Macroeconomics For Dummies®, uk edition Published by: John Wiley & Sons, Ltd

Seeing systemic risk in practice: The case of Lehman Brothers

We now present an example that illustrates the sheer scale of the devastation caused when a huge business fails: the bank Lehman Brothers. The highly complex and interconnected financial system meant that Lehman’s collapse quickly transmitted problems throughout the financial system and the wider economy.

What happened in mid-September 2008 set in motion a quite extraordinary cascade of events. People still discuss and debate the decisions made and are likely to do so for decades to come. The story begins late-afternoon on Friday 12 September; the heads of all the major US banks (except Lehman Brothers) are summoned to the Federal Reserve (the central bank of the US) at short notice. As John Thain, the head of Merrill Lynch at the time, commented, ‘Those types of phone calls are always bad.’

He was right. At the Fed, they were met by Hank Paulson (then secretary of the Treasury) and Timothy Geithner (then president of the New York Fed). Paulson and Geithner informed the bank heads that Lehman Brothers (a seriously large US investment bank) was on the verge of bankruptcy. This announcement probably wasn’t a huge surprise – people knew that Lehman was in serious financial difficulty due to its exposure to the US housing market.

What probably did surprise the bankers was that the US government wasn’t willing to bail out (give financial assistance to) Lehman in order to save it. Only recently, Bear Stearns (another investment bank) and Fannie Mae and Freddie Mac (two large financial institutions at the heart of the US mortgage market) had found themselves in similar trouble and were bailed out. The size and interconnectedness of Lehman meant that people assumed that something similar would be arranged for it. Paulson and Geithner were smart guys and knew about the dangers of systemic risk and cascading failures (see the two preceding sections): surely they wouldn’t allow Lehman to fail?

Nevertheless, they told the bank heads that if they were unable, between themselves, to come to the aid of Lehman, by the time that financial markets opened on Monday morning, Lehman Brothers would be no more. Everyone present knew that such an outcome would be enormously destructive to the other banks present and to the wider economy. One idea was that the banks would lend Lehman large sums of money in the hope that this would stave off bankruptcy.

This idea didn’t get very far for a number of reasons:

Lehman’s problems weren’t primarily due to a lack of liquidity (a