Too Big to Fail

by Andrew Ross Sorkin

  As they drove up the West Side Highway, McDade dialed Fuld on the speakerphone.

  “Dick, you’ve got to sit down,” he began.

  “I’ve bad news. Horrible news, actually,” he said. “Supposedly the FSA turned the deal down. It’s not happening.”

  “What do you mean ‘not happening’?” Fuld bellowed into the phone.

  “Paulson said it’s over. The U.K. government won’t allow Barclays to do the deal. Nobody’s saving us.”

  Fuld, too, was speechless.

  Across town, Greg Fleming of Merrill Lynch and Greg Curl of Bank of America were getting closer to formulating their own agreement, as lawyers began to draft the outlines of a deal document. The combined company would be based in Charlotte but would have a major presence in New York; the brokerage business would continue to use the iconic Merrill Lynch name and its familiar bull logo.

  Fleming was working through some of the details when he took a call from Peter Kraus, who was on his way back to Goldman Sachs. He told Fleming that he needed part of the diligence team sent over to meet him there.

  “I’m not sending anybody anywhere,” Fleming replied. “We’ve got a good deal in hand and we’re going to finish it.”

  Fleming was worried that Kraus, who he felt had been unhelpful from the day he had arrived at Merrill just over a week earlier, was trying to undermine the agreement with Bank of America and that he was more interested in a deal with his old pals at Goldman. Fleming was also concerned that if Bank of America officials discovered that Merrill was talking to Goldman, they would simply walk.

  “We need as many options as we can get,” Kraus told him. “You’re the president of the company, it’s your call, but you’re making a big mistake.”

  “Well, it is my call,” Fleming agreed, “and I just made it.”

  “John, we have to talk,” said Dick Fuld, almost begging, when he reached John Mack on his cell phone at the New York Fed. “There’s a way to make a deal work. Let’s set something up.” Mack was clearly devastated for his friend, but there was no way to do what he was asking. “I’m sorry, Dick,” he said sympathetically. “I’m really sorry.”

  When he got off the phone, he strolled over to a group of bankers that included Jamie Dimon and recounted the conversation, lamenting Lehman’s fate.

  Dimon furrowed his brow.

  “I just had the most surreal conversation with a guy at Lehman,” Dimon said. “He seems to be in denial.”

  Mack just shook his head. “This is bizarre.”

  Over at AIG, Chris Flowers, taking a break from working with Bank of America, had stationed himself at one of the secretarial desks in the hallway, waiting to meet with Willumstad. Accompanying him was Dr. Paul Achleitner of Allianz; together they had prepared an offer for the company.

  When they were invited into a conference room, they found Willumstad there with Schreiber and a group of his advisers, including Doug Braunstein from JP Morgan, Michael Wiseman from Sullivan & Cromwell, and several others.

  “We have an offer,” Flowers announced, producing a one-page term sheet that he handed to Willumstad.

  Flowers, who hadn’t yet heard about the additional $20 billion hole that JP Morgan’s bankers had discovered, explained that he had put together a deal that valued AIG at $40 billion. (The company’s actual market value on Friday had been about $31 billion.) Given the company’s problems, he asserted, it was the best estimate he could come up with quickly.

  He then spelled out the rough terms: His own firm and Allianz would put up about $10 billion of equity—$5 billion each—and they planned to raise $20 billion from banks; they would also sell $10 billion of assets. The investment they’d be making would be directly in AIG’s regulated subsidiaries, but they’d gain control of the parent company. That condition was a move to protect Flowers and Allianz: If the parent company were to falter, they’d still own the subsidiaries. Finally, Flowers said they would have to be able to convince the Federal Reserve to turn AIG into a broker-dealer, so that it had the same access to the discount window that investment banks like Goldman Sachs and Morgan Stanley had.

  Before ending his presentation, Flowers added that he had one other term that hadn’t been noted on the deal memo: “Bob, we would replace you as CEO.”

  The silence that greeted the offer reflected the fact that Willumstad and his advisers thought the bid had to be a joke—not because Flowers had the audacity to tell Willumstad that he would be fired, but because the deal was also filled with potential pitfalls; Flowers was putting up scarcely any of his own money, and he hadn’t lined up 80 percent of the funds needed to do the deal. They also thought the price ludicrously low. In their minds the company was worth at least twice that.

  “That’s fine,” Willumstad said calmly. “We have an obligation, we’ll take it to the board, but I have to tell you, you know, you’ve got contingencies in here that none of us can agree to,” he said, referring to the need for Flowers to still receive bank financing. “Thank you,” Willumstad said and stood, trying to get them to leave as quickly as possible. As soon as Flowers departed the room, Achleitner closed the door and took his seat again.

  “I don’t approve of what he just did,” Achleitner said, almost whispering.

  “Well, you read the letter before you came,” Willumstad said, his temper in check.

  “No, no, no, that’s not how we do business,” Achleitner said apologetically.

  “Okay. Whatever,” Willumstad responded. “Thank you very much.”

  When the entire group had finally left, Willumstad turned to Schreiber and whispered, “Don’t let those guys back in the building!”

  For a brief moment Dick Fuld allowed himself to smile. Ian Lowitt, Lehman’s CFO, had just gotten word that the Federal Reserve was planning to open the discount window even wider, a move that would enable broker-dealers like Lehman to pledge even more of their assets—including some of their most toxic assets—as collateral in exchange for cash.

  “Okay, here we go!” Fuld said, believing they might be able to hang on a bit longer as they sorted out their options.

  “This is great, great news,” Lowitt said, already tallying in his head the tens of billions of dollars of real estate assets he thought they might be able to pledge to the Fed. “We have enough collateral!”

  “Lehman’s got to file immediately,” Paulson, leaning back in his chair, instructed Geithner and Cox. He made it clear that he didn’t want Lehman adding to the uncertainty in the marketplace by dragging the situation out any longer.

  Paulson had another reason for insisting that Lehman file: If the Fed was going to open its discount window even wider to the remaining broker-dealers, he didn’t intend that Lehman be granted that access; doing so would represent another opportunity for moral hazard.

  Cox said that he wanted to hold a press conference to announce the bankruptcy. As the sole regulator with formal authority over the firm, he felt he needed to communicate the news to the public before it crept out on its own and panic ensued.

  He summoned Calvin Mitchell, the head of communications for the NY Fed, and Jim Wilkinson, Paulson’s chief of staff, into his temporary office and asked when a conference could be scheduled.

  “Well, can’t you do it at the SEC office somewhere? Isn’t that more appropriate?” Mitchell asked, clearly uncomfortable about arranging a media event in the middle of such chaos.

  “It’s easier to do it here; no one is there,” Cox insisted. “The journalists are here,” pointing out the window at the scrum of press lined up on Liberty Street.

  “Okay, so, we could do it on this floor,” Mitchell said. “Or, if we do it on the main floor, we have a podium we can bring down.”

  Cox liked the idea of holding the press conference downstairs and added, “That’s a good backdrop.”

  As they began discussing the substance of what Cox would say at the conference about Lehman’s bankruptcy, Erik Sirri, the SEC’s head of markets and trading, pointed out
a slight problem with the plan.

  “We can’t announce this,” Sirri said. “We can’t say a company has filed for bankruptcy until they decide to file. And that’s a decision for Lehman’s board.”

  Just after 1:00 p.m., Stephen Berkenfeld of Lehman called Stephen Danhauser of Weil Gotshal, the firm’s bankruptcy lawyer, frantically explaining that a group of Lehman executives—led by Bart McDade—had just been ordered to appear at the New York Fed. “You’d better get down there,” he urged, and said nothing further.

  Seconds later, Danhauser grabbed three senior partners—Harvey Miller, Thomas Roberts, and Lori Fife—and dashed to the street to find a cab. As the four sat sweating in gridlocked traffic, Roberts took a call from a partner back at the Weil Gotshal office who told him that Citigroup had just asked about the firm’s availability to represent it as a creditor in a Lehman bankruptcy.

  “That doesn’t make any sense,” Roberts told the partner. “We’re on our way to discuss a deal with Barclays.”

  An hour after leaving the General Motors Building, the cab finally approached the New York Federal Reserve Building. News camera crews were still camped outside, watched over by uniformed Fed security. As the lawyers finally entered the building, they encountered Vikram Pandit of Citigroup hurrying out, looking as if he was late for another appointment.

  Bart McDade and other Lehman representatives had already arrived upstairs and were sitting across from several rows of government officials and lawyers. Baxter, the general counsel for the New York Fed, was clearly running the meeting, as were lawyers from Cleary Gottlieb, representing the Securities and Exchange Commission.

  McDade was just then telling Baxter, “You don’t understand the consequences. You don’t understand what is going to happen!”

  Baxter, on noticing the arrival of the Weil Gotshal team, politely stopped the conversation to explain what was going on. “Harvey, we have had a great deal of deliberations and we’ve been thinking about this a lot, and it’s clear now that there isn’t going to be a Barclays transaction. We’ve come to the conclusion that Lehman has to go into bankruptcy.”

  Incredulous, Miller leaned forward until he was inches from Baxter. “Why? Why is bankruptcy necessary?” Miller demanded, “Can you explain, can you please elaborate on this?”

  “Well, I’m not sure it’s really necessary, given all the circumstances,” Baxter responded, sheepishly. “But, ah, there’s not going to be any kind of bailout, so we think it’s appropriate that Lehman go into bankruptcy.”

  Miller looked at his colleagues. “I’m sorry, Tom, but we don’t understand.”

  Alan Beller, a lawyer at Cleary Gottlieb, cut in peremptorily. “You need to do this, and it should be done before midnight tonight. We have a program to calm the markets.”

  Miller raised his voice. “Oh, you have a program to calm the markets, do you? Could you possibly tell me what that program is?”

  “No, it’s not necessary for your decision making,” Baxter shot back.

  “Tom,” Miller persisted, “this makes no sense. Yesterday, no one from the Fed was talking to us about bankruptcy, and now we have to have a filing ready before midnight. And what is the magic of midnight? The only way we could ever file, and it won’t be by midnight, is with a skinny Chapter 11 petition. What will that accomplish?”

  “Well, we have our program,” Baxter repeated.

  Miller stood up, his six-foot-two frame looming over the other lawyers.

  “What,” he slowly bellowed, “is this program?”

  Baxter just stared uneasily, offering no immediate answer.

  “If Lehman goes into bankruptcy, totally unprepared, there’s going to be Armageddon,” Miller warned. “I’ve been a trustee of broker-dealers, little cases, and the effect of their bankruptcies on the market was significant. Here, you want to take one of the largest financial companies, one of the biggest issuers of commercial paper, and put it in bankruptcy in a situation where this has never happened before. What you’re going to do now is take liquidity out of the market. The markets are going to collapse.” Miller waved his finger, and repeated, “This will be Armageddon!”

  Baxter looked at the SEC lawyers, and, considering for a moment, finally said, “Okay, I’ll tell you what we’re going to do, we’re going to caucus.”

  “This is insane,” Miller said to Roberts as soon as the Lehman team was alone in the conference room. “They’re telling us to fucking file. The government is telling us to file.”

  “I don’t even know what to say,” Roberts replied. “This has got to be illegal.”

  About a half hour later, Baxter and the other government lawyers returned to the room, and the meeting resumed. “Well,” Baxter announced, “we’ve considered everything you said, and it hasn’t changed our position. We are convinced that Lehman has to go into bankruptcy, but what we are prepared to do is keep the Fed window open for Lehman so that the broker-dealer can continue operating the business.”

  Baxter was making the case for compromise, that there could be a way for an orderly winding down of Lehman. The Fed would loan money to Lehman’s broker-dealer unit, but not indefinitely, only as part of a bankruptcy.

  Sandra C. Krieger, executive vice president at the NY Fed, asked, “How much cash are you going to need us to provide you tomorrow to fund yourself on Monday night?”

  “It’s impossible to know the answer to that,” Kirk told her.

  “Well, that seems highly irresponsible!” she replied edgily.

  “Really?” Kirk said, growing angry. “You want to tell me on the $50 billion of trades selling tomorrow how many of our counterparties are going to send us the money when we file for bankruptcy?”

  Seeing that the conversation was quickly devolving, Miller jumped in and asked again why this measure was necessary.

  “We’ve listened to your comments and we have concluded that our decision is correct, and we don’t have to discuss this any further,” Baxter said.

  Miller still persisted. “You are asking this company to make a very momentous decision. It is entitled to all the information it can get.”

  “You’re not going to get that information,” Baxter replied.

  Alan Beller interrupted to say, “Look, we will have a series of releases that we are fairly confident will calm the markets tomorrow.”

  “I’m sorry,” Miller responded sardonically, “you’re talking to me about press releases?”

  At that the meeting was brought to a close.

  Greg Fleming saw Peter Kelly in the hallway at Wachtell Lipton and gave him a big bear hug. As he did, he whispered into Kelly’s ear: “It’s done. Twenty-nine dollars. You owe me a beer,” he said with a big smile.

  Fleming had just gotten off the phone with Thain, who had given him the green light to go ahead with the deal at $29 a share.

  After an afternoon of haggling with Greg Curl, Fleming had not only persuaded him to accept the agreement but to fund Merrill’s bonus pool, up to the amount paid out in 2007. Nobody would get an employment contract, including Fleming and Thain—a point that Curl admired. To ensure that the deal would be completed, Fleming had convinced Curl to agree to a virtually airtight MAC agreement—meaning that even if Merrill’s business continued to deteriorate, Bank of America couldn’t later wiggle out of the transaction by claiming a “material adverse change” had occurred.

  By Curl’s thinking, as he explained to Ken Lewis before agreeing to the price, “We might be able to get it for cheaper later, but if we don’t do the deal today, we could lose the opportunity entirely.” For Curl, a journeyman dealmaker, this was his crowning achievement.

  Bank of America scheduled a board call for 5:00 p.m., while Merrill set up a board meeting at the St. Regis hotel at 6:00 p.m. to approve the deal. In a matter of hours, Merrill Lynch, with a history of nearly one hundred years as one of the most storied names on Wall Street, would be sold to Bank of America for the biggest premium in the history of banking mergers. It was, as one
newspaper later put it, as if Wal-Mart were buying Tiffany’s.

  At the NY Fed the banks had just finished trying to unwind their Lehman positions, an effort that had not gone particularly well. The Fed had passed out a memo to the CEOs earlier in the day explaining the program, which would be an extraordinary two-hour trading session in New York and London, during which firms that had opposing trades with Lehman tried to pair up and cut out the middleman.

  The process was based on the assumption that Lehman was going under: “All trades conducted will be done on a contingency basis, contingent on the filing of bankruptcy of the Lehman parent,” the Fed memo said. “Trades will ‘knock in’ if the Lehman Brothers Holding Inc. files for bankruptcy before 9am ET on Monday.” The memo was intentionally never distributed to anyone at Lehman.

  However neatly laid out the Fed proposal might have been, the various banks struggled to find matching trades that could remove Lehman from the picture. When frustrated traders left their desks at 4:00 p.m. in New York, many of them faced as much exposure to Lehman as they had on Friday afternoon.

  “The extraordinary trading session held today to facilitate a partial unwind of these positions saw very little trading—perhaps $1 billion total—but at much wider spread levels for corporate bonds,” Bill Gross, head of PIMCO, told reporters that afternoon. “It appears that Lehman will file for bankruptcy and the risk of an immediate tsunami is related to the unwind of derivative and swap-related positions worldwide in the dealer, hedge fund, and buy-side universe.”

  Word was also starting to spread that Merrill was about to be sold to Bank of America, a rumor that Gross, one of the nation’s most respected investors, said that he heavily discounted. “To some extent, the rumored bid for Merrill by Bank of America lends some confidence to all markets, although I am skeptical that BofA would pay such a premium on such short notice,” he said.