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How can a bank like Lehman go down so fast?





viraj
Quote:
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.
viraj
Quote:
So, what’s wrong in that?

The trouble is when the bank actually goes out to sell the derivatives, it discovers that there are no takers. And, even if there are buyers, they are willing to pay just a fraction. In other words, there is a sea of difference between the price that is being offered in the market and the high artificially-generated price thrown up by the model. So, when the bank ends up selling the instrument or unwinding derivatives, the loss suffered is far in excess of the mark-to-model loss. Such extra losses on thousands of securities and multiple portfolios can wipe out the capital of the bank.

How does one minimise such turmoil?

No easy answer to that. Maybe, some of the accounting norms need to be changed, so that the definition of MTM gets narrowed down. Besides, to stop banks from going overboard, capital requirement may have to be raised for derivatives position. But all this may be easier said than done.
lagoon
A little tip:

in the future, don't just copy a load of text from economictimes.com

http://economictimes.indiatimes.com/articleshow/msid-3491632,prtpage-1.cms
jonchalk
In short: Greed.

I know this is a simplistic answer. But greed is what brought down major corporations such as Enron and The Principal (I bet you do not even remember a company called "The Principal"). Greed also brought down Donald Trump the first time. If I recall correctly, he eventually lost a substantial portion of his assets many years ago. But after learning his mistakes, he rebuilt himself and now is back at the top again.

Yes, earning money the old fashion way (honesty) is hard, but more rewarding.
indianinworld
If one person buys a house on HOUSING LOAN and does not repays, then it is not a big deal.
But

If millions of people in US have got their HOUSING LOAN to buy a house and is unable to pay back, the fall happens. Also keep in the mind the below reasons -

Even if the Bank / Concern takes back the land / house, there is no one to buy it in return. Even if this is sold, the Bank will not get the actual loan amount which was provided to him when the loan was sanctioned.

FOR EXAMPLE - >
If 10 $'s was sanctioned as loan amount to one of the client and he has already paid 2 $'s which includes the interest and principle amount, and now the customer is unable to pay back the loan and this property value has declined to 4.5 $'s, then..............
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