2 Equally weighted critical thinking essay

Oral Testimony of

Luigi Zingales

on "Causes and Effects of the Lehman Brothers Bankruptcy”

Before the Committee on Oversight and Government Reform

United States House of Representatives October 6, 2008

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Chairman Waxman, ranking minority Davis, members of the Committee,

thank you for inviting me.

The demise of Lehman Brothers is the result of its very aggressive

leverage policy in the context of a major financial crisis. The roots of this

crisis have to be found in bad regulation, lack of transparency, and market

complacency brought about by several years of positive returns.

A prolonged period of real estate price increases and the boom of

securitization relaxed lending standards. The quality of these mortgages

should have been checked by the capital market that bought them, but

several problems made this monitoring less than perfect.

First, these mortgages were priced based on historical records, which

did not factor in the probability of a significant drop in real estate prices at

the national level nor did they factor the effect of the changes in the lending

standards on the probability of default.

Second, the massive amount of issuance by a limited number of

players (of which Lehman was one) changed the fundamental nature of the

relationship between credit rating agencies and the investment banks issuing

these securities. As a result, instead of submitting an issue to the rating

agency’s judgment, investment banks shopped around for the best ratings

and even received handbooks on how to produce the riskiest security that

qualified for an AAA rating.

The market was not completely fooled by this process. AAA-rated

asset backed securities had a higher yield than corporate AAA, a clear

indication of the higher risk. Unfortunately, regulatory constraints created

inflated demand for these products. Fannie Mae and Freddie Mac were

allowed, even induced, to invest their funds on these securities, creating an

easy arbitrage: they issued AAA rated debt and invested in higher-yield

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AAA debt. Another source of captive demand was money market funds.

Being required to hold only highly rated securities, money market funds

loved these instruments that satisfied the regulatory requirements and

boosted their yields. Most managers of these funds were aware of the

gamble they were taking, but could not resist taking it, under an intense

competition for yield-hungry customers. These managers were also hoping

that if a shock occurred, all their competitors would face the same problem,

thereby reducing the reputational costs and possibly triggering a

Government support. The September 19 decision to insure all money

market funds validated this gamble, forever destroying money market

managers’ incentives to be careful in regard to the risks they take.

The pooling of mortgages, while beneficial for diversification

purposes, became a curse as the downturn worsened. The lack of

transparency in the issuing process made it difficult to determine who owned

what. Furthermore, the complexity of these repackaged mortgages is such

that small differences in the assumed rate of default can cause the value of

some tranches to fluctuate from 50 cents on the dollar to zero. Lacking

information on the quality and hence the value of banks’ assets, the market

grew reluctant to lend to them, for fear of losing out in case of default.

In the case of Lehman (and other investment banks), this problem was

aggravated by two factors: the extremely high level of leverage (asset-to-

equity ratio) and the strong reliance on short-term debt financing. While

commercial banks cannot leverage their equity more than 15 to 1, Lehman

had a leverage of more than 30 to 1. With this leverage, a mere 3.3% drop

in the value of assets wipes out the entire value of equity and makes the

company insolvent.

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In turn, the instability created by the leverage problem was

exacerbated by Lehman’s large use of short-term debt. Reliance on short-

term increases the risk of “runs” similar to the ones bank face when they are

rumored to be insolvent.

The Lehman CEO will likely tell you that his company was solvent

and that it was brought down by a run. This is a distinct possibility. The

problem is that nobody knows for sure. When Lehman went down, it had 26

billion in book equity, but the doubts about the value of its assets combined

with its high degree of leverage created a huge uncertainty about the true

value of this equity: it could have been worth 40 billion or negative 20. It is

important to note that Lehman did not find itself in that situation by

accident; it was the unlucky draw of a consciously-made gamble.

Lehman’s bankruptcy forced the market to reassess risk. As after a

major flood people start to buy flood insurance, after the demise of Lehman

the market started to worry about several risks previously overlooked. This

risk-reassessment is crucial to support a market discipline. The downside is

that it can degenerate into a panic.