Lehman Collapse For Capital Markets: Causes And Implications

Introduction: Brief Description

Discuss about the Lehman Collapse for Capital Markets. 

Lehman Brother collapse in 2008 was considered as one of the most tragic events of failure among financial institutions. Before, it collapse the company was considered to be the fourth largest investment bank in America (Iminds, 2010). Began in 1844 by Henry Lehman, Lehman Brother was a small grocery and dry goods store, after two decades they traded cotton, and later Henry Lehman moved to New York to establish a New York Cotton exchange firm. After, the occurrence of this events Lehman went on with this road of success to be able to establish the fourth largest America investment bank. The main areas of business for Lehman before the collapse include; typical investment banking as well as participation in equities, capital markets, investment management and fixed incomes (Iminds, 2010). Their investment banking process could provide financial services such as mergers, underwritings, acquisitions and security issuing. They had also invested globally in fixed incomes, capital markets investment management parts. But, the main revenues of the firm came from fees derived from size of transaction or services being provided by the firm to their customers (Lee, 2009). Despite all these the firm had survived all traumatic events ranging from world wars to the great depression, but the collapse of U.S. housing market brought the company on its knees.

The following are reasons why Lehman Brother bank collapsed:

Here, the old saying of not putting all eggs in one basket tends to have a significance. It is evident that when the housing sector market was at peak Lehman borrowed in excessive and mostly invested all its proceeds in to the mortgage market. But for security reasons subprime loans had granted mortgage to houses that Lehman had already bought. Greed and recklessness became the order of the day as they tried to be leaders in the market for the subprime mortgage backed securities. As of 2006 to mid 2007, they had pursued an aggressive strategy where they thought of expanding into commercial real estate, private equities and leverage lending through their capital (Haas & Horen, 2012). Hence, their concentration in mortgage made them vulnerable and sensitive leading to the down fall.

Lehman brother similar to the great city of New York never slept. Whenever the trading bells rang at the NYS Exchange at four that is in the afternoon, the equity guys just packed up because there was nothing else to be done. Bank debts and high yield debts went till seven. In often instances the traders had a normal looking balance sheet that weren’t drastic; this is because losses were never loved by Lehman management (Dillian, 2011). Hence, the failure by the firm to acknowledge losses might be reasons as to why the business failed.

Causes of Failure

As of 2007 the American housing market began to crumble due to the increased numbers of default. Hence, this meant losses for Lehman and hence they were forced to write down billion of dollars as bad debts, which greatly deteriorated their financial position. Hence, they were unable manage their financial leverage and took too much risk (Mcdonald, 2015). For the purpose of hiding their poor financial status they ought to develop the Repo 105 transaction to show that they are still maintaining a positive grading based on the rating but that wasn’t the case. Such an act of fraud was also a reason to their downfall.

Above are reasons as to why Lehman Brothers collapsed but it is also important to at least try and shows the early signs of their collapse, in this case we will outline the activities that I believe are reasons as to why they collapsed.

Activities engaged in that showed early signs of collapse

Before the collapse, Lehman Brother risk management team had identified several specific inherent risks in the business that lead to the collapse:

Operational risk- this tends to be loss that originates from inadequate or failure by the Lehman internal process, including the responsible people and systems and also the external events that they engaged.

Credit risk-the firm also run the risk of loaned counterparty being unable to honour the contractual obligation to the Lehman Brothers. As a result, in the future it escalated the possibility of collapse (Benos et al, 2012).

Reputational risk-this tends to be the risk of losing the confidence from customers, public and the government as a result of the unfortunate decisions on the client’s selection and conduction of the business. In some way these had an influence in their collapse as they faked their records to remain attractive.

Market risk-this tends to be a representation of the potential unfavourable change in the value portfolio of the financial instruments as a result of the changes in the market rates, volatilities and prices.

Liquidity risk- this was the risk factor where Lehman was unable to fulfil payment obligations, they also borrowed funds in the markets at certain good regular prices for the purpose of funding actual commitment and liquidating their assets. This initiative came as an early sign of their downfall (Tibman, 2009).

In 2007 the firm raised a wide risk limit close to $2.3 billion to $ 3.3 billion, justifying it by the modifying of ways that calculate risk they can support. As of September 2007 it was increased to $3.5 billion and $4 billion in 2008. If risk limit were calculated under same assumptions, it would have been $2.5billion.

Poor Assets and Risk Management

In making analysis of Lehman Brothers mode of risk management, it tends to conclude that Lehman management in countless times had exceeded risk limits, ultimately exceeding risk policies by margins of close to 70% as on the commercial estate, and by 100% on the leverage loans (Paulson, 2010). An explanation to this is the dangerous behaviour in the compensation system. For attraction and sharpening the minds in the industry, they should reward the most revenue generating employee who makes big monetary bonuses. But, the bonus incentives were asymmetric.

It tends to be perceived that Lehman bankruptcy has some effects on the depreciation in price of the real estate commercial. For instance, when there was liquidatin of $4.3 billion in the mortgage security, it created a sell of in commercial mortgage that was to backed by securities (CMBS) market (Robinson et al, 2009). 

Some auditors perceive that the collapse of Lehman led to rise of top primary reserve fund. It was the only time since 1994 that the money market fund experienced a drop which was below $1 per share level. Hence, the collapse of Lehman wiped out over $46 billion in the market value. Collapsing of the firm acted as a catalysts to the purchasing of Merrill Lynch by the American bank as an emergency so as to deal with the issue. Loss of Lehman created a loss of close to $48 billion of the receivables in the derivatives that could be otherwise relaxed (Dziedzic, 2010), and a total of $75 billion was destroyed (Dziedzic, 2010.)   

Iminds (2010) perceives that Lehman collapse could have been easily avoided only if they were proactive initiatives held by the executives to make sure there is effective control of the risk management in their operations. Nuerberger officials had send Lehman Brother executive team some memos suggesting they forgo the multi-million dollar bonus as it created a strong message to investors and employees as the management accountability was decreasing. Hence, Iminds (2010) argues that the collapse of the financial institution could have been avoided only if there was adoption of effective risk management practice in the derivative trading.   

As of Lehman case they had invested more on the risky derivatives. It is perceived that the main motive of the derivatives was to assist the actors found in the real economy insurer against any risk, but in some cases the derivates trading had crossed the price stabilization and the risk management speculation. Therefore, if regulators of derivatives had effectively considered this Lehman Brother wouldn’t have collapsed.

Management Problems

Conclusion

It is evident that the failures of Lehman Brother mostly originate from their internal operations, thus a lot of questions have been asked as to whether the interaction of Lehman brother and government agencies had regulations and monitoring of Lehman leading to the fall. Thus, a lot of analyst tend to believe that Lehman bankruptcy had some set off in panic that created a threat to U.S financial system and also the entire global financial system (Mcdonald & Robinson, 2009). Hence, after the fall of Lehman a lot of concerns have risen as to what created the failure of the onetime leading investment bank. it is perceived that the questions are currently hard to answer because little knowledge is known of what happened in Lehman. Creating the need of coming up with effective strategies that could avoid an instance where there is collapse of a financial institution (Mcdonald & Robinson, 2009).

It tends to be believed that the bonus system had some encouragement to the management to increase their risk. In most cases, the operational errors and excluding assets in stress test created limitations and over-leverage in the balance sheet which greatly fuelled the bonus aspect (Dziedzic, 2010). Any banking system that has no bonus system tends to be unthinkable for many, as it is a way of decreasing future bonus in relation to risk taking in the building of risk aversion parameters as found in the bonus criteria. For instance, no bonus is to be rewarded if the test shows large risks even if the profits appear big, though it needs stress testing so as to be executed independently.

It is perceived that a lot of market risk could be avoided only if Lehman hadn’t focused on investing heavily on the correlated assets. Here, the credit crunch hit large because of subprime crisis as it affected both the commercial real estates and leverage loan assets (Hass & Horen, 2012). Thus, the ties between the assets was struck quickly by losses created in the fronts. Thus, the consequences greatly hit the chain making it less fatal if the bank was operating more diversely and no focusing mostly on the portfolio. They also made themselves vulnerable to the liquidity risks. Since, they depended on the short term funding for long term investment, which was a fatal mistake as credit market dried up and there was no illiquid assets.  

As of 2008, there was no government agency that had sufficient authority to compel Lehman operation in the best that made them avoid the viability of loss (McDonald, 2015). Hence, the need of a solution regime where analogous establishment of the failing banks took place, so as to avoid options in the future between baling out a fail, and systematic critical firm or allowing the disorderly bankruptcy. Hence, development of such a regime was expected by the global banking industry to protect the economy as well as maintaining that there is an improvement in the marketing discipline through maintenance of failing firm shareholders and creditors losses and replacement of the management.        

It is perceived if they had done adequate stress testing and simulations, they would not have changed their focus from brokerage and financial services. The high leverage ratio affected the other risks adversely making downfall fast and unstoppable

References

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