Ten years ago, today, Lehman Brothers was spending its last day in the Financial spectrum as a going concern, ahead of a bankruptcy that served as an awakening to the financial system, to resurrect itself in order to avoid any further instances of a catastrophic ripple caused by a single effect.
Deregulation? Inaccurate management systems? Lack of an ethical conduct? Risk Mismanagement?
An infinite pool of reasons, an infinite sea of fault, a cumulative effort of ignorance and negligence resulted in the financial system falling apart, causing a ripple effect which subsequently had a lasting impact in shaping unemployment, inflation and the markets around the globe. Given its repercussions on not just the financial system but to emerging markets in turn, affecting the masses, it would be criminal to not comprehend its significance and the reasons for the same.
To understand the crux, it’s imperative to get to the bottom of what caused this fiasco that opened the eyes if not permanently but remotely of both traders and consumers of the financial system.
THE HOUSING BUBBLE
In the most non-financial terms possible, the root cause of the crisis lies in the reckless buying of houses in an attempt to achieve ‘the American Dream’. This cause was also briefly recognized as the “housing bubble”. Now, what was this bubble about and how was it caused?
Stated simply, it was a phase wherein every individual just assumed that they could afford a house, and while they were at it, they assumed that they could buy a car, so all they thought they were simply doing, was that, they were buying house mortgages. Quite straightforward, right? As in turns out, most of them would not actually be able to pay back the mortgage or the loan. Also, the banks did not care, although at the back of their minds they were aware that these mortgages would default, they still kept on selling, without any scrutiny of any kind, reducing credit scores to a mere notional level, such that nobody would ever get rejected. Why didn’t they do anything about it? “The banks were making too much money”
The banks were making too much in dollars that they simply did not care about. The one that did could not imagine Real Estate going down. The kind of general perception that was being breathed in that financial spectrum did not consider the slightest possibilities of Real Estate ever falling. The dot-com bubble was not enough to awaken them. Models were still being made with same traditional unrealistic assumptions exposing them to model risk. Tail events were being observed in the manner that they should have. Risk divisions were underestimating risk like the old age. It was almost like they purposely closed their eyes in front of an approaching storm. The storm, which eventually brought down the system as we know it.
SECURITIZATION AND FINANCIAL ENGINEERING
Further, we had financial engineering play a major role. As progressive as the term may sound, it was equally destructive in terms of its role in the crisis. So, there were these new products that were being introduced in the market, which a lot of people could not understand, and in the process the ones who could decide to take advantage and in turn, absorb the system of itself. Securitization, soon became a common enigma, which was too full of itself to be understood. Financial products such as Collateralized Debt Obligation (CDO), Credit Default Swaps, were relatively new in the market and were only perfectly comprehended by a handful. It was the CDOs, which enabled packaging low credit mortgages into high credit mortgages, making them attractive for the public and hence, being sold in large numbers in the market. On top of this, we had reputed credit scoring agencies, functioning in the most unethical manners. In order to gain business and please their clients, they were unethically scoring them, to ensure that they would not leave them and go to their competitor who in turn would offer them a higher rating irrespective of the due diligence they were to perform, in reality. The coupling effect of these reasons is what initially exasperated the crisis.
THE RIPPLE EFFECT
This is what was the commencement of the crisis, which no one saw coming. A series of major events followed the first of which, was the buyout of Bear Stearns at 10$ a share (123$ less than, or 92.48% less than its pre-crisis 52 weeks high) by JP Morgan Chase, along with the help of the Government. At the time when this incident took place, it was becoming evident that Lehman Brothers, the 4th largest investment bank at the time was in line, next. There was a run on these banks, which basically meant that not traders or clients, but depositors were getting scared of the financial system and subsequently their institutions, and hence, were pulling their money out. This was a matter of grave concern for the banks, cause had that perception spread too far and to fast, it would have been catastrophic to another level. However, thankfully so, the runs weren’t too extreme. In the meanwhile, Lehman was searching for prospective buyers such that it could protect the exponential downfall of its share price, which had reached single digits. Management was revamped, precautions were being made, but the realisation of going down that fast and that the Government may not pitch in was not comprehended by the top executives. They were turning down offers on the basis of them being too low, which eventually turned out to be suicidal for them. At the same time, during this unimaginable setup, we had two extremely valuable entities going down as well, Fannie Mae and Freddie Mac. However, the Government did rescue them through “large purchase assistant packages” or a bailout, given its international presence. Then came the American International Group (AIG), which defined “too big to fail” in its entirety. Hence, before dealing with AIG, they had Merrill Lynch in the same field as Lehman Brothers, with only two buyers in the market, Bank of America and Barclays. With the size of Lehman, and its downside, and the short sellers driving their share price down, the deal of Bank of America, which almost going to close fell apart and Bank of America chose the relatively safer investment in terms of Merrill, thus, leaving Lehman only with Barclays. However, to pile up this pillar of problems, the British regulators would not sign off on the Barclays deal, thus, leaving Lehman naked and ready for the free fall. And that, that very moment, the system collapsed, with the 158-year old bank, Lehman Brothers, with over $600 billion in debt, filing for the biggest Chapter 11 bankruptcy in history. This as we know, it triggered the downfall without any redemption. What followed was catastrophic in every sense of the term, for the ripple effect caused, runs on banks, loss of faith in the financial institutes, widespread stock market crashes, a phase of recession spread across, suicides by traders and other uncountable repercussions, which could have been avoided, only if everyone would have been a touch more aware and careful.
This, in a nutshell, was the collapse of the bank, Lehman Brothers, which took place on 15th September, 2008 to which we have reached 10 years, but whose consequences are still felt, worldwide.
Author | Jivraj Singh Sachar