Finance

Illiquid Vs. Insolvent: Why Lehman Isn't Bear Stearns

Lehman Brothers is insolvent.

When you add up all the stuff they own and all the people they owe money to, they don't have enough to pay their debtors back.

They are fully, totally, completely broke. Not just "kind of broke, but a loan from their cousin will get them through the next few weeks, 'til they close that next big deal." They are broke and have no chance of coming out from under any time soon.

Bear Stearns was a different story. Their assets were worth more (or close to more) than their debts. But they didn't have liquid assets, ready cash. Too much of their money was tied up in long-term obligations, like mortgages and loans and the like.

Think of ordering a pizza. The delivery guy comes to your door and you say, "See, I'm worth a million dollars. Just look at this house. But I don't have any ready cash in my wallet. Give me the pizza and I'll pay you back."

Bear Stearns had the million dollar house. They just didn't have any ready cash.

Lehman didn't own the house. They were homeless. In fact, they owed someone a house. They had nothing that made their promise to the pizza guy credible.

Bear Stearns worked like many banks — they borrowed money every day from other banks to do their daily business with. All of a sudden, all the other banks got worried that Bear Stearns wouldn't pay them back right away. They knew Bear would be able to pay them back eventually. But not right away. So the banks stopped lending them that everyday money.

When the Federal Reserve Bank came in and helped JP Morgan Chase buy Bear Stearns, the risks weren't terribly high. The Fed promised to pay up on the very remote chance that Bear's various assets could never be accessed. But the Fed knew that Bear's assets were good.

It's like that house: the Fed stepped in and told JP Morgan: "Hey, we know Bear Stearns' house is good and worth $1 million. But if for any reason it's not, we'll cover the difference."

That made JP Morgan comfortable.

Since Lehman Brothers doesn't own a house and, in fact, owes someone else a house, the Fed would have to do a lot more. They would actually have to fork over real money to anyone thinking of buying Lehman Brothers. Not contingent, just-in-case money. They actually have to pay cash out to a private company to save another company.

There were plenty of debates over Bear Stearns: was it a bailout or not?

There would have been no debate over Lehman Brothers. This, my friends, would be a bailout the likes of which the U.S. has not seen in a long time.

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Fantastic. I hadn't spent a lot of time looking for this answer, but I *did* wonder last night and/or this morning about why Bear Stearns went down one way and Lehman another. This explains it perfectly!

Sent by Greg | 10:38 AM | 9-15-2008

I really enjoy this series, but could you give more detail as to why Lehman Brothers "owed someone a house"? Great analogy, just would like some more detail.

Sent by Pauline | 11:10 AM | 9-15-2008

requesting information regarding the "last great bailout that occurred" and who and when was that? This will, I am sure, will give to me a better idea of what is actually going on.Would that time be that of the "Great Depression"?

Sent by Richard & Toby Haynes | 12:13 PM | 9-15-2008

Thanks Adam, although, I would have extended the metaphor to say that the government told JP Morgan that if the house had termites and a bum heating system they'd give the money to have the exterminator/plumber come in and fix it. But I appreciate your clear explanation :).

Sent by Chris Collins | 12:33 PM | 9-15-2008

You use the pizza delivery analogy. If I understand correctly this situation has nothing to do with the institutions inherent value (i.e. physical and intellectual property) but it is strictly related to cash flow. And they aren't able to cut a deal with creditors, who would like to see some vs. none return?

Sent by robert | 3:07 PM | 9-15-2008

"... Bear Stearns was a different story. Their assets were worth more ...", but, how do you value the assets? at what point in time? I am sure the value is significantly less than what it was when nobody thought they needed a bailout.

"... if for any reason it's not, we'll cover the difference ..." There is a name for this kind of transaction. It's call purchasing insurance. And no real- world company will offer it without you paying real hard cash for it.

Sent by Hawkins | 5:13 PM | 9-15-2008

Very good explanation that a layman can understand. Very rare, especially when it comes to economics and banking. Thanks Adam.

Sent by Thrungphat Karungkorn | 7:07 PM | 9-15-2008

The analogy is very nice, but to be useful journalism, it is necessary to substantiate the claims of insolvency or illiquidity. In my view, some chunks of the balance sheets (and substantiation) should have been included in the article.

Sent by John B. | 10:00 PM | 9-16-2008