PS if you can’t figure Lehman out here is out it went. Banks buy a bunch of mortgages for X. Banks levered up - Lehman more than most. They package the mortgages together and CMBS over a few weeks and then sell them to investors for X + 1-2%. Works great with 50x leverage, as that works out to unbelievable profits. The banks counted on being out to get the CMBS off their books by selling them to fund their cash flow. However, within a few weeks, the CMBS debt went from very valuable to almost no value, and banks were stuck with what they had bought at face value. Given their liquidity relied on selling these assets every month, and every other asset they had besides US Treasuries was also losing value, they quickly ran out of cash. If you want the dumbed down version, simply watch the movie Margin Call, which is loosely based off Goldman Sachs in 2008.
Thanks for the movie suggestion. That isn’t what happened to Lehman.
You and I are viewing the Lehman transaction from two different perspectives. You seem to thinking in terms of a balance sheet (Assets = Liabilities + Retained Earnings). And I am coming at the Lehman failure from the perspective of their cash flow statement.
Stay with me- this gets into the weeds. But, I believe you will enjoy the exchange.
The liquidity of an investment bank is a DAILY battle. They must settle their trades DAILY and therefore they can’t wait for the selling of their MBS each month to fund their on going business. Yes they sell them. But the issue with Lehman was immediate. Thus the meeting of the investment banks, commercial banks, and the Fed the weekend before Lehman cracked. Lehman had no one wanting to lend them the capital on Monday to allow their clients to trade due to the uncertainty of Lehman collateral.
Think of it in these terms.
The investment bank must convert their holdings temporarily into cash to execute the trades made during THAT DAY. They don’t just hold the cash in their savings account each month. Instead they rely on repurchase agreements (REPO).
Those agreements are cash in exchange for collateral and are settled within hours. As Lehman collateral lost value each day other parties didn’t want to lend them the “cash” to settle their clients trades for that day.
Keep in mind that the collateral isn’t solely in the form of a MBS. It can be ANY type of security:
1) Corporate bonds
2) Covered bonds
3) MBS
4) Money market securities such as treasury bills and, in some countries, certificates of deposit (CD) and commercial paper (CP). However, CDs are not always popular because they represent an exposure to commercial banks and CP issues are difficult to use as collateral because they tend to be relatively small
5) Bank loans
6) Gold.
The Counterparty will base the cost of the cash (or the hair cut) given risk of not getting their cash back. Therefore the look at two key components
1) value of the collateral
2) the ability to quickly liquidate the pledged collateral.
If the Counterparty isn’t sure of those two considerations they will not trade with the other firm. Then that other firm CANNOT operate.
Now this is how contagion occurs- say you are holding that collateral (see my list above) and Lehman can’t return your “cash”. You now have to liquidate that collateral and the buyers know it is a distress sell because the collateral value is falling. Your firm now has to start selling other assets to cover your own trades for that day. This places those other securities in jeopardy of losing value as you are forced to sell them to satisfy your own liquidity needs.
So yes—-Lehman had too much debt. But as the value of that debt crashed their ability to obtain the necessary liquidity to operate each day is what caused them to file bankruptcy.
Back to my question regarding Blackstone being a modern Lehman…
Who is invested in their REITS and needs their “cash” that is gated by Blackstone? And what happens to that firms balance sheets as Blackstone (and the various real estate markets) REITS lose value because no one is willing to place funds with Blackstone?
If your still with me, I recommend you watch Too Big to Fail to see the weekend before Lehman failed and how the Fed scrambled to ensure market liquidity as they planned for the Lehman bankruptcy that following a Monday.
Good day.