Lehman Brothers was among the leading financial institutions in the United States before it collapsed. Although the organization survived various challenges for more than a century, it was unable to withstand the difficulties caused by the credit crisis of 2008. According to Wiggins et al. (2019), the financial organization filed a bankruptcy petition on September 15, 2008, which was the largest insolvency case in the history of the United States. Various factors contributed to Lehman Brothers’ inability to endure the credit crisis.
The organization had invested heavily in risky ventures in the market. The bank took a considerable risk that was not corresponding to its capability to raise adequate cash. Lehman Brothers’ assets value was $639 billion in 2008, which was enough to cover its debt of $613 billion (Amadeo & Kelly, 2021). Nevertheless, the demand for the assets was significantly low than what the bank had anticipated. As a result, the financial institution was unable to sell the assets to generate sufficient funds, a cash flow issue that contributed to its bankruptcy.
The Lehman brothers’ overconfidence is another factor that played a significant role in its collapse. Although the real estate market was declining at an alarming rate, the firm relied on intricate financial products based on the latter. Amadeo and Kelly (2021) note that the mortgage-backed securities facilitated a revenue growth of 130% between the year 2000 and 2006. The institution bought five mortgage lenders in 2003-2004, increasing its profitability. This factor encouraged the firm to invest heavily in commercial real estate and risky loans and keep on its books instead of selling them immediately. The leadership of the organization anticipated owning these assets would allow them to make more money (Egan, 2018). However, their timing was wrong because the real estate prices were declining, ultimately leading to the firm’s failure.
The inaction of the regulating agencies and Lehman Brothers’ culture also led to the organization’s bankruptcy. According to Wiggins et al. (2019), the Security and Exchange Commission (SEC) and other financial institutions’ regulators failed to take appropriate actions against the firm. For instance, the SEC was aware in the previous year that Lehman was taking a considerable risk, but did not encourage the company to do something about it. Additionally, SEC was adamant in disclosing that the financial institution had surpassed the recommended risk limits. The culture of rewarding excessive risk-taking was an incentive that further drew Lehman Brothers towards its collapse. The bank’s top management team was determined to be ahead of rivals who used similar high-risk strategies. They did not effectively evaluate the market tread, making the bank a victim of the credit crisis.
Some investors were concerned that Lehman Brothers was overstating its earning. More accurate and complete disclosure of the financial position could have helped the monetary problems encountered by the bank. Such transparent information alleviates the possibility of mispricing of risks. The disclosure allows investors to the financial position of their organizations and advice the latter to channel their resources into ventures that guarantee better profit. Equally, complete and accurate financial information generates confidence among existing and potential investors, who are willing to add more monetary resources to address the credit crisis.
Banks Should Not Restrict their Credit during the Credit Crisis
The credit crisis of 2008-2009 triggered a wave that found financial institutions restricting borrowers from getting money. People criticized banks for limiting their credit because their actions did more harm than good about the situation. Credit restriction deprives of companies money to pay their current expenses (Franklin et al., 2019). Some business organizations may not have enough money to pay for expenses that allow them to be on day-to-day operations. Some of the current expenses vital to business processes are utility bills, rent, and office supplies. Firms may end up experiencing significant difficulties in executing their daily activities if denied credit by banks.
Companies also lack financial resources to expand operations and start new investments when banks restrict credit during crisis. Both private and public organizations have a significant role in generating revenue for the government and creating employment. To achieve the former and the latter, firms require money to maintain and expand their operations. However, if the banks are unwilling to give credit, then there would be no revenue growth and the rise in unemployment level would be inevitable (Franklin et al., 2019). Equally, the economy would record an increased dependent ratio and no new investments. Therefore, banks should not restrict their credit during such a crisis as that of 2008-2009 because it can lead to collapsing of the economy.
Concerns about Systemic Risks Due to the Credit Crisis
Systemic risk refers to the probability of an occurrence at the company level triggering collapsing or instability of an industrial sector or an economy. Systemic risk is a concern during credit crisis because a bankruptcy of one financial institution due to defaulters can trigger cause fear among other banks (Moch, 2018). The issue can make them more cautious on who they lend money to and restrict the amount of credit they give. Consequently, there would be not enough money for investment and consumption, negatively impacting the entire economic system.
For instance, the collapse of Lehman Brothers during the 2008-2009 financial crisis made other banks restrict credit to the borrowers. The issue made firms have inadequate money to expand operations and others could not afford to pay for their current expenses. As a result, the rate of economic growth slowed or declined since some companies ended stopping operations (Franklin et al., 2019). Equally, the limitation of credit available for the consumers reduced their purchasing power, hurting the demand and supply of goods and services. The problem made companies reduce their rate of production and investment as well as the amount of labor. The level of unemployment rose, further negatively impacting the economy.
Moral Hazard Problem
Although the government was determined to prevent collapsing of banks during the credit crisis, some financial institutions like Lehman Brothers ended up filing for bankruptcy. A moral hazard issue may have received significant attention at the period because involved would be justifying their actions. According to Robertson et al. (2020), a moral hazard problem occurs when one participant a deal or transaction is more comfortable taking risks since they know the other will bear the consequences. If financial organizations like the Lehman brothers had insured their business, it could have been argued that the bank engaged in high-risk practices knowing that another party could settle the costs in case of failure. Conversely, insurance agencies would have been concerned whether the bank took the necessary precaution to minimize the possibility of bankruptcy.
Even though the regulators did not help Lehman Brothers from being declared bankrupt, they may argue the assistance it offered to Bear Stearns was justifiable. First, the bank was responsible for its problems due to poor risk management practices and miscalculations. Amadeo and Kelly (2021) noted that the firm may have overstated its earnings and rewarded high-risk strategies. Second, unlike Lehman Brothers, Bear Stearns had collateral that covered the bailout (Sraders, 2018). Therefore, it was necessary to take measures that prevented the collapse of Bear Stearns.
References
Amadeo, K., & Kelly, R. (2021). How the 2008 lehman brothers collapse affects you today. The Balance.
Egan, M. (2018). Lehman Brothers: When the financial crisis spun out of control. CNN.
Franklin, J., Rostom, M., & Thwaites, G. (2019). The banks that said no: The impact of credit supply on productivity and wages. Journal of Financial Services Research, 57(2), 149-179.
Moch, N. (2018). The contribution of large banking institutions to systemic risk: What do we know? A literature review. Review of Economics, 69(3), 231-257.
Robertson, C., Yuan, A., Zhang, W., & Joiner, K. (2020). Distinguishing moral hazard from access for high-cost healthcare under insurance. PLOS ONE, 15(4), 1-17.
Sraders, A. (2018). The lehman brothers collapse and how it’s changed the economy today. TheStreet.
Wiggins, R., Piontek, T., & Metrick, A. (2019). The Lehman Brothers Bankruptcy A: Overview. The Journal of Financial Crises, 1(1), 39-62.