Lehman Brothers Holdings, Inc. Essay

Lehman Brothers Holdings, Inc. Essay

Reasons of Lehman Brothers Failure

Lehman Brothers was one of the five largest investment banks in USA and was regarded as the leader in fixed interest transactions. The bank had a substantial amount of investment in the subprime mortgage market of America. When the investments in this market were rejected as being very risky, the confidence of investors in Lehman Brothers decreased and the share prices started declining. In 2007 the bank made write downs of $700 million and this write down amount rocketed to $7.8 billion in 2008 and the largest loss of the bank’s history was reported. Even after this tremendous write down of value the bank had a risky investment of $54 billion in mortgage securities. The problem for Lehman Brothers was worsened by the financial policy of the management as the bank had a very high level leverage of 30 to 1 and high dependence on short term financing (Zingales). After the record loss the shares of the company took a nosedive by shedding 95 percent in prices. Although the bank had a substantial amount of cash reserves the shareholders lost confidence in the bank when on August 22, 2008 the talks of the state owned Korea Development Bank acquisition of Lehman Brothers came to a halt. On September 10, 2008 the bank reported a loss of $3.9 billion and Barclays Bank also pulled out of the possible buyout of Lehman Brothers. The bank filed for chapter 11 bankruptcy protections on September 14, 2008 (Sorkin). Another catalyst in the failure of Lehman Brothers was the fact that the overall economic environment was unstable and financial and insurance giants like Bear Stearns, Merrill Lynch and AIG were also in crisis.

The Effects of Lehman Brothers Bankruptcy on U.S. and World Financial Systems

The bankruptcy of Lehman Brothers and acquisition of Merrill Lynch had a domino effect on the US and world economies causing the stock markets around the globe to crash. The failure of financial giants not only affected the US financial sector but also the global financial sector as the US Federal Reserves, European Central Banks and Bank of England had to intervene in the money markets and provide billions of dollars of liquidity to ease the money markets. Even though the central banks intervened in the money markets, stock markets of Asia and Europe fell by 5 percent, the oil prices went over $93 per barrel and the dollar lost significant value. The European and British central banks introduced $43 and $9 billion respectively in money markets in the aftermath of the Lehman Brothers failure. The German finance ministry was optimistic that the affects of Lehman Brothers on German banks could be handled. The Japanese regulatory authority ordered the Lehman Brothers Japanese operations to keep certain assets in Japan. A group of 10 big banks showed the intention of providing $70 billion to ease the global credit crunch (Agence France Presse). The financial system was a Pandora’s Box waiting to be opened and when one bank went under other giants followed in a domino effect. The three main flaws in the financial system were market satisfaction, bad regulation and deficiency of transparency. In answer to question one it was mentioned that the leverage ratio of Lehman Brothers was 30 to 1 while the regulation states that banks cannot have a leverage ratio greater than 15 to 1. The instability of the financial system is quite obvious as the banks started failing one after another. The regulations were so loose that banks not only lent money ignoring the set standards, the prime factors of credit analysis were ignored thus the name subprime mortgages. The worst hit financial sector was the money market. There were also some money market funds which were directly affected by the collapse of Lehman Brothers due to heavy investment in the bank. One such example is of $62 billion Primary Fund, the fund had to suspend redemptions for seven days because of losses suffered on a $785 million investment in Lehman Brothers. According to Zingales it only cost $2.50 to insure $100 worth of investment in junk bonds but after the crisis the cost has risen over $6 (Zingales).

Impact of Financial Crisis on Real Sector

United States of America is the world’s largest economy and the GDP of USA makes up for 21 percent of the gross world product. The GDP per capita is eleventh in the world and GDP measured by purchasing power parity basis was $13.8 trillion in 2007. The financial crisis which started in 2008 has had a great impact on the GDP growth rate and the country is in recession due to negative growth.

Year

March

June

September

December

Average

2008

2.5

2.1

0.7

-0.8

1.13

2009

-2.6

-2.6

Source: Tradingeconomics.com

As we can see from the quarterly growth rates of GDP during 2008 and 2009 growth declined from 2.5 in the first quarter to -0.8 in the last quarter of 2008 which further declined to -2.6 in 2009 which shows how significantly the financial crisis has affected the real sector and GDP and a negative growth in GDP of a country indicates a recession. The labor market, housing industry and equity markets have seen a sharp decline from 2008 to 2009. The outlook for the next quarter is also bleak as the trend in data of labor and housing is quite depressing with jobless rate at 8.9 percent and the current account deficit at -133 (Fedec).

Actions Taken by Federal Reserve to Solve the Financial Crisis

The Federal Reserve took many initiatives during September 2008 and March 2009 in order to solve the financial crisis. The first step taken was to enhance the liquidity facilities provided to banks and financial institutions. The step was taken in broadening of collateral for Primary Dealer Credit Facility – PDCF and Term Securities Lending Facility – TSLF. The auctions of TSLF were set to be conducted each week instead of every two weeks and the amounts in these auctions were increased from $125 billion to a total of $150 billion. The Federal Reserve authorized the Federal Reserve Bank of New York to lend $85 billion to American International Group – AIG for a 24 month term. The Federal Open Market Committee of The Federal Reserve also authorized an expansion of the temporary reciprocal currency arrangements – swap line by $180 billion in collaboration with ECB and Swiss National Bank. The board approved rules to offer liquidity to markets by providing loans to the banking sector to help finance purchase of Asset Backed Commercial Paper – ABCP. The board broadened liquidity support further through Term Auction Facility by offering $150 billion on 28 days credit. The Money Market Investor Funding Facility was changed by adding new money market investors other than money market mutual funds to facilitate liquidity structure of money markets. In January 2009 the bank published a policy that would help avoid needless foreclosures on mortgage assets held by banks. The Federal Reserve also announced that it would purchase $1.15 trillion in assets including mortgage backed securities, treasuries and agencies. In March 2009 a joint statement was issued by the Federal Reserve and the Treasury which indicated the points of agreement between both entities. The statement mentioned that the cooperation between the Reserve and Treasury was necessary to promote financial stability. The Federal Reserve was to avoid credit risk and credit allocation, attention to protect monetary stability and protection of important financial institutions were highlighted in the statement (Board of Governors of The Federal Reserve).

Actions Taken by U.S. Treasury to Solve the Financial Crisis

The major step taken by the U.S. Treasury immediately after the collapse of Lehman Brothers was to propose a $700 billion emergency bailout package for the financial crisis. The Emergency Economic Stabilization Act authorizes the Treasury to spend $700 billion to increase liquidity of the banks and purchase suffering assets, like mortgage backed securities and provide capital to the banks. The Bill was approved by the Senate and Congress and signed by President Bush within hours of enactment (Clark). In September the U.S Treasury took control of Fannie Mae and Freddie Mac to ease the financial pressure. In 2009 the U.S. Treasury proposed a $787 billion stimulus plan backed by the Obama administration which was approved by the Congress as the American Recovery and Reinvestment Act of 2009 to help in the recovery from the financial crisis. The plan involves provisions of spending, tax cuts and aid to families of the workers laid off in the aftermath of the financial crisis (Hitt and Weisman). As mentioned in the answer to the previous question the Treasury also highlighted the need of improved cooperation with Federal Reserve to resolve the crisis in a joint statement with the Federal Reserve.

Effects of Steps Taken by Federal Reserve and Treasury on Financial Markets

The steps taken by the U.S Federal Reserve and Treasury have affected the financial markets in various ways. First we look at the Federal Reserve policy to buy commercial paper with a term of three months; this policy was aimed at providing short term liquidity to the market. The market worsened during the financial crisis in September but the commercial paper market has shown improvements after the implementation of this policy as the spreads of rates and risk have declined and the maturity has increased. The asset backed securities program which is the joint initiative of the Federal Reserve and Treasury which is meant for long term loans with the terms of three years will show signs of improvement in the near future as the impact of these loans has yet to come as the program will help decrease the rates and increase the opportunity for consumers, small business loans and private lending. The plan of the Federal Reserve to buy $100 billion and $500 billion in Government sponsored enterprise debt and mortgage backed securities over a period of time has helped lower the mortgage rates which are declining further which would support the housing sector in the time to come. The policies of the Federal Reserve help in lowering the interest rates and ease the credit crunch in various markets (Bernanke).

Long Run Implications of the Actions taken by U.S. Federal Reserve and Treasury

The initiatives taken by the U.S Treasury department and the Federal Reserve may have short term advantages for the financial markets and the economy but on a long run basis these actions would not help the economy to grow. According to the Congressional Budget Office by 2019 the stimulus package will reduce GDP by an estimated 0.1 to 0.3 percent on net. The benefits would be seen in 2009 and 2010 which is a very short period of time but in the long run it would affect the Government debt substantially resulting in a decrease of GDP (Christ). The crisis was a result of bad regulations and subprime lending. The long run solution to this problem would be to make the regulatory framework more efficient in order to control the lending process. If the banks start lending money on low rated mortgage securities with high risks in anticipation of higher profits we could face a similar problem in the years to come. The current liquidity crunch would be diminished by these steps but in the future, steps have to be taken to avoid such an economic crisis.

Works Cited

Agence France Presse. Lehman Bankruptcy Shakes World Financial System. 15 September 2008. 28 May 2009 <http://afp.google.com/article/ALeqM5jpt_IYodoYFExtXjP_ywRRFR9NQw>.

Bernanke, B. The Crisis and the Policy Response. Lecture. London: London School of Economics, 2009.

Board of Governors of The Federal Reserve. Information Regarding Recent Federal Reserve Actions. 21 May 2009. 29 May 2009 <http://www.federalreserve.gov/newsevents/recentactions200903.htm>.

Christ, S. CBO Deems Obama Stimulus Package Harmful Long Term. 6 February 2009. 29 May 2009 <http://www.wealthdaily.com/articles/cbo-stimulus+package-demint/1686>.

Clark, A. Financial Crisis: Paulson Calls for Rest of World to Copy America’s $700 billion Financial Bail-out. 22 September 2008. 29 May 2009 <http://www.guardian.co.uk/business/2008/sep/22/wallstreet.marketturmoil>.

Fedec, A. United States GDP Growth Rate. 5 May 2009. 29 May 2009 <http://www.tradingeconomics.com/Economics/GDP-Growth.aspx?Symbol=USD>.

Hitt, G. and J. Weisman. Recovery Package Gets Congressional Approval. 14 February 2009. 29 May 2009 <http://online.wsj.com/article/SB123453885966183349.html>.

Sorkin, A. Lehman Files for Bankruptcy; Merrill Is Sold. 14 September 2008. 27 May 2009 <http://www.nytimes.com/2008/09/15/business/15lehman.html?_r=1&hp&oref=slogin>.

Zingales, L. Causes and Effects of the Lehman Brothers Bankruptcy. Testimony. Washington: United States House of Representatives, 2008.

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