Too Big to Fail

by Andrew Ross Sorkin

  Fuld was also pleased with himself for having kept the talks out of the press. He had been so concerned about leaks this time around that he had instructed the team he took with him to the meetings—Bart McDade, Skip McGee, Brad Whitman, Jesse Bhattal, and Kunho Cho—not to answer their phones. McGee had gone so far as to mislead his staff back in New York by leaving a voice-mail for Mark Shafir, who had gone on the earlier trip to South Korea, telling him that he had flown to China to visit with clients. Fuld had organized the meeting in Hong Kong, as opposed to the more likely Seoul, partly so that if anyone was tracking the firm’s plane, its destination would lead to less speculation.

  On the return trip the Lehman team watched The Bank Job, a British heist movie, on the plane’s large screen. Fuld had already seen it and made the case for an action film instead, but McDade, who was increasingly taking control of the firm, won out.

  As they taxied to the refueling station, Fuld’s good mood suddenly vanished: The maintenance crew had discovered an oil leak. As the pilot tried to coordinate a repair, the Lehman team ate lunch on the plane as it sat on the tarmac. But after an hour, it was uncertain whether that damage could be repaired.

  McDade started calling his secretary to see if they could book a commercial flight home.

  “When’s the last time you flew commercial?” McDade ribbed Fuld, who was plainly not amused.

  On August 6, 2008, a team of bankers from Morgan Stanley arrived at the Treasury building and was escorted up to a conference room across from Paulson’s office for what they all knew would be an unusual meeting. Looking for help with Fannie Mae and Freddie Mac, Paulson had called John Mack a week earlier to hire his firm as an adviser to the government. Paulson would have chosen Goldman were it not for the obvious public relations problem or the fact that it was advising Fannie. He also briefly considered hiring Merrill Lynch, but Morgan Stanley seemed the best option.

  Mack had originally been reluctant even to take the assignment, for the cost of serving as Treasury’s adviser on Fannie Mae and Freddie Mac was that the firm could not conduct any business with the mortgage giants for the next six months, and therefore stood to lose out on tens of millions of dollars in fees. “How can we tell our shareholders we’re walking away from this kind of money? I’m going to get asked about why I did that,” he told his team.

  But after some soul-searching, Mack decided working for the government was the patriotic thing to do. Morgan Stanley would receive a token payment of $95,000, which would barely cover the cost of their secretaries’ overtime.

  Just a week earlier the Senate had passed, and President Bush had signed into law, an act that gave Treasury the temporary authority to backstop Fannie and Freddie. Now the question that faced Paulson was: what to do with that authority?

  He recognized that he had created an odd dilemma: Investors now assumed the government was planning to step in. That would make it even harder for Fannie and Freddie to raise capital on their own, as investors worried that a government intervention would mean they would get wiped out. Any sort of investment by the government increasingly seemed as if it could become a self-fulfilling prophecy. “Either investors are going to be massively diluted, given the amount of equity they are going to need, or [Freddie and Fannie] are going to be nationalized,” Dan Alpert, managing director of Westwood Capital LLC, had told Reuters that morning. “Without a larger equity capital base, they are going to be incapable of surviving.”

  In a Treasury conference room, Anthony Ryan, assistant secretary for financial markets, briefed the bankers on the department’s work to date on the GSEs. Attending from Morgan Stanley were Robert Scully, fifty-eight, the firm’s co-president, who had worked on the government’s bailout of Chrysler nearly three decades earlier; Ruth Porat, fifty, the head of its financial institutions banking group; and Daniel A. Simkowitz, the forty-three-year-old vice chairman of global capital markets.

  Ten minutes into Ryan’s presentation, Paulson walked in, looking slightly distracted. “Everyone’s going to scrutinize what we do,” he told the group as he tried to inspire and scare them simultaneously. “I’m going to work you to the bone. But I’m confident of this: It will be the most meaningful assignment of your career.”

  Scully pressed Paulson to explain his rationale for the assignment. “Just tell us what you’re really looking to do here,” he said. “Do you want to kick the can down the road?”

  “No,” said Paulson, shaking his head. “I want to address the issue. I don’t want to leave the problem unsolved.” He was adamant that the project not become another bureaucratic exercise in producing PowerPoint presentations that would just get filed away. “I, ah, we have three objectives: market stability, mortgage availability, taxpayer protection.”

  Scully was still skeptical, certain there had to be some political calculus involved. And, with Freddie’s reported loss of $821 million that morning, doing nothing no longer seemed a viable option.

  “Are there any policy options that are off the table or, alternatively, are there any stakes you have in the ground in terms of starting points and approaches to this problem that you’d like us to think about?” Scully probed.

  “No, you have a clean sheet of paper,” Paulson said. “All options are on the table; I’m willing to consider everything.”

  A young child’s squeal a few doors down suddenly halted the discussion. It was Paulson’s granddaughter, Willa, who was visiting that day and waiting in a small conference room across from his office. Paulson was about to catch a flight with his family to attend the Olympic Games in Beijing. It was, however, a working vacation—he had a busy set of meetings with Chinese officials—and as they all knew, he would be attached to his cell phone.

  He apologized to the group for cutting the meeting short.

  “I’ll be back in ten days,” he told them. “I want a lot of progress.”

  In the first week of August, Min Euoo Sung, arrived in Manhattan from Seoul to continue talks with Lehman Brothers. The parties were still far from signing a final agreement, but they were inching closer to nailing down at least the outlines of one.

  On that Monday, McDade, who remained skeptical that a deal would come to pass, walked over to Sullivan & Cromwell’s Midtown offices with his colleagues to begin formal negotiations. “They are never going to have the balls to do this,” Mark Shafir said as he headed up Park Avenue with McDade and Skip McGee. Kunho Cho and Jesse Bhattal of Lehman, who were closest to Min, had flown over from Asia to help shepherd a deal. McGee had urged Fuld to stay at the office, despite his insistence on coming to the meeting. “Chill out,” McGee had told him. “You’re the CEO. You have to be the ‘missing man’”—Wall Street parlance for the handy excuse they could use when they closed in on the final terms of the deal but wanted to push for slightly better ones: They’d simply say they still needed approval from the CEO.

  McDade also had become increasingly anxious that Fuld’s fragile state wouldn’t help the negotiations. McDade was beginning to fear that Fuld suspected him of attempting to take over the firm. Often when he was in conversation with Gelband and Kirk, his protégés, Fuld would emerge seeming apprehensive, as if imagining they were plotting his ouster. Fuld’s paranoia was only further encouraged when McDade refused to inhabit Joe Gregory’s old office directly next to Fuld’s, citing its “bad karma” instead, he took an office farther down the hall, where it was harder for Fuld to monitor him.

  In truth, McDade was increasingly in control of Lehman. He was in the process of putting together a document called “The Gameplan,” a detailed examination of the firm’s finances and a vision for a way forward. It included a half dozen possible scenarios, most of which included some variation on dividing Lehman in two: a “good bank” that they’d keep and a “bad bank” that they’d spin off, thereby ridding themselves, at least on paper, of their worst real estate assets. The plan would enable Lehman to make a fresh start, unencumbered by assets that continued to fall in value. McDade also had p
ressed Fuld to put Neuberger Berman and the firm’s investment management business up for sale, and an auction was already under way among a series of private-equity firms.

  While the rumors about Lehman may have continued unabated, the leaks coming out of the company appeared to be shrinking in volume. A few weeks after McDade was appointed president, McGee gave him a T-shirt with the inscription: “A Person Familiar with the Situation”—a wry reference to how the financial press generically referred to its sources. McGee had told him, “Give it to Scott!” a not-so-subtle dig at Scott Freidheim, who managed much of the firm’s media strategy.

  The first meeting that morning at Sullivan & Cromwell was to allow the Koreans an opportunity to review Lehman’s commercial real estate assets. Mark Walsh, the architect of the firm’s foray into the commercial real estate market, gave a presentation to the group. But Min quickly found Walsh unprepared and pulled aside Kunho to tell him as much. “I need to understand this better,” he told him in Korean. “I feel very uncomfortable with the valuations.”

  It quickly became clear that Min wanted nothing to do with Lehman’s commercial real estate holdings. For at least an hour it looked like the talks could collapse. But that afternoon the two sides started working on a new structure: Min said he was interested in buying a majority stake in Lehman, but only if it were to spin off its commercial and residential real estate assets into a separate company so that KDB’s investment couldn’t be impacted. The discussions seemed to be going well, except for the fact that Fuld kept calling McDade’s and McGee’s cell phones every twenty minutes to ask for an update.

  By the next morning, at 11:00, Min said he had received authorization for Korean regulators to make an initial offer. He said he was prepared to pay 1.25 times Lehman’s “book value”—or the value at which Lehman held its assets on its balance sheet. The deal, which was still subject to a discussion about the firm’s true book value and would have included Lehman spinning off the real estate business, meant that KDB was valuing Lehman somewhere between $20 and $25 a share, a premium over its current share price, which had closed the day before at $15.57.

  Whether Min was posturing—as some of the Lehman bankers suspected—remained an open question, but McDade, McGee, and the rest of the Lehman team said they were inclined to accept his offer. However, McDade said he wanted to retreat back to the firm’s headquarters to discuss it with Fuld first. They agreed that both sides would return at 7:00 p.m. in hopes of reaching at least an agreement in principle.

  When both sides reconvened several hours later, a surprise guest arrived: Fuld. The goal for the Lehman team was to press Min to sign a letter of intent ahead of the final agreement, even if it meant it would take several more weeks to hammer out the details. That gesture, everyone agreed, would take some pressure off Lehman’s stock.

  Fuld took a seat alongside McDade, McGee, and Kunho, an inexplicable scowl on his face. Across from them at the table were Min and his banker, Gary Barancik of Perella Weinberg Partners.

  “Look, we hear you. We understand what you want to do,” McDade said, referring to Min’s plan to acquire a controlling stake in Lehman after it spun off the real estate assets. “Let’s start—”

  Fuld interjected. “I think you’re making a big mistake,” he told Min. “You’re going to miss a great opportunity. There’s a lot of value in these real estate assets,” pressing Min to buy at least some of them. As the conversation continued, Fuld suggested that Min’s plan to pay 1.25 times book value was “too low,” instead recommending they negotiate on the basis of 1.5 times book value.

  McDade and McGee couldn’t believe what they were witnessing. They had spent the past two days orchestrating a deal based on spinning off the real estate assets, and now Fuld was trying to retrade on their work. Worse, a look of horror crossed Min’s face. Min pulled Barancik aside and whispered, “I’m not comfortable with this,” and in response, Barancik spoke up on behalf of KDB. He said they would only negotiate on the basis of 1.25 times the book value valuation, and then, as his aggravation mounted, started questioning Lehman’s accounting. “I don’t believe that you’ve taken all the write-downs,” he said, reiterating why they weren’t interested in the real estate assets.

  “Okay,” Fuld said, his frustration showing. “What do you think our real estate portfolio should be marked at?”

  Before Barancik could answer, McDade piped up. “Well, we have a term sheet,” he interjected, trying to steer the conversation back in a more productive direction. “Why don’t we look at that?”

  “Look, I just think we need to take a break,” Barancik said, sensing the tension could topple the talks.

  As they stepped into the hallway, Fuld, having misread Min’s mood, approached him and again started promoting the idea of selling him the real estate.

  McGee, who was standing behind Min and could see this conversation was only antagonizing him, tried to signal Fuld, slicing his finger across his throat to urge him to stop badgering the Korean.

  Finally managing to break free of Fuld, Min took Barancik to a small room to study the term sheet—which was more a list of broad principles than a formal agreement. As they reviewed it, Min nodded at each bullet point until he reached the final one, which stipulated that KDB would provide credit to Lehman to help support it. To Min that was an instant red flag. Was Lehman seeking an open-ended credit line, hoping to leverage KDB’s balance sheet to bolster its own standing?

  Min, looking pained, grabbed Kunho Cho, his friend when they worked at Lehman together, and asked to talk with him privately. Even before Min spoke a word, Cho could tell it wasn’t going to be good.

  “There is a serious credibility problem here,” he said in Korean. “All of this time we have negotiated in good faith consistently, and we were moving toward the goal we all wanted, and now, all of sudden, it’s a new picture.”

  Clearly frustrated, Min continued, “Look, it’s not about 1.25 versus 1.5 times book, or a $2 billion versus a $4 billion credit line. It’s none of that. It’s the way you conducted the meeting. I just feel uncomfortable about the way this whole thing has been conducted by Lehman senior management. I cannot continue on this basis.”

  Cho, who had helped persuade Min to fly to New York for the meeting, was devastated.

  When Min returned to the main conference room he looked apologetically at Fuld, and then at the rest of the bankers assembled around the table. “I’d like to thank you all, but I don’t think we have a structure that works,” he said, and got up to leave. “Gary Barancik can continue the dialogue.”

  A dolorous look came over Fuld’s face. “So, you mean, that’s it?” he asked, raising his voice. “You’re just going back to Korea?”

  Steve Shafran was at a gas station in Sun Valley, Idaho, one brisk morning in August when Hank Paulson called. Shafran, one of Paulson’s special advisers at Treasury, was on vacation. “Give me an update on Lehman,” Paulson instructed.

  Shafran, who turned off the engine of his fifteen-year-old Land Rover, recognizing that this might take some time, had been assigned by Paulson earlier in the summer to a special project: to act as a coordinator between the SEC and the Federal Reserve to begin contingency planning for a Lehman Brothers bankruptcy. The original assignment had actually been to ascertain systemic risk in the banking system and to make sure the various government agencies were talking to one another, but it had soon morphed into focusing almost exclusively on Lehman.

  It was by its very nature a secret undertaking, given that he wasn’t allowed to let anyone—least of all Lehman Brothers—know that the government was even thinking about the possibility, no matter how improbable it might be. If the stock market caught even a whiff of it, Lehman’s shares would plunge. But Paulson, who had been speaking to Fuld almost every day, had become convinced that Lehman was going to face a struggle in its attempts to raise capital, and they needed to prepare for the very worst.

  Indeed, Paulson had become so frustrated with Fuld’s
various plans that he had assigned Ken Wilson to be Fuld’s personal liaison. “I’m going to tell Dick that he’s talking to you,” Paulson told Wilson. “It’s just a waste of time. I’ll talk with him when he’s got something really important to say to me.”

  For Shafran, dealing with other government agencies was something of a novelty. He had moved himself and his children to Washington only a year earlier, after his wife of twenty-four years, Janet, was killed in a plane accident. They had been living in Sun Valley, where he had gone after retiring from Goldman Sachs. Shafran had worked at the firm for fifteen years, serving as Paulson’s point person in Hong Kong, helping him in his efforts to gain entrée to China. He had come to Washington to start over.

  For Shafran the Lehman project was even more awkward than it would be for other Treasury staffers because he was a casual friend of Fuld’s. They knew each other from Sun Valley, where Shafran had become a city councilman in Ketchum and Fuld owned ninety-seven acres in the area (worth some $27 million), with a main home on a private road across the Big Wood River and a cabin on the shore of Pettit Lake, right near Shafran’s. They played golf together at the Valley Club and socialized occasionally. Shafran liked Fuld and admired his intensity.

  But now, as Shafran was sitting in the gas station parking lot on the phone, he gave Paulson a progress report. He said he had held some conference calls with the Fed and SEC, and while they thought it was impossible to truly estimate the systemic risk, he felt that they were finally at least paying attention to the challenge. “They are on it,” he said. “I’m comfortable.” He explained that they had identified four risks within Lehman: its repo book, or portfolio of repurchase agreements; its derivative book; its broker dealer; and its illiquid assets, such as real estate and private equity investment.