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  • 13Jan

    What caused Lehman Brothers to go bankrupt?

    It was an American ultra-success story. And, it is now a story of ultra-tragedy. How could a financial company established by German immigrants in 1850 that grew to be one of the biggest ($639 billion in assets) and one of the best known of the Wall Street investment banks meet with such miserable fate? Following its establishment, the firm became successful and rode the tide of world wars, domestic and foreign business uncertainty, and the 1930’s American Great Depression. What, then, was its downfall? Many factors converged on Lehman Brothers to what could be called a “perfect storm.”

    A Deteriorating Housing Market

    After a peak in 2006, U.S. housing prices and property values began a decline and reached a historic low in 2012 (Standard & Poors/Case-Shiller Home Price Indices Report). The year-end Case-Shiller home price index for 2008 recorded the sharpest drop in its history. Financial experts have come to a consensus that the housing “bubble” was a major contributor to the ensuing financial crisis of 2007-2009. Before 2006, many homeowners refinanced their homes. The interest rates were low and home values high, so there was equity to use for home improvement projects or to collateralize extensions of credit for other purposes. When home values fell, the original home purchase loans, junior mortgage loans, and equity loans became seriously under collateralized. 


    Deteriorating Credit Standards

    Although many banks and non-bank mortgage lenders upheld safe and sound credit standards, the high home values and low interest rates before 2006 led many lenders to become more aggressive with home loan lending than was prudent. The result was a flood of loans for which borrowers were not suitably qualified, and collateral was many times taken in excess of 100% of its value. Eventually, when home values dropped, the loans became seriously under collateralized, and borrowers, who were facing other economic challenges like rising unemployment and rising prices, became financially strained. Home loan foreclosures and defaults resulted, leaving consumers in financial difficulty and the lenders owning properties with outstanding loans much greater than the property market value.

    Lehman Brothers was American ultra-success story that turned into tragedy.

    Lehman Brothers was American ultra-success story that turned into tragedy.

    Popularity of Subprime Mortgages

    What is a subprime mortgage? The “prime” interest rate is a rate established in the financial sector that banks are charged on loans. Many banks establish mortgage rates related to the prime rate, such as prime plus 2%, or some similar margin. Subprime mortgage loans are those for which the interest rate for consumer borrowers is higher than the prime rate, and it means the borrowers have higher payments and causing the loans to be high cost.

    What does this have to do with Lehman’s failure?

    These and other factors trickled both up and down in the financial industry. Lenders and consumers were affected; however, the industry as a whole, including investors, correspondent institutions to mortgage lenders, stocks based in real estate, felt the ripple of the decline in property values and shortfalls in mortgage loan repayment. 

    While the markets were declining, the economy was deteriorating, and property values were falling, Lehman still held a significant portfolio of securities investments backed by mortgages. Values declined radically, Lehman stock experienced sharp losses, investors lost confidence, and the Federal Reserve Bank of New York, which was then led by Timothy Geithner, proposed the possibility of an emergency liquidation of the Lehman assets (“U.S. Gives Banks Urgent Warning to Solve Crisis”. The New York Times. September 16, 2008). A Chapter 11 bankruptcy protection action was filed by Lehman on September 15, 2008 (“Lehman folds with record $613 billion debt”. Marketwatch. September 15, 2008.)

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