The Sixth Anniversary of Lehman’s Collapse

Six years ago this month Lehman Brothers, a 158-year-old institution and one of the nation’s five largest investment banks, went bankrupt. Its demise produced the equivalent of a global financial blackout and marked the beginning of the biggest economic crisis since the Great Depression.

It was also completely avoidable.

Six years after Lehman’s collapse, the economy is still reeling.  In July, more than 10 million Americans were unemployed and another 9.8 million were underemployed. The labor participation rate of 62.9 percent is the lowest since 1978.

Lehman Brothers had become increasingly reliant on fixed-income trading and mortgage securities underwriting.  This went hand-in-hand with an increase in its leverage ratio, from 24 to 1 in 2003 to 44 to 1 in 2007.   Since much of this leverage took the form of very short-term debt, Lehman had to continuously sweet talk its lenders about the “solid value” of the assets it had pledged as collateral for these “here-today-gone-tomorrow” loans.

But this sweet talk was undermined by continued erosion of the housing and mortgage markets during the summer of 2007.  After Lehman’s stock price fell 37 percent from June to August, the firm closed its sub-prime mortgage arm, wrote off $3.5 billion in mortgage-related assets and laid off more than 6,000 employees by the end of the year.

Things only got worse in 2008.  In January, Lehman closed its mortgage lending unit and laid off another 1,300 employees in a vain attempt to stem further cash hemorrhages from its sub-prime mortgage operations.

After Bear Stearns collapsed in March, Standard & Poor’s rating arm downgraded its outlook on Lehman from “Stable” to “Negative” on the expectation that its revenues would decline by at least another 20 percent. That caused Lehman’s stock price to plunge by an additional 48 percent.

Lehman attempted to counter this by selling $4 billion in convertible preferred stock. But this fresh cash was quickly soaked up by more write-offs, including Lehman’s $1.8 billion bailout of five of its short-term debt funds.  Ravenous short-sellers (the “Vultures of Capitalism”) began circling and rumors flew that other firms were refusing to trade with Lehman.

With its common stock in virtual free fall, Lehman contemplated taking itself private, but the idea was abandoned when it became clear that the necessary financing wasn’t available. An effort to locate buyers for $30 billion of its commercial mortgages (such as office buildings and shopping malls) met with a similar fate.

The federal government had to step in if Lehman was to be saved. But any such move was complicated by the enormous public outcry that had arisen over the $29 billion “federal bailout” of Bear Stearns that March.  Voices from all sides of the political spectrum screamed about the feds using taxpayer funds to bail out big Wall Street firms that had caused the mess, while refusing to lift a finger to help American families who were losing their homes.

Since a presidential election loomed in a matter of weeks, Treasury and the Federal Reserve felt that nothing short of a Congressional directive to “save Lehman” would allow them to move. But the Bush administration did not approach Congress and the federal government was reduced to trying unsuccessfully to convince other financial giants to bailout Lehman.

On September 15, 2008, Lehman filed the largest Chapter 11 bankruptcy in American history to that point, listing assets of $639 billion and liabilities of $768 billion and leaving its viable businesses to be snapped up at fire-sale prices by sharp-eyed bottom feeders. The federal government’s inaction is generally regarded as its most disastrous financial decision since the early 1930s.

In retrospect, it was political fallout from the Bear Stearns collapse that proved to be Lehman’s death knell. The feds underestimated the impact Lehman’s demise would have on capital and credit markets.  Only after the true scope of the problem became clear in the subsequent days and weeks did the feds go to Congress to request the controversial $700 billion Troubled Asset Relief Program to protect other troubled banks from insolvency.

gigliojJoseph Giglio
Senior Academic Specialist and Executive Professor of General Management 

 

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