Understanding why Lehman/ Bear Stearns collapsed

I have written a fairly long post explaining the various nuances of Lehman Bankruptcy. Though I have explained why Lehman became bankrupt, I still wanted to know the details- the financials of the company etc.

I came across this excellent excellent paper from Stephen Morris and Hyun Song Shin. I had earlier pointed to another superb paper from Shin where he (along with Tobas Adrian) had pointed that we can no more ignore market brokers from the financial regulation imposed only on banks. Infact market brokers are as sensitive to monetary policy actions as commercial banks.

In the new paper, Shin discusses the need to have  a systemic approach to regulation. I will discuss the regulation aspects in another post. In this I want to focus on what went wrong with Bear Stearns and Lehman. (see page 14 onwards). The results are based on November 30 , 2007.

First Bear Stearns:

One notable feature of Bear Stearns is the large proportion of funding that comes from payables – fully 22% of total balance sheet size. …. the bulk of the payables are deposits of hedge fund customers, and reflect the large prime brokerage business at Bear Stearns. Because hedge fund customer deposits are payable on demand, they are vulnerable to a classic run that reflects coordination failure among the hedge fund customers. Such a coordination failure may reinforce whatever increase in repo haircuts that already prevail in the markets. During the run on Bear Stearns in March 2008, the defection of its hedge fund clients was one of the contributory factors in the funding shortage that eventually led to Bear Stearns approaching Federal Reserve support.

How about Lehman?

 

One notable item is the “payables” category, which is 12% of total balance sheet size. Payables include the cash deposits of Lehman’s customers, especially its hedge fund clientele. It is for this reason that “payables” are much larger than “receivables” on the asset side of the balance sheet (only 6%). Hedge fund customers’ deposits are subject to withdrawal on demand, and hence may be an important source of funding instability.

See the similarity. Both had short-term liabilitites to honor and if not nonored could lead to bankruptcy.  With Bear this was an important factor and same conditions should apply to Lehman as well. As we all know now Lehman could neither find anyone to inject capital nor sell its assets. Though Lehman had other issues as well like high leverage ratio (30.7 compared to commercial banks average of 10 to 12) , low cash holdings etc. Still this makes sense as there is numerous press coverage saying Lehman could not find anyone to lend to help honor its commitments.

 

 

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2 Responses to “Understanding why Lehman/ Bear Stearns collapsed”

  1. Money market mutual funds next to shut shops? « Mostly Economics Says:

    […] shut shops? I am not sure how far this crisis will go. After analysing why biggies collapsed (Lehman, AIG), I had mentioned about Fed going broke as […]

  2. Understanding AIG’s financial problems « Mostly Economics Says:

    […] reach out to an exigent clause to bail out AIG. After Lehman’s analysis (bankruptcy and source of problems), it is time to take a peek at AIG’s financial […]

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