Lehman Brothers
In September 2008 a big American investment bank went bust and triggered the worst financial crisis in decades. Behind it were high debts, hard to understand securities and falling house prices.
In the years before, banks in the US had handed out home loans on a large scale, including to households that could barely afford them. These loans were bundled, packaged into securities and sold on to investors all over the world.
As long as house prices rose, that worked. When they fell, more and more households couldn't pay, and nobody knew exactly what these securities were still worth. Banks distrusted each other and stopped lending to one another.
Lehman Brothers was highly indebted and had bought many such securities. On 15 September 2008 the bank filed for bankruptcy. Because the big banks were closely intertwined, the shock ran through the whole financial system.
Stock markets fell sharply around the world. The American S&P 500 lost about 57 percent from its peak in October 2007 to its low in March 2009. Recovery took years. Anyone who sold back then missed it. Anyone who stayed invested had made up the losses, including dividends, by about 2012.
Debt amplified everything. If you work heavily on credit, a small loss in value is enough to wipe out your own capital. Lehman had about thirty dollars of debt for every dollar of its own capital. So a loss of just over three percent was enough to erase its equity. The bank had to sell, that pushed prices down, and that forced others to sell in turn. It's the same mechanism as a chain of liquidations, just for the whole financial system.
A second cause lay in the ratings. The rating agencies assumed that loans from different regions would hardly ever default at the same time. That assumption collapsed when house prices fell across the whole country. It was once again the effect that in crises everything suddenly moves together.
For you, what happened afterwards is the most interesting part. Broad stock markets reached new highs in the following years. Lasting damage was done mainly to those who sold at the bottom and to those holding shares of individual affected banks that became worthless. So the case confirms both points: the risk of the whole market is rewarded over time, the risk of individual companies isn't.
Summary
- High leverage turns small value declines into insolvency.
- The assumption of independent defaults broke down once everything fell together.
- The market recovered; individual affected institutions didn't.
Did you get it?
How did leverage act as an amplifier?
If you work heavily on credit, even a small loss in value wipes out all your equity and forces you to sell.
Which model assumption broke down?
That loans from different regions would hardly ever default at the same time.
Who suffered the permanent damage?
Those who sold at the bottom and those holding shares of individual affected banks. The broad market recovered.
Your task
The bank carried about thirty dollars of debt for every dollar of its own capital. How much loss in value can a company with that ratio absorb? Work out why a little over three percent was enough, then find equity and debt in the annual report of a company of your choice and calculate its ratio.
Sources and further reading
- The final report of the US Financial Crisis Inquiry Commission, and public market data. View source ↗
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