The stoy of Financial Crisis 2008 and Lehman's bankruptcy

It was a little difficult for me to understand the causes of 2008's financial crisis and especially Lehman's Bankruptcy. I have read a few books on the same ("Too big to fail" being the favorite) and lots of reports, blogs and discussions on the same. Here I am trying to put a summary of how the crisis unfolded (mostly for my own understanding). A lot of the below is taken from FCIC's inquiry report. For any questions/comments, plz feel free to add in your comments:

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Introduction of Commercial papers and Repo: Rise of Shadow Banking and focus on money market, instead of capital.

Due to rise of shadow banking, traditional banks faced stiff competition due to Regulatory restrictions (Capital Base, Cap in interest rates, etc.)

This led to relaxed regulations and removal of interest cap.

Since interest cap was removed, traditional banks needed more security. Fed became the lender of the last resort. Concept of Too Big to fail was born.

Due to stiff competition and risky bets in Repo and papers market, a few banks went bust which in turn effected mortgages.

To support mortgages, FNMA/GNMA/FHLMC (Fannie Mae,Ginnie Mae,Freddie Mac) were constructed to guarantee loans.

Ginnie was first to securitize in 1970.

Being GSEs, they were highly profitable (low cost of borrowing).

In 1980s, IBs began to securitize different types of Loans. (ARMs, non-mortgages auto loans etc.)

They started to mimic banking activities outside the regulatory framework. And to fund, they used capital/money market instead of deposit base in traditional banks.

Introduction of Pooling & Tranching for diversification of products and risk.

This raised complexity giving hard times to rating agencies. Since, participants needed good ratings, they chose and paid high fees to rating agencies.

With favourable ratings and transfer of risk, subprime market started to boom.

Then boom in Derivatives and birth of CDS which increased complexity even further. CDS were not regularised like insurance and Naked CDSes placed risky bets.

90s saw huge mergers of banks. 10 largest banks owned 55% of industries assets. Late 90s, Banks started to work closely with Insurance agencies. In 1998, Citicorp merged with Travelers (Insurance) to form Citigroup. However, as per the Glass-Steagal act, Citigroup had to breakup and divest many Travelers Assets. Instead of breaking the largest bank, govt repealed the act.

Pooling and tranching got more and more complicated.

90s subprime lending became abusive.

Entire 90s upto end of 2000 economy grew in every quarter; but also the national debt.

2001, economy showed signs of slowing down was construction was still booming peaking in 2004.

Oct 2001,  introduced the “Recourse Rule”. it would have to keep a dollar in capital for every dollar of residual interest. it increased banks’ incentive to sell the residual interests in securitizations.

After securitization: Holding securities rated AAA or AA required far less capital than holding lower-rated investments.

And a final comparison: under bank regulatory capital standards, a $100 triple-A

corporate bond required $8 in capital—five times as much as the triple-A mortgage backed security. Unlike the corporate bond, it was ultimately backed by real estate.

2005-2007 – Some members in Fed, wanted to put stricter norms for predatory lending, but Alan greenspan was not in favour. During this time, funds rate (short term) were gradually increased from 1% to 5.25%. However, mortgage rates (long term) continued to fall as Foreign Investment into US was providing the long term liquidity.

Meanwhile, Option ARMs, esp with negative amortization (Paying less than the interest thereby increasing the Principal) were growing exponentially. If the house prices fall, the borrower is better off walking away from the house and the loan as the house will be of less worth than the loan itself.

Piggyback Mortgage: The lender offered a first mortgage for perhaps 80% of the home’s value and a second mortgage for another 10-20%. Borrowers liked

these because their monthly payments were often cheaper than a traditional mortgage plus the required mortgage insurance, and the interest payments were tax deductible. Lenders liked them because the smaller first mortgage—even without mortgage insurance—could potentially be sold to the GSEs.

asset-backed commercial paper (ABCP) : short term borrowing with MBSes as collateral. It not only was riskier for the lender, it also indirectly took them off the balance sheets and hence required less capital to back it up. Also, to keep the ABCPs running, banks provide liquidity support to these against a small fee. This liquidity support meant that the bank would purchase, at a previously set price, any commercial paper that investors were unwilling to buy when it came up for

renewal.

they built new securities that would buy the tranches that had become harder to sell. Bankers would take those low investment-grade tranches, largely

rated BBB or A, from many mortgage-backed securities and repackage them into the new securities—CDOs. Most of these CDO tranches would be rated triple-A despite the fact that they generally comprised the lower-rated tranches of mortgage-backed securities. CDO securities would be sold with their own waterfalls, with the risk-averse investors, again, paid first and the risk-seeking investors paid last. As they did in the case of mortgage-backed securities, the rating agencies gave their highest, triple-A ratings to the securities at the top

In 1998, Multisector CDOs (Pooling in mortgages, aircraft leases, Mutual Funds, etc.) were introduced. However, in 2002 they performed poorly and the wisdom gained was that the wide range of assets had actually contributed to the problem; according to this view, the asset managers who selected the portfolios could not be experts in sectors as diverse as aircraft leases and mutual funds.So CDOs came back to subprime mortgages.

It was common for CDOs to be structured with 5-15% of their cash invested in other CDOs; CDOs with more than 80% of their cash invested in other CDOs were typically known as “CDOs squared.”

Finally, the issuers of over-the-counter derivatives called credit default swaps, most notably AIG, played a central role by issuing swaps to investors in CDO

tranches, promising to reimburse them for any losses on the tranches in exchange for a stream of premium-like payments.

July 2007 – A pilot prog was launched to examine subprime under Ben Bernanke. The rules would not take effect until October 1, 2009, which was too little, too late.

Repo 105: an accounting manoeuvre to temporarily remove assets from the balance sheet before each reporting period.

Early 2008: decision by the federal government and the GSEs to increase the GSEs’ mortgage activities and risk to support the collapsing mortgage market was made despite the unsound financial condition of the institutions. While these actions provided support to the mortgage market, they led to increased losses at the GSEs, which were ultimately borne by taxpayers, and reflected the conflicted nature of the GSEs’ dual mandate.

Mar 2008: Bear Stearns’s demise. JP Morgan announced its acquisition of Bear Stearns on Mar 18.

Now the focus was on Lehman. The chief concerns were Lehman’s real estate–related investments and its reliance on short-term funding sources, including $7.8 billion of commercial paper and $197 billion of repos at the end of the first quarter of 2008. There were also concerns about the firm’s more than 900,000 derivative contracts with a myriad of counterparties.

On March 18, Lehman reported better-than-expected earnings of $489 million for the first quarter of 2008. Its stock jumped nearly 50%, to $46.49. But investors and analysts quickly raised questions, especially concerning the reported value of Lehman’s real estate assets.

Lehman built up its liquidity to $45 billion at the end of May, but it and Merrill performed the worst among the four investment banks in the regulators’ liquidity stress tests in the spring and summer of 2008.

The company was also working to improve its capital position. First, it reduced real estate exposures (again, excluding real estate held for sale) from $90 billion to $71 billion at the end of May and to $54 billion at the end of the summer. Second, it raised new capital and longer-term debt—a total of $15.5 billion of preferred stock and senior and subordinated debt from April through June 2008.

On June 9, Lehman announced a preliminary $2.8 billion loss for its second quarter—the first loss since it became a public company in 1994. The share price fell to $30. Three days later

Lehman announced it was replacing Chief Operating Officer Joseph Gregory and Chief Financial Officer Erin Callan. The stock slumped again, to $22.70.

On June 25, results from the regulators’ most recent stress test showed that Lehman would need $15billion more than the $54 billion in its liquidity pool to survive a loss of all unsecured borrowings and varying amounts of secured borrowings.

By July 10, Lehman’s major tri-party repo lenders pulled back. (Also because JPMorgan, Lehman’s clearing bank, had refused to negotiate for Lehman.)

Sep 04: LB told JPMorgan about the upcoming 3^rd quarter result and the plans to bolster capital by: Investment from Korea development bank, sale of IB division, sale of real estate assets, division of company, etc.

September 9: news that there would be no investment from Korea Development Bank shook the market. Lehman’s stock plunged 55% from the day before, closing at $7.79.

That same day, Fuld agreed to post an additional $3.6 billion of collateral to JPMorgan. Lehman’s bankruptcy estate would later claim that Lehman did so because of JP Morgan’s improper threat to withhold repo funding. Zubrow said JP Morgan requested the collateral because of its growing exposure as a derivatives trading counterparty to Lehman. Steven Black, JP Morgan’s president, said he requested $5

billion from Lehman, which agreed to post $3.6 billion.

10-Sep 2008: Lehman reports $28billion of shareholder equity (more reported equity than it had 1 year earlier). Shareholder equity is a measure of solvency. (=total assets minus its total liabilities.). Shareholders' equity represents the amount by which a company is financed through common and preferred shares.

However, it was believed that its real estate and other assets have been overvalued by 60-70billion dollars.

10-Sep night: a New York Fed official circulated a “Liquidation Consortium” game plan to colleagues. The plan was to convene in one room senior-level representatives of Lehman’s counterparties in the tri-party repo, credit default swap, and over-the-counter derivatives markets—everyone who would suffer most if Lehman failed—and have them explore joint funding mechanisms to avert a failure.

According to the proposed game plan, Secretary Paulson would tell the participants they had until the opening of business in Asia the following Monday morning (Sunday night, New York time) to devise a credible plan.

11-Sep: JP demanded another $5billion from Lehman in cash.

Friday, September 12, Lewis (BofA CEO) called Paulson to repeat his assessment—no government support, no deal. (Next day he finalized buying Merrill Lynch).

Sat Sep 13 night: Deal with Barclays looked probable, if the private consortium assist by taking care of $40-50billion toxic assets

.

Sun Morning: 14-Sep: Barclays informed that FSA has declined to approve the deal. (The issue boiled down to a guarantee—the New York Fed required Barclays to guarantee Lehman’s obligations

from the sale until the transaction closed, much as JP Morgan had done for Bear Stearns in March. Under U.K. law, the guarantee required a Barclays shareholder vote, which could take 30 to 60 days. Though it could waive that requirement, the FSA asserted that such a waiver would be unprecedented, that it had not heard about this guarantee until Saturday night, and that Barclays did not really want to take on that obligation anyway.)

Monday 15-Sep: 1:45AM Lehman filed for bankruptcy.