Source: WSJ
1973 was a terrible year on Wall Street. An unexpected crisis in the Middle East led to a quadrupling of oil prices and a serious global economic recession. The president was in serious trouble with Watergate. The S&P 500 index dropped 50% (after 23 years of rising markets), and much of Wall Street fell deeply into the red. There were no profits, and therefore no bonuses.
I was a 35-year-old, nonpartner investment banker then and was horrified to learn that my annual take-home pay would be limited to my small salary, which accounted for about a quarter of my previous year's income. Fortunately the partners decided to pay a small bonus out of their capital that year to help employees like me get by. The next year was no better. Several colleagues with good prospects left the firm and the industry for good. We learned that strong pay-for-performance compensation incentives could cut both ways.
Many wondered if that was still the case last week, when New York State Comptroller Thomas DiNapoli released an estimate that the "securities industry" paid its New York City employees bonuses of $18 billion in 2008, leading to a public outcry. Lost in the denunciations were the powerful benefits of the bonus system, which helped make the U.S. the global leader in financial services for decades. Bonuses are an important and necessary part of the fast-moving, high-pressure industry, and its employees flourish with strong performance incentives.
There is also a fundamental misunderstanding of how bonuses are paid that is further inflaming public opinion. The system has become more complex than most people know, and involves forms of bonuses that are not entirely discretionary.
The anger at Wall Street only grew at the news that Merrill Lynch, after reporting $15 billion of losses, had rushed to pay $4 billion in bonuses on the eve of its merger with Bank of America. Because Merrill Lynch and Bank of America were receiving substantial government funds to keep them afloat, the subject became part of the public business. The idea that the banks had paid out taxpayers' funds in undeserved bonuses to employees, together with a leaked report of John Thain's spending $1 million to redecorate his office, understandably provoked a blast of public outrage against Wall Street. The issue was so hot that President Barack Obama interrupted his duties to call the bonuses "shameful" and the "height of irresponsibility." Then, on Wednesday, he announced a new set of rules for those seeking "exceptional" assistance from the Troubled Asset Relief Program in the future that would limit cash compensation to $500,000 and restrict severance pay and frills, perks and boondoggles.
Lindsay Holmes
In the excitement some of the facts got mixed up. Mr. DiNapoli's estimate included many firms that were not involved with the bailout, and only a few that were. Merrill's actions were approved by its board early in December and consented to by Bank of America. But the basic point is that, despite the dreadful year that Wall Street experienced in 2008, some questionable bonuses were paid to already well-off employees, and that set off the outrage.
Many Americans believe that any bonuses for top executives paid by rescued banks would constitute "excess compensation," a phrase used by Mr. Obama. But no Wall Street CEO taking federal money received a bonus in 2008, and the same was true for most of their senior colleagues. Not only did those responsible receive no bonuses, the value of the stock in their companies paid to them as part of prior-year bonuses dropped by 70% or more, leaving them, collectively, with billions of dollars of unrealized losses.
That's pay for performance, isn't it?
"Wall Street" has always been the quintessential, if ill-defined, symbol of American capitalism. In reality, Wall Street today includes many large banks, investment groups and other institutions, some not even located in the U.S. It has become a euphemism for the global capital markets industry -- one in which the combined market value of all stocks and bonds outstanding in the world topped $140 trillion at the end of 2007. Well less than half of the value of this combined market value is represented by American securities, but American banks lead the world in its origination and distribution. Wall Street is one of America's great export industries.
The market thrives on locating new opportunities, providing innovation and a willingness to take risks. It is also, regrettably, subject to what the economist John Maynard Keynes called "animal spirits," the psychological factors that make markets irrational when going up or down. For example, America has enjoyed a bonus it didn't deserve in its free-wheeling participation in the housing market, before it became a bubble. Despite great efforts by regulators to manage systemic risk, there have been market failures. The causes of the current market failure, which is the real object of the public anger, go well beyond the Wall Street compensation system -- but compensation has been one of them.
The capital-markets industry operates in a very sophisticated and competitive environment, one that responds best to strong performance incentives. People who flourish in this environment are those who want to be paid and advanced based on their individual and their team's performance, and are willing to take the risk that they might be displaced by someone better or that mistakes or downturns may cause them to be laid off or their firms to fail. Indeed, since 1970, 28 major banks or investment banks have failed or been taken up into mergers, and thousands have come and gone into the industry without making much money. Those that have survived the changing fortunes of the industry have done very well -- so well, in fact, that they appear to have become symbolic of greedy and reckless behavior.
The Wall Street compensation system has evolved from the 1970s, when most of the firms were private partnerships, owned by partners who paid out a designated share of the firm's profits to nonpartner employees while dividing up the rest for themselves. The nonpartners had to earn their keep every year, but the partners' percentage ownerships in the firms were also reset every year or two. On the whole, everyone's performance was continuously evaluated and rewarded or penalized. The system provided great incentives to create profits, but also, because the partners' own money was involved, to avoid great risk.
The industry became much more competitive when commercial banks were allowed into it. The competition tended to commoditize the basic fee businesses, and drove firms more deeply into trading. As improving technologies created great arrays of new instruments to be traded, the partnerships went public to gain access to larger funding sources, and to spread out the risks of the business. As they did so, each firm tried to maintain its partnership "culture" and compensation system as best it could, but it was difficult to do so.
In time there was significant erosion of the simple principles of the partnership days. Compensation for top managers followed the trend into excess set by other public companies. Competition for talent made recruitment and retention more difficult and thus tilted negotiating power further in favor of stars. Henry Paulson, when he was CEO of Goldman Sachs, once remarked that Wall Street was like other businesses, where 80% of the profits were provided by 20% of the people, but the 20% changed a lot from year to year and market to market. You had to pay everyone well because you never knew what next year would bring, and because there was always someone trying to poach your best trained people, whom you didn't want to lose even if they were not superstars. Consequently, bonuses in general became more automatic and less tied to superior performance. Compensation became the industry's largest expense, accounting for about 50% of net revenues. Warren Buffett, when he was an investor in Salomon Brothers in the late 1980s, once noted that he wasn't sure why anyone wanted to be an investor in a business where management took out half the revenues before shareholders got anything. But he recently invested $5 billion in Goldman Sachs, so he must have gotten over the problem.
As firms became part of large, conglomerate financial institutions, the sense of being a part of a special cohort of similarly acculturated colleagues was lost, and the performance of shares and options in giant multi-line holding companies rarely correlated with an individual's idea of his own performance over time. Nevertheless, the system as a whole worked reasonably well for years in providing rewards for success and penalties for failures, and still works even in difficult markets such as this one.
At junior levels, bonuses tend to be based on how well the individual is seen to be developing. As employees progress, their compensation is based less on individual performance and more on their role as a manager or team leader. For all professional employees the annual bonus represents a very large amount of the person's take-home pay. At the middle levels, bonuses are set after firm-wide, interdepartmental negotiation sessions that attempt to allocate the firm's compensation pool based on a combination of performance and potential.
Saturday, February 07, 2009
From Awful to Merely Bad: Reviewing the Bank Rescue Options
Source: WSJ, Authors: Hubbard, Scott, and Zingales
When Henry Paulson, President Bush's Treasury secretary, first introduced the Troubled Asset Relief Program (TARP) in Congress last September, we cautioned against using government funds to buy mortgages and mortgage-related securities from banks. After the Emergency Economic Stabilization Act was signed into law in early October, the Treasury decided not to buy these assets. Instead, it used the first $350 billion of TARP funds to inject capital first into nine systemically important troubled banks, and later into insurer AIG (as part of a refinancing) and auto makers General Motors and Chrysler.
This approach seems to have achieved (albeit at a high cost for taxpayers) its principal objective of avoiding a massive collapse of the financial system. But it has not yet resulted in an increase in bank lending or the attraction of new private equity to the banking system, both of which are important to reviving the economy. There now appears to be active consideration of using TARP funds to buy "bad assets" from the banks. Major problems with so doing remain.
The central issue is how to price the assets. When the subprime crisis hit in the summer of 2007, the Treasury's first response was to encourage the private sector to create a fund -- the so-called Super SIV (structured investment vehicle) -- to buy mortgage-related assets. This proposal foundered due to the difficulty of setting a price for these assets, which come in complex and incomparable varieties. If Treasury pays close to par, it is paying far too much. If it pays current prices, no one will sell because of the adverse impact on their capital. If it pulls a price out of a hat, it will be acting arbitrarily.
Initial discussions focused on using a reverse auction with asset holders "bidding" to sell their mortgage-related securities to the Treasury. Such an approach raises significant problems -- most significant is the risk posed by asymmetric information regarding the value of these securities. Because the holders of complex and incomparable mortgage-related securities have more information regarding their worth than does Treasury, Treasury is at a huge disadvantage and will likely overpay. Moreover, there will have to be many auctions of very different securities. All of this will take months to execute.
Reportedly, thought is now being given to only buying "bad assets" and putting them in a fund (called a "bad bank") owned by the government. This new variation raises additional problems. First, how should "bad assets" be defined? As the recession deepens, bad assets have multiplied and will continue to multiply from mortgages and mortgage-related securities to many other assets classes, including credit-card portfolios. We see little sense in defining bad assets simply as those that have been already significantly written down. The bank may be more exposed to losses from assets that have not been significantly written down, but could well be.
Further, as the potential class of bad assets expands so does the cost of purchase. Total mortgage-related securities and mortgages held by banks alone are estimated to be $6 trillion, of which mortgage-backed securities are $1.3 trillion. Total bank assets are $16.5 trillion.
Another proposal is to guarantee the value of bad assets rather than buy them. This outcome could be accomplished by a direct guarantee of assets that remained on the balance sheet of banks (or were brought in from outside conduits or SIVs), or into one government-run bad bank.
A version of this approach was used in the second round of TARP financing for Citigroup and Bank of America. In the case of Citigroup, a $306 billion asset pool was created in which Citigroup absorbs the first $29 billion of losses, the Treasury and FDIC jointly fund 90% of the next $15 billion ($5 billion from the Treasury through TARP, and $10 billion from the FDIC), and the Fed finally funds 90% of the remaining losses. In return, the government received $7 billion in preferred stock (with an 8% yield) -- $4 billion to Treasury, $3 billion to FDIC. Under this approach, the problem of valuing the assets has been finessed into a problem of valuing the stock.
With more transparency, which Congress and its Oversight Panel would surely demand, that finesse would not work. A conservative estimate puts the value of the Citigroup option -- i.e., the potential cost to taxpayers -- at $60 billion, taking account of the stock warrants the government received. If one were to repeat this approach for all banks the cost would be as much as TARP. And, if the market for toxic assets were to fall further, the government could easily be responsible for trillions of dollars of losses. Last but not least, having the Fed become the residual risk bearer further undermines the Fed's financial stability and its ultimate independence, a concern recently voiced by the Committee on Capital Markets Regulation.
A more reasonable alternative would be to encourage banks to spin off the toxic assets into separate affiliated bad banks (as under a new reported German initiative). Ownership of these two entities would be allocated pro rata to all the financial investors as a proportion of the most updated accounting value of these assets. So a bank with $30 billion of bad assets and $70 billion of good assets will see its debt divided 30%-70% and its equity divided 30%-70%. Each $100 debt claim will become a $30 debt claim in the bad bank and a $70 debt claim in the good bank. The same would be true for equity. To limit the exposure of the FDIC to the bad bank, insured deposits and FDIC-guaranteed debt should remain in the good bank to the extent there are sufficient matching good assets. In addition, off-balance-sheet derivative contracts remain off balance sheet for the good bank to avoid the possibility that the failure of the bad bank would create systemic risk. Furthermore, convincing evidence would be needed before guaranteeing any of the liabilities of a bad bank because ordinarily a bad-bank failure should not result in systemic risk.
An alternative would be for the government to facilitate the injection of new, private-equity capital into banks by eliminating regulatory restrictions, such as bank ownership by private-equity or commercial firms, and providing protection against loss or dilution if there were to be subsequent government intervention. A subsidy for this private risk capital could even be given. As long as private capital holds most of the risk, it will certainly be allocated more efficiently than government money, minimizing the taxpayer cost of any subsidy. This idea would have to be more fully explored.
Whatever is done with respect to still solvent institutions, banks with dangerously low, or no or negative capital, should be taken over by the government through already established FDIC procedures, such as bridge loans. Just as with the Savings and Loan crisis of the 1980s, there is a significant risk that shareholders (and managers) with nothing to lose will roll the dice and lose even more. Existing shareholders with no equity should not benefit by government support. Further, a government takeover (just like a corporate bankruptcy) permits the restructuring of bank debt. As the S&L debacle shows, a decision worse than a nationalization of the banking sector is a nationalization of the losses, which still leaves the gains in private hands.
With still solvent institutions, there is no affordable and workable plan that will by itself assure that these banks will start lending and that private capital will return. We have stabilized the financial system against massive collapse, which is probably all the government can do. While we hope some more improvement may come from the bad bank or private-equity solutions outlined above, the road to further recovery of the financial system now lies principally with the economy's recovery and the success of the fiscal stimulus.
When Henry Paulson, President Bush's Treasury secretary, first introduced the Troubled Asset Relief Program (TARP) in Congress last September, we cautioned against using government funds to buy mortgages and mortgage-related securities from banks. After the Emergency Economic Stabilization Act was signed into law in early October, the Treasury decided not to buy these assets. Instead, it used the first $350 billion of TARP funds to inject capital first into nine systemically important troubled banks, and later into insurer AIG (as part of a refinancing) and auto makers General Motors and Chrysler.
This approach seems to have achieved (albeit at a high cost for taxpayers) its principal objective of avoiding a massive collapse of the financial system. But it has not yet resulted in an increase in bank lending or the attraction of new private equity to the banking system, both of which are important to reviving the economy. There now appears to be active consideration of using TARP funds to buy "bad assets" from the banks. Major problems with so doing remain.
The central issue is how to price the assets. When the subprime crisis hit in the summer of 2007, the Treasury's first response was to encourage the private sector to create a fund -- the so-called Super SIV (structured investment vehicle) -- to buy mortgage-related assets. This proposal foundered due to the difficulty of setting a price for these assets, which come in complex and incomparable varieties. If Treasury pays close to par, it is paying far too much. If it pays current prices, no one will sell because of the adverse impact on their capital. If it pulls a price out of a hat, it will be acting arbitrarily.
Initial discussions focused on using a reverse auction with asset holders "bidding" to sell their mortgage-related securities to the Treasury. Such an approach raises significant problems -- most significant is the risk posed by asymmetric information regarding the value of these securities. Because the holders of complex and incomparable mortgage-related securities have more information regarding their worth than does Treasury, Treasury is at a huge disadvantage and will likely overpay. Moreover, there will have to be many auctions of very different securities. All of this will take months to execute.
Reportedly, thought is now being given to only buying "bad assets" and putting them in a fund (called a "bad bank") owned by the government. This new variation raises additional problems. First, how should "bad assets" be defined? As the recession deepens, bad assets have multiplied and will continue to multiply from mortgages and mortgage-related securities to many other assets classes, including credit-card portfolios. We see little sense in defining bad assets simply as those that have been already significantly written down. The bank may be more exposed to losses from assets that have not been significantly written down, but could well be.
Further, as the potential class of bad assets expands so does the cost of purchase. Total mortgage-related securities and mortgages held by banks alone are estimated to be $6 trillion, of which mortgage-backed securities are $1.3 trillion. Total bank assets are $16.5 trillion.
Another proposal is to guarantee the value of bad assets rather than buy them. This outcome could be accomplished by a direct guarantee of assets that remained on the balance sheet of banks (or were brought in from outside conduits or SIVs), or into one government-run bad bank.
A version of this approach was used in the second round of TARP financing for Citigroup and Bank of America. In the case of Citigroup, a $306 billion asset pool was created in which Citigroup absorbs the first $29 billion of losses, the Treasury and FDIC jointly fund 90% of the next $15 billion ($5 billion from the Treasury through TARP, and $10 billion from the FDIC), and the Fed finally funds 90% of the remaining losses. In return, the government received $7 billion in preferred stock (with an 8% yield) -- $4 billion to Treasury, $3 billion to FDIC. Under this approach, the problem of valuing the assets has been finessed into a problem of valuing the stock.
With more transparency, which Congress and its Oversight Panel would surely demand, that finesse would not work. A conservative estimate puts the value of the Citigroup option -- i.e., the potential cost to taxpayers -- at $60 billion, taking account of the stock warrants the government received. If one were to repeat this approach for all banks the cost would be as much as TARP. And, if the market for toxic assets were to fall further, the government could easily be responsible for trillions of dollars of losses. Last but not least, having the Fed become the residual risk bearer further undermines the Fed's financial stability and its ultimate independence, a concern recently voiced by the Committee on Capital Markets Regulation.
A more reasonable alternative would be to encourage banks to spin off the toxic assets into separate affiliated bad banks (as under a new reported German initiative). Ownership of these two entities would be allocated pro rata to all the financial investors as a proportion of the most updated accounting value of these assets. So a bank with $30 billion of bad assets and $70 billion of good assets will see its debt divided 30%-70% and its equity divided 30%-70%. Each $100 debt claim will become a $30 debt claim in the bad bank and a $70 debt claim in the good bank. The same would be true for equity. To limit the exposure of the FDIC to the bad bank, insured deposits and FDIC-guaranteed debt should remain in the good bank to the extent there are sufficient matching good assets. In addition, off-balance-sheet derivative contracts remain off balance sheet for the good bank to avoid the possibility that the failure of the bad bank would create systemic risk. Furthermore, convincing evidence would be needed before guaranteeing any of the liabilities of a bad bank because ordinarily a bad-bank failure should not result in systemic risk.
An alternative would be for the government to facilitate the injection of new, private-equity capital into banks by eliminating regulatory restrictions, such as bank ownership by private-equity or commercial firms, and providing protection against loss or dilution if there were to be subsequent government intervention. A subsidy for this private risk capital could even be given. As long as private capital holds most of the risk, it will certainly be allocated more efficiently than government money, minimizing the taxpayer cost of any subsidy. This idea would have to be more fully explored.
Whatever is done with respect to still solvent institutions, banks with dangerously low, or no or negative capital, should be taken over by the government through already established FDIC procedures, such as bridge loans. Just as with the Savings and Loan crisis of the 1980s, there is a significant risk that shareholders (and managers) with nothing to lose will roll the dice and lose even more. Existing shareholders with no equity should not benefit by government support. Further, a government takeover (just like a corporate bankruptcy) permits the restructuring of bank debt. As the S&L debacle shows, a decision worse than a nationalization of the banking sector is a nationalization of the losses, which still leaves the gains in private hands.
With still solvent institutions, there is no affordable and workable plan that will by itself assure that these banks will start lending and that private capital will return. We have stabilized the financial system against massive collapse, which is probably all the government can do. While we hope some more improvement may come from the bad bank or private-equity solutions outlined above, the road to further recovery of the financial system now lies principally with the economy's recovery and the success of the fiscal stimulus.
The weekend that Wall Street died
Source: WSJ
Lehman Brothers Holdings Inc. Chief Executive Richard S. Fuld Jr., wearing tie, is heckled by protesters in October as he leaves Capitol Hill in Washington after testify before the House Oversight and Government Reform Committee on the collapse of Lehman Brothers.
With his investment bank facing a near-certain failure, Lehman Brothers Holdings Inc.'s chief executive officer, Richard Fuld Jr., placed yet another phone call to the man he thought could save him.
Fuld was already effectively out of options by the afternoon of Sunday, Sept. 14. The U.S. government said it wouldn't fund a bailout for Lehman, the country's oldest investment bank. Britain's Barclays PLC had agreed in principle to buy the loss-wracked firm, but the deal fell apart. Bank of America Corp., initially seen as Lehman's most likely buyer, had said two days earlier that it couldn't do a deal without federal aid -- and by Sunday was deep in secret negotiations to take over Lehman rival Merrill Lynch & Co.
Desperate to avoid steering his 25,000-person company into bankruptcy proceedings, Fuld dialed the Charlotte, N.C., home of Bank of America Chairman Kenneth D. Lewis. His calls so far that weekend had gone unreturned. This time, Lewis's wife, Donna, again picked up, and told the boss of Lehman Brothers: If Lewis wanted to call back, he would call back.
Fuld paused, then apologized for bothering her. "I am so sorry," he said.
Associated Press File Merrill Lynch Chairman and CEO John Thain, left, and Bank of America Chairman and CEO Ken Lewis shake hands following a news conference in New York.
His lament could also have been for the investment-banking model that had come to embody the words "Wall Street." Within hours of his call, Lehman announced it would file for bankruptcy protection. Within a week, Wall Street as it was known -- loosely regulated, daringly risky and lavishly rewarded -- was dead.
As Fuld waged his increasingly desperate bid to save his firm that weekend, the bosses of Wall Street's other three giant investment banks were locked in their own battles as their firms came under mounting pressure. It was a weekend unlike anything Wall Street had ever seen: In past crises, its bosses had banded together to save their way of life. This time, the financial hole they had dug for themselves was too deep. It was every man for himself, and Fuld, who declined to comment for this article, was the odd man out.
For the U.S. securities industry to unravel as spectacularly as it did in September, many parties had to pull on many threads. Mortgage bankers gave loans to Americans for homes they couldn't afford. Investment houses packaged these loans into complex instruments whose risk they didn't always understand. Ratings agencies often gave their seal of approval, investors borrowed heavily to buy, regulators missed the warning signs. But at the center of it all -- and paid hundreds of millions of dollars during the boom to manage their firms' risk -- were the four bosses of Wall Street.
Details of these CEOs' decisions and negotiations, many of them previously unreported, show how they sought to avert the death of America's giant investment banks. Their efforts culminated in a round-the-clock weekend of secret negotiations and personal struggles to keep their firms afloat. Accounts of these events are based on company and other documents, emails and interviews with Wall Street executives, traders, regulators, investors and others.
Summer Clouds
Earlier this year, when the financial crisis claimed its first victim, Bear Stearns Cos., the surviving masters of Wall Street thought the eye of the storm had passed. Bear Stearns, the smallest of Wall Street's big five stand-alone investment banks, imploded just months after bad subprime bets sunk two internal hedge funds. In March 2008, the government brokered Bear Stearns's sale to J.P. Morgan Chase & Co.
After Bear Stearns's brush with death, the Federal Reserve for the first time allowed investment houses to borrow from the government on much the same terms as commercial banks. Many on Wall Street saw investment banks' access to an equivalent of the Fed "discount window" as a blank check should hard times return. But it would also be the first step in giving the government more say over an industry that had until then been lightly regulated.
Associated Press File Lloyd C. Blankfein, of Goldman Sachs,
In April, Morgan Stanley's CEO, John Mack, told shareholders the U.S. subprime crisis was in the eighth or ninth inning. The same month, Goldman Sachs Group Inc.'s chief executive, Lloyd Blankfein, said, "We're probably in the third or fourth quarter" of a four-quarter game.
Mack and Blankfein had some reason to be confident. Mack had been late to steer Morgan into mortgage trading, and relatively early to sell assets and raise cash. Goldman, under Blankfein, had even less direct exposure to subprime investments. Blankfein also took comfort in a stockpile of government bonds and other securities his firm held in case it ran into deep funding problems. By the second quarter, Goldman had increased this store of funds more than 30 percent from earlier in the year, to $88 billion.
Problems were more acute at Merrill Lynch and Lehman.
John Thain, a former Goldman Sachs president and New York Stock Exchange head, had arrived at Merrill Lynch in December 2007. He moved quickly to cut costs, putting the corporate helicopter up for sale and replacing the fresh flowers on a Merrill floor used by nine or so executives -- an estimated annual expense of $200,000 -- with fakes
More monumentally, Thain faced $55 billion in soured mortgage assets that Merrill had acquired under his predecessor. Within weeks of his arrival, he had raised more than $12 billion in much-needed capital, including $5 billion from Singapore's state investment company, Temasek Holdings, at $48 a share.
Some of those early deals would end up being costly. With his would-be investors driving a hard bargain, Thain promised Temasek and others that if Merrill sold additional common stock at a lower price within a year, the firm would compensate them. Within months, after taking a big write-down on a portfolio of mortgage debts that Merrill sold for pennies on the dollar, the firm had to raise more cash at $25 a share. Merrill issued additional shares to pay off its earlier investors, diluting its common shares by 39 percent. The dilution essentially cost shareholders about $5 billion, well above the previously reported $2.5 billion cost of shares issued to Temasek.
Lehman, now the smallest of the major Wall Street firms, also faced billions of dollars in write-downs from bad mortgage-related investments. In June, Lehman reported the first quarterly loss in its 14 years as a public company. Under Fuld, Lehman raised capital. But critics say Fuld was slow to shed bad assets and profitable lines of business. He pushed for better terms with at least one investor that ended up driving it away.
Fuld had faced challenges to his firm before. Since taking Lehman's reins in 1994, he expanded the 158-year-old bond house into lucrative areas such as investment banking and stock trading. Over the years, he had tamped unfounded rumors about the firm's health and vowed to remain independent. "As long as I am alive this firm will never be sold," Fuld said in December 2007, according to a person who spoke with him then. "And if it is sold after I die, I will reach back from the grave and prevent it."
In the summer of 2008, Fuld remained confident, particularly given the security of the Fed's discount window. "We have access to Fed funds," Fuld told executives at the time. "We can't fail now."
Friday, Sept. 12
By Friday, Sept. 12, failure appeared to be an option for Lehman.
Over that week, confidence in Lehman plunged. The firm said its third-quarter losses could total almost $4 billion. Lehman's clearing bank, J.P. Morgan, wanted an extra $5 billion in collateral. Lehman's attempts to raise money from a Korean bank had stalled. Credit agencies were warning that if Lehman didn't raise more capital over the weekend, it could face a downgrade. That would likely force the firm to put up more collateral for its outstanding loans and increase its costs for new loans.
If Fuld couldn't find an investor for Lehman by Sunday night, the fiercely independent boss could be forced to steer his firm into bankruptcy proceedings.
Earlier that week, Fuld had approached Bank of America's Lewis about buying Lehman. A U.S. Treasury official, meanwhile, had contacted Barclays of Britain to suggest it consider taking a stake in Lehman. Fuld's top executives spent Friday shuttling between the two suitors' law firms.
Lehman was also exploring a third option: The night before, veteran bankruptcy lawyer Harvey Miller of Weil, Gotshal & Manges had secretly begun cobbling together a bare-bones bankruptcy filing for the firm.
Lehman's troubles were putting the rest of Wall Street on notice.
In a Merrill Lynch conference room in downtown Manhattan that morning, Thain was on a call with Merrill's board of directors, discussing how to address the chaos. "Lehman is going down, and the [short sellers] are coming after us next," warned Merrill director John Finnegan. "Tell me how this story is going to end differently."
Merrill would be fine, Thain said. "We are not Lehman," he responded, noting the firm held valuable assets, including its stake in BlackRock, a profitable asset-management firm.
But Merrill's clients, too, were beginning to pull out money. The firm's stock was sinking. Executives, including Merrill President Gregory Fleming, were nervous.
Fleming believed he'd identified the ideal partner for Merrill. Bank of America, with a strong balance sheet and retail operations, would mesh well with Merrill's securities franchise and 16,000-strong brokerage force. Fleming worried that Bank of America could buy Lehman instead.
Fleming called a long-time lawyer for Bank of America, Edward Herlihy of Wachtell, Lipton, Rosen & Katz. "You have to talk to us," Fleming said. He was told that Merrill's Thain would have to approach Bank of America's Lewis. "I know," Fleming responded. "I'm gonna try."
At 5 p.m. Friday, after a day of massive client withdrawals at Lehman, Thain's phone rang. It was the Treasury. "Be at the Fed at 6 p.m.," Thain was told.
Soon after, Thain gathered along with Morgan's Mack and Goldman's Blankfein at the New York Federal Reserve in downtown Manhattan, in a room once used to cash coupons on Treasury bills. The three men were greeted by the masters of the world's biggest economy -- Federal Reserve Chairman Ben Bernanke, Treasury Secretary Henry Paulson, New York Fed Chief Timothy Geithner and Securities and Exchange Commission chief Christopher Cox. It was a signal moment for the Wall Street firms, which after years of being monitored by the SEC would all soon come under the regulatory watch of a newly powerful Fed.
The federal officials told the Wall Street chiefs to return in the morning. If the mess at Lehman could be fixed, it would be the job of the Wall Street bosses. There would be no public bailout.
An industry-led solution wouldn't be without precedent. In the market panic of 1907, financier J.P. Morgan persuaded fellow bankers to help fund a bailout for failing rivals. Competitors united again in 1998, putting up money to insulate the financial system from the failure of hedge fund Long Term Capital Management.
But now, Fuld's problems at Lehman were possibly beyond repair.
By that night, Bank of America's team had concluded that Lehman's real-estate portfolio was worse than expected -- and as a result, the firm's liabilities likely exceeded its assets. "We need government assistance, and we are not getting it," the bank's top deal maker, Greg Curl, told his group. Some of the negotiators prepared to fly back early the next morning to headquarters in Charlotte.
Lewis hadn't come to New York for the Lehman talks. He called Fuld from Charlotte, telling him that Bank of America couldn't do a deal without federal help. "We will keep a team in New York in case things change," Lewis told him.
Saturday, Sept. 13
Fuld arrived at Lehman's office at 7 a.m. on Saturday, wearing a blue suit and tie. The talks with Barclays were still moving. If the government could be moved, there could also be hope for a Bank of America deal.
Merrill, meanwhile, was beginning its own pursuit of Bank of America.
At his home in Rye, N.Y., Thain was getting dressed for a day at the New York Fed when his phone rang. It was Merrill's president, Fleming.
"John, you really need to call Ken Lewis," Fleming said.
"Get me his number," said Thain, who added it to his papers for the day.
Thain's black SUV pulled up in front of the New York Fed just before 8 a.m. Top executives from all four investment banks -- minus Lehman's Fuld -- were there.
Federal officials broke Thain, Mack and Blankfein and their top aides into groups. One studied the potential fallout from a Lehman failure. Another was charged with putting a value on Lehman's controversial real-estate investments. A third group, which included Thain and Morgan's Mack, was supposed to discuss an industry-led bailout for Lehman.
Lehman's president, Bart McDade, walked the group through the embattled firm's books. McDade did not respond to requests for comment for this article.
Mack questioned Wall Street's ability to repair markets. The firms could try to backstop Lehman, he argued, but there was no guarantee they wouldn't have to rescue another rival later. "If we're going to do this deal, where does it end?" he said.
As McDade discussed Lehman's position, Thain had an epiphany: "This could be me sitting here next Friday."
Thain pushed his chair back and left the group to caucus with top Merrill officers. "Lehman is not going to make it," he told them.
Thain stepped to a sidewalk behind the New York Fed and called the Bank of America chief at his home in Charlotte. "I can be there in a few hours," Lewis said.
Members of Bank of America's deal team, exhausted from scrutinizing Lehman's books, had just landed in Charlotte. Lewis ordered them back to New York.
Up in Lehman's midtown office, Fuld was also dialing Lewis's North Carolina home. His calls went unreturned. "I can't believe that son of a bitch won't return my calls," he told a top adviser.
Lehman's bankruptcy team, meanwhile, was rolling into action. Shortly before noon, Miller, the Weil Gotshal bankruptcy head, sent an email to several partners. Lehman's name didn't appear in the email. Its subject line read: "Urgent. Code name: Equinox. Have desperate need for help on an emergency situation."
Throughout the day, Miller's attorneys, working with Federal Reserve officials and their attorneys, began seeking information from Lehman. But with Lehman's top officials tied up at the Fed and in Barclays negotiations, the lawyers were hard-pressed to get the details they needed.
"We were a distraction to the Lehman people," said Lori Fife, a Weil partner. "It felt like it was just a fire drill."
Later that afternoon, Merrill's chief executive met Bank of America's CEO, Lewis, in the bank's corporate apartment in the Time Warner Center. In a one-on-one meeting overlooking Central Park, the two men agreed that it looked like Lehman would be forced into bankruptcy.
Thain made his opening offer. "How about buying a 9.9 percent stake" in Merrill, he proposed.
Lewis said the bank doesn't tend to buy minority stakes. He suggested Bank of America could buy the whole firm.
"I am not here to sell Merrill Lynch," Thain responded.
"Well, that is what I want," Lewis countered.
The two parted with an agreement to keep talking.
Lehman's talks with Barclays, meanwhile, were moving forward at the New York Fed, under the eye of government officials. "Shouldn't I be there?" Fuld said to Lehman President Mr. McDade and to attorney Rodgin Cohen of Sullivan & Cromwell LLP, a longtime adviser.
What Fuld appeared not to know was that some top government officials had instructed key Lehman representatives at the Fed building to keep Fuld away that weekend. The federal officials had explained that Fuld -- not only Wall Street's longest-serving boss, but a director of the New York Fed -- could be an unnecessary distraction and a lightning rod for criticism.
At the Fed meetings, much of the talk was on the sidelines. When Thain returned to the New York Fed from his discussions with Lewis, Merrill advisers told him they had been approached by top Goldman executives. The rival house was interested in taking a 9.9 percent stake in Merrill and offered to extend a $10 billion line of credit.
Thain was digesting the news when he was approached by Mack of Morgan Stanley. "We should talk," Mack said. The bosses of Merrill and Morgan agreed to meet that evening. Soon, Thain and two advisers were en route to the Upper East Side apartment of a Morgan co-president.
Thain drank a Diet Coke as the Morgan and Merrill executives talked. Both sides felt there were benefits to merging. Thain indicated he needed a deal quickly. The meeting ended without a firm plan. "We have a board meeting Tuesday and can get back to you soon," Mack said before the group broke up.
As Thain and his advisers left the apartment, the Merrill chief suggested he had faint hopes for a deal with Morgan Stanley. "I don't think they share our sense of urgency," he said.
Merrill's talks with Bank of America, however, were on track at the bank's law firm, Wachtell Lipton. Merrill's team was camped out on Wachtell's 34th floor. Bank of America's team was on the 33rd. Around midnight, Lewis left the law firm for his apartment in the Time Warner Center. Pizza arrived at Wachtell at 3 a.m.
At Lehman's offices that evening, Fuld still hadn't heard back from Lewis. Attorneys from Weil were poring through documents, drawing up what would be the largest bankruptcy in U.S. history.
But in a rare piece of good news for Lehman, Barclays had agreed to buy Lehman, as long as it didn't have to take on its soured real-estate assets. Lehman's asset-management division would also be spun off. The Fed indicated that a syndicate of banks and brokers had agreed in principle to put up enough capital to support a separate company that would hold Lehman's bad real-estate assets.
Sunday, Sept. 14
A few hours later, at 8 a.m., Thain arrived at the Time Warner Center for a second one-on-one meeting in Lewis's corporate apartment. Over coffee, Thain made his case for a strong price for Merrill despite its stock's recent fall.
At the same time, Merrill officials were huddled with Goldman bankers. Some members of Merrill's team doubted that Goldman could save their firm by taking a 9.9 percent stake. Pete Kelly, a top Merrill lawyer, also had his reservations about letting rival Goldman see his firm's books. Still, the sides set a late-morning meeting at Merrill's offices.
At 9 a.m., the chiefs of finance arrived again at the New York Fed for a second day of meetings. By the time Thain arrived, the Merrill chief had a number of options in his back pocket.
Rolling up to the meetings at around the same time was Goldman's chief, Blankfein. A Goldman aide, referring to days of meltdowns and meetings, carped to Blankfein: "I don't think I can take another day of this."
Blankfein retorted: "You're getting out of a Mercedes to go to the New York Federal Reserve -- you're not getting out of a Higgins boat on Omaha Beach," he said, referring to the World War II experience of a former Goldman head. "So keep things in perspective."
At Lehman that morning, Fuld told his board of directors to gather at the firm's offices. By noon, he expected, the board would be able to approve Lehman's sale to Barclays.
One hurdle remained: To ink a Lehman deal, Barclays needed a shareholder vote. There was no way to get one on a Sunday. Barclays would need the U.S. or British government to back Lehman's trading balances until a vote could be held.
Government approval never came, though there are diverging views on why. Some blame the U.S. government for refusing to commit resources. Others say the British government refused to entertain a deal they worried would expose England to unnecessary risk.
Lehman's president, McDade, and Cohen, the attorney, called Fuld from the New York Fed. Passing McDade's cellphone back and forth, they broke the Barclays news.
Fuld postponed his board meeting. He made one more call to Charlotte, answered by Lewis's wife.
By midafternoon, word emerged that Bank of America was in talks with Merrill Lynch. Cohen, the attorney, broke the news to Fuld. "I guess this confirms our worst fears," Fuld said.
At the Fed, the Lehman executives and their bankruptcy attorneys faced roughly 25 officials from the Fed, Treasury and SEC. The Lehman officials pleaded for federal aid to keep Lehman afloat. But with Barclays and Bank of America off the table, Federal officials wanted a plan in place to soothe markets before trading opened in Asia.
A senior Fed official asked Miller, the Weil veteran who'd been involved in bankruptcy filings of companies including Bethlehem Steel and Marvel Entertainment, if Lehman was ready to file.
"No," Miller answered.
"You need more of a plan to prepare to do this," Miller continued. Lehman had tens of billions of dollars in derivative positions with countless parties. Unless these trades were unwound in an orderly way, it could shock all corners of the financial market. "This will cause financial Armageddon," he said.
Now, Merrill's Thain needed his own deal more than ever. With a Morgan tie-up looking like a long shot, Merrill focused its attentions on Goldman and Bank of America.
Tempers at Merrill flared as two rival teams pored over the firm's records. Merrill's head of strategy Peter Kraus, a Goldman alumnus hired by Thain, wanted to pull some of the firm's due-diligence staff away from the Bank of America project to look at Goldman's offer. "We need some people down here," Kraus said.
"We have a great deal in hand, and need to finish doing this deal," retorted Fleming, Merrill's president. A few minutes later, Thain called Fleming, telling him to send some people to work on the Goldman offer.
Fleming and Bank of America's lead negotiator, Curl, hammered out a price. Bank of America would buy Merrill for $29 a share.
Fleming informed Thain. At 6 p.m., Merrill's top managers and directors gathered in person and by phone.
"When I took this job this was not the outcome I intended," Thain told directors. After the board meeting broke up after 8 p.m., Thain called the chief of Bank of America. "The decision was unanimous," Thain told Mr. Lewis. "You have a deal."
A more somber scene was playing out at Lehman. Directors, who had been camped at the Midtown offices all day, gathered at around 8 p.m. in the firm's board room. Weil lawyers and Lehman executives summarized the Fed meeting to the frustrated board.
"They bailed out Bear," said Roland Hernandez, the former CEO of Spanish-language TV network Telemundo and a longtime Lehman board member. "Why not us?"
One of Fuld's assistants broke in to hand him a note: The SEC chairman wanted to address Lehman's board by speakerphone.
Cox, criticized for his allegedly minor role in the government's bailout of Bear Stearns, had been reluctant to call Lehman. The SEC chief finally called from the New York Fed, surrounded by several staffers, at the urging of Mr. Paulson, the Treasury secretary.
"This is serious," said Cox. "The board has a grave matter before it," he said.
John D. McComber, a former president of the Export-Import Bank and a Lehman director for 14 years, asked: "Are you directing us to authorize" a bankruptcy filing?
The SEC chief muted his phone. A minute later, he came back on the line. "You have a grave responsibility and you need to act accordingly," he replied.
As the meeting wrapped up around 10 p.m., Fuld, his suit jacket now off, leaned back in his chair. "I guess this is goodbye," he said. Lehman would file about four hours later.
Just a few blocks away, Merrill and Bank of America executives met to toast their deal. "I look forward to a great partnership with Merrill Lynch," Lewis said around midnight, a glass of champagne in hand.
The End
Rather than soothing markets, Lehman's bankruptcy filing roiled them -- slamming trading partners that had direct exposure to the firm and sowing fears that Wall Street's remaining giants weren't safe from failure. Shares of Morgan and Goldman plunged. In the credit-default swap market, the price of insurance against defaults of Morgan and Goldman soared.
Hedge funds sought to withdraw more than $100 billion in assets from Morgan Stanley. The firm's clearing bank, Bank of New York Mellon, wanted an extra $4 billion in collateral.
Morgan's chief, Mr. Mack, negotiated a cash infusion from Japan's Mitsubishi UFJ Financial Group. Fed and Treasury officials, concerned that a deal could be derailed by a declining Morgan share price, asked if Mack had other options. One regulator suggested Morgan Stanley consider selling itself to J.P. Morgan -- from which it had been famously split, 73 years earlier, amid post-Depression banking reform laws.
"We're going to get Mitsubishi done. There is no Plan B," Mack told one regulator.
Morgan did the deal. But investor fears remained. By Thursday, Fed officials were urging Morgan to become a commercial bank. Such a move would require Morgan to scale back its bets with borrowed money, run the risk of selling lucrative business lines and accept new onsite regulation from the Fed.
Mack consented, and the following weekend, Morgan Stanley formally ceased to be a securities firm.
The same weekend, Blankfein convened top lieutenants on his 30th-floor office. After 139 years as a securities firm, he said, Goldman, too, would also reshape itself as a commercial bank. Within hours, the era of Wall Street's giants was over.
Lehman Brothers Holdings Inc. Chief Executive Richard S. Fuld Jr., wearing tie, is heckled by protesters in October as he leaves Capitol Hill in Washington after testify before the House Oversight and Government Reform Committee on the collapse of Lehman Brothers.
With his investment bank facing a near-certain failure, Lehman Brothers Holdings Inc.'s chief executive officer, Richard Fuld Jr., placed yet another phone call to the man he thought could save him.
Fuld was already effectively out of options by the afternoon of Sunday, Sept. 14. The U.S. government said it wouldn't fund a bailout for Lehman, the country's oldest investment bank. Britain's Barclays PLC had agreed in principle to buy the loss-wracked firm, but the deal fell apart. Bank of America Corp., initially seen as Lehman's most likely buyer, had said two days earlier that it couldn't do a deal without federal aid -- and by Sunday was deep in secret negotiations to take over Lehman rival Merrill Lynch & Co.
Desperate to avoid steering his 25,000-person company into bankruptcy proceedings, Fuld dialed the Charlotte, N.C., home of Bank of America Chairman Kenneth D. Lewis. His calls so far that weekend had gone unreturned. This time, Lewis's wife, Donna, again picked up, and told the boss of Lehman Brothers: If Lewis wanted to call back, he would call back.
Fuld paused, then apologized for bothering her. "I am so sorry," he said.
Associated Press File Merrill Lynch Chairman and CEO John Thain, left, and Bank of America Chairman and CEO Ken Lewis shake hands following a news conference in New York.
His lament could also have been for the investment-banking model that had come to embody the words "Wall Street." Within hours of his call, Lehman announced it would file for bankruptcy protection. Within a week, Wall Street as it was known -- loosely regulated, daringly risky and lavishly rewarded -- was dead.
As Fuld waged his increasingly desperate bid to save his firm that weekend, the bosses of Wall Street's other three giant investment banks were locked in their own battles as their firms came under mounting pressure. It was a weekend unlike anything Wall Street had ever seen: In past crises, its bosses had banded together to save their way of life. This time, the financial hole they had dug for themselves was too deep. It was every man for himself, and Fuld, who declined to comment for this article, was the odd man out.
For the U.S. securities industry to unravel as spectacularly as it did in September, many parties had to pull on many threads. Mortgage bankers gave loans to Americans for homes they couldn't afford. Investment houses packaged these loans into complex instruments whose risk they didn't always understand. Ratings agencies often gave their seal of approval, investors borrowed heavily to buy, regulators missed the warning signs. But at the center of it all -- and paid hundreds of millions of dollars during the boom to manage their firms' risk -- were the four bosses of Wall Street.
Details of these CEOs' decisions and negotiations, many of them previously unreported, show how they sought to avert the death of America's giant investment banks. Their efforts culminated in a round-the-clock weekend of secret negotiations and personal struggles to keep their firms afloat. Accounts of these events are based on company and other documents, emails and interviews with Wall Street executives, traders, regulators, investors and others.
Summer Clouds
Earlier this year, when the financial crisis claimed its first victim, Bear Stearns Cos., the surviving masters of Wall Street thought the eye of the storm had passed. Bear Stearns, the smallest of Wall Street's big five stand-alone investment banks, imploded just months after bad subprime bets sunk two internal hedge funds. In March 2008, the government brokered Bear Stearns's sale to J.P. Morgan Chase & Co.
After Bear Stearns's brush with death, the Federal Reserve for the first time allowed investment houses to borrow from the government on much the same terms as commercial banks. Many on Wall Street saw investment banks' access to an equivalent of the Fed "discount window" as a blank check should hard times return. But it would also be the first step in giving the government more say over an industry that had until then been lightly regulated.
Associated Press File Lloyd C. Blankfein, of Goldman Sachs,
In April, Morgan Stanley's CEO, John Mack, told shareholders the U.S. subprime crisis was in the eighth or ninth inning. The same month, Goldman Sachs Group Inc.'s chief executive, Lloyd Blankfein, said, "We're probably in the third or fourth quarter" of a four-quarter game.
Mack and Blankfein had some reason to be confident. Mack had been late to steer Morgan into mortgage trading, and relatively early to sell assets and raise cash. Goldman, under Blankfein, had even less direct exposure to subprime investments. Blankfein also took comfort in a stockpile of government bonds and other securities his firm held in case it ran into deep funding problems. By the second quarter, Goldman had increased this store of funds more than 30 percent from earlier in the year, to $88 billion.
Problems were more acute at Merrill Lynch and Lehman.
John Thain, a former Goldman Sachs president and New York Stock Exchange head, had arrived at Merrill Lynch in December 2007. He moved quickly to cut costs, putting the corporate helicopter up for sale and replacing the fresh flowers on a Merrill floor used by nine or so executives -- an estimated annual expense of $200,000 -- with fakes
More monumentally, Thain faced $55 billion in soured mortgage assets that Merrill had acquired under his predecessor. Within weeks of his arrival, he had raised more than $12 billion in much-needed capital, including $5 billion from Singapore's state investment company, Temasek Holdings, at $48 a share.
Some of those early deals would end up being costly. With his would-be investors driving a hard bargain, Thain promised Temasek and others that if Merrill sold additional common stock at a lower price within a year, the firm would compensate them. Within months, after taking a big write-down on a portfolio of mortgage debts that Merrill sold for pennies on the dollar, the firm had to raise more cash at $25 a share. Merrill issued additional shares to pay off its earlier investors, diluting its common shares by 39 percent. The dilution essentially cost shareholders about $5 billion, well above the previously reported $2.5 billion cost of shares issued to Temasek.
Lehman, now the smallest of the major Wall Street firms, also faced billions of dollars in write-downs from bad mortgage-related investments. In June, Lehman reported the first quarterly loss in its 14 years as a public company. Under Fuld, Lehman raised capital. But critics say Fuld was slow to shed bad assets and profitable lines of business. He pushed for better terms with at least one investor that ended up driving it away.
Fuld had faced challenges to his firm before. Since taking Lehman's reins in 1994, he expanded the 158-year-old bond house into lucrative areas such as investment banking and stock trading. Over the years, he had tamped unfounded rumors about the firm's health and vowed to remain independent. "As long as I am alive this firm will never be sold," Fuld said in December 2007, according to a person who spoke with him then. "And if it is sold after I die, I will reach back from the grave and prevent it."
In the summer of 2008, Fuld remained confident, particularly given the security of the Fed's discount window. "We have access to Fed funds," Fuld told executives at the time. "We can't fail now."
Friday, Sept. 12
By Friday, Sept. 12, failure appeared to be an option for Lehman.
Over that week, confidence in Lehman plunged. The firm said its third-quarter losses could total almost $4 billion. Lehman's clearing bank, J.P. Morgan, wanted an extra $5 billion in collateral. Lehman's attempts to raise money from a Korean bank had stalled. Credit agencies were warning that if Lehman didn't raise more capital over the weekend, it could face a downgrade. That would likely force the firm to put up more collateral for its outstanding loans and increase its costs for new loans.
If Fuld couldn't find an investor for Lehman by Sunday night, the fiercely independent boss could be forced to steer his firm into bankruptcy proceedings.
Earlier that week, Fuld had approached Bank of America's Lewis about buying Lehman. A U.S. Treasury official, meanwhile, had contacted Barclays of Britain to suggest it consider taking a stake in Lehman. Fuld's top executives spent Friday shuttling between the two suitors' law firms.
Lehman was also exploring a third option: The night before, veteran bankruptcy lawyer Harvey Miller of Weil, Gotshal & Manges had secretly begun cobbling together a bare-bones bankruptcy filing for the firm.
Lehman's troubles were putting the rest of Wall Street on notice.
In a Merrill Lynch conference room in downtown Manhattan that morning, Thain was on a call with Merrill's board of directors, discussing how to address the chaos. "Lehman is going down, and the [short sellers] are coming after us next," warned Merrill director John Finnegan. "Tell me how this story is going to end differently."
Merrill would be fine, Thain said. "We are not Lehman," he responded, noting the firm held valuable assets, including its stake in BlackRock, a profitable asset-management firm.
But Merrill's clients, too, were beginning to pull out money. The firm's stock was sinking. Executives, including Merrill President Gregory Fleming, were nervous.
Fleming believed he'd identified the ideal partner for Merrill. Bank of America, with a strong balance sheet and retail operations, would mesh well with Merrill's securities franchise and 16,000-strong brokerage force. Fleming worried that Bank of America could buy Lehman instead.
Fleming called a long-time lawyer for Bank of America, Edward Herlihy of Wachtell, Lipton, Rosen & Katz. "You have to talk to us," Fleming said. He was told that Merrill's Thain would have to approach Bank of America's Lewis. "I know," Fleming responded. "I'm gonna try."
At 5 p.m. Friday, after a day of massive client withdrawals at Lehman, Thain's phone rang. It was the Treasury. "Be at the Fed at 6 p.m.," Thain was told.
Soon after, Thain gathered along with Morgan's Mack and Goldman's Blankfein at the New York Federal Reserve in downtown Manhattan, in a room once used to cash coupons on Treasury bills. The three men were greeted by the masters of the world's biggest economy -- Federal Reserve Chairman Ben Bernanke, Treasury Secretary Henry Paulson, New York Fed Chief Timothy Geithner and Securities and Exchange Commission chief Christopher Cox. It was a signal moment for the Wall Street firms, which after years of being monitored by the SEC would all soon come under the regulatory watch of a newly powerful Fed.
The federal officials told the Wall Street chiefs to return in the morning. If the mess at Lehman could be fixed, it would be the job of the Wall Street bosses. There would be no public bailout.
An industry-led solution wouldn't be without precedent. In the market panic of 1907, financier J.P. Morgan persuaded fellow bankers to help fund a bailout for failing rivals. Competitors united again in 1998, putting up money to insulate the financial system from the failure of hedge fund Long Term Capital Management.
But now, Fuld's problems at Lehman were possibly beyond repair.
By that night, Bank of America's team had concluded that Lehman's real-estate portfolio was worse than expected -- and as a result, the firm's liabilities likely exceeded its assets. "We need government assistance, and we are not getting it," the bank's top deal maker, Greg Curl, told his group. Some of the negotiators prepared to fly back early the next morning to headquarters in Charlotte.
Lewis hadn't come to New York for the Lehman talks. He called Fuld from Charlotte, telling him that Bank of America couldn't do a deal without federal help. "We will keep a team in New York in case things change," Lewis told him.
Saturday, Sept. 13
Fuld arrived at Lehman's office at 7 a.m. on Saturday, wearing a blue suit and tie. The talks with Barclays were still moving. If the government could be moved, there could also be hope for a Bank of America deal.
Merrill, meanwhile, was beginning its own pursuit of Bank of America.
At his home in Rye, N.Y., Thain was getting dressed for a day at the New York Fed when his phone rang. It was Merrill's president, Fleming.
"John, you really need to call Ken Lewis," Fleming said.
"Get me his number," said Thain, who added it to his papers for the day.
Thain's black SUV pulled up in front of the New York Fed just before 8 a.m. Top executives from all four investment banks -- minus Lehman's Fuld -- were there.
Federal officials broke Thain, Mack and Blankfein and their top aides into groups. One studied the potential fallout from a Lehman failure. Another was charged with putting a value on Lehman's controversial real-estate investments. A third group, which included Thain and Morgan's Mack, was supposed to discuss an industry-led bailout for Lehman.
Lehman's president, Bart McDade, walked the group through the embattled firm's books. McDade did not respond to requests for comment for this article.
Mack questioned Wall Street's ability to repair markets. The firms could try to backstop Lehman, he argued, but there was no guarantee they wouldn't have to rescue another rival later. "If we're going to do this deal, where does it end?" he said.
As McDade discussed Lehman's position, Thain had an epiphany: "This could be me sitting here next Friday."
Thain pushed his chair back and left the group to caucus with top Merrill officers. "Lehman is not going to make it," he told them.
Thain stepped to a sidewalk behind the New York Fed and called the Bank of America chief at his home in Charlotte. "I can be there in a few hours," Lewis said.
Members of Bank of America's deal team, exhausted from scrutinizing Lehman's books, had just landed in Charlotte. Lewis ordered them back to New York.
Up in Lehman's midtown office, Fuld was also dialing Lewis's North Carolina home. His calls went unreturned. "I can't believe that son of a bitch won't return my calls," he told a top adviser.
Lehman's bankruptcy team, meanwhile, was rolling into action. Shortly before noon, Miller, the Weil Gotshal bankruptcy head, sent an email to several partners. Lehman's name didn't appear in the email. Its subject line read: "Urgent. Code name: Equinox. Have desperate need for help on an emergency situation."
Throughout the day, Miller's attorneys, working with Federal Reserve officials and their attorneys, began seeking information from Lehman. But with Lehman's top officials tied up at the Fed and in Barclays negotiations, the lawyers were hard-pressed to get the details they needed.
"We were a distraction to the Lehman people," said Lori Fife, a Weil partner. "It felt like it was just a fire drill."
Later that afternoon, Merrill's chief executive met Bank of America's CEO, Lewis, in the bank's corporate apartment in the Time Warner Center. In a one-on-one meeting overlooking Central Park, the two men agreed that it looked like Lehman would be forced into bankruptcy.
Thain made his opening offer. "How about buying a 9.9 percent stake" in Merrill, he proposed.
Lewis said the bank doesn't tend to buy minority stakes. He suggested Bank of America could buy the whole firm.
"I am not here to sell Merrill Lynch," Thain responded.
"Well, that is what I want," Lewis countered.
The two parted with an agreement to keep talking.
Lehman's talks with Barclays, meanwhile, were moving forward at the New York Fed, under the eye of government officials. "Shouldn't I be there?" Fuld said to Lehman President Mr. McDade and to attorney Rodgin Cohen of Sullivan & Cromwell LLP, a longtime adviser.
What Fuld appeared not to know was that some top government officials had instructed key Lehman representatives at the Fed building to keep Fuld away that weekend. The federal officials had explained that Fuld -- not only Wall Street's longest-serving boss, but a director of the New York Fed -- could be an unnecessary distraction and a lightning rod for criticism.
At the Fed meetings, much of the talk was on the sidelines. When Thain returned to the New York Fed from his discussions with Lewis, Merrill advisers told him they had been approached by top Goldman executives. The rival house was interested in taking a 9.9 percent stake in Merrill and offered to extend a $10 billion line of credit.
Thain was digesting the news when he was approached by Mack of Morgan Stanley. "We should talk," Mack said. The bosses of Merrill and Morgan agreed to meet that evening. Soon, Thain and two advisers were en route to the Upper East Side apartment of a Morgan co-president.
Thain drank a Diet Coke as the Morgan and Merrill executives talked. Both sides felt there were benefits to merging. Thain indicated he needed a deal quickly. The meeting ended without a firm plan. "We have a board meeting Tuesday and can get back to you soon," Mack said before the group broke up.
As Thain and his advisers left the apartment, the Merrill chief suggested he had faint hopes for a deal with Morgan Stanley. "I don't think they share our sense of urgency," he said.
Merrill's talks with Bank of America, however, were on track at the bank's law firm, Wachtell Lipton. Merrill's team was camped out on Wachtell's 34th floor. Bank of America's team was on the 33rd. Around midnight, Lewis left the law firm for his apartment in the Time Warner Center. Pizza arrived at Wachtell at 3 a.m.
At Lehman's offices that evening, Fuld still hadn't heard back from Lewis. Attorneys from Weil were poring through documents, drawing up what would be the largest bankruptcy in U.S. history.
But in a rare piece of good news for Lehman, Barclays had agreed to buy Lehman, as long as it didn't have to take on its soured real-estate assets. Lehman's asset-management division would also be spun off. The Fed indicated that a syndicate of banks and brokers had agreed in principle to put up enough capital to support a separate company that would hold Lehman's bad real-estate assets.
Sunday, Sept. 14
A few hours later, at 8 a.m., Thain arrived at the Time Warner Center for a second one-on-one meeting in Lewis's corporate apartment. Over coffee, Thain made his case for a strong price for Merrill despite its stock's recent fall.
At the same time, Merrill officials were huddled with Goldman bankers. Some members of Merrill's team doubted that Goldman could save their firm by taking a 9.9 percent stake. Pete Kelly, a top Merrill lawyer, also had his reservations about letting rival Goldman see his firm's books. Still, the sides set a late-morning meeting at Merrill's offices.
At 9 a.m., the chiefs of finance arrived again at the New York Fed for a second day of meetings. By the time Thain arrived, the Merrill chief had a number of options in his back pocket.
Rolling up to the meetings at around the same time was Goldman's chief, Blankfein. A Goldman aide, referring to days of meltdowns and meetings, carped to Blankfein: "I don't think I can take another day of this."
Blankfein retorted: "You're getting out of a Mercedes to go to the New York Federal Reserve -- you're not getting out of a Higgins boat on Omaha Beach," he said, referring to the World War II experience of a former Goldman head. "So keep things in perspective."
At Lehman that morning, Fuld told his board of directors to gather at the firm's offices. By noon, he expected, the board would be able to approve Lehman's sale to Barclays.
One hurdle remained: To ink a Lehman deal, Barclays needed a shareholder vote. There was no way to get one on a Sunday. Barclays would need the U.S. or British government to back Lehman's trading balances until a vote could be held.
Government approval never came, though there are diverging views on why. Some blame the U.S. government for refusing to commit resources. Others say the British government refused to entertain a deal they worried would expose England to unnecessary risk.
Lehman's president, McDade, and Cohen, the attorney, called Fuld from the New York Fed. Passing McDade's cellphone back and forth, they broke the Barclays news.
Fuld postponed his board meeting. He made one more call to Charlotte, answered by Lewis's wife.
By midafternoon, word emerged that Bank of America was in talks with Merrill Lynch. Cohen, the attorney, broke the news to Fuld. "I guess this confirms our worst fears," Fuld said.
At the Fed, the Lehman executives and their bankruptcy attorneys faced roughly 25 officials from the Fed, Treasury and SEC. The Lehman officials pleaded for federal aid to keep Lehman afloat. But with Barclays and Bank of America off the table, Federal officials wanted a plan in place to soothe markets before trading opened in Asia.
A senior Fed official asked Miller, the Weil veteran who'd been involved in bankruptcy filings of companies including Bethlehem Steel and Marvel Entertainment, if Lehman was ready to file.
"No," Miller answered.
"You need more of a plan to prepare to do this," Miller continued. Lehman had tens of billions of dollars in derivative positions with countless parties. Unless these trades were unwound in an orderly way, it could shock all corners of the financial market. "This will cause financial Armageddon," he said.
Now, Merrill's Thain needed his own deal more than ever. With a Morgan tie-up looking like a long shot, Merrill focused its attentions on Goldman and Bank of America.
Tempers at Merrill flared as two rival teams pored over the firm's records. Merrill's head of strategy Peter Kraus, a Goldman alumnus hired by Thain, wanted to pull some of the firm's due-diligence staff away from the Bank of America project to look at Goldman's offer. "We need some people down here," Kraus said.
"We have a great deal in hand, and need to finish doing this deal," retorted Fleming, Merrill's president. A few minutes later, Thain called Fleming, telling him to send some people to work on the Goldman offer.
Fleming and Bank of America's lead negotiator, Curl, hammered out a price. Bank of America would buy Merrill for $29 a share.
Fleming informed Thain. At 6 p.m., Merrill's top managers and directors gathered in person and by phone.
"When I took this job this was not the outcome I intended," Thain told directors. After the board meeting broke up after 8 p.m., Thain called the chief of Bank of America. "The decision was unanimous," Thain told Mr. Lewis. "You have a deal."
A more somber scene was playing out at Lehman. Directors, who had been camped at the Midtown offices all day, gathered at around 8 p.m. in the firm's board room. Weil lawyers and Lehman executives summarized the Fed meeting to the frustrated board.
"They bailed out Bear," said Roland Hernandez, the former CEO of Spanish-language TV network Telemundo and a longtime Lehman board member. "Why not us?"
One of Fuld's assistants broke in to hand him a note: The SEC chairman wanted to address Lehman's board by speakerphone.
Cox, criticized for his allegedly minor role in the government's bailout of Bear Stearns, had been reluctant to call Lehman. The SEC chief finally called from the New York Fed, surrounded by several staffers, at the urging of Mr. Paulson, the Treasury secretary.
"This is serious," said Cox. "The board has a grave matter before it," he said.
John D. McComber, a former president of the Export-Import Bank and a Lehman director for 14 years, asked: "Are you directing us to authorize" a bankruptcy filing?
The SEC chief muted his phone. A minute later, he came back on the line. "You have a grave responsibility and you need to act accordingly," he replied.
As the meeting wrapped up around 10 p.m., Fuld, his suit jacket now off, leaned back in his chair. "I guess this is goodbye," he said. Lehman would file about four hours later.
Just a few blocks away, Merrill and Bank of America executives met to toast their deal. "I look forward to a great partnership with Merrill Lynch," Lewis said around midnight, a glass of champagne in hand.
The End
Rather than soothing markets, Lehman's bankruptcy filing roiled them -- slamming trading partners that had direct exposure to the firm and sowing fears that Wall Street's remaining giants weren't safe from failure. Shares of Morgan and Goldman plunged. In the credit-default swap market, the price of insurance against defaults of Morgan and Goldman soared.
Hedge funds sought to withdraw more than $100 billion in assets from Morgan Stanley. The firm's clearing bank, Bank of New York Mellon, wanted an extra $4 billion in collateral.
Morgan's chief, Mr. Mack, negotiated a cash infusion from Japan's Mitsubishi UFJ Financial Group. Fed and Treasury officials, concerned that a deal could be derailed by a declining Morgan share price, asked if Mack had other options. One regulator suggested Morgan Stanley consider selling itself to J.P. Morgan -- from which it had been famously split, 73 years earlier, amid post-Depression banking reform laws.
"We're going to get Mitsubishi done. There is no Plan B," Mack told one regulator.
Morgan did the deal. But investor fears remained. By Thursday, Fed officials were urging Morgan to become a commercial bank. Such a move would require Morgan to scale back its bets with borrowed money, run the risk of selling lucrative business lines and accept new onsite regulation from the Fed.
Mack consented, and the following weekend, Morgan Stanley formally ceased to be a securities firm.
The same weekend, Blankfein convened top lieutenants on his 30th-floor office. After 139 years as a securities firm, he said, Goldman, too, would also reshape itself as a commercial bank. Within hours, the era of Wall Street's giants was over.
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