Causes of the Financial Crisis

1

Contents Introduction ............................................................................................................................................ 2

Section 1 The Financial Crisis of 2007-2010 ............................................................................................ 2

FINANCE .............................................................................................................................................. 2

Compensation Issues ...................................................................................................................... 2

Collateralized Debt Obligations (CDO’s) and Credit Default Swaps (CDS’s) ................................... 3

Credit Rating Agency Behaviour ..................................................................................................... 3

Implications of CDO’s and CDS’s ..................................................................................................... 4

ROLE OF THE U.S. GOVERNMENT ....................................................................................................... 4

Regulators Fell Asleep at the Wheel with Lehman ......................................................................... 4

Credit Expansion Policies ................................................................................................................ 5

Repeal of the Glass- Steagall Act and Greater Debt-Capital Ratio .................................................. 6

THE HUBRIS OF WALL STREET EXECUTIVES THROUGH ‘TOO BIG TO FAIL’ ..................................... 6

Section 1 Conclusion ........................................................................................................................... 7

Section 2 Why Lehman Brothers Collapsed in October 2008 ................................................................. 8

FINANCE .............................................................................................................................................. 8

Collapse of Bear Stearns ................................................................................................................. 8

Bank of America Bought Merrill Lynch Instead of Lehman Brothers. ............................................ 9

Market Ignorance Towards Liquidity .............................................................................................. 9

Lehman’s Complex Financial Products ............................................................................................ 9

Window Dressing Capabilities ....................................................................................................... 10

ROLE OF THE U.S. GOVERNMENT ..................................................................................................... 10

Insufficient Power to Bailout Non-Banks ...................................................................................... 11

Emergency Powers Under Section 13(3) and the New Dodd-Frank Legislation ........................... 11

Emergency Powers for Bear Stearns and A.I.G. ............................................................................ 12

Barclays Proposed Takeover of Lehman ....................................................................................... 12

DICK FULD FORMER CEO OF LEHMAN BROTHERS ............................................................................ 13

Fuld’s Unethical Management Practices....................................................................................... 13

Fuld Believed Lehman Was Too Big to Fail ................................................................................... 14

Conclusion ......................................................................................................................................... 14

Bibliography ......................................................................................................................................... 16

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Introduction

The financial crisis was initially portrayed to be exclusively an American problem when

many of their financial institutions failed. However as we discovered after the Wall Street

Crash of 1929 when America sneezes the world catches a cold. This paper will be split up

into two sections. Part one will demonstrate how the causes of the financial crisis were not

strictly due to the world of finance alone as we will also analyse the US Governments’ role

through its policies as well as the actions taken by Wall Street’s elitist individuals who

thought they were too big to fail. In relation to part one, part two will explain exactly how

and why Lehman Brothers collapsed in October 2008.

Section 1 The Financial Crisis of 2007-2010

FINANCE

Here we will discuss the implications of flawed compensation structures which incentivised

high risk taking through the creation of more complex financialized products such as CDO’s

and CDS’s. We will then analyse the associated implications of credit rating agencies.

Compensation Issues

Former chief economist of the International Monetary Fund Raghuram Rajan’s raises an

important issue that “compensation practices in the financial sector are deeply flawed and

probably contributed to the ongoing crisis” which is no real surprise given the industry norm

of setting aside 40%-50% of company revenues for executive pay. (Rajan, 2008) He states

that employee compensation was not truly linked to the enormous losses which the banks

incurred for example Morgan Stanley increased its bonus pool by 18% despite suffering a

$9.4 billion charge-off. (Rajan, 2008) This leads us onto the suggestion that “firm’s

performance-based compensation did not produce a tight alignment of executives’ interests

with long-term shareholder value.” (Bebchuk, et al., 2009) One explanation for this includes

executives cashing out “large amounts of shares and options” which gave them “incentives to

place significant weight on the effect of their decisions on short-term stock prices.”

(Bebchuk, et al., 2009) At the same time we must consider Rajan’s suggestion regarding the

annual distribution of bankers’ bonuses. This compensation structure provides managers with

risk taking incentives to gain short term profits over long run losses because their short term

bonuses are not “clawed back” in the case of future losses. (Rajan, 2008) In other words this

limited liability “allows investors and executives the full upside benefits of their risk-taking,

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while limiting their downside exposure.” (Dowd, 2009) Therefore we can now see a clear

principal-agent problem which was only emphasized by Wolf’s suggestion as short run,

decisions taken by managers at the time “were extremely difficult to judge from outsiders.”

(Wolf, 2008) These factors fuelled the risk taking culture in the financial world.

Collateralized Debt Obligations (CDO’s) and Credit Default Swaps (CDS’s)

This greater risk taking culture meant financial institutions wanted greater business growth by

diversifying their product portfolio to target new markets to help drive shareholder value.

This helped to create CDO’s and CDS’s specifically designed for the higher risk subprime

mortgage market. A Collateralized Debt Obligation (CDO) is a complex financial product

which pools together cash generating assets such as loans, bonds and mortgages. In the event

of default these assets would be lost as they serve as collateral. This pool is then repackaged

into different tranches depending upon their perceived level of risk consisting of low (e.g.

AAA), medium (e.g. BBB) and high (unrated). The low risk (higher credit rating) will receive

the first payments from the CDO at a lower interest rate whilst having first say in the event of

a default. However as you move towards the higher risk tranch you would receive the

payments last (if there is any left) which is why you would receive the highest coupon rate

compensating for your highest risk. This product innovation was perceived to open up more

market opportunities to help match more individuals preferences regarding risk and reward

and was ultimately designed to spread thus reduce risk. However the assumptions behind the

formulator of a CDO were wrong as they incorrectly estimated the default correlations. Here

pooling mortgages to reduce risk only works if they are uncorrelated therefore do not default

at the same time which is mainly why the financial crisis occurred. (Economist, 2013) A CDS

is a credit default swap whereby the CDO would be insured by a third party such as A.I.G.

Therefore as these CDO’s were quickly shifted in the hands of insurance companies, financial

institutions did not have too much interest if these CDO’s defaulted or not as they would still

obtain the transaction fees. But how were companies able to quickly sell off these CDO’s?

Credit Rating Agency Behaviour

Standard & Poor’s amongst other credit rating agencies rated an estimated 70% of these

tranched CDO’s as AAA which was obscene considering their complexity of the

securitization chain and product nature. However these agencies bared no legal obligation or

responsibility if even their AAA (same rating as federal bonds) rated assets defaulted, which

questions their credibility. (Economist, 2013) Simultaneously this credibility was completely

flawed considering that the banks paid these agencies to rate their own products therefore

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there was no real surprise that these generous assessments were allocated. Essentially the

credit rating agencies payments were based upon quantity of ratings and not quality.

Therefore the incentive on the agency’s behalf would be to rate as many products as quickly

as possible which was in alignment with many financial institution’s interests because this

would allow them to sell even more CDO’s therefore generate even greater returns from

transaction fees.

Implications of CDO’s and CDS’s

The implications of these short run incentives can be explained by the Warwick commission

report. Firstly the housing bubble occurred during the economic cycle’s up-phase as the

“price based measures of asset values rose and price based measures of risk fell” whilst

“competition to grow bank profit increased” which we have seen with the credit rating

agencies. (The University of Warwick, 2009) Furthermore as the safer perceived banks

appeared more robust during this period “shareholders concluded the bank was under-

leveraged.” (The University of Warwick, 2009) Their response was expanding their balance

sheets, greater short term borrowing and leverage otherwise they would be “punished by the

stock markets” because “increasing leverage and expanding balance sheets puts a bid on asset

prices pushing them up further, amplifying the boom.” (The University of Warwick, 2009)

ROLE OF THE U.S. GOVERNMENT

Former Secretary of the Treasury Hank Paulson has time and time again stated that all

financial crisis stem from flawed policies. (The Huffington Post, 2013)The aim of this section

is to see which policies were flawed and why.

Regulators Fell Asleep at the Wheel with Lehman

Firstly regulators “fell asleep at the wheel” as Lehman went bankrupt because this shattered

confidence across all the financial institutions. (The Economist, 2013) It created a sense of

panic as no one believed in each other’s ability to repay its obligations therefore the industry

stopped loaning to each other, especially in the vitally important short term cash repo market.

This shortage of cash at the top had a detrimental knock on effect to thousands of non-

financial firms who heavily relied upon financial institutions to finance their daily operations

including supplier payments and employee wages. This cash flow was critical to the wider

economy because one major implication was for businesses to delay payments, lay off staff

and in many cases bankruptcy. This subsequently meant less confidence across all market

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sectors which led to further unemployment as this vicious downward spiral continued. In

essence businesses were starved of their oxygen (cash) because of Lehman’s collapse.

Credit Expansion Policies

The affordable housing quotas

The Bush Administration knew that house prices had risen steadily since World War 2 and

were perceived to be a safe investment for Americans. Therefore in a political attempt to

increase popularity their policies concentrated on enabling more Americans to live the

American Dream, especially those who did not have the most credible credit histories. For

example, according to a Cato Institute report, “the affordable housing quotas” on Fannie and

Freddie in 2002 and 2004 encouraged more involvement in the subprime market. (Dowd,

2009) This consequently led to their competitors such as Lehman doing likewise.

Why such a sharp fall in interest rates?

The sharp fall in interest rates was seen economically crucial to increase borrowing to

stimulate expenditure thus driving growth whilst borrowing was seen as socially beneficial as

it helped more to realise the American Dream. But why was this decision taken?

Controlling inflation is the primary aim of monetary policy. However this depends on the

policymaker’s views in America. (Dowd, 2009) Dowd suggests that the ‘Greenspan

Doctrine’ was vital as “the Fed could do nothing to stop asset bubbles from occurring, but

would stand by to cushion the fall if they did occur” meaning they would offer “partial

bailouts of bad investments.” (Dowd, 2009) This only emphasized the too big to fail

argument as Government financial assistance was likely if ever required in the future.

In 2002 the “false deflation scare” presented to the Fed policymakers by Bernanke was

another reason for monetary loosening which saw interest rates fall to around 1% in July

2003 as the U.S. economy was encircled by uncertainty following the .com bubble burst and

9/11. (Dowd, 2009) Consequently this encouraged both institutional and public borrowing as

riskier investments offered a comparatively larger reward relative to low risk U.S. bonds.

Therefore despite the goal of increasing home ownership their policies had the unintended

consequence of building the foundations of the financial crisis as higher expenditure raised

house prices which fuelled the housing bubble. Inevitably this greater spending raised the

inflation rate which pressurised the Fed to act as bondholders’ returns would diminish in real

terms. Subsequently the Fed responded by gradually raising its interest rates to a peak of

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5.26% in July 2007. (Dowd, 2009) This caused the subprime mortgage market to crash as

mortgage owners could no longer afford to pay their rents and consequently defaulted. The

Fed could have responded by again lowering interest rates until these financial institutions

became less exposed to subprime mortgages and by introducing tighter regulatory control but

instead they chose not to act. This left those insurers who engaged in CDS’ such as A.I.G. to

incur the bulk cost of defaulting mortgages. Only now did the world begin to truly realize the

liquidity crisis.

Repeal of the Glass- Steagall Act and Greater Debt-Capital Ratio

With America’s ambition to become the world’s financial hub above London the first alarm

bells rang from the Repeal of the Glass-Steagall Act known as the Gramm-Lach Blily Act

under President Clinton in 1999 which was labelled ‘public enemy number one’ by Nobel

Prize economist winner Joseph Stiglitz. (Brook & Watkins, 2012) This portrayed a lack of

standards because holding companies could now operate both commercial and investment

banks meaning they could accept deposits and gamble this money by underwriting or dealing

in securities. However the game changing policy came under the Bush Administration. The

credit expansion obsession surrounding the American Dream gathered pace in 2004 where

SEC allowed the debt-to-capital ratio to be increased from 12:1 to 30:1, a policy coincidently

supported by then Goldman Sachs CEO, Hank Paulson. This sent financial institutions, but

especially Lehman, into a leveraging frenzy as they were believed to have leveraged around

this upper threshold which left Lehman vulnerable to insolvency as anything just over a 3%

decrease in their asset value would have left them insolvent. (Morning Star, 2007) (This

proved to be the case when interest rates went up as many institutions’ subprime mortgage

defaults increased.) Theoretically this would raise great concern regarding liquidity as cash

flows are often perceived to be the oxygen of a company. Evidently this was not the case for

the credit rating agencies, investors or Wall Street executives but more importantly the US

Government. Their judgement had been clouded over by their policies tailored towards the

pursuit of living the ‘American Dream’ which was in fact more interventionist than

America’s so called free market tendency.

THE HUBRIS OF WALL STREET EXECUTIVES THROUGH ‘TOO BIG TO FAIL’

In business academia there is a huge case that many Wall Street executives believed they

were ‘too big to fail’ which is undoubtedly connected to the flawed compensation structures

and flawed Government policies which we have previously discussed. However to further

emphasize this claim, the shift in the financial industry’s concentration between 1990 and

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2008 was staggering. “The share of financial assets held by the 10 largest US financial

institutions rose from 10% to 50% as the number of banks fell from over 15,000 to 8,000.”

(Ferguson, 2009) These companies were bound to fail as the industry “was too important to

be left to bankers” whom had “talent for privatising gains and socialising losses.” (Wolf,

2008) Meanwhile the industry had received, as the market expected, numerous bailouts

including Government supported, but not owned, Fannie Mae and Freddie Mac who received

subsidies for 30 year mortgages. (Tyrangiel, 2013) Additionally the approval of JP Morgan’s

takeover of Bear Stearns with a bailout only emphasised this ‘too big to fail’ attitude amongst

Wall Street’s financial institutions. (In section two we will discuss Dick Fuld, CEO of

Lehman.) Further evidence suggests Wall Street CEO’s saw the liquidity warning signs of

France’s largest bank BNP Paribas in 2007 which had three sub-prime related bonds funds

frozen. (Tyrangiel, 2013) However as they were too big to fail subprime operations

continued.

Section 1 Conclusion

Throughout this paper we have learnt that the causes of the financial crisis of 2007-2010 do

not solely focus on the world of finance alone as the Government and executive behaviour

also had a significant influence. Nevertheless finance played a major role in creating the

crisis. Firstly, the flawed compensation structure allowed managers to generate high short

term profits by taking high short term systematic risk because they would not incur any future

financial repercussions as their business would. This led to the creation of complex financial

products such as CDO’s and CDS’s which were inaccurately rated by the credit rating

agency’s as it was in both sides’ financial interests to concentrate on quantity and not quality.

These products were designed to minimize risk to fuel the American Dream. However

realistically, its miscalculated formula and almost untraceable risk in the complex

securitization chain turned this dream into a nightmare. Secondly, we have seen the argument

of regulators falling asleep at the wheel regarding Lehman but we have mostly supported

Hank Paulson’s perception that the financial crisis of 2007-2010 like all financial crises stems

from flawed Government policies. Flawed policies such as the affordable housing quota,

falling interest rates, the Repeal of the Glass-Steagall Act and the increased debt-to-capital

ratio policy all helped to widen their macroeconomic imbalances regarding excessive

spending. They were aimed to assist the American Dream in order to help stimulate the

American economy, they acted like a short term fix for a sick patient as giving the patient

more pain relieving drugs does not fix the fundamental health issue which is why the

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Government played a key role in creating the financial crisis of 2007-2010. Finally we have

seen how the financial world and various government policies helped to grow the ‘too big to

fail’ belief planted in the minds of Wall Street executives who carelessly ran their companies

into the ground. Ultimately finance, the role of Government and executive behaviour all

helped to cause the financial crisis of 2007-2010. This leads us into section two where we

will explore precisely how Lehman collapsed.

Section 2 Why Lehman Brothers Collapsed in October 2008

On the 15th

September 2008 Lehman Brothers, the 4th

largest investment bank In America,

filed for chapter 11 bankruptcy protection. But how did this happen? The paramount areas for

analysis explored in this section again include the world of finance, the role of government

and the hubris of former CEO Dick Fuld who believed that Lehman was ‘too big to fail’.

FINANCE

In the financial world there were many reasons behind the collapse of Lehman Brothers.

Firstly we will explore the exogenous confidence shock to Lehman by the collapse of Bear

Stearns as well as the implication of Merrill Lynch’s actions. However the main reasons lie

behind the flawed compensation structure, which we explored in part one, that encouraged a

risk taking culture within the industry. Despite this risk we must wonder why there was there

no suggestion of the Lehman Brother’s fragility even in their final full year filing. This will

bring us to the crucial financial aspects of the markets’ ignorance towards liquidity,

Lehman’s complex financial products, and finally Lehman’s fraudulent window dressing

capabilities which all portrayed their superficial performance.

Collapse of Bear Stearns

On 17th

March 2008 the collapse of the second-largest underwriter of mortgage backed

securities Bear Stearns demonstrated that the CDO and CDS engagement in the subprime

market was a ticking time bomb. Simultaneously as JP Morgan took over the company for a

favourable $2 per share, this shattered confidence in the Lehman Brothers as the market

feared they would be next in line to fail. Consequently this sparked JP Morgan to demand

greater weekly collateral from Lehman in order to secure short-term loans, amounts which

essentially “suffocated” Lehman according to Bloomberg. (McDonald, 2009) Subsequently,

rumours spread about Lehman’s inability to externally raise capital which led to Lehman’s

share price plummeting by over 95% despite them having some cash reserves. (BBC, 2008)

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Bank of America Bought Merrill Lynch Instead of Lehman Brothers.

Merrill Lynch knew that in order for Bank of America to take over Lehman, another buyer

was required to take over Lehmans’ toxic assets and they could only afford one takeover.

Therefore knowing that Merrill Lynch themselves would also be on the brink of failure unless

they were recapitalized they successfully persuaded Bank of America to take them instead of

Lehman in a deal the New York Times believed to be worth around $50 billion. (Sorkin,

2008) If Merrill Lynch had not offered this proposal then Lehman may have been saved.

Market Ignorance Towards Liquidity

Despite Lehman’s huge leverage, liquidity was never considered a problem because of the

high market confidence and trust that financial institutions would lend and repay its cash

loans to one another. Therefore analysts turned a blind eye to the continual negative cash

flows Lehman ran up for investing activities during the three years up to its demise, including

£1,698 billion in 2007. (Morning Star, 2007) Clearly investors were distracted by Lehman’s

continuous record profits between 2005 ($3.26 billion) and 2007 ($4.2 billion) which also saw

rocketing share prices. (Morning Star, 2007)

Lehman’s Complex Financial Products

Prior to the crash, the American economy was dominated by low inflation and stable growth

which had saturated the prime mortgage market. This consequently encouraged risk taking in

the financial world through financial product innovations which included the previously

mentioned CDO’s CDS’s. These complex products involved many different products and

actors throughout the securitization chain. However they were designed to minimize but not

completely eradicate risk as Milton Friedman once famously said ‘there ain’t no such thing as

a free risk.’ Consequently, this gave Lehman Brothers the green light to expand their

portfolio into the capital markets. This mainly included the higher risk sub-prime mortgage

market which was aided inorganically by Lehman’s taking over five mortgage lenders

between 2003 and 2004 including BNC Mortgage. Instead the unintended consequence was

that these products had helped Lehman Brothers to lose track of and thus increase its risk.

Consequently, Lehman claimed it would write down its residential mortgages and

commercial property investments by $700 million in 2007 but instead reached $7.8 billion in

2008, its greatest historical net loss. (BBC, 2008) Simultaneously Lehman admitted it was

struggling to value its $54 billion exposure to other mortgage-backed securities. (BBC, 2008)

Such a complex structure was undermined by Lehman’s one lost bet regarding all house and

asset prices not falling at the same time which they did.

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Window Dressing Capabilities

As Fuld told his executives to reduce their debt, investors still continued to invest as nobody

could see Lehman’s huge exposure to subprime mortgages as the lies were hidden by top

management mainly through the repo (repurchase agreements) transaction manipulation

which later became known as repo 105 in Lehman’s case. In essence, this involved

transferring one company’s assets to another in exchange for short-term cash and is popular

in the financial world as firms may have short term illiquid assets therefore resorted to the

repo market to obtain short term cash. Furthermore the Financial Times reported evidence

from Anton Valukas, the Lehman bankruptcy court examiner, who found “credible evidence”

of an “accounting gimmick” which window dressed their results at a time where Lehman had

assured its board that it had “the strongest liquidity position of the brokers.” (Baer & Thomas,

2010) Valukas was referring to Lehman’s fraudulent and aggressive manipulation of its repo

market operations where it would borrow cash from the repo market in exchange for their

toxic assets (in which case even some of their AAA CDO’s were toxic as previously

discussed) just before it was due to release its financial reports. The implication for

shareholders, potential investors and regulators was that they would not see Lehman’s

illiquid, toxic assets but instead see propped up liquidity i.e. the cash borrowed from another

company obtained through the repo market. They were able to perform this method by

classifying these repo loans not as loans but as sales meaning they never actually disclosed

that they would have to pay back this repo loan to the other companies. This was supported

by Merrill Lynch who reported to regulators after Lehman’s first quarter results in 2008 that

Lehman had “regulatory capital in its calculation of excess liquidity” through “cash and

collateral locked up in other banks.” (Sender, 2010) Moreover once the financial reports were

published the cash plus interest would be repaid by Lehman in exchange for their illiquid,

toxic assets. Overall this fraudulent method painted a brighter picture of Lehman’s financial

health by improving their debt levels by an estimated $39 billion in quarter 4 2007, $49

billion in quarter 1 2008 and $50 billion in quarter 2 2008. (De La Merced & Sorkin, 2010)

ROLE OF THE U.S. GOVERNMENT

In section one we explored the Bush Administrations’ credit expansionary policies tailored

towards the American Dream which turned out to be a nightmare by helping to fuel the

financial crisis. Some suggest that Clinton should not had repealed the Glass-Steagall Act, or

Bush not changed the debt-to-capital ratio whilst many point the finger towards not

11

regulating those flawed remuneration schemes which we have analysed in part one. These

were credible at the industry level.

Hank Paulson believed with more power he may not have needed to go to Congress where

legislation was extremely difficult to pass unless there was an immediate crisis. On the other

hand the Financial Times reported an e-mail from Jim Wilkinson, Paulson’s chief of staff

who quoted “I just can’t stomach us bailing out Lehman. Will be horrible in the press.”

(Braithwaite, 2010) Maybe there was a moral hazard as no firm should be too big to fail.

Here specifically in Lehman’s case, we will concentrate on the lack of crucial policies at the

Government’s disposal such as TARP and the new Dodd-Frank legislation which in hindsight

could have saved Lehman from the brink according to Paulson.

Insufficient Power to Bailout Non-Banks

Firstly, unsurprisingly to Paulson’s support was Phillip Swagel, who was assistant secretary

for economic policy at the Treasury Department from 2006 to 2009, who believed that

“Lehman failed before the T.A.R.P. (Troubled Asset Relief Program) was passed or even

proposed to the Congress.” This essentially meant the “Treasury Department had no legal

authority to put government money into the firm or provide a guarantee for its obligations.”

He further claimed that this only changed “with the passage of the Emergency Economic

Stabilization Bill on October 3rd

2008 which provided $700 billion in T.A.R.P. financing to

be used to purchase troubled assets.” (Swagel, 2013)

Emergency Powers Under Section 13(3) and the New Dodd-Frank Legislation

Another option to impose was the emergency powers under Section 13(3) where an

emergency loan could be made to a firm during “unusual and exigent circumstances”.

(Swagel, 2013) However this was somewhat restricted to “classes of firms rather than

individual ones” by the old Dodd-Frank legislation where approval from the Treasury

Secretary, Hank Paulson and the Fed’s governing board were required. This was never truly a

viable route as it was illegal for the Fed to make a loan on which it expected to take a loss.”

(Swagel, 2013) Furthermore, the Fed clearly did expect a loss according to a testimony before

the Financial Crisis Inquiry Commission in Washington by the New York Fed General

Counsel in Thomas Baxter. He suggested that Lehman “had no ability to pledge the amount

of collateral required to satisfactorily secure a Fed guarantee, one large enough to credibly

withstand a run by Lehman’s creditors and counterparties.” (Baxter, 2010)

12

Emergency Powers for Bear Stearns and A.I.G.

This inability to offer collateral was the fundamental difference to other bailouts in which the

US Government had previously dealt with including Bear Stearns where they allowed JP

Morgan Chase favourable terms to buy them out. In this case the Fed risked $29 billion

against Bear Stearns’ estimated $30 billion assets which eventually proved to be a successful

deal as the Fed was repaid in full with interest. (Swagel, 2013) However a more interesting

case entails the events post Lehman Brothers collapse where “the Fed’s loans were

collateralized by the entire assets of insurance giant A.I.G.” because of the enormous

potential loss it could incur. During this volatile period it was very difficult to place a value

on A.I.G. meaning its assets may not have offset any Fed loan. (Swagel, 2013) Now we have

a visible grey area in interpreting Section 13 (3) because in A.I.G.’s situation there was no

certainty that the Fed’s $40 billion loan would not result in a loss because they clearly could

not place a value on A.I.G.’s assets. Therefore this suggests that the Government noticeably

viewed A.I.G. as too big to fail and not Lehman as Lehman’s problems involved solvency

and not just liquidity. (Swagel, 2013)This was critical to justify the Government allowing

Lehman to fail under their noses.

Barclays Proposed Takeover of Lehman

The last throw of the dice during Lehman’s final hours was a desperate one and proved that

the US Government had tried everything to prevent Lehman’s collapse. They had crossed

their fingers that UK Bank Barclays would miraculously acquire the essentially bankrupt

Lehman Brothers. In the meantime the FSA had essentially blocked the deal unless the US

Government would guarantee Lehmans’ trading obligations, in other words its incurring

losses, during the 30 day shareholder approval period in order to mitigate uncertainty. At the

time the US Government could not approve as it involved pumping in taxpayer money which

is both exponentially damaging during the election campaign for candidates and illegal as

previously discussed. This is where Paulson famously quoted “the British screwed us” but

later claimed he said this out of pure frustration with the somewhat limited powers they had

at their disposal. However Swagel believed the US Government would have utilized the

newly revised Dodd-Frank legislation had it been available at this stage because Lehmans’

financial losses would have been covered “by other financial firms and not taxpayers.”

(Swagel, 2013) Here Swagel presented a strong case as Hank Paulson had gathered a crisis

meeting in which he successfully persuaded the CEO’s of Wall Street’s top financial

institutions to collectively pay for Lehmans’ toxic assets through each institution pooling

13

some capital. Wall Street agreed because this was more favourable than the detrimental

alternative of a Lehman collapse as the implications involved systemic risk through a crash of

market confidence and trust in each institution’s ability to pay its trading obligations. They

knew this could destabilize the entire financial sector through a domino effect of failing

institutions whilst the pure existence of this meeting suggests the Treasury’s concern as it did

not want Lehman to fail. Surely if this new Dodd-Frank legislation had been available it

would have been used because standing up to Wall Street by making them pay for their

collective failures meant no use of taxpayer money which portrayed enormous potential for

political gain during the election campaign.

DICK FULD FORMER CEO OF LEHMAN BROTHERS

Throughout his 46 years, Dick Fuld, the former Lehman Brothers CEO was the man who

almost single handedly transformed the company into becoming one of the key players

amongst the financial world. Fuld was a charismatic man, famously known for his ‘ripping

their heart out’ speech regarding short investors which typified his hugely admired and feared

persona. Furthermore, although it may not seem unusual for Hank Paulson, former Goldman

Sachs CEO, to partially blame Dick Fuld for the collapse of Lehman we can clearly see why.

Fuld’s Unethical Management Practices

As Wall Street’s highest paid CEO Dick Fuld had a duty to sign Lehman’s financial reports

therefore he had both a legal and moral duty not to undermine his stakeholders, especially his

shareholders. Fuld knowingly helped to destroy Lehman because a man with 46 years of

experience with years as a responsible CEO cannot have made him incompetent at his job. To

touch upon the repo accounting scandal, Valukas’ report quotes the Lehman Senior Vice

President Matthew Lee who “wrote a letter to management to alleging accounting

improprieties” which proves Dick Fuld was more than aware of his company’s fraud. (De La

Merced & Sorkin, 2010) Furthermore he must have known about immoral dealings regarding

the loans his company made specifically to people who would never be able to pay the loans

back. This is supported by the former Lehman vice president’s book ‘A Colossal Failure of

Common Sense: The Inside Story of the Collapse of Lehman Brothers’ in which he suggested

your job would had been at risk if you starting questioning your required practices. They then

went one step further into saying “It was the Ivory Tower. Lehman was never rotten at the

core, that’s where all the beauty was, she was rotten at the head… there were 24,992 making

money and eight guys losing it.” (McDonald & Robinson, 2009) It was these executives who

even welcomed benefitting from defaulting securities by unethically backing against them

14

through their CDS operations which only emphasises Dick Fuld’s conflict of interest between

his clients and his own bonuses.

Fuld Believed Lehman Was Too Big to Fail

Paulson had advised Fuld on numerous occasions to solve their liquidity problems by

recapitalization but did nothing even during the 6 months he had to act after the collapse of

Bear Stearns. (Gapper, 2010) However Fuld’s greed became overwhelmingly apparent as he

ignored Paulson by rejecting multiple offers from private institutions including Blackstone,

Colony and the Korean Development Bank. The Korea bailout rejection alone in September

2008 sent Lehman’s stock plummeting by 77% through an exodus of investors. (McDonald &

Robinson, 2009) Consequently Moody’s informed Lehman that they needed to sell a majority

stake in order to avoid a downgrade which Fuld would not do leaving their stock in freefall.

This led to their $46 billion market value loss as they declared bankruptcy on September 15

2008. But why did Fuld reject these offers? He did so for two reasons, the first being a “false

sense of confidence” that the Government would bail them out like they did with Bear

Stearns. (McDonald, 2009) Secondly and most importantly, Fuld believed these offers were

too low which is no surprise for a man wanting to overtake his rivals to become the number

one bank in America after all he even had his own lift. Furthermore it was abundantly clear

that Fuld did not like being governed by his old rival Paulson as he wanted to keep hold of

Lehman at all costs. This is supported by a Bloomberg report which claims Fuld began

“thrashing around” investing in both domestic and overseas, major and small hedge funds and

even creating hedge funds around the time of the Korean bank’s negotiations. (McDonald,

2009) Fuld believed their price free fall from $66 to $23 was a blip but maybe if his vision

was not impaired with hubris then Lehman would have been taken over which may have

prevented Lehman’s collapse and “probably would have saved the world”. (McDonald, 2009)

Conclusion

Firstly, in the financial world we have analysed how the collapse of Bear Stearns shattered

confidence in Lehman who the market believed were next to fail as well as Merrill Lynch’s

actions which prevented Lehman from being taken over by Bank of America. We have seen

how the risk taking culture, stemmed from the flawed compensation structures, incentivised

the creation of complex financial products such as CDO’s and CDS’s which Lehman used to

become heavily involved in the toxic subprime mortgage market. Most importantly the

financial capability to window dress Lehman’s accounts through the repo 105 transactions

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portrayed superficial performance to shareholders, investors and to the world which allowed

them to continue trading whilst realistically suffocating from liquidity issues. Secondly the

Government played an enormous role in the collapse of the Lehman Brothers. Some blame

the Bush Administrations’ policies geared towards living the ‘American Dream’ through the

expansion of credit with low interest rates and greater leverage ratio legislation which

encouraged excessive risk. Some blame the Government’s free market ideology and ambition

to become the global financial hub above London which explains their regulatory negligence

towards the entire financial sector including the remuneration packages which further fuelled

the already excessive risk. Finally some blame the politically damaging impact of taxpayer

funded bailouts especially during the election campaign. However Lehman undoubtedly

failed because of the lack of available political powers specifically the new Dodd-Frank

legislation and T.A.R.P. which would have been used because most parties including

Lehman, the US Government, and most importantly society would have benefited. The final

driving factor behind Lehman’s collapse was the hubris of Lehman’s former CEO Dick Fuld,

the man who became so obsessed and arrogant in self-belief that he did not listen to anyone.

He was too obsessed in his bonus related pay and despite Hank Paulson’s constant advice to

recapitalize, he failed to do so. Clearly Fuld’s ego had a huge part to play but we can also

support Paulson’s claim that all financial crisis stem from flawed policies or lack of policy

which we also saw in section. This directly relates to Lehman’s collapse as Fuld believed that

Lehman was too big to fail and would always obtain financial backing by the Government.

Overall Lehman failed because of finance, the role of Government and finally the hubris of

their former CEO Dick Fuld.

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Causes of the Financial Crisis

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