Hank Paulson in Winter

Hank Paulson, former master of the universe, sits in a nondescript office in northwest Washington, D.C. He is trying to work on his memoirs, but he is struggling. He doesn't seem like the onetime All-Ivy tackle at Dartmouth, the Harvard M.B.A. who ran Goldman Sachs, the prince of Wall Street who went on to be come secretary of the Treasury. He comes across more like an athlete who has lost a game and can't stop talking about the dropped pass, the missed shot. He is trying to explain the weekend last September when Lehman Brothers went down—and the financial world collapsed.

The conventional wisdom, he admits, congealed quickly: it was a mistake for the government to let Lehman die, and the blame rested squarely with Hank Paulson. On the day that Lehman filed for bankruptcy, Paulson had tried to get out ahead of the story. If Lehman couldn't save itself, he told reporters, then he wasn't about to ask the taxpayers to step up. "I never once considered it appropriate to put taxpayer money on the line," he said. The message was that the government would no longer bail out failing companies—that would just invite more foolish risk-taking. It would create a "moral hazard."

But of course, in the weeks and months since the fall of Lehman Brothers, the government has gone on to bail out banks and other financial firms to the tune of hundreds of billions of dollars. So why didn't it save Lehman? If only the government had rescued Lehman, a financial panic could have been averted. Or so the story goes. The narrative was set from the beginning by Paulson's moralizing tone, followed by a market crash—and, as the once mighty bankers crawled out of the wreckage, the anguished testimony before Congress of Dick Fuld, the CEO of Lehman, who portrayed Paulson as a backstabbing Judas. "Until they put me in the ground," Fuld said, leaning into the microphone and baring his teeth, "I will wonder."

Paulson insists that he did not turn his back on Lehman. "There's no company that I spent more time with and worked harder to save. That's sort of the irony of the narrative that we wanted them to go under," he told NEWSWEEK in one of his first extended interviews since leaving office. He also dismisses the argument that the fall of Lehman provoked a panic. "It is absolutely a fiction that Lehman was anything more than a symptom." He says a perfect storm of other near failures caused the financial crisis—the troubles at Fannie and Freddie, the news that AIG faced huge liabilities from its financial insurance gambles, the teetering of giant mortgage lender Washington Mutual on the edge.

All this is true enough, but it doesn't mean that Paulson knew what he was doing when Lehman went down. The panicked scenes that played out between bankers and policymakers during Leh-man's last days were recounted in the newspapers in the weeks that followed. But now, more than half a year later, and with the most acute moments of the financial crisis behind us, the key players are better able to reflect on the decisions they made. Perhaps no one has spent more time reconstructing the events than Paulson. In retrospect, it appears that Paulson was not the callous titan of Wall Street, but rather an earnest, sometimes bewildered man caught in a whirlwind he could not tame or even fully understand. He did the best he could, reaching, sometimes lurching for answers, but in the end he was rescued by the sort of nerdy professor type who might have been devoured on the trading floors of Wall Street. To the extent that there was a hero during those weeks, it was arguably Ben Bernanke, the quiet, shy chairman of the Federal Reserve, whose problem-solving and salesmanship before a skeptical Congress were critical to avoiding financial disaster.

Paulson was known as "the Hammer" as a 6-foot-1, 200-pound tackle on the Dartmouth football team because he seemed to explode at the snap of the ball. Tenacity and drive, more than brainpower, have distinguished his career. He has been a champion arm-twister and shrewd enough: when he rescued Goldman's IPO in the wake of the Russian financial crash in 1998 he made hundreds of millions for his partners and shortly thereafter became their leader. Yet Paulson can be oddly inarticulate for such a powerful man. He is not a Wall Street smoothie: no trophy wife (he remains married to his college sweetheart), and at Goldman he was known for wearing penny loafers, not handmade Italian shoes. He's an avid bird watcher. A nonsmoking, nondrinking Christian Scientist, he did not head for the Hamptons on the weekend but visited his mother in Barrington, Ill. Yet, physically imposing, radiating a confident forcefulness, he came to stand for the dominating Goldman brand. In the Wall Street hierarchy, Goldman is the smartest and most confident of them all: the firm makes bets, but only ones it feels sure to win.

The Lords of Goldman, who tend to come from Ivy League schools, looked down on the hustlers at lower-ranked firms like Lehman, who came out of state schools and the trading pits. Lehman was an old firm, but its modern incarnation was built in the image of its scrappy CEO, Fuld, who came from the trading floor and liked to make big, risky bets. Fuld was called "the Gorilla," a nickname some might have resented. Fuld kept a toy gorilla in his office. His ethos was us (the public-school guys—Fuld went to the University of Colorado) against them (the Harvard know-it-alls like Paulson of Goldman Sachs). Paulson and Fuld have known each other for years. For the record, as well as in private, Paulson describes Fuld as a "good guy" and even as a "friend." (Fuld declined to speak to NEWSWEEK). But knowledgeable Wall Streeters and government officials who asked to remain anonymous in order to speak more freely say that Paulson regarded Fuld as a gambler who lost sight of reality.

Paulson began having his doubts about Fuld—and the future of Lehman—as early as October 2007, when Lehman made a big bet on commercial real estate even though there were signs the deal was unwise. Paulson remained dubious about Leh-man's rosy earnings reports for the first half of 2008, and when the red ink began to show in June, he began urging Fuld to scale back Lehman's leverage and find a buyer or a fresh infusion of capital. He was frustrated, say these knowledgeable sources, when Fuld stubbornly demanded terms that were too favorable to Lehman to attract any buyers or investors.

Fuld's 31st-floor midtown office had sweeping views of the Hudson River and the New York City skyscrapers. In early September, the executive suite of Lehman Brothers became a kind of war room; day and night, Fuld's lieutenants padded about, munching M&M's and chugging Diet Cokes, as they searched, with growing desperation, for a solution. A South Korean bank had seemed interested in investing, then backed off. Fuld and his men tried to stay hopeful. Six months earlier, in March, JPMorgan had rescued the failing investment bank Bear Stearns—with the help of a loan from the federal government. In early September, the Feds seized control of Fannie Mae and Freddie Mac, the two mortgage giants sucked down by the collapsing real-estate market. Surely, the Lehman team believed, the Feds would step in to help—if Lehman could only find a buyer.

Paulson does not seem to have grasped the urgency of the looming disaster. Although top financial experts were warning about the housing bubble back in 2006, Paulson—by his own admission—was not paying much attention to the way banks were slicing and dicing mortgages and selling them as complex securities. "I didn't understand the retail market; I just wasn't close to it," he told NEWSWEEK. But while he was at Goldman, he had lobbied Congress—successfully—for new rules allowing investment houses to at least double the amount of leverage they could carry.

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.