🚦 The Lehman Brothers collapse (2008): How misjudging macro risk led to a global crisis
**3/52** Learn from History (Macro Mistakes)
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🚦 This is part of a 52-week series on Macro Mistakes - Designed for those who want to learn from history.
I share lessons from the biggest macroeconomic mistakes made by investors, companies, and countries, helping you avoid similar pitfalls and capitalize on future opportunities. Feel free to catch up on previous emails here if you'd like to start from the beginning!
Dear all,
In today’s installment of "Macro Mistakes," we turn to one of the most significant financial disasters of the 21st century: The Collapse of Lehman Brothers in 2008.
This event wasn’t just the downfall of a single company - it triggered a global financial crisis that exposed the deep flaws in the financial system.
At the heart of it was a fundamental failure to understand and manage macroeconomic risks.
✍ The Story
Founded in 1850, Lehman Brothers grew into one of the largest investment banks in the world. By the early 2000s, it was heavily involved in the mortgage-backed securities (MBS) market, which was booming at the time.
Lehman, like many other banks, saw the opportunity to profit by bundling and selling subprime mortgages - loans made to borrowers with poor credit.
The strategy worked for a while. Between 2004 and 2006, Lehman’s profits soared, and its stock price climbed to new heights.
In 2007, the bank reported record revenues of $19.3 billion. But beneath the surface, the foundation was cracking.
❌🚫 The Macro Mistake
Lehman Brothers' downfall can be traced to a severe misjudgment of macroeconomic risk, particularly in the housing market.
For years, the bank had been relying on the assumption that housing prices would continue to rise indefinitely.
But macroeconomically, there were clear warning signs that the housing market was unsustainable:
Rising household debt: By the mid-2000s, U.S. household debt had skyrocketed, fueled by low interest rates and easy access to credit. Homebuyers were borrowing beyond their means, pushing prices higher and higher. But when the Federal Reserve began raising rates in 2004, the cost of borrowing increased, putting pressure on homeowners with adjustable-rate mortgages.
Slowing economic growth: The U.S. economy was already showing signs of slowing in 2007, with GDP growth dipping below 2%. The financial system’s exposure to the housing market - especially subprime loans - was far too large given the overall economic conditions.
Over-leveraging: Lehman had leveraged its balance sheet heavily, borrowing about $30 for every $1 in equity. This meant that even a small drop in the value of its mortgage-backed securities portfolio could wipe out its capital.
But Lehman wasn’t just a victim of macro trends - it ignored them.
Had the bank paid attention to the growing housing bubble, and the risks posed by rising interest rates, it could have reduced its exposure or hedged its bets.
Instead, Lehman doubled down, increasing its position in subprime mortgage-backed securities even as the cracks in the system were starting to show.
The Role of Systemic Risk
One of the key macroeconomic lessons from the Lehman collapse is the concept of systemic risk - the idea that the failure of one institution can create a chain reaction throughout the financial system.
Lehman Brothers was deeply intertwined with other financial institutions, holding massive amounts of debt and engaging in complex financial transactions with banks around the world.
When Lehman filed for bankruptcy on September 15, 2008, it triggered a global panic.
Stock markets plunged, credit markets froze, and companies that had exposure to Lehman found themselves in immediate trouble.
The S&P 500 dropped by more than 30% over the following months, while the global economy plunged into a recession.
The collapse revealed the dangers of a financial system where large institutions are too interconnected to fail without causing widespread damage.
This systemic risk is one of the reasons why central banks and regulators now keep a much closer eye on the macro stability of major financial institutions.
👨🎓 The Macro Lesson
There are several important macroeconomic lessons we can take from the Lehman Brothers collapse:
Beware of Bubbles: When any asset class - whether it’s housing, tech stocks, or commodities - starts to rise rapidly, it’s important to ask whether the growth is sustainable. In Lehman’s case, they ignored the macro signals that the housing market was in a bubble. Housing prices don’t rise indefinitely, and when they reversed, the impact was devastating.
Leverage Amplifies Risk: One of the core principles of macroeconomics is that leverage can multiply both gains and losses. Lehman’s 30-to-1 leverage meant that even small fluctuations in the value of its assets could have catastrophic consequences. As investors, it’s critical to manage leverage carefully, particularly in volatile macroeconomic environments.
Systemic Risk Matters: The Lehman crisis taught us that no institution operates in isolation. When macroeconomic risks start to build, they can spill over into the broader financial system, impacting markets and economies far beyond the immediate crisis point. Understanding the interconnectedness of the global financial system is crucial for navigating macro risks.
Lehman’s collapse marked the start of a cascade of financial failures.
In the months that followed, several other major institutions, including AIG, Washington Mutual, and Wachovia, either collapsed or required government intervention.
The U.S. government and the Federal Reserve stepped in with massive bailout packages, totaling over $700 billion to stabilize the banking system.
The global economy slid into the Great Recession, the worst economic downturn since the 1930s.
Unemployment in the U.S. shot up to 10%, and millions of people lost their homes to foreclosure.
The macroeconomic impact was felt across the world, with many economies experiencing sharp contractions in GDP.
The Importance of Macro Perspective
What could have been done differently?
Investors and institutions that understood the broader macroeconomic risks of the time were able to avoid the worst of the crisis - and some even profited by shorting the housing market or moving their assets into safer investments, like U.S. Treasuries or gold.
The Lehman Brothers collapse reminds us of the importance of maintaining a macro perspective in our investments.
By paying attention to economic fundamentals - such as rising debt levels, slowing growth, and excessive leverage - investors can better anticipate major turning points in the market.
The collapse of Lehman Brothers wasn’t just the result of poor management. It was the culmination of years of ignoring macro trends that were signaling danger.
Next time, we’ll explore another pivotal moment in financial history: Black Monday (1987) and how sudden panic can send shockwaves through markets when macro risks are ignored.
Alessandro
Founder of Macro Mornings
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