Lehman’s collapse and the 2008 funding freeze

Lehman had taken large losses on property and mortgage investments through 2007 and 2008, and on 10 September it reported a preliminary quarterly loss of about $3.9bn, the largest in its history. A firm that rolls over its borrowing every day lives on its lenders’ confidence. Once they doubted it, they stopped rolling, and it ran out of cash in days.

The failure then hit the plumbing of the financial system. Money market funds were big lenders to banks and companies through short-term debt such as commercial paper, and their investors treated them like bank accounts, without the deposit insurance that protects bank savers. When one fund broke the buck, investors ran from others, and the funds stopped buying short-term bank debt. Banks, unsure who held Lehman or AIG exposure, hoarded cash. It was a bank run on the whole system of short-term funding, not on one bank.

The clearest gauge of the freeze was the gap between three-month dollar Libor and the overnight indexed swap rate. It had been about 10bp before the crisis began in 2007 and was already several times that before Lehman failed; on 10 October it passed 360bp. Banks were paying more than three percentage points over expected policy rates to borrow for three months, if they could borrow at all.

The lesson for traders: policy rates and funding rates can split apart. Cutting the policy rate lowers both legs of that spread; it does not make banks trust each other. Restarting the market needed a lender of last resort for more than just banks, guarantees and fresh capital. And the contagion was global: the stress spread from Wall Street to banks in Europe and beyond, and central banks ended up cutting rates together.

The response came in waves. On 19 September the Treasury offered to guarantee money market funds, backed by its Exchange Stabilization Fund of about $50bn. The Fed began lending to banks that bought asset-backed commercial paper from money funds, lending $150bn in the first ten days. On 29 September the House rejected the $700bn bail-out bill and the Dow fell a record 778 points; a revised version became law on 3 October.

On 8 October the Fed, the ECB, the Bank of England and three other central banks cut rates together; the Fed went to 1.5%. On 14 October the Treasury said it would buy up to $250bn of preferred shares in banks, and the FDIC guaranteed new bank debt, with nine major institutions signing up at once. Funding spreads eased from their 10 October peak, but the damage to the economy was done: on 16 December the Fed set its target at 0–0.25%.