Story Of The Week

Lehman Brothers collapse: How the crisis unfolded and aftermath

 

We all knew this. We all knew that it would take more time than any of us want to dig ourselves out of this hole created by this financial crisis

-Barack Obama

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Source: marketwatch.com

Exactly ten years ago, Lehman Brothers, America’s fourth largest investment bank collapsed amid a worsening subprime mortgage crisis. The fall of the bank was attributed to burst of the bubble that was created due to excesses built in the financial system over the years. On September 15, 2008, Lehman Brothers filed for bankruptcy and officially sparked off the Financial crisis of 2008. With $639 billion in assets and $619 billion in debt, Lehman Brothers bankruptcy filing was the largest ever. As a result, investors got a clear signal of the ongoing trouble in the market and ran for their money. There are several strong reasons that point out that the collapse of Lehman Brothers was just a symptom of existing troubles in the system rather than a cause. To understand the reasons for the fall of Lehman Brothers, it is necessary to understand the prime reasons for a Subprime mortgage crisis

  1. Role of Hedge Funds

Hedge funds are those funds which engage in speculation using credit or borrowed capital and they are always under constant pressure to outperform the market. They created a huge demand for mortgage-backed securities by combining them with guarantees called credit default swaps. Everything was fine until the Federal Reserve started raising interest rates. As a consequence of those people with adjustable-rate mortgages couldn’t make the higher payments. Price for housing fell with the fall in demand and as a result, people were not able to sell their homes. This made them default on their existing loans.

  1. Collateralized Debt Obligations

CDOs are defined as structured financial products to pay cash flows to investors in a prescribed sequence. Not just mortgages, but, all kind of debt was combined, repackaged and resold as CDOs. This included large corporations, mutual funds and pension funds and soon risk was extended to individual investors. Just as housing prices declined in the market, people could not support their lavish lifestyles and started defaulting.

  1. Spreading of Subprime mess to the Banking Industry

Subprime lending refers to giving loans to people who generally, do not qualify for regular loans due to their poor credit history. Large banks were among the purchasers of CDOs and as defaults started to rise due to the subprime mess, banks were not in a position to sell these CDOs and eventually, had less money to lend. Those who had funds were not interested in lending to banks because of fear of defaults. The crisis had now come full circle. Banks had no other option but to lend too little, which caused the housing market to decline further.

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Source: Nanex

The aftermath of the crisis

The Fallout of Lehman Brothers had an enduring impact on the entire world economy. The impact was so fast and frightening that people started comparing this fall-out with the great depression. Almost six million people lost their jobs and unemployment rate doubled to almost ten per cent, due to the crisis that symbolically, begun with the fall of Lehman Brothers. The government had to bail out cash-starved banks by pledging trillions of dollars. From financial institutions alone, over $2 trillion was required to be written down. Additionally, loss of the economic growth was expected to be over $10 trillion.

Many of the effects of the crisis are still a matter of concern for advanced economies. Debt level across advanced economies is still far above than what it was before the crisis. Most of the banks in UK and US wrote off their Non-performing loans, but, some are still carrying the pre-crisis NPLs on their books.

Effects of the crisis are such that the global economy had to change itself in profound and permanent ways. Political power and balance sheet of central banks reached an unprecedented level to take on an increased role in regulating the financial systems and managing monetary policy. They employed new tools such as ‘Quantitative Easing’ and ‘Stress Testing’ to full proof of their monetary policy.

 

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Source: Bloomberg

Headwinds in the global markets

Ten years have passed after collapsing of Lehman Brothers but, the biggest question remains still, have the excesses in the financial system been addressed or are the system full proof enough to guard against another crisis?

Raghuram Rajan, former governor of the Reserve Bank of India who notably foresaw the crisis, recently noted down that Asset prices and Leverages have built up again in the system which is clearly not a good indicator for the world economy.

Policy measures taken in the US and other parts of the world have resulted in increased debt level. Though, China is the leading force, but more worrisome is that low-income countries have also seen a manifold rise in debt level. The tightening financial conditions in the global market is negatively impacting growth in emerging economies such as India, and it could become a risk factor globally.

Also, the global economy is not prepared to deal with a significant reversal in growth. Central banks in Europe and Japan are still grappling with crisis-era policy tools. Therefore, it is likely that systematically significant banks may find it difficult to fight another such crisis.

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Source: The Economist

 

Fall of Lehman Brothers: Lessons for India

All of this has implications for India as it was one of those strongly growing economies, which were largely affected by the crisis that erupted after the collapse of Lehman Brothers. The crisis showed that the Indian economy is far more integrated with the world than it is commonly perceived. As an immediate effect, the Indian economy slipped to 6.7% per cent GDP growth rate in 2007-08 from 9.3% in the year before. Recovery was quickly backed by the fiscal and monetary stimulus, but it could not be sustained. On the contrary, the stimulus led to higher inflation and a wider current account deficit that caused a near currency crisis in 2013. Fortunately, the crisis was averted, but it proved that consolidating India’s macroeconomic fundamentals is still a work in progress.

Managing macroeconomic factors is an uphill task for developing countries like India due to the non-systematic global monetary system. The current turbulence is the currency market is also a result of the way policies have been managed in India and other economies over the last decade.

It can be fairly concluded that the financial crisis is far away from being forgotten and consigned to history. It continues to cast a long shadow on the world economy.

References:

https://www.livemint.com/Opinion/UNoblXA1Tyb4AFI04REZRO/Opinion–The-long-shadow-of-the-2008-financial-crisis.html

https://www.bloomberg.com/view/articles/2018-09-13/lehman-brothers-collapse-10-years-later-do-we-ever-learn

https://www.thebalance.com/subprime-mortgage-crisis-effect-and-timeline-3305745

https://www.chathamhouse.org/expert/comment/lasting-effects-financial-crisis-have-yet-be-felt

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