Lehman Brothers' failure was primarily due to its high leverage, which significantly reduced its ability to absorb losses. Leverage refers to the use of borrowed funds to finance the purchase of assets, with the expectation that the income or capital gain from the new asset will exceed the cost of borrowing. In the case of Lehman Brothers, the firm had taken on an excessive amount of short-term debt to finance long-term assets, a strategy that exposed it to serious liquidity problems. When the housing bubble burst, the value of these long-term assets plummeted, leading to substantial losses. However, the firm's high leverage meant that it had a limited capacity to absorb these losses. As a result, it was unable to meet its debt obligations, leading to its eventual bankruptcy.

Choice B is incorrect. While it's true that a significant portion of Lehman Brothers' mortgage-backed securities were built upon sub-prime mortgage assets, this was not the primary reason for the firm's downfall. Many financial institutions had similar exposure to sub-prime mortgages but did not fail as Lehman Brothers did. The key difference was the level of leverage used by Lehman Brothers, which amplified losses and reduced its ability to absorb them.

Choice C is incorrect. The concept of "too big to fail" refers to the idea that certain financial institutions are so large and interconnected that their failure would be disastrous for the broader economy, thus necessitating government intervention or bailout. However, in Lehman Brothers' case, despite being a large institution, it was allowed to fail without any government intervention or bailout.

Choice D is incorrect. Although lack of confidence among investors leading to a lack of funding can contribute to a firm's downfall, it wasn't the primary reason in case of Lehman Brothers'. It was rather an outcome triggered by their high leverage and exposure to subprime mortgages which led investors losing confidence in them.

Things to Remember

• High leverage can amplify losses and reduce a firm's ability to absorb them, leading to potential bankruptcy.