Lehman Report: Why the U.S. Balked at Bailing Out Lehman


As Lehman Brothers teetered, a public debate raged: Would the U.S. government save it the way it saved Bear Stearns and AIG? The official line from the government was no. But many couldn't believe it, given the systemic risk posed by a Lehman collapse.

In the end, the government did let Lehman fail, which happened on Sept. 15, 2008. Bankruptcy examiner Anton Valukas's report details this debate via the answers he got from Treasury Secretary Henry Paulson, Securities and Exchange Commission Chairman Christopher Cox, New York Federal Reserve Bank President Timothy Geithner and Federal Reserve Chairman Ben Bernanke. But in the end, their explanations ring hollow, as the events of Lehman's final days make clear.

According to Valukas, Cox believed "no statutory framework existed that allowed the government to help Lehman in a material way." Bernanke also believed that the government lacked legal authority, and he focused on Lehman's lack of collateral as the key problem. The Federal Reserve could only make a loan, he explained, if collateral supported it.

However, Bernanke explained to Valukas that by mid-September, Lehman lacked "any" collateral. Bernanke believed Lehman was insolvent as of Sept. 8. Giving Lehman a loan then would be "lending into a run," Bernanke felt. He continued: "The assessment was that if there was a run, which there would be . . . all we would have accomplished would be to make counterparties whole and not succeed in preventing the collapse of the company."

Circular Reasoning

Paulson similarly believed the government couldn't legally inject capital into Lehman -- that power came later, with the Troubled Asset Relief Program -- and he agreed that unlike AIG, which had valuable insurance subsidiaries, Lehman lacked collateral for a loan. In response to Valukas's questions, Paulson acknowledged that the Fed had the legal power to lend against any collateral, but he essentially made the "lending into a run" argument, explaining that he feared giving Lehman an emergency loan would perversely cause its clients to flee, ensuring its demise.

Paulson also told Valukas that unlike Bear, Lehman lacked a willing buyer. However, as the final days of Lehman show, the government's refusal to aid the firm bolstered the unwillingness of two potential buyers -- Bank of America (BAC) and Barclays (BCS) -- to save it. So, distinguishing the government's rescue of Bear from its refusal to save Lehman on the absence of a willing buyer for Lehman seems circular at best.

All the claims of a lack of legal authority to help are hard to understand when looking at a document the government drew up in preparation for the last-ditch "Lehman Weekend." Laying out strategies and plans, including possible government aid, the document as cited by Valukas has a list of "Open Issues." But a concern about lacking legal authority to help Lehman isn't on it, not even under the "Legal" subsection. What's more, Valukas reports that Bernanke stayed in Washington, D.C., during the Lehman Weekend in case he needed to convene a Fed board meeting to approve financing for Lehman.

It Wasn't Moral Hazard

Despite all the public talk of "moral hazard" -- and teaching the markets a lesson by letting Lehman fail -- Bernanke rejected the idea, telling Valukas: "I speak for myself, and I think I can speak for others, that at no time did we say, 'We could save Lehman, but we won't.' Our concern was about the financial system, and we knew the implications for the greater financial system would be catastrophic, and it was."

New York Fed General Counsel Thomas Baxter, who participated in the government's final efforts to save Lehman in the days before its bankruptcy, confirmed to Valukas "In no way was the idea to make Lehman a 'poster child' for moral hazard."

Valukas reports that Paulson, the public face of the moral hazard argument, said while "economic health depends on Wall Street firms believing that the government cannot and will not rescue them in a crisis, economic stability was nevertheless more important to the economy than moral hazard." Lest his sincerity be doubted, note Paulson said the same thing after bailing out Bear.

Geithner's Conversations With Fuld

Since the collapse of Bear, Lehman CEO Richard Fuld had regular contact with various governmental officials. Geithner spoke with Fuld numerous times in 2008, clustered around key events such as Bear's collapse in March, Lehman's June second-quarter earnings announcement and the days leading up to Lehman's bankruptcy. Between Bear's fall and the end of May, for example, Valukas reports Geithner spoke with Fuld at least 18 times. Between June and September, they spoke at least 23 times.

According to Valukas, Fuld would give Geithner updates on Lehman, and Geithner responded by repeatedly sending three messages: The "government cannot solve this problem for you," thus "Lehman needed to raise more capital," or "form a strategic alliance" with a stronger entity. Geithner rejected Fuld's idea that Lehman become a bank holding company as "gimmicky." He explained to Valukas: "You can't solve a liquidity/capital problem by becoming a bank holding company."

Of course, both Goldman Sachs (GS) and Morgan Stanley (MS) later saved themselves by successfully converting to bank holding companies less than two weeks after Lehman's bankruptcy.

Given that Lehman's balance-sheet problems could have been solved in theory by selling assets, not just raising capital, it's interesting that Valukas doesn't report Geithner conveying that message. Although Geithner he may have, the report suggests he didn't.

Geithner explained to Valukas: "Selling assets could result in 'collateral damage' by demonstrating weakness and exposing 'air' in the marks." (The latter point refers to the valuations of assets that were being carried on firms' books at levels far higher than they would be worth if sold on the open market.) The New York Fed had "to make sure that the system would be held together and that the strongest institutions would not be imperiled by the weakest."

In short, Geithner believed that other banks also were misrepresenting the value of their assets to the markets, but that did not concern him. The fact that they might have to accurately value them did.

Paulson's Messages to Lehman

Paulson was similarly in frequent touch with Fuld, speaking with him over 30 times between March and September. In April they saw each other at a G-7 dinner in Washington, shortly after Lehman had raised some capital. According to Valukas, Fuld came away from the dinner reporting that "Lehman had a 'huge brand with [T]reasury and that Treasury 'loved [Lehman's] capital raise.'" Paulson didn't remember the conversation, he told Valukas, but "assumed that he gave Fuld 'a big pat on the back.'"

According to Bernanke's conversations with Valukas, Treasury, along with the Fed and the New York Fed, was "trying to pressure Fuld to be more aggressive" but they were conscious of their "appropriate role," meaning they weren't Lehman's regulator, the SEC was. Paulson confirmed to Valukas that he "repeatedly urged Fuld to raise capital, find a strategic partner or sell Lehman."

Paulson told Fuld in July that the government would not help Lehman, and he believes he even raised the possibility of Lehman's bankruptcy, says Valukas. Fuld agreed that Paulson never promised help, says Valukas, but he denied that Paulson explicitly ruled it out.

The Government Saw Fuld as Overly Optimistic

Paulson told Valukas that "Fuld heard what he wanted to hear and was more optimistic than he should have been." Moreover, "Fuld had 'quixotic . . . ideas' about boosting market confidence," citing the June removal of Chief Financial Officer Erin Callan, which Paulson believed was "more alarming than calming." Bernanke told Valukas that Paulson was "frustrated" and "dissatisfied" with Fuld's "'more inertial behavior' with respect to raising capital and finding strategic partners."

Bernanke believed Fuld didn't appreciate Lehman's vulnerability, he explained to Valukas, and thought Fuld "was always more optimistic about Lehman's condition than the markets were."

Geithner told Valukas that while "[t]here is always some denial in these things," by July Geithner believed that Fuld accepted that "Lehman required 'a very substantial and expensive change' to survive."

The SEC's Cox thought Fuld, and Lehman generally, wasn't more aggressive about saving Lehman because Lehman counted on a government rescue. He explained to Valukas: "[I]t came as a surprise [to Lehman] that the government would not financially participate." He elaborated: "I think people would have behaved differently if they were not expecting the government to do something. Maybe if the message could have been provided [that no government funding existed] more than a week before [the bankruptcy], people might have ordered their affairs differently."

Why Fuld Believed a Rescue Was Likely

Despite Paulson's insistence that he consistently told Fuld the government wouldn't help, and Geithner's reinforcement of that message, Valukas reports that Fuld continued to believe the government would step in. Valukas's report includes reasons Fuld might think that way, beyond being "more optimistic than he should have been."

For example, in July 2008, two different plans were drawn up by the New York Fed to help Lehman. One, presented by its analysts to Geithner, would help broker-dealers such as Lehman by supporting their trading with a loan to their clearing banks. While open to all broker-dealers, the bank "tailored this plan to Lehman's repo book," reports Valukas. The proposal acknowledged that further legal research was required. If such a plan had been open to Lehman, it definitely would have helped because the collateral demands Lehman's clearing banks made were the final push that sent it over the edge.

The other July plan was proposed by current New York Fed President William Dudley that was "[v]ery much in the spirit of what we did with Bear." Dudley proposed a "Maiden Lane type vehicle" that he explained to Valukas would hold $60 billion of Lehman's illiquid assets, supported by $5 billion of Lehman equity and $55 billion in financing, or financing guarantees, from the Federal Reserve. In exchange, the Fed would get an equity stake in the "Clean Lehman" that remained after the illiquid assets were removed.

In many ways, this plan was essentially a federally assisted version of Lehman's own "SpinCo" plan. Geithner's emailed response to Dudley, cited by Valukas, said that "further thought was required on 'how we decide what assets to take' and that it would require 'high procedural hurdles.'" What hurdles, and why weren't they explained in Valukas's report?

Heartening Signs

Fuld was a member of the New York Fed's board of directors, so did Fuld know either plan had been devised? Valukas doesn't say. But if Fuld had heard of either, especially the Maiden Lane one, it's not hard to see how he could discount Paulson and Geithner's statements that no help would come. In addition, Dudley's Maiden Lane plan for Lehman suggests that at least some in the government believed it had the legal tools it needed to rescue Lehman.

As Lehman's doomsday drew near, Fuld might also have drawn hope from the government's bailout of Fannie Mae and Freddie Mac on Sept. 7. On Sept. 11 -- right before the "Lehman Weekend," the final government push to save Lehman -- Fuld was surely further heartened by Geithner's and Baxter's request that Fuld resign from the New York Fed board. Fuld claimed that Geithner said it was necessary "in case [they had] to do something [for or with Lehman] that weekend."

Geithner told Valukas he didn't remember saying that and was certain he didn't imply Lehman could expect help from the Fed. Nonetheless, a draft New York Fed agenda for the "Lehman Weekend," cited by Valukas, discusses possible Fed aid for Lehman. Geithner explained to Valukas that any such aid was "contingent on Lehman having a willing buyer."

Lehman's World Collapses

By Sept. 9, Lehman was falling apart. Two potential investors -- Korea Development Bank and the Investment Corp. of Dubai -- backed out. Two clearing banks, JPMorgan (JPM) and HSBC (HBC), demanded significantly more collateral from Lehman. Credit rating agencies Fitch and Standard & Poor's put Lehman's rating on a negative watch. And Lehman's share price had collapsed to $7.79.

The next day, Lehman announced its third-quarter loss, and Moody's also put Lehman's rating on negative watch. Over the next few days JPMorgan continued to ask for additional collateral, and Citigroup (C) strengthened its liens on Lehman's collateral. The New York Fed was publicly saying no government aid was coming.

Behind the scenes, however, the government was trying to help. Valukas reports that in early September, Paulson told BofA CEO Ken Lewis to "buy Lehman." BofA began its due diligence on Sept. 11. Not content to pin all its hopes on BofA, Valukas reports that the government also reached out to Barclays and British regulators.

On Friday, Sept. 12, BofA continued its due diligence, and Barclays started its own its own. Valukas reports that by Friday night, as the government convened an extraordinary meeting to negotiate a rescue of Lehman, BofA concluded that no deal would work unless the government would provide assistance to offset some $65 billion in assets that BofA didn't want "at any price."

With deliberately little warning to prevent leaks, Valukas reports, 12 bank CEOs were summoned to the New York Fed offices, excluding BofA and Barclays because of their potential deals for Lehman. Bernanke stayed in Washington in case he had to convene a meeting of the Fed to approve funds for a Lehman rescue. Valukas cites documents that were drawn up for the meeting that make clear that while the government was ready to facilitate a Bear-type intervention for a willing buyer, the goal was to convince everyone it wasn't, and instead persuade the banks to supply the money to finance a Bear-style acquisition.

Negotiating Tactic

Persuading the convened banks to fund the sale was labeled a "Long Term Capital Management" approach, after the private sector intervention to orchestrate an orderly winding down of that hedge fund in the 1990s. Valukas reports that Paulson stressed to the assembled CEOs: "Not one penny will come from the government." Nonetheless, SEC Chairman Cox and others told Valukas they believed that everyone viewed Paulson's approach to be the negotiating tactic that it in fact was. By the end of the weekend, the banks had agreed to commit $20 billion to helping finance a sale of Lehman.

On Saturday, BofA's Lewis called Paulson and told him without government help, BofA wouldn't do the deal. Paulson told him there would be no such aid, but that he wanted to discuss other options, notes Valukas, presumably meaning financing from the other 12 banks. Nonetheless, that afternoon Lewis entered negotiations to buy Merrill Lynch instead. (Given how the BofA/Merrill deal turned out, I wonder if Lewis wishes he'd kept pursuing Lehman, or just walked from both.) So, on Saturday, the government's refusal to extend direct financing -- to admit it was willing to extend financing -- closed off one potential willing buyer, BofA.

The government then turned its focus on getting the Barclays deal done, reports Valukas, and it let the British government know that the Fed stood ready to help if necessary. There was just one hitch: The U.S. government demanded that Barclays guarantee Lehman's current and future business transactions until the deal closed, and the guarantee would survive even if the deal didn't close. When JPMorgan bought Bear, it had provided the same guarantee. Under British law, that could happen only if Barclay's shareholders approved, or if the British government waived that requirement for Barclays. The British government refused to give a waiver, and the deal died on Sunday. That afternoon, Lehman's board decided to file for bankruptcy.