kent nickell
Well-known member
We are approaching the one year anniversary of the Lehman collapse which has precipitated a few interesting articles...
One of the biggest problems with this failure seems to have been that money market funds started to look like they were going to 'break the buck', otherwise known as negative interest, otherwise known as watching what you thought was your super safe money market fund decrease in value...
"""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 In a two-day run on the fund, more than 60 percent of its money was withdrawn.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.""
This event led to President Bush going on TV and announcing that the FDIC would also insure money market funds to try and stem this massive run on the bank....
When money is put into banks and money market funds that money is 'put to work' by lending it out to others. So it's not always immediately available if everyone wants it back at once... Hopefully that money which represents the life savings of many people is lent out wisely.. We are now very aware that it wasn't... If people default and don't pay back that money then the fund contracts and has to 'freeze' by not letting people take their money out because the money isn't there... So everyone has a little less than what they put in resulting in 'breaking the buck'.
This also relates to being 'over leveraged'. If you lend out money based on some asset such as a house as collateral which you 'over value' then this lending also starts to fall apart if the asset loses its value... You have lost your collateral or backstop backing that loan... The Federal govt has massively stepped in to provide that backstop but the process of deleveraging back to prudent levels is continuing. This involves coming to terms with 'toxic assets' which essentially represents overvalued collateral.... This process is still in a fragile state and will certainly claim more victims....
http://www.washingtonpost.com/wp-dyn/content/article/2009/09/03/AR2009090303584.html
Lehman Brothers Failure May Have Saved Us All
By Steven Pearlstein
Friday, September 4, 2009
We're coming up on the one-year anniversary of the Great Financial Meltdown, and running through much of the retrospective coverage will be the notion that it was far worse than it needed to be because the government mistakenly allowed Lehman Brothers to fail.
Certainly that is the conventional wisdom. Janet Yellen, the president of the Federal Reserve Bank of San Francisco, told an academic conference that the decision not to rescue Lehman caused a "quantum jump" in the magnitude of the financial crisis. Economist Allan Meltzer bellowed on the op-ed pages last week that letting Lehman "fail without warning is one of the worst blunders in Federal Reserve history." French finance minister, Christine Lagarde, called it a "horrendous" decision. Sir John Gieve, who at the time was deputy governor of the Bank of England, told a British newspaper it was a "catastrophic error."
In truth, we'll never really know what would have happened if Lehman had been rescued, but we do know that it wasn't for lack of trying. That weekend a year ago, Treasury Secretary Hank Paulson and Fed Chairman Ben Bernanke summoned the heads of all the big Wall Street firms to the New York Fed and spent a long and frustrating time trying to orchestrate a rescue. Paulson and Bernanke claim that, in the end, there simply was no legal way they could commit taxpayer money to bail out a firm that was so highly leveraged and so deep into soured real estate investments that it had become insolvent. Those unwilling to accept that explanation, however, must ask themselves why equal blame shouldn't be assigned to the financiers who foolishly refused to pony up a few billions dollars each to avoid a far more costly calamity, and to Sir John and his British colleagues, whose refusal to bend the rules and offer the government guarantees that could have cleared the way for Barclay's Bank to ride to Lehman's rescue.
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There is also some reason to doubt that the financial crisis, and the recession, would have been significantly less severe if Lehman's collapse had been avoided.
It's true that financial markets went into a tailspin in the days after Lehman's bankruptcy filing. Credit and derivatives markets froze, banks hoarded cash, and the government was forced to bail out the country's largest insurance company, American International Group. And after a money-market fund that was holding too much Lehman paper announced that it was "breaking the buck," panicked investors began pulling money out of other money-market funds. Hoping to avoid Lehman's fate, rival Merrill Lynch threw itself into the arms of Bank of America, while the Federal Reserve hastily approved the applications of the two remaining independent investment banks, Goldman Sachs and Morgan Stanley, to become bank holding companies with free access to the Fed's lending window.
But it is also worth remembering that before Lehman's collapse, financial markets were already on edge and a sense of crisis was in the air. Financial stocks were in a free fall, and risk spreads had risen to levels well above historic averages. The government had already taken over Fannie Mae and Freddie Mac and seized one of the nation's biggest mortgage lenders, Indy Mac Bancorp. At that point, the failure or near-failure of any high-profile institution would surely have triggered the panic that eventually engulfed financial markets. Lehman happened to be the one that came along.
Moreover, subsequent events have only confirmed that, if Lehman had somehow been rescued, things would not have turned out a whole lot better for Citigroup, or Washington Mutual or Wachovia or Bank of America, or any of the institutions that eventually needed cash injections from the Treasury. And it certainly would have done nothing to save AIG or Merrill, whose rescues were set in motion during the same Lehman weekend. For the reality is that, underlying the liquidity crisis of last fall was a massive credit crisis -- too many risky loans made on loose terms and based on overly optimistic assumptions. Lehman's failure may have sped up the process by which all this lousy lending was revealed and the losses acknowledged, but the financial reckoning was inevitable.
The final point is a political one. A year ago, in the wake of the Bear Stearns rescue, the public -- left, right and center -- was hopping mad about government bailouts of Wall Street. Paulson isn't just kidding when he says that if he had used taxpayer money to save Lehman, impeachment proceedings would have begun against him the following day. It was only after the public witnessed the post-Lehman financial meltdown that Congress was willing to consider the idea of giving the Fed and the Treasury the money and the authority to launch a comprehensive rescue of the financial sector, and even then it took a second try before the House of Representatives would go along.
Far from being a mistake, letting Lehman fail may have turned out to have been the best thing Paulson and Bernanke could have done. Although they certainly didn't plan it this way, the events of that weekend not only accelerated a financial crisis that was inevitable, but accelerated a global policy response that would eventually prevent the total collapse of financial markets and save the world from a second Great Depression.
Steven Pearlstein can be reached at pearlsteins@washpost.com.
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http://www.nytimes.com/2009/09/08/business/economy/08sorkin.html?_r=1&ref=business
A Breakdown on Handling Big Failures
By ANDREW ROSS SORKIN
Published: September 7, 2009
Henry M. Paulson Jr., then the Treasury secretary, gave a little noticed speech in London in July 2008.
Even before the Lehman collapse, Henry Paulson called for a better way to handle such events.
?To address the perception that some institutions are too big to fail, we must improve the tools at our disposal for facilitating the orderly failure of a large, complex financial institution,? he said.
?We need to create a resolution process that ensures the financial system can withstand the failure of a large complex financial firm.?
It?s a little eerie now to read those prophetic words, which were uttered months after the Bear Stearns collapse.
But Mr. Paulson never got to the next step. Just two months later, Lehman Brothers collapsed, sending global markets and our economy into a tailspin.
As we approach the anniversary of some of the most cataclysmic failures in our economic history, we appear to be in perhaps no better position to manage the failure of an investment bank, a hedge fund or an insurance company than we were before.
Absent any legislation that would prevent another 9/15 (as some people are calling it on Wall Street) from happening, our only options are to throw money at problem companies or arrange shotgun marriages to keep them from failing. That hardly seems like a long-term solution.
Timothy F. Geithner, the current Treasury secretary, proposed legislation in March that would do exactly what his predecessor talked about ? give the government the ability to take over a failing firm like Lehman Brothers to prevent its collapse from infecting others. Little has happened.
Back then, the Obama administration said it was firmly behind the proposal; Senator Christopher J. Dodd, Representative Barney Frank and other leading Democrats similarly made noises about how they planned to try to pass the legislation by July 4.
But as the economy has seemingly recovered and President Obama has focused his attention on health care and other issues ? all of which no doubt merit attention ? perhaps the one piece of legislation that could prevent a repeat of what has arguably ruined the lives of millions of people has been left in limbo.
?It should be the first priority of both the Congress and the administration,? said Frederic S. Mishkin, a former governor of the Federal Reserve and an economics professor at Columbia. ?The public may be upset about bailouts. But by not having the resolution authority, we actually are making it more likely there has to be bailouts.?
Mr. Geithner?s proposal is part of a legislative effort aimed at reforming the financial services industry. As a result, the measure appears stuck in a bottleneck while Treasury, the Federal Reserve and the Federal Deposit Insurance Corporation battle over other parts.
So what would ?resolution authority? look like? It would allow the government to put an investment company into conservatorship, just like Fannie Mae or Freddie Mac, or receivership, the way the F.D.I.C. does with traditional banks.
The benefit is that it avoids bankruptcy protection, a drastic step that not only spells the end of a financial firm but can lock up trades of various counterparties and freeze markets, similar to what happened after Lehman Brothers filed.
Mr. Mishkin said he viewed ?the shock after Lehman to be worse and more complicated than the one that caused the Great Depression.?
Making a resolution authority would be complicated ? how do you compensate investors as you close out positions or liquidate assets ? and is one reason, in fairness to Congress, that the legislation has not advanced.
?Structured correctly, a credible resolution regime could force market participants to realize the full costs of their decisions and help reduce the ?too big to fail dilemma,? ? Mary L. Schapiro, the chairwoman of the Securities and Exchange Commission, testified over the summer. ?Structured poorly, such a regime could strengthen market expectations of government support, as a result fueling ?too big to fail? risks.?
But without any alternative, we are likely to be forced to continue the practice of ad hoc bailouts, out of fear that bankruptcy will be a worse outcome.
?If you don?t have resolution authority, you have a game of chicken,? Mr. Mishkin said, with the financial firms having the upper hand against, us, the taxpayers. ?They can basically say to the government, ?Either you give me the money or you can put me into bankruptcy ? and guess what? ? you?ll have another Lehman.? ?
That means, he added, that Treasury has little power to press financial firms to get their houses in order.
As we approach a different anniversary, that of 9/11, there is still no new building in the place of the World Trade Center, eight years after so many lives were lost and businesses destroyed.
Addressing the critical issue of resolution authority in less time could be essential to avoiding another financial crisis.
The latest news on mergers and acquisitions can be found at nytimes.com/dealbook.
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http://www.bloomberg.com/apps/news?pid=20601170&sid=aX8D5utKFuGA
Missing Lehman Lesson of Shakeout Means Too Big Banks May Fail
By Bob Ivry, Christine Harper and Mark Pittman
Sept. 8 (Bloomberg) -- 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.
One of the biggest problems with this failure seems to have been that money market funds started to look like they were going to 'break the buck', otherwise known as negative interest, otherwise known as watching what you thought was your super safe money market fund decrease in value...
"""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.""
This event led to President Bush going on TV and announcing that the FDIC would also insure money market funds to try and stem this massive run on the bank....
When money is put into banks and money market funds that money is 'put to work' by lending it out to others. So it's not always immediately available if everyone wants it back at once... Hopefully that money which represents the life savings of many people is lent out wisely.. We are now very aware that it wasn't... If people default and don't pay back that money then the fund contracts and has to 'freeze' by not letting people take their money out because the money isn't there... So everyone has a little less than what they put in resulting in 'breaking the buck'.
This also relates to being 'over leveraged'. If you lend out money based on some asset such as a house as collateral which you 'over value' then this lending also starts to fall apart if the asset loses its value... You have lost your collateral or backstop backing that loan... The Federal govt has massively stepped in to provide that backstop but the process of deleveraging back to prudent levels is continuing. This involves coming to terms with 'toxic assets' which essentially represents overvalued collateral.... This process is still in a fragile state and will certainly claim more victims....
http://www.washingtonpost.com/wp-dyn/content/article/2009/09/03/AR2009090303584.html
Lehman Brothers Failure May Have Saved Us All
By Steven Pearlstein
Friday, September 4, 2009
We're coming up on the one-year anniversary of the Great Financial Meltdown, and running through much of the retrospective coverage will be the notion that it was far worse than it needed to be because the government mistakenly allowed Lehman Brothers to fail.
Certainly that is the conventional wisdom. Janet Yellen, the president of the Federal Reserve Bank of San Francisco, told an academic conference that the decision not to rescue Lehman caused a "quantum jump" in the magnitude of the financial crisis. Economist Allan Meltzer bellowed on the op-ed pages last week that letting Lehman "fail without warning is one of the worst blunders in Federal Reserve history." French finance minister, Christine Lagarde, called it a "horrendous" decision. Sir John Gieve, who at the time was deputy governor of the Bank of England, told a British newspaper it was a "catastrophic error."
In truth, we'll never really know what would have happened if Lehman had been rescued, but we do know that it wasn't for lack of trying. That weekend a year ago, Treasury Secretary Hank Paulson and Fed Chairman Ben Bernanke summoned the heads of all the big Wall Street firms to the New York Fed and spent a long and frustrating time trying to orchestrate a rescue. Paulson and Bernanke claim that, in the end, there simply was no legal way they could commit taxpayer money to bail out a firm that was so highly leveraged and so deep into soured real estate investments that it had become insolvent. Those unwilling to accept that explanation, however, must ask themselves why equal blame shouldn't be assigned to the financiers who foolishly refused to pony up a few billions dollars each to avoid a far more costly calamity, and to Sir John and his British colleagues, whose refusal to bend the rules and offer the government guarantees that could have cleared the way for Barclay's Bank to ride to Lehman's rescue.
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There is also some reason to doubt that the financial crisis, and the recession, would have been significantly less severe if Lehman's collapse had been avoided.
It's true that financial markets went into a tailspin in the days after Lehman's bankruptcy filing. Credit and derivatives markets froze, banks hoarded cash, and the government was forced to bail out the country's largest insurance company, American International Group. And after a money-market fund that was holding too much Lehman paper announced that it was "breaking the buck," panicked investors began pulling money out of other money-market funds. Hoping to avoid Lehman's fate, rival Merrill Lynch threw itself into the arms of Bank of America, while the Federal Reserve hastily approved the applications of the two remaining independent investment banks, Goldman Sachs and Morgan Stanley, to become bank holding companies with free access to the Fed's lending window.
But it is also worth remembering that before Lehman's collapse, financial markets were already on edge and a sense of crisis was in the air. Financial stocks were in a free fall, and risk spreads had risen to levels well above historic averages. The government had already taken over Fannie Mae and Freddie Mac and seized one of the nation's biggest mortgage lenders, Indy Mac Bancorp. At that point, the failure or near-failure of any high-profile institution would surely have triggered the panic that eventually engulfed financial markets. Lehman happened to be the one that came along.
Moreover, subsequent events have only confirmed that, if Lehman had somehow been rescued, things would not have turned out a whole lot better for Citigroup, or Washington Mutual or Wachovia or Bank of America, or any of the institutions that eventually needed cash injections from the Treasury. And it certainly would have done nothing to save AIG or Merrill, whose rescues were set in motion during the same Lehman weekend. For the reality is that, underlying the liquidity crisis of last fall was a massive credit crisis -- too many risky loans made on loose terms and based on overly optimistic assumptions. Lehman's failure may have sped up the process by which all this lousy lending was revealed and the losses acknowledged, but the financial reckoning was inevitable.
The final point is a political one. A year ago, in the wake of the Bear Stearns rescue, the public -- left, right and center -- was hopping mad about government bailouts of Wall Street. Paulson isn't just kidding when he says that if he had used taxpayer money to save Lehman, impeachment proceedings would have begun against him the following day. It was only after the public witnessed the post-Lehman financial meltdown that Congress was willing to consider the idea of giving the Fed and the Treasury the money and the authority to launch a comprehensive rescue of the financial sector, and even then it took a second try before the House of Representatives would go along.
Far from being a mistake, letting Lehman fail may have turned out to have been the best thing Paulson and Bernanke could have done. Although they certainly didn't plan it this way, the events of that weekend not only accelerated a financial crisis that was inevitable, but accelerated a global policy response that would eventually prevent the total collapse of financial markets and save the world from a second Great Depression.
Steven Pearlstein can be reached at pearlsteins@washpost.com.
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http://www.nytimes.com/2009/09/08/business/economy/08sorkin.html?_r=1&ref=business
A Breakdown on Handling Big Failures
By ANDREW ROSS SORKIN
Published: September 7, 2009
Henry M. Paulson Jr., then the Treasury secretary, gave a little noticed speech in London in July 2008.
Even before the Lehman collapse, Henry Paulson called for a better way to handle such events.
?To address the perception that some institutions are too big to fail, we must improve the tools at our disposal for facilitating the orderly failure of a large, complex financial institution,? he said.
?We need to create a resolution process that ensures the financial system can withstand the failure of a large complex financial firm.?
It?s a little eerie now to read those prophetic words, which were uttered months after the Bear Stearns collapse.
But Mr. Paulson never got to the next step. Just two months later, Lehman Brothers collapsed, sending global markets and our economy into a tailspin.
As we approach the anniversary of some of the most cataclysmic failures in our economic history, we appear to be in perhaps no better position to manage the failure of an investment bank, a hedge fund or an insurance company than we were before.
Absent any legislation that would prevent another 9/15 (as some people are calling it on Wall Street) from happening, our only options are to throw money at problem companies or arrange shotgun marriages to keep them from failing. That hardly seems like a long-term solution.
Timothy F. Geithner, the current Treasury secretary, proposed legislation in March that would do exactly what his predecessor talked about ? give the government the ability to take over a failing firm like Lehman Brothers to prevent its collapse from infecting others. Little has happened.
Back then, the Obama administration said it was firmly behind the proposal; Senator Christopher J. Dodd, Representative Barney Frank and other leading Democrats similarly made noises about how they planned to try to pass the legislation by July 4.
But as the economy has seemingly recovered and President Obama has focused his attention on health care and other issues ? all of which no doubt merit attention ? perhaps the one piece of legislation that could prevent a repeat of what has arguably ruined the lives of millions of people has been left in limbo.
?It should be the first priority of both the Congress and the administration,? said Frederic S. Mishkin, a former governor of the Federal Reserve and an economics professor at Columbia. ?The public may be upset about bailouts. But by not having the resolution authority, we actually are making it more likely there has to be bailouts.?
Mr. Geithner?s proposal is part of a legislative effort aimed at reforming the financial services industry. As a result, the measure appears stuck in a bottleneck while Treasury, the Federal Reserve and the Federal Deposit Insurance Corporation battle over other parts.
So what would ?resolution authority? look like? It would allow the government to put an investment company into conservatorship, just like Fannie Mae or Freddie Mac, or receivership, the way the F.D.I.C. does with traditional banks.
The benefit is that it avoids bankruptcy protection, a drastic step that not only spells the end of a financial firm but can lock up trades of various counterparties and freeze markets, similar to what happened after Lehman Brothers filed.
Mr. Mishkin said he viewed ?the shock after Lehman to be worse and more complicated than the one that caused the Great Depression.?
Making a resolution authority would be complicated ? how do you compensate investors as you close out positions or liquidate assets ? and is one reason, in fairness to Congress, that the legislation has not advanced.
?Structured correctly, a credible resolution regime could force market participants to realize the full costs of their decisions and help reduce the ?too big to fail dilemma,? ? Mary L. Schapiro, the chairwoman of the Securities and Exchange Commission, testified over the summer. ?Structured poorly, such a regime could strengthen market expectations of government support, as a result fueling ?too big to fail? risks.?
But without any alternative, we are likely to be forced to continue the practice of ad hoc bailouts, out of fear that bankruptcy will be a worse outcome.
?If you don?t have resolution authority, you have a game of chicken,? Mr. Mishkin said, with the financial firms having the upper hand against, us, the taxpayers. ?They can basically say to the government, ?Either you give me the money or you can put me into bankruptcy ? and guess what? ? you?ll have another Lehman.? ?
That means, he added, that Treasury has little power to press financial firms to get their houses in order.
As we approach a different anniversary, that of 9/11, there is still no new building in the place of the World Trade Center, eight years after so many lives were lost and businesses destroyed.
Addressing the critical issue of resolution authority in less time could be essential to avoiding another financial crisis.
The latest news on mergers and acquisitions can be found at nytimes.com/dealbook.
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http://www.bloomberg.com/apps/news?pid=20601170&sid=aX8D5utKFuGA
Missing Lehman Lesson of Shakeout Means Too Big Banks May Fail
By Bob Ivry, Christine Harper and Mark Pittman
Sept. 8 (Bloomberg) -- 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.