By Mudit Dugar

Lehman Brothers – one of the biggest names in the world of banking and finance saw its downfall during 2008 financial meltdown. It merely took a few days for this bank to come back to scratch. As shown in the movie, all the other firms like Fannie & Freddie were bailed out, but for Lehman, there was no public money either. Starting from the non-payment of unsecured loans and the running out of capital at a sonic rate Lehman, could not keep up with the market conditions of the time. Both, the commodity as well as the money market was in a fluctuating stage and did not do much good to the firm. With Dick Fuld at the helm, Lehman was grasping onto straws in hope of a bailout. Now, we need to understand that at this point, not only Lehman Brothers, but also other big banking institutions like Morgan Stanley, Goldman Sachs and Merrill Lynch were also in line. But they were somehow bailed out. Lehman Brothers was put in a very bad position, stuck between a rock and a hard wall. Let us see, how those days changed the history of American Economy magnanimously.

There are several reasons why Lehman crashed and why there was no support from the Fed, which at the time was headed by Hank Paulson. Lehman was having a very rough time, its commercial real assets were written down from $40 billion to $33 billion, a huge $7 billion downfall. This was enough for agencies like Standard & Poor to downgrade Lehman’s ratings and for the shareholders to lose confidence.

Lehman had trouble repaying the loans it had taken worth $85 billion of which was troubled loan. Although, they had $10 billion of small, retail loans, it was risky to provide a bank like this with the taxpayer’s money. When Paulsen re-evaluated the worth of this bank, Dick Fuld slyly sent one of his associates to keep a check, as Paulsen was the ex-CEO of Goldman Sachs, Lehman’s rivals.

Surprisingly, the assets were devalued to $21 billion. Lehman had lost half its assets in one day.

One major reason was that of sub-prime mortgages – Sub prime mortgage happens when a person purchases a house on a loan and he is given another loan at a cheap interest rate to purchase another house. Many people undergo the same procedure and a lot of people have multiple homes using cheap credit. Now, the bank sells these mortgages to another bank, which is bigger with an advice from a credit rating agency. The big bank purchases from various banks and not just one. Then this big bank sells the mortgages further to a bigger bank and many big banks do the same. Thus, the transfers of mortgages are made to bigger and bigger banks until they finally land up at a bank like Lehman Brothers. When the people holding the houses start defaulting, when value of houses goes down, Lehman is not left with significant valuable assets. This impacts Lehman as it is losing the mortgage money and the value of the house is not sufficient. Accumulation of such devalued houses can be classified as accumulation of toxic assets. Assets, which cannot be sold at a price that will satisfy the owner, are deemed to be toxic in nature. The piling up of these toxic assets also discouraged the Fed to support Lehman.

It was not only the external factors, but internal factors also, for instance, a lot of mergers were made available to Lehman, like Blackstone etc., but Fuld was never satisfied with the price. As shown in the movie, Fannie and Freddie were bailed because of their small size, and Fed could cover it easily. AIG was supported because half of the banking systems were powered by their credit swaps.

Also, apart from Fed, Lehman did have some options that could have helped them save themselves. They are-

  • Barclays – CEO of this British Bank was at the Fed that day and gave Lehman a ray of hope. They agreed to take over Lehman at $25 a share. But a last minute problem arose – Barclays could not guarantee Lehman’s obligations without a shareholder vote, which was in accordance with the British law. However, they could vote by Tuesday and Lehman could have survived if someone would have supported them just for 2 days, but there was no one to look out for them.
  • Bank Of America – Initially they showed interest in taking over, but after considering the valuation of toxic assets they changed their minds. Later on, John Thain, CEO of Merrill Lynch, successfully convinced Bank Of America to side with them instead of Lehman at a take over rate of $29 a share.
  • One of the last straws to grasp on was that the rival banks bail out the toxic assets. It was initially agreed at $25 a share, but later on, this did not work out because firstly they had their own toxic shares to deal with and secondly why would they give money to a rival bank.

The fall Of Lehman brothers had a huge impact on the American Economy. Be it Employment, or the GDP, or the inflation rate.

Around 30,000 employees lost their jobs that led to a huge fluctuation and ultimate weakening of the labour market. Unemployment levels rose in huge numbers.

Unemployment is inversely proportional to inflation. Inflation rate started dipping as we moved ahead from July 2008, Lehman had collapsed around September 2008 and in January 2009, and inflation was low and reducing.

The real GDP took a dive after 2008. Going from an almost 3% yearly growth to a less than 1% growth.

Posted by The Indian Economist | For the Curious Mind