📝 Original Info
- Title: The Lehman Brothers Effect and Bankruptcy Cascades
- ArXiv ID: 1002.1070
- Date: 2011-10-18
- Authors: Researchers from original ArXiv paper
📝 Abstract
Inspired by the bankruptcy of Lehman Brothers and its consequences on the global financial system, we develop a simple model in which the Lehman default event is quantified as having an almost immediate effect in worsening the credit worthiness of all financial institutions in the economic network. In our stylized description, all properties of a given firm are captured by its effective credit rating, which follows a simple dynamics of co-evolution with the credit ratings of the other firms in our economic network. The dynamics resembles the evolution of Potts spin-glass with external global field corresponding to a panic effect in the economy. The existence of a global phase transition, between paramagnetic and ferromagnetic phases, explains the large susceptibility of the system to negative shocks. We show that bailing out the first few defaulting firms does not solve the problem, but does have the effect of alleviating considerably the global shock, as measured by the fraction of firms that are not defaulting as a consequence. This beneficial effect is the counterpart of the large vulnerability of the system of coupled firms, which are both the direct consequences of the collective self-organized endogenous behaviors of the credit ratings of the firms in our economic network.
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Deep Dive into The Lehman Brothers Effect and Bankruptcy Cascades.
Inspired by the bankruptcy of Lehman Brothers and its consequences on the global financial system, we develop a simple model in which the Lehman default event is quantified as having an almost immediate effect in worsening the credit worthiness of all financial institutions in the economic network. In our stylized description, all properties of a given firm are captured by its effective credit rating, which follows a simple dynamics of co-evolution with the credit ratings of the other firms in our economic network. The dynamics resembles the evolution of Potts spin-glass with external global field corresponding to a panic effect in the economy. The existence of a global phase transition, between paramagnetic and ferromagnetic phases, explains the large susceptibility of the system to negative shocks. We show that bailing out the first few defaulting firms does not solve the problem, but does have the effect of alleviating considerably the global shock, as measured by the fraction of fi
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The largest financial crisis since the great depression started in 2007 with an initially well-defined epicenter focused on mortgage backed securities (MBS). It has since been cascading into a global economic recession, whose increasing severity and uncertain duration has led and is continuing to lead to massive losses and damage for billions of people. This crisis has brought to the attention of everyone the concept that risk can be endogenous and can cascade as a growing avalanche through the financial and economic system. This is the opposite of the assumption held previously by many regulators, credit agencies and bankers that risks can be managed by using models essentially focusing on the risk of each single institution, and by combining them using assumptions of inter-dependencies calibrated in good times. The unveiled systemic nature of financial risks makes now clear the need for global approaches including economic and financial networks and modeling the collective behaviors that results from the coupling between institutions, firms, financial products and so on.
a e-mail: psieczka@if.pw.edu.pl b e-mail: dsornette@ethz.ch c e-mail: jholyst@if.pw.edu.pl During the development of the crisis in 2008, a succession of problems unfolded, the most prominent ones being associated with names such as Bear Stearns, Fannie, Freddie, AIG, Washington Mutual, and Wachovia. Except for the famous bankruptcy of Lehman Brothers Holding Inc., all the other “too-big-to-fail” financial institutions and insurance companies were bailed out, while thousands of smaller banks have been left alone to undergo bankruptcy.
We propose here a minimalist framework to account for the observed cascade of defaults, which incorporates the impact of changes of beliefs in credit worthiness of a given firm, resulting from the change of credit worthiness of other institutions in the same economic network. In this way, we are able to account for the cascade phenomenon, and explain how small changes can lead to dramatic consequences, all the more so, the more coupled is the economic network and the larger is the number of firms. Our framework allows us to also analyze the so-called “Lehman Brothers” effect, i.e., the crash on the stock market and the subsequent panic among financial institutions, following its filling for bankruptcy on 15 September 2008. We account for this aftermath by introducing a global field influencing every firm by enlarging the probability of rating downgrade, which embodies the psychological impact of the destruction of trust among institutions, which sud-denly realized that, after all, the US Treasury and the Federal Reserve might not bail them out. The abrupt drop in confidence led to a drop in credit supply and to the major recession. Finally, we investigate, within our set-up, the effect of a simple bail-out policy consisting of accepting to rescue a certain number of defaulting firms. We find that this rescue policy is the most efficient when the economy is functioning at its most vulnerable state of critical coupling between its constituting firms.
Many models have been proposed to investigate the effects of credit contagion on the default probability of individual firms. Motivated by the accounting scandals at Enron, Worldcom and Tyco, Giesecke [12] developed a structural model of correlated multi-firm default, in which investors update their belief on the liabilities of remaining firms after each firm default, which leads to contagious jumps in credit spreads of business partners. Eisenberg and Noe created a model of contagion in a network of liabilities [10]. When an agent cannot fulfill its obligation, it defaults and the loss propagates along the network. Propagation of this distress can trigger off another defaults by contagion. Battiston et al. [5] studied a simple model of a production network in which firms are linked by supplycustomer relationships involving extension of trade-credit. They recover some stylized facts of industrial demography and the correlation, over time and across firms, of output, growth and bankruptcies. Delli Gatti et al. [8] studied the properties of a credit-network economy characterized by credit relationship connecting downstream and upstream firm through trade credit and firms and banks through bank credit. They included a change in the network topology over time due to an endogenous process of partner selection in an imperfect information decisional context, which leads to an interplay between network evolution and business fluctuations and bankruptcy propagation. The bankruptcy of one entity can bring about the bankruptcy of one or more other agents possibly leading to avalanches of bankruptcies. Azizpour et al. [4] developed a self-excited model of correlated event timing to estimate the price of correlated corporate default risk. Sakata et al. [30] introduced an infectious default and recovery model of a large set of firms coupled through credit-debit contracts and
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