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FRM Part I · FRM Exam Part I · Anatomy of the Great Financial Crisis of 2007-2009

Which statement best describes why the failure of Lehman Brothers in September 2008 intensified the crisis?

Lehman's failure showed that a major institution could be allowed to fail, so counterparties feared losses on exposures to other firms. Interbank and wholesale funding froze and spreads widened sharply, which turned a mortgage-related problem into a systemic liquidity and confidence crisis.

  1. AIt was the first US bank to fail, which surprised regulators who had never seen a failure
  2. BIt showed that large institutions might not be rescued, raising counterparty risk fears and freezing interbank and wholesale fundingCorrect
  3. CIt caused an immediate fall in the LIBOR-OIS spread as risk was transferred to the government
  4. DIt eliminated exposure to credit default swaps because Lehman's contracts were canceled by the exchange

Explanation

Lehman's bankruptcy, unlike the earlier Bear Stearns rescue, signaled that creditors could suffer losses. Counterparties pulled back, and wholesale funding and interbank lending seized up. The LIBOR-OIS spread widened, not fell, and derivative contracts were not simply canceled.

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