Credit crunch deals killer blow

 
 

The collapse of Lehman Brothers could be the end of investment banking as we know it, writes Dara Martin.

Over the last week the financial world has witnessed and endured more destruction than ever before. The current crisis, originally stemming from the US subprime mortgage crisis, has brought long running financial giants to their knees in a matter of days. Wall Street has been crippled by risky assets, a lack of credit and dwindling investor confidence. As a result, stock markets around the world have plunged while financial firms have lost billions of dollars or collapsed altogether.

Questions about the future of the investment banking model have been raised. Less than a year ago five investment banks dominated Wall Street; Goldman Sachs, Morgan Stanley, Merrill Lynch, Lehman Brothers, and Bear Stearns. Now it seems likely that Goldman will be the only one remaining as an independently run firm. March saw the collapse of Bear Sterns following a liquidity crisis and the collapse of two hedge funds.
In the past week Lehman has gone bankrupt after talks of a possible takeover bid by British Bank Barclays faltered and the US Federal Reserve’s refusal to provide financial aid. Merrill has been acquired by Bank of America for $50 billion, less than half of what it was worth this time last year, while at the time of writing Morgan Stanley is considering a possible merger with either US bank Wachovia or Chinese state-owned bank CITIC.

Investment banks are hugely reliant on luck and the stability of current financial conditions. Therefore most Wall Street firms have unsurprisingly felt the pinch over the last 12 months as the credit crisis took its toll, with banks becoming increasingly reluctant to lend to each other. Unlike commercial banks such as Bank of America, investment banks do not have a regular supply of deposits from customers. Instead they borrow money for the short term and reinvest it in mortgage backed securities and other commodities and derivatives.

However, when markets are performing poorly and investors lose confidence other financial institutions stop lending to the investment banks, who in turn can only sell their holdings at a loss. As we have seen recently, stock markets can plummet in a matter of hours, if not minutes. If this happens investment banks have limited access to cash quickly and can run into liquidity problems, as was the case with Bear Stearns.

Lehman Brothers, the fourth largest US investment bank, filed for bankruptcy last Monday, bringing the demise to a once proud financial institution that had been in existence for 158 years. Lehman’s Chief Executive, Dick Fuld, who has been at the firm for nearly 40 years, spent countless hours on the phone trying to find a buyer for his failing company, but to no avail as both Barclays and Bank of America pulled out of negotiations.

What will become of the firm’s 26,000 employees scattered around the globe is still unclear, but the majority of them will be looking elsewhere for employment, while a few will remain to sort out the firm’s sizeable obligations.

Initially staff were unsure if they would even receive wages owed to them, however it seems likely that they will as the firm is raising cash by selling off some its assets. Senior managers stand to lose the most as their exorbitant bonuses often take the form of company shares which are essentially worthless at this stage. Shares in Lehman Brothers were trading at around $90 in recent months but had fallen to 19 cent by last week.

Former Federal Reserve Chairman, Alan Greenspan, stated that “We will see other major firms fail” shortly after Lehman’s claim for bankruptcy last Monday. He was not wrong as the following day the Fed had to provide the world’s largest insurance firm, AIG, with an $85 billion loan to prevent the firm from collapsing, while there are rumours that America’s sixth largest bank, Washington Mutual, is also in considerable financial difficulty.

Investment banks are hugely reliant on luck and the stability of current financial conditions

We have witnessed the ripple effects of the credit crunch on this side of the Atlantic as British bank Northern Rock almost became insolvent and had to be bailed out by the Bank of England last September, while only last week, Lloyds TSB acquired Halifax Bank of Scotland for €15 billion amid fears about the future of Halifax.

The future of investment banking is uncertain, but the current business model cannot survive. It seems probable that Morgan will be absorbed by another bank, similar to Bear Stearns and Merrill, where tighter restrictions and lower pay packages for employees will be imposed. They may continue to operate as the investment arm of their new parent companies, but on a much smaller scale. Goldman has the financial strength to readjust its approach but it is unclear if even the strongest Wall Street firm for many years can survive in the current climate.

Obviously the US financial regulator, the Securities & Exchange Commission (SEC), must impose stricter rules and regulations for firms that trade in securities. The collapse of two investment banks within the space of six months cannot solely be down to the state of the financial markets. These banks have had far too much freedom to do as they please, witnessed by Lehman’s shocking leverage ratio. At one stage the firm had 35 times its capital in debt, leaving it highly vulnerable to deterioration in the price of assets. A serious shake-up is required in the US financial regulatory system if future crisis’s are to be avoided.

The US economy has already suffered job losses surpassing 600,000 since the start of the year, and with more expected in the coming weeks from Wall Street firms the current financial crisis doesn’t appear to be coming to an end any time soon.

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