House of Cards (91 page)

The plan had been to announce the deal before the market opened Tuesday morning and Lehman's broker-dealer subsidiary ran out of cash to operate. But the deal could not get finalized that quickly. “The funding sources were killing us, and we knew we were hours away from a Chapter 7 liquidation proceeding,” one key participant said. “But the issue was just one of waiting and trying to get the agreement signed.” Barclays could not seek the FSA's approval until an agreement was close to being finalized. Finally, just as the market was opening, the terms of the deal were agreed upon: Barclays would buy the Lehman businesses it wanted for $250 million and pay another $1.45 billion for 745 Seventh Avenue and the two data centers (later reduced to $1.29 billion) plus assume some of Lehman's trading obligations. Barclays also agreed to provide a $500 million debtor-in-possession facility to the bankrupt holding company and also to refinance the $40 billion or so that Lehman's U.S. broker-dealer had borrowed from the Fed after the filing to keep operating.

With that in hand, Barclays asked the FSA for its blessing. According to a Lehman executive, “It took four hours to get out of the FSA, and we thought, ‘Here we go again. They're going to turn it down and we're going to be facing a Chapter 7 liquidation anyway.” At around 1
P.M.
Tuesday, the FSA signed off and Barclays announced it had bought much of Lehman's business in the United States, subject to bankruptcy court approval, which was granted—on an extremely expedited basis—on Friday, September 19. “Lehman Brothers became a victim,” Judge James Peck said in approving the deal. “In effect, the only true icon to fall in the tsunami that has befallen the credit markets. And it saddens me.”

With that approval, the Lehman bankers and traders in the United States were euphoric. “We saved the U.S. businesses and ten thousand jobs,” explained one senior Lehman executive. “When I walked down to my office and I smiled, the assistants and the people around started clapping and cheering, because everybody was on pins and needles to see if we could pull it off and get an agreement. There was a tremendous sense of relief, at least in the U.S., that people had jobs. Because the prospect of losing all of your equity, that's horrific. But to lose all your equity and then to find you're unemployed when there's very little prospect—unless
you're one of the most senior bankers or a very highly regarded person— of getting a job in an environment where the Street is retrenching at an exponential rate is not very pleasant.”

T
HE
L
EHMAN BANKRUTPTCY
filing unleashed a global deluge of economic misery—which, in fairness, might have happened anyway—the likes of which have not been seen in the United States since the Great Depression. Lehman's fall quickly had massive financial repercussions: the $125 billion bailout of AIG, the huge insurer; the sale of Merrill Lynch to Bank of America before it could fail; the failure of Washington Mutual; the near-failure of Wachovia; the near-failure of National City Bank; the failure of at least nineteen other financial institutions nationwide; the conversion of Goldman Sachs, Morgan Stanley, and American Express into bank holding companies to stave off their demise; and the virtual incapacitation of Citigroup, once the world's biggest, most valuable, and most powerful global financial services firm. “The financial system essentially seized up and we had a system-wide crisis,” Treasury Secretary Hank Paulson said in a speech at the Reagan Library on November 20. “Credit markets froze and banks substantially reduced interbank lending. Confidence was seriously compromised throughout our financial system. Our system was on the verge of collapse, a collapse that would have significantly worsened and prolonged the economic downturn that was already under way.”

To combat the near-collapse of capitalism as we have known it, the federal government used nearly every device it could think of, from further lowering interest rates to continuously revising the types of securities accepted by the Federal Reserve as collateral to the historic passage—on the second try—of the $700 billion Troubled Asset Relief Program (TARP), the brainchild of Paulson and Ben Bernanke, the Federal Reserve chairman. Such a massive bailout package would have been inconceivable without the bankruptcy of Lehman Brothers and the federal rescue of AIG.

Their idea was to use the money to buy the toxic assets that nobody else would buy from the balance sheets of the banks and securities firms that had bought or manufactured them in the first place. But before that strategy could be implemented, Paulson reversed course and decided to use $125 billion to buy equity stakes in the nation's eight largest banks. The government then used another $40 billion for AIG and another $47 billion to buy stakes in other, smaller banks around the country. Finally, on November 12, Paulson announced that he had abandoned the idea of
trying to buy the toxic assets. He also said he would let President-elect Barack Obama's administration figure out how to allocate the balance of the money left in the TARP.

When Bernanke and Paulson have discussed their decision to let Lehman fail, neither one has any doubts about the wisdom of their decision. “A public-sector solution for Lehman proved infeasible,” Bernanke said at the Economic Club of New York on October 15, “as the firm could not post sufficient collateral to provide reasonable assurance that a loan from the Federal Reserve would be repaid, and the Treasury did not have the authority to absorb billions of dollars of expected losses to facilitate Lehman's acquisition by another firm. Consequently, little could be done except to attempt to ameliorate the effects of Lehman's failure on the financial system.”

On Monday morning, September 15, as the Lehman volcano was spewing molten financial lava to every corner of the globe, a pale and tired-looking Paulson—whose brother worked for Lehman, in Chicago— said at a White House press conference that he “never once considered that it was appropriate putting taxpayer money on the line in resolving Lehman Brothers.” He added, “Moral hazard is not something I take lightly.”

S
OME SIX WEEKS
after Lehman's implosion, a relaxed Alan Schwartz reflected on the year that forever changed Wall Street. In the previous seven months, he had brushed aside numerous attractive employment opportunities in favor of setting up shop in modest office space that Rothschild made available to him at 1251 Avenue of the Americas. There he spoke to his media clients, such as Jeff Bewkes, the CEO of Time Warner, among others, and tried to keep a low profile while figuring out whether Microsoft would ever step up to take America Online off Time Warner's hands. He put his stocking feet up on his desk and started talking.

“Would Bear Stearns have survived, no matter what we did?” Schwartz wondered, according to several people who heard his soliloquy. “I don't see it. By staying solvent, might we have picked up a merger with Barclays, or something, once they realized our books were clean? Maybe. But to compete [after] the repeal of the Glass-Steagall Act [in 1999], the model became wholesale banks using collateral to finance themselves instead of using deposits. It didn't work when the collateral that was invading the world”—such as mortgage-backed securities—“became non-transparent. That's not to say that we did a good job running the firm. To me, it was a whole bunch of events that interrelated and swamped
the banks, too. It's just that the infrastructure of the world to support banks as opposed to investment banks—the regulatory authorities—was very well established. They still don't know if they can save Citibank, right? So this tsunami was so big that wholesale banks of every stripe could not be fixed.”

He scoffed at the idea—as many Wall Street insiders have—that the SEC's change to the net capital rules in June 2004—which allowed securities firms to increase the amount of leverage they could use on their balance sheets to forty times equity while traditional banks, by statute, had to keep the leverage closer to ten times equity—doomed them to inevitable failure. “The reality is if you take the scorecard of the banks and you take the scorecard of the investment banks, they're about the same,” he continued. “A bunch of banks didn't have enough capital and had to raise more, and some investment banks didn't have enough capital and had to raise more. Some did and some didn't. So the thirty and ten times issue would have meant Goldman was gone long before Citi or UBS or anybody had to dip into the capital pool.” Many people also blame what happened in 2008 on the SEC's decision in 2007 to eliminate the “uptick rule,” which required that every short sale be transacted at a price higher than the price of the previous trade. By eliminating the rule, the death spiral of a stock can be accelerated. The intent of the rule was to buy time for the stock as it free-falls and force short sellers to pause before transacting. Without the uptick rule, stocks are susceptible to “bear raids,” where short sellers can overwhelm a stock in huge surges of selling that intimidate buyers from stepping in. This creates a panic that can spiral ever downward. For banks and securities firms, where the confidence of counterparties is essential, the death spiral can indeed be irreversible.

To Schwartz, the near-collapse of the global financial system was caused by many factors, from Hyman Minsky's financial instability hypothesis—which suggests that whenever the economy is stable for a long period, the financial markets create their own instability—to the dramatic and unprecedented surge of global wealth. “If you go back to the period from 1970 to 1974,” he told his friends, “there was a doubling of commodity prices. Commodity producers got rich, the rest of the world got poor. When they doubled again, the world got poorer. Then commodity prices fell. Commodity guys got less rich, the rest of the world got more rich. From 2002 to 2006 commodity prices doubled again, and commodity producers got rich. But this time, China, India, and Brazil took those commodities and used cheap labor and made finished goods and got rich, and the developed world's profit margins went to all-time highs. If you had said
ahead of time that commodity prices are going to double, finished goods prices are going to be flat, and asked what's going to happen to profit margins, you wouldn't think they were going to record highs.

“But the way the world came together right then was the tsunami of liquidity,” he continued. “At exactly the same time that that liquidity was being built, the Fed is saying, ‘Hmm, we just had a collapse in
our
economy, we're missing what's going on over here.' Remember Greenspan's conundrum? ‘We had better flood the world with liquidity to avoid deflation.' That's what we learned from Japan. While global wealth was building up like crazy, artificial liquidity was pushing interest rates down to unbelievably low levels and, at the very same time, in the developed economies people are moving from being long-term savers to being short-term savers for retirement, saying, ‘I need a fixed-income return, but I can't take 1 percent.' You have this huge pool of money looking for return and what it was looking for was debt-backed-up assets. So they created this debt cycle. You had the rating agencies arbitraging what was there. It looked so good to everyone that it created a bubble that made the dotcom bubble look small. But, ironically, because it was against this huge, diverse pool of assets and there were real assets, it was a much more seductive bubble, because in the dot-com bubble the world got caught up, but you also had tons of people—anybody who'd been in the business as long as we have—was saying, ‘Guys, this ends badly. This dot-com bullshit ends badly. IPOs going up ten times, that's not lasting.'

“But this time,” he continued, “there were some naysayers, but nobody saw the kind of bubble it was because all these instruments are against hard assets that are newly diversified with lots and lots of history, and they're really safe, and that's better than just a few institutions, and it's a big market, and it's diversified and all that. What got missed in all of that was it created so much excess demand versus any historical period that it so inflated the price of the assets, and then I think the trigger was [that] the rest of the world started saying, ‘Wait a minute, we're going to build out our infrastructure,' so they started building these huge infrastructure projects that started to suck up some of the liquidity just as the Fed was trying to go back. So rates come up a little bit and all of a sudden you go, ‘Oops, maybe we'll call a time-out on house price appreciation for a little bit around the world.' Then you have all these things like FHA and HUD and all these people saying, ‘You better lend to all these poor people.' People at first said, ‘No, we won't,' and then they said, ‘Oh, this is a good gig.' So greed was a factor in all this, too. But these things do occur with some regularity, and we haven't ever figured out how to stop the next
one from happening. I'm sure we'll figure out how to prevent something like this from happening again. Wall Street is always good at fighting the last war. But these things happen and they're big, and when they happen everybody tries to look at what happened in the previous six months to find someone or something to blame it on. But, in truth, it was a team effort. We all fucked up. Government. Rating agencies. Wall Street. Commercial banks. Regulators. Investors. Everybody.”