Six years ago this weekend, Wall Street was rocked by the collapse of Lehman Brothers. What began as a banking crisis morphed into something that shook the U.S. economy to its core. Only federal intervention prevented an even more catastrophic result.
How the world’s biggest economy came to the brink of depression is a question that will be debated for a long time, but one could argue that the predicament stemmed from a financial system that was “too interconnected to fail.”
On Sunday, Sept. 14, 2008, Lehman CEO Dick Fuld had run out of options to save one of Wall Street’s grandest institutions. In the early hours of Sept. 15, the company issued a press release announcing that it was seeking bankruptcy protection.
On the day of Lehman’s filing, the Dow Jones Industrial Average plummeted 500 points, its largest decline since Sept. 11, 2001. Adding to the anxiety was the Sept. 14 announcement that America’s best known securities firm, Merrill Lynch, had decided to sell itself to Bank of America for $50 billion amid fears for its own survival.
All hell broke loose within hours of the Lehman bankruptcy. Credit markets froze and banks stopped lending to one another. Lenders no longer knew which borrower was a good risk, so they treated all of them as bad risks.
The Feds made an emergency $85 billion loan to the American International Group because of AIG’s enormous exposure to sub-prime mortgages through the underwriting of credit default insurance. Unlike for Lehman, here the feds opened the checkbook because they determined that the company had to be rescued to protect the financial system and the broader economy. They then allowed Morgan Stanley and Goldman Sachs to become bank holding companies and authorized the Federal Reserve Bank of New York to extend credit to both firms.
Lehman’s downfall created widespread panic in financial markets, as investors scrambled to withdraw their money. On Sept. 16, the nation’s largest money market fund was forced to cut its per-share value below the sacred $1 level because a major portion of its portfolio, invested in short-term debt issued by Lehman, was frozen in bankruptcy court.
The announcement brought Wall Street’s problems home to Main Street by undermining the confidence of millions of small investors in money market funds as a safe place to park their savings. That prompted the Treasury to announce a temporary program to guarantee investments in participating funds.
Much has been written about the causes of the crisis and different witnesses provided conflicting accounts. But it may be that being too interconnected to fail counted even more than size.
That’s why the feds decided so many financial institutions had to be bailed out; sold off to others with government guarantees to sweeten the deal, loaned enormous sums of taxpayer money or recapitalized with government equity.
The elaborately interconnected nature of the financial industry greatly increased the speed and efficiency with which money could move through society. But all the sophisticated technology in the world ultimately depends on one sacred principle: A person keeps his or her word. Suddenly people in the financial industry stopped trusting what their counterparts said about the .value of the portfolio being offered as collateral on a loan and a whole host of other avowals.
How can you do business with a person you can’t trust? As a result, the entire financial world melted down. And the feds had to rush in with open checkbooks to stave off the apocalypse.
originally published: September 2014