Lecture Notes on Lehman Brothers and Financial Markets

Introduction

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Lehman Brothers Financial Highlights (End of 2007)

• Net Revenues: $19 billion
• Net Income: $4 billion (not a great year, yet significant)
• Long-Term Capital: $145 billion
• Assets Under Management: $282 billion
• Major impact: 28,500 employees affected when the firm collapsed.

Key Factors Leading to Lehman Brothers’ Collapse

• Net Leverage Ratio: Indicates exposure relative to capital.
  • Example of personal leverage with mortgages.
  • Typical mortgage down payment: 20%.
  • Impact of leverage on asset value fluctuations.
• High leverage (16 to 1) and market risks.
• What happens during market downturns:
  • Small declines can lead to significant capital losses.
  • Personal examples illustrate risks associated with leverage.

Leverage and Risk Management

• Discussion on why firms leverage heavily (potential for high returns).
  • Risk becomes concerning only with high market volatility.
• Historical smooth appreciation in housing prices led to complacency in risk management.
• Mark-to-Market Accounting: Understanding real-time asset valuation.
  • Importance of recognizing asset value changes in market.

Subprime Mortgage Crisis

• The role of adjustable-rate mortgages and teaser rates in the crisis.
• Consequences for homeowners unable to meet rising payments.
• Anticipated actions from the Federal Reserve to cut rates to alleviate pressure on the system.

Bankruptcy and Market Dislocation

• Non-recourse Loans: Limitations of a lender's recovery.
• Effects of widespread defaults on housing market and financial institutions.
  • General loss of confidence leads to severe market consequences.
• Lehman’s collapse due to inability to secure backing and confidence.

Future Job Market Outlook

• Anticipation of short-term chaos in hiring due to market conditions.
• Entry-level positions may be least affected; opportunities may arise from market dislocations.
• Emphasis on preparedness for entering the finance industry during recovery periods.

Inflation and Purchasing Power Analysis

• Concept of Inflation: The purchasing power of wealth over time.
  • Differentiating between nominal and real returns.
• Mathematical framework for calculating real wealth and returns.
  • Importance of matching nominal cash flows and rates with real cash flows and rates in evaluations.

Fixed Income Securities Overview

• Introduction to fixed income securities: predictable payoffs and valuation.
• Market Size: Fixed income markets significantly larger than equity markets.
• Market Participants: Issuers, investors, and intermediaries.
• Types of Securities:
  • Treasury securities, corporate bonds, municipal bonds, mortgage-backed securities.

Valuation of Bonds

• Coupon Bonds: Defined as bonds that pay periodic interest.
• Discount Bonds: Bonds that are sold at a price lower than their face value.
• Pricing bonds involves calculating the present value of future cash flows using market interest rates.
  • The relationship between price, face value, and interest rate.

Conclusion

• Understanding the systemic risks in financial markets is crucial for future professionals.
• Emphasis on the need for a framework to evaluate financial decisions and market dynamics.

Next Steps

• Read chapters 23 through 25 of assigned textbook for better understanding of fixed income securities.