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Lehman's Clear Lesson

NEW YORK ( TheStreet) - If you ask almost anyone in a position to know whether Lehman Brothers was "too big to fail," the overwhelming response is something akin to "obviously."

"Lehman was definitely too big to fail," says Lawrence McDonald, a former vice president at the defunct investment bank, when asked whether the collapse of 10 "mini-Lehmans" would have had the same effect. "If smaller banks went down, it wouldn't have anywhere near the impact on the global markets."

Michael Driscoll, a former senior managing director at Bear Stearns' trading desk notes that Lehman's enormous leverage ratio, in effect, made the bank 30 times bigger than itself. "Lehman was in a very tenuous position. It was just a matter of time before, in a bad situation, all that leverage was going to come back to bite you in the rear," says Driscoll, who is now a visiting professor at Adelphi University.

Indeed, at $700 billion, Lehman's balance sheet was big and so was its failure - representing the largest bankruptcy in history. During the S&L crisis of the late-80s and early 90s, thousands of regional banks failed across the country without having nearly as severe an impact on financial markets as Lehman did. Other large investment banks have collapsed throughout the years, too, which pale in comparison to the Lehman debacle.

As Christopher Cox, the Securities and Exchange Commission chairman at the time of Lehman's failure put it: "It has been a fact of life in Wall Street's history that investment banks can and will fail. Wall Street is littered with the names of distinguished institutions -- E.F. Hutton, Drexel Burnham Lambert, Kidder Peabody, Salomon Brothers, Bankers Trust, to name just a few -- which placed big bets and lost, and as a result ended up either in bankruptcy or being sold to save themselves."

McDonald also notes that the scale of crises increased by a factor of 10 between the S&L crisis and the devastating near-collapse of the hedge fund Long Term Capital Management in 1998. But during the decade between LTCM and Lehman, the scale of financial damage increased by a factor of 100.

Yet it might be more accurate to say that Lehman Brothers was actually too opaque to fail, not too big.

Philipp Schnabl, an assistant finance professor at New York University's Stern School of Business, uses the example of the Reserve Primary Fund, a $60 billion money-market fund that "broke the buck" shortly after Lehman's failure because of its exposure to the investment bank's debt securities. While the fund wasn't the largest in the industry, panic quickly spread across all types of money-market funds, forcing the Federal Reserve to put a temporary backstop on the $3 trillion industry.
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