Lehman Bros. collapse triggered economic turmoil

The fallout was fast and frightening, and will reach far into the future.

Almost 6 million lost jobs. A 5,000-point Dow plunge. The government bailing out cash-starved banks. General Motors and Chrysler declaring Chapter 11. The unemployment rate doubling to almost 10%. Consumers getting $4,500 handouts from Uncle Sam to buy a car. Talk of a 1930s-style depression.

To modern-day Wall Street historians, these bizarre events mimic the other-worldly feel of a Ripley's Believe It or Not episode. But all those unthinkable occurrences made news in the past year. They all tie back to Sept. 15, 2008, the day Wall Street titan Lehman Bros. filed for bankruptcy. The collapse of the investment bank was so shocking it triggered a financial tsunami of such size and scope that it was compared to the Great Depression.

And while the events of that panic-drenched day are probably not etched into peoples' memories as are the "I remember where I was" vividness of the bombing of Pearl Harbor, the assassination of JFK, the space shuttle Challenger explosion or the Sept. 11 terrorist attacks, it will be remembered as the day Lehman's demise almost triggered a global financial meltdown.

"Lehman's bankruptcy will forever be synonymous with the financial crisis and (resulting) wealth destruction," says Paul Hickey, founder of Bespoke Investment Group.

The legacy of Lehman's fall is still playing out. Investors and consumers are adapting to a new world that many analysts warn will be far less ebullient than the high-risk, credit-fueled system that came crashing down a year ago in a rubble of bad loans.

"We are on a bumpy journey to a new destination," says Mohamed El-Erian, CEO of giant money manager Pimco. "The new destination will look much different than where we came from."

In the years leading up to the Lehman collapse, the economy was artificially fueled by cheap money that made it easy for anyone who wanted a loan to buy a house, a car or expand a business to get one. Before the housing crash, many Americans treated the rising value of their homes and other investments as a substitute for savings. But the $14 trillion in household wealth destruction caused by plunging home prices and the worst stock swoon since the 1930s has wiped away that false sense of financial security for a generation of Americans.

Trust in the stability of the financial system took a major hit when, after having hinted that it would not let any major financial institution fail, the government did a 180-degree turn and refused to bail out Lehman, says John Garvey, head of the U.S. financial services practice at PricewaterhouseCoopers.

"That shook market confidence to its core and caused people to believe the whole system could blow up," says Garvey. "I don't think anyone fully understood the impact of confidence and what it means to the proper functioning of the system."

The collapse in confidence was best illustrated in the banking system, where banks were unwilling to lend money to each other for fear of not getting paid back, a dramatic shift that froze credit markets and caused borrowing rates for banks and businesses to skyrocket.

El-Erian ticks off other ways in which the world has been altered by the banking crisis:

•Banks and other financial institutions, after being battered by the real estate bust caused in large part by their loose lending standards, will now be subject to greater government regulation. The financial sector must also operate with far less borrowed money, or leverage. "That means there will be less credit available," El-Erian says. "The banking sector will be a shadow of its former self."

•The federal government's role in the everyday workings of the financial system, which rose to unprecedented levels during the financial crisis, will remain elevated. The government must still unwind or exit the programs it's put in place in the past year in an effort to stabilize the system and jump-start the economy. The risk is that the transition will be handled poorly, creating problems such as an economic relapse or jumps in interest rates and inflation, he says.

•The bottom line is that the U.S. economy will likely grow at a slower pace than it has in the past. Sapping growth will be the combination of tighter credit and the need for consumers to save more money each month to offset the big losses they suffered from plunging real estate values and lost jobs.

"In the U.S., the speed limit for economic growth will come down from 3% to 2%," says El-Erian. That slowdown, he adds, has many negative implications, such as reduced retail sales, fewer jobs and skimpier profits at U.S. companies.

But not everyone on Wall Street thinks the financial crisis has radically changed the world of money. James Paulsen, chief investment strategist at Wells Capital Management, says the economic downfall was made worse by scary warnings about another depression by high-ranking government officials, including Presidents Bush and Obama, Federal Reserve Chairman Ben Bernanke, Treasury Secretaries Henry Paulson and Timothy Geithner, as well as members of Congress. Many investment strategists argue that the sharp drop in the Standard & Poor's 500-stock index from its pre-Lehman level of around 1250 to its bear market low of 676.53 was overdone, as investors incorrectly priced in a depression. The S&P closed Thursday at 1044.

"What made it so petrifying was that our leadership was on the airwaves talking about the threat of a depression," Paulsen says. "If they wouldn't have done that, I wonder if things would have gotten as bad. The tagline I put on this calamitous period is: 'The depression that wasn't.' "

It's too early to say that consumer spending won't bounce back to more normal levels, Paulsen says. He stresses that too much is being made of strapped consumers and a shift from free-market capitalism in the U.S. "What investors aren't focusing on is the emerging consumer base in Asia and the breakout of capitalism around the globe."

Still, other analysts say that there are many other ways in which the Lehman failure is a potential game-changer in the way consumers view money and investors weigh investments:

•Splurging consumers dialing back. The free-spending ways of consumers have been interrupted. It's not hard to figure out why. Housing prices in the nation's 20 biggest cities have fallen 31% since the July 2006 peak and 12% since Lehman's bankruptcy, based on the S&P/Case-Shiller Home Price Index.

Couple that with a weak job market and a stock market still down 33% from its October 2007 peak, and it's no wonder consumers are spending less and saving more.

"Animal spirits of consumers have not come roaring back," says Rod Smyth, chief investment strategist at Riverfront Investment Group. The unwillingness of consumers to spend is due largely to huge debt loads. "That necessitates more savings," he adds.

The consumer savings rate, which turned negative in the years leading up to the financial crisis, shot up to almost 7% in May, the Commerce Department says. This closely watched metric measures savings as a percent of disposable income. In July, the most recent reading, it dipped to 4.2%. This return to old-fashioned saving, however, acts as a depressant on economic growth at the very time consumption is needed most.

•Once-aggressive investors turn conservative. Investors who once chased big returns are now more concerned with protecting their money. "At the retail level, investors have been slow to jump back into the stock market," Smyth says.

A 57% drop in stock prices from the 2007 peak, coupled with homes now worth tens of thousands of dollars less, left investors feeling burned.

As a result, many investors in search of a good night's sleep are parking their money in safe places, such as certificates of deposit and money market funds, even though they're getting little, if any, return. According to data compiled by the Investment Company Institute and the Federal Reserve, there is now $9.3 trillion sitting in cash or cash-equivalent accounts despite the average yield of 0.98% on a one-year CD and 0.06% on money market funds.

The more money consumers direct to low-yielding investments, the more saving they will have to do to make up for the smaller investment returns.

"My sense is, individuals will be more sensitive to building their nest eggs via savings as opposed to speculation," says Bob Barbera, chief economist at ITG.

•Days of easy money are a thing of the past. It's not as easy to get a loan these days. Remember those 0% introductory offerings for credit cards? Or those no-money-down mortgages banks dangled in front of potential home buyers — even those with limited means? They're a thing of the past.

"In the current environment, lenders are looking for reasons to say no, not yes," says Greg McBride, analyst at Bankrate.com. "Lenders have become increasingly selective as to who gets credit and at what price."

Credit card issuers are also getting stingier. Many banks are scaling back credit limits, closing unused credit lines and raising rates on borrowers, even those with good track records of paying on time. Tighter credit reduces consumption, which places a drag on the economy.

•Employment picture turns cloudy. The U.S. economy is undergoing structural changes. Many former job-generating businesses, such as the auto industry, basic manufacturing, financial services and traditional media such as newspapers are not likely to generate the number of jobs they once did.

"The employment situation has changed," says Richard Bernstein, founder of Richard Bernstein Capital Management.

A consolidation in the retail sector is underway, which means fewer stores and jobs.

Many jobs simply won't come back, adds Abby Joseph Cohen, strategist at Goldman Sachs. "Many workers will need to be retrained and find some other line of work."

And it is likely to take longer than usual for the jobs that are coming back to do so, adds McBride of Bankrate.com. "This may well be the mother of all jobless recoveries," he says.

No doubt, Lehman's downfall was a watershed event.

"It almost seemed like the economy, which was kind of hanging in prior to the Lehman failure, entered recession a day after the bankruptcy filing," says Bob Doll, global chief investment officer of equities at BlackRock. "As a result, the stock market is still a bunch lower than before, and the size of the economy is also a lot smaller. Those are important aftereffects that will take time to work through."