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Lehman Brothers Case Study

1. Critics and supporters alike looked at causes, particularly past Congressional acts like the Community Reinvestment Act, the deregulation of the Glass Steagal Act and semi-government agencies like the Freddie Mac and Fannie Mae, as contributors to the subprime crisis. Based on your research, do you think that these Acts and agencies have a role to play in the subprime mortgage crisis?

There is no one specific agency responsible for the downward spiral of our economy. Rather, it was a collective assisted effort combining the de-regulation of the Glass Steagall Act by Senators Phil Gramm and Jim Leach, the power of the Community Reinvestment Act, and the bursting failure of both Fannie Mae and Freddie Mac. All were designed with good intent but were not thought to have a negative impact upon each other. The Community Reinvestment Act was passed in 1977 with the intent for banks to focus on meeting the needs of its borrowers in their corresponding communities. Congress passed the CRA in an attempt to avoid discrimination to people in need of loans, particularly those in low income neighborhoods. The CRA required any bank receiving insurance from the FDIC to meet the lending standards but it was not forcing lenders to take on high-risk loans that may cause a loss to the financial institute.

In 1999 a repeal to the Glass Steagall Act was passed. This gave more power to financial institutes in relation to their credit and loaning ability. The repeal allowed banks to buy and trade mortgage backed securities and collateralized debt obligations and to create instruments such as the structured investment vehicle. These activities gave banks the ability to sell their debt which in turn freed up their loaning ability. The high risk portfolios seemed safe to the buyer because each was being backed by the financial institutes’ credit history, not the credit history of the original borrowers. A conflict of interest arose when banks were allowed to grant and receive credit from themselves after the repeal.

These acts along with Freddie Mac and Fannie Mae allowed a constant flow of lending money for mortgages or buying and selling the debt to maintain this high demand for mortgages. More people in general were now able to buy homes because mortgages were readily available. Once the borrowers began to default on their loans a snowball effect commenced. This plummeted the economy into the recession we are currently experiencing. In short, a combination of loans being readily accessible to people in low income areas through the Community Reinvestment Act plus banks freeing up their debt by selling it in portfolios created with the repeal of the Glass Steagall Act plus Fannie Mae and Freddie Mac buying mortgages from banks that consist of poor credit and people who default on their loans results in a wealth of debt and no funds available to pay for such debt.

2. Do you believe that the U.S. government treated different financial institutions differently during the crisis? Was that appropriate?

The question is not whether the U.S. government treated some financial institutions differently than others, but why? Ideally the Federal Reserve, the Comptroller of the Currency and the Federal Deposit Insurance Company (FDIC) support, protect and buffer financial institutions when they feel as though the failure of those institutions might have a significant effect on the market as a whole. Just as banks review the credit of new clients wishing to borrow money, so the Federal Reserve looks at the collateral and the ability to repay loans of the institutions it is thinking about pouring capital into.

The Federal Reserve officials have said in retrospect that the companies that did receive bailouts, such as AIG, Fannie Mae and, Freddie Mac, clearly had the collateral and showed great promise of paying them back in the future, while Lehman Brothers did not. Those representing the Lehman Brothers have said that they did have the collateral and should have been bailed out, but because the government was expecting other companies, namely Bank of America and Barclays, to purchase parts of Lehman Brothers, they did not step in. It has also been rumored that Lehman Brothers was intentionally led to bankruptcy as a political move, though this has yet to be proven.

By the time that Lehman Brothers filed for bankruptcy, the financial crisis was well on its way. Some analysts view the Lehman Brothers’ fall as the government’s wake-up call in dealing with the ensuing financial crisis, prompting the bailouts of the other companies (though the sequence of events pokes holes in this theory). However, if Lehman Brothers had been aided, perhaps the financial world would not have come to a screeching halt, stopping lending and borrowing altogether for a brief period of time.

For those that oppose the bailouts altogether, it must be said that all people rely on banks and financial institutions in one way or another and in the long-run, aiding this banks was more likely than not the right move to make. Whether the different treatment given to financial institutions was “appropriate” is difficult to determine. It does not seem “fair” for Lehman Brothers to not have received any government aid, but then again they were known for taking large risks and with the chance to succeed also comes the risk to fail.

3. Many experts argue that when the government bails out a private financial institution it creates a problem called “moral hazard,” meaning that if the institution knows it will be saved, it actually has an incentive to take on more risk, not less. What do you think.

It is human nature to push limits, and the moral hazard argument fits very well with the Lehman brothers case. If rewards are associated with higher risk, one might think that an organization would push until punished. It is possible that the government let Lehman Brothers fall and fail to maintain its status in the financial markets as an example to other institutions. Perhaps it was very important to let one financial entity fall so others do not follow.

The moral hazard argument implies that a message or lesson has to be communciated. At the time of the fall of Lehman brothers, media outlets flooded the airwaves with fear of total financial collapse, or signs of the next great depression. The real message became, in part, that some of these big Wall Street firms could fail, and no one would have believed this before. Lehman was too big too fail. Because of problems with valuation of disguised bad assets and excessive liabilities, Lehman could hardly be assessed, so a lesson needed to emerge to prevent a moral hazard and create a moral marking point in the financial collapse. Precept had to be established to prevent further collapses and create a change in the practices of financial institutions.

On the other hand, the freezing of the commercial paper market, of which Lehman dominated, meant the drying of liqudity and the fostering or piling on to the impending financial doom. The question to frame-up is really this: Should the goverment have saved Lehman, then punished it? This might have created a blocking mechanism to avoid further bank failures and cease illiquidity. In effect, the failure caused problems of greater magnitude as commercial paper movement dried up, seizing the flows of cash and capital needed for short-term loans and other business financing needs.

The bottom-line is that with moral lessons also comes the potential move away from pragmatism into short-term collateral damage.

4. Do you think that the U.S. government should have allowed Lehman Brothers to fail?

The U.S. government’s decision to allow Lehman Brothers to fail is a double-edged sword. The implications behind allowing Lehman Brothers to fail include a massive domino effect on the U.S. market, the world markets and many large companies Lehman Brothers invested in and acquired over the years. During the first and second quarter of 2008 Lehman’s stock value decreased by 73% due to exorbitant losses which in turn led to 1,500 employees becoming unemployed. Lehman’s stock value decreased further when propositions for the Korean Development Bank to buy the struggling bank fell through. As a result of a steadily declining market value, “Swiss Re estimates its overall net exposure…as approximately CHF 50 million.” In addition to the foreign markets, U.S. investor confidence diminished causing the S&P 500 and the Dow Jones to plummet in September 2008. Due to the size of the bank, its collapse has been accused as the major force behind the downward spiral of economies, domestic and foreign.

Had the U.S. government assisted Lehman Brothers as it did with Fannie Mae and Freddie Mac and AIG, investor confidence across the globe may not have faltered as it did which in turn would not have negatively impacted the world markets. On the other hand, if the government had assisted Lehman the question comes to mind as to who would foot the bill for such a massive bailout? The government already provided AIG alone $85 billion in federal assistance. This movement put a bad taste in the mouths of individuals due to AIG’s upper management awarding themselves with lavish bonuses and vacations after the bailout. It was also believed that Lehman Brothers was “too big to fail” and with such an air of arrogance and AIG’s discretionary spending of the government loan, the government most likely was trying to make an example out of Lehman Brothers by letting it fail. Making such an example out of a large corporation set the tone for other large corporations to operate responsibly and ethically. If Lehman Brothers did not have such a consequential impact on the global economy, then yes, the government should have allowed the banking giant to fail, but since its failure was so astronomical there should have been some assistance to lessen the blow.

5. Why did the failure of Lehman Brothers, a U.S. investment banking firm, had such a contagion effect spreading to a global financial crisis?

I think it would be an erroneous misstep to ignore the financial environment of September 2008, of which Lehman Brothers was a part of. Yes, Lehman Brothers collapsed, and it did affect global finance, but there was also the fact that Merryl Lynch had surrendered its independence and AIG was on life support from the government. According to the Financial Time’s in depth coverage of the aftershock following Lehman’s fall, the final snap that threw the financial world into peril was trust. Investors simply lost trust in the markets and the U.S. government’s response to the problem, so they called in their loans from any fund deemed slightly risky.

When Lehman went bankrupt, hedge funds invested in Lehman had its assets frozen that forced investors to sell what they could. The government was forced into bailing out AIG and the Reserve Fund that held Lehman funds refused to allow access to funds to investors. The news afterwards was that money market funds were now unsure — people wanted to get out of their money market funds. What would have resulted would have been trillions of dollars getting transferred out of them but Ben Bernanke, head of the Fed, impulsively reacted to this by insuring the money markets completely. Money in banks, on the other hand, were only insured up to $100,000 so people transferred their cash from the bank into money market funds. Trillions of funds were going in and out and this increased the volatility of the market. Along with this transfer, two days after Lehman fell, trust in the market deteriorated and people sold anything they deemed risky and piled their into short term treasuries or gold.

Senator Paulson proposed a $700 billion bailout of the financial market. Unfortunately, a week later it was blocked by Congress. If investors trust in the markets was palpable before now it was destroyed. Investors lost complete faith in the government and the market and they wanted their money back. This was the most synchronized sell off in history. Loans were called in and prices fell all over the world causing a collapse of the global market.

Works Cited:

Stein, Sam. Glass-Steagall Act: The Senators And Economists Who Got It Right.www.huffingtonpost.com/2009/05/11/glass-steagall-act-the-se_n_201557.html >

Admin. Fannie Mae and Freddie Mac in the Financial Crisis.www.nextwave.org/lending/fannie-mae-and-freddie-mac-in-the-financial-crisis/ >.

How Lehman Collapsed and Shook the World Financial Times 9/22/10

Zakaria, Fareedine. Wall Street bailout a heroic move. CNN (2010): 17 Sep 2010. Web. 22 Sep 2010.