What Caused The Fall Of Lehman Brothers In 2008?

Summary: In June 2010, your author was able to interview Larry McDonald, author of A Colossal Failure of Common Sense, during the 2010 European Business Summit in Brussels, Belgium. Mr McDonald has written and commented in great detail about the fall of Lehman Brothers in 2008. This page details that interview.

Larry (known as Lawrence McDonald in the USA) participated in the financial services discussion in the 2010 European Business Summit in Brussels. Their debate included brief conversations relating to financial education for the population, the difficulty of finding work in Wall Street and investment banks, the amount of leverage in the financial system and much more.

As we all know, the failure and fall of Lehman Brothers in 2008 and the financial crisis more broadly, was caused by many different problems in the banking world. These reasons include sub-prime mortgages, an interconnected world of derivative contracts, poor understanding of the risks being taken and much more. Many of these issues played out in Lehman Brothers and are described in Larry's book, A Colossal Failure of Common Sense.

Here is some footage of Larry speaking during the session.

In our interview, we discuss a number of the broader issues. EBS is really about European government policy making, so we had to discuss some of the more related topics of regulators and regulations, wages and bonuses.

As interesting as this interview was, Larry was even more interesting off camera before and after (apologies for not catching more of it). He has some strong views on the increase in prop trading by the big investment banks, the impact this had on their business models and their relationships with clients. We also discussed at some length the role of pension funds and why their insistence to company boards of directors that they use limited amounts of borrowing (broadly a very sensible idea) opens them up to the more predatory private equity funds and their mountains of aggressively used borrowed money.

This leads to a central issue for Larry in the current financial world - that many of the new products and financial 'developments' have created ways to simply transfer wealth en masse from stockholder and pension fund investor to financiers.

In short, if you have an interest in finance or a desire to understand more about the workings of the world, he is a very interesting man!

After our conversations, I find it difficult to believe that it can be anything other than a revelation of facts about the mismanagement of global and corporate finance. You can visit Larry's website here.

In his book, he describes the months leading up to Lehman Brothers bankruptcy from his position within the company. In his job, he was looking for assets and companies that were likely to fall in price and it was his job to profit from those falls.

Tellingly, he spotted a number of opportunities in the US sub-prime mortgage market which he was able to trade on and make a profit for the bank. This was rather ironic though since his colleagues in the mortgage division were busy buying, repackaging and selling mortgage assets. Their exposure was so great that it caused Lehman Brothers stock to drop dramatically in price, putting the company under terrible pressure.

An issue that Larry brings up in the book was that while he and a couple of colleagues were selling mortgage assets short in fairly limited numbers, their colleagues on another floor had turned the bank into the equivalent of a sub-prime mortgage factory. No matter how much he sold and was proven to be correct, other colleagues were getting the bank into much bigger trouble, much faster.

Meanwhile, Lehman Brothers CEO and top management team were busy trying to take on more risk, despite already having leveraged their balance sheet to almost 50 to 1. As other Wall Street investment banks started to really struggle - most notably Bear Stearns - the Lehman Brothers news was bad enough that it kept pulling them further into trouble.

Bear Stearns was ultimately bought for a song by JP Morgan Chase, but the other major investment banks - such as Goldman Sachs and Merrill Lynch - could not be convinced to save Lehman Brothers. At the same time, the US government faced a terrible dilemma since the world's largest insurer, AIG, was also in deep financial trouble. Not having the money to rescue both institutions, the American government chose to save AIG and let Lehman and the rest of Wall Street learn some harsh lessons. In total the US government spent some $700 billion on the Wall Street bailout.

Going down

After the fact, it was alleged by the former Lehman Brothers CEO Richard Fuld and others that there had been significant short selling and naked short selling (information here) of the bank's stock by it's Wall Street rivals. Whether or not this is true, and in the kill or be killed world of investment banking it might well be, these short sales would have had far less impact had the balance sheet have been more sound. Typically, rumours of weakness are based on something and in banking a loss of confidence quickly becomes a self-fulfilling prophecy.

However, in the preceding 18 months or so, many banks (both retail and investment) had seen their stock prices fall significantly on capital markets around the world.

In the UK for example, both Bradford and Bingley and Northern Rock were under terrible pressure. It is hard to imagine that short selling by some investment banks and hedge funds was not underway, but these funds did seem to have identified real weaknesses in the business models of these banks. The short selling reduced confidence in the banks, but ultimately their management team took the decisions that made the institutions weak enough to become a target.

These business model problems (mainly related to long-term lending with short-term borrowed financing) also caused HBOS (formerly the Halifax Building Society and the Bank of Scotland) to be forced onto Lloyds Bank. Normally we imagine huge mega mergers like this taking months for analysts to pore over the accounts and records. Not this time. One of the largest mergers in UK corporate history was essentially hashed out at a cocktail party with members of the government forcing them together. Really...

Most of Wall Street (information here) was using a measure known as VaR, or Value at Risk. This was a calculation made at the end of every working day to quantify the amount of risk being taken by the investment bank that day in terms of US dollars. It was a guide to help management decide what could and could not be done and offer a daily snapshot of the company's balance sheet. With hindsight, it seems that too much faith was placed in VaR and the method has faced wide criticism since.

Parts of Lehman were sold off at very short notice to Barclays plc and Nomura Holdings amongst others. There was also a need to open the derivatives market for an unprecedented three hours on a Sunday to help unwind some of the trades and deals that the bank was involved in. It was hoped that by doing this the entire financial system would not be pulled under. Ultimately, it worked, though it did offer up many financial assets at fire sale prices.

To read more about bear markets and the financial crisis of 2008 on this site, please follow these links:

Understanding Bull And Bear Market Situations

Bear Market Definition

What Is A Bear Market?

Bear Market Investing Strategies

Secular And Cyclical Bear Markets

The Great Crash 1929 by J.K.Galbraith

What Caused The 2008 Financial Crisis?

What Caused The 2008 US Stock Market Crash?