bankruptcy of lehman brothers - a pointer of subprime crisis

8/20/2019 Bankruptcy of Lehman Brothers - A Pointer of Subprime Crisis

http://slidepdf.com/reader/full/bankruptcy-of-lehman-brothers-a-pointer-of-subprime-crisis 1/7

Electronic copy available at: http://ssrn.com/abstract=1507652Electronic copy available at: http://ssrn.com/abstract=1507652

USIN SS NVIRONM NT

ankruptcy of

lehman rothers

Pointer of Subprime Crisis

ankaj adhani

h

term subprime lending refers to the practice of making loans available to borrowers who do

not qualify for normal market interest rate loans due to various risk factors, such as income

level, size of the down payment made, credit history and employment status. Subprime

mortgages are defined as housing loans which do not conform to the criteria for prime mortgages,

and also have a lower probability of the full repayment of mortgages. Subprime mortgage .loans

are made to home loan borrowers who have higher credit risks compared to prime mortgages,

because of irregular payment in the past, higher amount of debt compared to income level and

such other factors. According to Federal banking and thrift regulatory agencies, sub prime

mortgages are those made to borrowers who display among other characteristics, (i) a previous

record of delinquency, foreclosure or bankruptcy, (ii) a low credit score, and/or (iii) a ratio of debt

service to an income of 50 or greater (Office of the Comptroller of the Currency, et aI, 2007).1

Subprime mortgages were mainly responsible for an increased demand in housing and home

ownership rates in the US. The overall US home ownership rate increased from 64 to 70

. between 1994 and 2004. This surging demand helped fuel housing price hike and consumer

spending. Between 1997 and 2006, American home prices increased by 124 . This is, partly, due

to the encouragement from the Federal government for the consumption economy after the

September 2001 disaster to boost domestic economy based on consumer spending.

During the period of the housing property bubble in the US, when property price was having a

continuous northward journey, many homeowners used the increased property value to refinance their

houses with lower interest rates available in the market. Such second mortgages against the increased

value of home ownership were used for personal consumer spending. In 2007, the US household debt

was 130 (as a percentage of income), which was considerably higher compared to 100 recorded _

www.federalreserve.gov/boarddocs/press bcreg/2006/20060929/defalilt.htm

© 2009The Icfai University Press. All Rights Reserved.



Bankruptcy of lehman Brothers: A Pointer of Subprime Crisis

in the last decade. The US subprime crisis began after the

housing bubble burst, which ultimately resulted in high

default rates on higher risk borrowers, such as subprime

and other Adjustable Rate Mortgages (ARM). Subprime

borrowers were influenced by mortgage loan incentives

and the trend of rising home prices to assume large

mortgage loans, considering that they would be able to

refinance existing mortgage loans with more favorable

terms later on. Once, the housing bubble burst and prices started dropping sharply, home loan

refinancing became more and more difficult. Defaults and foreclosure activity increased steeply

as ARM interest rates reset higher, making it even more difficult for borrowers to repay.

Origin of Subprime Crisis

Many factors related to housing and credit markets emerged over a number of years, which were

responsible for sub prime crisis. The major causes of subprime crisis include: the inability of the

homeowners to make their mortgage repayments; poor judgment by borrowers as well as lenders,

while dealing with property loans; excessive speculation in property prices, during the strong

period of economy; high-level of personal and corporate debt; lack of proper government control

and regulation and innovation of structured financial products that concealed the risk of mortgage

default for subprime clients. Subprime mortgages, which amounted to 35 bn (5 of total

originations) in 1994, had increased phenomenally to 600 bn (20 ) in 2006.2

According to a research study conducted by Federal Reserve of US, between 2001 and 2007,

the average difference between subprime and prime mortgage interest rates decreased drastically

from 280 to 130 basis points. It means that the risk premium considered by lenders or loan issuers

to offer a subprime loan to clients, declined. Surprisingly, this had happened even though the

credit ratings of subprime borrowers declined during this time period. Mortgage underwriting

practices, such as automated loan approvals, have also been responsible for subprime crisis, as

such approvals were not subjected to appropriate review and documentation. In 2007, 40 of all

sub prime loans resulted from automated underwriting.3

Basicsof the Securitization Process

Subprime mortgages are mainly securitized in the form of Mortgage-backed Securities (MBS). In

the traditional process of mortgage, the bank originates a loan to the home loan borrowers, while

the credit default risk remains with the issuing bank. With the initiation of securitization, the

traditional process has changed from the originating to the distributing process. Here, the credit

default risk is shifted or distributed to investors through MBS and Collateralized Debt Obligations

(CDOs). Securitization is a type of structured finance and involves the pooling of financial assets,

particularly assets for which readymade secondary market does not exist.

Securitization turns mortgage loans into financial securities by taking existing loans or assets

backed by their future cash flows. Securities are sold in the market, after separating them into

tranches. The main advantage of securitization is that the lender or the originator of the loan gets

a lump sum amount, rather than the interest and principal payments over the loan's term and

period. In this way, it provides lenders an additional cushion and flexibility to relend the capital

for new projects. Hence, it provides the capital to investors at the lowest cost, increases liquidity

for lenders and helps lenders and investors better manage their financial risk.

The securitization process provides a secondary market for mortgage transactions. Hence, the

issuers of mortgages were no longer compelled to hold them to maturity. Pooled assets created by

www.federalreserve.gov/newsevents/speech/bernanke20080314a.htm

www.nytimes.com/2007 /03/23/business/23speed.html? _r=2&partner=rssnyt&emc= rss&oref=slogin

The Accounting World



USINESS ENVIRONMENT

securitization, act as collateral for new financial assets issued by financial institutions or those

owning such underlying assets. In this way, mortgages with a high risk of default could be

derived effectively through MBS and COOs, by shifting inherent risks from the mortgage issuer to

the investors.

Lehman rothers ebacle

One of the major causes of the Lehman Brothers' (the fourth largest securities company in the US)

default was its exposure to the subprime market. In recent years, many home mortgages issued in

US were made to subprime borrowers. Compared to prime borrowers, subprime borrowers are

having lesser ability to repay the loan, based on various criteria. During 2006-07, housing prices

began to drop in the US, causing mortgage delinquencies to soar and huge losses to financial firms

as they hold financial securities backed with subprime mortgages. This resulted in a large decline

in the capital of many banks and government-backed enterprises of the US.

Lehman Brothers was a key player in the MBS market. A single MBSmight consist of a number

of mortgage loans clustered together and enclosed in a set of mortgage securities, which can be

bought and sold in the secondary market for securities. Although, the subprime MBS market was

having a high proportion of inherent risks, it looked much more attractive as the MBS market was

growing at an exponential rate with a market size in trillions, having doubled between 2001 and

2003. Many banks and financial institutes turned to such riskier investments as they promised

greater returns during the period of relatively slow economic growth. The massive size of the

MBS market also tempted many finance and securities firms to it. As residential property prices

soared, home owners and mortgage borrowers used their homes as collateral for increasing

indebtedness and that enhanced debt also provided the starting point for a stockmarket bubble.

Lehman Brothers had a huge exposure to property derivatives, such as MBS and COOs. These

mortgage derivatives were attached to underlying assets, such as value of homes and mortgages.

However, with the beginning of property price crash, the value of Lehman Brothers' investment

started to decline sharply. Lehman Brothers also had a large chunk of leveraged assets and was

exposed to a significant portion of subprime MBS. As Lehman Brothers was exposed to huge

amounts of bad debt, it suffered a severe credit crunch. Lehman Brothers collapsed, as it failed to

raise enough capital to secure its debts and filed Chapter 11 of the United States Bankruptcy Code

on September 15, 2008, causing panic in the entire global financial market.

Lehman Brothers' working model of securitization involved obtaining loans from other banks

and then selling them off as MBS in the secondary market. In this process, the bank would pay the

monthly interest it earned out of that loan to Lehman Brothers. Finally, Lehman Brothers would

pay the investors who bought the MBS. Here, the main risk was that, if the loans were unpaid and

defaulted, the bank was not obliged to pay Lehman Brothers, even though Lehman Brothers was

required to pay the customers who bought the MBS. Hence, when the mortgage loan customers

started defaulting on loan payment banks stopped paying Lehman Brothers. These were the

reasons behind the downfall of Lehman Brothers. After the bankruptcy of the Lehman Brothers,

the liquidity crisis deepened further, having an immediate impact on the American International

Group (AIG), the biggest US life insurer. To ease the liquidity crisis, AIG received emergency loans

from the US Federal Reserve on September 17, 2008 , and was effectively bailed out and placed

under government supervision.

The Indian Securitization Market

Though the securitization market in India is of recent origin, it looks promising. The Indian

structured finance market registered a growth rate of 44 , Rs. 370 bn in the year 2007. Out of this,

65 of the securitized assets were originated by banks and the remaining 35 by non-banking

June

9




financial companies. The following table provides the growth path of the Indian securitization

market:

Table: Growth of the Indian Securitization Market

Y02

Y03Y04

Y05Y06

Y07 12.96.40.922.978.534.2 0.84.8

9.63.4

0.16.1

19.1

4.38.35.81.019.2 4.0

.916

0.4.50.8 36.8

7.739.208.256.569.5

Subprime Crisis: Impact of Credit Monitoring System

Subprime crisis is the commonest word in financial circles worldwide in the recent past and has

had the lasting impact on the world s leading financial institutions, brokerage firms, investors,

as well as the overall global economy. The innovative financial products, such as mortgage

derivatives that ultimately led to the sub prime crisis, were produced by global financial firms.

An environment of irrational euphoria regarding property boom was responsible for the subprime

crisis, which ultimately resulted in the financial and stock market meltdown. The US markets

witnessed a prolonged period of low interest rates, beginning from the year 2001, which

encouraged housing loan borrowing and escalated housing prices. As the loan issuers and

mortgage lenders provided lenient and uncontrolied lending, coupled with innovative loan

mortgage products which provided more convenient repayment options at the start of the

mortgage for attracting home loan customers, housing boom started assuming a bubble like

proportion. These favorable home loan market situations encouraged borrowers to buy far more

expensive homes, even if their financial situation did not warrant or support such hefty borrowing

and subsequent mortgage installments.

Banks and major financial institutions refinanced these loans of home mortgages by

repackaging them into different types of financial products and selling them to financial

institutions and other investors in the secondary market for securitization. However, the situation

changed noticeably after a series of interest rate hikes by the US Federal Reserve. Such policies of

the US Central Bank led to an increase in the interest rates of floating housing loans and the

subsequent rising defaults by home loan borrowers. As a consequence of subprime crisis, many

major banks and financial institutes reported subprime related losses running into billions of

dollars. The ripple effects of sub p rime crisis were felt, not only in the US financial markets but

also across the global financial market. The deteriorating situation was further compounded by

the failure of the financial markets to recognize the fast changing mortgage scenario and suitably

modify their lending and risk management practices. The credit and default risk inherent in the

new mortgage structures was not fully recognized. Hence, such risks were not fully factored in

the overall credit ratings of the repackaged financial offerings such as MBS.

Basically, there is a prevailing need to streamline and strengthen the credit rating system for

a thorough assessment of the home loan borrower s creditworthiness. Any lapse at this stage is

likely to cause a series of unwarranted consequences in the future, no matter how rigorous the

subsequent monitoring processes are. The central regulatory agencies will have to check that

banks and financial institutions do not follow lenient, imprudent and predatory lending practices.




For all banks and financial

institutions institutional

membership as well as the

sharing of credit information

with CI should be made

obligatory

USINESS ENVIRONMENT

is imperative that banks and financial institutions share the credit history of home loan

orrowers to better assess their creditworthiness. One such step in this direction could be to

ncourage and support usage of the services of the Credit Informatipn Bureau CIB). For all banks

nd financial institutions, institutional membership as well as the sharing of credit information

ith CIB, should be made obligatory. This will help in sharing all the relevant information

ertaining to individual borrowers among all the lending banks and financial institutions.

A major drawback in the credit rating mechanism has been that the credit rating processes

rgely rely on past performance records. For MBS, such historical records has been very

pressive. However, such credit rating processes or models do not take into account, newer or

minent macro risks. Even the risks arising from newer mortgage structures, such as negative

mortization mortgage or ARM, which is more prone to loan repayment default, are not

Credit rating models used by the originators of the mortgage loans and rating agencies must

e able to comprehend potential risks in such financial innovations and should make sure that

ch impending risks are adequately accounted in their rating processes, so far as new risk is

oncerned. It must also ensure constant credit monitoring, so

at the fast changing environment of the global economy is

flected and accounted in the credit rating processes. Credit

ting agencies should learn lessons from subprime related

risis, to modify their rating methodologies and models, to

corporate certain predictive elements, and to build greater

gor in their rating mechanism. Immediate action by credit

ting agencies in identifying toxic MBS will help in boosting

vestors confidence in the efficiency and effectiveness of the

ntire credit rating system.

plications of the Subprime Crisis for India

he subprime mortgage crisis has adversely impacted the US

conomic growth and global market. There is a genuine

oncern that India s growth rate will also be greatly affected. In the current scenario of financial

rbulence, accompanied by global credit crunch and a major slowdown in the US and the

uropean economy, it is very important to understand the overall impact of all these factors on

dia s growth prospects. Hence, it is necessary to put this whole crisis in the Indian perspective,

nalyze the chain of cascading events responsible for this turmoil, and frame an action plan to

void or reduce the possibility of such occurrences in the future.

There are two main channels, viz., financial and delivery or trade channels, through which,

global credit crunch and a recession in the US and Europe can affect India. In the financial

hannel, a decline in the capital inflow from abroad and lower access of the Indian corporate to

redit in international markets will affect India. In the delivery or trade channel, a slowdown

the exports of goods and services from India to the US and European countries might impact

dia. Impact through delivery or trade channel appears to be small as Indian exports are well

iversified. However, the financial channel impacts are likely to be more significant through a

utback in capital inflows. The expected impact of a global credit crunch and slowdown in the

S and European economy on India through these channels is likely to be negative for the near

uture. Nevertheless, the sub prime-related events, which have unfolded in the recent months

US and Europe, offer valuable lessons for an emerging country like India. For India, the

ollowing are the key factors responsible for insulating it from the direct impact of subprime

elated global crisis.

2009




Sound Banking Practices

Lack of stringent credit monitoring practices was the main cause for subprime mortgage crisis in

the US. Hence, besides relying on credit ratings, banks and financial institutions will also playa

key role in avoiding any credit shocks by carrying out proper due diligence of underlying securities

and home loan borrowers.

Banks and financial institutions need to further strengthen their risk monitoring and

management systems in order to effectively tackle the ever-rising complexities of financial products

and services. The Reserve Bank of India RBI are taking a series of proactive measures to avoid or

curb a subprime crisis in India.

The RBI has directed banks and financial institutions to set up independent credit counseling

centers that will alarm borrowers, if they are raising mortgage and personal loans beyond their

means. This is necessary when borrowers are bombarded with numerous credit cards and

personal loan offers. The main reason for subprime crisis in US was disbursement of mortgage

loans to those people who could not afford mortgage repayment. It is envisaged that such major

financial crisis could have been controlled if loan borrowers were more aware of their total

liabilities. According to an RBI directive, such credit counseling centers should provide free advice

and should not indulge in selling the financial products while providing investment advice. RBI

has asked banks to set up credit counseling centers, either individually or collectively.

Controlled Derivatives Market

Derivatives for mortgage products are innovative financial securities, which can spread the

default risk attached to housing mortgage loans. However, the imprudent application of such

derivatives products can lead to excessive leverage, as it happened in the subprime crisis of the

US. Any failure in derivatives transactions leads to such a chain of events that, it becomes nearly

impossible to quantify the risk of exposure to bad mortgage loans. The RBI and Government of

India GOI should prohibit excessive use of such derivatives products.

Limited Investment by Indian Companies Abroad

Although the Indian capital and financial markets are experiencing the domino effect of global

financial meltdown, the Indian banking system has remained fairly detached from any direct or

immediate impact of the US subprime crisis. This is due to the limited exposure or non-exposure

of the Indian banks to subprime loans in the US. Yet, there was a major impact of subprime crisis

on the Indian equity markets as many Foreign Institutional Investors FIls sold off their securities

and investments to Indian firms, to partially balance their huge subprime mortgage losses in the

foreign market. The FIls have and, as of date, continue to withdraw themselves from the equity

markets of emerging countries such as India in order to cope up with subprime-related losses in

the US market. In the period of global financial crisis, for long-term growth and sustainability, a

well-planned strategy for investment in foreign market is required.

Excessive investment in the overseas derivatives market by banks and financial institutions

is to be regulated. As a spillover effect of subprime crisis, BNP Paribas of France and Macquarie

Bank of Australia have been severely affected because of their exposure to such overseas

investments in derivative prqducts. The exposure of Indian banks to the subprime crisis of US is

very limited. However, the exposure of ICICI bank to overseas derivative market, although minimal,

has greatly impacted its enterprise value. The ICICI bank has faced a net loss of Rs. 375 cr in the

current banking crisis.

As the subprime crisis intensified globally, counterparty risk aversion has become rigorous

and has encouraged banks and financial institutions to carry significant amount of liquid assets

as precautionary measures. This has resulted in banks restricting lending and exposures to




Reference

09M 2009 06 06 01

BUSINESS ENVIRONMENT

rporate and an increase in the outflow of foreign funds from the capital market. These adverse

obal developments will drastically slowdown capital inflows into India. For the year 2008-09,

is estimated to be between 40 and 50 bn. The recent downward trend in the Indian and global

pital markets, also a reflection of increased global risk aversion and reduction in market liquidity,

ill have a negative impact on global investment and consumption patterns.

Indian firms were active in the foreign debt markets for financing overseas expenditures

nominated in foreign currency, mergers and acquisitions. Hence, the Indian corporate houses

e facing mounting difficulty in raising foreign loans as liquidity crisis faced by the foreign

nks and their loss of risk appetite are the key hindrances in any such moves. Pricing for foreign

rrowing by even blue chip Indian borrowers (e.g., Tata Motors, Reliance, etc.), has increased

gnificantly since the beginning of January 2008.

Central banks, across various countries including India, made a quick decision to cut interest

tes along with the declaration of economic stimulus packages by respective governments. All

ese collective steps were taken to control risks to broader economy, created by subprime crisis

d subsequent financial meltdown. It is envisaged that these measures will stimulate economic

owth and rebuild confidence in the financial and capital markets. The effects of subprime crisis

d subsequent financial turmoil on the global stock markets have been severe. Between January

2008 and October 11, 2008, the market capitalization of the US stock market had suffered 8 tn

losses, as their value declined from 20 tn to 12 tn. Losses in other nine countries have averaged

40%4.

The major turbulence in the global capital and financial markets and subsequent lower risk

petite of financial institutions and FII, will impact India's ability to finance its capital intensive

frastructure projects. As credit growth has not responded positively to liquidity strengthening

easures by central banks across the globe, it is envisaged that the supply of long-term funds for

nancing infrastructure projects worldwide will remain restricted for the next 12 to 24 months.

here is a pressing need for the development of long-term debt market, locally.

A subprime-like crisis in India seems unlikely, given the current state of regulatory affairs. In

cent years, the home loan mortgage market has grown rapidly in India. However, the Indian

edit growth is far behind the levels of credit growth seen in Western countries. Mortgage loans,

a percentage of GDP in India, are still at a smaller percentage as compared to the US and the UK.

he approach of the Indian regulators regarding financial markets has been cautious, balanced

d forward-looking. The RBI's policy of strict watch on market liquidity, in order to ensure that

e money supply (and hence inflation) is kept within manageable limits, is helping to avoid any

ch full blown financial crisis like subprime crisis.

he aftershocks from subprime crisis caused widespread panic in the global financial and capital

arkets and encouraged investors to abandon risky mortgage bonds and volatile equities. The

bprirne crisis is likely to have long-lasting economic impacts on the world market. Continuously

clining home prices in the US have adversely affected household wealth and consumption

tterns. The immediate impact of subprime crisis on global banking industry, involves

ndamental changes in banking business models, eliminating volume and income, with net

fect of large percentage reduction in the available credit. The subprime crisis has altered investor

d lender risk preferences in a big way. Structured financial products are being avoided by

vestors and financial institutions, as they prefer holding in favor of cash or cash equivalent

Wall Street Journal October 11, 2008,p.l.

bankruptcy of lehman brothers - a pointer of subprime crisis

Documents