The Lehman Brothers Collapse

What Is The Lehman Brothers Collapse?

The collapse of Lehman Brothers in September 2008 was the largest instance of corporate bankruptcy in American history.^[1] The firm's failure is generally regarded as the seminal event of the global financial crisis, which triggered the Great Recession that followed. The effects are still being felt today in the form of weak economic growth and unprecedented central bank intervention in the global economy and financial markets.

The firm's demise was largely caused by a huge, ill-timed foray into subprime mortgage lending. Lehman made a large investment in the business, acquiring several large lenders, just as millions of homeowners began to default on their loans, the result of shoddy underwriting and by originators making loans to people with poor credit, low equity, and often both.^[2]

Lehman Brothers Beginnings

The firm got its start in 1844 in Montgomery, Alabama, as a general and dry-goods store founded by Henry Lehman, a German immigrant. The company took on the name Lehman Brothers in 1850 after he was joined in the business by siblings Emanuel and Mayer.

From there the firm grew into one of the largest investment banks on Wall Street, surviving various financial panics in the late 1800s, the Great Depression, two World Wars and several economic recessions over the next 150-plus years. But it was not to survive the subprime mortgage crisis, of which it was both a major perpetrator and its largest corporate casualty.^[2]

Subprime Mortgages

In the early 2000s, many U.S. lenders piled into the subprime mortgage business, lending money to people with spotty credit histories or with small or no down payments—and sometimes both. The business attracted Wall Street investment banks, which first underwrote and sold securities backed by the mortgages while others got into the origination business as well. Lehman Brothers was the most aggressive firm in both areas.^[2]

Not only was it the largest underwriter of mortgage-backed securities, but in 2003 and 2004 it bought five subprime mortgage lenders. These include:

• BNC Mortgage, which specialised in lending to people with weak credit
• Aurora Loan Services, which focused on so-called Alt-A loans, which were made to borrowers who could not—or would not—fully document their incomes or their ability to repay their loans.^[1]

This business model worked well for several years. Lehman became one of the fastest-growing investment banking and asset management firms in the country. In 2007 the firm reported a record US$4.2 billion of net income on just US$19.3 billion in revenue. It was even voted the "most admired securities firm" by Fortune magazine that year.^[3]

What Caused The Collapse?

Eventually, the Lehman Brothers' house of cards began to collapse. More and more homeowners defaulted on their loans, which meant securities backed by those loans began to lose value, as did home values themselves across the country. As the biggest player in both ends of the business, Lehman took the biggest fall and sustained huge losses not only on the securities it underwrote and traded but also on the origination side.

In March 2018 Bear Stearns, the second-largest underwriter of subprime mortgage loans after Lehman, nearly failed before it was acquired at a fire-sale price by JPMorgan Chase with the assistance of the U.S. Federal Reserve.

When Lehman was unable to find a buyer, it was forced to file for bankruptcy protection, with US$639 billion in assets and US$619 billion in liabilities. The remaining parts of Lehman Brothers were sold off in pieces. Barclays acquired its New York City-based core business while Japan-based Nomura Securities bought its businesses in Europe, Asia and the Middle East.^[1]

Aftermath Of The Collapse

Lehman was hardly the only casualty. The firm's problems also nearly brought down American International Group (AIG), one of the largest insurance companies in the world. AIG was the largest seller of credit default swaps—basically, insurance against a corporate borrower defaulting on its debt—for Lehman Brothers and other firms with large subprime mortgage exposure.

When Lehman went bankrupt, AIG was unable to cover all the credit default swaps it had written and was eventually rescued by the U.S. Treasury and the Fed. This was the first time the government stepped in to save a private insurance company.

To this day, some people—not least of whom are former Lehman executives—argue that the government should have rescued Lehman, as it did with AIG, or merge it with a healthier company, as it did with Bear Stearns.

While the wisdom of whether it should have been rescued or not is a moot point more than 10 years after the fact, it's probably not indisputable that Lehman Brothers is the poster child of the global financial crisis and the Great Recession. It led to the passage of the Dodd-Frank Financial Reform Act of 2010, which, among other things, forced U.S. commercial banks to hold more capital and lenders to more carefully underwrite mortgage and consumer loans.

Indeed, despite more than a decade passing since Lehman's demise, the subprime mortgage business is still largely nonexistent and the private mortgage-backed securities business moribund.

Summary

Lehman Brothers was one of the largest Wall Street investment banks before it failed spectacularly in 2008, largely triggering the global financial crisis and the Great Recession that followed. The firm was one of the most aggressive originators of subprime mortgage loans in the U.S. as well as one of the largest underwriters of securities backed by those loans. When many borrowers started to default on those loans, Lehman was the biggest casualty and eventually filed for bankruptcy.

Lehman's collapse had a domino effect that nearly brought down AIG, a large insurance company that had written billions of dollars of credit default swaps to protect investors against a Lehman default. While AIG and several large commercial banks were rescued by the U.S. government or merged with other companies, Lehman was not.