The Calculus of Collapse: Lessons from Lehman Brothers

17 years ago the financial system was on the verge of collapse. Lehman Brothers had just imploded (September 15, 2008) and counterparty trust vanished. Nobody trusted anyone.

For most of the world, this crash was yet another phase in what was already an ongoing recession, featuring rising unemployment, mortgage defaults, and personal bankruptcies. What the average person didn’t realize was that we were hours from the entire financial system collapsing.

That means no more access to bank accounts, payrolls would seize, business-to-business payments would freeze, shipments would stop, and grocery store shelves would empty. Without the massive amount of money shoveled into the system by the Federal Reserve and US Treasury there could have been complete anarchy. (Some still say this would have given the world the reset it needed.)

The issues have been studied. Looking back, the risks were clear. Yet, leading up to Lehman’s collapse, few foresaw how bad it would get. There were hints, such as the federal government absorbing Freddie Mac and Fannie Mae.

It’s not that the analysts were incompetent. Rather, they had a vested interest in making forecasts that didn't deviate from the well-worn path. Being wrong with the crowd is acceptable practice. But forecasting a sharp left turn when everyone else is staying straight can be a career-limiting move, especially if you’re wrong.

I've been reviewing several analyst reports from before the Lehman collapse, and it's interesting to take a time machine back to early September 2008.

Leading up to the collapse of Lehman Brothers, the general consensus among analysts was one of cautious optimism. Reports from firms like UBS, Bank of America, and Merrill Lynch acknowledged the significant challenges facing the company, primarily its large exposure to troubled real estate assets and the general market turmoil. However, they largely viewed Lehman as a firm with a solid, albeit damaged, foundation.

The common thread was a belief that Lehman was actively and prudently addressing its problems. Analysts frequently cited management’s strategic initiatives, such as the plan to spin off its commercial real estate assets into a "bad bank" and the sale of a majority stake in its investment management division, as positive, decisive actions. While they recognized the execution risk and a challenging path ahead, the prevailing view was that Lehman had enough capital, liquidity, and management acumen to survive a crisis that was seen as difficult but manageable, thereby avoiding a forced merger or bankruptcy.

Specific Examples and Quotes From the Reports

• Belief in Management and Federal Support: A Bernstein Research report dated September 11, 2008, maintained a "Market-Perform" rating and optimistically stated: "We do not believe the central bank can allow a broker to fail as this would release an avalanche of unquantifiable systemic risk into the global bond markets and the Federal Reserve clearly does not want to happen." This view suggested a belief that systemic importance would protect the firm.
• Focus on the De-risking Strategy: In a September 11 report, UBS noted that despite a larger-than-expected loss, Lehman had "definitely reduced risk in 3Q" and that its "capital ratios...liquidity profile...and core revenues...were all some version of pretty good considering the backdrop." This highlights a focus on the firm's progress in de-leveraging.
• Liquidity Not Seen as a Primary Concern: A Merrill Lynch report from September 12, 2008, explicitly downplayed one of the most critical factors leading to the collapse: "Despite the material erosion of liquidity in the wake of the debt and equity market sell-off, liquidity does not appear to be a major concern based on LEH reporting it had a $42bn gross liquidity pool at the end of 3Q, and maintains borrowing access through uncollateralized assets and has access to Federal Reserve facilities."
• Hope for a Strategic Buyer: An HSBC report on September 11 noted that while the firm had been unable to find a strategic buyer, "we believe that its business is worth preserving, and that eventually it will find that deep-pocketed strategic investor." This indicated a strong conviction that a solution was still on the horizon.

The idea is not to belittle the authors. They are part of a system that cannot see its own flaws.

In some ways, these analysts were correct. What they failed to see were financial tipping points and exogenous variables. Perhaps Lehman did technically have enough net assets to live another day, but a lack of trust and a hands-off approach from the Fed set off a rockslide of liquidation they couldn’t stop. Analysts were doing algebra while the market runs on calculus, psychology, and reflexivity. The same is true for the world today.

I could be talking about the financial industry’s current use of Collateralized Loan Obligations, private credit or capex spending on AI infrastructure.

But the real point of this article is that those who are paid to analyze the details often fail to see the bigger picture. Climate breakdown, government implosion, war, and collapse. Most experts can see slight bends in the road, but they almost always miss the collapsed bridge ahead.