Financial Crisis - Lehman Brothers Collapse - Essay Example

Financial crisis: Lehman Brother’s Collapse The world financial crisis from the year 2007 to the year was unprecedented from the great depression of 1929 to 1932. The crisis originated from the United States market of mortgage and spread fast to different other countries like the United Kingdom, Ireland, and Spain. When the Lehman Brothers bankruptcy happened in the year 2008, the financial crisis became a more general crisis of banking that in turn rapidly impacted on the actual economy of the world leading to the onset of a global recession. In attempts of understanding the financial crisis of 2007 -2010, this paper explores the financial crisis of 2007 to 2010. The paper accounts for the causes of the financial crisis while focusing on the world finance. The paper also explored why Lehman Brothers collapsed. The Origin of the Financial Crisis Introduction to the Financial Crisis From the leading economic figures, the 2007 to 2010 financial crisis is reported to be the most severe financial downturn from the great Depression in the year 1930. The crisis is referred to as the great recession because of the negative impacts that followed the crisis. Even though the causes are still debatable, different ramifications show that the causes included huge decline in the value of assets, failures in the major corporations, substantial government intervention, and huge declines in the economic activity. Different regulatory and solutions that are based on the market are suggested and executed in the attempts of combating the effects and causes of the crisis. In this respect, there are huge risks that remain for the economy of the world in the coming years. Immediately after the peak in the U.S in the year 2006, the globalbubble experiences the collapse. Nationally, the U.S home prices dropped by approximately 40% from 2006 to 2009. Risks and securities to exposing the plummeted housing market, resulting into great damage towards the financial institutions in the whole world. The markets of stock in the whole globe experienced huge drops between the years 2008 and 2009. The persisting epidemic continued to drain the wealth of consumers and eroding the financial strength of the institution of banking. Losses and defaults on different types of loan increased significantly when the crisis widened from the market of housing to different sections of the economy. The total amount of losses were estimated to be in trillions on the global U.S. dollar. Credit Expansion Even as the credit and the housing bubble were building, a number of factors lead to the financial system and became a fragile situation mostly referred to as financialization. The government of U.S and policy starting from the year 1970 put increased emphasis on deregulation for the reasons of encouraging business. This led to the oversight in disclosure of information and activities that pertain the new activities that are undertaken by banks and different evolving institution of finance. The formulators of policies did not immediately identify the high role that is played by the institutions of finance like the bank investment and the funds of hedge. Some studies show that these experts were of the view that the institutions gained relevance as the commercial banks in giving credits to the economy of U.S with no subjection to regulation. These institutions and some regulated banks assumed a huge debt burden when providing the loans and failed to have any financial cushioning sufficient in absorbing huge defaults of loan. The losses affected the potential of different financial institution in lending thus reducing the economic activity. The concerns that relate to the key stability of the financial institution made the central bank to give funds for encouraging the restoration and the lending in the commercial market. This was integral to the funding of business operations. On the other hand, the government equally bailed out major financial institutions and had the economic stipulus programs implemented providing the assumption of the additional commitments of finances. Different questions came up as to whether the solvency of key liquidity and institutions of finance dried up in the credit market. The worldwide growth reduced with the credit markets that were tightened and reduction in the international trade. The central bank, governments, and some international organizations implemented different plans such as monetary expansion, fiscal expansion, and bailout of institution in a scale that had never before be seen to curb the crisis. A number of analyses have shifted the blame of the crisis to the inaccurate rating of the credit for the securities that are mortgaged backed and the regulatory practices that are antiquity financed. The revised copy of Kindleberger shows forty events that were documented in over four hundred years between 1600 and 2012. The context of the manner in, which the financial crisis evolved. Kindleberger had a total appreciation for the weaknesses of human when faced with easy profits rather than the hard labor uncertainty that a slinked to the real creation of wealth. His approach was depended on Hyman Minsky take on the financial crisis as the calumniation process in which the expectations are financed through excessive creation of credit mostly lead into speculative manias or excesses. The speculation could be stabilizing and destabilizing and when given the opportunity to intensify or to be unchecked it can lead into panic or crash hence the excessive extent is realized. Kindleberger fails to blame the market for establishing the situations in which the irrationality may take over. He regards the human irrationality and the innovation power specifically the financial innovation in assisting people to get into actual trouble. A section of the Kindlebergers power insight in the current context involves the fact that the financial crisis may not come out of a thin air. They come up from a number of events that change the economic activity course they establishing the basis for the expectations that are changed. This is what was referred to as displacement. A number of changed circumstances are wars, dire or crop failures. A number of successes would be worse. They establish an economic mastery sense that is not readily affected by cold and plain facts. Displacement According to the displacement model, it is prudent to say that the financial crisis started in the 1980s. Reduced interest rates, disinflation, and initial financial market stages of deregulation of the gradual Reg Q ceilings suspension that resulted into an upswing during borrowing. There were a number of key financial crisis in the end of 1980. These included the bursts in the corporate boom buy-out and in the U.S market of housing that sent thousands of savings together with loans to some kind of receivership. The trust corporation resolution assisted in mopping up the housing crisis and a recovery from the recession of 1990, which aided and extended through early increases in the funds fed and the rates of 1994 that set the stage for a long cycle expansion. The disinflation process continues, the rates of interest declined, and the Federal Reserve minimized the fed funds rate following the financial crisis in Asia. The unusual action was a rare effort to stabilizing the international condition through which the domestic policy is altered. The rare effort was the evidence of pinpointing the fed confidence in the flexibility of the policy. This evidence marks the first real sign of displacement. In this case, the displacement was shaping the expectations and the attitudes of the general economic environment. Speculative mania After this, there came a tech boom that established the speculation concerning the business end cycle. The tech bubble with different mania qualities busted in the late 2000. The Federal Reserve took the unusual aggressive and early policy action that cut across the rates of interest during the early 2001. The recession resulting was of reduced duration but got cushioned through the continued consumer spending following the lower taxes and increased rates. The expectation of the public was adjusted to some new realities. There existed actual reasons for one to have expectations that the interest rates were to remain reduced for a long duration of time and the central bank had to warm well in the advances of different policy changes and the policy of the government including the monetary and the fiscal which worked aggressively in avoiding any unpleasantness of the economy. The acceleration of the financial innovation occurred due to relevant generators of risks such as the high interest rates or the uncertainty of the market. The rise in borrowing by the U.S growth money accelerated. In the bubble’s mania or peak, the people considered being ordinary were pulled into the process. The subprime market expansion over the true credit pulled in the new low income or the highly leveraged borrowers who were not part of the credit system. The shuttering of different commodities, hedge funds around the year 2007 were the initial sign of distress. The events were mixed by the bear steams that collapsed in the early 2008 when the financial crisis appeared to recover. In a contrarian view, the knell of death towards the speculative excesses happened when the fed and the treasury moved to launch the \Freddie Mac and the Fannie Mae into the custodianship. The institution were systematically relevant and essential in terms. Combining the in terms of the systems. Combining these instructions to form an ambiguous governance style did violet the beliefs which had established on the low rates of interest and the perfect foresight of the policy. T his undermined the operational conceptions within the markets for which the government security were. The authorities of the policy directly contravened the expectation of the market in whatever was considered to be the largest market of security in the world. This lead to the introduction of the basic financial system to be handled. The growth of CDO markets created new derivatives within themselves, with “the speculators who flipped houses to the mortgage brokers who scouted the loans, to the lenders who issued the mortgages, to the financial firms that created the MBSs, CDOs, CDO2s and synthetic CDOs”. Unlikely the CDOs, backed by the pools of loans, mortgages or bonds, CDO2s were backed by CDO tranches, which meant that the risk was no concentrated rather than being dispersed. CDSs played an essential role in the development of CDO2s. CDSs were the bets on the real mortgage-related securities and their performances. As it was possible to place multiple bets on the same securities, the losses incurred from a collapse of those securities were multiplied. The CRAs rated more than 70% of CDOs and MBSs with Triple-A, which then developed into these new derivatives as there were high bility for gaming when any asset was able to be channned using securitization thus transforming into a triple A asset rated, whenever a billion dollar industry is extremely eager to enhance the alchemy. There were also social and cultural problems in the Speculative Mania stage, such as the executive pay in the financial organisations. The executive pays were based on their performances, which encouraged them to focus on short-term goals to maximizecompensation rather than to concern about firm’s long-term value. Bebchuk et al (2009) supported this view as they argued, the performance-based compensation system of the two companies, Lehman Brothers and Bear Stearns. The cultural problem was encouraging US citizens to invest into homeownership, not only by the slogan, ‘Ownership Society’, under the Bush administration, but also through social-medias such as a TV program ‘Flip that House and Property Ladder’. Such a social movement was supported by neoliberal economic thinking, represented by financialization, as homeownership was symbolized as an old age safe net and a reputable investment and house prices dramatically increased during the last decade. Some economists warned about the risks associated with the growth of financial markets, for example, RaghuramRajan presented a paper alerting the expansion of a danger level of risks. Distress, crash and panic. The whole crisis resulted into the last stage. This stage was referred by Kindleberger distress, crash, and panic. In the panic stage, people had to switch out of the financial or real asset to money to repay this as the wealth store. In the stage of revolution, the banks stopped to lend calling for the collateral. The stage of revulsion advances up to when the prices of the assets are extremely low to an extent where people are tempted to shift into illiquid assets. The trade ability was reduced by the help of triggers and the floor of price together with the last lender had people convinced that the money was to be made available to satisfy their demands. The book of Kindleberg has been revised a number of times. His current edition of the financial crisis had a number of conclusions. Firstly the financial crises are expected to be part of the process. If one fails to understand the whole process and the manner in which it is connected to the economy, and the expectations of the economy that are unreal, it would not be easy to take the actions that could have the future financial crisis tamed. Secondly, the financial crisis came up as a result of excessive optimism regarding the innovation, policy control, and economic prospects. In this case, optimism is one vital driver of the economic and innovation growth. Humans need to be contending with the contradictions. One central policy involves some questions on the manner of controlling the money avenues expansion, personal demanded credit, and the personal wealth. One vital indicator involved the requirement of crash which is relatively low to the prospective and the prevailing price. Thirdly, jaw boning may not be helpful. History be littered with the treasury and central bankers officials who cautioned against the use of the terms of the irrational exuberance. The displacement process may take a longer duration, but the actual period can be very short mostly a few years. Similarly the revulsion may equally take years. Lastly, different modern financial crises can be said to be international in terms of scope. In this regard, the challenge of the international and domestic policy makers that the actions supported in the crisis became politically obsolete whenever the economy experience recovery. It may be possible but not practical in imposing the regulations stringency of the financial agents together with the institutions causing them to work against the existing economic policy and political will. [The Collapse of Lehman Brothers in Reference to the Financial Crisis] Introduction to the Collapse of Lehman Brothers On September 15 2008, Lehman Brothers, a financial services firm filed for bankruptcy protection (chapter 11). This has remained the largest bankruptcy filling in the history of the United States, with Lehman brothers holding well over 600 USD billion in assets. The Lehman’s assets surpassed the previous bankrupt giants such as Enron, and WorldCom. During its collapse, it was the fourth largest United States Investment bank. It had 25000 employees worldwide. Lehman holding’s demise also made the bank to be the largest victim among the United States subprime mortgage-induced financial crisis, which swept across the global financial market. The collapse of Lehman was a seminal event that largely contributed to the 2008 financial crisis. It also contributed to the 2008 erosion of about 10 trillion USD in market capitalization from the global equity. This was the biggest ever monthly decline. The group had a humble origin. It traces its roots to a small general stores, which was founded in 1844 by Henry Lehman in Montgomery (a German immigrant). In 1850, he (Henry Lehman) alongside his two brothers, Mayer and Emmanuel founded Lehman Brothers. In the following decades so the firm prosper with the growing of the U.S. economy, which transformed into an international powerhouse. There were, however, many challenges that the firm contented with them. Through proper strategies, the firm successfully overcame these challenges. Some of the most notable challenges included the 1800s railroad bankrutcies, the 1930s Great Depression, the 1994 capital shortage during when the firm was spun off by an American Express, the Long Term Capital Management collapse, the 1998 Russian debt default, and the two world wars. However, despite the firm’s ability to survive many disasters, the United States housing market collapse ultimately brought it to its collapse. The firm’s headlong rush into investing in the subprime mortgage market was disastrous. Graph2: Lehman Brothers Inc: Net Revenues vs. Employee compensation1 The Prime Culprits With the United States housing boom underway, in 2003 and 2004, the Lehman brothers acquired 5 mortgage lenders. These included Aurora Lon Services, and subprime lender BNC Mortgage. These firms dealt in ALT-A loans, which allowed borrowers to take loans without full documentation. At first, Lehman’s acquisitions seemed prescient as it recorded revenues from its real estate businesses which enabled revenues collected in the capital markets to surge 56 percent between 2004 and 2006. This was somewhat faster rate of growth when compared to other related businesses within the asset management or investment banking. In 2006, the firm was able to securitize 146 billion USD of mortgages, which was 10 percent increase from the previous year. In the subsequent years (2005 and 2007) the firm recorded profits. In 2007, it was able to record a net income of 4.2 billion USD on revenue of the $19.3 billion. Lehman’s Colossal Miscalculation The U.S stock reached a record of about $ 86.19 in February 2007. This gave the firm a market capitalization of about $ 60 billion. However, cracks in the United States housing market, were already becoming apparent in the first quarter. At the same time the defaults on subprime mortgages increased to 7-year high. On March 14, 2007, Lehman recorded profits and revenues for the fiscal first quarter. The firm’s chief financial officer, in a post-earnings conference call, indicated that any risk posed by the rising home delinquencies were contained and were not to impact on the earnings of the firm. Besides, the CEO noted that there was no foreseeable problems with regard to subprime market hurting the U.S. economy or spreading to other housing markets. The Beginning of the End In August 2007, the credit crisis erupted and the two Bear Streams hedge funds failed. The stock for the firm dropped sharply. In this month, the firm eliminated 2,500 mortgage-related jobs. It also shut down the BNC unit and closed its Alt-A lender Aurora offices in three states. Even with the U.S. housing market gaining momentum, the firm continued to leading in the mortgage market. The firm underwrote well over mortgage-backed securities in 2007 than any other firm. It accumulated a portfolio worth $ 85 billion. This was four times the firm’s equity shareholders. In 2007, in the fourth quarter, the firm’s stock rebounded. During this period the global market approached new highs with the prices for the fixed-income assets staging a temporal rebound. However, Lehman did not seize this opportunity and use it to help trim its massive mortgage portfolio. Hurtling Toward Failure In 2007, the firm’s high degree of leveraging the ratio of its total assets to equity of shareholders was 31. The large portfolio of the mortgage securities for the firm made it to be increasingly vulnerable to worsening market conditions. In the following year, on March 17, after the Bear Stearns’ near-collapse, Lehman’s shares dropped as much as 48 percent on the concern that it would become the next Wall Street organization to fail. In April, the very year, the company regained some confidence after raising about $ 4 billion through the preferred stock issue, which was converted into its shares at premium of 32 percent to the company’s price. The stock later resumed declining with the managers of the hedge fund questioning the evaluation done by the mortgage portfolio of Lehman. The Lehman announced, on June 9 a second-quarter $2.8 billion loss. This was the firm’s loss since the period it was spun off by the American Express. The firm also indicated that it had $6 billion that it had raised from its investors. It further indicated that it had increased its liquidity pool with a $45 billion, reduced its exposure to commercial and residential mortgages by 20 percent, reduced its gross assets by 147 billion USD, and reduced leverage from 32 to 25. Graph2: Lehman Brothers Inc: Net Revenues vs. Employee compensation2 Liquidity Crisis The measures put in place by the firm were perceived as too little and too late. During summer, the firm’s management made a number of unsuccessful overtures to several potential partners. In the 1st week of September, 2008, the stock reached 77 percent, amid plummeting equity worldwide markets, with the investors questioning Richard Fuld’s (COE) plan of keeping the Lehman independent by spinning off the firm’s commercial real estate assets and selling part of the firm’s management unit. It was hoped that the state-owned South Korean bank, the Korea Development Bank, have stake in the firm were dashed off on September 9, 2008, following the Bank’s decision to put the talks on hold. This was a big deathblow to the firm. This lead to a 45 percent plunge in stock and a further 66 percent spike in its credit-default swaps on its debt. Clients of the hedge fund started pulling out. Its short-term creditors opted to cut credit lines. On 10 September, the firm pre-announced a dismal fiscal results. This underscored its financial position. It further recorded a $3.9 billion loss. This included a $5.6 billion write-down. It also announced a strategic sweeping restructuring of its own businesses. That same day, another investor, the Moody’s Investor Services made an announcement that it was considering the credit ratings of Lehman. It also indicated that Lehman would be forced to sell off its majority stake to other strategic partners if it has to avoid a downgrade rating. This lead to a 42 percent plunging in the stock market. Remaining with only $ I billion in cash by the end of the given week, the firm was running out of time. Its last-ditch efforts during the weekend of 13 September between Bank of America, Barclays PLC, and Lehman, aimed at facilitating its takeover, were not successful. This last effort made the firm to declare bankruptcy, which resulted in the plunging of the stock by 93 percent. Graph 3: Lehman Brothers Stock Price History Chart3 Conclusion The collapse of Lehman roiled global financial markets for several weeks owing to the firm’s size as a key player in internationally and in the U.S. Many questioned the decision of the government of the United States to allow the Lehman to fail compared to the support it gave to Bear Stearns. The bankruptcy of Lehman resulted to well over $46 billion of the firm’s market value being removed. The collapse of the firm was also a catalyst for the Bank of America purchase of Merrill Lynch in the mergence deal, which was announced on 15 September. Read More