Accounting essay on: Financial crisis

IntroductionThe immediate consequences of the financial crisis are clear. It could be stated that financial global crisis of year 2007 & 2008 was not the single event but a group of series which rippled through the economy and financial system. Imperfection in one region of financial market led to the failures in other regions by the way of vulnerabilities and interconnections which, government official, bankers and others had dismissed or missed (Reavis, 2009). When risky and subprime mortgages issued throughout the housing bubble at that time, various experts were failed to investigate and started to default at the unexpected rates. At centre, imprudent lending or debt leverage and much of it in form of composite structured securities which permitted hedge funds, banks to make assets comprised of mortgage –back and corporate bonds and sell them to other and shift the borrowers risk to the buyers. Standards of financial reporting require companies to minimize the loans value whose recoverability is not sure and inform the market about the higher risks. It is examined that three of the largest investment banks of the U.S such as Merrill Lynch, Bear Stearns and Lehman Brothers were affected hard by the crisis and were either sold in government related acquisitions or filed bankruptcy (Schipper & Katherine, 2007). With the help of federal government, Bear Stearns was acquired by JPMorgan. Bankruptcy of the Lehman Brothers on Sep 15 of 2008 was considered as one of the largest bankruptcies in history of U.S. Nomura Holdings and Barclays purchased distinct portions of the Lehman Brothers throughout regional lines (Reavis, 2009). The greatest brokerage firm of the world, Merrill Lynch was purchased by the Bank of America in year 2008 throughout the distressed situations. The Government of U.S came out with the National Stabilization Act of 2008 that made a corpus of around $700 billion to buy distressed assets, specially mortgage –back securities (Bookstaber & Richard, 2008). The causes of the financial crisis from year 2007-2010 are as follows:

Growth of the Housing Bubble: It is viewed that prices of homes were increased significantly because of the strong appetite from investors for the exposure to great yielding U.S. CDO and MBS market throughout the low generating U.S treasury. In, fact flow of the foreign money in the U.S enhanced from year 2000 to 2007, outpacing the development in supply of considerably secure assets to invest it in. Moreover, investment banks utilized highly rated CDO and MBS securities and AAA to fulfill the demand (Bookstaber & Richard, 2008). By year 2003, the securities supply supported by the mortgages made in traditional way started to run out. It is observed that Fed started to slash the funds rate and discount rate and bad news remained to pour all sides. Lehman Brother had filed for the Bankruptcy, Bear Stearns was purchased by the JP Morgan, Lynch was sold to Bank of the America and Freddie Mac and Fannie Mac were placed under the guidance of the federal government of the U.S.

Easy Credit Conditions: It could be said that, lower rates of the interest made credit more available to the consumers of the America to enhance their borrowing. In year 2000, target rate of fed funds was nearly 6.5%. It is examined that perceived risk of the deflation, dot-cum bubble and terrorist attacks made the Fed to reduce the rate of fed funds to 1% by year 2003. Bernanke claimed that further reduction on the rates came out with the large current a/cc deficit of U.S (Zhang & Ivy, 2007). The two major reasons why the foreign countries were lend to the U.S because of high oil prices and high rates of personal savings. Consumers of American utilized these borrowed funds in order to finance existing consumption comprising housing. This kind of inflow of capital had enhanced demand for the financial assets of U.S. Institutions of foreign government wanted to invest in treasuries of whereas financial institutions invested in mortgage market. By Oct of 2008, discount rate and rate of federal funds were minimized to 1and 1.75% respectively (Zhang & Ivy, 2007).  In fact central banks in China, Sweden, England, Switzerland and Canada resorted to the rate cuts to help the economy of world. But liquidity support and rate cuts were not sufficient to stop a kind of financial meltdown.

Subprime Lending: Subprime loans are those which have higher risk of the default in comparison to the conventional loans. This could be because of poor credit rating of borrowers and distinct terms of loans like schedule of lower payments. In March year 2007, nearly 7.5 million loans of subprime mortgage were outstanding and totaling to $1.3 trillion (Zhang & Ivy, 2007). It can be said that high risk of the subprime lending enhanced because of the policies of the government and competition between the financial institutions such as Govt. Sponsored Enterprises and Investment banks such as Freddie Mac & Fannie Mac. In year 2004, the market of subprime had grown by 20% to overall housing market of U.S (Zhang & Ivy, 2007). At that point of time, SEC had relaxed its rules of net capital and therefore creating it more appealing for the investment banks to enhance leverage and diversify their issuance of MBS. The proof of poor loan screening is revealed in rise of the subprime defaults that increased to 25% in year 2008 after remaining among 10-15% in the 8 years prior to year 2006( Reavis, 2009).

Insufficient Regulation: Many persons had argued that the regulation lagged behind the changes in the modern finance. Some regions where change regulation comprise the enhanced significance of shadow banking system, regulation and standardization of the new derivative agreements and techniques of creative accounting that took benefit of the off-balance sheet financing. To compound the issues, financial deregulation was the common place.

Incorrect Risk Pricing: Pricing risk comprises adding higher rates of the interest or fees to compensate the investors for taking the higher risk. There are various reasons why the participants of the market failed to accurately calculate the risks embedded in its investments. One instance is structural risk which introduced CDO investment in the financial system. These huge losses made banks crippled with huge write-downs (Lakshman, 2010)

Predatory Lending: Predatory Lending considers to the practice of the unscrupulous lender, to make entry into unsound or unsafe secured loans for wrong purposes (Lakshman, 2010).  One instance is bait and switch procedure where low advertised rates of interest were exchanged for adjustable or higher interest terms. In some situations, negative amortization was made that perform to hide the accurate terms from borrowers. Speculative mortgages gave up the equity building advantages of the home ownership and depend entirely on home price increased element of their investments. With increasing defaults of homeowner, country wide is being purchased by the Bank of the America in year 2008 (Gilani, 2010). Workers at the mortgage lenders frequently explained the atmosphere where they pushed to create loans and sold them to the investors with the commission incentives. With no any intention of maintaining loans on their books, fraud and false documentation became more dominant. The agencies of credit rating played a significant role. Institutional investors like insurance companies, pension funds and trusts were needed to purchase investment-related securities rated by one of the nationally established agencies such as Standard& Poor’s and Moody’s. Ratings given by these agencies were used as a substitute for the procedure of the credit evaluation carried out by the credit committees and officers of bank loan.At last, it can be said that causes of the financial crisis from year 2007 to 2010 were linked to a failure of government regulation. The main reason was Government had no control on rates of interest which made credit more available to the consumers of the America to raise their borrowings. Distinct governments came out with several versions of the government guarantees, outright nationalization and bailout packages.

Lehman Business Model

As the global bank, risk was the main component of the Lehman Brothers. The business of the Lehman Brothers was impacted by the economic and financial markets conditions throughout the world. A favorable environment of the business is effected by other factors such as high GDP growth, growth of the product, constant geopolitical situations, efficient and transparent capital markets, liquid market with the active investors, high business, low inflation, and confidence of the consumer and strong earnings of the business (Gilani, 2010). Credit contraction, increasing prices of the energy, declines in investor or business confidence, higher unemployment, corporate and other scandals minimize confidence of the investor in natural disasters and capital markets which may impact the financial markets. It could be stated that global crisis started to reveal its consequences in middle of year 2007 and 2008. Throughout the world, great financial institutions had collapsed or been purchased out and stock markets had fallen and governments had came out with bailout packages to rescue the financial banks and institutions. As it is very clear that, key objective of the business model of the Lehman was to quickly enhance the yearly growth rate with the high risk and high leverage policies. The management of the Lehman continued to follow the aggressive strategy of growth at the time of sub-prime crisis, thinking that crisis could not diversify to other regions of market and could be capable to grab the higher positions as another bank started to shed and retrench risk Valukas (Valukas & Anton, 2010) highlighted the great risk-taking culture at the Lehman which was the main reason in the bankruptcy of Lehman. According to Valukas (Valukas & Anton, 2010), Lehman included Archstone risk and remained to exceed its limit of risk taking for various months. Inclusion of Archstone risk  was responsible for the high growth in the Net Assets that could be accredited to accumulation of the illiquid assets that doubled throughout the similar time period from $86.9 billion at end of quarter 4 2006 to $174.6 billion in quarter 1 2008 (Lakshman, 2010). It can be said that poor liquidity that the Lehman had under its business model made the bank incapable to achieve three significant objectives in midst of the financial crisis such as raise cash, sell assets and hedge risk to minimize the leverage on balance sheet.

Impending collapse of the Lehman Brothers could not have been avoided or foreseen, because of the warning signs and deeply flawed model of the business. It has been examined that shares of Lehman were fallen by nearly 45% from US $ 14.15 to 7.79 (Lakshman, 2010) after the announcement of the KDB’s. Lehman was not able to manage the confidence in markets and issued capital by selling the portion of its equity part and finally had to register for the bankruptcy. Whereas, several analysts attributed distinct factors for the destruction of the Lehman, and most of them said that ongoing subprime crisis was the major cause. Analysts argued that the step taken by the JP Morgan to freeze the assets of Lehman was one of the major reasons accountable for the collapse of the Lehman. Analysts argued that bankruptcy could have been foreseen or averted, if JP had not frozen the assets of Lehman, which had made a situation of liquidity crisis (Bookstaber & Richard, 2008).

During June 2008, prices of the house in UK had attained 0% growth and at the same time share price of the Lehman had reduced by 80%. Due to this, investors lost the confidence in the business model of the Lehman because of the reduced share price by 80%. In addition to this, business model of the Lehman was manipulated by senior executives who were indulged in manipulations of balance sheet with the help of Repo 105 transactions. These manipulations were done by the senior executives in order to remove inventory securities from its financial statements generally for the period of 7 to 10 days and to make a misleading image of the financial condition of the firm in year 2007 & 2008. With the help of creative accounting, Lehman was capable to reduce the leverage by 2% by implementing this type of transactions and revealed less risk to the credit risk agency.It has been examined that Lehman failed because it was not able to maintain the confidence among the counterparties and lenders and did not have adequate liquidity to fulfill its existing obligations. Lehman was not able to maintain the confidence due to a group of business actions which placed greater concentration of the illiquid assets with the diminishing values like commercial and residential real estate. In, fact officials of federal government had decided not to save Lehman for a number of reasons comprising uncertainty about the potential losses of the Lehman, concerns about political reaction and moral hazard and wrong presumptions which made Lehman’s failure could have a manageable consequence on financial system because participants of the market had forecasted it. Federal government justified their decision by revealing that the Federal Reserve had no any lawful authority to save Lehman. Lehman collapse revealed weakness which contributed to near failures or failures of other 4 large investment banks such as insufficient regulatory oversight, activities of risk trading, huge leverage and dependence on the short period funding. The failure of the Lehman took place because of the major problems in its governance comprising management of risk, increased compensation to its traders and executives which were related mainly on the short period profits. Lehman remained pursuit of its aggressive strategy of the growth, at the time of subprime crisis and related on two significant calculations by the management of the Lehman. First, like other participants of the market, not to inform officials of the government, the management of the Lehman thought that subprime crisis could not diversify to other kinds of market and economy generally. Secondly, management of the Lehman thought that other financial institution was reducing and retrenching its risk profile and Lehman had a chance to enhance its financial and competitive position. Lehman failure is to reveal the utilization of the accounting device to lower the leverage and at the similar time it presented those least leverage numbers to stakeholders and investors as the positive news and made a misleading picture of the financial health of the Lehman. In fact senior officers were accountable for the financial management and balance sheet disclosure who certified and signed financial statements of Lehman and who get failed to reveal Lehman’s usage of the Repo 105 transactions to maintain its financial statements such as Balance Sheet and Income Statement.

The dominant effect for the quick decline in equity position of the Lehman was the shift in firm’s assets mix to the illiquid assets comprising high yielding loans, principal investments and real estate. From Nov to Aug 2006, the illiquid holdings of the firm developed by 72% whereas Tier 1 Capital developed by around 26% (Bianco & Katalina, 2008). Lehman had group of the Board meetings in fall of year 2007. At these kinds of meetings, management of the Lehman remained to report on firm’s increased profile of the risk and the concentration of leverage loan risk and real estate, but not presented the Board with extra negative information regarding the liquidity and risk profile of the firm. Even the Board was also not informed about the risk appetite utilization of the Lehman’s leverage loan business which was nearly double the restriction applied to the business and that utilization had been more than the limit. Some directors thought that the action to exceed single transaction and high yield limits of Lehman must have been revealed to Board. Management had not told to the Finance or Board and the Risk Committee about the concerns of ALCO’s about the ability of Lehman’s to finance its commitments.

The compensation policy of the Lehman was made in order to penalize the excessive risk bearing. It is examined that, FID business which exceeded risk and balance sheet limits experienced diminution of its compensation pool. At some times, FID utilized a scorecard of compensation which comprised risk-weighted metrics like return on balance sheet and return on the risk equity to find out the compensation allocations.  The business strategy of Lehman’s in year 2006 & 2007 was based on utilizing more of its financial statements such as balance sheet in order to enhance its basic investments (Bianco & Katalina, 2008). In summation to risks in proprietary investments, most of the proprietary investments of firm comprised the commitment by the Lehman to the larger amount of equity or debt in comparison to Lehman who estimated to make for itself. Even these bridge debt and bridge equity transactions were risky and the management of the Lehman decided to indulge in these kinds of transactions because they were more profitable at its own right, because they assisted Lehman to develop long term relationships with clients (Bianco & Katalina, 2008). The proof that the Lehman had disregarded its risk controls is specifically strong in concern to bridge debt and bridge equity. Leman had excluded its bridge debt and equity commitments entirely from its metrics of risk. These kinds of exclusions were related on the assumptions of the management which it could be able to allocate the debt and equity successfully to another party. When subprime crisis exploded in the credit market, this kind of expectation can prove as erroneous. In many respect, transactions of Lehman were no distinct from those which were done by participants of other market and in some respect, they were less aggressive in comparison to the competitors. For instance: various financial institutions faced huge losses on the investments in credit default swap and CDOs, Lehman prudently restricted its exposure in these kinds of regions. In, fact officers of Lehman would claim that the analysis of the management of the Lehman risks must refer the risks which Lehman avoided with risks that the Company unsuccessfully took. In fact, controllers and risk managers are inclined to view controls and limits as less and harder susceptible to the judgment as compared to the businesspersons.

Some of the details which were reported in regards to Lehman Brothers were in terms of business & management of risk, valuation, survival, secured lenders and Lehman’s interaction with the various government agencies. Business & risk management has been rendered to as one of the central issues as to why Lehman had high levels of assets & could not monetize it in order to gain liquidity as well as accept confidence within the same. The Lehman’s reaction towards the subprime crisis could be seen with regards to the various economic events which would help in order to analyze whether the officials or the directors would be able to fulfill the various fiduciary duties. It has also been seen that, valuation is rendered to be one of the major questions which would help in order to calculate the accuracy levels of Lehman’s financials. The secured lenders would also act as one of the crucial means which would assign as a part of the Examiner order as well as address multiple communications amongst the parties (Bookstaber & Richard, 2008). The demands of collateral by the Lehman brothers would be able to impact the overall liquidity of Lehman’s pool & question upon the fact that why did Lehman failed. Lehman changed its business strategy from a lower risk brokerage model to higher risk as well as capital intensive model. It is well stated now that, Lehman did not use its balance sheet to acquire the assets in order to do its own investment. Rather Lehman made it a point to acquire the assets from various commercial as well as residential real estate mortgages. Lehman’s management was focusing upon expanding the three major areas such as commercial estate, private equity & loans. The firm aggressive strategy was one of the moves taken up by the senior management amongst the various high level business & risk taking decisions in the fiscal year 2007. The levels of risk have also increased by changing Lehman’s business strategy. Commercial real estate investments along with principal investments & leveraged loans were consumed. This has helped in order to entail more risk & become less liquid in case of the traditional business carried on at Lehman. The application of risk controls over the changed strategy at Lehman has helped in order to deal with the illiquid as well as increased forms of risk within the organization (Bookstaber & Richard, 2008).

It is examined that Lehman failed to utilize its limits of balance sheet in year 2007. Besides this, Lehman had enhanced volume of its financial statements such as Balance Sheet and utilized significantly large sizes of the Repo 105 in order to reduce the leverage.  During the period of 2007, there were various instances in which management of Lehman did not give sufficient information to Board. For Instance: Management had not revealed its decision to disregard or exceed the several concentration limits related to commercial estate business and leverage loan business, comprising particularly to the transaction limits (Baba & Nagano, 2008). At last it can be said that, Impending collapse of the Lehman Brothers could not have been avoided or foreseen, because of the inclusion of the poor liquidity in the business model of Lehman.The graph above states that, the US subprime mortgage market comes under stress. This has been explained with the help of three graphs i.e. housing indicators, ABX tranche spreads & Mezzanine CDO spreads. various financial institutions faced huge losses on the investments in credit default swap and CDOs, Lehman prudently restricted its exposure in these kinds of regions. In, fact officers of Lehman would claim that the analysis of the management of the Lehman risks must refer the risks which Lehman avoided with risks that the Company unsuccessfully took. In fact, controllers and risk managers are inclined to view controls and limits as less and harder susceptible to the judgment as compared to the businesspersons. During June 2008, prices of the house in UK had attained 0% growth and at the same time share price of the Lehman had reduced by 80%. Due to this, investors lost the confidence in the business model of the Lehman because of the reduced share price by 80%. In addition to this, business model of the Lehman was manipulated by senior executives who were indulged in manipulations of balance sheet with the help of Repo 105 transactions. These manipulations were done by the senior executives in order to remove inventory securities from its financial statements generally for the period of 7 to 10 days and to make a misleading image of the financial condition of the firm in year 2007 & 2008. With the help of creative accounting, Lehman was capable to reduce the leverage by 2% by implementing this type of transactions and revealed less risk to the credit risk agency.

In the year 2007-2009, in this period it has been seen that Lehman Brother collapsed as well as the unofficial bankruptcy amongst the financial institutions such as banks, societies have become more significant. There are various problems which have arisen & created high levels of problems due to the subprime mortgage loans in US. Similarly, the lending practices in the other countries such as UK & Europe were quite irresponsible. The problem had become quite widespread and the solution was unknown.

Subprime loans are those which have higher risk of the default in comparison to the conventional loans. This could be because of poor credit rating of borrowers and distinct terms of loans like schedule of lower payments. In March year 2007, nearly 7.5 million loans of subprime mortgage were outstanding and totaling to $1.3 trillion (Zhang & Ivy, 2007). It can be said that high risk of the subprime lending enhanced because of the policies of the government and competition between the financial institutions such as Govt. Sponsored Enterprises and Investment banks such as Freddie Mac & Fannie Mac. In year 2004, the market of subprime had grown by 20% to overall housing market of U.S (Zhang & Ivy, 2007). At that point of time, SEC had relaxed its rules of net capital and therefore creating it more appealing for the investment banks to enhance leverage and diversify their issuance of MBS. The proof of poor loan screening is revealed in rise of the subprime defaults that increased to 25% in year 2008 after remaining among 10-15% in the 8 years prior to year 2006 (Reavis, 2009).

It has been seen that, the Dow Jones industrial average has fallen down all together from 14279 in the year 2007 to a low of approximately 6440 in the year 2009. This means that a nominal drop of approximately 54.9% – 56.9% respectively have been reported in the same.

The second graph takes into consideration the performance of the macro-economic indicators. The graph majorly shows two aspects such as growth & inflation. Incorrect Risk Pricing: Pricing risk comprises adding higher rates of the interest or fees to compensate the investors for taking the higher risk. There are various reasons why the participants of the market failed to accurately calculate the risks embedded in its investments. One instance is structural risk which introduced CDO investment in the financial system. These huge losses made banks crippled with huge write-downs (Lakshman, 2010)

Predatory Lending: Predatory Lending considers to the practice of the unscrupulous lender, to make entry into unsound or unsafe secured loans for wrong purposes (Lakshman, 2010).  One instance is bait and switch procedure where low advertised rates of interest were exchanged for adjustable or higher interest terms. In some situations, negative amortization was made that perform to hide the accurate terms from borrowers. Speculative mortgages gave up the equity building advantages of the home ownership and depend entirely on home price increased element of their investments. With increasing defaults of homeowner, country wide is being purchased by the Bank of the America in year 2008 (Gilani, 2010). Workers at the mortgage lenders frequently explained the atmosphere where they pushed to create loans and sold them to the investors with the commission incentives. With no any intention of maintaining loans on their books, fraud and false documentation became more dominant. The agencies of credit rating played a significant role. Institutional investors like insurance companies, pension funds and trusts were needed to purchase investment-related securities rated by one of the nationally established agencies such as Standard& Poor’s and Moody’s. Ratings given by these agencies were used as a substitute for the procedure of the credit evaluation carried out by the credit committees and officers of bank loan.

At last, it can be said that causes of the financial crisis from year 2007 to 2010 were linked to a failure of government regulation. The main reason was Government had no control on rates of interest which made credit more available to the consumers of the America to raise their borrowings. Distinct governments came out with several versions of the government guarantees, outright nationalization and bailout packages.

Insufficient Regulation: Many persons had argued that the regulation lagged behind the changes in the modern finance. Some regions where change regulation comprise the enhanced significance of shadow banking system, regulation and standardization of the new derivative agreements and techniques of creative accounting that took benefit of the off-balance sheet financing. To compound the issues, financial deregulation was the common place.Easy Credit Conditions: It could be said that, lower rates of the interest made credit more available to the consumers of the America to enhance their borrowing. In year 2000, target rate of fed funds was nearly 6.5%. It is examined that perceived risk of the deflation, dot-cum bubble and terrorist attacks made the Fed to reduce the rate of fed funds to 1% by year 2003. Bernanke claimed that further reduction on the rates came out with the large current a/cc deficit of U.S (Zhang & Ivy, 2007). The two major reasons why the foreign countries were lend to the U.S because of high oil prices and high rates of personal savings. Consumers of American utilized these borrowed funds in order to finance existing consumption comprising housing. This kind of inflow of capital had enhanced demand for the financial assets of U.S. Institutions of foreign government wanted to invest in treasuries of whereas financial institutions invested in mortgage market. By Oct of 2008, discount rate and rate of federal funds were minimized to 1and 1.75% respectively (Zhang & Ivy, 2007).  In fact central banks in China, Sweden, England, Switzerland and Canada resorted to the rate cuts to help the economy of world. But liquidity support and rate cuts were not sufficient to stop a kind of financial meltdown.

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