Understanding the 2008 Crash, p2.

Posted by

The 2008 crash – it’s something I often talk about, but haven’t really delved that deeply into. Last week I explored some of the main causes: the housing bubble, subprime mortgages, and the fall of the Lehman Brothers, which triggered the broader global financial crisis.  

This week we’re looking at the fallout of Lehman’s collapse and ripple effects that unleashed chaos in markets around the world.

The immediate fallout

Lehman Brothers was one of the largest and most interconnected investment banks in the United States. It had a significant presence in various financial markets and held substantial exposure to mortgage-backed securities and other complex financial instruments. When Lehman Brothers collapsed, it sent shockwaves throughout the financial system due to its size and interconnectedness. Many other financial institutions had direct or indirect ties to Lehman, which amplified the crisis.

The failure of Lehman Brothers shattered investor confidence and trust in the financial industry. Until that point, there was a perception that large financial institutions were “too big to fail” and that the government would intervene to prevent their collapse. However, when Lehman was allowed to collapse, it created fear and uncertainty in the market, leading investors to question the stability of other financial institutions. This fear of contagion caused a widespread panic and led to a rush by investors and creditors to withdraw their funds from other institutions, exacerbating the crisis.

Why was Lehman allowed to fail?

The US government’s decision not to bail out Lehman Brothers was a complex one and involved a combination of considerations.

Firstly, the government faced legal limitations on its ability to intervene in private businesses, particularly without a clear statutory framework for dealing with failing investment banks. Unlike commercial banks, which had an established process for resolution, investment banks like Lehman Brothers did not have a similar regulatory safety net. This made it challenging for the government to provide a direct bailout.

Prior to the Lehman Brothers collapse, they had already intervened to rescue several troubled financial institutions, such as Bear Stearns. These bailouts raised concerns about moral hazard – the idea that providing such bailouts could encourage reckless behaviour in the financial industry, with firms believing they would always be saved from the consequences of their risky actions. By letting Lehman fail, policymakers were sending a message that not all failing institutions would receive government support.

It’s also important to consider public perception of the government bailouts. The idea that taxpayer money was being used to bail out wealthy Wall Street firms while many ordinary Americans were struggling with the effects of the crisis was met with anger.

The ripple effect

While the decision not to bail out Lehman Brothers was intended to discourage moral hazard, there were other unintended consequences. The disorderly collapse of Lehman sent shockwaves through the financial system, leading to a severe freeze in credit markets, widespread panic, and increased risks of contagion, affecting other financial institutions.

Banks and financial institutions became extremely cautious about lending money to each other, fearing potential losses. As a result, interbank lending practically ceased, making it difficult for businesses and consumers to access credit. This credit crunch had a crippling effect on economic activity, leading to a sharp decline in consumer spending, business investments, and overall economic growth.

The collapse of Lehman Brothers triggered a significant decline in asset values, particularly in the housing market. Lehman’s extensive exposure to mortgage-backed securities and other toxic assets meant that the market for these assets dried up, causing their value to plummet. This, in turn, resulted in massive losses for financial institutions worldwide, further weakening their financial positions and contributing to the crisis.

Meanwhile, in the rest of the world…

Of course, Lehman Brothers wasn’t just a U.S. bank; it had significant operations and exposure internationally. When it collapsed, its impact reverberated across global financial markets. International banks and investors with ties to Lehman also faced significant losses, amplifying the crisis on a global scale.

The UK financial sector was significantly impacted due to its close ties to Wall Street and its exposure to risky assets. Major British banks, such as Royal Bank of Scotland and Lloyds Banking Group, faced substantial losses and required government bailouts to survive, and the UK experienced a deep recession, with a significant contraction in economic activity and rising unemployment.

Several eurozone countries faced severe economic challenges, with some, like Greece, Ireland, Portugal, and Spain, experiencing sovereign debt crises. The cost of borrowing for these countries increased significantly as investors worried about their ability to repay their debts.

Many emerging market economies faced capital outflows and currency depreciation as investors sought safer assets elsewhere. Countries heavily reliant on foreign investment faced difficulties in financing their current account deficits.

Iceland’s banking system, which was heavily exposed to the global financial crisis, collapsed entirely. The country experienced a severe economic downturn, leading to a sovereign debt crisis and needed financial assistance from the IMF to stabilize its economy.

Overall, the collapse of Lehman Brothers acted as a catalyst that exposed the vulnerabilities and weaknesses in the global financial system, leading to the full-blown global financial crisis. It exposed the fragility of interconnected financial markets, eroded investor confidence, and triggered a chain reaction of events that had far-reaching economic and social consequences.

Next week we’ll be taking a look at how organisations and individuals (myself included), were affected by the crisis. See you then!