The fall of Lehman Brothers

#21

What?

Collapse of Lehman Brothers, a financial services firm, in the 2008 financial crisis

Related Concepts

• Subprime mortgage crisis
• Mortgage-backed security (MBS) 
• Collateralized debt obligation (CDO)
• Too big to fail

Timeline of events

• In 2004, amidst the housing bubble, Lehman acquired five mortgage lenders and dealt with loans without documenting the numbers
• Lehman's real estate business enabled revenues in the capital markets unit to surge 56% from 2004 to 2006
• In 2007, the firm announced $4.2 billion in net income on $19.3 billion in revenue
• When Lehman's stock price reached a record $86.18 per share, giving it a market capitalization of nearly $60 billion, defaults on subprime mortgages began to rise to a seven-year high
• Things started going downhill from then on
• On June 7, 2008, Lehman announced a Q2 (2nd quarter) loss of $2.8 billion
• Lehman's stock plunged by 45% while the firm's debt saw a 66% increase in credit-default swaps
• Lehman Brothers filed for bankruptcy on September 15, 2008, with $639 billion in assets and $619 billion in debt

Impact

• A company that had been alive for more than a century and a half was forced to file for bankruptcy, the largest bankruptcy filing in US history
• The failure of the fourth-largest investment bank in the US had severe ramifications for the global economy
• The bankruptcy triggered a 4.5% one-day drop in the Dow Jones Industrial Average (DJIA)

Aftermath

• President Bush announced a $700 billion bail-out plan to help salvage the remaining pieces of the financial sector
• The Dodd-Frank Act was implemented to help increase financial regulation

Related Movies

Too big to fail, The big short

Notes

Subprime mortgage crisis:

• Occurred when banks sold too many mortgages to feed the demand for mortgage-backed securities sold through the secondary market
• When the Federal Reserve increased the rate, it resulted in increased mortgage interest rates which in turn caused home prices to plummet, and borrowers to default on their loans

Mortgage-backed security (MBS):

• An investment similar to a bond 
• Constitutes a bundle of home loans bought from the banks that issued them
• Put simply, they are shares of a home loan sold to investors
• Working:
• A bank lends a borrower the money to buy a house and collects monthly payments on the loan
• This loan, one of many, is then sold to a larger bank 
• This bank ties the loans together into a mortgage-backed security and issues shares aka tranches (French for "slices") to investors
• Investors collect the dividends in the form of monthly mortgage payments

Collateralized debt obligations (CDOs):

• In the above working of an MBS, the shares or tranches can be repackaged and resold as other securities aka CDOs 

Too big to fail:

• A financial organization so massive to the global economy that the central bank must prevent it from going bankrupt