Why did Lehman Brothers go bankrupt?
In: Economics
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
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