Lehman Brothers: Did Markets Know?

On September 15, 2008, Lehman Brothers Inc. announced their filing for bankruptcy. This announcement did take markets by surprise causing widespread panic and disruptions in financial systems worldwide. It has been widely argued that financial contagion has escalated the insolvency into a systemic crisis. This paper studies the reaction of Lehman?s competitors and market participants to this bankruptcy announcement and its spill overs to other institutions. Specifically, we focus on transaction prices of major U.S. Investment and commercial banks prior to and after the bankruptcy. By decomposing their equity bid-ask spreads, we find evidence that the bankruptcy contributed to increasing adverse selection risk as well as inventory holding risk. Moreover, we find supporting evidence that the degree of competition among market makers did decline. All three components did contribute to a significant rise in transaction costs. Interestingly, the relative contribution of each channel has remained roughly constant. In the case of Lehman?s stocks the adverse selection component rises only in the last three days of trading prior to the bankruptcy filing announcement. Otherwise adverse selection costs are in line with the other US investment banks. Moreover, we find no evidence of an increase in the adverse selection component of potential bidders, from which we interpret that the market did not expect a take-over or merger. We explore the robustness of our decomposition by employing volume-synchronized probability of informed trading-measures and impact regressions on prices, quantities, and their respective innovations. In general, we find little evidence of informational contagion. Moreover, any information effects are rather short-lived. Even in periods of crisis price discovery in stock markets remains remarkably efficient.