The global financial crisis that erupted in September 2008 has thrown economies around the world into a recession. The root cause were sown in the credit boom that peaked in mid-2007, followed by the meltdown of sub-prime mortgages and securitized products. Fannie Mae and Freddie Mac were both taken over by the government and on September 24, 2008, Lehman Brothers declared bankruptcy after failing to find a buyer. The fall of Lehman Brothers rattled the global market and led to a great drop in the United States (U.S.) stock market the day after the announcement. The sudden failure of Lehman Brothers is widely viewed as a watershed moment in the global financial crisis of 2007 – 2009. With over $639 billion in assets and $613 billion in liabilities, it is one of the largest bankruptcies in the history of U.S. (Mamudi, 2008).
Lehman Brothers was founded in 1850 by three cotton brokers in Montgomery, Alabama. The firm moved to New York City after the Civil War and grew into one of Wall Street’s investment giants. Lehman Brothers is a global financial services firm; the fourth largest investment bank in the U.S. Lehman Brothers’ clients is big institutions, not small individuals. It is an innovator in global finance, serving the financial needs of corporations, governments, municipalities, institutional clients and high-net-worth individuals worldwide. Lehman Brothers investment banking operations accounted for just 20 per cent of the company’s 2007 revenue while most of its net revenue comes from fixed income sales and trading; about 40 per cent. Some of the different fixed income investments that Lehman Brothers deals with include derivatives and swaps, mortgage-backed securities and futures (Callan, n.d.). However, the investment management business still provides the stable earning base because of its fee-based structure.
This term paper will further look into the how Lehman Brothers started off as an investment bank began getting entangled to the subprime mortgages and how it led to its bankruptcy. Lessons from the downfall of Lehman Brothers and the causes and consequences of the collapse will be highlighted in this paper.
Subprime Mortgage Crisis
The subprime mortgage market lends money to people who don’t meet the credit scoring for ordinary mortgages. For example, a FICO score less than 620 will disqualify the applications from loans at the prime rate. Since subprime borrowers mostly have poor credit history or low incomes, there is a greater possibility that the debts won’t be paid. Thus, making subprime mortgages risky for lenders. Therefore, to compensate the added risk, banks and other lenders charge higher interest rates on subprime mortgages. This made subprime lending very lucrative. Fannie Mae and Freddie Mac have led the mortgage industry in the 1990s promoting home ownership amongst lower income borrowers.
The growth of subprime mortgage market can be attributed to a number of factors. The lower interest rates which resulted in home mortgage payments inexpensive led to a large number of demands for houses. Figure 1 show, a prolonged period of low interest rates which led to raise in house prices that was completely abnormal by historical standards. Banks searched for a method to meet the ever-increasing demand for mortgages and hence realized the perceived great profit opportunities in the real estate market. This prompted the innovation and design of new financial instruments and organizations such as securitized mortgage loans – mortgage backed securities (MBS), asset-backed securities (ABS) and collaterized debt obligations (CDOs) (Knutsen, 2011). As real estate prices rose in the early years of this decade and securitization provided more working capital for mortgage, lenders relaxed their underwriting criteria in order to issue more mortgages (Kirk, n.d.).
During the refinancing boom from 2001 to 2003, interest rates fell, borrowing demand increased, mortgage...