The Wolf of Wall Street and the Three Little Pigs with Subprime Mortgages

Lehman Brothers’ House of Cards

April 20 by Cristóbal Crespo

Sometimes a financial crisis can be even triggered or amplified by the collapse of a company, especially one that’s deemed “too big to fail.” In the case of the 2008 financial crisis, that subprime culprit was Lehman Brothers.

Everything was going so well…

Following the 9/11 attack and the dot-com bubble burst, interest rates were slashed to keep money flowing in the economy. With all this easy money sloshing around, banks started handing out mortgages with super-low interest rates which helped to push up housing prices.

Banks even started lending money to people with dodgy credit. No income, no job, no assets but have a big pile of credit card debt? No problem, here’s a mortgage for you!

These were called subprime mortgages – that is, mortgages with a high risk of default because they’re granted to people who would have never otherwise qualified for regular mortgages.

But what the heck does this have to do with an investment bank like Lehman? Well, during this housing boom, Lehman bought several mortgage lenders and it also invested heavily in securities linked to the subprime mortgage market. And they were showered with record profits.

But then the sh*t hit the fan…

By early 2007, the housing bubble was about to explode in everyone’s faces.

But Lehman ignored the red flags and continued taking on more of these risky securities, stacking its house of cards even higher. The trouble was, its greed for reward had made it greatly underestimate the risk, with its rationale being something like: “People still need to keep roofs over their heads – what can go wrong?”

Winds of change blow on the subprime mortgage market…

Soon enough, even the people with good credit were defaulting on their loans as higher interest rates and falling housing prices left them owing more than their homes were worth.

And just like that, the real estate used as collateral for mortgage-backed securities was suddenly worth a lot less on paper and Lehman’s assets became as good as garbage.

The final nail in Lehman’s coffin? Too much leverage. It had borrowed a ton of money to buy the securities and it’s been reported its leverage ratio was as high as 44:1 at one point. That’s like you making $10,000 a year but taking out a $440,000 loan on your birthday so you can party like Beyonce. (That’s why we offer limited leverage at BUX – so you don’t end up like Lehman.)

With debt topping $613 million, Lehman’s share price went into freefall and it lost 77% of its stock market value in the first half of 2008.

On September 15, 2008, Lehman Brothers finally went under, filing for bankruptcy after being in business for 158 years. This was followed by the worst economic meltdown since The Great Depression – though Lehman didn’t cause this, it sure as hell contributed to it.

So the lesson here for casual traders in a catchphrase: DON’T leverage it like Lehman.

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