The fall of Financial Giants

(Lehman bros story)
The biggest financial pandemic since the Great Depression roared through the USA and many parts of the world. Lehman Brothers and Merrill Lynch, the storied symbols of American money might no longer exist as they existed some days ago. Lehman Brothers, the 158-year old investment bank has filed for bankruptcy; Merrill Lynch, the premier brokerage and Wall Street’s third largest bank has agreed to be subsumed into Bank of America. Merrill worth $100 billion last year will sell itself for $50billion to Bank Am. To top it all, American International group (AIG) has asked the Fed to for an emergency loan of $40billion.If the appeal is turned down then AIG may have a few days for its survival.
Lehman Bros- How could such a big player like it fall?
Financial markets can be cruel and punishing at times. More so, if an institution is overleveraged-when loan and investment books are much , much bigger than its capital. What compounds the problem are strange accounting practice and high risk nature of loans and investments. There are also disclosure issues- Lehman, in its last conference with the investors did not give any clue that it was on the brink.
The Crisis build-up
An investment bank uses its proprietary book (own money) to lend others and invest. It started with the subprime crisis. Banks like Lehman, buy mortgage loans from other banks and then package them to sell bonds against the loan pool. Often they add cash to make the loan pool more attractive, so that the bonds can be sold at a higher price. Suppose mortgage was earning 6% and these bonds were sold at 4%. The difference is the spread which the investment bank earns. By selling these structured bonds, it raises money and frees capital. But when the homebuyers started defaulting , these bonds started losing value. It began all like this and spread like a virus across all markets. But according to the layman investment banks play only an advisory role. They do it, they also organize big loans for their clients for funding acquisitions. At times, they take up positions only to palm off securities to other clients and banks. In a crisis, they may not get the opportunity to down sell such positions . This adds to the panic.
How does this domino effect play out?
Suppose Lehman has to pay a bank from which it has borrowed. If it sells the mortgage-backed loans whose prices have fallen, it will not raise that much money as was earlier expected. So, it sells some of the other good assets or bonds which may have nothing to do with mortgages. But since the bank has started to dump these assets , prices of these bonds also dip. This is when the crisis spreads from subprime to prime.
Now, its effect on the balance sheet is attributed to the strange accounting of bonds and derivatives like mortgage-backed securities. All banks are required to mark to-market (MTM) their investments. So, if the price of an instrument falls, the difference between the prices it was bought and the current market price has to be provided-meaning, it has to be deducted from the earnings. So, a drop in the prices leads to a drop in MTM. But there’s a big problem which has really deepened the crisis. An MTM loss can be provided only if there’s a “MARKET”. The reason being that its very different from checking the price of a stock from the stock exchange website.
Many of the instruments are over-the counter derivatives, which are stuck over stuck on a one-to-one basis between the two parties. Suppose, a derivative is linked to variables like the yen-dollar rate , and may be prices of other activity traded assets, say gold price and US Treasury bills. What the bank does is construct a model, feeds the available market price of these variables to the computer to arrive at what the derivatives price could or should be. This is called mark-to-model.
The trouble is when the bank actually goes out to sell the derivatives; it discovers that there are no takers. Even if there are buyers they are willing to play only a fraction. In other words, there is a sea of difference between the price that is offered in the market and the high artificially generated price thrown up by the model. So, when the bank ends up selling the instrument or unwinding derivatives, the loss suffered is far in excess of the mark-to-model loss. Such extra losses on thousand of securities and multiple portfolios can wipe out the capital of the bank.
Nature of instruments-
There are collateralized debt obligations (CDOs), credit default swaps (CDSs) and all kinds of derivatives. CDOs are asset (or loan)-backed securities, while CDSs are like a guarantee. Say Bank A lends to a corporate but is unwilling to take the full credit risk. So, Bank A enters into a CDS deal with Bank B; under this , Bank B promises to pay Bank A if the corporate defaults. The money that Bank B earns for this is the CDS premium, which is similar to insurance premium. Now, if the markets turn choppy, risks go up and so does the CDS premium. So, bank B which is earning a lower premium has to promote a mark-to market loss against the CDS position.
So, what is the solution?
No easy answer to that. Maybe, some of the accounting norms need to be changed, so that the definition of MTM gets narrowed down. Besides, to stop banks from going overboard, capital requirement may have to be raised for derivatives position. But all this may be easier said than done.
The Lehman Story in a Nutshell-
Lehman’s slow collapse began as the mortgage market crisis unfolded during the summer of 2007. Its stock began a steady fall from a peak of $82 a share. The fears were based on the fact that the firm was a major player in the market for sub prime and prime mortgages. Lehman managed to avoid the fate of Bear Stearns, which was bought by JP Morgan Chase at a bargain basement price under the threat of bankruptcy. Lehman & Bear Stearns had some similarities. Both had relatively small balance sheets, they were heavily dependent on the mortgage market and they relied heavily on the repo market or the repurchase market most often used as a short term financing tool.
On June 9, 2008 Lehman announced a second quarter loss of $2.8 billion, far higher than analysts predicted. The situation became worse after the government announced on September 8 a take over of Fannie Mae and Freddie Mac. Lehman’s stock plunged as the markets wondered whether the move to save those mortgage giants made it less likely that Lehman might be bailed out. Treasury secretary Henry M. PaulsonJr. And Fed officials did encourage other financial institutions to buy Lehman, but by the end of the weekend, two main suitors Barclay’s and Bank of American, had both said no. Lehman had reached the end of line.
Effects of Lehman’s fall:
The move by Lehman Brothers Holdings, the fourth largest investment bank to file for bankruptcy in the US, will impact partly the country’s largest private bank-ICICI Bank. It will have to take a hit of $28 million on account of the additional provisioning that ICICI Bank’s UK subsidiary will have to make. During this quarter, it pared its Credit default swaps (CDS) exposures to overseas corporates from $65 million to $80 million. Some of the larger state owned banks are also likely to take small hits because of marked-to-market provisioning on their overseas investments.
Regulators in various markets are trying to ring fence their institutions from Lehman. RBI has barred Lehman Indian arm from remitting money to the parent, while Japan’s Financial Services agency has ordered Lehman to retain sufficient assets in Japan to cover its liabilities in the country.
Lehman Bros. won federal court approval to sell its North American business to Barclays Plc for $1.75 billion.
The Bush administration is asking the Congress to let the government buy$700 billion in toxic mortgages in the largest financial bailout since the Great Depression. (updated till 21.09.08)