Limitation of Lehman Brother

Question: Discuss about the Limitation of Lehman Brother. Answer: Stating the limitation of Lehman Brothers in derivatives market: Lehman Brothers scandal came as the devastating blow to the financial market, which started the financial crisis. High leveraged Credit Default Swap (CDS) and accumulation of bad loans reduced the overall value of its assets, which made the company insolvent. The high-risk trades mainly conducted by the company in the derivatives market increased its risk exposure and hampered its revenue generation capacity. The limitation of Lehman brother in derivatives market is depicted as follows. Corporate government failures: Lehman Brothers corporate government failure was identified after detecting the Repo 105 program, which was used by the company to portray its loans as sales in its balance sheet. The company straight away portrayed the loan acquired from asset collateral, as sales, which is ethically not correct and indicates the failure of corporate governance. The former Lehman directors stated that they were unaware of the Repo 105 program used in the balance sheet to hide the default assets (Rauterberg and Verstein 2013). The company has been using the Repo 105 since 2006, which states the unethical measures and volition of ethical rules laid down of GAAP. Highly leveraged risk taking business strategy: The company took higher leverage risk by reducing the income generation capacity from brokerages and raising its exposure in long term investment. The long-term investment strategy used by the company reduced its capital, which in turn raised its liquidity risk. The exposure to the CDS mainly blocked the companys capital and generated no return, which in turn hampered the companys ability to hedge its risks (Battiston et al. 2013). The high exposure to the liquidity risk and no hedging strategy mainly increased inherit risk of the company, which at last resulted in its insolvency. Depicting the limitation of MGRM in the derivative markets: The limitation of MGRM in derivatives market is depicted as follows. Contango price movement: Contango oil price movement was the major setback, which hampered profitability of MGRM. The contractual forward contract mainly sealed the companys short position exposure to oil. After the commencement of the forward contract decline in oil prices stared, this resulted in losses incurred by the company. Hedging strategy adopted by the company was stack and roll, which loses its fiction in the Contango market conditions. The future prices of the oil was higher than the spot price, which resulted in unexpected loses in future position. Lakshmi et al. (2013) argued that rolling stack strategies could be considered worse than no hedge position if cash flow is considered. Fixed exposure of risk: MGRM initially used a futures contract on monthly basis to hedge the 10-year forward contract. The hedging position was used as a cover to reduce the negative impact of rising prices of oil. However, the oil prices declined and the continuous loss from the exposure resulted to loss of $900 million. Biggins and Scott (2012) stated that stack and roll strategy is only viable if the market is in backward position. MGRM was not able to comprehend the change in market conditions, which might hamper its overall profitability. The contract was initiated by MGRM when the market was in backwardation position, which helped in generating higher profits. However, the change in derivate strategy resulted in huge looses, which liquidated all the forward and future contrast held by MGRM. Reference: Battiston, S., Caldarelli, G., Georg, C.P., May, R. and Stiglitz, J., 2013. Complex derivatives.Nature Physics,9(3), pp.123-125. Biggins, J. and Scott, C., 2012. Public-private relations in a transnational private regulatory regime: ISDA, the state and OTC derivatives market reform.European Business Organization Law Review,13(03), pp.309-346. Lakshmi, K.B., Saraswathi, S., Ramakrishna, Y. and Director, R.K., 2013. Performance of Financial Derivatives (Futures) in Indian Capital Market.Development,25, p.26th. Rauterberg, G. and Verstein, A., 2013. Assessing transnational private regulation of the OTC derivatives market: ISDA, the BBA, and the future of financial reform.Va. J. Int'l L.,54, p.9. Thetradenews.com. (2016).Lehman collapse spurs change in OTC derivatives trading | The Trade. [online] Available at: https://www.thetradenews.com/news/Asset_Classes/Derivatives/Lehman_collapse_spurs_change_in_OTC_derivatives_trading.aspx [Accessed 17 Nov. 2016].