Understanding the Lehman Shock

 Chapter 36

The Lehman Shock.

This term refers to a series of financial crises that began with the bankruptcy of the American investment bank Lehman Brothers on September 15, 2008.

It's worth noting that the term "Lehman Shock" is a Japanese coined term, and globally it's referred to as the "financial crisis."

The Lehman Shock involved a total debt amount of 64 trillion yen, comparable to the national budget of some countries.

This debt was largely due to securities called subprime mortgages.

A prime loan refers to a loan for creditworthy individuals. Since the term "subprime loan" includes "sub," it means loans for less creditworthy individuals.

A loan is a form of debt.

When borrowing money, one has to pay interest in addition to the principal.

Because the borrowers were less creditworthy than prime borrowers, the interest rates were naturally set higher.

This high-interest rate on the lender's side is also a reflection of the risk that the debt might not be repaid.

The traders on Wall Street of US, who still possess the most advanced financial engineering in the world, decided on this solution to manage this risk:

"That's right. Let's break up these loans and sell them to investors!"

Of course, investors are not foolish.

They understand that high-interest rates are a reflection of the risk of non-repayment.

So, they decided to mitigate this risk by bundling these loans with high-quality securities such as government bonds.

The logic was that even if these loans defaulted, the payments from other high-quality bonds would help distribute the risk.

This logic was endorsed by rating agencies, and investors who trusted these ratings flocked to subprime loans.

Additionally, investors were not entirely gullible. While trusting the rating agencies, they also insured themselves against defaults, ensuring they would get their money back in case of a default.

This insurance is known as CDS, or Credit Default Swap.

Now, if the logic described above worked perfectly, the Lehman Shock would not have occurred.

This means that there was a fatal flaw in the logic.

The fatal flaw was, "Since it was sold in pieces, we don't know what's inside."

The subprime loans were sold off in pieces like this:

They combined 1 million yen of subprime loans with 1 million yen of high-quality government bonds, creating two securities worth 1 million yen each.

The problem was that investors could see the amount and the interest rate of the securities but couldn't tell whether the contents were subprime loans or high-quality bonds.

Therefore, investors, thinking about the worst-case scenario, would insure 200 million yen worth of securities when they bought 1 million yen worth, in case of default.

Did you notice?

Only the 1 million yen of subprime loans should have been at risk of default, but insurance was taken out for the full 200 million yen worth of securities.

This was the trigger for the financial crisis during the Lehman Shock.

Lehman Brothers, unable to treat everything as non-performing loans due to the lack of transparency about what was inside, ended up with a total debt of 64 trillion yen.

After Lehman Brothers went bankrupt, insurance claims totaling 64 trillion yen were made to insurance companies, leading to a chain reaction of bankruptcies.

Investors, in a rush to liquidate their stocks to cover their losses, sold off stocks rapidly around the world, causing stock prices to plummet, and thus the Lehman Shock spread worldwide.

Japan, relatively speaking, managed to weather the Lehman Shock with less damage.

The reason is simple: the subprime loans were mortgages, essentially loans for real estate transactions.

Japanese financial institutions, still reeling from the bad debt caused by the real estate crash during the bubble burst in the 1990s, remembered their lessons.

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Authors Note

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There is an explanatory video about this which I would like to introduce.

[What is Subprime!? The Blunder of Lehman Brothers Part 1]

[The Worst Bankruptcy in History: The Blunder of Lehman Brothers Part 2]