15 years since US bank Lehman Brothers fall: Looking back to look ahead

15 years ago, a US investment bank collapsed and changed the financial world forever. Or, did it?

Infrastructure Leasing & Financial Services, set up in 1987 to fund India’s anticipated infrastructure boom, began to default on its debt repayment in 2018, sending shivers down the spine of financial markets. Fears arose that this could be India’s Lehman moment, now that the erstwhile investment bank has become this century’s Watergate, lending its name to all big financial crises.
 

However, Indian authorities moved swiftly. The government took control of IL&FS, sacked its board, appointed a new one, and started a process of resolution and monetisation that prevented a contagion. Ironically, IL&FS was probably prevented from becoming India’s Lehman because of the lessons learnt and measures taken after the United States-based entity had collapsed (see: FORTIFYING INDIA).
 

That was exactly 15 years ago.
 

On September 15, 2008, Lehman Brothers, a 164-year-old Wall Street institution, filed for bankruptcy. It was widely considered “too big to fail” but it transpired that it was too large to bail out. It was the largest bankruptcy case in history. Lehman’s balance sheet held $639 billion of assets and $619 billion of liabilities and yes, it employed more than 25,000 people globally.
 

The collapse of Lehman triggered panic across global financial markets. It highlighted the casual way the world’s largest financial institutions had piled onto the US housing mortgage market.
 

The so-called “Subprime Crisis” ruined invest­ors around the world and led to a two-year decline in the global gross domestic product (GDP). That period — 2008-09 — is now referred to as the “Glo­bal Financial Crisis” or “The Great Recession”. It triggered sympathetic collapse in other markets, and caused what is now called the “Second Global Financial Crisis”, which mainly affected Europe.
 

So, what really happened?
 

In 2007, Lehman declared $4.2 billion of profits on $19 billion of revenue and the stock hit a life­time high of $86. But Lehman declared losses of $2.8 billion in the April-June quarter of 2008 and it was facing an estimated loss of about $3.9 billion in Q3 (July-September) when it filed for bankruptcy.
 

It had run out of liquid cash and, despite its huge balance sheet, no lender would touch it. It was threat­ened with a catastrophic rating downgrade, unless it could find a buyer prepared to take it over. It failed to find a white knight. The US gov­ernment refused to bail it out. The stock price dropped to around $0.03 by Septem­ber 2008 and, even at that, there were few takers.
 

What set this off was elementally simple though it was dressed up in lots of complicated financial models and even more convoluted jargon. From around 2003, Wall Street was focused on US mortgages. The game plan was to hand out a mortgage to somebody. Then the mortgage holder would sell on the loan, and use the proceeds to fund a new mortgage and sell on that loan, to fund a third mortgage, and so on. In turn, the buyers of these mortgages would sell on their loans too, and use that cash to buy another set of mortgages. This sucked in more institutions.
 

When a lender makes a loan, there is always a default risk. A mortgage is backed by the value of the real estate, and in theory, the loan ticket size is at a discount to the land-value. In default, the hou­se can be repossessed and auctioned. More­over, land values usually rise — in the US, they had risen steadily over a 70-year period by the early 21st century. So a mortgage “should” be fairly safe.
 

“Of course”, you check for the credit-worthiness of the borrower to minimise default risk. Those complicated financial models treated the probability of defaults as separate risks. That is, they assumed that a default by Borrower A would not affect the probability of default by Borrower B. So Wall Street packaged together baskets of mortgages and sold them as bundled instruments.
 

But what if most of the borrowers were not credit-worthy? What if real estate value fell due to a series of combined defaults What if there were no takers for the repossessed properties that were auctioned? What if all this happened simultaneously?

It was an inevitable result of a large number of borrowers not being credit-worthy. This is what happened and every financial player who was part of that chain (and many who were not) was hit by the consequences.
 

The analysts who examined outstanding mortgages with a sceptical eye coined a new phrase: “NINJA loans”, or mortgages offered to borrowers with no income, no job, and (no) assets. In their greed to keep the mortgage pipeline flowing, Wall Street ignored risk-management experts and offered many NINJA mortgages.
 

As a result of the housing demand created, real estate values bubbled up. When the defaults occurred and they occurred in combination, the real estate bubble collapsed. When real estate values plummeted, even “non-Ninjas”, who could afford to service mortgages, decided it was rational to default.
 

Typically, in a mortgage you buy a house for a sticker-price of, let’s say, $100 and you have paid $20 upfront and mortgaged to borrow the rest. Now, suppose the price drops to $5. It makes sense to default and allow repossession. That meant a cascade

of yet more defaults.
 

Lehman’s liquidation finally completed in September 2022, 14 years after bankruptcy.  Nomura bought the firm’s operations in the Asia-Pacific region, and its investment banking and equities trading businesses in West Asia and Europe. Barclays purchased its North American investment banking and trading operations.
 

More than $115 billion was paid out on its brok­erage assets. Lehman’s 111,000 customers recei­ved all $106 billion they were owed, and secured creditors received full pay-outs. Unsecured creditors recovered $9.4 billion, or about 41 cents for every dollar. Barclays bought most of Lehman’s US brokerage assets. The trustee law firm, Hughes Hubbard & Reed, was awarded $424 million as final compensation for 14 years of work.
 

India was among the places least affected by the subprime tsunami. In India, the Nifty plunged 65 per cent in 2009. In the follow-up second crisis, the RBI had to open a swap window in 2013 asking member banks to borrow forex to boost forex reserves.
 

Other markets were hit even harder. America changed many of its laws and tightened credit rating regulations and instituted huge bailouts. The big central banks — the US Federal Reserve, the Bank of Japan and the European Central Bank — did a humongous amount of quantitative easing (QE) — pumping liquidity into the markets.
 

Meanwhile a computer programmer (or a group) who used the name, “Satoshi Nakamoto”, wrote a white paper outlining how a crypto­currency called bitcoin could help bypass fiat currencies. In January 2009, the bitcoin blockchain was launched.
 

The Reserve Bank of India governor has said he is apprehensive about a potential global crisis sparked off by something going wrong in the cryptocurrency ecosystem.
 

Now cut to March 2023. Swiss institution Cred­it Suisse is bought by UBS, another Swiss institu­t­ion, for $3.25 billion to prevent it from collapsing after the bankruptcy of three US banks left Credit Suisse exposed. In August 2023, UBS claimed rec­ord profits of $29 billion as the windfall gain result­ing from the difference between what it paid and what Credit Suisse’s assets are supposedly worth. But parts of CS are still producing huge losses and it will take at least three years of restructuring before the actual gains or losses can be assessed.
 

The more things change…

Beware another crisis?
 

Despite all the reforms, there have been collapses and financial market glitches in the last 15 years. Silicon Valley Bank, which had funded many iconic startups, crashed in march 2023, taking down two other US banks and triggering the enforced acquisition of Credit Suisse by UBS. China has had its Evergrande crisis.
 

Public debt to GDP has soared across the world as a result of measures taken to combat the crisis and growth has also been hit by Covid and the Ukraine war. This would make it much harder to combat another global financial crisis on this scale. However, bank balance sheets are much healthier due to the reforms and credit-worthiness of borrowers is scrutinised more closely.

The RBI governor has said that he is apprehensive about a potential global crisis sparked off by something going wrong in the cryptocurrency ecosystem that contaminates the conventional banking system.

Christine Lagarde, who heads European Central Bank, says risk-taking is still a cultural problem and unlikely to be tackled without better gender representation and more diversity in financial hiring. “If Lehman Brothers had been Lehman Sisters, the crisis would not have occurred.”

Fortifying global finance
 

Lehman Brothers was Wall Street’s fourth-largest investment bank before filing what remains the largest US bankruptcy on September 15, 2008. The Barack Obama Administration took charge in January 2009, in the same month that bitcoin started trading.
 

The US carried out key legislation such as the Dodd-Frank Wall Street Reform and Consumer Protection Act, the Emergency Economic Stabilization Act (EESA), and the Troubled Asset Relief Program (TARP), which played a pivotal role in resolving the subprime crisis. Even so, the average American will lose $70,000 in lifetime earnings due to the GDP decline caused by the crisis.
 

The EU created the European Systemic Risk Board and three supervisory authorities to oversee securities and markets (ESMA), the Banking Authority (EBA) and Insurance & Occupational Pensions Authority (EIOPA).
 

Credit rating agencies around the world had to tighten their norms. Regulators also examined benchmarks such as the LIBOR to try and prevent manipulation. Global banking norms were tightened by the Basel–III norms that increased the equity capital banks had to hold to provision against potential defaults. Central banks became more proactive in tackling potential crisis situations.

Fortifying India
 

- India was not affected by the sub-prime crisis, due to less global integration and because securitisation as a concept was not big

- RBI was gradual in its approach, any new concept introduced was not allowed before creating a regulatory structure

- In the case of cryptocurrency, the RBI has not permitted it and has so far been against this concept

- In terms of Basel-III, RBI has been ahead of the curve, with the transition being faster for India than what has been prescribed

- There has been regulation in place on credit rating agencies; Sebi has been ahead of the curve