The bankruptcy of Lehman Brothers in September 2008 put the already ongoing subprime crisis in overdrive because the highly leveraged investment bank couldn’t honour its obligations (Johnson 2013). The perceived counterparty risk, the risk of default of the counterparty of your loan or equity investment, on the market rose to unprecedented levels and credit markets froze as a result (Simkovic 2008, p. 274). This led to the single highest point drop of NYSE after short sellers swarmed over other investment banks and companies like AIG with high exposure to Lehman Brothers (Simkovic 2008, p. 267 )..
Lehman Brothers’ failure was dubbed as a “horrendous failure” by then financial minister of France Christine Lagarde. European banks were contaminated by exposure to both AIG and to Lehman Brothers, with collateralized debt obligations (CDOs) bought from Lehman Brothers and a kind of insurance instrument called credit default swap (CDS) bought from AIG. As Lehman Brothers failed, its CDOs in circulation were nullified and AIG was hit hard by demands to pay the insurance on those CDOs. In the end many European banks, even here in Finland, were forced to write off major losses on those particular instruments. (GPO. 2011. p. 50.)
All of this is just history right? I mean it happened in 2008, 7 years ago. Well, not exactly. Lehman Brothers’ failure caused the subprime crisis’ peak which in turn led to sovereign debt crisis in various European countries, even here in Finland. Many countries had notable problems with their finances with Greece being a prime example. (CIA 2012). Indeed, this Euro crisis, as it is called, might be a warning sign of a complete failure of a sovereign nation state.
The complete failure of a nation state would spell disaster to all counterparties that do business in any form, directly or indirectly. If the country fails, then its corporations won’t be seen as trusted. Credit markets will freeze and both inbound and outbound flows of capital are frozen solid. All of the country’s bonds (the #1 way a country usually finances itself after tax income) are nullified and all parties holding them will be forced to write losses on their account. Considering country bonds are a major way investors reduce risk in their portfolios by diversification, it would also impact parties only indirectly linked to those bonds.
Many Southern European states have hovered over the looming abyss of a complete failure of their financial system during this decade, with Greece as the poster boy for the Euro crisis. Curiously enough, failure of Greece wouldn’t spell disaster because its bonds are already traded at junk level, meaning that they have a high amount of risk.
The countries that are seemingly unaffected would be the worst case scenarios. A country like Germany with its high influx of migrants propping up housing prices and its liberal loan policies would be a prime place for a new subprime mortgage crisis. Germany has a strong economy, but it doesn’t have the tools available or the firepower of the dollar to deal with major financial institution’s complete collapse. This would kick off a systemic risk epidemic as countries in the Eurozone would be very reluctant to loan to each other.
I’m not a doomsayer though, so I’m ending this blog post on a good note. The aforementioned scenario is highly unlikely, at least in my opinion. It’s sometimes just fun to imagine what would happen if a doomsday scenario came true.
GPO 2011. The Financial Crisis Inquiry Report. p. 50. https://www.gpo.gov/fdsys/pkg/GPO-FCIC/pdf/GPO-FCIC.pdf
Michael Simkovic 2008. Secret Liens and the Financial Crisis of 2008, American Bankruptcy Law Journal, Vol. 83, p. 267 274.
CIA 2012, The World Factbook. https://www.cia.gov/library/publications/the-world-factbook/geos/gr.html. Retrieved 28.2.2016
Simon Johnson 2013. Three Unlearned Lessons From the Financial Crisis. http://www.bloombergview.com/articles/2013-09-26/three-unlearned-lessons-from-the-financial-crisis. Retrieved 28.2.2016