Subprime Series 3 of 5 - Implications of failing of Lehman brothers

To start off, have anyone thought how a bank of 168 years of history can fail? Historically, companies with long history are more likely to weather financial storms of such magnitudes -> longer history = more knowledge accumulated = can be operational, cost saving knowledge. To think 168 yrs of knowledge is ALOT! Moreoever, LM bros survived the worst economic shock of that time, the Great Depression! So the magnitude of this current financial shock must be of very very very to bring down this financial colossus.

So a brief history to the investment banks in US. They WERE Goldman Sach, Morgen Stanley, Lehman brothers and Bear Stern ( in according to size and market capitalization ). So Bear Stern went bankrupt when it's CEO was still playing competitive bridge somewhere (lol) and eventually, was bailout via a "arranged takeover" by a commercial bank JP Morgan Chase ( saved ) by the Feds ( US central bank, a.k.a brother of banks ). The Feds saved them by funding the commercial bank @ $2/share to buyover the troubled Bear Bear. To think the share was trading at $140+/share few years back, you effectively lose 70x of your $$ if you bought their shares.

LM bros were not so lucky to be saved and they had to declare bankrupt. But why did the US govt let them fail? What happened after LM bros failed?

The number one reason that I thought of and wasnt reflected on the papers was: the US treasury boss, Hank Paulson. This baldy was the ex CEO of Goldman Sach. So by definitions, GMS and LM Bros were all along loggerheads. So, if im the US treasury boss, I also wont save la. Why should I save my old time enemy?

But of coz, you cant govern a country by gut feeling and disliking someone. You need reason (excuses) to finish off your hatred. So as the Feds already spent a decent amount to bailout Bear Bear, AIG appeared to be in trouble, threatening to be bankrupt along w LM bros. So, you can only choose to save one, given limited funding at that time. Who will you RATHER save? Your old time rival? Or a traditionally OK insurance company that gone into trouble at the wrong time? Of coz I will choose to finish off my rival.

Hence, the US govt (steered by Paulson) loaned an amount of 85billion to AIG and chose to let LM bro fail. But by letting such a BIG bank fail, the US govt is effectively telling the whole world: "Hey, even banks too large to fail can fail! No companies are guranteed safety anymore!"

So a) the stock market plunged after LM bros failed. As stock market is a fairly accurate indicator of wealth: people of all status can choose to speculate/invest; when the stock market plunge, it means people start to feel bearish ( negative ) and fear comes into the market. The reckless of selling at first sight ( especially the financial stocks ) drove the market even further down. Hence, a massive amount of wealth ( mind u, its in trillions ) is wiped out in the stock market.

b) Global Credit Squeeze - I believe anyone who reads the paper had came across this term. But it aint simple like squeezing your colgate at home. It means money/funds are not readily avail in the whole world. Why? Lets return to point a - when people dump shares for cash, they are indirectly hoarding money and not lending money to businesses listed in the share market. They are RISK ADVERSE ( kia si already ). However things get worse when banks start hoarding cash as well. Why?

i) Most banks are already in trouble as mentioned in my previous post. So to remain solvent ( not getting bankrupt ) they can 1)sell their assets they hold 2)not to lend to anyone 3)raise capital via issuing shares into the market to sell. The problem with 1) is that the panic selling of share market already drove the value of assets dirt cheap. So if they sell now, they are really lu gi and definitely lose alot of money. 3) No sane people will issue shares into the market NOW, knowing kia si people will never buy. So the best way out is 2) not lending to anyone at all.

ii) Banks have this mechanism, called interbank borrowing. It simply means these big boys will pool extra $$ altogether, lending to whoever bank that doesnt have enough to cover daily/weekly expense - can be financing of loans etc. However, the failure of LM bros effectively shut down this market as 1) LM bros, once a mightly leader in the banking sector can fail, 2)and this fellow owe the rest of banks alot of $$ with its bankruptcy. With loans to LM bros that are not recoverable, banks are better off NOT lending due to risk adversity again. " I never know when you gonna die like LM bros, so I might as well not lend. " "Even LM bros can die without government banking, lets hoard more cash to survive."

However, the ideas painted above is quite extreme meant to be digested by non - economics background people. So, the real story is, lending and borrowing is still available, but at ridiculous interest rate. A few % interest rate change on a loan of few hundred millions is really quite significant. Hence, the global credit squeeze effectively means banks failing to act as lenders, and even if they lend, they lend at ridiculously hight interest rate that I might as well NOT borrow.

So, companies also suffered. First of all, getting of loans ( for day to day operations) are much more difficult from banks as they also no $$ like you. 2nd) borrowing from retail investors are also more difficult coz we all became risk adverse. So, companies can fail as well, along side w LM Bros.

Hence, ank failures ( esp size of LM bros ) literally have a ripple effect on global economy and everyone. Havent thought of the next topic, will KIV. Hope my entry have brought value to my non economics friends. =)