Paulson’s Complaint

In September, Lehman reported huge third-quarter losses, totaling nearly $4 billion. Two days later, the Feds stepped in. On Friday, Sept. 12, the heads of the Wall Street investment banks were summoned to an emergency meeting at the New York Federal Reserve. The black Town Cars began pulling up to the fortresslike Fed, which sits atop much of the nation's gold reserve, around 6 p.m. Paulson was there, along with Tim Geithner, president of the New York Fed. The century-old building was going through asbestos removal, so Paulson had to set up his command center in a makeshift conference room. "The furnishings were like a Ramada Inn in Toledo," recalled one of the participants, who, like the others who were there at the time, would not speak for the record because of the sensitivity of the negotiations. Paulson told the assembled Wall Street chieftains that it was up to them—not the taxpayers—to find a solution to the Lehman mess.

Back at Lehman, no one really believed that the Feds would stay on the sidelines. They thought Paulson was bluffing. But he wasn't. Paulson would later say that he was powerless—that under the laws governing the Federal Reserve, the government could not make a loan to an investment bank that lacked the necessary collateral. Paulson believed that Lehman had a multibillion-dollar hole in its balance sheet. There was not nearly sufficient collateral. Federal Reserve chairman Bernanke took the same view. To this day, former Lehman officials insist to NEWSWEEK that Paulson and Bernanke never told them that the Fed was required by law to stay out of the game. Speaking not for attribution (because of pending lawsuits from disgruntled former shareholders), these Lehmanites recall a lot of talk from Paulson about moral hazard, which they regarded as posturing from a Goldman stuffed shirt.

Fuld did not attend the summit meeting at the Fed; the Lehman board instead sent his No. 2, Bart McDade. Fuld refused to accept the signs that the end was near. He stayed in his office at what he called "the Mother Ship," working the phones, searching for a white knight. On that same weekend, he was reaching out to Ken Lewis, chairman of Bank of America. B of A was big enough to buy Lehman, and Lehman offered the giant bank a chance to get in the Wall Street game with a veteran player. But as Friday night dragged into Saturday, Lewis was not calling back. "Dick didn't understand," recalls a colleague who was there. According to this person, Fuld kept asking, "What's the story? Why is he not calling me? What's happening here? I don't understand it." Even in the cutthroat world of dealmaking, calls are usually returned, if only to say no. Fuld thought Lewis was being rude. Unknown to the Lehman team, Lewis had been buying a Wall Street firm that day—just not Lehman Brothers. The chairman of the Bank of America had been secretly closeted with John Thain, the chairman of Merrill Lynch, at B of A's corporate apartment in the Time Warner Center. Merrill, like Lehman, was in deep financial trouble. But Merrill employed a vast network of retail stockbrokers that made it an attractive target for B of A.

Another important person was not returning Fuld's calls that day: Hank Paulson was suddenly nowhere to be found. (Fuld was calling "every 10 minutes," according to a former Treasury official who was present.) Later, the Lehmanites suspected that Paulson had quietly encouraged Thain of Merrill to meet with Lewis of Bank of America, and they saw a plot. Thain, like Paulson, is a Goldman Sachs alumnus. Some on the Lehman team later groused that the Goldman men had gotten together to stab Lehman in the back—to ruin Lehman's courtship of Bank of America by secretly arranging the marriage of Merrill and B of A. To NEWSWEEK, Paulson rejected this notion, though he acknowledged that he did encourage Thain to speak to Lewis—simply because Merrill was in trouble, too.

Never known for giving up, Fuld had one more card to play—with Barclays, a well-known British bank. Indeed, as late as Sunday morning, some of Fuld's lieutenants believed they had a deal. But complications arose: the British government was balking, and Barclays shareholders had not been given a chance to meet. Time was running out. Sunday evening, Lehman's McDade returned from all-day meetings with other Wall Street barons and top government officials at the Fed with some very bad news: the government wanted Lehman to declare bankruptcy—that night, before the markets in Europe and Asia opened. "I can't believe it," Fuld said when he learned the Barclays deal had fallen through, according to someone who spoke with him about Lehman's position late Sunday. A call came from Christopher Cox, the head of the Securities and Exchange Commission. Over the speakerphone, Cox informed the Lehman bosses, "You have a grave responsibility." The Lehman executives were aghast. They knew that the consequences of a bankruptcy would be severe—that Lehman would default on debts owed to big Wall Street players. Paulson also knew the consequences would be serious. But none of the top federal officials foresaw just how bad it would get—money markets so severely hit that, for a time, it seemed that massive, global bank runs were a real possibility.

They were saved by the quick thinking of the chairman of the Federal Reserve. Ben Bernanke is so mild, his voice is gentle and sometimes quavery. He grew up in a small South Carolina town and spent his life as an academic. But Bernanke's academic specialty was the Great Depression, and the lesson he learned, above all, was that the federal government could not afford to wait to step in. In the days after the fall of Lehman, Bernanke basically threw open the banking window of the Fed and poured out $1 trillion in loans. "People are referring to you as 'The Loan Arranger,' with your faithful companion Hank," Barney Frank, the irrepressible chairman of the House Financial Services Committee, told Bernanke.

The frontman remained Paulson, who seemed to stumble about through late September and early October. It was Bernanke who persuaded Paulson to go to Capitol Hill for massive bailout money, but it was a very tough sell, and Paulson nearly blew it. Congress originally rejected the bailout and approved it only with last-minute revisions—and after the stock market had plummeted. Bernanke's low-key but incisive manner worked better with lawmakers than Paulson's bluster. With the House resisting Paulson's proposal to give him virtually unlimited authority to disperse funds to banks, House Speaker Nancy Pelosi announced that she was getting ready to leave town the weekend after Lehman's collapse and would be back Monday. Bernanke quietly but forcefully piped up, "We may not have an economy on Monday." Paulson is proud that he and Bernanke were able to prevent the entire global financial system from collapsing, through their emergency use of the Treasury's Exchange Stabilization Fund and Fed guarantees that kept money-market funds afloat. "If we hadn't come up with that, whoa," says Paulson.

At Lehman, the story is over—but not quite. Many of the Lehman traders found jobs at Barclays, where they trade today. The atmosphere is not quite the same. No one wears neckties, and there are no longer Brazilian shoeshine boys walking the rows of trading consoles, offering a shine for $10. But when the traders answer the phones, they sometimes still defiantly shout, "Lehman!"

Paulson's book, which will be published in October by Business Plus, will play down Lehman's fall and play up the steps taken by the government to save the economy. And in some ways, he's right. Though Lehman's collapse traumatized policymakers and banks for months—no one talks about moral hazard any more— it was mainly a sideshow to a larger crisis. Off the football field, the Hammer, it appears, was sometimes more of a nail.

With Suzanne Smalley, Matthew Philips and Nick Summers

© 2009