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KWAK Jee Eun 1
Briefing on Lehman Brothers’ Bailout and
Current Financial Crisis
June-3rd, 2009
KWAK Jee Eun
The causation of the current global financial crisis was the dropping housing prices. But the more
fundamental causation of today’s panic was “moral hazard”. In seeking greater and greater profit in
the housing boom, each party in the financial market passed their responsibility to another party and
being indulgent in taking greater risk. (1)
-
Regulators went easy in giving attention and relied on tax payers’ money.
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Financial institutions were only focused in making more profit.
-
Credit rating agencies did not evaluate the complicated financial products carefully.
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Individuals were into consuming that became indulgent of granting unaffordable loans.
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Foreign financial institutions bought derivatives without knowing the product and just
trusting the credits rated by the agencies.
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Politicians considered real estate boom will be their political achievement.
Lehman Brothers bankruptcy was a reasonable decision. Lehman Brothers’ bankruptcy attacked
the market severely crashing down 504 points of the Dow Jones Industrial Average Index which was
the greatest decline after 911. Lehman Brothers’ stock price declined 94% from 3$ to 15 cents on the
day they filed for bankruptcy. Lehman Brother’s default gave severe losses to all the share holders and
customers. But on the other hand, after the bankruptcy, new competition was created in the market
between Barclays and Nomura over the Lehman Brothers. The Lehman failure alerted the market
pushing institutions to take painful actions for restructuring: Merrill lynch & Co. agreed to be taken
over by Bank of America, Goldman Sachs and Morgan Stanley decided to go commercial,
Washington Mutual acquired by JPMorgan (2)
Government’s bailout of Lehman Brothers would not have prevented the financial crisis. As will
be shown later in this paper, today’s financial crisis is not just a problem of few parties. Bailing out
few giant institutions will not rescue the whole market system from the threat of corruption. Bailing
out Lehman brothers would have saved many of the investors and related parties but would not have
done anything in solving out the core problem. It is more likely that Lehman Brothers’ bail out would
have ended up wasting enormous amount of tax payers money. We have already seen this from the
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previous government’s bail outs; Freddie Mac, Fannie Mae, Bear Stearns, AIG and CITI Group. In
case of AIG, government ended up spending 162 billion dollars which was almost as same as the 2007
US annual deficit. Number four investment bank, Lehman Brothers’ bail out would not have been
different from this. (3)
Lehman Brothers bail out could have lessened the shock to the market but would not have been able
to touched the main problem; moral hazard. As previous bail outs had deepen the underlying moral
hazard and made Lehman Brothers to lose their chance to take right action for their own salvation,
Lehman Brothers bail out would have given the same negative impact to other institutions by
discouraging them from going over self reconstruction and making them expect free ride. (2)
Development of today’s panic and moral hazard started from
Public/Borrowers
the government’s effort to encourage the mortgage system. To
provide more mortgages to the public, US government created
Interest
payment
Funding
Fannie Mae (1930s) and Freddie Mac (1970s) which were later
privatized but remained as Government-sponsored enterprise.
Fannie Mae and Freddie Mac purchased loans from banks and
Bank/Lenders
lenders and this encouraged those firms to make more loans
without concerning the liquidity problem. In 1980s, US
Mortgage
(Prime)
(Alt-A)
(Sub-prim)
Funding
government provided more incentives in the mortgage market by
removing mortgage loan interest rate limitation, allowing
adjustable –rate mortgage and deducting tax on mortgage interest
payment. (4)
Fannie Mae, Freddie Mac
Mortgage companies
Investment Banks
(Asset-Backed Securities)
(Mortgage-Backed Securities)
↓
Pool
Leverage
Low mortgage interest rate boosted up the housing market through
1990s. More mortgage companies entered the market and big
investment companies also participated in the mortgage business.
CDS
↓
Collateralized Debt Obligation
Especially sub-prime mortgage products became popular for its
high profit which was just a compensation of a higher risk.
(Tranche: Senior  Equity Tranche)
Credit,
Pricing
Repurchasing
Fee
Risk
Guarantee
Monolines
Credit Risk
Agencies
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Low mortgage interest rate boosted up the housing market through 1990s. More mortgage companies
and big investment companies participated in the mortgage business. Especially sub-prime mortgage
products became popular for its high profit which was also a compensation of a higher risk.
Mortgages were classified by the credit rates of the borrowers (Prime < Alt-a < Sub-prime) and
securities was issued backed by these classified mortgages of different risks; Mortgage-backed
securities (MBS). This later expanded to asset-backed securities.
In effort to take the risk away, financial institutions brought monolines in the market. Since monolines
originally guaranteed state securities which were very safe, their credit rate was high and guaranteed
by these companies imposed same credit to the products. As derivatives developed, such as
collateralized debt obligations which were assigned with different level of risks and priorities
“tranche,” investors were needed additional institution to guarantee the credit and risk of these
products; credit rating agencies. Price was also set by the evaluation from the credit rating agencies.
Under the housing boom, to guarantee banks signed for repurchasing contracts guaranteeing that they
will repurchase the product if the profit is lower than expected. Credit default swap, which was
insurance for the financial instrument. This took away the exposure to default. Banks were able to
reduce their debt by purchasing CDS and financial institutions made lots of money by selling out CDS
that the actual possibility of default seems extremely low. (5)
Several occasions in the beginning of the millennium caused concerns of recession in the market; dot
com bubble crash, 911 attach and several giant companies bankruptcy such as Enron and WorldCom.
Concerning possible recession, government lowered the interest rate which encouraged the housing
market even more. Sub-prime mortgage market boomed and more speculation was conducted in the
real estate market.
In 2004, annual inflation rate exceeds the FED interest rate and the government had to raise interest
rate. Raising 17times in 2 years, the U.S. interest rate ended up reaching 5.25% at the end of 2006
June. Sudden rise of interest rate raised the mortgage interest rate provoking late payments. Late
payments gave negative impact to the liquidity in MBS market. Value of MBS fell down. It became
difficult to get loan from the mortgage companies which dropped the housing price. (5) (6)
Fallen MBS value also raised accounting problem. Since companies already accounted the MBS
value in advance applying present value of the securities and they deceived by not applying the fallen
value. Credit rating agencies also showed moral hazard problem by not evaluating the securities fairly
because of the relationship with the publishers of the securities who are their client. (5) (6)
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As credit rate agencies decided to downgrade most of the CDO products, it affected the credit of the
investment banks and mortgage companies. Value crash in the financial market led two hedge funds
owned by Bear Stearns who mainly invested in subprime CDOs filed for bankruptcy in July 2007.
Many mortgage loan companies filed for bankruptcy and this starting crisis did not stay at sub-prime
mortgage but expanded to the Alt-a and prime mortgages. (6)
2007, Sept,18th, Government decided to lower the 2007, lowering the US interest rate again deciding
that it is not a time to concern inflation. But starting from 2007 October the decreased value of the
assets and loss from banks became opened to the public. As the asset declined, capital declined in
the same rate. Reduced capital meant reduced buffer from risk and problem in maintaining the BIS
rate. Banks started to sell their assets but oversupply in the market declined the price of their financial
instruments while raising the mortgage loan interest and again dropping the housing prices. Increased
loan interest also brought late payments while affect the credit and the price of their securities again
lowering the value of the asset of the banks. This vicious circle continued and brought today’s crisis.
Figure 1. ABS issuers, home mortgages and other loans
Source : OECD, Datastream.
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Reference
1. ANDREWS, EDMUND L. A ‘Moral Hazard’ for a Housing Bailout: Sorting the Victims From
Those Who Volunteered. 2 23, 2008.
2. Jagger, Suzy. No federal bailout of Lehman Brothers, the free ridewas over for financiers. The
Times. 9 16, 2008.
3. Sorkin, Andrew Ross. Echoes of Bear Stearns, One Year Later. The New York Times. 3 19, 2009.
4. The Current Financial Crisis: Causes and Policy Issues. Adrian Blundell-Wignall, Paul
Atkinson and Se Hoon Lee. s.l. : OECD, 2008.
5. Hyuck, CHOI. 2008 Global Financial Crisis. s.l. : K-books, 2009.
6. 소영일, 고종문. 글로벌 금융위기와 경제성장종말. s.l. : 지구문화사, 2009.