Lehman crisis 101: An introduction to the worst financial crisis since the Great Depression

Christie's employees pose for a photograph with a Lehman Brothers sign at Christie's in central London September 24, 2010. Various items are on display before the auction of Lehman Brothers: Artwork and Ephemera, which will take place on September 29. REUTERS/Andrew Winning (BRITAIN - Tags: ENTERTAINMENT BUSINESS SOCIETY) - RTXSLK5

The collapse of the storied US investment bank Lehman Brothers on September 15, 2008, worsened the sense of panic in an already jittery financial system. As the contagion spread, governments and central banks scrambled to come up with unconventional measures to restore confidence.

Moneycontrol explains some basic terminology and questions on the crisis which shook the world.

What is a recession?

In technical terms, an economy is in recession when the country’s national income (gross domestic product) registers negative growth in two consecutive quarters of a year. During recession, the GDP falls as compared to an economic slowdown where the GDP grows at a relatively slower pace.

What caused the recession in 2008?

It was caused by the housing loan crisis brought on by a competitive banking system that resorted to sub-prime lending. Banks extended housing loans to many customers who did not possess the requisite repayment ability. The resultant payments default triggered massive fall in banks’ and real estate incomes.

What is sub-prime?

Sub-prime refers to a loan given to a borrower who does not qualify for a regular home loan, because of a poor credit record, low income and no job security.

What was the immediate trigger?

Lehman Brothers and Merill Lynch, two of the world’s largest financial institutions, booked big losses on account of their exposures to highly risky assets. Lehman ended up filing for bankruptcy, though Merrill Lynch managed to draw Bank of America to its rescue.

What led to the huge losses?

Lehman Brothers had overexposed its investments in the real estate sector. As property prices tanked so did Lehman’s prospect on those investments.

What are the lessons?

The sub-prime crisis is a result of individual incentives and lack of accountability. Credit history of borrowers is essential. There has to be greater check on the background of borrowers and their repayment ability. Also, rating agencies are typically paid by issuers and only for the initial rating. A true assessment should be carried out by a robust re-rating system.

What are the other recessionary periods in world economy?

The Great Depression between 1929 and 1933 was one of the most severe economic downslides in modern history; GDP declined almost 33%. The previous recession in the US was in 2000-01. It was triggered by a stock market crash as dot com companies went bust. The country’s GDP growth did not cross 3 percent until September 2003.