Consequences of Lehman Brothers Bankruptcy - Research Paper Example

Introduction Many companies around the world are affected by bankruptcy at a certain time in their financial year. When a company is declared bankrupt, it can no longer invest in the stock exchange. The government declares the company insolvent. An example of such company is the Lehman Brothers, a housing and real estate company that went into bankruptcy in 2008. Below is a visual aid of the event that impacted the company to bankruptcy. This later had an impact on the company and as a result made the company declare it self bankrupt. Before we look at the effects that rose from Lehman Brothers declaring it self bankrupt, we have to consider also the things that brought about this. Market complacency As the fig shows, continuous period of low interest rates led to an incline in house prices that was totally irregular by historic standards. From March 1997 to June 2006, the national index of real estate by Sheller and Case, showed prices increase in every month except for two months an alone. This sustained price brought about the illusion in a lot of aspiring home owners hoping that prices will go down a few months time. As the table show, the reason was not only due to good economics bit the constant real estate price increment. First home owners pay hard on their mortgages as the home equity increases. Secondly there was the accessibility of pioneering mortgages outlooks which allowed buyers to acquire houses that they could not keep up the credits payments in stability as well as on the ability to refinance them constantly at higher prices. This made the lending rate deteriorate as the conditions were favorable. (Ariccia et al, 2008). This attributed to increased competition among lenders. The massive amount of issuance added by an inadequate number of players changed the primary nature of the relationship between credit evaluation agencies and the savings bank issuing these collaterals. (Sherlund, 2008). As result of these outcomes, the economy was affected that the revenues collected from the housing company fell and the company started increasing its sale. In the past every customer issued a combined of securities had no market place power over the ranking agencies. Bad regulation Regulatory constraints brought about the inflation demand for products thus seeing Fannie Mae and Freddie Mac getting the approval of investing in these securities. (Mian et al, 2008). Another source of captive demand was the money market funds. This boosted their yields since they were required to hold only the high rated securities. The managers that funded these securities knew well what gamble they were playing with these funds but could not resist the temptations and benefit it came with them. The managers also hoped that if any shock arose from these funds, their immediate competitors would also face the same consequences which would result in a reduced reputational cost and this may result in the government interference and may end up supporting these companies through incentives and lowering of taxation. The problem was even strict and severe in the short bond funds. In contrast to the market funds, short bonds fund are not restricted to the types of gadgets they can own. Generally the regulation relies greatly on credit- rating agencies procedures of risks without understanding the incentive created on the regulatory game system. As stated, (Morris and Shin, 2002) in circumstances where there are numerous equilibrium, an increase in public information does not necessarily to enhance welfare since it can direct to unproductive bank runs. (Diamond and Dybvig 1983 ). Lack of transparency The other major problem that contributed to the downfall to bankruptcy of the Lehman Brother company was the lack of transparency in big markets. In the last ten years the market for acclaimed default swaps grew uncontrolled from almost zero to 44 trillion, which was more than the of the us stock market in twice the number. Generally the levels of these contracts were very low and did not exist creating the possibility of a systematic failure. For instance in the middle of a hurricane and all of the Florida residents lost their insurance for their houses in the mess, there would be a huge rush to acquire new insurance. Insurance capacity is limited in the short term; hence the prices to buy new ones will shoot to the roof. If a number of home owners fail to reach these high prices, they would have their mortgages automatically defaulted leaving them prone to foreclosures and real estate crisis. Lehman financial policy In the case of invested bank and Lehman, the problem of financial policy was aggravated by two factors which were exceptionally high levels of leverage and the short dependence on short-range financing. In sequence the instability brought about by the leverage problem was worsened by the large use of short- term debt by Lehman. With this leverage, the entire worth of equity asset of the company will be insolvent hence the company would go into bankruptcy. Consequences of the bankruptcy Market reassessment risks The market was forced to reassess its risks due to the bankruptcy effect of the Lehman Company. People tend to buy flood insurance after a major flood crisis, but after the fall of Lehman there was worry in the market about the previously over looked risks. After Lehman filed for bankruptcy, there was a more dramatic impact on the money market funds. It announced that because it suffered a lot of losses, the company was forced to enforce a seven –day freeze on collections since the net advantage of it’s allocates fell below one dollar. However the government has played an important role in minimizing these side effects. Unemployment When a company goes into bankruptcy, the overall number of its employed workers is decreased so that the company cuts down on its expense. The company strategizes by putting off a huge number of staff and personnel nearly a quarter of them. This is a setback to the government since all those workers that are laid off tend to be a burden to the government since they do not participate in any income generating activity. The overall output of the company decrease hence low profit to the company resulting in high operating cost. The effect of unemployment in the country and economy is that the overall income per capita would decrease and this will cause the living standards of people go down and the levels of poverty would be on the rise hence there would be a rise in starvation. As a result of starvation and unemployment, the cases of theft and robbery would be on the increase since the unemployed would be looking for alternatives means of acquiring money to sustain themselves. The government intervenes by giving support to the company through providing incentives that will boost the company out of bankruptcy. This would in turn make the company rise from the critical situation that it was in, hence will bring back the employment opportunities that it had previously offered. Government revenue The government gets a lot of income from a company through various means. One of the ways is through taxation. As the company declares bankruptcy, it is by the government policy to exempt or decrease the amount of tax it puts on that particular company or organization. This moves cuts down the government revenue resulting from the taxation of the government. As a government, it becomes difficult to invest in development of the economy if the revenue it collects from the individual, or company decreases or is not available for some time. This will I turn result from poor economic growth as roads, hospitals, schools, market and other government funded project will be put on halt due to insufficient funds to operate them. Meanwhile as a result of this outcome, the expected number of unemployed people in the country will continue to be on the rise since those that benefited from the government projects will be out of job. This is very common in such cases al over the world. As the housing company of the Lehman Brothers went to bankruptcy, one of the outcomes expected was the lack and decline of the revenue it gave to the market. Investors’ confidence In most cases investors tend to loose confidence in a country if the country experiences major economical crisis. Bankruptcy is a major issue that affects the credibility of a country’ economy since investors tends to loose confidence in the country. As a result of investors’ lack of confidence, they tend to keep away from that country and do not come to the country to invest in any sector, especially the manufacturing sector. If they do not invest, there would be no jobs created in the country and that would result in lack of employment in the country. The government also tends to loose revenues that would have been generated if the investors had come to the country to invest. This result in low revenue income hence will hinder development of the country’s economy. If the government enforces strict policies that pressures the company and burdens them to a point where they become insolvent, the company is forced to declare its self bankrupt. The government should play part in ensuring that the economy is stable and it has to make it possible or investors to find it easy to invest in the country whether the investors are foreign or local. The government should give incentives to small companies that are in the rising market so that they can sustain themselves and can help boost the countries economy. Customer relations The relationship between the customer and the company that declares itself in a state of insolvency is greatly destroyed. People loose confidence with the company and it result in a low out put for its products and services since the services that are offered are not appreciated by the customers. This will reduce the overall out put per unit and the company will result in not selling their products and commodities hence low profits for the company. This will cause the company to operate in high cost and fails to meet the maximum requirements for the running of the company. This will cause the liabilities to be more than the assets making the company deep into bankruptcy. Stock exchange When a company goes into bankruptcy, it is exempted from the stock exchange and can not invest in shares. This will cause the company to remain underground as investors would fear investing in it. This would have an overall effect to the company and it will lack the confidence of many investors willing to share in it. This has an effect on the economy as the government relies on revenues and employment opportunities from the company Conclusion As it has bee stipulated in this report, a lot of factors affect a company and causes the company to declare it’s self as being in a state of bankruptcy. Many factors contribute to this including the government itself which should be on the front line in ensuring it supports a company or a major business in ensuring that it does not fall in the case of being insolvent. The effect that accrues from a company being declared as bankrupt is huge and enormous. Businesses and companies should ensure that they adopt proper measures that will make them stay healthy and avoid being insolvent. They should do this by getting involved and seeking support from the government especially if the business is new in the market. The business should also encourage investors from foreign and local to invest in them. This will always make the company earn good profit and it will greatly avoid the effects of being insolvent, hence saving a lot of people from being unemployed. Work cited Efraim and Jennifer Dlugoszb, 2008, “The Alchemy of CDO Credit Ratings”, Harvard University Working Paper. Print Dell'Ariccia, 2008, Credit Booms and Lending Standards, Evidence from the Subprime Mortgage Market, CEPR, Discussion Paper No. DP6683. Print Diamond, D. and P. Dybvig, 1983, “Bank runs, Deposit Insurance and Liquidity”, Journal of Political Economy. Print Demyanyk, Yuliya and Otto Van Hemert, 2008, “Understanding the Subprime Mortgage Crisis”, Working Paper. Print Dolan k, 2008, Ultra short-Term Bond Funds Suffer Massive Blow, Moningstar.com. Print Duffie, Darrell, 2004, Irresistible Reasons for Better Models of Credit Rating, Financial Times Apr 16, 2004. Print Read More