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

The company’s immediate difficulties stemmed from the fact that it had written huge amounts of credit default swap insurance on obligations backed by mortgages. Those contracts included triggers: if AIG got downgraded, it had to post additional collateral. AIG’s collateral requirements also depended on the fair market value of the securities it insured, which was eroding with the declining housing market. In this Saturday meeting, Doug Braunstein, AIG’s financial adviser from JPMorgan, described AIG’s books as aggressively marked.

“What do you mean by aggressively?” I asked.

“The opposite of conservatively,” the veteran banker shot back quickly.

Not long afterward, I shared my concerns about Lehman with Josh Bolten at the White House. “This is one of the most difficult situations I could have imagined,” I said. “There’s a big difference between what Lehman assets were marked at and what the buyers are willing to pay.”

Josh got an earful from me as I explained the other two balls we were juggling in New York. We had gone into the weekend to save Lehman Brothers, and now AIG was facing a liquidity crisis that had put it on the verge of bankruptcy, and we had become concerned enough about Merrill Lynch to urge John Thain to sell that firm.

Meantime, the CEOs and their teams were all working hard. It was an amazing scene, all these financial industry executives reviewing spreadsheets, crunching numbers, trying to devise a solution. Rivals from different firms were working together. Senior traders sat at one set of tables, figuring out how to net out firms’ exposures if Lehman went down. In another area, people studied Lehman’s private-equity portfolio, trying to get a handle on the losses their firms would have to absorb if they lent money against it. It was inspiring to see all these fierce competitors trying to save a rival.

By evening the CEOs had agreed to support in principle a proposal under which Barclays would leave behind a pile of bad real estate and private-equity investments and wipe out Lehman’s preferred and common shareholders. To make the deal work, Barclays wanted the consortium of Wall Street firms to agree to loan up to $37 billion to a special purpose vehicle that would hold the assets. These had been carried by Lehman at $52 billion, but after their analyses the firms estimated their value at closer to $27 billion to $30 billion. The firms stood to lose collectively up to $10 billion. Barclays was also going to contribute some of its own shares, which would reduce the loss to the firms. It would still cost them dearly, but Lehman would be saved.

I left the New York Fed before 9:00 p.m. optimistic about the prospects for a deal. The industry was doing its part to come up with funding, and I had reason to believe we would find a solution to Barclays’s need for a shareholder vote.

Anticipating another sleep-deprived night, I arrived back at the hotel exhausted. I went into the bathroom of my room and pulled out a bottle of sleeping pills I’d been given in Washington. As a Christian Scientist, I don’t take medication, but that night I desperately needed rest.

I stood under the harsh bathroom lights, staring at the small pill in the palm of my hand. Then I flushed it—and the contents of the entire bottle—down the toilet. I longed for a good night’s rest. For that, I decided, I would rely on prayer, placing my trust in a Higher Power.

I had gone to bed modestly optimistic about our chances of saving Lehman and hopeful that John Thain would find a partner for Merrill Lynch. I’d left Steve Shafran and Dan Jester behind, working at the New York Fed with Bob Diamond and the Barclays team to nail down their offer, and with the Wall Street consortium to structure the loan terms. When I spoke to Steve and Dan first thing Sunday morning, they’d barely had time to take a shower or shave, much less sleep. Reasonably confident that the Barclays bid was proceeding, they’d left the Fed at 4:00 a.m., when Diamond said he had to plug into a board meeting. They also reported that they had made good progress with the consortium on a preliminary term sheet for the loan that the Wall Street firms would need to provide for the Barclays deal.

Tim spoke with Diamond after the Barclays board meeting, at 7:15 a.m. New York time, and Bob warned him that Barclays was having problems with its regulators. Forty-five minutes later Chris and I joined Tim in his office to talk with Diamond and Varley, who told us that the FSA had declined to approve the deal. I could hear frustration, bordering on anger, in Diamond’s voice. He and Varley indicated that they were surprised and embarrassed by this turn of events.

We were beside ourselves. This was the first time we were hearing that the FSA might not support the deal. Barclays had assured us that they were keeping the regulators posted on the transaction. Now they were saying that they didn’t understand the FSA’s stance. We told them we would contact the U.K. officials right away and get to the bottom of this.

Subsequently, Tim and Chris spoke separately with Callum McCarthy, the FSA chairman. The British regulator, they learned, was not prepared to approve the merger, but at the same time, the FSA was careful to say it was not disapproving the merger, either. I recall both Tim and Chris saying that the FSA had raised concerns about the need for more due diligence, Barclays’s plans to raise capital to fund the acquisition, and guaranteeing Lehman’s trading book during the shareholder vote. All this added up to a delay, and delaying the deal was the same as killing it: we needed certainty today.

As I listened to Tim and Chris, I went over again in my head my Friday conversation with Alistair Darling, and it occurred to me that I had not caught his true meaning when he’d expressed concern about a British bank’s buying Lehman. What I had taken as understandable caution should have been taken as a clear warning.

Tim spoke with Callum McCarthy again around 10:00 a.m. in an attempt to get the British to waive the listing requirement for a shareholder vote so that Barclays could go ahead and buy Lehman. But the FSA chief put the onus on Darling, saying that only the chancellor of the Exchequer had the authority to do that.

With Bank of America gone and Barclays now in limbo, we were running out of options—and time. Treasury had no authorities to invest capital, and no U.S. regulator had the power to seize Lehman and wind it down outside of very messy bankruptcy proceedings. And unlike with Bear Stearns, the Fed’s hands were tied because we had no buyer.

Markets demand absolute certainty, and we had known all along that Lehman couldn’t open for business on Monday unless it had lined up a major institution, like Barclays, to guarantee its trades. That had been the crucial element of the Bear Stearns rescue. Even after JPMorgan, backed by the Fed, had announced that it would lend to Bear Stearns on Friday, March 14, the investment bank had continued to disintegrate. A collapse was only avoided on Sunday when JPMorgan agreed to buy Bear and guarantee its trading obligations until the deal closed. That halted the ongoing flight of counterparties and clients, averting Bear’s bankruptcy.

The Lehman situation differed from Bear’s in another important way. The Bear assets that JPMorgan left behind were clean enough to secure sufficiently a $29 billion Fed loan. But an evaluation of Lehman’s assets had revealed a gaping hole in its balance sheet. The Fed could not legally lend to fill a hole in Lehman’s capital. That was why we needed a buyer. And we hoped that the private sector would assist the buyer by providing $37 billion in financing that was exposed to $10 billion or so of expected losses from minute one.