Why did Lehman Brothers go bankrupt?



Why did Lehman Brothers go bankrupt?

In: Economics

they put almost all their eggs in the collapsing house lending market,so they lots a lot of money and can’t pay debts in time

They did poor business decisions in hindsight… like many institutions at that time.

The rumor was that the CEO didn’t have a likable personality so when it became politically expedient that someone takes the fall, it was easier for his peers to look the other way instead of fight for him….

It pays to be sociable

Lehman created and sold a lot of contracts based on pools of mortgages. The way these work is that you put together thousands of mortgages and then split them into tranches, with the top tranches getting paid first in the event of default on those mortgages.

These contracts are, in general, a pretty standard thing – they are called collateralized debt obligations, and there are broadly good reasons why you may want the financial system to have them.

However, the ones that Lehman made were particularly bad for two reasons:
1) the quality of the loans backing those contracts was very bad (you may have heard of subprime mortgages, given to people who essentially couldn’t afford them)
2) the people who were supposed to assess the quality of these CDOs (rating agencies) thought that they were really good. Explaining why is pretty complicated, there is no ELI5 way imho, but if you’re curious let me know and I’ll elaborate

So to recap Lehman makes a ton of these contracts that are very high quality in theory but very toxic in practice. Now, as the housing downturn hits, they want to keep selling these, but people are getting squeamish with what they’re buying. So they will only buy the higher quality tranches of these obligations. Therefore, Lehman starts keeping the bottom tranches in their books. This is again, standard behavior for a bank: if you originate a crappy loan, part of what you get paid for as a bank is that if you cannot sell that loan, you will take the hit and keep it in your books.

However, because rating agencies think these contracts are actually good, Lehman can keep a ton of them on their books. So by the time it’s about to go bankrupt, its capital has a ton of these toxic assets. As they stop paying, its capital gets eroded, Lehman runs out of money, and bankruptcy happens

Because they were largely funded on short term debt, meaning every few days they would need to borrow tens of billions of dollars from other banks and corporations. So when concerns grew about the state of their business this funding was pulled and there was nowhere else to get it that quickly.

After Lehman failed the other banks who funded using short term debt, got acess to government lines of credit and more importantly government guarantees to prevent similar concerns from sinking them, too.