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2008 Financial Crisis: a quick look

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Thanks the New York Times I found two articles that could help to clarify what the hell is going on in the financial market during this 2008 financial crisis, mostly related to the subprime mortgages.

Lights out for Lehman Brothers - modified version

[ slightly modified version of "Lights out for Lehman Brothers", CC licensed picture by Joseph Hoetzl ]

The first article, written by economists Doug Diamond and Anil Kashyap, is a FAQ on the 2008 financial crisis and, quoting a reader's comment, " [the authors] did what 10,000 journalists and reporters haven't been able to do for a week": they actually explain us, in human-readable english, why and how this moment could happen.

The second article is a editorial by Nicholas D. Kristof who asks himself how the hell Richard Fuld (former CEO of Lehman Brothers) managed to bring a wealthy company into dust (but the data-centers).

I think they're definitely a must-read. After the jump the most interesting parts (according to me, of course :) ).

Diamond and Kashyap on the Recent Financial Upheavals

The common denominator in all three cases [ Fannie Mae, Freddie Mac and Lehman Brothers ] was the ability of the firms to secure financing. The reasons, though, differed in each case. 

The Fannie and Freddie situation was a result of their unique roles in the economy. They had been set up to support the housing market. They helped guarantee mortgages (provided they met certain standards), and were able to fund these guarantees by issuing their own debt, which was in turn tacitly backed by the government. The government guarantees allowed Fannie and Freddie to take on far more debt than a normal company. In principle, they were also supposed to use the government guarantee to reduce the mortgage cost to the homeowners, but the Fed and others have argued that this hardly occurred. Instead, they appear to have used the funding advantage to rack up huge profits and squeeze the private sector out of the “conforming” mortgage market. Regardless, many firms and foreign governments considered the debt of Fannie and Freddie as a substitute for U.S. Treasury securities and snapped it up eagerly.

Fannie and Freddie were weakly supervised and strayed from the core mission. They began using their subsidized financing to buy mortgage-backed securities which were backed by pools of mortgages that did not meet their usual standards. Over the last year, it became clear that their thin capital was not enough to cover the losses on these subprime mortgages. The massive amount of diffusely held debt would have caused collapses everywhere if it was defaulted upon; so the Treasury announced that it would explicitly guarantee the debt.

But once the debt was guaranteed to be secure (and the government would wipe out shareholders if it carried through with the guarantee), no self-interested investor was willing to supply more equity to help buffer the losses. Hence, the Treasury ended up taking them over.

Lehman’s demise came when it could not even keep borrowing. Lehman was rolling over at least $100 billion a month to finance its investments in real estate, bonds, stocks, and financial assets. When it is hard for lenders to monitor their investments and borrowers can rapidly change the risk on their balance sheets, lenders opt for short-term lending. Compared to legal or other channels, their threat to refuse to roll over funding is the most effective option to keep the borrower in line.

This was especially relevant for Lehman, because as an investment bank, it could transform its risk characteristics very easily by using derivatives and by churning its trading portfolio. So for Lehman (and all investment banks), the short-term financing is not an accident; it is inevitable.

Why did the financing dry up? For months, short-sellers were convinced that Lehman’s real-estate losses were bigger than it had acknowledged. As more bad news about the real estate market emerged, including the losses at Freddie Mac and Fannie Mae, this view spread.

Lehman’s costs of borrowing rose and its share price fell. With an impending downgrade to its credit rating looming, legal restrictions were going to prevent certain firms from continuing to lend to Lehman. Other counterparties that might have been able to lend, even if Lehman’s credit rating was impaired, simply decided that the chance of default in the near future was too high, partly because they feared that future credit conditions would get even tighter and force Lehman and others to default at that time.

Need a Job? $17,000 an Hour. No Success Required.

[ "Lehman Brothers Evacuation", CC licensed picture by goron ]

Are you capable of taking a perfectly good 158-year-old company and turning it into dust? If so, then you may not be earning up to your full potential. 

You should be raking it in like Richard Fuld, the longtime chief of Lehman Brothers. He took home nearly half-a-billion dollars in total compensation between 1993 and 2007.

Last year, Mr. Fuld earned about $45 million, according to the calculations of Equilar, an executive pay research company. That amounts to roughly $17,000 an hour to obliterate a firm. If you’re willing to drive a company into the ground for less, apply by calling Lehman Brothers at (212) 526-7000.

Oh, nevermind.

[...] Perhaps it seems frivolous to be handing out shower curtains to chief executives when we’re caught in a deepening economic crisis. Well, it is.

But one of our broad national problems is rising inequality, and it is exacerbated by corporate executives helping themselves to shareholders’ cash. Three decades ago, C.E.O.’s typically earned 30 to 40 times the income of ordinary workers. Last year, C.E.O.’s of large public companies averaged 344 times the average pay of workers.

John McCain seems to think that the problem is that C.E.O.’s are greedy. Well, of course, they are. We’re all greedy. The real failure is one of corporate governance, which provides only the flimsiest oversight to curb the greed of executives like Mr. Fuld.

“Compare the massive destruction of wealth for shareholders to what he gets at the end of the day,” said Lucian Bebchuk, the director of the corporate governance program at Harvard Law School. A central flaw of governance is that boards of directors frequently are ornamental and provide negligible oversight.

As Warren Buffett has said, “in judging whether corporate America is serious about reforming itself, C.E.O. pay remains the acid test.” It’s a test that corporate America is failing.

... and from a reader's comment: "The CEO's of which Mr. Kristof writes are a greater threat to the United States than any of the terrorists who have physically attacked us. They have caused damage that injures millions -- not just thousands. They are fiscal terrorists and it would be perfect justice to see them hustled off to Guantanamo and their personal assets confiscated."

Written by orangeek

Friday 19 September 2008 at 11:40 am

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