Business & Finance Economics

Lehman Crisis Simplified

Through this article, the author tries to explore the background of one of the biggest financial failures in the world.
Investors across the globe lost billions of dollars in this great financial trauma in the US.
The banking system in the US was crippled down; thousands and thousands of people lost their jobs and their social status too.
Let's first examine the normal scenario in which the Wall Street firms like Lehman Brothers used to operate.
Part-I Everyone in this world wants to own his/her house.
People always try to buy a dream house from their own fund or by availing a home loan from any banking institution.
There was a great demand for American Home loans in early 2004.
US banks used to facilitate home loans to people who desired to buy a house.
Since these loans had a payback period of over 20-30 years and it would take a long time for the issuing banks to recover its money, the US banks wanted any easier alternatives.
Wall Street firms and investment banks like Lehman Brothers Inc.
would buy these American home loans from US banks.
Their investment bankers and so called experts at mortgage securities desk would convert these loans into another investment vehicles called as Collateralised Debt Obligations (CDOs).
In other words, investment banks in the US used to buy home loans which banks had already issued to customers, cut them into smaller pieces, packages the pieces on the basis of interest rate, value, and duration of the loans, and then sell them to investors across the world.
This new type of structured investment vehicles (SIVs) were named as "High Grade Structured Credit Enhanced Leverage Fund".
Investors from all over the world, e.
pension funds from Japan, insurance funds from Finland, buy shares in nay of these SIVs, like mutual funds.
The banks from whom investment banks like Lehman Brothers had purchased home loans would send monthly cheques which they received from the borrowers of home loans.
When an investor purchased CDOs, he was supposed to receive a share of the monthly EMI paid by the actual borrowers of the home loans.
This was exactly what Lehman Brothers and other investment bankers used to do.
They distribute the EMI received from the loan-issuing banks among the investors in the funds like SIVs.
As demand for the CDOs started growing across the global investment community, the investment bankers (like Lehman Brothers) who were meant to sell these instruments also started investing a significant portion of their own capital in these funds.
Gradually the markets for CDOs started expanding with traders and investors buying and selling these as if they were shares of a company.
They happily forgot that the safety of these loan based products depended upon the repayment capacity of the borrowers who took the loans.
As American investment banks like Lehman were churning more and more home loans into CDOs and selling them or investing their own money, there was a pressure on the banks to issue more loans so that they can be sold to the Wall Street firms for a commission.
Flowing with the stream of demand for more loans, slowly banks started lowering the credit quality (i.
qualification criteria for availing a home loan) and aggressively used agents to source new loans.
It was sometime in 2005 that this slippery slope went to such an extent that almost anyone in the US could buy a home worth $100,000 (Rs.
45,00,000) or more without income proof, without other assets, without credit history, sometimes even without a regular source of income.
These loans were termed as NINA (No Income No Assets).
Home loans were easy to get, so more and more people were buying houses.
And as the eternal Law of Demand suggests, the increased demand for houses caused the price to increase.
The rising prices created even more demand, as people started to look at homes as investment - that never went down in value.
Herding behaviour was working over there and people in the real estate business were on cloud nine then.
Part-II In late 2006, Mortgage lenders smelled something wrong that they had never seen before.
People would choose a house, sign all the mortgage papers, and then fail to make even their very first payment.
This phenomenon was attributed to the rising rate of interest from 2004-2006.
Most of the borrowers had taken loans on variable rates that started getting reset to higher rates, which in turn meant higher EMIs the borrowers had to pay.
But it was unexpected and unplanned for the borrowers.
Earlier, in case a loan was defaulted, the house was seized and sold in the market for higher prices.
But now the scene was different.
As more people defaulted, more houses came to the market for sale.
But where were the buyers now?? With no buyers, prices went even further down.
In early 2007, the bad times for the US investment banks had already begun.
They were no more getting EMIs in time from the borrowers, but there were the calls from investors about not getting their interest payments that were due.
Wall Street firms stopped buying home loans from the local banks.
This had a devastating effect on particularly the small banks and finance companies, which had borrowed money from larger banks to issue more home loans thinking they could sell these loans to Wall Street firms (like Lehman) and make money.
Everyone got into a mad scramble to seize and sell the homes in order to get back at least some of the money.
But there were just not enough buyers.
Consequently, the global financial cobweb waived around mortgage was to collapse.
Lehman Brothers - once a top US investment bank - was ruined into ashes.
A number of large and small firms were crumbled over the dwindling asset values.
Others like AIG, Washington Mutual and Wachovia are still struggling to sustain.
The Indian Stock market also reacted sharply as Lehman Brothers and others sold their investments in the country in an effort to salvage whatever is good in order to make up for the mortgage related loss.
Investors including hedge funds, pension funds, and insurance companies all over the world have lost billions of bucks.
Everyone is blaming the people who could not repay their home loans for this crisis.
But, financial institutions who lent all this money to the people with low credit quality should also be blamed for this entire episode, as they built fancy derivative packages and in effect facilitated billions of dollars to these low quality loans.
Abhijeet Chandra Lecturer (Management) BLS-ITM, Bahdurgarh (Haryana)

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