European leaders are now keenly aware of the myriad strands that bind together the world’s financial system. And they say they are determined not to commit the same mistakes that, in their view, the Bush administration and the Federal Reserve made when they did not prevent Lehman’s bankruptcy in September 2008.
The ghost of Lehman has been ever present at the negotiations among top European officials, Europe’s central bank and investors in bonds issued by cash-strapped countries such as Greece over how to prevent a catastrophic default.
“Remember in 2008, when the U.S. let Lehman Brothers fail, the global financial system paid the price,” French President Nicolas Sarkozy said last month. “For both economic reasons and moral reasons, we can’t let Greece fail.”
German Chancellor Angela Merkel drew the same parallel late last month in a television interview, saying, “What we can’t do is destroy the confidence of all investors mid-course.”
Jean-Claude Trichet, the president of the European Central Bank, says he warned U.S. officials three years ago that allowing Lehman to go bankrupt would be “something which is exceptionally grave,” and is now pressing to avoid a similar upheaval in Europe on his own watch.
One of the main lessons of Lehman is that even relatively small failures — the Wall Street firm was only the fourth largest U.S. investment bank at the time of its bankruptcy — can cause devastating ripple effects.
In the lead up to its collapse, Lehman had suffered billions of dollars in losses on commercial real estate loans, including for hotels and office buildings. As investors became more worried about the scale of those losses, they became reluctant to provide any of the short-term loans that Lehman and other investment banks use to finance themselves. Without access to that money and no lifeline from the government, Lehman filed for bankruptcy on Sept. 14, 2008, the victim of an old-fashioned run on the bank.
The failure caused a series of unforeseen ripple effects. For example, a large money market mutual fund that had invested heavily in short-term loans to Lehman lost so much money that its shares fell below $1. That prompted fearful withdrawals from other money market funds, leading them to sell off the corporate IOU’s they own. That in turn made it hard for the companies that rely on those loans, such as industrial giant General Electric, to finance their day-to-day operations. Markets around the world seized up.
In the Lehman episode, the other major banks it did business with were exposed to losses due to the bankruptcy. That was bad enough. But the impact was greatly magnified because no one knew which other banks were facing such large losses that they, too, were at risk of failing. No longer could anyone tell who else was a good risk so lending between banks froze up entirely. The basic trust that underpins the financial system evaporated.