Lehman collapse: it’s bad and it’s going to get worse

Many people assumed Lehman Bros was 'too big to fail' - that there would be another government bailout. But no - this time the market will have to deal with the mess itself. And as Lehman's bones are picked over, it will become clear to us all just how badly damaged the financial system is.

Finally. The Federal Reserve found a big bank that wasn't "too big to fail".

158-year old Lehman Brothers, the fourth-biggest US investment bank, has just made history. It's become the biggest bankrupt ever after collapsing with $613bn in debt, reports Bloomberg.

The group has filed for Chapter 11 bankruptcy protection, after various attempts to find someone to buy it over the weekend (more overtime for Hank Paulson and the Treasury) failed.

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As if that wasn't enough heart-stopping news for the markets, we've also got the fact that Merrill Lynch has been bought by Bank of America for a deal worth at least $44bn, and insurance giant AIG has asked the Federal Reserve for a $40bn bridge loan.

All I can say is this is going to be a day to remember for all the wrong reasons

"This isn't the beginning of the end, but it might be the end of the beginning."

How many times have you heard that phrase so far during the credit crunch? They said it after Bear Stearns, it was half-heartedly muttered after Fannie and Freddie (or 'Frannie', as Charles Dumas at Lombard Street Research handily calls them) were nationalised a couple of people even suggested if after the death of Northern Rock, for goodness' sake but every time, it's been wrong.

Everyone assumed that Lehman Brothers would be bailed out

It's too early to say if it'll be any more correct this time round. It certainly feels like the biggest disaster so far. And more to the point, it has the element of surprise which earlier events didn't. Everyone knew Lehman Brothers was in trouble, but the assumption was that it would be bailed out, just as everyone assumed Frannie and Bear Stearns would be saved.

However, now we'll get to see what a major investment bank failure looks like at firsthand. Sure, it's Chapter 11 bankruptcy, which is very different to liquidation half the US airline industry (or it seems like it at least) is in Chapter 11 at any given moment in time but it's still bankruptcy.

"We will be entering uncharted territory," Ladenburg Thalmann & Co analyst Richard Bove told Bloomberg. "Forcing liquidation will set off problems in other companies and markets everywhere." But then, as Gilbert Schwartz of Schwartz & Ballen puts it, "if every time a big institution went bust the markets expected the government to step in, no one would ever adapt."

This is the thin silver lining on this particular blow-up. The market's worst fears have been realised. The event that governments, regulators and finance bosses have been trying to avoid has finally happened, and the market is just going to have to deal with the fallout.

We are nowhere near the end of the crisis

Of course, that doesn't mean that it's time to pile into financials, or any other stocks for that matter. It just means that things are even worse than most people had dared believe. "This just confirms that we are nowhere near the end of the crisis. And it could get really ugly in the next six months or so because there's a lot more to be uncovered," said Christopher Moltke-Leith at Saxo Capital Markets in Singapore, to Reuters.

This is the problem. We're now reaching the stage at which no one can pretend that all the dodgy assets on banking books can just be ignored. As Lehman is unwound, and with insurance giant AIG also planning a massive firesale, it's going to become increasingly obvious just how badly damaged the financial system is, and how little value is left on balance sheets.

It's not as if the banks have given up trying to find ways to bail each other out. Ten of the world's biggest banks also agreed to establish a $70bn emergency fund over the weekend, which any one of them will be able to tap up to a third of. Though one wonders what will happen if more than three of them need to borrow the money at the same time.

As Alan Greenspan puts it (without a blush, incredible given the former Fed chairman's role in creating the easy credit conditions that led to this point) "we will see other major firms fail."

"This will be the first time we've tested how much damage will be done by a bankruptcy," says David Kotok of US money management group Vineland to Bloomberg. It's not going to be pretty.

John Stepek

John is the executive editor of MoneyWeek and writes our daily investment email, Money Morning. John graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.

He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news. John joined MoneyWeek in 2005.

His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.