Lehman Brothers Collapse

The Lehman Brothers collapse of September 15, 2008, was the largest bankruptcy in US history. Lehman, a 158-year-old investment bank that had survived the Great Depression, was crippled by enormous losses on mortgage-backed securities. Unable to raise capital or find a merger partner and with the Federal Reserve unwilling to provide a rescue, Lehman filed for bankruptcy. The collapse sent shockwaves through global financial markets and accelerated the financial crisis.

Lehman’s accumulation of mortgage exposure

Lehman Brothers had grown into one of the world’s largest investment banks by 2007. The firm, like many investment banks, had accumulated enormous positions in mortgage-backed securities, commercial real estate loans, and related derivatives, betting on the perpetual appreciation of real estate and the stability of mortgage markets.

By 2008, as housing prices began to fall and subprime defaults accelerated, Lehman’s positions deteriorated. The firm reported losses of roughly $3 billion in the second quarter of 2008, then larger losses in the third quarter. Its capital base, already depleted, was shrinking rapidly.

The failed rescue

In mid-September 2008, with Lehman’s stock price in freefall and clients withdrawing deposits, the Federal Reserve and the Treasury attempted to arrange a rescue. The hope was to find another bank willing to acquire Lehman, with government support if necessary.

Barclays, a UK bank, initially expressed interest but withdrew when the UK Financial Services Authority refused to allow the transaction without explicit government guarantees. Other potential acquirers also withdrew. The Fed was unwilling to provide an open-ended bailout, having exhausted its patience with Bear Stearns earlier in the year.

The bankruptcy and the shock

On September 15, 2008, Lehman filed for bankruptcy. The bankruptcy was unprecedented in size — roughly $619 billion in assets, far exceeding the Enron bankruptcy.

The shock to global markets was immediate and severe. Lehman had counterparties worldwide: banks that had transacted derivatives with Lehman, clients that had deposits at Lehman, investors that held Lehman bonds. The bankruptcy threw all of these into question. Did the counterparty still exist? Would contracts be honored? Were deposits safe?

The uncertainty triggered a systemic crisis. Money market funds, supposedly ultra-safe, revealed losses (a prominent money market fund “broke the buck,” meaning its value fell below $1.00 per share). Credit markets froze entirely. The commercial paper market, crucial for short-term business financing, ceased functioning. Banks stopped lending to each other.

The global contagion

The Lehman collapse had global consequences. Banks worldwide faced losses on Lehman debt and derivatives. Credit markets in Europe began to seize. The financial system was on the verge of complete collapse.

The Lehman failure convinced policymakers that no large financial institution could be allowed to fail without government support. Within days, the Federal Reserve announced unprecedented lending facilities and the Treasury announced TARP, the $700 billion bank bailout program.

The legacy of the decision not to rescue

The decision to allow Lehman to fail, rather than to rescue it as the Fed had done with Bear Stearns months earlier, remains controversial. Some argue that the Fed had no choice — there was no obvious acquirer, and unlimited bailouts create moral hazard. Others argue that the Fed’s failure to rescue Lehman accelerated the panic and made the financial crisis much worse than necessary.

Economists and policymakers have since concluded that the Lehman collapse was a critical turning point in the crisis. The shock to confidence and the systemic stress that followed demonstrated that large financial institutions could not be allowed to fail unexpectedly.

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