Economic Crisis as a Breakdown of Communication: The Case of Lehman Brothers

1. Economic Crisis as a Breakdown of Communication: The Case of Lehman Brothers Presented by: Jean Bosco SIBORUREMA. Masters degree in Port and Maritime Business Management and Maritime Law. Deusto University.

2. Economics crisis is related to an unstable and dangerous Economics situation; The causes of economic crisis are many, and breakdown of communication has played its role in deteriorating the current situation, many scholars and economists have identified different causes of current crisis but no deep analysis have been given to the role of communication in today�s economic situation. Communication plays a huge role in interconnected system , once broken down it results in the fail of all the system. In current crisis the Economics profession appears to have been unaware of the long build-up to the current worldwide financial crisis and to have significantly underestimated its consequences on global economy.

3. Cont�d The Economists have focused their efforts in developing economic models but did not focus on follow up and monitoring of their implementation. the economics profession has failed in communicating the limitations, weaknesses, and even dangers of its preferred models to the public. This crisis itself was not independent, but was connected to problems created by different policies and models developed in the past. This situation as identified above implies the need for a major reorientation of focus in the research economists undertake, as well as for the establishment of an ethical code that would ask economists to understand and communicate the limitations and potential misuses of their models.

4. Great Depression in 1929-1933: Overproduction in the American agriculture and industry was at the basis of the Great Depression. On Thursday, October 29, 1929, Wall Street crashed. The banks were besieged by people wanting their money. The Great Depression had devastating effects in virtually every country, rich and poor. Personal income, tax revenue, profits and prices dropped, and international trade plunged by a half to two-thirds. Unemployment in the United States rose to 25%, and in some countries rose as high as 33%. (Wikipedia, 22 March 2010) The financial crisis of 2007�present is a financial crisis triggered by a liquidity shortfall in the United States banking system. It has resulted in the collapse of large financial institutions, the "bail out" of banks by national governments and downturns in stock markets around the world. In many areas, the housing market has also suffered, resulting in numerous evictions, foreclosures and prolonged vacancies. It is considered by many economists to be the worst financial crisis since the Great Depression of the 1930s. (Wikipedia, 22 March 2010) Examples of Economic Crises

5. The Economics Profession failed to communicate the current crisis. The economics profession appears to have been unaware of the long build-up to the current worldwide financial crisis and to have significantly underestimated its dimensions once it started to appear. This lack of understanding may be due to a misallocation of research efforts in economics. The deeper roots of this failure can be traced to the profession�s insistence on constructing models that, by design, disregard the key elements driving outcomes in real-world markets. The global financial crisis has revealed the need to rethink fundamentally how financial systems are regulated. It has also made clearly a systemic failure of the economics profession. Over the past three decades, economists have largely developed and come to rely on models that disregard key factors�including heterogeneity of decision rules, revisions of forecasting strategies, and changes in the social context�that drive outcomes in asset and other markets (David et al, 2008)

6. There was an increased innovation in structured finance products, willingness by lenders to take excessive risks, low interest rate and obscure financial engineering. The majority of economists thus failed to warn policy makers about the threatening system crisis. The failure of economists to address the above mentioned issues is even rooted to fact that research generally loses track of the inherent dynamics of economic systems and the instability that accompanies its complex dynamics, which leads researchers to disregard questions about the coordination of actors and the possibility of coordination failures. Cont�d

7. Many of the financial economists who developed the theoretical models upon which the modern financial structure is built should have been aware of the strong and highly unrealistic restrictions imposed on their models to assure stability. Yet, financial economists gave little warning to the public about the fragility of their models; even as they saw individuals and businesses build a financial system based on their work. (David et al, 2008) When the economic situation started to slowdown many actors relied on the myth that the �market would sort itself out in the end�, and ignore the possibilities of adopting new curative measures. Cont�d

8. There are a number of possible explanations for this failure to warn the public. One is a �lack of understanding�, may be the researchers did not know the models were fragile. A second, more likely explanation, is that they did not consider it, their job to warn the public. If that is the cause of their failure, we believe that it involves a misunderstanding of the role of the economist, and involves an ethical breakdown (David et al, 2008) The failure in communication of Economic profession and other economics� players has already had a spill-over effect on the world economy turning it into a global, synchronized recession. The contraction of all types of demand brought about by tight financial conditions, falling wealth and greater uncertainty has led to an unprecedented collapse in world trade. Cont�d

9.  Lehman Brothers Holding inc. was a global financial services firm which, until declaring bankruptcy in 2008, participated in business in investment banking, equity and fixed- income sales, research and trading, investment management, private equity, and private banking. In 1844, 23-year old Henry Lehman emigrated from Germany to Alabama where he established a small shop, H. Lehman, selling dry goods and other requisites to the local cotton farmers. In the following years his two brothers joined the firm and in 1850 the firm changed its name and Lehman Brothers was founded. In 1984, Lehman Brothers was acquired by American Express and merged with its retail brokerage Shearson to form Shearson Lehman Brothers. American Express began to divest its financial services by business lines in 1992 and eventually, in 1993, the firm was spun off and once again became known solely as Lehman Brothers. In the 21st century the company became entangled in the subprime mortgage lending crisis, which led to its demise in 2008. (Wikipedia, 20 October 2009)

10. The subprime mortgage crisis was a large reason behind the fall of Lehman Brothers. A subprime loan in finance means making loans that are in the riskiest category of consumer loans. The subprime loans is connected to the subprime mortgage crisis in the way that subprime loans offered an opportunity for borrowers with a less-than-ideal credit record to become a home owner. The crisis was triggered by a dramatic rise in mortgage delinquencies and foreclosures in the United States which led to major consequences for financial actors around the world. Lehman Brothers had a loan portfolio consisting of a large share of loans connected to purchasing of real estate�s (Guardian, 15 September 2008). When the prices on the property market decreased in the United States in early 2007, the values of the properties became lesser than the value of the loan outstanding which was devastating for Lehman Brothers.

11. The reasons which may have led Lehman Brothers to end up in this situation: There were not enough regulations that decreased the risk taking in Lehman Brothers. One mechanism behind the crisis is that Lehman Brothers and other financial institutions did not have incentives enough to avoid system-risks since the US government previously always had taken a large share of the costs when an institution important to the system had been close to failing. (Fahlin et al, 13 September 2009) Not sufficient risk management by Lehman Brothers. A guideline for the maximum leverage ratio of a Wall Street stock dealer was 20 to 1. That value is said to be fine when the company�s assets consist of commercial papers, bonds and shares that are relatively easy-valued because they are more liquid. Though, this ratio is far too high when the asset mix includes for example investments in real estate, as in the case of Lehman Brothers. In November 2007, the leverage ratio of Lehman Brothers were 30,7 to 1. (Hutchinson, 12 September 2008)

12. The American banking regulation system was divided in two parts before the crisis. Lehman Brothers was an investment bank and did therefore not have as hard regulations as commercial banks. (Fahlin et al, 13 September 2009) Commercial banks were regulated by the US Federal Government but investment banks are not regulated. One example of this is that commercial banks have an accepted maximum leverage ratio of 10 to 1 while there is no limit for investment banks. The American government did not have enough insight in the complex network between Lehman Brothers and other financial institutes worldwide. The lack of understanding makes it hard to provide a good legal framework. (Fahlin et al, 13 September 2009) There was miscommunication between the US. State, USA Federal Government and English government, on who could take the first step to save Lehman, before it files to bankruptcy in 2008. Cont�d

13. Consequences of the collapse of Lehman Brothers: Two months later Henry Paulson, the Treasury Secretary of USA, explained that the failure of Lehman Brothers had led to a systemic crisis and to the evaporation of confidence in the financial system: �We had a system crisis. Credit markets froze and banks substantially reduced interbank lending. Confidence was seriously compromised throughout our financial system. Our system was on the verge of collapse, a collapse that would have significantly worsened and prolonged the economic downturn that was already under way� (Paulson 2008a). Lehman�s bankruptcy set off a panic that would end up by threatening not only the U.S. financial system, but also the global financial system.

14. When the market now realized the fact that the government was ready to let a large financial institution file for bankruptcy due to its actions, it created instability where lenders did not venture lending their capital to banks (Fahlin et al, 13 September 2009). Other banks� reaction was to stop their lending and started to sell of their financial assets which led to liquidity crisis allover the world. The consequences of the financial actors� actions in the US spread to many parts of the world, which were not directly involved with the US financial market. Now the developing countries are suffering the consequences of the problems which they did not create or know about, because of interconnection of financial institutions and miscommunication. Cont�d

15. What can be done for crisis management: Crisis prevention, to prevent a repeat in the future. This should be mapped onto a collective judgment as to what the principal causes of the crisis were and how changes in macroeconomic, regulatory and supervisory policy frameworks could help prevent their recurrence. Policies to boost potential economic growth and competitiveness could also bolster the resilience to future crises. Crisis resolution, to bring crises to a lasting close, and at the lowest possible cost for the taxpayer while containing systemic risk and securing consumer protection. This requires reversing temporary support measures as well action to restore economies to sustainable growth and fiscal paths. Inter alia, this includes policies to restore banks' balance sheets, the restructuring of the sector and an orderly policy 'exit'. An orderly exit strategy from expansionary macroeconomic policies is also an essential part of crisis resolution.

16. Crisis control and mitigation, to minimize the damage by preventing systemic defaults or by containing the output loss and easing the social hardship stemming from recession. Its main objective is thus to stabilize the financial system and the real economy in the short run. Communication strengthening, communication should be used as tools to deal with crisis of any form, the global should be aware of dependence on decisions taken by one country or group of countries, and all countries should be involved in economic decisions which impact on their welfare. Achieving adequate communication between planners and policy makers, on the one hand and resettlers on the other hand, when communication processes are absent and break down the result is what Cernea call �negative participation� that is �active opposition movement against development� (cernea 1997) Cont�d

17. Conclusion The information and Communication Technology must be used to eradicate the break down of communication, and facilitate the decisions makers at all level to take informed decisions and to intervene as soon as possible where the economic situation is being challenged. Once the economists, economics actors and decision makers communicate between themselves and share relevant information, it will be an important step toward sustainable economic development. Government must seek solution which will not impede responsible innovation and Entrepreneurship; the focus must be on ensuring that market function properly within a robust but facilitative supervisory and governance framework. All the governments� actions must be complemented by a responsible oversight of financial institutions by Board of Directors, Audit, remunerations committees and risk committees.

18. Cont�d The organizations must reinforce communicative behaviors inside the organizations from lower level to upper level and from upper level to lower level. To try to avoid a similar crisis in the future, the communication must not be biased at all, and transparency must reigns in economics profession, economics actors, decision makers and all financial institutions.

19. Further readings Alliance of Liberals for Democrats in Europe. International Crisis: Its causes and what to do about it. Workshop, February 27th, 2008. Christian Merup , et al. Reading projects: Lehman Brother. http://www.cs.chalmers.se/~rootzen/finrisk/Lehmanbrothers.pdf (last consulted, March 26th 2010) David Colander, et al. The Financial Crisis and the Systemic Failure of Academic Economics*. http://www.econometica.it/events/2009/30-11/prof_Kirman.pdf (last consulted, March 26th 2010) European Commission, Economic and Financial Affairs. Economic Crisis in Europe: Causes, Consequences and Responses. European Economy 7/2009 Richard Swedberg. �The Structure of Confidence and the Collapse of Lehman Brothers�. Cornell University, Department of Sociology, November 12, 2009.

20. MURAKOZE !!! THANK YOU VERY MUCH MERCI BEAUCOUP MUCHAS GRACIAS ASANTE SANA sibonta@gmail.com