Research Paper on Lehman Brothers' Fall & its Impact on US Financial Crisis

Paper Type:  Research paper
Pages:  7
Wordcount:  1801 Words
Date:  2023-04-23


The collapse of Lehman Brothers, the fourth-largest bank in the United States, had a huge impact on ushering in the 2007-2008 financial crisis. The financial investment bank filed for bankruptcy in 2008. Lehman Brothers, as well as other Wall Street firms, were involved in collateral debt obligations and mortgage-backed securities (MBSs) in the period between the early and mid-2000s (Aragon & Strahan, 2012). During this period, there was a housing boom in the US, thus allowing the firm to acquire five mortgage lenders, including BNC Mortgage and Aurora Loan Services. The lenders specialized in Alt-A loans and were made to the borrowers without full documentation of the services. In the beginning, the acquisitions made by Lehman Brothers recorded an increment in real estate business resulting in a unit surge of 56% of the capital markets from 2004-2006 (Aragon & Strahan, 2012). The unit surge was the fastest growth rate recorded during this period as compared to other businesses in investment banking and asset management. The collapse of Lehman Brothers had a direct cause of the 2008 financial crisis since the effects of the collapse spread through contagion and negatively affected the global economies. Because the firm engaged in the purchase of massive non-liquid assets, issuance of ill-advised and risky loans, borrowers defaulting to pay loans, the increase of unstable subprime mortgages, and the crash of the housing market which started in 2006, Lehman Brothers became bankrupt and ushered in the 2008 financial crisis.

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Types of Business Conducted by Lehman Brothers

As of 2006, Lehman Brothers operated in three categories; capital markets, investment banking, and investment management. Services provided included equity and fixed income sales, all aspects of trade and research, all the necessities of investment banking and asset management, among others. The firm was headquartered in New York and at the same time managed to maintain regional headquarters internationally in regions like London and Tokyo. Lehman Brothers operations were subject to financial industry regulations both domestically and globally, including the US SEC, and UK's Financial Service Authority (Cochrane & Zingales, 2009). Its global presence was vital in increasing the ability of the firm to seek out new investment opportunities that improved the economy, created jobs and developed the standard of living for the individuals.

2008 Financial Crisis and Failure of Lehman Brothers OperationsThe firm invested in the massive purchase of real-estate-related-assets throughout 2006 and by late 2007, it held various significant positions in commercial real estate. As a result, the business practices made it challenging to raise cash, hedge risks or sell the assets that would have been vital in the reduction of leverage in the balance sheet (Wiggins et al., 2014). As at the end of the 2007 fiscal year, the commercial real-estate-related-assets and securities held by Lehman Brothers amounted to $111 billion which was more than double the amount held in 2006 (Aragon & Strahan, 2012). There were various concerns from the investors regarding the types of assets acquired since they were risky to sell due to their illiquidity level. The business practice maintained by the company was not the best option since it risked the company having substantial losses if the commercial assets and securities were not sold. The company also constantly re-evaluated the assets and hence contributing to significant write-offs that took place in 2008.

Various reasons contributed to the 2008 financial crisis, which included lenders defaulting on different risky loans, the increase of unstable subprime mortgages, the crash of the housing market which started in 2006, and the rise of Lehman Brothers' real estate to a profound $111 billion in assets and securities in 2007 (Wiggins et al., 2014). With time, it was clear that the loans issued were ill-advised and risky for the continued development of the firms. Lehman Brothers competitor, Bear Stearns, suffered first and was bought out by J.P Morgan Chase (JMP) in a deal that was supported by the Federal-Reserve in 2008 (Wiggins et al., 2014). The fate of the Lehman Brothers firm was questioned, and they tried to restore the confidence of the investors by raising $6 billion in equity in June 2008 (Burkhanov, 2011). The main objective was to ensure that the investors would not panic and therefore continue supporting the risky investment opportunities that the company was undertaking.

As of September 2008, Lehman Brothers announced unexpected losses in the write-down of toxic assets. The firm attempted to remain above water through an indication that it had boosted its liquidity to around $45 billion and reduced the number of mortgages taken by 20% (Wiggins et al., 2014). Despite the changes undertaken, Lehman Brothers announced its intention to off $50 billion of the toxic assets into another company (Wiggins et al., 2014). As a result, Moody's report considered downgrading the debt rating of the firm and the Federal Reserve met to determine the types of actions that would assist the operations of the company in the future. There was a significant drop of 77% of Lehman Brothers' stock by the end of the first week in September 2008 that resulted in investors and backers of the firm jumping ship (Wiggins et al., 2014). Bank of America tried to take over Lehman Brothers but the efforts were unsuccessful. As a result, Lehman Brothers declared Bankruptcy on September 15th, 2008 resulting in a decrease of the firm's stock by 93% from its standing just three days earlier (Wiggins et al., 2014).

The acquisition of the five lending firms whose primary focus was subprime lending was a risky investment for Lehman Brothers. Although the investment earned approximately $60 billion in 2007, the crash that followed was; as a result, subprime loan-defaults hence resulting in the overleveraging of the firm's as well as its mortgage portfolio (Wiggins et al., 2014). Lehman Brothers was considered as a firm that was "too big to fail", and thus the failure was a shock to many (Burkhanov, 2011). However, firms like Bear Stearns and AIG which were bailed out by the Federal-Reserve had collateral while the firm did not. Therefore, any actions by the Fed to try to bail out Lehman Brothers would have been considered illegal since the firm was responsible for its gross miscalculations as well as poor risk management. During the bankruptcy hearing, the judge claimed, "this is the most momentous bankruptcy hearing I've ever sat through. It can never be deemed precedent for future cases. It's hard for me to imagine a similar emergency" (Wiggins et al., 2014).

International Impact of Lehman Brothers' Bankruptcy

The collapse of Lehman Brothers was considered as one of the biggest economic crisis after the Great Depression. After the firm filed for bankruptcy on September 15th, 2008, the Dow Jones dropped by 504 points after the markets opened the next day (Aragon & Strahan, 2012). On September 16th, 2008, Barclays agreed on a deal to purchase the capital markets division in the US for $1.75 billion (Aragon & Strahan, 2012). The consequences of the collapse of the firm also affected other investment companies that relied on the operations as well as business services offered. The resulting financial crisis resulted in the collapse of insurance giant AIG thus forcing the Federal Government to bail it out with a package worth $182 billion (Aragon & Strahan, 2012). The Fed needed to intervene since AIG's operations were collapsing fast.

The Primary Fund had Lehman Brothers exposure, and thus the filing of the bankruptcy resulted in a sharp decline of the company. The shares of the Primary Fund dropped to below $1 per share (Aragon & Strahan, 2012). The collapse of Lehman Brothers as well as the financial crisis that followed, there was a massive increase in the unemployment levels as over 6 million people lost their jobs. During the financial crisis, the unemployment rate in the US rose by 10% (Aragon & Strahan, 2012). The country was going through economic turmoil and thus the passing of the Trouble Asset Relief Program on October third, 2008. The program saw the government step in with $700 billion to bail out the remaining and still operational financial sector (Aragon & Strahan, 2012). The financial crisis was directly proportional to the challenges that were being faced globally, thus negatively affecting the international economy.

The Lehman Brothers bankruptcy was a credible source of aspects of a negative shock to capital liquidity. There is a mechanism through which Lehman Brothers collapse resulted in the reduction of liquidity in international markets as well as the hedge funds (Burkhanov, 2011). An illiquidity index conducted pre-post the failure indicated that the decline in liquidity would be more significant for the various stocks held by hedge funds that were in that time using Lehman Brothers as their brokers (Burkhanov, 2011). The collapse of the firm hindered hedge fund managers from reacting to the dramatic and dynamic market changes hence contributing to the downward spiral (Burkhanov, 2011). Another indication, in this case, was the immediate impact on the emerging markets which was a clear revelation of the fact that liquidity shocks affect emerging economies more severely. The movement of stock after the last trading day before Lehman Brothers bankruptcy filing is a contribution of the decline in the performance of both financial and non-financial firms globally.

There was a global economic crisis whereby the non-financial firms around the world were spiraling downwards. There was a contraction of demand among the non-financial firms; thus, the poor performances exhibited. The issue was made worse by the financial crisis itself since it was a form of a negative shock to the aspects of the supply of external financial services that were available. The non-financial firms were cut off from the amount of the available working capital even-though the orders of their products were fulfilled. The illiquidity crunch experienced in the emerging markets was too much for the demand required by the importers (Burkhanov, 2011). Liquidity shocks, in this case, were more severe for the emerging economies that had higher exposure to foreign portfolio investments and loans. Still, they were less critical for the economies that had exposure to direct investments. Therefore, emerging markets that relied on portfolio investments were more susceptible because of the factors contributing to the liquidity of the bond holding.

After the financial instability of 2008, various sovereign spreads rose in the Eurozone. After the Fed bailed out Bear Stearns, there was an establishment of a relationship between the bail-outs offered by banks and public finance (Mody, 2009). The association was responsible for the tie of Eurozone domestic financial sectors and the various spreads of sovereign debt. Research on the Eurozone markets highlights that the spreads had varying impacts on the markets. The post-Lehman Brothers phase was characterized by an increase in the sovereign bond spreads that were usually about four basis points in a given week. In the Eurozone, the bank's collapse rattled the differing equilibrium of the economy, which was shaky after the bail-out of Bear Stearns (Mody, 2009). The European financial status at this point was not okay, and therefore, the collapse of the two firms that is Bear Stearns and Lehman Brothers was affecting their operations.

Another international impact of the collapse of Lehman Brother's firm was the arrival of the global recession. Different report...

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