Assignment no.

3
International Finance

Submitted to: Mam Sana Saleem

Submitted by: Wasim Cheema
Sap Id: 70057284
Program: BBA 8th
Department: LBS

UNIVERSITY OF LAHORE (Chenab Campus)

Lehman Brothers:
On Sept. 15, 2008, Lehman Brothers filed for bankruptcy. That name may bring up images
millions of people saw in the news for the first time: Hundreds of employees, mostly dressed in
business suits, leaving the bank's global offices one-by-one with banker’s boxes in their hands. It
was a sombre reminder that nothing is forever even in the richness of the financial and
investment worlds.
With $639 billion in assets and $619 billion in debt, Lehman's bankruptcy filing was the largest
in history, as its assets far surpassed those of previous bankrupt giants such
as WorldCom and Enron. Lehman was the fourth-largest U.S. investment bank at the time of its
collapse, with 25,000 employees worldwide. Lehman's demise also made it the largest victim of
the U.S. subprime mortgage-induced financial crisis that swept through global financial markets
in 2008. Lehman's collapse was a seminal event that greatly intensified the 2008 crisis and
contributed to the erosion of close to $10 trillion in market capitalization from global equity
markets in Oct. 2008, the largest monthly decline on record at the time.
The company, along with many other financial firms, branched into mortgage-backed securities
(MBS) and other collateral debt obligations (CDOs) in 2003 and 2004. With the U.S. housing
boom—read: bubble—well under way, Lehman acquired five mortgage lenders including
subprime lender BNC Mortgage and Aurora Loan Services, which specialized in Alt-A loans.
These were made to borrowers without full documentation. At first, Lehman's acquisitions
seemed prescient. Record revenues from Lehman's real estate businesses enabled revenues in the
capital markets unit to surge 56% from 2004 to 2006, a faster rate of growth than other
businesses in investment banking or asset management. The firm securitized $146 billion of
mortgages in 2006—a 10% increase from 2005. Lehman reported record profits every year from
2005 to 2007.4 In 2007, the firm reported net income of a record $4.2 billion on revenues of
$19.3 billion.
In Feb. 2007, the stock reached a record $86.18, giving Lehman a market capitalization of close
to $60 billion.5 But by the first quarter of 2007, cracks in the U.S. housing market were already
becoming apparent. Defaults on subprime mortgages began to rise to a seven-year high. On
March 14, 2007, a day after the stock had its biggest one-day drop in five years on concerns that
rising defaults would affect Lehman's profitability, the firm reported record revenues and profit
for its fiscal first quarter. In the company's post-earnings conference call, Lehman's chief
financial officer said the risks posed by rising home delinquencies were well contained and
would have little impact on the firm's earnings. He also said he did not foresee problems in the
subprime market spreading to the rest of the housing market or hurting the U.S. economy.
The Beginning of the End
Lehman's stock fell sharply as the credit crisis erupted in August 2007 with the failure of two
Bear Stearns hedge funds. During that month, the company eliminated 1,200 mortgage-related
jobs and shut down its BNC unit.5 It also closed offices of Alt-A lender Aurora in three states.
Even as the correction in the U.S. housing market gained momentum, Lehman continued to be a
major player in the mortgage market.
In 2007, Lehman underwrote more mortgage-backed securities than any other firm,
accumulating an $85 billion portfolio, or four times its shareholders' equity. In the fourth quarter
of 2007, Lehman's stock rebounded, as global equity markets reached new highs and prices for
fixed-income assets staged a temporary rebound. However, the firm did not take the opportunity
to trim its massive mortgage portfolio, which in retrospect, would turn out to be its last chance.
American International Group (AIG):
You may be surprised to learn that the American International Group Inc., better known as AIG
is still alive and kicking, and is no longer considered a threat to the financial stability of the
United States. Almost a decade after it was handed a government bailout worth about $150
billion, the U.S. Financial Stability Oversight Council (FSOC) voted to remove AIG from its list
of institutions that are systemic risks, or in headline terms, "too big to fail." In 2013, the
company repaid the last installment on its debt to taxpayers, and the U.S. government
relinquished its stake in AIG.
In quarterly earnings announced in August 2019, AIG posted a nearly 18% increase in revenue,
and the company's turnaround was deemed to be well underway. But it had been forced to cut
itself in half, including selling off a valuable Asia unit, in order to repay its massive debt to U.S.
taxpayers.
Understanding How AIG May Have Fallen
High-Flying AIG
For decades, AIG was a global powerhouse in the business of selling insurance. But in
September 2008, the company was on the brink of collapse. The epicenter of the crisis was at an
office in London, where a division of the company called AIG Financial Products (AIGFP)
nearly caused the downfall of a pillar of American capitalism. The AIGFP division sold
insurance against investment losses. A typical policy might insure an investor against interest
rate changes or some other event that would have an adverse impact on the investment. But in
the late 1990s, the AIGFP discovered a new way to make money.
How the Housing Bubble's Burst Broke AIG?
A new financial product known as a collateralized debt obligation (CDO) became the darling of
investment banks and other large institutions. CDOs lump various types of debt from the very
safe to the very risky into one bundle for sale to investors. The various types of debt are known
as tranches. Many large institutions holding mortgage-backed securities created CDOs. These
included tranches filled with subprime loans. That is, they were mortgages issued during the
housing bubble to people who were ill-qualified to repay them. The AIGFP decided to cash in on
the trend. It would insure CDOs against default through a financial product known as a credit
default swap. The chances of having to pay out on this insurance seemed highly unlikely. The
CDO insurance plan was a big success, for a while. In about five years, the division's revenues
rose from $737 million to more than $3 billion, about 17.5% of the company's total. A big chunk
of the insured CDOs came in the form of bundled mortgages, with the lowest-rated tranches
comprised of subprime loans. AIG believed that defaults on these loans would be insignificant.
A Rolling Disaster
And then foreclosures on home loans rose to high levels. AIG had to pay out on what it had
promised to cover. The AIGFP division ended up incurring about $25 billion in losses.
Accounting issues within the division worsened the losses. This, in turn, lowered AIG's credit
rating, forcing the firm to post collateral for its bondholders. That made the company's financial
situation even worse. It was clear that AIG was in danger of insolvency. To prevent that, the
federal government stepped in. But why was AIG saved by the government while other
companies affected by the credit crunch weren't?
Too Big to Fail
Simply put, AIG was considered too big to fail. A huge number of mutual funds, pension funds,
and hedge funds invested in AIG or were insured by it, or both. In particular, investment banks
that held CDOs insured by AIG were at risk of losing billions. For example, media reports
indicated that Goldman Sachs Group, Inc. (NYSE: GS) had $20 billion tied into various aspects
of AIG's business, although the firm denied that figure. Money market funds, generally seen as
safe investments for the individual investor, were also at risk since many had invested in AIG
bonds. If AIG went down, it would send shockwaves through the already shaky money markets
as millions lost money in investments that were supposed to be safe.
Who Wasn't at Risk
However, customers of AIG's traditional business weren't at much risk. While the financial
products section of the company was close to collapse, the much smaller retail insurance arm
was still very much in business. In any case, each state has a regulatory agency that oversees
insurance operations, and state governments have a guarantee clause that reimburses
policyholders in cases of insolvency. While policyholders were not in harm's way, others were.
And those investors, who ranged from individuals who had tucked their money away in a safe
money market fund to giant hedge funds and pension funds with billions at stake, desperately
needed someone to intervene.
Government Measurement and Steps:
While AIG hung on by a thread, negotiations took place among company executives and federal
officials. Once it was determined that the company was too vital to the global economy to be
allowed to collapse, a deal was struck to save the company.
$22.7 billion
The amount the U.S. government eventually made in interest payments for its AIG bailout.
The Federal Reserve issued a loan to AIG in exchange for 79.9% of the company's equity. The
total amount was originally listed at $85 billion and was to be repaid with interest.
Later, the terms of the deal were reworked and the debt grew. The Federal Reserve and the
Treasury Department poured even more money into AIG, bringing the total up to an estimated
$150 billion.
Exchange Rate Situation:
The cost imposed by the financial crisis has resulted in a legislative and regulatory reaction to
rein in risk-taking and speculative behavior. One effort has been attempting to reduce
compensation at banks that have accepted government assistance. In one instance, a UK bank
paid no bonuses for 2008. This government reaction to the crisis is not surprising, but it is
doubtful that those setting the rules fully understand the implications of the changes they are
forcing on the financial industry.
The losses experienced by financial institutions did not come from foreign exchange trades,
imposed compensation restrictions treat the foreign exchange function the same as other areas of
the bank. We expect bank employees to respond in a predictable manner to a changed incentive
structure. Since compensation is severely limited compared to the past, the risk-return tradeoff
has changed in a manner that is probably consistent with public policy; less incentive to take risk
results in less risk taking.
For example, in the foreign exchange market, market-making dealers are expected to provide
liquidity to their counterparties and then manage the risk of their positions while earning a profit
for their banks. Competition across banks resulted in tight spreads and a willingness to provide
good two-way prices for large trade size. This willingness to bear risk on the “sell-side” was
beneficial to the “buy-side” bank clients. In fact, given the large spreads reported and the large
volume of trading that occurred in 2008, bank profits from foreign exchange were very large. In
the aftermath of the crisis, dealers are charging wider spreads and dealing in smaller amounts
than in the past. This will lower the bank’s risk exposure but impose greater costs on the banks’
clientele – non-bank financial institutions, corporate customers, governments, central banks,
international travelers, and others who benefit from liquidity and risk-management services
provided by banks.
A predictable implication of the public policy response to the financial crisis is to lower liquidity
and raise the risks and costs associated with non-bank currency trades. The “buy-side” faces
greater costs associated with currency trading along with greater volatility of exchange rates. It
should be more difficult for non-banks to transfer their currency risks to a bank than in the past,
while the non-bank entities face greater risk in the foreign exchange market than they used to. It
is not clear that there is a net gain to society from these changes.

Reference:
https://voxeu.org/article/lessons-foreign-exchange-market-global-financial-crisis
https://www.researchgate.net/publication/227347995_Exchange_Rates_during_Financial_Crises
https://www.thebalance.com/lehman-brothers-collapse-causes-impact-4842338
https://www.thebalance.com/aig-bailout-cost-timeline-bonuses-causes-effects-3305693
https://www.cashfloat.co.uk/blog/money-borrowing/government-measures-crisis/