In the financial market one can notice that there were various financial crisis which had a negative impact on the banking system and the financial market overall. As a result there were diverse collapses of financial institutions and most of the stocks were also being down-rated.
2.1.i. LEHMAN BROTHERS HOLDINGS
Lehman Brother Holdings was an enterprise that historically had a great impact on the United States' economy. It contributed significantly to the expansion of American industry, especially in the growth of the financial sector.
In 1844, Henry Lehman decided to set up a small outlet, selling groceries utensils to the farming community. After five years his two brothers Emanuel and Mayer joined him and they renamed the business as Lehman Brothers, which was then established as a commodities broker that bought cotton from and sold it to Alabama's cultivators. Lehman Brothers Holdings was a family owned business as relatives were the only individuals that were able to run the business. In order to continue growing Lehman Brothers joined a partnership with John Wesley Durr, another cotton merchant, to be in a better position to build a storage warehouse, thereby increasing their ability to buy in bulk and generating more sales.
Lehman Brothers Holdings survived from the civil war and even though the building was destroyed this did not make any harm to the reputation. As soon as it was rebuilt again Lehman Brothers decided to improve by forming the Coffee and Petroleum Exchanges which also lead to the formation of New York Cotton Exchange, making Lehman Brothers Holdings the first commodities future venture. The board of directors noticed that there was an opportunity to enhance their business activity as in U.S there was a huge need of money as government wanted to expand the industry. "The firm was also assigned to service the state's debts, interest payments, and other obligations, beginning a long tradition in municipal finance." (school)
Consequently, railroad securities were being issued after Kuhn, Loeb & Co. and Lehman Brothers merged together. Such bonds were traded at affordable prices; hence an essential number of first-time buyers were entering the market. In 1887 Lehman Brothers was listed on the New York Stock Exchange, identifying its business as a merchant-banking firm. The beginning of 1900 the firm was also concerned in financial advisory services.
Robert Lehman, Emanuel's grandson was the leader of Lehman Brothers Holdings from 1925 till 1969 the year in which he was dead. He believed that consumption was more important than production, and that consumption would determine America's future prosperity. Thanks to him, there was remarkable growth in the firm, which expanded in line with American industry. The enterprise became an active financier of the airline sector while continuing Lehman Brothers' substantial support of the retailing industry.
In 1930s, Lehman Brothers was also involved in the entertainment industry in the U.S. In addition, the directors also helped in developing a communication sector as well as funding the radio business. Afterwards the world has faced the Great Depression. Each and every functioning enterprise, irrespective in which country or industry it operates in, suffered considerable damage. The flow of fund to businesses became unavailable. However because of its financial strength Lehman Brother survived in such difficult period as well.
In order to raise the level of investment while trying to reduce the risk Lehman Brothers came up with a new idea to create finance. Such activity, known as Private Placements, refers to loans in the form of securities that were being issued by companies (borrowers) who needed capital for their day-to-day operation and bought by private investors (lenders). Private placements provide security to the investors as they restrict the company due to the fact that investors have a tendency to expect substantial return with the lowest risk possible. It is important to mention that this technique is still practiced nowadays.
The oil industry, the electronic technology and commercial paper also interested Lehman Brothers Holdings, as they invested in such sectors as well. The latter sector led the enterprise to become the official dealer for U.S Treasury securities and this was accompanied by an international expansion as Lehman Brothers Holdings opened their offices in Europe and Asia.
The terrorist attack in September 11, 2001 had an impact on Lehman Brothers as well as the offices in the World Trade Centre were destroyed.
INSERT A PARAGRAPH DESCRIBING THE EVENTS THAT DAMAGED LEHMAN BROTHERS
Systematic risk in the general financial sector is the major issue that damaged Lehman Brothers. Since it happened in a contagion sense it was considered to be more dangerous in the financial sector than in other industries because:
it take place in a faster way ;
it spreads more broadly within the industry;
it results in a greater number of failures and larger losses to creditors;
it can affects otherwise solvent financial institutions (Kaufman, 1994).
As a result it tends to be believed that systemic risk is the strongest argument justifying the intervention of public authorities in the financial sector.
In August 2007 Lehman Brothers closed its BCN mortgage subsidiary which was engaged in subprime lending activity which resulted in serious mortgage and credit problems. A lot of industries such as banking, entertainment, treasury, financing airlines and railroads and much more (EXAMPLES) were depending on this particular institution and this is the main reason that it was considered as the firm that was "too big to fail". However this was what happened in 2008; Lehman Brothers Holdings was a victim in the subprime mortgage lending crisis, which led to its termination.
Fifteenth September, 2008 will certainly be remembered as one of the worst days in the financial industry. Despite the fact that many were not expecting this to happen, it was the day when Lehman Brother Holdings announced that it would file for chapter eleven bankruptcy protection. The assets held by the enterprise were purchased by various firms such as Barclays Bank. Such announcement sent all banking and financial industry into panic and gave birth to the most terrible financial crisis followed by a world economic recession ever experienced which would be later addressed to as the credit crunch.
ADD TEXT ON THE REFUSAL BY AUTHOTIES TO BAIL OUT LEHMAN BROTHERS
Even though Lehman Brothers Holdings management expected their enterprise was going to be bailed out since it had a great impact on U.S economy through out the years this did not happen. "The government did not want to bail out Lehman, because it had to draw the line somewhere, and other financial institutions could not get comfortable with Lehman's assets in an instant." (Siris, September,2008)
A lot of enterprises were effeted negatively as financial markets were unstable leading various assets of Lehman to be left unsold. Consequently, Lehman Brothers bankruptcy caused a huge decline in share prices and the market became even more volatile with no direction. An important statement that the Fed said is: "has grown increasingly uncomfortable with the growing perception that it will craft bailouts for the U.S. economy." (Eisinger, September, 2008) As Bear's fall took place, executives of Lehman should have been aware of the problems arising in the marketplace and they should have acted accordingly but they actually did nothing. At the same time of Lehman Brothers bankruptcy, the federal government had to save Fannie Mae and Freddie Mac, in the biggest Federal intervention in decades. Therefore there was no money available to bail out Lehman Brothers Holding as well.
2.1.ii. THE CREDIT CRUNCH AND THE SUBPRIME MORTGAGE CRISIS
The credit crunch refers to the situation that occurred when there was a diminution in the money available in the financial marketplace. Due to this change in the monetary conditions, fewer loans were made and credit became unavailable. It had a varying impact in different countries but in many countries financial transactions became more complicated.
The U.S housing market was the main reason for such a huge fall in financial market because those responsible for debt problems were not taking into account that the concurrent problem would have negative effects on the overall economy as well. Banks were trying to attract new investors in real estate by providing lower interest rates for first-time home buyers. Consequently, the subprime home mortgage was developed.
Subprime mortgages can be defined as loans that were considered to possess a higher risk exposure when compared to the normal loans since they had higher possibility of default. These mortgages had these characteristics:
Loans were also given to borrowers who do not qualify for standard mortgage loans. Consequently, loans to subprime borrowers were poorly collateralized and the capacity of borrowers to service their loans was low.
Offering loans to low- credit borrowers with poor employment history and even past bankruptcies who were enticed with low interest rates. This was the case as far as their initial payments were concerned; however since loans were not at a fixed interest rate, fluctuations in market interest rates lead to higher repayments
Huge amounts of money were being borrowed exceeding the federal limits regarding mortgages.
Such mortgages were pooled together and were being sold to other banks and investment companies as securities the motivation of the original mortgage lenders was to get loans off their balance sheets; securitization allows lenders to avoid interest rate risk by packaging the loans into securities, selling these securities to investors and use the proceeds to make new loans. It is important to mention that the investors did not have the necessary information on how these securities were pooled.
The only fact that seemed to be critical was the fact assigned to a very low risk and since such securities were rated as AAA they were attracting investors from around the world. People were purchasing more than they could afford. Unfortunately, buyers did not know that systematic risk (EXPLAIN) was not taken into consideration. Interest rates increased leading other problems to actual borrowers while high prices of houses were depleting and investors became aware of the risk in the market.
Banks wanted to keep their cash so loans were not available anymore. Since liquidity of the securities was not an option as they had become widely spread, governments had to intervene by offering guarantees. In order to eliminate a lot of bankruptcies governments were also letting domestic companies to shift their losses on them. This is due to the fact that to a certain extent governments do not fail.
Borrowers and investors lost their faith in their domestic banking systems as losses have amplified. One can notice such issue taking place as the majority of investors are trying to eliminate the risk associated in their financial situations by purchasing government-guaranteed assets that are likely to be less risky from a certain point of view. Consequently, a frozen-to-fear capital markets have been created. Mortgage rates continued to go up and higher demand for deposits was needed. Hence banks had to admit that this was the worst situation they had ever faced when dealing with subprime losses which led a global economic slowdown and a higher rate of default to take place.
Some important factors that contributed to the credit crunch include:
Cases of fraud in the U.S both with underwriters and brokers,
Little documentation on mortgages offered
Volume margins were being impressed as banks wanted to boost their proceeds,
There were not enough return when considering the amount of risk that was taken by investors
As house prices were falling borrowers with subprime loans could not keep up resulting in payment shocks
Credit Support was not being implemented by governments to eliminate bankruptcies, and
Rating of securitised assets was innaccurate in the highly volatile markets.
Even though the housing sector used to be one of the best in the industry it still collapsed leading the value of securities to fall drastically, declining investors' wealth. It also served to damage the international financial market because a lot of major firms were failing to meet their commitments which had affected the banking system of various countries. Lately, most of the active companies and other investors that are found in today's market are afraid to trade and invest their money as there is the tendency that markets are highly volatile and are exposed to greater risks .
On the other hand Regulators are also trying to reset the asset valuation rules as many firms were moving away from the current applied rules. In most of the countries various analysts noticed that such elements affected the growth rates as they apt to be slower when compared with the rates generated before the financial crisis.
