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

As a group, the CEOs were nonetheless working hard to agree on a plan, but there was, understandably, some pushback. John Mack wanted to know why the government couldn’t arrange another assisted transaction, like the Bear Stearns rescue.

Tim quickly dismissed the possibility. “It’s not a feasible option,” he said. “We need to put another plan in place.” He made clear that the Fed could not lend against Lehman’s dubious assets but asserted that it wasn’t the government’s place to dictate the terms of any deal.

The three groups that Tim had organized to examine Lehman scenarios had worked through the night and reported on their progress. Citi, Merrill Lynch, and Morgan Stanley had been looking into an LTCM-type rescue, but that approach faded quickly as an option because it was impractical to liquidate Lehman without incurring huge losses, given the poor quality of its assets.

The team looking into how the industry might assist an independent buyer had spawned a series of subgroups to, among other things, scour Lehman’s books, identifying and valuing its toxic assets, and devise a deal structure that would allow an industry consortium to finance the purchase of, and absorb the losses on, those assets. Credit Suisse and Goldman Sachs led the way on valuing Lehman’s dubious real estate (Goldman had taken a look at the portfolio on its own earlier in the week). Credit Suisse’s Brady Dougan reported that private-equity assets carried by Lehman at $11 billion were worth around $10 billion, while real estate assets carried at $41 billion were more accurately valued at between $17 billion and $20 billion.

Brady’s report wasn’t a complete surprise, given the Street’s doubts about Lehman’s health, but it was shocking nevertheless. There was a more than $20 billion difference between what Lehman said its assets were worth and their true value. The CEOs were left wondering how their firms could fill a hole that size and what other bad assets—and losses—they would be asked to take.

With their background as major custodian banks, JPMorgan and Bank of New York Mellon had led the way on the “lights out” scenario. Noting the frailty of the market, and especially of the banks’ funding sources, Bob Kelly of Bank of New York Mellon remarked: “We have to figure out how to organize ourselves and how to do something, because we’re toast if we let this thing go,” he said.

I reiterated the severity of the situation. “I’m just going to say bluntly that you need to help finance a competitor or deal with the reality of a Lehman failure,” I told them.

“We must be responsible for our own balance sheet and now we’re responsible for others’?” Blankfein asked. “If the market thinks we’re responsible for other firms’ assets, that ups the ante.” The market, he believed, would now see all the investment banks as more vulnerable.

His observations had to trouble every free-marketer in the room. At what point were the interests of individual firms overridden by the needs of the many? It was the classic question of collective action. If the firms were forced to jointly support one failing institution, would they have to pony up aid for the next player to run into trouble? Where would it end? And what would the impact be on anyone’s ability to discern the industry’s true health? Potential investors assessing any bank’s balance sheet would have to consider not only its assets and liabilities, but whether it had properly accounted for the risk that it might have to bail out any one of its competitors. Under the circumstances, how could the market accurately gauge the condition of any financial institution?

When we stepped out into the main lobby, I noticed that the Fed building was filling up quickly. Before long, it seemed as if everybody I knew from Wall Street was there—CFOs, chief risk officers, heads of investment banking, senior staff from financial institutions groups, and specialists on lending, real estate, and private equity. Dozens of bankers were working on foldout tables spread throughout the lobby, in rooms off the lobby, and in offices all over the building, trying to come up with a rescue plan. Barclays had set up shop four floors above; Lehman was on the sixth floor; Bank of America was working at its New York offices. Each bank had a team of lawyers, and an unmistakable war-room atmosphere was evolving.

Tim and I decided we should meet individually with Jamie Dimon, Lloyd Blankfein, and John Thain. Jamie and Lloyd were the CEOs of the two strongest institutions and had been reducing their exposure to Lehman. We believed others would likely follow if they stepped up as leaders of a collaborative effort to save the stricken bank. John was a different matter entirely. Tim and I were concerned that if Lehman went down, his firm, which had the next-weakest balance sheet among investment banks, would be the next to go. We planned to ask him to find a buyer for Merrill Lynch.

Shortly before 11:00 a.m., Tim, Dan Jester, and I met in a 13th-floor conference room with Bank of America’s deal team: CFO Joe Price, head of strategy Greg Curl, financial adviser Chris Flowers, and legal adviser Ed Herlihy. Price and Curl explained that after poring over Lehman’s books, Bank of America now believed that to get a deal done it would need to unload between $65 billion and $70 billion worth of bad Lehman assets. BofA had identified, in addition to $33 billion of soured commercial mortgages and real estate, another $17 billion of residential mortgage-backed securities on Lehman’s books that it considered to be problematic. In addition, its due-diligence team had also raised questions about other Lehman assets, including high-yield loans and asset-backed securities for loans on cars and mobile homes, as well as some private-equity holdings. The likely losses on all of those bad assets, they estimated, would wipe out Lehman’s equity of $28.4 billion.

We asked if they would be willing to finance any of the assets they wanted to leave behind or take more losses. They said no.

To say the least, it was a disappointing session. Price and Curl weren’t even working off paper—they simply sat back in their chairs, reeling off ranges of huge numbers that would require an enormous private-sector bailout. At another time it might have been a humorous charade, but we were desperate to find a solution. Still, I wasn’t prepared to give up just yet, so I asked them if they would be available for a meeting or a call later to discuss in more detail what assets they wanted to leave behind. At a minimum I wanted to keep BofA warm as a bidder, because the presence of another buyer would help us negotiate more effectively with Barclays.

As everyone got up to leave, Chris Flowers motioned me aside and said, “Hank, can I tell you what a mess it is over at AIG?” He produced a piece of paper that he said showed AIG’s day-by-day liquidity. Scribbling arrows and circles on the sheet to outline the problem, Flowers told me that according to AIG’s own projections the company would run out of cash in about ten days.

“Is there a deal to be done?” I asked.

“They are totally incompetent,” Flowers said. “I would only put money in if management was replaced.”

I knew AIG was having problems—its shares had been pummeled all week—but I didn’t expect this. In addition to its vast insurance operations, the company had written credit default swaps to insure obligations backed by mortgages. The housing market crash hurt AIG badly, and it had posted losses for the last three quarters. Bob Willumstad, who had shifted from chairman to CEO in June, was expected to announce a new strategy in late September.

I relayed Flowers’s information to Tim, and we agreed to invite Willumstad over. He surprised me by saying Flowers shouldn’t attend. “Flowers is the problem, not the solution,” Willumstad said. I suspected that Chris was trying to buy pieces of AIG on the cheap, and I promised he would not be part of the meeting.