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

But Willumstad had a new plan, in which the Fed would provide a $40 billion bridge loan, in addition to the $10 billion AIG would generate from unencumbered securities. The company would sell some of its insurance company subsidiaries and use the proceeds to pay back the loan.

It was unnerving. Tim and I knew that an AIG bankruptcy would be devastating, leading to the failure of many other institutions. In one day the company’s shortfall had mushroomed to $50 billion. Tim said that the Fed was not prepared to lend to AIG and that the company should get a consortium of private lenders to make a bridge loan.

I joined Tim and Fed governor Kevin Warsh on a call with Ben, Fed vice chairman Don Kohn, and the rest of Ben’s team in Washington. We reviewed the day’s dreadful events. We were doing all we could, in Tim’s phrase, to spread foam on the runway to cushion the coming crash of Lehman.

Among these measures, the Fed had expanded the range of collateral that brokers could pledge to receive loans via the Primary Dealer Credit Facility (PDCF) to include anything accepted in the triparty repo system—such as stocks and non-investment-grade bonds. The big worry was that in the wake of a Lehman failure repo lenders would shy away from investment banks and other financial firms heavily dependent on that kind of financing. By expanding the PDCF’s eligible collateral, the Fed aimed to reassure repo lenders that if any investment bank counterparty ran into problems, it could get cash from the Fed for any collateral and use that to repay the triparty repo lender.

Separately, with encouragement from Tim and me, ten of the Wall Street firms had come together to create a $70 billion facility of their own that would provide emergency liquidity support for any of the participating banks that needed it.

After all these measures, though, we had run out of gas. None of us had any confidence that they would be sufficient. Some in the group asked if we should revisit the idea of putting public money into Lehman, but Tim said there was no authority to do that.

We were all frustrated to have worked so hard and come up empty. We knew that the consequences of the Lehman failure would be awful, but even so, we did not know what would face us in the morning—or in the days to come. I had a sense that the situation had gone beyond our ability to handle it on our own. I told Ben and Tim and the others on the call that the time had probably come to go to Congress for fiscal authorities to deal with the unfolding crisis. We had all wanted this for some time.

After the Fed call, I heard the only good news of the weekend: Bank of America was going to buy Merrill Lynch for $50 billion. Thain had managed to arrange a sale at $29 per share, a 70 percent premium over Merrill’s market price. I was relieved: without this, I knew, Merrill would not have lasted the week.

We had planned to announce Lehman’s bankruptcy at 4:00 p.m., four hours before Japan’s markets opened, to allow as much time as possible for market participants to prepare themselves. The SEC was supposed to take the lead on this, but all afternoon I got reports from the Fed that the commission was moving slowly. Chris Cox had been in his office for hours working on a press release to assure Lehman’s broker-dealer customers that they would be protected under SEC regulations. He was also supposed to discuss Lehman’s planned course of action with the company’s board of directors, but he had yet to do so.

Pressed by Tim and others, I finally walked into Chris’s office around 7:15 p.m. and urged him to move quickly to execute the SEC’s plan. “The Asia markets are opening!” I said. “You need to get your announcement out soon, and you can’t do that unless you are coordinating with Lehman. It is essential that you call the company now.”

Chris was waiting for Lehman to file for bankruptcy of its own volition. I understood that it was unusual and awkward for a regulator to push a private-sector firm to declare bankruptcy, but I stressed that he needed to do something to get the process moving for the good of the rest of the system. And although Chris wanted Tim and me to join him on the call, I said that as Lehman’s regulator, he should make the call by himself.

Finally, sharing the line with Tom Baxter, the general counsel of the New York Fed, and other Fed and SEC staffers, Cox called Fuld shortly after 8:00 p.m. to reiterate that there would be no government rescue. Lehman had no alternative to bankruptcy. Fuld connected Cox to Lehman’s board.

“I can’t tell you what to do,” Cox told them. “I can only tell you to make a quick decision.”

As it was, Lehman did not file for bankruptcy until 1:45 a.m. Monday, well after the Asian markets had opened.

While Tim and I waited together for Chris to complete the call with Lehman, I phoned Michele Davis and told her that despite the good news on Merrill Lynch, I was expecting a tough week. As difficult as it was going to be to get fiscal authorities from Congress, we didn’t have much choice, and it was going to take an all-out effort on the Hill. I told her I had alerted the president.

Kevin Fromer had been dealing with the legislative staffs, but I needed to brief the major congressional players and called Chuck Schumer, Barney Frank, Chris Dodd, and Spencer Bachus. “How are all of these free-market people going to feel about letting the markets work?” Barney asked me pointedly. But he clearly understood the ugly ramifications of these developments. He added that he was disappointed not to have heard from me earlier.

Before I left the New York Fed I met a final time with Tim. He had his work cut out for him, navigating the Lehman mess and trying to forestall an even worse one at AIG. Tim was still hoping to fashion a private-sector solution for the insurer. I agreed to have Dan Jester stay in New York to help with AIG, and Jeremiah Norton, deputy assistant secretary for financial institutions policy, would fly up to relieve Steve Shafran. I would return to Washington the next morning, while Tim’s team—with no time to rest after Lehman—tried to determine AIG’s liquidity needs and develop a plan to raise money.

I got back to the Waldorf about 10:00 p.m. Shortly after I arrived, John Mack called me. I could tell that the Morgan Stanley CEO was on edge. In just one day, Wall Street had irrevocably changed: Lehman Brothers was headed for bankruptcy, and Merrill Lynch was about to be bought by Bank of America. Morgan Stanley had held up well so far, but with those two firms gone, John was deeply worried.

“Come tomorrow morning,” he said, “the shorts will be on us with a vengeance.”

I woke up exhausted Monday morning after a few troubled hours of sleep, tormented by the increasing size of AIG’s problems and John Mack’s haunting words from the night before: with Lehman Brothers gone, Morgan Stanley could be next. From a window of my room in the Waldorf-Astoria, I watched as the still-quiet streets of Midtown Manhattan came slowly to life. It was just after 6:00 a.m. and not yet light, but I could see taxis dropping off passengers, trucks off-loading deliveries, workers hurrying to their offices to get a jump on the day.

Only a few hours before, just after midnight, Lehman Brothers had filed for bankruptcy, the biggest in U.S. history. I wondered if anyone out there on the streets could possibly imagine what was about to hit them.

President Bush called for an update shortly after 7:00 a.m., but I had nothing new to tell him. Lehman would have gone into administration by now in London, but the markets had not yet opened in New York. All I could offer were assurances that we would stay on top of the situation and keep him informed throughout the day. With luck, I told him, the system could withstand a Lehman failure, but if AIG went down, we faced real disaster. More than almost any financial firm I could think of, AIG was entwined in every part of the global system, touching businesses and consumers alike in many different and critical ways.