Five years on, what can we learn from the collapse of Lehman Brothers? The conventional opinion is that we should have saved Lehman Brothers just like we saved the rest of the financial sector in the immediate aftermath of the Lehman collapse. But some critics assert that the decision to save Bear Stearns convinced everybody that Lehman would be saved when push came to shove. When this expectation was not met, chaos ensued.

Market data from March 2008 to September 2008 supports the critics. Lehman’s credit spreads halved between March and June 2008. Even when Lehman’s stock price started falling in May and June, its credit spreads barely reacted. The below graph (courtesy the WSJ) captures just how dramatically Lehman credit spreads fell in the aftermath of the Bear Stearns bailout:

Lehman CDS

The Bear Stearns bailout convinced everybody that Lehman would be treated no differently as a Wall Street Journal article from June 2008 explains:

The ouster of two top executives at Lehman Brothers Holdings Inc., including the person responsible for keeping the company’s books, sent the bank’s share price tumbling to a new six-year low, but the normally jittery bond market shrugged off the move.

While Lehman’s stock price fell 4.4%, investors were bidding up some of Lehman’s bonds, and the price of protection against default on Lehman debt ultimately declined on the day. It costs an investor $280,000 annually to protect against default on $10 million of Lehman debt for five years – down from $285,000 Wednesday, according to Phoenix Partners Group.

The tempered reaction in the bond markets underscores investors’ conviction the Federal Reserve won’t let a major U.S. securities dealer collapse and that Lehman Brothers may be ripe for a takeover. In March, when Bear Stearns was collapsing, protection on Lehman’s bonds cost more than twice as much as it does now.

Of course allowing Bear Stearns’ creditors to take a loss may just have brought forward the chaos of September 2008 to March 2008. Given that bank creditors had been bailed out in the United States since Continental Illinois this is entirely plausible. Nevertheless, the policy actions of 2008 made things worse. If an evil genius had taken over the world in March 2008 with the sole aim of causing financial chaos, he could not have done any better  - bail out Bear Stearns, convince everyone that no failures will be allowed and then renege on this implicit promise six months later.


Rajiv Sethi

Great Post. It's well known that one of the key links between the Lehman collapse and the run on money market funds was the exposure of Reserve Primary. Less well known is how the fund responded to the rescue of Bear. From the FCIC: "Earlier in 2008, Primary Fund’s managers had loaned Bear Stearns money in the repo market up to two days before Bear’s near-collapse, pulling its money only after Bear CEO Alan Schwartz appeared on CNBC in the company’s final days, Primary Fund Portfolio Manager Michael Luciano told the FCIC. But after the government-assisted rescue of Bear, Luciano, like many other professional investors, said he assumed that the federal government would similarly save the day if Lehman or one of the other investment banks, which were much larger and posed greater apparent systemic risks, ran into trouble. These firms, Luciano said, were too big to fail."

Ashwin Parameswaran

Rajiv - Thanks. I was not aware of Reserve Primary's response but it's not that surprising I guess.

Diego Espinosa

The Bear bail out was a false commitment to protect the capital structure north of equity capital. That signal came into doubt in July when rumors began to circulate of a haircut on GSE subordinated debt and preferreds. This erosion of the Fed put eventually led to Lehman failing.

Ashwin Parameswaran

Diego - thanks. I'd just add that the implicit put in CDS spreads was fairly significant right uptil the Lehman weekend.

Lovell Nabors

The demise of Lehman was part of in my opinion one of the largest frauds in the world. The attack on housing, banks committing fraud to steal homes(Robo signings), the banks were co-conspirators and could not feed the frenzied appetite for loans..banks attacking 700+ FICO credit card holders without cause by lowering their credit limits to napalm any potential buyers..wallstreet being filled with gamblers did not initially intend to crash the housing market. The banks could not satisfy the demand for mortgages so wallstreet originated, then manufactured their own..but once they saw the opportunity to make money doing shorting housing...think about the are going to attack the American Public? Steal the value of their homes?? they were all-in...others were brought in..the prostitute ratings agencies given a get-out-of-jail free card were keen to rate anything AAA for a fee..this was blatant misrepresentation, done with malice...the Monoline insurers filled with lust for fees lost their minds..since when does a FICO score prove income or ability to pay..they were used..not knowing Alt-A (non-reporting credit history that they stopped verifying) was used to create Frankenstein credit scores..they didn't think..if a file has an average FICO of 680 it means half the scores in the file have scores lower. Fannie also caught up..blind..naive...allowed themselves to be tricked into betting against what world do you invest in loans that you guarantee, but have no impact on the pricing? CDOs were crap on steroids stamped with a purchased AAA one could value them...they were internally many had to fight to get paid when loans started defaulting but Goldman didn't change their pricing? This is why Lehman alone was allowed to die..once everyone else started bleeding from CDO holdings...all sellers and no buyers ..they needed help...the Bear fell their own fault(story for another day) but to help the other firms...Lehman had to go. Why? Because they were not on the hook with CDO crap..they had real estate..they lived on short term meant that Lehman would have been the last man standing...all the other firms would be bailed out except Lehman. That was not going to happen...THIS IS WHY HOUSING WAS ATTACKED..WHY REAL ESTATE HAD TO BE CRASHED...TO KILL LEHMAN...once they were gone the other firms could be aided without any one questioning it since they all had the same could not justify bailing out firms and Lehman was would have shown they were better managed...can you imagine Fuld as the last man standing as Goldman went wasn't going to happen..the FED gamblers too saw an opportunity and used the Treasury to grab Billions (TARP) on the deception the world would end...yet it did not and they did not do with their blank check what they said they would do...instead they forced the banks to take a hard money loan...this country has been exposed..when the FED defaults on a Gold claim..(refusing to return Germanys Gold and not even letting them see it)..the Chinese hit the gas and will own most of worlds physical gold...they are playing to win the war..not the battles..when they and Russia and India decide they no longer want to play with monopoly money...he who owns the gold will make the rules....again!