Lehman Brothers
The insolvency of a major US investment bank in September 2008 triggered the worst financial crisis in decades. The cause was a combination of high leverage, opaque securitizations, and a declining asset class.
In the years before, the US had issued mortgage loans on a large scale, including to households with poor creditworthiness. These loans were bundled, packaged into securities, and resold.
As long as home prices rose, that worked. Once they fell, defaults rose, and nobody knew exactly what these securities were worth anymore. Banks distrusted each other and stopped lending to one another.
Lehman Brothers was highly leveraged and held large amounts of such securities. Its insolvency followed in September 2008. Because many institutions were interconnected, the shock spread through the entire system.
Stock markets fell sharply worldwide, by more than half at the peak. Recovery took years. Anyone who exited then missed it. Anyone who stayed invested saw the losses recovered over the years.
The amplifying mechanism was debt financing. At high leverage, a small decline in asset value is enough to wipe out equity. The resulting forced deleveraging pushes prices down further and forces other participants to sell. It's the same mechanism as a liquidation cascade, just at the level of the financial system.
A second cause lay in how the securitized products were valued. Credit ratings rested on models assuming a low joint default probability for geographically dispersed loans. That assumption broke down once the price decline occurred nationwide, again triggering the effect of rising correlations during stress.
For retail investors, the most notable finding is what happened afterward. Broad stock markets reached new highs in the following years. The permanent damage hit those who sold at the bottom, and holders of individual affected institutions whose securities became worthless. The case therefore confirms both core claims: market risk is compensated over time, individual-stock risk 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?
At high leverage, even a small value decline wipes out equity and forces selling.
Which model assumption broke down?
The low joint default probability of geographically dispersed loans.
Who suffered the permanent damage?
Those who sold at the bottom and holders of individual affected institutions. The broad market recovered.
Sources and further reading
- The final report of the US Financial Crisis Inquiry Commission, and public market data.
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