15 September 2008: When Lehman Brothers Crash Took Down World Financial System

In a moving speech to his employees – his first after the events of 9/11 – chief executive officer (CEO) Richard S Fuld Jr broke into tears after he was asked when the firm would resume trading. “We don’t even know who is alive,” he lamented.

Working on a street from across the World Trade Center, Lehman Brothers had to vacate its office space in the aftermath of 9/11. Working out of rooms in the Sheraton, the employees of Lehman showed great resolve, led by their CEO Fuld.

When Fuld took over as the chief executive of Lehman in 1994, the firm was recovering from an annual loss of $102 million in 1993. From 1994 to 2007, under Fuld, Lehman registered profits each year with $4.2 billion in 2007. In 2008, when the financial crisis crashed the banks on Wall Street, Fuld was the longest-tenured CEO.

Contrary to popular opinion, it wasn’t Fuld alone who had crashed the Wall Street. Reckless in their lending, the banks had worked with high leverage in the years after the dot-com bubble. Eventually, investment banks on the Wall Street took over mortgage lenders across the United States. Working with high leverage, investment banks undertook a debt of $30 for every single dollar in equity.

Creating financial derivatives like Credit Default Swaps (CDS), Collateralised Debt Obligations (CDO), and synthetic CDOs, these investment banks increased their exposure to each other through extensive trading. While the gullible homeowner paying their mortgage assumed that they were paying back the lender, they were paying back the investment banks who were trading millions of such subprime mortgages in the form of financial derivatives among themselves.

Starting in 2007, the defaults on those subprime mortgages began rising. By the end of the first quarter of 2008, it had all gone haywire. Investment banks trading complex financial derivatives were left with assets in the form of surplus houses that had no value, thus putting the entire financial system at risk.

It fell to Hank Paulson, the United States (US) Treasury Secretary and former CEO of Goldman Sachs; Ben Bernanke, chairman of the Federal Reserve and the successor to Alan Greenspan, the brains behind the deregulation spree that the financial system underwent in the 1990s; Timothy Geithner, president of the New York Federal Reserve, the youthful banker who had managed to get together a $100 billion for bailing out Asian countries in 1997; and Christopher Cox, chairman of the Securities and the Exchange Commission (SEC) to come to the aid of the Wall Street.

The first Wall Street victim of the crisis was not Lehman Brothers, but Bear Stearns. Paulson discreetly aided the negotiations that resulted in the Bear Stearns merger with JP Morgan Chase. While JP Morgan bought Bear Stearns for $2 a share, the government assisted JP Morgan with a $30 billion bailout for the troubled assets Bear Stearns held.

The trouble for the government did not stop there. Days before the Lehman collapse, the government had to pledge over $200 billion to rescue private mortgage lenders Fannie Mae and Freddie Mac. This move of the government got the Republicans and Democrats together in criticising Paulson and Bernanke. One of the Senators termed Paulson’s actions as that of a finance minister in China while stating that socialism was alive in the United States.

Staring at the collapse of Lehman Brothers, Paulson knew he was without the option of a bailout. For long, Lehman Brothers had failed to raise any cash. Fuld, in his delusion, had blamed the short sellers for driving down the value of Lehman’s stocks. Geithner, in a statement to Bernanke, stated that Lehman would not be able to meet its obligations on 15 September 2008.

The Treasury, for a brief while, flirted with an idea known as the ‘Break the Glass’ plan. For a trillion dollars in troubled assets, the Treasury was going to purchase roughly $600 billion worth of assets via the auction mechanism. The bidder – in this case, the investment banks, would be given Treasury securities. The option of providing cash in exchange for assets was not considered for it would have equalled a bailout and the government agencies feared reckless lending by the banks.

The plan was to get the best investment minds from Wall Street to host weekly auctions for three to four months, with the Treasury buying $50 billion worth of assets each week. The plan was, however, shelved, for it would have taken long before the Treasury could stabilise the markets. The banks needed saving urgently. Lehman needed it both urgently and desperately.

In the March of 2008, Fuld had reached out to Warren Buffett after Paulson refused to intervene on Fuld’s behalf. Buffett was willing to invest in preferred shares, each valued at $40 at 9 per cent dividend. The same day, Lehman’s stock had closed at less than $38. Thus, for a $4 billion investment in Lehman, Buffett would be due for $360 million a year. Fuld turned down the offer.

For a few months at the time, Lehman had been looking at three saviours from three different continents.

Lehman’s survival idea was called ‘The Gameplan’. Under this plan, the bank would segment its most troubled assets into a different bank and let the valuable assets remain under the holdings of Lehman Brothers.

The first to the rescue was Korea Development Bank (KDB). They had been in discussions with Lehman for long with latter’s team visiting South Korea to secure a deal. This time the Koreans were in Lehman’s office. Having made clear that the KDB will not take over Lehman’s troubled assets in real estate, the Koreans were ready to make an initial offer with the backing of their regulator. KDB valued Lehman’s share at $25. Ironically, the marked had closed a day before with the same shares trading for $15.57. This was a steal for Lehman before Fuld stepped in and wrecked the deal.

Fuld, who had been asked to stay away from negotiations by his staff, stepped in before the Koreans were to sign the letter of intent. Pushing on the KDB to look at real estate, Fuld estimated their value to be 20 per cent higher than what they were valuing them for. Visibly upset, the KDB saw Fuld’s stunt as a desperate attempt to boost Lehman’s credit capacity. A while later, the Koreans walked out, leaving Fuld confused. The deal was off.

The next contender was Bank of America (BoA). Unlike Lehman, which was an investment bank, the BoA was a commercial one, dealing in deposits and loans without investing in any financial instruments. In their evaluation of Lehman’s assets, the BoA had discovered an additional $32 billion in risky investments in commercial real estate assets. The BoA now wanted a deal similar to what JP Morgan Chase had got in the case of Bear Stearns. Paulson, however, was not interested in another bailout.

The final contender for Lehman was Barclays Capital. Eager to gain a foothold in the US, Barclays had been hoping for a Lehman buyout for quite a while. Goldman Sachs, Paulson’s former workplace, had already been digging into Lehman’s books for asset evaluation. Thus, Fuld was hopeful of a buyer before the morning of 15 September.

Working towards a private sector solution that could interest BoA or Barclays, the office of the Federal Reserve summoned CEOs from Wall Street. These included Jamie Dimon from JP Morgan Chase, Vikram Pandit from Citigroup, Brady Dougan from Credit Suisse, John Mack (Fuld’s closest ally) from Morgan Stanley, Lloyd Blankfein, Paulson’s successor at Goldman Sachs, and John Thain from Merrill Lynch, the bank projected to collapse in case Lehman went down.

The bankers were summoned to the New York Federal Reserve, in the underground vault of which lies the largest stockpile of gold in the world. Their job was to pool in enough money to sponsor Lehman’s ‘The Gameplan’, which meant taking over its troubled assets for the deal to be lucrative for either the BoA or Barclays.

Leaving them in a conference room for the weekend, Paulson advised them to come up with a working solution or else they all risked going down. By Saturday, 13 September, the group had come together with $33 billion to take over Lehman’s toxic assets. However, it was not going to be enough.

The BoA had identified $40 billion in troubled assets with Lehman Brothers. However, the number had increased to $70 billion upon further scrutinisation. The BoA was no longer interested in buying Lehman. John Thain, unlike Fuld, was not alien to the realities of Wall Street, had struck a deal with BoA. Merrill had been saved while Lehman’s only hope was Barclays.

When Paulson learned about the merger of BoA and Merrill from Thain, the latter expected him to be upset, for he had threatened a solution for Lehman. However, Paulson was visibly happy with the news and asked Thain not to worry about Lehman, for Barclays was still in play. Paulson always used to fear that the British play around but never close the deal. He wasn’t wrong.

The regulator of Barclays reached out to Geithner, president of the New York Federal Reserve, and told him that they were not ready to go forward with the deal. Citing many reasons which included guaranteeing Lehman’s trades, Barclays’ current capitalisation, and shareholder approval, the British regulator called off the deal. When Paulson tried to reach out to them, he was told that the British were not interested in importing America’s cancer.

Left with no options, Paulson requested the SEC Chairman, Christopher Cox, to ask the Lehman Board to file for bankruptcy before the government could announce it. Fuld, who was with his board when the call was made from the New York Fed, was confused before he agreed to call for the board to vote to file for bankruptcy. Forty-five minutes after midnight on 15 September, Lehman Brothers, a 158-year-old company, filed for bankruptcy. The Pandora’s box had been opened.

Lehman’s bankruptcy took down American Insurance Group (AIG), which was downgraded by credit rating agencies. Eventually, the government stepped in with a Wall Street bailout in the form of TARP or Troubled Asset Relief Programme.

The collapse of Lehman cost Fuld $640 million while the deal with Buffett, had it gone through, would have cost Lehman a mere $360 million, and could have given it a lease of life to hang on to. Could a small investment by Buffett have saved Lehman Brothers and, consequentially, Wall Street is a question that history may not have an answer to.

The Lehman Brothers crash was not a doctored one, nor was it unprecedented. It was a clear case of inflated egos, valuations, and beliefs – the same beliefs that marked the beginning of a global recession, on this day, 10 years ago.

This article is the third of a multi-part series on the Great Recession, which marks 10 years this September.

Read Parts 1, 2:

Ten Years Of 2008 Financial Crisis: How US Created The Great Recession

Ten Years Of 2008 Financial Crisis: The Housing Bubble Drama That Crashed The Global Economy