The Financial Crisis and Lehman Brothers
Date of submission
The Federal Reserve chief in 2007 switched his main concern from inflation to financial stability in August 2007. To many, this was the initial start of the recession. In 2008 and 2009, the recession increased in intensity, and finally it dissipated in 2010. The recession was characterized with a spiraling of the American economy as well as the economies of most other major economic powers around the world. There are many suggestions that have been put forward as to the cause of the financial crisis. However, the cause that has been suggested by many is the increase of the subprime assets and loans in the financial systems all over the world. Many of the companies tried to sell their assets in an attempt to drop their bad debt. However, not all companies were successful with many having massive imbalances in their assets. One such case is the case of Lehman Brothers who had so many imbalances that it was no longer able to meet any of its operations requirements. The case of Lehman Brothers sheds light on the liquidity issues that companies and economies have when they invest in non-assured areas. The imbalances in the economy can be attributed to the financial sector. However, it was not the only cause of the subprime loans. The financial sector may have contributed greatly to the problem, but it was not the only cause. Throughout the financial period, many individuals panicked and sought to withdraw their savings from the financial sector . This led to further imbalances in financial records. This paper reviews the cause of the financial recession that started in 2007 as well as looking at the case of the Lehman Brothers collapse.
The link between the mortgage and financial industries in the recession
The financial industry and the mortgage industry are two sectors that are always interconnected. Most people who want to buy a house are not able to purchase in a lump sum amount. In most cases, they seek mortgage loans that are repaid slowly. Financial institutions make the provision of these mortgages. This means that the housing markets have a significant influence on the financial markets. Many of the analysts attributed subprime mortgages to the financial recession. One way to understand this is by defining what subprime means. The term subprime refers to the provision of financing for an individual who has a low credit score. The opposite is prime loans that are offered to individuals with high qualification rates. Subprime loans, therefore, carry a greater risk to the financial institution. In most cases, they are offered with high-interest rates to deter people from seeking such loans and to reduce the risk that the financial institutions have when offering subprime financing. The subprime loans are attractive to many financial institutions because they have a higher revenue as compared to prime loans that have low-interest rates . During the crisis, subprime loans were assumed to have a higher rate of interest as compared to the other countries.
Since the subprime loans carry such a high amount of risk, they pose a problem not only to the borrower but the lender as well. In order to counter this risk, the lender increases the rate of interest to match the risk of default on these loans. In some cases, the rate of interest can be as high as four times the amount. This makes the loans unattractive to people. Financial institutions resolve this by making the interest rates on subprime loans adjustable. This means that a loan can start with a low-interest rate that is then increased in future to accommodate the increase in risk (Gad, 2007, p. 3). This makes subprime loans very attractive to individuals because they seem to have a lower interest rate.
It is also vital to comprehend the nature of subprime borrowers. Subprime borrowers are individuals who have a limited credit limit due to either past actions. In America, one is assumed to be a subprime borrower when they have more than one 30 days past due loan payment. Alternatively, a subprime borrower may only have one loan payment that is 90 days past due. This indicates that they have issues with making regular payments. The likelihood of default of the loans is a lot higher than people who are considered to be prime borrowers. Apart from the regular payments, a subprime borrower is someone who has had a non-payment loan, foreclosure or repossession within a four year period. Additionally, any person who has filed for bankruptcy in the last seven years is also considered to be a subprime borrower. The American credit score for anyone who is considered to be a subprime borrower is someone who has a credit tally that is below 620. Based on this, it is clear that most people in America are subprime borrowers either due to the credit score of issues with loan repayments and repossession.
In truth, many people view the financial recession as something that arose from the housing sector. In truth, financial institutions introduced the problem to the mortgage sector, but the nature of the sector led to the ultimate collapse. The structure of the housing market was such that most of the major mortgage companies were government sponsored. An example is Freddie Mac. The main problem was that such institutions only financed mortgages for people who were considered to be prime borrowers. When the private sector ventured into the property market, they had to compete with the financial services that were being offered by government-sponsored companies. Most people who were able to get access to a loan opted for loans from government-sponsored mortgage companies. Private companies needed to attract subprime borrowers to be successful in the mortgage business. As private companies invested in the mortgage industry, the amount that subprime lenders were able to borrow increased. Initially, most subprime borrowers were unable to get any amount above 85,000. With time, the rate increase to 130,000 dollars. The time required for making the repayments was also reduced to increase the return on capital . In a way, the subprime lending was being made profitable by financial institutions especially in the housing market.
Figure : Johnson, L., 2010. Elizabeth Warren Destroys Financial Crisis Myth. [Online]
Since the lending to subprime borrowers had been made profitable, the financial institutions introduced several different measures that sought to increase income generation while going against some of the ethics of money lending. The first was the reduction in due diligence in the ability of the individual in repaying their debt. Financial institutions were now actively looking for subprime borrowers to offer them loans. The problem was that some of the borrowers were in so much debt that they could not service the loans that they were being offered by the financial institutions. The most attractive thing to most people in America is the option of owning a home . Financial institutions took advantage of this need by offering most people the opportunity to own homes using subprime mortgages.
Figure : Dr housing Bubble, 2010. California Investing and Housing 2009 Forecast: The Rise of the Bottom Caller. Bottom Investment Callers out Again, Foreclosures Dominate Market, Home Prices near 2002 Levels. [Online]
Another problem was that most of the borrowers were not given full information on what the loans entailed. The mortgages and loans offered had adjustable interest rates. This meant that a financial institution could attract borrowers for low-cost mortgages with low-interest rate. This interest rate was then adjusted to make it higher as the loan repayment progressed. This increased the profit margins for the companies that engaged in the subprime lending. With the large profits that were being made, many commercial banks ventured into the property market in order to make quick profits in a market that was greatly unregulated. When commercial banks started dealing in subprime loans, they exposed the entire economy to the risk that subprime loan had. When the subprime mortgage and loan problems began, they quickly spread all over the economy and cause the recession.
The spread of risk by underwriters and mortgage brokers
While many can blame the mortgage companies and commercial banks for the recession, there is one group of financial institutions that were responsible for the spread of the risk from the property sector to other areas of the economy. These are mortgage brokers and insurance underwriters. Mortgage brokers are considered the main cause of the financial crisis because they were actively involved in the process of creating the subprime loans. Mortgage brokers earn money from the convincing borrowers to take mortgages. They earn a commission for every person whom they convince to obtain a mortgage. The rate of returns determines the commission that the mortgage company was to get from the borrowers. At the time, the mortgage return for prime loans was not as high as that of subprime loans. This made subprime mortgages more attractive to mortgage brokers. Many mortgage brokerage companies took advantage of this and increased their efforts to sell subprime loans to willing borrowers. A review of the property market showed that 42 percent of all the mortgages given to borrowers prior to the recession were subprime in nature. Out of these, 68 percent of them came from mortgage brokerage firms. What is more perturbing is that most of the mortgage brokerage firms did not make any effort to inform the borrowers that the loans had adjustable interest rates . Their main concern was to sell the mortgages to earn a commission.
Figure : fleckensteincapital.com, 2007. The Big Picture (with Pictures) – Conforming Loan Secondary Market. [Online]
Apart from mortgage brokers who sold the subprime loans to borrowers in bulk, there is a need for mortgage companies to review the qualification of borrowers in a process that is called underwriting. Underwriters normally review the credit score and the background of a borrower to determine whether they could repay. At the time, the mortgage industry had started shifting from human underwriters to automated underwriters. Automated underwriting software decreased the speed of reviewing a borrower. However, it came at the cost of lack of documentation that is normally used by a normal underwriter. This meant that the assessment process was not as thorough as it would have been of a human underwriter had done it. In addition to this, the underwriting software was set to provide a percentage premium based on how subprime the borrowers were. This means that instead of withholding the mortgage to a subprime borrower, the software increased the premium based on the level of risk. A review of the underwriting process after the recession revealed that many of the people who would have been denied mortgages by the normal underwriting process were given access to mortgages with high premium rates.
How securitization spread risk throughout the economy
Based on the situation highlighted above, the problem that arises would have been confined to the property and mortgage sector, while the other sectors of the economy were left protected. However, a process called securitization spread the risk beyond the housing market. The risk was even spread to companies that were in different countries. The securitization process refers to the practice of offering assets, receivables and other financial instruments as collateral in investment. This means that account receivables can be transferred to an insurer or an investment vehicle. In essence, the asset is sold to an investor with the promise of receiving the receivables. The process of securitization began in the 1970s, where housing loans were allowed to be transferred as receivables to others in the organization . This made it possible for commercial banks and other financial institutions to provide mortgages and then offer the mortgage to third party investors who will collect the premiums. One factor that is important to note is that the property market is normally quite stable, and this makes the mortgage securities attractive. In addition to this, the assets that back these securities can be repossessed in cases where the mortgage is unpaid.
The securitization is done mainly by credit agencies. Credit agencies are supposed to place a rating of securities based on the risk that is associated with a specific loan. Prior to the crisis, credit agencies found themselves in a moral dilemma due to the relationship with investment banks. Credit agencies are paid by investment banks money to provide a valuation of the securities. This means that it is in the interest of the credit agencies to rate the securities of an investment bank as high as possible to increase the amount that is being paid. Credit agencies were supposed to place a high risk to securities that arise from subprime loans. However, they instead rated the subprime loans higher than they were supposed to be. This led to an increase in trading of subprime mortgage loan securities in the financial sector. The review of the financial trend shows that 54 percent of the securities that were sold in 2004 were subprime in nature. By 2007, the percentage trading in subprime securities has grown to over 75 percent . Since the investment banks dealt with money that arises from third party investors, the risk of these subprime securities were transferred to these investors without their knowledge or consent. This flooded the financial sector with assets that had a high risk of default. Since the third party investors are normal people or companies from different walks of life, the risk was spread all over the economy. This means that the properties market was now affecting the entire financial economy.
While most of the blame can be placed on financial institutions, the government holds a large part of the blame. Even though commercial banks and other financial institutions are responsible for the provision of the securities from subprime mortgages and loans, the government is ultimately responsible for regulating the financial sector. Most of the issues that affected the industry could have been resolved by government regulation. The government would have placed higher restrictions on subprime lending as well as ensuring that the underwriting process is done properly . The government should have also done more to control the mortgage brokerage firms.
Another issue is the reduction of the interest rate that was being offered by the commercial banks. The initial rate was six percent. However, the rate was reduced preceding the crisis to 1.24 percent. This meant that the commercial banks could offer loans at low-interest rates. However, the interest rates offered were adjustable and most of the time the interest rates were hiked up in order to increase the speed of returns. Additionally, the low-interest rates meant that the rates offered by adjustable rates were a lot lower than those that were offered by companies that offered fixed prime mortgage rates. This meant that many borrowers shifted from higher fixed loan repayments to lower adjustable loan repayments. This in essence turned many prime borrowers to opt for products that were made for subprime borrowers .
When discussing the financial crisis, it is important to investigate the effect that global deficits have on the economy. There are countries like China, Japan and Germany that have surpluses due to their high number of exports. However, America has large deficits. These deficits normally mirror the deficits that are experienced in the housing sector. Prior to the recession, the housing sector showed that there was considerable strain of the economy . This should have been addressed at this point. Measures should have been put to stem the tide. However, the government adopted a free market policy that allowed the situation to become worse.
How the subprime mortgage collapse started the recession
Signs that the economy was going through a recession started at the end of 2005. The subprime mortgages had started to fail. This was principally due to the return of the Federal Reserve rates to their normal percentages. This meant that commercial banks had to increase their interest rates. This was reflected when the adjustable interest rates were increased. This led to the increase in defaults, repossession, and foreclosures. By 2006, the rate of foreclosures had increased to 30 percent. As subprime securitization continued in the financial sector, the rate of foreclosure proportionately climbed. By 2007, the subprime mortgage niche was collapsing, and the mortgage brokers who had misled borrowers were in a state of affairs where they had to reimburse many clients. An example is Ameriquest that had to pay 325 million to borrowers .
Commercial banks also started to feel the effect of the collapsing subprime mortgage sector. The securities started to devalue as the rate of foreclosure increased. This continued to spread to the economy since the mortgage securities had been spread all over the economy. Investment banks had already been affected by the recession by the middle of 2007. At the time, over 25 percent of American subprime lenders declared bankruptcy. Investment banks quickly followed due to the devaluation of the mortgage-backed securities .
The subprime mortgage problem then penetrated the money markets in July 2007. Since investment banks trade securities on behalf of members, the risk had reached many third party investors like banks and other businesses that invest in investment banks. This loss of assets in the economy was seen in the drop of the Dow Jones in 13000. As many investors pulled away from the market, the S&P closed in the negative. Panic spread across the country. Businesses and individuals withdrew all their income from the money markets. The risk had even spread across the world. Financial institutions were the hardest hit because they suffered losses due to the devaluation of current assets as well as a withdrawal by depositors and investors. The withdrawal of investors from investment banks caused massive devaluation that affected many companies around the world. The entire world was in recession. Even countries like China that had more restricted economies also suffered. Ultimately the un-monitored practice of trading in subprime mortgage securities had spread a risk throughout the world. American financial practices had caused a global recession.
Figure : Finfacts.com, 2008. World Economic Outlook: IMF forecasts global recession; Predicts major Global Slowdown amid Financial Crisis. [Online]
Case study: Lehman Brothers Collapse
In 2008, Lehman Brothers, which was one of the largest investment banks in America, declared bankruptcy. The collapse was shocking to the whole world since Lehman Brothers had at one point had over 600 billion in assets . Lehman Brothers, like many investment banks, had based its main business on investing on behalf of clients in fixed incomes, capital markets, and securities. The company provides underwriting services, issuance of securities as well as overseeing acquisitions and mergers. The company not only invested within American soil, but it also invested in other areas around the world . This section of the paper reviews one of the largest financial company collapses in American history.
Risk taking is an important part of investment banking because revenue and risk are directly proportional. The business model that Lehman Brothers used identified five major areas of risk. The first type of risk was attributed to the unfavorable change in financial instruments. The second type was credit risk while the type was liquidity risk that refers to the ability to meet short –term financial obligations. The fourth type was operational risk that occurs due to internal processes. The final risk involved reputational risk that arises from loss of confidence from stakeholders . Active management of these risks is required to ensure that the organization can generate revenue. It is also important to mention the competitive nature of the investment banking industry. Investment banking is a trillion dollar industry where the businesses have fierce competition. Reputation is built on how much growth and how large an investment bank has amerced the portfolio. In 2006, Lehman Brothers was the fourth largest investment bank in America. The main aim of the bank at the time was the continued growth of a 25 percent rate for four years in order to surpass the closest rivals. This was quite an ambitious growth and could only be achieved by investing in high risk but high rewards assets. The growth path took the company from one of low-risk brokerage to a high risk and capital intensive model. This was to be done by concentrating on leveraged loans, private equity, and commercial real estate. Since subprime mortgages and loans were the most lucrative securities at the time, Lehman Brothers heavily invested in the niche . At the time, this seemed to be a prudent task since subprime loans were popular at the time, and the interest rates were low enough to allow most people to make payments.
The aggressive strategy failed to recognize the risk that existed from subprime securities. Lehman Brothers continued to increase assets that arose from subprime securities without any contingency measures of what would happen when the securities collapsed due to default. Apart from that, Lehman Brothers was involved in the conversion of subprime loans and mortgages into securities and selling them to third parties. The securities are split to reduce the amount, as well as the risk. Problems for the investment bank started when the housing bubble burst in 2007. Property prices dropped, and the adjustable interest rates started to increase to cover the investment that most people had made. As the interest rates increased, more subprime borrowers started to default and fall back on their loan repayments. Investors soon opted to forego investing in securities that had subprime mortgages and loans attached . This mean that any assets that had not been sold by Lehman Brothers were now difficult to dispose. Lehman Brothers was soon left with a large bulk of assets that were quickly dropping in price with no way of selling them.
By the 2008’s first quarter, Lehman Brothers had made a 2.5 billion dollar loss. The strategy that had been adopted had concentrated in the real estate area. This loss was attributed to the great drop in housing prices in America. The financial books showed a grim picture of assets that could not be liquidated to meet any of the long-term and short-term obligations. This meant that the operational risk was realized, the credit risk as well as the liquidity risk. The first quarter loss was then damaging to the reputation of the investment bank. This meant that Lehman Brothers was no longer able to acquire any additional credit to allow it to meet operational costs. The lack of liquidity in assets meant that no operations could be run, and the assets could not be disposed. This was compounded by the mounting number of investors who were withdrawing their money from the investment bank. Short-term obligations were being demanded by creditors, and the company could not find a way to meet the obligations. By September 2008, Lehman Brothers had to sell itself to other companies or to declare bankruptcy. The weekend from 12th to 14th September was busy with an acquisition being discussed with other investment banks. The government also failed to provide any monetary assistance because the investment bank had heavily been involved in unscrupulous banking practices. Lehman Brothers officially filed for bankruptcy on 15th September. This was one of the biggest companies ever to declare bankruptcy in America. In a span of four years, Lehman Brothers had come from being the fourth largest investment bank in America to complete bankruptcy.
The great recession is said to have been caused by a multitude of factors. However, the blame can be rested mainly on financial institutions for their disregard of the risk. The housing and property sector was very solid before the introduction of subprime mortgages and loans. The subprime mortgages and loans were attractive to most borrowers because of their low-interest rates. However, when the housing bubble burst, the price of the property dropped while the adjustable interest rates were increased. Many of the subprime defaulters were unable to pay their mortgages . This led to a high number of defaults and foreclosures. This risk in the investment banking industry had been spread to other areas of the financial markets by the securitization practices by most investment banks. This spread the risk in the housing market to the entire economy. The decline in property prices was registered by most individuals and company portfolios due to the spread of the securitized subprime loans. The situation led many investment banks like Lehman Brothers to have assets that had very low value and no ability to be resold . This caused liquidity problems that ultimately led to the collapse of Lehman Brothers. The financial recession is a serious reminder of the importance of prudent policies not only in the financial and real estate sector but to all sectors of the economy.