The Wall Street Journal  

September 15, 2008



Ultimatum by Paulson
Sparked Frantic End

September 15, 2008; Page A1


One of the most tumultuous weekends in Wall Street's history began Friday, when federal officials decided to deliver a sobering message to the captains of finance: There would be no government bailout of Lehman Brothers Holdings Inc.

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Officials wanted to prepare the market for the possibility that Lehman could simply fail. The best way to do that in an orderly way would be to get everyone together in a room.

Treasury Secretary Henry Paulson, Federal Reserve Chairman Ben Bernanke and his top New York lieutenant, Timothy Geithner, summoned some 30 Wall Street executives for a 6 p.m. Friday meeting at the Fed's offices in Lower Manhattan.

"There is no political will for a federal bailout," Mr. Geithner told the assembled executives, according to a person familiar with the matter. "Come back in the morning and be prepared to do something."

Over the next 48 hours, these marching orders developed into a nerve-wracking test of the ability of the U.S. financial system to hold itself together amid the worst series of shocks it has faced in decades.

[Henry Paulson]

By taking the rescue option off the table, the U.S. government was declaring that there are limits to its role as backstop-in-chief. A week earlier it had seized mortgage giants Fannie Mae and Freddie Mac, and months prior had brokered the sale of Bear Stearns & Co. to J.P. Morgan Chase & Co. But now, Washington appears to want Wall Street to largely fix its own problems, and feels that flailing institutions shouldn't expect the government to commit money to save them.

"We've re-established 'moral hazard,'" said a person involved in the talks, referring to the notion that the government should eschew bailouts, since financial firms might take more risks if they're insulated from the consequences. "Is that a good thing or a bad thing? We're about to find out."

One immediate impact: As Lehman's future darkened, Merrill Lynch & Co., another vulnerable firm, raced into the arms of Bank of America Corp.

This account of the weekend's events was compiled from interviews with Wall Street executives, traders, government officials and other participants in the talks.

Barring some last-minute, late-night alternative, Lehman will likely file for liquidation, people familiar with the situation said.

The storied firm's decline occurred in slow motion this year. Heavily exposed to troubled real-estate investments, the firm tried to raise fresh capital, only to be thwarted. The most recent disappointment came last Monday when a possible deal with a Korean bank faded, sending Lehman's shares down 45% the next day. They had already fallen 80% since the start of 2008.

On Tuesday and Wednesday, when Mr. Paulson called Wall Street CEOs to give them early notice of his no-bailout stance, some argued to him that the government needed to structure a rescue like that of Bear Stearns, according to people familiar with the matter. To prevent Bear Stearns's collapse in March, the Fed agreed to put up $30 billion to help complete the acquisition of the failing bank by J.P. Morgan Chase.

Repeating that move with Lehman, however, would create a terrible precedent, Mr. Paulson worried. Which other firms would take that as a cue to ask for U.S. government help -- and from what other industries? Detroit auto makers were already knocking at the door.

Mr. Paulson was also irked that Wall Street saw him as someone who would always ride to the rescue. And because Lehman's troubles have been known for a while, Mr. Paulson felt the market had had time to prepare.

In addition, Lehman had access to special emergency lending from the Fed -- something Bear Stearns didn't have when it was struggling. This was another reason Mr. Paulson there shouldn't be a Bear-like rescue for Lehman.

The government's no-bailout decision emerged as serious obstacle for Lehman's two most likely buyers, Bank of America and Barclays PLC. Indeed, this past Friday, federal officials monitoring talks to sell Lehman to Bank of America realized that deal probably wouldn't be consummated without federal backing.

That triggered the call for the Friday-evening meeting of financial titans. The gathering was attended by at least 30 executives, a Who's Who of Wall Street.

Mr. Geithner laid out two potential scenarios. One involved an orderly dismantling of Lehman that would essentially end its existence. But he also suggested that Wall Street firms come up with their own solution -- perhaps by joining forces among themselves to remove Lehman's riskiest and most toxic assets. That move would make Lehman more attractive to potential buyers, but would also require Wall Street firms to commit their own scarce money to the cleanup.

Mr. Paulson told the group it was in their interest to find a solution. "Everybody is exposed" to Lehman, Mr. Paulson said, according to two people in attendance.

Most of the Wall Street executives present at the meeting listened and asked questions, but didn't show what hand they might play. The meeting broke up just after 8 p.m. Friday.

Finding a Buyer

Saturday morning, the CEOs and their closest advisers reconvened at about 9 a.m. and broke into groups to discuss various scenarios. Lehman representatives weren't present.

One group focused on the possible dismantling of Lehman; it included both government officials and Wall Street representatives. Among the things the group discussed was having every bank borrow from the Fed under an emergency lending provision it has offered since the collapse of Bear Stearns. With that borrowed money, the banks would buy up Lehman's assets, preventing it from filing for bankruptcy.

The other main track focused on finding a buyer. Either Barclays or Bank of America would buy Lehman's "good assets," such as its stock-trading and analysis business, people familiar with the matter say. Lehman's more toxic real-estate assets would be placed in a "bad" bank containing about $85 billion in souring assets. Other Wall Street firms would inject some capital into the bad bank to keep it afloat. The goal would be to avoid a flood of bad assets pouring into the market, pushing prices even lower.

But getting Wall Street firms to cooperate among themselves, without government assistance, was proving tough. Several CEOs openly questioned why they should bear the cost of Lehman's problems when others who also face exposure -- such as institutional investors, hedge funds and foreign investors -- aren't being asked to do the same.

Morgan Stanley CEO John Mack raised serious questions, saying that this time it was Lehman and next time it would be Merrill, according to people in attendance. "If we're going to do this deal, where does it end?" he said, according to a person familiar with the matter. Other bankers in the room felt the same way, this person added.

By noon on Saturday, Bank of America hadn't budged from its position that it needed government support to consummate a deal. The bottom line: It was effectively out of the running.

Outside the Fed's downtown New York headquarters, a fortress-like building of stone and iron, a fleet of black limousines waited for the bankers inside. At one point, they blocked the narrow streets around the building, causing a traffic jam that had to be broken up by the Fed's uniformed guards.

Bankers and Fed staffers milled outside, smoking cigarettes and talking on their cell phones about subjects such as counterparty risk, a normally arcane matter of contract law, suddenly front and center. On one occasion, in the men's bathroom, a trio of bank CEOs debated the merits of a rescue plan.

The bond- and derivative-trading heads of major investment banks, assuming that a deal to save Lehman was a diminishing possibility, gathered to discuss how to deal with their exposure to minimize havoc Monday when markets opened.

Shortly after 5 p.m., a clutch of Fed staffers left the building. The day hadn't gone well. The government and potential buyers remained miles apart, mainly due to the bailout issue. Wall Street executives left in cars parked in a garage to avoid being photographed by the waiting press.

One person in the Fed meetings Saturday night described them as "the world's biggest game of poker."

With different doomsday scenarios being batted around the meeting rooms, some participants felt the government would blink and do a bailout. "This is going to go down to the last second," one participant said.

With Bank of America backing away from a deal, the enormity of a potential bankruptcy filing by Lehman started settling in. Even understanding Lehman's current trading positions was tough. Lehman's roster of interest-rate swaps (a type of derivative investment) ran about two million strong, said one person familiar with the matter.

Overnight, the outlines of possible deals started to crystallize. The idea that Wall Street firms would fund a "bad bank" full of Lehman's problematic assets was dead. Unlike when Wall Street firms stepped in to bail out hedge fund Long-Term Capital Management a decade ago, today's banks are much weaker. Some were loathe to provide support when a rival like Barclays might still buy Lehman.

By Sunday morning, the U.K.'s Barclays looked like the sole potential buyer. That further minimized the chances of a government bailout: If the Bush administration wouldn't help to fund a Wall Street solution, aiding a foreign buyer was even less likely.

Lehman employees followed their firm through news reports. One manager said he was encouraging his staff to show up Monday and hang tough for a few more days. "It is not like there are a million jobs to go to," he said.

The Chance to Transform

Barclays pushed ahead, eager at the chance to transform itself into a U.S. powerhouse at potentially a fire-sale price. Its advisers thought the U.S. Treasury could be persuaded to support a foreign buyer. By Sunday morning in London, after working around the clock for three days, the British bank -- whose roots date to the late 1600s as a goldsmith banker in London -- thought it had a shot. Documents were drawn up to pitch the deal to investors and journalists.


During the afternoon on Sunday, two Fed policeman wheeled a large, double-decker cart filled with cakes, cookies, sandwiches, chips and bottles of water into the Fed building.

But soon after, Barclays was threatening to walk as it argued with the Fed and Treasury over seemingly mundane matters, such as whether it would have to hold a shareholders' meeting to ratify any deal. Barclays was still insisting on some kind of federal financing.

By the middle of Sunday afternoon, Barclays was out. Its plan -- to buy Lehman's subsidiaries -- was contingent on government support, which wasn't coming.

At a meeting held at the Fed offices, Mr. Paulson, Mr. Geithner and Securities and Exchange Commission Chairman Christopher Cox addressed a group of about one dozen banking chiefs. Their message was steadfast: They would not put up money to assist in salvaging Lehman. In the meetings with Mr. Paulson were his chief of staff, Jim Wilkinson, and two advisers, Dan Jester and Steve Shafran, both of whom used to work at Goldman Sachs.

Somber Mood

The mood turned somber as it became clear that the group would have to turn its attention to dismantling Lehman in a way that didn't seriously disrupt the financial system. Soon the group began discussing the mechanics of such a plan.

A sense of foreboding descended over the rival bankers. They focused on the fear that drove down shares in Lehman, worried that would now spread to Merrill, another storied name facing losses from mortgage-related holdings, despite the reputation of its wealth-management business.

"I think the government is playing with fire," said a top executive of a big bank.

The worry for Merrill, said people briefed on the conversations, was that as its stock tumbles, its credit rating could change, increasing its cost of borrowing. Faced with rising borrowing costs -- a key expense for giant Wall Street financial firms -- its business might be severely crimped. As well, as concerns mount, its trading partners might stop doing business with it.

Many in the room began to wonder when Merrill would sell itself. "Tonight, or tomorrow?" said one of these people in an interview. In fact, within a few hours, the bankers learned that Merrill was in talks to be acquired by Bank of America.

As word that a Barclays deal was off filtered across Wall Street, traders scrambled to extricate themselves their various financial transactions with Lehman. Traders at many Wall Street firms were told to come to work immediately.

The European Central Bank was also in a state of high alert on Sunday, with employees in divisions from money-market operations to financial stability camped out in the bank's 37-story glass-and-steel tower in Frankfurt, preparing for what Monday might bring. "We are in the hands of the Americans," said one employee.

--Aaron Lucchetti, Serena Ng, Jon Hilsenrath, David Enrich, Joellen Perry and Matthew Karnitschnig contributed to this article.

Write to Deborah Solomon at deborah.solomon@wsj.com2, Dennis K. Berman at dennis.berman@wsj.com3, Susanne Craig at susanne.craig@wsj.com4 and Carrick Mollenkamp at carrick.mollenkamp@wsj.com5



After 73 years: the last gasp of the broker-dealer

By John Gapper

Published: September 15 2008 19:15 | Last updated: September 15 2008 19:15

Ingram Pinn illustration

It sometimes feels as though my two decades as a financial journalist have been spent, first in London and then in New York, watching investment banks either collapse or be acquired: Barings, SG Warburg, JPMorgan, Bear Stearns, and now Lehman Brothers and Merrill Lynch.

This Sunday was different, however, because it marked not simply the end of Lehman and surrender of Merrill, but the last gasp of the independent investment bank itself. Morgan Stanley opened on Wall Street on Monday September 16 1935 and, 73 years later, almost to the day, the institution of the broker-dealer died.

Goldman Sachs and Morgan Stanley are the last hold-outs among Wall Street’s independent investment banks (although even Morgan Stanley sold out once before, to Dean Witter, in 1997). How long these two will spurn the capital backing of a commercial bank remains to be seen.

There will, of course, be investment banks in future. But they will be smaller, specialist institutions, like the merchant banks of old. There are plenty of advisory firms, hedge funds and private equity funds and this Wall Street crash will create more. All of those unemployed financiers will need something to do.

The full-service investment bank, buying and selling shares and bonds for customers as well as advising companies and trading with its own capital, is doomed. In order to generate the revenues needed to match larger institutions, banks such as Lehman scurried into risk-taking that eventually sunk them.

Stockbrokers such as Morgan Stanley were pushed out on their own by the 1933 Glass-Steagall Act, which enforced the separation of banks and investment banks. Their fate was probably sealed on May 1 1975, when fixed commissions for trading securities were abolished, setting off a squeeze on broking revenues.

“To stockbrokers, May Day means nothing less than the abolition of the system that has enriched them in good times and pulled many of them through during long periods of market slack,” Time magazine noted that year. Investment banks had relied on these commissions during the financial doldrums following the 1973 oil crisis.

Investment banks went on to enjoy 30 years of prosperity. They grew rapidly, taking on thousands of employees and expanding around the world. The big Wall Street firms swept through the City of London in the 1990s, picking up smaller merchant banks, such as Warburg and Schroders, on their way.

Under the surface, however, they were ratcheting up their risk-taking. It was increasingly hard to sustain themselves by selling securities – the traditional core of their business – because commissions had shrunk to fractions of a percentage point per trade. So they were forced to look elsewhere for their profits.

They started to gamble more with their own (and later others’) capital. Salomon Brothers pioneered the idea of having a proprietary trading desk that bet its own money on movements in markets at the same time as the bank bought and sold securities on behalf of its customers.

Banks insisted that their safeguards to stop inside information from their customers leaking to their proprietary traders were strong. But there was no doubt that being “in the flow” gave investment banks’ trading desks an edge. Goldman Sachs’ trading profits came to be envied by rivals.

Investment banks also expanded into the underwriting and selling of complex financial securities, such as collateralised debt obligations. They were aided by the Federal Reserve’s decision to cut US interest rates sharply after September 11 2001. That set off a boom in housing and in mortgage-related securities.

The catch was that investment banks were taking what turned out to be life-threatening gambles. They did not have sufficient capital to cope with a severe setback in the housing market or markets generally. When it occurred, three (so far) of the five biggest banks ended up short of capital and confidence.

This leaves Goldman and Morgan Stanley on the spot. A bank can be highly skilled in risk management and trading, as Goldman has proved. Yet a single big mistake, as we have now witnessed, may spark a fatal spiral. Even a Fed guarantee of short-term funding could not save Lehman from chapter 11 bankruptcy protection.

It seems to me that Goldman and Morgan Stanley have two options. One is to follow Merrill and sell out to a large commercial bank with a big capital and deposit base. That could provide them with sufficient backing for their capital markets divisions, which can be revenue and profit powerhouses in good times.

The second is to scale back heavily, or abandon, their broker-dealer arms and become more like big hedge funds or private equity funds. In Wall Street jargon, this would involve a switch from sell side to buy side, where most money is now made. In exchange for becoming much smaller, they might retain their high margins.

My guess is that Morgan Stanley will opt for the first and Goldman for the second. It is sad to witness 73 years of investment banking history end this way but there is no use in denying it. Goodbye to all that.


Old-School Banks Emerge
Atop New World of Finance

More than 200 years after it was born at the base of a buttonwood tree, Wall Street as we have known it is ceasing to exist.

The rapid demise of 158-year-old investment bank Lehman Brothers Holdings Inc., together with the takeover of 94-year-old Merrill Lynch & Co., represent a watershed in the banking industry's biggest restructuring since the Great Depression.

For decades, the world of banking was divided largely into two kinds of businesses. Commercial banks took deposits and made loans, eking out a decent return under the burden of heavy regulations designed to protect depositors. Standalone securities firms such as Lehman, Merrill and the now-defunct Bear Stearns Cos. took no deposits and were lightly regulated, freeing them to take big risks and make fat profits at the cost of occasional losses. More recently, some of the biggest institutions, such as UBS AG and Citigroup Inc., combined the two.

Now, as many securities firms are consumed in the wake of a disastrous foray into financial wizardry, the balance of power is shifting. On the wane are the heavy borrowing and complex securities that financiers embraced in recent years. On the rise is a more old-fashioned business of chasing customer deposits and building branch networks, conducted with the backing of federal insurance programs to keep depositors from pulling out en masse.

Of the five major independent investment banks that existed a year ago, only two -- Goldman Sachs Group Inc. and Morgan Stanley -- remain standing. Two others, Merrill and Bear Stearns, have been acquired by big deposit-taking institutions, Bank of America Corp. and J.P. Morgan Chase & Co. Other giant commercial-banking players, such as Wells Fargo & Co. in the U.S., as well as Germany's Deutsche Bank AG and Spain's Banco Santander SA, have emerged as some of the most powerful players in an industry that is likely to be safer but less lucrative for shareholders.

Banks are heading "back to basics -- to, if you like, the core purpose of the system with less bells and whistles," says Douglas Flint, finance chief at HSBC Holdings PLC and co-chair of the Counterparty Risk Management Policy Group, a task force of finance executives working on a framework to prevent systemic financial shocks. "There is a recognition that when the dust settles...the construct of the industry will be different."

Evidence of the new importance of bread-and-butter banking is appearing around the globe. Deutsche Bank, which had been focused on building its global investment-banking business, last week agreed to pay nearly €3 billion ($4.3 billion) in a two-stage deal to acquire the 850 domestic branches of Deutsche Postbank AG, the retail banking arm of the German postal system. Santander, which also wooed Postbank, paid £1.26 billion ($2.26 billion) in July for troubled U.K. mortgage lender Alliance & Leicester.

The shift reflects a broader reassessment of how best to do the essential business of banking, which plays a crucial role in the economy by turning their short-term liabilities -- savers' cash and deposits -- into longer-term investments such as mortgages and corporate loans. In recent years, commercial banks moved a lot of that business off their heavily regulated balance sheets and into the realm of securities firms.

The investment banks packaged the loans into an array of ever more complex securities, which they kept on their books or sold to a broad range of investors -- including hedge funds and bank-affiliated funds known as conduits and structured-investment vehicles, or SIVs. To fund their activities, the securities firms and investors borrowed heavily in the commercial-paper market and the so-called repo market, where borrowers put up securities as collateral for short-term loans.

This alternative banking system proved profitable, in part because participants weren't required to meet commercial banks' more rigid reserve requirements against potential losses. But these banks' strategies backfired with the onset of the credit crunch last summer, as heavy losses on mortgage and other investments in some cases proved too much for their thin capital bases, and the markets on which they relied for funding dried up.

A federal bankruptcy-court filing by Lehman on Monday in New York highlights the quick spiral. As of May 31, Lehman depended on repo loans for $188 billion in borrowings. But as the value of the securities Lehman had put up as collateral for the loans fell amid the broader market turmoil, its lenders started demanding extra collateral. Because the amount it could borrow against its securities kept falling, Lehman was forced to dip ever deeper into its cash reserves, prompting ratings firms to consider cutting its credit ratings, according to the filing. Lehman's efforts this month to raise money by selling an investment-management firm proved too late.

As repo loans and other market-based funding on which investment banks rely becomes more expensive, the question becomes whether independent broker-dealers, unattached to big banks with ample deposits, will survive. "In the coming months, we expect a significant overhaul of all the brokers' business models," wrote Matt King, a credit strategist at Citigroup in London, in a recent report.

The new financial order also highlights the lasting impact of the elimination of the Glass-Steagall Act, a Depression-era law that prevented U.S. commercial banks from doing investment-banking business. The repeal of Glass-Steagall, in 1999, allowed commercial banks to break into the securities business and ultimately gain the heft to compete with the likes of Bear Stearns and Merrill.

This universal banking model has proved hard to manage, with the likes of Citigroup and UBS knitting together a vast empire of operating units. Even so, these and other big deposit-taking banks that are required by regulators to maintain bigger cushions against losses, such as Bank of America, have so far survived the credit crunch better than some of the stand-alone securities firms.

Thanks in large part to government programs that insure them, deposits have been a rare bright spot during the credit crunch. In the U.S., savings and small time deposits -- two important classes of customer money -- stood at $6.9 trillion at the end of August, up 7.6 % from a year earlier, according to the Federal Reserve. In the euro area, total deposits stood at €6.3 trillion as of the end of July, up 12.8% from a year earlier, according to the European Central Bank.

Meanwhile, the U.S. market for the IOUs known as asset-backed commercial paper, a key source of short-term funding for the bank and brokerage industry, has shrunk by more than a third since the crisis began last year, to $780 billion as of Sept. 10.

Sticking to the basic banking model hasn't worked for everyone. Smaller banks in the U.S. and Europe have suffered, in part because they lack the scale and diversification to absorb heavy losses generated by growing defaults on mortgage and corporate loans.

To be sure, some stand-alone investment banks, such as Goldman Sachs Inc., are well funded. And some innovations and markets will rebound when the credit crunch fades. Consumer debts such as mortgages, credit-card balances and student loans will still be packaged into securities.

But such securitization, analysts say, will likely happen in smaller volumes and in more conservative forms, such as so-called covered bonds. Many of the instruments central to the current crisis were created and sold by banks with no stake in their performance. In contrast, covered bonds have payments that are bank-guaranteed regardless of how poorly the packaged loans perform. Covered bonds are the main source of mortgage-loan funding for banks in Europe, where a $2.75 trillion market has long thrived. Some analysts predict a U.S. market could grow to $1 trillion over the next few years.

"Securitization will play a lesser role for the well-capitalized, highly rated banks," says Ganesh Rajendra, a researcher at Deutsche Bank in London. "But it will still help them manage their capital and risks in many cases."

Internationally, banks that haven't been disabled by write-downs are moving aggressively to buy deposit-rich lenders. Deutsche Bank, which declined the opportunity to bid for Postbank a few years ago, chose to outbid Santander last week in part because it didn't want to see the large retail operation fall into the hands of a foreign rival.


In July, France's Crédit Mutuel, one of France's largest bank-branch operators, paid a hefty $7.7 billion to outbid Deutsche Bank and buy Citigroup's lucrative German retail operations. Two weeks ago, Germany's Commerzbank AG said it would pay $13.9 billion for German rival Dresdner Bank, creating a combined retail network with some 1,500 branches and 11 million customers. Dresdner also has an investment bank, but Commerzbank plans to ax half its staff and drastically scale back the unit's trading operation.

The deals are often complicated by the credit crunch and the presence of toxic investment-banking assets. Allianz SE, Dresdner's parent, had to agree to insure Commerzbank against €1 billion of losses at a structured-investment vehicle Dresdner was forced to fund as a result of the credit crunch. Deutsche Bank only agreed to buy only 29.75% of Postbank upfront at a price of €57.25 a share, with an option to buy more. That helps Deutsche Bank preserve capital amid a worsening economic outlook, said a person familiar with the situation.

Bank of America Chairman and Chief Executive Kenneth D. Lewis said Monday he saw this wave coming. "For seven years now as CEO, I have said I thought that the commercial banks would eventually own investment banks because of the funding issue," he told reporters.

—Dana Cimilluca and Neil Shah contributed to this article.