Lehman used a high-leverage business model that required it to raise billions of dollars every day to keep the doors open. In 2006, it had invested heavily in high-risk real estate and subprime mortgages. When these markets turned south, Lehman couldn’t raise enough cash to stay in business.
How the Government Tried To Save Lehman Brothers
U.S. Treasury Secretary Hank Paulson and Federal Reserve Chairman Ben Bernanke grew concerned over a potential Lehman Brothers bankruptcy in March 2008. That was after the Fed rescued investment bank Bear Stearns. The expectation was that Lehman would be the next to need help. Paulson urged Dick Fuld, Lehman’s president, to find a buyer as Bear Stearns had done, and Paulson personally encouraged the only two banks who were interested: Bank of America and British Barclays. He warned both that neither the Treasury nor the Fed could help with government funds. Since Lehman Brothers was an investment bank, the government could not nationalize it like it did government enterprises Fannie Mae and Freddie Mac. For that same reason, no federal regulator, like the FDIC, could take it over. Moreover, the Fed couldn’t guarantee a loan as it did with Bear Stearns. Lehman Brothers didn’t have enough assets to secure one. Bank of America didn’t want a loan, anyway. It wanted the government to cover $65 billion to $70 billion in anticipated losses. Paulson said no. Instead, he and Federal Reserve of New York President Tim Geithner sponsored a weekend retreat with the nation’s top bankers to find funding for Lehman Brothers. The bankers spent the next two days trying to find a way to make it work. But before they could, Bank of America backed out of the deal. The next day, Barclays announced its British regulators would not approve a Lehman Brothers deal. Everyone spent the rest of the day preparing for Lehman’s bankruptcy.
Causes of Lehman’s Bankruptcy
Lehman’s bankruptcy had four underlying causes:
Impact of Lehman’s Bankruptcy
Lehman’s bankruptcy sent financial markets reeling. The Dow Jones Industrial Average fell 504.48 points, its worst decline in seven years. Losses continued until March 5, 2009, when the Dow closed at 6,594.44. That was a 53% drop from its peak of 14,164.53 on October 10, 2007. Investors fled to the relative safety of U.S. Treasury bonds, sending prices up. Investors knew that Lehman’s bankruptcy threatened the financial institutions that owned its bonds. On September 16, 2008, the Reserve Primary money market fund “broke the buck.” That meant its shares, normally worth at least $1, were only worth $0.97. Investors lost confidence in the money market fund when it announced losses of $785 million in Lehman’s commercial paper. On September 17, 2008, the collapse spread. Investors withdrew a record $196 billion from their money market accounts. If the run had continued, businesses wouldn’t have been able to get money to fund their day-to-day operations. In just a few weeks, the economy would have collapsed. For example, shippers wouldn’t have had the cash to deliver food to grocery stores. On September 18, 2008, Paulson and Bernanke met with congressional leaders to explain that credit markets were only a few days away from a meltdown. They asked for $700 billion to bail out the banks, which would allow the Treasury Department to buy shares of troubled banks; It was the fastest way to inject capital into the frozen financial system. On September 29, 2008, Congress rejected the proposal. That sent the Dow down 777.68 points, the most in any single day in history until 2018.
How the Bankruptcy Affects You Today
The Lehman Brothers bankruptcy kicked off the 2008 financial crisis and the recession that followed. The millennial generation was just entering the workforce and therefore were the most heavily impacted. Unemployment rates skyrocketed, but millennials suffered the most—unemployment rates for those aged 16-24 rose from 9.9% in May 2007 to a record 19.5% by April 2010. Unemployment was at 8.8% for 25-54-year-olds and 7.0% for those 55 and older. By December 2017, unemployment had fallen to 8.9% for millennials, but the damage had already been done. The recession’s impact on millennials is striking when compared to previous generations at the same age.
They have less wealth.They have more student debt.They are more likely to live with their parents. They are slower in forming families.
The one positive impact is that millennials are more highly educated than in past generations. Since jobs weren’t available, Millennials went to school, which has paid off for those with a college degree. Their median household income is double that for those with only a high school degree. Lehman’s bankruptcy also set the stage for the Dodd-Frank Wall Street Reform Act. It was the most comprehensive financial reform since the Glass-Steagall Act. Glass-Steagall regulated banks after the 1929 stock market crash, but it was repealed in 1999. That allowed banks to once again invest depositors’ funds in unregulated derivatives like mortgage-backed securities. Dodd-Frank established the Financial Stability Oversight Council, which identifies risks that affect the entire financial industry. If any firm becomes too big, the FSOC will turn them over to the Federal Reserve for closer supervision. For example, the Fed can make a bank increase its reserve requirement, making sure they have enough cash on hand to prevent bankruptcy.
