Lehman Brother Crisis

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FINAL CAPSTONE PROJECT- SEM IV
Submitted by:
Prateek Saxena
201350169

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Table of Contents
Acknowledgement..................................................................................................................... 4
INTRODUCTION......................................................................................................................... 5
HISTORY:............................................................................................................................... 5
BANKRUPTCY OF LEHMAN BROTHERS......................................................................................... 6
SUBPRIME MORTGAGE CRISIS .................................................................................................... 8
DEMISE OF LEHMAN BROTHERS ................................................................................................. 9
1. MARKET COMPLACENCY..................................................................................................... 9
HOMEOWNER SPECULATION.............................................................................................. 9
THE PROBLEM:..................................................................................................................11
2.BAD REGULATION:.............................................................................................................11
THE GOALS SET BY H.U.D: ..................................................................................................11
MONEY MARKET FUNDS ....................................................................................................12
ULTRA SHORT BOND FUNDS...............................................................................................12
THE PROBLEM:..................................................................................................................13
3.LACK OF TRANSPARENCY....................................................................................................14
4.LEHMAN FINANCIAL POLICY:..............................................................................................15
5. CONSEQUENCES AFTER LEHMAN DEFAULT:.......................................................................15
References...............................................................................................................................19

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Acknowledgement
Firstly I would like to thank god for providing me with the opportunity to
make use of my knowledge while doing this project and enabling me to
complete it in time.
I would like to thank my mentor, Jyotirmay Dasgupta Sir, who was helpful,
friendly and cooperative and never shirked from giving me any guidance that i
needed. I thank him for all his support and for helping me get a broader
perspective of Investment banking.
And Last but not the least I would like to thank my parents and all of my
teachers here at ITM-Institute of Financial Markets for equipping me with the
necessary skills and abilities which helped in successfully completing this
project.

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INTRODUCTION
Lehman Brothers founded in 1850, is a global financial-services firm. The
firm does business in investment banking, equity and fixed-income sales,
research and trading, investment management, private equity, and private
banking. It is a primary dealer in the U.S. Treasury securities market. The
firm’s worldwide headquarters are in New York City, with regional
headquarters in London and Tokyo, as well as offices located throughout
the world.
HISTORY:
In 1844, 23-year-old Henry Lehman, the son of a cattle merchant,
emigrated to the United States from Rimpar, Bavaria. He settled in
Montgomery, Alabama, where he opened a dry-goods store, “H. Lehman”.
In 1847, following the arrival of Emanuel Lehman, the firm became “H.
Lehman and Bro.” With the arrival of their youngest brother, Mayer
Lehman, in 1850, the firm changed its name again and “Lehman Brothers”
was founded. In 1850 Lehman brothers set up the merchant bank in New
York after making money in railway bonds. In this way this finance giant
came into existence in USA.
During the 1850s, cotton was one of the most important crops in the
United States. Capitalizing on cotton's high market value, the three brothers
began to routinely accept raw cotton from customers as payment for
merchandise, eventually beginning a second business trading in cotton.
Within a few years this business grew to become the most significant part
of their operation. Following Henry's death from yellow fever in 1855, the
remaining brothers continued to focus on their commodities-
trading/brokerage operations.
By 1858, the center of cotton trading had shifted from the South to
New York City, where factors and commission houses were based. Lehman
opened its first branch office in New York City's Manhattan borough at
119 Liberty Street, and 32-year-old Emanuel relocated there to run the
office. In 1862, facing difficulties as a result of the Civil War, the firm
teamed up with a cotton merchant named John Durr to form Lehman, Durr
& Co. Following the war the company helped finance Alabama's
reconstruction. The firm's headquarters were eventually moved to New
York City, where it helped found the New York Cotton Exchange in
1870; Emanuel sat on the Board of Governors until 1884. The firm also

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dealt in the emerging market for railroad bonds and entered the financial-
advisory business.
In 2003, the company was one of ten firms which simultaneously
entered into a settlement with the U.S. Securities and Exchange
Commission (SEC), the Office of the New York State Attorney
General and various other securities regulators, regarding undue influence
over each firm's research analysts by their investment-banking divisions.
Specifically, regulators alleged that the firms had improperly associated
analyst compensation with the firms' investment-banking revenues, and
promised favorable, market-moving research coverage, in exchange for
underwriting opportunities. The settlement, known as the “global
settlement”, provided for total financial penalties of $1.4 billion, including
$80 million against Lehman, and structural reforms, including a complete
separation of investment banking departments from research departments,
no analyst compensation, directly or indirectly, from investment-banking
revenues, and the provision of free, independent, third-party, research to the
firms' clients.
BANKRUPTCYOF LEHMAN BROTHERS
Lehman borrowed significant amounts to fund its investing in the
years leading to its bankruptcy in 2008, a process known as leveraging or
gearing. A significant portion of this investing was in housing-related
assets, making it vulnerable to a downturn in that market. One measure of
this risk-taking was its leverage ratio, a measure of the ratio of assets to
owners’ equity, which increased from approximately 24:1 in 2003 to 31:1
by 2007. While generating tremendous profits during the boom, this
vulnerable position meant that just a 3-4% decline in the value of its assets
would entirely eliminate its book value or equity. Investment banks such as
Lehman were not subject to the same regulations applied to depository
banks to restrict their risk-taking.
In August 2007, Lehman closed its subprime lender, BNC Mortgage,
eliminating 1,200 positions in 23 locations, and took a $25-million after-tax
charge and a $27-million reduction ingoodwill. The firm said that poor
market conditions in the mortgage space "necessitated a substantial
reduction in its resources and capacity in the subprime space".
In 2008, Lehman faced an unprecedented loss due to the
continuing subprime mortgage crisis. Lehman's loss was apparently a result
of having held on to large positions in subprime and other lower-rated
mortgage tranches when securitizing the underlying mortgages. Whether

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Lehman did this because it was simply unable to sell the lower-rated bonds,
or made a conscious decision to hold them, is unclear. In any event, huge
losses accrued in lower-rated mortgage-backed securities throughout 2008.
In the second fiscal quarter, Lehman reported losses of $2.8 billion and was
forced to sell off $6 billion in assets. In the first half of 2008 alone, Lehman
stock lost 73% of its value as the credit market continued to tighten. In
August 2008, Lehman reported that it intended to release 6% of its work
force, 1,500 people, just ahead of its third-quarter-reporting deadline in
September.
On August 22, 2008, shares in Lehman closed up 5% (16% for the
week) on reports that the state-controlled Korea Development Bank was
considering buying Lehman.[7] Most of those gains were quickly eroded as
news emerged that Korea Development Bank was "facing difficulties
pleasing regulators and attracting partners for the deal." It culminated on
September 9, 2008, when Lehman's shares plunged 45% to $7.79, after it
was reported that the state-run South Korean firm had put talks on hold.
Investor confidence continued to erode as Lehman's stock lost roughly
half its value and pushed the S&P 500 down 3.4% on September 9, 2008.
The Dow Jones lost nearly 300 points the same day on investors' concerns
about the security of the bank. The U.S. government did not announce any
plans to assist with any possible financial crisis that emerged at Lehman.
On September 10, 2008, Lehman announced a loss of $3.9 billion and
their intent to sell off a majority stake in their investment-management
business, which includes Neuberger Berman. The stock slid 7% that day.
On September 13, 2008, Timothy F. Geithner, then president of
the Federal Reserve Bank of New York called a meeting on the future of
Lehman, which included the possibility of an emergency liquidation of its
assets. Lehman reported that it had been in talks with Bank of
America and Barclays for the company's possible sale. The New York
Times reported on September 14, 2008, that Barclays had ended its bid to
purchase all or part of Lehman and a deal to rescue the bank from
liquidation collapsed. It emerged subsequently that a deal had been vetoed
by the Bank of England and the UK's Financial Services Authority. Leaders
of major Wall Street banks continued to meet late that day to prevent the
bank's rapid failure. Bank of America's rumored involvement also appeared
to end as federal regulators resisted its request for government involvement
in Lehman's sale.

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SUBPRIME MORTGAGE CRISIS
Low interest rates and large inflows of foreign funds created easy credit
conditions for a number of years prior to the crisis, fueling a housing market
boom and encouraging debt-financed consumption. The USA home ownership
rate increased from 64% in 1994 (about where it had been since 1980) to an
all-time high of 69.2% in 2004. Subprime lending was a major contributor to
this increase in home ownership rates and in the overall demand for housing,
which drove prices higher.
Between 1997 and 2006, the price of the typical American house increased by
124%. During the two decades ending in 2001, the national median home
price ranged from 2.9 to 3.1 times median household income. This ratio rose
to 4.0 in 2004, and 4.6 in 2006. This housing bubble resulted in quite a few
homeowners refinancing their homes at lower interest rates, or financing
consumer spending by taking out second mortgages secured by the price
appreciation. USA household debt as a percentage of annual disposable
personal income was 127% at the end of 2007, versus 77% in 2003.
While housing prices were increasing, consumers were saving less and both
borrowing and spending more. Household debt grew from $705 billion at
yearend 1974, 60% of disposable personal income, to $7.4 trillion at yearend
2000, and finally to $14.5 trillion in midyear 2008, 134% of disposable
personal income. During 2008, the typical USA household owned 13 credit
cards, with 40% of households carrying a balance, up from 6% in 1970. Free
cash used by consumers from home equity extraction doubled from $627
billion in 2001 to $1,428 billion in 2005 as the housing bubble built, a total of
nearly $5 trillion dollars over the period. U.S. home mortgage debt relative to
GDP increased from an average of 46% during the 1990s to 73% during 2008,
reaching $10.5 trillion.
This credit and house price explosion led to a building boom and eventually to
a surplus of unsold homes, which caused U.S. housing prices to peak and
begin declining in mid-2006. Easy credit, and a belief that house prices would
continue to appreciate, had encouraged many subprime borrowers to
obtain adjustable-rate mortgages. These mortgages enticed borrowers with a
below market interest rate for some predetermined period, followed by market
interest rates for the remainder of the mortgage's term. Borrowers who could
not make the higher payments once the initial grace period ended would try to

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refinance their mortgages. Refinancing became more difficult, once house
prices began to decline in many parts of the USA. Borrowers who found
themselves unable to escape higher monthly payments by refinancing began to
default.
DEMISE OF LEHMAN BROTHERS
The demise of Lehman Brothers can only be understood within the
context of the current financial crisis, the biggest financial crisis since the
Great Depression. The roots of this crisis have to be found in bad
regulation, lack of transparency, and market complacency brought about by
several years of positive returns.
1. MARKET COMPLACENCY
The seeds of current crisis were sewn during the real estate boom. A
prolonged period of low interest rates lead to a rise in house prices, that was
completely abnormal by historical standards. From March 1997 to June
2006 the Case and Shiller national index of real estate prices increased every
month. During the same period the average increase in real estate prices was
12.4% per year. This increase was in part fueled by extraordinary low
interest rates.
This sustained price increase engenders the illusion in many actual
and aspiring home owners thatprices will alwaysgo up. In a 2005 survey of
San Francisco home buyers Case and Shiller find that the mean expected
price increase over the next ten years was 14% per year, while the median
9% per year (Shiller, 2008).
HOMEOWNER SPECULATION
Speculative borrowing in residential real estate has been cited as a
contributing factor to the subprime mortgage crisis. During 2006, 22% of homes
purchased (1.65 million units) were for investment purposes, with an additional
14% (1.07 million units) purchased as vacation homes. During 2005, these figures
were 28% and 12%, respectively. In other words, a record level of nearly 40% of
homes purchases were not intended as primary residences. David Lereah, NAR's
chief economist at the time, stated that the 2006 decline in investment buying was
expected: "Speculators left the market in 2006, which caused investment sales to

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fall much faster than the primary market.
Housing prices nearly doubled between 2000 and 2006, a vastly different
trend from the historical appreciation at roughly the rate of inflation. While homes
had not traditionally been treated as investments subject to speculation, this
behavior changed during the housing boom. Media widely reported
condominiums being purchased while under construction, then being "flipped"
(sold) for a profit without the seller ever having lived in them. Some mortgage
companies identified risks inherent in this activity as early as 2005, after
identifying investors assuming highly leveraged positions in multiple properties.
Nicole Gelinas former Lehman bank managerdescribed the negative
consequences of not adjusting tax and mortgage policies to the shifting treatment
of a home from conservative inflation hedge to speculative investment. New York
State prosecutors are examining whether eight banks hoodwinked credit ratings
agencies, to inflate the grades of subprime-linked investments. TheSecurities and
Exchange Commission, theJustice Department, theUnited States attorney’s
officeand more were examining how banks created, rated, sold and traded
mortgage securities that turned out to be some of the worst investments ever
devised. In 2010, virtually all of the investigations, criminalas well as civil, are in
their early stages.
Warren Buffetttestified to theFinancial Crisis Inquiry Commission:
"There was the greatest bubble I've ever seen in my life...The entire American
public eventually was caught up in a belief that housing prices could not fall
dramatically.
During the real estate boom delinquency rates dropped which was
the first initiation of problems for Lehman Brothers. But they did not
anticipate it very well and thought of it as a good sign. The reason was not
only the relatively good economic conditions, but the sustained real estate
price increase. First of all, home owners fought hard to be able to pay their
mortgages when their home equity increased.
Second, the availability of innovative mortgage options, like interest
only and negative amortization, allowed buyers to purchase houses for which
they could not sustain the mortgage payments in equilibrium counting on the
ability to refinance them continuously at higher prices. This caused the share
of interest-only mortgages to fly from zero to 38%.
As a result of these favorable conditions, lending standards
deteriorated. Lending standards declined in areas of high home price
appreciation and attribute this decline to increased competition among
lenders. The share of low documentation mortgages went from 29% to 51%
and the debt-to- income ratio from 39.6 to 42.4. This relaxation was

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exacerbated by securitization, i.e. the practice of pooling mortgages together
to resell them in packages. So far the bank was happy with all this
happenings. For the first time, this practice, which had been used for decades
on standard mortgages with beneficial results for both mortgage rates and
home ownership, wasapplied to lower quality mortgages. Knowing that they
would not bear the ultimate risk of default, Lehman Brothers who are
mortgage originators further relaxed their lending standards. The quality of
these mortgages should have been checked by the bank itself that bought
them, but several problems made this monitoring less than perfect.
THE PROBLEM:
These models did not properly account for the cross-correlation among
defaults and between defaults and the rest of the economy.
Second, the massive amount of issuance made by Lehman changed
the fundamental nature of the relationship between credit rating agencies
and the investment banks issuing these securities.
In the past each customer, issuing only a couple of securities, had no
market power over the rating agencies. With the diffusion of collateralized
debt obligations, the major investment banks were purchasing hundreds of
rating services a year. As a result, instead of submitting an issue to the rating
agency’s judgment, Lehman bank shopped around for the best ratings and
even received manuals on how to produce the riskiest security that qualified
for a AAA rating. Lehman through CDO Evaluator (an optimization tool)
achieved the highest possible credit rating at the lowest possible cost.
2. BAD REGULATION:
Unfortunately, regulatory constraints created inflated demand for
mortgage products.
The Federal Housing Enterprises Financial Safety and Soundness Act
of 1992 required the Department of Housing and Urban Development
(HUD) to ensure that Lehman operates in compliance with their charter
purposes. This act mandates that HUD carry out specific responsibilities
that include setting annual housing goals for the GSEs and monitoring and
enforcing the GSEs' performance in meeting these housing goals.
THE GOALS SETBY H.U.D:
In 2004, to encourage Lehman to facilitate greater financing and home
ownership opportunities for families and neighborhoods targeted by the
housing goals, especially first-time homebuyers, the HUD established goals
for the two Government Sponsored Entities (GSE). These goals are

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expressed as percentages of the total number of mortgages purchased by the
GSEs that finance the purchase of single-family and owner-occupied
properties located in metropolitan areas for low and moderate income
people.
While there is no penalty for failure to meet these goals, it is clear
from the press release that HUD exerts political pressure. Since these goals
could be met also with the purchase of subprime collateralized debt
obligations (CDOs), such pressure found no resistance from the GSE who
loved the arbitrage this opportunity created: they could issue AAA-rated
debt and invest in higher-yield AAA debt, gaining the spread.
MONEY MARKET FUNDS
Another source of captive demand was money market funds. Being
required to hold only highly rated securities, money market funds loved
these instruments because they satisfied the regulatory requirements and
boosted their yields. Most managers of Lehman were well aware of the
gamble they were taking with these funds, but could not resist taking it,
under an intense competition for yield-hungry customers. These managers
were also hoping that if a shock occurred, all their competitors would face
the same problem, thereby reducing the reputational costs and possibly
triggering a Government support.
ULTRASHORTBOND FUNDS
To be fair, the problem was even more severe in the ultra short bond
funds. Unlike money market funds, these funds are not restricted as to which
types of instruments they can own. Their aim is to beat money market funds
without delivering much more volatility. In the last year, the ultrashort-term
bond category performed very poorly. The category's worst performers have
lost between 10% and 30% over the past year . As the mutual find rater
Lehman admits, “We can't say that we saw this coming. We didn't. There
were risks in these portfolios that were hard to see and had never
materialized in the past, so backward-looking risk measures suchas standard
deviation and past losses proved unreliable. Given the near- term maturities
of the bonds in the portfolio, we underestimated the damage that subprime
and other low-quality bonds could cause.”
More generally, regulation relied heavily on credit-rating agencies
measures of risk without understating the incentives this creates on the
regulated to game the system and lobby the credit-rating agencies for sweet
deals.

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THE PROBLEM:
First of all, the bin-approach to risk advocated by Basel risk-based
capital requirements induce banks to invest in the highest risk security in
each bin, sensibly altering the distribution of asset risk. As a result, during
the Argentina crisis, domestic banks loaded up on government bonds, in
spite of the declaration of default, because they provided a regulation
arbitrage: a very high yield and zero capital requirement
This problem is present also in the United States. Lehman was
allowed to allocate zero capital to loans which were hedged with credit
default swaps. But the insurance buy was less than certain because of the
possibility that the insurer will default – what it is known as counterparty
risk – since the amount of collateral posted for this contract is often zero.
Second, this regulation failed to appreciate the enormous pressure it
put on the shoulder of credit-rating agencies. Lehman’s revenues from
structured finance ratings increased from a little more than $100 million in
1998 to more than $800 million in 2006, representing more than 80% of
its total rating revenues.
To worsen the problem, at least as far as Lehman is considered,
comes a Security and Exchange Commission ruling in April 2004,
which relaxed the pre-existing limits on leverage. As a consequence, the
leverage of Lehman investment bank shot up.
Buyers have an option to treat sub-prime mortgage securities as
trading or available for sale (AFS) or held to maturities (HTM). AFS
securities are accounted for at the lower of cost or fair value. HTM securities
are accounted for at amortized costs, subject to other-than- temporary
impairments. Originators usually treat mortgages as available for sale.
While this system was designed to increase the transparency of
reporting it did encounter some problems, especially at the time of a major
generalized crisis.
As market liquidity dried out, Lehman had to move to mark-to-model.
Given the relative novelty of this approach, there was not a well-established
method to deal with this. Hence, Lehman was at the mercy of their external
auditors, who had different approaches. Since, there is not an adequate
disclosure of all the assumptions that go in the models, a rule that was
invented to increase transparency lead to more opacity at a time the market
needed transparency the most.
Second, write-offs calculated in this way had major impact in the
rating-firm decisions to downgrade financial institutions, which in turn had
strong effect on their ability to survive. Unfortunately, given the limited
credibility credit rating agencies enjoy in this moment, they could not

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afford to be seen as overruling the implications of the write offs.
3. LACK OF TRANSPERENCY
The other major source of problems that contributed to the crisis was
the lack of transparency in major markets. During the last ten years the
market for credit default swaps (CDS) grew unregulated from almost zero to
more than $44 trillion (more than twice the size of the U.S. stock market).
More importantly, the level of collateral posted for these contracts was very
low or non-existent, generating the possibility of a systemic failure. If in the
middle of the hurricane season all of a sudden all Florida homeowners lost
the insurance for their house, there would be an enormous run to buy new
insurance. Given that in the short term, insurance capacity is limited, the
prices will go to the roof. If some home owners could not afford these prices,
their mortgages will automatically default, triggering foreclosures and a real
estate crisis. This is one of the reasons why the Lehman wanted the insurance
market to be regulated.
LEHMAN had massive exposure to CDS. Most of their positions were
hedged; hence the net exposure was much smaller. Nevertheless, when
Lehman a major player defaulted, all the other ones found themselves un-
hedged, triggering a run to buy insurance, with consequences not dissimilar
from the case described above. In spite of its potential systemic effects, the
market for CDS was completely unregulated.
The same is true for the mortgage-backed security market. In 2007
there were almost 6 trillion mortgage-backed securities outstanding. Most of
these securities were issued under the 144A rule, with limited disclosure.
This lack of transparency in the issuing process made it difficult to
determine who owned what. Furthermore, the complexity of these
repackaged mortgages is such that small differences in the assumed rate of
default can cause the value of some tranches to fluctuate from 50 cents on
the dollar to zero. Lacking information on the nature and hence the value of
banks’ assets, the market grew reluctant to lend to them, for fear of losing
out in case of default. One often-used measure of this reluctance is the
spread between Libor and the overnight indexed swap (OIS) rate of the same
maturity. Before the beginning of the crisis the multi-year average of this
spread was 11 basis points. On August 10 2007 it was over 50 basis points
and it was over 90 basis points by mid-September. While fluctuating it has
mostly remained above that level ever since, 2008.

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4. LEHMAN FINANCIAL POLICY:
In the case of Lehman (and other investment banks), this problem was
aggravated by two factors: the extremely high level of leverage (asset-to-
equity ratio) and the strong reliance on short-term debt financing. While
commercial banks are regulated and cannot leverage their equity more than
15 to 1, at the beginning of the crisis Lehman had a leverage of more than 30
to 1, i.e. only $3.30 of equity for every $100 of loans (Table 6). With this
leverage, a mere 3.3% drop in the value of assets wipes out the entire value
of equity and makes the company insolvent.
In turn, the instability created by the leverage problem was
exacerbated by Lehman’s large use of short-term debt, which financed
more than 50% of the asset at the beginning of the crisis. In a low interest
rate environment, reliance on short-term borrowing is very profitable, but
increases the risk of “runs” similar to the ones bank face when they are
rumored to be insolvent. Any doubt regarding the solvency of the borrower
makes short-term lenders leery to renew their lending. These doubts can be
self-fulfilling, in that if enough short-term lenders withdraw their funds, the
borrower faces a liquidity shortage, which cannot be easily dealt with in the
current economic environment, forcinga firm to default.
After the beginning of the crisis, Lehman did try to reduce its leverage
and reduce its reliance on short term debt. But it was too little, too late.
Lehman succumbed.
The Lehman CEO told that his company was solvent and that it was
brought down by a run. This is a distinct possibility. The problem is that
nobody knows for sure. When Lehman went down, it had
$20 billion in book equity, but the doubts about the value of its assets
combined with its high degree of leverage created a huge uncertainty about
the true value of this equity: it could have been worth $40 billion or negative
20. It is important to note that Lehman did not find itself in that situation by
accident; it was the unlucky draw of a consciously-made gamble.
5. CONSEQUENCES AFTER LEHMAN DEFAULT:
The Lehman fallout is likely to have a significant direct and indirect
impact on a number of large banks globally.Here are three areas worth
mentioning:
 Exposure to debt in (selective) default. LBHI had outstanding long-
term debt of approximately $110 billion as of Aug. 30, 2008. Short-

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term commercial paper outstanding was around $8 billion at the end
of May, but has likely been reduced significantly since that time. The
fact that trustees hold a majority of this debt means the bankruptcy
petition sheds little light on the economic ownership of Lehman's
obligations. We believe, though, that a broad range of institutions, not
just large capital market players, are likely to hold some of this
paper.Managed conduits, which are typically subject to available–for-
sale (AFS) accounting, could also contain meaningful amounts of
Lehman debt where the risk ultimately lies with the managing bank.
Money market funds managed by banks could also be holding some
Lehman debt, leading to potential compensation to clients. This has
already happened with some structured credit exposure that such
funds held. So far, we have not yet identified particular
concentrations that would threaten a rating, but some exposures are
material. It will take some time to get the full picture, including
among smaller players. LBHI also has some $8 billion of hybrid
capital outstanding. It is possible that some of this could be held by
collateralized debt obligations (CDOs) of trust-preferred securities,
some of which may have been distributed widely.
 Counterparty exposure. Likely to be more significant is counterparty
exposure to the various companies within the Lehman Bros. group.
These exposures should be largely confined to the biggest banks and
broker-dealers, but smaller institutions could have some as well. These
exposures are likely to be large in gross terms (mostly via repurchase
agreements and securities lending transactions) and to vary
considerably among institutions. Again, so far, we believe that such
exposures are manageable for the institutions involved. Given the
probable movements in the value of the collateral, potential future
exposure could yet rise materially and be subject to considerable
volatility, although we would expect these exposures to have largely
crystallized into current exposures by now. Furthermore, given
possible differences in the treatment of the various Lehman entities, it
is not yet clear whether positive and negative exposures across the
group can be netted. As noted above, although the main U.S. broker-
dealer subsidiaries remain operational, the German bank subsidiary is
effectively frozen, and the primary U.K. subsidiary, which conducts a
majority of the group's derivative exposures, has been placed in
administration.

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 Market price impact. Even entities active in the capital markets that
have negligible direct exposure to Lehman will likely suffer, in our
view--and to a potentially greater extent. This is because we expect the
parent company's Chapter 11 filing to intensify pressure on the group
to shrink its balance sheet. Indeed, we believe that the secured nature
of the bulk of the exposures to Lehman enables banks to seize the
group's collateral and attempt to liquidate it, this will likely result in
further downward pressure on a wide range of assets. That could, in
turn, force highly leveraged institutions to liquidate to meet margin
calls, putting further pressure on assets. It is too early to gauge the
likely impact of this, but it seems probable that third-quarter 2008--
already shaping up to be weak--can only worsen as a result of
Lehman's Chapter 11 filing and lead to still more disadvantageous
market prices at the end-of-September balance-sheet date. In addition,
the precedent that would be set concerning the valuation of assets in
the Lehman portfolios could, in our opinion, become a benchmark for
marks to market of real estate-related assets as well as other asset
classes to which these institutions are exposed. It is important to note
that asset liquidations are coming from all corners, either to cover
losses or because the global economy is slowing.
Lehman’s bankruptcy forced the market to reassess risk. As after a
major flood people start to buy flood insurance, after the demise of Lehman
the market started to worry about several risks previously overlooked. One
way to valuate quantitatively this reassessment of risk is to look at the price
of credit default swaps. Figure 4 reports the cost of insuring an index of junk
bond issuers during the last one and a half year. Before the crisis it cost only
$2.50 to insure $100 invested in junk bonds. In July 2007 the price moved
above $4. During the Bear Stearns crisis, the price shot above $6, to return to
about $4.50 in June. After the demise of Lehman the price returned slightly
above $6, a very high level, but comparable to the one experienced around
the time of the Bear Stearns crisis. Given that two different policy responses
-- Bear Stearns was saved, while Lehman not – lead to the same market
response, the most likely interpretation is that these extreme events force the
market to reassess the risk, regardless of the policy response adopted.
Lehman’s filing for bankruptcy had a more dramatic impact on
money market funds. On September 16th
Primary Fund, a $62 billion fund,
announced that because of the total loss it suffered on its $785 million
holding of Lehman Brothers debt, it was forced to put a seven-day freeze on
redemptions, since the net asset value of its shares fell below $1. By

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contradicting a long-standing belief that money market fund will never
“break the buck,” this decision did contribute to increase the sense of
uncertainty. The guarantee offered by the Government, however, has
minimized this side effect.
Why the government couldn't save Lehman:
"[Treasury secretary Hank]Paulson believed that the Government lacked
authority to inject capital into Lehman Brothers. The Federal Reserve's
willingness to provide financial help to Bear Stearns (toward the JPMorgan
purchase) and AIG was not, in his view, inconsistent with the Federal
Reserve's decision to deny aid to Lehman. With Bear Stearns, the Federal
Reserve had a willing buyer (JPMorgan); Lehman did not. With AIG, AIG
had valuable insurance subsidiaries to use as collateral; again, Lehman had
nothing comparable."

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References
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Subprime Mortgage Credit”, Wharton Financial Institutions Center Working
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Benmelech, Efraim and Jennifer Dlugoszb, 2008, “The Alchemy of CDO Credit
Ratings”, Harvard University Working Paper.
Dell'Ariccia, Giovanni, Deniz Igan and Luc A. Laeven, 2008, “Credit Booms and
Lending Standards: Evidence from the Subprime Mortgage Market”, CEPR
Discussion Paper No. DP6683.
Diamond, D. and P. Dybvig, 1983, “Bank runs, Deposit Insurance and Liquidity”,
Journal of Political Economy.
Demyanyk, Yuliya and Otto Van Hemert, 2008, “Understanding the Subprime Mortgage
Crisis”, Working Paper.
Dolan, Karen, 2008, “Ultrashort-Term Bond Funds Suffer Massive Blow”,
Moningstar.com, 09-03-08.
Duffie, Darrell, 2004, “Irresistible Reasons for Better Models of Credit Rating”,
Financial Times, Apr 16, 2004.