Stability of global financial system

Executive Summary

Firstly, the efficiency and stability of the global financial system is interrelated by each country's financial system. In this case, the United States (US) subprime mortgage crisis, which occurred at the end of 2007, affects progressively financial markets in the US and other countries. Moreover, Lehman Brothers, a global financial-services firm, announced its big loss in consequence of a liquidity shortage and filed the Chapter 11 Bankruptcy Protection on September 15, 2008. Unfortunately, the US government did not offer attractive guarantees to the potential buyers or give a loan package to prevent its failures, therefore the court approved the bankruptcy of Lehman Brothers.

As per financial points of view, starting 2008, Lehman Brothers' net income had been rapidly declined from a net loss of around ($2.8) billion in the second quarter of 2008 to a net loss of ($3.9) billion in the third quarter of 2008. Even though expenses were gradually dropped during 2008, this company unable to raise net incomes because its revenues were negatives, particularly from fixed income. Furthermore, Lehman Brother's published balance sheets for the period of 2007-2008 were intentionally modified by the practice of a Repo 105, therefore its leverage declined.

Lastly, there are several actions to avoid an outright collapse or deep recession. The government, financial institutions, financial regulation and treasury should work together to manage a liquidity deficit in the financial system that caused by debts, securitization, derivatives, deregulation, capital mobility and illiquid markets during the crisis.

Introduction

Background

The US subprime crisis, which initiates a global financial crisis, had been happened at the end of 2007. This crisis makes a major financial distress and serious difficulties on markets and institutions at the global financial system. On the other hand, this crisis also declines financial system and economies in the US and other countries, such as Europe, Australia and so forth (Shabri Abd Majid et al. 2009).

At first, the implementation of new credit scoring methods guides poor practices in the US subprime mortgages that allow lenders to admit borrowers with poor credit histories and charges them at higher interest rates (Hampel et al. 2008). Lenders also attract borrowers with low "teaser" interest rates, so they can obtain greater mortgages, which make larger future payments for their households. If borrowers fail to repay on schedule, a rise in the property values will help them to obtain a refinancing under assumption that the property values continue to increase and loan-to-value ratios always be declining. Furthermore, these subprime loans are changed into securities by lenders and the majority of these securities obtains the highest rating as all investors wanted (Dodd et al. 2008).

Secondly, starting 2005, the decrease of housing demand and the growth of housing inventories had considerably turned down home prices in the US (Harvard 2008). Many borrowers, especially who have poor credit background, unable to pay and refinance their loans, or sell properties because house prices are dramatically fallen (Hampel et al. 2008). At this time, as the effect of a liquidity shortfall, most subprime mortgage lenders stop their lending operation and begin to declare bankruptcy, while insurance companies raise a "bad acts" to reject any coverage related to the subprime mortgage crisis because this condition generates huge payments for insurers (Portfolio Media 2009).

Finally, the domino model of financial contagion is occurred because the subprime loans have been changed into securities and sold to other investors in the financial market. During the housing bubble, many investors cannot get any payment because the subprime mortgage sector is collapse. If the loss is large enough, this condition may eliminate investors' capital (Adrian et al. 2008). For instance, Lehman Brothers, a global financial-services firm, announced its loss, which approximately $600 billion in debt and submitted the Chapter 11 Bankruptcy Protection on September 15, 2008. Its failure was caused by the freezing of credit markets worldwide and the global financial crisis (Frean et al. 2010).

Objective

This report provides evaluation and recommendation about the bankruptcy of Lehman Brothers in consequence of the subprime mortgage crisis in the US. The result of this study will be utilized as a basis to understand the failure of Lehman Brothers, therefore other financial companies can perform some actions to evade a similar collapse during this crisis.

Scope

This report focuses on two key factors, which are evaluation and recommendation about the insolvency of Lehman Brothers as a result of the subprime mortgage crisis in the US. During evaluation, recent financial crisis market data, such as charts, graphs, tables and so forth, are utilized to carry this analysis. On the other hand, recommendation will be considered based on the result of this analysis, so other financial institutions can keep away from a similar failure during this crisis.

Content

The General History of Lehman Brothers

During 1844, Henry Lehman from Rimpar, Germany, immigrated to Montgomery, Alabama and opened a small store, which provides groceries, dry goods and tools to the local cotton farmers, while six years later, his younger brothers, Emanuel and Mayer, joined him in this business and they named it, Lehman Brothers. As the business grew, from a general merchandising business to a commodities broker in the southern US, a New York agency was established by this company in 1858 and then twelve years later, it became the New York Cotton Exchange as the first commodities futures trading venture. Due to the dramatic expansion of the railroads, many bonds were created in the market to acquire more funds. In this case, Lehman Brothers enlarged its commodities business to include the sales and trading of securities, and became a member of the New York Stock Exchange in 1887. Moreover, from 1925 to 1969, Lehman Brothers accomplished the significant growth, which led by Robert Lehman, Emanuel's grandson. This firm funded the retailing, airlines, motion picture and other industries by underwriting security issues, and also developed its capital markets trading in commercial paper. Starting 1980, Lehman Brothers had a new function as financial advisory on mergers and acquisitions to help the enlargement of many big companies both nationally and globally. Its global offices in Asia and Europe also well assisted this new function (Harvard 2010).

On the other hand, a latest Lehman Brothers (Lehman Brothers Holdings Inc.), which was incorporated in December 29, 1983, provides the financial needs of corporations, governments and municipalities, institutional clients and high-net-worth individuals worldwide, while its services consist of equity and fixed income sales, trading and research, investment banking, asset management, private investment management and private equity. As a result of a recent credit crunch, on September 15, 2008, this corporation submitted the Chapter 11 Bankruptcy Protection to the US Bankruptcy Court of the Southern District of New York and then several months later, the court gave its approval (Reuters 2010).

The Performance and Financial Condition of Lehman Brothers

Firstly, the following tables were summaries of financial information from Lehman Brothers during the period of 2004 - 2008 that consist of balance sheets statements, income statements and cash flows statements.

As per financial points of view, starting 2008, this corporation had experienced loss and negative net incomes as a result of a recent financial crisis, although its net incomes were moderately increased from approximately $2.4 billion to $4.2 billion during 2004 - 2007. Lehman Brothers stated a beginning net loss of about ($3.9) billion or ($5.92) per common stock (diluted) for the third quarter ended August 31, 2008, and a net loss of ($2.8) billion or ($5.14) per common stock (diluted) for the second quarter of 2008. However, its net income was still positive during the first quarter of 2008. On the other hand, net revenues (total revenues less cost of revenues/interest expenses) for the third quarter of 2008 and the second quarter of 2008 were projected to be negative ($2.9) billion and negative ($0.7) billion respectively (Reuters 2010).

Secondly, the below table illustrated net revenues according to business segments for the period of 2007 - 2008.

Capital markets was estimated to state net revenues of negative ($4.1) billion in the third quarter of 2008 and negative ($2.4) billion in the second quarter of 2008. The large portion of negative net revenues in capital markets was given by fixed income. Moreover, this company still had positive net revenues from both investment banking and investment management during 2008. Investment banking stated projected net revenues of $0.6 billion for the third quarter of 2008 and $0.9 billion in the second quarter of 2008, while investment management gave estimated net revenues of $0.6 billion during the third quarter of 2008 and $0.8 billion for the second quarter of 2008. Even though cost of revenues (interest expenses) and non-interest expenses (selling/general/admin, research & development and other operating expenses) were gradually fallen during 2008, Lehman Brothers cannot increase its net incomes. This net loss was caused by gross mark-to-market adjustments stemming from write downs on commercial and residential mortgage and real estate assets (Lehman 2008).

Thirdly, there was a rapid decrease in its cash reserves between 2008 and 2007. The company's cash flows from financing were 17.7 billion in the period ended May 31, 2008 and 48.6 billion in 2007. Moreover, this company utilized 0.6 billion in the period ended May 31, 2008 and 1.7 billion in 2007 for investing, while the utilization of cash for operation was 17.9 billion in the period ended May 31, 2008 and 45.6 billion in 2007 (Reuters 2010).

In addition, Lehman Brother's published balance sheets for the period of 2007-2008 were intentionally modified by the practice of a Repo 105, therefore its leverage declined. Bad assets were lent to other companies at the end of quarter for short-term financing and then paid out bad debts. In this case, balance sheets of this company looked better because its bad debts were temporarily turned down. However, Lehman Brothers would promptly pay back its bad assets after the company's financial reports were published. As a result of this practice, Lehman Brothers covered $39 billion at the end of the last quarter of 2007, $49 billion in the first quarter of 2008 and $50 billion in the second quarter of 2008 (Carty 2010).

At last, the company's performances during the period of 2007-2008 were also showed by financial condition in the next table.

There was an increase in total stockholders' equity from $26.3 billion for the second quarter of 2008 to an expected $28.4 billion for the third quarter of 2008, which reflects the growth of Lehman Brothers' capital activities. Furthermore, total long-term capital, which comprises long-term borrowings and total stockholders' equity, was estimated to be approximately $143.0 billion for the third quarter of 2008 and $154.5 billion for the second quarter of 2008. Investors can use this indicator to evaluate the company's financial strength. On the other hand, this company was estimated to deduct its net leverage ratio from 12.1x to 10.6x during the third quarter of 2008. Net leverage ratio is net assets divided by tangible equity capital and also suitable for the company's estimated lower-risk asset composition (Lehman 2008).

Remedial Actions

At initial, during the summer 2008, Richard Fuld Jr. as Lehman Brothers' director was pushed by stakeholders to solve its financial problem in consequence of a recent credit crunch. This company would be collapse, if he failed to sell Lehman Brothers in the third quarter of 2008, particularly after gigantic losses announced by its June financial reports. Unfortunately, his efforts to seek prospective buyers were not succeed because the US government did not offer the same attractive guarantees that provided during the sale of Bear Stearns. For instance, the Fed declined to give guarantee $65 billion in potential Lehman Brothers' bad loans when Bank of America and Barclay interested to buy this company. In the end, after US government approved the bankruptcy of Lehman Brothers, Barclay took over this company in the US, while operations in Asia and Europe were taken by other entities. In summary, Lehman Brothers would be survived if the Fed offered attractive guarantees to potential buyers or gave a loan package to prevent its failures (Eiteman et al. 2009)

On the other hand, there are several actions to avoid a similar failure during a liquidity deficit in the end of 2007. Firstly, financial institutions should decline to provide additional loans to the market, except if the government offers a loan package to maintain their long-term stability. Secondly, financial companies should disclose a modified set of "rules" for their operations, especially during the crisis times. For example, based on a new "operational standing facility", banks can borrow against top-quality collateral without risks and up to 1 month during the financial crisis. Thirdly, financial regulator should review risk-assessment and risk-mitigation practices for all financial institutions and also supervise them more strictly to ensure their financial strength, such as liquidity requirement, contingency funding plans, and so forth. At last, treasury should improve the deposit protection agreement, maintain financial stability by ensuring better cooperation and coordination between financial institutions, financial regulator and treasury itself, and also mainly responsible for financial regulations, which related to systematic risks, the solvency of bank and so on (Hall 2009). In summary, all parties (the government, financial institutions, financial regulation and treasury) should shun a liquidity shortfall in the financial system that caused by current complex debts, securitization, derivatives, deregulation, capital mobility and illiquid markets, mainly during the crisis times (Eiteman et al. 2009).

Conclusion

In conclusion, the US subprime crisis, which happened at the end of 2007, generates inefficiency and instability of the global financial system. Furthermore, a liquidity shortage, which resulted by the housing bubble, strikes financial markets in the US and other countries. In this case, Lehman Brothers, a global financial-services firm, had suffered a great loss and filed the Chapter 11 Bankruptcy Protection on September 15, 2008. Sadly, the US government did not give attractive guarantees to prospective buyers or bailout this company to stop its failures.

Additionally, some actions should be performed in order to evade an outright collapse or deep recession. The government, financial institutions, financial regulation and treasury should work together to solve a liquidity shortfall in a recent financial system, therefore other companies can maintain their long-term stability during this crisis times.

Reference List

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