Lehman brothers - 1 year on

It seems like a good idea to start this blog as it's the 1st anniversary of the collapse of Lehman brothers. A lot of people are now aware of the reasons behind their collapse but it's probably worth re-iterating some of it.

Lehman brother's was an investment bank. Investment banks make their money in a variety of ways, the main ways being:-

1. Raising capital (capital's a posh word for money). The main way's that an investment bank raises money for it's clients (which are mainly companies) is to sell shares in that company or to sell the client company's debt to other companies and people. An investment bank makes money by taking a cut of the money that it's raised for a client.

2. Trading (buying and selling) in securities. Securities is an all encompassing word, which covers company shares, a company's debt, credit notes i.e. ious that a company may issue and any derivative (i.e. complex and opaque) of these. An investment bank makes money by taking a cut of any trade - this is known as market making, or by trading in securities itself, in the same way as a private individual may buy and sell shares, for example.

3. Advisory. Investment banks provide advice to companies and rich folk about which investments, they believe will make the most money.

4. Investment management. This is actively managing investments for companies, rich people and pension funds (who own rich and poor people's money).

Given all of the relatively lucrative ways of making money highlighted above, why did it all go horribly wrong for Lehman's. Well the short answer is that they got greedy.

The general US and UK economy grows by 3% on average per year. This means that if you invested in every person and company in the UK, say, you could expect to make a 3% return on your investment each year.
If an investment bank were to offer you a 3% return on your money, you might feel ok about this as bank rates are pretty low at the moment, but when they've been higher, you'd likely not be rushing to put your money in.

Luckily, for investment banks, they can get better returns by not investing in non-productive
people and faiing companies. So they can boost the returns to 5-7%, say. Now, for most people this would be a nice return but for rich people, they like to make more money than this. As there are a few investment banks around, they therefore have to convince companies and rich people that they can get higher rates of return than this. The manner in which investment banks chose to inflate their returns was by trading on margin/leveraging their assets.

What does trading on margin/leveraging their assets mean? Well an analogy is - if you buy your house for £150k without a mortgage, then you're not trading on margin/leveraging your assets, since you're merely transferring £150k in cash in to £150k in property. However, if you buy your house by putting down a £15k deposit, then you're leveraging your assets by 10 times. i.e. you originally only had £15k in cash, but now you've got £150k in property. A lot of people do this and, for most people it works out well. However, you've likely heard of negative equity. Negative equity happens when you buy a £150k house with £15k and the price drops below £135k. i.e. assets (in this case property) have dropped by more than the capital (cash) that you put in. When this happens, your bank usually starts to get a bit nervous and if your mortage is up for renewal whilst you're still in negative equity then you could get problems getting another offer.

So going back to why Lehman's went bust. To attract business away from other investment banks, they needed to offer attractive rates of return and the only way to do this was by leveraging the assets. In their case, rather than putting their money in to property, a lot of their money went in to reinsurance paperwork based on mortages lent to poor US people, many of whom had no chance of ever paying back the mortage (these mortgages are known as subprime, because most sensible people wouldn't have lent to such folk). Lehman's originally did the sensible thing of just selling on these substandard products to their clients but when the property market in the US turned south, they realised they had a major problem on their hands. The magnified returns which their clients had previously enjoyed would turn in to magnified losses, and there wouldn't be many people happy with Lehmans. So, what they tried to do is to prop up the market by buying the dodgy paperwork themselves. Their problem was that independent commentators had cottoned on to who was most exposed to the subprime market and had started to highlight this in various financial articles. There then ensued a run on the value of Lehman's brothers on the stock market, which highlighted the problem to the financial authorities.

Lehman brother's finally collapsed because, just as normal people have to pay their mortgage every month, Lehman had to pay for the leveraged debt that they'd taken on when buying the dodgy subprime paperwork. As most of their money was tied up in this and they were making losses rather than profits, the only way of paying the monthly fees to their lenders was by selling some of their assets. However, as they were leveraged so highly (44*assets at one stage), the debt which was owed was more than their entire assets so they were heading for bankruptcy. Their one hope would have been if somebody had come along and bought them. Although, you'd think you'd have to be mad to buy a company that was heading for bankruptcy, the thing is that Lehman brother's amongst the public was still well known and a buyer could hide all of the problems that Lehman's had suffered until the market turned around again and they'd have a bigger slice of the investment banking market. Many of the potential buyers were also owed the money which Lehman's couldn't pay, as well, so it may have been better to buy them rather than lose the money they were owed when Lehman's went bankrupt. Another reason why Lehman's figured that they'd got bought out was that they were too big to fail i.e. their losses were so huge that allowing them to fail would have an unacceptable ripple effect on the entire financial system. The US government, however, decided not to bail out Lehman's with taxpayers money. Commentator's say that this was because they'd already bailed out other institutions and wanted to draw a line. This left Barclay's capital as the one potential knight in shining armour. The problem there was that under UK law, BarCap would have to hold a shareholder's meeting to approve the deal and this couldn't be arranged before the financial markets opened. As soon as the financial market's opened, there was sure to be a further run on Lehman's share price. The lower Lehman's share price went, the lower it's financial rating becomes and this has a knock on effect of making the cost of it's debts higher, making it less attractive for any potential buyer. The UK government was also reticent to allow BarCap to step in, when it may have later needed to have been bailed out itself.

1 year on, there's talk of green shoots of recovery etc. and the investment banks are hiring once more. All seems rosy. Don't bet on it. The problem remains that the only way that investment banks can attract business is by offering high rates of return. The only way to achieve high rates of return is through leveraging. In the good times, leveraging creates huge profits and huge bonuses for investment bankers. In the bad times, it creates huge losses and inevitable bailout by other financial institutions/taxpayers. The UK&US financial authorities so far have taken no steps to prevent this from happening again out of fear that the investment banks that account, in the case of the UK, for a disproportionate amount of the economy will move their casinos to another country e.g. Singapore.