The issues of Lehman Brothers banking failure

Lehman Brothers was a US based fiscal services company, which provided a broad assortment of commercial fiscal services, including investing, market research, trading and banking services. It was one of the oldest investing banking houses in the US, subventioning its first public offering in 1899 – the preferable and common stock of the International Steam Pump Company. In 2007, Lehman Bros was the fourth-largest U.S. investing bank with 25,000 employees worldwide

Traditionally, Lehman Bros pursued a comparatively low-risk investing and concern theoretical account, ( the house would purchased assets designed chiefly to sell to the markets ) . It steered manner from the investing of its ain capital to add extra assets to its ain balance sheet to back up higher-risk banking theoretical accounts.

During the period 2001-05 Lehman Bros ‘s rivals were seen to be make much stronger twelvemonth on twelvemonth net incomes compared to them. This was being achieved through the usage of their balance sheets for proprietary investings and in 2006 Lehman Bros decided they need to follow the same scheme as its rivals, predating the low-risk scheme it had ever followed, to sharply achieve the higher net income degree which seemed to be accomplishable in the market.

This new aggressive growing scheme was apparent from a statement made by David Goldfarb, a Lehman Bros executive in 2006, which referenced what Lehman Bros objectives hoped to accomplish ;

“ A 13 % one-year growing in grosss, and this would be supported by an even faster addition in the house ‘s balance sheet, entire capital base and hazard appetency. ”

To accomplish this Lehman Bros decided to prosecute a scheme that focused on three types of investings: –

Commercial existent estate,

Leveraged loans, and

Private equity

To back up this the Lehman Bros executives started to increase it put on the line bounds – both in the sum and at an single dealing degree and as it reached these it kept raising and transcending both types of bounds in chase of its concern growing scheme. Between 2007-2008, it raised its sum hazard bound from $ 2.3 billion to a‚¬4 billion and decided to take it individual dealing bound for leveraged loans wholly.

This was a major job for Lehman Bros, as its new investings were illiquid, doing them peculiarly hazardous as it had now developed a high purchase and low equity base. These illiquid investings types could non sold easy or rapidly to raise hard currency and hence there possible sale could non be considered as an effectual scheme should they which to cut down their leveraged place.

To intensify the issue of their new growing scheme and hazard tolerance degrees, the Lehman Bros internal emphasis testing was ne’er updated to see its new and increasing exposure to illiquid assets ( which was non antecedently an issue for the company as it had such an undistinguished degree of such investings within its portfolio ) . However as they go oning to disregard this freshly introduced and quickly turning component of their portfolio the hazard degrees of their hazard profile shifted dramatically without being reflected in the emphasis proving consequences which were used to pull off the company.

The existent issue for Lehman Bros was that direction for the first clip in its history put the bulk of the company ‘s trading focal point on grosss and growing desires and steadfastly put its balance sheet, hazard tolerances, liquidness and capital deductions as the secondary concern – which was compound by the deficiency of updated hazard direction techniques to countervail the alteration in way. It got so caught up in the sensed chance and the growing frenzy that its rivals seemed to be involved in, moved off from its nucleus competences and into a concern scheme which took an ailment fated dive into belongings assets at the tallness of the US bubble while going over reliaint on short-run support agreements.

On 15th of September 2008, Lehman Bros filed for bankruptcy with $ 639 billion in assets and $ 619 billion in debt. Lehman Bros bankruptcy filing was the largest in history with assets/debts far outreaching those of Enron ( who had file bankruptcy in Dec. 2001 ) , with debts of $ 16 billion and listed $ 63.4 billion in assets or Worldcom ( who had file bankruptcy in July 2002 ) with $ 41 billion in debts and $ 107 billion in assets – WorldCom ‘s bankruptcy was the largest in US history, shadowing that of Enron, until Lehman Bros filed in 2008.

So why was Lehman Bros. allowed to neglect by the US authorities. Be it non obvious at the clip that there was already an bing crisis of assurance and that the failure of a banking giant could hold a contagious disease consequence? In the months before Lehman Bros had filed for bankruptcy both the US and European authoritiess had been step ining to avoid the prostration of Bankss that were in trouble ; for illustration in the US – Bear Sterns and in the UK – Northern Rock. So hence why was the possible failure of one the US ‘s biggest investing Bankss non prevented?

Some newsmans have muted that the ground was a political one as the timing of the Lehman Bros bankruptcy had closely followed the US Treasury taking on the ample debt of Fannie Mae and Freddie Mac, a determination which was to a great extent criticised in the US press/media. Could it hold been a instance that the US Treasury where concerned about utilizing public money to salvage Lehman Bros so shortly once more – could the force per unit area of public sentiment played a function in the determination doing procedure? Would the potency for a negative public reaction in relation to the bank bailouts and upcoming US elections be plenty for members of Congress in the US to allow Lehman Bros fail. This is something I do n’t believe I can replies but should be considered as a possible factor forestalling the deliverance of Lehman Bros.

It can be really hard to convert the general populace that the losingss of a bank must be nationalised albeit the fact that the net incomes it may hold made in the yesteryear were being privatised. However without a deliverance bundle put into effect/operation there is the important danger that the whole economic system could be impacted and suffered the effects as a direct consequence. Given the possible contagious disease consequence, which could be created by the prostration of a bank, the procedure of nationalizing the losingss prevents the greater impacts being felt. The fiscal sector, unlike other industries or sectors, has the hazard of a systemic and contagious disease effects on all the other sectors as it impacts liquidness and its handiness. It is hence in the involvements of society to back up the deliverance of a bank in trouble as it is finally in the public involvement.

Lorenzo Bini Smaghi, a European Central Bank executive board member, in an appraisal of the U.S. ‘s determination to let Lehman Bros to neglect said:

“ The failure of Lehman Bothers could and should hold been avoided ”

Mr. Smaghi, suggested that the Lehman Bros failure was one factor that turned the anterior market convulsion “ into a matured crisis ” , and the effects were clear in progress – “ the failure of a bank would hold a contagious disease consequence on the system. ”

The chief US bureaus involved in the Lehman Bros. instance – The Federal Reserve, the United States Treasury Department, the Securities and Exchange Commission ( SEC ) , have stated that they did non “ let ” Lehman Bros to neglect or travel belly-up but instead tried difficult to salvage it – and even though they did non win, the attempt made was serious and determined.

Thomas C. Baxter Jr. , the General Counsel to the bureaus above and who was involved in the instance to salvage Lehman Bros. commented ;

“ We came really close ”

Unlike Lehman Bros, in the instance of Bear Stearns, which was sing serious liquidness issues during March 2008, the New York Fed received authorization from the Board of Governors of the Federal Reserve to make/facilitate a loan to enabled Bear Stearns avoid registering for bankruptcy and to go on merchandising through the in-between hebdomad for March. During the weekend of the 15th of March the Fed together with the US Treasury Department managed to ease the acquisition of Bear Stearns by Morgan Chase. The US authorities has claimed that by easing Bear Stearns and pull offing its purchase that it was designed to quiet the market frights and supplying those like Lehman Bros, who at this point new the place it was in, more clip to place the options available to them and set into action the necessary solutions. However as we can see the six months Lehman Bros had to happen a solution to its troubles were non plenty and the capital issues, oncoming of the liquidness drain, inability to liquefy its assets and record depressions in footings of market assurance proved to be to disputing for them.

A deliverance operation of Lehman Bros failed finally due to the deficiency of a willing and capable amalgamation spouse that could supply the needed stableness needed. Barclays were the lone existent rival for purchase of Lehman Bros nevertheless they were non able to present a warrant of Lehman Bros trading duties which was required for the clip between the sign language of the amalgamation understanding and its shutting. This warrant is a critical success factor in any rescue bundle as it would hold maintained the ability of Lehman Bros to run as a traveling concern – continuing its value by supplying the protection to counterparties during the period between amalgamation contract and the shutting. The chief US bureaus have stated that the Federal Reserve, nor the Treasury Department, could non supply this warrant as lawfully it did non hold the authorization to supply warrant for an limitless sum – which could set the U.S. at hazard for the entireness of Lehman ‘s trading duties.

It is of import to observe that Congress later passed the “ Emergency Economic Stabilization Act ” ( EESA ) , which now does provides the Treasury Department with legal authorization to publish a warrant – this warrant if available to the Federal Reserve could hold been provided to let the Barclays acquisition of Lehman Bros to travel caput.

It is obvious that the combination of Fannie Mae and Freddie Mac, Merrill Lynch ‘s sale to Bank of America, ( Lehman Bros prostration served as the accelerator for the purchase of Merrill Lynch by Bank of America in an exigency trade ) and finally Lehman Bros prostration, among other factors – such as the US authorities ‘s coup d’etat of AIG shortly afterwards, should be considered the trigger for the systemic effects that were to come and where the chief cause of an remarkably big figure of market participants to get down the procedure of protecting their balance sheets. Unlike anything seen before, Lehman Bros caused the most synchronized sell off/disposal in the universe ‘s fiscal history – everything from stock/equities to bonds to the money markets plunged to enter depressions – a genuinely alone planetary fiscal crisis.

However likely more of import that what happened in the immediate wake of the Lehman Bros failure, was what all of a sudden stopped happening in the planetary economic system – the prostration of Lehman Bros induced a worldwide panic onslaught, which caused recognition to stop dead up during the subsequent months and what caused the downswing to travel into over-drive. The deficiency of recognition handiness became a major issue, as Bankss started to fear that other Bankss could neglect and they decided to halt imparting money to each other – this in bend caused the interbank market, which had already been under emphasis for a few months, to practically vanish.

This deficiency of trust between Bankss caused a sudden addition in involvement rates charged to companies and authoritiess likewise. The effects where that international trade started to stop dead up, which in bend wedged manufacturers around the universe coercing mills closings and finally the loss of occupations.

This has created a crisp diminution in household income, as households deal with job-losses or additions in financial step introduced by authoritiess to battle fast turning authorities debt – as states fight off the systemic and contagion effects of Lehman Bros in their ain national banking systems though the purchasing up of banking debt to better liquidness and this has created a societal and political conflict/unrest across Europe over how to cover with this crisis.

Greece, shortly followed by Ireland, offers the most serious illustration of how the fiscal crisis has moved into a new stage. The fiscal crisis has now put the existent endurance of the Euro in hazard. The planetary fiscal crisis, which started with the prostration of the Lehman Brothers, has lead to monolithic province bail-outs affecting the transportation of bank debt to the populace sector and so weaker states, such as Ireland, Spain, Greece and Portugal are more susceptible to bankruptcy. This shows how the planetary fiscal system has become improbably incorporate and to fragile to manage the emphasis associated with the death of a big planetary fiscal participant, such as Lehman Bros – which brought the fiscal crisis to all new degrees of multiple bank failures, Government bail out strategies for Bankss and even authorities bailouts. Unless a good managed action program in firmly put in topographic point the Eurozone economic systems may see a drawn-out period of small or no growing.

Mohamed El-Erian, the main executive of the pension fund Pimco stated that ;

“ Thingss that you take wholly for granted in a fiscal system stopped. And that is why everything fell off a drop in the planetary economic system. It was a complete paradigm displacement that will take us old ages to populate out. ”

However an even bigger narrative of the fiscal crisis could hold been the prostration of AIG. The monolithic US authorities bailout of AIG could hold dwarfed what was required to salvage Lehman Bros. So how was the US Federal Reserve able to impart more than $ 85 billion to AIG and non bailout Lehman Bros. The reply to this inquiry comes down to AIG holding sufficient collateral to back up the committedness to impart. Unlike the warrant that was required to ease the amalgamation of Barclays and Lehman Bros, the US Governments committed recognition was to the full secured by good collateral through AIG ‘s highly sound retail insurance concerns.

Similar to insurance companies, there are a figure of possible causes that can take to the ultimate death of a bank, nevertheless Bankss are observed to neglect under three chief conditions ;

When Bankss start to turn excessively fast or one-year net incomes achieve dual figure growing twelvemonth on twelvemonth,

Liquidity jobs or deficiency of handiness of liquidness

When Bankss engage in collateral loaning,

I would see fast plus growing as a certain expression for bank failure – as in the instance of Anglo Irish or Lehman Bros. peculiar when combined with liquidness deficits.

Although economic conditions can be ascribed as the grounds why a bank may hold failed, in general the misdirection of the Bankss concern and hazard direction scheme has a much larger function in its failure. The degree of hazard that a bank may take seldom reflect their penchant for incurring such hazard or uncertainness, but instead reflects the competitory construction under which direction have decided to run. This competitory construction or concern scheme and its strength is normally attributed to the degree of competition within the market infinite. One can do the premise that the greater the figure of rivals in the market, the greater the competition between these establishments will be in order to pull the greater figure of depositors and borrowers, as bank ferociously compete to retain or increase market portion.

There are a figure of cardinal indexs when sing the fiscal strength of a bank, albeit these can be misdirecting if a bank has had a new scheme in topographic point merely a short clip or changed its attack to put on the line, its hazard tolerance or hazard direction attack ;

Capital Adequacy

Asset quality

Management quality/ability

Net incomes,

Liquidity, and

Sensitivity to market hazards

Losingss from loans are a possible beginning of bank failure – normally from excessively much hazard taking by such Bankss while seek to increase net incomes. At an single loan degree ( or the lowest possible degree ) , loan losingss occur because of some of the undermentioned illustrations ;

Collateral overvalued ; improperly margined, failure to acquire assessment.

Provision of financess before entering the to the full complete certification or the proviso of loans to alterative A type loans ( loans made to borrowers without full certification ) ,

Personal relationships between the loan officer and the borrower,

Loans provided to a new concern venture,

Regenerating or increasing loan sums, with no extra collateral/security,

Repeated revisions of a loan to cover delinquent involvement due or lost payments

Failure to understand the borrower ‘s hard currency flows and ability to refund,

Failure to reexamine loan position often,

Fundss non used as represented,

Fundss used out of the bank ‘s market country ; hapless communications with borrowers

The bank ‘s failure to follow its ain policies and processs in relation to the proviso of loans or hazard appetency,

Banks concern scheme to aggressive in the loan market,

Failure to name loan or to travel against indirect rapidly when impairment becomes evidently hopeless,

Failure to monetary value adequately.

As the Godheads of liquidness, the holders of public sedimentations and the operator of payment mechanisms the ordinance of Bankss must hold a clear aim of making a sound, secure, and advanced banking system that is antiphonal to the consumer demands and market forces. The deficiency of or hapless supervision/regulation by both regulators and internal corporate governance/risk direction can take to a figure of characteristics which can take to bank failure such as moral jeopardy, undue hazard pickings, increased degree of fiscal invention in fiscal markets that are complex and frequently their hazards understated and misunderstood by direction, poor/inadequate capital or liquidness jobs and finally the failure to command and understand the assorted hazards of loaning, ( such as recognition, market, and operational hazard etc ) . These jobs will frequently interact and overlap with each other and if non identified and controlled by the hazard direction squad and/or understood by direction they can rapidly take to bank failure.

As we have seen late were Bankss take higher degrees of hazard onto their books or introduce increased hazard tolerances within their concern theoretical account without taking the necessary safeguards, frequently due to times of increased degrees of competition for market infinite or the force per unit area to accomplish similar net income degrees to those of rivals, they face increased hazard of failure. We have seen Bankss non acquiring the needed border ( pricing the concern right ) on the hazards being taken and a displacement in focal point to low border but high volume concern theoretical accounts – which normally require a moderation of internal loaning practises/policies when it comes to credit/asset allotment determinations.

Banks have become accustom to the increased usage of purchase to increase returns nevertheless this besides dramatically increases the hazard by multiplying the possible loss – overleveraging their place as with the subprime crises by the funding of homes/constructions undertakings with no sedimentation required ( 100 % finance ) based on continued belongings monetary value rising prices. This has left many Bankss over exposed to the belongings clang, as the debt needs to go on to be serviced which leads to increased capital and liquidness issues ( note: the more equity capital which provides a shock absorber against losingss to borrowed financess and lower the purchase ratio the greater the opportunity of the Bankss has of bearing the losingss ) .

Normally a bank will raise liquidness by running down hard currency assets, selling off liquid assets or borrowing extra financess on the inter bank market to run into its backdown demands. However where a bank suffers from an increased degree of recognition hazards combined with the worsening value of its assets, comparative to its liabilities, it will get down to endure from capital and liquidness lack. Where consumer assurance begins to run low in the bank, it can see sedimentation drains, which finally lead to an increased hazard of failure. This hazard of failure may besides do the interbank markets to stop dead up, and depending on the degree of market integrating there can be an addition in the velocity and volatility of the impact of such a freezing on all Bankss in the state, taking to rapid impairment of liquidness and capital places.

Bank must set in topographic point or update their specific hazard direction procedure when altering concern theoretical accounts to mensurate the new or extra hazard degrees it is taking and possible diminutions in liquidness ( plus quality ) /credit hazard quality. Banks besides need to guarantee that their variegation scheme is to the full implemented to guarantee it does non over expose itself to extremely correlative sectors or locations/areas, as an under diversified portfolio combined with an aggressive growing scheme can make a state of affairs for the bank were it underestimates the true extent of the hazard exposure.

But while hazard direction should be a tool for commanding hazard, the executive direction of bank must be prevented from increasing purchase in order to increase the value to the stockholder – with merely a position on the short-run consequences – direction must see a long term scheme which smoothes out public presentation – prevent extremums and troughs – which creates existent long term stockholder value and non merely a speedy injection/wins. We have besides seen that single bank hazard direction will non do to command over all hazard within the industry, as even if the bulk of Bankss in a state pull off their ain hazard good, this nevertheless does non prevent an accretion of a system broad hazard developing due to a little figure of rivals who do non pull off their hazard and make an accelerated loss of assurance in local or world-wide fiscal markets ( as was evidenced by several fiscal market indexs following the Lehman Bros failure ) . The control of the system broad hazard requires regulators, nevertheless ordinance does demands to be careful – to utilize an route safety concept – if you build wider and better constructed roads it can salvage lives, but non if drivers merely increases their velocities due to the new ace roads, therefore you need rush bounds and enforcement of those bounds. Banks need to see capital demands as the velocity bounds of banking.

Capital demands are an indispensable portion of making a bank system, which can endure such fiscal crisis in the hereafter, but they are non sufficient in isolation – ordinance and improved hazard direction must be portion of the foundation of the new banking universe. Capital demands need to be able to absorb losingss originating from fiscal and economic emphasis and prevent the hazard of taint from the fiscal sector to the domestic economic system. Indications from the Basel Committee on banking show that there is a demand to better the quality of capital and the demand to raise the degree of capital held every bit good as a cardinal betterment to be introduced – a macro prudential focal point, to turn to the system broad hazard and the intensification of hazard over clip – it is critical that Bankss should better their capital places in good times to protect against the cyclical nature of concern ( which may convey the bad times ) .

While capital demands traveling frontward will play a cardinal portion in the reforming of the banking industry, the recent crisis has highlighted the importance of liquidness direction. When a bank is good capitalised it is more robust and improbable to see a tally nevertheless to be genuinely resilient it needs a solid liquidness buffers in topographic point. Therefore Bankss need to keep a sufficient degree of good quality liquid assets to be in a place to last should entree to the inter-bank or support markets disappear ( as we have seen has been a major issue for Bankss in the current crisis ) . This is one of the countries the Basel Committee on banking reforms are looking to turn to.

Drumhead

Even if it had been lawfully possible to salvage Lehman Bros the US Government would hold us believe that the warrant would hold placed the US taxpayer at an tremendous hazard because it would hold potentially undermined trade certainty between Barclays and Lehman Bros. It is true that there is importance behind the fact that Barclays would hold had less of an inducement to shut the Lehman Bros trade by the authorities publishing the warrant while the trade was being done and Barclays would hold had all the benefits if Lehman Bros status improved in the interim period ( while avoiding any of the possible load if Lehman Bros status declined ) .

In a different clip possibly, when market assurance had non been so weak and the fiscal system non under every bit much force per unit area, non salvaging Lehman Bros would hold brought the effects of hazard back into the planetary banking system. But unluckily the timing in the planetary economic system was non right to let such a failure as the money/credit markets seized up in the aftermath of Lehman Bros.

Mr Thain, an executive at Merrill Lynch, stated:

“ Leting Lehman to travel insolvent was a enormous error – it led to 100s of 1000000s, if non millions of dollars, in losingss. ”

However should the US authorities have rush through the needed statute law to give the bureaus the powers and the financess to approve a bailout of Lehman Bros? Their actions post Lehman Bros, ( the creative activity of the troubled plus alleviation programme to bailout Bankss which allows the US authorities to vouch the liabilities of a fiscal group without inquiring Congress for permission ) , seem to bespeak they should hold. Should the US authorities have saved Lehman Bros? I believe that it was a awful failure of the US authorities that it did non hold the legal authorization in topographic point to salvage Lehman Bros or it could non acquire the needed statute law enacted to let it to go on. Similar to the Bear Stearns instance, if the US authorities had underwritten the liabilities of Lehman Bros for the period I have no uncertainty that a purchaser could hold been found for Lehman Bros ( even if it was non Barclays in the terminal ) .

I besides have no uncertainty that the Bankss in the US and Europe which survive this fiscal crisis will profit long term with improved net incomes in the longer term as borrows accept higher fees to make concern with a smaller figure of Bankss and fiscal establishments. However new ordinances ( capital demands, liquidness demand, hazard direction techniques and describing ) demand to be enforced to guarantee that the post-Lehman Bros subsisters do non fall back into old wonts with hazardous concern or trading schemes.

As we have seen in the recent crisis, capital and liquidness demands to be a core portion of the reforms in the banking industry along with an improved model for capturing hazard information on a Bankss merchandising book – as Bankss can no longer be in a place that their hazard weighted ratio can be distorted by an unequal hazard appraisal of their assets.

Bibliography

Fiscal Institutions Management – A Risk Management Approach – Anthony Saunders/ Marcia Millon Cornett – 6th Edition – McGraw-Hill International

Lecture Study notes – The Institute of Bankers School of Professional Finance

hypertext transfer protocol: //www.financialregulator.ie – Imperativeness Release – The Irish banking crisis: lessons learned, future challenges – Research on current regulative demands of Banking Sector and lessons learnt

Basel Committee on Banking Supervision – Report and recommendations of the Cross-border Bank Resolution Group, September 2009

hypertext transfer protocol: //www.lehman.com

hypertext transfer protocol: //www.federalreserve.gov

hypertext transfer protocol: //www.reservefunds.com