Wait. Lehman Brothers collapsed? When did this happen?

This week marks the 10th anniversary of the spectacular collapse of one of America’s most famous financial firms based in Wall Street, but with a key office in London. The first losses for Lehman were posted on the 10th of September with the situation deteriorating throughout the week and investors dumping stock and fleeing the bank. On the 14th, the US Treasury refused to bail the bank out and that weekend other banks – Bank of America and Britain’s Barclays – pulled out of purchasing talks. On the 15th, Lehman had to file for bankruptcy; the first major bank collapse in the US of the credit crisis. Financial markets plummeted: the Dow Jones dropped 4.5%, the largest single-day drop since 9/11. Global markets were hit and other banks were in precarious positions.

Why did Lehman collapse?

Lehman Brothers had become heavily involved in the mortgage market, owning the subprime mortgage seller BNC Mortgage. By 2008, the bank held thirty times as much in real estate products as it had capital, and it had been borrowing too much money to fund its mortgage investments. When the market turned, Lehman was stuffed. As Lehman had held onto, or could not sell, so many risky low-rated mortgages, the subprime mortgage crash affected the bank badly and, in the first half of 2008, it lost of 73% of its value. Investor confidence in the bank quickly declined, leading to the crises of early September.

What is a subprime mortgage again?

A subprime mortgage is a loan given to someone who has a poor credit score. Because subprime borrowers are seen as less likely to be able to pay the money back, the lender is normally compensated with higher interest rates. However, in the years preceding the 2008 crash, these loans in the US were given out with artificially low rates for the first couple of years of each mortgage.

What could possibly go wrong?

Oh, only the near collapse of the global financial system because of the collapse of trust and the interconnection, thanks to technology, between banks across borders. This crisis had mundane roots. By making house-purchasing more accessible, the banks thought that house prices would rise as a result of increased demand. As house prices rose, they would lend greater security to the banks who would then be holding high-valued real estate. The loans could be packaged up and sold on, for another profit. The idea was also to mix up the riskier loans with more secure mortgages lent to people with high credit scores. The mixed bag of bonds of risky and safe mortgages were stamped by ratings agencies as AAA, top dollar investments.

This went wrong, didn’t it?

Yep. As a result of banks lending to people who were less likely to be able to pay the mortgages back, especially after the one or two years of lower interest rates had ended, many mortgage payments were defaulted on. Houses poured onto the market, the availability of housing stock increased and prices fell. The US housing bubble burst.

Not only were many people left homeless, but the banks that had financed these mortgages now faced a problem. The underlying loans could not be repaid, the real estate value of the houses which the loans were secured against had declined dramatically, and the value of the investment products built around this market collapsed.

It was as a result of this subprime crash that the fortunes of the most exposed banks declined so rapidly. As no bank would accept the mortgage-backed bonds as collateral for a loan, the banks refused to lend to each other and the financial system was threatened with collapse.

What happened as a result of the collapse of Lehman?

The collapse of Lehman Brothers transformed a US subprime mortgage crash into a global economic downturn which lasted until late 2009. Banks across the world were bailed out, including the Royal Bank of Scotland by the UK government; stock markets plummeted and debt spiralled; and hundreds of thousands lost their houses. More about all that to come on Reaction in the next few weeks.