Lehman brothers, credit crunch and the recession

Introduction

This report will focus on the credit crunch and recession and how they have affected the business environment that firms that operate within it and how their resources were affected. A case study on Lehman Brothers Inc is also included and will analyse the strategies of the firm and how it coped.

It is important to understand that the credit crunch and recession are to separate situations but can occur at the same time. A credit crunch happens when banks and other credit companies are less willing to lend money and charge high interest rates to compensate the increased risk of lending; where as the term for a recession is used when an economy experiences two consecutive quarters of negative growth. For example the total number of goods and services produced by a country (Gross Domestic Product) would have to decline on a quarter by quarter basis for six months to be deemed a recession.

The Credit Crunch

The term ‘credit crunch’ was once a term only understood and used by economists but over the past two years it has been widely used in the media and in day to day life to describe the money troubles people are experiencing.

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The credit crunch can be simplified as banks and other credit lending firms being more aware of the risk customers and each other pose when lending therefore placing higher interest rates on loans to cover risk or simply declining to offer loans to higher risk customers. This cautious behaviour leads to dearer credit cards and mortgages becoming very expensive, pensions and Isa rates will decline. Investors will also be less willing to part with their money as stock markets fluctuate rapidly and in some cases bankruptcy and repossession will occur.

Current Credit Crunch

The credit crunch we are currently experiencing started in 2007 but was caused by companies’ strategies that worked in the economic boom but as the boom ended and the economic climate changed companies failed to react. Before 2007 the world economies were experiencing a boom and with money flowing freely financial companies became reckless, lending money with cheap interest rates to high risk customers who invested into property.

The US Recklessness

In the US companies were even more reckless giving billions of dollars worth of mortgages to customers who were high risk; for example no job, income or assets to secure against. The companies justified these risky mortgages by insisting if the customers ran into trouble rising house prices would allow them to remortgage their properties. At the time this strategy worked as the central bank interest rates were low but as they rose companies still carried on with the same strategy not suited to accommodate the rise and as house prices began to fall borrowers started to default on payments sending everyone into panic.

These factors alone were not the sole reason for the global credit crunch; it was the way in which the debt was sold on to investors that spread the problem global. US banks were packaging sub-prime loans (people with weak credit ratings) into mortgage backed securities (collateralised debt obligations) these were sold on to hedge funds and investment banks who decided they were a great way to generate high returns, resulting in higher bonuses and profit margins. When interest rates rose and house prices fell customers started to default on their loans, the value of these investments plummeted resulting in huge losses for banks globally.

How it affected the UK

UK banks and financial companies were watching how easy the US companies were making money so invested heavily to gain a piece of the high returns the US companies were reporting, the investment of choice was the sub-prime backed investments and as the US housing market crumpled and interest rates rose the returns decreased and resulted in companies writing off billions of pounds worth of debt. As the risk of these investments increased finding new investors became impossible and many UK banks were using a securitisation strategy by using the investment market to fund their mortgage business and as the investments could not be sold the banks were left with the debt, causing them to decrease lending to safe guard their finances or in some cases fall into administration or become nationalised as Northern Rock did.

The result of the credit crunch meant borrowing rates increased rapidly meaning the good value mortgages people were enjoying were no longer available, financial businesses became paranoid as to whom to lend money, increasing interest rates and asking for higher deposits to secure against default on payments.

Businesses in trouble

The stock markets were in turmoil and dropped sharply as confidence plunged and as powerful financial companies fell to the credit crunch paranoia set in and companies tried to secure themselves against facing the same fate. This resulted in businesses being unable to run their day to day operations. In most product based companies there is a time gap between production and sales, and some credit is needed to pay for production before receiving cash from sales. Many companies relied on credit for these cash flow issues and in the economic boom overdraft facilities etc were easily accessed, but as the credit crunch set in financial companies cut down on lending leaving many companies with higher costs than income leading to cuts in production and workforce to balance their finances.

As the credit crunch caused banks to be nationalised and financial firms to go bust, the rate in which banks lend to each other (libor rate) rose to its highest since 1998 way above the Bank of England’s base rate this indicated that they were concerned as to who may go bust or simply didn’t have any money to lend. This tense environment increased people’s worries and loss of confidence in each other indicated how hard the credit crunch had it the financial sectors once vast resources hard.

Recession

The term recession is used when an economy experiences two consecutive quarters of negative growth. For example the total number of goods and services produced by a country (Gross Domestic Product) would have to decline on a quarter by quarter basis for six months to be deemed a recession. The latest recession has been blamed on the fall of the financial markets but many causes have attributed to the severe downturn of the global markets.

As the credit crunch hit the world economies slowed down, and the price of raw materials increased. Within a year the price of oil soared 40%, other materials such as steel and wheat etc saw similar rises. This resulted in higher production costs for companies that use these materials and transportation, energy and the service sector also saw costs increase due to the increased cost of gas and oil. When a business develops increased costs they tend to try and overcome them by raising the cost of their product or service so their consumers incur the cost which is called cost push inflation, this is where income becomes squeezed thus reducing disposable income.

They can also cover these costs by cutting down on other costs such as workforce, some companies margins could not stretch to meet the higher material costs and subsequently went out of business. For example Silverjet, all these factors affect the economic downturn and contribute to the recession.

The collapse of the housing market also contributed to the decline in the world economies. In boom years confidence was high and borrowing and saving was encouraged, this meant consumer spending was at a high and became a major factor behind economic growth. Consumers were able to remortgage their home easily as their homes grew in value, which enabled more spending and construction was easily affordable and profitable as people had money to buy or build new homes.

As the boom came to an abrupt end the factors are reversed, borrowing is now harder and less attractive as higher interest rates are attached thus meaning less money to spend meaning less demand, leading to economic growth to contract. With borrowing limited and spending low, house prices continue to decrease reducing the effectiveness of the policies being used to combat the economic downturn such as the monetary and expansionary fiscal policy.

The loss of confidence in the financial sector as the credit crunch hit has created a sense of paranoia amongst people who have lost their confidence in the wider economy. This has stopped people investing even if they have money to do so they are keen to keep hold of it as security as they are unsure what to expect. Spending has also decreased for the same reasons consumers are cutting back on shopping etc, this causes companies to enter into price wars or to cut down on production, costs are cut to enable the company to offer the lowest price or to simply survive.

Cost cutting measures usually mean job losses, this increases unemployment which limits the amount people can spend therefore meaning companies need to make me cuts; it turns into a vicious cycle that government stimulus packages try to combat.

Lehman Brothers Inc.

Lehman Brothers Inc operated at a wholesale level, dealing with governments, companies and other financial institutions. Its core business included buying and selling shares and fixed income assets, trading and research, investment banking, investment management and private equity.

In September 2008, Lehman Brothers filed for chapter 11 bankruptcy protection. The company became insolvent with finances totalling $639 billion in assets and debt worth $619 billion; it became the largest bankruptcy in history. The company employed 25,000 employees worldwide including 5,000 and was the fourth largest US financial bank at the time of the bankruptcy. It also became the biggest victim of the subprime mortgage disaster that had put the global financial sector into meltdown.

History

In 1844 23 year old Henry Lehman the son of a cattle merchant immigrated to the United States from Rimpar, Bavaria. He set up home in Montgomery, Alabama where he opened a dry-goods shop. In 1847, following the arrival of his brother Emanuel Lehman, the firm became “H. Lehman and Bro.” With the arrival of their youngest brother, Mayer Lehman, in 1850, the firm changed its name again and “Lehman Brothers” was founded.

The brothers expanded their dry goods store into a cotton business after noticing the potential the highly valued cotton had, even accepting cotton as a payment for products within their shop. Cotton trading became a key part of their business and they eventually relocated to New York, there Lehman became a member of the Coffee Exchange and then on to the New York Stock Exchange in 1887. In 1899, it underwrote its first public offering, the preferred and common stock of the International Steam Pump Company.

The company then went from strength to strength underwriting many companies and becoming a powerhouse in the financial industry, prospering through world wars, civil wars and the great depression but the US house market crash proved to be its undoing as greed and the need for higher profits led them to take the decision to invest heavily into the subprime mortgage market which led to its demise.

Subprime Mortgages

Subprime Mortgages are loans offered to customers who would not usually be accepted for credit due to a poor credit score. The loans often have higher interest rates due to the higher risk a company takes by lending to a subprime borrower.

There are many types of subprime mortgage plans on offer, the most common is the adjustable rate mortgage (ARM) which at first charges a fixed interest rate and then switches to a floating rate plus a margin.

ARMs can be misleading to subprime borrowers who jump at the chance to take out a mortgage they were previously denied. By charging lower rates at first the mortgages reined in borrowers but as their rates were reset to variable rate which were considerably higher than the rates the borrowers were previously paying and many could not offered the new payment requirements resulting in loan defaults.

During the boom Lehman were trading tremendously well and decided to invest in mortgage lending by acquiring five mortgage lenders, which included subprime mortgage lenders BNC Mortgage and Aurora Loan services which specialised in Alt-A Loans. Alt-A Loans are categorised between prime and subprime loans, Alt-A borrowers have clean credit histories but have limited documentation therefore occurring a higher risk, these borrowers proved very attractive to lenders as they could charge them higher interest rates than normal prime loans but were less risky than subprime borrowers.

Lehman Brothers Success

Lehman Brothers acquisitions proved a success at first; record revenues from Lehman’s real estate businesses enabled revenues in the capital markets unit to surge 56% from 2004 to 2006, a faster rate of growth than other businesses in investment banking or asset management. The firm securitised $146 billion of mortgages in 2006, a 10% increase from 2005. Lehman reported record profits every year from 2005 to 2007. In 2007, the firm reported net income of a record $4.2 billion on revenue of $19.3 billion.

Lehman Brothers were still continuing to grow and in February 2007 stock reached a record $86.18, meaning Lehman had a market capitalisation of close to $60 billion. This masked the real problem as by the first quarter of 2007 defaults on subprime mortgages rose to a seven-year high. Investors started to have concerns that rising defaults would affect Lehman’s profitability, but the firm reported record revenues and profit for its fiscal first quarter. These concerns led to Lehman’s chief financial officer (CFO) insisting that the risks posed by rising home delinquencies were well contained and would have little impact on the firm’s earnings. He also said that he did not foresee problems in the subprime market spreading to the rest of the housing market or hurting the U.S. economy. This statement showed the company had become reckless and the prospect of higher profits and keeping investors happy became their main concern and as long as profits were good the strategy stayed the same

Credit Crunch hits

Five months after Lehmans Brothers chief financial officers assurances that the company would be unaffected and safe from the housing problems the company’s risks seemed to be catching up with it. Lehman’s stocks fell sharply as two of Bear Stearns hedge funds failed, it caused them to shut down the BNC unit and cut 2500 jobs and also shut down some of its Aurora offices but as this may have been a sign of them cutting down their mortgage portfolio they continued to pursue the mortgage market becoming the major player gaining a portfolio of mortgage backed securities four times that of shareholder equity. The risk seemed to have paid off as their stocks increased and calm returned to the market, this was the opportunity to trim down their massive portfolio and release funds to secure against any losses the mortgage market may encounter by investing in other areas, however they seemed to choose to keep hold of the bulging portfolio.

Lehman Brothers leverage was a high 31 in 2007 which in tandem with its massive mortgage portfolio made it increasingly vulnerable to any change in the market. In March 2008 Bear Stearns struggles continued and confidence in Lehman was fading resulting in a drop in shares of over 40% and although they managed to increase confidence by raising $4billion dollars people were becoming increasingly worried about the size of the company’s high risk portfolio.

In June Lehman recorded a second quarter loss of $3billion but managed to keep confidence high by raising $6billion through investors and noticing the ticking time bomb they were sitting on boosted its liquidity pool to an estimated $45 billion, decreased gross assets by $147 billion, reduced its exposure to residential and commercial mortgages by 20%, and cut down leverage from a factor of 32 to about 25.

However, these measures were perceived as being too little, too late. On August 22, 2008, shares in Lehman closed up 5% (16% for the week) on reports that the state-controlled Korea Development Bank was considering buying the bank. Most of those gains were quickly eroded as news came in that Korea Development Bank was facing difficulties pleasing regulators and attracting partners for the deal. On September 9 Lehman’s shares plunged 45% to $7.79, after it was reported that the state-run South Korean firm had put talks on hold.

This caused the company’s hedge fund clients to pull out, while its short-term creditors cut credit lines. On September 10, Lehman announced shocking fiscal third-quarter results early that highlighted the feebleness of its financial position. The firm reported a loss of $3.9 billion, including a write-down of $5.6 billion as well as these shocking results Moody’s Investor Service dealt the company another blow as it announced that it was reviewing Lehman’s credit ratings, and also said that Lehman would have to sell a majority stake to a strategic partner in order to avoid a rating downgrade. These developments led to a 42% plunge in the stock on September 11.

With $1 billion left in liquidised assets, Lehman was quickly running out of time. Last-ditch efforts over the weekend of September 13 between Lehman, Barclays PLC and Bank of America, aimed at working out a takeover of Lehman, were unsuccessful. On Monday September 15, Lehman declared bankruptcy, resulting in the stock plunging 93% from its previous close on September 12