Why Lehman Brother's Collapsed?

The three Ls that killed Lehman:

1. Leverage

During the good times, the best way to enhance your returns is to 'gear up' by borrowing money to invest in assets which are rising in value. This enables you to 'leverage' (magnify) your returns, which is particularly useful when interest rates are low. However, leverage cuts both ways, as it also magnifies your losses when asset prices fall. (Witness the recent return of negative equity to the UK property market.)

A sensibly run retail bank would have leverage of, say, 12 times. In other words, for every £1 of cash and other readily available capital, it would lend £12. In 2004, Lehman's leverage was running at 20. Later, it rose past the twenties and thirties before peaking at an incredible 44 in 2007.

Thus, Lehman was leveraged 44 to 1 when asset prices began heading south. Think of it this way: it's a bit like someone on a wage of £10,000 buying a house using a £440,000 mortgage. If property prices started to slide, or interest rates moved up, then this borrower would be doomed. Thanks to its sky-high leverage, Lehman was in a similar pickle.

2. Liquidity

Most businesses fail not because of lack of profits but because of cash-flow problems. Like all banks, Lehman was an upturned pyramid balanced on a small sliver of cash. Although it had a massive asset base (and equally impressive liabilities), Lehman didn't have enough in the way of liquidity. In other words, it lacked ready cash and other easily sold assets.

As markets fell, other banks started to worry about Lehman's shaky finances, so they moved to protect their own interests by pulling Lehman's lines of credit. This meant that Lehman was losing liquidity fast, which is a dangerous state for any bank. Only six months earlier, in March 2008, Lehman rival Bear Stearns faced a similar loss of liquidity before JPMorgan Chase rode to its rescue.