Missing Lehman Lesson of Shakeout Means Too Big Banks May Fail
Sept. 8 (Bloomberg) -- The warning was ominous: “Massiveglobal wealth destruction.”
That’s what Lehman Brothers Holdings Inc. executivespredicted before they filed the biggest bankruptcy in U.S.history. “Impacts all financial institutions,” read one bulletpoint in a confidential memo prepared for government officialsobtained by Bloomberg News. “Retail investors/retirees assetsare devastated.”
The message didn’t get through. Two dozen of the world’smost powerful bankers, brought together by Treasury SecretaryHenry M. Paulson Jr. and Federal Reserve Bank of New YorkPresident Timothy F. Geithner the weekend of Sept. 13, 2008, todevise a rescue plan for Lehman, were too busy saving themselvesto see the larger threat.
“The discussion among the CEOs was ‘How do we prevent thenext firm from going under?’” former Merrill Lynch & Co. ChiefExecutive Officer John A. Thain, who cut a deal to sell hiscompany that weekend, said in an interview. “There should havebeen much more discussion about the impact directly on themarkets if Lehman went bankrupt.”
While everyone assembled at the New York Fed was aware thatunbridled subprime-mortgage lending and the packaging of suchinferior loans into investment vehicles such as collateralized-debt obligations had pushed the financial system to the breakingpoint, what the bankers missed almost destroyed them -- and therest 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-termloans called commercial paper used by businesses worldwide tocover everyday expenses, including payroll and utilities. Thepanic left companies such as Goodyear Tire & Rubber Co. strandedwith insufficient cash and ravaged the accounts of millions ofpeople.
For Goldman Sachs Group Inc. CEO Lloyd C. Blankfein,JPMorgan Chase & Co.’s Jamie Dimon and the rest of the financialchieftains who spent a weekend trying to unwind derivativestrades and keep bank-to-bank loans flowing, ignoring thecommercial-paper market, the lifeblood of the economy, proved acatastrophic oversight. Within a week, the U.S. stepped in tohalt withdrawals from money market funds, leading to a $1.6trillion industry backstop, part of $13.2 trillion it hascommitted to beating back the worst financial crisis since theGreat 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 FreddieMac and the salvaging of American International Group Inc. inSeptember -- the failure to account for the effects of Lehman’sdemise was the most critical because its aftershocks cameclosest to wrecking the world economy.
“They put the entire financial system at risk, and theydidn’t have to,” said Harvey R. Miller, a partner at WeilGotshal & Manges LLP in New York who represented Lehman in thebankruptcy, referring to government officials. “They werewarned. I told them, ‘Armageddon is coming. You don’t know whatthe consequences will be.’ Their response was, ‘We have itcovered.’”
Paulson and Geithner, who succeeded him as Treasurysecretary, both declined to comment.
Inviting ‘Catastrophe’
One year later, policymakers haven’t learned the lesson ofthe bankruptcy, said Richard Bernstein, CEO of Richard BernsteinCapital Management LLC in New York and former chief investmentstrategist for Merrill Lynch.
Rather than break up institutions such as Bank of AmericaCorp. and Citigroup Inc., or limit their expansion, the U.S. hasgiven them billions of dollars in tax incentives and loanguarantees that enabled them to grow even bigger. To protectagainst a bank collapse touching off another freefall, PresidentBarack Obama has proposed regulatory changes that rely on thewisdom of bankers and government overseers -- the same peoplewho created the conditions that led to Lehman’s bankruptcy andwere unable to foresee its consequences.
“Designating certain institutions as too big to fail, andnot having a thorough regulatory process to match, practicallyinvites another catastrophe,” Bernstein said.
Rescue efforts exposed a financial system with so manymoving parts that U.S. regulators and the world’s top bankerscouldn’t keep track of them all. A reconstruction of themeetings 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 commercialpaper and how that market would be affected by the collapse ofthe 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 VonnegutJr.’s 1963 novel “Cat’s Cradle,” a seed of which set off achain reaction that transformed all the world’s water into ice,Lehman’s failure froze credit markets, said Simon H. Johnson, aformer chief economist at the International Monetary Fund.
“Ice-nine was invented by a crackpot scientist, and it wasunleashed by mistake,” said Johnson, now a professor of financeat the Massachusetts Institute of Technology’s Sloan School ofManagement in Cambridge. “How did the financial system get sofragile that this could happen? What were the guys overseeing itdoing?”
The bankers and regulators who met at the New York Fedunwittingly dropped the first seed.
‘Take Cash Out’
Within days, Mohamed El-Erian, CEO of Pacific InvestmentManagement Co., the world’s largest bond-fund manager, wasfearful of a banking breakdown.
“I remember at the end of the week calling up my wife andsaying, ‘Jamie, go to the ATM, go to the cash machine, and takecash out,’” said El-Erian, who spent the prior weekend at thefirm’s Newport Beach, California, headquarters trying toanticipate what might happen to Lehman. “She said, ‘Why?’ Isaid, ‘I don’t know whether the banks are going to opentomorrow.’ The system was freezing in front of our eyes.”
The crisis shattered household and business confidencearound 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 remarkablysharp and sudden intensification of the financial crisis lastfall, its rapid global spread, and the fact that the abruptdeterioration in financial conditions was largely unforecastedby standard market indicators,” Bernanke said.
Bernanke, Paulson
Subsequent actions by Bernanke, Paulson and Geithner helpedstabilize equity and credit markets and may have prevented adeeper recession. As the lender of last resort, the Fed doubledits balance sheet, providing twice as much lending in dollarsworldwide, an unprecedented bulwark of the banking system. TheTreasury’s Troubled Asset Relief Program, or TARP, pumped almost$300 billion into the U.S. banking system; no major banks havefailed since its October inception.
It’s what happened, or didn’t happen, before the Lehmanbankruptcy that ended up pushing the system to the brink, saidPeter J. Solomon, a vice chairman at Lehman before founding hisNew York-based investment bank, Peter J. Solomon Co., in 1989.
“How could Geithner and the Fed generally, and Paulson andthe Treasury generally, not have seen the buildup during thesummer?” Solomon said. “The fault with these guys lies not intheir 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 problemsstemmed from borrowing too much to finance too many hard-to-sellinvestments, such as mortgage-backed securities, that weredeclining in value as a result of the deteriorating real estatemarket. Lehman was different because the government let itdeclare bankruptcy, meaning the company’s creditors were wipedout 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 BruceR. Bent, founder and CEO of New York-based Reserve ManagementCo.
In the fund’s 2008 annual report, Bent promised to boreinvestors to sleep. Those same investors woke with alarm onSept. 15. Reserve Primary had lent Lehman $785 million, about1.3 percent of its assets, some of it in short-term loans thatLehman was now unable to repay. In a two-day run on the fund,more than 60 percent of its money was withdrawn. Its net assetvalue fell below $1 a share, or “broke the buck,” on Sept. 16,making investors vulnerable to losses and triggering withdrawalsat other funds.
Lung Transplant
Willard Scolnik, a 78-year-old retired architect in PalmHarbor, Florida, who said he had $400,000 in Reserve Primarythat 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 outfor projects such as a new road or sewer improvements. BoulderCounty was forced to write off $687,000, its share of thetrust’s losses, according to Bob Hullinghorst, the countytreasurer. That would have paid for 20 new health-careemployees, he said.
“It makes me mad,” Hullinghorst said. “We thought ourmoney was safe.”
Commercial Paper
The run on money market funds, considered the safestinvestments after bank deposits and the major buyers ofcommercial paper, sent shivers through the global economy. Worldstock markets lost $2.85 trillion, or more than 6 percent oftheir value, in three days. Banks’ cost of borrowing overnightfrom other banks, as measured by the London Interbank OfferedRate, or Libor, jumped 4.29 percentage points between Friday,Sept. 12, and Tuesday, Sept. 16.
“We did not expect how the Lehman Brothers bankruptcywould transmit through the commercial-paper market and cause allthe stress in the money funds,” said David Nason, a formerassistant Treasury secretary for financial institutions underPaulson and now a managing director at Washington-basedPromontory Financial Group.
The disintegration of the commercial-paper market camearound to bite banks such as Morgan Stanley and Citigroup, whoseCEOs, John J. Mack and Vikram S. Pandit, were at the weekendmeetings. It sapped them of the capital they needed to extendcredit, even to one another.
Foam on Tarmac
One bank CEO, assigned to a group of executives asked byGeithner to consider what would happen in the event of a Lehmanbankruptcy, said he couldn’t recall any conversations thatweekend about commercial paper or money markets. The bankerdeclined 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 investmentresearch company Graham Fisher & Co. They were all bankers.There were no corporate treasurers, academics, consumeradvocates or labor representatives.
“It wasn’t a mistake to let Lehman fail; it was a mistaketo let them go without putting foam on the tarmac,” Rosnersaid. “If they had a variety of stakeholders in the room, thosestakeholders would’ve told the regulators they needed to dosomething about commercial paper.”
For some participants, such as Merrill’s Thain and PaulCalello, CEO of Credit Suisse Group AG’s investment bank, thegathering resembled a similar meeting at the New York Fed adecade earlier in which executives from 16 banks bailed outhedge fund Long-Term Capital Management LP. The key difference:That rescue, coordinated by then-New York Fed President WilliamJ.N. McDonough, required $3.5 billion from the banks, an eighthof what Lehman needed.
Blind Spot
Steven Shafran, a senior adviser to Paulson at the Treasuryand a former Goldman Sachs partner, said the bankers andregulators were limited in what they could accomplish this time.
“We knew we’d never be smart enough to think ofeverything, so we picked the big problems and reacted to therest,” said Shafran, who attended the meetings.
The blind spot led to borrowing rates on 30-day commercialpaper issued by investment-grade companies without the highestrating doubling to 6.02 percent in the four days after Lehman’sbankruptcy, according to a presentation made by Brad Fox,chairman of the National Association of Corporate Treasurers, atthe group’s annual meeting in May.
Fox, who is also treasurer of Pleasanton, California-basedSafeway Inc., the third-largest U.S. supermarket chain, said inan interview that nervous CEOs and boards ordered some membersof his association to restrict purchases to money market fundsthat bought only government securities. Corporate treasurers usemoney market funds to set aside cash in the same way individualsmight use a bank account.
Hong Kong Minibonds
“The fear factor that went through the markets was prettyamazing” as credit concerns caused banks to stop lending toeach other, Fox said. “The ripple effect was huge.”
The ripples reached as far as Hong Kong, where Lehman’sdefault on commercial-paper debt paralyzed payments on so-calledminibonds, structured notes sold in $5,000 denominations andguaranteed by Lehman.
Sun Kwan, 58, a retired parks worker, said he invested$285,000, most of his life savings, in Lehman minibonds. He wasamong an estimated 43,000 in the city who bought $1.8 billion ofthe notes, according to the Hong Kong Monetary Authority. Sunlost it all and has taken part in protests since October, rainor shine, trying to get his money back.
Molasses Reef
Real estate projects whose funding relied on Lehman’sability to sell commercial paper came to a halt.
On the otherwise uninhabited Atlantic Ocean island of WestCaicos, work stopped in October on the Molasses Reef Ritz-Carlton Hotel and Residences, where cottages were priced at $6.5million. About 400 Chinese employees of an Israeli constructionfirm, Ashtrom Properties Ltd., didn’t get paid, according toJonathan Siegel, New York-based managing director of the projectfor 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 Septemberanticipated little of this. Instead, their meetings were filledwith confusion, false starts and dust-ups.
Discussions began Friday evening during a pelting rain witha statement by Paulson, 63, who sat opposite Geithner, 48, at arectangular table in a first-floor conference room and informedthe bankers in a raspy voice that the Bush administration wasn’tabout to commit one dime of taxpayer money to salvage Lehman.
‘Not Another Bailout’
A week earlier, the Treasury had engineered the rescue ofgovernment-sponsored mortgage-finance companies Fannie Mae andFreddie Mac. Six months before that, Paulson had arranged forthe Fed to guarantee $29 billion of Bear Stearns toxic assets tofacilitate the firm’s sale to JPMorgan Chase.
“If you look back at what was being said on TV and inCongress, the constant refrain was, ‘No, not another BearStearns, not another bailout,’” said Michele Davis, assistantTreasury secretary for public affairs under Paulson.
If Lehman was going to be saved, Paulson said, it wouldhave to be by those sitting around the table, all of whom knewthat without a buyer or a bailout in place by the time marketsopened Monday morning the 158-year-old firm would be history.
Some participants said the bankruptcy filing took them bysurprise because they were betting Paulson and Geithner wouldpull off a last-minute rescue.
“There was always a tiny thought in my mind that thegovernment would flinch at the last minute,” said Gary D. Cohn,president and chief operating officer of New York-based GoldmanSachs, who attended the meetings.
Geithner ‘Homework’
Geithner divided the bankers on Friday evening into threeteams to do what one participant called “homework.”
The first group, which included Cohn of Goldman Sachs andCredit Suisse’s Calello, was assigned to evaluate Lehman’s realestate and private equity holdings to determine how much of acapital deficiency the firm faced. The second team, with Mackand Thain, tried to cobble together a funding mechanism for thecompany’s bad assets in the event Lehman could woo a whiteknight, participants said.
“The No. 1 priority was to find a buyer,” said Davis, nowa partner at Brunswick Group LLP, a public relations firm basedin Washington.
Lehman executives, who had watched the share price tumble94 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, CEOof Bank of New York Mellon Corp., the world’s biggest custodybank, which keeps records, tracks performance and lendssecurities to institutional investors -- was asked to look atthe risks of a possible bankruptcy.
Every few hours, the teams would regroup at the conferencetable and report back. The bankers discussed which firms mightfollow Lehman down the drain, according to Thain, 54. There waslittle doubt Merrill would be next, he said.
By Saturday, Thain had snatched one of Lehman’s suitors andwas in talks to sell Merrill, the third-biggest U.S. investmentbank, to Charlotte, North Carolina-based Bank of America forabout $50 billion. At one point, Paulson looked at the MerrillLynch chief and said, “John, you know what to do,” accordingto another executive who attended the meetings.
The marriage, approved by the banks’ boards before Lehmandeclared bankruptcy, took less than two days to consummate.
Barclays Talks
That left only Barclays. While the London-based bank wasinterested in Lehman, it didn’t want to touch the firm’s realestate holdings, especially after the team responsible forscrutinizing the books estimated that Lehman had overvalued themby as much as $30 billion, three participants said. One saidBarclays kept coming back with less attractive offers, leavingmore of the business’s worst assets behind.
By Saturday evening, the bankers -- many of whom stood togain business after Lehman’s demise -- were still discussing howto come up with the $30 billion needed for a rescue. Barclayssought a temporary guarantee from the U.K. government to coverLehman’s commitments until its shareholders could approve thedeal. When Paulson phoned Chancellor of the Exchequer AlistairDarling, his counterpart in London, Darling told him he didn’twant to import the U.S. cancer, according to two people who saidPaulson mentioned the remark later.
Darling, through a spokesman, denied using the word“cancer.”
“At no point were the British authorities asked to approveor reject a deal for the purchase of Lehman Brothers,” saidJason Knauf, senior press officer for the U.K. Treasury.
1 Million Bets
On Sunday morning, shortly before noon, Paulson announcedthat Barclays wouldn’t be buying Lehman on any terms,participants said. By then, the bankers had turned theirattention to their own survival. Cohn of Goldman Sachs said heled the charge to make sure the banks didn’t lose money onderivatives trades either with Lehman or on Lehman.
Derivatives are contracts whose value is derived fromstocks, bonds, loans, currencies, commodities or linked tospecific events such as changes in interest rates. Lehman hadmade 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-counterderivatives, 41 times the size of the U.S. economy, contributedmore than half of some banks’ trading revenue and had never beentested by the bankruptcy of a major Wall Street firm.
Unwinding Trades
The Fed had already begun trying to untangle Lehman’scredit-default swaps on Saturday morning, calling in a group ofexperts in derivatives operations from Wall Street firms andasset-management companies. They were given one hour to show upat the New York Fed.
Swaps are a way for investors to gamble on whethercompanies will continue making debt payments or for lenders tobuy insurance against borrowers who stop paying. If the companydefaults, one side in the bet pays the buyer face value of thedebt in exchange for the underlying securities or the cashequivalent.
In order to unwind the trades, the team would need to doso-called portfolio compression, reducing the number ofoutstanding swaps by eliminating duplication and combiningsimilar bets made by the same counterparties. The processinvolves sending the trades to an outside vendor, running themthrough a software program, reviewing the results and decidingwhich ones to settle.
It couldn’t be done, at least not before trading began inAsia on Monday morning, the person said.
Repo Market
On Sunday, the banks called in their own traders to see ifthey could minimize any losses from dealings with Lehman. Thatalso proved impossible. One snag was that some corporationsinvolved in the trades couldn’t get their representatives to theNew York Fed in time, said one participant. Another was thatmany of the banks couldn’t determine what bets they’d made on orwith Lehman.
A last-ditch attempt on Sunday to try to resolve someoutstanding derivatives contracts between Lehman and the otherbanks at the Fed had little success, according to two people whowere in the room. One reason: The banks were only interested inresolving the contracts in which Lehman owed them money and notthose where the banks owed Lehman money, said one of the peopleat the meeting.
The bankers acknowledged that one of their favorite avenuesfor borrowing would be disrupted by Lehman’s collapse. Makingsure the market wouldn’t freeze for short-term loans called bankrepurchase agreements, or repos, was where the participants hadtheir biggest success -- and their bitterest disagreements.
‘Default Scenario’
In a repo arrangement, a lender sends cash to a borrower inreturn for collateral, often Treasury bills or notes, which theborrower agrees to repurchase as soon as the next day for theface value of the securities plus interest. When lendersperceived that Lehman might not pay repo loans or be able topost adequate collateral, they required more and higher qualityassets from the firm.
The presentation prepared by Lehman employees, titled“Default Scenario: Liquidation Framework,” predicted, amongother things, that a bankruptcy would trigger a freeze in thebroader repo market.
“Repos default,” they wrote. “Financial institutionsliquidate Lehman repo collateral. Repo defaults trigger defaultof a significant amount of holding company debt and cause theliquidation of hundreds of billions of dollars of securities.”
Repo collateral caused what might have been the tensestmoment 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 Lynchvice president and now CEO of New York-based AllianceBernsteinHolding LP, accused JPMorgan’s Dimon of being too aggressive indemanding more collateral and margin from other banks to coverdeclining values, according to two people who were there.
JPMorgan, as a so-called clearing bank, holds collateralfor other banks in what are known as tri-party repotransactions. When the value of the collateral declines,JPMorgan can require a borrower bank to post more or higherquality assets so the lending bank is protected.
Dimon didn’t respond to Kraus, the participants said, andthe confrontation died down. Both declined to comment.
The Fed was sufficiently anxious about a standstill in repofunding that on Sunday, Sept. 14, it temporarily modified Rule23(a) of the Federal Reserve Act to allow banks to use customerdeposits to fund securities they couldn’t finance in the repomarket. That change, scheduled to expire in January, has sincebeen extended through Oct. 30.
Monday Morning Calm
Also that day, the Fed announced that in exchange for loansit would take the same collateral that private repocounterparties 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 remainopen after the bankruptcy filing to allow for repo deals to beresolved in an orderly way.
Monday morning dawned breezy and warm on Wall Street. Itwas already 79 degrees Fahrenheit when Thomas G. Wipf, MorganStanley’s white-bearded head of secured financing, arrivedbefore 6 a.m. at his office in Times Square, four blocks fromwhere the ball drops on New Year’s Eve and around the cornerfrom Lehman’s headquarters. Wipf, who participated in theweekend meetings, had worked for three decades in the short-termfinancing market and was used to busy mornings as clientcompanies renewed their loans. Instead, he said there was aneerie 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.
Last Updated: September 7, 2009 19:01 EDTSource: Bloomberg
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