Financial Crisis and Lehman Brothers (Case Report)
Financial Crisis and Lehman Brothers Case Report
Starting in 2002, spectacular growth has taken place in the financial services and the entire industry was booming several years afterward. By the mid of 2007, the world economy began mutated into downturn markedly and the financial crisis burst. It is widespread that the global financial crisis of 2007-2010 has been considered the largest and most calamitous financial catastrophe since the Great Depression of 1930s; even now the impact still remains significant. Lehman Brothers, the fourth largest investment bank in the U.S., was collapsed in September 2008, which signalled a profound and enduring global financial crisis.
Should we account of its causes focus on the world of finance alone? The answer is absolutely not. Finance is inherently volatile and a financial crisis refers to a situation when a country or a region’s financial market is characterized by ‘a series of events beginning with an exogenous shock to the macro-economic system, opening up new sources of profit. This promise of future profits attracts speculators who enter the market, and the intensity of inflowing funds creates a bubble that ultimately bursts, resulting in crisis” (Granter & Tischer, 2014).
The causes of the financial crisis are complex and multi-dimensional. This paper reviews the literature on financial crisis focusing on two aspects. First, I will explain the crucial factors cause the financial crisis of 2007-2010. This comprises financial and economic causes as well as political failures. Based on this, I will illustrate the history and collapse of the Lehman Brothers to help understanding why the crisis took place.
1.2 U.S. Housing bubble
There is a general consensus that the global financial crisis was triggered by the credit crisis resulting from the bursting of the U.S. housing bubble. From the beginning of 2001, following the collapse of dot-com bubble, the large number of people were turn to investments in the real estate instead of stock market. The Americans were greatly encouraged to purchase homes as the public perception that the prices of the real estate will go up inevitably through time (Shiller, 2008). People buy the houses because there was a widely held belief that they are able to sell later at a profitable price. As a consequence of the increase in the demand of house ownership, the housing prices were rocketing up since 2003. U.S. Federal Reserve overestimated the power of housing wealth and continued to cut the interest rates and eventually lowered to only 1% and kept them for extended period in order to fuel the rocket. The excessively low interest rates motivated unprecedented upsurge in buying real estates.
Figure 1 Source: S&P Dow Jones Indices LLC
The chart above, S&P/Case-Shiller U.S. National Home Price Index (2015), shows the index levels for the real housing prices in the U.S. since 1975. We can see that the real estate prices experienced a rapid run-up over the period from 1997 to 2006, according to the index, American house prices increased by 125%. Unfortunately, after the housing price index peaked in July 2006 at 184.62, it plummeted year over year thereafter. In 2006, as interest rates started to increase, the delinquency rate on mortgages also started to rise. Verick and Islam (2010) have pointed out the main factor in driving delinquencies rise was the expiration of low teaser rates on sub-prime loans. As the housing prices continued to drop moderately in the U.S., refinancing became more difficult to the homeowners. The bubble burst and leaving numerous householders in a position of negative equity, which means mortgages greater than the total value of their homes. Since the homeowners default, the lenders get the houses and started adding risks to new mortgages and lend them to the disadvantaged and low income borrowers instead of credit-worthy borrowers, these riskier segments of the market were known as the subprime market.
1.3 Subprime Mortgage Crisis
The collapse of the real estate bubble brought about the subprime mortgage crisis. Decades ago, there was a considerable innovation that banks reform a new model where they can sell mortgages to the bond markets. Since mortgages are no longer been dominated by the government-sponsored agencies, the private institutions have remarkably expanded mortgage lending that they are major in new kind of mortgages such as subprime lending to borrowers. A subprime mortgage refers to a high-risk loan given to individuals who are not creditworthy and would not normally meet the rigorous standards by lending institutions (Selig, 2011). The interest rates on these subprime mortgages are typically higher than those for prime loans in order to compensate for the added risk associated with the subprime lending (NCRC, 2002). There was a significant growth of non-standard and non-prime mortgages during the years preceding the crisis, which including NINJA loans, ARMs, Alt-A and Jumbo loans.
Figure 2 Source: More Mortgage Meltdown
As Figure 2 shows, subprime loans never exceed far from $100 billion prior to 2002 and the percentage remained below 10% of total originations until 2004. Then the originated volume rose rapidly peaking at approximately $600 billion through 2005 to 2006, which is accounted for 20% of all mortgage origination. In the last quarter of 2006 and early 2007, with a large number of U.S. holders of subprime mortgages found they were unable to meet their mortgage repayments, subsequently resulting in the failure of several large mortgage brokers in February to the late summer 2007 (Blackburn, 2008).
Securitisation is a sophisticated process of converting illiquid loan assets to tradable securities that are backed by expected cash flows from these assets. This technique increases the capital availability and reduces the cost of capital, also enables issuers and investors to diversify systematic risk. The rapid growth of securitisation was considered as a fundamental factor leading up to the financial crisis. Historically, the mortgage market was dominated by the government sponsored enterprises (GSEs), which are Fannie Mae, Freddie Mac and Ginnie Mae. These financial institutions were buying mortgages from originators and packaging into mortgage-backed securities (MBSs) then selling to investors. These mortgages were rated ‘AAA’ by credit ratings agencies because they have the payment guarantee of GSEs.
However, as time went on, there was a dramatic expansion in securitisation of mortgage bonds after the deregulation of the financial market. The private institutions, particularly investment banks, became the new market force in issuing MBSs. These private labelled MBSs were designed with ‘the division of the securities backed by a pool of mortgages into a cash flow waterfall that allocated default risk on the mortgages by a hierarchy of tranches’ (Levitin, Pavlov & Wachter, 2009). Generally, the higher the tranche, the higher the credit rating, which means the tranche is relatively safer than a pool of high-risk mortgages. Oppositely, the lower tranches were associated with lower credit ratings and therefore paid the higher yields to compensate the investor for taking the risk, and the lowest tranches were the first to bear the losses if borrowers default.
There is another more complex form of financial instrument called Collateralized Debt Obligations (CDOs). CDOs are asset-backed securities that may include a combination of various forms of debt obligations, such as bonds, loans and mortgages. Banks repackaged the unsellable tranches of MBSs and then selling them as new products. Investment banks were hugely lucrative by selling the safest tranches to investors who are risk-averse, selling riskier tranches to risk-neutral investors and selling the lowest tranches to risk-takers such as hedge funds. More about CDOs will be discussed through the case of Lehman Brothers.
After packaging MBSs into CDOs, investment banks sought to add insurance to against the default on bond payments and mortgages, which is known as Credit Default Swaps (CDSs). The buyer of a CDS pays a premium to the seller, who agrees to cover losses in the event of a default (Tischer, 2015). However, CDSs were lack of transparency due to asymmetric information between counterparties, they were also unregulated, which ultimately created confusion and encouraged excessive risk taking (Berlatsky, 2010). It significantly influenced the financial market and made it vulnerable.
1.5 Risk Management
It is important for a financial institution to measure and manage the risks effectively. The main problem associated with the risk valuation models is that they were based on normal market conditions, therefore risks may not be accurately measured if firms apply the same mode under the abnormal market conditions such as financial crisis. Ashby (2010) states that some financial institutions placed excessive reliance on the quantitative models rather than qualitative models, which means they did not implement adequate risk management tools such as stress testing and scenario analysis, these would cause failures of implementing risk management. A successful risk management occurs when risk managers and senior managers are both aware about risk and consider carefully before making any strategic decisions, they also have to ‘act quickly and decisively when they find that their institution is exposed to an excessive degree of risk’ (Ashby, 2010). However, the senior managers may not always in favour of the risk actions done by the risk managers when there are conflicts of interests between risk management and senior management.
1.6 Relaxation of regulation (Deregulation)
The rise of neoliberal economics has strongly influenced the financial market regulation and policies that many changes were implemented since the beginning of 1970s. Lax regulation and deregulation of the financial system were considered as instrumental in causing the financial crisis. For example, the Glass-Steagall Act 1933, which separated the commercial banking from the investment banking activity, thereby impeding commercial banks from underwriting securities and preventing investment banks from engaging in deposit-taking activities (H.M. Treasury, 2009). It was repealed ultimately via Gramm-Leach-Bliley in 1999 because of the fast growing of capital flows and the expanding power of investment bankers.
Moreover, the U.S. Commodity Futures Modernization Act of 2000 (CFMA) enabled the self-regulation of the over-the-counter derivatives traded between sophisticated parties because finance lobbyists want to ‘open up lucrative markets based on their new-won ability to join commercial and investment activities’ (Granter & Tischer, 2014).
In addition, another vital deregulation action was taken place in 2004, when the Securities and Exchange Commission (S.E.C.) relaxed the net capital rule for five biggest investment banks, allowed them to maintain a high debt-equity ratio to fuel the growing of mortgage-backed securities. These investment firms, Goldman Sachs, Morgan Stanley, Merrill Lynch, Lehman Brothers and Bear Stearns, ‘substantially increased their debt, both increasing their risk of failure and enabling them to invest more heavily in riskier assets’ (Teall, 2012). Eventually, they were all failed and suffered significant financial distress during 2007-2009 and four of them were survived with bailout.
Last but not least, since interest rate became unusually low, investors were encouraged to sought new ways to make money as they were unable to receive decent yields from the treasury bills or municipal bonds. Therefore, both the growth and decline of housing market were caused by the loosened regulation, which ultimately result in financial crisis to some extent.
Leverage is a technique used to borrowing money to amplify the gains and losses of a deal. Excessive leverage was another crucial cause of financial crisis. The Figure 3 depicts all debt outstanding as a percentage of GDP, which shows that U.S. households and financial institutions became increasingly indebted from 1950s to 2007. According to the figure, from 1950s to early 1980s, the debt-to-GDP ratio remained under 150% then it sharply increased during the period preceding the financial crisis and reached more than 325% in 2007.
Figure 3 Source: Credit Writedowns
There are many different cause of excessive leverage. Firstly, the lax monetary policy in the U.S. has enabled debt and leverage became more affordable to households and companies. Secondly, when there was a decrease in the economic vitality in Great Moderation from mid-1980s, individuals and firms were encouraged to take more risks to improve financial returns. Moreover, financial innovation also benefited them to obtain finance or gearing. In addition, Chan (2011) pointed out another main causes of over-leveraging was market failure, which means the ‘market had been sending out wrong signals to the borrowers, be they households, companies or governments, that increased indebtedness was nothing to worry about’. Over-leveraging increased the vulnerability of financial institutions to a financial shock. As we mentioned previously, loosened regulation enabled five biggest financial investment banks to maintain a higher debt to equity ratio, which ended up in bankruptcy or being bailed out.
Lehman Brothers’ Case
- The background of Lehman Brothers
Lehman Brothers Holdings Inc. was one of the most profitable investment banks before the collapse. In 2007, Lehman reported record net income of $4.2 billion on revenue of $19.3 billion (Lehman Brothers Case Pack, 2015). The company’s stock price was peaked at $65.73 in January 2007 and dropped to only $3.65 in September 2008, which is approximately 95% of the January value (Valuka, 2010). On September 15, 2008, Lehman Brother filed for Chapter 11 bankruptcy protection with approximately $639 billion in assets and $613 billion in debts (Investopedia, 2009). The collapse of Lehman’s was marked the largest U.S. corporate bankruptcy in the history and it raised panic in the global financial markets.
Lehman Brothers experienced a significant success in the early/mid 2000s. The net revenue had gone up over 600% from $2.73 billion to $19.2 billion and the employee headcount had risen more than 230% from 8500 to 28600 since Lehman going public in 1994(Lehman Brothers Case Pack, 2015). What factors have driven such a big investment bank into collapse? This part of the report will analyse and evaluate the main causes of the failure of Lehman Brothers which including securitisation and the rating agencies, excessive leverage and Short-term funding as well as the collapse of market confidence.
The main reason for the collapse of the Lehman Brother’s case is over-using the mortgage-backed collateralized debt obligations (CDOs). As we mentioned in 1.4, banks construct an asset pool from buying various credit level bonds with different returns and risks, then repackaging and converting the asset pool into different risk and return level of financial products, which were then sold to the particular investors with different risk preferences and return expectations. The higher the return, the higher the risk and the lower the credit rating will be rated. Lower credit rating products have to bear the losses before the higher credit rating one collect their returns if the debt defaults. The assets (bonds) that bought by banks are usually mortgages with the assets from the originating bond sellers in appropriate valuation by credit rating agency. The credit rating agency are expected to rate the mortgages and the bond sellers accurately, however, it is difficult for them to have adequate information to achieve it in reality. Therefore, the flaws of asymmetric information occurred in this process, which means that the information holder, the originating bond sellers themselves, will provide unreal information in order to protect their credit rating.
In addition, Buiter (2008) identified that the credit rating agencies only rate default risk so the market risk and securities price risk were being neglected. Furthermore, agencies are paid to provide consultation services for the clients, teaching them to improve the rating of the assets. The credit rating should be updated rapidly to keep the reliability, but this is hard to achieve. As a result, the mortgages that were accepted by banks may be inappropriately rated by the agency, resulting in highly underestimate the risk level of securities, which will mislead investors and bank financial products’ rate setting.
In the Lehman Brothers case, over-using mortgage-backed collateralized debt obligations without accurate credit rating should be blamed as the main reason of its bankruptcy. According to the 2006-2007 annual report (Lehman, 2007), Lehman held $55.1 million of CDOs in 2006, and then dramatically rose to $581.2 million in 2007. Even though CDOs are designed to reduce risks through diversification, over expanded it may bring more risks without corresponding returns.
As the disadvantage mentioned above, the credit ratings are confused and the situation will become even worse because of the large amount of CDOs. In this case, Lehman expanded largely the number of CDOs to keep the leader position in the housing market, even though the housing market was tend to shrink from 2007. The fallen of housing prices depreciated the value and credit rating of mortgages, which decreased the true value of CDOs.
Unfortunately, Lehman underestimated this problem and still expanded CDOs rapidly. After the emergence of subprime crisis, most of banks and investors were unwilling to take any higher risk assets to protect themselves. Consequently, the large amounts of CDOs of Lehman Brothers were unable to be sold, which were eventually written down on the event of default. More than half of Lehman’s CDOs estimated at $431 billion, which originated in 2006-2007, were written into default by November 2008 (Valukas, 2010). The number of default CDOs was even worse after Lehman Brothers was estimated to collapse. The investors lost confidence with Lehman Brothers as they have significant illiquid assets, and they started to doubt the Lehman Brothers’ valuation system. The valuation control group of Lehman Brothers were blamed that the assets were valued by inappropriate models (Valukas, 2010). The valuation given by those models were misguided and leading to overestimate the CDOs of Lehman, which brought huge loss of wealth of investors.
Leverage level of a firm is defined as debt to equity proportion. By increasing the leverage level, firms are able to generate more revenues by taking more risks of accepting more debts. However, the loss of the investment will also be magnified by higher leverage and the risk of firm’s bankruptcy will be increased when there are losses of asset values. The pro-cyclical behaviour of leverage can be taken advantages, as during boomed economics, the higher leverage is likely to generate more incomes and the lower leverage during economic recession is likely to get rid of huge losses. The level of leverage will influence the credit rating of the financial institutions and it also has an impact on the confidence of investors, which means that higher leverage level will bring lower credit rating and less confidence of investors. As a result, the investors will choose a high credit rating bank with lower leverage and lower risk.
Figure 4 Source: Wikimedia Commons
Figure 4 depicts the leverage ratios for the U.S. five major investment banks, Lehman Brothers, Bear Steams, Merrill Lynch, Goldman Sachs and Morgan Stanley. According to the graph, we can find that each of these largest investment banks significantly increased their leverage ratios during the fiscal years of 2003 to 2007. Theoretically, 10-15 is a typical leverage ratio of a conservative bank. However, these firms had very high ratios which are closer to 30 or more than 30. All of the five firms reached the highest leverage level just preceding the crisis. Lehman was leveraged 31 times when asset prices fell in 200, it became increasingly vulnerable to the degenerated market conditions due to its huge portfolio of mortgage securities (Lehman Brothers Case Pack, 2015).
Before 2004, the regulator set the allowance of leverage is 12:1, but leverage level was allowed to beyond this level in 2004. Those changed allowed investment bank to generate more earnings from booms but lost more from recession. In 2007, every 1 dollar earning from shareholding came with 30 dollars earnings from leverage almost. Then the subprime crisis led to the collapse of housing market, which caused a large amount of low credit lenders insolvent because the mortgages become illiquid. Lehman Brothers underestimate the damage of the subprime market and insisted to be the largest trader of this market, holding a large amount of CDOs. Lehman Brothers was then unable to sell its securities and the assets became illiquid again. Even though Lehman Brothers previously earned huge profit by using high leverage, all revenues still cannot bail out this financial disaster.
2.4 Short-term Funding
As the financial crisis spread out in 2007, Lehman wanted to reduce the leverage, so they began to sell the assets into cash flows. However, it was not an appropriate time to sell the assets and pay back debts. Meanwhile, Lehman employed an accounting device named ‘REPO 105’ to manage its balance sheet, which is to short-term funding. The ‘REPO 105’ can be used to temporarily remove the illiquid assets off the balance sheet (Valukas, 2010). In a repo market, banks raise cash by selling some of the company’s asset with a simultaneous obligation to repurchase those assets just days after it sells it. These transactions will be accounted for ‘financings’ and remains on the company’s balance sheet.
However, when Lehman dealt with ‘REPO 105’, the asset was worth slightly more because it took less cash to repo. As the ‘accounting rules permitted transactions to be treated as sales rather than financings, so that the assets could be removed from the balance sheet’ (Valukas, 2010). This action has been described as the ‘accounting gimmick’ because it allowed Lehman to sell ‘packages of mortgages, T-bills, Eurobonds, even Canadian government instrument’ (Clark, 2010) and it created an illusion of Lehman’s financial conditions. This method has successfully helped Lehman to wiped out over $50 billion of assets from their balance sheet at the first two quarters of 2008 (Valukas, 2010). The ‘REPO 105’ has misled the credit rating agencies and regulators. Lehman relies heavily on‘REPO 105’ indicates that it neglect the sustainability of this accounting model, which ultimately drove them into the bankruptcy.
2.5 Collapse of market confidence
Loss of confidence is another cause to the failure of Lehman. Basically, Lehman Brothers collapsed because it ran out of cash. Consequently, it lost the ability to pay back the debt and this fact pulled Lehman’s credit lines. After the loss of credit, other banks refused to trade with Lehman because they perceived it associated with high risky. Therefore, Lehman had neither credit nor business, it ultimately involved in the crisis of confidence. There were moral hazard issues between Lehman and the government. The senior management of Lehman Brothers did not recognise the excessive risks they were taking because they were in belief that the Federal Reserve and U.S. government would bail it out. Unfortunately, government refused to bail it out and eventually Lehman declared bankruptcy on 15 September 2008.
The financial crisis of 2007-2010 had considerable impact on the individuals and institutions worldwide. The emergence of the global financial crisis has to be taken into account that was not only caused by the finance, but also caused by economic, political and other dimensions. The bust of U.S. housing bubble triggered the crisis and brought about the subprime mortgage crisis. The lax regulation of financial system has lead the investors into the financial innovation, poor risk management ultimately result in excessive leverage. Liquidity crisis triggered while investors began to lose market confidence. The combination of these factors together made the financial crisis spiral out of control. Consequently causing large number of financial institutions meltdown, which include the collapse of the world’s fourth biggest investment bank, Lehman Brothers.
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