Impact of the Lehman Brothers Collapse on the UK Financial Market

On September 15^th 2008, the collapse of Lehman brothers, the 4^th largest investment bank in the US, signalled what many now believe to be one of the key trigger points and indicators to the financial crisis that closely ensued after. Upon filing Bankruptcy, and the refusal from the federal reserve to Bail out the bank, some 25,000 employees lost their jobs and the firm’s stock plummeted a final 93%. This effect of this shockwave rippled throughout Wall St and still echoes today. (Editors, 2018)

History of Lehman Brothers

Lehman brothers was founded in 1884 as a general goods store by German immigrant Henry Lehman, who’s brothers Emanuel and Mayer then ventured to join him 6 years later. In the space of a century and a half, it transitioned from the general goods store, to a commodities brokerage to eventually the 4^th largest investment bank in the country. In 1929, the investment branch of its enterprise was created – named Lehman corporation. Investment banking, and advisory services for the Government, enterprises and private individuals with an emphasis upon emerging industries became the forefront of expansion and revenue generation. (Library HBS, 2018)

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April 10, 1984 marked the changeover of Lehman Brothers – one of the last privately-owned firms on Wall St. into a merger with Shearson – at a cost of $360m. The merger lasted 9 years, before American express divests the Shearson subsidiary and reinstates Lehman brothers firm. (Nellis, 2018). 1994, the year the firm engages an IPO and common stock begins trading on the stock exchanges.

The Glass-Steagall Act of 1933, forbidding banks from operating in both the commercial and investment sectors is repealed in 1999, this opened an era of proprietary trading for Lehman Brothers, and they begin to diverse into asset and real estate management. Over four years, Lehman Brothers acquired Bank of Tokyo-Mitsubishi, Lincoln Capital Management, Neuberger Berman and The Crossroads Group. This rapid inorganic growth led to the value of the assets rising from $10bn in 2000 to $275bn in 2007. (Lynn, 2018)

By the mid 2000’s, the housing market was booming. Lehman Brothers, acquired 5 lenders of which were BNC Mortgage and Aurora Loan Services – their speciality was in sub-prime loans. (Sraders, 2018). 2006, the year the boom was entering a downturn and yet they still continued to acquire real estate assets and securities – effectively doubling its investment into them to $111bn. This proved top be a fatal error.

Background and history of the financial crisis 2008/9

Whether the financial crisis first reared its head in 2007, or 2008 is open to speculation, but economists do agree that it lasted until 2011, and is regarded as the largest financial disaster since the great depression and has moulded and changed the financial world. (Cox, 2018)

The crisis cannot be attributed to one factor but many confluences and some stretch back as far as the 1970’s. One factor was the Community Reinvestment Act of 1977 instated by Bill Clinton, which gave higher ratings for home loans for areas that are credit deprived. This negated the sound underwriting standards banks upheld and allowed loans to be issued to those with high risk of defaulting. (THOMA, 2018)

In the early 2000’s, a drastic fall in the interest rates in the central banks occurred, such as the FED, BOJ and ECB, in order to keep in line with inflationary policies and drive growth. The low policy rates drove down wholesale funding, increased credit supply and contributed to the surge in US housing demand. (Federal Reserve Bank of St. Louis, 2008)

Low interest rates coupled with a world which was regarded as “less risky” than the dotcom bubble bust, brought about a surge in the uptake of mortgages. Mortgage backed securities (MBS’s) (sold by firms such as Fannie Mae, Freddie Mac) –were bought by banks happily as current basel regulations at the time favoured securities over loans – requiring banks to hold only $1.60 in every $100 in reserve – over $4. (Carney, 2018)

Investment banks then emerged, buying re-packaged MBS’s that were considered unsellable/risky, now turned into Collateralised debt obligations. By 2004, the housing market was becoming overheated, with inflation needing to be managed. By March 2005, new home sales peaked at 127,000. Federal Reserve Chairman Alan Greenspan took action and raised interest rates to counter it reaching 2.25 percent by December 2004. Over the course of two years it hit highs of 5.25 percent by June 2006. (AMADEO, 2018)

Those with subprime loans, were in trouble. Many took out interest-only loans due the affordability of the lower monthly payment. As interest rates had now increased, monthly repayments skyrocketed. This, plus the fact that the fall in credit supply had now caused housing prices to fall for the first time in 11 years, and now homes were no longer worth the payments – led many to default on their payments. Suddenly, investors started to lose confidence in the top AAA tranches and banks, which had exposure to such assets.

The first casualty of the crisis was Bear Stearn, the 5^th largest investment bank, followed by Northern Rock and Lehman Brothers. Eventually the US government had to inject $700 billion into the economy and the Bank of England £500 billion to stabilise the situation.

Alternatives available to regulators and governments

As homeowners defaulted on their mortgages in the millions, Bear Stearns one of Lehmans competitors was the first to fall, and be sold to Bank of America with government backing – narrowly avoiding bankruptcy – this brought with it, rumours that Lehman Brothers was next to go. In hopes to reassure investors, $6 billion was raised in June, however in the September that followed, a write-down of $5.6 billion, a $3.93 billion loss for the third quarter and a planned $50 billion toxic-asset spin off was presented. Lehman brothers was left with no other option, but bailout, or a sale. Ultimately, neither option went ahead, with George Bush refusing another bailout and other potential buyers such as Bank of America and Barclays choosing to invest elsewhere or being blocked from an acquisition by regulators. (Chalmers University of Technology, 2018)

Bailouts of other prestigious firms such as AIG, Bank of America with Merrill Lynch in the US and RBS and Lloyds came at the detriment to other options available. One option was to simply let the institutions affected fail – why should the tax payer front their losses? Indeed, ethically this may seem like the right option to choose, however financially it would have caused a global recession. The S&P fell by 60% even with intervention, if this had not happened mass unemployment, the inability to borrow and perhaps even civil disturbances would have resulted. 

Another alternative was to potentially freeze all new home construction. This would quickly reduce the housing inventory overhang, and then slowly cause housing prices to rise again. This would have negatively impacted the construction industry but be cheaper than bailouts, and not an immediate solution. (Saving to Invest, 2018)

Free loans (interim debt relief) to consumers on “Main Street” to those that could not afford the repayments was also suggested. This would help them regain their footing during the turbulence – although background checks would need to be performed and many homeowners would likely not pass them.

Although alternatives were available it is wholly agreed that they would not come into effect quickly enough to mitigate financial ruin. A large cash bailout injection and mark-down of toxic assets was the only approach that could guarantee results in the timeframe required.

Impact of the collapse of Lehman’s on the UK financial markets

Lehman Brothers, although originally based in the US, grew and branched out throughout the world via subsidiaries. One such subsidiary was Lehman Brothers International Europe (LBIE), which contained four UK entities. (PwC, 2018) LBIE had 5,500 staff when its parent company collapsed, these workers were made redundant, and a bill of £662m was presented to the administrators (PricewaterhouseCoopers). In 2015 the partner in charge of the administration Tony Lomas, stated “there were still thousands of claims to settle and billions of bounds to return to creditors” – a task that is still being continued to this day. (Wilson, 2018)

When Lehman Brothers Collapsed, it was the triggering of cataclysmic financial consequences in both the US and the UK. At 9:00am in the UK, HBoss the largest mortgage lender in the UK slumped 34% in its share value and was saved by Lloyds. Panic engulfed the market, and the FTSE fell by almost 400 points. (Hume and Elder, 2008) 3 weeks later it manifested into a footfall of 4000 points, later plateauing around 6000 – wiping billions off the market.

Banks in the UK became worried about their financial positions – no-one was deemed safe. To protect capital, banks almost completely stopped lending to each other and consumers. Market values fell and speculators who bargained on asset values increasing, now had to now sell their assets.

In 2009 Government support reached a new high of £850bn with RBS and Lloyds needing government bailout. The final figure stands at £1.2t of which only 5% has been paid back currently. 

After government intervention bank confidence had been knocked and the rate loans were being repaid was now greater than the rate new loans were being created. As the Bank of England describes it, the repayment of loans, effectively destroys that money – Banks making loans and consumers repaying them are the most significant ways in which bank deposits are created and destroyed in the modern economy.” (Bank of England, 2014) As the economy slows, prices fall, and a debt-deflation spiral starts to occur i.e. wages and prices fall but debt value does not, ultimately leading to a recession.

Recommendations for future of UK financial markets and regulators

Many countries and regulatory bodies have conducted enquires into the banking crisis and subsequent regulatory responses one such review was conducted by the IMF IN 2014.

One such suggestion was direct reporting of business risk to regulatory authority by external auditors. Banks before the crisis were deemed to have unhealthy risk appetites, using risky asset value lending guidelines rather than the more prudent principles adopted in the past. External auditors would take an unbiased approach and ensure banks in the future maintain healthy lending principles and risk appetites laid out clearly from board level – or risk being fined. (IMF, 2014)

A clause to link pay to medium term performance in contracts of senior executives is also a popular suggestion. Pre-2008, there was a failure to fully ensure senior executives took responsibility with many positions having bonuses paid based upon short term goals. Bonus payments in London trebled from £5bn to £16bn, (2003-2008) this is wrong as in the same year the financial crisis occurred. (Clark, 2008) By linking pay to medium term performance, then employees will be mindful of their actions and longer-term performance as that will impact their rewards.

In regards to financial framework, in 2010 the G20 approved a revision to the Basel Solvency and Liquidity rules – creating Basel III – dude to be implemented fully by 2019. Basel III is the strengthening of regulations, supervision and risk management for banks over its predecessors (Basel I and II). Since then, there has been slight modifications in 2011 and 2013 in order to adapt to the dynamic and volatile financial industry and the rate at which it is diverging away from the norm. (Casu, Girardone and Molyneux, 2015)

From Basel III consumers will have greater levels of protection from bank failures and the need for government intervention is omitted. By introducing greater capital requirements, such as the capital ratio of more liquid tier 1 capital, around €700bn will need to be raised in European banks to meet the requirements. (Norton Rose Fulbright, 2010)

There has been a clear recommendation to recognise that financial markets thrive when regulation is scaled back and left to market self-discipline. It is wholly agreed that inadequate regulation is partly to blame for the financial crisis, but being mindful that the adoption of overly stringent regulatory controls subsequently, may be counterproductive.

Ethical considerations for past and future behaviour

The ethics in the financial sector in particular the banking sector in the past, have not been considered immoral, but rather amoral – they believe they have a sole purpose to generate revenue. This is in part, why so few were convicted of crimes after the crisis. (Luyendijk, 2016) In order to solve this issue, we have to address the amorality in the market.

Banks state that they do have a code of ethics, however it is believed that it is little more than the term “box ticking”. High risk speculation is expected which is underwritten by the tax payer and on the contrary, high remuneration rewards if the trades pay off.  Financial Times banking commentator Philip Augar commented “The industry has to be serious about cultural change. This means reforms on pay to remove the grotesque incentives that encourage corrupt behaviour, and the introduction of an ethical code consistent with the business model. There is no point telling staff the client comes first and then rewarding them on the profit they make for the firm.” This quote is in essence damning pay incentives based on profits and it should be condemned as it benefits not the consumer but the firms/employees themselves.

It is true that smaller national/ regional banks faired better than larger institutions and its speculated that the reason why is that they have adopted a triple-bottom-line banking approach. Triple-bottom-line banking expands a firm’s responsibilities to include environmental and social rather than just financial. A report published on the matter stated that “it shows that a sustainable approach to banking offers all of us the prospect of a stable, prosperous future.” (Global alliance for banking, 2012) By adopting this approach in the future the risks to the consumer and economy can be reduced as greed from corporate entities will not take precedence.

Final Thoughts

The fall of Lehmans Brothers was a clear example that Globally significant institutions are not “Too big to fail”. It has highlighted how vastly interconnected financial institutions are both domestic and globally and the financial consequences that can result from inappropriate risk appetites and lax regulations. It is clear that the cultural ethos surrounding the industry was geared towards ensuring maximal financial gain rather than taking into consideration consumer risk. In light of these findings I hope a dramatic shift in the ethics surrounding financial decision-making takes place and the introduction of more prudent regulatory procedures (Basel III) will minimise another crisis from occurring again.

References

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