Financial Crisis and Lehman Brothers - Case Study Example

Collapse of Lehman Brothers] By Insert Your Name Presented to Instructor’s Name, Course Institution Name, Location Date Due Table of Contents Introduction Lehman Brothers was begun in 1847 as a business organization dealing in dry goods. Over several years, the business diversified and embarked on strategic refocusing until it started trading in coffee and cotton. It also dealt with railroad bonds and ventured into the new issues market at the start of 20th century. During the early days of the business, Lehman was run as a partnership owned by a family. The business remained this way until 1969 when Robert Lehman who was the last member of the family to be involved in the partnership died. After his death, a series of acquisitions started streaming in, notable among them being Abraham and Co then Kuhn Loeb and Co in the 70s. This made Lehman the fourth largest investment bank (Hbs, 2010). The first part of this essay will look at what caused the financial crisis that led to the collapse of Lehman brothers. The second part will discuss reasons that led to failure of the business model adopted by Lehman brothers. The collapse of Lehman brothers was caused by too little government intervention. In my opinion, Lehman brothers collapsed due to lack or regulation from the government on acquisition of own homes. Academic and Journalistic Explanations of the Crisis The financial crisis in America has been explained from different perspectives with academic and journalist sources offering competing explanations. The financial crisis that took place was significant in America as a sensitive part of the economy. Part of the cause of the financial crisis was the continued increase in debts. The graph below tries to show how the estimates in national debt have been changing from year to year. It is evident from the graph that there is a huge gap between the old and current estimates. From: www.businessinsider.com The ancient checks and balances for what caused the financial crisis in America have been ignored since the financial crisis took place. The real estate industry has been accused of encouraging people to engage in mortgage applications that posed great risks to them. The banking industry is supposed to assess the credit worthiness of those who apply for mortgage but this has not been happening. Theoretically, the financial crisis that happened in the United States was not supposed to happen. The administration of George Bush was expected to provide the necessary management and leadership roles to ensure that federal agencies did not sleep on their job. However, a breakdown of the system resulted in the financial crisis that was witnessed. The Bush administration has been accused of being asleep bureaucratically, a situation which developed for several years (Jansen, Beulig, & Linsman, 2009) There are several departments of the government that led to the financial crisis that was witnessed in America. Among them is the treasury department which is mandated with ensuring that the US financial resources are utilized effectively hence achieving financial stability. However, different bodies are not in agreement regarding what caused the financial crisis. For instance, the democratic laid the blame squarely on Bush administration for the crisis that occurred (MarketOracle, 2008). They have been doing this in total oblivion of the fact that they were charged with managing the affairs of the congress when the financial crisis took place. The federal government participated in transferring thousands of US dollars into bonds. The new mortgages that were acquired by Fannie and Freddie amounted to the financial crisis due to the large debts. The appreciation of home price was un-uniform in such a way that economist pointed out that America was not being exposed to a housing bubble of a nationwide nature but a number of housing bubbles. In 2007, Greenspan concurred that there was a bubble in the housing market of United States and further pointed out that a collection of froth bubbles make up an aggregate bubble. Although there were very low interest rates, and the lending standards relaxed, many parts of the United States experienced low economic growth and a bad financial crisis. The Financial Crisis of 2007-2010 There were many factors both direct and indirect that caused the continued financial crisis experienced between 2007 and 2010. It started with United States subprime mortgage crisis, but financial experts placed different emphasis on particular causes of the financial crisis. The complexity and interdependence of many causes, as well as competing political, economic and organizational interests, have resulted in different explanation about the financial crisis (Mboya, 2011). The financial crisis is an important aspect when discussing American economy because it led to problems such as unemployement. As indicated in the chart below, unemployement rates have been fluctuating and increased during the periods of financial crisis (Businessinsider, 2008). From: www.businessinsider.com The financial crisis that occurred in 2007 was as a result of liquidity shortfall in the US banking system, which made large financial institutions to collapse, governments to bail out banks, and downturns of stock markets in many countries in the world. Also, the housing market suffered as a result of numerous evictions, prolonged vacancies and foreclosures. According to economists, financial crisis (2007-2010) was the worst since the Great Depression of 1930s which contributed to key businesses making losses, consumer wealth decline, governments incurring financial commitments, and decline in economic activities(Credit write downs, 2010). Many causes for this crisis have been advanced, and solutions which are both market-based and regulatory have been either implemented or are under consideration. At the moment, there are still significant risks that world economy over the 2010-2011 periods faces. The subsiding of the housing market which was doing well in the U.S market in 2006, made the value of securities which were tied to housing market to plummet thereafter. This caused a negative ripple effect to financial institutions in the world (Credit Write Downs, 2010). Questions regarding declines in credit availability, investor’s confidence and bank solvency…etc had an impact on the stock markets, where securities in most countries suffered losses in 2008-2009 period causing sluggishness in world economy during this period. Financial credit had to tighten and world trade declined, but financial critics argued that both investors and credit rating agencies failed to accurately quantify the risk involved with mortgages related financial products, and most government did not adjust their rules and regulations to be in tandem with current financial markets-21st century. Most government responded with unplanned fiscal stimulus, institutional bailouts, and expansion of monetary policies (Duncan, 2008). Causes of Financial Crisis Housing market Between 1997- 2006, it was noted the price of housed in America increased by 124 per cent, and this was during the two decades ending in 2001. The median price for homes in America was ranging between 2.9 to 3.1 times household income median, this ratio rose both in 2004 and 2006, at 4.0 and 4.6 respectively. This bubble in the housing market made few homeowners to refinance their homes at lower interest rates- taking second mortgages which were secured by the current price appreciating. In late 2008, the housing prices declined by over 20 per cent from its peak in mid-2006, easily availability of credit and belief that housing prices in the country will appreciate in the coming months or years, made subprime borrowers to adjust their mortgages rates; these rates enticed many borrowers to adjust their mortgages with a below market interest rate for some predetermined period, and follow by market interest rates for the rest of the mortgages period (Gup, 2010). Those borrowers who were not able to make high payments once their grace period was over tried to refinance their mortgages, but refinancing became more difficult once prices in the housing sector started to decline. This resulted in those borrowers who were unable to pay their high monthly installments by refinancing began to default. In 2007, the financial lenders started foreclosure, and nearly 1.3 million properties were affected, this was 79 per cent increase as compared to 2006, in 2008, this increased to 2.3 million properties; an 8 per cent increase vs. 2007. As for the late 2008, it was noted that 9.2 per cent of all mortgages outstanding were either delinquent or in foreclosure (Global Economic Crisis, 2009). Subprime Lending This is a term which refers to the credit quality of an individual. These individuals have weak credit history and are at greater risk of defaulting there loans than prime borrowers. In 2004 to 2006, subprime lending increased dramatically and this was in addition to easy credit conditions. Economists believe there is evidence linking government and competitive pressures to increase of subprime lending in years before the financial crisis. It was noted during years preceding the financial crisis that major investment banks and enterprises like Fannie Mae- government sponsored- had a role to play in the expansion of higher-risk lending rates. In 2004, the decision by Securities and Exchange Commission (SEC) to flex the net capital rule also contributed to this crisis, because this made the five largest investment banks to increase their financial leverage and expand their issuance of mortgage-backed securities to these individuals, it was noted that between 1998 to 1996, subprime mortgage delinquency rates were stagnant at 15 per cent, but it begun to increase rapidly, reaching 25 per cent by early 2008. Mortgage Underwriting Financial institutions considering higher risk borrowers, banks and financial institutions offered increasingly risky loans options and borrowing incentives to borrowers. In years preceding the financial crisis, many banks and financial institutions relaxed their mortgages underwriting standards; they used automated loan approval which allowed loans to be made without appropriate review and documentation. In 2007, it was noted that 40 per cent of all the subprime loans given were as a result of automated underwriting. According to the Chairman of the Mortgage Bankers (US) Association, brokers in the mortgages profited from loans boom but they did not do enough to determine if borrowers will manage to repay their loans, As a result, mortgage fraud in both lenders and borrowers increased enormously during that period (Global Economic Crisis, 2009). According to the findings of Federal Reserve Bank (Cleveland), there was a decline in difference between subprime and prime mortgages interest rates in 2001- 2007 period. Also, the quality of loans worsened in the same period. These factors of decline in risk premiums and credit standards that are common to boom and bust credit cycles and this resulted in sudden jumping of defaults s because loan quality among borrowers was hard to detect with the rise in housing prices. As more banks and financial institutions provided refinancing options, the defaulting rate was kept lower. Government Role in Causing Financial Crisis The government was responsible for the financial crisis because for instance, it increased the rates for home ownership. This enabled millions of people to own homes without having the financial sources that were required to honour their commitments. In addition, others bought larger homes than they could actually afford or bought homes speculating that prices would go up later. The increased demand for houses led to shooting of the prices posing a risk to anybody who bought the houses at the inflated prices. Bubble wealth lead to massive destruction of wealth especially in financial institutions causing many other problems known today (Gup, 2010). It is evident that the US government played a major role of encouraging borrowing for people to buy residential houses. As Peter Wallisson from the American enterprise pointed out recently, government policy and GSEs played a major role in causing the financial crisis that America witnessed. He argued that if the GSEs were not there, then the financial crisis would not have been witnessed. Home ownership has social benefits to the people of United States in that those who own homes are in a position of taking good care of their family members and are more concerned about their neighbourhood. The belief in such benefits led US government into encouraging home ownership for American citizens. One of the factors that encouraged US government to compel people to own their homes is that the rent people earn from their homes is not exposed to taxation. Another reason is that the government established GSEs for middle income people to get mortgages. An important feature when it comes to looking at how the US government encouraged citizens to buy their own homes was through allowing people to borrow more money and reduce down payments. Instead of granting direct subsidy to potential homeowners, over-leverage was endorsed by policy makers. The policy of encouraging people to own homes started experiencing problems in various ways. To begin with, Freddie and Fannie because of their link with the government they were allowed to borrow from the capital market at low premium rates. It is clear that the government contributed towards expanding the housing market that became very large and with increased prices. However, the mistakes done by the government were only part of a complex series of mistakes that were made by many institutions. The government made the banking system become more risky by doing away with many sources that functioned as market discipline. Those who blame the government argue that it had created a mentality among reputable financial institutions that if by any chance they got into problems they would be bailed out (Bill, 2010). When the financial crisis arose and Bear Stearns was covered, there trust that large financial institutions were covered increased. The bank bail outs were not taking into consideration shareholders belonging to banks that were failing. When Lehman started experiencing problems, the government did not step forward to rescue it or the counter parties. Fed and treasury made attempts to establish a deal with Barclays but problems from US authorities made the whole plan difficult leading to the collapse of Lehman. The collapse of Lehman was described as one of the factors that contributed to the worsening of the financial crisis hence the importance of the government protecting larger entities was reinforced. The Collapse of Lehman Brothers In September 2008, Lehman Brothers filed for chapter 11 bankruptcy protection while it had debts amounting to approximately $613. Since this was the largest corporate bankruptcy, it caused panic in the global financial markets. The result was credit freeze; write downs on financial stocks and a risk of causing collapse in the entire international financial systems. The collapse prompted the government to involve itself in intervention mechanisms to prevent the credit market from collapsing. The stock of Lehman reached $86.18 in Feb 2007 which gave the firm a market capitalization of nearly $60 billion. However, as the first quarter of 2007 ended, loopholes in the housing market of United States started manifesting themselves owing to a rise in the number of people defaulting subprime mortgages (Gup, 2010). The table below shows the net revenues, operating Profit and Net income (Nominal) of Lehman Brothers from the year 1994 to the year 2007. This chart is important in my analysis of this question because it shows how Lehman brothers earned its revenue and the profits it made from 1994 to 2007. Revenues Interest Expense - Total Net Revenue Personnel Expenses Other expenses Operating Income before income, tax and accounting adjustments Provision for income taxes Other adjustments Net Income 1994 10080 6899 3181 - - #VALUE! #VALUE! 1995 13476 10405 3071 - - #VALUE! #VALUE! 1996 14260 10816 3444 - - #VALUE! #VALUE! 1997 16883 13010 3873 - - #VALUE! #VALUE! 1998 19894 15781 4113 - - #VALUE! #VALUE! 1999 18989 13691 5298 2707 1002 1589 457 1132 2000 26447 18796 7651 3931 1197 2523 748 1775 2001 22392 15712 6680 3437 1424 1819 437 -127 1255 2002 16781 10682 6099 3139 1517 1443 368 -100 975 2003 17287 8712 8575 4318 1716 2541 765 -77 1699 2004 21250 9698 11552 5730 2309 3513 1125 -19 2369 2005 32420 17790 14630 7213 2588 4829 1569 3260 2006 46709 29126 17583 8669 3009 5905 1945 47 4007 2007 59003 39746 19257 9494 3750 6013 1821 4192 On March they reported that Lehman brothers had made a profit for the first quarter, a day after the stock had experienced a big drop and concerns arose that defaulters would affect the profitability of the company. During the post-earnings conference call, the chief financial officer of the firm reported that the challenges that were being posed by increasing home delinquencies were not a risk to the firm because appropriate measures had been taken. He added that he did not envisage any problem resulting from subprime market moving to other housing market or causing a dent on US economy (Bill, 2010). The credit crisis erupted in August 2007 when two Bear Stearns hedge funds failed causing Lehman stocks to drop sharply. During that month, the company was forced to lay off 2500 mortgage related workers and closed its BNC unit. However, while the downturn in the housing market of United States continued to increase, Lehman firm did not lose its reputation as an important player in the mortgage industry of United States. Lehman undertook underwriting of mortgage backed securities more than the rest of the firms and accumulated a portfolio of $ 85 billion. According to some reports in the US, this was the largest real estate loan underwriter. In the fourth quarter of 2007, the stocks of Lehman regained their reputation after an increase in global equity markets. The firm did not however, take the chance of reducing its enormous mortgage portfolio not knowing that this was the last chance. The levels of leverage for Lehman were as high as 31 in 2007 and coupled with the large mortgage portfolio, continued making it prone to dwindling market conditions. On 17 March 2008, Bear Stearns which is the second largest mortgage backed securities underwriter nearly collapsed causing the shares of Lehman to fall for fears that it would be the next firm to fail. In April when the company raised $4billion through preferred issue stock, its confidence started to be gained again. However, the stock started declining again after the hedge fund managers questioned valuation of the portfolio of Lehman mortgage (Bill, 2010). In June Lehman recorded a loss of $2.8 billion in the second quarter which was the first loss after it had been taken over by American express. The firm further reported that it had improved its pool of liquidity to approximately $45 billion, reduced gross assets by $ 147 billion and reduced leverage from about a factor of 32 to 25. It had also cut down its residential and commercial exposure by 20 %. However, these strategies were perceived as being too small and coming too late. Over summer, the management of Lehman unsuccessfully made overtures to potential partners. The stock went down by 77 % during the first week of September, a time when equity markets were going down across the world. Investors were at the same time questioning the CEO why he had kept the firm independent through selling away commercial real estates and asset management units. Lehman had hopes that Korea development bank was going to take a stake in the company were killed on September 9 after the bank halted the talks. This was a serious blow to Lehman and the stock went down by 45 % with an increase of 66% in credit defaults on the debts of the company (Elliot & Baily, n.d). The graph below shows the stock movement for Lehman brothers between 2007 and 2008. According to the graph, we can picture downward trend assumed by stock movement of Lehman brothers. Between 2007 and 2008, the stock was going downwards something which explains the collapse of Lehman brothers. (Housingbubble, n.d) Lehman was also negatively speculated on by investors and short sellers. The hedge fund clients of the company started disappearing while the short-term creditors severed the credit lines. On 10th September, Lehman announced that the results for the third quarter were dismal, a preannouncement that confirmed that the financial position of the firm was fragile. The firm incurred a loss of $ 3.9 billion alongside a $5.6 billion write down in addition to announcing its intention of restructuring its businesses. The same day an investor service said that it was analyzing the credit ratings of Lehman. Lehman was therefore supposed to sell a big part of its stake to a strategic partner to avoid its downgrade rating (Hbs, 2010). These developments caused the stock to reduce by 42 % on the 11th of September 2008. By the end of the week, Lehman had only $1 billion left in cash and as a result, it was running out of time speedily. The firm made last time efforts with Bank of America and Barclays PLC to aid a takeover but it was unsuccessful. On Monday September 20th 2008, the stock of Lehman plunged by 93% from its previous close forcing it to declare itself bankrupt. The bankruptcy declaration caused $46 billion in market value of Lehman to vanish. The collapse also led to Bank of America purchase Merrill Lynch faster than it had planned initially. This deal was an emergency announced on the 15 of September (Hbs, 2010). The Declaration of bankruptcy by Lehman was not the first one in the history of United States. Other companies had been experiencing problems and eventually becoming bankrupt. However, the bankruptcy of Lehman brothers was the most significant among them. The following graph shows the ten largest cases of bankruptcies which have been recorded in the US. As indicated in the graph, the collapse of Lehman brothers is the largest case of bankruptcy recorded in the US. As we can see from the chart, it is evident that the financial crisis in America had adverse effects on Lehman brothers because it recorded the highest number of pre-bankruptcy assets. From www.Chartoftheday.com The collapse of Lehman brothers led to all sorts of speculations. Many people had questions concerning why the US government allowed Lehman to fail. The eventual collapsing of Lehman and the financial crisis brought to the fore the relief in bonuses incentives and remuneration. Banks decided to set aside a proportion of between 40-50% of their revenue to be used in paying employees. Causes of Collapse of Business model Used by Lehman Brothers Market Complacency The beginning of the financial crisis that led to the collapse of Lehman brothers started during the estate boom. A protracted period of low rates of interest caused an increase in the prices of house prices, a phenomenon which was not common historically. Since March 1997 to June 2006, real estate prices for Shiller and Case continued to shoot up every month, with an exception of only two. During this time, there was an average increase of 12.4 % every year for real estates. The increase was partly as a result of extremely low rates of interest. From January 2002 to January 2004, the t-bill rate which is calculated on average was 1.3% while it had been 6.1 % in the previous 40 years. The sustained increase in price cheated people who aspired to own homes that there was the possibility of prices going up. In a survey conducted in 2005, Shiller and Case who were home buyers from San Francisco discovered that the mean increase ion prices that was expected within a period of 10 years was 14 % per year and a median of 9% (Shiller, 2008). Delinquency rates dropped when there was a boom in real estate. The reasons for this were the good economic conditions and a steady increase in real estate prices. The favourable conditions caused the standards of lending to deteriorate. The decline was witnessed in areas with high home price appreciation and this was ascribed to increased competition. Lack of Transparency Another major problem that caused the collapse of Lehman Brothers business model is lack of transparency in main markets. As shown in the figure below, the market for credit default swaps (CDS) grew in a manner that was not regulated during the last ten years (ISDA, 2006). As we can see from the diagram above, credit default swaps were low in 2001 and continued to increase until 2007. It is only in 2008 that there was a small decline. Source: International Swaps and Derivatives Association (ISDA) Market Survey In addition, there was a very low or non-existent collateral level posted for the contracts which raised the possibility of systemic failure. If Florida homeowners suddenly lost their insurance during the hurricane season, this would cause new demand for insurance. The prices would most likely go up since in the short term insurance prices were limited. When some home owners could not afford the high prices, this could have caused an automatic defaulting of their mortgage which triggers real estate crisis and foreclosures. This justifies the regulation of insurance industry. The same case applies when large CDS players such as AIG default since huge commercial banks are exposed to CDS. Their net exposure is much smaller because most of their positions are hedged. If they become major defaulters, they cause all the others to become un-hedged. Despite the fact that CDS is capable of causing systemic effects, CDS market is not regulated. Bad Regulation A regulatory constraint is another reason that led to failure of business model of Lehman brothers. Freddie Mac and Fannie Mae were given a chance and encourage in making investment with the securities of Lehman brothers. The 1992 Federal Housing Enterprises Financial Safety and soundness Act advices the Housing and Development department to see to it that Mae and Mac comply with charter purposes. In 2004, HUD came up with goals for two entities (Inman, 2008). There is no penalties imposed on failure to meet these goals but it is clear that HUD imposes political pressure on those who fail to meet them. Money market is also another source of captive demand. Money market funds were interested in these highly rated securities hence boosting the yields. Majority of the managers were aware of the gamble they were involving themselves in but they could not avoid doing it because of the intense competition of customers who wanted to get high yields. The managers also had the hope that in case a shock occurred, the rest of the competitors would face the same problem. This would reduce the cost they have to incur because of their reputation and possibly getting support from the government. When it was decided that all money market funds were to be insured, this validated the gamble. Consequently, the incentives of money market managers regarding the risks they take were destroyed. Conclusion Studying the collapse of Lehman brothers is important because it not only gives information regarding models of investment banking businesses but also gives us information on how operations can go wrong in the sector. The other interesting side of the case is the questions it raises concerning the social function played by financial markets and the rewards gotten from the sector and their relationship with certain narratives in the market like efficient risk marketization. The case also elicits wider social questions with regard to the nature of worries in financial markets which are based on certainty, trust and emotion. It is evident in this case that lack of faith in the presumptions that are involved in the complex algorithms setting risk in CDSs and CDOs heightened the panic. However, the role played by complexity of CDO structures could not be ignored. It was not easy to ascertain impaired assets or the sections that were likely to be affected by certain write-downs. This gave way for the emergence of an environment of fear, and where fear reigns, stories, narratives and rumours can become true. Reference List Bill, T. (2010). The Financial Crisis Inquiry Report: . Government Printing Office. Businessinsider. (2008). Collapse of Lehman Brothers. Retrieved 05 02, 2011, from http://www.businessinsider.com/ Downs, C. (2010). Why did Lehman Fail. Retrieved 04 29, 2011, from http://www.creditwritedowns.com/2008/09/disappearance-of-capital-sources-is.html Duncan, G. (2008, 09 16). Lehman Brothers collapse sends shockwave round world. The Times , p. 1. BIBLIOGRAPHY \l 1033 Elliot, D., & Baily, M. (n.d). Telling the Narrative of Financial Crisis:Not Just a Housing Bubble. Retrieved 04 29, 2011 GlobalEconomicCrisis. (2009). Lehman Brothers One Year After Its Collapse. Retrieved 04 29, 2011, from http://www.globaleconomiccrisis.com/blog/archives/589 Gup, B. (2010). The Financial and Economic Crises: An International Perspective . Edward Elgar Publishing. 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Chart of the day: Bank regulation is hitting wrong targets. Retrieved 04 29, 2011, from http://www.efinancialnews.com/story/2011-04-07/banks-regulation-focus Read More