In Fed We Trust Research Assignment

In Fed We Trust Research Assignment

ECON-315

Brock Bailey

Grand View University

February 27, 2019

In Fed We Trust Research Assignment

There were many individuals and organizations that contributed to one of the most devastating financial crisis’ in U.S history. However, the organization I will be focusing on in this paper is Lehman Brothers. Throughout this paper, I will exam how moral hazard may have impacted Lehman Brothers, analyze the impacts the crisis had on Lehman brothers, and conclude with my own assessment of how I think Lehman Brothers handled the crisis. Lehman Brothers made a lot of poor decisions that ultimately led to its demise. Since its collapse, there has been a lot of speculation on whether it was the right decision to let Lehman fail. Despite the criticism, Lehman Brothers had multiple opportunities to try and avoid bankruptcy, but, due to greed and ignorance, decided to wait for the same government bailout that Bear Stearns had recently acquired.

        Lehman Brothers was founded in 1850, in Montgomery, Alabama. It started as a small general store, but ended up growing into the fourth largest U.S. investment bank, at the time of its collapse. Even though it had been prosperous over the years, there were plenty of challenges Lehman Brothers had to face. According to Lioudis’ case study:

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 of American Express Co. in 1994, and the Long Term Capital Management collapse and Russian debt default of 1998. (para. 4)

Despite overcoming all of these obstacles throughout the years, Lehman Brothers was unable to overcome the 2008 U.S. subprime mortgage financial crisis.

Moral Hazard

        Moral hazard had a big impact on Lehman Brothers’ decision making process, which ultimately resulted in its bankruptcy. The source of the moral hazard can be traced back to March of 2008. One of the first bailouts by the Fed was of Bear Stearns. The Fed lent $30 billion to help induce J.P. Morgan Chase to buy Bear Stearns. This was unprecedented for the Federal Reserve because Bear Stearns was an investment bank, which wasn’t under the Fed’s regulation or protection (Wessel, 2010, p. 2).

        Following the bailout of Bear Stearns, the next bailout to take place was in August 2008. Ben Bernanke and U.S. Treasury Secretary Henry Paulson decided to seize Fannie Mae and Freddie Mac, nationalizing them and essentially wiping out any stockholders’ wealth. Fannie and Freddie were two government-sponsored enterprises that bought mortgages from banks, and would then package them into mortgage-backed securities to resell to investors (Wessel, 2010, p.2). Fannie and Freddie were so involved in the secondary market that their collapse would have had very bad consequences on the housing market.

        Both of those bailouts led to moral hazard being introduced, not only to Lehman Brothers, but to the entire industry. Moral hazard is the lack of incentive to guard against risk where one is protected from its consequences. Lehman Brothers felt like it had near to zero risk because it would get bailed-out, just like the Fed had done for those other firms.

        However, this was not the case. Paulson was going to avoid using taxpayer’s money to bail out another firm that made poor business decisions at all costs:

In a conference call with Bernanke and Geithner, Paulson had stated unequivocally that he would not publicly support spending taxpayers’ money – the Fed’s included – to save Lehman. “I’m being called Mr. Bailout,” he said. “I can’t do it again.” (Wessel, 2010, p. 14)

Instead of a bailout, Paulson sat the CEOs of the twenty largest banks and investment firms down in one room, and told them it was up to them to make Lehman look attractive. There were two suitors left on the table, but ultimately neither could make a deal. With Lehman out of buyers, it was forced to file for bankruptcy.

Impact of the Crisis on Lehman

         Well before Lehman Brothers’ collapse, Lehman decided to venture into the housing market. Between 2003 and 2004, Lehman acquired five mortgage lenders, including subprime lender BNC Mortgage and Aurora Loan Services, which specialized in Alt-A loans. Alt-A loans are loans that are made to borrowers without full documentation. Lehman was securitizing mortgages at record pace, and also reported record profits every year from 2005 to 2007 (Lioudis, 2018, para. 5).

By early 2007, defaults on subprime mortgages were becoming more common, and cracks were starting to show in the U.S. housing market. This didn’t cause any concern for Lehman’s CEO, however. According to Lioudi’s (2018) case study, “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” (para. 7). He went on to say how he didn’t foresee the subprime market problems spreading to the rest of the housing market or even hurting the U.S economy.

        As the credit crisis started taking shape in August 2007, Lehman’s stock fell sharply. Lehman decided to shut down its BNC unit and also closed Aurora offices in three states. Even though Lehman Brothers was taking steps in the right direction, it continued to play a big role in the mortgage market. During 2007, Lehman underwrote $85 billion in mortgage-backed securities, more than any other firm (Lioudis, 2018, para. 8-9). This resulted in a very high degree of leverage, which is the ratio of total assets to shareholders’ equity. A high degree of leverage also means a firm is more vulnerable in unfavorable market conditions.