The Lehman Brothers Collapse and How It's Changed the Economy Today

In one of the most massive bankruptcies in United States history, the Lehman Brothers collapse marks its 10-year anniversary in September 2018. The firm's demise is nearly synonymous with the 2008 financial crisis, and the economy is still feeling the repercussions of its destruction. But, how did one of the largest investment banks meet its demise in such a catastrophic fashion? 

How Did Lehman Brothers Collapse? 

While there may have been several reasons for the firm's ultimate failure, it was caused in large part by the housing crisis in 2008. 

The firm survived many of the world's largest disasters, including two world wars, the Great Depression, and many crises. However, it was its over-leveraging and unwieldy venture into subprime lending that caused its ultimate downfall. 

And while the firm itself was simply one of many factors contributing to the economic disaster that was 2008 and beyond, it was perhaps the catalyst of the collapse of the banking and housing industries, and proved that even those that boast enormous success one year can be bankrupt the next. 

History of Lehman Brothers

Lehman Brothers was originally started by a German immigrant in 1844 in Montgomery, Ala. as a general and dry-goods store. Founded by Henry Lehman, the company soon was joined by his brothers Emanuel and Mayer in 1850 - getting the name the Lehman Brothers.

The firm grew to a place of prominence and power - both domestically and internationally. After owning the firm for nearly 10 years, in 1994, American Express (AXP)  spun off Lehman Brothers and created its initial public offering with a $3.3 billion capitalization. And, after the 1999 repeal of the Glass-Steagall Act, Lehman Brothers expanded their offerings (with the newfound freedom to combine commercial and investment banking activities). 

With new capacities to deal with proprietary banking, securities and asset management, Lehman Brothers expanded their services, which may have been the beginning of the end. 

2008 Financial Crisis

During the mid-2000s, the housing boom was in full force, and Lehman, like many other firms, were becoming more and more heavily involved in issuing mortgage-backed securities, MBSs, and collateral debt obligations, or CBOs. However, Lehman took it to the next level between 2003 and 2004 by extending into loan origination - acquiring, among three other lenders, BNC Mortgage and Aurora Loan Services - both of which specialized in subprime loans. 

Between 2004 and 2006, the capital markets unit surged 56% due to Lehman's real estate businesses - causing the firm to become one of the fastest-growing investment banking and asset management businesses than any other. By 2007, Lehman was reporting big numbers - with $19.3 billion in revenues and a record $4.2 billion net income. 

But things were about to take a drastic turn for the banking giant.

For several reasons, including lenders defaulting on the risky loans and unsustainable subprime mortgages, the housing market began to crash in 2006 - but, undeterred, Lehman Brothers continued increasing (doubled, in fact) its share of the real estate pie to the tune of $111 billion in assets and securities in 2007. As it became clearer and clearer, these loans were ill advised and detrimental to the health of the firms - Bear Stearns found out the hard way first. 

When Lehman Brothers' competitor Bear Stearns went under, being bought out by J.P. Morgan Chase (JMP) in a Federal Reserve-backed deal in 2008, Lehman's fate was thrown into question. Weakened by its reliance on repurchasing agreements ("repos"), which gave them short-term funding for daily operations, Lehman had to bolster the confidence of its investors in a short time - and attempted to do so by raising some $6 billion in equity in June of 2008. But this wasn't as convincing as the firm had hoped. 

By September, Lehman was announcing an expected $3.9 billion loss in its third quarter, as well as a near $5.6 billion loss in write-downs of so-called "toxic" assets. But in a desperate attempt to keep its head above water, Lehman claimed to have boosted its liquidity to around $45 billion, decreased mortgages by 20%, and reduced its  leverage factor by some 7 points. Despite these measures, after the firm announced its intention to spin off $50 billion in toxic assets to a side company in September, ratings agency Moody's (MCO) considered downgrading Lehman's debt rating, and the Federal Reserve (led by Federal Reserve Chairman Timothy Geithner) met to consider the firm's future.

In the first week of September, Lehman's stock dropped drastically - about 77%. Investors' doubts were growing as CEO Richard Fuld attempted to keep the firm afloat by selling off asset management units, trying to develop a relationship with Korea Development Bank for aid, and spinning off commercial real estate assets. Once it was clear to investors that Lehman was sinking, an upsurge in credit default swaps on its debt of some 66% and the backing-out of hedge fund investors signaled everyone was jumping ship. 

Once Moody's told Lehman that it would have to give up a majority stake of its company to investors to maintain its  ratings, the stock once again plunged around 42% on Sept. 11 - leaving Lehman with only $1 billion in cash when the week was over. 

Despite Barclays (BCS) and Bank of America (BAC) attempting to throw Lehman a life raft via a takeover, the efforts were fruitless. And by Sept. 15, 2008, Lehman Brothers declared bankruptcy, causing the firm's stock to plummet a final 93% from its standing just three days prior. 

With the collapse of one of the world's biggest and most successful banks, the markets took an unprecedented beating that is still, in some ways, being felt today. 

What Caused Lehman Brothers to Collapse? 

Fortune magazine declared Lehman Brothers as the No. 1 "most admired securities firm" in 2007 - just one year before the firm filed for bankruptcy. So how did Lehman meet its demise after being at the top of its game just one year before? 

While there were several factors contributing to its collapse, many experts seem to agree that it was in large part due to a lack of trust, over-leveraging, poor long-term investments, and shaky funding.

One of the primary causes for the firm's collapse was due to their overzealous lending during the housing bubble in 2003 to 2004. By acquiring five lending firms that focused primarily in subprime lending, Lehman was investing in a risky enterprise that, although earning a huge market capitalization in 2007 of around $60 billion, soon came crashing down due to a historic high of subprime loan defaults - and, despite the firm's assurances to the contrary, inevitably came back to bite them. The firm was over-leveraged, and the value of its mortgage portfolio was no longer compelling. 

But many have wondered at the role of the federal government's "too big to fail" policy in regard to Lehman. If Lehman Brothers was truly one of the biggest firms around, why wasn't it too big to fail? 

According to Fed Chair Ben Bernanke, Treasury secretary Henry Paulson, and Timothy Geithner, president of the Federal Reserve Bank of New York, other firms like Bear Stearns and AIG had collateral that covered the bailout, while Lehman did not. This fact, the Guardian reported earlier this week, made it "illegal" for the Fed to bail Lehman out. Still, even today, many don't think the Fed's explanation covered all the bases - in fact, according to an email sent by Paulson's chief of staff to his press secretary, things may have been slightly murkier.

"I can't do it again. I can't be Mr. Bailout." Paulson's chief of staff wrote to Paulson's press secretary, the Guardian reported. "I just can't stomach us bailing out Lehman ... will look horrible in the press, don't u think?"

But despite continued skepticism over the Fed's rationale, the bailout was Lehman's last option. 

Once there was no aid to be provided by the Fed, Lehman had to call it quits. 

The bailout snafu only heightened distrust in the Fed, which seems present still today. But despite claims that the Fed could have possibly helped keep Lehman afloat, the firm itself was responsible for its own gross miscalculations and poor risk management. 

Once Lehman went under, judge James Peck approved a deal for Barclays to acquire some of the firm's investment and capital market business (and, along with it, rescuing some 10,000 jobs). But the judge seemed to make it clear that Lehman was an exception.

"I have to approve this transaction because it is the only available transaction," Peck said in court. "Lehman Brothers became a victim, in effect the only true icon to fall in a tsunami that has befallen the credit markets. This is the most momentous bankruptcy hearing I've ever sat through. It can never be deemed precedent for future cases. It's hard for me to imagine a similar emergency."

Aftermath of the Lehman Brothers Collapse

The fallout from Lehman Brothers' collapse was nothing short of disastrous.

While other factors surely contributed to the economic turmoil that ensued, the firm's failure seemed to be the triggering element that unleashed the floodgates of widespread recession. Over an estimated 6 million jobs were lost, unemployment rose 10%, the Dow Jones Industrial Average (DOW) dropped an astounding 5,000 points, according to ABC News, as well as an international ripple effect that devastated economies in countries like Latvia, Hungary, and Lithuania (not to mention the European Union). Even Pakistan sought a bailout after the crisis from the International Monetary Fund (IMF), and Iceland faced a crisis when officials announced the government had no funds to prop up major banks in the country. 

"Lehman's bankruptcy will forever be synonymous with the financial crisis and (resulting) wealth destruction," Paul Hickey, founder of Bespoke Investment Group, told ABC News. 

But what of the repercussions of the firm's failure in the United States? 

President George Bush announced a $700 billion bail-out plan to help save what remained of the financial sector. Additionally, as consequence of the 2008 financial crisis, the Dodd-Frank Act was implemented to help increase financial regulation. 

How Lehman Brothers Collapse Caused Distrust 

Trust remained an enormous question mark following Lehman's collapse. The public, who had previously placed so much trust (and money) into "too big to fail" firms like Lehman were suddenly finding themselves skeptical of the economy altogether. Lehman's example proved perhaps a turning point in finance to a historic degree.

"That shook market confidence to its core and caused people to believe the whole system could blow up," John Garvey, head of the U.S. financial services practice at PricewaterhouseCoopers, told ABC News. "I don't think anyone fully understood the impact of confidence and what it means to the proper functioning of the system."

It seems clear that Lehman's collapse had a no less than pivotal effect on the economy - and, as Andrew Ross Sorkin wrote for The New York Times on the eve of Lehman's bankruptcy, it had "reshape[d] the landscape of American finance." 

The trust that once accompanied large financial institutions is no longer implicit.

Is Deutsche Bank the New Lehman Brothers? 

There have long been comparisons drawn between Deutsche Bank (DB) and Lehman Brothers - especially in recent years. Deutsche has had some of the highest credit default swap (CDS) numbers in the past, hitting 235 basis points (the highest among investment banks) a couple years back in 2016. Additionally, the bank has failed its stress test multiple years, most recently in 2018, according to Reuters. And while several other historic factors have persistently drawn comparisons between the bank and Lehman, others suggest it may be more closely related to the Fannie Mae and Freddie Mac crisis.

Bloomberg reported this year that Deutsche currently holds $145 billion of "total loss absorbing capital," or TLAC, which is decreasing in value and may eventually cause the bank's downfall. But, according to Bloomberg, the government may chose to take over the bank (much like the U.S. government did with Fannie Mae and Freddie Mac during the financial crisis). 

"Deutsche Bank unlike Lehman will not be allowed to fail," Alastair Winter, chief economist at Daniel Stewart wrote to CNBC in 2016. "It is also likely that they are much more aware of their problems even if they are unable or unwilling to quantify them properly."

While crisis is merely speculated for Deutsche, the cautionary tale of Lehman Brothers may still be relevant - as for economies worldwide.

Is the 2018 Economy Still Impacted by the Crash? 

The real question should be, what have we learned from Lehman? 

While some may argue that the financial sector still hasn't learned their lesson, the move away from high-risk activities like reselling or repackaging mortgages could be a sign that banks are becoming better at managing risk. And, investors seem to have learned that they need to diversify more. 

"The Lehman Brothers collapse made financial institutions realise that the most precious thing they are entrusted with is trust - and that winning that back was going to take both structural and cultural change that would have been unimaginable just a few years before," Michael Cole-Fontayn, EMEA Chairman at BNY Mellon wrote to CNBC in 2016. "Since 2008, banks around the world have strengthened their balance sheets, held more capital and more liquid assets. They've invested heavily in risk management."

Headed for Disaster? 

But for many, the economy is steadily chugging along toward another financial crisis - undeterred by the warning signs of Lehman. 

The global economy currently has a $237 trillion total debt - some $70 trillion higher than before the Lehman Brothers collapsed, according to Financial Times. Additionally, concerns over monetary policy and quantitative easing, as well as  back-to-back negative GDP growth, could contribute to another recession

Additionally, despite much better numbers of employment (unemployment sits at around 3.9% currently - compared to the 10% during 2008), a bullish stock market, and a revitalized housing market, some experts argue that the economy may be making the same mistakes as pre-Lehman times.

According to a report by the Federal Reserve Bank of San Francisco, the economy is "unlikely to regain" pre-2008 recession GDP numbers - having been reduced since the crisis. And, according to The New York Times this year, the current market may be overvalued - which, coupled with the recent vote to reduce aspects of the Dodd-Frank Act's regulatory processes, could lead to another disaster comparable to the post-Lehman fiasco. 

To make matters worse, TheStreet's Brian Sozzi feels investors still aren't researching their stocks enough, and are perhaps starting to leverage up their own balance sheets.

"Most tech stocks have gone through the roof without any consideration on valuations. People are simply riding momentum because everyone else is and they don't know how to read a cash flow statement," Sozzi wrote this week. "Some continue to hold Lehman lessons dear, but it's my view the majority have moved on without revisiting that time every quarter - as they should. It's sad and it will come back to bite investors - again - within the next five years."

Still, the stock market has seen some record highs recently, but speculations over a coming bear market leave the market at a seeming turning point.

Sozzi sees the daily global advance-decline line of 73 country indices from their peak in 2018 as a red flag - especially given that the market has faced a pretty brutal correction every time it has happened in the past. 

But in addition to the economic repercussions of the bank's collapse, some have argued that a major shift in the Democratic party in favor of more bank regulation was a direct result of the Lehman disaster. According to CNBC, movements like Occupy Wall Street in 2011, as well as increasingly populist politicians like the likes of Sen. Bernie Sanders and Sen. Elizabeth Warren, are merely examples of the increasingly leftist move toward greater government control over industries like banking and investment. 

"I think [the financial crisis] has generally reinforced the confidence with which we leading Democrats defend a strong role for government," former Rep. Barney Frank, who was involved in legislating Dodd-Frank, told CNBC. "The importance of appropriate regulation."

Has Lehman Collapse Influenced Politics? 

But some suggest that the collapse of the titan of finance has also sparked a wave of Democratic socialism that has only intensified an anti-large-financial-institutions sentiment. 

Still, despite claims that Lehman's collapse has influenced leftist policy in the past 10 years, economic policy is not expected to be a central issue in the upcoming 2020 campaign, according to CNBC.

However, although banks have made several strides toward greater risk management, the financial sector continues to leave a lot to be desired.

"Ten years after Wall Street crashed the economy, you would think Washington would still be vigilant about risks to our economy and American families," Sen. Sherrod Brown, the Senate Banking Committee's ranking Democrat, told CNBC this week. "But at one agency after another, the rules are being rewritten to suit the special interests, raising the risk that taxpayers will once again be on the hook for Wall Street's recklessness." 

So, has Wall Street learned its lesson? 

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