On 15 September 2008, the giant US investment bank Lehman Brothers declared their bankruptcy. This triggered global financial stress and turned into a full-blown international emergency.
But what exactly happened on this unfortunate day? Let’s look deeper into the matter, its consequences and whether there’s a possibility of it happening again.
Lehman Brothers were deep in debt and were failing to roll over its borrowings in the markets when the
US government refused to bail the bank out.
The failure of this US giant with the liabilities of around $700bn shockingly hit the entire global financial system. The global money markets froze; even the banks and insurance companies of the most
developed nations discovered that they could not borrow either.
The chair of the Federal Reserve (the US’ central bank), Ben Bernanke, subsequently called it “the worst financial crisis in global history”.
Central banks were forced to lend to banks huge sums to prevent the outpouring of bankruptcies in the financial sector, that could be bigger than Lehman. And a collapse of such level could have meant global financial crisis with salaries not being paid, liquidity affected, jobs lost, in all likelihood, total panic.
“If you can’t buy food or petrol, or medicine for your kids, people will just start breaking the windows and helping themselves … it’ll be anarchy,” agonized Gordon Brown at the time.
Speaking of the commotion in the global financial system as the US government was hesitating in bailing out the bank, George W Bush simply quoted: “This sucker could go down.”
Eventually, those banks were bailed out with huge sums of taxpayers’ money to restore some balance and normality in financial markets.
Why did it happen?
Although, the famous global financial crisis of 2008 was not entirely triggered by the bankruptcy of Lehman Brothers. This was not a sudden shock that disrupted a well-functioning system.
The financial system was already under stress for more than a year. Another big US investment bank, Bear Sterns, had been retrieved of such crisis earlier in March. And a mortgage lender in the UK, Northern Rock, had experienced a similar run in 2007. The most relative cause of this stress could perfectly be drawn out with a systematic mistrust amongst financiers in the solvency of other institutions.
In the US, bankers had developed a lucrative habit of buying the mortgages of poor Americans (known as “subprime”), packaging them real nice and selling them as risk-free assets known as mortgage-backed securities.
When the Central Bank of the US raised interest rates in 2006, many American homeowners started to default, prices in the housing sector fell enormously and all these securities turned out to be very risky. And it could be made clear that there were huge losses occurring in the system, ultimately.
But it was hard to figure out the presence of these toxic securities and whose balance sheets were most under bad debts. This resulted in banks charging higher rates of interest to lend to other financial institutions, who they suspected were under massive unrecognised losses. This was the phase of “credit crunch”.
The incident of Lehman’s bust made the crunch distort panic all-out where everyone just stopped lending money entirely. Until then, what was happening was the bank executives had been juicing their profits to fund their fast-expanding balance sheets with huge debts rather than shareholder’s funds. Their readily-saleable assets’ reserves went dangerously low. The entire banking system in the West was fatally undercapitalised and illiquid. And this was not just the scenario of US, it took a toll across Europe. Had they maintained their balance sheets in a more robust way, there would still have been a crisis but they could have survived it unlike facing such a meltdown
we saw in September 2008.
According to the IMF (International Monetary Fund), there had been more than 120 banking crises between 1970 and 2007. But one of such a magnitude resulted in the global financial meltdown in 2008 and revealed the vulnerability of the entire global system.
Why was the system so weak?
Congress established an independent Financial Crisis Inquiry Commission blamed continuous deregulation of finance by politicians and negligent attitude of greedy and incompetent bank executives.
While this was a piece of factual evidence by the commission, there were some who stated corruption as the root cause of deregulation in the finance sector, as financial services in the US poured colossal donations to
politicians for decades.
Politicians and regulators then decided to right the system even if there was a crisis, with the help of some cut in interest rates of Central Bank.
After operational independence was given to the Bank of England in 1997, they’ve downgraded the importance of analysing financial stability. And the old Financial Services Authority was simply incompetent.0 Despite frequent condemnation of “Anglo-Saxon” finance, the Europeans and Japanese
were no better at regulating the activities of their megabanks.
What was the fallout?
International trade fell at a faster rate than it did during the 1930s. Industrial production, business and household, all sectors collapsed. Unemployment rose higher all around the world and sent the global economy in recession.
The Great Depression would have been even more socially destructive, had it not been for trillions of dollars of taxpayer funding and guarantees. The global economic recovery in many Western countries over the following decade was extremely weak, partly due to the fact that the cause of the recession was a financial bust.
The chief economist of the Bank of England, Andy Haldane, estimated the total cost of the crash in economic growth to be between $60 trillion and $200 trillion, around between one and five times the planet’s GDP.
“To call these numbers ‘astronomical’ would be to do astronomy a disservice,” he said.
Living standards took a huge hit in almost all countries. Governments added to the agony by imposing severe public sector rigidness to respond to soaring state borrowing which needed to stop falling demand even further during the collapse.
Many credits the populist surge in a lot of countries – from electing Donald Trump to the Brexit vote, to the populist earthquake in Italy – partly to the economic discontent and disastrous fall down in confidence in political elites caused by the financial crisis of 2008.
Could it happen again?
Regulators stand firm that the safety of the global financial system has been significantly enhanced, as they have imposed higher liquidity requirements on banks, forced them to noticeably increase their capital buffers and they generally monitor the system much more closely.
And thanks to mergers in the crisis, banks are even bigger today than they were before the collapse.
Also, experts still believe megabanks remain dangerously overleveraged, funding themselves with too much debt, revealing the vulnerability of even a relatively small fall in the value of their assets.
“In the run-up to the meltdown leverage was excessive and behaviour was egregious. Ten years on, leverage remains excessive and egregious behaviour has gone largely unpunished,” says the former UK regulator Bob Jenkins.
And as guided by his Wall Street advisors, Donald Trump is de-regulating high finance in the US, planning to undermine the post-crisis “Volcker Rule”, which prevents large significantly-important banks, like Lehman. Like the banks that are making bets with their own money, rather than merely transacting on behalf of customers.
“It is inevitable that weakening the Volcker Rule will result in banks again pushing the envelope, gaming the system and ramping up their dangerous trading,” says Dennis Kelleher of the US think tank Better Markets.
Historically, there’s evidence that financial crises have tended to come in unexpected forms. If one knew where, when or how they would happen one could take early preventive action.
The best, perhaps the only real insurance against the kind of catastrophic system-wide collapse in trust that materialised in September 2008 is a very well capitalised global banking system.
A decade on, this is something that we still, alas, lack.