Sep 24 2009

The Lehman Brothers Failure Was a Sham

Category: Economy,My Web Log — Admin @ 12:31

By Pratik Desai, class of 2010, Finance major @ Loyola University Chicago

Why did the federal government let Lehman Brothers fail? When mortgage giants Fannie Mae and Freddie Mac were found to be on shaky ground in late 2008, they were immediately placed under federal conservatorship. It was also just one week before Lehman CEO Dick Fuld filed for bankruptcy. Soon afterward, the Treasury Department pushed for the creation of the contentious TARP (Troubled Asset Relief Program) fund and publicly financed a number of takeovers such as JPMorgan’s purchase of Bear Stearns and Bank of America’s purchase of Merrill Lynch. 

So why bother with Lehman Brothers? It is because it was a good company, with a good corporate culture and good business model. It failed because of the misgivings of a few. Former Lehman trader Lawrence McDonald, author of A Colossal Failure of Common Sense: The Incredible Inside Story of the Collapse of Lehman Brothers, writes of the company’s 25,000 employees, “it was 24,992 people making money and eight guys losing it.” Those “few” got involved in risky securities and tanked the company. Arguably, the same could be said all of Wall Street.  

Simply put, financial institutions (such as banks) made subprime (low quality) loan contracts to consumers with low creditworthiness that were packaged into securities (like stocks and bonds) through a process known as securitization. These bundles came to known as mortgage-backed securities (MBS), and they are not inherently bad. Problems arose when the payments rights to a loan in an MBS were used to guarantee other securities. Further securitization with other debts morphed them into collateralized debt obligations (CDO). Using a risky asset—such as a loan with someone who is unlikely to pay it back—as collateral for another asset or security increases risk and spreads it to everyone who holds a stake in the underlying asset through a phenomenon called counterparty credit risk. This form of risk both inflates the value of the security and makes it difficult to price. Couple that with leverage—or borrowing— and firms risk magnifying their losses tens of times over (in the case of Lehman, 44 times over).  

The crisis comes full circle when one considers that Fannie Mae and Freddie Mac were two of the largest buyers and sellers of such toxic MBS’s. Every firm on Wall Street had their fingers in CDO’s, and the government was partially responsible for regulatory failure. These instances of debt securitization far removed the borrower of a loan from the initial lender; investors in foreign countries ended up owning loans in Florida. Risk was spread so far out that America’s problem eventually became the world’s problem. Lehman’s fall was colossal because nobody expected a company so large, and so connected to investors across the world, would fail.  

FDR’s Glass-Steagle Act of 1933 forced JPMorgan to spin off its investment-banking unit into its own company Morgan Stanley decades ago. That law mandated that commercial banks remain separate from unrelated businesses such as investment banking because they should not be in the business of taking risky bets when dealing with depositors’ money. But this law was repealed by Congress in 1998. Banks like Citi then made a charge into a number of unrelated businesses. Morgan Housel of Motley Fool Insider states, “Without regulatory handcuffs, [banks such as] Citigroup could slap together whatever…[they]…pleased: a commercial bank, a brokerage, home insurance, currency trading, credit cards, investment banking, wealth management, whatever. If it had a dollar sign in front of it…[they]… wanted it.” Citi is now trying to go back to its previous state (over 10 years ago) using bailout funds. 

What did Wall Street’s big investment banks do in the wake of a post-Lehman and post-Glass-Steagle world? Ironically, Goldman Sachs and Morgan Stanley became bank holding companies in order to gain access to cheap capital (previously prohibited by Glass-Steagle). Lehman Brothers also tried to become a bank holding company right before it failed but the federal government did not allow it to do so, for reasons unknown to most Americans. 

I suspect that somebody in the federal government wanted to scapegoat Lehman Brothers and set an example for others. They handcuffed it and pushed it off a cliff when companies engaging in dubious behaviors were graciously saved. Lehman Brothers was truly a gem, but in the midst of the economic downturn, our government let it go bankrupt. Why was Lehman Brothers “too big to fail”? It is because it was, and we are still paying the price for it.

Sep 09 2009

CHINA’s Achilles’ Heel

Category: Economy,My Web Log,Politics — Admin @ 07:00

All over the world, everyone talks about the behemoth of a country, China, and its irrepressible economic growth. It is projected by the World Bank that China’s Gross Domestic Product (GDP) will surpass that of America’s by the year 2023, and also by independent economists, that it’s annual GDP will sustain an unmatched 8% growth for the next several years. I have heard both sides of the argument for and against the “China” hype and I must say: nobody truly knows. As I was once told, “there is no China expert”.

After living in China for about four weeks now and gaining first hand experience of the culture and the mentality of the people, I do believe China is indeed in a “league of its own” and is a country too unique to be subjected to easy criticism. I have visited well over eight different major Chinese cities and have come in close contact with people of almost every Chinese nationality, especially from the ethnic minority groups, which is why I am writing this piece to display my view on China from a first-hand perspective.

As a westerner, I am usually prone to practicing ethnocentrism and judging other cultures based on Western ideologies and so it was hard to think about China, without a predisposed Western agenda. My approach to China is as such: the chicken or the egg? Which came first? Why not both at the same time? Does it even matter? What are the ramifications for either or both? If “chicken” is replaced with “economic progress” and “egg” is replaced with “social progress”, then my approach begins to get clearer. There is without a doubt in my mind that China is only going to continue to grow economically with its 1.3 billion population, eager workforce, infrastructure expenditures, and foreign investments; but, the socio-political environment is what can make or break the country (e.x. India’s troubled political past until just recently). Due to China’s vast socio-political problems, I will only focus on the social diversity and mentality of China.

Real contact with the world did not happen in China until the late 1970′s and as the world took advantage of globalization and a growing diversity within urban areas up to that point in time, China was already far behind socially (Still today, it is not uncommon for westerners in any Chinese city, no matter how commercially developed, to get stared at by the locals). The Chinese government has taken several steps to increasing diversity in China from its indigenous population to a globally diverse population by setting up cultural contacts with other countries to bolster mutual tourism and educational opportunities, as well as trade initiatives.

Most countries like America function very well due to an “open-minded” attitude towards diversity; the lack of this in China, in some parts more than others, is what will be China’ achilles’ heel if not improved upon exponentially. The “catch” to global diversity is that social progress is a must-have, as well as a supplement to economic progress. As new ideas come from a diverse body of people and economic prosperity achieves greater heights, a new demand for more social freedoms will be awaken in China and this is what the current one-party Chinese government fears the most. China is currently running on a “controlled chaos” model and if the Chinese government continues on its current path, while still wanting to prevent the country from social unrest…they simply can’t. The status change from a “developing country” to a ”developed” one can only occur if social progress achieves up to par with economic progress.