History About The Bank Solvency

Published Date: 02 Nov 2017

LehMan Case Study

International Business analysis Report

Part 1

Background

The Financial crisis of 2007-2008 was considered, as the worst crisis of this decade since the Great depression of 1930s. The carnage of this meltdown was not limited to U.S economy, its impact was borne globally almost by every economy associated or in trade with U.S. It resulted due to artificial assumptions of large financial institutions that housing prices will continue to escalate. But unfortunately the unexpected burst of property bubble in 2007, which bought many of the financial institutions nearly to the collapse. The lax regulation and sub-prime mortgages are the main factors behind this meltdown; moreover debt crises of European Sovereign and poor measures taken by government and central bank further deteriorated the circumstances, which bought the entire global economy into the rotation of economic slump. The causes and impact of the recession are thoroughly discussed in this chapter.

Bursting of the U.S real estate bubble was the consequences of complex interplay of relax policies. These policies of persuade financial institutions to lend out on easy terms. In 2006 the prices of houses was on its peak, because at that moment every financial institutions want to capture the market share and earn revenue, the intense competition between lenders led the standard for gaining loan access to go down. While the financial cushion was not enough to back the mortgages by financial institutions. According to financial analysts, the solvency of financial institution was uncertain as the relaxed underwriting standard source the lending to even less creditworthy borrowers. Private investment bank were not only the solo players behind this boom; this was equally propped up by the government sponsored enterprises. It was not wrong to refer that Fannie Mae played an important role in the expansion of lending. On September 30, 1999, The New York Times reported that "Fannie Mae, the nation's biggest underwriter of home mortgages, has been under increasing pressure from the Clinton Administration to expand mortgage loans among low and moderate income people and felt pressure from stock holders to maintain its phenomenal growth in profits. In addition, banks, thrift institutions and mortgage companies have been pressing Fannie Mae to help them make more loans to so-called subprime borrowers..."

With Fannie Mae, Freddie Mac also follows the policies of private banks in order to catch-up the market trends. They adapted the easy-to-qualify underwriting standards, which increases the default risk as no down-payments products were launched by lenders to grab the market share. More and more risk was taken almost by every financial institution, as they were assuming that real-estate prices will continue to escalate. Furthermore innovation in financial products and growth in network of financial institution fuel the market of credit more than expectations. The potential of U.S financial institution fascinated number of investors around the world, who invested by means of holding securities tied to U.S real estate. The investment banks were on the peak at that time, they were leading the stock exchange. Investors were willing take more and more risk and they keep on investing in riskier business ventures as they undermine the systematic and market risk. As stock market was flourishing, escalating housing prices and high consumption of consumer mislead the policy makers, who thought this trend will prolong in future as continuous innovation in financial products will generate more wealth in economy.

Then this was time when suddenly everything began to fall as the assets were over-valued with respect to their real value. The incorrect pricing of risk and lax regulations were the main reason behind this meltdown. This let many strong Insurance companies and investment banks to collapse, as liquidity began to dry up. Loose monetary policy and innovative credit-structured products misguided the consumers by pursuing them to over spend as interest rates were really low. In addition, facilitation of ARM (Adjustable Rate Mortgage) by banks was gaining popularity, which further increased the credit-demand. The increased credit-fueled demand escalated the housing prices, which caused the un-intended Real-estate bubble to bust in 2007.

Deregulations:

The busting of real-estate bubble was the consequence of over-speculation by both borrowers and lenders, furthermore false policies also misguided the market players. The abolishment of Glass Steagall has been seen as one of the greatest policy mistakes in the late 90s/early 2000s. The Glass Steagall Act of 1933 enforced a wall between commercial and investment banks (McDonald, Robinson) and prevented banks to act as investment houses (Madrick 2011). The merging of Weill’s Travelers Group and Citicorp required the Act to be repealed. It has been argued, that the repealing of Glass Steagall allowed banks, such as Citigroup, to become so large, that they used the size of their balance sheets to back up their purchases of mortgage-backed securities and supporting both conventional lending and trading securities. It subsequently made it very difficult for lenders and borrowers to evaluate their risk (Crotty 2009, 570). It is also discussed that by Madrick that repealing the Act will transfer the control of financial conglomerates from the Fed to SEC to oversee bank subsidiaries that dealt with securities. Lack of policies and deregulation further deteriorated the problem which causes banks to take off the assets from balance sheet .Especially Basel II led the banks to increase their leverage ratio in order to maintain its credit rating, which cause Lehman brother to collapse. Credit rating agencies also ill-advised the investors and banks, they were remain occupied in just maintaining their credit ratings during fiscal boom.

Financial institutions which were also referred as shadow banking system were not obliged to full fill the same regulation as depository banks. It allows them to assume additional debt obligations much easier, relative to their financial cushion or capital base. This mistake was repeated despite the Long-Term Capital Management tragedy in 1998, which was a highly leveraged shadow institution failed due to systemic implications. The compiled data and evidence show that worst performing mortgages were funded by shadow banks; this competition also led the other traditional commercial banks to lower their underwriting standards.

Deregulation causes banks to originate riskier loans and even to those who do not meet the basic collateral requirement. These cause financial institutions to carry out controversial trading practices on behalf of investors and borrowers as compensation framework allow them to prioritize the short term benefits over the long term value creation. Many critics raise the question regarding the bank solvency, which used estimate the potential of bank’s current assets to cushion against their current liabilities. It also assesses, whether the bank will be able to meet its expenses in long-term and also depicts the real future prospects.

The bank solvency triggered the major crises as there was lack of adequate capital holdings by banks and insurance companies in order to provide cushion against their financial commitments. The risk associated with the financial products was not properly calculated and the lack risk management causes the market failure. The excessive risk taken up to 2007 can be easily explained by the overreliance on complicated and defective mathematical models, which turn out to be dysfunctional with beginning of recession.

In the first phase of market failure, liquidity crises began to surface in the economy. This further causes the ARM and Non-performing loans to go up. Since there was no strict regulation, number of loan defaulters began to augment with time.