1
ARMAGEDDON
ON SEPTEMBER 15, 2008, a harried and exhausted Richard Fuld reluctantly authorized the filing for bankruptcy of Lehman Brothers, the 158-year-old firm he (and only he) had headed since it was spun off from American Express in 1994. At the time, Lehman was the fourth-largest independent investment bank in the United States. Its bankruptcy filing reported liabilities of $613 billion, which made it nearly three times larger than America's previous largest bankruptcy, that of WorldCom in 2002.
Fuld, sixty-two, had not enjoyed the balmy weather that summer at all. An intense man under any circumstances, he had been locked in a life-or-death struggle to save his firm that began soon after Bear Stearns's merger into JPMorgan Chase in March—when Lehman's stock fell nearly 50 percent following rumors that Lehman would be the market's next victim, before recovering to close out the day with a drop of only 19 percent. A former trader known within the firm as "the Gorilla" for his domineering ways, Fuld was an autocratic leader accustomed to giving orders and ignoring dissent. He was angered by the idea that the market might doubt Lehman's ability to weather the storm. So he roused his associates and ordered everyone to hit the phones to get the word out to clients, counterparties, and the press that Lehman was no Bear Stearns and would survive. This was what he had done to turn the stock around in 1998, when markets were rattled by the sudden failure of Long-Term Capital Management, a large hedge fund, and again in 2002, when the market turned viciously on Wall Street firms after the collapse of WorldCom. The approach had worked before, and Fuld was confident that it would again.
Lehman Brothers, after all, had made itself a reputation for being a scrappy, street-smart overachiever who moved quickly to take risks and was nimble enough to get out in time. The firm had been especially active in the mortgage origination and securitization businesses, which had been very profitable. Fuld was given much of the credit for Lehman's success, and in 2006 the board granted him a ten-year stock award bonus valued at $186 million. In October of 2007, despite generally negative views about the economy, and after the mortgage-backed securities market had already begun to fall sharply, Lehman joined Tishman Speyer, a property developer, in a $15 billion acquisition of Archstone-Smith Trust, an owner of a large portfolio of residential apartments. Archstone had a $30 billion investment in commercial real estate that, together with another $46 billion or so of Lehman's mortgage-backed securities (MBS), would serve as a millstone around the neck of the firm as the markets soured.1
Fuld sensed in early 2008 that although Lehman had raised some new capital earlier in the year, he would need more if he was going to get through the current difficult market unscathed. So, soon after Bear Stearns fell, Lehman approached Warren Buffett, the seventy-eight-year-old chairman of Berkshire Hathaway, to propose an investment. Buffett was interested and proposed his usual recipe of high-coupon preferred stock with expensive warrants, which Fuld rejected as being too costly. A few days later Lehman issued $4 billion in convertible debentures to the public at a better price.2
In May, David Einhorn, manager of the hedge fund Greenlight Capital and one of Lehman's biggest critics and short sellers, gave a speech to a group of influential investors criticizing the firm's performance and the valuation of its mortgage-backed assets. Einhorn, who would make a fortune on his negative bet on Lehman, was constantly telling anyone who would listen of Lehman's problems, and soon other short sellers took up positions.
In June, a group of Lehman executives flew to Seoul to attempt to negotiate a substantial investment from the Korea Development Bank, headed then by a former Lehman executive. They returned a few days later without a deal, but with discussions still in process. On June 9 the firm pre-announced its second-quarter results, which showed a loss of $2.9 million, down from a profit of $489 million in the first quarter, and an increase in its holdings of Alt-A mortgages (those with a risk rating between prime and subprime), which some observers felt were not marked down enough to reflect their true trading values. After the results were announced, Fuld polled his top executives to ask them what else they thought Lehman should do. They thought there needed to be management changes, and some apparently suggested that Joe Gregory, Fuld's close friend and the firm's longtime president and chief operating officer, should resign. Reluctantly, Gregory stepped forward and volunteered to take the heat and resign along with Erin Callan, a former investment banker who had served for a year as Lehman's CFO and thus had become a principal lightning rod. The changes seemed to make little difference to Lehman's stock price, however, which dropped from $40 per share at the beginning of May to $17 by the beginning of July.
In August the Koreans came back with an offer to buy 25 percent of the firm at the then market price, but Fuld thought the price was too low and was reluctant to give up any control. The Koreans also wanted a better fix on the valuation of Lehman's asset-backed securities, but in any case, the Korea Development Bank would have to obtain government approval to make the investment, which Korean sources seemed to doubt would occur.
The situation was made even more acute when Treasury Secretary Henry Paulson told Fuld that he had better look for a merger partner right away, suggesting that there was likely to be no other way out for Lehman. This was painful news for a man who was fiercely committed to the idea of Lehman's remaining an independent firm, something he had especially learned to value after experiencing Lehman being owned by American Express for nearly ten years. According to a colleague, Fuld had exclaimed in December 2007, "As long as I am alive this firm will never be sold. And if it is sold after I die, I will reach back from the grave and prevent it."3
Nevertheless, Fuld canvassed the market broadly for a strategic investor. Over the summer he contacted Bank of America, HSBC, Met Life, GE Capital, and the ruler of Dubai. In July, Fuld suggested to Timothy Geithner, then president of the New York Federal Reserve Bank, that the Fed allow Lehman to become a bank holding company, and thus be regulated (and protected) by the federal banking system. This was an unprecedented request, one that would force the Fed to assume responsibility for all or some of the assets of Lehman. Geithner brushed off the proposal without much discussion, saying it wouldn't be enough to solve Lehman's current problems. He may not have been ready to allow such a radical change in banking regulation or he might not have liked Lehman's collateral, but no reasons were given for why the idea, later successfully put forward by Goldman Sachs and Morgan Stanley, was dismissed.
Lehman also came up with a plan to create a new company that would be capitalized by the firm and to which Lehman's troubled assets would be off-loaded. This company would then be spun off to shareholders, leaving Lehman with a clean balance sheet. The plan was approved by the Securities and Exchange Commission, but would take about three months to be put into effect. By then, however, time was running short.4
In the meantime, Lehman borrowed heavily from a facility set up by the European Central Bank; it eschewed borrowing from a post–Bear Stearns Federal Reserve credit facility for investment banks in order not to appear to be desperate to its U.S. creditors. The word got out, though, that Lehman was scrambling for capital, and this caused a number of its hedge fund and other brokerage customers to withdraw funds from the firm, compounding its problems. By early September the Korean talks were pronounced dead and Lehman's stock fell another 45 percent, erasing a decade of market gains.5
On September 9, after the Korean investment was abandoned, Fuld had to turn to Bank of America and Barclays Bank, the only potential merger partners still showing any signs of interest. On the same day, JPMorgan Chase, Lehman's clearing bank, had asked for $5 billion more in collateral to support its trading lines to the firm. This was the bank's second request for additional collateral, over and above $5 billion requested five days earlier.
The next day, September 10, Lehman convened a conference call for investors and attempted to reassure them by announcing a major restructuring plan, together with the announcement that it expected to lose an additional $3.9 billion in the third quarter. The restructuring plan would involve selling all or part of its blue-chip investment management division, Neuberger Berman (estimated then to be worth about $7 billion), and cutting its dividend. Fuld said the plan would "create a very clean, liquid balance sheet," and that the firm was on the "right track to put these last two quarters behind us." The call did not mention raising new capital, and when asked whether the firm would need to add another $4 billion, Ian Lowitt, the firm's new CFO, seeking to avoid panicking the market further, replied that "we don't feel we need to raise that extra amount." The following day, September 11, the market price of Lehman credit default swaps (CDS)—the cost to insure against losses on $10 million of its debt for five years—soared to $800,000 a year, up from $219,000 at the end of May. More institutional investors withdrew funds, and Fuld went back to Geithner to tell him that Lehman was running out of cash and would have to borrow a sizeable amount from the Fed's broker-dealer facility in order to stay in business on Monday. Paulson, meanwhile, was putting out the word that the taxpayer should not be expected to rescue every failing bank, while at the same time urging Bank of America's chairman, Ken Lewis, to consider acquiring Lehman.
On Friday, September 12, the credit rating agencies warned that they would downgrade Lehman's debt (forcing it to provide more collateral to back up its trading positions) if it didn't raise fresh equity capital by Monday morning, and JPMorgan froze $17 billion in cash and securities that it was holding for Lehman, denying the firm access to its own funds.6 The freeze created chaos at Lehman as customers seeking to withdraw their funds could not and as money transfers between offices, or to meet maturing overnight loans, were blocked. Paulson and Geithner convened a meeting at the New York Fed of Wall Street leaders and challenged them to find a private solution to Lehman's troubles, saying it was in their best interest to do so.
Much of Saturday was spent trying to unlock Lehman's cash positions, and to advance merger discussions with Bank of America and Barclays, both of which needed to become more comfortable with Lehman's financial position to take on its business without some sort of guaranty from the Fed. The Fed, on the other hand, was scrambling to identify acceptable collateral that might be put up for an additional loan, but it was unable to come up with enough to meet its strict requirements. Questions were raised about the relatively high valuation of Lehman's large portfolio of commercial real estate holdings, which analysts would later suggest was overvalued by as much as 35 percent.7
Meanwhile, a key meeting convened at the New York Fed. John Thain, CEO of Merrill Lynch, was there, along with Lloyd Blankfein, CEO of Goldman Sachs, and John Mack, CEO of Morgan Stanley. The group spent hours trying to put together a deal to purchase $30 billion or so of Lehman's troubled assets, but was too unsure of their value to proceed without a government guarantee of the sort that had been extended to facilitate the Bear Stearns deal. The government was unwilling to extend such a deal, so the meeting broke up inconclusively.
Back at Lehman, meetings were simultaneously being held with representatives of the New York Fed, Bank of America, Barclays, the rating agencies, and with Lehman's lawyers, who, should all else fail, were exploring filing for bankruptcy. Fuld and his senior colleagues were required at all of these meetings and hopped from one to another all day.
By this time, Thain was convinced that Lehman was likely to be left to fall into bankruptcy, and if so, the market would come after Merrill next. Though he was confident that Merrill had more cash and a better story, he knew that the bank was vulnerable. "This could be me sitting here next Friday," Thain was reported to have said. After the Saturday meeting at the New York Fed, he stepped out onto the sidewalk behind the bank, called Ken Lewis at home in Charlotte, North Carolina, and suggested that Bank of America acquire Merrill instead of Lehman. "I can be there in a few hours," Lewis told him.8 The idea appealed to Lewis, whose interest in Lehman's sophisticated, fast-moving, but dangerous bond trading business was probably limited to being able to get it at a very low price with a government guaranty (which Paulson kept saying wasn't going to happen). Indeed, Lewis had told the Financial Times some months earlier, after some disappointing trading losses of his own, that "I have had all the fun I can stand from investment banking." He was much more interested in the prospect of owning Merrill's huge retail brokerage and mutual fund management businesses, knowing he could either suppress or close down the investment banking parts that had gotten Merrill in trouble.
When Thain returned to the New York Fed after calling Lewis, he was told by his colleagues that some top Goldman Sachs representatives had suggested buying a 9.9 percent interest in Merrill Lynch and extending it a $10 billion line of credit. Then John Mack of Morgan Stanley said that Merrill should merge with it. There were follow-up meetings, but Thain was concerned that the firms did not "share our sense of urgency."9
But Lewis did, and moved rapidly to settle a deal with Thain.
Merrill's move left Lehman dealing only with Barclays, who also wanted a guaranty, though a more modest one than Bank of America had required. But it didn't want Lehman's troubled assets, which Fuld had figured he could spin off to shareholders. Paulson and Geithner, according to some on the scene, had talked a group of banks into backstopping the spin-off deal with a $55 billion facility, which seemed to be the last step needed to prevent Lehman's bankruptcy.10 But the Barclays deal could work only if the Fed guaranteed all of Lehman's trading positions when the markets opened on Monday. No other Wall Street firm was willing to do this, so Barclays considered doing it itself, but it was prevented by London Stock Exchange rules from making such a large pledge without first getting shareholder approval. The Fed tried to get the British government to waive the rules, but it refused on the grounds that if rules had to be waived to save a floundering American firm, they should be American rules.
By Sunday afternoon, September 14, Lehman was out of options. Barclays couldn't move without a guaranty, the Fed did not believe it could make such a guaranty without adequate collateral, and the Treasury was not ready or willing to bail out Lehman with its funds. Paulson, who had just nationalized the two federally chartered national mortgage finance companies, and was just beginning to deal with a teetering AIG, had made it clear that he wasn't about to underwrite the moral hazard in the system by rescuing yet another stricken firm that had been sunk by its own actions, though he might have found a way to fudge things for a few weeks so Lehman could complete a deal with Barclays. Paulson believed that the market had had enough time to grasp the situation at Lehman and to protect itself accordingly. He was going to draw the line at bailing out Lehman.
A senior Fed official asked Harvey Miller, Lehman's bankruptcy lawyer from Weil, Gotshal, and Manges, if Lehman was ready to file. "No," he said, "you need more of a plan to prepare to do this." Lehman had tens of billions of dollars in derivative positions with thousands of counterparties. Unless these trades were unwound in an orderly way, or taken over by someone else, bankruptcy "would cause financial Armageddon," Miller said.11 No one seemed to consider keeping Lehman alive on life support long enough to find a merger partner or properly prepare for bankruptcy.
ALL HELL BREAKS LOOSE
After the Fed's intervention in March 2008 to assist JPMorgan in acquiring Bear Stearns, the markets had seemed to relax a bit. The government, after all, had set the too-big-to-fail bar at Bear Stearns, signaling that those investment banks larger than Bear Stearns would be given similar treatment if need be. Their lenders, in other words, could expect to be guaranteed by either a merger partner or the Fed itself. By early June 2008, the S&P 500 index had risen about 5 percent, and Washington Mutual, the country's largest (but weakened) savings bank, had been able to reject a merger proposal from JPMorgan and raise $7 billion in new capital from a group of private equity firms led by Texas Pacific Group (TPG).
Later in June, Bank of America announced that it had completed its acquisition of troubled mortgage broker Countrywide Financial at a renegotiated, knockdown price and was optimistic about its long-term prospects. Its crosstown rival in Charlotte, Wachovia Bank, however, announced that the board had requested the resignation of Ken Thompson, its long-standing and dynamic CEO, after reporting $8.9 billion in mortgage write-downs for its second quarter.
In July, the Federal Deposit Insurance Corporation (FDIC) took over IndyMac Bank, a $34 billion California thrift institution, the largest bank takeover since the banking crisis of the 1980s. Also in July, Merrill Lynch would report a second-quarter loss of $4.7 billion and a sale of approximately $30 billion in securitized commercial loans to the private equity group Lone Star Funds for only twenty-two cents on the dollar. The price, most commentators thought, was well below the debt's intrinsic value, but Merrill, headed by John Thain since December 2007, wanted to get rid of the debt to put its exposure to weakening debt prices behind it. Merrill's stock price rose in subsequent weeks.
Late in July, Secretary Paulson sought congressional approval to advance funds to the Federal National Mortgage Association (Fannie Mae) and the Federal Home Mortgage Corporation (Freddie Mac), the two home-mortgage finance giants, if they should need them. Both of these companies were struggling with a long history of being chronically undercapitalized, and current market conditions were devaluing the assets they held, but both were also considered to carry implicit guarantees of the U.S. government and appeared to be able to roll over their maturing obligations without difficulty. The mortgage companies had strong supporters in Congress who claimed that they were solid, healthy institutions. No one but the Treasury seemed to think they were on their way out, but the requested funds were to be for just in case. With total assets of $890 billion, it was pretty clear that Fannie Mae would have to be considered too big to fail no matter what it cost to bail it out. The same would be true for the somewhat smaller Freddie Mac. The news of Paulson's request did not stir much up—for some time the markets had realized that the government might have to do something to help out these companies—and August went on to be the quiet month in the markets that it is supposed to be. Credit markets were operating normally, the economy was still thought to be expanding,* if slowly, oil prices were dropping, and Ben Bernanke was feeling more relaxed about the markets; as he said in August, "A lot can still go wrong, but at least I can see a path that will bring us out of this entire episode relatively intact."12
The lull ended abruptly on September 7 with the government's sudden nationalizing of Fannie Mae and Freddie Mac by taking them into "conservatorship" in much the same way it might have seized two failing S&Ls. Paulson's explanation for why he took them over was a little vague:
Based on what we have learned about these institutions over the last four weeks—including what we learned about their capital requirements—and given the condition of financial markets today, I concluded that it would not have been in the best interests of the taxpayer for Treasury to simply to make an equity investment in these enterprises in their present form.13
The government jumped in with both feet. It provided a net worth support agreement to the two agencies, bought $1 billion in 10 percent senior preferred stock, with warrants representing a 79.9 percent ownership in each firm, and arranged for them to pay the Treasury a quarterly consulting fee starting in 2010. It also dismissed the boards of the two companies, appointed new CEOs, and guaranteed all the debt (but not the preferred stock in which many U.S. banks had invested portions of their reserves). The most alarming part of the seizing of the shareholder-owned companies was that it revealed just how aggressive their managements had been in pursuing growth and profit opportunities—by buying large amounts of mortgage-backed securities from the market (something that was not part of their missions)—despite their weak capital structure and the highly uncertain mortgage-backed securities market. Both firms were out of money and would need to raise more, now with an explicit government guaranty, in order to return actively to the mortgage finance market, where their presence was badly needed to support falling home sales.
Fannie and Freddie were taken over just a few days before Lehman's last week began. This was a week that would end with Lehman's equity worth nothing and its considerable amount of long- and short-term debt worth less than ten cents on the dollar. It would also end with Merrill Lynch being snatched up in a last-minute rescue, leaving only two of the five largest independent U.S. investment banks still standing to face a hurricane of market anxiety, uncertainty, and fear.
THE HAMMER
Hank Paulson was a reluctant secretary of the treasury when he took office in the summer of 2006, having declined the position when sounded out about it once or twice before. Paulson is a comparatively simple man, by Wall Street standards: he is a Christian Scientist who doesn't drink alcohol and prefers bird-watching and hanging out on weekends at the family farm in Illinois to the New York social scene. He was in his eighth year as CEO of Goldman Sachs, where he was respected and doing his best to live up to the high standards of competence and dedication set by a series of predecessors. He was also a loyal Republican, having served as a White House Fellow in the Nixon administration. When John Snow was replaced as treasury secretary, President George Bush wanted someone who would be seen as more authoritative and on top of things and he was attracted to the former Dartmouth football player, whose nickname was the Hammer. In the end, Bush was able to persuade Paulson to give it all up to join him for the last two years on his sinking ship in Washington. Paulson was able, however, to extract a commitment that if he accepted the job, he would be the undisputed chief economic officer of the administration and have the support of the president for whatever actions he believed were appropriate. No doubt many rookie secretaries of the treasury have had such promises made to them only to find out otherwise once they arrived, but the president supported Paulson through all his untiring efforts and ordeals, and his seizing of leadership of the economic realm was never contested within the administration.
Paulson, however, was ignorant of Washington's wily political ways and roundabout tactics, which frustrated him as they do everyone who comes into office unprepared for them. He had never had any kind of political or economic experience or training to prepare him for what began to unfold within a few months of his taking up the job. No one filling the Treasury position had ever had any more or better training in markets and finance, but the events that occurred on his watch were simply entirely new to the financial system and would come to test it beyond anything since the 1930s. As he put it in an article in The New York Times:
* The U.S. economy had actually entered a recession in December 2007, according to a November 2008 announcement by the National Bureau of Economic Research, which keeps the official records of when recessions begin and end.
Excerpted from Paper Fortunes by Roy C. Smith.
Copyright © 2009 by Roy C. Smith.
Published in January 2010 by St. Martin's Press.
All rights reserved. This work is protected under copyright laws and reproduction is strictly prohibited. Permission to reproduce the material in any manner or medium must be secured from the Publisher.
