The fall of Lehman Brothers is a cautionary tale of bad risk management, as well as an example of what could have occurred all over Wall Street. Prior to its fall, Lehman would take on subprime debt and then unload it onto others using a financial instrument that basically worked in this manner: as the owner of the instrument, I receive the inflows from the person who took out the debt (mortgages). However, if that person can no longer pay, then there is little I can do. Lehman had bought insurance from AIG so that if a localized market event drove the prices down, AIG would have an obligation to pay the difference. The problem was that these mortgage tranches, or collections of pieces of different mortgages that were packaged and sold, were very interconnected, and when they began failing, would not stop failing. Suddenly, when the mortgage crisis broke loose, no one wanted subprime debt anymore. Additionally, AIG had backed so many of these credit default swaps that paying them all was not feasible. Lehman was forced to swallow the toxic assets, and as the number of buyers remained low, the situation grew worse. Lehman Brothers's weak balance sheet became relevant, as it could not continue to bleed capital, and bankruptcy turned into the only viable path. This put the already-scared financial markets into a state of panic, as it was now plain to see that a number of other banks could very easily fall as well. Another issue in the bankruptcy proceedings was that it was almost impossible to calculate an estimate for the value of many of the assets that were for sale. For example, derivatives are a type of security that derives its value from another security, such as a stock/collection of stocks. Its value only changes based on the fluctuation of the other security's value. An office building can be appraised to attempt to find an estimate of its value, but the future price of a stock as well as the fluctuations that get it there cannot be anticipated in the same manner, which leads to the question of how to find what a derivative should be sold for in bankruptcy proceedings. These were the types of issues that could have torn down all of Wall Street had bailouts not been appropriated to various firms.
Resources to view:
http://www.bloomberg.com/apps/news?pid=newsarchive&sid=a63mWc3ILlTo
Kenneth Moussavian
This is a very intriguing post on a very contentious topic. I find the politics of Wall Street quite interesting and enjoyed reading about it. You explained the economics of subprime debt pretty well, but some of these terms are still unfamiliar. It's interesting to note that Lehman Brothers is still going as a business, and I'd love to know more about how they came to survive.
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