1. Sub-prime Crisis - Collapse of Lehman Brothers essay
The collapse of Lehman Brothers
Introduction
As the subprime crisis becomes deteriorated, Lehman Brothers finally collapse in the sub-prime
crisis, because a large number of subordinated debts held by the company's financial products, as
well as other lower-grade mortgage-backed financial products. In addition, the other four large
investment banks disappeared after the deepening of the subprime crisis. They are bankrupt,
acquired or become held by American government through nationalization (Gerardi et al., 2008). In
general, the collapse of Lehman Brothers is the epitome of the subprime crisis, which attracted more
and more attention of the businessmen, scholars and government. In addition, it can be learnt a lot
through analysis the case of the collapse of Lehman Brothers, such as the risk management
knowledge of the financial institution, the government supervision of the financial corporation, the
experience and lessons to avoid the similar incidents and so on. This essay will critically analyze the
case (the collapse of Lehman Brothers) to find the reason of the collapse and gain some experience
and lessons from the case of Lehman Brothers. This essay proceeds as follows. The first part will
briefly introduce the essay, and then the second part will review the relevant literature about the
collapse of Lehman Brothers. The third part will briefly introduce the case of Lehman Brothers. The
fourth part will critically analyze the case and the final part will make some conclusions.
Literature review about the collapse of Lehman Brothers
A large number of scholars analyze the case of Lehman Brothers through different perspectives,
which can be divided into the following parts. (The process of the collapse of Lehman Brothers, the
reasons of the collapse, the influence of the collapse of Lehman Brothers and the experience and
lessons from the collapse)
Most studies about the process of the collapse of Lehman Brothers aim to describe how the Lehman
Brothers gradually become bankrupt to reflect the facts about the operation of the Lehman Brothers.
Beth (2010) depicts the details of the operation of the Lehman Brothers in the subprime crisis and
points out the gains and losses of the Lehman Brothers in the subprime crisis. In addition, the other
studies about the process of the collapse of Lehman Brothers aim to analyze the failure of the
Lehman Brothers in order to make some useful recommendations to the financial institution, which is
involved in the financial derivative products. Sender (2010) analyzes the case of the Lehman
Brothers and makes the recommendations that the financial institution will pay attention to the real
value of the underlying assets of the financial derivative products and establish the risks
management system. In addition, he also points out that the government should enhance the
financial supervision to avoid the similar incidents (Sender, 2010).
As a lot of financial institutions are bankrupt in the subprime crisis, many scholars pay more attention
to the reasons why the Lehman Brothers collapse in the subprime crisis and make several
recommendations to the financial institutions. Some scholars analyze the reasons from the corporate
perspectives such as the wrong operation strategy, the inappropriate risk management and so on.
Ricardo and Krishnamurthy (2008) analyze the operation strategies of Lehman Brothers and point
out that the diversified operation of the commercial banks is the direct reason for the collapse of the
Lehman Brothers. In addition, Caballero, Farhi and Pierre-Olivier (2008) argue that high leverage
2. operation and investment strategies will lead to the collapse of the Lehman Brothers and advocate
that the financial institutions can decrease the high leverage of operation to avoid the losses in the
balance table. However, Peretz and Schroedel (2009) argue that the high leverage operation and
investment strategies can not result in losses in the condition that the risk management is effective
and efficient. They also point out the ineffective risk management has to account for the collapse of
the Lehman Brothers (Peretz and Schroedel, 2009). In addition, they also suggest that the financial
institution should pay attention to establish the alarm system to warn the risk management and
adopts various risk management measures to control the financial risks under the acceptable level
(Peretz and Schroedel, 2009).
Besides, a large number of scholars analyze the reasons for the collapse of Lehman Brothers from
the economy and government perspectives. Carl (2009) argues that the collapse of the American
credit system finally leads to the failure of the Lehman Brothers. He points out that the aggravating
economic environment (the high inflation rate) force the American Federal Reserve to raise the
interest rate, which increase the unemployment rate and the pressure of paying back the housing
loans. Thus, many financial institutions involved in the housing loans are bankrupt and the American
credit system collapse, which accounts for the failure of the Lehman Brothers (Carl, 2009). However,
some scholars argue that the imbalance of the industries structure should be responsible for the
collapse of the Lehman Brothers. Dong-An and Bostic (2009) points out that the imbalance of the
industries structure finally result in the subprime crisis and Lehman Brothers is no more than one of
the large number of victims in the subprime crisis.
In addition, some scholars hold the opinion that the ineffective financial supervision of the
government should be blamed for the collapse of the Lehman Brothers. Anne (2009) argues that no
specialized laws and institutions can supervise the financial derivative products designed by the
banks because of the American financial supervision systems. He also points out that lacking of
ineffective supervision will result in the accumulated risks of the financial markets, which finally lead
to the collapse of the Lehman Brothers. Thus, he makes the recommendation that the government
should modify the supervision model to accommodate the change in the financial fields (Anne,
2009). However, there are some scholars, who argue that both the corporate factors and the factors
outside the corporation have to account for the collapse of the Lehman Brothers (Giselle, 2009). In
summary, this opinion summarizes the opinions from different scholars and is widely acceptable
now.
Most studies about the influence of the collapse of Lehman Brothers mainly focus on the negative
influence on the global economy. Lucas and Souleles (2008) analyze the economic circumstance
from the macroeconomic perspective and argue that the collapse of Lehman Brothers will break
down the credit system, which will has great negative influence on the economic development in
America. He also points out that the collapse of Lehman Brothers will decrease the confidence of the
American consumers, which will negatively affect the global economy (Lucas and Souleles, 2008). In
addition, Cassell and Hoffmann (2009) analyze the negative influence from the microeconomic
perspective. They argue that the collapse of Lehman Brothers will not also decrease the financing
channel of the corporations, but also increase the non-performance loans of the corporations, which
lead money to or buy the housing loans products from the Lehman Brothers (Cassell and Hoffmann,
2009). However, there are some scholars, who pay attention to the positive influence the collapse of
Lehman Brothers will have. Hatzius (2008) argues that the collapse of Lehman Brothers will warn
3. the government of the importance of the financial supervision, which will be beneficiary for
establishing the effective and efficient financial supervision system. In addition, he also believes that
the collapse of Lehman Brothers will enhance the international cooperation about the global financial
supervision (Hatzius, 2008).
The studies about the experience and lessons learnt from the collapse are mainly concluded from
the reason for the collapse of Lehman Brothers. Caballero, Farhi and Pierre-Olivier (2008) analyze
the reason from the perspectives of high leverage operation and investment strategies and conclude
that the financial institutions can decrease the high leverage of operation to avoid the shock from the
subprime crisis. In addition, Howell (2006) analyzes the reason from the perspectives of government
supervision and concludes that the government has to modify the previous supervision system to
enhance the financial supervision about the financial derivative products. In addition, he also
concludes that the government has to will improve the international cooperation to avoid the
appearance of the similar incidents (Howell, 2006). Besides, there are some scholars, who analyze
the reason for the collapse of Lehman Brothers and conclude that the individual investors should
choose the financial products carefully to avoid the evitable losses (Giselle, 2009).
In summary, different scholars make studies about on the collapse of Lehman Brothers from the
diversified perspectives and gain different conclusions. The studies about the reason for the collapse
of Lehman Brothers can be divided into two kinds (the corporate factors and the factors outside the
corporations). To understand the reasons for the collapse of Lehman Brothers completely, this paper
aims to adopt the method of extensive survey on the collapse of Lehman Brothers to find the primary
reason and gain some experience and lessons from the case of Lehman Brothers.
Case about the collapse of Lehman Brothers
This section will briefly introduce the case about the collapse of Lehman Brothers from the following
perspectives (the fundamental circumstance of the American economy (especially the financial
markets), which has much to do with the collapse of Lehman Brothers, the fundamental
circumstance about the process of the collapse and the influence of the collapse of Lehman
Brothers.
As the bubbles of the network economy crashed and the 911 event happened, the Federal Reserve
adopts the policy of decreasing the interest rate to accelerate the development of the economy,
which stimulates the booming of the housing industry and the American intension of purchasing the
houses (Cassell and Hoffmann, 2009). In this circumstance, the subprime loans become the prior
choice of those, whose credit standards can not reach the prior loans. Thus, some financial
institutions operated the business about the housing loans products and the financial derivative
products about housing loans. Lehman Brothers is one of the leading financial institutions in the
financial derivative products about housing loans. However, as American economy become hot and
the inflation rises, the Federal Reserve gradually increases the interest rate to avoid inflation, which
is the direct reason of subprime crisis. Thus, some institutions operating subprime loans are
bankrupt; some investment funds are closed and the stock markets vibrate frequently.
As one of the five largest investment banks all over the world, Lehman Brothers is the leading
corporation to operate the financial derivative products about housing loans; Lehman Brothers
accounts for about 11% of the market share in derivative products of housing loans (Karl, 2008). In
addition, Lehman Brothers adopts the aggressive financial strategies. On one hand, Lehman
4. Brothers adopts the high leverage coefficients (the assets/ equity ratio is higher than 30), which is far
from the supervised standard of the American commercial banks (Karl, 2008). The high leverage
coefficients will be apt to the financial risks and will be easily affected by the external stocks. On the
other hand, Lehman Brothers depends on the short-term financing bonds; the ratio of the short-term
financing bonds/total assets is as high as 50%, which will undoubtedly decrease the financing cost,
but increase the financial risks of bankrupt (Crowley, 2009). As the subprime crisis broke out, the
managers of Lehman Brothers were aware of the danger of the aggressive financial strategies and
made every effort to decrease the leverage coefficients and short-term financing bonds. But it is too
late to adopt these methods to save the corporation. Finally, Lehman Brothers hand out the bankrupt
application on September 15th, 2008 (John, 2009). Collapse of the Lehman Brothers has great
negative influence on the American even the global economy. Firstly, the collapse of the Lehman
Brothers not only does great harm to the financial industry in America, but also hurt the confidence
of the American consumers. Secondly, the collapse of the Lehman Brothers will increase the market
panic, which will do great harm to the short-term financing of the enterprises. Finally, the collapse of
the Lehman Brothers will result in the vibration of the stock markets all over the world, which will be
harmful for the global economic stability (Corder, 2009).
Critical analysis about the collapse of Lehman Brothers
Based on the literature review and analysis above, this part will critically analyze the reason for the
collapse of Lehman Brothers from external factors and the corporate, government and industry
perspectives. What's more, the author also wants to discuss the experience and lessons from the
collapse of Lehman Brothers in order to avoid the similar incidents.
Firstly, the macroeconomic control policy and the subprime crisis is the direct reason of the collapse
of Lehman Brothers. As the Federal Reserve increases the interest rate in order to decrease the
inflation rate and control the hot economy, those people, who borrow the housing loans from the
banks, can not afford the expense. Thus, the probability of the default about the housing loans begin
to rise and the value of the derivative products of the housing loans begin to decrease (Cassell and
Hoffmann, 2009). The financial institutions, who invest in the derivative products of the housing
loans will lose and face up to the financial difficulty. As the leading investors in the derivative
products of the housing loans, Lehman Brothers has to sell the assets to balance the loss. However,
the amount of the loss of the investment in the derivative products of the housing loans is large that
Lehman Brothers has to borrow money from the other banks. In the meanwhile, as the subprime
crisis broke out, none of the commercial banks are willing to take risks at saving Lehman Brothers,
which is on the edge of bankrupt (Caballero, Farhi and Pierre-Olivier, 2008). Thus, Lehman Brothers
has no choice but hand out the bankrupt application.
Secondly, this section will mainly discuss the reason for the collapse of Lehman Brothers from the
corporate perspectives.
On one hand, the aggressive financial strategies have to account for the collapse of Lehman
Brothers. The high leverage coefficients will decrease the corporate competence to reject the risks.
The number of the high leverage coefficient of Lehman Brothers reaches as high as 30.3 in August
31st, 2008 (Karl, 2008), which means the investment bank will be bankrupt if the losses reach 3.4%
of the total assets (Karl, 2008). In fact, the loss of investment in the derivative products of the
housing loans is so large that the total assets can not balance the losses, which means Lehman
5. Brothers is bankrupt. In addition, the financing channel of Lehman Brothers mainly depends on the
short-term loans, which will increase the financial risks of the corporation. The single financing
channel means the financial risks when the corporation faces up to the financial difficulty (Cassell
and Hoffmann, 2009). What's more, although the high short-term loans will decrease the financial
costs in the long-term run, it will also increase the financial burden of Lehman Brothers in the shortterm run. Thus, it is no doubt to see that none of the commercial banks are willing to borrow money
for Lehman Brothers when Lehman Brothers is about to be bankrupt (Caballero, Farhi and PierreOlivier, 2008).
On the other hand, the diversified operation and investment strategies will be blamed for the
collapse of Lehman Brothers. In order to achieve the profits increase through diversification, Lehman
Brothers entered the diversified business fields including commercial banks, insurance, capital
management; housing investment and so on. In general, the diversified operation and investment
strategies will decrease the operational and financial risks. However, because of the specialization of
the housing products and the relevant derivative products, the diversified business fields of Lehman
Brothers are closely related to the housing industry and the housing products (Caballero, Farhi and
Pierre-Olivier, 2008). Thus, when the housing industry is no longer prospect, the price of the housing
products will decrease. Thus, all the business fields of Lehman Brothers will suffer from the losses.
Finally, the ineffective risks management of Lehman Brothers will result in the collapse of Lehman
Brothers. Crowley (2009) argues that the financial product is dangerous unless it is under the control
of the corporate risks management. In addition, he also points out the ineffective risks management
of Lehman Brothers may result from the diversified operation model, the ineffective measure tools
about the risk management and the dependent risk management institutions of the corporation
(Crowley, 2009). On one hand, the diversified business will increase the exposure position of
Lehman Brothers. On the other hand, the trust risks and the liquidity risks can not be measured by
the tools that Lehman Brothers adopts. What's more, the excitation mechanism will stimulate the
managers to invest in the housing products at high risks. Thus, the ineffective risks management of
Lehman Brothers will account for the collapse of Lehman Brothers.
Thirdly, lack of the effective government supervision will lead to the collapse of Lehman Brothers. On
one hand, the effective supervision from the government can warn the financial institutions of the
financial risks, which can effectively avoid the accumulation of the financial risks (Peretz and
Schroedel, 2009). On the other hand, the effective supervision from the government will raise the
risk awareness of the financial institutions and enhance the competence of the risks management
(Cassell and Hoffmann, 2009). The managers of Lehman Brothers are willing to invest the financial
products, which are at high risks and profits. As the risks are not warned by the effective government
supervision, the risks begin to accumulate and lead to the collapse at last. Thus, lack of the effective
government supervision is the indirect reason for the collapse of Lehman Brothers.
Finally, this section will mainly discuss the reason for the collapse of Lehman Brothers from the
industry perspectives. On one hand, the imbalance of the industries in America tends to intensify. As
the industry structure change in America, the financial industry will rapidly increase in and the
manufacture industry will decrease accordingly. The surplus of the financial industry in America
finally leads to the subprime crisis. In addition, the relationship between the financial industry and
manufacture industry is being closer and closer. Thus, the subprime crisis will affect the financial
institutions through “Domino effect of bone”. Lehman Brothers is one of the victims of the imbalance
6. of the industries in America (Caballero, Farhi and Pierre-Olivier, 2008). On the other hand, the
imbalance of the financial industry in America will be the primary reason for the subprime crisis.
Firstly, the rapid increase of the virtual assets begins to take place of the financial entities. Secondly,
the rapid increase of the financial derivative products begins to surpass the underlying products. In
the end, the increasing new derivative products can not be effectively supervised to warn the risks,
which finally lead to the financial crisis and the collapse of Lehman Brothers.
In summary, the change of the economic environment (the macroeconomic control of the American
government), the error of the Lehman Brothers, the ineffective supervision by the government and
the imbalance of the industries structure has to account for the collapse of Lehman Brothers.
Based on the analysis about the collapse of Lehman Brothers, it can be learnt a lot to avoid the
similar incidents. As for the financial institutions, on one hand, it is necessary to establish the
effective and efficient department of risk management. On the other hand, the risk factors should be
taken into consideration when decisions are made or the operation and investment strategies are
adopted. What's more, the collapse of Lehman Brothers also reminds the corporate managers that
the short-term profits can not be gained at the expense of the long-term benefits. As regarding to the
government, it is essential to modify the current risk supervision systems to accommodate the
financial derivative products and institutions. In addition, the collapse of Lehman Brothers also
reminds the government of the importance of improving the competence of risk supervision.
Conclusion
Based on the analysis above, it can be concluded as follows. The collapse of Lehman Brothers is
resulted from the four factors--the change of the economic environment (the macroeconomic control
of the American government), the error of the Lehman Brothers, the ineffective supervision by the
government and the imbalance of the industries structure. In addition, it can be learnt from the
collapse of Lehman Brothers that the financial institutions should improve the risk management
competence and take the risks into considerations when making decision, while the government
should change pay attention to the risk supervision and change the current risk supervision systems
to accommodate the financial market.
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