THE COLLAPSE OF LEHMAN BROTHERS SOLUTIONS - CASE STUDY
THE COLLAPSE OF Lehman Brothers
QUESTION NO 01
Could the Fed save Lehman Brothers from bankruptcy? How?
Lehman Brothers Holdings Inc. officially announced its bankruptcy on 15th September, 2008 on Monday. It filed bankruptcy in the Bankruptcy Court of the United States for New York’s Southern District. It was the most dramatic financial crisis event in the duration of the financial crisis 2007 – 2008, after the Great Recession.
Many financial analysts and economists believe that the Federal Reserve Board which is the central banking system of the United States of America is somehow responsible for it. It could have saved Lehman Brothers from bankruptcy by making another loan to save it from crisis as it was the only bank to file bankruptcy at that time. It could have rescued the firm by lending them some money but the Fed officials reported that they did everything they could do to save it but actually it's not true. According to some, they lacked the legal authority to save them but that’s not true as well. One of the economists of Hopkins University, Laurence M. Balls wrote a book on Fed and Lehman Brothers and stated in it that the failure of Lehman Brothers could have been avoided but the policy makers were too clever to stop its failure.
Goldman Sachs says that the company borrowed short term loans with lower interest rates for lending and investment purposes. Later on, two weeks ago before being bankrupt, the company had borrowings worth $572 billion and assets worth $600 billion. The shareholder’s equity of the company was worth $28 billion and all these figures indicate that the company was much vulnerable. The decrease in equity would have negatively affected the assets value and if the lenders of the company wouldn’t have renewed their loans or other short-term borrowings all the assets value got dumped at lowest prices in the market. And unfortunately, all of these happened to Lehman Brothers Inc. Holdings.
If the Federal Reserve Board had lent money to the company, it wouldn’t have fallen to the financial crisis and gone bankrupt and could save it this way.
QUESTION NO. 02
Why did Lehman Brothers not manage to survive the mortgage crisis though they survived the great depression previously?
The Lehman Brothers survived the severe crisis of Great Depression of 1930s but could not manage the mortgage crisis due to following reasons:
Risk:
The company took too much risk without corresponding to the availability of cash and monitoring its ratio analysis. The company hadn’t enough assets that would have been sufficient to overcome its debt. The company did not have sufficient funds. Therefore, the cash flow problems led the company to bankruptcy and thus, failure.
Culture of company:
According to the Chief Risk Officer of the company, the top managers didn’t notice many risk factors and ignored risk – management practices.
Inaction of Regulator:
The Securities and Exchange Commission didn’t take action against too much risk taken by companies. If the regulator had warned the company about it, it wouldn’t have failed.
Owing BNC Mortgage; a subprime mortgage seller:
The company owned a subprime mortgage seller i.e. BNC Mortgage earlier but due to less sales of these low-rated and riskier mortgages resulted in the failure of the company due to the mortgage crisis.
Effect of subprime mortgage crash:
The mortgage crash of the company affected it so badly that during the first half months of 2008, the company lost almost 73 percent of its value.
Heavily exposed to the housing market
One of the main reasons of the company’s failure is its high exposure to the housing market.
Heavily exposed to the writing-off the default credit swap
The company’s exposure to the writing-off default credit swap has also caused its failure.
Overconfidence:
The problem occurred when the firm completely relied on the data of growth of quick real-estate. In 2006, the firm bought more from the commercial real-estate and bought more loans instead of selling the prior ones. The management were overconfident that borrowing more will increase the money but real-estate prices fell and the situation worsened that caused the company's failure.
Cash Flow problems:
The company faces cash flow problems when it does not maintain its liquidity and profitability ratios. If the company has not enough assets that could overcome its debt, it would definitely face loss. Same happened with the Lehman Brothers, they did not notice the availability of cash and assets and its debt value increased over assets and its liquidity fell. In 2008, the company had debt of $613 billion whereas had assets of $639 billion which are enough to cover the debt but the problem was that it was difficult to sell the asset. This led to the cashflow problems of the company.
QUESTION NO. 03
In your opinion, can asymmetric problem be blamed (partially) for what happened?
Yes, asymmetric information can be blamed for the company’s failure. This can be considered as one of the main reasons for the failure of a company. Asymmetric information is considered to be a problem in the borrowing and lending financial markets. The borrower is known to have more better information as compared to the lender, about his own financial condition but this information is limited information. The result is that the buyer is charged higher for compensating the risks. The company was selling the riskier products i.e. Mortgage backed securities that caused the lender to charge higher interest, resulting in the company’s failure.
The intermediation of information was an important factor in financial and commercial USA and other countries during the financial crisis of 2007 – 2008. (FCIC, 2010) The presence of complex financing instruments has increased the phenomena of asymmetric information. Also, the smaller crisis in the period of financial crisis were due to the asymmetric information. It is due to the deficiency of the Securities and Exchange Commission and other financial regulators that didn’t monitor the flow of information and didn’t maintain the risks.
Thus, asymmetric information can be blamed partially for the company’s failure.
QUESTION NO. 04
Are rating agencies liable for the financial crisis? Explain.
Somehow, credit rating agencies can be blamed for the financial crisis as during this period, many securities related to mortgages were given high ratings despite being worthless. The worthless securities are titled as safest and highest investment grade.
Credit rating agencies are present because of the asymmetry of information between lenders and borrowers. These are important for both parties as they remove the communication barriers between the parties and different nations. During the crisis, the rating agencies were being blamed for the interest conflicts and methodology flaws in the financial reporting products.
The credit rating agencies' impact remains unaccountable and highly criticized during the financial crisis. The Lehman Brothers was downgraded by the rating agencies during the financial crisis and thus, its share prices decreased and counterparties and customers decreased. The credit rating agencies have high ratings to other market participants which further degraded the Lehman Brothers. The three rating agencies: Moody, S&P and Fitch changed their outlooks for Lehman Brothers, from stable to negative and from positive to stable. These agencies reported further real-estate write-downs in the late July.
All of the above reasons depict that credit rating agencies played a crucial role in the failure of Lehman Brothers failure and can be held liable for the financial crisis.
QUESTION NO. 05
What effects had Government bailouts on the market during the crisis? Discuss.
High leverage business models of Lehman were required by the company to raise more billion dollars. The company invested highly in subprime mortgages and high-risk real-estate without considering the results and without foreseeing the future situations. When the situation went opposite, companies could not raise money and have enough cash to exist in the market.
The government tried to bail out Lehman Brothers Holdings Inc. but couldn’t because the company could not be bailed out without the presence of a buyer. The Federal Reserve chairman noticed Lehman Brothers' matter in March 2008. It considered this matter when the Federal Reserve Board rescued Bear Stearns- an investment bank. The Board expected Lehman to be the next one who will need to be rescued.
The Bear Stearns was rescued as they brought a buyer and the Board’s chairman asked the same to the chairman of Lehman Brothers but they couldn’t. The chairman of the Board also tried to convince the British Barclays and Bank of America, personally, to become buyers of Lehman Brothers but also gave them a warning that the government will not help with its funds.
British Barclays couldn’t accept it because British rules and policies didn’t allow it and Bank of America refused due to the absence of legal authorities. The government couldn’t nationalize it because it was an investment bank. Thus, it led to the bankruptcy of Lehman Brothers.
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