Don't let it get away!
Keep track of the stocks that matter to you.
Help yourself with the Fool's FREE and easy new watchlist service today.
Next Tuesday, Sept. 15, marks one year since Lehman Brothers filed for bankruptcy protection. The company's failure was the biggest bankruptcy in history, and it sparked one of the largest-ever financial panics -- large enough to nearly drag the entire economy down with it. As my colleague Alyce Lomax brilliantly put it, Lehman's demise was the onset of The Autumn of the Massive Collective Pants-Soiling.
The key to Lehman's failure was, of course, leverage. At the end of 2007, leverage stood at more than 30-to-1, with $22 billion of equity supporting $691 billion in assets. The mechanics of such leverage is nauseating: A little more than a 3% decline in asset values, and it's game over. Anyone with a handle on fifth-grade arithmetic gets this, and the pre-Lehman leveraged failures of Long-Term Capital Management and Bear Stearns reiterated its cruelty. Name one bank that's flourished long-term on gross leverage, and you'll find thousands that met a quick death. It just doesn't work.
But leverage in itself wasn't the sole problem. What ultimately took Lehman Brothers (as well as Bear Stearns) down was how that leverage was financed.
Same industry, many types of stupid
Banks such as Bank of America (NYSE: BAC ) , JPMorgan Chase (NYSE: JPM ) , and Wells Fargo (NYSE: WFC ) finance their operations primarily through customer deposits. Thanks to FDIC insurance, this is a stable source of funding not prone to instantaneous evaporations.
Lehman was a different story. At the end of 2007, its balance sheet had $691 billion of total assets, financed largely by $28 billion in short-term debt, $123 billion in long-term debt, $150 billion in sold securities waiting to be purchased, and some $182 billion in various repurchase agreements.
Repurchase agreements -- called "repo" loans -- are collateralized financing instruments made in terms as short as 24 hours. Institutional investors with idle cash, such as mutual funds, pension funds, and hedge funds, lend banks like Lehman money in exchange for securities held as collateral. Once the term of the loan expires, the borrower promises to "repurchase" the collateral at a slight premium. The lender typically just rolls the loan from one day to the next, so the actual repurchasing of assets doesn't always occur.
In essence, repo loans are very, very short-term loans that investment banks use to cheaply finance their operations. Banks get a low cost of capital; investors invest cash at favorable rates. Everyone's happy.
Until things go BOOM
Everyone's happy, that is, as long as each party trusts each other. As lenders questioned the quality of the collateral being put up -- as was the case last fall -- they started backing away en masse. Then things hit the fan. Instantly.
Think of it this way: Imagine, rather than a 30-year mortgage, you bought your house with 24-hour repo financing. Every evening, you have to go to the bank and ask for an extension on your loan to the next day. Most of the time, especially when real estate prices are going up, the bank is more than happy to do so.
Then one day, the bank gets worried about the value of your home and decides not to roll your over mortgage to the next day. You're suddenly forced to repurchase the house at its full price. If you don't have the cash to do it, the bank takes the house on the spot. You go from happy homeowner to homeless in the course of a few minutes. And with no more home, your other lenders might either back away, demand their money back, or ask for more collateral.
Similarly, banks reliant on the repo market could literally go from well-capitalized to bankrupt almost instantly if repo loans couldn't be rolled over to the next day.
This was a major concern among Wall Street CEOs last fall. After Morgan Stanley CEO John Mack suggested that letting Merrill Lynch fail was a sensible option, JPMorgan CEO Jamie Dimon said, "John, if we do that, how many hours do you think it would be before [mutual fund giant] Fidelity would call you up and tell you it was no longer willing to roll your paper?"
The viability of some of the largest banks in the world rested on the day-to-day confidence of a few counterparties. It was an incredibly dangerous, and incredibly stupid, way to conduct business.
Here's why that should bother you
In the days after Lehman's demise, Goldman Sachs (NYSE: GS ) and Morgan Stanley (NYSE: MS ) became bank holding companies, in what was seen as an exit from the short-term fickleness of short-term repo financing. The two investment banks, the thought went, would either form commercial banks or they'd buy something like SunTrust (NYSE: STI ) or even Citigroup (NYSE: C ) , as a way to gain a stable deposit base and end the era of short-term financing that proved so faulty.
A year later, that hasn't happened. While leverage has decreased and massive amounts of capital have been raised, a flurry of measures designed to prop up and guarantee lending markets has made it possible for the two banks to continue on as before, still heavily reliant on short-term funding. "Our model really never changed," said Goldman's CFO in July. "We've said very consistently that our business model remained the same."
As my colleague Matt Koppenheffer put it, nothing has changed in banking. Come the next financial panic -- which will happen -- we wonder what that means for the industry.
Read more of our coverage, as we look back one year later.