Tsunami of Credit Crunch gulp down Lehman Brothers & The structure of confidence collapsed completely

Student ID: 4745353 Subject: Finance and Accounting Management

Tsunami of Credit Crunch gulp down Lehman Brothers & The structure of confidence collapsed

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Table of Contents
1. 2. Executive Summary:........................................................................................................................ 3 Introduction to Credit Crunch: ........................................................................................................ 4 2.1 Definition & Terminology:............................................................................................................. 4 2.2 What exactly caused this to happen? ........................................................................................... 4 3. 4. 5. SUB PRIME MORTAGAGE WORKED AS OPERATOR: ....................................................................... 5 The Economic Situation before the Collapse of Lehman Brothers: ................................................ 7 Lehman Brothers up to the Weekend of September 13-14: .......................................................... 8 5.1 Thought from one of the prime investor of Lehman Brothers: .................................................. 10 6. 7. 8. 9. The DREADFUL Lehman Weekend (September 13-14, 2008): ..................................................... 11 The Accident that Punctured Confidence and Unleashed the Financial Panic: ............................ 12 CONCLUSION:................................................................................................................................ 14 APPENDIX ...................................................................................................................................... 16 9.1 APPENDIX: History - 1929 to present ..................................................................................... 16 9.2 APPENDIX: Sequence of events happened during credit crunch (Rayner, 2008) ..................... 17 9.3 APPENDIX: Introducing the Argument: Confidence and Its Double Structure .......................... 18 9.4 APPENDIX: Confidence and Fear Index plays huge role............................................................. 21 9.5 APPENDIX: Securitisation and Leverage ..................................................................................... 21 9.6 APPENDIX: ABOUT LEHMAN BROTHERS ..................................................................................... 22 9.7APPENDIX: Nature of Credit Crisis Worsened:............................................................................. 23 9.8 APPENDIX: Consequences of Lehman Failure ....................................................................... 24

9.8.1 Bailouts and Busts: ............................................................................................................... 24 9.9 APPENDIX: Policy makers & Regulators Response...................................................................... 26 9.10 APPENDIX: Solutions for Credit crunch ..................................................................................... 28 10. REFERENCES: ............................................................................................................................. 29

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1. Executive Summary:
On September 15, 2008 Lehman Brothers filed for bankruptcy, something that nearly caused a meltdown of the world’s financial system. A few days later Bernanke made his famous statement that “we may not have an economy on Monday.” This report includes the situation Lehman Brothers before and after the bankruptcy and how exactly this event triggered the huge financial panic all across the globe termed as credit crunch. It was a nonlinear and sudden catastrophic event for the global economic system, unprecedented in scale in human history. I analysed two major aspects, which pulled the worst possible recession of the century. First one is Hidden losses and the second one is that confidence plays key role in finance. Confidence can be conceptualized as a belief that action can be based on proxy signs, rather than on direct information about the economic situation itself. I have also studied how exactly Lehman went bankrupt, and how this worry transformed into a total disbelief in existing proxy signs - a loss of confidence as well as a withdrawal of confidence in this report. This report includes the series of action happened or taken before and after Lehman Brother went bankrupt. Although the debate of those actions will continue on and only time will be able to answer what could have been right or wrong about it..!!

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2. Introduction to Credit Crunch: 2.1 Definition & Terminology: An economic condition in which investment capital is difficult to obtain. Banks and investors become wary of lending funds to corporations, which drives up the price of debt products for borrowers. A credit crunch makes it nearly impossible for companies to borrow because lenders are scared of bankruptcies or defaults, which results in higher rates. The consequence is a prolonged recession (or slower recovery), which occurs as a result of the shrinking credit supply. 2.2 What exactly caused this to happen?

Fig1. How exactly housing bubble end up with one of the biggest financial recession
The R's mean reinforcing feedback, the B's are balancing feedback, the S's (same) are where more of one thing lead to more of another, and the O's (opposite) are where more of one thing lead to less of another.

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The market for subprime mortgages grew very fast. Jaffee (2008) documents two periods of exceptional subprime mortgage growth. These expansions occurred because changes in the law allowed mortgage lending at high interest rates and fees, and tax advantages were available for secured borrowing versus unsecured borrowing. Another strong influence was the desire of mortgage originators to maintain the volume of new mortgages for securitization by expanding lending activity into previously untapped markets. Subprime loans were heavily concentrated in urban areas where prime borrowers that faced financial difficulties switched from prime to subprime mortgages.

At the same time, U.S. residential subprime mortgage delinquency rates have been consistently higher than rates on prime mortgages for many years Pennington-Cross (2006) record figures from the Mortgage Bankers Association with delinquencies 5½ times higher than for prime rates and foreclosures 10 times higher in the previous peak in 2001-02 during the U.S. recession.

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A worrying characteristic of loans in this sector is the number of borrowers who defaulted within the first three to five months after receiving a home loan and the high correlation between the defaults on individual mortgage loans. The growth in the scale of subprime lending in the United States was compounded by the relative ease with which these loans could be originated and the returns that could be generated by securitizing the loans with (apparently) very little risk to the originating institutions. The demand was strong for high-yielding assets. Much of this demand was satisfied by residential MBSs and CDOs, which were sold globally, but as a consequence the inherent risks in the subprime sector spread to international investors with no experience or knowledge of U.S. real estate practices.

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4. The Economic Situation before the Collapse of Lehman Brothers:
From about 2001 and onwards, a credit bubble started to appear in the United States. Huge amounts of capital moved into the country, in search of profit higher than the low rate of interest that existed at the time (real risk-free rate of interest). A housing bubble was also in the making; and through the process of securitization the housing market was closely linked to the credit bubble in the U.S. financial system as well as to the international financial system. Mortgages, traditionally the business of local banks, were now pooled, turned into bonds and CDOs that were sold on to investors, in the United States and elsewhere. This is exactly what happened in 2007, when the decline of the U.S. housing market started to register in a major way in the financial system. The financial crisis, it is generally agreed, began in August 2007, when a major mortgage outfit went under and the Fed as well as the European Central Bank had to infuse billions of dollars and Euros into their financial systems. The failing subprime mortgages were, to repeat, at the centre of what was now going wrong; and by August 2007 the amount of subprime mortgages was estimated at $ 2 trillion. It is also true that if the new securities had been fully transparent, then the investors at the end of the chain would have had to take their losses; and that would have been all. This, however, is not what happened. Instead the trouble spread to other parts of the financial system: inter-bank lending started to freeze up and a run on SIVs took place. Why was this case? The reason was that it was impossible for the investors to determine which bonds and CDOs had suffered losses, and to what extent. The way that these securities had been constructed made them impenetrable. The result was a fear about hidden losses that spread to all subprime mortgage related bonds and CDOs as well as to the institutions suspected of owning these. Gorton sums up his argument as follows: “The ABX information, together with the lack of information about location of the risks, led to a loss of confidence on the parts of the banks in the ability of their counterparties to honour contractual obligations. The panic was on, starting with a run on structured vehicles” (Gorton 2009:568).

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As 2007 became 2008, the economic problems continued and mortgages other than subprime began to fall in value. This meant that the potential losses – the hidden losses - were now extended to a pool of mortgage-backed securities worth somewhere between $ 5-10 trillion. An increasing number of mortgage-related originators were also going bankrupt; and the price of housing continued to go down. The end for Bear Stearns began on March 10, when one of its mortgage-based debts was downgraded by Moody’s, something that started a rumour that the bank was in deep trouble. Bear Stearns immediately denied that it had liquidity problems but, as is often noted, when a bank denies that it has a liquidity problem it is already lost. “When confidence goes, it goes,” as Paulson said when asked about the chances of Bear Stearns to survive. During the months after the fall of Bear Stearns the general economic situation continued to worsen. As the prices on the housing market were going down, securities that at first had seemed safe now entered into the danger zone, including those with an AAA rating. By August, according to information from the IMF, the value of many assets had fallen dramatically, something that was especially dangerous for those institutions that depended on short-term financing. As the economic situation continued to worsen during the fall of 2008, the pressure shifted to the remaining investment banks and especially to Lehman Brothers. To better understand what happened during the fatal weekend of September 13-14, when the fate of Lehman was decided, we will now turn to the economic activities of Lehman during 2007 and 2008.

5. Lehman Brothers up to the Weekend of September 13-14: 1
In 2005 and 2006 Lehman was the largest producer of securities based on Subprime mortgages. By 2007, more than a dozen lawsuits had been initiated against Lehman on the ground that it had improperly made borrowers take on loans they could not afford. “Anything to make the deal work,” as one of Lehman’s former mortgage underwriters put it. In 2007 the housing market also continued to go down and Lehman was increasingly getting stuck with mortgage bonds and CDOs that it could not pass on.


Fuld was the CEO of Lehman Brother. His full name is Richard Fuld. Referred as Fuld here.

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Richard Fuld does not seem to have understood what a great threat this constituted. He knew of course that the housing market was going down; and in order to counter this, he decided to invest heavily in commercial real estate and in assets outside the United States. What was behind this strategy was a lack of insight into the close link between what was going on in the financial system and in the U.S. housing market, thanks to securitization. As things turned out, Lehman’s dealings in commercial real estate created even more bad debt on its books than its dealings in residential housing. During 2008 the position of Lehman worsened and its shares continued to go down. The day after the fall of Bear Stearns on March 16, 2008, its shares fell 19 percent and many believed that Lehman was the next investment bank to go off. Secretary of the Treasury Henry Paulson was one of these persons; and therefore he initiated regular contacts with Fuld. He emphasized to Fuld that Lehman was in a very difficult economic situation and needed to find a buyer. People from the SEC and the Fed were stationed at Lehman. Contrary to what is believed, the Fed also started to help Lehman with enormous loans and would do so till its collapse on September 15. Fuld, it appears, did not realize the seriousness of either what Paulson was telling him or of the situation in general. For one thing, he thought that he had the full backing of Paulson. “We have huge brand with treasury,” as he famously phrased it in an e-mail, after a meeting with Paulson on April 12. From March to the September 13-14 weekend Fuld turned down several opportunities to sell Lehman as well as an infusion of capital from Warren Buffett and attempts to cut deals with Morgan Stanley, Goldman Sachs and Bank of America.

Fuld over believed that Lehman could weather any storms it faced during the spring and summer of 2008, investors were getting increasingly nervous. While many banks had declared heavy losses and write-downs, Lehman had not. In fact, Lehman declared a profit of several hundred million dollars for the first quarter of

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The three major rating agencies were also applauding Lehman’s performance, as they would do till the very end. Still, rumours were strong that Lehman was covering up its losses. Some investors also started to look for information on their own, and what they found made them suspicious. 5.1 Thought from one of the prime investor of Lehman Brothers: One of these investors was David Einhorn, the head of a hedge fund called Greenlight Capital gave a speech in a conference for investors in April, he argued that investment banks and specially Lehman Brothers is dangerous for a number of reasons as they used half of their revenue for compensation like its employees have a very strong incentive to increase the leverage of their firm. If you calculate its leverage properly, it comes 44:1. This means that if the assets of Lehman fell by 1 %, the firm would have lost almost half of its equity. The consequences of this were dramatic: “suddenly, 44 times leverage becomes 80 times leverage and confidence is lost.” In late May he made another public attack on Lehman. This time he announced that his hedge fund was shorting Lehman and he explained the reason as “Lehman does not provide enough transparency for us to even hazard a guess as to how they have accounted for these items.” Lehman responds to requests for improved transparency begrudgingly but it was not enough so he suspected that their amount of transparency on these valuations would not inspire market confidence.

But now by that time Fuld was desperately trying to raise capital or to find a buyer. He contacted a number of potential investors, including Citigroup, which sent over a team to go through Lehman’s books. Lehman’s last chance of being bought up disappeared on September 10, when Korea Development Bank announced that it had decided to withdraw from a possible acquisition. The very same day Lehman also declared a loss of $ 3.9 billion and was warned by Standard & Poor that it might be downgraded. The next day Lehman had great difficulty in scraping together the extra collateral of $ 8 billion that JP Morgan Chase now demanded; and it was clear that the financing of Lehman’s daily operations was quickly drying up. The end, in other words, was near. On September 12 a number of the key CEOs on Wall Street each got a call from staff members at the Fed, telling them to attend an emergency meeting at 6 pm at the New York Federal Reserve Bank. Lehman’s fate was to be decided.

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6. The DREADFUL Lehman Weekend (September 13-14, 2008):
After the fall of Fannie and Freddie, anyone with high leverage and lots of real estate exposure was suspect. Lehman Brothers was an obvious candidate. It was a broker/dealer, like the Bear. Also like the Bear, it had significant exposure to mortgages. Lehman took both significant residential and commercial mortgage risk, so clearly 2008 was not a good year for it. The firm posted significant losses during the second quarter of 2008. It needed more capital to restore confidence. It was needed liquidity but none of their moved worked, hence Lehman’s share price tumbled, and the firm started to feel difficulty to survive. Firms which rely on confidence sensitive funding and then lose the confidence of the market fail quickly. On the 9th September 2008, Lehman’s shares fell by 45%. Borrowing became well nigh impossible for Lehman. By the 15th, it had filed for bankruptcy protection. This was one of the largest failures in American corporate history.

Fig. 1 The Lehman Brothers share price in 2008

The weekend of September 13, During Saturday the group of people by Treasury Dept that had been assigned to estimate Lehman’s economic situation, concluded that its losses were much larger than had been thought. Beside its mortgage related losses,

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which were already known, Lehman also had tens of billions of dollars of losses in its portfolio for commercial real estate. Altogether, Lehman’s losses – hidden as well as already known losses – amounted to something like $ 30-80 billion.

Lehman failed, and declared bankruptcy in the early hours of September 15.

Despite these failures, Fuld insists that it was rumours and short selling that brought down Lehman, not its huge losses in a deteriorating economy and his own failure to deal with this. “Ultimately what happened to Lehman Brothers,” Fuld said later when he testified at Congress, “was caused by a lack of confidence”

7. The Accident that Punctured Confidence and Unleashed the Financial Panic:
Lehman’s bankruptcy set off a panic that would end up by threatening not only the U.S. financial system, but also the global financial system. Did the bankruptcy work as a kind of detonator, and if so, exactly how did it work? Or was Lehman’s bankruptcy rather the first in a series of explosions, so to speak, that helped to set off an avalanche? These questions are currently hard to answer, among other reasons because there is very little exact knowledge about what happened once Lehman went bankrupt. This event triggered immediate direct and indirect effects on the market. The direct effects of Lehman’s bankruptcy were on those who were tied with Lehman in credit default swap, simply can imagine by contemplating the fact that this was a $ 613 bn bankruptcy –the largest ever in U.S. history. In the Indirect losses you can refer to below diagram.

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Paulson told his staffs on September 16th that “This is an economic 9/11!” as

confidence was disappearing quickly from the financial world was, for example, clear from what was happening to the two remaining investment banks. During the days after Lehman’s bankruptcy, the shares of Goldman Sachs and Morgan Stanley fell quickly and it seemed clear that both of them might go down. At the same time the shares of Citigroup kept going down after the collapse of Lehman. From 2007 and onwards the giant bank conglomerate had taken heavy mortgage related 29 losses; it was also suspected of having much more hidden losses of this type. The Fed, however, had confidence in the solvency of Citigroup. On October 1, however, the Senate passed the bill to fund the Troubled Asset Relief Program (TARP). On October 3, after pressure, the House passed the bill as well.


VIX : Volatile Index

LIBOR: London Inter Bank Offered Rate

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In this paper, the focus is mainly on the role of confidence. To recapitulate the core idea of this theory is that confidence has to do with people’s capacity to base their actions on indicators or proxy signs for what some situation are alike, in those cases where they lack direct knowledge of the situation. When the proxy sign is properly aligned with the economic situation, investors will feel confidence. The situation when confidence disappears very suddenly (collapse of confidence) and then there is the situation when actors do not engage in some economic action because they lack the confidence to do so (withdrawal of confidence) lead to finance recessions. What characterized the situation before Lehman went down was a general worry that the existing proxy signs (ratings, reported earnings and so on) did not adequately represent the economic situation of various financial institutions. Each Country’s Government and financial body and regulators play huge roles in such circumstances. In this case, US Treasury, FED & government initiated preventive measures for credit crunch at good time. Please refer to the few other ways or solutions for credit crunch in appendixes. Although the debate of those actions will continue on and only time will be able to answer right or wrong about it..!!

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Source: Figures from Bloomberg Terminal

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9.1 APPENDIX: History - 1929 to present

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9.2 APPENDIX: Sequence of events happened during credit crunch

(Rayner, 2008)
Date Event
After months of concerns about the exposure of financial institutions to US subprime mortgages, Bear Stearns, one of the world's biggest investment banks, stops clients from withdrawing cash from a fund which has lost billions of dollars. The fund closure sets alarm bells ringing in financial markets around the world Short-term lending between banks, which they rely on to balance their books, dries up after French giant BNP Paribas suspends three investment funds worth 2 billion Euros because of exposure to US subprime mortgages. The European Central Bank, the US Federal Reserve and the Bank of Japan offer to lend banks tens of billions to ease what is already being called the Credit Crunch.

July 31, 2007

Aug 9, 2007

Sept 13, 2007

Northern Rock, Britain's fifth-biggest mortgage lender is granted emergency funding by the Bank of England after finding itself unable to secure loans from elsewhere. The news leads to the first run on a British bank for more than a century as thousands of depositors queue to get their money out. The crisis only passes when Chancellor Alistair Darling agrees to guarantee all savings.
Stan O'Neal resigns as chief executive of US investment banking giant Merrill Lynch after it writes down £4 billion from its asset books because of exposure to bad debt. Within days, Charles Prince, chief executive and chairman of Citigroup, resigns after the bank reveals losses of around £5 billion because of subprime exposure. Nationwide building society warns that house prices will stagnate in 2008. On the same day, Adam Applegarth resigns as chief executive of Northern Rock. Later in the month, Mervyn King, governor of the Bank of England, warns that growth in the UK economy will slow down and inflation will rise. Bank of England cuts interest rates for the first time since 2005, amid signs the economy is slowing. Two weeks later it makes £10 billion available in loans to UK banks to ease the credit crunch as many banks and building societies withdraw 100 per cent mortgages. With banks around the world revealing more and more losses, US Federal Reserve boss Ben Bernanke admits the outlook for the US economy is bleak. James Cayne, head of Bear Stearns, finally resigns over subprime losses. On January 21, global stock markets, including the FTSE 100 index in London, suffer their biggest falls since the terrorist attacks of September 11, 2001. Bradford & Bingley reduces the value of its subprime related investments by £144 million, having said just weeks earlier it did not expect to suffer any write-downs. Bear Stearns is bought by JPMorgan Chase for £120 million, having been valued at £9 billion a year earlier. Royal Bank of Scotland, Britain's second-biggest banking group, asks shareholders for £12 billion to shore up its finances, one of the largest rights issues in the country's history. Two days later, house builder Persimmon calls a halt to all new building projects as house sales collapse. Bradford & Bingley launches an emergency £300 million rights issue as full scale of its subprime losses becomes clear. UK inflation hits 3 per cent as the cost of food and fuel goes through the roof.

Oct 30, 2007

Nov 16, 2007

Dec 6, 2007

Jan 11, 2008

Feb 13, 2008 March 18, 2008

April 22, 2008

May 14, 2008

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June 25, 2008

Barclays becomes the latest big bank to admit to problems as it announces plans to raise £4.5 billion by issuing 1.6 billion new shares, which are mostly sold to Middle Eastern investors. Shares tumble as world stock exchanges slump into a bear market (one in which shareholders want to sell) with the FTSE 100 index recording its seventh straight weekly fall. Property sales in the UK slump to a 30-year low. Alistair Darling says Britain is suffering its worst economic crisis for 60 years. Days earlier, figures reveal that house prices have dropped 10 per cent in the past year, the biggest fall since 1990. US Treasury steps in to rescue Fannie Mae and Freddie Mac, the two companies which guarantee half of all US mortgages, exposing US taxpayers to £2.9 trillion of debt in the world's biggest financial bail-out. US Treasury Secretary Hank Paulson says the two companies are simply too big to be allowed to fail. Lehman Brothers files for bankruptcy and becomes the first major bank to collapse since the start of the credit crisis. Alan Greenspan, the former chairman of the US Federal Reserve, describes the failure as "probably a once in a century type of event" and warns that other major firms will also go bust. This event came to operate as trigger for the financial panic that occurred in the fall of 2008 and almost caused a meltdown of world’s financial system.

July 1, 2008

Aug 30, 2008

Sept 8, 2008

Sept 14,



9.3 APPENDIX: Introducing the Argument: Confidence and Its Double Structure Despite its importance, there only exists a very small number of studies that look at the role of confidence in finance (e.g. Walters1992; for a review, see Swedberg forthcoming). Walter Bagehot’s classic work Lombard Street (1873). Bagehot is interesting in this context because he was well aware of the special role that confidence plays in the banking world. He also tried to explain the role that confidence plays in unleashing a financial panic, something that is of special relevance for this paper. The banking system, Bagehot notes, always demands an extraordinarily high level of trust, much higher than elsewhere in the economy. In this part of the economy there has to exist, as he puts it, “[an] unprecedented trust between man and man” There are mainly two reasons for this, one having primarily to do with liquidity, the other with solvency. The first reason for the unprecedented level of trust to exist in the banking system has to do with maturity transformation - that deposits are short-

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term, while loans are long-term. If the depositors do not have full confidence that their money is safe, they will demand it back. And when they do so, the bank will be in trouble since it lacks liquid resources to pay the depositors. The larger the amount that is lent out, in relation to the amount deposited, the more tenuous this type of confidence will also be. The second reason for confidence being extraordinarily important in the banking system has to do with losses that the bank may occur through its loans. A bank is extraordinarily vulnerable, in other words, not only because of liquidity-related troubles, but also because of its losses, since these must be offset against the capital of the bank. Again, the more that has been lent out, the more vulnerable a bank is and losses increase in their turn the leverage ratio dramatically. What this means, to repeat, is that the level of trust or confidence has to be higher in the area of banking than elsewhere in the economy. Bagehot also explicitly states that what is especially dangerous for the banking system is a situation in which there are hidden losses. The reason for this is that when these losses become known, a general panic can be set off that goes well beyond the problem banks. Anything may suddenly reveal the true economic situation, with a free fall of the whole banking system as a result. Or in Bagehot’s words: “We should cease…to be surprised at the sudden panics [in the banking system]. During the period of reaction and adversity, just even at the last instant of prosperity, the whole structure is delicate. The peculiar essence of our banking system is an unprecedented trust between man and man; and when that trust is much weakened by hidden causes, a small accident may greatly hurt it, and a great accident for a moment may almost destroy it” (Bagehot [1922 [1873]:151-52; emphasis added). Sometimes investors suddenly losing confidence in the banking system, when they realize that there are hidden losses. In order to get a more fine-tuned understanding of how a financial panic may be unleashed by hidden losses, this topic has to be addressed. My argument in this report is that while Merton has focused on one important role that a loss of confidence plays in the financial system, it is not the only one, and perhaps not even the central one for understanding a financial panic. The real problem
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with a loss of confidence occurs not when banks are solvent and there exist rumours to the contrary (the proxy sign is negative and the economic situation is positive). It occurs instead when some banks are not solvent, and this is not known ( (the proxy sign is positive and the economic situation is negative). We are then in Bagehot’s dangerous situation, in which it is not known who has losses and who has not, and in which an accident may set off a general panic that endangers the whole financi system (see financial Fig.1). Or to phrase it differently, Merton’s mechanism only comes into play in an important way, in the situation of hidden losses, as described by Bagehot. Fig. 1: Proxy Signs and Nature of Confidence

Explanation: A proxy sign can in the ideal case be assumed to be either aligned with the state of affairs or not. In the former case, a positive proxy sign correctly indicates a positive state of affairs; and a negative sign correctly indicates a negative state of affairs. Confidence is maintained in both of these cases, since the actor has correct information tained (++/--).When, in contrast, the proxy sign and the situation are not aligned and the proxy ).When, sign therefore misrepresent the situation, confidence will suffer.

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9.4 APPENDIX: Confidence and Fear Index plays huge role

Source: Figures from Bloomberg Terminal

9.5 APPENDIX: Securitisation and Leverage

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9.6 APPENDIX: ABOUT LEHMAN BROTHERS The modern Lehman Brothers (founded in 1844 as a dry goods business in Alabama), emerged once more as an independent investment bank in 1994 when it was spun off from American Express (e.g. McDonald and Robinson 2009, Rose and Ahuja 2009). Richard Fuld, who had joined Lehman in 1969, was now appointed its President and CEO. Under his leadership, Lehman continued to not only carry out the traditional tasks of an investment bank, but also to push deeply into the new financial markets that were emerging at the time. For one thing, it early on became a leader in the subprime securitization market. Till Fuld was pushed to the side in June 2008, he ran Lehman in an authoritarian manner, creating the very aggressive and competitive type of corporate culture that seems to be characteristic of modern investment banks.3 Anyone who was 15 perceived as a threat by Fuld was eliminated, and so were critics who from early on argued that Lehman was heading for trouble (McDonald and Robinson 2009). As many successful

CEOs, he also kept a lifestyle that isolated him from the real world. It should also be emphasized that Fuld’s personal experience was as a bond trader and that he had little understanding of such new financial instruments such as collateralized debt obligations, credit default swaps. As we soon shall see, this lack of sophistication on Fuld’s part helps to explain some of his clumsy attempts to deal with the crisis. Lehman was one of the leaders in the production of securitized mortgages and also owned two mortgage firms, BNC in California and Aurora Loan Services in Colorado.5 According to The Wall Street Journal, “Lehman established itself [in the mid- 1990s] as a leader in the market for subprime-mortgage-backed securities. It built a staff of experts who had worked at other securities firms and established relationships with subprime-mortgage lenders” (Hudson 2007).

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9.7APPENDIX: Nature of Credit Crisis Worsened: The growing concern caused a sharp drop in the issuance of asset-backed securities, particularly those of lower quality, in August 2007. All types of asset-backed securities and CDOs were adversely affected from September 2007, subprime residential MBSs and CDOs of asset-backed securities issues shrank, and even prime residential MBSs were substantially lower (Figure). Investors realized that the assets were riskier than had previously been thought, and the cost of insurance to cover default risk using credit default swaps (CDS) also had become much more expensive. President Bush expressed the same idea, but in his own language, when he said, “this sucker could go down.” According to economist Robert Lucas, “Until the Lehman failure the recession was pretty typical of the modest downturns of the post-war period…After Lehman collapsed and the potential for crisis had become a reality, the situation was completely altered” (Lucas 2009:67). According to Alan Blinder, another well-known economist, “everything fell apart after Lehman…After Lehman went over the cliff, no financial institution seemed safe. So lending froze, and the economy sank like a stone. It was a colossal error, and many people said so at the time” (Blinder 2009). Two months later Henry Paulson, the Treasury Secretary, explained that the failure of Lehman Brothers had led to a systemic crisis and to the evaporation of confidence in the financial system:

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9.8 APPENDIX: Consequences of Lehman Failure For a few days, this decision seemed harsh but fair. But then the markets realised the implication of Lehman’s failure: no financial institution’s debt was safe. If you lent to someone, not only might they not pay you back; the government wouldn’t either. Given that it was unclear who was running which risks, no financial institution was safe. At that point the argument was decided firmly in favour of the debt market’s pessimism, and equity markets plunged. This led immediate consequences for the other three large broker/dealers. Merrill Lynch, the next most vulnerable firm, quickly sold itself to Bank of America. The final two, Goldman Sachs and Morgan Stanley, turned themselves into banks. This allowed them to access funding from the FED and to be able to fund themselves using retail deposits (something broker/dealers could not easily do). Meanwhile, the money markets dried up. Financial institutions became increasingly unwilling to lend, either to each other or to anyone else. This began to seriously affect the broader economy. Share prices crashed as the market digested the likely impact of slowing demand and more expensive credit.

9.8.1 Bailouts and Busts: The fallout from the failure of Lehman arrived quickly. Washington Mutual was the largest thrift in America. As a prominent loser in the Crunch, WaMu, as it was known, was already looking vulnerable. A downgrade of its credit rating on the 15th September raised concerns further. WaMu found deposits being withdrawn. The resulting pressure on funding caused WaMu’s regulator to act. On the 26th September 2008, the Office of Thrift Supervision took control and appointed the FDIC as receiver. WaMu’s branches and assets were quickly sold to JPMorgan. An institution with total assets of over $300B had failed in less than two weeks. It was clear at this point that dramatic action was needed to prevent a string of bank failures. Not saving Lehman might have been a good decision ethically, but it began to look like very bad economics. Many financial institutions were vulnerable, and even the largest banks were having problems rising funding. Government intervention was needed across the whole financial system.
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The U.S. Treasury suggested a program to purchase distressed assets from financial institutions, the Troubled Asset Relief Program or TARP. This did not meet with favour from legislators, not least because the original plan gave extraordinary discretion to the Treasury with rather little oversight. The House of Representatives voted down the first version of the TARP, presumably taking the view that if the Treasury bought troubled assets for their fair value then it would not have done any good, but if it bought them for more than they were worth, then it amounted to a simple subsidy to the banks who had taken the biggest risks. The TARP was restructured to include extra oversight and require that the Treasury obtain equity stakes26 in the firms that they assist. This at least involved less moral hazard than buying assets, and the new TARP was passed on the 3rd October 2008. The program was immediately put to use. Over $125B of new capital was injected into leading American financial institutions. At the same time, other governments were intervening to save their banking systems. For instance, the UK government enacted a £500B plan28; Fortis was rescued by the Dutch, Belgian and Luxembourgeois governments; Hypo Real Estate Holding was bailed out by a consortium including the Bundes bank; and all three of Iceland’s big banks were nationalised. Figure shows some of the larger injections of state capital: in addition a number of banks raised extra capital privately.

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The immediate crisis was thereby averted. The recapitalisations and rescues gave the largest financial institutions some breathing space, and a modicum of confidence returned to the market. The Central Banks helped too, flooding the markets with liquidity and cutting interest rates in a coordinated move. Various European nations including Ireland, Denmark and Austria extended the scope of their deposit protection, further bolstering confidence. Further bank recapitalisations continued through the rest of October 2008: the Swiss banks got more money on the 16th; ING on the 19th; smaller U.S. banks on the 27th. But the pattern was now clear. Governments would bail out their financial institutions by lending hem money and injecting extra capital. Shareholders would suffer, but the financial system would not be allowed to collapse. The position of taxpayers was less clear. A lot of money had been spent by governments in a short period of time. Significant stakes had been purchased for that money in a depressed market. Some of these would prove to be good investments. But there are other assets the taxpayer made which, in the Deputy Governor of the Bank of England’s words ‘clearly have a level of defaults in them [which we are] not quite sure how will balance out against the residual of the capital. That is, losses are possible.

9.9 APPENDIX: Policy makers & Regulators Response The principles for mitigating financial crises were established more than 100 years ago in the book "Lombard Street: A Description of the Money Market" (1873) by Walter Bagehot. In his book, Bagehot stressed that in order to stop a panic, the central bank should give the impression that "though money may be dear, still money is to be had." Bagehot went on to say that the central bank should "lend freely, boldly, and so that the public may feel you mean to go on lending." Central bankers continue to follow this prescription, which is why they usually lower interest rates when a financial crisis occurs. A second important principle for minimizing the effects of a financial crisis is to maintain confidence in the safety of the banking system. This prevents a "run on the bank" in which consumers rush to withdraw their deposits. Confidence in the banking system is often secured by providing government guarantees on bank deposits, such as the U.S. FDIC insurance program. It is also important for policymakers to react swiftly when a crisis strikes. Indeed, the earlier policy-makers recognize and react to a crisis, the more effective their actions are likely to be. If adequate liquidity is quickly provided and confidence in the banking system is maintained, the effects of a crisis can be mitigated.

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Policy/ Regulators

What they did?
1. Has been extremely active in making sure that the financial system continues to function properly during the credit crisis. 2. The Fed lowered its key federal funds rate to provide additional liquidity to the financial system 3. Expanded the range of collateral it would willingly to accept in return for loans. 4. Provided direct lines of credit to a broader variety of financial institutions (previously only commercial banks could borrow directly from the Fed.) 1. The executive branch of the government has also been closely involved in maintaining stability in the financial system. 2. These efforts have included direct aid to a number of prominent financial firm (named as FHFA in conjunction with treasury department) 3. The famous bailout plan for nig financial firms (refer to below table for figure)

Market Effects
1. Helped to maintain confidence 2. Liquidity in the financial system as part of efforts to mitigate the effects of the credit crisis.

1. When Bear Stearns was on the verge of bankruptcy the Fed guaranteed a large portion of Bear Stearns' liabilities in order to facilitate a takeover by JPMorgan.

The Federal Reserve

The Government

1. Providing fiscal stimulus to the economy. 2. Took extraordinary measures to secure confidence in the financial system through a variety of guarantees, insurance programs, loans and direct investments. 1. Helped to gain the confidence of public

1. placed Fannie Mae and Freddie Mac under conservatorship as part of a four-part plan to strengthen the housing agencies

The centralised bank

1. Continue to follow the same policy (lend freely, boldly, and so that the public may feel you mean to go on lending) 2.lowered their interest rates on lending and increased interest rate on deposits

1.State Bank of India

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9.10 APPENDIX: Solutions for Credit crunch This depends on which phase of credit crunch that bank is in: Three Phases of Crisis Management 1. Short-term: Immediate Damage Containment 2. Medium-term: Restructuring Insolvent Banks 3. Long-term: Systemic Restructuring Traits of good strategies 1. Transparent, early recognition preserves trust 2. Politically and financially independent agencies 3. Maintain market discipline 4. Repair the real economy esp. Creditworthiness

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Baesens, B. (2009). Credit Risk Management. Oxford, United States: Oxford University Press. Bagehot, W. (1922). A Description of the Money Market. Lombard Street , 151-52. Barker, T. (2009, Jun 5). Understanding and Resolving the “Big Crunch”. The Cambridge Trust for New Thinking in Economics . Ben Bernanke, Paulson Henry, and Sheila Bair. (2008, October 14). Statements by Paulson, Bernanke Bair. Wall Street Journal . Bryan-Low, C. (2009). “Lehman Europe Claims Begin to Come In”. Wall Street Journal , September 25. Gabaix, X. A. (2007). Limits of Arbitrage: Theory and Evidence from the MBS market. Journal of Finance , 557-596. Mizen, P. (2008). The Credit Crunch of 2007-2008. FEDERAL RESERVE BANK OF ST. LOUIS REVIEW , 531-568. Rayner, G. (2008, Sept 15). Credit crunch Time line from Northern Rock to Lehman Brothers. Retrieved April 1, 2010, from www.telegraph.co.uk: http://www.telegraph.co.uk/finance/newsbysector/banksandfinance/2963415/Credit-Crunchtimeline-From-Northern-Rock-to-Lehman-Brothers.html

Runde, Jochen (1994b). ‘Keynesian uncertainty and liquidity preference’, Cambridge Journal of Economics, Vol. 18, No. 2, pp. 129–144.

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