At the height of the Financial Crisis of 2007–2008, Lehman Brothers, one of the world’s oldest and largest investment banks with assets upwards of $600 billion, toppled.
When & How Did Lehman Brothers Collapse?
Its spectacular implosion happened during an already turbulent time for financial markets and only added fuel to the fire. On September 15, 2008, Lehman Brothers filed for Chapter 11 bankruptcy—the largest in U.S. history—citing $613 billion in debts on assets of $639 billion.
By the end of the day, the Dow Jones Industrial Average lost 500 points, marking its lowest close since the September 11, 2001, terrorist attacks. The next day, AIG, the world’s largest insurance company, which had $400 billion credit default swaps with Lehman Brothers and an additional $6 trillion with other banks, also threatened to go under.
Declaring AIG “too big to fail,” the Federal Reserve sent the insurer an $85 billion emergency bailout while Congress debated whether or not to provide taxpayer-funded assistance to other financial institutions. But when the U.S. House of Representatives vetoed the $700 billion “Bailout Bill” on September 29, 2008, the stock market crashed as the Dow tumbled another 700 points, ushering in a steep, 2-year recession known as the Great Recession. Facing mounting pressures, Congress eventually approved the bill, officially known as the Troubled Asset Relief Program, on October 3, 2008.
Lehman Brothers was the poster child of the excessive borrowing, risky lending, and lack of transparency that had characterized the era. The crisis itself had stemmed from the collapse of the U.S. housing bubble, which had inflated to dangerous proportions due to irresponsible lending in the form of risky, subprime mortgages.
Fueled by easy credit and seemingly limitless demand, investment banks like Lehman Brothers had assumed more and more risks with the expectation of even bigger rewards. These banks were so interconnected that when a problem emerged at one, the entire financial system became threatened.
But no one thought Lehman Brothers would fail. In testimony to the Financial Crisis Inquiry Commission (FCIC), a national commission on the causes of the crisis, Harvey Miller, the bankruptcy counsel for Lehman Brothers, said that the hedge funds “expected the Fed to save Lehman,” based upon its history of bailing out other troubled institutions, as it had with Long Term Capital Management in 1998.
And while regulators had held emergency eleventh-hour meetings to try to secure a buyer for Lehman, ultimately, they weren’t successful, and the investment behemoth collapsed. Yet, the bailout of Lehman’s main insurer, AIG, as well as the rescue of other investment banks, such as Bear Stearns, left some wondering why Lehman was sacrificed.
What Is the History of Lehman Brothers?
Three brothers, Henry, Emanuel, and Mayer Lehman, immigrated from Rimpar, Bavaria, to Montgomery, Alabama, in the 1840s. It was the Antebellum South, and the Lehmans owned slaves; they opened a dry-goods store but also traded commodities, like cotton, which brought them financial success.
The Lehman Brothers opened their first brokerage in New York City in 1858. After the Civil War, they helped found the New York Cotton Exchange and became underwriters of major IPOs like the International Steam Pump Company. Their business dealt with venture capital and survived the Great Depression; through subsequent mergers and acquisitions, Lehman Brothers would become one of the largest investment banks in the country.
Why Did Lehman Brothers Fail?
Lehman Brothers specialized in trading—and minting profits—from collateralized debt obligations, which were securities containing thousands of risky, subprime mortgages. Geared toward low-income and minority homebuyers who were targeted by predatory lenders, subprime mortgages contained adjustable rates of interest that rose sharply after a low introductory period—often by several hundred dollars a month.
Unable to afford these higher rates, millions of Americans defaulted on their mortgages, unleashing a tsunami of destruction through the housing market, stock market, and economies around the globe.
Initially, banks had pooled the toxic subprime loans into interest-bearing securities, while investment banks had packaged these securities into “private label” CDOs, which were sectioned into tranches based on their risk level. During the housing boom of the early 2000s, the market for these securities exploded from $30 billion in 2003 to more than $225 billion by 2006.
Not only was Lehman Brothers a major player in trading derivatives based on subprime mortgages; it was also one of the first Wall Street firms to get into the mortgage origination business. Doing so guaranteed it with a supply of loans that it could securitize and trade, essentially providing an endless supply of profits—so long as the homeowners paid their mortgages.
Lehman Brothers acquired six mortgage-lending companies between 1998 and 2004; in 2007, it was even lauded for its acquisition of an “innovative” collateralized debt obligation underwritten by synthetic assets that it had purchased for $400 million from Airlie Capital Management.
By then, trouble had been brewing in the housing market. Delinquency rates on subprime mortgages were ascending to astounding highs: 14.5% in 2007 and then 21% in 2008.
The country’s five biggest investment banks (Bear Stearns, Goldman Sachs, Lehman Brothers, Merrill Lynch, and Morgan Stanley) had become incredibly overleveraged—according to the FCIC report, they were leveraged by a ratio of 40:1, which meant that for every $40 in assets they had, there was only $1 in capital to cover their losses.
By the end of 2008, 91% of CDOs had been downgraded to junk status by credit-ratings agencies. Credit spreads tightened, and CDOs tanked. Investment banks reported huge quarterly losses, confidence plummeted, and banks became less willing to lend, causing credit markets to seize up. When all was said and done, more than seven trillion dollars were wiped out forever.
Could Lehman Brothers Have Been Saved?
In the first half of 2008, Lehman Brothers' stock plummeted by almost 75%. The company reported second-quarter losses of $2.8 billion as well as an executive restructuring. By August, it had laid off nearly 10% of its 25,000-person workforce.
Korea Development Bank, owned by the government of South Korea, had expressed an interest in acquiring Lehman Brothers, but by September, it had withdrawn its interest due to government resistance and a lack of investment partners. Lehman’s stock tanked another 45%. The company announced a third-quarter loss of $3.9 billion on September 10, as well as plans to sell its key business holdings.
U.S. Treasury Secretary Hank Paulson, President of the Federal Reserve Bank of New York Timothy Geithner, and a consortium of Wall Street executives, including CEO of JPMorgan Chase Jamie Dimon, held emergency talks over the weekend of September 13 to try to save Lehman.
First, they tried arranging a sale to Bank of America. When BoA instead announced it would be acquiring Merrill Lynch, the consortium attempted to partition the “good” and “bad” assets of Lehman and sell the “good” (i.e., non-privately financed) to the UK-based bank, Barclays, but ultimately, British regulators disapproved of the deal.
The Fed’s hands were tied—or were they?
Testimony from then-Fed Chairman Ben Bernanke declared it was legally impossible for the Fed to bail out Lehman Brothers, saying, “I will maintain to my deathbed that we made every effort to save Lehman, but we were just unable to do so because of a lack of legal authority.”
But critics contended that asserting emergency lending was, in fact, a mandate of the Federal Reserve as outlined under section 13 (3) of the Federal Reserve Act.
After an examination of the Act, the FCIC weighed in on the Fed’s side:
Under section 13 (3), the authority to lend under that provision is very broad. It requires not that loans be fully secured but rather that they be “secured to the satisfaction of the Federal Reserve Bank. Indeed, in March 2009, Federal Reserve General Counsel Scott Alvarez concluded that requiring loans under 13 (3) to be fully secured would “undermine the very purpose of section 13 (3), which was to make credit available in unusual and exigent circumstances to help restore economic activity.” —Financial Crisis Inquiry Commission Report, 2011
Others believed that the Fed allowed Lehman Brothers to fail because their attention that weekend was diverted to an even bigger systemic risk—AIG’s collapse.
In an examination of Lehman’s balance sheets, Fed analysts believed that the company had overvalued its assets by around $15–$25 billion, although it still might be a candidate for a bailout. Lehman Brothers CEO Richard Fuld later countered this assertion by stating, “As of August 31, 2008, two weeks prior to the bankruptcy filing, Lehman had $26.7 billion in equity capital. Positive equity of $26.7 billion is very different from the negative $30 or $60 billion ‘holes’ claimed by some.”
However, as analysts worked on their estimates, Geithner was dispatched to handle the AIG crisis, and so they had to deliver their findings to other team members in his place. The New York Times reported that Geithner never heard these results.
At 1:45 AM on September 15, 2008, Lehman Brothers announced its bankruptcy.
