Principles of Managerial Economics
Economic principles assist in rational reasoning and defined thinking. They develop logical ability and strength of a manager. Some important principles of managerial economics are: Marginal and Incremental Principle This principle states that a decision is said to be rational and sound if given the firm’s objective of profit maximization, it leads to increase in […]
What is Employment ? – Definition and Its Fallacies
In the previous few articles, we were studying about the definition of unemployment. The idea was to understand in a clear and unambiguous way what unemployment meant. However, the definition of unemployment is contingent on the definition of employment. Since the definition stated that unemployment is the inability to find employment, we need to understand […]
The Case Of Freddie Mac, Fannie Mae and Ginnie Mae
The role that the government played in causing the subprime mortgage crisis is highly debatable. However, the same cannot be said regarding the role performed by the so called government sponsored entities. The Federal Home Loan Mortgage Corporation (Freddie Mac), Federal National Mortgage Association (Fannie Mae) and Government National Mortgage Association (Ginnie Mae) are three […]
GDP and Healthcare
In the past article, we discussed how GDP views war and why it is dangerous for all of us since GDP insinuates the idea that war is good for the economy. Now, war as a phenomenon may not be applicable to every human being on the planet. There are quite a few countries going to […]
Myth: Inflation and Scarcity
The change in the definition of inflation has caused a lot of confusion. A prime example of this confusion is when modern day economic students tend to confuse two different economic phenomena as being the same. These two phenomena are inflation and scarcity and according to traditional economists they are not the same. ✓Consider the […]
Lehman Brothers started as a grocery store in Alabama in 1844. Over the years Lehman Brothers grew into a global behemoth. This growth continued till 2008.
Lehman Brothers was the fifth largest investment bank in the world and had over 25,000 people directly on its payroll as well as several thousand people indirectly dependent on the company for employment.
The company was an icon of American finance and its toughness since it had survived two world wars, the great depression, the Russian default, the Long Term Capital Management crisis, the savings and loans crisis and many others.
Prior to 2008, the world believed that any financial decisions taken by Lehman Brothers were based on sound financial planning.
However, in 2008, Lehman Brothers became the biggest victim of the subprime mortgage crisis. The bank had been extensively dealing in securitizing these assets and had a large amount on its books as well. This is what led to the fall of this once glorious institution.
When the housing boom was underway in the early 2000’s, Lehman Brothers wanted a big slice of the mortgage market pie for itself. It is for this reason that Lehman Brothers undertook five big ticket and numerous small acquisitions of mortgage lenders.
Most of these acquisitions were of lenders who specialized in giving loans to the lower segment of the market i.e. Alt-A and subprime loans. The idea was that these banks would make loans which would then be sold off to other Lehman subsidiaries for securitization.
The strategy seemed to have paid off at first. On an average Lehman Brothers was doing 10% more securitization business than it did the previous year for the period from 2003 to 2007. The rate of earnings growth was faster than it usually is for the other businesses such as investment banking and asset management. The real estate unit was providing all the profits at this investment bank and Lehman did end up putting all its eggs in the real estate basket!
The rise of Lehman Brothers in the mortgage market was historic. Apart from the quasi government agencies, Lehman Brothers was the biggest player in the secondary mortgage market. The profits rose over 17% during the period from 2003 to 2007.
Lehman had taken on extraordinary leverage to achieve this high rate of growth. Lehman had one dollar in shareholder equity for every thirty three dollars that the bank held in debt. Thus, a movement of about 3% had the potential to wipe out the entire valuation of the company.
In 2007, the fall of Lehman Brothers had started in full swing. The Fed had raised interest rates. Therefore there were very few borrowers in the market for mortgages and the existing housing prices had crashed causing foreclosures. Lehman Brothers was stuck with a large amount of mortgage backed securities on its books.
As a desperate attempt to save the company, the management decided to eliminate thousands of jobs and undertake drastic cost cutting measures. However, the austerity was too little and too late as it did not work as intended and the Lehman Brothers stock continued to collapse.
The stocks of Lehman Brothers had plunged by about 40% during this period. In the same period, the credit default swaps on Lehman Brothers had gone up by 66% predicting what seemed to be an imminent bankruptcy.
The market had come to believe that Lehman Brothers was not financially fit enough to make good the over $600 billion in debt obligations. This downward investor confidence was fuelled by the fact that Lehman had been reporting massive losses for the past three quarters.
Investors and bankers alike had put their hopes on talks of acquisition between Lehman and a South Korean Bank materializing. However, when that did not end well, Lehman faced a credit crunch.
Investors began pulling out their deposits and short term creditors started cutting the credit available. Lehman found itself in a liquidity crunch. At this moment, the price of Lehman Stock had plunged by over 93%.
Finally a few days later Lehman Brothers declared bankruptcy. The stocks which were worth over $20 billion were worthless just a few months later! The Lehman Brothers fiasco was well written about in the US media. This is because it became the cause for a worldwide crisis of confidence as well as crisis of credit.
Also, another pertinent question was raised when the US government interfered and stopped the other banks from collapsing.
Investors started wondering as to why was Lehman allowed to collapse and some people had to lose their money whereas that of some others was protected. The debate rages on even today. However, the fall of Lehman Brothers is without a doubt the most defining moment of the subprime mortgage crisis.
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