In a few days from now, on 15th September, we will remember the demise of the investment bank Lehman Brothers.
The largest bankruptcy in the history - much bigger than Enron, WorldCom and Adelphia combined, with an assets-write off worth over US$ 639 Billion, making 25000 employees jobless overnight, playing havoc on the stock markets and national economies, and triggering a Tsunami of bankruptcies and bailouts.
It is the story of the basic instincts – greed and fear – operating in international financial markets. It is the story of how global banks, politicians, governments, rating agencies all failed - together. How the checks and balances were tampered with. It is the story of herd mentality - naïve homeowners, retail investors, employees losing their homes, life’s savings, jobs. It is the story of decisions based on good intentions wrongly implemented. It is the story of how the world economic order came on the verge of a collapse, and how we were saved from the Great Depression – part II.
The Humble Origins of Lehman Brothers
Way back in 19th Century a German immigrant – Henry Lehman – started a small store selling general merchandise in the state of Alabama. Henry’s brothers – Emmanuel and Mayer soon joined him, and in 1850 they formed Lehman Brothers. Initially, they were trading in cotton and Alabama State bonds. They also were instrumental in formation of New York Cotton Exchange, Coffee Exchange, and Petroleum Exchange in the USA. Lehman Brothers survived many crises, but prospered and never looked back – well, until 15th September 2008!
Good Intentions, Bad Implementation
It all started with the good intentions of fulfilling the “Great American dream” of home ownership by the poor. During President Clinton as well as George W Bush’s presidencies – late 1990’s to early 2000’s - abundant cheap money was available in the USA, and in most of the western world. US's primary lending rates went as low as 1.75%. Too much credit was available for the takers, and too much cash was in the economy. Money was chasing the borrowers.
The home prices - the world over, barring some prudent locations- were moving only in one direction – north! You take a loan – buy a house – sell it after a year or two – you would have made a 50-100% profit. There could not be any downside to this model – or so everybody thought!
For home loans or home mortgages – as they are called in the US, typically a bank verifies - the need, and capability of the borrower to repay. And against the security of the house, lends the money. It demands 10-20% contribution from the home-owner him-/herself.
During the housing bubble in the USA, the situation looked somewhat different.
This crisis is also known as “subprime” crisis since the loans were “sub-prime” – below prime. In case of prime loans – the capacity of the borrowers is verified and considered to be good. Usually the borrower has a good job, regular income and has considerable self-contribution to the construction of own house. The people with a credit rating of below-prime are subprime.
The loans were given recklessly. Anybody approaching the banks could get a loan. They had developed funny acronyms for the unsophisticated borrowers - like NINJA borrowers – no income, no job, no assets. Usually, it’s Governments responsibility to provide subsidized housing to the poor.
The poor “subprime” borrowers were given 100% of their home value as loans – sometimes even 10-20% on top – in order to furnish their new house. So generous of the bankers!?
There was a catch in small print though. Often such loans will start at a “teaser interest rate” – which could be, say 2% in the first year – but jumps to 10% from the 2nd year. There could be no repayment in the first year – which again, could start from the 2nd year. Unsuspecting borrowers were tricked in accepting such conditions.
One may say – it is good if the private banks were taking the role of the Government, and the risks. But their intentions were not all that benevolent.
Securitization is - converting an immobile asset – like house – into a security – say 1000 bonds – which can then be sold individually and traded on the stock exchange. So, all the thousand bond-holders hold a fraction of a house. Rating agencies - supposed to be independent and acting in the interest of the investor, were paid by the banks selling the bonds for rating them as safe. A clear conflict of interest.
One may wonder – why should the world be worried about a real estate bubble, that too in the distant USA – the strongest economy in the world.
Well, the bonds were bundled and re-bundled and got sold the world over. Like many packs of cards - you shuffle those and reshuffle them - many times over! Housing Loan companies sold them to Investment Banks on the Wall Street. And investment bankers sold them to individuals, corporations, foreign investors, foreign banks, and foreign governments.
One Kaito Yamamoto sitting in a Japanese village might be financing the suburban home of an American Maria Roudrigez from Texas through the purchased securities. And he may never be able to know or trace that.
Things were getting too anonymous and cloudy.
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