Bankruptcy with consequences

24 September 2008 20:35

(updated: 7 March 2016 20:40)

Bankruptcy with consequences

What happens when one of the USA's largest investment banks goes bankrupt?

On the morning of Monday 15 September when the American investment bank, Lehman Brothers, announced that it sought bankruptcy protection, the shocking crisis poured out into the world's financial market. Lehman Brothers, the USA's fourth largest investment bank declared Chapter 11 Bankruptcy today. This means that in reality the bank is bankrupt, but that it seeks assistance in paying wages to its employees in the short term, and that it attempts to rescue parts of the company.

Housing bubble

Like many other American banks, Lehman Brothers found itself in trouble after the American housing market collapsed in 2006.

"There has been a highly volatile economic cycle in the USA during both the Clinton and Bush periods. Each time there have been indications of a cool down tax and interest rate relief has been granted. This has given fuel to the fire resulting in inflation," says professor Ola H. Grytten of The Norwegian School of Economics and Business Administration (NHH).


In recent years the big American investment banks have bought up large portfolios of mortgages from smaller banks, and sold securities that are based on the earnings from these loans when loan owners pay back their mortgages. But as many as 60 percent of these loans are subprime loans, which are loans given to customers with low solvency (ability to pay); a risky venture.

"The bubble pops and a portion of loan owners cannot manage to maintain their loans and banks can go over the edge as a result," explains Grytten.

When the housing market collapses and customers cannot honor their loans, the banks are stuck with worthless houses.

Collapse in the stock markets

On Monday the losses became too much for Lehman Brothers to swallow, and stock markets around the world were hit by the down turn.

"Severe financial bankruptcies push markets down. Many banks will reveal their results in the near future, and we do not know what they will present. Also there are psychological effects related to the economic cycle situation. We constantly read notices about how "now we are over the worst of it' in the newspapers. I have little belief in this. I think we will have a considerable international economic down turn," says professor Jan Tore Klovland of NHH.

According to Klovland it is difficult to say whether many banks will be hit as hard as Lehman Brothers.

"No one has a complete overview of how many and how bad the loans in these banks are," he says.

In deep water

All of the large, independent investment banks in the USA are having problems. Merril Lynch was bought out by Bank of America on Monday, and there is now speculation that the same thing will happen with both Morgan Stanley and Goldman Sachs. Additionally insurance giant AIG is in deep water.

According to Klovland the above mentioned problems can be very serious due to the fact that many banks have their securities insured by AIG. If the insurance giant goes under, these banks will face large consequences.

Effects on interest rates

The financial crisis is spreading to Europe and Asia, both directly as banks and investors are losing on their U.S. investments, and indirectly due to the consequences of the psychological effects associated with an economic down turn.

"What has happened makes it possible to see a reduction and stabilization of central bank interest rates. Norges Bank has discussed whether it should raise interest rates by an additional 25 points (up 0.25 percentage points). That's probably less likely now," thinks Klovland.

But another effect of the crisis is that the banks now must cover their losses by taking a higher margin on their lending rates, as well as tightening control on loan routines because they are no longer willing to take on as much risk as before.

"The market price risk lowers. Then it burst. This is a re-pricing of risk," explains Klovland.

Therefore, the interest rate effect for Norwegian loan customers is not easily predictable. If Norwegian banks lose a great deal of money due to the turbulence in the USA market it could lead to more expensive loans for Norwegians.

Not hitting Norwegian banks for the time being

"The USA is still the world's financial engine, and the crisis has come a relatively short way. But to understand the full effect, the crisis must also include the Norwegian finance sector. So far we see few signs of crisis. For Norwegian companies that have their businesses closely tied to the American economic system, this can however have a few big effects in the short term," says NHH Professor, Kjell Gunnar Salvanes to Technical Weekly magazine Tuesday.

Text: Knut André Karlstad