Too Big to Fail

by Andrew Ross Sorkin

  As they were making yet another pass through the earnings call script, Kirk’s cell phone rang. It was Harvey Schwartz from Goldman Sachs, phoning about the confidentiality agreement that Kirk was preparing. Before Schwartz began to discuss that matter, however, he said that he had something important to tell Kirk: “For the avoidance of doubt, Goldman Sachs does not have a client. We are doing this as principle.”

  For a moment Kirk paused, gradually processing what Schwartz had just said.

  “Really?” he asked, trying to keep the shock out of his voice. Goldman is the buyer?

  “Yes,” Schwartz replied calmly.

  “Okay. I have to call you back,” Kirk said, nervously ending the conversation, and then almost shouted to Fuld and McDade, “Guys, they don’t have a client!”

  “What do you mean?” Fuld asked, looking up bleary-eyed from his notes.

  “They’re doing this for themselves. For Goldman. That’s what he told me.”

  For the next few minutes the three men frantically brainstormed about their course of action. McDade, reasonably, was concerned about sharing information with a direct competitor: How much did they really want to divulge? At the same time, he felt they couldn’t take a stand against a plan that he believed had originated with Paulson.

  Kirk was even more apprehensive. “Why are we letting Goldman Sachs in here? Haven’t you read When Genius Failed? The reference was to Roger Lowenstein’s bestselling book about the Long-Term Capital Management crisis. In it Goldman Sachs is depicted in one scene as trying to take advantage of the disaster by using its offer of assistance as a way to get inside Long-Term Capital’s books and download all its positions into a laptop—a charge Goldman fervently denied.

  “They will rape us,” Kirk cautioned.

  McDade, turning back to his preparations for the fast-approaching call, made his position clear: “We were told by Hank Paulson to let them in the door. We’re going to let them in the door.”

  Twenty-seven floors below, Lehman traders gathered for a preview of SpinCo, the “bad-bank” spin-off that would be discussed an hour later during the earnings call. McDade had appointed Tom Humphrey and Eric Felder to explain what investors were about to hear.

  After learning the details of the plan, the traders were unusually quiet, and the silence was broken only when Mohammed Grimeh, global head of emerging markets, stood up with a horrified look on his face.

  “That’s it? That’s fucking it?” he asked. “Well, what the hell have those fucking idiots up on thirty-one been working on for the past two months? This? You have to be kidding me. If this is all we have, we’re toast!”

  In the time it had taken Humphrey and Felder to describe SpinCo, Grimeh had already seen through it—had seen exactly what JP Morgan and Citigroup saw the night before, and what he feared the market would see as well.

  “All we’ve done is to take a dollar out of our right pocket and put it in our left. The heavy debt load would make it insolvent before it started,” he said, backed by a growing chorus of angry muttering from the disconcerted bankers.

  Gregory J. Fleming, Merrill Lynch’s president and chief operating officer, had one eye on CNBC as he jogged on a treadmill at the health club at the Ritz-Carlton hotel in downtown Dallas. He had spent the day before with clients in Houston and had scheduled a town hall session here with Merrill employees before hopping on a flight back to New York.

  As he leaned into his jog, CNBC reported that Lehman Brothers had just announced its earnings ahead of its conference call. The firm, the reporter elaborated, had also described its extraordinary spin-off plans in its press release. When Fleming returned to his room, he got a colleague to send him the announcement, which included an important headline buried at the bottom: “The firm remains committed to examining all strategic alternatives to maximize shareholder value,” which meant that it was open to just about anything. He knew the company had been quietly shopping pieces of itself, but that statement effectively made it official, at least to those paying attention. Lehman, the entire firm, was up for sale.

  From his days as a merger banker focusing on financial services, he knew that if Lehman was on the auction block, Bank of America would be the likely buyer. But if Lehman was sold to Bank of America, the implications for his own firm, Merrill Lynch, would be enormous. He had long believed that Bank of America was the natural buyer for Merrill; at a Merrill board meeting just a month earlier, Bank of America had been listed in a presentation as just one of a handful of compatible merger partners.

  Fleming began trying to figure out whom he knew who might be working on a deal with Bank of America. Ed Herlihy of Wachtell, a longtime friend and one of the legal deans of banking M&A, immediately came to mind. Herlihy had worked on nearly every deal Bank of America had orchestrated over the past decade.

  “This is getting ugly,” Fleming told Herlihy when he reached him on his cell. “How are my friends in Charlotte?”

  Herlihy could see where this conversation was heading and took steps to deflect it immediately. “Let’s not go there, Greg,” he replied.

  “Just tell me. If you’re thinking about Lehman, you have to tell me. We could be interested in talking at some point. You and I both know that would be a much better deal.”

  Herlihy, clearly uncomfortable, said, “We’ve been down this road before. We’re not going to do anything unless we’re invited in. If you are serious, now would be a good time to get moving on that.”

  That was all the confirmation Fleming needed to be convinced that Bank of America was indeed bidding for Lehman.

  Fleming had one more call to make before his first meeting that morning. He wouldn’t contact John Thain just yet—Thain, he suspected, wouldn’t be interested at this point, for whenever Fleming had tried previously to discuss contingency plans to sell the bank, he had been dismissive. Instead he phoned Peter Kelly, Merrill’s deal lawyer, and recounted his conversation with Herlihy.

  “Look, you have to make sure Bank of America is there for us,” Kelly instructed him after the two had discussed the ramifications. “You have to convince John.”

  “That’s a high bar,” Fleming said. They both knew that he and Thain had a fundamentally antagonistic relationship.

  “I know,” Kelly said, “but that’s why you get paid the big bucks.” Before hanging up, he made one last point: They might have to go over Thain’s head. “If you can’t convince John—and I know this is subversive behavior, but this is in the interest of the shareholders—you need to reach out to the board.”

  The conference room on the thirty-first floor of Lehman Brothers was more crowded than usual for an earnings call, but what was typically a fairly routine affair had lately begun to be perceived as something more akin to an impeachment trial. Lehman was taking the situation seriously enough to have stocked the room with additional lawyers. Lehman technicians, meanwhile, were scrambling to ensure that the conference call and Webcast would go off without a major hitch. The firm had ordered hundreds of extra phone lines to keep up with the demand. The press release issued that morning, forecasted a third-quarter loss of $3.9 billion—the firm’s biggest ever.

  Fuld strode in assuredly, as if nothing was out of the ordinary. Everyone in the room, however, knew that for years he had always let his chief financial officer handle these calls, as he had never been truly comfortable participating in them. As he took his seat at the head of the table, Fuld looked around the room with his trademark disarming glare, trying to settle in with his script and papers. He knew what the stakes were. Moments earlier he had taken a quick glance at the Bloomberg terminal to see if U.S. stock index futures might be higher on the hopes that he, Dick Fuld, would be able to ease fears about Lehman. But overnight, Asian stocks had slid, and Europe was even lower. There was a lot riding on what he would say today; millions of dollars would either be made or lost on exchanges the world over depending on how his presentation was received.

  Shaun Butler, the head of investor relat
ions, looked over at his boss. “Are you ready?”

  “Yeah,” answered Fuld, faintly growling.

  As the call was engaged, he slowly lowered his head and launched into his script, intoning deliberately: “In light of these last two days, this morning we prereleased our quarterly results. We are also announcing several important financial and operating changes that amount to a significant repositioning of the firm, including aggressively reducing our exposure to both commercial real estate and residential real estate assets.

  “These will accomplish a substantial de-risking of our balance sheet and reinforce the emphasis on our client-focused businesses. They are also meant to mitigate the potential for future write-downs, and to allow the firm to return to profitability and strengthen our ability to earn appropriate risk-unadjusted equity returns.”

  The executive summary: Lehman Brothers will be just fine. We appreciate your concern, but we have the situation under control.

  “This firm has a history [of facing adversity] and delivering,” he continued. “We have a long track record of pulling together when times are tough and then taking advantage of global opportunities…. We are on the right track to put these last two quarters behind us.”

  Fuld now handed off to his CFO, Lowitt, who, in his clipped South African accent, outlined what Lehman billed as its “key strategic initiatives.” The firm would seek to sell a 55 percent stake in its money-management business, which included Neuberger Berman, and it would spin off much of its commercial real estate holdings—otherwise known as “the bad stuff.”

  Shifting as much as $30 billion of Lehman’s commercial real estate holdings, including its investments in Archstone-Smith, the owner of 360 high-end apartment buildings, and SunCal, a property developer, was no small undertaking. One thing that would be changing immediately was how Lehman valued its real estate assets.

  Lowitt continued: “The real estate held-for-sale portfolio, consisting of assets across the capital structure, is booked at lower of cost or market as we take write-downs on this book, but do not reflect market value gains until a sale event occurs. REI Global”—the new entity’s infelicitous acronym—“will account for its assets on a held-to-maturity basis and will be able to manage the assets without the pressure of marked-to-market volatility. REI Global will not be forced to sell assets below what it believes to be their intrinsic value.”

  On the surface the spin-off appeared to be a clean, elegant solution. It removed the troubled assets from Lehman’s balance sheet, leaving a stronger firm, just as Fuld had indicated that it would. But what was left unsaid was precisely what had concerned the bankers at the meeting with JP Morgan and Citi the night before: The new company would likely need to be funded. Where was Lehman going to come up with the money to accomplish that when it needed to retain as much capital as possible?

  Less than half a mile away, in his office near Grand Central terminal, David Einhorn huddled with his team of analysts listening to the Lehman earnings call on a speakerphone. He could not believe what he was hearing. They were still trying to avoid writing this garbage—the toxic stuff—down. What did they hope to accomplish? It was clear to him that the assets in question were worth much less than what Lehman was claiming.

  “There’s an admission right in the press release that they’re not writing these things down!” Einhorn told his analysts. He zeroed in on a sentence in the company’s statement: “‘REI Global will be able to manage the assets without the pressure of mark-to-market volatility.’” Instead, Lehman maintained, by spinning off the real estate assets they’d be able “‘to account for its assets on a hold-to-maturity basis.’”

  In other words, as Einhorn continued to rail, “they can keep making up the numbers however they want.”

  Downtown, Steven Shafran and a team of staffers at the New York Federal Reserve Building were also listening to the call, some of them also in a state of utter disbelief. Shafran, the special assistant from Treasury, had flown to New York the night before at Paulson’s urging to help coordinate communication between the Treasury, the Fed, and the SEC in the event that Lehman’s situation quickly deteriorated. He and most of the Fed team had already been given a preview of the plan the night before by Lehman but hearing it presented live proved to be a completely different experience. A former investment banker at Goldman, Shafran shook his head in exasperation and announced, “This isn’t going to work.”

  As the investor call went on, Shafran observed to the staffers, “What’s really amazing about this is that these guys are investment bankers who get paid by large corporations for tough advice in tough situations. You know the old saying about how a doctor should never treat himself? It feels like one of those situations.”

  About halfway into the question-and-answer portion of the call, Michael Mayo, the prominent analyst with Deutsche Bank, addressed the capitalization issue with blunt directness: “To the extent you might need $7 billion to capitalize that entity,” his voice boomed over the speakerphone, “and you’ll get $3 billion with the spin of part of IMD [the more viable investment management division], how would you get the other $4 billion?”

  Lowitt paused as he recalled the explicit instructions, given the conversation the firm had had the night before with the JP Morgan and Citigroup bankers: Don’t get pinned down talking about any specific numbers. You will be crushed. He was now being asked the one question that he didn’t want to answer.

  “Well, we don’t feel that we need to raise that extra amount to cover the $7 billion,” he replied, trying to sound confident about the firm’s capital position, “because you will have less sort of leverageable equity in core Lehman than in, you know, where you are at the end of this quarter.”

  In other words, the plan was essentially an accounting gimmick: Lehman would be smaller and less leveraged as a result of the spin-off, and would therefore need less capital.

  Mayo responded that he had his doubts about Lehman’s plan, but in adherence to Wall Street protocol, he left it at that. This was not the place for a showdown.

  For a few moments it almost appeared as if Fuld would be able to claim victory: Shares of Lehman Brothers opened that morning up 17.4 percent. The rise might give him the breathing room he needed.

  Across the Atlantic a group of senior executives from Barclays in London were likewise intently listening in on the call, taking meticulous notes as they sat in a conference room at the firm’s headquarters, known as “The Bungalow,” in Canary Wharf. They had registered for the call under an assumed name. Bob Diamond, Barclays Capital’s CEO, had been mulling buying Lehman for months, ever since he had received the call from Bob Steel, when he was still at Treasury in April. In June, Diamond had broached the idea with Barclays’ board, which had been discussing possible expansion plans in the United States. The group ultimately decided against pursuing Lehman—unless, as John Varley, the firm’s chairman, put it, “the firm could be bought at a distressed price.” Diamond had in turn communicated that message directly back to Steel.

  But the timing now seemed ripe for a deal. “I’m surprised, given how shaky this is, that I actually haven’t had a call from Treasury, because it knows that we would be willing to do this at a distressed price, and it’s not that far off,” Diamond had told Varley only a day earlier. Diamond had been in the middle of giving a recruiting presentation at Wharton, the elite business school at the University of Pennsylvania, on Tuesday, when his cell phone vibrated. Seeing that it was Varley, he abruptly stopped his presentation and walked off the stage. “If we’re going to meet with the board, we’re going to meet with the board tomorrow,” Varley told him. Diamond found one of the only three direct overnight flights to Heathrow from Philadelphia.

  He took the last-minute overnight return flight to London to resolicit support to buy Lehman. He would have to win over Varley and the board—and do so quickly.

  Varley was a model of the conservative Englishman and had married into one of the bank’s founding Quaker families
. Soft-spoken and courtly, he wore suspenders every day, listed table tennis and fishing as his hobbies, and had far less tolerance for risk than Diamond. Whatever his own professional predilections, however, Varley had always given Diamond a long leash, even if he did maintain a quiet uneasiness with his colleague’s appetite for deal making.

  The two men had long had a complicated relationship, having both vied for the top job in 2003. Although Varley won the position, Diamond was paid nearly six times what Varley, his superior, made. (In 2007, Diamond earned $42 million to Varley’s $8.4 million.) For years, Diamond had avoided taking a seat on the Barclays’ board to avoid disclosure of his compensation agreement, which would have landed him squarely in the pages of the British tabloids as a “Fat Cat.” Despite his title, Diamond was to many the de facto CEO. In 2006 a Dresdner Kleinwort analyst wrote a report provocatively titled “Bob Diamond 3, John Varley 0.”

  As soon as the Lehman call came to an end, the Barclays executives discovered they were in agreement: They’d make a play for the firm. But only—Varley reiterated the point—if they could get it for a song.

  Diamond went back to his office and phoned Bob Steel at his new number at Wachovia. “Remember our conversation about Lehman?” he asked.

  “Of course,” Steel answered.

  “Well, we’re now interested.”

  Lehman’s stock may have temporarily stabilized after the earnings call, but only hours later Fuld was faced with a new problem: Moody’s Investors Service announced that it was preparing to place Lehman’s credit rating on review, warning that if the firm did not soon enter into “a strategic transaction with a stronger financial partner,” it would cut its rating.

  Fuld decided to call John Mack, CEO of Morgan Stanley; he needed options. And, unlike his relationships with Ken Lewis and Lloyd Blankfein, he actually trusted Mack.