DELHI METROPOLITAN

EDUCATION

NAME: YASH BARALIYA

SUBJECT: EONOMICS
CLASS: BBA.LLB-B 2ND YEAR 4TH SEMSTER
PROFESSOR: MS. ISHA JAISWAIL
ENROLLMENT NO. 15451103820

Concept of Sub Prime Loan

Subprime loans are loans with high interest rates offered to people of
minority and low income to help them acquire a home of their own.
These loans were meant to helps people or households with low
income and low credit rating to purchase a home or refinance an
existing home. Although, this sound great but the interest rates on this
loans were very high. Due to these loans and the housing boom in the
early 1990s, lenders acquired a lot of interest on their investments.
From 1990s to 2005 subprime loans increased from $18.5 billion to
507.9 billion (Watkins, 2011). By 2005, the interest rates got to a
point that borrowers were unable to pay their monthly installments
and this led to more homes foreclosed. The lenders, economy and the
borrowers were affected from this crisis. This also led to high
unemployment rates as more mortgage lenders and banks lay off their
workers. This paper summarized the concept of subprime loans and
the risks they pose to the lender and borrower, critique the role of
leadership decision-making in the subprime loan financial crisis, also,
evaluate subprime loans with the notion of social responsibility and
finally, compare and contrast the resulting consequences for these
actions and what measures have been taken since that time to assure
this will not happen again.

Bankruptcy of Lehman Brothers

Lehman Brothers filed for bankruptcy on September 15, 2008.1
Hundreds of employees, mostly dressed in business suits, left the
bank's offices one by one with boxes in their hands. It was a somber
reminder that nothing is forever—even in the richness of the financial
and investment world.
At the time of its collapse, Lehman was the fourth-largest investment
bank in the United States with 25,000 employees worldwide. It had
$639 billion in assets and $613 billion in liabilities. The bank became
a symbol of the excesses of the 2007-08 Financial Crisis, engulfed by
the subprime meltdown that swept through financial markets and cost
an estimated $10 trillion in lost economic output.
On 15 September 2008 when the US government allowed the
investment bank Lehman Brothers to go bankrupt.
When Lehman Brothers went down, the notion that all banks were
"too big to fail" no longer held true, with the result that every bank
was deemed to be risky. Within a month, the threat of a domino effect
through the global financial system forced western governments to
inject vast sums of capital into their banks to prevent them collapsing.
Credit flows to the private sector were choked off at the same time as
consumer and business confidence collapsed. All this came after a
period when high oil prices had persuaded central banks that the
priority was to keep interest rates high as a bulwark against inflation
rather than to cut them in anticipation of the financial crisis spreading
to the real economy.

In this article, we examine the events that led to the collapse Lehman
Brothers.
KEY TAKEAWAYS
• Lehman Brothers had humble beginnings as a dry-goods store,
but eventually branched off into commodities trading and brokerage
services.
• The firm survived many challenges but was eventually brought
down by the collapse of the subprime mortgage market.
• Lehman first got into mortgage-backed securities in the early
2000s before acquiring five mortgage lenders.
• The firm posted multiple, consecutive losses and its share price
dropped.
• Lehman filed for bankruptcy on September 15, 2008, with $639
billion in assets and $619 billion in debt.1 2
Lehman Brothers History
Lehman Brothers had humble origins, tracing its roots to a general
store founded by German brothers Henry, Emanuel and Mayer
Lehman in Montgomery, Alabama, in 1844. Farmers paid for their
goods with cotton, which led the company into the cotton trade. After
Henry died, the other Lehman brothers expanded the scope of the
business into commodities trading and brokerage services.2
The firm prospered over the following decades as the U.S. economy
grew into an international powerhouse. But Lehman face plenty of
challenges over the years. The company survived the railroad
bankruptcies of the 1800s, the Great Depression, two world wars, a
capital shortage when it was spun off by American Express (AXP) in
1994 in an initial public offering, and the Long Term Capital
Management collapse and Russian debt default of 1998.3
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
The company, along with many other financial firms, branched into
mortgage-backed securities and collateral debt obligations. In 2003
and 2004, with the U.S. housing bubble well under way, Lehman
acquired five mortgage lenders along with BNC Mortgage and Aurora
Loan Services, which specialized in Alt-A loans. These loans were
made to borrowers without full documentation.4
At first, Lehman's acquisitions seemed prescient. Lehman's real estate
business enabled revenues in the capital markets unit to surge 56%
from 2004 to 2006. 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, it announced $4.2 billion in
net income on $19.3 billion in revenue.4
The Colossal Miscalculation
In February 2007, Lehman's stock price reached a record $86.18 per
share, giving it a market capitalization of nearly $60 billion.5 But by
the first quarter of 2007, cracks in the U.S. housing market were
already becoming apparent. Defaults on subprime mortgages began to
rise 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. Following the earnings
report, Lehman said the risks posed by rising home delinquencies
were well contained and would have little impact on the firm's
earnings.6
The Beginning of the End
Lehman's stock fell sharply as the credit crisis erupted in August 2007
with the failure of two Bear Stearns hedge funds. During that month,
the company eliminated 1,200 mortgage-related jobs and shut down
its BNC unit.5 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.5
Hurling Toward Failure
In 2007, Lehman's high degree of leverage was 31, while its large
mortgage securities portfolio made it highly susceptible to the
deteriorating market conditions. On March 17, 2008, due to concerns
that Lehman would be the next Wall Street firm to fail following Bear
Stearns' near-collapse, its shares plummeted nearly 48%.7
By April, after an issue of preferred stock—which was convertible
into Lehman shares at a 32% premium to its concurrent price—
yielded $4 billion, confidence in the firm returned somewhat.7
However, the stock resumed its decline as hedge fund managers
began to question the valuation of Lehman's mortgage portfolio.
On June 7, 2008, Lehman announced a second-quarter loss of $2.8
billion, its first loss since it was spun off by American Express, and
reported that it raised another $6 billion from investors by June 12.5
According to David P. Belmont, "The firm also said it boosted its
liquidity pool to an estimated $45 billion, decreased gross assets by
$147 billion, reduced its exposure to residential and commercial
mortgages by 20%, and cut down leverage from a factor of 32 to
about 25."7
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2:38
Dalio: Are we repeating a historical financial crisis?
Too Little, Too Late
These measures were perceived as being too little, too late. Over the
summer, Lehman's management made unsuccessful overtures to a
number of potential partners. The stock plunged 77% in the first week
of September 2008, amid plummeting equity markets worldwide, as
investors questioned CEO Richard Fuld's plan to keep the firm
independent by selling part of its asset management unit and spinning
off commercial real estate assets. Hopes that the Korea Development
Bank would take a stake in Lehman were dashed on September 9, as
the state-owned South Korean bank put talks on hold.8
The devastating news lead to a 45% drop in Lehman's stock, along
with the firm's debt suffering a 66% increase in credit-default swaps.8
Hedge fund clients began abandoning the company, with short-term
creditors following suit. Lehman's fragile financial position was best
emphasized by the pitiful results of its September 10 fiscal third-
quarter report.7
Facing a $3.9 billion loss, which included a $5.6 billion write-down,
the firm announced an extensive strategic corporate restructuring
effort. Moody's Investor Service also announced that it was reviewing
Lehman's credit ratings, and it found that the only way for Lehman to
avoid a rating downgrade would be to sell a majority stake to a
strategic partner. By September 11, the stock had suffered another
massive plunge (42%) due to these developments.7
With only $1 billion left in cash by the end of that week, Lehman was
quickly running out of time. Over the weekend of September 13,
Lehman, Barclays, and Bank of America (BAC) made a last-ditch
effort to facilitate a takeover of the former, but they were ultimately
unsuccessful.7 On Monday, September 15, Lehman declared
bankruptcy, resulting in the stock plunging 93% from its previous
close on September 12.

Lehman stock plunged 93% between the close of trading on

September 12, 2008, and the day it declared bankruptcy.
Where are They Now?
Former chair and CEO Richard Fuld runs Matrix Private Capital
Group, which he founded in 2016. The company manages assets for
high-net worth individuals, family offices and institutions.9 He
reportedly sold an apartment in New York City for $25.9 million as
well as a collection of drawings for $13.5 million.
In years following the collapse, Fuld acknowledged the mistakes the
bank made though he remained critical of the government for
mandating that Lehman Brothers file for bankruptcy while bailing out
others. In 2010, he told the Financial Crisis Inquiry Commission the
bank had adequate capital reserves and a solid business at the time of
its bankruptcy.10
Erin Callan (now Erin Montella) became chief financial officer at the
age of 41 and resigned in June 2008 following suspicions she had
leaked information to the press.11 Her LinkedIN profile lists her as an
advisor at Matrix Investment Holdings. Other stints include six
months serving as head of hedge fund coverage for Credit Suisse and
co-founding a non-profit that provides paid maternity leave to
mothers.1213 In 2016, Montella published an autobiography, Full
Circle: A Memoir of Leaning in Too Far and the Journey Back, about
her experiences in the financial world.14
The Bottom Line
Lehman's collapse roiled global financial markets for weeks, given its
size and status in the U.S. and globally. At its peak, Lehman had a
market value of nearly $46 billion, which was wiped out in the
months leading up to its bankruptcy.1
Many questioned the decision to allow Lehman to fail, compared with
the government's tacit support for Bear Stearns, which was acquired
by JPMorgan Chase (JPM) in March 2008. Bank of America had been
in talks to buy Lehman, but backed away after the government
refused to help with Lehman's most troubled assets. Instead, Bank of
America announced it would buy Merrill Lynch on the same day
Lehman filed for bankruptcy.15
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The bankruptcy of Lehman Brothers

Understanding the 2007-08 Financial Crisis: Causes
The massive flow of savings from the surplus countries to the deficit
countries lowered global interest rates by encouraging reckless
investment into risky housing-related assets such as subprime
mortgages. These macroeconomic imbalances affected the financial
interactions. Apart from this, loose monetary policy in the U.S left the
banks with a decrease in net interest margins for the banks, decreasing
their profits. The bloated financial sector, flawed belief in efficient
markets, greedy bankers, incompetent rating agencies are considered
to be some of the other causes for the financial crisis.
However, failure of regulation on the banks’ parts was one of the
major reasons behind the crisis. Banks were allowed extraordinarily
high levels of debt in relation to equity capital. Also, investment by
banks in the advanced economies in complex assets called
“securitised” assets (securities derived from sub-prime loans or the
housing loans of relatively higher risk) added to the vulnerability of
the financial infrastructure. When debt defaults increased with interest
rates while income growth remained subdued, the world became more
vulnerable to financial crisis.
Banks’ dependence on short-term, riskier loans was not just an
American problem but a problem for large chunks of the global
banking system. Banks in Europe and some in Asia were affected as
well. Further, the failure of banking systems around the world was
aggravated by the by fiscal and monetary expansion. The loss of jobs
and output has been enormous.
The Problem of Regulatory Capture
The ability of financial institutions to influence policies of
governments and regulators also known as ‘regulatory capture’ was
experienced after the breakdown of the global financial system.
Financial institutions are a big source of political funding. Various
political consequences were observed in the wake of the crisis. Many
European countries like Greece, Spain, Portugal were found to be
loaded with government debt that they were unable to refinance (the
Eurozone crisis). The United Kingdom withdrew from the European
Union (Brexit). The U.S. observed the rise of nationalism and anti-
immigrant policies along with the return of protectionism.
India and the Crisis
India did not suffer much on account of the financial crisis. Absence
of full capital account convertibility, a strict check on short-term
foreign borrowings and its relative disconnect with the foreign banks
insulated it from the devastation that was faced by the global financial
system at that time.
Capital account convertibility: Capital controls are used by the state to
protect the economy from potential shocks caused by unpredictable
capital flows. Capital account convertibility means the freedom to
convert a currency for capital transactions and the rupee is not fully
convertible on that front yet, though capital flows have been
liberalised in recent years.
Capital Account Convertibility is not just the currency convertibility
freedom, but more than that, it involves the freedom to invest in
financial assets of other countries.
Way Forward: Lessons Learnt and Issues Yet to be Addressed
 Increasing the equity capital of the banks and reducing their
dependence on short-term loans were the steps that were taken post-
crisis. The measures have made banks safer than before the crisis,
however, a lot needs to be done.
 Financial sectors of emerging market economies now have more
and deeper links with international financial markets, also reflected in
high foreign ownership of stocks and government bonds, with large
sudden capital outflows causing financial crises. Measures to make
the system safer and more resilient must be supplemented by a
workable set of crisis intervention tools.
 The provision of emergency liquidity to the banking system
remains a core function of central banks. Such stabilisation efforts can
help avert broader turmoil and buy time to address the underlying
problems.
 Some of the biggest banks in the world have grown even bigger
after the crisis. Concentration in banking has increased. The ‘too big
to fail problem’ (some banks being so large that they cannot be
allowed to fail) needs focused analysis and resolution.
 A crucial aspect of the financial crisis was the build-up of
private debt, that is, the debt of households and non-financial firms.
The key driver of the recession in the U.S. was the rise in household
debt and the consequent drop in household consumption. The growth
in credit as well as the flow of credit into sectors such as real estate
needs strict regulation.
 The international rules that standard-setters such as the Basel
Committee on Banking Supervision have already agreed must be
consistently implemented across jurisdictions and their effects should
be carefully monitored by both regulators and industry. Authorities
should aim to establish trust and institutionalised co-operation,
limiting the need for unduly burdensome local capital and liquidity
requirements of the countries.
The collapse of the Bretton Woods system in 1971 witnessed the
emergence of the US dollar as the main international reserve currency
in the world. The dependence on the dollar needs to be reduced in the
times of deepening financial globalisation, as it will continue to
significantly affect the vulnerable emerging markets, as observed in
the present conditions.