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The Lehman crisis explained
Just what is going on in the United States and how did the crisis come about?
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by Charlie Parker on Sep 15, 2008 at 15:47
The press is full of the US crisis, with talk of banks going bankrupt and the financial system in chaos, but what does it all mean?
What is Lehman Brothers?
Lehman Brothers is a US investment bank which operates by dealing in securities, such as derivatives, with other banks. It is a major
player in the United States and a major employer worldwide, with around 25,000 employees in total. Some 5,000 people work for
the bank in the UK.
Why is it going bankrupt?
It all starts with the US housing market. In the United States mortgage lenders begun lending money to people who were unable to
pay off their mortgages, known as sub-prime lending. These people were unable to get loans ordinarily but were given the
opportunity in a frenzy of lending which took place up until around a year ago. Lehman Brothers traded heavily in financial
instruments which were exposed to these loans. The financial instruments default and become worthless if the borrowers failed to
pay back their debt.
To keep afloat Lehman's needed to be able to trade these securities and needed to be able to ascribe a value to them. However,
other institutions have been reluctant to trade in the instruments because they are unsure what, if any, value they have if the
mortgages they are linked to are not being repaid.
As a result, Lehman Brothers has a massive black hole on its balance sheet. It has tried to sell itself to another institution but nobody
is buying which has left it no choice but to file for bankruptcy.
Why has the US government not stepped in?
When Northern Rock was in trouble last year, the UK government stepped in to bail it out and plug the problem on its balance sheet.
With Lehman's this has not happened. There are many reasons for this. One is that Lehman's is not a retail bank, nobody has a
Lehman Brothers cheque book and credit card so in the short-term the effect on ordinary people is less. However, it is also the case
that the US central bank has wanted to draw a line under what it is and what it is not willing to do in the current credit crisis.
It was likely that if the US Government had been willing to guarantee Lehman's trading our own British bank, Barclays, may have
bought it. However, the US government decided that it has already intervened enough to maintain the US financial system. Only last
week it nationalised two massive players in the US mortgage market, Fannie Mae and Freddie Mac. It has also announced that it will
provide additional liquidity to the system in general.
I have been hearing about Merrill Lynch and Bank of America what have they got to do with it?
Merrill Lynch has been affected by the same issues as Lehman Brothers. However, it has succeeded in selling itself at a premium
to its current share price to one of the world's largest financial institutions the Bank of America. Because it has managed to sell itself
it will not go bankrupt.
What happens next?
Lehman Brothers must now wind down its business. This is going to be an enormously complex task because the bank has hundreds
of billions of pounds of assets and liabilities. It is involved in thousands of different deals. Often in these deals it has acted as a
'counterparty', effectively backing other financial products. Each one of these has to be unwound as painlessly as possible.
European Debt Crisis Explained

The European debt crisis refers to Europes inability to pay the debts it built up in recent decades. The European debt crisi s grew out
of the U.S. financial crisis of 2008-2009. A slowing global economy exposed the unsustainable financial policies of certain eurozone
countries.
The eurozone is made up of 17 European countries that use the euro, including France, Germany, Spain, and Ireland. Several
countries in the eurozone have borrowed and spent too much since the global recession began, causing them to lose control of their
finances.
The European debt crisis can be traced back to October 2009, when Greeces new government admitted the budget deficit would be
double the previous governments estimate, hitting 12% GDP. After years of uncontrolled spending and nonexistent fiscal reforms,
Greece was one of the first countries to buckle under the economic strain.
It was also the first eurozone country to take a multi-billion pound bailout from other European countries (followed by Portugal and
Ireland).
Fast-forward and Greece is still in a recession, more than a quarter of adults are unemployed, and the future looks bleak. Things
dont look any better in Spain, where the jobless rate is at 26%. The jobless rate in the eurozone as a whole is at 12%; the highest
level since the euro was created in 1999.
If Greece fails to pay what it owes, the country will go bankrupt and most likely become the first country to leave the euro currency.
Greeces departure could open a floodgate with other countries following suit; thereby weakening Europes economic clout.
Today, the European debt crisis is on the brink of pulling the entire eurozone into a recession; dragging the global economy down
with it. Ten European countries have already slipped into a recession and three more have needed to be bailed out in order to avoid
going into default.
In March 2013, the government in Cyprus raided personal bank accounts to bail out the countrys financial system; setting a
dangerous precedent. While politicians are saying this is a one-time event, one has to wonder if this tactic wont be used again
elsewhere. Its not as if there isnt just cause.
While Germany has been the economic engine for the eurozone, its slowing economy could join the rest of the region in recessi on.
Thanks to the deep recessions in the other eurozone countries and austerity programs, Germanys ability to carry the region is in
serious jeopardy.
Germanys central bank, the Deutsche Bundesbank, is predicting growth of just 0.4% in 2013; down from a June 2012 forecast of
1.6%. The Bundesbank also expects the jobless rate to hit 7.2% in 2013, up from 6.8% in 2012.
1

That said, there is more to the European debt crisis than just debt. Despite a shared currency, the eurozone is made up of di fferent
countries with vastly different cultures, histories, philosophies, and economies. And those differences illustrate just how difficult it is
for disparate countries to work together with one unified voice.
In fact, the head of the Bank of England referred to the European debt crisis as the most serious financial crisis at least since the
1930s, if not ever.
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eeling nervous about paying the bills? Anxious? Stressed about money? Youre in good company, because thats just how the
eurozone feels.
Its difficult to get to grips with the financial crisis. Whenever somebody with a bit of authority an economist, say, or a senior
politician tries to explain whats going on, they start bandying around terms such as bond yield, Grexit, haircut and junk.
In this serialised report we try to explain, jargon-free, whats happening in the eurozone and what the action-plan is for getting
things back on track.
In this introductory section to the report, we reveal the key factors which led to the financial crisis. In PART 2 we will take a look at
the different types of investment funds being adopted by investors as a way to weather the economic storm.
Which key factors led to the eurocrisis?
In a nutshell: Europe is in crisis because it has been living beyond its means. No single European country is to blame; the entire
eurozone arguably threw economic caution to the wind.
During the good times, countries in the eurozone could borrow money cheaply, at low rates of interest. Because of this cheap
debt the euro area countries, lured by the prospect of economic growth, began to borrow more and more. If the interest rates had
remained low, perhaps the debt crisis could have been averted, but they didnt. They rose.
Eventually the eurozone bit off more debt than it could chew and just at the point when Europes spending spree was veering out
of control, rising interest rates came along to poop Europes spending party.
Key factor No. 1 = cheap debt.
Higher interest rates meant that Europe was suddenly facing a substantial debt. Whereas before, Europe was borrowing at an
affordable level (i.e. at a low rate of interest that it could easily repay), all of a sudden, the repayments werent quite so affordable
any longer.
Key factor No. 2 = rising interest rates.
Europes worst fear was (and still is) that a country in the euro area, unable to manage its debts, might default on repayment. If one
country using the euro currency cant make repayments, the flow of cash between the euro zone stagnates.
Keen to avoid a default, the central European institutions such as the International Monetary Fund (IMF) and the European Central
Bank (ECB) have been paying out lump sums of money (bailouts) to high risk eurozone countries (those in danger of defaulting).
Europe is collectively crossing its fingers, hoping these bailouts will help insulate fragile eurozone finances, saving the euro currency.
Key factor No.3 = Bailouts.
We knew that prospects for rescuing the euro were looking dicey when bond yields a type of investment fell to an all-time low.
The returns on government bond yields are currently at record lows in the US, the UK and Germany. Good news if youre trying to
borrow, bad news if youre a lender.
Low bond yields mean two things: (1) economic prospects on the horizon look a bit gloomy, and (2) investors, aware that they may
see a better return elsewhere, are getting twitchy. Economic theory isnt quite this simple of course financiers and economists
argue that low bond yields can be both good and bad but as a general rule economists dont clap their hands with joy at the news
of low yields.
Why not?, you ask. Well, low yields make investors mighty fidgety. Investors want a secure investment portfolio (one with a low
level of risk) with a great return (an investment which makes them a lot of money). Thats a tricky thing to offer even at the best of
times, but during a time of economic instability security and high returns are especially hard to come by. The worry is that investors
will take their money out of Europe and transfer it into US treasuries (the United States equivalent to government bonds), taking
money away from the eurozone.
Key factor No. 4 = Investor confidence wavers.
In times of economic instability, key stakeholders in the economy e.g. businesses, investors, and pension-holders start to think
about transferring money away from problem areas, searching for a better return elsewhere. This cash exodus creates a real drain
on a countrys resources, which only serves to further weaken an already-fragile economy. Basically; investors want to earn more
money from a better interest rate, and they leave, hoping to find it elsewhere.
By evacuating cash to safe zones, a sort of financial hurricane plays out; picking up cash deposits at random and dropping them
elsewhere, leaving behind it a path of economic destruction. All sectors from healthcare to small businesses begin to experience
cash flow problems.
When investors revoke investments, it becomes harder for people to borrow money because there are fewer lenders. For
businesses, paying suppliers becomes more difficult, and unpaid suppliers cant pay their employees). Employment opportunities are
fewer, salaries lower and spending power diminished, and a higher rate of unemployment means that more applications for loans
are being rejected. Eventually, the flow of money reduces as all parties reduce their spending. This is one of the key factors to
recession (where a country spends more than it earns).
Key factor No. 5: Key stakeholders tighten their wallets
As spending reduces across the eurozone, economies begin to contract (get smaller). This means that the government has a smaller
income and debts became harder to repay. To fund repayments, the government has to get the money for repayments elsewhere.
In most cases the funds are raised via austerity cuts.
Austerity simply means that governments reign in their spending in the following areas: defence, state pensions, tax credits, the
jobseekers allowance, child benefits, housing benefit and income support, as well as prisons, roads and motorways, healthcare,
education and the arts. It also raises taxes and cuts state salaries. These saved funds are then redirected towards loan repayments.
Key factor No. 6: Austerity stifles growth
Austerity is very unpopular, because it makes life very hard. It also divides people into two camps: supporters (who argue that
austerity is the best last-ditch solution to reduce debt) and detractors (who believe that austerity blacklists a country, panicking
investors and delaying economic recovery).
Is Europe headed for disaster, then?
Much as wed all like to believe that the financial storm in the jar of Europe can be weathered, its not looking too rosy for the euro
at the moment. In theory, we know how to fix the crisis, but putting that theory into practise, well.
The financial spine of Europe the European Central Bank (ECB) may yet be able to avert disaster. If the ECB continues to fund
bailouts, Europe may buy itself a little recuperation time. Europe can then tackle the two things which could turn things around
for Europe: a central trading platform (a place where eurozone countries can buy and sell without obstacles) and a free labour
market (a shared eurozone workforce).

Definition of 'Recession'

A significant decline in activity across the economy, lasting longer than a few months. It is visible in industrial production,
employment, real income and wholesale-retail trade. The technical indicator of a recession is two consecutive quarters of negative
economic growth as measured by a country's gross domestic product (GDP); although the National Bureau of Economic Research
(NBER) does not necessarily need to see this occur to call a recession.
Investopedia explains 'Recession'

Recession is a normal (albeit unpleasant) part of the business cycle; however, one-time crisis events can often trigger the onset of a
recession. The global recession of 2008-2009 brought a great amount of attention to the risky investment strategies used by many
large financial institutions, along with the truly global nature of the financial sytem. As a result of such a wide-spread global
recession, the economies of virtually all the world's developed and developing nations suffered extreme set-backs and numerous
government policies were implemented to help prevent a similar future financial crisis.

A recession generally lasts from six to 18 months, and interest rates usually fall in during these months to stimulate the economy by
offering cheap rates at which to borrow money
Recession is a slowdown or a massive contraction in economic activities. A significant fall in spending generally leads to a recession.

Definition: Recession is a slowdown or a massive contraction in economic activities. A significant fall in spending generally leads to a
recession.

Description: Such a slowdown in economic activities may last for some quarters thereby completely hampering the growth of an
economy. In such a situation, economic indicators such as GDP, corporate profits, employments, etc., fall.

This creates a mess in the entire economy. To tackle the menace, economies generally react by loosening their monetary policies by
infusing more money into the system, i.e., by increasing the money supply.

This is done by reducing the interest rates. Increased spending by the government and decreased taxation are also considered good
answers for this problem. The recession which hit the globe in 2008 is the most recent example of a recession.