Why Lehman Brothers collapsed

6 years ago by in Other Stuff

On Monday, 15 September 2008, monetary markets around the world convulsed in sheer panic.

In new york, the Dow Jones Industrial Index suffered one of its biggest-ever falls, falling 504 factors (down 4.4%) in a single session. On this facet of the Atlantic, the FTSE 100 index tumbled almost a tenth (9.9%) in the four days to 18 September. while stock markets plunged, the price of credit score soared, with credit score spreads blowing out to document ranges. This was no bizarre monetary crisis.

What brought about this market mayhem?

the answer is the chapter of a company, however this was once no extraordinary bankruptcy and no extraordinary company. On Sunday, 14 September, prime US investment financial institution Lehman Brothers– having failed to be rescued by means of a buyer or a executive bailout — went underneath.

The chapter of Lehman rocked the monetary machine to its core, not least as a result of it was once the most important corporate bankruptcy in US history. With over $600 billion in property to administer, Lehman’s chapter was once repeatedly more complicated than Enron’s failure in 2001. also, as a leading investment financial institution, Lehman used to be deeply plumbed into the global financial system, due to a spider web of corporations, contacts and contracts around the globe.

Why did Lehman fail?

In recent days, there have been lots of articles written about the collapse of Lehman Brothers. Some blame chief government Dick ‘the Gorilla’ Fuld for his overconfidence and failure to recognise that Lehman faced a momentous hindrance. Arguably, Fuld’s combat to salvage something for Lehman’s suffering shareholders ultimately price them each cent.

Some commentators blame financial institution of the us for ending takeover talks with Lehman in favour of buying its better rival Merrill Lynch for $50 billion the next day. other pundits blame Barclays for refusing to buy Lehman without US government backing, within the form of emergency funding.

alternatively, i’ve give you three quite simple the explanation why Lehman used to be doomed to fail. here they’re…

The three Ls that killed Lehman:

1. Leverage

all the way through the good times, one of the best ways to make stronger your returns is to ‘equipment up’ by borrowing money to invest in assets that are rising in worth. This allows you to ‘leverage’ (enlarge) your returns, which is particularly helpful when interest rates are low. however, leverage cuts each methods, because it also magnifies your losses when asset prices fall. (Witness the contemporary return of terrible fairness to the uk property market.)

A sensibly run retail financial institution would have leverage of, say, 12 instances. In different words, for each £1 of cash and other without problems on hand capital, it might lend £12. In 2004, Lehman’s leverage was running at 20. Later, it rose past the twenties and thirties ahead of peaking at an out of this world forty four in 2007.

as a result, Lehman was leveraged forty four to 1 when asset costs commenced heading south. bring to mind it this fashion: it’s kind of like someone on a wage of £10,000 buying a home the usage of a £440,000 loan. If property prices started to slip, or interest rates moved up, then this borrower would be doomed. thanks to its sky-high leverage, Lehman used to be in a equivalent pickle.

2. Liquidity

Most companies fail now not as a result of lack of profits but because of money-drift problems. like any banks, Lehman was once an upturned pyramid balanced on a small sliver of cash. despite the fact that it had an immense asset base (and equally spectacular liabilities), Lehman did not have enough in the way in which of liquidity. In other phrases, it lacked prepared cash and other easily offered assets.

As markets fell, other banks started to worry about Lehman’s shaky price range, in order that they moved to offer protection to their very own pursuits via pulling Lehman’s traces of credit. This intended that Lehman used to be shedding liquidity fast, which is a perilous state for any financial institution. most effective six months previous, in March 2008, Lehman rival endure Stearns faced a similar lack of liquidity sooner than JPMorgan Chase rode to its rescue.

Believing that Lehman did not have sufficient liquidity at hand, other banks refused to exchange with it. as soon as a bank loses market confidence, it loses the whole thing. Being unable to exchange meant that Lehman and its business ceased to exist in different banks’ eyes.

three. Losses

After the terrorist attacks of 11 September 2001, US rates of interest plummeted, causing a 5-12 months boom in domestic and commercial property prices. This growth ended in 2006 and US housing prices have because fallen for three years in a row.

Lehman was once closely exposed to the usa real-property market, having been the largest underwriter of property loans in 2007. via the tip of that yr, Lehman had over $60 billion invested in commercial actual property (CRE) and was once very big in subprime mortgages (loans to unsafe homebuyers). additionally, it had enormous publicity to modern but arcane investments such as collateralised debt responsibilities (CDO) and credit default swaps (CDS).

As property costs crashed and repossessions and arrears sky-rocketed, Lehman was caught in a super storm. In its 1/3-quarter results, Lehman announced a $2.5 billion write-down as a result of its publicity to commercial real property. Lehman’s complete announced losses in 2008 got here to $6.5 billion, however there was once a ways extra ‘poisonous waste’ ready to be unearthed.

In abstract…

Lehman once employed 28,000 individuals the world over, including 5,000 in London. At their height, its shares traded at $85, however they’re now roughly 10¢. Lehman’s remains had been shared out between Barclays, which bought its US broking arm, and eastern large Nomura, which sold its European and Asian belongings. These companies, plus number-one investment financial institution Goldman Sachs, have profited most from selecting over the bones of Lehman’s companies.

in short, Lehman Brothers — an organization with a 158-yr historical past, together with 14 years as an NYSE-listed giant — failed just because it took on too much risk in a booming market. in any case, its move from the protection of company finance and M&A (mergers and acquisitions) income into the dangerous world of proprietary trading proved to be its downfall.

The lesson here is that any agency, irrespective of how large and strong, may also be dashed to pieces on the rocks of leverageliquidity and losses!

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