Want to know how exactly these banks had failed? The underlying idea is that they gave out bad loans. But what happened after that? Below is an attempted explanation picked up from a discussion thread in Google.
It’s complicated, but here’s the 30-second version of what happened with Bear Stearns and Lehman:
People went to traditional banks and mortgage brokers and bought mortgages. All of these mortgages carry different amounts (e.g. $100,000 mortgage vs. a $500,000 mortgage) and different risk levels. The ones that are more likely to default have a higher interest rate, so the bank stands to gain more money…but at a greater risk of the home owner defaulting on the mortgage.
The problem with this is it is very difficult to balance your risk-reward ratio. So they created an investment vehicle called a mortgage-backed security (MBS). This is referred to as a “derivative” because it is based off of the mortgage. The way it works is the banks chopped up all these different mortgages into different securities that were worth different amounts and different risk levels. They then sold these to other banks and investments firms. The firms who bought these MBS then received a payment based off of the mortgages.
For the banks selling MBS, it helped them pool risk and generate capital, and for the firms who bought the MBS, it provided a source of cash flow with what was thought to be a very safe, secure underlying
commodity: real estate.
Since real estate was so “safe,” these banks used huge amounts of leverage (borrowed money to buy the securities) because they didn’t think they were that risky. Some firms, like Lehman, were leveraged 30:1, meaning that for every $30 they borrowed, they had $1 of underlying assets. That would be like you making $1000 a year but taking out a loan of $30,000.
While all this is going on, people are buying up adjustable interest rate mortgages (ARMs). They offer a cheap introductory rate, but then skyrocket. So all of a sudden, all these people discovered they couldn’t make their monthly payments. The default rate shot through the roof. The firms that had purchased MBS did so based on certain calculations of default. In other words, X number of people could default on their mortgages, but they could still make a profit and have a positive cash-flow. However, when the default rate shot up, this threw all of their calculations off.
Now the firms faced a real problem. They had HUGE amounts of debt on their balance sheets, and the assets that were supposed to balance that debt were becoming worth less and less because of the rising default rate and the drop in housing prices. These are the “write-downs” that you hear about. The firms had to pay interest on that debt, but they did not have the corresponding cash flow to be able to pay the debt. Lehman, for example, had $5.4B of debt obligations last quarter, but only had $2.3B in income.
When you can’t pay your debt obligations, that’s called being insolvent. Many people think that bankruptcy is caused by having more liabilities than assets, but that’s not true. It’s caused when you
can’t make good on your debts, so the repo man comes and claims your assets in order to make up for it.
When that happens, you have to file for bankruptcy in order to make sure that people get paid in the correct order because otherwise different creditors are going to be suing you to make sure they get what you owe them.
So that’s where we are now with Lehman. They couldn’t pay their debts, so they had to file for bankruptcy.