In September 2008, the US investment bank Lehman Brothers filed for bankruptcy. This event was the first time in decades that a major US bank had collapsed. In the UK, major retail banks had to be bailed out by the government, and in Germany, the second-largest bank, Commerzbank, was partly nationalized.
These banks were deemed too big to fail, meaning that the government felt compelled to intervene fearing that allowing the banks to fail would create a crisis across the entire banking system.
This financial crisis was a complicated event (you can find whole books on it – not just a paragraph) but it boils down to the fact that the banks lent way too much money and lent some of it to people who were unlikely ever to pay it back. You can be forgiven for thinking they just weren’t doing their job properly.
A lot of this lending was done using mortgage-backed securities. These securities are a bit like bonds where the coupon payments and final principal repayments come from a portfolio of residential mortgages. By ingenious methods, the banks made these securities appear less risky than they really were. These methods allowed the bank to earn yet more fees from the lending but at the expense of building a financial time bomb.
Will something like this happen again?