September 15 marks the three-year anniversary since Lehman Brothers declared bankruptcy. A global financial crisis erupted and there was the race to the bottom in the entire financial sector. Some of the biggest losers were the Lehman Brothers itself, the 150 years old, fourth largest investment bank inAmerica. Also General Electric (GE) plunged 68% at that day, and American International Group (AIG) went down 90% within several days after Lehman’s collapse. Not to mention 14 million people, who lost their jobs since the financial crisis erupted.
To show a big picture, shortly before Lehman Brothers’ failure, its total assets portfolio consisted of $ 691 billion. However, only $ 22.5 billion was shareholder’s equity. It meant, that $ 668.5 billion were liabilities. Simple calculation reveals, that leverage ratio was 30 to 1, meaning Lehman’s liabilities were 30 times more than its equity. It therefore only takes slight downturn in return on investments to wipe out all shareholders equity. And this is what happened. Lehman Brothers were heavily involved in different kinds of subprime lending and mortgage instruments, which market was booming since 2001. However, a bubble of cheap loans and growing real property prices burst in 2006. Lehman Brothers were stuck with unsellable assets with steadily decreasing market-values. In consequence, in the beginning of 2008, Lehman Brothers made a quarterly loss of over $2.5 billion, following with $ 3.5 billion quarterly loss announced in September. With such a high debt ratio, huge losses, and a balance sheet filed with weak, illiquid assets, it was inevitable for Lehman Brothers to fail.
Three years later, what can we learn from Lehman’s failure?
“If there’s any lesson from three years ago, it is that leverage has its limits,” said Rick Bastian, CEO of Beloit, Wis.-based Blackhawk Bank. “People bought things they couldn’t afford. It isn’t strange that we found out businesses and governments did the same thing. Now we have a global debt crisis, and it’s taking forever to climb out of it.”
According to Federal Reserve Chairman Ben S. Bernanke the Lehman “Failure provides at least two important lessons. “First, we must eliminate the gaps in our financial regulatory framework that allow large, complex, interconnected firms like Lehman to operate without robust consolidated supervision. In September 2008, no government agency had sufficient authority to compel Lehman to operate in a safe and sound manner and in a way that did not pose dangers to the broader financial system. Second, to avoid having to choose in the future between bailing out a failing, systemically critical firm or allowing its disorderly bankruptcy, we need a new resolution regime, analogous to that already established for failing banks. Such a regime would both protect our economy and improve market discipline by ensuring that the failing firm’s shareholders and creditors take losses and its management is replaced.”