5 Days of Pressure, Fear and Ultimately, Failure

September 16, 2008
5 Days of Pressure, Fear and Ultimately, Failure
By ERIC DASH
A crisis of confidence in financial markets on Wall Street culminated in a weekend of brinksmanship and failed appeals that caused the demise of some of the nation’s storied financial institutions.

It began on Tuesday, just two days after the Bush administration took control of Fannie Mae and Freddie Mac, the mortgage finance giants. Fears began to mount in earnest on Wall Street that Lehman might founder — and that the government might not ride to the rescue this time. As stock markets around the world tumbled, Lehman’s shares were hit by waves of selling that wiped out nearly half its value.

The next day, skittish employees inside Lehman’s Times Square headquarters held their breath as Richard S. Fuld Jr., Lehman’s chief executive, held an urgent conference call with investors and analysts to announce the biggest quarterly loss in the company’s 158-year history — as well as a master plan to pull the firm back from the brink. The blueprint centered on splitting Lehman into a “good” bank and a “bad” one that would get rid of troubled mortgages and real estate. Lehman would also sell most of its investment management division and cut its dividend to shareholders.

But there was little new in Mr. Fuld’s remarks, and by the end of the day, Lehman’s share price had fallen an additional 7 percent, leaving the shares down 55 percent over three days.

Employees who had clung to the belief that Lehman would never go under started polishing résumés in earnest, taking calls from headhunters and openly passing around job offers.

On Thursday, executives established a war room at the headquarters in Midtown Manhattan. As confidence in Lehman’s survival ebbed, Mr. Fuld redoubled efforts to execute his plan to sell parts of the firm. The once unthinkable notion of selling Lehman in its entirety was also put on the table. Traders, meanwhile, were instructed to start pulling together data so that potential buyers could start examining Lehman’s positions.

When the shares plunged to a bargain-basement price below $4, potential suitors came out of hiding, including Barclays of Britain and Bank of America, as well as several private equity firms. With fresh memories of the government-arranged fire sale of Bear Stearns to JPMorgan Chase, and the weekend bailout of Fannie Mae and Freddie Mac, each sought assurances from the Federal Reserve to help make an acquisition palatable.

Meanwhile, Wall Street surveyed the landscape for the next financial domino, setting its sights on Merrill Lynch and the American International Group, which were exposed to Lehman, and on Washington Mutual, the long-troubled giant savings and loan that was having problems raising capital.

On Friday, the uncertainty surrounding Lehman sent a new wave of fear rippling through the markets. Federal Reserve officials convened the heads of the major Wall Street banks for an emergency meeting at 6 p.m. in Lower Manhattan. The goal was to hash out a plan to rescue Lehman Brothers and stabilize the global markets. The group included the heads of 10 to 15 Wall Street banks, flanked by their top lieutenants and finance and risk chiefs. Among them were James Dimon of JPMorgan, Brady Dougan of Credit Suisse, Lloyd Blankfein of Goldman Sachs, John Thain of Merrill Lynch and John Mack of Morgan Stanley. Also participating were officials from Barclays, Deutsche Bank and Royal Bank of Canada.

Kenneth D. Lewis of Bank of America phoned in from Charlotte, N.C. Vikram S. Pandit delayed his trip to a Citigroup board meeting in London to participate. Lehman Brothers was conspicuously absent.

The Treasury Department and the Federal Reserve had been preparing for a failure of Fannie Mae and Freddie Mac for months. Some on Wall Street say they believe that Lehman Brothers’ crisis caught the government flat-footed and without a contingency plan.

“They thought that if they rescue Fannie and Freddie, there would be such support for the market that things would stabilize,” said one observer who spoke on condition of anonymity because his institution was involved in the discussions. “They also thought Lehman management would have things under control.”

The clock, however, was ticking. Timothy F. Geithner, the president and chief executive of the Federal Reserve Bank of New York, appearing with Treasury Secretary Henry M. Paulson Jr. and Christopher Cox of the Securities and Exchange Commission, struck a serious tone. Over the next two hours, he and Mr. Paulson stressed that the government would not put taxpayer money on the line. They wanted an industry solution to prevent the crisis from worsening, according to two people who did not attend the meeting but were briefed on it.

Mr. Geithner made an impassioned appeal to the group for an industry solution. His message, these people were told, was clear: it is not about any individual bank, it is about the industry; if you don’t create an industry solution, you will be next.

Most of the bankers quietly listened. But some questioned the need for them to play a role in a bailout. Lehman Brothers had overreached and brought its troubles upon itself, they argued. Why should they put up their own money in a rescue?

Both Bank of America and Barclays, a large British bank, expressed interest in making a bid. HSBC also suggested it might pursue Lehman, though its interest quickly faded.

Because they had little time to inspect Lehman’s toxic assets, Barclays and Bank of America made it clear that any deal would be contingent on the government’s agreement to absorb a portion of the losses. The government had committed about $30 billion to supporting JPMorgan Chase’s emergency takeover of Bear Stearns, and just last weekend put up $200 billion in its rescue of Fannie Mae and Freddie Mac.

But fearing they had created a moral hazard and were already pushing the Fed’s budget, Mr. Paulson and Mr. Geithner were adamant that the government would not participate in a bailout. With all sides digging in their heels, one thing was clear: Lehman was, as one participant at the meeting put it, a “dead bank walking.”

Mr. Geithner told the Wall Street firms to start developing plans for an orderly liquidation. Lehman Brothers hired Weil, Gotshal & Manges to start drafting bankruptcy plans.

The tense session was similar to one held a decade ago with the leaders of Wall Street to stave off the failure of Long-Term Capital Management, a hedge fund that plunged into esoteric derivatives and other complex investments. Its failure threatened to send shock waves through the global markets.

But the potential fallout from Lehman Brothers could be more severe. It is a vastly larger institution with trading partners around the world. There also was another problem. When Wall Street bailed out Long-Term Capital Management, its banks were healthy. This time around, they have already been weakened by heavy losses credit problems of their own.

On Saturday, shortly before 9 a.m., black town cars carrying a who’s who of Wall Street arrived at the Federal Reserve Bank in New York for several hours of meetings. At an opening session, Mr. Geithner echoed his remarks from Friday evening: put aside your competitive interest to preserve the health of the markets. If you all do it together, nobody will point the finger at any of you, he said, according to a person briefed on the meeting but who did not participate in the talks.

Meanwhile, senior Wall Street executives met at their corporate offices to examine their exposure to Lehman Brothers and other wobbly institutions, with an eye toward mapping out emergency plans for the next week. Senior traders began overseeing huge efforts to find banks with offsetting trades with Lehman Brothers and take them out so that the troubled firm was no longer involved. Bankers with two or three decades of experience used the words “scary,” “terrifying” and “horrible” to describe the situation.

The broad outlines of two proposals began to take shape. One option was to have the major banks and brokerage firms agree to keep doing business with Lehman while the bank unwound its positions over several months. Another was a daring rescue, in which Barclays or Bank of America would buy the good assets of the bank with a group of 10 to 15 Wall Street firms agreeing to absorb the losses.

At 3. p.m., Mr. Paulson called a meeting to brief the participants. Fears were swirling about troubles gripping financial companies. A.I.G., the global insurance giant, needed to raise $30 billion and $40 billion to avoid severe ratings downgrade that would lead to its swift demise, and the financial health of Washington Mutual was quickly deteriorating. The prospect of the failure of Lehman and others would send shockwaves through the global markets.

Some of the banks requested that the S.E.C. reinstate its temporary short-selling ban to try to limit the market impact, though it ultimately never agreed to such a move. Others feared that relatively healthier institutions might get swept up in the fallout. Merrill Lynch and then Morgan Stanley — and even Goldman Sachs — could be next.

By Saturday evening, Bank of America’s interest in a bid was fading. It insisted that it would not buy the embattled bank without government support. The proposal involving Barclays appeared to be gaining steam.

But on Sunday morning the last hope unraveled. As the group of banks reconvened at the Federal Reserve Bank, Barclays said it was withdrawing its proposal. It could not obtain a shareholder vote to approve a transaction before Monday morning, which was required under London Stock Exchange listing rules, one person close to the matter said. Other people involved in the talks said the British securities regulator, the Financial Services Authority, had discouraged Barclays from pursuing the transaction. Peter Truell, a Barclays spokesman, declined to comment.

By 2 p.m., Barclays was officially out of the deal. Bank of America, meanwhile, remained uninterested. Its executives had already been meeting privately with their counterparts at Merrill Lynch to settle the framework for a shotgun merger.

That effectively put Lehman on the track for a bankruptcy filing. The goal, then became, figuring out the best possible way to unwind Lehman without adding to the turmoil.

Across Wall Street, traders rushed in to work to try to make sure they were out of the Lehman positions. “Every single person I know in New York is at work today,” one long-time banker said. “Everybody who isn’t blown up is figuring out their counterparty risk. Everybody who is, is cleaning out their desk.”

That sent the first indications that the markets were awry. Traders had to pay 80 cents on every dollar to buy protection against Lehman defaulting on its bonds. Insuring $10 million in bonds against default, in other words, required a payment of $8 million. Lehman traders, meanwhile, were called back to their desks as news seeped out about their pending bankruptcy. Most said they believed it would be the last time.

They sent out goodbye messages to colleagues and gathered their belongings. Some huddled in a corner on the fourth floor, eating pizza and drinking beer, according to a person who was there. They were dumbstruck that their firm could evaporate in days. Its employees left their offices unsure if they should return to work.

Lehman did not file for bankruptcy until early Monday morning. Some employees were planning to head in Monday around 9 a.m. as they normally do. Others were planning to head to the local unemployment office for the very first time.