I have been tracking Lehman Brothers & Merrill Lynch since March (Bear Stearns implosion). Let’s wrap up our Lehman story, now that it has been wiped out and no longer exists. 

It is widely held that the federal government had a choice between 2 bad options. Option 1: continue to bail-out investment banks (after Bear Stearns) and in so doing set a very dangerous pattern that would encourage bankers to take risks (called a moral hazard). Option 2: let Lehman fail and thereby send a signal that there will be no more bail-outs. We now know that option 2 was selected. The result was the carnage we saw in late September and early October that took others down: Merrill, AIG, Wachovia, WaMu etc.

Lehman had a pile ($160B) in unsecured bonds. These bonds were widely distributed around the globe – especially in Europe & Asia. Lehman’s high credit rating gave confidence that they could not fall. How wrong they were. The price on Lehman’s bonds fell to 15 cents on the dollar prior to the bankruptcy. Picture your $100K bond portfolio dropping to $15K. Once Lehman’s bonds tanked, investors around the globe pulled their money out of money market funds to ensure they were not loaning to Lehman inadvertently. We know that at least 1 large US money market fund had to “break the buck” on their fund because of losses sustained by the Lehman bankruptcy.

Businesses rely on money market funding for their daily operations. Suddenly not having access to short term credit put a severe damper on economic activity. Instant recession.
The full cost of Lehman’s bankruptcy will take some time to compute. Credit markets have seized-up to an all-time low – but are improving. We don’t know what value will be recovered from the defaulted bonds. Hedge Funds lost money because they were trading with Lehman and lost possession of assets that will damage their balance sheet.