The US government had rescued other enterprises before and after Lehman Brothers, but, for some reason, it let this Wall Street firm sink
Image: Joshua Lott / Reuters
Lehman Brothers, the fourth largest investment bank on Wall Street, filed for bankruptcy in the southern district court of New York at 1.45 am on Monday, September 15, 2008.
In April that year, while speaking at a conference, hedge fund manager David Einhorn had said investment banks were dangerous because half the money they made was used to give high salaries and bonuses to employees. And employees had strong reasons to increase the leverage of their trades, in the hope of making more money, and thus getting higher bonuses. The average bonus in the securities industry in New York (more popularly referred to as Wall Street) had gone up from around $60,900 in 2002 to $191,360 in 2006. In 2007, it fell to $177,830.
These high bonuses, Einhorn said, were risky. He substantiated his argument with the example of Lehman Brothers. If calculated properly, the firm had had a leverage of 44:1. This meant, for every dollar of its own money, the firm had borrowed $44 to spruce up the returns on its trades. Hence, even a 1 percent fall in the value of its investments would have wiped out half of its equity, and pushed the leverage to almost 80 times. “Suddenly, 44 times leverage becomes 80 times leverage and confidence is lost,” Einhorn said.
It is this high leverage that ultimately led to the company’s collapse. The American government had rescued Fannie Mae and Freddie Mac, two government-sponsored enterprises, just over a week earlier. A day later, it would bail out AIG, the world’s largest insurance company. But, for some reason, it let Lehman Brothers sink. Henry Paulson, the then American treasury secretary, had come in for a lot of criticism for rescuing Fannie and Freddie. “I’m being called Mr Bailout; I can’t do it again,” he had reportedly said.
Mr Bailout did rescue AIG and several other American financial firms (both normal and investment banks), after letting Lehman Brothers go. All over the world, central banks and governments came to the rescue of many financial firms on the verge of bankruptcy. These firms had piled on loads of debt, and in the process had excessive leverage (ie, they did not have enough of their own capital against the money they had borrowed).
It has been close to a decade since Lehman went down. The question is, has the world changed since then?
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(This story appears in the 14 September, 2018 issue of Forbes India. To visit our Archives, click here.)