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The Journal of Credit Risk (57–76)
Volume 5/Number 2, Summer 2009
Balance sheet exposures leading toward the
credit crunch in global investment banks
Business School, University of East London, Docklands Campus, University Way, London E16 2RD, UK; email: email@example.com
This paper examines the effect of the 2007–8 predicament in the investment banking sector from a balance sheet perspective. The main factors that led to the crisis are identified and discussed, along with how an investment banking sector searching for high yields got involved in mortgage-related securities. Data from the five major US investment banks between 2004 and the second quarter of 2008 is used to argue that the predicament is the result of the combined effect of the subprime crisis and the credit crunch. The main focus of this paper is an analysis of the effect of leverage and liquidity factors on the balance sheet during the crisis, using data from Goldman Sachs and, more importantly, Lehman Brothers from 1999 to the second quarter of 2008. The two investment banks are compared and analyzed to assess whether the balance sheet argument is holding as the crisis deepens.
The 2007–8 predicament is the product of two crises: the subprime crisis and the credit crunch, which combine to create the perfect storm. Individually, neither crisis would have created a big problem but combined they have had a lasting effect on the banks, albeit in different ways. However, as Adrian and Shin (2008b) point out, the subprime securities market is relatively small compared with the overall financial market, and the total loss in overall write-downs from the entire investment banking sector, which stands at US$81.5 billion (Onaran and Pierson (2008)), is less than or equivalent to an average daily gain or loss on the stock market under normal conditions.
In order to fully understand the problems affecting the investment banking sector, there is a need to define the term “investment bank”. Hughes and MacDonald (2002, p. 459) define an investment bank as “a bank whose function is the provision of longterm equity and loan finance for industrial and other companies, particularly new securities”. However, after the Gramm–Leach–Bliley Act of 1999, this definition could fit any commercial bank. What distinguishes investment banks is the method used to raise the majority of the required capital: namely, to rely on high leverage, as suggested by Buiter (2007).
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According to Adrian and Shin (2008b), banks, especially investment banks, tend to grow their balance sheets under booming market conditions and shrink them under busting market conditions. In order to grow their balance sheets they leverage against the assets held upon them, thereby causing the banks’ liabilities to grow. During the subprime market boom of 2004 to mid 2007, the banks grew their assets by investing in subprime securities, eg, mortgage-backed securities (MBSs) and collateralized debt obligations (CDOs), using leverage. The problem occurred when the subprime market collapsed and credit rating agencies downgraded some subprime securities to junk assets, leaving the banks with assets that were losing value every day on their balance sheets. This affected confidence within the banking sector and led to the credit crunch.
In general, the banking sector’s response to a crisis is to raise liquidity on their balance sheets (Cifuentes et al (2005)). This means raising capital levels held on the balance sheet by selling illiquid assets. This is the problem at the heart of the growing number of write-downs.
With the above factors in mind, this paper focuses on the effect of the predicament of 2007–8 on the balance sheets of the investment banking sector. The next section will outline the...
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