders of organisations. It includes business ethics, transparency and delivering maximum protection to stakeholders from unforeseeable adversities. Questions have been raised regarding corporate governance practiced by most of the TBTF financial institutions in terms of risk taking and compensation structure of executives. The financial crisis unveiled unethical practices undertaken by the investment banks and the rating agencies. It was also gathered that negligible amount of transparency regarding the offerings was maintained with the investors (UNCTAD, 2010). Collapse of Lehman Brothers in 2008 Lehman Brothers crashed in September 2008 and at that period, the company was fourth largest investment bank in the US having asset worth $639 billion. The estimated loss was determined to be greater than GDP of Sweden at that period. The company reported a loss of $3.93 billion in its third quarter while the firm written down around $5.6 billion worth mortgage. Lehman Brothers was pushed to file bankruptcy because after bailing out Freddie Mac, Fannie Mae and Bear Stearns, the Fed and US Treasury declined to bailout the firm. In the following section, the Lehman Brothers’ collapse has been discussed in the light of the financial and non-financial aspects that were mentioned previously in context of the financial crisis. Financial innovation Financial innovation created products like derivatives which are extremely complex for layman investors to understand. Financial innovation entered in the financial system of the US essentially by means of housing bubble. The housing bubble was outcome of low interest rate by the Fed. The bubble was financed by various investment banks who also participated in retail activities. As the bubble burst, the collateral mortgages declined significantly. Financial institution such as Lehman Brothers combined various kinds of subprime loans and mortgages into CDOs and sold the same to investors. The company insisted lenders on creating greater number of mortgages so that more and more CDOs can be sold. For continuing its risk appetite, Lehman Brothers secretly raised their risk limits to $2.3 billion to $3.5 billion. By 2007 and 2008, the company could not sale majority of its CDOs and Lehman held $21 billion derivatives worldwide in 2008. By 2008, the risk level of Lehman was as high as 74% and inability of the firm to sell off the CDOs can be considered as a strong reason for the bankruptcy of the company (SEC, 2007; Los Angeles Times, 2012). Economic policies The economic policies are mainly focused on three acts that were removed and/or affirmed prior to the financial crisis. These are the Gramm-Leach-Bliley Act, 1999, Commodity Futures Modernization Act, 2000 and New Community Reinvestment Act, 1995. The repeal of the Glass-Steagull act did not cause the crisis but it definitely contributed significantly therein. The section 20 of the act that prevented retail banks from engaging in market related activities. The law prohibited commercial banks for underwriting and dealing in securities. The GLB act practically reversed the course of Glass-Steagull act and opened several new avenues for the banking sector to expand. The enactment of GLB act empowered investment banks such as Lehman Brothers, Merrill Lynch, Goldman Sachs, Morgan Stanley and Bear Stearns to merge commercial as well as investment activities. Greed of short term gains made Lehman Brothers and others to take up riskier market activities such as principle trading in derivatives. The global financial integration resulted in greater connection between Lehman Brothers and global economy and thereby raised vulnerability of the global economy (Boz and Mendoza, 2014). Taxes and subsidies According to Bloomberg (2013), tax payers in the US pay around $83 billion on yearly basis to the largest banks in the country as subsidy. Such large sum of subsidy has been discussed as unhealthy for an economy by economists. It has also been proposed that consequences of high subsidy available should be mitigated by means of increase in capital requirements. Financial institutions such as Lehman Brothers enjoyed the subsidy as a result of low borrowing costs as creditors and investors of these firms expect the treasury’s intervention in case of bankruptcy and other emergencies. Different assessments revealed close subsidy values between 2007 and 2010 for the largest banks in the US. It was further gathered that the estimate of subsidy was less than $10 billion before 2004 and it crossed $100 billion by 2009. This drastic change distorted competition level among banks and encourages institutions like Lehman Brothers to engage in greater risk taking. Additionally, the tax returns and subsidies also distorted balance sheet of the company (Bloomberg, 2013, IMF survey, 2014). End of “Too Big To Fail” notion The notion of TBTF created perennial issue in the US economy as several large financial and non-financial firms collapsed in 2008 and crippled the economy. TBTF firms largely comprised institutions such as Freddie Mac, Fannie Mae, Bear Stearns, and Lehman Brothers and so on. Additionally, their failure did not raise concern among creditors and investors because it was assumed that Government will bailout these organisations in case of emergency as they were essential for the economy. Such notion was maintained in Lehman Brothers till the day before it declared bankruptcy as they expected government intervention. Factors that further contributed to the sinking of Lehman Brothers is the last minute disapproval by Barclays Bank to purchase Lehman. After rescue of Bear Stearns by selling it to JPMorgan Chase, the treasury declined to rescue Lehman brothers as the CEO of the company declined offer by Korea Development Bank in anticipation of greater valued support from the treasury (Wheelock, 2012; McDonald, 2009). Leveraging the financial position It was determined that enactment of GLB act raised debt to equity capital from 12:1 to 30:1. For Lehman Brothers, the ratio was between 30:1 and 60:1 at different point of time before the crisis. According to the researchers, the ratio implies the level of debt that a firm has with respect to each dollar of equity capital (Berman and Knight, 2009). For most commercial banks, the accepted ratio is 10:1 which suggests that for every $10 of debt, it should have $1 equity. Arguably, 10:1 debt equity ratio ensures that a bank is capable of weathering financial storms such as bad debt and defaulted loans. Considering market activities, investment banks are assumed to have higher debt to equity ratio but the ratio of Lehman Brothers was determined to be exceptionally high indicating poor risk absorption capability (Berman and Knight, 2009). Such high ratio often indicates that the leverage of a firm is higher than its net worth. For Lehman Brothers, the situation was alike. SEC report (2007) of Lehman Brothers suggested that the firm had only $22,490 as equity capital; while the liabilities of the firm has been as high as $190,886. Liquidity crisis The bankruptcy of Lehman Brothers was worth $639 billion and possibly the greatest in the financial history of the US. The main causes of the bankruptcy were determined to be loss of confidence among counterparties and lack of sufficient liquidity. Citi Group and JP Morgan were primary lenders of Lehman Brothers and sudden changes in guarantee agreements collateral demands. The demand changes in collateral resulted in vaporisation of Lehman Brothers’ liquidity. The illiquidity has been argued to have central role in the bankruptcy of Lehman Brothers (Berman and Knight, 2009). Loss of liquidity is considered as an extreme critical condition for a bank. In this perspective, Lehman Brothers was surviving only on a meagre amount of cash in 2008 and this situation can be best described by calling it as an upturned pyramid having support from splinter of liquid cash. Based on the assumption that Lehman did not have sufficient liquidity in short term, most of its lending banks withdrew their lines of credit for protecting their personal interests. Lehman brothers had global footprint interconnecting the company to several financial market players such as insurance company, mortgage and bond issuers and money market and hedge fund issuers. Lehman Brothers consistently bought large and large amount of CDOs and invested in CDSs from various sources resulting to unsold and blocked capital therein as the market crashed (McDonald, 2009). Executive compensation structure The short term gain of firms like Lehman Brothers affected the global economy for more than just few years. The economy is yet to recover from slowdown and unemployment. Downfall of Lehman Brothers not only crashed the stock market but also crashed the confidence of investors. However, if there is anybody who got least affected by the end of Lehman Brothers, it is the executives of the company (Bloomberg, 2010). The situation was determined to be similar for Bear Stearns and others large financial institutions. Assessment suggests that CEO of Lehman Brothers, Richard Fuld, earned $500 million between 2004 and 2009 while the US taxpayers lost around $700 billion in the Wall Street crash. Fuld only lost that money which he had in the form of stock options. The net worth of the stock options was approximately $900 million which post crash became worthless (Los Angeles Times, 2012). Richard Fuld very conveniently ignored the accounting discrepancies in the financial statements of Lehman Brothers only because it was not against his personal interest. The death of Lehman Brothers killed series of other banks but its executives continues to live a comfortable and expensive lifestyle. Other executives at Lehman Brothers also received compensation ranging between $8 million and $51 million either as cash or as cashless compensation (Yahoo Finance, 2013). Woes of rating agencies Three of the largest credit rating agencies, namely, S&P, Moody’s and Fitch mainly rated the mortgage backed CDOs of Lehman Brothers and other companies. In these credit rating agencies, AAA rating implies investment grade while BBB implied junk. Incidentally, it was observed that majority of mortgage backed debts issued by Lehman Brothers, Bear Stearns and others were rated as AAA by these agencies while they were of ‘junk’ quality because of the underlying asset being subprime mortgage. Moody’s rated junk stocks of Lehman Brothers as AAA grade even days before the company busted and filed for bankruptcy. Arguably, if the rating agencies had maintained honesty in their practices and with the investors then Lehman Brothers might not have to face bankruptcy. When these agencies were questioned regarding unethical practice, they argued that they favoured stocks of Lehman Brothers and AIG only based on the assumption that like Bear Stearns, these organisations will also be provided protection blanket by the government. Interestingly, when Lehman Brothers declared bankruptcy, the rating by Fitch dropped from A+ to CCC and from A to C respectively. This suggested that overrated situation created by the rating agencies also played an important role in downfall of Lehman Brothers (The guardian, 2012). Practicing corporate governance Lack of governance plays a primary role in the collapse of Lehman Brothers and similar firms at the Wall Street. The first and foremost thing that should be noted regarding accounting practices at Lehman Brothers is that the company covered up its unethical financial practices by means of repo accounting while undertaking repo 105 transactions. These transactions borrowed billions of dollars but were kept hidden from firm’s balance sheet and no obligation to repay was disclosed by the company. Use of repo 105 in itself is extremely unethical as it misleads investors (Aubin, 2011). The other unethical practice of Lehman Brothers is excessive investment in CDOs and CDSs and selling the same to investors as healthy investment. Lehman Brothers took significant advantages of loopholes in existing accounting standards to cover up financial manipulations. However, these practices affected the firm in the long run because excessive leverage created by means of repo 105 transactions killed risk cushioning efficiency of the firm (Stevens and Buechler, 2013). Reference list Alworth, J. and Arachi, G., 2010. Taxation and the financial crisis. Oxford, London: Oxford University Press. Aubin, D., 2011. FASB changes repo accounting rule used by Lehman. [online] Available at: [accessed 01 April 2015]. Benston, G. J., 1990. The separation of commercial and investment banking: the Glass-Steagall Act revisited and reconsidered. New York: Macmillan Press. Berman, K. and Knight, J., 2009. Lehman’s Three Big Mistakes. [online] Available at: [accessed 01 April 2015]. Bloomberg, 2010. How Much Did Lehman CEO Dick Fuld Really Make? [online] Available at: [accessed 01 April 2015]. Bloomberg, 2013. Why You Should Care About That $83 Billion Bank Subsidy. [online] Available at: [accessed 01 April 2015]. Boz, E. and Mendoza, E. G., 2014. Financial innovation, the discovery of risk, and the US credit crisis. Journal of Monetary Economics, 62, pp. 1-22. Choi, J. W., 2013. The 2007–2010 US financial crisis: Its origins, progressions, and solutions. The Journal of Economic Asymmetries, 10(2), pp. 65-77. Cooper, E. and Kish, A., 2014. Executive compensation and securitization: pre-and post-crisis. The Journal of Risk Finance, 15(4), pp. 437-457. Das, S. and Sy, A. N. R., 2012. How risky are banks’ risk weighted assets? Evidence from the financial crisis. [pdf] IMF. Available at: [accessed 31 March 2015]. Dong, G. N., 2009. Excessive Bank CEO Pay and Financial Crisis: Evidence from Structural Estimation. New York: Wall Street Journal. Federal Reserve, 2013. Banking Act of 1933, commonly called Glass-Steagall. [online] Available at: [accessed 31 March 2015]. Financial Times, 2015. Financial innovation. [online] Available at: [accessed 31 March 2015]. IMF survey, 2014. Big Banks Benefit From Government Subsidies. [online] Available at: [accessed 01 April 2015]. IMF, 2014. Global Financial Stability Report, April 2014: Moving from Liquidity- to Growth-Driven Markets: Moving from Liquidity- to Growth-Driven Markets. Washington D.C.: IMF. Kaufman, G. G., 2014. Too big to fail in banking: What does it mean? Journal of Financial Stability, 13, pp. 214-223. Kim, T., Koo, B. and Park, M., 2013. Role of financial regulation and innovation in the financial crisis. Journal of Financial Stability, 9(4), pp. 662-672. Los Angeles Times, 2012. Lehman Bros. elite stood to get $700 million. [online] Available at: [accessed 01 April 2015]. McDonald, L.G., 2009. Paulsons Decision Cost Lehman, Then the World. [online] Available at: [accessed 01 April 2015]. Mishkin, F. S., 2011. Monetary policy strategy: lessons from the crisis (No. w16755). Cambridge, MA: National Bureau of Economic Research. Reinhart, C. and Rogoff, K., 2008. Is the 2007 US sub-prime financial crisis so different? An international historical comparison. American Economic Review, 98 (2), pp. 339–344. SEC, 2007. Consolidated financial statement of Lehman Brothers. [online] Available at: [accessed 01 April 2015]. Shahrokhi, M., 2011. The Global Financial Crises of 2007–2010 and the future of capitalism. Global Finance Journal, 22(3), pp. 193-210. Statista, 2015. Subsidies for banks during financial crisis. [online] Available at: [accessed 31 March 2015]. Stevens, B. and Buechler, S., 2013. An Analysis of the Lehman Brothers Code of Ethics and the Role It Played in the Firm. Journal of Leadership, Accountability and Ethics, 10(1), pp. 43-57. Taylor, J. B., 2014. The role of policy in the Great Recession and the Weak Recovery. The American Economic Review, 104(5), pp. 61-66. The guardian, 2012. How credit ratings agencies rule the world. [online] Available at: [accessed 01 April 2015]. UNCTAD, 2010. Corporate Governance in the Wake of the Financial Crisis. [pdf] UN. Available at: [accessed 31 March 2015]. Victoravich, L. M., Xu, P. and Gan, H., 2012. Institutional ownership and executive compensation: Evidence from US banks during the financial crisis. Managerial Finance, 39(1), pp. 28-46. Wheelock, D.C., 2012. Too Big To Fail: The Pros and Cons of Breaking up Big Banks. [online] Available at: [accessed 31 March 2015]. White, L. J., 2010. Credit-Rating Agencies and the Financial Crisis: Less Regulation of CRAs is a Better Response. Journal of international banking law, 25(4), pp. 170-195. Yahoo Finance, 2013. CEO Behind Lehman Collapse Isn’t Sorry: Dick Fuld 5 Years Later. [online] Available at: [accessed 01 April 2015]. Read More