Describe the collapse of the Lehman Brothers in 2008. Some institutional investo

Question

Describe the collapse of the Lehman Brothers in 2008. Some institutional investors were concerned that Lehman Brothers might have been overstating its earnings in 2007 and early 2008. Explain why more complete and accurate disclosure by banks and other financial institutions may help to resolve financial problems.

During the credit crisis in the 2008 – 2009, banks were criticized for restricting their credit. Do you think banks should be allowed to restrict their credit during the credit crisis? Why or Why not?

Explain why the credit crisis caused concerns about systemic risk.

During the credit crisis, the government was attempting to prevent failures of banks. Explain why the moral hazard problem may have received so much attention during the credit crisis. Explain why regulators might argue that the assistance they provided to Bear Stearns was necessary.

Explanation / Answer

On 15 September 2008, financial markets around the world convulsed in sheer panic. In New York, the Dow Jones Industrial Index suffered one of its biggest-ever falls, falling 504 points (down 4.4%) in a single session. On this side of the Atlantic, the FTSE 100 index tumbled almost a tenth (9.9%) in the four days to 18 September. While stock markets plunged, the cost of credit soared, with credit spreads blowing out to record levels. This was no ordinary financial crisis.

The answer is the bankruptcy of a company, but this was no ordinary bankruptcy and no ordinary company. On Sunday, 14 September, leading US investment bank Lehman Brothers -- having failed to be rescued by a buyer or a government bailout -- went under.The bankruptcy of Lehman rocked the financial system to its core, not least because it was the biggest corporate bankruptcy in US history. With over $600 billion in assets to administer, Lehman's bankruptcy was many times more complex than Enron's failure in 2001. Also, as a leading investment bank, Lehman was deeply plumbed into the global financial system, thanks to a spider web of companies, contacts and contracts around the world.

During the good times, the best way to enhance your returns is to 'gear up' by borrowing money to invest in assets which are rising in value. This enables you to 'leverage' (magnify) your returns, which is particularly useful when interest rates are low. However, leverage cuts both ways, as it also magnifies your losses when asset prices fall. (Witness the recent return of negative equity to the UK property market.)

A sensibly run retail bank would have leverage of, say, 12 times. In other words, for every £1 of cash and other readily available capital, it would lend £12. In 2004, Lehman's leverage was running at 20. Later, it rose past the twenties and thirties before peaking at an incredible 44 in 2007. Thus, Lehman was leveraged 44 to 1 when asset prices began heading south. Think of it this way: it's a bit like someone on a wage of £10,000 buying a house using a £440,000 mortgage. If property prices started to slide, or interest rates moved up, then this borrower would be doomed. Thanks to its sky-high leverage, Lehman was in a similar pickle.

Most businesses fail not because of lack of profits but because of cash-flow problems. Like all banks, Lehman was an upturned pyramid balanced on a small sliver of cash. Although it had a massive asset base (and equally impressive liabilities), Lehman didn't have enough in the way of liquidity. In other words, it lacked ready cash and other easily sold assets.

As markets fell, other banks started to worry about Lehman's shaky finances, so they moved to protect their own interests by pulling Lehman's lines of credit. This meant that Lehman was losing liquidity fast, which is a dangerous state for any bank. Only six months earlier, in March 2008, Lehman rival Bear Stearns faced a similar loss of liquidity before JPMorgan Chase rode to its rescue. Believing that Lehman did not have enough liquidity at hand, other banks refused to trade with it. Once a bank loses market confidence, it loses everything. Being unable to trade meant that Lehman and its business ceased to exist in other banks' eyes.

After the terrorist attacks of 11 September 2001, US interest rates plummeted, causing a five-year boom in domestic and commercial property prices. This boom ended in 2006 and US housing prices have since fallen for three years in a row.

Lehman was heavily exposed to the US real-estate market, having been the largest underwriter of property loans in 2007. By the end of that year, Lehman had over $60 billion invested in commercial real estate (CRE) and was very big in subprime mortgages (loans to risky homebuyers). Also, it had huge exposure to innovative yet arcane investments such as collateralised debt obligations (CDO) and credit default swaps (CDS). As property prices crashed and repossessions and arrears sky-rocketed, Lehman was caught in a perfect storm. In its third-quarter results, Lehman announced a $2.5 billion write-down due to its exposure to commercial real estate. Lehman's total announced losses in 2008 came to $6.5 billion, but there was far more 'toxic waste' waiting to be unearthed.

What is systemic risk? Is the current financial crisis an example of systemic risk becoming a reality? Policy development, like the practice of medicine, is a process of diagnosis and prescription. First we have to understand what exactly we are dealing with, and then we must adopt solutions that are tailored to address it. If we want to prevent another crisis like this one in the future, we should adopt policies that are directed at that goal, not at problems we do not have. If the current crisis is not the result of systemic risk, it would do no good–and might do substantial harm–to adopt policies designed to curb or control it. This Outlook will attempt to define what is meant by systemic risk and will compare that definition to what we know thus far about the causes of the financial crisis. This is only a preliminary and tentative effort; there is much still to be learned about the causes of the crisis, but it is useful to establish a framework for judging whether what we are facing today is the result of a failure of our current regulatory system to address and contain systemic risk. The classic case of systemic risk arises in the banking system and has been defined as “the probability that cumulative losses will occur from an event that ignites a series of successive losses along a chain of institutions or markets.” It envisions a cascade of losses flowing from the failure of a single large bank, brought on by the interconnections of the banking and payment systems. If a large bank cannot meet its obligations at the end of a business day, other banks–awaiting a payment from the failing bank–cannot meet their own obligations, and so on down the chain. Unless the supervisors act quickly, the result could be losses throughout the banking system and the economy; hence, a systemic event. There is also a broader concept of systemic risk, focusing on markets rather than institutions. The Commodity Futures Trading Commission defines it as “the risk that a default by one market participant will have repercussions on other participants due to the interlocking nature of financial markets. For example, Customer A’s default in X market may affect Intermediary B’s ability to fulfill its obligations in Markets X, Y and Z.” For example, credit default swaps (CDSs) have been blamed by many commentators–including some as sophisticated as George Soros–for creating “interconnectedness” among financial institutions that has made it possible to transmit losses from one institution to others. If this interconnectedness is in fact a significant contributing factor to current market conditions, then serious consideration should be given to regulations that control or limit it. But if interconnectedness is not a causal factor in the current crisis, it would be a serious error to restrict the use of CDSs, which are also very important and effective hedging and risk management tools for financial institutions and others. In fact, if the transmission of losses from one institution or market to another is not a factor in the current crisis, restricting the use of CDSs would, on the whole, increase rather than reduce the risks of financial institutions–without doing anything to reduce significantly the likelihood of similar financial crises in the future.

Now Bear Stearns was being bailed out by the Fed via JPMorgan Chase, which was buying the troubled firm for $2 a share. And as one might expect, the finger-pointing and recriminations had already begun. Bear Chairman Jimmy Cayne was at a bridge tournament in Detroit while the Fed was arranging the bailout package, which didn't help the perception that management wasn't paying enough attention to looming catastrophes. The Fed itself was dodging criticism from people who worry that its willingness to play lender of last resort to the embattled brokerage would cause similar institutions to expect that their worst mistakes could be fixed with a Fed bailout.These were not irrelevant concerns, but regardless of whether Jimmy was playing bridge while Bear burned or whether the Fed was going to find itself perpetually crowbarring financial institutions out of the corners into which they've wedged themselves, bailout was the least disastrous possible outcome. If Bear had been left alone to collapse under the weight of its own problems, the broader effects would have been devastating.The alternative would have been to let Bear slide into a Chapter 11 bankruptcy, which would have happened quickly. Among other things, Moody's, S&P, and Fitch all downgraded Bear, potentially forcing the firm to put up additional collateral to meet the requirements of a credit-default swap triggered by the downgrades—collateral it didn't have. Bear notionally held $13 trillion in derivatives contracts, and even if credit-default swaps were only a small fraction of that, any sort of credit event would have been catastrophic for both Bear and its buyers, the latter of whom would find themselves holding guarantees from a firm that was not in a position to guarantee anything.

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