Financial Risk Manager Part 1
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In the lead-up to the 2007/2009 financial crisis, Lehman Brothers had positioned itself as the leading institution in the mortgage-backed securities market. Which of the following best explains why the firm failed so spectacularly despite boasting huge amounts of capital?
Other
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TTanishq
A
The firm was highly leveraged, reducing its ability to absorb losses
B
A large number of the firm's mortgage-backed securities were built upon sub-prime mortgage assets
C
The firm was considered too big to fail
D
A lack of confidence among investors which in turn led to a lack of funding
Explanation:
Explanation
Lehman Brothers' failure was primarily due to its high leverage, which significantly reduced its ability to absorb losses.
Key Points:
- Leverage refers to the use of borrowed funds to finance asset purchases
- Lehman had taken on excessive short-term debt to finance long-term assets
- This strategy exposed the firm to serious liquidity problems
- When the housing bubble burst, asset values plummeted, causing substantial losses
- High leverage meant limited capacity to absorb these losses
- Unable to meet debt obligations, leading to bankruptcy
Why Other Options Are Incorrect:
Choice B: While Lehman had significant exposure to sub-prime mortgage assets, this was not the primary reason. Many institutions had similar exposure but didn't fail - the key difference was Lehman's leverage level.
Choice C: The "too big to fail" concept didn't apply here - Lehman was allowed to fail without government intervention or bailout.
Choice D: Lack of investor confidence was an outcome, not the primary cause. It was triggered by the high leverage and subprime exposure.
Key Risk Management Lesson:
High leverage amplifies losses and reduces a firm's ability to withstand market downturns, making it a critical risk factor that must be carefully managed.
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