A bank with 158 years of history and unsustainable leverage
Lehman Brothers was founded in 1850 by three German immigrant brothers in Alabama, and survived the American Civil War, two world wars, and the Great Depression before becoming the fourth-largest investment bank in the United States. That longevity is precisely what made its collapse so shocking: this wasn't a young or reputationally speculative firm, but a century-old institution considered part of the core of the financial system.
In the years before 2008, Lehman had bet aggressively on mortgage-backed assets, including the subprime mortgages we cover in detail in our guide to the 2008 financial crisis. To finance those bets, the bank operated with extreme leverage: for every dollar of its own capital, it held more than $30 in assets financed with debt. At that level of leverage, a drop of just 3% in the value of its assets was enough to wipe out its entire capital base.
Repo 105: how Lehman hid its true leverage
Shortly before reporting its quarterly results, Lehman used an internal accounting maneuver known as 'Repo 105': it temporarily sold assets to other entities in exchange for cash, classifying those transactions as real sales rather than collateralized loans (which is what they actually were in practice), and repurchased those same assets just days later, once the balance sheet had already been published. The result was that, on the dates investors and regulators looked at its books, Lehman appeared to have up to $50 billion less debt than it actually carried.
This maneuver wasn't technically illegal under the letter of the accounting rule that permitted it, but its sole purpose was to mislead about the bank's true level of risk. When the bankruptcy examiner published his report in 2010, Repo 105 became one of the most cited examples of how accounting engineering can hide a real problem until it's already too late to fix it.
- Repo 105: temporary asset sales classified as real sales, not as collateralized loans.
- Accounting effect: up to $50 billion in debt disappeared from the balance sheet right before reporting results.
- The assets were repurchased days later, once investors had already seen a healthier balance sheet than the real one.
The weekend at the Federal Reserve Bank of New York
on Friday, September 12, 2008, with Lehman's stock in free fall and its short-term funding sources drying up, the president of the Federal Reserve Bank of New York called the top executives of Wall Street's major banks to an emergency meeting. Throughout the weekend, bankers and regulators (including Treasury Secretary Hank Paulson and the New York Fed's own president, Tim Geithner) tried to find a private buyer to absorb Lehman without needing public money.
Bank of America, which had been one of the most serious candidates, decided in the final hours to buy Merrill Lynch instead, another investment bank on the brink of collapse. Barclays, the British bank, reached a preliminary agreement to acquire Lehman, but the British financial regulator refused to approve the deal without a guarantee from the US government against losses, a guarantee Paulson refused to offer. Without a buyer and without a public bailout, Lehman Brothers filed for bankruptcy in the early hours of Monday, September 15, 2008.
Why the government let Lehman fail (and bailed out others)
The decision not to bail out Lehman looks even more puzzling when compared to what happened right before and after. In March 2008, the Federal Reserve had facilitated the rescue of Bear Stearns, another investment bank, by financing its purchase by JPMorgan Chase. Just one day after Lehman's collapse, the government bailed out insurer AIG with an $85 billion injection, judging that its collapse would endanger the entire global financial system.
Paulson and Bernanke later argued that, unlike Bear Stearns and AIG, Lehman didn't have sufficient collateral to back an emergency loan without exposing taxpayers to certain losses, and that they lacked clear legal authority to intervene without a willing buyer. Many economists have since questioned that explanation, suggesting the real reason may have been political: the government needed to demonstrate it wouldn't bail out everyone, without fully anticipating the scale of panic that letting an institution of that size fail would unleash.
The consequences: global panic and a lesson about systemic risk
Lehman's bankruptcy, with around $639 billion in assets, remains the largest corporate bankruptcy in US history. Its collapse froze short-term credit markets worldwide almost instantly: banks stopped trusting each other and lending to one another, a phenomenon that severely worsened the recession already underway, exactly the kind of systemic risk we cover in our guide to the 2008 financial crisis.
The lesson Lehman left behind shaped much of the banking regulation that followed (the Basel III capital requirements, bank stress tests) and also how regulators would act in future crises: as we'll see in the coming chapters of this series, when Silicon Valley Bank and Credit Suisse collapsed in 2023, regulators acted with a speed and willingness to intervene very different from that fateful 2008 weekend.
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Frequently Asked Questions
Due to extreme leverage (more than 30 times its capital) invested largely in assets tied to subprime mortgages, whose value collapsed during the 2008 financial crisis, combined with a loss of confidence that cut off its short-term funding.
An accounting maneuver Lehman used to temporarily move up to $50 billion in debt off its balance sheet right before reporting quarterly results, repurchasing those assets days later, with the sole purpose of hiding its true level of leverage.
The Treasury and the Federal Reserve argued that Lehman lacked sufficient collateral to back an emergency loan without certain losses for taxpayers. Many economists believe political considerations, the need to show not everyone would be bailed out, also played a role.
Around $639 billion in assets, making its bankruptcy the largest in US corporate history, a figure that has not been surpassed since.
Capital and leverage requirements for large banks were significantly tightened (the Basel III accords), and periodic stress tests were introduced to assess whether institutions could survive a crisis scenario similar to 2008.