The Devil's Casino (28 page)

In other words, Hank Paulson was out of friends on Capitol Hill.

On the Tuesday afternoon after Dimon’s lunch at the Fed, Dimon instructed his investment banking chief, Steve Black, to call Dick Fuld. The gist of the call, Black later said, was to gently warn Fuld that unless he could find a buyer fast, Lehman had to start thinking in terms of arranging a Long-Term Capital Management style rescue.

And by the way, JPMorgan Chase was going to need another $5 billion in collateral.

When Lehman’s senior management heard about JP Morgan’s collateral calls they went berserk. After consulting with McDade, Fuld decided there was only one way he could survive: He would preannounce Lehman’s earnings results and launch SpinCo into the world in hopes of placating the market.

One person involved explained it this way: “In terms of capital, the feeling was that we would have a capital hole at the time we did SpinCo, which would have been in the first quarter of 2009. But we had the time between then and the first quarter of the next year. . . . We could either fill it with the sale of Neuberger, which nobody wanted to do, . . . or get people to put money into the firm. So we sort of felt we had a fallback position on someone saying, ‘ Ah, but you won’t have enough capital if you do SpinCo.’ We thought SpinCo may take $8 billion. So when the plan was put together by Bart, there was a feeling that ‘ Boy, it sounds pretty good. ‘ And the theory would be that at the time of our earnings in September, we would go through the whole plan, and people would say, ‘Wow.’ ”

On September 10 at 8 A.M. Eastern time, Fuld delivered his announcement in a conference call to investors. From around the world, Lehman’s 25,000 employees listened in with countless others, and knew this was a historic moment. “I heard his voice and it was so tired, and it was cracking—and I just knew this is over,” said a London-based managing director who was listening in on his cell phone while waiting for a flight.

“So today, we’ re taking a number of necessary actions,” Fuld began. “Here’s the summary: We put a concrete plan in place to exit the vast majority of our commercial real estate; we are reducing our residential and leveraged loan exposures down to appropriate operating levels; we are in the final stages of raising capital with sale of a majority stake in
IMD
[the investment managing division], strengthening our capital base—as we strengthened our capital base in June, protected our liquidity, and are cutting our dividend; we reshaped our human capital and product [set expense base] to these changing markets; lastly, we implemented a series of management changes, some of which you saw in the last couple of days. Taken together, these actions have quickly derisked and resized the firm. Let me just go through each in more detail:

“Today we announced a plan to separate a vast majority of our commercial real estate assets from our core business by spinning off those assets to our shareholders and to an independent, publicly traded entity which will be adequately capitalized. The spin-off improves our balance sheet while preserving value for our shareholders. The spin-off entity will be able to manage its assets for economic value maximization over a longer time horizon, given the fact that it will not be a mark-to-market entity, but rather use held-to-maturity accounting. This will preserve economic value for our shareholders.”

Then, Ian Lowitt laid out the details of SpinCo, while the banking analysts on the call waited for someone to ask the obvious question: Since Lehman had not sold NeubergerBerman (talks were still ongoing with the private equities firms Bain Capital and Hellman & Friedman), how was SpinCo going to be financed?

Within the firm’s senior management there had been debate—throughout the night, right up to the moment of the call—as to what Lowitt should say when asked this inevitable question. Lowitt had not got much sleep because of the continual back-and-forth over
exactly
what words he should use. McDade had insisted it would be disastrous to convey to the market the lack of certainty over the execution of their plan, even though the reality was that Lehman hadn’t yet tied up all of SpinCo’s numerous loose ends.

After Lowitt had laid out the company’s plans and opened the call to questions, Deutsche Bank analyst Mike Mayo asked the big question: “To the extent you might need $7 billion to capitalize that entity and [assuming] you will get $3 billion with the spin-off part of
IMD
, how would you get the other $4 billion?”

Lowitt replied: “We don’t feel that we need to raise that extra amount to cover the seven because you will have less leverageable equity in core Lehman than in, you know, where you are at the end of this quarter.”

In other words, he didn’t have a good answer.

The market’s response was indeed “Wow!”—just not in the way Lehman had hoped.

A close friend of Dick Fuld, who does not want to be named, shook his head when he heard the announcement. “Dick’s just highlighted the wart at the end of his nose,” he said to himself.

Mayhem ensued. As the
Wall Street Journal
later reported: “By the following day, Sept. 11, the price of Lehman’s credit-default swaps—the cost to protect against losses on $10 million of its debt for five years—had soared to $800,000 a year, from $219,000 at the end of May. Clients began calling and emailing Lehman to get their money out. Lehman scrambled to comply so as not to betray weakness.”

JPMorgan Chase was worried about holding lending positions with Lehman if the firm collapsed. For the past week, Morgan had been advancing collateralized lending to the tune of at least $100 billion a day, so that Lehman could stay in business. By the night of September 11, though, Morgan froze $17 billion of Lehman’s cash and securities. Jane Buyers Russo, head of JPMorgan’s broker-dealer unit, phoned Lehman’s treasurer, Paolo Tonucci. She told him that Lehman would have to turn over the $5 billion in collateral that Morgan had asked for days earlier. The amount was big enough to temporarily freeze Lehman’s computerized trading systems; it nearly broke the firm’s trading arm.

A run on the bank had begun, and there was nothing Fuld or McDade could do to stop it.

Once Wall Street CEOs heard that Dimon was asking for more collateral, they started calling each other—and the government—to get a sense of how badly they would be hit if Lehman went down.

By Thursday afternoon, Bank of America
CEO
Ken Lewis had soured on Lehman. Earlier in the week, Bank of America had come to Christopher Flowers, whose private equity firm J. C. Flowers & Company was always on the hunt for failing banks, and asked him to partner on the deal. Flowers, a math genius, had spent 24 hours poring over Lehman’s books with a team from Bank of America and found the firm’s $32 billion portfolio of commercial real estate assets highly questionable—to say nothing of Lehman’s exposure to residential mortgages. The team didn’t value the firm at anything close to Lehman’s self-valuation of $600 billion.

Lewis called Paulson and said, “We’ve looked at it and we can’t do it without government assistance. We just can’t get there.” He wanted out of this deal. Instead, he wanted Merrill Lynch.

“Tell us what you need help on, and we will come up with a way to get there,” Paulson told him.

Meanwhile, Lehman thought Bank of America was neck deep in the deal: An acquisition by BofA made sense. Bank of America was a retail bank. Why wouldn’t it want an investment bank?

Fuld believed that by Thursday afternoon it was all but done. He mentioned to a colleague that Lewis had even said to him Thursday night, “You know, we’ re going to do this deal.” Lewis had given him his home phone number in Charlotte, North Carolina, and signed off with “We will need to stay in touch over the weekend.”

Fuld was optimistic.

Over at Lehman’s offices at 745 Seventh Avenue, Steve Berkenfeld put in a precautionary call to Stephen Dannhauser, head of Weil, Gotshal & Manges, asking him to start preliminary work on bankruptcy papers. Dannhauser conveyed the message to Harvey R. Miller, the country’s leading bankruptcy attorney and a member of the firm. Miller understood this was an important client (the firm’s largest) and started in immediately.

Meanwhile, sensing Lewis’s nervousness, Paulson finally called Bob Diamond in London and asked, “Are you serious? ” He says Diamond told him he was. Very.

“That’s what made me so optimistic—they kept saying they couldn’t stand to get to the altar and be topped by someone again,” Paulson recalled.

Before Diamond left, Paulson told him, “Don’t come unless you are serious.”

Bob Diamond and a team got on a plane to New York.

Diamond
was
interested in buying Lehman—but only its U.S. assets, and at a distressed price. Diamond and his boss, John Varley, the
CEO
of the parent company Barclays, had been chewing the idea over with the Barclays board in the United Kingdom and with their regulator, the Financial Services Authority (
FSA
), all summer.

“Lehman was number one in equity research for six or seven years, number one in fixed income research; the Greenwich survey said they had the deepest, highest quality of penetration of U.S. institutional clients,” Diamond explained later.

“So all of a sudden we realized that as proud as we were . . . of our strength in the UK and Europe, the biggest strategic issue we faced was, ‘ How do we get into the equity business without a U.S. franchise? And how do we become a scale player in the U.S.?’ ”

The consensus was that if Barclays could get Lehman cheaply, according to Diamond, “the U.S. franchise was worth the pain of integrating the rest.” Provided, of course, that due diligence did not throw up any surprises.

But BarCap had a major obstacle.

Diamond believes he had warned Paulson that the other key player in a deal with Barclays was the British regulator. The Financial Services Authority (
FSA
) would never sanction the deal unless Barclays got a guarantee for funding when markets opened Monday morning. Under British law, Barclays had to have a shareholder vote before it could stand behind Lehman’s liabilities. It could not hold a vote in time and “the
FSA
would not waive that requirement.” The funding would have to come from the United States, either from a third party, such as Warren Buffett (a rerun of the
LTCM
scenario) or from the Fed, which would, of course, mean U.S. taxpayer dollars were at stake. The British were not going to put their taxpayers’ money at stake for a private deal by Barclays.

Diamond says he told Hector Sants, the
CEO
of the
FSA
, that he would explain to the U.S. Treasury secretary and to Tim Geithner of the Federal Reserve Bank of New York that the UK regulator should not be called for help that weekend. He and the Americans would find a way around it.

But was he conning himself? Even as Diamond and his crew flew over the Atlantic on Thursday night, the staff inside the British regulator was skeptical that Barclays could pull of a deal that met their requirements.

A source inside the
FSA
says: “We just thought, ‘Oh, God, there go the Americans . . . Diamond and Paulson and all their buddies thinking they can make us be part of their deal with all their big talk.’”

But Diamond believed he could make it work.

Around lunchtime on Friday, September 12, Diamond entered the Lehman building through a back elevator, so no one could see him.

He was meeting with Fuld, and the conversation was going to be brief and delicate.

According to Diamond, Fuld asked if he could be involved in the new company once Barclays bought Lehman. “It was a really difficult conversation,” Diamond says. “But I had to have it. I had to say: ‘ If we’ re able to do this, whether I wanted you to be a part of it or not, the regulators are not going to allow it. And we should just get this off the table now.’”

Diamond then left for the midtown law offices of Simpson, Thatcher and Bartlett, where his team was waiting. He was surprised to see that no Lehman executives were there.

“We had an army of people,” Diamond recalls, “but we couldn’t find Bart McDade. We couldn’t find any of [Lehman’s] senior people. There was absolutely no data for us. The reason was, they were with BofA.”

He was irked partly because Paulson and Geithner had told him to rush over to get a head start on due diligence and partly because both men had also assured Diamond that if he was serious, they wouldn’t hand Lehman to another suitor. And Bank of America was a particular thorn for Diamond since he’d recently lost the La Salle bid to BofA in the takeover battle for the Dutch bank
ABN
Amro.

But Diamond would not stay angry for long. He would soon discover that a deal between Lehman and Bank of America was all but kaput.

Fuld called Ken Lewis’s home number three times that Saturday. Every time, Lewis’s wife Donna picked up and told him that her husband wasn’t there. Fuld kept apologizing: “I’ m only calling because Ken gave me this number. . . .”

Eventually, she said to him, “If he wanted to talk to you, he would.”

Friday evening. Desperate times screamed for desperate measures. In an echo of the Long-Term Capital Management rescue 10 years before, Paulson told Geithner to summon all the heads of Wall Street to the Federal Reserve, where he laid out the situation.

Paulson wanted to figure out a way to save Lehman—but with the criticism over what had happened with Fannie and Freddie still burning in his ears, Paulson was determined to do it without spending a cent of taxpayer money.

“Remember, there was no public policy issue,” Bob Steel, Paulson’s erstwhile deputy, said many months later, “so he [Paulson] had to deal with the political issue, which was: ‘So let me get this straight—you’re going to bail out Lehman Brothers so that the clowns who live in mansions with long driveways can continue to send their kids to private schools?’ That’s how people think.”

Paulson agrees. He owns a modest house, wears socks with holes, and is a very moderate Republican (his wife Wendy is a registered Democrat). Paulson would never suggest, even in jest—as Lloyd Blankfein, his successor, later would—that bankers do “God’s work.” Far from it.