Financial Risk Manager Part 1

Explanation

Lehman Brothers' failure was primarily due to its high leverage, which significantly reduced its ability to absorb losses.

Key Points:

• Leverage refers to the use of borrowed funds to finance asset purchases
• Lehman had taken on excessive short-term debt to finance long-term assets
• This strategy exposed the firm to serious liquidity problems
• When the housing bubble burst, asset values plummeted, causing substantial losses
• High leverage meant limited capacity to absorb these losses
• Unable to meet debt obligations, leading to bankruptcy

Why Other Options Are Incorrect:

Choice B: While Lehman had significant exposure to sub-prime mortgage assets, this was not the primary reason. Many institutions had similar exposure but didn't fail - the key difference was Lehman's leverage level.

Choice C: The "too big to fail" concept didn't apply here - Lehman was allowed to fail without government intervention or bailout.

Choice D: Lack of investor confidence was an outcome, not the primary cause. It was triggered by the high leverage and subprime exposure.

Key Risk Management Lesson:

High leverage amplifies losses and reduces a firm's ability to withstand market downturns, making it a critical risk factor that must be carefully managed.