Lehman Brothers

Tsunami of Credit Crunch gulp down Lehman Brothers & The structure of confidence collapsed Page 1

Tsunami of Credit Crunch gulp down Lehman Brothers

&

The structure of confidence collapsed completely

Student ID: 4745353

Subject: Finance and Accounting Management


Table of Contents

1. Executive Summary: ........................................................................................................................ 3

2. Introduction to Credit Crunch: ........................................................................................................ 4

2.1 Definition & Terminology: ............................................................................................................. 4

2.2 What exactly caused this to happen? ........................................................................................... 4

3. SUB PRIME MORTAGAGE WORKED AS OPERATOR: ....................................................................... 5

4. The Economic Situation before the Collapse of Lehman Brothers: ................................................ 7

5. Lehman Brothers up to the Weekend of September 13-14: .......................................................... 8

5.1 Thought from one of the prime investor of Lehman Brothers: .................................................. 10

6. The DREADFUL Lehman Weekend (September 13-14, 2008): ..................................................... 11

7. The Accident that Punctured Confidence and Unleashed the Financial Panic: ............................ 12

8. CONCLUSION: ................................................................................................................................ 14

9. APPENDIX ...................................................................................................................................... 16

9.1 APPENDIX: History - 1929 to present ..................................................................................... 16

9.2 APPENDIX: Sequence of events happened during credit crunch (Rayner, 2008) ..................... 17

9.3 APPENDIX: Introducing the Argument: Confidence and Its Double Structure .......................... 18

9.4 APPENDIX: Confidence and Fear Index plays huge role ............................................................. 21

9.5 APPENDIX: Securitisation and Leverage ..................................................................................... 21

9.6 APPENDIX: ABOUT LEHMAN BROTHERS ..................................................................................... 22

9.7APPENDIX: Nature of Credit Crisis Worsened: ............................................................................. 23

9.8 APPENDIX: Consequences of Lehman Failure ....................................................................... 24

9.8.1 Bailouts and Busts: ............................................................................................................... 24

9.9 APPENDIX: Policy makers & Regulators Response ...................................................................... 26

9.10 APPENDIX: Solutions for Credit crunch ..................................................................................... 28

10. REFERENCES: ............................................................................................................................. 29


1. Executive Summary:

On September 15, 2008 Lehman Brothers filed for bankruptcy, something that

nearly caused a meltdown of the world’s financial system. A few days later Bernanke

made his famous statement that “we may not have an economy on Monday.” This report

includes the situation Lehman Brothers before and after the bankruptcy and how

exactly this event triggered the huge financial panic all across the globe termed as

credit crunch. It was a nonlinear and sudden catastrophic event for the global economic

system, unprecedented in scale in human history.

I analysed two major aspects, which pulled the worst possible recession of the

century. First one is Hidden losses and the second one is that confidence plays key role

in finance. Confidence can be conceptualized as a belief that action can be based on proxy

signs, rather than on direct information about the economic situation itself.

I have also studied how exactly Lehman went bankrupt, and how this worry

transformed into a total disbelief in existing proxy signs - a loss of confidence as well as

a withdrawal of confidence in this report. This report includes the series of action

happened or taken before and after Lehman Brother went bankrupt. Although the

debate of those actions will continue on and only time will be able to answer what could

have been right or wrong about it..!!


2. Introduction to Credit Crunch:

2.1 Definition & Terminology:

An economic condition in which investment capital is difficult to obtain.

Banks and investors become wary of lending funds to corporations, which drives up the

price of debt products for borrowers.

A credit crunch makes it nearly impossible for companies to borrow because

lenders are scared of bankruptcies or defaults, which results in higher rates. The

consequence is a prolonged recession (or slower recovery), which occurs as a result of

the shrinking credit supply.

2.2 What exactly caused this to happen?

Fig1. How exactly housing bubble end up with one of the biggest financial recession

The R's mean reinforcing feedback, the B's are balancing feedback, the S's (same) are where

more of one thing lead to more of another, and the O's (opposite) are where more of one thing

lead to less of another.


3. SUB PRIME MORTAGAGE WORKED AS OPERATOR:

The market for subprime mortgages grew very fast. Jaffee (2008)

documents two periods of exceptional subprime mortgage growth. These

expansions occurred because changes in the law allowed mortgage lending at

high interest rates and fees, and tax advantages were available for secured

borrowing versus unsecured borrowing. Another strong influence was the desire

of mortgage originators to maintain the volume of new mortgages for

securitization by expanding lending activity into previously untapped markets.

Subprime loans were heavily concentrated in urban areas where prime

borrowers that faced financial difficulties switched from prime to subprime

mortgages.

At the same time, U.S. residential subprime mortgage delinquency rates

have been consistently higher than rates on prime mortgages for many years

Pennington-Cross (2006) record figures from the Mortgage Bankers Association

with delinquencies 5½ times higher than for prime rates and foreclosures 10

times higher in the previous peak in 2001-02 during the U.S. recession.


A worrying characteristic of loans in this sector is the number of

borrowers who defaulted within the first three to five months after

receiving a home loan and the high correlation between the defaults on

individual mortgage loans. The growth in the scale of subprime lending

in the United States was compounded by the relative ease with which

these loans could be originated and the returns that could be

generated by securitizing the loans with (apparently) very little risk to

the originating institutions. The demand was strong for high-yielding

assets. Much of this demand was satisfied by residential MBSs and

CDOs, which were sold globally, but as a consequence the inherent

risks in the subprime sector spread to international investors with no

experience or knowledge of U.S. real estate practices.


4. The Economic Situation before the Collapse of Lehman Brothers:

From about 2001 and onwards, a credit bubble started to appear in the United

States. Huge amounts of capital moved into the country, in search of profit higher than

the low rate of interest that existed at the time (real risk-free rate of interest). A housing

bubble was also in the making; and through the process of securitization the housing

market was closely linked to the credit bubble in the U.S. financial system as well as to

the international financial system. Mortgages, traditionally the business of local banks,

were now pooled, turned into bonds and CDOs that were sold on to investors, in the

United States and elsewhere.

This is exactly what happened in 2007, when the decline of the U.S. housing

market started to register in a major way in the financial system. The financial crisis, it

is generally agreed, began in August 2007, when a major mortgage outfit went under

and the Fed as well as the European Central Bank had to infuse billions of dollars and

Euros into their financial systems. The failing subprime mortgages were, to repeat, at

the centre of what was now going wrong; and by August 2007 the amount of subprime

mortgages was estimated at $ 2 trillion. It is also true that if the new securities had been

fully transparent, then the investors at the end of the chain would have had to take their

losses; and that would have been all.

This, however, is not what happened. Instead the trouble spread to other parts of

the financial system: inter-bank lending started to freeze up and a run on SIVs took

place. Why was this case? The reason was that it was impossible for the investors to

determine which bonds and CDOs had suffered losses, and to what extent. The way that

these securities had been constructed made them impenetrable. The result was a fear

about hidden losses that spread to all subprime mortgage related bonds and CDOs as

well as to the institutions suspected of owning these. Gorton sums up his argument as

follows:

“The ABX information, together with the lack of information about location of

the risks, led to a loss of confidence on the parts of the banks in the ability of their

counterparties to honour contractual obligations. The panic was on, starting with a run

on structured vehicles” (Gorton 2009:568).


As 2007 became 2008, the economic problems continued and mortgages other

than subprime began to fall in value. This meant that the potential losses – the hidden

losses - were now extended to a pool of mortgage-backed securities worth somewhere

between $ 5-10 trillion. An increasing number of mortgage-related originators were

also going bankrupt; and the price of housing continued to go down.

The end for Bear Stearns began on March 10, when one of its mortgage-based

debts was downgraded by Moody’s, something that started a rumour that the bank was

in deep trouble. Bear Stearns immediately denied that it had liquidity problems but, as

is often noted, when a bank denies that it has a liquidity problem it is already lost.

“When confidence goes, it goes,” as Paulson said when asked about the chances of Bear

Stearns to survive.

During the months after the fall of Bear Stearns the general economic situation

continued to worsen. As the prices on the housing market were going down, securities

that at first had seemed safe now entered into the danger zone, including those with an

AAA rating. By August, according to information from the IMF, the value of many assets

had fallen dramatically, something that was especially dangerous for those institutions

that depended on short-term financing. As the economic situation continued to worsen

during the fall of 2008, the pressure shifted to the remaining investment banks and

especially to Lehman Brothers. To better understand what happened during the fatal

weekend of September 13-14, when the fate of Lehman was decided, we will now turn

to the economic activities of Lehman during 2007 and 2008.

5. Lehman Brothers up to the Weekend of September 13-14: 1

In 2005 and 2006 Lehman was the largest producer of securities based on

Subprime mortgages. By 2007, more than a dozen lawsuits had been initiated against

Lehman on the ground that it had improperly made borrowers take on loans they could

not afford. “Anything to make the deal work,” as one of Lehman’s former mortgage

underwriters put it. In 2007 the housing market also continued to go down and Lehman

was increasingly getting stuck with mortgage bonds and CDOs that it could not pass on.

1 Fuld was the CEO of Lehman Brother. His full name is Richard Fuld. Referred as Fuld here.


Richard Fuld does not seem to have understood what a great threat this

constituted. He knew of course that the housing market was going down; and in order to

counter this, he decided to invest heavily in commercial real estate and in assets outside

the United States. What was behind this strategy was a lack of insight into the close link

between what was going on in the financial system and in the U.S. housing market,

thanks to securitization. As things turned out, Lehman’s dealings in commercial real

estate created even more bad debt on its books than its dealings in residential housing.

During 2008 the position of Lehman worsened and its shares continued to go

down. The day after the fall of Bear Stearns on March 16, 2008, its shares fell 19

percent and many believed that Lehman was the next investment bank to go off.

Secretary of the Treasury Henry Paulson was one of these persons; and therefore he

initiated regular contacts with Fuld. He emphasized to Fuld that Lehman was in a very

difficult economic situation and needed to find a buyer. People from the SEC and the Fed

were stationed at Lehman. Contrary to what is believed, the Fed also started to help

Lehman with enormous loans and would do so till its collapse on September 15.

Fuld, it appears, did not realize the seriousness of either what Paulson was

telling him or of the situation in general. For one thing, he thought that he had the full

backing of Paulson. “We have huge brand with treasury,” as he famously phrased it in an

e-mail, after a meeting with Paulson on April 12. From March to the September 13-14

weekend Fuld turned down several opportunities to sell Lehman as well as an infusion

of capital from Warren Buffett and attempts to cut deals with Morgan Stanley, Goldman

Sachs and Bank of America.

Fuld over believed that Lehman could weather any

storms it faced during the spring and summer of 2008,

investors were getting increasingly nervous. While many

banks had declared heavy losses and write-downs,

Lehman had not. In fact, Lehman declared a profit of

several hundred million dollars for the first quarter of


The three major rating agencies were also applauding Lehman’s performance, as

they would do till the very end. Still, rumours were strong that Lehman was covering up

its losses. Some investors also started to look for information on their own, and what

they found made them suspicious.

5.1 Thought from one of the prime investor of Lehman Brothers:

But now by that time Fuld was desperately trying to raise capital or to find a

buyer. He contacted a number of potential investors, including Citigroup, which sent

over a team to go through Lehman’s books. Lehman’s last chance of being bought up

disappeared on September 10, when Korea Development Bank announced that it had

decided to withdraw from a possible acquisition. The very same day Lehman also

declared a loss of $ 3.9 billion and was warned by Standard & Poor that it might be

downgraded. The next day Lehman had great difficulty in scraping together the extra

collateral of $ 8 billion that JP Morgan Chase now demanded; and it was clear that the

financing of Lehman’s daily operations was quickly drying up. The end, in other words,

was near. On September 12 a number of the key CEOs on Wall Street each got a call from

staff members at the Fed, telling them to attend an emergency meeting at 6 pm at the

New York Federal Reserve Bank. Lehman’s fate was to be decided.

One of these investors was David Einhorn, the head of a hedge fund called

Greenlight Capital gave a speech in a conference for investors in April, he argued

that investment banks and specially Lehman Brothers is dangerous for a number

of reasons as they used half of their revenue for compensation like its employees

have a very strong incentive to increase the leverage of their firm. If you calculate

its leverage properly, it comes 44:1. This means that if the assets of Lehman fell

by 1 %, the firm would have lost almost half of its equity. The consequences of

this were dramatic: “suddenly, 44 times leverage becomes 80 times leverage and

confidence is lost.” In late May he made another public attack on Lehman. This

time he announced that his hedge fund was shorting Lehman and he explained

the reason as “Lehman does not provide enough transparency for us to even

hazard a guess as to how they have accounted for these items.” Lehman responds

to requests for improved transparency begrudgingly but it was not enough so he

suspected that their amount of transparency on these valuations would not

inspire market confidence.


6. The DREADFUL Lehman Weekend (September 13-14, 2008):

After the fall of Fannie and Freddie, anyone with high leverage and lots of real

estate exposure was suspect. Lehman Brothers was an obvious candidate. It was a

broker/dealer, like the Bear. Also like the Bear, it had significant exposure to mortgages.

Lehman took both significant residential and commercial mortgage risk, so clearly 2008

was not a good year for it. The firm posted significant losses during the second quarter

of 2008. It needed more capital to restore confidence. It was needed liquidity but none

of their moved worked, hence Lehman’s share price tumbled, and the firm started to

feel difficulty to survive. Firms which rely on confidence sensitive funding and then lose

the confidence of the market fail quickly. On the 9th September 2008, Lehman’s shares

fell by 45%. Borrowing became well nigh impossible for Lehman. By the 15th, it had

filed for bankruptcy protection. This was one of the largest failures in American

corporate history.

Fig. 1 The Lehman Brothers share price in 2008

The weekend of September 13, During Saturday the group of people by Treasury Dept

that had been assigned to estimate Lehman’s economic situation, concluded that its

losses were much larger than had been thought. Beside its mortgage related losses,


which were already known, Lehman also had tens of billions of dollars of losses in its

portfolio for commercial real estate. Altogether, Lehman’s losses – hidden as well as

already known losses – amounted to something like $ 30-80 billion.

Lehman failed, and declared bankruptcy in the early hours of September 15.

Despite these failures, Fuld insists that it was rumours and short selling that brought

down Lehman, not its huge losses in a deteriorating economy and his own failure to deal

with this. “Ultimately what happened to Lehman Brothers,” Fuld said later when he

testified at Congress, “was caused by a lack of confidence”

7. The Accident that Punctured Confidence and Unleashed the

Financial Panic:

Lehman’s bankruptcy set off a panic that would end up by threatening not only

the U.S. financial system, but also the global financial system. Did the bankruptcy work

as a kind of detonator, and if so, exactly how did it work? Or was Lehman’s bankruptcy

rather the first in a series of explosions, so to speak, that helped to set off an avalanche?

These questions are currently hard to answer, among other reasons because there is

very little exact knowledge about what happened once Lehman went bankrupt.

This event triggered immediate direct and indirect effects on the market. The

direct effects of Lehman’s bankruptcy were on those who were tied with Lehman in

credit default swap, simply can imagine by contemplating the fact that this was a $ 613

bn bankruptcy –the largest ever in U.S. history.

In the Indirect losses you can refer to below diagram.


2 Paulson told his staffs on September 16th that “This is an economic 9/11!” as

confidence was disappearing quickly from the financial world was, for example, clear

from what was happening to the two remaining investment banks. During the days after

Lehman’s bankruptcy, the shares of Goldman Sachs and Morgan Stanley fell quickly and

it seemed clear that both of them might go down.

At the same time the shares of Citigroup kept going down after the collapse of

Lehman. From 2007 and onwards the giant bank conglomerate had taken heavy

mortgage related 29 losses; it was also suspected of having much more hidden losses of

this type. The Fed, however, had confidence in the solvency of Citigroup.

On October 1, however, the Senate passed the bill to fund the Troubled Asset

Relief Program (TARP). On October 3, after pressure, the House passed the bill as well.

2 VIX : Volatile Index LIBOR: London Inter Bank Offered Rate


8. CONCLUSION:

In this paper, the focus is mainly on the role of confidence. To recapitulate the

core idea of this theory is that confidence has to do with people’s capacity to base their

actions on indicators or proxy signs for what some situation are alike, in those cases

where they lack direct knowledge of the situation. When the proxy sign is properly

aligned with the economic situation, investors will feel confidence. The situation when

confidence disappears very suddenly (collapse of confidence) and then there is the

situation when actors do not engage in some economic action because they lack the

confidence to do so (withdrawal of confidence) lead to finance recessions.

What characterized the situation before Lehman went down was a general worry

that the existing proxy signs (ratings, reported earnings and so on) did not adequately

represent the economic situation of various financial institutions.

Each Country’s Government and financial body and regulators play huge roles in

such circumstances. In this case, US Treasury, FED & government initiated preventive

measures for credit crunch at good time. Please refer to the few other ways or solutions

for credit crunch in appendixes. Although the debate of those actions will continue on

and only time will be able to answer right or wrong about it..!!


Source: Figures from Bloomberg Terminal


9. APPENDIX

9.1 APPENDIX: History - 1929 to present


9.2 APPENDIX: Sequence of events happened during credit crunch

(Rayner, 2008)

Date Event

July 31, 2007

After months of concerns about the exposure of financial institutions to US subprime mortgages, Bear Stearns, one of the world's biggest investment banks, stops clients from withdrawing cash from a fund which has lost billions of dollars. The fund closure sets alarm bells ringing in financial markets around the world

Aug 9, 2007

Short-term lending between banks, which they rely on to balance their books, dries up after French giant BNP Paribas suspends three investment funds worth 2 billion Euros because of exposure to US subprime mortgages. The European Central Bank, the US Federal Reserve and the Bank of Japan offer to lend banks tens of billions to ease what is already being called the Credit Crunch.

Sept 13, 2007

Northern Rock, Britain's fifth-biggest mortgage lender is granted

emergency funding by the Bank of England after finding itself unable to

secure loans from elsewhere. The news leads to the first run on a British

bank for more than a century as thousands of depositors queue to get

their money out. The crisis only passes when Chancellor Alistair Darling

agrees to guarantee all savings.

Oct 30, 2007

Stan O'Neal resigns as chief executive of US investment banking giant Merrill Lynch after it writes down £4 billion from its asset books because of exposure to bad debt. Within days, Charles Prince, chief executive and chairman of Citigroup, resigns after the bank reveals losses of around £5 billion because of subprime exposure.

Nov 16, 2007

Nationwide building society warns that house prices will stagnate in 2008. On the same day, Adam Applegarth resigns as chief executive of Northern Rock. Later in the month, Mervyn King, governor of the Bank of England, warns that growth in the UK economy will slow down and inflation will rise.

Dec 6, 2007

Bank of England cuts interest rates for the first time since 2005, amid signs the economy is slowing. Two weeks later it makes £10 billion available in loans to UK banks to ease the credit crunch as many banks and building societies withdraw 100 per cent mortgages.

Jan 11, 2008

With banks around the world revealing more and more losses, US Federal Reserve boss Ben Bernanke admits the outlook for the US economy is bleak. James Cayne, head of Bear Stearns, finally resigns over subprime losses. On January 21, global stock markets, including the FTSE 100 index in London, suffer their biggest falls since the terrorist attacks of September 11, 2001.

Feb 13, 2008 Bradford & Bingley reduces the value of its subprime related investments by £144 million, having said just weeks earlier it did not expect to suffer any write-downs.

March 18, 2008 Bear Stearns is bought by JPMorgan Chase for £120 million, having been valued at £9 billion a year earlier.

April 22, 2008

Royal Bank of Scotland, Britain's second-biggest banking group, asks shareholders for £12 billion to shore up its finances, one of the largest rights issues in the country's history. Two days later, house builder Persimmon calls a halt to all new building projects as house sales collapse.

May 14, 2008 Bradford & Bingley launches an emergency £300 million rights issue as full scale of its subprime losses becomes clear. UK inflation hits 3 per cent as the cost of food and fuel goes through the roof.


June 25, 2008 Barclays becomes the latest big bank to admit to problems as it announces plans to raise £4.5 billion by issuing 1.6 billion new shares, which are mostly sold to Middle Eastern investors.

July 1, 2008

Shares tumble as world stock exchanges slump into a bear market (one in which shareholders want to sell) with the FTSE 100 index recording its seventh straight weekly fall. Property sales in the UK slump to a 30-year low.

Aug 30, 2008 Alistair Darling says Britain is suffering its worst economic crisis for 60 years. Days earlier, figures reveal that house prices have dropped 10 per cent in the past year, the biggest fall since 1990.

Sept 8, 2008

US Treasury steps in to rescue Fannie Mae and Freddie Mac, the two companies which guarantee half of all US mortgages, exposing US taxpayers to £2.9 trillion of debt in the world's biggest financial bail-out. US Treasury Secretary Hank Paulson says the two companies are simply too big to be allowed to fail.

Sept 14, 2008 .

Lehman Brothers files for bankruptcy and becomes the first major bank to collapse since the start of the credit crisis. Alan Greenspan, the former chairman of the US Federal Reserve, describes the failure as "probably a once in a century type of event" and warns that other major firms will also go bust. This event came to operate as trigger for the financial panic that occurred in the fall of 2008 and almost caused a meltdown of world’s financial system.

9.3 APPENDIX: Introducing the Argument: Confidence and Its Double Structure

Despite its importance, there only exists a very small number of studies that look

at the role of confidence in finance (e.g. Walters1992; for a review, see Swedberg

forthcoming). Walter Bagehot’s classic work Lombard Street (1873). Bagehot is

interesting in this context because he was well aware of the special role that confidence

plays in the banking world. He also tried to explain the role that confidence plays in

unleashing a financial panic, something that is of special relevance for this paper.

The banking system, Bagehot notes, always demands an extraordinarily high

level of trust, much higher than elsewhere in the economy. In this part of the economy

there has to exist, as he puts it, “[an] unprecedented trust between man and man”

There are mainly two reasons for this, one having primarily to do with liquidity,

the other with solvency. The first reason for the unprecedented level of trust to exist in

the banking system has to do with maturity transformation - that deposits are short-


term, while loans are long-term. If the depositors do not have full confidence that their

money is safe, they will demand it back. And when they do so, the bank will be in

trouble since it lacks liquid resources to pay the depositors. The larger the amount that

is lent out, in relation to the amount deposited, the more tenuous this type of confidence

will also be.

The second reason for confidence being extraordinarily important in the banking

system has to do with losses that the bank may occur through its loans. A bank is

extraordinarily vulnerable, in other words, not only because of liquidity-related

troubles, but also because of its losses, since these must be offset against the capital of

the bank.

Again, the more that has been lent out, the more vulnerable a bank is and losses

increase in their turn the leverage ratio dramatically. What this means, to repeat, is that

the level of trust or confidence has to be higher in the area of banking than elsewhere in

the economy. Bagehot also explicitly states that what is especially dangerous for the

banking system is a situation in which there are hidden losses. The reason for this is that

when these losses become known, a general panic can be set off that goes well beyond

the problem banks. Anything may suddenly reveal the true economic situation, with a

free fall of the whole banking system as a result. Or in Bagehot’s words: “We should

cease…to be surprised at the sudden panics [in the banking system]. During the period

of reaction and adversity, just even at the last instant of prosperity, the whole structure

is delicate. The peculiar essence of our banking system is an unprecedented trust between

man and man; and when that trust is much weakened by hidden causes, a small accident

may greatly hurt it, and a great accident for a moment may almost destroy it” (Bagehot

[1922 [1873]:151-52; emphasis added).

Sometimes investors suddenly losing confidence in the banking system, when

they realize that there are hidden losses. In order to get a more fine-tuned

understanding of how a financial panic may be unleashed by hidden losses, this topic

has to be addressed.

My argument in this report is that while Merton has focused on one important

role that a loss of confidence plays in the financial system, it is not the only one, and

perhaps not even the central one for understanding a financial panic. The real problem

Tsunami of Credit Crunch gulp down Lehman Brothers & The structure of confidence collapsed

with a loss of confidence occurs not when banks are solvent and there exist rumours to

the contrary (the proxy sign is negative and the economic situation is positive). It occurs

instead when some banks are not solvent, and this is not known (

positive and the economic situation is negative). We are then in Bagehot’s dangerous

situation, in which it is not known who has losses and who has not, and in which an

accident may set off a general panic that endangers the whole financi

Fig.1). Or to phrase it differently, Merton’s mechanism only comes into play in an

important way, in the situation of hidden losses, as described by Bagehot.

Fig. 1: Proxy Signs and Nature of Confidence

Explanation: A proxy sign can in the

state of affairs or not. In the former case, a positive proxy sign correctly

positive state of affairs; and a negative sign correctly indicates a negative state of affairs.

Confidence is maintained in both of these cases, since the actor has correct information

(++/--).When, in contrast, the proxy sign and the situation are

sign therefore misrepresent the situation, confidence will suffer.

gulp down Lehman Brothers & The structure of confidence collapsed



instead when some banks are not solvent, and this is not known (



accident may set off a general panic that endangers the whole financi



Fig. 1: Proxy Signs and Nature of Confidence

A proxy sign can in the ideal case be assumed to be either aligned

state of affairs or not. In the former case, a positive proxy sign correctly


tained in both of these cases, since the actor has correct information

).When, in contrast, the proxy sign and the situation are not aligned and the proxy

sign therefore misrepresent the situation, confidence will suffer.

gulp down Lehman Brothers & The structure of confidence collapsed Page 20



instead when some banks are not solvent, and this is not known (the proxy sign is



accident may set off a general panic that endangers the whole financial system (see



ideal case be assumed to be either aligned with the

state of affairs or not. In the former case, a positive proxy sign correctly indicates a


tained in both of these cases, since the actor has correct information

aligned and the proxy


9.4 APPENDIX: Confidence and Fear Index plays huge role

Source: Figures from Bloomberg Terminal

9.5 APPENDIX: Securitisation and Leverage


9.6 APPENDIX: ABOUT LEHMAN BROTHERS

The modern Lehman Brothers (founded in 1844 as a dry goods business in

Alabama), emerged once more as an independent investment bank in 1994 when it was

spun off from American Express (e.g. McDonald and Robinson 2009, Rose and Ahuja

2009). Richard Fuld, who had joined Lehman in 1969, was now appointed its President

and CEO. Under his leadership, Lehman continued to not only carry out the traditional

tasks of an investment bank, but also to push deeply into the new financial markets that

were emerging at the time. For one thing, it early on became a leader in the subprime

securitization market.

Till Fuld was pushed to the side in June 2008, he ran Lehman in an authoritarian

manner, creating the very aggressive and competitive type of corporate culture that

seems to be characteristic of modern investment banks.3 Anyone who was 15 perceived

as a threat by Fuld was eliminated, and so were critics who from early on argued that

Lehman was heading for trouble (McDonald and Robinson 2009). As many successful

CEOs, he also kept a lifestyle that isolated him from the real world. It should also be

emphasized that Fuld’s personal experience was as a bond trader and that he had little

understanding of such new financial instruments such as collateralized debt obligations,

credit default swaps. As we soon shall see, this lack of sophistication on Fuld’s part

helps to explain some of his clumsy attempts to deal with the crisis. Lehman was one of

the leaders in the production of securitized mortgages and also owned two mortgage

firms, BNC in California and Aurora Loan Services in Colorado.5 According to The Wall

Street Journal, “Lehman established itself [in the mid- 1990s] as a leader in the market

for subprime-mortgage-backed securities. It built a staff of experts who had worked at

other securities firms and established relationships with subprime-mortgage lenders”

(Hudson 2007).


9.7APPENDIX: Nature of Credit Crisis Worsened:

The growing concern caused a sharp drop in the issuance of asset-backed

securities, particularly those of lower quality, in August 2007. All types of asset-backed

securities and CDOs were adversely affected from September 2007, subprime

residential MBSs and CDOs of asset-backed securities issues shrank, and even prime

residential MBSs were substantially lower (Figure). Investors realized that the assets

were riskier than had previously been thought, and the cost of insurance to cover

default risk using credit default swaps (CDS) also had become much more expensive.

President Bush expressed the same idea, but in his own language, when he said,

“this sucker could go down.”

According to economist Robert Lucas, “Until the Lehman failure the recession

was pretty typical of the modest downturns of the post-war period…After Lehman

collapsed and the potential for crisis had become a reality, the situation was completely

altered” (Lucas 2009:67). According to Alan Blinder, another well-known economist,

“everything fell apart after Lehman…After Lehman went over the cliff, no financial

institution seemed safe. So lending froze, and the economy sank like a stone. It was a

colossal error, and many people said so at the time” (Blinder 2009).

Two months later Henry Paulson, the Treasury Secretary, explained that the

failure of Lehman Brothers had led to a systemic crisis and to the evaporation of

confidence in the financial system:


9.8 APPENDIX: Consequences of Lehman Failure

For a few days, this decision seemed harsh but fair. But then the markets realised

the implication of Lehman’s failure: no financial institution’s debt was safe. If you lent to

someone, not only might they not pay you back; the government wouldn’t either. Given

that it was unclear who was running which risks, no financial institution was safe. At

that point the argument was decided firmly in favour of the debt market’s pessimism,

and equity markets plunged.

This led immediate consequences for the other three large broker/dealers.

Merrill Lynch, the next most vulnerable firm, quickly sold itself to Bank of America. The

final two, Goldman Sachs and Morgan Stanley, turned themselves into banks. This

allowed them to access funding from the FED and to be able to fund themselves using

retail deposits (something broker/dealers could not easily do).

Meanwhile, the money markets dried up. Financial institutions became

increasingly unwilling to lend, either to each other or to anyone else. This began to

seriously affect the broader economy. Share prices crashed as the market digested the

likely impact of slowing demand and more expensive credit.

9.8.1 Bailouts and Busts:

The fallout from the failure of Lehman arrived quickly. Washington Mutual was

the largest thrift in America. As a prominent loser in the Crunch, WaMu, as it was

known, was already looking vulnerable. A downgrade of its credit rating on the 15th

September raised concerns further. WaMu found deposits being withdrawn. The

resulting pressure on funding caused WaMu’s regulator to act. On the 26th September

2008, the Office of Thrift Supervision took control and appointed the FDIC as receiver.

WaMu’s branches and assets were quickly sold to JPMorgan. An institution with total

assets of over $300B had failed in less than two weeks. It was clear at this point that

dramatic action was needed to prevent a string of bank failures. Not saving Lehman

might have been a good decision ethically, but it began to look like very bad economics.

Many financial institutions were vulnerable, and even the largest banks were having

problems rising funding. Government intervention was needed across the whole

financial system.


The U.S. Treasury suggested a program to purchase distressed assets from

financial institutions, the Troubled Asset Relief Program or TARP. This did not meet with

favour from legislators, not least because the original plan gave extraordinary discretion

to the Treasury with rather little oversight. The House of Representatives voted down

the first version of the TARP, presumably taking the view that if the Treasury bought

troubled assets for their fair value then it would not have done any good, but if it bought

them for more than they were worth, then it amounted to a simple subsidy to the banks

who had taken the biggest risks.

The TARP was restructured to include extra oversight and require that the

Treasury obtain equity stakes26 in the firms that they assist. This at least involved less

moral hazard than buying assets, and the new TARP was passed on the 3rd October

2008. The program was immediately put to use. Over $125B of new capital was injected

into leading American financial institutions. At the same time, other governments were

intervening to save their banking systems. For instance, the UK government enacted a

£500B plan28; Fortis was rescued by the Dutch, Belgian and Luxembourgeois

governments; Hypo Real Estate Holding was bailed out by a consortium including the

Bundes bank; and all three of Iceland’s big banks were nationalised. Figure shows some

of the larger injections of state capital: in addition a number of banks raised extra

capital privately.


The immediate crisis was thereby averted. The recapitalisations and rescues

gave the largest financial institutions some breathing space, and a modicum of

confidence returned to the market. The Central Banks helped too, flooding the markets

with liquidity and cutting interest rates in a coordinated move. Various European

nations including Ireland, Denmark and Austria extended the scope of their deposit

protection, further bolstering confidence.

Further bank recapitalisations continued through the rest of October 2008: the

Swiss banks got more money on the 16th; ING on the 19th; smaller U.S. banks on the

27th. But the pattern was now clear. Governments would bail out their financial

institutions by lending hem money and injecting extra capital. Shareholders would

suffer, but the financial system would not be allowed to collapse. The position of

taxpayers was less clear. A lot of money had been spent by governments in a short

period of time. Significant stakes had been purchased for that money in a depressed

market. Some of these would prove to be good investments. But there are other assets

the taxpayer made which, in the Deputy Governor of the Bank of England’s words

‘clearly have a level of defaults in them [which we are] not quite sure how will balance

out against the residual of the capital. That is, losses are possible.

9.9 APPENDIX: Policy makers & Regulators Response

The principles for mitigating financial crises were established more than 100

years ago in the book "Lombard Street: A Description of the Money Market" (1873) by

Walter Bagehot. In his book, Bagehot stressed that in order to stop a panic, the central

bank should give the impression that "though money may be dear, still money is to be

had." Bagehot went on to say that the central bank should "lend freely, boldly, and so

that the public may feel you mean to go on lending." Central bankers continue to follow

this prescription, which is why they usually lower interest rates when a financial crisis

occurs.

A second important principle for minimizing the effects of a financial crisis is to

maintain confidence in the safety of the banking system. This prevents a "run on the

bank" in which consumers rush to withdraw their deposits. Confidence in the banking

system is often secured by providing government guarantees on bank deposits, such as

the U.S. FDIC insurance program.

It is also important for policymakers to react swiftly when a crisis strikes. Indeed, the

earlier policy-makers recognize and react to a crisis, the more effective their actions are

likely to be. If adequate liquidity is quickly provided and confidence in the banking

system is maintained, the effects of a crisis can be mitigated.


Policy/

Regulators What they did? Market Effects Example

The Federal

Reserve

1. Has been extremely active in

making sure that the financial

system continues to function

properly during the credit crisis.

2. The Fed lowered its key federal

funds rate to provide additional

liquidity to the financial system

3. Expanded the range

of collateral it would willingly to

accept in return for loans.

4. Provided direct lines of credit to a

broader variety of financial

institutions (previously

only commercial banks could

borrow directly from the Fed.)

1. Helped to

maintain

confidence

2. Liquidity in the

financial system as

part of efforts to

mitigate the

effects of the

credit crisis.

1. When Bear

Stearns was on the

verge of bankruptcy

the Fed guaranteed

a large portion of

Bear Stearns'

liabilities in order to

facilitate

a takeover by

JPMorgan.

The

Government

1. The executive branch of the

government has also been closely

involved in maintaining stability in

the financial system.

2. These efforts have included direct

aid to a number of prominent

financial firm (named as FHFA in

conjunction with treasury

department)

3. The famous bailout plan for nig

financial firms (refer to below table

for figure)

1. Providing fiscal

stimulus to the

economy.

2. Took

extraordinary

measures to secure

confidence in the

financial system

through a variety of

guarantees,

insurance

programs, loans

and direct

investments.

1. placed Fannie

Mae and Freddie

Mac under

conservatorship as

part of a four-part

plan to strengthen

the housing

agencies

The

centralised

bank

1. Continue to follow the same

policy (lend freely, boldly, and so

that the public may feel you mean

to go on lending)

2.lowered their interest rates on

lending and increased interest rate

on deposits

1. Helped to gain

the confidence of

public

1.State Bank of

India


9.10 APPENDIX: Solutions for Credit crunch

This depends on which phase of credit crunch that bank is in: Three Phases of Crisis Management

1. Short-term: Immediate Damage Containment 2. Medium-term: Restructuring Insolvent Banks 3. Long-term: Systemic Restructuring

Traits of good strategies

1. Transparent, early recognition preserves trust 2. Politically and financially independent agencies 3. Maintain market discipline 4. Repair the real economy esp. Creditworthiness


10. REFERENCES:

Baesens, B. (2009). Credit Risk Management. Oxford, United States: Oxford University Press.

Bagehot, W. (1922). A Description of the Money Market. Lombard Street , 151-52.

Barker, T. (2009, Jun 5). Understanding and Resolving the “Big Crunch”. The Cambridge Trust for New

Thinking in Economics .

Ben Bernanke, Paulson Henry, and Sheila Bair. (2008, October 14). Statements by Paulson, Bernanke

Bair. Wall Street Journal .

Bryan-Low, C. (2009). “Lehman Europe Claims Begin to Come In”. Wall Street Journal , September

25.

Gabaix, X. A. (2007). Limits of Arbitrage: Theory and Evidence from the MBS market. Journal of

Finance , 557-596.

Mizen, P. (2008). The Credit Crunch of 2007-2008. FEDERAL RESERVE BANK OF ST. LOUIS REVIEW ,

531-568.

Rayner, G. (2008, Sept 15). Credit crunch Time line from Northern Rock to Lehman Brothers.

Retrieved April 1, 2010, from www.telegraph.co.uk:

http://www.telegraph.co.uk/finance/newsbysector/banksandfinance/2963415/Credit-Crunch-

timeline-From-Northern-Rock-to-Lehman-Brothers.html

Runde, Jochen (1994b). ‘Keynesian uncertainty and liquidity preference’, Cambridge

Journal of Economics, Vol. 18, No. 2, pp. 129–144.

Documents

Lehman Brothers