(BBA 8-F)

Submitted to: Sir AHMER ATHER
Submitted by: ALI IMRAN
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Table of Contents
Acknowledgement...............................................................................................4 INTRODUCTION...................................................................................................5 HISTORY:..........................................................................................................5 BANKRUPTCY OF LEHMAN BROTHERS.................................................................6 SUBPRIME MORTGAGE CRISIS.............................................................................8 DEMISE OF LEHMAN BROTHERS..........................................................................9 1. MARKET COMPLACENCY...............................................................................9 HOMEOWNER SPECULATION.........................................................................9 THE PROBLEM:............................................................................................11 2. BAD REGULATION:......................................................................................11 THE GOALS SET BY H.U.D:..........................................................................12 MONEY MARKET FUNDS..............................................................................12 ULTRA SHORT BOND FUNDS.......................................................................12 THE PROBLEM:............................................................................................13 3. LACK OF TRANSPARENCY...........................................................................15 4. LEHMAN FINANCIAL POLICY:.......................................................................16 5. CONSEQUENCES AFTER LEHMAN DEFAULT:..............................................17 References........................................................................................................20 References

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Firstly we would like to thank Almighty Allah for providing us with the opportunity to make use of our knowledge while doing this project and enabling us to complete it in time. We would like to thank our teacher, Sir AHMER ATHER, who was helpful, friendly and cooperative and never shirked from giving us any guidance that we needed. We thank him for all his support and for helping us get a broader perspective of the Investment banking. And Last but not the least we would like to thank our parents and all of our teachers here at Bahria University for equipping us with the necessary skills and abilities which helped us in successfully completing this project.

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INTRODUCTION Lehman Brothers founded in 1850, is a global financial-services firm. The firm does business in investment banking, equity and fixed-income sales, research and trading, investment management, private equity, and private banking. It is a primary dealer in the U.S. Treasury securities market. The firm’s worldwide headquarters are in New York City, with regional headquarters in London and Tokyo, as well as offices located throughout the world.

In 1844, 23-year-old Henry Lehman, the son of a cattle merchant, emigrated to the United States from Rimpar, Bavaria. He settled in Montgomery, Alabama, where he opened a dry-goods store, “H. Lehman”. In 1847, following the arrival of Emanuel Lehman, the firm became “H. Lehman and Bro.” With the arrival of their youngest brother, Mayer Lehman, in 1850, the firm changed its name again and “Lehman Brothers” was founded. In 1850 Lehman brothers set up the merchant bank in New York after making money in railway bonds. In this way this finance giant came into existence in USA. During the 1850s, cotton was one of the most important crops in the United States. Capitalizing on cotton's high market value, the three brothers began to routinely accept raw cotton from customers as payment for merchandise, eventually beginning a second business trading in cotton. Within a few years this business grew to become the most significant part of their operation. Following Henry's death from yellow fever in 1855, the remaining brothers continued to focus on their commoditiestrading/brokerage operations. By 1858, the center of cotton trading had shifted from the South to New York City, where factors and commission houses were based. Lehman opened its first branch office in New York City's Manhattan borough at 119 Liberty Street, and 32-year-old Emanuel relocated there to run the office. In 1862, facing difficulties as a result of the Civil War, the firm teamed up with a cotton merchant named John Durr to form Lehman, Durr & Co. Following the war the company helped finance Alabama's reconstruction. The firm's headquarters were eventually moved to New York City, where it helped found the New York Cotton Exchange in 1870; Emanuel sat on the Board of Governors until 1884. The firm also dealt in the emerging market for railroad bonds and entered the financialadvisory business. In 2003, the company was one of ten firms which simultaneously
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entered into a settlement with the U.S. Securities and Exchange Commission (SEC), the Office of the New York State Attorney General and various other securities regulators, regarding undue influence over each firm's research analysts by their investment-banking divisions. Specifically, regulators alleged that the firms had improperly associated analyst compensation with the firms' investment-banking revenues, and promised favorable, market-moving research coverage, in exchange for underwriting opportunities. The settlement, known as the “global settlement”, provided for total financial penalties of $1.4 billion, including $80 million against Lehman, and structural reforms, including a complete separation of investment banking departments from research departments, no analyst compensation, directly or indirectly, from investment-banking revenues, and the provision of free, independent, third-party, research to the firms' clients. BANKRUPTCY OF LEHMAN BROTHERS Lehman borrowed significant amounts to fund its investing in the years leading to its bankruptcy in 2008, a process known as leveraging or gearing. A significant portion of this investing was in housing-related assets, making it vulnerable to a downturn in that market. One measure of this risk-taking was its leverage ratio, a measure of the ratio of assets to owners’ equity, which increased from approximately 24:1 in 2003 to 31:1 by 2007. While generating tremendous profits during the boom, this vulnerable position meant that just a 3-4% decline in the value of its assets would entirely eliminate its book value or equity. Investment banks such as Lehman were not subject to the same regulations applied to depository banks to restrict their risk-taking. In August 2007, Lehman closed its subprime lender, BNC Mortgage, eliminating 1,200 positions in 23 locations, and took a $25-million after-tax charge and a $27-million reduction ingoodwill. The firm said that poor market conditions in the mortgage space "necessitated a substantial reduction in its resources and capacity in the subprime space". In 2008, Lehman faced an unprecedented loss due to the continuing subprime mortgage crisis. Lehman's loss was apparently a result of having held on to large positions in subprime and other lower-rated mortgage tranches when securitizing the underlying mortgages. Whether Lehman did this because it was simply unable to sell the lower-rated bonds, or made a conscious decision to hold them, is unclear. In any event, huge losses accrued in lower-rated mortgage-backed securities throughout 2008. In the second fiscal quarter, Lehman reported losses of $2.8 billion and was forced to sell off $6 billion in assets. In the first half of 2008 alone, Lehman
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stock lost 73% of its value as the credit market continued to tighten. In August 2008, Lehman reported that it intended to release 6% of its work force, 1,500 people, just ahead of its third-quarter-reporting deadline in September. On August 22, 2008, shares in Lehman closed up 5% (16% for the week) on reports that the state-controlled Korea Development Bank was considering buying Lehman.[7] Most of those gains were quickly eroded as news emerged that Korea Development Bank was "facing difficulties pleasing regulators and attracting partners for the deal." It culminated on September 9, 2008, when Lehman's shares plunged 45% to $7.79, after it was reported that the state-run South Korean firm had put talks on hold. Investor confidence continued to erode as Lehman's stock lost roughly half its value and pushed the S&P 500 down 3.4% on September 9, 2008. The Dow Jones lost nearly 300 points the same day on investors' concerns about the security of the bank. The U.S. government did not announce any plans to assist with any possible financial crisis that emerged at Lehman. On September 10, 2008, Lehman announced a loss of $3.9 billion and their intent to sell off a majority stake in their investment-management business, which includes Neuberger Berman. The stock slid 7% that day. On September 13, 2008, Timothy F. Geithner, then president of the Federal Reserve Bank of New York called a meeting on the future of Lehman, which included the possibility of an emergency liquidation of its assets. Lehman reported that it had been in talks with Bank of America and Barclays for the company's possible sale. The New York Times reported on September 14, 2008, that Barclays had ended its bid to purchase all or part of Lehman and a deal to rescue the bank from liquidation collapsed. It emerged subsequently that a deal had been vetoed by the Bank of England and the UK's Financial Services Authority. Leaders of major Wall Street banks continued to meet late that day to prevent the bank's rapid failure. Bank of America's rumored involvement also appeared to end as federal regulators resisted its request for government involvement in Lehman's sale.

SUBPRIME MORTGAGE CRISIS Low interest rates and large inflows of foreign funds created easy credit conditions for a number of years prior to the crisis, fueling a housing market boom and encouraging debt-financed consumption. The USA home ownership rate increased from 64% in 1994 (about where it had been since 1980) to an
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all-time high of 69.2% in 2004. Subprime lending was a major contributor to this increase in home ownership rates and in the overall demand for housing, which drove prices higher. Between 1997 and 2006, the price of the typical American house increased by 124%. During the two decades ending in 2001, the national median home price ranged from 2.9 to 3.1 times median household income. This ratio rose to 4.0 in 2004, and 4.6 in 2006. This housing bubble resulted in quite a few homeowners refinancing their homes at lower interest rates, or financing consumer spending by taking out second mortgages secured by the price appreciation. USA household debt as a percentage of annual disposable personal income was 127% at the end of 2007, versus 77% in 2003. While housing prices were increasing, consumers were saving less and both borrowing and spending more. Household debt grew from $705 billion at yearend 1974, 60% of disposable personal income, to $7.4 trillion at yearend 2000, and finally to $14.5 trillion in midyear 2008, 134% of disposable personal income. During 2008, the typical USA household owned 13 credit cards, with 40% of households carrying a balance, up from 6% in 1970. Free cash used by consumers from home equity extraction doubled from $627 billion in 2001 to $1,428 billion in 2005 as the housing bubble built, a total of nearly $5 trillion dollars over the period. U.S. home mortgage debt relative to GDP increased from an average of 46% during the 1990s to 73% during 2008, reaching $10.5 trillion. This credit and house price explosion led to a building boom and eventually to a surplus of unsold homes, which caused U.S. housing prices to peak and begin declining in mid-2006. Easy credit, and a belief that house prices would continue to appreciate, had encouraged many subprime borrowers to obtain adjustable-rate mortgages. These mortgages enticed borrowers with a below market interest rate for some predetermined period, followed by market interest rates for the remainder of the mortgage's term. Borrowers who could not make the higher payments once the initial grace period ended would try to refinance their mortgages. Refinancing became more difficult, once house prices began to decline in many parts of the USA. Borrowers who found themselves unable to escape higher monthly payments by refinancing began to default.
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DEMISE OF LEHMAN BROTHERS The demise of Lehman Brothers can only be understood within the context of the current financial crisis, the biggest financial crisis since the Great Depression. The roots of this crisis have to be found in bad regulation, lack of transparency, and market complacency brought about by several years of positive returns.


The seeds of current crisis were sewn during the real estate boom. A prolonged period of low interest rates lead to a rise in house prices, that was completely abnormal by historical standards. From March 1997 to June 2006 the Case and Shiller national index of real estate prices increased every month. During the same period the average increase in real estate prices was 12.4% per year. This increase was in part fueled by extraordinary low interest rates. This sustained price increase engenders the illusion in many actual and aspiring home owners that prices will always go up. In a 2005 survey of San Francisco home buyers Case and Shiller find that the mean expected price increase over the next ten years was 14% per year, while the median 9% per year (Shiller, 2008). HOMEOWNER SPECULATION Speculative borrowing in residential real estate has been cited as a contributing factor to the subprime mortgage crisis. During 2006, 22% of homes purchased (1.65 million units) were for investment purposes, with an additional 14% (1.07 million units) purchased as vacation homes. During 2005, these figures were 28% and 12%, respectively. In other words, a record level of nearly 40% of homes purchases were not intended as primary residences. David Lereah, NAR's chief economist at the time, stated that the 2006 decline in investment buying was expected: "Speculators left the market in 2006, which caused investment sales to fall much faster than the primary market. Housing prices nearly doubled between 2000 and 2006, a vastly different trend from the historical appreciation at roughly the rate of inflation. While homes had not traditionally been treated as investments subject to speculation, this behavior changed during the housing boom. Media widely reported condominiums being purchased while under construction, then being "flipped" (sold) for a profit without the seller ever having lived in them. Some mortgage companies identified risks inherent in this activity as early as 2005, after identifying investors assuming highly leveraged positions in multiple properties.
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Nicole Gelinas former Lehman bank manager described the negative consequences of not adjusting tax and mortgage policies to the shifting treatment of a home from conservative inflation hedge to speculative investment. New York State prosecutors are examining whether eight banks hoodwinked credit ratings agencies, to inflate the grades of subprime-linked investments. The Securities and Exchange Commission, the Justice Department, the United States attorney’s office and more were examining how banks created, rated, sold and traded mortgage securities that turned out to be some of the worst investments ever devised. In 2010, virtually all of the investigations, criminal as well as civil, are in their early stages. Warren Buffett testified to the Financial Crisis Inquiry Commission: "There was the greatest bubble I've ever seen in my life...The entire American public eventually was caught up in a belief that housing prices could not fall dramatically. During the real estate boom delinquency rates dropped which was the first initiation of problems for Lehman Brothers. But they did not anticipate it very well and thought of it as a good sign. The reason was not only the relatively good economic conditions, but the sustained real estate price increase. First of all, home owners fought hard to be able to pay their mortgages when their home equity increased. Second, the availability of innovative mortgage options, like interest only and negative amortization, allowed buyers to purchase houses for which they could not sustain the mortgage payments in equilibrium counting on the ability to refinance them continuously at higher prices. This caused the share of interest-only mortgages to fly from zero to 38%. As a result of these favorable conditions, lending standards deteriorated. Lending standards declined in areas of high home price appreciation and attribute this decline to increased competition among lenders. The share of low documentation mortgages went from 29% to 51% and the debt-to- income ratio from 39.6 to 42.4. This relaxation was exacerbated by securitization, i.e. the practice of pooling mortgages together to resell them in packages. So far the bank was happy with all this happenings. For the first time, this practice, which had been used for decades on standard mortgages with beneficial results for both mortgage rates and home ownership, was applied to lower quality mortgages. Knowing that they would not bear the ultimate risk of default, Lehman Brothers who are mortgage originators further relaxed their lending standards. The quality of these mortgages should have been checked by the bank itself that bought them, but several problems made this monitoring less than perfect.

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THE PROBLEM: These models did not properly account for the cross-correlation among defaults and between defaults and the rest of the economy. Second, the massive amount of issuance made by Lehman changed the fundamental nature of the relationship between credit rating agencies and the investment banks issuing these securities. In the past each customer, issuing only a couple of securities, had no market power over the rating agencies. With the diffusion of collateralized debt obligations, the major investment banks were purchasing hundreds of rating services a year. As a result, instead of submitting an issue to the rating agency’s judgment, Lehman bank shopped around for the best ratings and even received manuals on how to produce the riskiest security that qualified for a AAA rating. Lehman through CDO Evaluator (an optimization tool) achieved the highest possible credit rating at the lowest possible cost.

Unfortunately, regulatory constraints created inflated demand for mortgage products. The Federal Housing Enterprises Financial Safety and Soundness Act of 1992 required the Department of Housing and Urban Development (HUD) to ensure that Lehman operates in compliance with their charter purposes. This act mandates that HUD carry out specific responsibilities that include setting annual housing goals for the GSEs and monitoring and enforcing the GSEs' performance in meeting these housing goals. THE GOALS SET BY H.U.D: In 2004, to encourage Lehman to facilitate greater financing and home ownership opportunities for families and neighborhoods targeted by the housing goals, especially first-time homebuyers, the HUD established goals for the two Government Sponsored Entities (GSE). These goals are expressed as percentages of the total number of mortgages purchased by the GSEs that finance the purchase of single-family and owner-occupied properties located in metropolitan areas for low and moderate income people. While there is no penalty for failure to meet these goals, it is clear from the press release that HUD exerts political pressure. Since these goals could be met also with the purchase of subprime collateralized debt obligations (CDOs), such pressure found no resistance from the GSE who loved the arbitrage this opportunity created: they could issue AAA-rated debt and invest in higher-yield AAA debt, gaining the spread.
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MONEY MARKET FUNDS Another source of captive demand was money market funds. Being required to hold only highly rated securities, money market funds loved these instruments because they satisfied the regulatory requirements and boosted their yields. Most managers of Lehman were well aware of the gamble they were taking with these funds, but could not resist taking it, under an intense competition for yield-hungry customers. These managers were also hoping that if a shock occurred, all their competitors would face the same problem, thereby reducing the reputational costs and possibly triggering a Government support. ULTRA SHORT BOND FUNDS To be fair, the problem was even more severe in the ultra short bond funds. Unlike money market funds, these funds are not restricted as to which types of instruments they can own. Their aim is to beat money market funds without delivering much more volatility. In the last year, the ultrashort-term bond category performed very poorly. The category's worst performers have lost between 10% and 30% over the past year . As the mutual find rater Lehman admits, “We can't say that we saw this coming. We didn't. There were risks in these portfolios that were hard to see and had never materialized in the past, so backward-looking risk measures such as standard deviation and past losses proved unreliable. Given the near- term maturities of the bonds in the portfolio, we underestimated the damage that subprime and other low-quality bonds could cause.” More generally, regulation relied heavily on credit-rating agencies measures of risk without understating the incentives this creates on the regulated to game the system and lobby the credit-rating agencies for sweet deals. THE PROBLEM: First of all, the bin-approach to risk advocated by Basel risk-based capital requirements induce banks to invest in the highest risk security in each bin, sensibly altering the distribution of asset risk. As a result, during the Argentina crisis, domestic banks loaded up on government bonds, in spite of the declaration of default, because they provided a regulation arbitrage: a very high yield and zero capital requirement This problem is present also in the United States. Lehman was allowed to allocate zero capital to loans which were hedged with credit default swaps. But the insurance buy was less than certain because of the possibility that the insurer will default – what it is known as counterparty risk – since the amount of collateral posted for this contract is often zero.
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Second, this regulation failed to appreciate the enormous pressure it put on the shoulder of credit-rating agencies. Lehman’s revenues from structured finance ratings increased from a little more than $100 million in 1998 to more than $800 million in 2006, representing more than 80% of its total rating revenues. To worsen the problem, at least as far as Lehman is considered, comes a Security and Exchange Commission ruling in April 2004, which relaxed the pre-existing limits on leverage. As a consequence, the leverage of Lehman investment bank shot up. Buyers have an option to treat sub-prime mortgage securities as trading or available for sale (AFS) or held to maturities (HTM). AFS securities are accounted for at the lower of cost or fair value. HTM securities are accounted for at amortized costs, subject to other-than- temporary impairments. Originators usually treat mortgages as available for sale. While this system was designed to increase the transparency of reporting it did encounter some problems, especially at the time of a major generalized crisis. As market liquidity dried out, Lehman had to move to mark-tomodel. Given the relative novelty of this approach, there was not a wellestablished method to deal with this. Hence, Lehman was at the mercy of their external auditors, who had different approaches. Since, there is not an adequate disclosure of all the assumptions that go in the models, a rule that was invented to increase transparency lead to more opacity at a time the market needed transparency the most. Second, write-offs calculated in this way had major impact in the rating-firm decisions to downgrade financial institutions, which in turn had strong effect on their ability to survive. Unfortunately, given the limited credibility credit rating agencies enjoy in this moment, they could not afford to be seen as overruling the implications of the write offs.

The other major source of problems that contributed to the crisis was the lack of transparency in major markets. During the last ten years the market for credit default swaps (CDS) grew unregulated from almost zero to more than $44 trillion (more than twice the size of the U.S. stock market). More importantly, the level of collateral posted for these contracts was very low or non-existent, generating the possibility of a systemic failure. If in the middle of the hurricane season all of a sudden all Florida homeowners lost the insurance for their house, there would be an enormous run to buy new insurance. Given that in the short term, insurance capacity is limited, the prices will go to the roof. If some home owners could not afford these prices,
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their mortgages will automatically default, triggering foreclosures and a real estate crisis. This is one of the reasons why the Lehman wanted the insurance market to be regulated. LEHMAN had massive exposure to CDS. Most of their positions were hedged; hence the net exposure was much smaller. Nevertheless, when Lehman a major player defaulted, all the other ones found themselves unhedged, triggering a run to buy insurance, with consequences not dissimilar from the case described above. In spite of its potential systemic effects, the market for CDS was completely unregulated. The same is true for the mortgage-backed security market. In 2007 there were almost 6 trillion mortgage-backed securities outstanding. Most of these securities were issued under the 144A rule, with limited disclosure. This lack of transparency in the issuing process made it difficult to determine who owned what. Furthermore, the complexity of these repackaged mortgages is such that small differences in the assumed rate of default can cause the value of some tranches to fluctuate from 50 cents on the dollar to zero. Lacking information on the nature and hence the value of banks’ assets, the market grew reluctant to lend to them, for fear of losing out in case of default. One often-used measure of this reluctance is the spread between Libor and the overnight indexed swap (OIS) rate of the same maturity. Before the beginning of the crisis the multi-year average of this spread was 11 basis points. On August 10 2007 it was over 50 basis points and it was over 90 basis points by mid-September. While fluctuating it has mostly remained above that level ever since, 2008.

In the case of Lehman (and other investment banks), this problem was aggravated by two factors: the extremely high level of leverage (assetto- equity ratio) and the strong reliance on short-term debt financing. While commercial banks are regulated and cannot leverage their equity more than 15 to 1, at the beginning of the crisis Lehman had a leverage of more than 30 to 1, i.e. only $3.30 of equity for every $100 of loans (Table 6). With this leverage, a mere 3.3% drop in the value of assets wipes out the entire value of equity and makes the company insolvent. In turn, the instability created by the leverage problem was exacerbated by Lehman’s large use of short-term debt, which financed more than 50% of the asset at the beginning of the crisis. In a low interest rate environment, reliance on short-term borrowing is very profitable, but
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increases the risk of “runs” similar to the ones bank face when they are rumored to be insolvent. Any doubt regarding the solvency of the borrower makes short-term lenders leery to renew their lending. These doubts can be self-fulfilling, in that if enough short-term lenders withdraw their funds, the borrower faces a liquidity shortage, which cannot be easily dealt with in the current economic environment, forcing a firm to default. After the beginning of the crisis, Lehman did try to reduce its leverage and reduce its reliance on short term debt. But it was too little, too late. Lehman succumbed. The Lehman CEO told that his company was solvent and that it was brought down by a run. This is a distinct possibility. The problem is that nobody knows for sure. When Lehman went down, it had $20 billion in book equity, but the doubts about the value of its assets combined with its high degree of leverage created a huge uncertainty about the true value of this equity: it could have been worth $40 billion or negative 20. It is important to note that Lehman did not find itself in that situation by accident; it was the unlucky draw of a consciously-made gamble.

The Lehman fallout is likely to have a significant direct and indirect impact on a number of large banks globally.Here are three areas worth mentioning: • Exposure to debt in (selective) default. LBHI had outstanding longterm debt of approximately $110 billion as of Aug. 30, 2008. Shortterm commercial paper outstanding was around $8 billion at the end of May, but has likely been reduced significantly since that time. The fact that trustees hold a majority of this debt means the bankruptcy petition sheds little light on the economic ownership of Lehman's obligations. We believe, though, that a broad range of institutions, not just large capital market players, are likely to hold some of this paper.Managed conduits, which are typically subject to available–forsale (AFS) accounting, could also contain meaningful amounts of Lehman debt where the risk ultimately lies with the managing bank. Money market funds managed by banks could also be holding some Lehman debt, leading to potential compensation to clients. This has already happened with some structured credit exposure that such funds held. So far, we have not yet identified particular concentrations that would threaten a rating, but some exposures are material. It will take some time to get the full picture, including among smaller players. LBHI also has some $8 billion of hybrid capital outstanding. It is possible that some of this could be held by
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collateralized debt obligations (CDOs) of trust-preferred securities, some of which may have been distributed widely.

Counterparty exposure. Likely to be more significant is counterparty exposure to the various companies within the Lehman Bros. group. These exposures should be largely confined to the biggest banks and broker-dealers, but smaller institutions could have some as well. These exposures are likely to be large in gross terms (mostly via repurchase agreements and securities lending transactions) and to vary considerably among institutions. Again, so far, we believe that such exposures are manageable for the institutions involved. Given the probable movements in the value of the collateral, potential future exposure could yet rise materially and be subject to considerable volatility, although we would expect these exposures to have largely crystallized into current exposures by now. Furthermore, given possible differences in the treatment of the various Lehman entities, it is not yet clear whether positive and negative exposures across the group can be netted. As noted above, although the main U.S. brokerdealer subsidiaries remain operational, the German bank subsidiary is effectively frozen, and the primary U.K. subsidiary, which conducts a majority of the group's derivative exposures, has been placed in administration. Market price impact. Even entities active in the capital markets that have negligible direct exposure to Lehman will likely suffer, in our view--and to a potentially greater extent. This is because we expect the parent company's Chapter 11 filing to intensify pressure on the group to shrink its balance sheet. Indeed, we believe that the secured nature of the bulk of the exposures to Lehman enables banks to seize the group's collateral and attempt to liquidate it, this will likely result in further downward pressure on a wide range of assets. That could, in turn, force highly leveraged institutions to liquidate to meet margin calls, putting further pressure on assets. It is too early to gauge the likely impact of this, but it seems probable that third-quarter 2008-already shaping up to be weak--can only worsen as a result of Lehman's Chapter 11 filing and lead to still more disadvantageous market prices at the end-of-September balance-sheet date. In addition, the precedent that would be set concerning the valuation of assets in the Lehman portfolios could, in our opinion, become a benchmark for marks to market of real estate-related assets as well as other asset classes to which these institutions are exposed. It is important to note

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that asset liquidations are coming from all corners, either to cover losses or because the global economy is slowing. Lehman’s bankruptcy forced the market to reassess risk. As after a major flood people start to buy flood insurance, after the demise of Lehman the market started to worry about several risks previously overlooked. One way to valuate quantitatively this reassessment of risk is to look at the price of credit default swaps. Figure 4 reports the cost of insuring an index of junk bond issuers during the last one and a half year. Before the crisis it cost only $2.50 to insure $100 invested in junk bonds. In July 2007 the price moved above $4. During the Bear Stearns crisis, the price shot above $6, to return to about $4.50 in June. After the demise of Lehman the price returned slightly above $6, a very high level, but comparable to the one experienced around the time of the Bear Stearns crisis. Given that two different policy responses -- Bear Stearns was saved, while Lehman not – lead to the same market response, the most likely interpretation is that these extreme events force the market to reassess the risk, regardless of the policy response adopted. Lehman’s filing for bankruptcy had a more dramatic impact on th money market funds. On September 16 Primary Fund, a $62 billion fund, announced that because of the total loss it suffered on its $785 million holding of Lehman Brothers debt, it was forced to put a seven-day freeze on redemptions, since the net asset value of its shares fell below $1. By contradicting a long-standing belief that money market fund will never “break the buck,” this decision did contribute to increase the sense of uncertainty. The guarantee offered by the Government, however, has minimized this side effect. Why the government couldn't save Lehman: "[Treasury secretary Hank]Paulson believed that the Government lacked authority to inject capital into Lehman Brothers. The Federal Reserve's willingness to provide financial help to Bear Stearns (toward the JPMorgan purchase) and AIG was not, in his view, inconsistent with the Federal Reserve's decision to deny aid to Lehman. With Bear Stearns, the Federal Reserve had a willing buyer (JPMorgan); Lehman did not. With AIG, AIG had valuable insurance subsidiaries to use as collateral; again, Lehman had nothing comparable."

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Ashcraft, Adam B. and Til Schuermann, 2008, “Understanding the Securitization of Subprime Mortgage Credit”, Wharton Financial Institutions Center Working Paper No. 07-43. Benmelech, Efraim and Jennifer Dlugoszb, 2008, “The Alchemy of CDO Credit Ratings”, Harvard University Working Paper. Dell'Ariccia, Giovanni, Deniz Igan and Luc A. Laeven, 2008, “Credit Booms and Lending Standards: Evidence from the Subprime Mortgage Market”, CEPR Discussion Paper No. DP6683. Diamond, D. and P. Dybvig, 1983, “Bank runs, Deposit Insurance and Liquidity”, Journal of Political Economy. Demyanyk, Yuliya and Otto Van Hemert, 2008, “Understanding the Subprime Mortgage Crisis”, Working Paper. Dolan, Karen, 2008, “Ultrashort-Term Bond Funds Suffer Massive Blow”,, 09-03-08. Duffie, Darrell, 2004, “Irresistible Reasons for Better Models of Credit Rating”, Financial Times, Apr 16, 2004.

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