Lehman Brothers Collapse: Causes of the 2008 Bankruptcy
This paper examines the collapse of Lehman Brothers, which filed for bankruptcy on September 15, 2008, in what became the largest bankruptcy filing in U.S. history. Beginning with the origins of the subprime mortgage crisis in the early 2000s, the paper traces how lax lending standards, excessive leveraging, and the securitization of risky mortgage pools created systemic vulnerabilities. It also analyzes how the freeze in interbank lending left Lehman without the liquidity it needed to survive, and how the firm's own misleading accounting practices concealed the true extent of its financial distress. Together, these factors provide a comprehensive picture of how greed, poor risk management, and regulatory failure combined to bring down one of Wall Street's oldest institutions.
- Introduction: Lehman's collapse and paper scope
- Origins of the Subprime Mortgage Crisis: Fed rate cuts, NINJA loans, and CDO boom
- Lax Lending Standards and Business Decisions: Lehman's risky growth strategy and lending failures
- Securitization and Systemic Risk: Mortgage-backed securities and tranche mechanics
- The Collapse of Interbank Lending: Liquidity freeze that ended Lehman's survival
- Accounting Manipulation and Concealment: Repo accounting tricks hid Lehman's true debt
- Conclusion: Greed and mismanagement as fatal combination
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What makes this paper effective
- The paper builds its argument logically, moving from macro-level policy decisions (Federal Reserve rate cuts) to firm-level failures (Lehman's leverage and accounting tricks), creating a coherent causal chain rather than a list of unrelated facts.
- It uses specific quantitative evidence throughout — rate percentages, leverage ratios, tranche credit ratings, and the $900 million loan pool study — giving abstract financial concepts concrete grounding.
- The Ashcraft and Schuermann securitization case study is used effectively as an extended example, illustrating how systemic risk was built into the mortgage pipeline from origination through to the investor level.
Key academic technique demonstrated
The paper demonstrates effective multi-causal analysis: rather than attributing Lehman's failure to a single villain or event, it layers contributing causes — loose monetary policy, predatory lending, leveraging, securitization, interbank freeze, and accounting manipulation — and shows how each amplified the others. This approach is well-suited to complex financial or historical events where no single factor tells the whole story.
Structure breakdown
The paper opens with a brief historical introduction to Lehman Brothers before establishing the macroeconomic backdrop of the subprime crisis. It then moves through progressively more firm-specific causes: lending standards, securitization mechanics, liquidity collapse, and finally internal fraud. The conclusion ties these threads together with a judgment about the role of human greed and managerial failure. This funnel structure — from systemic to specific — is characteristic of financial case study writing at the undergraduate level.
Introduction
On September 15, 2008, Lehman Brothers, the fourth largest U.S. investment bank at the time, filed for bankruptcy. At the time of its collapse, Lehman Brothers had $639 billion in assets and $619 billion in debt, making it the largest bankruptcy filing in history. Lehman's collapse also made it the largest victim of the U.S. subprime mortgage crisis. This paper examines the collapse of Lehman Brothers and the factors that led to that failure.
Lehman Brothers started as an investment bank dating back to the 1850s. During its 158-year history, the firm survived the railroad bankruptcies of the 1800s, the Great Depression, and two World Wars. It did not, however, survive the subprime mortgage meltdown, or its own bad business decisions.
Origins of the Subprime Mortgage Crisis
The subprime mortgage crisis had its beginnings in the early 2000s, when fear of recession was significant. To head off recession, the Federal Reserve lowered the federal funds rate 11 times from May 2000 to December 2001, dropping it from 6.5% to 1.75%. This drop in rates led to a flood of liquidity in the economy. More and more banks made NINJA loans — no income, no job, and no assets — to subprime borrowers who wanted to realize their dream of home ownership. The easy credit environment led to more home loans, more home buyers, and greater appreciation in home prices. Investment in higher-yielding subprime mortgages skyrocketed. The Fed continued to slash interest rates until June 2003, when the 1% interest rate was at its lowest in 45 years (Singh, 2009).
Bankers began to repackage subprime loans into collateralized debt obligations (CDOs), which led to the development of a large secondary market for originating and distributing subprime loans. In October 2004, the SEC relaxed the net capital requirement for five investment banks, including Lehman Brothers, which allowed them to leverage up to 30 or even 40 times their initial investment (Singh, 2009).
The early signs of trouble appeared when interest rates began rising and home ownership reached a saturation point. The Fed raised interest rates so aggressively that, by June 2006, the federal funds rate reached 5.25%. During the last quarter of 2005, home prices began to fall, leading to a 40% decline in the U.S. Home Construction Index during 2006. At this point, not only were new homes being affected, but many subprime borrowers could not manage the higher interest rates: they started defaulting on their loans (Singh, 2009).
The year 2007 began with a number of subprime lenders filing for bankruptcy. During February and March, more than 25 subprime lenders filed for bankruptcy — the start of a gathering tide. In April 2007, New Century Financial, once the second largest originator of subprime mortgages in the U.S., became the latest major firm to file for bankruptcy (Singh, 2009).
News reports in 2007 indicated that financial firms and hedge funds owned more than $1 trillion in securities backed by failing subprime mortgages. By August 2007 it was apparent that the financial market could not solve the subprime crisis on its own, and the problem grew to international proportions. The interbank market froze, and governments around the world began working together to prevent further financial catastrophe. Notwithstanding the efforts of central banks and governments to provide liquidity support for financial institutions, the crisis deepened. In September 2008, Lehman Brothers was forced to file for bankruptcy (Singh, 2009).
Lax Lending Standards and Business Decisions
There was no single cause of the Lehman Brothers failure; instead, a number of factors contributed to the collapse. However, there can be little question that the single biggest driver of the mortgage meltdown was the conduct of subprime mortgage originators — the lenders themselves.
The process of qualifying for a home loan involves a determination of the buyer's creditworthiness. Typically, the buyer was expected to bring a down payment of twenty percent of the purchase price of the new home, which might consist of equity from the sale of an existing home, cash, or some combination of the two. Along with meeting those requirements, the homebuyer was also expected to earn sufficient income to afford the new mortgage.
Lenders may have satisfied themselves with a homebuyer's then-current income and ability to make initial mortgage payments, but nothing in the literature about the financial crisis suggests that lenders tried to account for future income and future ability to meet payments after a mortgage adjusted upward — typically two to three years after origination.
This lack of foresight amounted to lax lending standards, and the failure to consider a buyer's creditworthiness over a realistic timeframe constituted the single biggest error in judgment that lenders made. When Lehman Brothers climbed to near the top of the investment banking industry with a portfolio of highly leveraged loans, it pursued a strategy that involved an ever-escalating degree of risk. As the subprime crisis unfolded, Lehman perceived it as a countercyclical growth opportunity and believed the damage would not spread to other economic sectors (Field, 2010). By issuing significant volumes of subprime loans, Lehman Brothers and others set themselves up for inevitable liquidity problems.
According to Hamilton (2008), a study by economists Adam Ashcraft and Til Schuermann clearly demonstrates the flaws in the system that brought Lehman down. Their analysis investigated the securitization of a pool of approximately 4,000 subprime mortgage loans with a principal value of just under $900 million. These loans were originated by New Century Financial in the second quarter of 2006 — a small percentage of the $51.6 billion in loans the company originated that year before declaring bankruptcy in early 2007 (Hamilton, 2008).
The most striking feature of this loan pool was the magnitude of the increase in monthly payments to which borrowers were agreeing, even if LIBOR rates remained unchanged. This increase resulted from the teaser-rate structure of the majority of loans in the study:
"According to which the borrower would be virtually certain to need to make a huge increase in the monthly payments within two or three years. Ashcraft and Schuermann calculate that the monthly payments that the recipients of the loan were supposed to pay were scheduled to increase by 26–45%, depending on other details, within two and a half years of the loan being issued, even if LIBOR rates held steady at their values at the time the loan was originated, and by which time the principal owed would have increased substantially relative to the sum that had originally been borrowed. One has to wonder what circumstances one would be counting on to expect such payments to be made on schedule from a pool of borrowers with a history of other credit problems." (Hamilton, 2008).
Once mortgage defaults were systematically underforecast, the consequences of bad business decisions were magnified many times over by leveraging. Leveraging allows lenders to use borrowed capital for investing, and again the cost-benefit ratio was misapplied. The possibility of making profits proved irresistible to Lehman Brothers, and their leverage climbed as high as 32-to-1 (Hamilton, 2008).
Conclusion
Overall, there was a combination of factors that led to the Lehman Brothers failure. Ultimately it was the mixture of human behavior and greed that drove the demand, supply, and investor appetite for subprime mortgages that were Lehman's undoing. Along with poor decision-making by its management, the combination proved fatal for Lehman Brothers.
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