How can a bank like Lehman go down so fast?
FINANCIAL markets can be punishing and reversal of fortunes can be dramatic. More so, if an institution is overleveraged — when loan and investment books are much, much bigger than its capital. What compounds problems are strange accounting practice and high-risk nature of the loans and investments. There are also disclosure issues: Lehman, in its last conference call with investors, gave no clue that it was actually on the brink.
How did the crisis build up?
An investment bank uses its proprietary book (own money) to lend others and invest. It started with the subprime crisis. Banks like Lehman, buy mortgage loans from other banks, and then package them to sell bonds against the loan pool. Often they add cash to make the loan pool more attractive, so that the bonds can be sold at a higher price. Suppose mortgage was earning 6%, these bonds are sold at 4%. The difference is the spread which the investment bank earns. By selling these structured bonds, it raises money and frees capital. But when homebuyers started defaulting, these bonds lost their value. It all began like this, and then the virus spreads across markets.
But don’t investment banks play the advisory role?
They do, but slowly over the years, their prop books have multiplied. Investment banks also organise big loans for their clients for funding acquisitions. At times, investment banks take positions, only to palm off the securities to other clients and banks. In a crisis, they may not get the opportunity to down-sell such positions. This adds to the panic.
Can’t central banks step in to stem the crisis?
Well, they can and they have, to an extent. It’s precisely to discourage banks and bond houses from selling securities to generate liquidity, Fed has relaxed the rules under which it lends to institutions against securities. Moreover, if there’s a financial chaos of this magnitude, banks refrain from lending each other, fearing that the money would get stuck. A liquidity window from the central bank thus comes handy.
How does the domino effect play out?
Suppose Lehman faces a redemption and has to repay another bank it has borrowed from. If it sells the mortgage-backed bonds, whose prices have fallen, it will not raise as much as was earlier expected. So, it sells some of the other good assets or bonds which may have nothing to do with mortgages. But since
the bank starts dumping these assets, prices of these bonds also dip. This is when the crisis spreads
from subprime to prime.
How does it impact the balance-sheet?
Herein lies the strange accounting of bonds and derivatives like mortgage-backed securities. All banks are required to markto-market (MTM) their investments. So, if the price of an instrument falls, the difference between the price at which it was bought and the current market price has to be provided — meaning, it has to be deducted from the earnings. So, a drop in price leads to the MTM loss. But there’s a bigger problem which really has deepened the crisis. An MTM loss can be provided only if there’s a ‘market’. How do you provide when there is no market?
But aren’t these instruments traded? How can the market suddenly vanish?
Remember, it’s very different from checking the price of a stock from a stock exchange website. Many of the instruments are over-the-counter derivatives, which are struck on a one-toone basis between two parties. Suppose, a derivative is linked to variables like the yen-dollar rate, and may be prices of other actively traded assets, say gold price and US Treasury bill. What the bank does is construct a model, feeds the available market price of these variables in the computer, to arrive at what the market price of the derivatives could or should be. This is an artificial model-generated price. This is called the mark-to-model against mark-to-market.
So, what’s wrong in that?

The trouble is when the bank actually goes out to sell the derivatives, it discovers that there are no takers. And, even if there are buyers, they are willing to pay just a fraction. In other words, there is a sea of difference between the price that is being offered in the market and the high artificially-generated price thrown up by the model. So, when the bank ends up selling the instrument or unwinding derivatives, the loss suffered is far in excess of the mark-to-model loss. Such extra losses on thousands of securities and multiple portfolios can wipe out the capital of the bank.

What is the nature of the instruments?

There are collateralised debt obligation (CDOs), credit default swaps (CDSs) and all kinds of derivatives. CDOs are asset (or loan)-backed securities, while CDSs are like a guarantee. Say Bank A lends to a corporate but is unwilling to take the full credit risk. So, Bank A enters into a CDS deal with Bank B; under this, Bank B promises to pay Bank A if the corporate defaults. The money that Bank B earns for this is the CDS premium, which is similar to an insurance premium. Now, if markets turn choppy, risks go up and so does the CDS premium. So, Bank B, which is earning a lower premium has to promote a mark-to-market loss against the CDS position.
How does one minimise such turmoil?
No easy answer to that. Maybe, some of the accounting norms need to be changed, so that the definition of MTM gets narrowed down. Besides, to stop banks from going overboard, capital requirement may have to be raised for derivatives position. But all this may be easier said than done.