Project report on 2008 financial crisis

1

BITS Pilani K.K Birla Goa Campus

A Report on 2008 Financial Crisis

For

Functions and Working of Stock Exchanges – ECON F422

Prepared By-

Student Name ID Number

Yash Bhargava

2013A3PS162G

Dharmaji Sharath 2013A3PS680G

Ishan Yelurwar 2013A8PS492G

Aakarsh Shukla

2013A1PS523G

Acknowledgement

We would sincerely like to thank Dr. Geeta Rani Duppati for giving us this unique opportunity

to work in such a new and dynamic field.

We would like to thank her for taking such an active interest in our learning process. Her

valuable nuggets of knowledge and lessons on practical learning have been very illuminating

and have shown us a new dimension of learning.

Our heartfelt gratitude to her for guiding us through the project and exhibiting great patience

with all our queries- big or small and for helping is in focusing our efforts in the right direction,

Our gratitude to BITS Pilani University for giving us this platform to hone our skills and

talents in an environment which will be of great importance in our future.

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Contents

Acknowledgement i

1 Introduction 1

2 Causes Of The Crisis 2

2.1 Bursting of the Housing Bubble . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 2

3 Impact On American Stock Markets 5

3.1 The Year 2007 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5

3.2 The Year 2008 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5

3.3 The Year 2009 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 7

4 Impact On London Stock Exchange 8

5 Impact on India 9

5.1 Information Technology: . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9

5.2 Exchange Rates: . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9

5.3 Foreign Exchange Outflows: . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 9

5.4 Stock Market: . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 10

5.5 Major SENSEX stock market plunges . . . . . . . . . . . . . . . . . . . . . . . . . . . 11

5.6 TIMELINE . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11

5.7 Why did this huge fall happen? . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12

5.8 Nifty Index Chart . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12

6 Case Studies 14

6.1 Lehman Brothers . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14

6.1.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14

6.1.2 History of Lehman Brothers . . . . . . . . . . . . . . . . . . . . . . . . . . . . 14

6.1.3 Primary Cause . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15

6.1.4 Lehmans Colossal Error . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 15

6.1.5 Downfall . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16

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6.1.6 Collapse of Lehman . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 17

6.1.7 Brief Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 18

6.2 Bear Stearns Inc. . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19

6.2.1 Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 19

6.2.2 Lead-up to the failure increasing exposure to subprime mortgages . . . . . . . 19

6.2.3 Start of the crisis – two subprime mortgage funds fail . . . . . . . . . . . . . . 20

6.2.4 Fed bailout and sale to JP Morgan Chase . . . . . . . . . . . . . . . . . . . . 21

6.2.5 Time line - Bear Stearns Hedge Funds Collapse . . . . . . . . . . . . . . . . . 22

6.2.6 The Mistakes Made . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23

7 Conclusion 25

8 REFERENCES 27

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List of Figures

2.1 History of Financial Crisis: Mid 2007-2010 . . . . . . . . . . . . . . . . . . . . . . . . 4

4.1 FTSE 100 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8

4.2 FTSE 100 vs Dow Jones . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 8

5.1 Current and Capital Account Balances as % of GDP . . . . . . . . . . . . . . . . . . 10

5.2 Plunge in Stock Market . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11

5.3 NIFTY Index Chart . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 13

6.1 Lehman Brothers: Selected Indicators . . . . . . . . . . . . . . . . . . . . . . . . . . . 15

6.2 Lehman Brothers Holdings: NYSE . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 16

6.3 Bear Stearns Stock Price: NYSE . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 21

6.4 Cummulative Returns (%) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 24

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Introduction

The following report is undertaken to study reasons and effects of one of the major financial crisis of

the previous decade i.e. Financial Crisis of 2008. The report gives a detailed account of what were the

origins of the crisis and what were its impact on the Stock markets and economy of worlds biggest

economy i.e. USA and the further ripples felt across the Indian Market. The time period of crisis

was not entirely restricted to the year 2008, rather the various precursors are mapped from the year

2006 and the various effects that lasted till the year of 2009.

We have adopted the Technical approach i.e. study of the phenomenon by focusing on the charts

providing various trends and information of the stock prices. We will present the various underlying

factors that on the first look didnt seem will impact the stock market but proved otherwise. Moreover,

we will draw concurrence between the theories taught in classes and the facts presented regarding the

crisis. As a case study we will also review some major stocks that underwent massive changes when

the crisis struck. We will also map the various policy decisions taken by the governments, specifically

USA and India to mitigate the effect of falling prices and if that helped to bring back the faith of

customers on the stock markets.

It starts with the cause of the crisis, which and what led to a big turmoil in the US markets,

the worlds largest economy and subsequently to whole of world. Then comes the impact of these

crisis on the major stock markets all around the world and then we have the impacts of the crisis

on the Indian Economy like the changes in the Indian Stock Market, changes in the exchange rate

and other important stuffs. Finally, we end with the case studies on the two companies that went

bankrupt during the crisis and what all they could have avoided and the lessons that can be learnt

for the future from the effects on these two companies.

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Causes Of The Crisis

2.1 Bursting of the Housing Bubble

It was started in 1999 when the Federal National Mortgage Association (also known as Fannie

Mae) started the efforts to make home loans more accessible to those with lower credit and savings

than lenders which was typically required. The main objective was to help everyone attain the

American dream of owning a house for themselves. Since these borrowers were considered high-risk,

their mortgages had unconventional terms that reflected that risk, such as higher interest rates and

variable payments.

As the prosperity of the subprime market (mortgage market for borrowers with lower credit ratings)

increased, the risk of defaulting also increased with it, posing a potential danger for the economy.

As of 2002, government-sponsored mortgage lenders Fannie Mae and Freddie Mac had extended

more than $3 trillion worth of mortgage credit. The role of Fannie and Freddie is to repurchase

mortgages from the lenders who originated them, and make money when mortgage notes are paid.

Thus, ever-increasing mortgage default rates led to a crippling decrease in revenue for these two

companies.

Initially if the borrowers could not pay the high interest rates they opted to sell their mortgage

as the prices of the properties were on the rise, but gradually as the defaulters began to increase

the prices of the properties stopped growing. Investors also benefitting from the interest payments

and premiums also had their incomes cut-off. Homeowners were defaulting at high rates as all of

the creative variations of subprime mortgages were resetting to higher payments while home prices

declined. Homeowners were upside down - they owed more on their mortgages than their homes were

worth - and could no longer just flip their way out of their homes if they couldn’t make the new,

higher payments. Instead, they lost their homes to foreclosure and often filed for bankruptcy in the

process.

Despite all this the Dow Jones was on the rise, but eventually the turmoil caught up and by December

2007 US started to go into a phase of recession. By early July 2008, the Dow Jones Industrial Average

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would trade below 11,000 for the first time in over two years.

On Sunday September 7, 2008, with the financial markets down nearly 20% from the October 2007

peaks, the government announced its takeover of Fannie Mae and Freddie Mac as a result of losses

from heavy exposure to the collapsing subprime mortgage market. One week later, on September

14, major investment firm Lehman Brothers succumbed to its own overexposure to the subprime

mortgage market, and announced the largest bankruptcy filing in U.S. history at that time. The

next day, markets plummeted, and the Dow closed down 499 points at 10,917.

The collapse of Lehman cascaded, resulting in the net asset value of the Reserve Primary Fund

falling below $1 per share on September 16, 2008. Investors then were informed that for every $1

invested, they were entitled to only 97 cents. This loss was due to the holding of commercial papers

issued by Lehman and was only the second time in history that a money market funds share value has

broken the buck. Panic ensued in the money market fund industry, resulting in massive redemption

requests. On the same day, Bank of America (NYSE: BAC) announced that it was buying Merrill

Lynch, the nation’s largest brokerage company. Additionally AIG (NYSE: AIG), one of the nation’s

leading financial companies, had its credit downgraded as a result of having underwritten more credit

derivative contracts than it could afford to pay off. On September 18, 2008, talk of a government

bailout began, sending the Dow up 410 points. The next day, Treasury Secretary Henry Paulson

proposed that a Troubled Asset Relief Program (TARP) of as much as $1 trillion be made available

to buy up toxic debt to ward off a complete financial meltdown. Also on this day, the Securities

and Exchange Commission (SEC) initiated a temporary ban on short selling the stocks of financial

companies, believing this would stabilize the markets. The markets surged on the news and investors

sent the Dow up 456 points to an intraday high of 11,483, finally closing up 361 at 11,388. These

highs would prove to be of historical importance as the financial markets were about to undergo

three weeks of complete turmoil.

Summarizing all the above points it can be said that the excess liquidity in the market proved

to be very harmful for the economy, making money easily available led to excessive loans and when

the interest rates were hiked again the markets in US went into a vicious cycle of recession, defaults

and bankruptcy.

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Figure 2.1: History of Financial Crisis: Mid 2007-2010

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Impact On American Stock Markets

The widely-watched Dow Jones Industrial Average hit its pre-recession, all-time high on October 9,

2007, closing at 14,164.43. Less than 18 months later, it had fallen more than 50% to 6,594.44 on

March 5, 2009. This wasn’t the largest decline in history – during the the Great Depression, the

stock market took a 90% hit. However, it was more vicious – it took only 18 months, while the fall

during the Depression took over three years.

3.1 The Year 2007

The Dow opened the year at 12,459.54. It rose fairly steadily throughout most of the year, despite

concerns about a slowdown in the overheated housing market. Housing prices were falling in 2006,

triggering the default of subprime mortgages. However, government officials didn’t think the housing

slowdown would affect the rest of the economy.

By August 2007, the Federal Reserve recognized that banks had a liquidity problem. It began adding

liquidity by selling its reserves of Treasuries and accepted subprime mortgages from the banks as

collateral. Shortly after the Dow hit its peak, some economists warned about the potential general

impact of widespread use of collateralized debt obligations and other derivatives.

However, as the year drew to a close, the BEA revised its estimate of third quarter GDP growth,

(Gross Domestic Product) up to a phenomenal 4.9%. It seemed the healthy U.S. economy could

shrug off a housing downturn, and financial market liquidity constraints, as 2007 drew to a close.

The Dow ended the year just slightly off its October high, at 13,264.82.

3.2 The Year 2008

By the end of January, the BEA announced that GDP growth was a paltry .6% for the fourth quarter

of 2007. The economy lost 17,000 jobs, the first time since 2004. The Dow shrugged off the news,

and hovered between 12,000-13,000 until March.

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On March 17, the Federal Reserve intervened to save the failing investment bank Bear Stearns,

the first casualty of the subprime mortgage crisis. The Dow dropped to an intraday low of 11,650.44,

but seemed to recover. In fact, many thought the Bear Stearns rescue would keep markets from

sliding below 20% of the October high, and avoid a bear market. In fact, by May the Dow rose above

13,000 again and it seemed the worst was behind us.

However, in July 2008 the subprime mortgage crisis had spread to government sponsored agencies

Fannie Mae and Freddie Mac, requiring a Federal government bailout. The Treasury Department

guaranteed $25 billion in their loans and bought shares of Fannie’s and Freddie’s stock, while the

FHA to guaranteed $300 billion in new loans. The Dow closed on July 15 at 10,962.54, before

bouncing back above 11,000 for the rest of the summer.

The month of September started with chilling news – On Monday, September 15, 2008, Lehman

Brothers declared bankruptcy. The Dow dropped 504.48 points.

On Tuesday, the Federal Reserve announced it was bailing out insurance giant AIG with an $85

billion loanın return for 79.9% equity, effectively taking ownership. AIG had run out of cash in

its attempt to pay off credit default swaps it had issued against mortgage-backed securities. On

Wednesday, money market funds lost $144 billion as investors panicked, and switched to ultra-safe

Treasury notes. The Dow fell 449.36 points.

On Thursday, markets rose 400 points as investors learned about a new bank bailout package. On

Friday, the Dow ended the week at 11,388.44 – slightly below its Monday open of 11,416.37.

On Saturday, September 20, Hank Paulson and Ben Bernanke sent the $700 billion bailout package

to Congress. The Dow bounced around 11,000 until September 29, when the Senate voted against

the bailout bill. The Dow fell 777.68 points, the most in any single day in history.

Congress finally passed the bailout bill in early October, but by now panic had set in. The Labor

Department reported that the economy had lost a whopping 159,000 jobs in the prior month. On

Monday, October 6, the Dow dropped 800 points, closing before 10,000 for the first time since 2004.

The Federal Reserve fought the ongoing banking liquidity crisis by lending $540 billion to money

market funds, coordinating a global central bank bailout, and lowering the Fed funds rate to just

one percent. However, the LIBOR bank lending rate rose to its high of 3.46%.

The Dow responded by plummeting 13% throughout the month. By the end of October, the BEA

released more sobering news – the economy had contracted .3% in the third quarter. The nation was

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in recession.

The Labor Department reported that the economy had lost a staggering 240,000 jobs in October.

The AIG bailout grew to $150 billion, Treasury announced it was using part of the $700 billion

bailout to buy preferred stocks in the nation’s’ banks, and the Big 3 automakers asked for a Federal

bailout, as well. By November 20, 2008, the Dow had plummeted to 7,552.29, a new low. However,

the stock market crash of 2008 was not yet over.

The Federal Reserve dropped the Fed funds rate to zero, its lowest level in history. The Dow ended

the year at a sickening 8,776.39, down nearly 34

3.3 The Year 2009

The Dow climbed to 9,034.69 on January 2, 2009 in a burst of optimism that the new Obama

Administration could tackle the recession with his team of economic advisers. However, continued

bad economic news sent the Dow down to 6,594.44 on March 5, 2009 – its true market bottom.

Soon afterwards, Obama’s economic stimulus plan started to create the confidence needed to stop

the panic. On July 24, 2009, the Dow reached a higher high, closing at 9,093.24 and beating its

January high. For most, the stock market crash of 2008 was over.

However, the scars remained and investors remained skittish throughout the next four years. On June

1, 2012, panicked over a poor May jobs report and the Eurozone debt crisis, they piled into ultra-safe

Treasuries. The Dow dropped 275 points, and the 10-year benchmark Treasury yield dropped to

1.443 during intraday trading. This was the lowest rate in more than 200 years. This indicated that

the confidence that evaporated during 2008 had not yet returned to Wall Street.

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Impact On London Stock Exchange

Figure 4.1: FTSE 100

Figure 4.2: FTSE 100 vs Dow Jones

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Impact on India

Though the cause of the financial crisis were basically in US but the CDOs were shared with investors

worldwide and also the globalization escalated the troubles in the others markets also. Majorly

affected markets were of the European Union’s, UK and the Asian. The report here focuses on the

impact on the Indian Economy -

5.1 Information Technology:

With the global financial system getting trapped in the quicksand, there was uncertainty across the

Indian Software industry. The U.S. banks have had huge running relations with Indian Software

Companies. A rough estimate suggested that at least a minimum of 30,000 Indian jobs could were

impacted immediately in the wake of happenings in the U.S. financial system.

5.2 Exchange Rates:

Exchange rate volatility in India had increased in the year 2008-09 compared to previous years.

Massive selling by Foreign Institutional Investors and conversion of their holdings from rupees to

dollars for repatriation had resulted in the rupee depreciating sharply against the dollar. Between

January 1 and October 16, 2008, the Reserve Bank of India (RBI) reference rate for the rupee fell

by nearly 25 per cent, from Rs.39.20 per dollar to Rs.48.86. This depreciation may had been good

for Indias exports that were adversely affected by the slowdown in global markets but it was not so

good for those who had accumulated foreign exchange payment commitments.

5.3 Foreign Exchange Outflows:

The Indian economy had been greatly integrated with the global economy. The financial institutions

in India were exposed to the world financial market. Foreign institutional investment (FII) was largely

open to Indias equity, debt markets and market for mutual funds. The most immediate effect of the

crisis had been an outflow of foreign institutional investment from the equity market. There was

a serious concern about the likely impact on the economy because of the heavy foreign exchange

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outflows in the wake of sustained selling by Foreign Institutional Investors in the stock markets and

withdrawal of funds by others. The crisis resulted in net outflow of $10.1billion from the equity and

debt markets in India.

5.4 Stock Market:

The financial turmoil affected the stock markets even in India. The combination of a rapid sell

off by financial institutions and the prospect of economic slowdown had pulled down the stocks

and commodities market. Foreign institutional investors pulled out close to $ 11 billion from India,

dragging the capital market down with it. Stock prices had fallen by 60 per cent. Indias stock market

indexSensex touched above 11,000 mark in the month of January,2008 and had plunged below 10,000

during October 2008. The movement of Sensex showed a positive and significant relation with Foreign

Institutional Investment flows into the market. This also had an effect on the Primary Market. In

2007-08, the net Foreign Institutional Investment inflows into India amounted to $20.3 billion. As

compared to this, they pulled out $11.1 billion during the first nine-and-a- half months of the calendar

year 2008, of which $8.3 billion occurred over the first six-and-a-half months of the financial year

2008-09 (April 1 to October 16).

Figure 5.1: Current and Capital Account Balances as % of GDP

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5.5 Major SENSEX stock market plunges

In the third week following the crisis, the SENSEX experienced huge falls along with other markets

around the world. On 21 January 2008, the SENSEX saw its highest ever loss of 1,408 points at the

end of the session. This was due to the high volatility of the market which created panic amongst

investors following weak global cues and fall of US economy.

BSE Sensex which had a pre-crisis high of 21,234 fell down to about 7,969 by the end of the crisis.

Figure 5.2: Plunge in Stock Market

5.6 TIMELINE

The free fall of the SENSEX accelerated in March 2008. The month started out with the Sensex

losing 900.84 points on 3 March 2008, on concerns emanating from growing credit losses in the US .

• 14,810, 17 March 2008 - The SENSEX dropped by 951.03 points on the global credit crisis

and distress, to fall below the 15,000 mark, closing at 14,810.

• 13,802, 27 June 2008 - The SENSEX dropped by 600 points, to fall below the 14,000 mark,

closing at 13,802.

• 12,962, 1 July 2008 - The SENSEX falls below the 13,000 mark, closing at 12,962.

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• 11,802, 6 October 2008 - The SENSEX dropped by 724.62 points amid fears of the US

recession and attempts by governments across the world to save their failing banks, to fall

below the 12,000 mark, closing at 11,802.

• 10,527, 10 October 2008 - The SENSEX dropped by 800.51 points amid weak industrial

production data and concerns over impact of global economic crisis on IT and banking firms

in India, to fall below the 11,000 mark, closing at 10,527.

• 9,975, 17 October 2008 The SENSEX crashes below the psychological 5-figure mark of

10,000 points, closing at 9,975.35, following extremely negative global financial indications in

US and other countries. Just ten months earlier, in December 2007, SENSEX had closed above

the 20,000 mark for the first time.

• 8,701.07, 24 October 2008 - The SENSEX lost 10.96

• 8,509.56, 27 October 2008 - The SENSEX hit an intraday low of 7,697.39, before closing

at 8,509.56, for its lowest close since 14 November 2005.

5.7 Why did this huge fall happen?

There was a huge change in the then global investment climate. One of the primary triggers was the

huge fear of the United States’ economy going into a recession with foreign institutional investors

trying to reallocate their funds from risky emerging markets to stable developed markets.

The volatility is linked to global bourses. There is a big correlation among global markets. The

presence of hedge funds across asset classes, along with increased global movement of capital, has

increased event-related volatility.

Volatility in commodities markets had also significantly affected equity markets.

On the local front there was a huge build-up in derivatives positions and volatility which led to

margin calls. Also many IPOs then had sucked out liquidity from the primary market into the

secondary market.

5.8 Nifty Index Chart

• Small individual investors lost a whopping over 2.2 trillion rupees(close to 55 billion dollars) in

market meltdown of 2008,

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• The overall market capitalization plunged by a third or about Rs 23 trillion from a peak of

over Rs 72 trillion, that started after the benchmark Sensex had

• breached 21,000 points mark on January 11, 2008.

• There was around 60 per cent loss in the promoters kitty themselves, with their holding

depreciating by about Rs 16 trillion.

• Foreign institutional investors (FIIs) were the biggest investor class in terms of their share in

the total market loss.

• The market barometer Sensex fell by nearly 8000 points from an all-time peak of 21,206.77 on

January 10,2008 to settle at 13,461.60 on June 30,2008.

• Two companies alone Reliance and DLF saw their market value erode by more than whopping

1.2 trillion rupees.

Figure 5.3: NIFTY Index Chart

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Case Studies

6.1 Lehman Brothers

6.1.1 Introduction

On September 15, 2008, Lehman Brothers filed for bankruptcy. With $639 billion in assets and

$619 billion in debt, Lehman’s bankruptcy filing was the largest in history, as its assets far surpassed

those of previous bankrupt giants such as WorldCom and Enron. Lehman was the fourth-largest U.S.

investment bank at the time of its collapse, with 25,000 employees worldwide. Lehman’s demise also

made it the largest victim, of the U.S. subprime mortgage-induced financial crisis that swept through

global financial markets in 2008. Lehman’s collapse was a seminal event that greatly intensified the

2008 crisis and contributed to the erosion of close to $10 trillion in market capitalization from global

equity markets in October 2008, the biggest monthly decline on record at the time.

6.1.2 History of Lehman Brothers

Lehman Brothers had humble origins, tracing its roots back to a small general store that was founded

by German immigrant Henry Lehman in Montgomery, Alabama, in 1844. In 1850, Henry Lehman

and his brothers, Emanuel and Mayer, founded Lehman Brothers.

While the firm prospered over the following decades as the U.S. economy grew into an international

powerhouse, Lehman had to contend with plenty of challenges over the years. Lehman survived them

all the railroad bankruptcies of the 1800s, the Great Depression of the 1930s, two world wars, a

capital shortage when it was spun off by American Express in 1994, and the Long Term Capital

Management collapse and Russian debt default of 1998. However, despite its ability to survive past

disasters, the collapse of the U.S. housing market ultimately brought Lehman Brothers to its knees,

as its headlong rush into the subprime mortgage market proved to be a disastrous step.

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6.1.3 Primary Cause

In 2003 and 2004, with the U.S. housing boom well under way, Lehman acquired five mortgage lenders,

including subprime lender BNC Mortgage and Aurora Loan Services, which specialized in Alt-A loans

(made to borrowers without full documentation). Lehman’s acquisitions at first seemed prescient;

record revenues from Lehman’s real estate businesses enabled revenues in the capital markets unit

to surge 56% from 2004 to 2006, a faster rate of growth than other businesses in investment banking

or asset management. The firm securitized $146 billion of mortgages in 2006, a 10% increase from

2005. Lehman reported record profits every year from 2005 to 2007. In 2007, the firm reported net

income of a record $4.2 billion on revenue of $19.3 billion.

6.1.4 Lehmans Colossal Error

In February 2007, the stock reached a record $86.18, giving Lehman a market capitalization of close

to $60 billion. However, by the first quarter of 2007, cracks in the U.S. housing market were already

becoming apparent as defaults on subprime mortgages rose to a seven-year high. On March 14, 2007,

Figure 6.1: Lehman Brothers: Selected Indicators

a day after the stock had its biggest one-day drop in five years on concerns that rising defaults would

affect Lehman’s profitability, the firm reported record revenues and profit for its fiscal first quarter.

In the post-earnings conference call, Lehman’s chief financial officer (CFO) said that the risks posed

by rising home delinquencies were well contained and would have little impact on the firm’s earnings.

He also said that he did not foresee problems in the subprime market spreading to the rest of the

housing market or hurting the U.S. economy.

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6.1.5 Downfall

As the credit crisis erupted in August 2007 with the failure of two Bear Stearns hedge funds, Lehman’s

stock fell sharply. During that month, the company eliminated 2,500 mortgage-related jobs and shut

down its BNC unit. In addition, it also closed offices of Alt-A lender Aurora in three states. Even

as the correction in the U.S. housing market gained momentum, Lehman continued to be a major

player in the mortgage market. In 2007, Lehman underwrote more mortgage-backed securities than

any other firm, accumulating an $85-billion portfolio, or four times its shareholders’ equity. In the

fourth quarter of 2007, Lehman’s stock rebounded, as global equity markets reached new highs

and prices for fixed-income assets staged a temporary rebound. However, the firm did not take the

opportunity to trim its massive mortgage portfolio, which in retrospect, would turn out to be its last

chance. Lehman’s high degree of leverage - the ratio of total assets to shareholders equity - was 31 in

Figure 6.2: Lehman Brothers Holdings: NYSE

2007, and its huge portfolio of mortgage securities made it increasingly vulnerable to deteriorating

market conditions. On March 17, 2008, following the near-collapse of Bear Stearns - the second-largest

underwriter of mortgage-backed securities - Lehman shares fell as much as 48% on concern it would

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be the next Wall Street firm to fail. Confidence in the company returned to some extent in April,

after it raised $4 billion through an issue of preferred stock that was convertible into Lehman shares

at a 32% premium to its price at the time. However, the stock resumed its decline as hedge fund

managers began questioning the valuation of Lehman’s mortgage portfolio.

On June 9, Lehman announced a second-quarter loss of $2.8 billion, its first loss since being spun

off by American Express, and reported that it had raised another $6 billion from investors. The firm

also said that it had boosted its liquidity pool to an estimated $45 billion, decreased gross assets by

$147 billion, reduced its exposure to residential and commercial mortgages by 20%, and cut down

leverage from a factor of 32 to about 25.

6.1.6 Collapse of Lehman

However, these measures were perceived as being too little, too late. Over the summer, Lehman’s

management made unsuccessful overtures to a number of potential partners. The stock plunged

77% in the first week of September 2008, amid plummeting equity markets worldwide, as investors

questioned CEO Richard Fuld’s plan to keep the firm independent by selling part of its asset

management unit and spinning off commercial real estate assets. Hopes that the Korea Development

Bank would take a stake in Lehman were dashed on September 9, as the state-owned South Korean

bank put talks on hold. The news was a deathblow to Lehman, leading to a 45% plunge in the

stock and a 66% spike in credit-default swaps on the company’s debt. The company’s hedge fund

clients began pulling out, while its short-term creditors cut credit lines. On September 10, Lehman

pre-announced dismal fiscal third-quarter results that underscored the fragility of its financial position.

The firm reported a loss of $3.9 billion, including a write-down of $5.6 billion, and also announced a

sweeping strategic restructuring of its businesses. The same day, Moody’s Investor Service announced

that it was reviewing Lehman’s credit ratings, and also said that Lehman would have to sell a majority

stake to a strategic partner in order to avoid a rating downgrade. These developments led to a 42%

plunge in the stock on September 11.

With only $1 billion left in cash by the end of that week, Lehman was quickly running out of

time. Last-ditch efforts over the weekend of September 13 between Lehman, Barclays PLC and Bank

of America, aimed at facilitating a takeover of Lehman, were unsuccessful. On Monday September

15, Lehman declared bankruptcy, resulting in the stock plunging 93% from its previous close on

September 12.

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6.1.7 Brief Conclusion

Lehman’s collapse roiled global financial markets for weeks, given the size of the company and its

status as a major player in the U.S. and internationally. Many questioned the U.S. government’s

decision to let Lehman fail, as compared to its tacit support for Bear Stearns (which was acquired by

JPMorgan Chase) in March 2008. Lehman’s bankruptcy led to more than $46 billion of its market

value being wiped out. Its collapse also served as the catalyst for the purchase of Merrill Lynch by

Bank of America in an emergency deal that was also announced on September 15.

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6.2 Bear Stearns Inc.

6.2.1 Introduction

The Bear Stearns Companies, Inc. was a New York-based global investment bank and securities

trading and brokerage firm that failed in 2008 as part of the global financial crisis and recession and

was subsequently sold to JPMorgan Chase. Its main business areas before its failure were capital

markets broker, wealth management and global clearing services.

In the years leading up to the failure, Bear Stearns was heavily involved in securitization and issued

large amounts of asset-backed securities, which in the case of mortgages were pioneered by Lewis

Ranieri, the father of mortgage securities. As investor losses mounted in those markets in 2006 and

2007, the company actually increased its exposure, especially the mortgage-backed assets that were

central to the subprime mortgage crisis. In March 2008, the Federal Reserve Bank of New York

provided an emergency loan to try to avert a sudden collapse of the company. The company could

not be saved, however, and was sold to JP Morgan Chase for $10 per share, a price far below its

pre-crisis 52-week high of $133.20 per share, but not as low as the $2 per share originally agreed

upon by Bear Stearns and JP Morgan Chase.

The collapse of the company was a prelude to the risk management meltdown of the investment

banking industry in the United States and elsewhere that culminated in September 2008, and the

subsequent global financial crisis of 20082009. In January 2010, JPMorgan ceased using the Bear

Stearns name.

6.2.2 Lead-up to the failure increasing exposure to subprime

mortgages

By November, 2006, the company had total capital of approximately $66.7 billion and total assets of

$350.4 billion and according to the April 2005 issue of Institutional Investor magazine, Bear Stearns

was the seventh-largest securities firm in terms of total capital.

A year later Bear Stearns had notional contract amounts of approximately $13.40 trillion in derivative

financial instruments, of which $1.85 trillion were listed futures and option contracts. In addition,

Bear Stearns was carrying more than $28 billion in level 3assets on its books at the end of fiscal

2007 versus a net equity position of only $11.1 billion. This $11.1 billion supported $395 billion in

assets, which means a leverage ratio of 35.6 to 1. This highly leveraged balance sheet, consisting of

many illiquid and potentially worthless assets, led to the rapid diminution of investor and lender

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confidence, which finally evaporated as Bear was forced to call the New York Federal Reserve to

stave off the looming cascade of counterparty risk which would ensue from forced liquidation.

6.2.3 Start of the crisis – two subprime mortgage funds fail

On June 22, 2007, Bear Stearns pledged a collateralized loan of up to $3.2 billion to bail outone

of its funds, the Bear Stearns High-Grade Structured Credit Fund, while negotiating with other

banks to loan money against collateral to another fund, the Bear Stearns High-Grade Structured

Credit Enhanced Leveraged Fund. Bear Stearns had originally put up just $35 million, so they were

hesitant about the bailout; nonetheless, CEO James Cayne and other senior executives worried about

the damage to the company’s reputation. The funds were invested in thinly traded collateralized

debt obligations (CDOs). Merrill Lynch seized $850 million worth of the underlying collateral but

only was able to auction $100 million of them. The incident sparked concern of contagion as Bear

Stearns might be forced to liquidate its CDOs, prompting a mark-down of similar assets in other

portfolios. Richard A. Marin, a senior executive at Bear Stearns Asset Management responsible for

the two hedge funds, was replaced on June 29 by Jeffrey B. Lane, a former Vice Chairman of rival

investment bank, Lehman Brothers. During the week of July 16, 2007, Bear Stearns disclosed that

the two subprime hedge funds had lost nearly all of their value amid a rapid decline in the market

for subprime mortgages.

On August 1, 2007, investors in the two funds took action against Bear Stearns and its top board

and risk management managers and officers. The law firms of Jake Zamansky & Associates and Rich

& Intelisano both filed arbitration claims with the National Association of Securities Dealers alleging

that Bear Stearns misled investors about its exposure to the funds. This was the first legal action

made against Bear Stearns. Co-President Warren Spector was asked to resign on August 5, 2007, as

a result of the collapse of two hedge funds tied to subprime mortgages. A September 21 report in the

New York Times noted that Bear Stearns posted a 61 percent drop in net profits due to their hedge

fund losses. With Samuel Molinaro’s November 15 revelation that Bear Stearns was writing down a

further $1.2 billion in mortgage-related securities and would face its first loss in 83 years, Standard &

Poor’s downgraded the company’s credit rating from AA to A. Matthew Tannin and Ralph R. Cioffi,

both former managers of hedge funds at Bear Stearns Companies, were arrested June 19, 2008. They

faced criminal charges and were found not guilty of misleading investors about the risks involved in

the subprime market. Tannin and Cioffi have also been named in lawsuits brought forth by Barclays

Bank, who claims they were one of the many investors misled by the executives.

They were also named in civil lawsuits brought in 2007 by investors, including Barclays Bank, who

claimed they had been misled. Barclays claimed that Bear Stearns knew that certain assets in the

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Bear Stearns High-Grade Structured Credit Strategies Enhanced Leverage Master Fund were worth

much less than their professed values. The suit claimed that Bear Stearns managers devised a plan

to make more money for themselves and further to use the Enhanced Fund as a repository for risky,

poor-quality investments.The lawsuit said Bear Stearns told Barclays that the enhanced fund was

up almost 6% through June 2007when ”in reality, the portfolio’s asset values were plummeting.

Other investors in the fund included Jeffrey E. Epstein’s Financial Trust Company.

Figure 6.3: Bear Stearns Stock Price: NYSE

6.2.4 Fed bailout and sale to JP Morgan Chase

On March 14, 2008, the Federal Reserve Bank of New York agreed to provide a $25 billion loan

to Bear Stearns collateralized by free and clear assets from Bear Stearns in order to provide Bear

Stearns the liquidity for up to 28 days that the market was refusing to provide. Apparently the

Federal Reserve Bank of New York had a change of heart and told Bear Stearns that the 28 day loan

was unavailable to them. The deal was then changed to where the NY FED would create a company

to buy $30 billion worth of Bear Stearns assets. Two days later, on March 16, 2008, Bear Stearns

signed a merger agreement with JP Morgan Chase in a stock swap worth $2 a share or less than 7

percent of Bear Stearns’ market value just two days before. This sale price represented a staggering

loss as its stock had traded at $172 a share as late as January 2007, and $93 a share as late as

February 2008. The new company is funded by loans of $29 billion from the New York FRB, and $1

billion from JP Morgan Chase (the junior loan), with no further recourse to JP Morgan Chase. This

non-recourse loan means that the loan is collateralized by mortgage debt and that the government

cannot seize JP Morgan Chase’s assets if the mortgage debt collateral becomes insufficient to repay

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the loan. Chairman of the Fed, Ben Bernanke, defended the bailout by stating that a Bear Stearns’

bankruptcy would have affected the real economy and could have caused a chaotic unwindingof

investments across the US markets.

On March 20, Securities and Exchange Commission Chairman Christopher Cox said the collapse

of Bear Stearns was due to a lack of confidence, not a lack of capital. Cox noted that Bear Stearnss

problems escalated when rumors spread about its liquidity crisis which in turn eroded investor

confidence in the firm. Notwithstanding that Bear Stearns continued to have high quality collateral to

provide as security for borrowings, market counterparties became less willing to enter into collateralized

funding arrangements with Bear Stearns,said Cox. Bear Stearnsliquidity pool started at $18.1 billion

on March 10 and then plummeted to $2 billion on March 13. Ultimately market rumors about Bear

Stearns’ difficulties became self-fulfilling, Cox said.

On March 24, 2008, a class action was filed on behalf of shareholders, challenging the terms of

JPMorgans recently announced acquisition of Bear Stearns. That same day, a new agreement was

reached that raised JPMorgan Chase’s offer to $10 a share, up from the initial $2 offer, which meant

an offer of $1.2 billion. The revised deal was aimed to quiet upset investors and any subsequent legal

action brought against JP Morgan Chase as a result of the deal as well as to prevent employees, many

of whose past compensation consisted of Bear Stearns stock, from leaving for other firms. The Bear

Stearns bailout was seen as an extreme-case scenario, and continues to raise significant questions

about Fed intervention. On April 8, 2008, Paul A. Volcker stated that the Fed has taken actions

that extend to the very edge of its lawful and implied powers.See his remarks at a Luncheon of the

Economic Club of New York. On May 29, Bear Stearns shareholders approved the sale to JPMorgan

Chase at the $10-per-share price

An article by journalist Matt Taibbi for Rolling Stone contended that naked short selling had a

role in the demise of both Bear Stearns and Lehman Brothers. A study by finance researchers at

the University of Oklahoma Price, College of Business studied trading in financial stocks, including

Bear Stearns and Lehman Brothers, and found ”no evidence that stock price declines were caused

by naked short selling.

6.2.5 Time line - Bear Stearns Hedge Funds Collapse

In early 2007, the effects of subprime loans started to become apparent as subprime lenders and

homebuilders were suffering under defaults and a severely weakening housing market.

• In early 2007, the effects of subprime loans started to become apparent as subprime lenders

and homebuilders were suffering under defaults and a severely weakening housing market.

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• June 2007 - Amid losses in its portfolio, the Bear Stearns High-Grade Structured Credit Fund

receives a $1.6 billion bait out from Bear Stearns, which would help it to meet margin calls

while it liquidated its positions.

• July 17, 2007 - In a letter sent to investors, Bear Stearns Asset Management reported that

its Bear Stearns High-Grade Structured Credit Fund had lost more than 90% of its value, while

the Bear Stearns High-Grade Structured Credit Enhanced Leveraged Fund had lost virtually

all of its investor capital. The larger Structured Credit Fund had around $1 billion, while the

Enhanced Leveraged Fund, which was less than a year old, had nearly $600 million in investor

capital.

• July 31, 2007 - The two funds filed for Chapter 15 bankruptcy. Bear Stearns effectively wound

down the funds and liquidated all of its holdings.

• Aftermath - Several shareholder lawsuits have been filed on the basis of Bear Stearns misleading

investors on the extent of its risky holdings.

6.2.6 The Mistakes Made

The Bear Stearns fund managers’ first mistake was failing to accurately predict how the subprime

bond market would behave under extreme circumstances. In effect, the funds did not accurately

protect themselves from event risk.

Moreover, they failed to have ample liquidity to cover their debt obligations. If they’d had the

liquidity, they wouldn’t have had to unravel their positions in a down market. While this may have

led to lower returns due to less leverage, it may have prevented the overall collapse. In hindsight,

giving up a modest portion of potential returns could have saved millions of investor dollars.

Furthermore, it is arguable that the fund managers should have done a better job in their macroeconomic

research and realized that subprime mortgage markets could be in for tough times. They then

could have made appropriate adjustments to their risk models. Global liquidity growth over recent

years has been tremendous, resulting not only in low interest rates and credit spreads, but also an

unprecedented level of risk taking on the part of lenders to low-credit-quality borrowers.

Since 2005, the U.S. economy has been slowing as a result of the peak in the housing markets,

and subprime borrowers are particularly susceptible to economic slowdowns. Therefore, it would

have been reasonable to assume that the economy was due for a correction.

Finally, the overriding flaw for Bear Stearns was the level of leverage employed in the strategy,

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which was directly driven by the need to justify the utterly enormous fees they charged for their

services and to attain the potential payoff of getting 20% of profits. In other words, they got greedy

and leveraged the portfolio to much.

Figure 6.4: Cummulative Returns (%)

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Conclusion

After going through the content and research we have presented we concluded that this crisis was

actually avoidable. It found widespread failures in financial regulations; dramatic breakdowns in

corporate governance; excessive borrowing and risk-taking by households and Wall Street; policy

makers who were ill prepared for the crisis; and systematic breaches in accountability and ethics at

all levels. There was an explosion in risky subprime lending and securitization, an unsustainable rise

in housing prices, widespread reports of egregious and predatory lending practices, dramatic increases

in household mortgage debt, and exponential growth in financial firms trading activities, unregulated

derivatives, and short-term repo lending markets, among many other red flags. Yet there was pervasive

permissiveness; little meaningful action was taken to quell the threats in a timely manner.

We conclude dramatic failures of corporate governance and risk management at many systemically

important financial institutions were a key cause of this crisis. There was a view that instincts for

self-preservation inside major financial firms would shield them from fatal risk-taking without the

need for a steady regulatory hand, which, the firms argued, would stifle innovation. Too many of

these institutions acted recklessly, taking on too much risk, with too little capital, and with too much

dependence on short-term funding. In many respects, this reflected a fundamental change in these

institutions, particularly the large investment banks and bank holding companies, which focused their

activities increasingly on risky trading activities that produced hefty profits. They took on enormous

exposures in acquiring and supporting subprime lenders and creating, packaging, repackaging, and

selling trillions of dollars in mortgage-related securities, including synthetic financial products. Many

of these institutions grew aggressively through poorly executed acquisition and integration strategies

that made effective management more challenging. The CEO of Citigroup told the Commission that

a $40 billion position in highly rated mortgage securities would not in any way have excited my

attention, and the cohead of Citigroups investment bank said he spent a small fraction of 1% of

his time on those securities. In this instance, too big to fail meant too big to manage. Financial

institutions and credit rating agencies embraced mathematical models as reliable predictors of risks,

replacing judgment in too many instances. Too often, risk management became risk justification.

We conclude a combination of excessive borrowing, risky investments, and lack of transparency put

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the financial system on a collision course with crisis. Clearly, this vulnerability was related to failures

of corporate governance and regulation, but it is significant enough by itself to warrant our attention

here. In the years leading up to the crisis, too many financial institutions, as well as too many

households, borrowed to the hilt, leaving them vulnerable to financial distress or ruin if the value

of their investments declined even modestly. For example, as of 2007, the five major investment

banksBear Stearns, Goldman Sachs, Lehman Brothers, Merrill Lynch, and Morgan Stanleywere

operating with extraordinarily thin capital. By one measure, their leverage ratios were as high as

40 to 1, meaning for every $40 in assets, there was only $1 in capital to cover losses. Less than a

3% drop in asset values could wipe out a firm. To make matters worse, much of their borrowing

was short-term, in the overnight marketmeaning the borrowing had to be renewed each and every

day. For example, at the end of 2007, Bear Stearns had $11.8 billion in equity and $383.6 billion in

liabilities and was borrowing as much as $70 billion in the overnight market.

We conclude there was a systemic breakdown in accountability and ethics. The integrity of our

financial markets and the publics trust in those markets are essential to the economic well-being of

our nation. The soundness and the sustained prosperity of the financial system and our economy rely

on the notions of fair dealing, responsibility, and transparency. In our economy, we expect businesses

and individuals to pursue profits, at the same time that they produce products and services of

quality and conduct themselves well. Unfortunately, as has been the case in past speculative booms

and busts, we witnessed an erosion of standards of responsibility and ethics that exacerbated the

financial crisis. This was not universal, but these breaches stretched from the ground level to the

corporate suites. They resulted not only in significant financial consequences but also in damage to

the trust of investors, businesses, and the public in the financial system. Indians were somewhat saved

from their habits of saving and spending judiciously but still there was a slowdown in the Indian

Market. The fund managers were wrong. The market moved against them, and their investors lost

everything. The lesson to be learned, of course, is not to combine leverage and greed.

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