As markets reflect on the 10-year anniversary of the Lehman Brothers bankruptcy filing, it’s important to remember what put that financial powerhouse into a situation that helped usher in the 2008 financial crisis.
While there were a number of factors at play, leverage and oversight stand out as two key offenders.
Before the crash, U.S. banks were giving mortgages to anyone who wanted to buy a house. Much of that cheap debt was supported by mortgage-backed securities, which had been created by banks, for hedge funds and covered by insurance companies with credit default swaps.
At the time, banks could sell those mortgages in full to another financial institution, which was then able to create a pool of mortgages to repackage as series of securities to sell into the market.
The general belief that residential real estate prices would continue to rise (or at least remain the same), combined with subprime lenders and banks whose business model was “originate to sell,” contributed to the growing implosion.
Once homeowners found they weren’t able to afford their mortgage payments banks began closing in – they foreclosed on those properties to recoup their investment (since it was the banks and subprime lenders who’d provided the loans needed to buy these homes in the first place.) That’s when we saw the dangers of leverage.
But residential homeowners were not the only ones who were over-leveraged. Through various financial products such as mortgage-backed securities and collateralized debt obligations, investment firms had been lending money to each other, but as home prices dropped and the housing market became more volatile the underlying debt, or the premise upon which the money is borrowed (in this case, houses) had no worth.
Bear Sterns was the first investment firm to take a big hit in March of 2008, and at that point, the market knew that it was just a matter of time before the dominos came tumbling down. Lehman was not able to make good on their debt and was forced to file for bankruptcy that September.
Those were two key firms – and ones that are often associated with the onset of the crisis – but there were many more involved, including the Royal Bank of Scotland in the U.K., Germany’s Deutsche Bank, Goldman Sachs, Merrill Lynch, Freddie Mac, Fannie Mae and even the Icelandic government.
The U.S. Federal Reserve recognized the excessive systemic risk and made changes. Regulatory oversight became increasingly important, and led to all kinds of changes, from mortgage stress tests to expanded banking regulations and changes to the ways financial advisors handle their fees.
Banks now also have to keep an interest in their mortgages, which means that while these are still leveraged, the banks actually have a percentage ownership in their mortgage loans.
While challenges still remain, especially at a time when interest rates are rising and the U.S. is threatening a trade war, markets have been in a better place once they rebounded from the 2008 financial crisis, which taught them many lessons about the dangers of overextending yourself and lacking proper oversight.