Lehman Brothers Bankruptcy: Tipping point of Recession

Into the Meltdown

Lehman Brothers Bankruptcy

It was Friday evening, September 12^th 2008, employees at Lehman Brothers were leaving office, unaware that by the time they will return to their office on Monday, the 158 year old investment giant would be declared bankrupt.

Lehman Brothers, set up in 1850 was a global financial service provider, 4^th largest investment bank in US just after Goldman Sachs, Morgan Stanley and Merrill Lynch. It had a well diversified business in the field  of investment Banking, equity and fixed income sales, investment management, private equity and private banking. It was a primary dealer in US Treasury securities market. On September 15^th 2008 the bank filed for chapter 11 bankruptcy protection following massive losses in its business worldwide due to its exposure to the sub prime market, drastic losses in its stock and devaluation of its assets by credit rating agencies. The bankruptcy of Lehman Brothers remains the largest bankruptcy filing in history with Lehman holding over $600 billion in assets.

Background

After the dot com bubble burst in 2000 and 9/11 terrorist attack the US economy was hit hard, the US Federal Reserve felt the need of having a stronger US economy, to fulfill this the US Fed started reducing lending rates and soon the lending rates were as low as 1% this made borrowing for financial institutions almost for free. This enabled these institutions to highly leverage themselves thereby increasing their leverage ratio, a leverage ratio is 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. At the time of Bankruptcy Lehman leveraged itself in the ratio 44:1. So with credit becoming  cheaper the financial institutions started investing heavily in housing industry giving loan to prime borrower at lower interest rates but soon there was shortage of primer borrower. There are certain rules prescribed by US government for lending money to people by financial institutions, in order to boost the economy and fulfill the American dream of house ownership US government gave certain relaxation in these rules. Now the institutions were allowed to give loan to subprime borrower  who had greater chances of defaulting, even  without having any proof of their income source. Lehman was the front runner in subprime lending which ultimately led to its bankruptcy. When the subprime lender started defaulting in 2007 leading to subprime mortgage crisis Lehman was completely exposed to the crisis due to its heavy investment in housing related asset. And it suffered huge losses. In August 2007, Lehman closed its subprime lender, BMC Mortgage, eliminating 1200 positions in 23 locations.

September 2008

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. 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 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 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 12, Lehman was losing $8 million every minute in shares value and by the end of day the share were trading at 3 cents a share, the same being traded at $80 at its peak. By the end of day the company was running out of cash to open itself for business on Monday.

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.

Bankruptcy Filing

Seeing no chances of a takeover and no assistance from the Federal Reserve the bank was left with no other options than to file for bankruptcy. On September 15^th, Lehman Brothers filed for chapter 11 bankruptcy protection in the US bankruptcy court. This was the end of a 158 year old Financial Institution that survived the great depression and other major crisis. It was the largest bankruptcy in history.

After Effects

The bankruptcy of Lehman Brothers had a catastrophic effect not only on the US economy but the whole world economy. On September 15^th  share market tumbled all over the world  and a total of $700 billion were wiped off from the stock market. There was a complete panic in the market, everybody feared that if Lehman Brothers can go down than who else cannot. The rate the bank charges to lend money doubled within night and it become extremely difficult for banks to raise money. Two days after the bankruptcy on September 17^th money market all over the world froze. The banks lost confidence that they need to lend  to each other fearing of a possible default. The fall of Lehman Brothers brought the global financial system on its knees. Soon not only financial institution but large companies started finding it difficult to raise capital to carry their day to day work. In fact bankruptcy of Lehman Brothers led to deep recession which soon gripped the world economy. Soon Lehman Brothers bankruptcy was followed by the bankruptcy of Washington Mutual, US largest commercial bank, this was the second largest bankruptcy after Lehman, Later J P Morgan took over Washington Mutual. Soon banks all over the world started running out of cash, the major being the European Nation mainly Ireland and Iceland, on 29^th september the government of Iceland nationalize its largest bank, but it proved to be a costly move, Iceland banks had debt 8 times the country’s GDP, international depositors didn’t believe they could meet them and started withdrawing money, this led to a bank run later the government of Iceland decided  that its payment system continue to function while creditor, not the taxpayer shouldered the losses of banks. Soon this spread to other European countries like Greece, Portugal, Spain. Ireland guaranteed deposits of six of its major banks, similar steps were taken by Greece Portugal and Spain . Till now Greece, Ireland and Portugal has been bailed out by billions of dollars by European Union. Still the European countries have not recovered and are getting bailouts. The interest rate on bonds of Greece are at its highest point. And with bonds maturing soon and countries still under crisis there seems very less chance to these countries to recover in near future.

Analysis

Historians would debate if weather the US government should have bailed out  Lehman Brothers leading to a greater degree of financial stability. My personal view point is that a company like Lehman Brother should have never left for bankruptcy, this was too big company to fail, before letting it go, the US fed should have analyzed the consequences of failure of Lehman Brothers, bailing out Lehman would have hardly cost the US treasury some 30 to 40 billion dollars but the effect the bankruptcy had on world economy is beyond measures, not only companies but countries went bankrupt, government across the globe pumped billions of dollars in their banking system to save their economy. We can see the effects of these as major developing nation are now facing problem of high inflation with India being hit hard in particular. The European countries are still in crisis. US till now has pumped trillions of dollars in its banking system to boost its recovery. The American debt has increased from $9.2 trillion in 2007 to $14.3 trillion till now  and at present US is facing debt crisis and if US is unable to raise its debt ceiling and defaults on its payment it will lead to a worse financial crisis that will have a more catastrophic effect than that of recession of 2008.