Why Lehman Brothers collapsed

It's exactly a year since the failure of investment bank Lehman caused financial terror and market meltdowns. Here are three very simple reasons for its failure.

On Monday, 15 September 2008, financial markets around the world convulsed in sheer panic.

In New York, the Dow Jones Industrial Index suffered one of its biggest-ever falls, falling 504 points (down 4.4%) in a single session. On this side of the Atlantic, the FTSE 100 index tumbled almost a tenth (9.9%) in the four days to 18 September. While stock markets plunged, the cost of credit soared, with credit spreads blowing out to record levels. This was no ordinary financial crisis.

What caused this market mayhem?

The answer is the bankruptcy of a company, but this was no ordinary bankruptcy and no ordinary company. On Sunday, 14 September, leading US investment bank Lehman Brothers -- having failed to be rescued by a buyer or a government bailout -- went under.

The bankruptcy of Lehman rocked the financial system to its core, not least because it was the biggest corporate bankruptcy in US history. With over $600 billion in assets to administer, Lehman's bankruptcy was many times more complex than Enron's failure in 2001. Also, as a leading investment bank, Lehman was deeply plumbed into the global financial system, thanks to a spider web of companies, contacts and contracts around the world.

Why did Lehman fail?

In recent days, there have been thousands of articles written about the collapse of Lehman Brothers. Some blame chief executive Dick 'the Gorilla' Fuld for his overconfidence and failure to recognise that Lehman faced a momentous crisis. Arguably, Fuld's battle to salvage something for Lehman's suffering shareholders eventually cost them every cent.

Some commentators blame Bank of America for ending takeover talks with Lehman in favour of buying its larger rival Merrill Lynch for $50 billion the following day. Other pundits blame Barclays for refusing to buy Lehman without US government backing, in the form of emergency funding.

However, I have come up with three very simple reasons why Lehman was doomed to fail. Here they are...

The three Ls that killed Lehman:

1. Leverage

During the good times, the best way to enhance your returns is to 'gear up' by borrowing money to invest in assets which are rising in value. This enables you to 'leverage' (magnify) your returns, which is particularly useful when interest rates are low. However, leverage cuts both ways, as it also magnifies your losses when asset prices fall. (Witness the recent return of negative equity to the UK property market.)

A sensibly run retail bank would have leverage of, say, 12 times. In other words, for every £1 of cash and other readily available capital, it would lend £12. In 2004, Lehman's leverage was running at 20. Later, it rose past the twenties and thirties before peaking at an incredible 44 in 2007.

Thus, Lehman was leveraged 44 to 1 when asset prices began heading south. Think of it this way: it's a bit like someone on a wage of £10,000 buying a house using a £440,000 mortgage. If property prices started to slide, or interest rates moved up, then this borrower would be doomed. Thanks to its sky-high leverage, Lehman was in a similar pickle.

2. Liquidity

Most businesses fail not because of lack of profits but because of cash-flow problems. Like all banks, Lehman was an upturned pyramid balanced on a small sliver of cash. Although it had a massive asset base (and equally impressive liabilities), Lehman didn't have enough in the way of liquidity. In other words, it lacked ready cash and other easily sold assets.

As markets fell, other banks started to worry about Lehman's shaky finances, so they moved to protect their own interests by pulling Lehman's lines of credit. This meant that Lehman was losing liquidity fast, which is a dangerous state for any bank. Only six months earlier, in March 2008, Lehman rival Bear Stearns faced a similar loss of liquidity before JPMorgan Chase rode to its rescue.

Believing that Lehman did not have enough liquidity at hand, other banks refused to trade with it. Once a bank loses market confidence, it loses everything. Being unable to trade meant that Lehman and its business ceased to exist in other banks' eyes.

3. Losses

After the terrorist attacks of 11 September 2001, US interest rates plummeted, causing a five-year boom in domestic and commercial property prices. This boom ended in 2006 and US housing prices have since fallen for three years in a row.

Lehman was heavily exposed to the US real-estate market, having been the largest underwriter of property loans in 2007. By the end of that year, Lehman had over $60 billion invested in commercial real estate (CRE) and was very big in subprime mortgages (loans to risky homebuyers). Also, it had huge exposure to innovative yet arcane investments such as collateralised debt obligations (CDO) and credit default swaps (CDS).

As property prices crashed and repossessions and arrears sky-rocketed, Lehman was caught in a perfect storm. In its third-quarter results, Lehman announced a $2.5 billion write-down due to its exposure to commercial real estate. Lehman's total announced losses in 2008 came to $6.5 billion, but there was far more 'toxic waste' waiting to be unearthed.

In summary...

Lehman once employed 28,000 people across the world, including 5,000 in London. At their peak, its shares traded at $85, but they are now roughly 10¢. Lehman's remains were shared out between Barclays, which bought its US broking arm, and Japanese giant Nomura, which bought its European and Asian assets. These firms, plus number-one investment bank Goldman Sachs, have profited most from picking over the bones of Lehman's businesses.

In short, Lehman Brothers -- a company with a 158-year history, including 14 years as an NYSE-listed giant -- failed simply because it took on too much risk in a booming market. In the end, its move from the safety of corporate finance and M&A (mergers and acquisitions) income into the risky world of proprietary trading proved to be its downfall.

The lesson here is that any firm, no matter how big and powerful, can be dashed to pieces on the rocks of leverage, liquidity and losses!

More: Start saving for a rainy day | The Financial Crash In Plain English | Five Ways To Beat The Credit Crunch