Economics, 3rd Edition



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Economics Mankiw

The Collapse of Lehman 

Lehman Bros had been a bank at the forefront of the sub-prime and CDS 

market. It had built its business on leveraging – borrowing heavily to finance its activities. Over the 

weekend of 13 and 14 September 2008, last-ditch talks were convened to try and find a way of res-

cuing Lehman Bros. The debts at Lehman and the extent of their exposure to sub-prime and CDS were 

too great, however,  and Lehman Bros filed for Chapter 11 bankruptcy protection on 15 September. 

When Lehman collapsed it led to billions of dollars of claims on Lehman CDS – payments which had to 

be made by those who sold the protection. As a means of settling these claims, Lehman’s bonds were 

sold via auction in early  October 2008. The value of the bonds was set by the auction at around 8 cents 

to the dollar. So a 

$10 million bond would only be worth $800,000 meaning that protection sellers 

would have to make up the remaining 

$9,200,000 to meet the CDS obligation. With claims estimated 

at anything between 

$400 and $600 billion this put a massive strain on the financial system and many 

banks who had sold CDS on Lehman were now exposed and in danger of failing themselves, which 

put further pressure on the system. Basically, banks found that they had to meet payment obligations 

and did not have the funds available in reserves to do so. Banks who were struggling to meet their 

obligations may have looked to the interbank market to raise funds which we have already seen, was 

almost at a standstill. Banks around the world found themselves in this difficult position as the extent 

of the web of securitization began to become clearer. As the problems surrounding securitization 

unwound, banks had to take some of the assets back onto their balance sheet. This then meant that 

they had to reinstate sufficient reserves to support these liabilities and this further reduced their will-

ingness to lend. Instead the focus shifted to trying to restore balance sheets by taking in deposits but 

not lending.

The drip feed of news from banks, large and small, regarding the perilous position they were in sparked 

a drop in confidence in the whole system. If Lehman could fail what about other banks? Banks that had to 

make payments would either have to deplete their capital and thus become seriously overstretched and 

thus at greater risk, or take on the liabilities of the special purpose vehicles (see Chapter 26) and take them 

onto their balance sheet further depleting their positions. As their positions worsened their credit ratings 

would fall; if this happened and they held CDS seller positions this would further increase the  collateral 

calls on them and put them under further pressure.

The collapse of Lehman was seen as a spectacular event because it showed that central banks were 

not prepared to step in to help any bank that got into trouble. Bear Stearns and Merrill Lynch had survived 

by being bought by J.P. Morgan and Bank of America and the US government had stepped in to bail out 

the mortgage lenders, Fannie Mae and Freddie Mac. The collapse of Lehman Bros was closely followed 

by it becoming clear that insurance group AIG was in trouble. AIG had been an active seller of CDS and 

the collapse of Lehman had left it seriously exposed. The US government stepped in to support this 

company because so much of the rest of the economy and financial institutions were implicated if AIG 

had been allowed to go to the wall. In the UK, Northern Rock, RBS and HBOS were all subject to  support 

of various kinds including the speeding up of permission for Lloyds TSB to take over HBOS before it 

collapsed. Some have suggested, however, that Lehman may have been a sacrificial lamb at the altar of 

moral hazard.


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