Lehman Brothers files for bankruptcy
Lehman Brothers, a major American investment banker, has filed paperwork for bankruptcy. It would be the largest collapse of an investment firm in 18 years.
Lehman attempted to find a buyer over the weekend but it met with no success. The last remaining bidder, Barclays PLC bank pulled out Sunday afternoon. Barclays, a United Kingdom-based bank, had become the sole bidder after a consortium led by Bank of America pulled out early Sunday morning citing that it would need government support before considering a bid. The support would consist of backing bad debts owed by Lehman. Barclays cited a similar reason for withdrawing its bid.
As of Monday morning, no buyer has come through to take control of the firm. As a result, the firm filed for bankruptcy protection.
The main sticking point for potential buyers appears to be the unwillingness for the U.S. government to provide financial support. Hank Paulson, Treasury secretary, has repeatedly said that no government money will be given to Lehman or used in any takeover the firm. Government money was used in the takeover of Bear Stearns by JPMorgan Chase in March of this year. Bear Stearns suffered similar problems as Lehman.
A spokesmen for Barclays told the Financial Times, “the proposed transaction required a guarantee for the trading operations of Lehman Brothers that was potentially open-ended, and we were not willing to provide that guarantee.”
Paulson, along with other government officials, proposed a solution that Lehman would get split into two separate entities. However, this proposal has been discarded by many of Wall Street banks.
Members of the G8 have reportedly been keep abreast of the situation by U.S. government.
The firm, which has over 25,000 staffers, has suffered bad results due to the subprime mortgage crisis.
Backgrounder: The Subprime Mortgage Crisis
The subprime mortgage crisis is a current economic problem characterized by contracted liquidity in the global credit markets and banking system. An undervaluation of real risk in the subprime market cascaded, rippled and ultimately adversely affected the world economy.
The crisis began with the bursting of the US housing bubble and high default rates on “subprime” and adjustable rate mortgages (ARM). Loan incentives, such as easy initial terms, in conjunction with an acceleration in rising housing prices encouraged borrowers to assume difficult mortgages on the belief they would be able to quickly refinance at more favorable terms. However, once housing prices started to drop moderately in 2006–2007 in many parts of the U.S., refinancing became more difficult. Defaults and foreclosure activity increased dramatically, as easy initial terms expired, home prices failed to go up as anticipated, and ARM interest rates reset higher. Foreclosures accelerated in the United States in late 2006 and triggered a global financial crisis through 2007 and 2008. During 2007, nearly 1.3 million U.S. housing properties were subject to foreclosure activity, up 79% from 2006.
The mortgage lenders that retained credit risk (the risk of payment default) were the first to be affected, as borrowers became unable or unwilling to make payments. Major banks and other financial institutions around the world have reported losses of approximately U.S. $435 billion as of 17 July 2008. Owing to a form of financial engineering called securitization, many mortgage lenders had passed the rights to the mortgage payments and related credit/default risk to third-party investors via mortgage-backed securities (MBS) and collateralized debt obligations (CDO). Corporate, individual and institutional investors holding MBS or CDO faced significant losses, as the value of the underlying mortgage assets declined. Stock markets in many countries declined significantly.
The widespread dispersion of credit risk and the unclear effect on financial institutions caused reduced lending activity and increased spreads on higher interest rates. Similarly, the ability of corporations to obtain funds through the issuance of commercial paper was affected. This aspect of the crisis is consistent with a credit crunch. The liquidity concerns drove central banks around the world to take action to provide funds to member banks to encourage lending to worthy borrowers and to restore faith in the commercial paper markets.
The subprime crisis has adversely affected several inputs in the economy, resulting in downward pressure on economic growth. Fewer and more expensive loans tend to result in decreased business investment and consumer spending. The initial leveling off in the housing market has become a downturn in many areas due to a surplus inventory of homes. The reduction and shift in demand versus supply has resulted in a significant decline in new home construction.
With interest rates on a large number of subprime and other ARM due to adjust upward during the 2008 period, U.S. legislators, the U.S. Treasury Department, and financial institutions are taking action. A systematic program to limit or defer interest rate adjustments was implemented to reduce the effect. In addition, lenders and borrowers facing defaults have been encouraged to cooperate to enable borrowers to stay in their homes. Banks have sought and received over $250 billion in additional funds from investors to offset losses. The risks to the broader economy created by the financial market crisis and housing market downturn were primary factors in several decisions by the U.S. Federal reserve to cut interest rates and the economic stimulus package passed by Congress and signed by President George W. Bush on 13 February 2008. Both actions are designed to stimulate economic growth and inspire confidence in the financial markets.
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