A Project

On

“LEHMAN BROTHERS COLLAPSE IN 2008”

Submitted By:

______________visit for any project

www.solvezone.in____________________________

Under the Guidance of:

______________________________________________

IN PARTIAL FULFILMENT OF THE REQUIREMENT OF PGDM

PROGRAMME OF INSTITUTE OF MANAGEMENT AND
TECHNOLOGY GHAZIYABAD

Page 1 of 61
 Title Page

Student Name:

Enrollment ID –

Course Name:

Subject Name:

Subject Code:

Page 2 of 61
 CERTIFICATE OF GUIDE

This is to certify that _____________________________, a student of IMT – CDL Ghaziabad

has completed the project work on “LEHMAN BROTHERS COLLAPSE IN 2008” under

my guidance and supervision. I certify that this is an original work and has not been copied

from any source.

Signature of Guide -------------------------------------

Name of Project Guide ------------------------------------------

Date ----------------------

Page 3 of 61
 CERTIFICATE

I, ______________________ certify that the project report entitled “LEHMAN BROTHERS

COLLAPSE IN 2008” is an original one and has not been submitted earlier to any other

institution for fulfillment of the requirement of a course of Management Programmed MBA.

Student Signature

Rajat Sharma

Page 4 of 61
 ACKNOWLEDGEMENT

It has been a very knowledgeable experience of my life to carry out the research work. Thus,

the research is carried out to enrich my knowledge towards the role of marketing activities that

ensure the sustainability of the business operations. To carry out the research work many

challenges have been faced and thus it has been overcome through the research work. This

research work would not be possible without the guidance and help of the friends and

professors to complete the research work. This research would not be completed without the

support of my friends as well. My academic guide need to be thank the most without who’s

help the research work would have been impossible to complete. My friends continuous

support and encouragement throughout the research work help me to complete the research

work completely. Finally, I would thank all my professional from the retail industry who help

me out to carry out the research work and the survey of the research. The support and guidance

from all has been most inspiring for me throughout the research work.

Heartfelt thanks and warm wishes,

Yours sincerely,

Rajat Sharma

Page 5 of 61
 Table of Content

Sr. No. Chapter Name Page Nos.

1] Chapter I: Introduction 07-09

2] Chapter II: Theoretical Framework 10-15

3] Chapter III: Review of Literature 16-18

4] Chapter IV: Objectives and Scope of Study 19-22

5] Chapter V: Research Methodology 23-25

6[ Chapter VI: Data Analysis 26-49

7] Chapter VII: Findings, Recommendations 50-57

8] Chapter VIII: Conclusion 58-58

9] Chapter IX: References 59-61

Page 6 of 61
 Chapter I: Introduction

The global financial crisis of 2007 has cast its long shadow on the economic fortunes of many
countries, resulting in what has often been called the ‘Great Recession’. What started as
seemingly isolated turbulence in the sub-prime segment of the US housing market mutated into
a full blown recession by the end of 2007. The old proverbial truth that the rest of the world
sneezes when the US catches a cold appeared to be vindicated as systemically important
economies in the European Union and Japan went collectively into recession by mid-2008.
Overall, 2009 was the first year since World War II that the world was in recession, a
calamitous turn around on the boom years of 2002-2007.

The crisis came largely as a surprise to many policymakers, multilateral agencies, academics
and investors. On the eve of the outbreak of the financial crisis, Jean-Philippe Cotis of the
OECD (2007) declared: ‘...for the OECD area as a whole growth is set to exceed its potential
rate for the remainder of 2007 and 2008, supported by buoyancy in emerging market
economies and favourable financial conditions’. In the wake of the global recession of 2008-
2009, the economics profession has come under a great deal of criticism from leading scholars.
Krugman (2009a) chides fellow economists for their ‘...blindness to the very possibility of
catastrophic failures in a market economy’. Galbraith (2009) offers a robust critique of the
economics profession and argues that both explicit and implicit intellectual collusion made it
difficult for the leading members of the profession (invariably associated with elite American
universities) to encourage a genuine discourse based on alternative views. The result was that
a rather limited intellectual conversation took place between essentially like-minded scholars.

Following events in 2008, particularly the collapse of Lehman Brothers in September, risk-
loving banks and investors around the world rapidly reversed their perceptions. Due to the
complexity of the mortgage-backed securities, they were, however, unaware of the true extent

Page 7 of 61
of the liabilities linked ultimately to a rapidly deteriorating US housing sector. Consequently,
liquidity quickly dried up, almost bringing the global financial system to its knees. Some
commentators even questioned whether American-style capitalism itself had been dealt a death
blow

Many – but by no means all – developing and emerging economies felt the deleterious effects
of the US recession by the end of 2008. The typical outcome was a growth deceleration
(ranging from mild to major) in many parts of the developing world, but there were cases of
outright recessions too. Hard-hit countries include Armenia, Mexico, South Africa, Turkey,
the Baltic States, and Ukraine. At the same time, the two most successful globalizers of recent
times have avoided a major downturn, which has been crucial for kick-starting the recovery in
2009. China has, in particular, managed to keep their economy growing in 2009 at a rate of 8.7
per cent, which was supported by the massive stimulus package put together by the Chinese
authorities (amounting to US$585 billion). With a smaller stimulus, the Indian economy has
also proven to be resilient thanks to strong domestic demand, with growth only falling to 6.7
per cent in 2009.

The world economy enters 2010 in an environment fraught with considerable degree of
uncertainty. While the worst seems to be over, and while one hears proclamations of a robust
recovery, the jury is still out on the lessons and legacies of the tumultuous economic events of
2008 and 2009. How apposite is the epithet of the ‘Great Recession’? What were the historical
and global circumstances that led to its seemingly sudden emergence? To what extent were
policy errors by past US administrations responsible for the crisis? How have policymakers
across the world responded to such economic volatility? How effective have these responses
been? What is the way forward in a post-crisis world? These are the questions that are probed
in this paper. In raising these questions and seeking to respond to them, the paper does not
intend to offer a blueprint for a post-crisis world, nor does it aim to offer policy prescriptions
that seek to uphold the institutional agenda of any particular international organization or
national government.

Page 8 of 61
Lehman Brothers’ bankruptcy created the biggest bankruptcy in the U.S. history with its bank
debt of $613 billion, bond debt of $155 billion against total assets of $639 billion, and more
than 100,000 creditors (Onaran & Scinta, 2008). Lehman's hundreds of billions of dollars in
losses was a result of having held on to large positions in subprime and other lower-rated
mortgage tranches, bad mortgage finance and real estate investments. Lehman Brothers started
to lose investors’ confidence and its shares plunged during summer 2007, when the subprime
mortgage crisis began. As the situation of the mortgage market worsened, Lehman Brothers
suffered a huge loss as being one of the biggest mortgage players (Hudson, 2007).

Page 9 of 61
 Chapter II: Theoretical Framework

2.1 Background of Study:

After losing government backing, Lehman desperately began to find a buyer, focusing on
Barclays, the big British bank, and Bank of America. Bank of America eventually lost interest
in acquiring Lehman after it learned about Lehman’s losses in commercial real estate and could
not get support from the government on some of Lehman’s most-troubled real-estate assets.
By Sunday September 14, the other hope from Barclays vanished as its English financial
authorities were afraid that Lehman was a lot weaker than it thought and refused to approve
the deal (Swedberg, 2009).

On September 15 Lehman Brothers filed for Chapter 11 bankruptcy protection after failing to
find government rescue and any buyers. One day later, Barclays announced its agreement to
purchase the core business of Lehman Brothers. On 4 September 20, 2008, a revised version
of the deal, which includes Lehman’s North American investment-banking and trading
divisions along with its New York headquarters building and responsibility for 9,000 former
employees, was approved by U.S. Bankruptcy Judge James Peck. After a 7-hour hearing,
James Peck ruled, "I have to approve this transaction because it is the only available
transaction." Luc Despins, a lawyer for the creditors committee, said the creditors were not
objecting to the sale, but not supporting it, either. He said, "The reason we're not objecting is
really based on the lack of a viable alternative," adding that they did not support the transaction
because there had not been enough time to properly review it (as cited in Chasan, 2008).

2.2 A History of Crisis:

Page 10 of 61
Given the historical evidence, insufficient attention was paid to the costs associated with low
frequency, high impact events, particularly among the proponents of the ‘Great Moderation’.
This inadequate perception of risk stands in contrast to the fact that between 1970 and 2008,
there were: 124 systemic banking crises; 208 currency crises; 63 sovereign debt crises; 42 twin
crises; 10 triple crises; a global economic downturn about every ten years; and several price
shocks (two oil shocks in the 1970s, the food and energy price shock in 2007-2008 discussed
below)

Contemporary studies of the historical evidence such as IMF (2009a) and Reinhart and Rogoff
(2009) have shown that such financial crises typically induce a sharp recession, which last
approximately two years. Consumption, private investment and credit flows are also slow to
improve, which is driven by deleveraging of debts and risk perceptions. As a consequence,
recovery is slow with unemployment levels continuing to rise for a number of years after the
economy has started to grow again.

Economic crises are not just a peculiarity of advanced economies. Indeed, developing countries
have been highly vulnerable to a plethora of banking, external debt, currency, and inflation
crises during recent decades. The debt crisis of the 1980s, the Asian financial crisis of the late
1990s and the more recent debt crisis in Latin America in the 1990s and 2000s have all resulted
in deep recessions. Many developing countries have repeatedly suffered crises due to poor
macroeconomic management and policymaking. For example, Argentina has experienced four
banking crises since 1945 (Reinhart and Rogoff 2009)

2.3 The Synchronized global boom of 2002-2007

Amid the doom and gloom of 2008 and 2009, it was easy to forget that the pre-crisis period
between 2002 and 2007 was one of historically high rates of growth, especially for developing
countries. There was a relatively mild global downturn in 2001 after the bursting of the dotcom
bubble. This was followed by a synchronised boom that lasted until 2007. Many countries,
particularly in such regions as Africa, grew at rates not seen since the 1960s and early 1970s,
signaling a departure (at least statistically) from the ‘Lost Decades’. This led some economists

Page 11 of 61
to hail the onset of a global ‘platinum age’. These advocates of the platinum age are pitted
against those who still maintain that the golden age of global growth was the 1950-1973 period.
Indeed, a former Chief Economist of the World Bank once noted that the 1960s represent the
golden age of economic development

However, in hindsight, the 2002-2007 period stands out as a case of an unsustainable boom.
There was a surge in various forms of external finance (export revenues, remittances, private
capital flows) that fed a consumption boom in advanced economies and a surge in investment
and exports in the developing world led by China and other emerging economies. Overall, the
increase in credit flows pushed the cost of capital down (World Bank 2010).

In addition to this phenomenon, during 2007 and the early part of 2008, many developing
countries were buffeted by food and energy price shocks that impaired the fiscal and current
balances of the affected economies, led to food riots and protests in many countries and pushed
millions into poverty. This process was also an outcome of the global boom and the surging
demand for goods in China, India and other fast-growing emerging economies. This situation
was more pronounced for the non-oil or mineral exporters, but even within countries benefiting
from the commodity bonanza, the poor were suffering from skyrocketing inflation without
seeing much of the returns from the exports. The 2007-2008 food and energy price shocks
appears to have pushed more than 100 million people in the developing world into transient
episodes of poverty.

The bankruptcy of Lehman Brothers indeed has caused a considerable impact on the economy,
and the consequences are ongoing to an unpredictable end. The scope of the impact is in a wide
variety of levels; economic, political, social, personal, and the national and global levels.
Needless to say, individuals and organizations which have been and will be affected by this
crisis have been overwhelmed.

Cause of the Crisis of Lehman Brothers’ bankruptcy

Bursting of the Housing Bubble

Page 12 of 61
It was started in 1999 when the Federal National Mortgage Association (also known as Fannie
Mae) started the effort to make home loans more accessible to those with lower credit and
Savings than lenders which was typically required. The main objective was to help everyone
Attain the American dream of owning a house for themselves. Since these borrowers were
Considered high-risk, their mortgages had unconventional terms that reflected that risk, such
as higher interest rates and variable payments.

As of 2002, government-sponsored mortgage lenders Fannie Mae and Freddie Mac had
extended more than $3 trillion worth of mortgage credit. The role of Fannie and Freddie is to
repurchase mortgages from the lenders who originated them, and make money when mortgage
notes are paid. Thus, ever-increasing mortgage default rates led to a crippling decrease in
revenue for these two companies. Initially if the borrowers could not pay the high interest rates
they opted to sell their mortgage as the prices of the properties were on the rise, but gradually
as the defaulters began to increase the prices of the properties stopped growing. Investors also
benefiting from the interest payments and premiums also had their incomes cut-off.

 Key issues arising from Lehman Brothers’ bankruptcy continue to challenge

industry participants. Firms on both the buy-and sell-sides of the market are beginning

to identify and implement risk mitigation measures to reduce the likelihood of future

credit and liquidity-based losses.

 Market participants, in particular large and complex financial institutions, continue to

address the challenges of accurately quantifying, aggregating, monitoring, and reporting

market, credit, and liquidity risks.

 Clients have placed increased scrutiny on selecting and monitoring derivative and other

counterparties, including their prime brokerage relationships. This focus includes

Page 13 of 61
 evaluating risks inherent in contractual agreements and the legal rights and remedies

afforded by such arrangements.

 Investors and counterparties are requiring added assurance that their assets and trade

obligations are adequately safeguarded, moving business and assets away from

arrangements and institutions perceived as less secure, or seeking to modify existing

contractual arrangements.

Focus on the critical aspects of risk management

Firms should focus on the following areas in order to mitigate the likelihood of future

market-and credit-based losses:

 Understand and monitor counterparty, market, and credit risks

 Firms should aggressively address the contractual, operational, and technical challenges

posed by counterparty risk, particularly on bilateral derivative trades and repurchase

agreements. Obtaining an accurate, consolidated view of risk across business units

remains challenging for many sell-side firms due to legacy infrastructure and disjointed

risk governance models.

 Measure, monitor and manage liquidity risk

 Management must have accurate daily views of positions, values, and liquidity measures.

The ability to monitor and quickly react to changes in liquidity of various asset classes

remains essential to maintaining solvency and financial creditability and viability in the

market place.

 Increase the operational effectiveness of collateral management and accurately capture

contractual terms

Page 14 of 61
 Counterparty collateral management functions at dealers may present hidden ongoing

sources of credit risk due to overtaxed systems and processes. The buy-side faces

different yet equally significant challenges in managing collateral efficiently in order to

optimize funding and reduce excess credit exposure to dealers and banks.

Page 15 of 61
 Chapter III: Review of Literature

The age of derivatives such as mortgage back securities (MBS), and Asset Back Securities
(ABS), with Collateralized Debt Obligation (CDO) as the number one product that have
produce a breed of rash financial officers who conjured Lehman’s billion of dollar profits out
of one of the most complex markets ever to show its head above Wall Street’s ramparts. Such
products had powered one of the most reckless housing booms in history (McDonald &
Robinson, 2010).

Lehman attempted to pledge illiquid, Lehman-structured instruments, such as certain

collateralized loan obligations, to Citigroup and JPMorgan, two of its principal settlement
banks. Citigroup rejected the assets proposed by Lehman, due to their illiquid characteristics
and the inability to establish reliable marks for such assets. While JPMorgan accepted
Lehman’s structured instruments, that bank demanded additional cash collateral after
conducting analyses showing that the collateral appeared less worth than par values assigned
by Lehman. JPMorgan’s collateral call was one of the contributing factors to the liquidity
problems that hastened Lehman’s bankruptcy (Valukas, 2010).

The proximate cause of the insolvency was that Lehman was overly exposed to the commercial
property market, and was sitting on a large warehouse of securities, CDOs, the value of which
were falling rapidly as a result of credit rating agency downgrades (Valukas, 2010). As the
economy downturn became more pronounced, Lehman inflated the value of its assets, thereby
further concealing the extent to which Lehman had increased its risk and leverage. In the year
preceding its bankruptcy, Lehman grossly overstated its expected return on investments
(Denbeaux, et al., 2011).

The housing problem was broad based; with a total US mortgage market of $ 14 trillion,
including the increase in subprime loans to borrowers with poor credit classified as subprime,
Page 16 of 61
which had mushroomed to $2 trillion. However, a number of other critical factors, such as the
fact that the link between the housing market, and the financial system was further complicated
by the growing use of exotic derivatives. Securities whose income and value came from a pool
of residential mortgages were being combined, sliced up, and reconfigured again, and soon
became the underpinnings of new investment products marketed as CDOs (Sorkin, 2009).

The financial institutions had kept a small fraction of the subprime loans they originated on
their books, for they might have learned a simple lesson from the market, not to make loans to
people who can't repay them. Or keep on making these loans; then sell them off to the fixed
income departments of big Wall Street investment banks, which will in turn package them into
bonds and sell them to investors. Thus they adopted what was called the "originate and sell"
model. This proved a hit, such that Wall Street would buy the loans. BNC mortgage was
founded to do nothing but originate and sell. Lehman Brothers thought that was such a great
idea that they bought BNC (Lewis, 2010).

The bankruptcies of the mortgage brokers in the US in late 2006, along with over supply of
housing, were the first signs of adjustment of the extraordinary rise in house prices that started
in 2002 (Kindleberger & Aliber, 2011). That followed by growing defaults on mortgages, and
made it difficult for financial institutions to determine the true value of the mortgage-related
assets held on their balance sheet. The markdowns in valuation reduced the value of bank
regulatory capital, forcing banks to raise additional capital, and creating uncertainty among
investors about the health of the banks (Harris & Kutasovic, 2010).

The increase of supply of credit available for mortgages was facilitated by securitization,
which begun in 1970 and initially involved depositing mortgages with similar attributes in
terms of maturity in a trust, essentially its own corporation, and then issuing new securities
called collateralized debt obligation (CMO) (Kindleberger & Aliber, 2011). However, the
abundance of credit accompanied by low interest had sprung numerous mortgage brokers,
motivated by fast profits, functioning as shadow banks, particularly in California, Florida, and
Nevada; they would lend, finance, and provide capital for house purchases, but they had to

Page 17 of 61
borrow the money in the first place from proper banks, mainly because they didn’t have the
money themselves
Minsky believed that increases in the supply of credit in good economic times and the
subsequent decline in the supply led to fragility in financial arrangements, and increased the
likelihood of a crisis. He focused on the variability in the supply of credit, and attached great
importance to the behavior of heavily indebted borrowers, particularly those that increased
their indebtedness to buy real estate in search for short-term capital gains. Their motive was
the profits from the increases in the prices of these assets, which they anticipated would greatly
exceed the interest payments on the borrowed money. When the economy slowed, many of
these borrowers would become distressed sellers, for the prices of these assets would be falling
(Kindleberger & Aliber, 2011).

Page 18 of 61
 Chapter IV: Objectives and Scope of Study

The present study is carried out based on the following objectives:

i) To comprehend the concept of ‘Financial Crisis-2008’ in detail

ii) To study the factors responsible for Financial Crisis in 2008 in United States

iii) To identify the reasons for bankruptcy of Lehman Brothers

iv) To examine the impact of Lehman Brothers Crisis on US and Global Economy

Scope of Study:

 Risk Management

When the major investment banks such as Lehman Brothers was a partnership, it was much
more conservative since the partners were risking their own money. Once it became a public
company, they did not mind taking on huge amounts of risk since they were no longer risking
their own wealth. In effect, they were using other people’s money to become super wealthy
(Friedman & Friedman, 2009).

 Corporate Governance

Regulators mostly trusted in market actors to self-regulate. As a result, some regulators were
convinced that there never was a mortgage bubble, because markets operated efficiently
(Kaufman, 2009). On the contrary, Valukas (2010) provides evidence that Lehman middle
management, and auditors possessed knowledge of risks, but obscured it from the directors.
Further, regulators warned the CEO Fuld on the excessive risk exposure of the firm months
before the firm failed, but he did not have the will to act (Turnbull & Pirson, 2014).

Page 19 of 61
  Incorrect Risk Pricing

Pricing risk involves adding fees or higher interest rates to compensate an investor for taking
on higher risk. There are several reasons why market participants failed to accurately price the
risks embedded in their investments. One example is the structural risk that CDO investment
introduced into the financial system. The average loss for senior CDO tranches was 68% while
mezzanine tranches lost 95% on average. These massive losses left banks crippled with
massive write-downs.

Another instance of incorrect risk pricing relates to CDS. A CDS contract has one party paying
a periodic premium and a counterparty that pays a lump sum in the case of a credit event, such
as the default of a pre-specified company. Bondholders used CDS as way of credit insurance.
AIG was a major player in the CDS market. When defaults mounted, it was unable to meet its
obligations as a default insurer and was taken over in 2008 by the U.S. government. $180
billion in government funds were needed to fulfill its obligations to its CDS counterparties,
including many large financial institutions. The bailout of AIG was argued to have prevented
many more failures through the fulfillment of its CDS obligations.

As financial assets became more and more complex, and harder and harder to value, investors
were reassured by the fact that both the rating agencies and bank regulators, who came to rely
on agencies, accepted as valid some complex mathematical models which theoretically showed
the risks were much smaller than they actually proved to be in practice. George Soros
commented, “The super-boom got out of hand when the new products became so complicated
that the authorities could no longer calculate the risks and started relying on the risk
management methods of the banks themselves. Similarly, the rating agencies relied on the
information provided by the originators of synthetic products. It was a shocking abdication of
responsibility.

 Principles of Financial Reform and Regulatory Proposals

Page 20 of 61
The recent financial crisis has brought some consensus on the changes that are needed in the
global financial sector. As Lipsky (2010) pointed out, some of the needed reforms include:1
Strengthen risk management at many financial firms.
 Re-evaluation of compensation schemes.
 Bolster capital standards.
 Reform regulation and improve supervision.
 Remove impaired assets from financial institutions’ balance sheets.

The reform will have to be weighed against both preserving efficiency and restoring growth,
both of which call for renewed credit flows. It is expected that reform of this nature will be
politically difficult, as various interest groups will try to influence the direction and the
outcome of the reform. There are, however, some key principles that must serve as guidelines
for the reform

 Financial Stability Oversight Council

The Financial Stability Oversight Council is charged to identify and address systemic risks
posed by large, complex companies, products, and activities before they threaten the stability
of the economy. It will make recommendations to regulators for increasingly stringent rules on
firms that grow large and complex enough to pose a systemic risk to the U.S. economy. It is
empowered to require nonbank financial companies that would pose a risk to the financial
stability to be regulated by the Federal Reserve. Under this provision the next AIG would be
regulated by the Federal Reserve. The Council will have the power to approve a Federal
Reserve decision to require a large, complex company to divest some of its holdings if it poses
a grave threat to the financial stability of the United States. The Council will create an Office

Page 21 of 61
of Financial Research within the Treasury with a staff of economists, accountants, lawyers,
former supervisors, and other specialists to support the council's mission.

 Improving Bank Supervision and Regulation

The Act will implement the Volcker Rule on banks, their affiliates and holding companies that
prohibits proprietary trading, investment in and sponsorship of hedge funds and private equity
funds, and to limit relationships with hedge funds and private equity funds. Nonbank financial
institutions supervised by the Fed will also face restrictions on their proprietary trading and
hedge fund and private equity investments.

 Financial Innovation

Financial innovation, or financial engineering, describes the creation of more and more
specialized investment instruments designed to meet specified risk exposure profiles or diverse
funding instruments, which can aid in credit flow. Examples pertaining to the financial crisis
are ARM (adjustable-rate mortgage), CDO (collateralized debt obligation), CDS (credit default
swap),2 CMO (collateralized mortgage obligation) and MBS (mortgage-backed security). All
of these instruments gained in popularity prior to the crisis and some can be very difficult to
value when the market for trading them becomes illiquid. An even more extreme example is
the “CDO-square” instrument. This is a CDO whose underlying reference entities are
themselves other CDOs. Such complex instruments became commonplace leading up to the
crisis.

Page 22 of 61
 Chapter V: Research Methodology

Research Type: Intrinsic Case Study

On Sunday, September 14, 2008, Lehman Brothers filed for bankruptcy after the U.S.
government declined to rescue the firm and after Bank of America decided to merge with
Merrill Lynch instead of Lehman Brothers. Now that the Federal Reserve has released data on
its extensions of credit, we can measure the funding shortfall at Lehman and compare it to
other firms that were rescued during the crisis. Under the Dodd-Frank Act of 2010, the Board
of Governors of the Federal Reserve was required to disclose the identities and relevant
amounts for borrowers under various credit facilities during the 2007-2010 financial crisis.
These credit facilities provide perhaps the best source of data about liquidity risk and funding
shortfalls of the last century. This data is available for purchase from Kamakura Corporation
and is taken from the Kamakura Risk Information Services Credit Crisis Liquidity Risk data
base.

The data used for Lehman Brothers in this analysis is described in more detail below. The data
consists of every transaction reported by the Federal Reserve as constituting a “primary,
secondary, or other extension of credit” by the Fed. Included in this definition are normal
borrowings from the Fed, the primary dealer credit facility, and the asset backed commercial
paper program. Capital injections under the Troubled Asset Relief Program and purchases of
commercial paper under the Commercial Paper Funding Facility are not included, but Lehman
Brothers did not survive long enough to be the beneficiary of either program.

A detailed chronology of the credit crisis through February 28, 2008 is given

Page 23 of 61
The key dates in the chronology relevant to Lehman Brothers are summarized here. The “Levin
Report” refers to the bi-partisan study of the root causes of the credit crisis submitted to the
U.S. Congress on April 13, 2011:

Dates Events
June 20, 2007 Merrill Lynch seizes $850 million in assets from the two Bear
Stearns hedge funds. Merrill tries to auction the bonds, but
the auction fails

June 17, 2007 Two Bear Stearns subprime hedge funds collapse (Source:
Levin report, page 47)

June 21, 2007 “Bear Stearns Fund Collapse Send Shock Through CDOs”
article on Bloomberg details losses on mortgage-backed
securities-related CDOs

July 17, 2007 Bear Stearns sends letter to investors stating that two Bear
Stearns hedge funds specializing in subprime debt have lost
at least 90% of their value. The funds invested only in AAA
tranches of subprime-related debt. (Source:investopedia.com)

August 1, 2007 Bear Stearns' two troubled funds file for bankruptcy
protection and the company freezes assets in a third fund.
(Source: www.investopedia.com)

November 29, 2007 Bear Stearns cuts 650 more jobs, bringing total job cuts to
1,500, 10% of its total work force. (Source: www.ft.com)

December 19, 2007 Morgan Stanley announces $9.4 billion in write-downs from
subprime losses and a capital injection of $5 billion from a
Chinese sovereign wealth fund. (Source: www.ft.com)

December 20, 2007 Bear Stearns reports its first quarterly loss in 84 years, $854
million, after write downs of $1.9 billion on mortgage holdings
(Source: www.ft.com)

January 17, 2008 Lehman Brothers cuts 1,300 jobs in its domestic mortgage
division after previously cutting 2,500 jobs due to subprime
lending problems. (Source: www.bankingtimes.co.uk)

January 17, 2008 Merrill Lynch announces net loss of $7.8 billion for 2007 due to

Page 24 of 61
 $14.1 billion in write-downs on investments related to
subprime mortgages. (Source: http://news.bbc.co.uk)

March 24, 2008 Federal Reserve Bank of New York forms Maiden Lane I to
help JPMorgan Chase acquire Bear Stearns (Source: Levin
report, page 47).

May 29, 2008 Bear Stearns shareholders approve sale (Source: Levin
report, page 47).
September 7, 2008 U.S. takes control of Fannie Mae & Freddie Mac (Source:
Levin report, page 47).

September 14, 2008 Lehman Brothers bankruptcy (Source: Levin report, page 47).

September 14, 2008 Merrill Lynch announces sale to Bank of America (Source:
Levin report, page 47).

It is a report on “primary, secondary, or other extensions of credit” by the Federal Reserve to

Lehman Brothers during the period February 8, 2008 to March 16, 2009. Lehman Brother’s
borrowings from the Federal Reserve can be summarized as follows:

 Borrowing dates: First borrowings March 18, 2008, with only 10 days of borrowings
from the Fed on or before September 12, 2008.

 Average from2/8/2008 to 3/16/2009 : $195.6 million

 Average when Drawn $5.3 billion including borrowings after the September 14, 2008
bankruptcy filing, with no borrowing more than $2.73 billion prior to bankruptcy

 Maximum Drawn $2.73 billion before bankruptcy announced, $28 billion on

September 15, 2008 after bankruptcy filing was announced

Implications of Funding Shortfall Data:

Lehman Brothers’ bankruptcy filing was followed by a significant $28 billion borrowing on
September 15, 2008, despite having no borrowing outstanding from the Federal Reserve from
July 29, 2008 through September 14, 2008. The dramatic erosion of Lehman Brothers’ ability
to borrow is chronicled in detail in Sorkin’s Too Big to Fail. Compared to the U.S. government
support of other institutions, Lehman Brother’s borrowings were medium sized at best. One

Page 25 of 61
can only conclude that, after allowing Lehman Brothers to fail, the U.S. government realized
that it had made a mistake and changed its mind about who was too big to fail. Dick Fuld was,
indeed, left as the only schmuck among CEOs of the big financial services firms.

Chapter VI: Data Analysis

Part A
4.1 The global financial and economic crisis of 2007-2009:

This historical perspective on the decades leading up to the financial crisis shows that the
global economy was by no means as stable as suggested by many observers. That said, the
crisis was largely unexpected and due to its complex roots, it continued to puzzle policymakers,
economists and other commentators as it unraveled and sucked in at first banks and companies,
and then economies across the globe. The collapse in the real economy has had devastating
consequences for households as a result of rising unemployment and surging poverty. At the
same time, some countries have been affected more than others due to differences in initial
conditions (state of economy, labour market, fiscal space, institutional framework) and
exposure to direct and indirect impact of the crisis via credit and trade channels. These issues
are further explored in this section.

4.2 Key Factors Responsible for the Global Financial Crisis:

(Rates, risk, regulations and global imbalances)

Leading up to the crisis there were many telltale signs that should have set off alarm bells. The
vast majority of academics, officials and investors ignored the signals and rather made profuse
claims about a new era. There was a general euphoria about the conditions in the global
economy and with many commentators claiming that ‘this time is different’. As argued by this

Page 26 of 61
study, there are, however, many similarities between the US sub-prime crisis and previous
banking crises such as the massive surge in housing and equity prices, the growing current
account deficit and rising level of (private) debt. At the same time, the exposure of lenders and
investors was complicated by the unprecedented level of securitization of mortgages (through
collateral debt obligations), which created considerable uncertainty in financial markets as the
crisis unfolded. This, in turn, resulted in a sudden reversal of risk perceptions (from risk
seeking to risk aversion).

The causes of the crisis have become, understandably, a major topic of discourse among both
academics and policymakers. The debate surrounding this issue has generally focused on the
role of market failure in precipitating the crisis, namely the catastrophic performance of the
financial market that was in stark contrast to the theoretical proposition that it is efficient (i.e.
prices in the stock and bond markets instantly and accurately reflect all available information
at the time). This puts one of the core tenets of capitalism into question. At the same time, most
contributions to the ongoing post-mortem analysis of the crisis recognizes that government
failure has played a major role in allowing banks and other financial institutions to capitalize
on loop-holes in the regulatory system to increase leverage and returns. In terms of government
policy, Taylor (2009) stresses that the excessively loose US monetary policy fuelled the credit
boom, while others such as Elmendorf (2007) conclude that interest rates were not too low. In
addition to these dimensions, the debate has considered both the contribution of domestic
issues (US financial regulation and monetary policy) and global imbalances (the glut of savings
flowing from surplus countries to deficit economies).

Overall, drawing from a comprehensive review of crisis-related studies, four core, but
interrelated, factors can be identified: interest rates, global imbalances, perceptions of risks and
regulation of the financial system. These factors are captured in Figure 2 (though this
diagrammatic representation of the crisis excludes the complex interactions between the
different elements to ensure readability).

Page 27 of 61
Key Factors Responsible for the Global Financial Crisis

(Figure 1: Key Factors Responsible for the Global Financial Crisis)

Loose monetary policy versus global imbalances

Any post-mortem of the first decade of the 21st century cannot avoid the role that past US
administrations have played in shaping it. When faced with a recession in 2001 following the
bursting of the so-called ‘dot.com’ bubble, the US monetary authorities aggressively reduced
the policy interest rate to unprecedented levels and thus fuelled a debt-financed consumption

Page 28 of 61
boom that led the way in boosting global aggregate demand. Interest rates in the US stood at
just 1 per cent in 2003 (Figure 3). This ensured that the 2001 recession was shallow and short-
lived, but it paradoxically sowed the seeds of the global recession of 2008-2009. In this respect,
Taylor (2009) argues that over the period 2001-2006, the Federal Reserve’s policy was too
loose resulting in interest rates that were far lower than suggested by the Taylor rule, which,
in fact, was the largest deviation since the 1970s. Indeed, the real (inflation-corrected) funds
rate was negative for 31 months (from October 2002 to April 2005).

Interest Rates:
Elmendorf (2007) claims that interest rates were only ‘a little too easy for too long, but the
adjustments that appear optimal in hindsight would not have fundamentally altered the housing
cycle and related developments.’(Elmendorf 2007: 3). In any case, by focusing on a narrow
definition of price stability, monetary policy in the US and elsewhere failed to tackle the
ballooning bubble in asset markets. At the same time, Shiller (2008) points out that the housing
boom in the US started in the late 1990s and thus predates the period of excessively low interest
rates, but acknowledges that loose monetary policy contributed to the rapid growth in
mortgages to sub-prime borrowers

Page 29 of 61
 (Figure 2)

US interest rates were too low following the bursting of the dotcom bubble (monthly Federal
funds effective rate)

What then is the link between the global financial crisis and the imbalances leading up to 2007?
It is argued that the flows of capital from China and other exporting countries fed into the US
housing bubble and credit boom along with its depressing effect on bond yields. For this
reason, mortgage rates remained low in the US even after the Federal Reserve started
tightening monetary policy in 2004 (Baily et al. 2008). In addition, foreign borrowing directly
funded both investment in US companies and the mortgage debt instruments that were at the
centre of the sub-prime disaster. Overall, during the decade preceding the crisis, credit indeed
grew most strongly in deficit countries, which was only possible to maintain through the ever-
increasing flows of capital from surplus economies (Astley et al. 2009).

The search for higher yields, misperception of risk and lax financial regulation

Low interest rates and yields on government bonds ultimately encouraged investors to search
for higher-yielding assets. Yields on emerging market or corporate bonds also narrowed
relative to T-bills thus leading investors to search for higher returns; hence, the demand for

Page 30 of 61
mortgage-backed securities. In the United States, lenders took advantage of low interest rates
to expand activities but, having exhausted credit-worthy borrowers, they turned to riskier
segments of the market (sub-prime, alt-A and other non-standard loans). These efforts at
financial innovation were enabled by lax regulation of the financial system, which had begun
in the 1990s and culminated in the Gramm-Leach-Bilely Act of 1999, which over-turned the
restrictions on banks posed by the Glass-Steagall Act of 1933. On top of this regulatory aspect,
lending was encouraged by political authorities who sought to enhance home ownership rates
among disadvantaged and low-income groups (though the role of legislation in promoting sub-
prime lending has been disputed)

The economic consequences of the global financial crisis

The United States was the epicenter of the crisis and its economy was hit directly by the
meltdown in the sub-prime mortgage market along with the repercussions of the financial crisis
and the ensuing credit crunch. As a consequence, the United States economy fell into recession
in December 2007 and is estimated to have shrunk by 2.7 per cent in 2009.However, this
contraction is smaller than most G20 countries and smaller than the average for advanced
economies (-3 per cent)

An important theme of this paper is that, while this downturn may be the worst since World
War II, the ensuing impact of the crisis on economies across the globe has been by no means
the same. Indeed, diversity is a hallmark of the Great Recession of 2008-2009. Since the United
States went into recession at the end of 2007, most advanced economies have joined the ranks,
particularly those exposed through financial and later trade channels. But, at the same time,
others, particularly in the Asia region (namely China and India but also Australia), have
avoided a major contraction, despite their integration with the global economy. A number of
low-income countries such as Ethiopia and Uganda also continue to grow strongly despite the
downturn.

Economic growth across the world, real GDP growth (annual % change)

Page 31 of 61
 (Figure 3)

Indeed, in contrast to some of the early predictions, the impact of the crisis on developing
countries has been far from universal. The most severely affected are middle-incomes
countries, especially in Central and Eastern Europe and the Commonwealth of Independent
States (Figure 4). This has been driven by the combination of the credit crunch and domestic
imbalances such as large current account deficits and housing bubbles (the two being not
unrelated). The countries estimated to contract by the greatest margin include Lithuania,
Latvia, Armenia, Estonia and Ukraine, which are expected to experience a decline in GDP of
14 per cent or more in 2009 (Figure 4). These are depression-like contractions. The overall
similarities between the ‘Great Depression ‘of the 1930s and the ‘Great Recession ‘of 2008-
2009 are presented in Box 1.

The fastest growing and contracting countries in 2009

Page 32 of 61
 (Figure 4)

Due to its links with the United States, most of Latin America fell into a deep recession (a
contraction of 2.1 per cent has been estimated for 2009), though there is consideration variation
within the region. Mexico has been hit hardest and is expected to have contracted by 7.1 per
cent in 2009. In comparison, Brazil grew by 0.1 per cent (World Bank 2010). Most low-income
countries, however, evaded a recession, but the growth slowdown witnessed in these countries
has nonetheless negative implications for poverty. Overall, the smaller, more open economies
have been hit harder, while the larger emerging economies have been supported by domestic
demand and government spending. China and India have notably continued to grow strongly
during the crisis.

According to the ILO’s Global Employment Trends (January 2010), the number of
unemployed persons is estimated at 212 million in 2009, an increase of almost 34 million on
the number in 2007 (ILO 2010b). The five hardest hit OECD countries in terms of a surge in
the unemployment rate from 2007Q3 to 2009Q3 are Estonia (+10.9 percentage points), Spain
(+10.3 ppts), Ireland (+8.1 ppts), United States (+4.9 ppts) and Turkey (+4.6 ppts). The average

Page 33 of 61
increase in the OECD is 2.9 percentage points. At the same time, a number of countries have
experienced a mild impact on the labour market in terms of rising unemployment. In Poland
and Germany, the unemployment rate has, in fact, decreased over this period (by 1.2 and 0.7
percentage points, respectively). In others such as Austria, the Slovak Republic, Republic of
Korea and the Netherlands, the change in unemployment rate has been marginal.

In order to analyze the output and unemployment adjustment jointly provides a mapping of
OECD countries that reflects both the diversity and complexity of the crisis. For example,
Norway and Malta have experienced only a mild economic contraction and labour market
impact, while others including Austria, Germany and the Netherlands have avoided a major
deterioration in the labour market despite a greater fall in output. In comparison,
unemployment in the United States has risen far more than other countries with a comparable
economic contraction, which reflects the flexibility of the US labour market. A similar story is
evident for Denmark, Spain, Slovakia and Turkey. The worst hit countries are Estonia, Ireland,
Lithuania, and Latvia, which have all suffered both a severe fall in output and deterioration in
the labour market. Australia is an outlier in this matrix as it is the only country to have avoided
negative growth in 2009. As illustrated by Figure 5, this data suggests that for every 1
percentage point decrease in the GDP growth rate, the unemployment rate increases by a
further 0.47 percentage points.

Growth and Expansion

Under the direction of Dick Fuld, Lehman expanded its portfolio of services to include the

riskier and complex financial products that were being developed during the 2000s in the wake

of deregulation of the financial industry, including, in particular, the 1999 repeal of the Glass-

Steagall Act that had prohibite affiliations between commercial banks and investment banks

and their activities.

Page 34 of 61
Lehman aggressively pursued opportunities in proprietary trading (trading with its own money

to make a profit for itself rather than for its clients), derivatives, securitization, asset

management, and real estate. In 2000, proprietary trading comprised 14% of the firm’s total

revenues. By 2006, that figure had increased to 21%. The change in business composition was

accompanied by significant growth in revenues and an increase in market capitalization (see

Figure 1). From 2000 to 2006, the firm’s revenue growth of 130% outpaced that of its rivals,

Goldman Sachs and Morgan Stanley. During Fuld’s tenure, the firm’s revenues grew 600%,

from $2.7 billion in 1994 to $19.2 billion in 2006. Equity markets recognized this performance

by bidding up the firm’s stock price such that its market capitalization appreciated by some

340% over the same period. Again, this significantly outpaced its rivals' growth.

Part II: Questionnaire

Page 35 of 61
 QUESTIONNAIRE

Q.1. What is subprime Crisis?

Ans. The blame can be put on three key players:

1. Alan Greenspan, then Chairman of the US Federal Reserve
2. Rating agencies like Standard and Poor's and Moody's
3. Greed of Wall Street

Alan Greenspan kept interest rates very low after 2001. Two things happened due to this: a)
this allowed borrowers to borrow more. b) people with money looking to make good returns
give it to Wall Street banks which converted housing mortgages into bonds. Everyone thought
that the price of a house never goes down. The bonds would fetch an interest more than what
the investors would get if they deposited money in US banks. Rating agencies blessed these
bonds with highest ratings (AAA) and the Wall Street banks were thus able to sell them to
interested buyers. Wall Street symbolizes 2 things: greed and smartness. Traders, bond
salesmen, etc. quickly figured out that this can be turned into a money minting machine. So,
they devised a system where housing mortgages will be given to even most undeserving (with
no real job, no capacity to repay the mortgage, no down payment, lowered interest payment
for first 2 years) people. Effectively, people were told to lie in the documents and they got the
loan. This way, migrants from other countries working daily wage jobs also got housing loans.

The ratings agencies looked at average FICO (credit) scores and not the individual FICO
scores of each person taking the mortgage. So, all that needed to be done was to stuff a bond
with mortgages of people with substandard FICO score and put mortgages of some individuals
with high FICO score. The only challenge was finding some people with high FICO scores.
This was solved by taking advantage of the fact that people with a short credit history or no
credit history tend to have high such scores. That's how a migrant also got mortgage. Such a
mortgage is basically subprime (below prime). The crisis which it brought is famously known
as Subprime Mortgage Crisis or the Financial Crisis of 2008.Once the ratings agencies
stamped AAA rating on such pool of mortgages (a bond), the Wall Street banks sold it to

Page 36 of 61
institutional investors, pension funds, university endowment funds, insurance companies (AIG
FI) etc.

The ratings agencies were in competition with each other and were paid fees by Wall Street
banks for the process of ratings. They didn't want to say no to Wall Street as banks would have
taken their business to competitive rival firms. It was basically a job done shabbily with utter
disregard to the responsibility bestowed upon them. Wall Street didn't stop there. They
collected the most useless tranches (it's like picking the lowest floor from a building where the
bond quality deteriorates as you go from top to bottom) from various such rated bonds and
created a CDO (Collateralized Debt Obligation). Wall Street is notorious in giving
incomprehensible names to products. It has nothing to do with complexity. They just want that
common public should believe that they do some magical work by giving their products such
esoteric names. To draw an analogy, a CDO is basically all bad apples from dozen different
crates put together to create a new crate of apples. Then they got good ratings for this CDO too
(like 80 percent AAA rated). AIG FI was a sucker for these bonds and CDOs. Some wall street
banks also bought them. They even created a synthetic CDO!

Mike Burry (played by Christian Bale in the movie - The Big Short), a loner with Asperger's
and a hedge fund manager, first predicted the crisis by betting against the subprime mortgage
bonds. He secured CDS (Credit Default Swaps) from Wall Street Banks. A CDS is simply a
bet that bond price of mortgage bonds will crash and in the event of this happening, the bank
would pay the insurance securer (Mike Burry) the equivalent amount of the value of such
bonds. If the reverse happened (that is, the bond prices didn't crash), Burry would pay fee in
installments to the same bank. He correctly predicted that after 2 years the teaser rate (lower
rate of interest initially given to borrowers) would expire and the higher floating rate would
kick in. This would happen around 2007 and then the number of defaulters would dramatically
increase. This would erode the quality of the bonds, CDOs, and Synthetic CDOs as the
underlying asset (the houses) drop in value. This is exactly what happened. Prominent Wall
Street banks like Lehman Brothers and Bear and Stearns collapsed in 2008. Other banks like
Goldman Sachs, etc. survived when the US government decided to bail them out with taxpayer
money to prevent global meltdown of financial institutions. It also bailed out AIG FI with $85
billion dollars.

Page 37 of 61
Q. 2 Why Lehman collapsed?

Ans. The collapse of Lehman Brothers: A case study. On September 15,

2008, Lehman Brothers filed for bankruptcy. With $639 billion in assets and $619 billion in
debt, Lehman's bankruptcy filing was the largest in history, as its assets far surpassed those of
previous bankrupt giants such as WorldCom and Enron. While the firm prospered over the
following decades as the U.S. economy grew into an international powerhouse, Lehman had
to contend with plenty of challenges over the years. Lehman survived them all – the railroad
bankruptcies of the 1800s, the Great Depression of the 1930s, two world wars, a
capital shortage when it was spun off by American Express Co. (AXP) in 1994, and the Long
Term Capital Management collapse and Russian debt default of 1998. However, despite its
ability to survive past disasters, the collapse of the U.S. housing market ultimately brought
Lehman to its knees, as its headlong rush into the subprime mortgage market proved to be a
disastrous step.

The Prime Culprit

In 2003 and 2004, with the U.S. housing boom (read, bubble) well under way, Lehman
acquired five mortgage lenders, including subprime lender BNC Mortgage and Aurora Loan
Services, which specialized in Alt-A loans (made to borrowers without full documentation).
Lehman's acquisitions at first seemed prescient; record revenues from Lehman's real
estate businesses enabled revenues in the capital markets unit to surge 56% from 2004 to 2006,
a faster rate of growth than other businesses in investment banking or asset management. The
firm securitized $146 billion of mortgages in 2006, a 10% increase from 2005. Lehman
reported record profits every year from 2005 to 2007. In 2007, the firm reported net income of
a record $4.2 billion on revenues of $19.3 billion.

Lehman's Colossal Miscalculation

In February 2007, the stock reached a record $86.18, giving Lehman a market capitalization of
close to $60 billion. However, by the first quarter of 2007, cracks in the U.S. housing market

Page 38 of 61
were already becoming apparent as defaults on subprime mortgages rose to a seven-year high.
On March 14, 2007, a day after the stock had its biggest one-day drop in five years on concerns
that rising defaults would affect Lehman's profitability, the firm reported record revenues and
profit for its fiscal first quarter. In the company's post-earnings conference call, Lehman's chief
financial officer said that the risks posed by rising home delinquencies were well contained
and would have little impact on the firm's earnings. He also said that he did not
foresee problems in the subprime market spreading to the rest of the housing market or hurting
the U.S. economy.

The Beginning of the End for Lehman :- As the credit crisis erupted in August 2007 with
the failure of two Bear Stearns hedge funds, Lehman's stock fell sharply. During that month,
the company eliminated 2,500 mortgage-related jobs and shut down its BNC unit. In addition,
it also closed offices of Alt-A lender Aurora in three states. Even as the correction in the U.S.
housing market gained momentum, Lehman continued to be a major player in the mortgage
market. In 2007, Lehman underwrote more mortgage-backed securities than any other firm,
accumulating an $85 billion portfolio, or four times its shareholders' equity. In the fourth
quarter of 2007, Lehman's stock rebounded, as global equity markets reached new highs and
prices for fixed-income assets staged a temporary rebound. However, the firm did not take the
opportunity to trim its massive mortgage portfolio, which in retrospect, would turn out to be
its last chance. Lehman's Hurtling Toward Failure Lehman's high degree of leverage – the ratio
of total assets to shareholders equity – was 31 in 2007, and its huge portfolio of mortgage
securities made it increasingly vulnerable to deteriorating market conditions. On March 17,
2008, following the near-collapse of Bear Stearns – the second-largest underwriter of
mortgage-backed securities – Lehman shares fell as much as 48% on concern it would be the
next Wall Street firm to fail.

Q.3. What kind of toxic assets Lehman have on their balance sheet?

Ans. Lehman Brothers’ disastrous balance sheet was not a secret to the insiders on Wall Street,
reveals former United States Treasury Secretary Henry Paulson in his new memoir, “On the
Brink.” Yet this knowledge did not encourage anyone within UBS and other financial service
firms from continuing to sell Lehman Brothers principal protected notes to thousands of main

Page 39 of 61
street investors around the world. These investors believed their principal would be protected
from losses, but when Lehman Brothers filed for bankruptcy in September 2008, it became
apparent that the majority of their investment would be lost. Investors with high-dollar losses
have been encouraged so far by awards in arbitration through FINRA, the Financial Industry
Regulatory Authority, where Vernon Litigation Group is representing investors from multiple
states.

Vernon Litigation Group is representing numerous Lehman Brothers principle protected notes
investors, the majority of whom have losses well in excess of $500,000, in cases against
UBS. Investors around the world – particularly from the U.K – who were affected by the
collapse of Lehman Brothers have sought information about Lehman Brothers principal
protected notes through Vernon Litigation Group. In “On the Brink,” Paulson describes
Lehman Brothers as being “loaded with toxic assets worth far less than the value at which they
were carried, creating a capital hole.” Paulson declines to accuse any specific executives of
violating the rules, however. According to Paulson, investment heavyweights on Wall Street
were concerned with excessive risk taking in the markets and appalled by the erosion of
underwriting standards. However, this did not change their behavior in terms of selling
structured notes such as the Lehman Principal Protected Notes. Paulson’s memoir indicates
that some banks did not want an industry-backed rescue. “They knew that to make the math
work, they would have to make a loan secured by assets worth much less than their stated
value,” he writes. This was the case at Lehman Brothers. There, a particular set of bad
investments had been carried at $52 billion but were later analyzed and estimated at closer to
$27 to $30 billion. Vernon Litigation Group is representing multiple Lehman structured
product investors in FINRA arbitration. Vernon Litigation Group, a Naples, Florida-based law
firm, represents investors nationwide who are victims of stock fraud and stock losses due to
broker fraud and brokerage firm fraud and misconduct. Vernon Litigation Group securities
attorneys are experienced in arbitration and litigation. The firm assists clients in attempting to
recover losses caused by all manner of financial fraud and negligence. It focuses its practice
on complex financial litigation and arbitration as well as business and commercial litigation.

Page 40 of 61
Q.4. Why did Subprime Crisis happen in 2008?

Ans. The United States subprime mortgage crisis was a nationwide banking emergency,
occurring between 2007 and 2010, that contributed to the U.S. recession of December 2007 –
June 2009. ... Two proximate causes were the rise in subprime lending and the increase
in housing speculation. The United States subprime mortgage crisis was a nationwide banking
emergency, occurring between 2007 and 2010, that contributed to the U.S. recession of
December 2007 – June 2009. It was triggered by a large decline in home prices after the
collapse of a housing bubble, leading to mortgage delinquencies and foreclosures and the
devaluation of housing-related securities. Declines in residential investment preceded the
recession and were followed by reductions in household spending and then business
investment. Spending reductions were more significant in areas with a combination of high
household debt and larger housing price declines. The housing bubble that preceded the crisis
was financed with mortgage-backed securities (MBSes) and collateralized debt
obligations (CDOs), which initially offered higher interest rates (i.e. better returns) than
government securities, along with attractive risk ratings from rating agencies. While elements
of the crisis first became more visible during 2007, several major financial institutions
collapsed in September 2008, with significant disruption in the flow of credit to businesses and
consumers and the onset of a severe global recession.

There were many causes of the crisis, with commentators assigning different levels of blame
to financial institutions, regulators, credit agencies, government housing policies, and
consumers, among others. Two proximate causes were the rise in subprime lending and the
increase in housing speculation. The percentage of lower-quality subprime
mortgages originated during a given year rose from the historical 8% or lower range to
approximately 20% from 2004 to 2006, with much higher ratios in some parts of the U.S. A
high percentage of these subprime mortgages, over 90% in 2006 for example, were adjustable-
rate mortgages. Housing speculation also increased, with the share of mortgage originations to
investors (i.e. those owning homes other than primary residences) rising significantly from
around 20% in 2000 to around 35% in 2006–2007. Investors, even those with prime credit
ratings, were much more likely to default than non-investors when prices fell. These changes
were part of a broader trend of lowered lending standards and higher-risk mortgage

Page 41 of 61
products, which contributed to U.S. households becoming increasingly indebted. The ratio of
household debt to disposable personal income rose from 77% in 1990 to 127% by the end of
2007.

When U.S. home prices declined steeply after peaking in mid-2006, it became more difficult
for borrowers to refinance their loans. As adjustable-rate mortgages began to reset at higher
interest rates (causing higher monthly payments), mortgage delinquencies soared. Securities
backed with mortgages, including subprime mortgages, widely held by financial firms
globally, lost most of their value. Global investors also drastically reduced purchases of
mortgage-backed debt and other securities as part of a decline in the capacity and willingness
of the private financial system to support lending. Concerns about the soundness of U.S. credit
and financial markets led to tightening credit around the world and slowing economic growth
in the U.S. and Europe.

The crisis had severe, long-lasting consequences for the U.S. and European economies. The
U.S. entered a deep recession, with nearly 9 million jobs lost during 2008 and 2009, roughly
6% of the workforce. The number of jobs did not return to the December 2007 pre-crisis peak
until May 2014. U.S. household net worth declined by nearly $13 trillion (20%) from its Q2
2007 pre-crisis peak, recovering by Q4 2012. U.S. housing prices fell nearly 30% on average
and the U.S. stock market fell approximately 50% by early 2009, with stocks regaining their
December 2007 level during September 2012. One estimate of lost output and income from
the crisis comes to "at least 40% of 2007 gross domestic product". Europe also continued to
struggle with its own economic crisis, with elevated unemployment and severe banking
impairments estimated at €940 billion between 2008 and 2012. As of January 2018, U.S.
bailout funds had been fully recovered by the government, when interest on loans is taken into
consideration. A total of $626B was invested, loaned, or granted due to various bailout
measures, while $390B had been returned to the Treasury. The Treasury had earned another
$323B in interest on bailout loans, resulting in an $87B profit.

Q. 5. What is CDS?

Page 42 of 61
Ans. A credit default swap is a particular type of swap designed to transfer the credit
exposure of fixed income products between two or more parties. In a credit default swap, the
buyer of the swap makes payments to the swap’s seller up until the maturity date of a contract.
In return, the seller agrees that, in the event that the debt issuer defaults or experiences
another credit event, the seller will pay the buyer the security’s premium as well as
all interest payments that would have been paid between that time and the security’s maturity
date. A credit default swap is the most common form of credit derivative and may
involve municipal bonds, emerging market bonds, mortgage-backed securities or corporate
bonds. Many bonds and other securities that are sold have a fair amount of risk associated with
them. While institutions that issue these forms of debt may have a relatively high degree of
confidence in the security of their position, they have no way of guaranteeing that they will be
able to make good on their debt. Because these kinds of securities will often have lengthy terms
to maturity, like ten years or more, it will often be difficult for the issuer to know with certainty
that in ten years’ time or more, they will be in a sound financial position. If the security in
question is not well-rated, a default on the part of the issuer may be more likely.A credit default
swap is, in effect, insurance against non-payment. Through a CDS, the buyer can mitigate the
risk of their investment by shifting all or a portion of that risk onto an insurance company or
other CDS seller in exchange for a periodic fee. In this way, the buyer of a credit default swap
receives credit protection, whereas the seller of the swap guarantees the credit worthiness of
the debt security. For example, the buyer of a credit default swap will be entitled to the par
value of the contract by the seller of the swap, should the issuer default on payments. If the
debt issuer does not default and if all goes well the CDS buyer will end up losing some money,
but the buyer stands to lose a much greater proportion of their investment if the issuer defaults
and if they have not bought a CDS. As such, the more the holder of a security thinks its issuer
is likely to default, the more desirable a CDS is and the more the premium is worth it.

Credit Default Swap in Context

Any situation involving a credit default swap will have a minimum of three parties. The first
party involved is the financial institution that issued the debt security in the first place. These
may be bonds or other kinds of securities and are essentially a small loan that the debt issuer

Page 43 of 61
takes out from the security buyer. If an institution sells a bond with a $100 premium and a 10-
year maturity to a buyer, the institution is agreeing to pay back the $100 to the buyer at the end
of the 10-year period as well as regular interest payments over the course of the intervening
period. Yet, because the debt issuer cannot guarantee that they will be able repay the premium,
the debt buyer has taken on risk. The debt buyer in question is the second party in this exchange
and will also be the CDS buyer should they agree to enter into a CDS contract. The third party,
the CDS seller, is most often an institutional investing organization involved in
credit speculation and will guarantee the underlying debt between the issuer of the security and
the buyer. If the CDS seller believes that the risk on securities that a particular issuer has sold
is lower than many people believe, they will attempt to sell credit default swaps to people who
hold those securities in an effort to make a profit. In this sense, CDS sellers profit from the
security-holder’s fears that the issuer will default.

CDS trading is very complex and risk-oriented and, combined with the fact that credit default
swaps are traded over-the-counter (meaning they are unregulated), the CDS market is prone to
a high degree of speculation. Speculators who think that the issuer of a debt security is likely
to default will often choose to purchase those securities and a CDS contract as well. This way,
they ensure that they will receive their premium and interest even though they believe the
issuing institution will default. On the other hand, speculators who think that the issuer is
unlikely to default may offer to sell a CDS contract to a holder of the security in question and
be confident that, even though they are taking on risk, their investment is safe. Though credit
default swaps may often cover the remainder of a debt security’s time to maturity from when
the CDS was purchased, they do not necessarily need to cover the entirety of that duration. For
example, if, two years into a 10-year security, the security’s owner thinks that the issuer is
headed into dangerous waters in terms of its credit, the security owner may choose to buy a
credit default swap with a five-year term that would then protect their investment until the
seventh year. In fact, CDS contracts can be bought or sold at any point during their lifetime
before their expiration date and there is an entire market devoted to the trading of CDS
contracts. Because these securities often have long lifetimes, there will often be fluctuations in
the security issuer’s credit over time, prompting speculators to think that the issuer is entering
a period of high or low risk.

Page 44 of 61
Q.6 What is CDO?

Ans. A collateralized debt obligation (CDO) is a structured financial product that pools
together cash flow-generating assets and repackages this asset pool into discrete tranches that
can be sold to investors. A collateralized debt obligation is named for the pooled assets — such
as mortgages, bonds and loans — that are essentially debt obligations that serve
as collateral for the CDO. The tranches in a CDO vary substantially in their risk profiles. The
senior tranches are generally safer because they have first priority on payback from the
collateral in the event of default. As a result, the senior tranches of a CDO generally have a
higher credit rating and offer lower coupon rates than the junior tranches, which offer higher
coupon rates to compensate for their higher default risk.

Collateralized debt obligations are created by as many as five parties:

 Securities firms, who approve the selection of collateral, structure the notes into
tranches and sell them to investors;
 CDO managers, who select the collateral and often manage the CDO portfolios;
 Rating agencies, who assess the CDOs and assign them credit ratings;
 Financial guarantors, who promise to reimburse investors for any losses on the CDO
tranches in exchange for premium payments; and
 Investors such as pension funds and hedge funds.

The earliest CDOs were constructed by Drexel Burnham Lambert, the home of former junk
bond king Michael Milken, in 1987 by assembling portfolios of junk bonds issued by different
companies. Securities firms subsequently launched CDOs for a number of other assets with
predictable income streams, such as automobile loans, student loans, credit card receivables
and even aircraft leases. However, CDOs remained a niche product until 2003–04, when the
U.S. housing boom led the parties involved in CDO issuance to turn their attention to non-
prime mortgage-backed securities as a new source of collateral for CDOs. CDOs subsequently
exploded in popularity, with CDO sales rising almost tenfold from $30 billion in 2003 to $225
billion in 2006. But their subsequent implosion, triggered by the U.S. housing correction, saw
CDOs become one of the worst-performing instruments in the broad market meltdown of

Page 45 of 61
2007–09. The bursting of the CDO bubble inflicted losses running into hundreds of billions on
some of the biggest financial institutions, resulting in them either going bankrupt or being
bailed out through government intervention, and contributing to escalation of the global
financial crisis during this period. Despite their role in the financial crisis, collateralized debt
obligations are still an active area of structured finance. CDOs and even the more
infamous synthetic CDOs are still in use, as they are ultimately a tool for shifting risk and
freeing up capital, two things Wall Street always has an appetite for.

Q.7 Why did American home prices dope drastically in 2007-08?

Ans :- The global macroeconomic recession that began in late 2008 and continued through
most of 2009 was the deepest and most synchronized recession since the Great Depression of
the 1930s. The origin of the recession was the collapse of U.S. house prices, which began in
2006 and continued for over two years. This collapse in prices, by causing losses in major
financial institutions around the world, triggered a global financial crisis in 2007 which then
led to macroeconomic recession in most countries. A detailed understanding of the causes of
the financial crisis requires a close examination of several aspects of the U.S. financial system,
especially those related to the creation and selling of residential mortgages. Moreover, it
requires understanding how these various aspects interacted to create serious problems in the
global financial system. Most economists now look back in retrospect and agree that the
financial crisis did not have one or even a few isolated causes; rather, it was the result of a
complex collection of institutional arrangements, macroeconomic trends, and regulations that
combined together to produce a dramatic outcome. When individuals wish to purchase a home,
which often costs several times’ their annual income, they generally have two choices. First,
they can save a significant fraction of their income each year for many years, at which point
they will have accumulated enough to purchase a home. In this case, even the thriftiest
individuals with an average income would be unable to purchase an average home before
reaching their forties or fifties. The second option is for the individual to borrow money from
a lender, usually a commercial bank, and then regularly pay back the loan (plus interest) every
month over a long period of time, typically 25-30 years. In this case, the individual is able to

Page 46 of 61
purchase a home as soon as his or her annual income is sufficient to permit the regular monthly
payments. Such a loan is called a residential mortgage.

Q.8 Why couldn’t the American Government save Lehman Brothers?

Ans:- Inside the Federal Reserve Bank of New York, time was running out to answer a question
that would change Wall Street forever. At issue that September, six years ago, was whether the
Fed could save a major investment bank whose failure might threaten the entire economy. The
firm was Lehman Brothers. And the answer for some inside the Fed was yes, the government
could bail out Lehman, according to new accounts by Fed officials who were there at the time.
But as the world now knows, no one rescued Lehman. Instead, the firm was allowed to collapse
overnight, a decision that, in cool hindsight, let problems at one bank snowball into a full-
blown panic. By the time it was over, nearly every other major bank had to be saved. The US
Federal Reserve chairman, Ben Bernanke, bluntly declared today that it would have been
unlawful for the US government to rescue Lehman Brothers, arguing that the Wall Street
bank's finances were too weak to justify an emergency injection of public money in the run-up
to its 2008 bankruptcy. In almost three hours of testimony to America's cross-party financial
crisis inquiry commission (FCIC), Bernanke flatly contradicted claims by Lehman's former
boss, Dick Fuld, that the bank was a victim of an unjustified panic and a refusal by the
government to step in. The Fed chief expressed regret for failing to be more "straightforward"
about Lehman's fate in the past, saying his past equivocation may have "supported the mistaken
impression that in fact we could have done something".

Q.9 Which other companies did get impact by this?

Ans. The public and political outcry after the collapse of Lehman’s has led to some reforms.
Large bonuses are now paid in shares and with provisions that allow the awards to be clawed
back if the business turns sour. But there are no controls on the overall amount that can be paid
out to individuals. The structure of regulation is being changed with the Bank of England set
to take over responsibility for banking supervision from the Financial Services Authority. But

Page 47 of 61
while the structure is important, even more significant is the change in attitudes among
regulators and bankers, according to Alistair Milne of the Cass Business School.

"The biggest change is that risk management is taken much more seriously than it was in the
past," he says. New international agreements - the so-called Basel III arrangements - mean that
banks will have to hold much larger amounts of capital to absorb potential losses, although the
changes will take up to eight years to be fully implemented. When you put all these reforms
together it looks like a lot has altered or is in the process of altering. New capital requirements,
controls on the way bonuses are paid, new regulatory structures and new attitudes to risk taking
should all make a difference. But the suspicion remains that in many ways City banking carries
on very much as before. "The business model that enables investment banks to do all sorts of
things - in foreign exchange, in commodities, in stocks and shares, in advising investors, in
advising companies, in trading for themselves - that very powerful business model still exists,"
according to Mr. Augar. It enables the major players to know more about what is happening in
the financial world and position themselves to take advantage, he reasons, hence the City is
not much changed.

Q. 10 What does the Investment bank actually do?

Ans. Raising Capital & Security Underwriting. Banks are middlemen between a company that
wants to issue new securities and the buying public. Mergers & Acquisitions. Banks advise
buyers and sellers on business valuation, negotiation, pricing and structuring of transactions,
as well as procedure and implementation. Several things, actually. Below we break down each
of the major functions of the investment bank and provide a brief review of the changes that
have shaped the investment banking industry through the aftermath of the 2008 financial crisis.
Click on each section to learn more.

Raising Capital & Security Underwriting. Banks are middlemen between a company that wants
to issue new securities and the buying public. Mergers & Acquisitions. Banks advise buyers
and sellers on business valuation, negotiation, pricing and structuring of transactions, as well
as procedure and implementation. Sales & Trading and Equity Research. Banks match up

Page 48 of 61
buyers and sellers as well as buy and sell securities out of their own account to facilitate the
trading of securities Retail and Commercial Banking. After the repeal of Glass-Steagall in
1999, investment banks now offer traditionally off-limits services like commercial banking.
Front office vs back office. While the sexier functions like M&A advisory are “front office,”
other functions like risk management, financial control, corporate treasury, corporate strategy,
compliance, operations and technology are critical back office functions.

History of the industry. The industry has changed dramatically since John
Pierpont Morgan had to personally bail out the United States from the Panic of 1907. We
survey the important evolution in this section. After the 2008 financial crisis. The industry was
shaken to the core during and after the financial crisis that gripped the world in
2008.An investment bank is typically a private company that provides various finance-related
and other services to individuals, corporations, and governments such as raising financial
capital by underwriting or acting as the client's agent in the issuance of securities. An
investment bank may also assist companies involved in mergers and acquisitions (M&A) and
provide ancillary services such as market making, trading of derivatives and equity securities,
and FICC services (fixed income instruments, currencies, and commodities).
Unlike commercial banks and retail banks, investment banks do not take deposits. From the
passage of Glass–Steagall Act in 1933 until its repeal in 1999 by the Gramm–Leach–Bliley
Act, the United States maintained a separation between investment banking and commercial
banks. Other industrialized countries, including G7 countries, have historically not maintained
such a separation. As part of the Dodd–Frank Wall Street Reform and Consumer Protection
Act of 2010 (Dodd–Frank Act of 2010), the Volcker Rule asserts some institutional separation
of investment banking services from commercial banking.

All investment banking activity is classed as either "sell side" or "buy side". The "sell side"
involves trading securities for cash or for other securities (e.g. facilitating transactions, market-
making), or the promotion of securities (e.g. underwriting, research, etc.). The "buy side"
involves the provision of advice to institutions that buy investment services. Private
equity funds, mutual funds, life insurance companies, unit trusts, and hedge funds are the most
common types of buy-side entities. An investment bank can also be split into private and public
functions with a Chinese wall separating the two to prevent information from crossing. The

Page 49 of 61
private areas of the bank deal with private insider information that may not be publicly
disclosed, while the public areas, such as stock analysis, deal with public information.

Chapter VII: Findings & Recommendations

Findings:

 Collapse of the Shadow Banking System

Without understanding the need for radical changes in the currently accepted system of
governance regulators, and policy advisers are left with the two questionable options, either to
seek ever-greater powers with ever-tighter controls to prevent a crisis that we and
commentators cited earlier believe cannot be effective, or to take a palliative approach of being

Page 50 of 61
better prepared, to cope with a crisis by requiring banks to reduce leverage, and increase
liquidity, as proposed by the Basel guidelines.

To prevent similar failures in future, there is a demonstrable need for banking regulators,
especially of “significantly important” banks, to address such critical deficiencies in corporate
governance and strategic risk management. The bankruptcy of Lehman had ramifications far
beyond the narrow confines of the event itself. The liquidation of Lehman did not cause the
global financial crisis but the firm’s failure exposed serious fault lines in the structure of the
global financial markets where a cat’s cradle of opaque and complex interconnections
collapsed like a house of cards when Lehman was removed.

 Trouble in the Credit Markets

In September of 2008 there was a run on money market mutual funds. These funds typically
invest in short term commercial paper, which is often used as a way for corporations to obtain
working capital. Weekly withdrawals from these funds hit $144.5 billion, up from $7.1 billion
the week before. Investors’ own fears for the safety of their money lead to corporations being
unable to rollover their shot term debt.

Economist Paul Krugman and current U.S. Treasury Secretary Timothy Geithner explain the
credit crisis in light of the implosion of the shadow banking system. Investment banks and
other entities in the shadow banking system could not provide funds to mortgage firms and
other corporations when their access to investor funds dried up.

Nearly one-third of the U.S. lending mechanism was frozen or locked-up and continued to be
into June 2009. According to the Brookings Institution, the traditional banking system does
not have the capital to close this gap as of June 2009: “It would take a number of years of
strong profits to generate sufficient capital to support that additional lending volume.”

 The Commodity Bubble

Page 51 of 61
Following the collapse of the housing bubble the global commodity market entered its own
bubble. From early 2007 to mid-2008 oil prices skyrocketed from $50 to $140 a barrel then
plunged to $30 by the end of 2008. The bubble has been attributed to the flight of capital from
the housing market, pure speculation, increasing concern over the limited supply of natural
resources and increased demand from growing, resource-hungry economies in Asia. With
more money flowing to oil producing nations, economic growth in the rest of the world
suffered under the increased cost burden.

 Impact on Major Financial Institutions

The International Monetary Fund (IMF) estimated that large U.S. and European banks lost
more than $1 trillion from investments in toxic assets backed by bad loans between January
2007 and September 2009. These losses are expected to top $2.8 trillion from 2007-2010. U.S.
banks’ losses were forecast to hit $1 trillion and European bank losses will reach $1.6 trillion.
The IMF estimated that U.S. banks were about 60 percent through their losses, but British and
Eurozone banks only 40 percent. A recession that is caused by the asset price bubble leaving
many private-sector balance sheets with more liabilities than assets has been called the
“balance sheet recession.”

 Some statistics regarding the decline in wealth during the crisis:

- From June 2007 to November 2008, the average American lost approximately 25% of
their collective net worth.
- The S&P 500 index had lost 45% from the prior year’s highs.
- In November, home prices had fallen 20% from the high in late 2006 with a further
30% drop signaled in the futures market. See Figure 7.
- Total home equity was at $8.8 trillion in the middle of 2008. In 2006 it was at $13
trillion.
- Retirement assets declined 22% while pensions and other savings and investments
declined by $1.3 and $1.2 trillion, respectively.
- U.S. home mortgage debt relative to GDP increased from an average of 46% during
the 1990s to 73% during 2008, at $10.5 trillion.

Altogether, losses total a staggering $8.3 trillion. Since peaking in the second quarter of 2007,
household wealth is down $14 trillion.

Page 52 of 61
Further, consumption during the boom was fueled when homeowners tapped the increased
equity in their homes. Cash used by consumers from home equity extraction doubled from
$627 billion in 2001 to $1,428 billion in 2005, totaling nearly $5 trillion over the period. To
counter this drop in spending, the U.S. government authorized $13.9 trillion to boost demand.
The Fed has transitioned from being the “lender of last resort” to the “lender of only resort” to
the “buyer of last resort” as economic activity stalled.

 New Regulation on Hedge Funds

Hedge funds that manage over $100 million will have to register with the SEC as investment
advisers and disclose information about their trades and portfolios. The data will be shared
with the systemic risk regulator. The SEC will provide annual report to Congress on how it
uses the data to protect investors and market integrity. Those not covered by the SEC will be
regulated by individual states.

 Office of National Insurance

The Act creates the Office of National Insurance housed in the Treasury Department to
monitor the insurance industry and coordinate international insurance issues. It is charged to
study ways to modernize insurance regulation and to provide Congress with reform
recommendations.
Boards and management need the ability to effectively measure, monitor, and manage market,

credit, and liquidity risks at an enterprise level. A common challenge at financial companies

that trade multiple, complex asset classes is obtaining an enterprise-wide integrated view of

risks from an increasingly diverse range of front-and middle-office applications that support

various financial products. Absent a comprehensive view, market participants cannot

effectively manage business risks. Long-term, firms should endeavor to manage these risks on

a real-time basis. In the short term, however, financial companies should ensure that

Page 53 of 61
monitoring techniques are comprehensive, risk models are based on reliable data, and decisions

are made using well-understood and robust risk models.

It is not uncommon for risk governance frameworks and policies to vary considerably within

a single firm. Both buy-and sell-side firms are reassessing the ways in which they use

technology to integrate risk management into their daily decisions. Firms are also emphasizing

the use of meaningful stress testing techniques and ensuring that appropriate documentation is

maintained to support risk management procedures and valuation models. In order to achieve

the desired outcome, substantial investments may be required to upgrade and optimize

technology, and improvements to governance and accountability may need to be introduced.

In addition, firms will need to address the challenges of changing risk behaviors.

Management must have accurate daily views of positions, values, and liquidity measures. The

ability to monitor and quickly react to changes in liquidity of various asset classes remains

essential to maintaining solvency and financial creditability and viability in the market place.

 Banks and hedge funds can both draw lessons from the liquidity challenges and risks

observed in Lehman Brothers' bankruptcy.

 The illiquid market for some structured credit products, auction rate securities, and other

products backed by opaque portfolios led to major write-downs across the industry in 2008.

The resulting depletion of capital led to credit downgrades, which in turn drove

counterparty collateral calls and sales of illiquid assets. This further depleted capital

balances. Widening CDS spreads have become widely viewed as a leading indicator of a

bank’s financial health and viability.

Page 54 of 61
 Management needs an accurate and complete daily view of gross and net positions, values,

and marks. The continued ability to raise and renew short-term borrowing depends to a

great extent on a borrower’s reputation. As many firms came to understand firsthand in

2008, a company's entire reputation and viability can be irreparably damaged by a single

event if it results in the loss of confidence by market participants. Managers of leveraged

pools of capital should be vigilant about changing market depth for less liquid asset classes,

especially when an asset class shows signs of becoming less liquid.

Increase the operational effectiveness of collateral management and accurately capture

contractual terms The counterparty collateral management functions at sell-side firms may

present hidden and ongoing sources of credit risk due to over taxed systems and processes.

The role of collateral management is straightforward: to reduce expected losses in the event

of counterparty default. In some dealer firms, however, the volume, diversity, and

complexity of collateralized transactions have surpassed the ability of the collateral

management function to respond effectively. This leads to increased counterparty default

exposure. The market downturn and CDS portfolio compression may have provided

temporary relief, but if underlying issues persist, they may be masking substantial

counterparty default exposures. Underperforming collateral management functions can

also create potentially dangerous latent exposures by causing or hiding significant risks,

such as:

 Portfolio concentration

 Inaccurate credit and/or customer data

 Substandard or missing legal documentation

Page 55 of 61
 We have observed increased efforts by firms across the industry to remediate the

operational processes and data that support collateral management and margin functions.

In addition, industry and organizational changes have required assignments and novation’s

that potentially impact thousands of OTC derivative trades and associated agreements. To

mitigate risks associated with under-collateralization, firms should:

 Ensure that contractual terms and trade data are accurate and updated

 Make certain that processes are being employed to verify that sufficient eligible collateral

is ―called and collected from each counter party on a timely basis.

The buy side faces different, yet equally significant, challenges in managing collateral

efficiently in order to optimize funding and reduce excess credit exposure to dealers and

banks. Firms engaged in collateralized transactions, including margin trading, repurchase

agreements, securities borrowing/lending and OTC derivatives, increasingly want to

optimize funding costs and minimize unnecessary counterparty exposure. Firms seek to

achieve these goals through effective portfolio reconciliation and collateral management

practices. Buy-side firms should: Perform regular and rigorous portfolio reconciliations

with all counterparties in order to ensure daily margin requirements are based on the correct

set of positions and balances. Where appropriate, recall excess collateral from dealers

promptly in order to lower both funding requirements and counterparty risk. The financial

crisis of 2007-2009 has highlighted the importance of transparency of internal controls over

the safekeeping of assets held at prime brokerage firms or other custodians Funds and their

investors are increasingly seeking assurance that prime brokers and custodians holding

their assets maintain effective internal controls and that such assets are appropriately

segregated, when appropriate.

Page 56 of 61
•As investment funds seek to improve their own risk management practices and provide

additional transparency to their investors, they are likely to demand additional information

surrounding their prime broker’s internal controls over trade processing, asset custody, and

recordkeeping. In light of the Madoff scandal and other recently uncovered financial

frauds, hedge funds and their investors are increasingly focused on verification of cash,

securities positions, and other assets held by their custodians and prime brokers.

•While increased transparency around the segregation of client assets appears likely,

certain industry practices still in use will make it difficult to provide the necessary

information. For example, existing prime brokerage arrangements and other related

agreements may allow the prime broker to pledge, re-pledge, hypothecate, and re-

hypothecate (lend out) the securities in a prime brokerage account, or trans-fertitle.

•Clients should seek to better understand the safekeeping controls implemented by their

prime brokers and/or custodians. Prime brokers who are able to provide assurances

regarding their internal controls over client assets will have a competitive advantage in the

market and be better prepared to respond to increased regulatory requirements regarding

the safeguarding of client assets. Proposed amendments to custody rules will require more

robust internal controls over client assets.

Leading practices around custody of hedge fund assets, prime brokerage agreements, and

counterparty risk management are rapidly being redefined in response to the lessons

learned and implications from Lehman Brothers' bankruptcy. The recently issued proposed

amendments to the SEC’s Custody Rule would require the following: Registered

investment advisors would be subject to annual surprise examinations of client assets by

an independent public accountant. If an investment advisor is a qualified custodian and

Page 57 of 61
 maintains custody of client funds or securities, the advisor would need to obtain an annual

written report regarding internal controls accompanied by an opinion by an independent

public accountant registered with, and subject to regulation by, the PCAOB (for example,

a SAS 70 internal controls report).

The internal controls report would need to include a description of the advisor’s controls

in place relating to custodial services, including the safeguarding of cash and securities

held by the advisor or a related person on behalf of the advisor’s clients, as well as tests of

operating effectiveness.

Firms are reevaluating existing systems and policies. Firms that have weathered the

financial crisis are beginning to invest in needed improvements to the systems and policies

they use to measure and control risk, while addressing a changing regulatory landscape.

Chapter VIII: Conclusion

Economic Theory states that when there is no risk, there is no profit. However, it is necessary

for everyone to take calculative risk and not follow blindly. Lehman’s failure proved that

bankruptcy of a large investment bank could have harmful aftereffects on the entire financial

sphere, due to its broad connections to the entire market. The main points of the Court

Examiner’s report show that Lehman systematically, and continuously breached its own

internal risk management guidelines, thought did not give rise to the colorable claims.

However, the overall picture based on the facts is rather disturbing, especially, when the upper

management of publicly traded firms such as Lehman deliberately exploit accounting, and

Page 58 of 61
legal loopholes, which enabled them to take excessive risk, and hide financial statement

distress in order to unjustly enrich themselves at the cost of the public shareholders, and hence

end up in dire financial condition beyond the rescue of lender of last resort.

No risk tool or model, however well designed, will produce consistently useful results without

high-quality position data and robust, independently verified price information. Firms should

review their data management, valuation processes, and operational risk exception reports.

Any substandard processes should be remediated. In some cases, this may require substantial

investment to replace legacy infrastructure and/or bring enterprise data management up to

industry standards. To ensure effective and prompt response to deteriorating credit and market

conditions, firms should allocate risks by business division or function and assign ownership

of risk within each business. Linking business-unit management of risks with the enterprise-

wide governance structure should improve a firm’s ability to respond quickly and effectively

to changing market conditions.

REFERENCES

 Auletta, Ken, Greed and Glory on Wall Street: The Fall of House of Lehman, Random

House, NY 1986.

 Baxter, Thomas C. Jr., EVP & General Counsel, Federal Reserve Bank of New York,

Statement by Thomas C. Baxter, Jr. [before the] Financial Crisis Inquiry Commission,

September 1, 2010.

 Bodie, Z., Kane, A., & Marcus, A. J. (2011). Investment and portfolio management.

McGraw-Hill Irwin.

 Brealey, M., & Myers, S., Allen, F. (2011). Principles of Corporate Finance. McGraw

Hill.

Page 59 of 61
 Cox, Christopher, Statement of Christopher Cox Former Chairman, U.S. Securities and

Exchange Commission before the Committee on Financial Services U.S. House of

Representatives, April 20, 2010.

 Cruikshank, Thomas, Statement by Thomas H. Cruikshank to the House Financial

Services Committee.

 Denbeaux, M., Dabek, E., Gregorek, J., Kennedy, S. A., & Miller, E. (2011). Lehman

Brothers: A License to Fail with Other People’s Money. Seton Hall Public Law Research

Paper, (2003618).

 Gallu, Joshua, SEC Staff Ends Probe of Lehman Without Finding Fraud, Bloomberg,

May 24, 2012. Gorton, Gary B., The Subprime Panic, National Board of Economic

Review, Working Paper 14398, October 2008.

 Financial Crisis Inquiry Commission. (2011). The Financial Crisis Inquiry Report: The

Final Report of the National Commission on the Causes of the Financial and Economic

Crisis in the United States Including Dissenting Views. Cosimo, Inc.

 Friedman, H. H., and Friedman, L. (2009). The Global Financial Crisis of 2008: What

Went Wrong?

 Jones, B., & Presley, T. (2013). Law and Accounting: Did Lehman Brothers Use Of Repo

105 Transactions Violate Accounting And Legal Rules? Journal of Legal, Ethical &

Regulatory Issues, 16(2), 55-91.

 Kaufman, H. (2009). The road to financial reformation: warnings, consequences, reforms.

John Wiley & Sons.

 Kindleberger, C. P., & Aliber, R. Z. (2011). Manias, panics and crashes: a history of

financial crises. Palgrave Macmillan.

Page 60 of 61
 Larcker, David and Brin Tayan, Lehman Brothers: Peeking Under the Board Façade,

Stanford Closer Look Series, June 4, 2010.

 Larson, Erik, Lehman Settles Freddie Mac Claim for $767 Million, Bloomberg, February

13, 2014. Lehman Brothers Holdings Inc. Form 10-K for fiscal year ended November 30,

2007.

 Lewis, M. (2011). The big short: Inside the doomsday machine. WW Norton &

Company.

 Mikes, A., Hamel, D., & Yu, G. (2011). Lehman Brothers and Repo 105. Harvard

Business School Cases, 1.

 McDonald, L. G., & Robinson, P. (2010). A colossal failure of common sense: the inside

story of the collapse of Lehman Brothers. Crown Business.

 __________, Press Release: Lehman Brothers Announces Preliminary Third Quarter

Results and Strategic Restructuring, September 10, 2008 (LB 9/10/08 Press Release).

 Sorkin, A. (2009). Too big to fail: The inside story of how Wall Street and Washington

fought to save the financial system. Penguin.

 Silver, N. (2012). The signal and the noise: Why so many predictions fail-but some don't.

Penguin.

 Valukas, A. R. (2010). Lehman Brothers Holdings Inc. Chapter 11 Proceedings

Examiner’s Report. US Bankruptcy Court Southern District of New York, Jenner and

Block LLP.

Page 61 of 61