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The Global Financial Crisis and the Collapse of Lehman Brothers [Name] [Subject] [Professor] 04 December 2008 Introduction The current global financial crisis has made the future outlook on the global economy dim. The current crisis also underscored the dangers of the interconnectivity of market economies. Some of the possible causes of the financial meltdown included high levels of market liquidity, low global interest rates, low cost of capital, and very low yields on safe investments. (Gurria 17) Lehman Brothers announcement on Bloody Monday, September 15, 2008 triggered a confluence of events that were felt all over the world. Some lessons could be gleaned from all these challenges as the world start picking up the pieces and start over. The Global Financial Crisis and the Collapse of Lehman Brothers As the current global financial tumult continue to assault global financial markets, one could not help but wonder if the crisis was avoidable.
With globalization, the interconnectivity of financial markets appeared to exacerbate the problem. The global financial crisis is only a product of unprecedented and radical developments in the markets and when it fails, everyone appeared to hold an empty basket. Angel Gurria in The Global Financial Crisis observed that one of the main causes of the financial meltdown is the rapid increase in securities mortgages. The author mentioned could be a result of a confluence of activities and events that may result in a myriad of consequences. Among the possible causes include high levels of market liquidity, low global interest rates, low cost of capital, and very low yields on safe investments. (17) With the key developments and changes in the financial sector fueled by technological development, regulatory changes, liberal policies and the desire for more profit, they also gave momentum to the rapid growth of the subprime lending market in the 1990 s (Gramlich).
According to the National Community Reinvestment Coalition (NCRC) subprime loans are defined as a loan to a borrower with less than perfect credit. In order to compensate for the added risk associated with subprime loans, lending institutions charge higher interest rates. (q in Squires 7) This is essentially a high-risk loan. Compared to prime loans where it is only extended to borrowers that have good credit rating and strong capacity to pay, subprime loans are generally extended to customers who failed to meet the standard criteria imposed by prime lenders. The Root of the Problem Banking is most visibly affected by the financial crunch. With OECD estimating the losses of US and European banks on non-performing loans related to residential mortgages US$ 400 billion (Gurria 17).
These losses resulted in substantial reduction in the banks capitalization. The banks countered by raising their capitalization. The US banks and other investment houses were able to accumulate enough capitalization equivalent to the losses and write-downs while the European banks lagged behind. Asian banks, though not exempt from the effects of the crisis, were less affected and they were able to recover. Despite the efforts to mitigate the danger posed by the subprime crisis, they were not enough to allow banks balance sheets to grow (17). Lehman Brothers, one of the investment giants announced on September 14, 2008 that it would file for liquidation after the firm incurred losses in the mortgage market.
Unable to find potential investors and the company essentially lost investor confidence, the company had no option but to file Chapter 11 on September 15, 2008. The announcement of the collapse sent ripples across the global markets (Lehman Brothers Holdings, Inc. ). Paul Mizen in The Credit Crunch of 2007 - 2008: A Discussion of the Background, Market Reactions, and Policy Responses traced the beginnings of the credit crunch in early 2007 but the problem was localized and confined to low-quality US mortgage markets in February of 2007. It did quiet down by March. However, by April New Century Financial, a subprime specialist, filed for Chapter 11 and retrenched half of its employees. Several other big lending companies also followed suit (533).
Mizen also mentioned two significant developments that provided a favorable environment for the credit market. First, global finance experienced unusually tranquil macroeconomic condition in combination with global savings from emerging oil-exporting countries. This became conducive to long term interest rates and less macroeconomic uncertainties (533). The second is the rapid expansion of securitization in the subprime mortgage backed assets (533). Although they are high risk investments, these promise high yields and good credit ratings (533). The subprime loan problem initially surfaced during the 2001 recession and retreated from 2002 - 2005 when the US economy recovered.
What helped eased the stresses of the subprime loans on the economy were higher home prices and lower interest rates. With the appreciation of the housing market, troubled homeowners were able to either borrow against their equity to make house payments or sell their homes to settle their debts. (Di Martino and Duca 4) With lower interest rates, it helped lower the base rates of adjustable rate mortgages and put a halt to further increases. This shifted the focus of instability to unemployment and ignored or underestimated the risks associated with non prime loans (4). When the condition reversed and the market experienced a slide in housing prices, the past due rate rose despite low unemployment rate (4).
In early 2007, the lenders and investors felt the effects of easing lending standards. Delinquency rates for prime and subprime loans undertaken in 2006 were higher compared to the same type and age issued in 2004 (5). Past due rate for outstanding subprime loans increased nearly reaching the critical point. The initial reaction of the lenders was to tighten credit standards on risky loans (5). The stricter standard meant less borrowers availing of the loan facility and pushing the prices for prime and subprime borrower.
Single family home sales fell in 2007. The supply glut pushed house prices lower and the lack of appreciation in house prices made it difficult for many homeowners to refinance their debts (5). By August 2007, the problem escalated with housing market weakness, loan-quality problems, uncertainty about inventories, interest rate resets and spillovers from weaker home prices. (Di Martino and Duca 5) Rating agencies downgraded many subprime RMBS thus a marked reduction in trading in subprime instruments were observed. On August 14, 2007, the market granted to a halt, with the three big investment funds unable to ascertain the value of their shares. This spiked the interest rates for both mortgage backed commercial paper and jumbo mortgages, which heightened financial market uncertainty. (6) Michael Youngblood of the Friedman, Billings, Ramsey Group (FBR) in Arlington, Va pointed out that towards the end of 2005, there was a major shift in the strategies of lenders.
He said, Lenders went from competing for customers on price (by lowering rates) to competing for customers on easy terms (by lowering lending standards). The change went unnoticed because majority did not disclose their change in strategy publicly (Coy). Peter Coy traces the trouble as far as 2004 when interest rates war escalated among subprime lenders. With lower interest rates, it should have been a positive development because it attracted legitimate and qualified borrowers. On the negative side, a lower rate meant fewer profits. Hence, profitability spread shrunk from 6 percentage points in 2003 to 3 percentage points in 2005.
To enable them to rebound, the subprime lenders had to raise interest rates. However, this drove away potential borrowers. The subprime lenders needed to maintain the volume to realize any increase in profits. To do that, they relaxed the underwriting guidelines and made exceptions to accommodate more borrowers. People whose credit worthiness and ability to pay were generally weak were allowed to obtain loans at considerably higher interest rates.
The unsound fundamentals soon backfired as many of those who obtained loans had difficulty repaying them back. Comparing with prime loans, subprime loans had higher loan-to-value ratios, reflecting the greater difficulty that subprime borrowers have in making downpayment's and the propensity of these borrowers to extract equity during refinancing. Troubled accounts in prime loans are only 1 percent but for subprime loans, it accounted for 7 percent (Gramlich). Several marketing promotions adopted by banks and lending institutions to attract customers include option adjustable rate mortgages (ARMs), no doc interest-only's and zero-downs with a piggyback. (Di Martino and Duca 2) Presently, about 80 percent of US mortgages are prime while 14 percent are composed of subprime loans. The remaining 6 percent are near-prime categories. The non prime and subprime loans increased from 8 percent in 2001 to 40 percent in 2006.
The boom created by such increases in the subprime loan markets made it easier for people to obtained loans. With the relaxed regulations, people can obtain loans even without or little proof of income (2). With these new practices, it opened the housing market to more families and individuals. Homeownership increased from 63. 8 percent in 1994 to 69. 2 percent in 2004 (2). There were two major developments that increased the growth in non prime mortgages.
First, lenders adopted the credit-scoring techniques first used in making subprime auto loans. (2) Second, the spread of new products offering default protection drove the growth of subprime lending (2). Lenders also found a way of creating a new flow of funds from the savers and investors to prime borrowers through government-sponsored enterprises (GSEs). (2) Relaxed federal regulations complicity contributed to the subprime problem. By introducing the Community Reinvestment Act (CRA) of 1977, the banks extended loans to low- and moderate-income borrowers or areas, possibly with a significant proportion assigned with subprime loans (Gramlich). The Federal Housing Administration whose main responsibility was to guarantee loans extended to first time borrowers liberalized its rules for guaranteeing mortgages, increasing competition in the market and lowering interest rates faced by some subprime mortgage borrowers. (Gramlich) While the subprime facility primed more people to own their homes and improve their lives, there were obvious disadvantages such as elevated rates of foreclosure and of the incidence of households seriously delinquent on their mortgages. (Gramlich) The overly optimistic outlook for Residential Mortgaged Backed Security (RMBS) purchased by investors proved to be a miscalculation on the part of financial managers. The misjudgment was attributed to the difficulty to forecast default losses because of the short history of non prime loans (Di Martino and Duca 4). The government sponsored enterprises such as the Fannie Mae, Freddie Mac and Ginnie Mae essentially guarantee the loans and group large groups into RMBS.
These are sold to investors and they receive a share of payments from the underlying mortgages (2 - 3). The Collapse of Lehman Brothers Soon after Bear Stearns collapsed, Lehman Brothers followed suit. In seemingly surreal series of events that shocked the global financial markets to a rumbling halt. In the summer of 2007, as the credit markets began their tailspin downward, Lehman stocks plunged from its $ 82 peak. This reflected investors sentiments and loss of confidence in the firm whose main business was focused on the subprime and prime mortgages market (Lehman Brothers Holdings, Inc. ).
The best efforts of Lehman to keep afloat begin to disintegrate as they announced a 2008 second-quarter loss of $ 2. 8 billion. The firm vowed to raise the needed $ 6 billion capitalization to avoid going under. However, all road leads to Chapter 11 as the company failed to entice willing investors to infuse new funds. By September 10, 2008, the situation was direr with the firm announcing a total of $ 3. 9 billion losses (Lehman Brothers Holdings, Inc. ) The weekend of September 13 - 14, 2008, the companys last resort failed to convince two potential saviors, Barclays and Bank of America to buy into the company. With no Treasury bailout in sight, Lehman filed for Bankruptcy (Lehman Brothers Holdings, Inc. ) The story of the Lehman collapse was a compendium of lost opportunities and poor decision-making on the part of the management. Primarily, other banks refused to trade with Lehman because they were unable to risk betting on a company with questionable long-term viability.
With no one willing to do business with Lehman, there was no business to talk about (Inman). Lehman's heavy investments in securities linked to the US subprime mortgage market, which many analysts considered as high risks eroded investor confidence (Q&A: Lehman Brothers Bank Collapse). A year before the collapse, Lehman admitted that their net loss was estimated at $ 7. 8 billion. It also had a $ 54 billion exposure to hard-to-value mortgage-backed securities. Lehman's stock prices plunged 95 % after the disclosure (Q&A: Lehman Brothers Bank Collapse) The Impact of the Collapse on the Market September 15, 2008 or Bloody Monday as stock market players, investors and the world refer to the events that were precipitated with the announcement of Lehman Brothers bankruptcy.
The announcement sparked sharp losses with Dow Jones industrial average (DJIA) declining by 504 points (4. 4 %) (Chossudovsky). In less than a week, Dow Jones shed 800 points. Due to the interconnectivity of the financial markets around the world, the impact was felt in the European as well as the Asian markets. The impact of the crisis is not limited to companies in the red and the financial markets. It also affected the real economy at the national and international levels, its institutions, [and] its productive structures. When stock values plunge, this also implied that lifelong household savings are eroded, not to mention pension funds.
The impact will also be felt in the consumer markets, the housing market, and more broadly on the process of investment in the production of goods and services. (Chossudovsky). The credit crisis is also feared to impact on the economy because of the ability of the financial sectors to generate growth. With higher loan interests and costs passed on to households and consumers, it will have a trickle down effect where consumers are less likely to borrow money, curtail their spending and weaken overall economic growth (Williams 208). Consumer confidence will also be eroded but Williams reported that the impact of the financial crisis is still unfolding (208).
The R word or recession is most feared among developed countries. The United States has recently admitted that it is in recession. Will other economies follow? It is only a matter of time before they also make a similar announcement.
Conclusion The global financial crisis only illustrated how internet worked, interconnected economies could be disadvantageous. The domino-effect that many markets experienced on Bloody Monday is a testament of this. The crisis all boils down to mismanagement and abject greed of some groups or individuals. Yet, they had drag the entire world economy to the pits. The investors should have the foresight of the impending trouble.
Reforms need to be instituted to arrest the further slide of the markets. John Chiang and Kevin Stein in Solving the Loan Crisis Requires Vision, Reform suggested that lenders must modify the loans of the troubled borrowers to make it more affordable for them to pay. This avoids the borrower from completely abandoning the loan. Too many loan defaults spell trouble for the overall market. If it is unavoidable that the property is foreclosed, the bank should sell properties to qualified community groups that can put first-time homebuyers into those houses. This will preserve those properties as a community resource and not a money-making scheme for outside speculators.
The lending agencies must revert back to its more stringent practice of screening loan applicants. In hindsight, it would have been the wisest to stick to regulations and it would have averted current crisis. Cited Works Chiang, John and Kevin Stein, Solving the Loan Crisis Requires Vision, Reform, (11 October 2007) sacred. com 03 December 2008 < web > Chossudovsky, Michel, Global Financial Meltdown, (18 September 2008 } global research. ca 03 December 2008 < web > Coy, Peter, Why Subprime Lenders Are In Trouble, (02 March 2007) businessweek. com 03 December 2008 < web > Di Martino, Danielle and John V.
Duca, The Rise and Fall of Subprime Mortgages, Economic Letter, 2 (11) (November 2007) dallas fed. org 03 December 2008 < web > Gramlich, Edward, Subprime Mortgage Lending: Benefits, Costs, and Challenges, (21 May 2004) federal reserve. gov 03 December 2008 < web > Gurria, Angel, The Global Financial Crisis, New Zealand International Review, 33 (6) (Nov 2008), p 17 - 19. Inman, Philip, Q&A: The Collapse of Lehman Brothers, (15 September 2008) quar dian.
co. uk 03 December 2008 < web > Lehman Brothers Holdings, Inc. topics. nytimes. com 03 December 2008 < web > Mizen, Paul, The Credit Crunch of 2007 - 2008: A Discussion of the Background, Market Reactions, and Policy Responses, Federal Reserve Bank of St. Louis Review, 90 (5) (September-October 2008), 531 - 567 Q&A: Lehman Brothers Bank Collapse, (16 September 2008) news.
bbc. co. uk 03 December 2008 < web > Squires, Gregory D. , The New Redlining: Predatory Lending in an Age of Financial Service Modernization, SAGE Race Relations Abstracts, 28 (3 / 4) (2003), 518. Williams, Trevor, How has the global credit crisis impacted the global and UK economy? Journal of Corporate Treasury Management, 1 (3) (Feb 2008), 206 - 210.
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