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shortage of short-term cash). Instead, Lehman had serious solvency problems (its liabilities substantially exceeded its assets). You may wonder how on earth such a major investment bank can find itself in such a desperate position.
A crucial explanation is that Lehman took leverage to the extreme – by some estimates its leverage ratio at its peak was 44, which means that Lehman borrowed £44 for every £1 of its own capital! If true, this would mean that a fall in the value of Lehman’s assets of only 3 per cent would be sufficient to bankrupt it: because Lehman was insolvent, the other banks were quite rightly worried that any loans made would never be repaid.
The other banks had financial problems of their own. They were all exposed to the US housing market and incurred substantial losses as a result. They had little appetite to lend money to anyone, let alone
Lehman.
Each bank hoped that someone else would come to Lehman’s rescue
so it wouldn’t have to. Never mind that the outcome where no one came to Lehman’s rescue would be much worse than everyone contributing a little bit.
This is known as the free-rider problem, because each bank has an incentive to free-ride on the contributions of the other banks.
Lehman’s failure would be so catastrophic that many of the bank heads must have thought that Paulson and Geithner were bluffing when they said that a public bailout wouldn’t happen. The bank heads soon found that the two men meant what they said.
With no one willing to lend to Lehman, the next possibility was that one of the banks take over Lehman outright. Lehman had lots of very valuable assets; unfortunately they also had substantial liabilities. Potential buyers were interested in the assets, of course, but they wanted the government to take at least some responsibility for the liabilities.
At the time Lehman was effectively insolvent: its liabilities outweighed its assets (see the earlier section ‘Types of bank failure’). Without some kind of government support, taking over Lehman just wasn’t an attractive proposition. Ultimately, the two initially interested banks, Bank of America and Barclays, walked away. In fact, Bank of America did a deal with Merrill Lynch in the hope that the combined company would be able to better weather the financial storm that was to come.
So even though each bank knew that Lehman’s failure would be potentially devastating for them (due to systemic risk and contagion), no one bank was willing to take on the responsibility of saving Lehman. Each bank hoped that someone else (either another bank or the government) would come to the rescue.
On Monday 15 September 2008, with nowhere else to go, Lehman Brothers – one of the oldest and most prestigious banks on Wall Street – filed for
bankruptcy. It was the largest bankruptcy in history by some distance: ten times bigger than the collapse of energy giant Enron. The fallout was felt immediately as global stock markets tanked; by the end of the day $700 billion had been wiped from their value. Chaos ensued and global credit markets effectively shut down – companies found that borrowing money was almost impossible.
Many well-run businesses rely on being able to borrow money on a short-term basis: as a result even large blue-chip companies were struggling with their cash flow. The potential collapse of insurance giant AIG was the final straw and forced the US government to intervene on a massive scale: AIG was bailed out with $85 billion and Hank Paulson went before the US Congress to ask for a $700 billion bailout package (yes, you read that right, Hank Paulson, the man who only a few days earlier said that no public money was available for a bailout!).
The interconnected web of financial transactions meant that the problems wouldn’t be restricted to the US. The UK was always going to be hit hard by these events: London vies with New York as the world’s pre-eminent financial centre. Just two days after Lehman’s failure, HBOS, the UK’s largest mortgage lender, had to be rescued (read: taken over) by Lloyds TSB. By the end of the month two further US banks had failed: Washington Mutual and Wachovia. Things didn’t improve: in October, HBOS and Lloyds TSB found themselves in trouble again; as if things weren’t bad enough, Royal Bank of Scotland (RBS, one of the world’s largest banks) was on the edge of failure – to avoid the collapse of the entire UK banking sector, the UK government had to bail out all three banks. All this chaos was the result of systemic risk and the contagion that resulted from the failure of Lehman.
The jury is still out on whether US policy makers were correct to allow Lehman to fail. Critics point to the ensuing devastation and argue that the $20–30 billion it would have cost the government to save Lehman was small fry in comparison. Others point out that policy makers were in an impossible situation and that eventually they had to let someone fail in order to show the world that taxpayers can’t always be expected to bail out failing banks.
Chapter 15
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