Loading...

The TiL Rundown is where we analyze current and future trends in society, technology, inovation and culture: a column tailored for those of you seeking to be constantly ahead of time.

Lehman Brothers, Volume I

Facebook
Twitter
LinkedIn
WhatsApp
Email
Reading time: 4 minutes

More than a decade has passed since the Lehman Brothers bankruptcy, which marked the end of what academics worldwide defined as the Great Moderation period. But why did it happen? Why did Lehman Brothers fail so spectacularly? A challenging question, which is why we decided to provide our readers with a streamlined narration of the events that led the then-fourth largest investment firm in the US to apply for Chapter 11 protection on the 15th of September 2008. Most of the information in this article originates, unless stated otherwise, from the first volume of the report made by Mr. Anton R. Valukas, at the time chairman of Jenner & Block Law Firm, tasked with the unenviable role of Examiner for the Lehman Brothers bankruptcy case.

The build-up to the crisis

The biennium from 2007 to 2008 saw a rapid increase in missed or delayed payments across all types of mortgages. In the first year alone the US delinquency rate grew by about a fifth, to then accelerate and replicate the performance in less than three quarters. Cumulatively, the number of persons that were not able to meet their mortgage obligations doubled in less than 20 months. 

According to the Federal Reserve, most of this growth was attributable to non-prime mortgages (i.e., near-prime, bundled into Alt-A securities, or subprime mortgages), which at the time numbered slightly lower than ten million. These loans had as their main characteristic that of being accessible to individuals with low credit scores to whom they were usually presented as “credit repair” mortgages because of the type of repayment plan employed (so-called “short-term hybrid,” one would initially pay interest expenses calculated on a fixed rate, then switch to a variable one for the remainder). However, most borrowers did not understand the type of financial product they were buying because of the frame used by lenders to present it or because they were too confident in their ability to repay later-on their loan. 

Related:  30 Days of War: The Prospects of the War in Ukraine And the Impact It Holds on the World

A moral hazard was also present on the origination side: brokers were incentivized to originate as many loans as possible because of the possibility of being rapidly freed of risk through insurance. The number of insured loans without proper or any documentation grew exponentially, while loan-to-value ratios reached unprecedented levels. Deteriorating underwriting standards were, according to academic literature, another cause of the financial crisis that would manifest in the fall of 2008. Notable is the case of AIG, an insurer company particularly active in this kind of market, which the federal government saved with an injection of more than $US240bln in today’s money not long before Lehman Brothers’ bankruptcy. 

Finally, it must be noted that macroeconomic factors were also at play, specifically the decision by the Federal Reserve Bank to increase the primary credit rate to 6.25% by the first quarter of 2007 and lower it too late to avoid the crisis.

Mortgage for sale

The general perception that the financial sector was aware of the phenomenon was confirmed by  actions taken in the years prior to the crisis. Nevertheless, it would be an error to believe that anyone expected the situation to deteriorate so rapidly and in such a catastrophic manner. So much so that in 2006, Lehman Brothers decided to enter riskier investments, in particular leveraged lending and commercial real estate. In the same year delinquency rate for all mortgages would register an increase of 6%. The reasoning provided by management was related to the opportunity to improve the company’s competitive position: thanks to the acquisition in 2004 of BNC Mortgage Inc., Lehman would have been able to originate the non-prime mortgages itself (which it did at the tune of $US14bln just twelve months after implementing this strategy) to then be securitized as CDOs (Collateralized Debt Obligation). 

Related:  The Unexplored Potential of the Internet

Unfortunately, this vertical integration would prove fatal for the firm. The volume of illiquid assets, which is to say, commercial, residential real estate, and leveraged loan positions, that Lehman had to keep on its balance sheet rapidly increased because of the inability to repack and sell them on the market. This would go on to limit the ability of the company to raise cash, hedge risk, and reduce leverage through conventional means. Lehman Brothers’ senior executives allowed this to happen by relaxing risk controls. Stress tests required by the SEC (Security and Exchange Commission) were performed only on easily tradeable, liquid, in other words, assets. Risk appetite limits set at the beginning of each fiscal year and calculated daily were regularly exceeded during this period. Adopting the new “principal investment” (using the bank’s capital instead of raising it from investors) strategy was seen as the priority, and everything was done to reach the yearly return target of 13%.

The last stage before failure 

The fourth quarter of 2007 might have been the last chance for the company to avoid going bankrupt. According to a document presented to the Executive Committee in October of 2007, switching from originating assets for securitization and syndication to making long-term investments had cost Lehman Brothers more than $US7.5bln in equity since Q1 2006. The decision to not raise capital or sell assets (instead, they increased by $US23.7bln) further worsened the situation. It was at this time that Lehman Brothers began aggressively using an accounting device (internally known as REPO 105; in 2009, the FAS Board closed the loophole that permitted this kind of transaction) through which it was able to move from its balance sheet more than US$38bln in Equity & Fixed Income instruments. This number was destined in the first six months of 2008 to grow to more than US$50bln, slightly short of half the combined movements for the prior year. The objective of this action was not only to reduce the reported balance sheet but also to increase liquidity pool numbers and lower the net leverage artificially. This strategy, devised to convince investors to put even more funds in the firm, would be rendered useless by the events regarding Merrill Lynch and Bear Stearns. A few months later, the company would file for Chapter 11 Protection.

Related:  Circondati d'Arte: mostre, musei ed esibizioni da visitare questo autunno

SOURCES:

Mayer, C., Pence, K. and Sherlund, S.M., 2009. The rise in mortgage defaults. Journal of Economic perspectives, 23(1), pp.27-50.

Frame, S., Lehnert, A. and Prescott, N., 2008. A snapshot of mortgage conditions with an emphasis on subprime mortgage performance. Federal Reserve’s Home Mortgage Initiatives, Federal Reserve Bank of Richmond, Richmond.

Author profile

I’m an Economics and Finance student at Bocconi University.
My main passions are finance (what a surprise!), technology, as well as coding (mainly Python), and politics.

Leave a Reply

Your email address will not be published.

%d bloggers like this: