The film Too Big to Fail brings the financial crisis into the rooms where decisions had to be made before the markets opened again. Executives, regulators and potential buyers negotiate against an approaching deadline, trying to judge exposures that have spread through securities and financing relationships far beyond any single institution. The people making the decisions are dealing with risks that have been accumulating for years, while the time available to respond is rapidly disappearing.
By September 2008, mortgage-related losses had already been mounting for months. Loans had been pooled, sliced, repackaged and sold through a vast network of financial institutions. Risk remained in the system, often embedded in instruments and funding arrangements whose exposures were difficult to trace. Gorton and Metrick (2012) later described the crisis through the development of securitised banking and the run on repo financing. Their analysis helps explain how uncertainty about collateral values could undermine the short-term funding on which major institutions depended.
The investment banks had grown within an environment where size and interconnectedness increasingly influenced expectations about government intervention. A large institution could have thousands of counterparties, obligations spread across markets and positions that would be difficult to unwind in an orderly fashion. The rescue of Bear Stearns earlier in 2008 gave those expectations a concrete precedent. No formal guarantee existed, but the practical difficulty of allowing a major institution to collapse had become impossible to ignore. Size had acquired a peculiar additional value: it made failure more dangerous for everyone else.
Lehman Brothers had expanded rapidly, accumulated substantial mortgage-related exposure and become heavily dependent on short-term financing. Repo agreements were central to this structure. Securities were pledged in exchange for cash, with an agreement to repurchase them shortly afterwards, often the next day.
The mechanism was technically ordinary and behaviourally fragile.
The arrangement functioned while lenders continued to believe two things at once: that the collateral would still be acceptable tomorrow, and that the institution itself would still be standing tomorrow. These were judgements made repeatedly, under changing conditions, by counterparties with their own exposure to manage. Copeland, Martin and Walker (2014) documented how Lehman’s tri-party repo funding came under severe pressure in September, even as funding for most other borrowers in that market remained comparatively stable.
Each renewal required a fresh decision. A lender could continue financing Lehman, demand more protection or withdraw. As concerns about the institution grew, the individual decision to reduce exposure became easier to justify. Every withdrawal placed further pressure on the borrower and could make the next lender more cautious. The process could accelerate without waiting for a final assessment of the institution’s underlying assets.
A funding structure built on daily renewal is also built on repeated acts of confidence. When those judgements change, the institution’s time horizon collapses. Lehman needed enough lenders to keep providing cash while it searched for solutions to problems that could take months to resolve. Its funding obligations continued to arrive on schedule, regardless of how long the underlying problems required.
By Friday, 12 September 2008, the negotiations in New York had become an attempt to prevent Lehman from failing before Monday morning. Senior figures from Wall Street and the authorities worked through possible transactions under extraordinary time pressure. Barclays was seriously interested in an acquisition, but the proposed deal encountered regulatory obstacles, including the British authorities’ unwillingness to permit the necessary arrangement without adequate guarantees. Other possibilities weakened as the weekend progressed. The remaining options depended on agreements about financing, losses, approvals and responsibility that could not be assembled quickly enough.
By Sunday evening, Lehman had no rescue and no workable acquisition. It filed for bankruptcy protection on Monday, 15 September.
The decision carried consequences beyond Lehman’s own creditors and shareholders. Earlier interventions had encouraged the expectation that the authorities might prevent the disorderly collapse of an institution whose failure threatened others. Lehman’s bankruptcy forced market participants to reassess how far that protection extended. Sorkin’s account of the weekend describes officials struggling with the immediate danger of collapse while also considering the precedent another rescue might establish (Sorkin, 2009).
Markets reacted by reassessing other institutions whose survival depended on continued access to short-term funding. Morgan Stanley came under particularly severe pressure as credit default swap spreads widened and counterparties became more cautious. Its funding prospects were now being judged in a market that had just witnessed the bankruptcy of a major investment bank. A lender contemplating whether to renew financing had to consider the possibility that others were preparing to withdraw.
That reassessment could itself worsen an institution’s position. When lenders become less willing to provide money because they fear that funding will disappear, their decisions help create the shortage they anticipate. An individual counterparty may be acting prudently. The combined effect of many such decisions can leave a financial institution with very little room to manoeuvre.
The authorities were already operating emergency liquidity facilities, and the response continued to expand. On 21 September, Morgan Stanley and Goldman Sachs received approval to become bank holding companies. The change offered access to a different regulatory and liquidity-support framework at a moment when their traditional investment-bank funding model was under intense strain. Their survival depended on maintaining access to finance and convincing counterparties that the support available to them was credible.
AIG presented another form of the same danger. The company faced enormous pressure from collateral obligations associated with credit derivatives and from its securities-lending programme. As conditions deteriorated, cash demands grew and the ability to meet them became increasingly uncertain. The Congressional Oversight Panel (2010) documented how fears about AIG’s extensive financial connections influenced the government’s decision to intervene. Its failure threatened losses and disruption across a wide network of counterparties.
General Electric encountered funding difficulties through GE Capital, which relied heavily on short-term borrowing, including commercial paper. The company was known internationally for industrial products, but its financial operations exposed it to the deteriorating credit markets. As short-term financing became more expensive and difficult to secure, a familiar industrial name was drawn into the same liquidity crisis affecting investment banks.
At Lehman, the immediate pressure came through repo funding. At AIG, collateral obligations and securities lending created urgent demands for cash. GE Capital had to contend with deteriorating conditions in the commercial paper market. These businesses had different assets, customers and obligations, yet their capacity to continue operating depended on financing arrangements that could become unreliable much faster than their underlying activities could be changed.
That dependence helps explain the speed with which the crisis spread. Financial institutions had built enormous businesses on the assumption that collateral would remain financeable and short-term funding would continue to be available. Counterparties evaluated those assumptions continuously, adjusting their willingness to lend as new information appeared. Once enough of them began questioning an institution’s ability to survive, the institution could lose the financing necessary to demonstrate that survival was still possible.
Emergency lending, guarantees, capital support and changes in institutional status eventually helped stabilise the financial system. Funding channels reopened. Several institutions survived conditions that could otherwise have forced their collapse. Banks later returned to profitability, while households and workers continued to bear substantial economic losses. The interventions addressed an immediate emergency, although the wider questions surrounding risk-taking, interconnectedness and expectations of rescue remained.
The consequences of the Lehman bankruptcy also exposed an uncomfortable feature of financial stability. A lender’s decision can be entirely reasonable from the perspective of its own balance sheet and still contribute to an outcome that damages everyone involved. Each counterparty has an incentive to leave before the others, particularly when the value of its collateral or the borrower’s access to funding becomes uncertain. The institution facing those decisions must somehow remain financeable while its financiers are individually reconsidering whether to stay.
That is the tension running through Too Big to Fail. The people negotiating through the weekend were confronting the consequences of financial commitments accumulated over years. The available solutions had to satisfy regulators, buyers, creditors and political authorities whose interests and responsibilities differed. Every delay narrowed the remaining options, while every failed option increased pressure on the next institution that markets considered vulnerable.
Lehman’s collapse revealed how much of a financial institution’s apparent stability could depend on the continued willingness of other institutions to finance it. Its assets, obligations and exposures had been accumulating for years. The decisive financing decisions arrived within days, sometimes hours.
The lenders making those decisions were reacting to the risk of failure. Collectively, their withdrawal could help bring that failure about. Once the process reached that point, the institution’s ability to survive was being determined partly by the very expectations its deteriorating position had created.
References
Congressional Oversight Panel. (2010). The AIG rescue, its impact on markets, and the government’s exit strategy.
Copeland, A., Martin, A., & Walker, M. (2014). Repo runs: Evidence from the tri-party repo market. The Journal of Finance, 69(6), 2343–2380.
Gorton, G., & Metrick, A. (2012). Securitized banking and the run on repo. Journal of Financial Economics, 104(3), 425–451.
Sorkin, A. R. (2009). Too big to fail. Viking.