Ultimatum by Paulson Sparked Frenzied End

One of the most tumultuous weekends in Wall Street's history began Friday, when federal officials decided to deliver a sobering message to the captains of finance: There would be no government bailout of Lehman Brothers Holdings Inc.

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Officials wanted to prepare the market for the possibility that Lehman could simply fail. The best way to do that in an orderly way would be to get everyone together in a room.

Treasury Secretary Henry Paulson, Federal Reserve Chairman Ben Bernanke and his top New York lieutenant, Timothy Geithner, summoned some 30 Wall Street executives for a 6 p.m. Friday meeting at the Fed's offices in Lower Manhattan.

"There is no political will for a federal bailout," Mr. Geithner told the assembled executives, according to a person familiar with the matter. "Come back in the morning and be prepared to do something."

Over the next 48 hours, these marching orders developed into a nerve-wracking test of the ability of the U.S. financial system to hold itself together amid the worst series of shocks it has faced in decades.

By taking the rescue option off the table, the U.S. government was declaring that there are limits to its role as backstop-in-chief. A week earlier it had seized mortgage giants Fannie Mae and Freddie Mac, and months prior had brokered the sale of Bear Stearns & Co. to J.P. Morgan Chase & Co. But now, Washington appears to want Wall Street to largely fix its own problems, and feels that flailing institutions shouldn't expect the government to commit money to save them.

"We've re-established 'moral hazard,'" said a person involved in the talks, referring to the notion that the government should eschew bailouts, since financial firms might take more risks if they're insulated from the consequences. "Is that a good thing or a bad thing? We're about to find out."

One immediate impact: As Lehman's future darkened, Merrill Lynch & Co., another vulnerable firm, raced into the arms of Bank of America Corp.

This account of the weekend's events was compiled from interviews with Wall Street executives, traders, government officials and other participants in the talks.

Barring some last-minute, late-night alternative, Lehman will likely file for liquidation, people familiar with the situation said.

The storied firm's decline occurred in slow motion this year. Heavily exposed to troubled real-estate investments, the firm tried to raise fresh capital, only to be thwarted. The most recent disappointment came last Monday when a possible deal with a Korean bank faded, sending Lehman's shares down 45% the next day. They had already fallen 80% since the start of 2008.

On Tuesday and Wednesday, when Mr. Paulson called Wall Street CEOs to give them early notice of his no-bailout stance, some argued to him that the government needed to structure a rescue like that of Bear Stearns, according to people familiar with the matter. To prevent Bear Stearns's collapse in March, the Fed agreed to put up $30 billion to help complete the acquisition of the failing bank by J.P. Morgan Chase.

Repeating that move with Lehman, however, would create a terrible precedent, Mr. Paulson worried. Which other firms would take that as a cue to ask for U.S. government help -- and from what other industries? Detroit auto makers were already knocking at the door.

Mr. Paulson was also irked that Wall Street saw him as someone who would always ride to the rescue. And because Lehman's troubles have been known for a while, Mr. Paulson felt the market had had time to prepare.

In addition, Lehman had access to special emergency lending from the Fed -- something Bear Stearns didn't have when it was struggling. This was another reason Mr. Paulson there shouldn't be a Bear-like rescue for Lehman.

The government's no-bailout decision emerged as serious obstacle for Lehman's two most likely buyers, Bank of America and Barclays PLC. Indeed, this past Friday, federal officials monitoring talks to sell Lehman to Bank of America realized that deal probably wouldn't be consummated without federal backing.

That triggered the call for the Friday-evening meeting of financial titans. The gathering was attended by at least 30 executives, a Who's Who of Wall Street.

Mr. Geithner laid out two potential scenarios. One involved an orderly dismantling of Lehman that would essentially end its existence. But he also suggested that Wall Street firms come up with their own solution -- perhaps by joining forces among themselves to remove Lehman's riskiest and most toxic assets. That move would make Lehman more attractive to potential buyers, but would also require Wall Street firms to commit their own scarce money to the cleanup.

Mr. Paulson told the group it was in their interest to find a solution. "Everybody is exposed" to Lehman, Mr. Paulson said, according to two people in attendance.

Most of the Wall Street executives present at the meeting listened and asked questions, but didn't show what hand they might play. The meeting broke up just after 8 p.m. Friday.

Finding a Buyer

Saturday morning, the CEOs and their closest advisers reconvened at about 9 a.m. and broke into groups to discuss various scenarios. Lehman representatives weren't present.

One group focused on the possible dismantling of Lehman; it included both government officials and Wall Street representatives. Among the things the group discussed was having every bank borrow from the Fed under an emergency lending provision it has offered since the collapse of Bear Stearns. With that borrowed money, the banks would buy up Lehman's assets, preventing it from filing for bankruptcy.

The other main track focused on finding a buyer. Either Barclays or Bank of America would buy Lehman's "good assets," such as its stock-trading and analysis business, people familiar with the matter say. Lehman's more toxic real-estate assets would be placed in a "bad" bank containing about $85 billion in souring assets. Other Wall Street firms would inject some capital into the bad bank to keep it afloat. The goal would be to avoid a flood of bad assets pouring into the market, pushing prices even lower.

But getting Wall Street firms to cooperate among themselves, without government assistance, was proving tough. Several CEOs openly questioned why they should bear the cost of Lehman's problems when others who also face exposure -- such as institutional investors, hedge funds and foreign investors -- aren't being asked to do the same.

Morgan Stanley CEO John Mack raised serious questions, saying that this time it was Lehman and next time it would be Merrill, according to people in attendance. "If we're going to do this deal, where does it end?" he said, according to a person familiar with the matter. Other bankers in the room felt the same way, this person added.

By noon on Saturday, Bank of America hadn't budged from its position that it needed government support to consummate a deal. The bottom line: It was effectively out of the running.

Outside the Fed's downtown New York headquarters, a fortress-like building of stone and iron, a fleet of black limousines waited for the bankers inside. At one point, they blocked the narrow streets around the building, causing a traffic jam that had to be broken up by the Fed's uniformed guards.

Bankers and Fed staffers milled outside, smoking cigarettes and talking on their cell phones about subjects such as counterparty risk, a normally arcane matter of contract law, suddenly front and center. On one occasion, in the men's bathroom, a trio of bank CEOs debated the merits of a rescue plan.

The bond- and derivative-trading heads of major investment banks, assuming that a deal to save Lehman was a diminishing possibility, gathered to discuss how to deal with their exposure to minimize havoc Monday when markets opened.

Shortly after 5 p.m., a clutch of Fed staffers left the building. The day hadn't gone well. The government and potential buyers remained miles apart, mainly due to the bailout issue. Wall Street executives left in cars parked in a garage to avoid being photographed by the waiting press.

One person in the Fed meetings Saturday night described them as "the world's biggest game of poker."

With different doomsday scenarios being batted around the meeting rooms, some participants felt the government would blink and do a bailout. "This is going to go down to the last second," one participant said.

With Bank of America backing away from a deal, the enormity of a potential bankruptcy filing by Lehman started settling in. Even understanding Lehman's current trading positions was tough. Lehman's roster of interest-rate swaps (a type of derivative investment) ran about two million strong, said one person familiar with the matter.

Overnight, the outlines of possible deals started to crystallize. The idea that Wall Street firms would fund a "bad bank" full of Lehman's problematic assets was dead. Unlike when Wall Street firms stepped in to bail out hedge fund Long-Term Capital Management a decade ago, today's banks are much weaker. Some were loathe to provide support when a rival like Barclays might still buy Lehman.

By Sunday morning, the U.K.'s Barclays looked like the sole potential buyer. That further minimized the chances of a government bailout: If the Bush administration wouldn't help to fund a Wall Street solution, aiding a foreign buyer was even less likely.

Lehman employees followed their firm through news reports. One manager said he was encouraging his staff to show up Monday and hang tough for a few more days. "It is not like there are a million jobs to go to," he said.

The Chance to Transform

Barclays pushed ahead, eager at the chance to transform itself into a U.S. powerhouse at potentially a fire-sale price. Its advisers thought the U.S. Treasury could be persuaded to support a foreign buyer. By Sunday morning in London, after working around the clock for three days, the British bank -- whose roots date to the late 1600s as a goldsmith banker in London -- thought it had a shot. Documents were drawn up to pitch the deal to investors and journalists.

During the afternoon on Sunday, two Fed policeman wheeled a large, double-decker cart filled with cakes, cookies, sandwiches, chips and bottles of water into the Fed building.

But soon after, Barclays was threatening to walk as it argued with the Fed and Treasury over seemingly mundane matters, such as whether it would have to hold a shareholders' meeting to ratify any deal. Barclays was still insisting on some kind of federal financing.

By the middle of Sunday afternoon, Barclays was out. Its plan -- to buy Lehman's subsidiaries -- was contingent on government support, which wasn't coming.

At a meeting held at the Fed offices, Mr. Paulson, Mr. Geithner and Securities and Exchange Commission Chairman Christopher Cox addressed a group of about one dozen banking chiefs. Their message was steadfast: They would not put up money to assist in salvaging Lehman. In the meetings with Mr. Paulson were his chief of staff, Jim Wilkinson, and two advisers, Dan Jester and Steve Shafran, both of whom used to work at Goldman Sachs.

Somber Mood

The mood turned somber as it became clear that the group would have to turn its attention to dismantling Lehman in a way that didn't seriously disrupt the financial system. Soon the group began discussing the mechanics of such a plan.

A sense of foreboding descended over the rival bankers. They focused on the fear that drove down shares in Lehman, worried that would now spread to Merrill, another storied name facing losses from mortgage-related holdings, despite the reputation of its wealth-management business.

"I think the government is playing with fire," said a top executive of a big bank.

The worry for Merrill, said people briefed on the conversations, was that as its stock tumbles, its credit rating could change, increasing its cost of borrowing. Faced with rising borrowing costs -- a key expense for giant Wall Street financial firms -- its business might be severely crimped. As well, as concerns mount, its trading partners might stop doing business with it.

Many in the room began to wonder when Merrill would sell itself. "Tonight, or tomorrow?" said one of these people in an interview. In fact, within a few hours, the bankers learned that Merrill was in talks to be acquired by Bank of America.

As word that a Barclays deal was off filtered across Wall Street, traders scrambled to extricate themselves their various financial transactions with Lehman. Traders at many Wall Street firms were told to come to work immediately.

The European Central Bank was also in a state of high alert on Sunday, with employees in divisions from money-market operations to financial stability camped out in the bank's 37-story glass-and-steel tower in Frankfurt, preparing for what Monday might bring. "We are in the hands of the Americans," said one employee.

Mixed Economic Data Show A Changing Business Cycle

By JON HILSENRATH and KELLY EVANS

September 8, 2008; Page A2, WSJ

The U.S. economy looks like it is traveling along two tracks.

If you look at output -- the amount of goods and services Americans produce -- the economy has been rising at a decent clip. But people aren't feeling it in their wallets because the factors driving their own incomes -- such as jobs and wages -- are under strain.

The point has been underscored by a slew of economic reports released in the past few weeks. The government's measure of inflation-adjusted gross domestic product expanded at a surprisingly robust 3.3% annual rate in the second quarter. Exports were a big driver, in particular exports of industrial supplies and capital goods.

Yet employment has fallen for eight straight months by a cumulative 605,000 jobs. More than half of the losses have been in manufacturing. You might expect manufacturing employment to hold up better during an export boom. But it isn't.

With job losses mounting, companies are cutting back on hours and getting tough on wages. Year-to-year personal income growth has slowed from more than 7% a couple of years ago to a little more than 4% in July, not enough to keep up with inflation.

In theory, output and income should go up and down together. If the economy is still expanding, why are so many households being squeezed?

One answer is that the business cycle itself is changing. Recessions in the past used to follow a predictable script. Business would slow or inventories would go up too much and catch companies flat-footed. As their own productivity dropped, they would belatedly respond by cutting back on workers. Then, as the process fed on itself, everything would go down together -- output, employment, income and productivity.

The 2001 recession changed the script -- productivity held up surprisingly well throughout. Companies cut back ahead of the business slowdown and kept doing it even after demand started rising again. The productivity they managed to squeeze out of existing workers bolstered output, even as it strained households.

The same thing seems to be happening again: To the surprise of many economists, worker productivity is rising, not falling.

"There seems to be a change in how businesses operate," says Dean Maki, economist for Barclays Capital. With better technology, businesses get ahead of inventory buildups or demand slowdowns more quickly. The declining influence of unions is also putting management in a position to fire workers more quickly.

Associated Press

A customer holds his wallet as he pumps gas at a Shell gas station in Menlo Park, Calif.

The result: While incomes are getting squeezed, the output per hour of workers was up at an annual rate of more than 3% in the first half of the year.

More than ever, it seems, this puts the brunt of a downturn on workers. But there are important upsides to the shift. Better productivity helps bolster corporate profits, so while the stock market is weak it hasn't collapsed as have stock markets elsewhere in the world this year. It also helps restrain inflation and give the Federal Reserve leeway to keep interest rates low and help the economy heal.

It also makes it harder to read a business cycle. The collection of economists at the National Bureau of Economic Research who date recessions debated for months about the beginning and end of the last downturn because of the striking disconnect between output and income.

"If you dated it based on the labor market you'd have it be one of the longest recessions in history, and that didn't feel right," says Christina Romer, an economics professor at the University of California, Berkeley. The group finally decided November 2001 -- when output growth restarted -- was the point at which the recession ended, making the eight-month slowdown one of the shortest on record.

But the debate hasn't gone away. "What matters to individuals more than anything else is the behavior of the labor market," says John Lonski, chief economist at Moody's Investor Service. "If I were the NBER I would simplify the entire process and focus on the labor market. From the perspective of the economy and social welfare it's labor-market behavior that matters the most."

There are other factors at play now, including confusion about how statisticians measure all of these trends. Some economists are skeptical of the 3.3% annualized increase in gross-domestic-product growth registered in the second quarter. The figure, produced by the government's Bureau of Economic Analysis, is out of line with another BEA figure called gross domestic income -- a measure of the income earned by businesses and households.

In theory, the two figures should go up and down together. But gross domestic income expanded at a much smaller 1.9% annual rate in the second quarter, after contracting the two previous quarters. The income number might have been skewed as government statisticians try to make sense of the massive write-offs being recorded by banks. The output number might also have been skewed, for instance by big shifts in the trade environment and the price of oil. Data revisions could ultimately show output wasn't as strong as it now appears.

Statistics aside, it is also possible output won't hold up under the pressures building against the U.S. economy, even with better productivity. Exports have been the bright light in the growth picture. But the global economy is slowing.

Neil Soss, a Credit Suisse economist, notes that three quarters of the economy's growth in the past year came from an improved trade position. "How much can I count on that for the future?" he asks.

Meantime, the strain on incomes might finally be catching up to households. They will clearly be helped by the drop in gasoline prices, but tax rebates have run their course and the housing and credit squeezes run unabated.

Adjusted for inflation, consumer spending -- the biggest driving force of growth -- contracted in June and July. It hasn't contracted for an entire quarter since late 1991. That 17-year run is now being put to the test. If consumers crack, output and income might finally meet up again -- in recession.