Why did Lehman Brothers fail?

In the wake of recent bank failures in Switzerland and the United States, a retrospective on the 2008 fall of Lehman Brothers is timely. To avoid another banking collapse, it’s worth looking at what caused Lehman to fail and trigger the most severe financial crisis in history.

This month marks the 15^th anniversary of the failure of the Wall Street investment bank Lehman Brothers. The resulting global financial crisis, engulfed by the subprime meltdown, roiled financial markets around the world and led to a loss of around $10 trillion in global economic output (US Government Accountability Office, 2013).

The demise of this giant of the industry – founded in 1847 – was a turning point in the global financial crisis of 2007-09. It was also pivotal in the subsequent overhaul of banking regulations.

What happened?

At the time, Lehman’s collapse represented the largest corporate failure in US history. It was around six times bigger than the largest previous failure (see Table 1).

In addition, this bankruptcy was emblematic of a devastating loss of trust in both the financial system and regulators. The then chair of America’s central bank, the Federal Reserve (‘the Fed’), Ben Bernanke, called the financial upheavals following Lehman’s failure ‘the worst financial crisis in global history, including the Great Depression’.

Table 1: The top 10 largest US public company bankruptcies, 1980 to 2008

Source: New Generation Research, Bosto
Note: Financial services firms in italics.

Should we really care about the 15^th anniversary of the collapse of Lehman Brothers?

Yes, we should. Lehman was not deemed to be a particularly important financial institution systemically, and it was not ‘even’ insolvent when it failed. Indeed, the main long-term solvency ratios, since 2003, were not indicating any concerns about the bank’s solvency or economic default (see Table 2).

Table 2: Lehman’s long-term solvency ratios, 2003 to 2008Q2

Source: S&P Capital IQ

The balance sheet in Table 3 illustrates the trend of Lehman’s financial position before filing for bankruptcy. It reveals that it was not vulnerable to an expected failure.

Further, in term of its systemic importance, it was ranked the sixth most systemically risky financial institution in first quarter of 2008, accounting for only 9% of the aggregated systemic risk in the US financial market.

In contrast, Citigroup was the most systemically important bank in the United States, accounting for 17% of the aggregated systemic risk (see Table 4).

Table 3: Lehman’s stylised balance sheet for 2008Q1

Source: S&P Capital IQ
Note: Figures are expressed in millions of US dollars.

Table 4: The top 10 systemic US financial bankruptcies by SRISK%, 2006Q1 to 2008Q1

Source: V-Lab Stern NYU and Brownlees and Engle, 2017

This raises the broader question of how a 160-year-old financial institution – the fourth largest investment bank in the United States, holding $639 billion of assets and $613 billion of liabilities, with a market value of around $45 billion – could collapse abruptly over a weekend.

There is no single and straightforward answer. Rather, there were multiple, and complex, causes. The short answer was that Lehman was illiquid and lacked sufficient collateral to borrow enough from the Fed or to renew the repurchase agreement contracts (repos) to avert collapse.

Surprisingly, just before filing for bankruptcy, Lehman was given investment-grade ratings by the big three independent rating agencies. These ratings were reflected somehow in its share price and market capitalisation, which hit their highest levels ever in 2006 (see Figure 1).

Figure 1: Lehman’s market capitalisation, 1994Q1 to 2008Q3

Source: S&P Capital IQ
Note: Figures are expressed in millions of US dollars.

Too much leverage

Lehman was highly leveraged. This was due to the adoption of an aggressive growth strategy, as well as excessive borrowing and a risk-taking business model supported by limited equity.

In the years leading up to the global financial crisis, the banking industry had been deregulated. The Glass-Steagall Act (which had separated investment and commercial banking since 1933) was repealed in 1999 under President Clinton and financial standards had become more lax.

These developments ultimately led Lehman to expand its portfolio of assets to include more risky and complex financial products, including huge subprime mortgage loans. By and large, such a strategy enabled growth. But it also brought excessive borrowing and, as a result, increasing profits while maintaining limited capital. In reality, such high leverage also magnifies potential losses.

In 2007, Lehman held a record value of $111 billion of commercial or residential real estate-related assets and securities. This was double the $52 billion that it held at the end of 2006, and around four times its equity. As such, Lehman’s leverage was tremendous, exceeding 30%, double the maximum requirements of US regulation set at 15%.

To recover the confidence of the regulators, rating agencies and financial markets, Lehman started deleveraging. The bank tried to reduce its debt liabilities as well as shrink its balance sheet by selling off assets.

It also recapitalised by raising $6 billion in additional capital in early 2008. But it still preferred faster downsizing ? by selling off assets and reducing real estate positions ? since its access to equity markets became increasingly restricted. The leverage ratios went from over 26% in 2008, up to over 32% in 2007, and to 33% a year later in the second quarter of 2008 (see Figure 2).

Figure 2: Lehman’s leverage, 2003 to 2008Q2

Source: S&P Capital IQ
Note: Leverage ratios using the standard book value approach.

Liquidity pressures

Conversely, Lehman was unsuccessful at selling off these assets at acceptable prices. This was a result of the collateral damage and the decline in house prices that sparked the uncertainty about the incidence of losses on mortgage-related assets.

Deleveraging pressures with the non-performance of subprime mortgages and the resultant defaults pushed Lehman, in late 2007 and early 2008, to sell assets at discounted prices or even at losses in order to reduce leverage.

This situation put a lot of pressure on Lehman’s liquidity. It meant that the bank was unable to meet its short-term obligations or to roll over its debts. As a result, Lehman started over-relying on the short-term wholesale funding of commercial paper loans and employing repos to manage its short-term cash liquidity.

Further, Lehman used repos to manage its balance sheet and net leverage in order to hide its leverage ratio for financial statement reporting (see Table 5). To hide its true net leverage ratio and manage its balance sheet, the bank moved more than $40 billion of assets off its balance sheet on a daily basis using repos. It then used these funds to finance its trading positions without any increase in liabilities.

Table 5: Lehman’s Repo105 transactions

Source: Valukas, 2010

Dubious management practices

By relying heavily on repos, Lehman took advantage of a loophole in financial standards, and manoeuvred its risky assets and ‘window-dressed’ their financial statements. This allowed the bank both to hide its high leverage during reporting times and to win back the confidence of investors, regulators and rating agencies.

Eventually, such deceit and the excessive use of repos resulted in a loss of confidence in the bank’s soundness. The market’s opinion of Lehman’s financial stability began to decline (see Figure 3).

Its default risk – the spread on its credit default swaps – began to rise drastically around mid-2007. On 15 September 2008, this spread hit 1,450 basis points.

Figure 3: Lehman’s stock price and default risk

Source: S&P Capital IQ
Note: LEH share price is expressed in US dollars; LEH CDS is the Lehman credit default swap (senior X1-year) mid-price expressed in basis points.

Complex capital structure

In retrospect, Lehman had reinvented itself from a traditional local bank into an investment bank, conducting complex and sophisticated global business. It was also offering risky and complex financial products in over 3,000 different legal entities worldwide.

This expansion strategy ended up contributing to the high degree of capital structure complexity. Neither bank managers nor regulators were adequately prepared to examine and assess its overall functioning and financial soundness.

Ultimately, the collapse of Lehman Brothers was a symbol of the failure of supervision and inadequacies of regulation in financial markets.

Such concerns are still reverberating in the banking sector 15 years later. Similarly unforeseen problems could make another bank failure and financial crisis more likely.