Lehman Brothers - What happened exactly?

jj99

Why did Lehman brothers go bankrupt? im not sure exactly how all this works? why did the us govt. choose not to save Lehman, yet they did save fanny and freddie? what happened there? overall what caused all this trouble?
i have no idea what is going on

thanks

Économiste Monétaire

jj99 wrote: »

overall what caused all this trouble?
i have no idea what is going on
thanks

Although your question seems quite simple, there is no short answer. To keep it really basic and short consider the following situation: You’re a bank employee, you interview people for mortgages. What incentive do you have to ensure that they are able to pay the loan bad and are of good credit worthiness? They may default and that will cost the bank to repossess the collateral. But, what if I told you that you could take that mortgage and give it to someone else, and make some money by doing it? What incentive do you now have to ensure that the people who get the loans are credit worthy? Well, none--because you’re going to sell the mortgage on to someone else, what do you care any more? That’s a gross simplification and generalisation but it gives you the gist of what happens when you create a derivative out of mortgages (MBS, Mortgage Backed Securities) and people abuse it.

Another term you may have heard is sub-prime mortgages. Those were given to people who didn’t have good credit history and/or had sporadic earnings. These mortgages carried a greater risk of default and so were priced higher to reflect that (higher interest payments). The interest rate was set at a teaser level (to attract people to take one out) and would then adjust to a higher level after a predetermined amount of time. Mortgages were bundled up, so to speak, into a derivative (into different levels of tranches for complex CDOs, collateralised debt obligations) and sold to the market. Again, let’s do some more role-playing: You’re an investor (company/investment bank/whatever) who has €100 million. You take out a loan of €900 million at a good interest rate, you pay back, say, €50 million a year in interest payments on your €900 million loan. Well you take your €1 billion and buy €1 billion worth of MBS/CDO. The interest payments on those will be €80 million, say for simplification. You make your €50 million in interest payments out of the payments you receive on the derivative and are left with €30 million in profit. Again, it’s a gross simplification, but it’s a very complicated issue with complex financial instruments.

Now on to the effects of this. It wasn’t just basic investors who bought these products, it was large commercial banks in the U.S., the UK, and other countries. They made quite good money on them. But, as you can imagine, people started to default on the mortgages when the teaser rate ran out (and sometimes before). Large amounts of defaults in an area will devalue (sometimes quite substantially) the property market in an area. The collateral of the mortgages wasn’t covering the value of the loan in some cases. The tranches in the derivatives fell through, other events occurred, and basically the poop hit the fan. The assets (CDOs/MBS) became difficult to price at current market prices because no one knew what they were holding, even the banks themselves.

You’ve probably heard the term ‘liquidity crises’ being floated around. This has to do with monetary economics and how the banking system works, so to speak. Monetary policy effects the economy through clearing banks, i.e. what the ECB (European Central Bank) and ESCB (European System of Central Banks) do doesn’t really directly affect you or I. For this I need to explain how the system actually works, or what really happens when you watch on RTE news that the ECB has raised/lowered interest rates. The wholesale money market is where banks get their liquidity from, by loaning each other very large amounts of money for, usually, very brief periods of time. Some banks have an excess of reserves, others have a need for reserves. This is done in the Eurozone by EURIBOR (Euro interbank offer rate), LIBOR (London interbank offer rate), and the Federal Funds market in the U.S (there is also the EONIA for the Euro).I’ll try to give a Euro prospective seeing as that’s closest to home The ECB attempts to influence the interbank rate by conducting Open Market Operations (OMOs), (this is called the transmission mechanism of monetary policy.) Here’s a graph on the transmission mechanism from the ECB site that gives a nice graphical illustration:

Main refinancing operations are conducted weekly at a predetermined interest rate (the minimum bid rate), by the ESCB lending to banks on a limited basis based on a bidding procedure. The banks give collateral for these loans, usually government bonds (the specific collateral has been relaxed recently due to the whole ‘credit crisis’ situation), and they pay an interest rate for the loan. The loans are repaid by the banks after a period of time and the collateral is returned to the banks. The minimum bid rate is set by the Governing Council. The liquidity committee at the ECB analyses the bids by the Banks and passes on that information to the Executive Board of the ECB (you can read about the different bodies in the ECB at the ECB site). Based on this information the Executive Board will decide how much money will be allocated in the auction. The money is then allocated based on the bids by the banks, above the minimum bid rate already set. This influences the wholesale money market because anyone who fails to be allocated money in the auction by the ECB will have to borrow from the money market. The rate in the interbank money market is usually quite close to the minimum bid rate, with a small premium (that’s in bold because that’s the key point I’ll make in a minute).

Basically, if the ECB decides it wants to raise the rate in the interbank market it will create a shortage in the interbank reserve market and thus raise the price on interbank lending, or vice versa. That’s how the rate, the ECB sets on the minimum bid rate, effects what the commercial bank will charge you, i.e. how easily, and at what price, the bank can get liquidity in the market, either directly from the ECB, or indirectly from the excess reserves of other banks through the interbank money market.

It’s important to understand that we need a smooth running wholesale money market, and that banks are able to allocate reserves in an efficient and low cost way. But, as I mentioned above, there will be a premium on interbank lending. This premium reflects expectations of future ECB rates and general market conditions. Banks are typically risk averse, i.e. they avoid it if they can and, if they can’t avoid the risk, they attempt to quantify the risk and put an appropriate charge on it. Interbank lending from the money market works on the same principal. If banks are unsure of the financial conditions that another bank is in (maybe it is quite exposed to the subprime market...) then they will be reluctant to lend to that bank by fear of losing the money should the borrower default. This increased risk is what has happened across the world. The fact that banks were unsure of their own risk, and the risk of others, caused them to increase the premium for interbank lending/stopped lending to each other completely--the interbank money market froze to an extent. This completely interrupts the TARGET2 (Trans European Automated Real-time Gross Settlement Express Transfer) system that the ECB operates for the smooth running of the money market. This is why Central Banks, generally, have either stepped up lending, or coupled that with the introduction of new monetary policy instruments (case in point the Fed in the U.S.), to tackle the liquidity problem that banks have because of restricted access to the money market.

But, the problems for Irish banks, according to some economists, is that it isn't solely a liquidity problem, but a capital one too which is why you've seen capital 'injections' into banks by governments in, for example, Europe over the past two weeks. It's a complicated situation which continues to evolve every week. In regards to Fannie, Freddie, and Lehman, you can probably look that up on Bloomberg or the WSJ for specifics. I've tried to keep it simple and made some generalisations (and probably left quite a bit out), but I hope some of it makes sense :pac:

lisbon_lions

Check out this guys analysis of what happened. Very clear overview(4 videos) of the lending cycle that happened over a few years recently and the markets are now reacting to it.

Video 1. (others linked to from here)....

http://www.youtube.com/watch?v=8IR5LefXVPY

redroar1942

:pac:

jj99

Thanks a mill UCD. very comprehensive answer...much appreciated!

Économiste Monétaire

jj99 wrote: »

Thanks a mill UCD. very comprehensive answer...much appreciated!

You're welcome.