Why Lehman Brothers was allowed to fail
In a departure from its strategy on other banks, the US Federal Reserve refused to assume any of the risk faced by potential buyers. That decision had massive repercussions
The headquarters of Lehman Brothers in New York on September 15th, 2008, the day the bank filed for bankruptcy.
W hen Lehman Brothers filed for bankruptcy on September 15th, 2008, the financial sector shook across the world. The bank was forced to seek Chapter 11 bankruptcy protection, the largest ever such filing in US history.
Six months previously, Bear Stearns had faced a similar fate but survived when the US central bank, the Federal Reserve, intervened with the US treasury department’s support. Why did the US government not intervene in the Lehman case?
In the case of Bear Stearns, the Fed engineered a sale to JPMorgan Chase by agreeing to assume $29 billion of the risk of losses from Bear Stearns. When potential purchasers of Lehman sought similar assurances from the Fed, the regulator demurred, and the bank was left with little choice but to file for bankruptcy.
According to Lehman’s bankruptcy examiner, Lehman’s business model was not unique. All of the major investment banks of the time had some high-risk model that required the confidence of counterparties.
While Lehman’s assets and liabilities of about $700 billion cancelled each other out, it had insufficient hard cash (about $25 billion) to meet its needs. Confidence in the institution was so low that clients were withdrawing funds at a rate the bank couldn’t keep up with.
Lehman funded itself through the short-term money markets and had to borrow tens of hundreds of billions of dollars in those markets each day from counterparties to be able to open for business. Confidence was critical.
Lehman’s problems began when it embarked on an acquisition spree of subprime mortgage lenders. These were lenders who provided loans to those with impaired credit ratings. Lots of Americans got loans that they couldn’t afford.
In 2006, Lehman made the deliberate decision to embark on an aggressive growth strategy, to take on significantly greater risk. In 2007, as the subprime residential mortgage business progressed from problem to crisis, Lehman was slow to recognise the developing storm and its spillover effect on commercial real estate.
Rather than pull back, Lehman made the conscious decision to double its bet, and significantly and repeatedly exceeded its own internal risk limits.
With the implosion and near collapse of Bear Stearns in March 2008, it became clear that Lehman’s growth strategy had been flawed, so much so that its survival was now under threat.
The markets were shaken by the Bear Stearns crisis. Lehman, an independent investment bank, was widely considered to be the next bank that might fail. To buy more time, Lehman painted a misleading picture of its financial condition.
After Bear Stearns’s near-collapse, the US government sent in teams of monitors from the Securities and Exchange Commission and the New York Federal Reserve Bank. As late as September 2008, Lehman told the markets that it had liquidity of $41 billion. In fact, the pool of assets it could readily monetise was just $2 billion.