The Case of Lehman Brothers
Financial models are widely criticized for underestimating and therefore mispricing the risk prior to the crisis. Statistical pricing and risk forecasting models played an important part in the build up to the current crisis. The essay has highlighted the case of Lehmann Brothers of USA. The firm had to face a number of different difficulties during its course of business and was successful in achieving its goals. The company survived every possible disruptions including the Great Depression of 1930’s, bankruptcies of the 1800’s, capital shortage, two world wars and the debt default of Russia. But every business had its end as the company got stuck in the collapse of the US housing sector. The failure of the company was due to a number of different reasons that took a toll on its survival.
Over the time the market prices lose the connection with the basic ideas. This leads to the collapse in the prices of the products and services and in turn increases the perceived risks subsequently. The following process is reinforced by the external changes in the behavior of the participants of the market. For example the margin requirements during times of financial turmoil can lead to the fall in the prices of the goods and services. Globalization has brought in a number of financial interdependencies among the different kind of organizations especially banks, financial institutions and other companies that transacts money. However such organizations are prone to risks as too many interdependencies can lead to defaults and failures exactly in the case of Lehman Brothers.
Financial modeling is the task involved in the setting up of a model that revolves around the financial decision making situation. Repo 105 model can be used as the model to determine the failure of Lehman Brothers. The following model is referred too as an accounting trick in which the company classifies a short term loan as a sale and accordingly uses the cash proceeds from the sale in order to reduce the liabilities of the company. The sudden collapse of the mentioned financial firm in the month of September 2008 is seen as the trigger for financial crisis that put an end to the lending activities. However a new report says that the officers of Lehmann Brothers intentionally concealed the facts about the risks that they had taken from the market in an extraordinary manner. Such concealing activities made up a new financial term named Repo 105. The firm had appointed different accountants and financial experts to make sure that they present a false image of their position to the people. The management of the company wanted to make the borrowings from the market look not to be borrowing so much money, rather it used a special technique to avoid this particular rule. It invested in repo deals where it took slightly less cash than the net worth of the particular asset.
The Role of Financial Models in the Crisis
This gap allowed the management of Lehman to record the transaction as it had been a original sale of the bond. However it agreed upon repurchasing the bond within a week or two. However Lehman did not repurchased the bond and used the technique of Repo 105 to move to $50 billion off of its own balance sheet. Moreover the management of the company also did not mention the use of the following technique to the government and the rating agencies. It also did not disclose the facts to the board members as well as the investors and thus created a huge gap of communication between the concerned parties and the management of the organization. The main task was allocated to the accounting firm named Ernst and Young who was in charge to maintain the accounting department of the firm. The company was aware of the use of Repo 105 by the mentioned organization but failed to keep a proper check on the amount of use by the following bank. The company did not approved the use of the financial model nbut rather used them for making the auditing purpose easier.
The range of relevant safeguards that can be put in place to mitigate model risks
Taking the example of the failure of Lehmann Brothers the companies are now adapting new strategies to make sure that they have a proper safeguard policy in place which will be helpful to prevent them from possible model failures. The businesses face different risks but can reduce the risks and their personal liability by means of specific risk reduction measures. These risk reduction measures involves the development of the products, creation of new and innovative products, upgrading the old products and many more as such.
- Limiting the Personal Guarantees- The owner of the business or the company must protect the personal assets of the company and limit the number of personal guarantees that are issued as collateral for the different financial uses of the company like obliging the different financial payments and obliging the performance bonds of the company. The Organizations have the ability to procure the bonds or the equivalent protection without the use of a personal guarantee at the time when the bonds are not guaranteed statutorily.
- Business Structure- The business structure must be transformed from a single ownership in which one of the person is directly liable for business operations to a corporation or a limited liability company where the owner have a very limited power.
- Transferring Risk- The risks of the company must be passed on to insurance companies and other parties with much higher benefits. These helps to reduce the financial risks especially in cases of fire, theft and damage to the products or the manufacturing units.
- Perform a risk analysis- The performance of a risk analysis must be based on the evaluation of the risky activities and the likelihood of the impact occurring and the different benefits on the risky activities. The organizations must also avoid risks by not carrying out undertaking the tasks that are deemed to be risky.
- Transfer the risk- The most important task of the management of the organization is to transfer the risk of the task that have a high chance of frequent occurrence and the risky activities must be assigned to be solved or tackled by other companies which are experts in their own fields.
- Reduce risk-The risk involved in the failure of the product and warranty claims are implemented in the form of a quality assurance program. The risks can be reduced by development of a system to report the feedbacks of the customers and accordingly identify all the existing problems.
- Reduce risk of surprises- Risk of Surprises can be reduced by keeping an exact figure of the records and by implementing effective controls. It can also be reduced by putting in place a system that can limit the usage of the particular actions and the amount they spend. It can also evaluate the controls and reporting system by comparing the control process and the actual profit and performance of the system.
- Reduce financial risk- The reduction of the financial risk of the organization is another main task of the management of the business organization. The management must reduce the outstanding balances and must determine the credit liabilities of the organization. The management must also implement the credit and the payment standards and ask for the payments of the consumers of the companies or ask for payment from the consumers who are generally prone to miss the standards required in the industry.
- Reduce other financial risks-The other financial risks include reducing or paying the full amount of the outstanding loans. The growth rate must be controlled in such a way that the company has the capability to manage its finance easily and can finance internally. If the company is unable to pay off the loans they tend to replace the short term credit with the long period credit loans. According to Stephen and Peter (2014) The differentiation between uncertainty and risk has been the fundamental concept in the risk management process even in the present day. The economic factors and the uncertainty and risk that exist in today’s world are analyzed in this part.
Reasons behind the failure of Lehman Brothers
The following paper has discussed about the reasons behind the failure of the Lehman brothers in the market. The paper analyses the reasons as well as the possible tasks that could have prevented the organization from failure. Some of the original reasons behind the failure of the Lehman Brothers were as follows,
- There Was No Buyer
The most key problem was the absence of a proper buyer for the products in the market. There were other such institutions which faced similar crisis situations. The most notable among them were organizations like Bear Sterns, Washington Mutual, Merill Lynch and Wachovia. But these companies had a stark difference with Lehman Brothers as these companies were not declared bankrupt and they survived the initial scare of being bankrupted. However Bank of America showed some interest in buying Lehman Brothers but instead opted out for Merill Lynch. In another development Barclays tried to buy the company but backed up after the balking from the British Regulators.
Safeguards to Mitigate Model Risks
This is one of the most important points as because the U.S regulators of the mentioned financial institution believed that a deal or an agreement could be reached upon which would help the organization to sail on the turbulent waters in the market. However the management of Lehman was reluctant and never wanted to save the firm. Another option to save it was acquisition which was also not practiced by the organization. Finalizing the deal with Barclays was almost done but it got screwed up by the interference of the British regulators. If the British regulators allowed the acquisition to proceed, then no debate topics could have been present now.
- Its Balance Sheet Was a Disaster
The absence of potential buyers meant the only possible way to save the institution was the support of an emergency loan to help the institution stand up tall in the crisis moment. However the Federal Reserve refused to grant the loan as because they estimated that Lehman did not have the strong collateral to repay back the loan and it would bring in additional misery for the Federal Reserve. Thus the Federal Reserve was wise enough to not grant the loan as its calculations showed that Federal Reserve would be open to a significant loss while trying to revive an organization that would fail the either way.
- There Was No Political Palatability for Bailouts
There was no politically desirable option for the organization as because the common people were becoming utterly impatient about the financial company. The idea about the reserve or any other institutions will come forward and save the firm were considered void by the people. The loss of the company was considered to be insignificant with the presence of a proper acquirer.
- Its Failure Wouldn’t Directly Affect Average Americans
The time when it came to AIG, no other reasons mattered. The company was bailed on the day when it failed to generate the amount needed to survive in the market. It also failed to have any buyer and the annual balance sheet also was in a mess. The losses were significant and it failed to stand up which resulted in its closure. The politics that existed in the field were quite different from the other companies in the market. The failure of the mentioned financial institution would directly and indirectly affect the institutional investors and the ones who had acquired the shares of the company. However on the other hand failure of AIG would directly affect the Americans.
After the failure of the Lehman Brothers the other financial institutions of the world realized the problems and had to undergo a sea of change to meet the new challenges in the market. Standing in such a tough time the failure of one or more organizations could be devastating for the economy of U.S.A.
Conclusion
The impact of the bankruptcy has been analyzed widely. The different studies related to the bankruptcy have provided solid evidence to the effect of such an event and the impact of the same on the stock markets. Some other studies also assessed the failure of the financial institution in the Chinese stock market and concluded that the impact was very much insignificant. While analyzing the impact of the bankruptcy of Lehman Brothers on the structure of ISE-100 benchmark showed a increase in the deviation on the following benchmark that is ISE-100. CNN New York estimated that the failure of the mentioned financial institution was one of the major sources that led to the worst performances of large markets across the globe. New York Dow Jones closed 504 points below or 4.4% below the average which was the largest fall in the last seven years, while NASDAQ on the other hand dropped by 3.6% which was the largest fall since 20003. Even the European stock market suffered as a result of such a large failure o0f a financial institution which had its roots all over the world. The FTSE index of London fell by 3.92% and the Paris CAC fell by 3.78% which was by far the worst performance of these stock indexes.
The sudden fall in the price of the shares of the company spelt doom for many investors and there was a sudden crash in the economic system of the country. The indicators of a healthy economy like modern living, purchasing power and other factors were clearly violated. The bankruptcy of the financial institution that is mentioned here has had dire effects on the investors and the other parties that were concerned with the following. The day after the firm declared itself bankrupt the reserve fund minimum average value stood at just $1, an incident referred to as “breaking the buck”. This was mainly because the amount held US$785 million in the organizations securities held in securities of debts on the day before the organization filed for bankruptcy. The US Securities and Exchange Commission on May 5, 2009, filed a suit against Reserve Management Company Inc., its Chairman, Vice Chairman and President, and Reserve Partners, Inc., and alleged their failure to provide important documents in times of need including investors, the Fund’s board of trustees, and the rating agencies and as a result submitted a lawsuit for financial bankruptcy. The suit was capable to enforce the fund to increase the distribution of the remaining assets of the funds. The reserve fund was clear of different fraud charges that were imposed on them but on the other hand, Reserve Partners, Inc and Reserve Management Company, Inc were found guilty of committing illegal transactions with Lehmann Brothers. The investigating court however ordered the remaining assets of the organization to be distributed among the shareholders of the business.
There are several models for forecasting the financial bankruptcy of the banks over the years. But the negative factor lies in the fact about the short time for the stakeholders to change the particular situation in the market. The final model includes the expectations from the market and the sector variables. The variables are statistically tested and the problems are assessed the recommendations are provided to improve the particular situation. The following research has identified the existence of the financial distress that exists in more than 96% of the companies that went bankrupt. The paper by (sun et al. 2016) has discussed about the particular hypothesis that exists within the structure and the main causes that leads to the failure of the models.
In a similar incident the then CEO and the president of the federal agricultural mortgage corporation, pointed out that that the third part of the company quarter in the year 2008 earnings conference would have to abide by the rules of the statutory guidelines and provide a hefty sum of US $52.4 million in the company debt as a result of the bankruptcy. The mentioned company has also used the $22 billion hedge funds in the form of assets to ensure the safety the trading and borrowings. The acquisition of the mentioned company’s business in London by the responsible organization behind the probe of the bankruptcy by the US holding company resulted in the freezing up of the accounts of Lehman.
The failure of the hedge funds to carry out the burden of bankruptcy showed the over dependence on the management of Lehmann Brothers. Thus it can be assessed that taking decisions of investment must be done carefully and it should not be based on only confidence and trust on the business and the management. The decisions rather must be based on the performance of the business and the investments that have been done in the business in the past, present and the future. However in cases like the one mentioned in the assignment decisions must not and should not be taken just based on past performances of the investments done. There are instances on the global front where hugely successful business have reaped huge revenue on the investments but have failed in the long run. Similarly the person or an organization must think a thousand times, analyze the situation and the market, analyze the performance of the business, should have a clear and transparent idea on the future course of business and most importantly must have a provision of backup in case of the business failure.
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