House of Cards (88 page)

A few weeks after the government unsealed its indictment against the Bear Stearns hedge fund managers, Skip McGee, at Lehman, called a group of bankers and let them know that there would be an all-hands meeting with Fuld and most of the executive committee on July 11 to discuss any and all strategic alternatives the firm might consider. “The stock was getting hit again, the shorts were all over us, Einhorn had kind of killed us off pretty well, and Erin Callan was gone and others, so we ceased talking to the media,” one participant in the weekend meetings said. “Because it was feeling like the beginning of another crisis of confidence around us.”

No possible solution was off the table, including radically shrinking the firm by ten thousand people in order to get out of businesses that
required capital, instead becoming more like the businesses that Barclays ultimately bought out of Lehman: the investment management division and the commercial real estate assets. The group also decided to seriously pursue strategic or financial investors. “That weekend to me was pivotal,” one Lehman banker said, “because it really set the stage for finally getting very serious and realizing that we needed to get off our tails.” In addition to starting the process of spinning off the real estate assets and selling the investment management division, calls were made all around the globe looking for capital. HSBC, Royal Bank of Canada, Abu Dhabi Investment Authority, Sumitomo Bank, Citic, Bank of America, the Carlyle Group, KKR, Silver Lake Partners, and Met Life all took a quick peek before passing.

There was also the growing sense among Lehman loyalists that the hedge fund community—to say nothing of Goldman Sachs—was out to get the firm. On July 23, Lehman's new president, Bart McDade, sent Fuld a copy of an e-mail about a visit to the firm by Jarett Wait, a former Lehman senior banker who had recently joined the hedge fund Fortress Investments. “Jarett stopped by yesterday [and] commented that in just a few weeks on the ‘buy' side … ‘it is very clear that GS is driving the bus with the hedge fund kabal [and] greatly influencing downside momentum, LEH [and] others!’”

Fuld responded to McDade: “Should we be too surprised[?] Remember this though—I will.”

The market's response to potentially investing in Lehman was tepid at best. Still, through the late summer, the Koreans would occasionally rekindle their interest. In early August, Fuld, McDade, and McGee, among others, headed off to Hong Kong for a meeting with the Koreans. By this time, KDB had hired Perella Weinberg, for financial advice, and Cleary Gottlieb, for legal advice, and appeared to be getting more serious. Remembered one senior banker: “But they came back again frustrated and rolling their eyes. ‘Yeah, we're going to continue conversations.' But again, it was like pushing on a rope.”

The Koreans resurfaced again at the beginning of September. “They thought they were getting close to a deal,” explained one Lehman banker, “and the champagne was on ice.” KDB had decided to invest in what was then being called “CleanCo,” everything in Lehman but the commercial real estate assets. But Fuld was pushing them instead to invest in “DirtyCo,” the real estate assets to be spun off. “Dick overplayed his hand,” this banker continued. “He alienated them and they sort of disappeared. The conversations kept going, but they were on a respirator from that point on.”

On September 8, the U.S. government announced it was taking control of Fannie Mae and Freddie Mac, the two mortgage giants. At a news conference in Washington, Treasury Secretary Paulson described the plan to put the companies into a conservatorship run by the government. The CEOs of the two companies were replaced. The plan called for the Treasury to make capital injections into the companies over time, of up to $100 billion each, and in return the government received 80 percent of the equity ownership of the companies. On September 9, Jun Kwang-woo, the chairman of Korea's Financial Services Commission, announced that the discussions between KDB and Lehman were definitively over. “There will be other opportunities,” he said. Lehman's stock fell 37 percent on the news, to $7.79 per share.

After the KDB deal fell apart once and for all, hard-to-fathom rumors started circulating throughout Wall Street that Lehman would soon be filing for bankruptcy and that an announcement to that effect would be made after the market closed on September 9. Instead, Lehman said it would make an announcement early the next morning of its third-quarter earnings as well as of several “strategic initiatives.”

As promised, at 7:30
A.M.
, Lehman announced a third-quarter loss of $3.9 billion along with its intention to sell 55 percent of its investment management division and to spin off $25 billion to $30 billion of its commercial real estate assets into a separate publicly traded company by the first quarter of 2009. All of the financing for the spinoff—including around $8 billion in equity—was to be provided by Lehman itself, but Lehman would not need to raise new equity to do it. Fuld also announced he would cut the firm's dividend to 5¢ a share, from 68¢ per share, in order to save $450 million annually. “This firm has a history of facing adversity and delivering,” he said. “We have a long track record of pulling together when times are tough and then taking advantage of global opportunities.”

The spinoff of the real estate assets was a tough sell in the market, made all the more difficult by the fact that Lehman had to finance the whole company, raising questions about whether it was really a sale at all. “We looked under every rock to try to do something,” one Lehman banker said. “It didn't work, candidly, and then when people realized we were still seller-financing the SpinCo and that if you ate through $8 billion of equity on a $40-odd-billion portfolio then you'd be eating into the debt. The market came away not really believing we'd separated the real estate, and that, to my judgment, was really the beginning of the end.”

Soon after the market had voted on the proposed Lehman restructuring, Henry Paulson began to orchestrate his private market solution for Lehman. He called Bart McDade and told him that Bank of America
was interested in taking a look at Lehman Brothers. A SWAT team from Bank of America in Charlotte—which one Lehman executive referred to as akin to the Wehrmacht—parachuted into the New York offices of Sullivan & Cromwell in midtown to review Lehman's books and records. Lehman then contacted Bob Diamond, the president of Barclays, the large UK bank, to see if he wanted to take a look. Yes, at those levels he would potentially like to take a look, Diamond told the Lehman bankers. Then, of course, in a replay of the Bear Stearns meltdown scenario, Lehman's counterparties and overnight repo financing sources “started to go wiggy on us,” a Lehman executive said, “and once people won't take your good collateral it was only a matter of days before we were in Bear mode.” By the time Friday night rolled around and Paulson and Geithner had called Wall Street down to the Fed, JPMorgan—like others of Lehman's counterparties—had already pulled its $17 billion of cash collateral from the firm at the request of some of its clients and to protect itself. The fuse had been lit.

W
HEN THE MOST
powerful men in American capitalism convened at the New York Federal Reserve Bank's Italianate palazzo in lower Manhattan on Friday evening, September 12, to try to save Lehman Brothers from certain death, what confronted them was the knowledge that whatever actions they did or did not take that weekend could push the financial system into the abyss.

“We went into the weekend knowing it was very dark,” explained Tim Geithner, then the president of the New York Fed and now the Secretary of the Treasury. “There was nobody that was part of this process that did not believe the world was exceptionally fragile and that Lehman was systemic and that the consequences of its default would be traumatic. There was nobody in that room—from the Treasury, the Fed, or from the Federal Reserve Board or from the private sector—that could have told you exactly what would happen or what the consequences would be. I made it clear over and over again in that room that if we didn't solve this, everything else would be harder to deal with. Solving this was not going to make all the other problems go away, but we did not feel we had the ability to insulate the markets from the broader consequences of default.”

Henry Paulson and Christopher Cox flew up from Washington on Friday for a six o'clock meeting with Geithner to discuss what the plan for the weekend would be. Meanwhile, Ben Bernanke, the chairman of the Federal Reserve, stayed in Washington to coordinate a response with the leaders of other central banks around the globe. With Geithner at his
side, at 6:15 Paulson stood before the assembled Wall Street CEOs and their top lieutenants and “pulled the fire alarm,” one of them said, along with delivering a harsh message. “There will be no bailout for Lehman,” Paulson said, according to someone who was there. “The only possible way out is a private sector solution.” At that moment, Ian Lowitt, Lehman's CFO since June 2008, knew it was over for his firm. That night “government officials … indicated that emergency federal funding would not be forthcoming to stabilize Lehman Brothers and provide the liquidity needed for its operations,” he wrote in an affidavit accompanying the firm's September 15 bankruptcy filing. “While the Company continued to explore a number of strategic alternatives, after the September 12 meeting no viable alternative was available.”

Unlike what the government did for Bear Stearns in March or Fannie Mae and Freddie Mac in early September, or what it would soon do for AIG, there would be no taxpayer money made available to support a Lehman bailout. “There was a lot of rhetoric going into the weekend both from the Congress and from people around the Treasury about how this shouldn't be public money,” Geithner said. Whether that was a clever negotiating tactic or the line in the sand that would not be crossed, the Treasury secretary had set the definitive tone for the weekend: The future of Lehman Brothers, a 158-year-old firm with origins as a dry-goods store and cotton trader in Montgomery, Alabama, rested solely with men sitting around the table in the Fed's ornate board room at 33 Liberty Street. They had to come up with a plan in forty-eight hours to save the firm from insolvency or suffer the consequences of a catastrophic unwind of the Gordian knot of Wall Street's complex and internecine financial relationships.

For better or worse, Paulson and Geithner had conceived three possible scenarios for Wall Street to consider during the weekend. First was to investigate whether there could be a “private sector liquidation consortium” that would somehow finance a gradual sale of Lehman's assets outside of bankruptcy. Second was a potential acquisition of parts of Lehman by either Bank of America or Barclays, the only two firms that had expressed even a remote interest in Lehman's assets. And third, how could the free world “contain the damage in the event there was no solution possible”? The first idea quickly became untenable, and at the outset nobody had the slightest interest in considering seriously the third scenario.

The focus of the meetings quickly became how to finance the Lehman assets that either Bank of America or Barclays did not want. (Representatives of Bank of America, Barclays, and Lehman were in and around the Fed that weekend but were not included in the meetings of the wider
group for obvious reasons.) But things began to go awry by the time the teams had reconvened at the Fed on Saturday morning. Bank of America had proposed a plan that would leave “a huge chunk of stuff” behind, one participant said, and reportedly wanted the Fed to provide it with $65 billion to cover exposure to Lehman's “bad assets,” more than twice the $29 billion secured loan the Fed had made to JPMorgan to facilitate its acquisition of Bear Stearns. Not only was the Bank of America proposal of a magnitude beyond what the Fed or Treasury could realistically consider, but also the request quickly became moot, as Bank of America turned its attention to what quickly became the blockbuster $50 billion acquisition that same weekend of Merrill Lynch. “I think they always preferred Merrill, and I don't think this thing was really that viable,” Geithner said. “It certainly wasn't attractive in an economic sense to anybody.”

That left a somewhat more attractive proposal by Barclays, whereby the British bank would take all of Lehman except for the firm's commercial real estate asset book, with a face value of $40 billion (before writedowns). These real estate assets had formed the core of the spinoff proposal that Fuld and Lowitt had announced three days before, when Lehman's stock was trading around $7.80 per share. Fuld and Lowitt, who had been vetting the spinoff proposal with the Fed and the SEC for months before its September 13 announcement, had hoped—perhaps naively—that the market would react favorably. “It was like a lead balloon,” one of the participants said of the spinoff idea. “The market didn't like it. And by the weekend”—with Lehman's stock having closed at $3.65 a share on Friday—“Fuld was increasingly nervous, although he was already at a high level of anxiety. The feeling inside Lehman from friends that I have that worked there was one of increasing desperation, tinged with increasing sense of having been betrayed, misled, and let down by Fuld and by senior management.”