Case of Problems for Financial Institutions during the Credit Crises (Term Paper Sample)

Case of Problems for Financial Institutions during the Credit Crises
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Case of Problems for Financial Institutions during the Credit Crises
Introduction
Credit crisis occurs when the availability of loans or credit to individuals and other institutions reduces resulting into tightened conditions for obtaining credit. Credit and loans availability reduce without being significantly influenced by the interest rates levels in the economy. The occurrence of the credit crisis in any economy results into a reduction in the number of financial institutions who are willing to advance loans to individuals and institutions.
Financial institutions have been blamed for their careless financial policies which have been attributed to the escalation of the 2007 credit crunch. Most financial institutions had prolonged careless lending behaviors which resulted into massive defaulting by borrowers whose trustworthy was not predetermined. One of the major causes of these behaviors among financial institutions is the escalation of credit competition resulting into the advancement of non-collateralized loans to individuals and institutions. As a result of the losses caused by defaulting borrowers, financial institutions are thus faced with no option apart from the reduction of credit availability. Others increase the overall cost of acquiring loans by individuals to cushion themselves from the unpredictable credit market. An increase and persistence in these conditions results into increased foreclosures and the bankruptcy of individuals and institutions who are attempting to access credit.
From the beginning of 2008, the credit crisis was graduating into a major crisis was crippling the operation of a number of institutions in the United States. A number of banks, insurance companies, mortgage companies and other manufacturing companies were experiencing financial problems. However, the financial sector was the hit hardest by the crisis, and this led to the collapse, liquidation, insolvency and bankruptcy of a number of them. Lehman Brothers was among the many financial institutions which were affected by the credit crisis.
Established by two brothers, Lehman Brothers operated as a financial service and was considered as the fourth largest investment company. The company majored in investment banking, equity and the offering of other financial instruments to financial investors. However, in 2008, the company was declared bankrupt and was purchased by Barclays bank.
As one of the financial institutions that collapsed due to the credit crisis, Lehman Brothers was faced by a number of challenges which contributed to the collapse. This paper will seek to highlight the causes of the problems that faced the company during the financial crisis that led to collapse and takeover by Barclays bank. It will also provide an evaluation of how the company should have acted to avoid the problems that it faced which led to its collapse.
Causes of the problems that faced Lehman Brothers during the credit crisis
Before the credit crisis developed into a complex financial situation, the US subprime mortgage crisis had faced major ripples. These ripples created significant impacts on the United States housing sector but spread to other sectors and even beyond the boundaries of the United States by 2008. This was one of the causes of the problems that escalated the credit crisis in the United States which led to the collapse of financial institutions like Lehman Brothers. The United States mortgage sector is highly connected to the financial institutions that any ripples within this sector affects the financial institutions like banks. Players in the United States subprime mortgage sectors are capable of passing the risks they are facing to the banks.
The banks involved are the normal deposit taking banks and investment banks like Lehman Brothers. Many investment analysts attributed the problems at Lehman Brothers to their participation in the subprime mortgage sector of the United States. The policies and approach to the loans and investment decisions increased their risks as will be highlighted in this paper. Despite being a smaller investment bank as compared to other institutions like Goldman Sachs and Merrill Lynch, Lehman Brother established itself as a major player in the global financial sector. The subprime mortgage crisis arose as a result of a number of reasons, actions and inactions of those concerned.
Accountants and auditors played a significant role in the period before, after and during the crisis. This has made them part of the problem and several questions have been raised over their actions and inactions. During the crisis, accountants were blamed for overvaluing the bundled mortgaged assets. While doing this, the accountants did not provide the actual value of the bundled sub-prime loans, leaving the financial institutions and the government to act on false values. The accountants also allowed the advancement of loans to individuals with poor credit history without providing a complete valuation of such a move. This made it possible for a number of people to acquire loans they were unable to pay back. As a result, a decline in the housing markets led to a rise in the interest rates resulting to mass defaulting
As a result, the engaged in massive transaction with other banks and maintained hedge funds. This resulted to a situation in which the bank created a large fund pool to increase its investment leverage. Many investors and analysts criticized this, arguing that it would expose the company to massive losses in case of crisis which would be fatal. Despite the criticism, the company maintained its operations and avoided the financial cripples into the beginning of 2008. This changed in the summer of the same year when the company announced major write-offs, and this marked the beginning of the problem for the Lehman’s Brothers.
Despite the previous warning by market analysts, Lehman Brothers, through its executives continued to provide an opposite illustration of the situation. The company depicted a normal situation to the customers and investors despite the fact that it was feeling the pangs of the crisis. When the crisis outgrew the boardroom, it was too major, and this resulted into a massive fall in its short sales. Short sales enable trades to borrow stock from Brokerage Company through betting that the price of the stock will ultimately decline. The profit from such an undertaking is the difference in the price at which the trader will sell the stock. This is subtracted from the price at which he will ultimately sell it back to the brokers. By not being open about the extent of the losses the company faced as a result of the ripples created by the subprime mortgage crisis, Lehman brothers lost the confidence and trust of investors. This was the first and the major cause of the problems that Lehman faced during and at the end of the credit crisis.
Apart from the subprime mortgage crisis that directly impacted on the failure of the institution, the liquidity policy of the company had significant influence on its ability to withstand the tide. Cash flow problems have been shown by various analysts as a major cause of business failure. The company operated on a subverted pyramid financial management approach that had little cash. Despite its big asset base and positive liability records, the company lacked enough fluid cash to take it through the crisis. Most of the assets of the company were also not easily disposable, and this complicated the approach of recovery for the institution. This created a lack of confidence during the crisis as a number of institutions doubted the shaky financial position of the institution.
As a result, most banks moved to withdraw their lines of credit from the company in a move seen as protecting their own interests. This exposed the investment bank to the pangs of the crisis as its liquidity reduced drastically from an already insufficient base. Most banks also ignored Lehman’s requests to trade with it, steps that would have quelled and changed the situation for the bank. As highlighted with the subprime mortgage crisis causes, the loss of market confidence that faced the company escalated the situation for the company. This created room for most banks and financial institutions to withdraw their businesses and engagements with the company. Left isolated and without a willing business partner, Lehman Brothers faced the pangs of the credit crisis and this directly resulted into its fall.
Risk management approaches also play a significant role during credit and financial crisis in an economy. The risks management strategies adopted a business especially those in the financial sector will influence its ability to withstand the waves of downfall. This did not occur with Lehman Brothers due to the shoddy and casual approach that the company gave to risks management. As a result, the credit crisis found a company that was laid bare and an easy target to failure. A culture of risk management gives financial institutions leverage to withstand the impacts of the crisis and remain strong. This was not the culture that was developed by Lehman and this exposed it as compared to other companies like JPMorgan Chase.
Investment analysts argue that Lehman Brothers adopted a reckless credit policy during the housing boom that occurred in 2007. This occurred despite the company maintaining a low liquidity ratio as compared to its disposable assets. Once the foreclosure occurred after the tides changed on the housing markets, the company was exposed to the pangs of the credit crisis, and this attributed to drop in its share value and final decline.
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