Lehman Brothers

Tsunami of Credit Crunch gulp down Lehman Brothers
&
The structure of confidence collapsed completely
Student ID: 4745353
Subject: Finance and Accounting Management
Tsunami of Credit Crunch gulp down Lehman Brothers & The structure of confidence collapsed Page 1
Table of Contents
1. Executive Summary:........................................................................................................................ 3
2. Introduction to Credit Crunch: ........................................................................................................ 4
2.1 Definition & Terminology:............................................................................................................. 4
2.2 What exactly caused this to happen? ........................................................................................... 4
3. SUB PRIME MORTAGAGE WORKED AS OPERATOR: ....................................................................... 5
4. The Economic Situation before the Collapse of Lehman Brothers: ................................................ 7
5. Lehman Brothers up to the Weekend of September 13-14: .......................................................... 8
5.1 Thought from one of the prime investor of Lehman Brothers: .................................................. 10
6. The DREADFUL Lehman Weekend (September 13-14, 2008): ..................................................... 11
7. The Accident that Punctured Confidence and Unleashed the Financial Panic: ............................ 12
8. CONCLUSION:................................................................................................................................ 14
9. APPENDIX ...................................................................................................................................... 16
9.1 APPENDIX: History - 1929 to present ..................................................................................... 16
9.2 APPENDIX: Sequence of events happened during credit crunch (Rayner, 2008) ..................... 17
9.3 APPENDIX: Introducing the Argument: Confidence and Its Double Structure .......................... 18
9.4 APPENDIX: Confidence and Fear Index plays huge role............................................................. 21
9.5 APPENDIX: Securitisation and Leverage ..................................................................................... 21
9.6 APPENDIX: ABOUT LEHMAN BROTHERS ..................................................................................... 22
9.7APPENDIX: Nature of Credit Crisis Worsened:............................................................................. 23
9.8 APPENDIX: Consequences of Lehman Failure ....................................................................... 24
9.8.1 Bailouts and Busts: ............................................................................................................... 24
9.9 APPENDIX: Policy makers & Regulators Response...................................................................... 26
9.10 APPENDIX: Solutions for Credit crunch ..................................................................................... 28
10. REFERENCES: ............................................................................................................................. 29
1. Executive Summary:
On September 15, 2008 Lehman Brothers filed for bankruptcy, something that
nearly caused a meltdown of the world’s financial system. A few days later Bernanke
made his famous statement that “we may not have an economy on Monday.” This report
includes the situation Lehman Brothers before and after the bankruptcy and how
exactly this event triggered the huge financial panic all across the globe termed as
credit crunch. It was a nonlinear and sudden catastrophic event for the global economic
system, unprecedented in scale in human history.
I analysed two major aspects, which pulled the worst possible recession of the
century. First one is Hidden losses and the second one is that confidence plays key role
in finance. Confidence can be conceptualized as a belief that action can be based on proxy
signs, rather than on direct information about the economic situation itself.
I have also studied how exactly Lehman went bankrupt, and how this worry
transformed into a total disbelief in existing proxy signs - a loss of confidence as well as
a withdrawal of confidence in this report. This report includes the series of action
happened or taken before and after Lehman Brother went bankrupt. Although the
debate of those actions will continue on and only time will be able to answer what could
have been right or wrong about it..!!
2. Introduction to Credit Crunch:
2.1 Definition & Terminology:
An economic condition in which investment capital is difficult to obtain.

Banks and investors become wary of lending funds to corporations, which drives up the
price of debt products for borrowers.
A credit crunch makes it nearly impossible for companies to borrow because

lenders are scared of bankruptcies or defaults, which results in higher rates. The
consequence is a prolonged recession (or slower recovery), which occurs as a result of
the shrinking credit supply.
2.2 What exactly caused this to happen?
Fig1. How exactly housing bubble end up with one of the biggest financial recession
The R's mean reinforcing feedback, the B's are balancing feedback, the S's (same) are where
more of one thing lead to more of another, and the O's (opposite) are where more of one thing
lead to less of another.
3. SUB PRIME MORTAGAGE WORKED AS OPERATOR:
The market for subprime mortgages grew very fast. Jaffee (2008)
documents two periods of exceptional subprime mortgage growth. These
expansions occurred because changes in the law allowed mortgage lending at
high interest rates and fees, and tax advantages were available for secured
borrowing versus unsecured borrowing. Another strong influence was the desire
of mortgage originators to maintain the volume of new mortgages for
securitization by expanding lending activity into previously untapped markets.
Subprime loans were heavily concentrated in urban areas where prime
borrowers that faced financial difficulties switched from prime to subprime
mortgages.
At the same time, U.S. residential subprime mortgage delinquency rates

have been consistently higher than rates on prime mortgages for many years
Pennington-Cross (2006) record figures from the Mortgage Bankers Association
with delinquencies 5½ times higher than for prime rates and foreclosures 10
times higher in the previous peak in 2001-02 during the U.S. recession.
A worrying characteristic of loans in this sector is the number of
borrowers who defaulted within the first three to five months after
receiving a home loan and the high correlation between the defaults on
individual mortgage loans. The growth in the scale of subprime lending
in the United States was compounded by the relative ease with which
these loans could be originated and the returns that could be
generated by securitizing the loans with (apparently) very little risk to
the originating institutions. The demand was strong for high-yielding
assets. Much of this demand was satisfied by residential MBSs and
CDOs, which were sold globally, but as a consequence the inherent
risks in the subprime sector spread to international investors with no
experience or knowledge of U.S. real estate practices.
4. The Economic Situation before the Collapse of Lehman Brothers:
From about 2001 and onwards, a credit bubble started to appear in the United
States. Huge amounts of capital moved into the country, in search of profit higher than
the low rate of interest that existed at the time (real risk-free rate of interest). A housing
bubble was also in the making; and through the process of securitization the housing
market was closely linked to the credit bubble in the U.S. financial system as well as to
the international financial system. Mortgages, traditionally the business of local banks,
were now pooled, turned into bonds and CDOs that were sold on to investors, in the
United States and elsewhere.
This is exactly what happened in 2007, when the decline of the U.S. housing
market started to register in a major way in the financial system. The financial crisis, it
is generally agreed, began in August 2007, when a major mortgage outfit went under
and the Fed as well as the European Central Bank had to infuse billions of dollars and
Euros into their financial systems. The failing subprime mortgages were, to repeat, at
the centre of what was now going wrong; and by August 2007 the amount of subprime
mortgages was estimated at $ 2 trillion. It is also true that if the new securities had been
fully transparent, then the investors at the end of the chain would have had to take their
losses; and that would have been all.
This, however, is not what happened. Instead the trouble spread to other parts of
the financial system: inter-bank lending started to freeze up and a run on SIVs took
place. Why was this case? The reason was that it was impossible for the investors to
determine which bonds and CDOs had suffered losses, and to what extent. The way that
these securities had been constructed made them impenetrable. The result was a fear
about hidden losses that spread to all subprime mortgage related bonds and CDOs as
well as to the institutions suspected of owning these. Gorton sums up his argument as
follows:
“The ABX information, together with the lack of information about location of
the risks, led to a loss of confidence on the parts of the banks in the ability of their
counterparties to honour contractual obligations. The panic was on, starting with a run
on structured vehicles” (Gorton 2009:568).
As 2007 became 2008, the economic problems continued and mortgages other
than subprime began to fall in value. This meant that the potential losses – the hidden
losses - were now extended to a pool of mortgage-backed securities worth somewhere
between $ 5-10 trillion. An increasing number of mortgage-related originators were
also going bankrupt; and the price of housing continued to go down.
The end for Bear Stearns began on March 10, when one of its mortgage-based
debts was downgraded by Moody’s, something that started a rumour that the bank was
in deep trouble. Bear Stearns immediately denied that it had liquidity problems but, as
is often noted, when a bank denies that it has a liquidity problem it is already lost.
“When confidence goes, it goes,” as Paulson said when asked about the chances of Bear
Stearns to survive.
During the months after the fall of Bear Stearns the general economic situation
continued to worsen. As the prices on the housing market were going down, securities
that at first had seemed safe now entered into the danger zone, including those with an
AAA rating. By August, according to information from the IMF, the value of many assets
had fallen dramatically, something that was especially dangerous for those institutions
that depended on short-term financing. As the economic situation continued to worsen
during the fall of 2008, the pressure shifted to the remaining investment banks and
especially to Lehman Brothers. To better understand what happened during the fatal
weekend of September 13-14, when the fate of Lehman was decided, we will now turn
to the economic activities of Lehman during 2007 and 2008.
5. Lehman Brothers up to the Weekend of September 13-14: 1
In 2005 and 2006 Lehman was the largest producer of securities based on
Subprime mortgages. By 2007, more than a dozen lawsuits had been initiated against
Lehman on the ground that it had improperly made borrowers take on loans they could
not afford. “Anything to make the deal work,” as one of Lehman’s former mortgage
underwriters put it. In 2007 the housing market also continued to go down and Lehman
was increasingly getting stuck with mortgage bonds and CDOs that it could not pass on.
1
Fuld was the CEO of Lehman Brother. His full name is Richard Fuld. Referred as Fuld here.
Richard Fuld does not seem to have understood what a great threat this
constituted. He knew of course that the housing market was going down; and in order to
counter this, he decided to invest heavily in commercial real estate and in assets outside
the United States. What was behind this strategy was a lack of insight into the close link
between what was going on in the financial system and in the U.S. housing market,
thanks to securitization. As things turned out, Lehman’s dealings in commercial real
estate created even more bad debt on its books than its dealings in residential housing.
During 2008 the position of Lehman worsened and its shares continued to go
down. The day after the fall of Bear Stearns on March 16, 2008, its shares fell 19
percent and many believed that Lehman was the next investment bank to go off.
Secretary of the Treasury Henry Paulson was one of these persons; and therefore he
initiated regular contacts with Fuld. He emphasized to Fuld that Lehman was in a very
difficult economic situation and needed to find a buyer. People from the SEC and the Fed
were stationed at Lehman. Contrary to what is believed, the Fed also started to help
Lehman with enormous loans and would do so till its collapse on September 15.
Fuld, it appears, did not realize the seriousness of either what Paulson was
telling him or of the situation in general. For one thing, he thought that he had the full
backing of Paulson. “We have huge brand with treasury,” as he famously phrased it in an
e-mail, after a meeting with Paulson on April 12. From March to the September 13-14
weekend Fuld turned down several opportunities to sell Lehman as well as an infusion
of capital from Warren Buffett and attempts to cut deals with Morgan Stanley, Goldman
Sachs and Bank of America.
Fuld over believed that Lehman could weather any

storms it faced during the spring and summer of 2008,
investors were getting increasingly nervous. While many
banks had declared heavy losses and write-downs,
Lehman had not. In fact, Lehman declared a profit of
several hundred million dollars for the first quarter of
The three major rating agencies were also applauding Lehman’s performance, as
they would do till the very end. Still, rumours were strong that Lehman was covering up
its losses. Some investors also started to look for information on their own, and what
they found made them suspicious.
5.1 Thought from one of the prime investor of Lehman Brothers:
One of these investors was David Einhorn, the head of a hedge fund called
Greenlight Capital gave a speech in a conference for investors in April, he argued
that investment banks and specially Lehman Brothers is dangerous for a number
of reasons as they used half of their revenue for compensation like its employees
have a very strong incentive to increase the leverage of their firm. If you calculate
its leverage properly, it comes 44:1. This means that if the assets of Lehman fell
by 1 %, the firm would have lost almost half of its equity. The consequences of
this were dramatic: “suddenly, 44 times leverage becomes 80 times leverage and
confidence is lost.” In late May he made another public attack on Lehman. This
time he announced that his hedge fund was shorting Lehman and he explained
the reason as “Lehman does not provide enough transparency for us to even
hazard a guess as to how they have accounted for these items.” Lehman responds
to requests for improved transparency begrudgingly but it was not enough so he
suspected that their amount of transparency on these valuations would not
inspire market confidence.
But now by that time Fuld was desperately trying to raise capital or to find a
buyer. He contacted a number of potential investors, including Citigroup, which sent
over a team to go through Lehman’s books. Lehman’s last chance of being bought up
disappeared on September 10, when Korea Development Bank announced that it had
decided to withdraw from a possible acquisition. The very same day Lehman also
declared a loss of $ 3.9 billion and was warned by Standard & Poor that it might be
downgraded. The next day Lehman had great difficulty in scraping together the extra
collateral of $ 8 billion that JP Morgan Chase now demanded; and it was clear that the
financing of Lehman’s daily operations was quickly drying up. The end, in other words,
was near. On September 12 a number of the key CEOs on Wall Street each got a call from
staff members at the Fed, telling them to attend an emergency meeting at 6 pm at the
New York Federal Reserve Bank. Lehman’s fate was to be decided.
6. The DREADFUL Lehman Weekend (September 13-14, 2008):
After the fall of Fannie and Freddie, anyone with high leverage and lots of real
estate exposure was suspect. Lehman Brothers was an obvious candidate. It was a
broker/dealer, like the Bear. Also like the Bear, it had significant exposure to mortgages.
Lehman took both significant residential and commercial mortgage risk, so clearly 2008
was not a good year for it. The firm posted significant losses during the second quarter
of 2008. It needed more capital to restore confidence. It was needed liquidity but none
of their moved worked, hence Lehman’s share price tumbled, and the firm started to
feel difficulty to survive. Firms which rely on confidence sensitive funding and then lose
the confidence of the market fail quickly. On the 9th September 2008, Lehman’s shares
fell by 45%. Borrowing became well nigh impossible for Lehman. By the 15th, it had
filed for bankruptcy protection. This was one of the largest failures in American
corporate history.
Fig. 1 The Lehman Brothers share price in 2008
The weekend of September 13, During Saturday the group of people by Treasury Dept
that had been assigned to estimate Lehman’s economic situation, concluded that its
losses were much larger than had been thought. Beside its mortgage related losses,
which were already known, Lehman also had tens of billions of dollars of losses in its
portfolio for commercial real estate. Altogether, Lehman’s losses – hidden as well as
already known losses – amounted to something like $ 30-80 billion.
Lehman failed, and declared bankruptcy in the early hours of September 15.
Despite these failures, Fuld insists that it was rumours and short selling that brought
down Lehman, not its huge losses in a deteriorating economy and his own failure to deal
with this. “Ultimately what happened to Lehman Brothers,” Fuld said later when he
testified at Congress, “was caused by a lack of confidence”
7. The Accident that Punctured Confidence and Unleashed the

Financial Panic:
Lehman’s bankruptcy set off a panic that would end up by threatening not only
the U.S. financial system, but also the global financial system. Did the bankruptcy work
as a kind of detonator, and if so, exactly how did it work? Or was Lehman’s bankruptcy
rather the first in a series of explosions, so to speak, that helped to set off an avalanche?
These questions are currently hard to answer, among other reasons because there is
very little exact knowledge about what happened once Lehman went bankrupt.
This event triggered immediate direct and indirect effects on the market. The
direct effects of Lehman’s bankruptcy were on those who were tied with Lehman in
credit default swap, simply can imagine by contemplating the fact that this was a $ 613
bn bankruptcy –the largest ever in U.S. history.
In the Indirect losses you can refer to below diagram.
2 Paulson told his staffs on September 16th that “This is an economic 9/11!” as
confidence was disappearing quickly from the financial world was, for example, clear
from what was happening to the two remaining investment banks. During the days after
Lehman’s bankruptcy, the shares of Goldman Sachs and Morgan Stanley fell quickly and
it seemed clear that both of them might go down.
At the same time the shares of Citigroup kept going down after the collapse of
Lehman. From 2007 and onwards the giant bank conglomerate had taken heavy
mortgage related 29 losses; it was also suspected of having much more hidden losses of
this type. The Fed, however, had confidence in the solvency of Citigroup.
On October 1, however, the Senate passed the bill to fund the Troubled Asset
Relief Program (TARP). On October 3, after pressure, the House passed the bill as well.
2
VIX : Volatile Index LIBOR: London Inter Bank Offered Rate
8. CONCLUSION:
In this paper, the focus is mainly on the role of confidence. To recapitulate the
core idea of this theory is that confidence has to do with people’s capacity to base their
actions on indicators or proxy signs for what some situation are alike, in those cases
where they lack direct knowledge of the situation. When the proxy sign is properly
aligned with the economic situation, investors will feel confidence. The situation when
confidence disappears very suddenly (collapse of confidence) and then there is the
situation when actors do not engage in some economic action because they lack the
confidence to do so (withdrawal of confidence) lead to finance recessions.
What characterized the situation before Lehman went down was a general worry
that the existing proxy signs (ratings, reported earnings and so on) did not adequately
represent the economic situation of various financial institutions.
Each Country’s Government and financial body and regulators play huge roles in
such circumstances. In this case, US Treasury, FED & government initiated preventive
measures for credit crunch at good time. Please refer to the few other ways or solutions
for credit crunch in appendixes. Although the debate of those actions will continue on
and only time will be able to answer right or wrong about it..!!
Source: Figures from Bloomberg Terminal
9. APPENDIX
9.1 APPENDIX: History - 1929 to present
9.2 APPENDIX: Sequence of events happened during credit crunch
(Rayner, 2008)
Date Event
After months of concerns about the exposure of financial institutions to US
subprime mortgages, Bear Stearns, one of the world's biggest investment
July 31, 2007 banks, stops clients from withdrawing cash from a fund which has lost
billions of dollars. The fund closure sets alarm bells ringing in financial
markets around the world
Short-term lending between banks, which they rely on to balance their
books, dries up after French giant BNP Paribas suspends three investment
funds worth 2 billion Euros because of exposure to US subprime
Aug 9, 2007
mortgages. The European Central Bank, the US Federal Reserve and the
Bank of Japan offer to lend banks tens of billions to ease what is already
being called the Credit Crunch.
Northern Rock, Britain's fifth-biggest mortgage lender is granted
emergency funding by the Bank of England after finding itself unable to
secure loans from elsewhere. The news leads to the first run on a British
Sept 13, 2007
bank for more than a century as thousands of depositors queue to get
their money out. The crisis only passes when Chancellor Alistair Darling
agrees to guarantee all savings.
Stan O'Neal resigns as chief executive of US investment banking giant
Merrill Lynch after it writes down £4 billion from its asset books because of
Oct 30, 2007 exposure to bad debt. Within days, Charles Prince, chief executive and
chairman of Citigroup, resigns after the bank reveals losses of around £5
billion because of subprime exposure.
Nationwide building society warns that house prices will stagnate in 2008.
On the same day, Adam Applegarth resigns as chief executive of Northern
Nov 16, 2007
Rock. Later in the month, Mervyn King, governor of the Bank of England,
warns that growth in the UK economy will slow down and inflation will rise.
Bank of England cuts interest rates for the first time since 2005, amid
signs the economy is slowing. Two weeks later it makes £10 billion
Dec 6, 2007
available in loans to UK banks to ease the credit crunch as many banks
and building societies withdraw 100 per cent mortgages.
With banks around the world revealing more and more losses, US Federal
Reserve boss Ben Bernanke admits the outlook for the US economy is
bleak. James Cayne, head of Bear Stearns, finally resigns over subprime
Jan 11, 2008
losses. On January 21, global stock markets, including the FTSE 100 index
in London, suffer their biggest falls since the terrorist attacks of September
11, 2001.
Bradford & Bingley reduces the value of its subprime related investments
Feb 13, 2008 by £144 million, having said just weeks earlier it did not expect to suffer any
write-downs.
Bear Stearns is bought by JPMorgan Chase for £120 million, having been
March 18, 2008
valued at £9 billion a year earlier.
Royal Bank of Scotland, Britain's second-biggest banking group, asks
shareholders for £12 billion to shore up its finances, one of the largest
April 22, 2008
rights issues in the country's history. Two days later, house builder
Persimmon calls a halt to all new building projects as house sales collapse.
Bradford & Bingley launches an emergency £300 million rights issue as full
May 14, 2008 scale of its subprime losses becomes clear. UK inflation hits 3 per cent as
the cost of food and fuel goes through the roof.
Barclays becomes the latest big bank to admit to problems as it
June 25, 2008 announces plans to raise £4.5 billion by issuing 1.6 billion new shares,
which are mostly sold to Middle Eastern investors.
Shares tumble as world stock exchanges slump into a bear market (one in
which shareholders want to sell) with the FTSE 100 index recording its
July 1, 2008
seventh straight weekly fall. Property sales in the UK slump to a 30-year
low.
Alistair Darling says Britain is suffering its worst economic crisis for 60
Aug 30, 2008 years. Days earlier, figures reveal that house prices have dropped 10 per
cent in the past year, the biggest fall since 1990.
US Treasury steps in to rescue Fannie Mae and Freddie Mac, the two
companies which guarantee half of all US mortgages, exposing US
Sept 8, 2008 taxpayers to £2.9 trillion of debt in the world's biggest financial bail-out. US
Treasury Secretary Hank Paulson says the two companies are simply too
big to be allowed to fail.
Lehman Brothers files for bankruptcy and becomes the first major bank
to collapse since the start of the credit crisis. Alan Greenspan, the former
chairman of the US Federal Reserve, describes the failure as "probably a
once in a century type of event" and warns that other major firms will
Sept 14, 2008 .
also go bust.
This event came to operate as trigger for the financial panic that
occurred in the fall of 2008 and almost caused a meltdown of world’s
financial system.
9.3 APPENDIX: Introducing the Argument: Confidence and Its Double Structure
Despite its importance, there only exists a very small number of studies that look
at the role of confidence in finance (e.g. Walters1992; for a review, see Swedberg
forthcoming). Walter Bagehot’s classic work Lombard Street (1873). Bagehot is
interesting in this context because he was well aware of the special role that confidence
plays in the banking world. He also tried to explain the role that confidence plays in
unleashing a financial panic, something that is of special relevance for this paper.
The banking system, Bagehot notes, always demands an extraordinarily high
level of trust, much higher than elsewhere in the economy. In this part of the economy
there has to exist, as he puts it, “[an] unprecedented trust between man and man”
There are mainly two reasons for this, one having primarily to do with liquidity,
the other with solvency. The first reason for the unprecedented level of trust to exist in
the banking system has to do with maturity transformation - that deposits are short-
term, while loans are long-term. If the depositors do not have full confidence that their
money is safe, they will demand it back. And when they do so, the bank will be in
trouble since it lacks liquid resources to pay the depositors. The larger the amount that
is lent out, in relation to the amount deposited, the more tenuous this type of confidence
will also be.
The second reason for confidence being extraordinarily important in the banking
system has to do with losses that the bank may occur through its loans. A bank is
extraordinarily vulnerable, in other words, not only because of liquidity-related
troubles, but also because of its losses, since these must be offset against the capital of
the bank.
Again, the more that has been lent out, the more vulnerable a bank is and losses
increase in their turn the leverage ratio dramatically. What this means, to repeat, is that
the level of trust or confidence has to be higher in the area of banking than elsewhere in
the economy. Bagehot also explicitly states that what is especially dangerous for the
banking system is a situation in which there are hidden losses. The reason for this is that
when these losses become known, a general panic can be set off that goes well beyond
the problem banks. Anything may suddenly reveal the true economic situation, with a
free fall of the whole banking system as a result. Or in Bagehot’s words: “We should
cease…to be surprised at the sudden panics [in the banking system]. During the period
of reaction and adversity, just even at the last instant of prosperity, the whole structure
is delicate. The peculiar essence of our banking system is an unprecedented trust between
man and man; and when that trust is much weakened by hidden causes, a small accident
may greatly hurt it, and a great accident for a moment may almost destroy it” (Bagehot
[1922 [1873]:151-52; emphasis added).
Sometimes investors suddenly losing confidence in the banking system, when

they realize that there are hidden losses. In order to get a more fine-tuned
understanding of how a financial panic may be unleashed by hidden losses, this topic
has to be addressed.
My argument in this report is that while Merton has focused on one important
role that a loss of confidence plays in the financial system, it is not the only one, and
perhaps not even the central one for understanding a financial panic. The real problem
with a loss of confidence occurs not when banks are solvent and there exist rumours to
the contrary (the proxy sign is negative and the economic situation is positive). It occurs
instead when some banks are not solvent, and this is not known (the
( proxy sign is
positive and the economic situation is negative). We are then in Bagehot’s dangerous
situation, in which it is not known who has losses and who has not, and in which an
accident may set off a general panic that endangers the whole financial
financi system (see
Fig.1). Or to phrase it differently, Merton’s mechanism only comes into play in an
important way, in the situation of hidden losses, as described by Bagehot.
Fig. 1: Proxy Signs and Nature of Confidence
Explanation: A proxy sign can in the ideal case be assumed to be either aligned with the
state of affairs or not. In the former case, a positive proxy sign correctly indicates a
positive state of affairs; and a negative sign correctly indicates a negative state of affairs.
Confidence is maintained
tained in both of these cases, since the actor has correct information
(++/--).When,
).When, in contrast, the proxy sign and the situation are not aligned and the proxy
sign therefore misrepresent the situation, confidence will suffer.
9.4 APPENDIX: Confidence and Fear Index plays huge role
Source: Figures from Bloomberg Terminal
9.5 APPENDIX: Securitisation and Leverage
9.6 APPENDIX: ABOUT LEHMAN BROTHERS
The modern Lehman Brothers (founded in 1844 as a dry goods business in

Alabama), emerged once more as an independent investment bank in 1994 when it was
spun off from American Express (e.g. McDonald and Robinson 2009, Rose and Ahuja
2009). Richard Fuld, who had joined Lehman in 1969, was now appointed its President
and CEO. Under his leadership, Lehman continued to not only carry out the traditional
tasks of an investment bank, but also to push deeply into the new financial markets that
were emerging at the time. For one thing, it early on became a leader in the subprime
securitization market.
Till Fuld was pushed to the side in June 2008, he ran Lehman in an authoritarian
manner, creating the very aggressive and competitive type of corporate culture that
seems to be characteristic of modern investment banks.3 Anyone who was 15 perceived
as a threat by Fuld was eliminated, and so were critics who from early on argued that
Lehman was heading for trouble (McDonald and Robinson 2009). As many successful
CEOs, he also kept a lifestyle that isolated him from the real world. It should also be
emphasized that Fuld’s personal experience was as a bond trader and that he had little
understanding of such new financial instruments such as collateralized debt obligations,
credit default swaps. As we soon shall see, this lack of sophistication on Fuld’s part
helps to explain some of his clumsy attempts to deal with the crisis. Lehman was one of
the leaders in the production of securitized mortgages and also owned two mortgage
firms, BNC in California and Aurora Loan Services in Colorado.5 According to The Wall
Street Journal, “Lehman established itself [in the mid- 1990s] as a leader in the market
for subprime-mortgage-backed securities. It built a staff of experts who had worked at
other securities firms and established relationships with subprime-mortgage lenders”
(Hudson 2007).
9.7APPENDIX: Nature of Credit Crisis Worsened:
The growing concern caused a sharp drop in the issuance of asset-backed
securities, particularly those of lower quality, in August 2007. All types of asset-backed
securities and CDOs were adversely affected from September 2007, subprime
residential MBSs and CDOs of asset-backed securities issues shrank, and even prime
residential MBSs were substantially lower (Figure). Investors realized that the assets
were riskier than had previously been thought, and the cost of insurance to cover
default risk using credit default swaps (CDS) also had become much more expensive.
President Bush expressed the same idea, but in his own language, when he said,
“this sucker could go down.”
According to economist Robert Lucas, “Until the Lehman failure the recession
was pretty typical of the modest downturns of the post-war period…After Lehman
collapsed and the potential for crisis had become a reality, the situation was completely
altered” (Lucas 2009:67). According to Alan Blinder, another well-known economist,
“everything fell apart after Lehman…After Lehman went over the cliff, no financial
institution seemed safe. So lending froze, and the economy sank like a stone. It was a
colossal error, and many people said so at the time” (Blinder 2009).
Two months later Henry Paulson, the Treasury Secretary, explained that the
failure of Lehman Brothers had led to a systemic crisis and to the evaporation of
confidence in the financial system:
9.8 APPENDIX: Consequences of Lehman Failure
For a few days, this decision seemed harsh but fair. But then the markets realised
the implication of Lehman’s failure: no financial institution’s debt was safe. If you lent to
someone, not only might they not pay you back; the government wouldn’t either. Given
that it was unclear who was running which risks, no financial institution was safe. At
that point the argument was decided firmly in favour of the debt market’s pessimism,
and equity markets plunged.
This led immediate consequences for the other three large broker/dealers.
Merrill Lynch, the next most vulnerable firm, quickly sold itself to Bank of America. The
final two, Goldman Sachs and Morgan Stanley, turned themselves into banks. This
allowed them to access funding from the FED and to be able to fund themselves using
retail deposits (something broker/dealers could not easily do).
Meanwhile, the money markets dried up. Financial institutions became
increasingly unwilling to lend, either to each other or to anyone else. This began to
seriously affect the broader economy. Share prices crashed as the market digested the
likely impact of slowing demand and more expensive credit.
9.8.1 Bailouts and Busts:

The fallout from the failure of Lehman arrived quickly. Washington Mutual was
the largest thrift in America. As a prominent loser in the Crunch, WaMu, as it was
known, was already looking vulnerable. A downgrade of its credit rating on the 15th
September raised concerns further. WaMu found deposits being withdrawn. The
resulting pressure on funding caused WaMu’s regulator to act. On the 26th September
2008, the Office of Thrift Supervision took control and appointed the FDIC as receiver.
WaMu’s branches and assets were quickly sold to JPMorgan. An institution with total
assets of over $300B had failed in less than two weeks. It was clear at this point that
dramatic action was needed to prevent a string of bank failures. Not saving Lehman
might have been a good decision ethically, but it began to look like very bad economics.
Many financial institutions were vulnerable, and even the largest banks were having
problems rising funding. Government intervention was needed across the whole
financial system.
The U.S. Treasury suggested a program to purchase distressed assets from
financial institutions, the Troubled Asset Relief Program or TARP. This did not meet with
favour from legislators, not least because the original plan gave extraordinary discretion
to the Treasury with rather little oversight. The House of Representatives voted down
the first version of the TARP, presumably taking the view that if the Treasury bought
troubled assets for their fair value then it would not have done any good, but if it bought
them for more than they were worth, then it amounted to a simple subsidy to the banks
who had taken the biggest risks.
The TARP was restructured to include extra oversight and require that the
Treasury obtain equity stakes26 in the firms that they assist. This at least involved less
moral hazard than buying assets, and the new TARP was passed on the 3rd October
2008. The program was immediately put to use. Over $125B of new capital was injected
into leading American financial institutions. At the same time, other governments were
intervening to save their banking systems. For instance, the UK government enacted a
£500B plan28; Fortis was rescued by the Dutch, Belgian and Luxembourgeois
governments; Hypo Real Estate Holding was bailed out by a consortium including the
Bundes bank; and all three of Iceland’s big banks were nationalised. Figure shows some
of the larger injections of state capital: in addition a number of banks raised extra
capital privately.
The immediate crisis was thereby averted. The recapitalisations and rescues
gave the largest financial institutions some breathing space, and a modicum of
confidence returned to the market. The Central Banks helped too, flooding the markets
with liquidity and cutting interest rates in a coordinated move. Various European
nations including Ireland, Denmark and Austria extended the scope of their deposit
protection, further bolstering confidence.
Further bank recapitalisations continued through the rest of October 2008: the
Swiss banks got more money on the 16th; ING on the 19th; smaller U.S. banks on the
27th. But the pattern was now clear. Governments would bail out their financial
institutions by lending hem money and injecting extra capital. Shareholders would
suffer, but the financial system would not be allowed to collapse. The position of
taxpayers was less clear. A lot of money had been spent by governments in a short
period of time. Significant stakes had been purchased for that money in a depressed
market. Some of these would prove to be good investments. But there are other assets
the taxpayer made which, in the Deputy Governor of the Bank of England’s words
‘clearly have a level of defaults in them [which we are] not quite sure how will balance
out against the residual of the capital. That is, losses are possible.
9.9 APPENDIX: Policy makers & Regulators Response
The principles for mitigating financial crises were established more than 100
years ago in the book "Lombard Street: A Description of the Money Market" (1873) by
Walter Bagehot. In his book, Bagehot stressed that in order to stop a panic, the central
bank should give the impression that "though money may be dear, still money is to be
had." Bagehot went on to say that the central bank should "lend freely, boldly, and so
that the public may feel you mean to go on lending." Central bankers continue to follow
this prescription, which is why they usually lower interest rates when a financial crisis
occurs.
A second important principle for minimizing the effects of a financial crisis is to

maintain confidence in the safety of the banking system. This prevents a "run on the
bank" in which consumers rush to withdraw their deposits. Confidence in the banking
system is often secured by providing government guarantees on bank deposits, such as
the U.S. FDIC insurance program.
It is also important for policymakers to react swiftly when a crisis strikes. Indeed, the
earlier policy-makers recognize and react to a crisis, the more effective their actions are
likely to be. If adequate liquidity is quickly provided and confidence in the banking
system is maintained, the effects of a crisis can be mitigated.
Policy/
What they did? Market Effects Example
Regulators
1. Has been extremely active in 1. Helped to 1. When Bear
making sure that the financial maintain Stearns was on the
system continues to function confidence verge of bankruptcy
properly during the credit crisis. 2. Liquidity in the the Fed guaranteed
2. The Fed lowered its key federal financial system as a large portion of
funds rate to provide additional part of efforts to Bear Stearns'
liquidity to the financial system mitigate the liabilities in order to
The Federal
3. Expanded the range effects of the facilitate
Reserve
of collateral it would willingly to credit crisis. a takeover by
accept in return for loans. JPMorgan.
4. Provided direct lines of credit to a
broader variety of financial
institutions (previously
only commercial banks could
borrow directly from the Fed.)
1. The executive branch of the 1. Providing fiscal 1. placed Fannie

government has also been closely stimulus to the Mae and Freddie
involved in maintaining stability in economy. Mac under
the financial system. 2. Took conservatorship as
2. These efforts have included direct extraordinary part of a four-part
aid to a number of prominent measures to secure plan to strengthen
The financial firm (named as FHFA in confidence in the the housing
Government conjunction with treasury financial system agencies
department) through a variety of
3. The famous bailout plan for nig guarantees,
financial firms (refer to below table insurance
for figure) programs, loans
and direct
investments.
1. Continue to follow the same 1. Helped to gain 1.State Bank of
policy (lend freely, boldly, and so the confidence of India
The that the public may feel you mean public
centralised to go on lending)
bank 2.lowered their interest rates on
lending and increased interest rate
on deposits
9.10 APPENDIX: Solutions for Credit crunch
This depends on which phase of credit crunch that bank is in:
Three Phases of Crisis Management
1. Short-term: Immediate Damage Containment

2. Medium-term: Restructuring Insolvent Banks
3. Long-term: Systemic Restructuring
Traits of good strategies
1. Transparent, early recognition preserves trust

2. Politically and financially independent agencies
3. Maintain market discipline
4. Repair the real economy esp. Creditworthiness
10. REFERENCES:
Baesens, B. (2009). Credit Risk Management. Oxford, United States: Oxford University Press.
Bagehot, W. (1922). A Description of the Money Market. Lombard Street , 151-52.
Barker, T. (2009, Jun 5). Understanding and Resolving the “Big Crunch”. The Cambridge Trust for New
Thinking in Economics .
Ben Bernanke, Paulson Henry, and Sheila Bair. (2008, October 14). Statements by Paulson, Bernanke
Bair. Wall Street Journal .
Bryan-Low, C. (2009). “Lehman Europe Claims Begin to Come In”. Wall Street Journal , September
25.
Gabaix, X. A. (2007). Limits of Arbitrage: Theory and Evidence from the MBS market. Journal of
Finance , 557-596.
Mizen, P. (2008). The Credit Crunch of 2007-2008. FEDERAL RESERVE BANK OF ST. LOUIS REVIEW ,
531-568.
Rayner, G. (2008, Sept 15). Credit crunch Time line from Northern Rock to Lehman Brothers.
Retrieved April 1, 2010, from www.telegraph.co.uk:
http://www.telegraph.co.uk/finance/newsbysector/banksandfinance/2963415/Credit-Crunch-
timeline-From-Northern-Rock-to-Lehman-Brothers.html
Runde, Jochen (1994b). ‘Keynesian uncertainty and liquidity preference’, Cambridge

Journal of Economics, Vol. 18, No. 2, pp. 129–144.

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Tsunami of Credit Crunch gulp down Lehman Brothers

Student ID: 4745353

Subject: Finance and Accounting Management

2.1 Definition & Terminology:

An economic condition in which investment capital is difficult to obtain.

A credit crunch makes it nearly impossible for companies to borrow because

2.2 What exactly caused this to happen?

At the same time, U.S. residential subprime mortgage delinquency rates

5. Lehman Brothers up to the Weekend of September 13-14: 1

Fuld over believed that Lehman could weather any

5.1 Thought from one of the prime investor of Lehman Brothers:

Fig. 1 The Lehman Brothers share price in 2008

7. The Accident that Punctured Confidence and Unleashed the

In the Indirect losses you can refer to below diagram.

9.1 APPENDIX: History - 1929 to present

The banking system, Bagehot notes, always demands an extraordinarily high

Sometimes investors suddenly losing confidence in the banking system, when

Fig. 1: Proxy Signs and Nature of Confidence

Source: Figures from Bloomberg Terminal

9.5 APPENDIX: Securitisation and Leverage

The modern Lehman Brothers (founded in 1844 as a dry goods business in

9.8.1 Bailouts and Busts:

9.9 APPENDIX: Policy makers & Regulators Response

A second important principle for minimizing the effects of a financial crisis is to

1. The executive branch of the 1. Providing fiscal 1. placed Fannie

This depends on which phase of credit crunch that bank is in:

Three Phases of Crisis Management

1. Short-term: Immediate Damage Containment

Traits of good strategies

1. Transparent, early recognition preserves trust

Bagehot, W. (1922). A Description of the Money Market. Lombard Street , 151-52.

Runde, Jochen (1994b). ‘Keynesian uncertainty and liquidity preference’, Cambridge

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