|Financial markets can be punishing and reversal of fortunes can be dramatic. More so, if an institution is overleveraged — when loan and investment books are much, much bigger than its capital. What compounds problems are strange accounting practice and high-risk nature of the loans and investments. There are also disclosure issues: Lehman, in its last conference call with investors, gave no clue that it was actually on the brink.
How did the crisis build up?
An investment bank uses its proprietary book (own money) to lend others and invest. It started with the subprime crisis. Banks like Lehman, buy mortgage loans from other banks, and then package them to sell bonds against the loan pool. Often they add cash to make the loan pool more attractive, so that the bonds can be sold at a higher price. Suppose mortgage was earning 6%, these bonds are sold at 4%. The difference is the spread which the investment bank earns. By selling these structured bonds, it raises money and frees capital. But when homebuyers started defaulting, these bonds lost their value. It all began like this, and then the virus spreads across markets.
But don’t investment banks play advisory role?
They do, but slowly over the years, their prop books have multiplied. Investment banks also organise big loans for their clients for funding acquisitions. At times, investment banks take positions, only to palm off the securities to other clients and banks. In a crisis, they may not get the opportunity to down-sell such positions. This adds to the panic.
Can’t central banks step in to stem the crisis?
Well, they can and they have, to an extent. It’s precisely to discourage banks and bond houses from selling securities to generate liquidity, Fed has relaxed the rules under which it lends to institutions against securities. Moreover, if there’s a financial chaos of this magnitude, banks refrain from lending each other, fearing that the money would get stuck. A liquidity window from the central bank thus comes handy.
How does the domino effect play out?
Suppose Lehman faces a redemption and has to repay another bank it has borrowed from. If it sells the mortgage-backed bonds, whose prices have fallen, it will not raise as much as was earlier expected. So, it sells some of the other good assets or bonds which may have nothing to do with mortgages. But since the bank starts dumping these assets, prices of these bonds also dip. This is when the crisis spreads from subprime to prime.