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Missing Lehman Lesson of Shakeout Means Too Big Banks May Fail


Date: Tuesday, September 8, 2009
Author: Bob Ivry, Christine Harper and Mark Pittman, Bloomberg.com

The warning was ominous: “Massive global wealth destruction.”

That’s what Lehman Brothers Holdings Inc. executives predicted before they filed the biggest bankruptcy in U.S. history. “Impacts all financial institutions,” read one bullet point in a confidential memo prepared for government officials obtained by Bloomberg News. “Retail investors/retirees assets are devastated.”

The message didn’t get through. Two dozen of the world’s most powerful bankers, brought together by Treasury Secretary Henry M. Paulson Jr. and Federal Reserve Bank of New York President Timothy F. Geithner the weekend of Sept. 13, 2008, to devise a rescue plan for Lehman, were too busy saving themselves to see the larger threat.

“The discussion among the CEOs was ‘How do we prevent the next firm from going under?’” former Merrill Lynch & Co. Chief Executive Officer John A. Thain, who cut a deal to sell his company that weekend, said in an interview. “There should have been much more discussion about the impact directly on the markets if Lehman went bankrupt.”

While everyone assembled at the New York Fed was aware that unbridled subprime-mortgage lending and the packaging of such inferior loans into investment vehicles such as collateralized- debt obligations had pushed the financial system to the breaking point, what the bankers missed almost destroyed them -- and the rest of the global economy.

Blankfein, Dimon

Lehman’s downfall on Monday, Sept. 15, sparked a run on the $3.6 trillion money market industry, which provides short-term loans called commercial paper used by businesses worldwide to cover everyday expenses, including payroll and utilities. The panic left companies such as Goodyear Tire & Rubber Co. stranded with insufficient cash and ravaged the accounts of millions of people.

For Goldman Sachs Group Inc. CEO Lloyd C. Blankfein, JPMorgan Chase & Co.’s Jamie Dimon and the rest of the financial chieftains who spent a weekend trying to unwind derivatives trades and keep bank-to-bank loans flowing, ignoring the commercial-paper market, the lifeblood of the economy, proved a catastrophic oversight. Within a week, the U.S. stepped in to halt withdrawals from money market funds, leading to a $1.6 trillion industry backstop, part of $13.2 trillion it has committed to beating back the worst financial crisis since the Great Depression.

‘System at Risk’

Of all the quakes of 2008 -- the fall of Bear Stearns Cos. in March, the takeover of mortgage buyers Fannie Mae and Freddie Mac and the salvaging of American International Group Inc. in September -- the failure to account for the effects of Lehman’s demise was the most critical because its aftershocks came closest to wrecking the world economy.

“They put the entire financial system at risk, and they didn’t have to,” said Harvey R. Miller, a partner at Weil Gotshal & Manges LLP in New York who represented Lehman in the bankruptcy, referring to government officials. “They were warned. I told them, ‘Armageddon is coming. You don’t know what the consequences will be.’ Their response was, ‘We have it covered.’”

Paulson and Geithner, who succeeded him as Treasury secretary, both declined to comment.

Inviting ‘Catastrophe’

One year later, policymakers haven’t learned the lesson of the bankruptcy, said Richard Bernstein, CEO of Richard Bernstein Capital Management LLC in New York and former chief investment strategist for Merrill Lynch.

Rather than break up institutions such as Bank of America Corp. and Citigroup Inc., or limit their expansion, the U.S. has given them billions of dollars in tax incentives and loan guarantees that enabled them to grow even bigger. To protect against a bank collapse touching off another freefall, President Barack Obama has proposed regulatory changes that rely on the wisdom of bankers and government overseers -- the same people who created the conditions that led to Lehman’s bankruptcy and were unable to foresee its consequences.

“Designating certain institutions as too big to fail, and not having a thorough regulatory process to match, practically invites another catastrophe,” Bernstein said.

Rescue efforts exposed a financial system with so many moving parts that U.S. regulators and the world’s top bankers couldn’t keep track of them all. A reconstruction of the meetings at the New York Fed that preceded Lehman’s bankruptcy, drawn from more than a dozen interviews with participants, reveals a failure to understand the importance of commercial paper and how that market would be affected by the collapse of the New York investment bank.

Ice-Nine

It turned out to be a $3.6 trillion blind spot.

Like the fictitious substance ice-nine in Kurt Vonnegut Jr.’s 1963 novel “Cat’s Cradle,” a seed of which set off a chain reaction that transformed all the world’s water into ice, Lehman’s failure froze credit markets, said Simon H. Johnson, a former chief economist at the International Monetary Fund.

Ice-nine was invented by a crackpot scientist, and it was unleashed by mistake,” said Johnson, now a professor of finance at the Massachusetts Institute of Technology’s Sloan School of Management in Cambridge. “How did the financial system get so fragile that this could happen? What were the guys overseeing it doing?”

The bankers and regulators who met at the New York Fed unwittingly dropped the first seed.

‘Take Cash Out’

Within days, Mohamed El-Erian, CEO of Pacific Investment Management Co., the world’s largest bond-fund manager, was fearful of a banking breakdown.

“I remember at the end of the week calling up my wife and saying, ‘Jamie, go to the ATM, go to the cash machine, and take cash out,’” said El-Erian, who spent the prior weekend at the firm’s Newport Beach, California, headquarters trying to anticipate what might happen to Lehman. “She said, ‘Why?’ I said, ‘I don’t know whether the banks are going to open tomorrow.’ The system was freezing in front of our eyes.”

The crisis shattered household and business confidence around the world, Fed Chairman Ben S. Bernanke said in an Aug. 21 speech in Jackson Hole, Wyoming.

“The role played by panic helps to explain the remarkably sharp and sudden intensification of the financial crisis last fall, its rapid global spread, and the fact that the abrupt deterioration in financial conditions was largely unforecasted by standard market indicators,” Bernanke said.

Bernanke, Paulson

Subsequent actions by Bernanke, Paulson and Geithner helped stabilize equity and credit markets and may have prevented a deeper recession. As the lender of last resort, the Fed doubled its balance sheet, providing twice as much lending in dollars worldwide, an unprecedented bulwark of the banking system. The Treasury’s Troubled Asset Relief Program, or TARP, pumped almost $300 billion into the U.S. banking system; no major banks have failed since its October inception.

It’s what happened, or didn’t happen, before the Lehman bankruptcy that ended up pushing the system to the brink, said Peter J. Solomon, a vice chairman at Lehman before founding his New York-based investment bank, Peter J. Solomon Co., in 1989.

“How could Geithner and the Fed generally, and Paulson and the Treasury generally, not have seen the buildup during the summer?” Solomon said. “The fault with these guys lies not in their action and not in their inaction on that day in September. It lies in the summer.”

Money Market Panic

Like other financial institutions, Lehman’s problems stemmed from borrowing too much to finance too many hard-to-sell investments, such as mortgage-backed securities, that were declining in value as a result of the deteriorating real estate market. Lehman was different because the government let it declare bankruptcy, meaning the company’s creditors were wiped out as well as its stockholders.

The ensuing panic doomed the oldest U.S. money market fund, the $62.5 billion Reserve Primary Fund, started in 1971 by Bruce R. Bent, founder and CEO of New York-based Reserve Management Co.

In the fund’s 2008 annual report, Bent promised to bore investors to sleep. Those same investors woke with alarm on Sept. 15. Reserve Primary had lent Lehman $785 million, about 1.3 percent of its assets, some of it in short-term loans that Lehman was now unable to repay. In a two-day run on the fund, more than 60 percent of its money was withdrawn. Its net asset value fell below $1 a share, or “broke the buck,” on Sept. 16, making investors vulnerable to losses and triggering withdrawals at other funds.

Lung Transplant

Willard Scolnik, a 78-year-old retired architect in Palm Harbor, Florida, who said he had $400,000 in Reserve Primary that he needed to help pay for a lung transplant for his son, was one of the unlucky ones. He couldn’t get his money out. Neither could Akron, Ohio-based Goodyear, the largest U.S. tiremaker by revenue, which had $360 million stuck in the fund.

Another loser was Colorado Diversified Trust. Municipalities park their cash in the trust before shelling out for projects such as a new road or sewer improvements. Boulder County was forced to write off $687,000, its share of the trust’s losses, according to Bob Hullinghorst, the county treasurer. That would have paid for 20 new health-care employees, he said.

“It makes me mad,” Hullinghorst said. “We thought our money was safe.”

Commercial Paper

The run on money market funds, considered the safest investments after bank deposits and the major buyers of commercial paper, sent shivers through the global economy. World stock markets lost $2.85 trillion, or more than 6 percent of their value, in three days. Banks’ cost of borrowing overnight from other banks, as measured by the London Interbank Offered Rate, or Libor, jumped 4.29 percentage points between Friday, Sept. 12, and Tuesday, Sept. 16.

“We did not expect how the Lehman Brothers bankruptcy would transmit through the commercial-paper market and cause all the stress in the money funds,” said David Nason, a former assistant Treasury secretary for financial institutions under Paulson and now a managing director at Washington-based Promontory Financial Group.

The disintegration of the commercial-paper market came around to bite banks such as Morgan Stanley and Citigroup, whose CEOs, John J. Mack and Vikram S. Pandit, were at the weekend meetings. It sapped them of the capital they needed to extend credit, even to one another.

Foam on Tarmac

One bank CEO, assigned to a group of executives asked by Geithner to consider what would happen in the event of a Lehman bankruptcy, said he couldn’t recall any conversations that weekend about commercial paper or money markets. The banker declined to be identified.

That may have had something to do with who was in the room, said Joshua H. Rosner, managing director at New York investment research company Graham Fisher & Co. They were all bankers. There were no corporate treasurers, academics, consumer advocates or labor representatives.

“It wasn’t a mistake to let Lehman fail; it was a mistake to let them go without putting foam on the tarmac,” Rosner said. “If they had a variety of stakeholders in the room, those stakeholders would’ve told the regulators they needed to do something about commercial paper.”

For some participants, such as Merrill’s Thain and Paul Calello, CEO of Credit Suisse Group AG’s investment bank, the gathering resembled a similar meeting at the New York Fed a decade earlier in which executives from 16 banks bailed out hedge fund Long-Term Capital Management LP. The key difference: That rescue, coordinated by then-New York Fed President William J.N. McDonough, required $3.5 billion from the banks, an eighth of what Lehman needed.

Blind Spot

Steven Shafran, a senior adviser to Paulson at the Treasury and a former Goldman Sachs partner, said the bankers and regulators were limited in what they could accomplish this time.

“We knew we’d never be smart enough to think of everything, so we picked the big problems and reacted to the rest,” said Shafran, who attended the meetings.

The blind spot led to borrowing rates on 30-day commercial paper issued by investment-grade companies without the highest rating doubling to 6.02 percent in the four days after Lehman’s bankruptcy, according to a presentation made by Brad Fox, chairman of the National Association of Corporate Treasurers, at the group’s annual meeting in May.

Fox, who is also treasurer of Pleasanton, California-based Safeway Inc., the third-largest U.S. supermarket chain, said in an interview that nervous CEOs and boards ordered some members of his association to restrict purchases to money market funds that bought only government securities. Corporate treasurers use money market funds to set aside cash in the same way individuals might use a bank account.

Hong Kong Minibonds

“The fear factor that went through the markets was pretty amazing” as credit concerns caused banks to stop lending to each other, Fox said. “The ripple effect was huge.”

The ripples reached as far as Hong Kong, where Lehman’s default on commercial-paper debt paralyzed payments on so-called minibonds, structured notes sold in $5,000 denominations and guaranteed by Lehman.

Sun Kwan, 58, a retired parks worker, said he invested $285,000, most of his life savings, in Lehman minibonds. He was among an estimated 43,000 in the city who bought $1.8 billion of the notes, according to the Hong Kong Monetary Authority. Sun lost it all and has taken part in protests since October, rain or shine, trying to get his money back.

Molasses Reef

Real estate projects whose funding relied on Lehman’s ability to sell commercial paper came to a halt.

On the otherwise uninhabited Atlantic Ocean island of West Caicos, work stopped in October on the Molasses Reef Ritz- Carlton Hotel and Residences, where cottages were priced at $6.5 million. About 400 Chinese employees of an Israeli construction firm, Ashtrom Properties Ltd., didn’t get paid, according to Jonathan Siegel, New York-based managing director of the project for Logwood Hotel Development Co. Some of them protested, surrounding the temporary housing occupied by their supervisors, preventing them from leaving until they received their money.

The bankers who gathered at the New York Fed last September anticipated little of this. Instead, their meetings were filled with confusion, false starts and dust-ups.

Discussions began Friday evening during a pelting rain with a statement by Paulson, 63, who sat opposite Geithner, 48, at a rectangular table in a first-floor conference room and informed the bankers in a raspy voice that the Bush administration wasn’t about to commit one dime of taxpayer money to salvage Lehman.

‘Not Another Bailout’

A week earlier, the Treasury had engineered the rescue of government-sponsored mortgage-finance companies Fannie Mae and Freddie Mac. Six months before that, Paulson had arranged for the Fed to guarantee $29 billion of Bear Stearns toxic assets to facilitate the firm’s sale to JPMorgan Chase.

“If you look back at what was being said on TV and in Congress, the constant refrain was, ‘No, not another Bear Stearns, not another bailout,’” said Michele Davis, assistant Treasury secretary for public affairs under Paulson.

If Lehman was going to be saved, Paulson said, it would have to be by those sitting around the table, all of whom knew that without a buyer or a bailout in place by the time markets opened Monday morning the 158-year-old firm would be history.

Some participants said the bankruptcy filing took them by surprise because they were betting Paulson and Geithner would pull off a last-minute rescue.

“There was always a tiny thought in my mind that the government would flinch at the last minute,” said Gary D. Cohn, president and chief operating officer of New York-based Goldman Sachs, who attended the meetings.

Geithner ‘Homework’

Geithner divided the bankers on Friday evening into three teams to do what one participant called “homework.”

The first group, which included Cohn of Goldman Sachs and Credit Suisse’s Calello, was assigned to evaluate Lehman’s real estate and private equity holdings to determine how much of a capital deficiency the firm faced. The second team, with Mack and Thain, tried to cobble together a funding mechanism for the company’s bad assets in the event Lehman could woo a white knight, participants said.

“The No. 1 priority was to find a buyer,” said Davis, now a partner at Brunswick Group LLP, a public relations firm based in Washington.

Lehman executives, who had watched the share price tumble 94 percent since the beginning of the year, were talking to two: Bank of America and Barclays Plc.

Selling Merrill

The third team of bankers -- including Robert P. Kelly, CEO of Bank of New York Mellon Corp., the world’s biggest custody bank, which keeps records, tracks performance and lends securities to institutional investors -- was asked to look at the risks of a possible bankruptcy.

Every few hours, the teams would regroup at the conference table and report back. The bankers discussed which firms might follow Lehman down the drain, according to Thain, 54. There was little doubt Merrill would be next, he said.

By Saturday, Thain had snatched one of Lehman’s suitors and was in talks to sell Merrill, the third-biggest U.S. investment bank, to Charlotte, North Carolina-based Bank of America for about $50 billion. At one point, Paulson looked at the Merrill Lynch chief and said, “John, you know what to do,” according to another executive who attended the meetings.

The marriage, approved by the banks’ boards before Lehman declared bankruptcy, took less than two days to consummate.

Barclays Talks

That left only Barclays. While the London-based bank was interested in Lehman, it didn’t want to touch the firm’s real estate holdings, especially after the team responsible for scrutinizing the books estimated that Lehman had overvalued them by as much as $30 billion, three participants said. One said Barclays kept coming back with less attractive offers, leaving more of the business’s worst assets behind.

By Saturday evening, the bankers -- many of whom stood to gain business after Lehman’s demise -- were still discussing how to come up with the $30 billion needed for a rescue. Barclays sought a temporary guarantee from the U.K. government to cover Lehman’s commitments until its shareholders could approve the deal. When Paulson phoned Chancellor of the Exchequer Alistair Darling, his counterpart in London, Darling told him he didn’t want to import the U.S. cancer, according to two people who said Paulson mentioned the remark later.

Darling, through a spokesman, denied using the word “cancer.”

“At no point were the British authorities asked to approve or reject a deal for the purchase of Lehman Brothers,” said Jason Knauf, senior press officer for the U.K. Treasury.

1 Million Bets

On Sunday morning, shortly before noon, Paulson announced that Barclays wouldn’t be buying Lehman on any terms, participants said. By then, the bankers had turned their attention to their own survival. Cohn of Goldman Sachs said he led the charge to make sure the banks didn’t lose money on derivatives trades either with Lehman or on Lehman.

Derivatives are contracts whose value is derived from stocks, bonds, loans, currencies, commodities or linked to specific events such as changes in interest rates. Lehman had made about 1 million such bets in the over-the-counter market, according to a person with access to that information.

The unregulated $592 trillion market for over-the-counter derivatives, 41 times the size of the U.S. economy, contributed more than half of some banks’ trading revenue and had never been tested by the bankruptcy of a major Wall Street firm.

Unwinding Trades

The Fed had already begun trying to untangle Lehman’s credit-default swaps on Saturday morning, calling in a group of experts in derivatives operations from Wall Street firms and asset-management companies. They were given one hour to show up at the New York Fed.

Swaps are a way for investors to gamble on whether companies will continue making debt payments or for lenders to buy insurance against borrowers who stop paying. If the company defaults, one side in the bet pays the buyer face value of the debt in exchange for the underlying securities or the cash equivalent.

In order to unwind the trades, the team would need to do so-called portfolio compression, reducing the number of outstanding swaps by eliminating duplication and combining similar bets made by the same counterparties. The process involves sending the trades to an outside vendor, running them through a software program, reviewing the results and deciding which ones to settle.

It couldn’t be done, at least not before trading began in Asia on Monday morning, the person said.

Repo Market

On Sunday, the banks called in their own traders to see if they could minimize any losses from dealings with Lehman. That also proved impossible. One snag was that some corporations involved in the trades couldn’t get their representatives to the New York Fed in time, said one participant. Another was that many of the banks couldn’t determine what bets they’d made on or with Lehman.

A last-ditch attempt on Sunday to try to resolve some outstanding derivatives contracts between Lehman and the other banks at the Fed had little success, according to two people who were in the room. One reason: The banks were only interested in resolving the contracts in which Lehman owed them money and not those where the banks owed Lehman money, said one of the people at the meeting.

The bankers acknowledged that one of their favorite avenues for borrowing would be disrupted by Lehman’s collapse. Making sure the market wouldn’t freeze for short-term loans called bank repurchase agreements, or repos, was where the participants had their biggest success -- and their bitterest disagreements.

‘Default Scenario’

In a repo arrangement, a lender sends cash to a borrower in return for collateral, often Treasury bills or notes, which the borrower agrees to repurchase as soon as the next day for the face value of the securities plus interest. When lenders perceived that Lehman might not pay repo loans or be able to post adequate collateral, they required more and higher quality assets from the firm.

The presentation prepared by Lehman employees, titled “Default Scenario: Liquidation Framework,” predicted, among other things, that a bankruptcy would trigger a freeze in the broader repo market.

“Repos default,” they wrote. “Financial institutions liquidate Lehman repo collateral. Repo defaults trigger default of a significant amount of holding company debt and cause the liquidation of hundreds of billions of dollars of securities.”

Repo collateral caused what might have been the tensest moment of the weekend, according to two participants.

Rule 23(a)

While poring over Lehman’s mortgage portfolio on Saturday, former Goldman Sachs partner Peter S. Kraus, a Merrill Lynch vice president and now CEO of New York-based AllianceBernstein Holding LP, accused JPMorgan’s Dimon of being too aggressive in demanding more collateral and margin from other banks to cover declining values, according to two people who were there.

JPMorgan, as a so-called clearing bank, holds collateral for other banks in what are known as tri-party repo transactions. When the value of the collateral declines, JPMorgan can require a borrower bank to post more or higher quality assets so the lending bank is protected.

Dimon didn’t respond to Kraus, the participants said, and the confrontation died down. Both declined to comment.

The Fed was sufficiently anxious about a standstill in repo funding that on Sunday, Sept. 14, it temporarily modified Rule 23(a) of the Federal Reserve Act to allow banks to use customer deposits to fund securities they couldn’t finance in the repo market. That change, scheduled to expire in January, has since been extended through Oct. 30.

Monday Morning Calm

Also that day, the Fed announced that in exchange for loans it would take the same collateral that private repo counterparties accepted. Instead of demanding only investment- grade securities, the central bank would take the mortgage- backed bonds that had sparked the financial crisis.

The Fed arranged for Lehman’s broker-dealer unit to remain open after the bankruptcy filing to allow for repo deals to be resolved in an orderly way.

Monday morning dawned breezy and warm on Wall Street. It was already 79 degrees Fahrenheit when Thomas G. Wipf, Morgan Stanley’s white-bearded head of secured financing, arrived before 6 a.m. at his office in Times Square, four blocks from where the ball drops on New Year’s Eve and around the corner from Lehman’s headquarters. Wipf, who participated in the weekend meetings, had worked for three decades in the short-term financing market and was used to busy mornings as client companies renewed their loans. Instead, he said there was an eerie hush.

The phones were quiet.

No one was calling.

No one was lending.

The ice-nine was silently spreading.

(Lehman’s Lessons: Next, the Money Market Freeze)

To contact the reporters on this story: Bob Ivry in New York at bivry@bloomberg.net; Christine Harper in New York at charper@bloomberg.net; Mark Pittman in New York at mpittman@bloomberg.net.