Henry Paulson - On the Brink - Inside the Race to Stop the Collapse of the Global Financial System

By and large, traders in the marketplace, and many commentators in the financial press, agreed that the price was too low. On Monday, Bear shares traded at $4.81—more than twice JPMorgan’s $2 offer—in expectation that JPMorgan would have to offer more to be sure to close the deal.

This created real uncertainty, which wasn’t good for anyone. Not for Bear, not for JPMorgan, and not for the markets, which were settling down. The Dow jumped 420 points on Tuesday, and credit insurance rates on financial companies fell away sharply: Bear’s CDS dropped from 772 basis points on Friday to 391 basis points on Tuesday, while those on Lehman fell from 451 basis points to 310 basis points and Morgan Stanley from 338 basis points to 226 basis points. We certainly didn’t want to return to the previous week’s tumultuousness.

JPMorgan understandably wanted to get the deal closed as soon as possible. As long as there was uncertainty, clients would continue to leave Bear Stearns, reducing the value of the acquisition. Why would a prime brokerage account or any other account want to stay when they could do business with any other bank or investment bank in the world?

Toward the end of the week, the deal looked like it was in danger of breaking apart. After talking to Alan Schwartz on Friday, March 21, Jamie was concerned that Bear could shop for another buyer and leave JPMorgan on the hook. Worried what might happen if shareholders did turn down his offer, Jamie wanted to be sure he could lock in enough votes to assure acceptance.

On Friday afternoon, I had a conference call with Tim Geithner, Bob Steel, Neel Kashkari, and Bob Hoyt in my office. We were on edge. We knew that the deal was far from certain, but we had no choice but to complete it.

The key was to deliver certainty. JPMorgan could raise its offer, but the bank and the market needed to be sure that at a higher price, Bear shareholders couldn’t hold up the deal in an attempt to get even more.

Sweetening the deal to lock in shareholder approval made sense, but it gave me another idea. “We should also try to get more for the government,” I said to Tim.

He agreed and pointed out that we had some leverage we could use. “They can’t change the deal unless we let them,” Tim said. “Our commitment is based upon the whole deal.”

“Maybe we can now get JPMorgan to take all the mortgages without government support,” I suggested.

But neither Tim nor I could get Jamie to agree. However, he did accept that with the Bear shareholders getting a higher price and JPMorgan’s shares up on news of the acquisition, the government deserved a better deal, too.

The question now was how to improve the U.S.’s position. There was a whole lot of discussion and turning in circles about whether we should try to share in the upside—by taking an interest in the mortgage assets so that if they were sold above their appraised value, we could participate in the gains. But in the end it was clear to everyone that negotiating downside protection for the taxpayer was the more prudent course. So JPMorgan agreed to take the first $1 billion loss on the Bear portfolio.

Meantime, the lawyers on both sides had restructured the deal to give JPMorgan the certainty it needed and Bear shareholders a boost in price. As part of the agreement, JPMorgan would exchange some of its shares for newly issued Bear Stearns stock that would give JPMorgan just under 40 percent of Bear’s shares. This arrangement came close to locking up the transaction.

The key to the share exchange was price. By Sunday, JPMorgan was ready to offer Bear stockholders $10 a share to close the deal. When I heard that Tim had signed off on $8 to $10, I wanted to go back and say, “Don’t go above eight.”

But Ben Bernanke said, “Why do you care, Hank? What’s the difference between $8 and $10? We need certainty on this deal.”

I realized that he was right. Even though it was an unseemly precedent to reward the shareholders of a firm that had been bailed out by the government, I knew that getting a deal done was critical. Bear had continued to deteriorate in the past week and had the capacity to threaten the entire financial system. So I called Jamie Dimon and gave him my blessing. Bear’s shareholders would vote on May 29 to approve, overwhelmingly, the $10-a-share offer.

I’ve read through old newspaper reports and recently published books about the Bear weekend. None of them quite captures our race against time or how fortunate we were to have JPMorgan emerge as a buyer that agreed to preserve Bear’s economic value by guaranteeing its trading obligations until the deal closed. We knew we needed to sell the company because the government had no power to put in capital to ensure the solvency of an investment bank. Because we had only one buyer and little time for due diligence, we had little negotiating leverage. Throughout the process, the market was determined to call our bluff. Clients and counterparties were going to leave; Bear was going to disintegrate if we didn’t act. And even though many people thought Jamie Dimon had gotten a great deal, the Bear transaction remained very shaky to the end.

We learned a lot doing Bear Stearns, and what we learned scared us.

For the first few days after the Bear Stearns rescue, the markets calmed. Share prices firmed up, while credit default swap spreads on the investment banks eased. Some at Treasury, and in the market, thought that after seven long months, we had finally reached a turning point, just as the industry intervention in Long-Term Capital Management had marked the beginning of the end of 1998’s troubles.

But I remained wary. Bear Stearns’s failure had called into question not only the business models but also the very viability of the other investment banks. This uncertainty was unfair for those firms that, after adjusting for accounting differences, had stronger capital positions and better balance sheets than many commercial banks. But these doubts threatened the stability of the market, and we needed to do something about the situation.

The Fed’s opening of its discount window to the primary dealers on March 17 had been a big boost. Because of its potential exposure, the Fed, working jointly with the SEC, began to put examiners on-site. This was a critical move. Investors who had lost confidence in the SEC as the investment banks’ regulator would be reassured to see them under the Fed umbrella.

The regulators’ initial analyses showed that Merrill Lynch and Lehman Brothers had the most work to do to build larger liquidity cushions. Merrill suffered from its share of well-publicized mortgage-related problems, but the firm was diversified and had by far the best retail brokerage business in the U.S., along with a strong brand name and a global franchise. I believed they would be able to find a buyer if they had to. Having worked with John Thain when he was Goldman’s president and COO, I was optimistic that he would get a handle on Merrill’s risk exposure and take care of its balance sheet. If anyone understood risk, it was John.

Lehman was another matter. I was frankly skeptical about its business mix and its ability to attract a buyer or strategic investor. It had the same profile of sky-high leverage and inadequate liquidity, combined with heavy exposure to real estate and mortgages, that had helped bring down Bear Stearns. Founded in 1850, Lehman had a venerable name but a rocky recent history. Dissension had torn it apart before it was sold to American Express in 1984. A decade later it was spun off in an initial public offering. Dick Fuld, as CEO, had done a remarkable job of rebuilding it. But in many ways, Lehman was really only a 14-year-old firm, with Dick as its founder. I liked Dick Fuld. He was direct and personable, a strong leader who inspired and demanded loyalty, but like many “founders,” his ego was entwined with the firm’s. Any criticism of Lehman was a criticism of Dick Fuld.