What really happened

Lehman Brothers was 158 years old when it collapsed on September 15, 2008 in what was then the largest bankruptcy in US history. The investment bank had become one of the most aggressive players in the US mortgage market from 2003 to 2007. With about $691 billion in assets, Lehman controlled a mortgage-backed securities portfolio of roughly $250 billion — dominated by subprime loans and related derivatives.

Leverage was extreme: Lehman operated at a leverage ratio of around 30:1 — for every dollar of equity, 30 dollars of liabilities. Once the US housing market began to roll over in 2007, equity melted. In June 2008 Lehman reported a quarterly loss of $2.8 billion — its first since the 1994 IPO. An emergency capital raise in Asia failed; the stock dropped almost 90% in Q3 2008.

Over the weekend of September 12–14, 2008, Treasury Secretary Hank Paulson together with Fed Chair Ben Bernanke tried to sell Lehman to Barclays or Bank of America. Both deals fell apart — Barclays because of UK regulatory hurdles, Bank of America because it was simultaneously acquiring Merrill Lynch. Unlike with Bear Stearns six months earlier, the Fed decided not to fund a bailout. Sunday at midnight Lehman filed Chapter 11. Global equity markets lost trillions of dollars in the days that followed.

The warning signs everyone ignored

Lehman had been on the watchlist of virtually every market participant since Bear Stearns collapsed in March 2008. The stock was already down 50% by April. Hedge funds such as Greenlight Capital (David Einhorn) had publicly shorted the bank since mid-2007 and published detailed analyses of its mortgage exposure. The accounting tricks — particularly the infamous “Repo 105” transactions, which Lehman used to temporarily move $50 billion of debt off the balance sheet at quarter-end — were later documented by examiner Anton Valukas.

The structural warning was obvious: 30:1 leverage only works if asset prices are stable. With a 5% decline in asset values a 30:1 balance sheet is technically insolvent — and US home prices fell 30-50% in some regions in 2008. Yet many pension and money-market funds held Lehman bonds until the very end, because rating agencies only downgraded them shortly before the bankruptcy.

What investors can learn today

First: leverage can multiply returns — and accelerate insolvency. A firm with 30:1 leverage has no cushion for negative surprises. Second: “too big to fail” is not a guarantee. Lehman was not rescued, even though it was the fourth-largest US investment bank. Politics can choose against individual market participants. Third: liquidity matters more than solvency. Lehman technically still had assets, but nobody was willing to finance them at fair prices anymore — the breakdown of trust is the final phase of every collapse.