Investment Risk Management – Lehman Brothers.
Introduction
Lehman Brothers was founded in the year 1850 in Montgomery, Alabama by immigrant German Brothers. Henry, Emmanuel and Mayer Lehman originally started their business as a general store in the year 1944 before it expanded and later acquired the name Lehman Brothers. Lehman Brothers prospered under the U.S. economy which continued to grow becoming a global powerhouse despite the many challenges it faced in the financial spheres globally and at home.
Lehman Brothers survived the 1930s Great Depression, the Russian debt crisis, the two world wars and the 1944 American Express crisis. Despite Lehman Brothers ability to survive past financial crisis it could not survive the collapse of the Housing market in the US. The acquisition of the business in subprime mortgage market was huge mistake as it contributed immensely to its downfall.
- Based on the information you researched related to Lehman Brothers, assess the factors that contributed to the financial failure of the firm, indicating how management failed to manage the risk related each factor. Make a recommendation for how firms should manage these types of risks in the future. Provide support for your recommendation.
On 15th September the year 2008, one of the largest investments Banks in America’s history filed for bankruptcy. Lehman Brothers had assets worth slightly over $639 billion and debts worth $619 billion and over 25000 employees worldwide. Lehman Brothers was the largest producer of subprime securities between the years 2005 and 2006. By the end of the year 2007, it was facing a myriad of cases on grounds that it made borrowers to take more loans than they could service or afford. Lehman’s collapse led to a massive erosion of almost $10 trillion in gross market capitalization in the global equity market.
Lehman Brothers participated in three types of common transactions i.e. credit default swaps, foreign exchange real derivatives and the interest swap rate to curtail its equity market losses and to restore confidence in its investors. (Lartey, 2012).
The journey to disaster for Lehman brothers begun in the year 2003 during the U.S housing boom. Lehman acquired through its vast influence at the time five mortgage lenders, among was the BNC Mortgage that dealt in the subprime mortgage market and Aurora Loan Services which dealt in Alt-A loans i.e. loans without full documentation by lenders. Lehman Brothers made record breaking income during this period. For instance in the year 2007, it reported a net income of $4.2 billion. (Investopaedia, 2009)
In august the year 2007, the credit crisis was triggered with the total failure of two (2) Bear Sterns hedge funds, Lehman brothers stock lost a lot of its share values. It further retrenched a total 2500 employees and shut down its BNC unit together with three major units of the troubled Alt-A company lender Aurora. Lehman continued to underwrite more mortgage backed securities accumulating a total of $85 billion portfolio i.e. more than four times its shareholders worth of equity. Lehman Brothers increased its mortgage backed securities instead of trimming its massive and even shakier mortgage portfolio. It wasted the final opportunity to cut down its risky mortgage portfolio. (Cooper, 2005).
Lehman’s leverage degree was very high i.e. 31 in the year 2007 and its liquidity was also deteriorating at a higher speed. Following Bear Stearns near collapse on 17th March 2008, Lehman Brother’s shares fell further by 48%.
On 9th June 2007, Lehman announced a $ 2.8 billion loss during its second quarter. Lehman Brothers tried to boost its financial position by raising $6 billion from investors, boosted its liquidity to $45 billion, decreased its gross assets by more than $147 billion and reduced its risk exposure to residential together with commercial mortgages by almost 20%. It also cut down the leverage from 33 to 25. These measures came a little too late. All its attempts or plans for an independent investment sellout to potential investors all failed. Lehman stocks faced another erosion of its stock which plunged further by 45% and later by 93% shortly before it was declared bankrupt. (Bernanke, 2010).
Lehman’s major mistake was holding the subprime large lower rated mortgage securities and also the failure of the international banking system, Lack of stringent and effective risk management practices in the acquisition of illiquid assets and its continued operations on derivative instruments also contributed to its bankruptcy. Basically, Lehman failed because of leverage, liquidity and losses. (D’ Archy, 2009)
- High risk investments such as mortgage backed securities had a significant impact on the valuation of investments held with Lehman Brothers, yet many financial institutions continued to use these investments today. Assess the sufficiency of risk management techniques used by financial institutions today, indicating whether or not you belief the risk is appropriately managed to avoid a subsequent financial crisis. Provide support for your position.
After the collapse of Lehman Brothers, most of investment banks adopted several risk management techniques to stay afloat and counter any threats from the volatile mortgage backed securities. Some of these principles and techniques used are: Assessment of risks before investment for those institutions that invest in alternative asset classes like private equity and hedge funds or which are exposed to complex use of instruments like derivatives and other structured products. Risk management managers nowadays weigh every option and class of investment before making a decision to invest. This reduces the chances of acquiring huge amounts of unprofitable securities and bond. Risk management teams are nowadays proactive instead of reactive. They are prepared for the worst or the most unlikely scenario and other non market cases such as counterparty, liquidity, operational and leverage and simple application and use of the output models and the related tools. The risk managers have a global outlook and they possess knowledge on aggregate portfolio exposures on all the asset classes. They have aligned their investment objectives and horizons frameworks that tackle every aspect of risks involved and are not limited to single measures. They have put in practice an effective measure that measures, monitors and manages any exposures to economics and other kinds of risks. They have adopted the three pillars for any risk management department. These are Risk measurement, Monitoring and effective management. Risk measurement weighs the tools used by institutional investors to assess the risks involved. Risk monitoring mostly focuses on the evaluation processes of changes in portfolio over a given time period. The risk adjustment investment management (RAIM) refers to the method of adjustment investors may adopt in their portfolio in direct response to the expected changes in any risks.
The recent outcomes have exposed the stark inadequacy of the risk management operations and the need for improvement in the risk management operations. Risk management operations are dynamic and all the best practices and operations are eventually bound to evolve over time. Risk management without the right tools will lead to disaster as the risks involved have to be calculated accurately on all aspects and perspectives. Risk monitoring involves observing the risks measures regularly and counter checking their effectiveness on a timely basis. Risk adjusted investment involves the use and the correct interpretation of information from the other departments i.e. the measurement and monitoring departments. The portfolio process if not manned intelligently may lead to losses for the firm. All the risks expectations and tolerance limits should be determined and set by the management and adhered to without any compromise. All the pillars encompass the different aspects of efficient risk management and they are all indispensable and are interdependent as such they should be aligned with the goals and objectives of the organization.
(Altınkılıç, Hansen, & Hrnjić, 2007)
- Evaluate management’s role within a financial investment firm for establishing proper risk management procedures for high risk investments and the appropriate level of accountability for portfolio performance. Determine the consequences that should be enacted when financial Firm Management fails to perform their fiduciary obligation to investors indicating how these consequences should be implemented. Provide support for your answers.
The management of an investment firm has the primary role of ensuring the client’s investments are well protected and they earn the best rates in the market with minimum risk involved. They set up their internal control systems to provide the best management system with adequate controls and enhanced feedback systems to warn against possible risks in its assessment and management processes.(Lang & Jagtiani, 2010).
The risk manager’s tools may include several measures that are aimed at capturing the different kinds of risks involved. The institution investors have to manage the total risk involved in their investment which includes protecting themselves from the asset- liability losses, reduction in broad assets classes and any other loss that can make it hard to meet the investors’ obligation. Also the management of risks that underperform their benchmarks must be monitored and the errors tracked while a relative performance index attached to the benchmark.
When the investment firms fail in their primary objective of maintaining the fiduciary relationship with their clients, then the only option available is to revoke their licenses through the Securities and Exchange Commission. The effects of lack of control of investment advisers were disastrous and the effects of the 1930 market crash are still evident many years after it occurred.
The management, while assessing the future risks, it’s vital to measure and monitor all the risks i.e. both at the aggregate level and the factor level. For the risk measurement role, institutional investors measure the aggregate portfolio risks and its tracking errors or its volatility. Management’s role also involves distinguishing the sources of risks. These are; market risks, credit risks, sector risks, and interest risks. The analysis and evaluation of the major sources of risks needs portfolio decomposition to calculate how much return and risks are involved.
- Given the recent debt crisis within the EURO zone of Europe, analyze the impact to the performance of foreign markets and recommend a strategy for financial firms to minimize investment risk in these markets. Provide support for your recommendations.
The excessive weaknesses and the collapse of many banks during the crisis have had a negative effect in the foreign markets. The interbank market is still reeling from the effects of the crisis and they are still to recover fully. The LIBOR (London Interbank Offered Rate) is still very high. LIBOR is the actual rate banks are willing and able to lend to each other. The higher the uncertainty of loan repayment the higher the rate of loan. These high LIBOR rates have greatly affected the steady free and steady flow of money to very small drops. The major effect of the financial crisis is the entire erosion of confidence in the market, between banks, insurance and brokerage companies, pension funds, individual investors and other financial firms. Most markets are very distrustful and are not willing to either invest or even to lend their spare capital. (www.ise.com). The 2008 financial credit crisis was like an earthquake in financial spheres. Investors were affected all over the world. From money centers in Tokyo, Sydney, Frankfurt, London, New York
among other investors in the world.
The most effective and the best way to minimize risks is diversification. It involves portfolio spreading over well researched and promising investment opportunities. You can diversify asset classes, or move and diversify globally or by sector or style. Minimization of risks can also take the form of combination of different stocks and bonds from different industries and avoiding single investing. Others are short term investments.
- Evaluate the role of the federal government, if any, related to the regulation of investments by financial institutions including the scope of the role, the authority and enforcement capability within the regulatory agency, the benefits, and the consequences of the regulation. Predict how the regulatory environment may change in the next five years. Provide support for your prediction.
In the United States of America, investment companies are regulated under the Securities and Exchange Commission. (SEC) The federal government through SEC sets the laws and rules necessary for the proper functioning of the investment and securities markets. SEC oversees the operations of investment companies, brokerage firms and other related financial companies. They also include the money managers’ investment and financial consultants and planners. They are herein referred to as advisers. It draws its jurisdiction from the investment Advisers Act of the year 1940. The adviser’s Act is one of the last series of Federal statutes that seeks to eliminate abuses in the securities market that the house of congress strongly believed contributed to the 1929 stock market crash and later the depression of the year 1930. Its major role was to define the roles of the adviser’s and remove any conflicts of interest between them and their clients. The main contention was the adviser’s financial interest and the client’s and whose interest should prevail above the other. The Act recognizes the delicate fiduciary and sensitive nature of the advisory relationship and the needs to expose all the conflicts of interest that may result or cause the adviser’s either consciously or even unconsciously to advice or render an advice that they are not disinterested in. SEC attempts to define the scope of investment companies that form the basis of its mandate in regulating the adviser’s Act. The benefits of the regulation are the reduction of chances of losses resulting from bad risk management practices and wrong judgment of risk managers. Also the involvement of the commission agents in advising the investment managers on what action to take in case of challenges.
Risk management operations and practices are dynamic. The best practices and operations are eventually bound to evolve over time. Risk management without the right tools will lead to disaster as the risks involved have to be calculated accurately on all aspects and perspectives. Risk monitoring will involve more observation and the risks measured regularly and counter checked and their effectiveness compared from time to time. Risk adjusted investment methods have to be reformulated and the correct interpretation of information from the other sources compared with the final results.
References
Lang, W. W. & Jagtiani, J. (2010). The Mortgage and Financial Crises: The Role
of Credit Risk Management and Corporate Governance. Atlantic Economic Journal. Retrieved February 03, 2011 from http://fic.wharton.upenn.edu/fic/papers/10/10-12.pdf. LaRoche, K.
Lartey, R. (2012). What part did derivative instruments play in the financial crisis of 2007-2008? Retrieved May 31, 2012 from
http://ssrn.com/author=1670788. Failure of Lehman Brothers 24
Altınkılıç, O., Hansen, R. S. & Hrnjić, E. (2007). Investment bank governance.
Bernanke, B. (2010). Lessons from the failure of Lehman Brothers. Retrieved May 29, 2012 from http://www.federalreserve.gov/newsevents/testimony/bernanke20100420a.htm.
Cooper, J. (2005). Financial Statement Fraud: Corporate Crime of the 21st Century. Retrieved February 11, 2012 from
http://www.asic.gov.au/asic/pdflib.nsf/LookupByFileName/AICD_speech_080605.pdf/$file/
Investopedia (2009). Case Study: The Collapse of Lehman Brothers. Retrieved June 1,
2012 from http://www.investopedia.com/articles/economics/09/lehman-brothers-collapse.asp.
D’Arcy, C. (2009). Why Lehman Brothers collapsed. Retrieved May 11, 2012 from
http://www.lovemoney.com/news/the-economy-politics-and-your-job/the-economy/3909/why-lehman-brothers-collapsed. European Commission. (2009). Ensuring efficient, safe and sound derivatives markets. Retrieved
www.ise.com/asset/files/articles/credit_crisis_Final_101118.pdf
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