Abstract
Why did the failure of Lehman Brothers make the financial crisis dramatically worse? Our answer is that the financial crisis was a process of a build-up of risk during the crisis prior to the Lehman failure. During the crisis market participants tried to preserve an option to withdraw by shortening maturities — the “flight from maturity”. We show that the flight from maturity was manifested in a steepening of the term structures of spreads in money markets. With increasingly short maturities, lenders created the possibility of fast exit. The failure of Lehman Brothers was the tipping point of this build-up of systemic fragility. A crisis is a dynamic process in which “tail risk” is endogenous.
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