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The ghosts of Lehman Brothers: 10 years later

It is scarcely believable that precisely a decade has passed since the once-mighty Lehman Brothers collapsed. Time certainly does fly.

Yet even more rapid was the demise of this venerable investment bank. In February 2007, Lehman’s share price reached a record high of $86.18. Even as defaults within the sub-prime mortgage sector began to rise later that year, the bank's share price rebounded in the fourth quarter, and it reported record profits for a third year in a row by the end of 2007.

However, the cracks began to show following the bailout of Bear Stearns in March 2008, and Lehman Brothers reported Q2 losses of $2.8bn. Yet it was during the first week of September that matters really came to a head, as its stock plummeted by nearly 80 per cent.

The failure of the Korean Development Bank to purchase a stake in Lehman on 9 September was a hammer blow, and the bank's final hopes of survival hinged on a 72-hour secret meeting the following weekend between chief executives of rival investment banks, their deputies and Treasury Secretary Hank Paulson at the New York Federal Reserve. 

The objective was to broker a takeover of the ailing firm, with Bank of America rumoured to be interested. When they unexpectedly purchased Merrill Lynch instead, Barclays emerged as a potential safety net. However, the refusal by British Chancellor Alistair Darling to provide state guarantees for a takeover pulled the plug on a deal. So, despite holding an estimated $600bn in assets, Lehman Brothers declared bankruptcy on the morning of Monday 15 September, 2008.

Should Lehman have been rescued?

The chaos which followed the Lehman Brothers bankruptcy was instant and widespread. Money markets froze, banks ceased lending to each other and trillions were wiped off the value of the global economy. Insurance giant AIG had to be bailed out to the tune of $700bn later that week, while in early October, RBS - the world's biggest bank at the time - only avoided running out of money courtesy of an 11th-hour state bailout. Such measures helped to calm financial markets, but the ensuing global recession was the deepest since the 1930s, and, 10 years later, the world economy still endures a painfully-slow recovery.

Which begs the question: should the US government have prevented it all from happening by saving Lehman?

Darling and many other senior economists believe so. Paulson and his fellow decision-makers have staunchly argued in the years since that there was no legal mechanism through which to bail the bank out, as Lehman Brothers was deemed to have insufficient collateral to protect the Fed and taxpayers if the loans it provided were not repaid, as required by the Federal Reserve Act.

However, critics point to the Fed loans provided to the likes of AIG, and, earlier in 2008, to Freddie Mac and Fannie Mae (coupled with the assistance the Fed provided to the rescue of Bear Stearns), and deem Paulson's interpretation of the law to be arbitrary. 

Furthermore, the decision appeared all the more political given that Paulson was quoted in early September 2008 as saying, "I can’t do it again. I can’t be Mr Bailout.” No doubt bailouts are politically unpopular, but many argue that even the provision of temporary assistance would have enabled Lehman to unwind its books in a more orderly manner, and thus significantly reduce the shock to an interconnected global financial system.

Moral hazard and porous regulation

Whether Lehman Brothers should have been bailed out is a debate that will continue to rage for years. But apportioning sole blame to Paulson and the Fed seems ludicrous. The fall of this Wall Street giant was very much of its own making; one which epitomised a culture of so-called 'casino banking'. Reckless lending was at the heart of it all, with Lehman more exposed than any other to the sub-prime mortgage market.

And while most of its competitors were leveraged to the tune of 30:1, Lehman Brothers' leverage ratio was said to be 44:1 at the point of its collapse. In other words, for every one per cent it lost in asset value, nearly half of its equity would disappear. With bonuses paid as a proportion of revenue, rather than profits, employees were incentivised to increase leverage, resulting in a moral hazard which ultimately brought Lehman Brothers - and many rivals - to its knees.

For such behaviour to go on undeterred by the 'light-touch' regulation in place at the time is a damning indictment of regulators across the world. Indeed, there is much public outrage at the absence of arrests in the wake of the financial crisis. Yet this in itself leads you to wonder: were these bankers even breaking any laws? If the answer is no, then that is shameful in itself.

10 years later: A new dawn?

Despite the lack of prosecutions, there has undoubtedly been a strong degree of overhaul within the global financial system. In the UK, we've seen banking regulation become considerably more stringent under the auspices of the Financial Conduct Authority, Financial Policy Committee and Prudential Regulation Authority.

Banks are leveraged to a lesser extent these days, have endured hefty penalties, and are far better capitalised than they were a decade ago. European regulators have also clamped down on executive pay since 2010, while a levy has been imposed on UK banks since 2011. In addition, consumers have seen protection under the Financial Services Compensation Scheme increase more than two-fold to £85,000 since 2008. 

Whether such measures have gone far enough is open to debate. But it would appear that some lessons have been learned. One reality will never change though: where there is leverage, fractional reserve banking and a mismatch in the timings of money lent and borrowed, there will always be risk. It is one of the reasons peer-to-peer lending has grown in popularity since the financial crisis. Not a single penny is created, money is invested and borrowed over equal terms, and the efficiencies of the transaction are shared between lender and investor. The absence of inflated executive pay, and a reputation for simplicity and excellent customer service add to its economic standing even further.

That said, banking remains the heartbeat of the global financial system, and there is no doubt regulators and ratings agencies alike have sharpened their game to ensure this particular ecosystem is more robust.

Yet these difficult lessons in the wake of Lehman Brothers' collapse must not be forgotten. It is the hard-working public who have suffered the consequences of an ingrained banking culture of recklessness and greed. Never again can the balance of power shift away from the asylum towards the inmates in such a manner. Our prosperity, and possibly even the very future of capitalism, depends on it.

Our website offers information about saving, investing, tax and other financial matters, but not personal advice. If you're not sure whether peer-to-peer lending is right for you, please seek independent financial advice, and if you decide to invest with Lending Works, please read our Key Lender Information PDF first.

As with all investments, your capital is at risk.