Source: WSJ
Treasury Secretary Timothy Geithner is expected to announce that the government will become a partner with the private sector to purchase banks' troubled assets, according to people familiar with the matter.
The plan for a so-called aggregator bank, a variation on a theme that Obama administration officials have wrestled with for weeks, is among four main components of Mr. Geithner's bailout revamp, which he is expected to announce Tuesday.
The effort to restore confidence to the financial system comprises a broad range of tools and government agencies. It includes fresh cash injections into banks; new programs to help possibly 2.5 million struggling homeowners; a significant expansion of a Federal Reserve program designed to jump-start consumer lending; and, lastly, the mechanism to allow banks to get rid of bad assets.
The administration's plans have evolved over the past several weeks as it has considered and discarded a host of ideas, with financial markets anxiously awaiting details. Mr. Geithner had planned an announcement Monday but delayed it a day to allow the focus to remain on the stimulus bill in Congress.
The aggregator bank, which some refer to as a "bad bank," would be designed to solve a fundamental challenge: How can banks purge themselves of their bad bets without worsening their weakened condition?
The entity would be seeded with funds from the $700 billion financial-sector bailout fund, but the idea is that most financing would come from the private sector. Some critical elements remained unclear, including exactly how the government would entice investors to participate in the private bank, given that they can already buy soured assets on the open market if they want to. The government will likely offer some type of incentive, such as limiting the risk associated with buying the assets.
The administration hasn't settled on exactly how it will work and intends to hash out the structure with the private sector over the next few weeks, the people familiar with the matter said. Investors would likely buy a stake in the entity, which would then buy mortgage-backed securities and other troubled assets.
The government would also be an investor, but the terms aren't yet decided. The entity might also raise funds by selling government-backed debt or through financing from the Fed, the people familiar with the matter said.
The Obama administration views the private bank as a way to get around the thorny issue of having to determine a price for soured assets such as certain mortgage-backed securities, many of which are illiquid and hard to value. The government has long worried that if it bought toxic assets and paid too much for them, banks would benefit at the expense of taxpayers -- while if the price was too low, it would force banks to take further write-downs and exacerbate their woes.
The Treasury's working theory for the government/private-sector partnership is that investors wouldn't overpay, because if they did, they'd stand to lose money; but they also wouldn't underpay, since the selling banks wouldn't be willing to part with their assets too cheaply.
Bankers and investors cautiously welcomed the idea, saying it could help avoid more large-scale federal intrusions into the financial sector while tackling the bad-asset problem. Brian Sterling, co-head of investment banking for advisory firm Sandler O'Neill & Partners, called the idea an "interesting tool" worth exploring.
"We think that anything that helps facilitate taking nonperforming assets off bank balance sheets or putting a ringfence around them is a good thing," Mr. Sterling said. Some investors expressed concern about joining with the government in such an arrangement if the rules of engagement weren't guaranteed to remain consistent.
Executives at J.P. Morgan Chase & Co. have been cool to the idea of selling assets into a "bad bank" structure. They believe it may be wiser to hold on to sour assets that have already been written down, in the hope the bank can recoup losses when markets revive.
Many of the administration's ideas appear to build on policies begun under former Treasury Secretary Henry Paulson, whose handling of the bailout helped tar its reputation among lawmakers and the public. Mr. Paulson's plan initially envisioned buying toxic assets but shifted to having the government inject cash into banks in return for preferred stock. Many of the housing ideas under consideration also stem from work done in the Bush administration, illustrating the constrained range of options.
Mr. Geithner is expected to sell the program as a break with the past, pitching it as a comprehensive framework to address the root causes of the financial crisis: defaulting loans and soured assets that are shaking confidence in banks.
Other likely elements of the plan, subject to last-minute changes, include:
An expansion of the Fed's Term Asset-Backed Securities Loan Facility to include assets beyond the student-loan, auto-loan and credit-card debt it was set up to absorb. Under the revamp, the so-called TALF is likely to buy securities backed by commercial real estate and possibly other assets as well. The program was set up during the Bush administration to spur the consumer-loan market by providing financing for investors to buy securities backed by such loans.
A second round of cash injections in financial firms but with tougher terms, such as a requirement to modify troubled mortgages and better track the federal funds. The government is looking to get money into banks by buying preferred shares that convert into common shares in seven years; the idea is to avoid diluting current shareholders' stakes while helping banks better withstand losses. The Treasury may also allow banks that have already received capital to convert the Treasury's preferred shares to common stock over time.
Dow Jones Newswires columnist Simon Constable finds out from MarketBeat blogger David Gaffen what U.S. Treasury Secretary Timothy Geithner is expected to unveil in his new plans to fix the financial crisis.
Giving the Federal Deposit Insurance Corp. power to help dismantle troubled financial firms beyond the depository institutions over which it now has authority. This could require legislation.
Mr. Geithner, his predecessor Mr. Paulson and Fed Chairman Ben Bernanke have said there needs to be a government entity empowered to wind down failed financial institutions that aren't banks. Regulators have said one problem the government faced when Lehman Brothers Holdings Inc. and American International Group Inc. ran into trouble was that no federal body had authority to step in and steer the firms toward an orderly demise.
Having the FDIC guarantee a wider range of debt that banks issue to fund loans is also a likely element of the plan, said people familiar with the matter. The guarantees could help free up credit to both companies and consumers. Currently, the FDIC temporarily backs certain debt with a three-year maturity. Government officials could increase this to maturities up to 10 years.
More help for homeowners, at a cost of between $50 billion and $100 billion. The administration is expected to create national standards for loan modifications that would be adopted by mortgage giants Fannie Mae and Freddie Mac. The plan could include a mechanism to determine the value of homes facing foreclosure, which could speed negotiations with borrowers. The difficulty of valuing such homes is one reason many loan-modification efforts have stalled.
A related move would see the government using taxpayer dollars to give mortgage companies an incentive to modify loans. One idea would help reduce interest rates for consumers by having the government match mortgage companies' interest-rate reductions to some degree. For instance, if a mortgage company agreed to shave one point off the rate on a loan, the government might match that so the rate would be reduced by two points. Mr. Geithner is also expected to express support for legislation that would allow judges to modify the terms of mortgages in bankruptcy court.
A public-relations makeover. To improve the bailout's poor image, which owes partly to the shifting nature of the government's remedies, the administration is considering renaming the $700 billion Troubled Asset Relief Program and making it independent of the Treasury. The U.S. is going to announce new terms and conditions for companies that receive or have already taken government aid -- in addition to the new executive-compensation limits announced this week -- including a demand that they report how the money is being spent.
Showing posts with label Banking crisis. Show all posts
Showing posts with label Banking crisis. Show all posts
Sunday, March 01, 2009
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.
Wednesday, October 15, 2008
A Short Banking History of the United States
Source: WSJ, by John Steele Gordon
We are now in the midst of a major financial panic. This is not a unique occurrence in American history. Indeed, we've had one roughly every 20 years: in 1819, 1836, 1857, 1873, 1893, 1907, 1929, 1987 and now 2008. Many of these marked the beginning of an extended period of economic depression.
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The Granger CollectionPresident Andrew Jackson destroying the Bank of the United States. Lithograph, 1828.
How could the richest and most productive economy the world has ever known have a financial system so prone to periodic and catastrophic break down? One answer is the baleful influence of Thomas Jefferson.
Jefferson, to be sure, was a genius and fully deserves his place on Mt. Rushmore. But he was also a quintessential intellectual who was often insulated from the real world. He hated commerce, he hated speculators, he hated the grubby business of getting and spending (except his own spending, of course, which eventually bankrupted him). Most of all, he hated banks, the symbol for him of concentrated economic power. Because he was the founder of an enduring political movement, his influence has been strongly felt to the present day.
Consider central banking. A central bank's most important jobs are to guard the money supply -- regulating the economy thereby -- and to act as a lender of last resort to regular banks in times of financial distress. Central banks are, by their nature, very large and powerful institutions. They need to be to be effective.
Jefferson's chief political rival, Alexander Hamilton, had grown up almost literally in a counting house, in the West Indian island of St. Croix, managing the place by the time he was in his middle teens. He had a profound and practical understanding of markets and how they work, an understanding that Jefferson, born a landed aristocrat who lived off the labor of slaves, utterly lacked.
Hamilton wanted to establish a central bank modeled on the Bank of England. The government would own 20% of the stock, have two seats on the board, and the right to inspect the books at any time. But, like the Bank of England then, it would otherwise be owned by its stockholders.
To Jefferson, who may not have understood the concept of central banking, Hamilton's idea was what today might be called "a giveaway to the rich." He fought it tooth and nail, but Hamilton won the battle and the Bank of the United States was established in 1792. It was a big success and its stockholders did very well. It also provided the country with a regular money supply with its own banknotes, and a coherent, disciplined banking system.
But as the Federalists lost power and the Jeffersonians became the dominant party, the bank's charter was not renewed in 1811. The near-disaster of the War of 1812 caused President James Madison to realize the virtues of a central bank and a second bank was established in 1816. But President Andrew Jackson, a Jeffersonian to his core, killed it and the country had no central bank for the next 73 years.
We paid a heavy price for the Jeffersonian aversion to central banking. Without a central bank there was no way to inject liquidity into the banking system to stem a panic. As a result, the panics of the 19th century were far worse here than in Europe and precipitated longer and deeper depressions. In 1907, J.P. Morgan, probably the most powerful private banker who ever lived, acted as the central bank to end the panic that year.
Even Jefferson's political heirs realized after 1907 that what was now the largest economy in the world could not do without a central bank. The Federal Reserve was created in 1913. But, again, they fought to make it weaker rather than stronger. Instead of one central bank, they created 12 separate banks located across the country and only weakly coordinated.
No small part of the reason that an ordinary recession that began in the spring of 1929 turned into the calamity of the Great Depression was the inability of the Federal Reserve to do its job. It was completely reorganized in 1934 and the U.S. finally had a central bank with the powers it needed to function. That is a principal reason there was no panic for nearly 60 years after 1929 and the crash of 1987 had no lasting effect on the American economy.
While the Constitution gives the federal government control of the money supply, it is silent on the control of banks, which create money. In the early days they created money both through making loans and by issuing banknotes and today do so by extending credit. Had Hamilton's Bank of the United States been allowed to survive, it might well have evolved the uniform regulatory regime a banking system needs to flourish.
Without it, banking regulation was left to the states. Some states provided firm regulation, others hardly any. Many states, influenced by Jeffersonian notions of the evils of powerful banks, made sure they remained small by forbidding branching. In banking, small means weak. There were about a thousand banks in the country by 1840, but that does not convey the whole story. Half the banks that opened between 1810 and 1820 had failed by 1825, as did half those founded in the 1830s by 1845.
Many "wildcat banks," so called because they were headquartered "out among the wildcats," were simple frauds, issuing as many banknotes as they could before disappearing. By the 1840s there were thousands of issues of banknotes in circulation and publishers did a brisk business in "banknote detectors" to help catch frauds.
The Civil War ended this monetary chaos when Congress passed the National Bank Act, offering federal charters to banks that had enough capital and would submit to strict regulation. Banknotes issued by national banks had to be uniform in design and backed by substantial reserves invested in federal bonds. Meanwhile Congress got the state banks out of the banknote business by putting a 10% tax on their issuance. But National banks could not branch if their state did not allow it and could not branch across state lines.
Unfortunately state banks did not disappear, but proliferated as never before. By 1920, there were almost 30,000 banks in the U.S., more than the rest of the world put together. Overwhelmingly they were small, "unitary" banks with capital under $1 million. As each of these unitary banks was tied to a local economy, if that economy went south, the bank often failed. As depression began to spread through American agriculture in the 1920s, bank failures averaged over 550 a year. With the Great Depression, a tsunami of bank failures threatened the collapse of the system.
The reorganization of the Federal Reserve and the creation of the Federal Deposit Insurance Corporation hugely reduced the number of bank failures and mostly ended bank runs. But there remained thousands of banks, along with thousands of savings and loan associations, mutual savings banks, and trust companies. While these were all banks, taking deposits and making loans, they were regulated, often at cross purposes, by different authorities. The Comptroller of the Currency, the Federal Reserve, the FDIC, the FSLIC, the SEC, the banking regulators of the states, and numerous other agencies all had jurisdiction over aspects of the American banking system.
The system was stable in the prosperous postwar years, but when inflation took off in the late 1960s, it began to break down. S&Ls, small and local but with disproportionate political influence, should have been forced to merge or liquidate when they could not compete in the new financial environment. Instead Congress made a series of quick fixes that made disaster inevitable.
In the 1990s interstate banking was finally allowed, creating nationwide banks of unprecedented size. But Congress's attempt to force banks to make home loans to people who had limited creditworthiness, while encouraging Fannie Mae and Freddie Mac to take these dubious loans off their hands so that the banks could make still more of them, created another crisis in the banking system that is now playing out.
While it will be painful, the present crisis will at least provide another opportunity to give this country, finally, a unified banking system of large, diversified, well-capitalized banking institutions that are under the control of a unified and coherent regulatory system free of undue political influence.
Saturday, September 15, 2007
Understanding the impact of credit market problems on the macroeconomy
Banks' New Credit Austerity To Help Set Economy's Path, by David Wessel, WSJ:
The outlook for the U.S. economy turns on two factors: One is how much worse the nation's housing market gets. ... The other is how much of the continuing disturbance in financial markets infects the rest of the economy. ...
The key is what banks will do and how much impact it will have. There's irony in that because ... banks have become increasingly less important players.
In the old days, banks made loans carefully -- because they got burned if the borrower didn't repay. ... Today, banks make loans, turn many of them into securities, and sell them to investors, pocketing the fees. Someone else gets burned if the borrower defaults. ...
But, it turns out, banks may not have unloaded as much of the risk as they thought. And that's the rub.
Wall Street firms and commercial banks ... hold about $250 billion in bridge loans made to finance acquisitions -- loans they intended to lay off in markets that are no longer quite so interested in them. The banks may be stuck with those merger loans. ...
Then there's the mushrooming problem -- one hardly anyone saw coming -- of entities called structured investment vehicles and conduits. Many of them hold subprime mortgages and related securities, and counted on selling more than $1 trillion in short-term IOUs called commercial paper to finance their holdings. Investors no longer want that commercial paper.
So what do these entities do now? They turn to U.S. and European banks, some of which sponsored the conduits, and remind them of the commitments the banks made to provide credit if the commercial-paper market dried up. ...
Suddenly, banks find themselves with all sorts of unanticipated loans on their books. So what? In the antiseptic language of central bankers, Mr. Bernanke explained, "These banks" -- the ones stuck with merger loans they didn't intend to hold and those providing backup lines of credit to conduits -- "have become more protective of their liquidity and balance-sheet capacity." They are hoarding cash or buying short-term Treasurys, and that means making fewer new loans. ...
Saddled with loans to finance mergers or back-stop conduits that can't sell commercial paper, banks are likely to be less willing to lend to ordinary consumers and businesses or, at the very least, will be charging more for those loans. So, consumers and businesses are likely to borrow a little less -- and spend a little less -- and a financial disturbance could be transmitted through the banking system to the rest of the economy.
No wonder there's growing worry the U.S. is going to slide into recession. ...
As if that wasn't enough, there's another layer: Everyone knows banks have a lot of loans on their books that they'd like to sell, but can't -- or won't at today's prices. So some deep-pocketed speculators, the ones who buy when prices plummet and then help bring them back up, are waiting for prices to fall further. And that increases the risk of a prolonged period of financial market turmoil which, in turn, increases the risks to the rest of the economy which, in turn, makes bankers -- understandably -- a little more wary about lending.
The issue isn't whether all this is happening. It is. The issue is how big an impact banks' behavior will have on the economy. ...
No doubt it will be one of the big issues on the table when Mr. Bernanke and his colleagues meet next week to ponder how much to cut interest rates to offset the markets' tightening of the credit spigot.
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