Analysis on the Financial Crisis and Lehman Brothers Collapse

Analysis on the Financial Crisis and Lehman Brothers Collapse

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For ten years between the year 1998 and 2007, the global economy enjoyed a relatively successful period in which annual growth averaged an annual rate of 4.5%. In its semi-annual predictions made in April, 2007, the World Bank expected that the global economy would grow by an average of 7% in the subsequent months. However, that was not to be as the world went into turmoil as from September of the same year. According to the International Monetary Fund, a recession is said to have occurred when the economy, national or local, grows by an annual rate that is below 3%. In the two years between 2007 and 2009, the global economy grew by a marginal one percent. The growth rate is widely considered to be the lowest achieved since the great depression of the year 1930. The recession of 2007 to 2009 was marked by the collapse of Lehman Brothers. A company with hundreds of subsidiaries and thousands of employees, Lehman Brothers was a colossus of a company. Its collapse triggered mass panic in the global financial market, leading it to the blink of collapse that was only averted through the use of taxpayers’ money to revive some of the most affected companies. Since then, the global recession continues to be a subject of study with the main focus being on the causes and preventive measures that are to be adopted in the future. The aim of this study is to investigate some of the reasons put forth as leading to the economic crisis. These reasons will be classified as being either financial or non-financial.
Structural factors outside the financial world
The Monday of 15th September, 2008 marks an important day in the history of the modern economy. This is the day that one of the oldest firms in finance, Lehman Brothers, filed for bankruptcy under the rules set forth in Chapter 11 of the Bankruptcies Code of the US. The filing was to allow the company restructure its debts and develop a new capital structure that would allow it operate in the future. The filing was the culmination of a series of events within the company and the global financial market. In itself, the filing for bankruptcy would expose the fragility of the global economy as it set off mass panic across major markets, leading to the closure and several business combinations for those firms intent on avoiding a fate similar to Lehman Brothers’. While it would be easy to lay blame on Lehman Brothers’ internal policies and organization for its collapse, there are other factors that made a major contribution to the global financial crisis of 2007-2009.
According to Buiter (2008), one of the contributing factors to the global crisis was the creation of excessive liquidity within the market by the world’s major central banks. After the Asian crisis of 1997-1998, global economies was aware to the fact that high interest rates had made a significant contribution to the crisis that affected major economies in Asia. Moreover, the turn of the millennium marked an important period for economies such as the US and UK as it heralded a wave of corporate failures, especially in the technology industry. Learning from the Asian crisis and to avoid a repeat of corporate failures in the future, central banks made key decisions that would contribute to what is regarded as the worst financial crisis the world has experienced since the great depression of the 1930s.
One of the decisions made was to keep interest rates low. According to Buiter (2008), central banks across the world sought to keep their interest rates at record lows for various reasons. One, central banks in the developed world were keen to ensure that a repeat of technology bubble did not repeat itself in the future. The bubble was primarily caused by high interest rates that encouraged the influx of investments into developing countries. Given that these nations were yet to develop systems that would take in increased investments, the Asian crisis developed with the remedial action being that the affected countries directed the newly found wealth into securities issued by the developed world through their central banks. The world was dealing with a new order where developed countries were now the primary holders of debt instruments as issued by the developed world. With too much money being availed onto the hands of the developed nations, there was an increase in the amount of leverage used in these nations both at the household level and in companies. In nations such as Greece, Spain, Portugal, and Italy, much of the newly found debt was spent chasing ghost projects. As of the year 2014, these nations have scars of excessive debt in the form of ghost towns and even airports. It was only a matter of time before the credit bubble went burst.
Low interest rates led to an excessive influx of investments that were ready to make a quick exit once there were better opportunities in alternative markets or when there was sign of trouble within the market. The result was that markets became extremely sensitive to capital movements, a situation known as volatility. Increased market volatility meant that governments were in a frantic search for ways to calm market movements with regulation and stability measures being applied alternatively. The frenzy only contributed in escalating panic within the markets as investments moved in and out with every announcement of regulations changes.
According to Davar (2011), national governments make economic decisions based on Keynesian beliefs regarding how employment, government spending, income, and consumption relate to each other. Through the use of models developed by Keynes, governments make policy changes on matters such as how much to charge as interest, taxes, and how much to spend in order to stimulate national growth. However, these models are fundamentally flawed. Davar (2011) argues that there appears to be a contradiction in the arguments put forth by Keynes, with a foremost being that which relates to government spending and taxes. According to Keynes, an increase in government spending increases the amount of income that is available to the population of country. This much is correct only to an extent as a sustainable increase in income relies on other factors such as the quality and quantity of the factors of production present in human capital and raw materials. At the same time, Keynes was of the opinion that decreased government taxes would lead to an increase in the level of income attributable to the citizens. Taxes are considered to be a major source of income in any nation. For example, the US government collects about $5.5 trillion from taxes and $0.5 trillion from business income when funding its federal budget.
Therefore, the argument that reducing taxes will increase national income while increased government spending has the same effect leads to a contradiction. This is based on the fact that the government is expected to achieve two contradicting matters simultaneously. These are collect less in taxes and increase government expenditure. These are goals that are difficult, if not impossible to achieve. Yet, such a flaw did not stop governments from spending in ghost projects in a bid to increase national income. This was done without the hindsight of the fact that the funds used in chasing grand projects were mainly sourced from debt that would have to be repaid at some time in the near future. Therefore, the lack of a clear match between the economic feasibility of government spending and the application of Keynesian economics made a contribution towards the financial crisis when it was time to meet debt obligations.
A second problem that is posed by modern economic thinking is that there is an equilibrium between the supply of goods and services and their related prices. Davar (2011) points out that the assumptions used in deriving the equilibrium are exactly the factors that come to affect the state of affairs in the real world. For example, the assumption that there exists uniformity of prices cannot hold in the real economy as companies are willing to charge different prices in order to achieve divergent goals. Moreover, the equilibrium theory posits that the prices of services, such as employment might be equal to zero when they are in excess supply. The theory seems to imply that when the supply of a service such as employment is in excess, then its price is likely to be zero and even negative. Such an assumption cannot hold in the real economic world where employment has a minimum wage set. Yet, even with such serious setbacks, the modern equilibrium law was used by governments in determining the minimum prices of goods and services through the use of interest rates.
The third fundamental problem in modern decision making processes in economics is that fiat money can replace commodity money. Fiat money is simply defined as legal tender whose only backing is government laws. On the other hand, commodity money is legal tender that is backed by both laws and a commodity such as silver and gold. In the very beginning, fiat money was intended to be a representative of the gold and silver held by the central bank. However, in 1971, the US officially did away with the gold standard as a measure and representative of value. The implication was that money could now be used as a measure of policies and beliefs instead of value. It is now possible, as witnessed in recent company valuations and the technology boom, for a company to be valued purely on the basis of its expected future value or the systems on which is founded. This is because there lacks a backing measure of value that was present in commodity money. Moreover, fiat money exacerbated another problem; that governments could now print money without any inhibitions of value. The fact that governments could print money with interest rates being the only limitations meant that there was increased liquidity in the economy. This was a contributing factor in the run-up to the financial crisis of 2007-2009.
Factors from the financial world
Apart from the financial policies adopted to stimulate employment, spending, investing, and taxes, governments also undertook other measures to stimulate the financial sector. One of the measures adopted was the introduction and even encouragement of securitization as a way of protecting assets from risks. The economic crisis experienced in the 1960 and 70s led governments to open up their borders to trade. The result was that there was an influx in the amount of futures, forwards, options, and other financial innovations that were put forth as a way of protecting individuals, companies, and entire governments from the volatilities of open foreign exchange markets. However, these transactions were organized by little-known organizations, partnerships, and companies that did not fall under the direct control and regulation of the government. Realising the immense opportunities, and reduced regulation, presented in this opaque market, there was marked increased in firms that offered hedges, options and other financial derivatives. When these innovations were not enough, financial experts created new ideas where investors could put their money. Thus the emergence of the industry that is shadow banking.
According to Pozsar et al (2012), shadow banking refers to financial intermediaries that conduct maturity, credit and liquidity transformation without the explicit access to central bank. Hedge funds, security lenders, special purpose vehicle designers, and similar entities create an excellent example of the shadow banking industry. The rise of this industry is not to be taken for granted. Figure 1 shows the rise of assets held by these institutions over a period of two decades. The main difference between a traditional bank and a shadow bank is that a shadow bank is in the opaque area of government restrictions. This is unlike the traditional deposit-taking bank that is subject to strict government regulation and government access. However, Figure 1 clearly illustrates that shadow banks control larger amounts of assets and liabilities than the traditional banks, with the amount only waning as from the year 2008. While shadow banking in itself is not a bad idea, its magnitude in roles within the global economy and the fact that its activities were largely unchecked until recently makes the industry a main contributor to the financial crisis of 2007-2009. This is because shadow banking allows for the shifting of money from one market to the next remarkably fast through the use of modern technology. Such movements only lead to increasing the volatility of the market even on matters as crucial as liquidity these are actions that are propelled by the need to make profits and increase personal returns.
Figure 1: Assets managed by shadow banking industry
Despite the role played by financial factors in the years before the economic crisis, there were other factors at play too. One of them was the issue of government regulation, or more specifically, the lack of government regulation. As illustrated in the shadow banking industry, government regulation only intervened in the highly potent and volatile industry after there was a crisis. Moreover, it has been noted that the government opted to stay off the market even as banks and other financial institutions engaged in precarious activities such as subprime lending. Applying the classical definition of a neoliberal market, governments appeared not to be interested in curbing excessive risk taking as exemplified in shadow banking, subprime lending, and securitization. Unlike in years before the 1960s and 70s, the government has shown reluctance in regulating major factors in the governance of a company such as executive compensation. The government has left that obligation to shareholders and market operations.
Moreover, it is not easy to refute the matter of pay and the role it played in encouraging bankers to undertake excessive risks. According to Bebchuk et al (2008), bankers’ pay is deeply flawed for the reason that it encourages the banker to undertake excessive risk for which he will obtain enormous paycheques and perks. In a chilling account, Godechot (2009) noted that bankers have realized their value to the financial industry and hold their current employers at ransom unless they are awarded perks and pay rises. By acknowledging that their association with the firm confers the firm with a brand that would be too costly to lose, bankers can “hold-up” the company during annual reviews and pay negotiations. The result is that the banker would obtain a pay rise even when one is not deserving. According to Dowd (2009), such behaviour became prevalent owing to bankers becoming insensitive to the needs of their customers and putting his needs before theirs.  It was a classic case of there being a moral hazard within the financial industry that later became the bane of executive pay across board. Bebchuk et al (2009) illustrate that chief executives and top managers at failed Bear Stearns and Lehman Brothers routinely cashed in on their perks and equity holdings even when the firms they headed performed dismally. Recent media reports indicate that pay continues to be attached to excessive risk taking within the financial industry across the world.
Based on these arguments, it would be erroneous to conclude that the financial crisis emanated from the world of finance alone. On the contrary, there were other contributing factors other than improper application of economic theory, increased securitization and shadow banking. A major factor that has to be considered in analysing the financial crisis is the role played by deregulation of the market. Moreover, the role of executive pay as applied to the financial industry and beyond is to be considered as a factor that is not directly related to the financial world.
The collapse of Lehman Brothers
Established in the year 1847, Lehman Brothers grew to be one of the largest and most significant financial institutions in the world until it filed for bankruptcy in the year 2008, one year after celebrating its 160th birthday of operations. At its initiation, LB was a company that dealt in the dry goods market trading items such as coffee and grains within the US. However, LB made entry into railway bonds and was soon making underwriting agreements in the newly created market of issues. Underwriting would form a core part of its business until the last of operations. Underwriting would also be one of the areas that led to problems at LB. The company was privately held until the year 1994 when it was listed in the NYSE as part of a divestment decision from its parent company at the time, American Express.
The listing of LB heralded a new era for the company. Under the leadership of Richard Fuld, LB would change in how it viewed risks and rewarded its employees. With the aim of becoming the largest financial institution in the US, LB would make a series of business combinations within the financial industry. These combinations were in the risky area of subprime lending, though its subsidiaries dealt in class A loans that were considered to be a safer than the alternative lending of unsecured loans to customers who had doubtful credit history and rating. LB was also the underwriter in many of the securitised subprime lending that was conducted by other banks at the community level. These underwriting transactions were done in the shadow banking sector where LB was not required to show these transactions on its balance sheet. Instead a mere statement of amounts held as a result of these transactions was all that was needed.
LB’s interests and bets on the subprime lending industry making improvements proved to be its undoing. Subprime lending is defined as lending to those individuals who have a questionable credit history. In normal circumstances, such risky behaviour would not have been permitted in a depository bank that had strict corporate governance codes. This is because lending to an individual who had a poor credit history meant that the bank would have to recognize higher write-offs when the individual eventually defaulted on his loan obligations. However, the US was experiencing an influx of liquidity that was driven by increased appetite for its federal debt instruments by the developing world. This was part of the changing wealth distribution process that saw developing and emerging markets from Asia and South America become net debtor in the global economy. Therefore, there was an incentive to lend more and make profits at the expense of shareholders’ interests at LB.
As a company whose main business was in the insurance industry, Berkshire Hathaway Inc. was deeply involved in the real estate market as a risk underwriter. In this regard, natural catastrophes such as hurricane Katrina wreaked havoc on the company’s insurance business especially that covering small home owners as claims for damages exceeded premiums obtained. However, the hurricane occurred in the year 2005 while Lehman Brothers would file for bankruptcy three years later. The relationship between the two is the fact that LB should have taken the insurance loss recognized by Berkshire as a warning that the housing market was about to go burst. This is based on the fact that the shortly after the hurricane, companies in the insurance industry made significant improvements to reduce their risk exposure that occurs through house insurance. However, instead of reducing its interest in the market, LB made a series of business acquisitions that would have the very opposite effect. Increasing its stake in the housing market regardless of the risks its posed to the company made LB particularly vulnerable to any shocks that would result should its bets go wrong.
As an investment bank, LB also practiced the hazardous behaviour of excessive executive pay. In a study conducted by Bebchuck and his colleagues in the year 2009, it was found that the top five executives at LB made as much as $173 million in cash bonuses during the year 2000 and 2007, one year before the company went burst.  Over the same period, executives at LB made about $860 million from the sale of their equity options in the open market with about half of this amount being attributable to the company’s chief executive. Of importance is the fact that these options could be exercised at any time after the stock price passed a targeted stock price. This was in line with modern executive reward scheme that seeks to balance the needs of shareholders to those of executives. The idea was forwarded by Jensen and Meckling (1976) in their seminal paper on agency theory. However, the argument is erroneous because it gives these executives the incentive to poke the stock market for sudden stock price improvements that would be to their personal benefit. Rajan (2008) was of the opinion that the compensation program adopted by investment banks including LB was flawed in that it based pay on short term borrowing and highly leveraged operations with the hope that a liquidity crisis would not erupt.
The combination of these factors made a significant impact in the collapse of LB. With its business being concentrated in the housing market, an increase in defaults meant that LB was faced with the acute reality that it would soon run out of cash that was necessary to conduct operations. Moreover, high default rates left LB with the burden of writing off substantial portions of assets held on the balance sheet. Consequently, LB’s book value was reduced with each write down in loans advanced in the subprime market. These were events that were not taken kindly in the stock market where LB’s stock price reduced in value with every announcement of a write off in assets. Moreover, the collapse and subsequent takeover of Bear Sterns placed enormous pressure on LB to report positive results, though this was not possible as loan defaults reached record levels. All this while, the US government showed reluctance in bailing out an ailing LB even when it was clear that this was the only possible solution to its problems. Controversies over the refusal continue to be a great source of debate among academics and experts in the financial world. LB was willing to be bought by South Korean banks but when the deal failed, LB declared bankruptcy the following morning. After that, LB’s assets were sold to various bankers including Barclays, which bought the company’s operations in North America. It was the end to one of the most significant banks in the modern financial world. It would also mark an important date after which financial markets across the developed world took in losses as LB was associated with almost all sectors in their economies. Its tentacles were felt by both companies and the nations that had borrowed through the bank.
The collapse of LB was primarily caused by an internal failure in the governance and assessment of risk. The company’s internal culture was one that encouraged the taking of risk as was illustrated in the large compensation packages that were given to its top executives even when there was little shareholder value created. However, it would be simplistic to argue that this were the only reasons. The bank was operating in an era of lax government regulations in the shadow banking industry. It could be argued that it was simply taking advantage of existing market conditions. Moreover, LB’s decisions were fuelled by the ready availability of credit within the US monetary market as induced by the government’s increased borrowing. This is not to mention that the collapse was accelerated by the increased interconnectedness in global markets that is the hallmark of modern markets. Therefore, LBs collapse was the culmination of both internal factors that are derived from the world of finance and external factors present in the wider economy.
The aim of this study was to investigate some of the reasons put forth as leading to the economic crisis. These reasons were classified as being either relating to the financial world and those from other industries. Reasons emerging from the financial sector include the sector’s appetite for large risks as the cost of increasing personal gains. Excessive pay is a hallmark of the financial industry and it has been argued as being a core contributor towards equally excessive risk taking. This was illustrated in increased securitization and the creation of the highly lucrative shadow banking industry. Outside the financial world, reduced government regulation over financial markets made significant contributions towards the financial crisis. Moreover, the adoption of outmoded economic models in the development of monetary and budgetary policies is argued to have created an environment that was ripe for bankers such as LB to take in more risks. Therefore, the collapse of LB was the culmination of factors from within and outside the financial industry.

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