How Did Lehman Brothers Collapse in 2008?

“You only find out who is swimming naked when the tide goes out.”
— Warren Buffett

For years, Wall Street had been riding a rising tide, powered in large part by America’s housing boom. Lehman Brothers went aggressively into that market.

Then the tide turned.

On 15 September 2008, Lehman Brothers filed for bankruptcy with nearly $639 billion in assets. A 158-year-old institution that had survived wars, recessions and market crashes could no longer find the funding it needed to keep operating.

How did one of Wall Street’s biggest institutions reach this point? The answer was not one bad trade or one disastrous quarter. To understand why Lehman Brothers collapsed, we first need to understand the boom that encouraged it to take those risks.

How the Housing Boom Set the Stage

In the early 2000s, borrowing in the US became unusually cheap. After the dot-com crash and the economic shock following 9/11, interest rates were pushed sharply lower. Mortgages became more affordable and demand for homes increased.

As house prices kept rising, a powerful assumption took hold: property prices would continue to go up. That belief changed behaviour across the financial system. Lenders became more comfortable giving mortgages to borrowers with weaker credit profiles because rising property values provided a sense of protection.

Wall Street found another opportunity. Mortgages could be bundled together into mortgage-backed securities and sold to investors looking for returns. The more mortgages lenders created, the more securities investment banks could package and sell. Housing was no longer only about families buying homes. It had become a huge financial market. And Lehman wanted a much bigger share of it.

Lehman’s Growing Bet on Housing

Lehman expanded across the mortgage business, acquiring lenders such as Aurora Loan Services and BNC Mortgage. This gave the firm access to a growing stream of home loans that could be packaged into securities and sold to investors.

For several years, the strategy worked. House prices kept rising, demand for mortgage products remained strong and the business generated significant profits. But Lehman was not simply earning fees by moving mortgages through the system. It was also keeping large amounts of mortgage and real-estate exposure on its own balance sheet. And much of that exposure had been financed with borrowed money.