Lehman Brothers Failed on a Monday and the System Nearly Went With It
The largest bankruptcy in United States history was not caused by bad assets alone. It was caused by short term funding that could be withdrawn faster than the assets could be sold.
The Funding Model
Investment banks did not fund themselves primarily with deposits. They funded themselves in wholesale markets, heavily through repurchase agreements, known as repo.
In a repo, a firm sells a security and agrees to buy it back the next day at a slightly higher price. Economically it is a secured overnight loan, with the security as collateral. It is cheap because it is short and collateralized.
The vulnerability is obvious once stated. A firm financing long dated, hard to sell assets with borrowing that must be renewed every single morning is exposed to the lender simply declining to renew.
The Haircut Spiral
Repo lenders protect themselves with haircuts, lending slightly less than the collateral is worth. In calm conditions a haircut on high grade collateral might be very small.
When lenders grow nervous, they raise haircuts. The borrower must then post more collateral for the same funding, which means selling assets to raise it. Selling into a falling market lowers prices, which makes lenders more nervous, which raises haircuts again.
Lehman did not need lenders to demand their money back. It only needed them to decline to lend again tomorrow morning, which required no decision more dramatic than caution.
What Made It Fatal
Lehman held large positions in commercial real estate and mortgage related assets that had become genuinely difficult to value. Difficult to value means difficult to use as collateral, because a lender cannot size a haircut on an asset with no reliable price.
The firm was also highly leveraged, with a very thin equity cushion relative to assets. At that leverage, a small percentage decline in asset values wipes out the equity entirely. There was no room to absorb losses while renegotiating funding.
Why No Rescue Came
Bear Stearns had been arranged into a sale earlier that year with government support. Lehman was allowed to fail, and the reasons remain debated.
Officials argued afterward that Lehman lacked sufficient collateral to secure a central bank loan, and that there was no legal authority to inject capital into a failing investment bank. Others contend the decision was substantially about avoiding the political consequences of another rescue.
What is not debated is the consequence. The failure demonstrated that large institutions could fail, which caused every market participant to reassess every counterparty simultaneously. A money market fund holding Lehman paper fell below a dollar per share, triggering a run on funds that were supposed to be cash equivalents.
The Real Lesson
The instructive point is that Lehman's assets were not worthless. Much of the estate eventually paid out substantially over the following years of liquidation.
The firm died because it could not fund itself for the weeks required to sell those assets in an orderly way. That is a liquidity failure, and it is the same mechanism, in different clothing, as every bank run in history.
The Bottom Line
Lehman failed on funding rather than on solvency, and the assets eventually paid out to a meaningful degree. Financing long assets with overnight money works until the morning nobody renews.