Liquidity Crisis at Lehman Brothers

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During the late 1990s and early 2000s, investment bank Lehman Brothers invested heavily in the securitized U.S. real estate market. The 150-year-old institution pioneered an integrated business model in which it sold mortgages to residential customers, turned portfolios of these loans into highly rated securities, and then sold these securities to investors.

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The real estate market in the United States started to sour in 2006 and housing prices started falling following a years-long boom. During this time, however, Lehman continued to build up its real estate securitization business.

 

Critically, the bank also continued to increase the amount of mortgage-related assets it held as longer-term investments for its own account (rather than simply acting as a middleman during the securitization process).3 As part of this aggressive growth strategy, Lehman also began to make outsized bets on U.S. commercial real estate. But if the firm's business model came to look like a risky bet on the U.S. housing market, it was ultimately Lehman's leverage ratio and funding strategy that threatened to turn this investment position into a disaster.

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Next investors turned their attention to Lehman. Specifically, they began to question how accurately the firm had valued its real estate-based assets. Market confidence, so critical to the firm's funding strategy (and therefore its liquidity), was ebbing fast. As the crisis mounted, many of Lehman's major counterparties began to demand more collateral for funding transactions, others began reducing their exposure, and some institutions simply refused to deal with the firm. Attempts to organize an industry rescue or to sell the firm to another large bank ultimately failed. In the early hours of September 15, 2008, Lehman Brothers was forced to file for bankruptcy, inciting months of panic and uncertainty in the global financial markets.

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Banks are naturally highly leveraged entities (i.e., they take on a large amount of debt rather than issue equity to fund their activities). In the run up to the crisis, however, Lehman (like other investment banks in the boom years) pursued leverage to excess. By 2007, the bank had an assets-to-equity ratio of approximately 31:1. Meanwhile, the bank's funding strategy (i.e., the way it borrowed money to grow its operations) introduced a fatal element of fragility. Specifically, Lehman began borrowing huge amounts of money on a short-term basis (e.g., borrowing daily from the repo markets) to fund relatively illiquid long-term real estate assets. This meant that the firm had to depend heavily on the confidence of its funders and counterparties if it was to continue to borrow the funds necessary to stay in business.

 

During the second half of 2007, it became evident that the U.S. housing bubble had burst and that the subprime mortgage market was in deep trouble. As a result, confidence began to erode in firms heavily invested in subprime securities. In July of that year, Bear Stearns (another highly leveraged subprime- linked firm) had to support two of its hedge funds following steep losses caused by their subprime mortgage exposures. In March 2008, these weaknesses caused Bear Stearns to collapse after its repo lenders and bank counterparties lost confidence in the firm's ability to repay its debts. J.P. Morgan then bought the fallen firm at a fraction of its prior market value.