The Lehman Brothers was a global financial investment firm that despite its large footprint in the industry filed for bankruptcy in 2008. The firm was the fourth largest investment firm and employed over 25,000 people at the time of its bankruptcy filing. Lehman Brothers was in operation for over 158 years before its filing. The firm provided investment management, trading, investment banking, private banking, brokerage, private equity and other related services. The downfall of the investment firm was cause primarily by sub prime mortgage loans and the acquisition of 5 mortgage lenders during the housing boom that started around 2003.
The Lehman Brothers downfall started during the housing boom of 2003 and its exposure to the real estate and subprime loan market. The firm acquired five mortgage lenders, which two of those lenders specialized in sub-prime mortgages and Alt-A loans. Alt-A loans are loans that fall in between the prime and sub prime mortgage category. The Alt-A loans required less than full documentation which made them riskier than others. Sub prime loans are loans given to individuals who may have trouble following the payment schedule or with low credit ratings. The firm in 2006 adopted a new business strategy with its goal of with increasing the revenues from its asset investments and this new strategy exposed the firm to more capital risk. The slowdown of the sub-prime mortgage markets drove the firm to provision a risk management strategy that contracted their rate of short-term loans against the unknown exposure of the short- term markets. The firm relied on this method to raise billions in capital in order to cover their everyday operations and eventually its inability to secure these funds led to it downward spiraling. The high leverage and excessive risk-taking strategies along with limited equity made difficult the corporate structure and products that spread risk throughout the whole firm and its risk-taking culture that had developed.
Management contributed to the firms demise by its inability to control the risk associated the firm. The low equity levels and high leverage was a significant factor in which management should had established measures to reduce the amount and rate of risk the firm assumed by depending on short term loans to operate daily. The firm’s management failed to understand and mitigate the risk that came with the real estate activities and short- term borrowing. The firm also failed to act against the excessive risk taking that grew within the firm. The firm’s complex business practices and structure complicated the ability of managers to understand and correct the issues at hand.
Firms can avoid the issues the Lehman Brothers encountered by hiring individuals who specialize in risk mitigation and help avoid the exposure to risk. The firms should establish clear and concise business practices for its associates to understand and follow through with them. The firm should stray away from short term loan dependence for daily operation. The amount of leverage that a firm holds or takes on should be measured properly in order for success. Firms should also stay away from acquiring businesses that will have a negative impact on the current business performance.
Assess the sufficiency of risk management techniques used by financial institutions today, indicating whether or not you believe the risk is appropriately managed to avoid a subsequent financial crisis.
The Lehman Brothers collapse contributed to the adoption of risk management techniques by firms in order to be able to stay afloat and correct those threats by the mortgage backed securities market. I do believe that firms have equipped themselves with proper tools to avoid subsequent crises. One tool is the proper assessing of risk before taking on the investment for these firms that invest in different asset classes like hedge funds and private equity or which are exposed to complicated use of instruments like derivative or other structured products. Majority of managers currently take in consideration every class of investment and option before deciding to invest. The consideration of managers reduced the chance of the firm acquiring big amounts of unprofitable bonds and securities. Managers now are prepared for the worse scenario and other non- market issues such as liquidity, counterparty, leverage and operational, and simple applications with use of output models and related tools. Managers now possess a global outlook and have the ability to understand portfolio exposures on types of assets classes. Firms have come to include the three main points in risk management which are risk measurement, monitoring and effective management. The three points incorporate the different aspects of efficient risk management. The points are indispensable and interdependent and should effective be aligned with the goals and objective of the firms.
Consequences that should be enacted when Financial Firm Management fails to perform their fiduciary obligation to investors. The managers primary role at a firm is to ensure that the investments of its clients are well protected while earning the best market rates with the least risk involved. The managers responsibility is to measure different risk and the sources of them such as market, credit, sector and interest risks. The managers should establish controls internally that will provide the best managing system with feedback systems and adequate controls to be able to provide warning against possible risk during the management and assessment process. The firm’s managers toolbox should include various methods that are directed at projecting the different kinds of associated risk. They should be able to monitor the total risk involved in the investment which may include protection against asset liability loss, the reduction of vast asset classes and other losses that may affect the ability to meet the obligation to its client. The managers failure in meeting the primary objective of maintaining the fiduciary relationship with their clients should be reported with the proper entity in charge, which in this matter is the Securities Exchange & Commission (SEC). The revocation of their license through the SEC would be the only viable action in order to prevent future issues with a firm that has failed to meet its fiduciary obligation.
Given the recent debt crisis within the EURO zone of Europe, analyze the impact to the performance of foreign markets and recommend a strategy for financial firms to minimize investment risk in these markets.The impact of the crises has taken a toll especially in Italy with its high budget spending. The bailing out of Greece from tremendous debt also contributed. The surge of migrant entering into Europe has also affected the instability in those markets. The continue weakness of many bank that survived the crises continues to have a negative effect in foreign markets. The interbank market has not recovered fully from the crises and will continue to suffer unless significant measures are put in place. The rates at which banks borrow continues to be high making the ability to borrow funds much harder due to the high rates. The biggest effect was the erosion of confidence people had in the market.
The best and most effective way to reduce the amount of risk is to diversify. Diversification is the process in which the portfolio is spread throughout well researched and favorable opportunities. Diversification can be done in various way such as by sector, style, globally or by asset class. You can also reduce risk by investing in stocks and bonds.
Evaluate the role of the Federal government, if any, related to the regulation of investments by financial institutions including the scope of the role, the authority and enforcement capability within the regulatory agency, the benefits, and consequences of regulation. Predict how the regulatory environment may change over the next five (5) years. Provide support for your prediction.
The SEC is an independent agency of the United States federal government that regulates the markets and investment firms by enforcing the federal securities laws. The SEC has a 3-part mission which is to protect investors, maintain fair, orderly and efficient markets and facilitate capital formation. The SEC requires that public companies submit quarterly and annual reports and other periodic reports. The SEC has five different divisions within it which are corporate finance, trading and markets, investment management and enforcement and economic and risk analysis. The corporate finance division oversees public company disclosures and mergers made by companies. The trading and markets division oversees self -regulatory organizations within the SEC. The investment management division oversees investment advisors and registered investment companies. The enforcement division works alongside the other divisions to investigate violations of laws and regulations and bring action against the perpetrators. The main laws the SEC enforces are the Securities Act of 1933, Trust Indenture Act of 1939, the Investment Company Act of 1940, the Investments Advisors act of 1940 and the Sarbanes-Oxley Act of 2002.
The change in the regulatory environment will see a significant change over time. Technology will change the way in which the markets are monitored. The regulation of crypto currencies will also bring significant change to how regulations are drawn to cover these new products. The availability and continued growth of firms that operate electronically that offer securities will cause for existing regulation to be amended or new ones created in order to cover protections for consumers who are susceptible to fraud. The new investment firms such as Stash or Acorns who offer securities purchase will have to be regulated much harder due to their incorporation of banking services which could affect consumers negatively and make them susceptible to fraud. The bottom line is that as technology grows the ability for fraud and other issues arise and with these changes new laws need to be created to control and avoid the issues we have experienced in the past.
