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Monday, October 6, 2008

What happened to Lehman Brothers?

An investment bank doesn't deal with the general public - people like you and I, but instead with companies. Retail banks, which deal with 'small' customers like us, lent money to people for mortgaged property. Now, retail banks don't have unlimited money - they need to finance their deals. So, they contact investment banks, to help them arrange for the money. Essentially, an investment bank is supposed to be a middleman between an investor (like an insurance firm) and a customer like a retail bank.

But, the investment banks found the deal so lucrative that they decided to invest their own money, instead of looking for investors. After all, who doesn't want profits?

After the sub-prime crisis, the value of these 'packages' plummeted, and the investment banks lost billions of dollars. (This dealing with one's own money is called 'proprietary trading' in the industry.)

These losses destroyed their capital, and share prices dipped. Hence, banks could not even generate money through their shareholders, and this led to their collapse.

Goldman Sachs and Morgan Stanley are still surviving, and more will be known about them soon.

However, even if they sink, investment banking will not be dead and buried. Huge retail banks like Citi, JPMorgan Chase, Bank of America etc. have i-banking arms, which are more stable, because these banks have massive reserves of their own money.Yes, i-banking will be more regulated, but it'll still live on.


ramaa said...

Hey, there's a very nice cartoon strip which illustrates the whole i-bank collapse routine, from the individual borrower all the way to teh i-bank. Mansi Chandra of BM sent it to the xlri 2008-10 Google group. You may want to hyperlink that here; it'd make a nice, relevant addition.
Just a suggestion. :)