Lehman lessons
Date: 09 July 2010
Authors: Anthony Connerty
Issue: Vol 160, Issue 7425
Categories: Features, Commercial
Lehman Brothers, a Wall Street institution that could trace its origins back over 150 years, declared itself insolvent by filing for Ch 11 protection against its creditors in the early hours of Monday, 15 September, 2008.
It was to be the biggest bankruptcy in US history. President Bush would later sign an emergency order providing government insurance to the $3.5trn that was tied up in money market funds. The Lehman collapse affected not only the US: it triggered a global financial crisis.
What led to the collapse of institutions like Lehman Brothers?
Breach of a classic rule of banking
The traditional UK building society takes in deposits from investors and uses those deposits to lend out money to house purchasers, taking a mortgage on the property to secure the money loaned. Care is taken in valuing the property to be purchased and in checking out the borrower: are the borrower’s circumstances—job/wages/commitments, and so on—such as to indicate that the borrower will be able to finance the loan: a loan which may well be repayable over something like 25 years?
The same approach applied in the US. Alex Brummmer, in his book, The Crunch: how greed and incompetence sparked the credit crisis says: “America’s traditional housing market, dealing with prime borrowers, had worked along well-established lines for many years. Banks financed mortgages through deposits received from customers. At the same time, potential home buyers were scrutinised closely for their ability to make repayments, and there was a vigorous valuation of the house they planned to buy. In other words, proper precautions were taken.”
Lehman Brothers breached the classic banking rule in two ways. First, by lending recklessly to borrowers who were a bad risk: the so-called sub-prime borrowers. Second, by lending—not out of deposits from bank customers—but by borrowing in the market. They borrowed short (at high interest rates in the market) and lent long (at comparatively lower interest rates to their sub-prime borrowers). This latter manoeuvre—leverage—is fine: until interest rates rise and property prices go down.
Reckless lending
The sub-prime game
There were millions of people in America who could not satisfy the strict criteria for borrowing long-term to buy a home. But low interest rates might help them to get onto the housing ladder. So the sub-prime mortgage was invented—Alex Brummer explains: “Prime mortgages went to the better off; sub-prime went to the far end of the market, to those who had never
qualified for a mortgage before.”
These type of loans were high risk. Ben S Bernanke in a speech made at the Federal Reserve Bank of Chicago’s 43rd Annual Conference in Chicago in May 2007 said: “Subprime mortgages are loans made to borrowers who are perceived to have high credit risk, often because they lack a strong credit history or have other characteristics that are associated with high probabilities of default. Having emerged more than two decades ago, sub-prime mortgage lending began to expand in earnest in the mid-1990s, the expansion spurred in large part by innovations that reduced the costs for lenders of assessing and pricing risks. In particular, technological advances facilitated credit scoring by making it easier for lenders to collect and disseminate information on the creditworthiness of prospective borrowers. In addition, lenders developed new techniques for using this information to determine underwriting standards, set interest rates, and manage their risks.”
Sub-prime mortgage loans were dubbed Ninja Loans: loans issued to borrowers with “No Income, No Job, and No Assets”. The similar Liar Loan refers to a category of mortgages known as low-documentation or no-documentation mortgages.
Many of the sub-prime borrowers were from the trailer parks and the inner cities of the US. The impact on these borrowers—some faced with initially low interest rates on their mortgages that would later increase alarmingly—could be devastating.
Leverage
What made reckless lending in the sub-prime market worse was that Lehman was providing finance for that market—not by using money banked by its depositors —but by borrowing in the money market.
Gearing up—borrowing money to invest—enables an investor to increase its returns. Fine when interest rates are low. But when rates rise the picture is different.
A cautious bank might have leverage of, say, 10 times: so for every £1m of cash/assets it will lend £10m. Lehman got to the stage where it was leveraged over 44 times. Lehman had $18bn of equity on its balance sheet, but had investments—home loans and other investments—of nearly $800bn. Lehman’s shares would fall from a peak of $85 to 10 cents.
Securitisation: slicing and dicing
A third factor contributing to the collapse of institutions like Lehman Brothers was securitisation: the practice under which lenders package up mortgage loans and sell them on to investment banks in the form of mortgage-backed securities—and in the process getting the loans off the lenders’ balance sheets. “…banks were anxious to avoid holding loans on their balance sheets; they preferred to package them and sell them off to investors who were not subject to supervision and persuasion by the regulatory authorities” (George Soros, The Crash of 2008 and What it Means).
New products were created out of the securitisation of mortgages: “credit derivatives.” Lehman Brothers was among the US institutions that operated in this area: “Tens of thousands of mortgages were placed in pools to spread out the risks and then divided into slices, known as tranches, based on quality” (Alex Brummer). But at the end of the day much of the backing for these sophisticated financial instruments was still the sub-prime mortgage. With rising interest rates and the fall in property values many of those sub-prime mortgages were not worth the paper they were written on.
Credit rating agencies
Part of the securitisation process relied on credit agencies. The packaging process whereby bundles of mortgages could be sold on and traded as securities on the market—just like company shares—depended on those packages of home loans gaining a credit rating.
The Lehman collapse: claims
Various losers in the so-called “Credit Crunch” triggered by the collapse of Lehman Brothers may have claims in relation to investments that have gone radically wrong: claims, for example, against Lehman Brothers itself. Those entitled to make such claims will include investors, shareholders, trustees, liquidators and receivers. The claims may be against investment banks that devised securities deriving from sub-prime mortgages; underwriters; pension funds; and salesmen. Those claims could be based on negligent mis-statement, misrepresentation, breach of contract or the tort of deceit.
Hong Kong mediation & arbitration
In October 2008 the Hong Kong Monetary Authority (HKMA) announced that the Hong Kong International Arbitration Centre (HKIAC) would administer a Lehman Brothers-Related Products Dispute Mediation and Arbitration Scheme: information at: http://www.info.gov.hk/hkma/eng/new/lehman/explanatory_b.htm. The basis of the scheme is that the parties try to reach terms of settlement in relation to their dispute through mediation. If that fails, it is then open to them to proceed to arbitration.
HKMA stated that, under the scheme, the mediation process would be a confidential, voluntary, non-binding and private dispute resolution process “in which a neutral person (the mediator) helps the parties to reach a negotiated settlement or to narrow the issues in dispute. Successful settlement through mediation will obviate the need for costly and lengthy litigation”.
If mediation under the scheme is not successful, the parties involved may agree to binding arbitration by the HKIAC: “a separate person is appointed as arbitrator, using as far as possible a documents-only process. The arbitrator decides the claim and the decision is final.” The purpose of the scheme is to help resolve “questions of compensation between investors in Lehman-Brothers-related products and licensed banks”. Once the two parties have agreed to mediation, the parties may agree on a mediator from a list to be provided by HKIAC: alternatively, HKIAC will appoint a mediator from that list..
The mediator is to commence the mediation process as soon as possible after appointment and is to “use best endeavours to conclude the mediation within 21 calendar days of appointment”. If a settlement is reached, the mediation process ends. The process is also terminated if the mediator considers that further attempts at mediation are no longer justified—or if either party gives written notification of the termination of the mediation.
If settlement is not achieved, the parties can then consider whether to move to arbitration under the scheme. If the parties do agree to arbitrate, they may either choose an arbitrator from a list provided by the HKIAC, or the HKIAC will itself appoint an arbitrator from that list. The arbitrator is to conduct a “documents-only” arbitration under the scheme. Legal representation is not permitted for either party. The arbitrator is to aim to conclude the arbitration within 21 days.
Operation of the scheme
Since October 2008, the HKMA has referred a total of 334 Lehman-Brothers-related cases to the Securities and Futures Commission. These cases involved 16 banks.
As at November 2009, a total of some 250 cases had been received by the HKIAC for mediation under the scheme. Of these, some are ongoing and in some cases the invitations to mediate have been rejected. A total of 85 cases had actually proceeded to mediation. Of these, 75 achieved full settlement: a settlement rate of around 85%. In addition, there are believed to have been 37 cases settled by direct negotiation between the parties following the request for mediation.
Final thoughts
The collapse of Lehman Brothers triggered a financial crisis worldwide. Governments in many countries were obliged to consider pumping considerable funds into banks to prevent their collapse. At the root of many of the problems faced by the banks was the fallout from the sub-prime mortgage fiasco. Irresponsible lending caused problems for lenders and borrowers: problems worsened by the effect of complex financial instruments created out of the packaging of bundles of often worthless sub-prime or “toxic” loans.
Court actions have been launched by those who have suffered losses as a result of the financial crisis that followed the collapse of Lehman. Perhaps not the flood of litigation that was expected in the UK—but in the US at any rate class actions are on the move. And the first major criminal prosecution relating to sub-prime mortgages has already taken place in America.
In one jurisdiction—Hong Kong—a possibly unique method of dealing with Lehman Brothers claims has been launched. The Hong Kong Monetary Authority announcement that the Hong Kong International Arbitration Centre would administer a Lehman Brothers-related products dispute mediation and arbitration Scheme may set an example that other jurisdictions might usefully follow. Litigation in the civil courts and prosecutions in the criminal courts may be inevitable. But arbitration and mediation have much to offer: not least in potential savings in time and cost —and a degree of confidentiality.
Anthony Connerty, Lamb Chambers.
E-mail: anthonyconnerty@lambchambers.co.uk
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