On September 15, 2008, Lehman Brothers, the fourth largest U.S. investment bank at the time, filed for bankruptcy. At the time of its collapse, Lehman Brothers had $639 billion in assets, and $619 billion in debt, making it the largest bankruptcy filing in history. Lehman's collapse also made it the largest victim of the U.S. subprime mortgage crisis. This paper examines the collapse of Lehman Brothers and the factors that led to that failure.
Lehman Brothers started as an investment bank that dated back to the 1850s. During its 158-year history, the firm survived the railroad bankruptcies of the 1800s, the Great Depression and two World Wars. It did not, however, survive the subprime mortgage meltdown, or its own bad business decisions.
The subprime mortgage crisis had its beginnings in the early 2000s when fear of recession was significant. To head off recession, the Federal Reserve lowered the Federal funds rate 11 times from May 2000 to December 2001, dropping it from 6.5% to 1.75%. This drop in rates led to a flood of liquidity in the economy. More and more banks made NINJA loans -- no income, no job, and no assets -- to subprime borrowers who wanted to realize their life's dream of home ownership. The easy credit environment led to more home loans, more home buyers, and more appreciation in home prices. Investment in higher yielding subprime mortgages skyrocketed. The Fed continued to slash interest rates until June 2003, when the 1% interest rate was at its lowest in 45 years (Singh, 2009).
Bankers began to repackage subprime loans into collateralized debt obligations (CDOs), which led to the development of a large secondary market for originating and distributing subprime loans. In October 2004, the SEC relaxed the net capital requirement for five investment banks, including Lehman Brothers, which allowed them to leverage up to 30 or even 40 times their initial investment (Ibid).
The early stages of trouble started when interest rates began rising and home ownership reached a saturation point. The Fed started raising interest rates so much that, by June 2006, the Federal funds rate reached 5.25%. During the last quarter of 2005, home prices started to fall, which led to a 40% decline in the U.S. Home Construction Index during 2006. At this point, not only were new homes being affected, but many subprime borrowers could not manage the higher interest rates: they started defaulting on their loans (Ibid).
The year 2007 began with a number of subprime lenders filing for bankruptcy. During the months of February and March, more than 25 subprime lenders filed for bankruptcy, the start of the tide. In April 2007, the latest firm to file bankruptcy was New Century Financial, once the second largest originator of subprime mortgages in the U.S. (Ibid).
News reports in 2007 indicated that financial firms and hedge funds owned more than $1 trillion in securities backed by the failing subprime mortgages. By August 2007 it was apparent that the financial market could not solve the subprime crisis on its own and the problem grew to international proportions. The interbank market froze, and governments around the world started to come together to prevent further financial catastrophe. Notwithstanding the efforts of central banks and governments around the world to provide liquidity support for financial institutions, the crisis deepened. In September 2008 Lehman Brothers was forced to file bankruptcy (Ibid).
There was no one single cause of the Lehman Brothers failure; instead a number of factors contributed to the collapse. However there can be little question that the single biggest cause of the mortgage meltdown was the single biggest factor; much of the fault with the subprime implosion lies with subprime mortgage originators, the lenders.
The process of qualifying for a home loan involves a determination of the buyer's credit-worthiness. Typically the buyer was expected to bring a down payment of twenty percent of the purchase price of the new home, which down payment might consist of equity from the sale of an existing home, or cash, or some combination of the two. Along with meeting those requirements, the homebuyer was also expected to earn sufficient income to be able to afford the new mortgage.
Apparently lenders may have satisfied themselves with a homebuyer's then current income and ability to make initial mortgage payments, but nothing in the literature that has since been written about the financial crisis suggests that lenders tried to take into account future income and future ability to meet payments after a mortgage adjusted upward in the future, typically two to three years after mortgage origination.
It can be argued that this lack of foresight amounted to lax lending standards, and that the failure to consider buyer's credit-worthiness over a more realistic timeframe constituted the single biggest error in judgment that lenders made. When Lehman Brothers climbed to the almost-top of the investment banking industry with a portfolio of highly leveraged loans, they pursued a strategy that involved an ever-escalating degree of risk. As the subprime crisis unfolded, Lehman perceived it as a countercyclical growth opportunity. They believed the damage would not spread to other economic sectors (Field, 2010). By issuing significant volumes of subprime loans, Lehman Brothers and others set themselves up for inevitable liquidity problems.
According to Hamilton (2008) one study by economists Adam Ashcraft and Til Schuermann clearly demonstrates the flaws that existed in the system that brought Lehman down. Their analysis investigated details of the securitization of a pool of about 4,000 subprime mortgage loans whose principal value came to a little under $900 million. These loans were originated by New Century Financial in the second quarter of 2006, a small percentage of the $51.6 billion in loans that the company originated in 2006 before declaring bankruptcy in early 2007 (Hamilton, 2008).
The striking feature that analysis of this pool of loans reveals is the magnitude of the increase in monthly payments to which borrowers were agreeing, even if there were no change in the LIBOR rates to which the adjustable mortgages were keyed. This increase would result from the teaser rate feature of the majority of the loans in this study:
"According to which the borrower would be virtually certain to need to make a huge increase in the monthly payments within two or three years. Ashcraft and Schuermann calculate that the monthly payments that the recipients of the loan is supposed to pay were scheduled to increase by 26-45%, depending on other details, within 2- 1/2 years of the loan being issued, even if LIBOR rates held steady at their values at the time the loan was originated, and by which time the principal owed would have increased substantially relative to the sum that had originally been borrowed. One has to wonder what circumstances one would be counting on to expect such payments to be made on schedule from a pool of borrowers with a history of other credit problems." (Ibid).
Once the number of mortgage defaults were set to be misforecasted, the consequences of bad business decisions were magnified many more times by leveraging. Leveraging allows lenders to use borrowed capital for investing, and again the cost-benefit ratio was misapplied. The possibility of making profits proved irresistible to Lehman Brothers, and their leveraging climbed as high as 32-to-1 (Ibid).
Securitization further amplified the risk associated with overextension of credit to buyers with significant likelihood of defaulting on their mortgages. Several aspects of securitization worked to make an already bad situation worse for Lehman Brothers, and ultimately all other victims of the financial crisis. In recent years, the practice of bundling loans into packages known as mortgage backed securities came to be standard practice in the financial community. A typical scenario was as follows: The money with which a homebuyer paid for a home came from a mortgage originator. The originator in turn sold the rights to receive future mortgage payments to another entity, an arranger, who in turn also did not hold onto the loan. In the case of many private arrangers, they set up a separate legal entity, a trust to which the arranger sold the loan. The money that the trust paid to the arranger came from investors, who in many cases let a separate fund manager make the actual decision as to where their dollars got invested. So the cash that was delivered to the seller of the house ultimately came from an investor at the end of the chain (Ibid).
Trusts in this scenario made payments to the investors not just from the individual borrower's mortgage payments, but pooled them with a large number of other borrowers. A given pool of mortgages was divided into tranches, that is, specific classes of related securities that are offered at the same time, but with different risks, rewards, and/or maturities. (Investopedia, 2011). If some households in the pool defaulted on their mortgage payments, then buyers of securities in the top tranches received their payments, and any shortfall would be made up by…