Paulson's Decision Cost Lehman, Then the World

What, I ask, would have happened if Paulson had simply stepped aside and let Bear Stearns collapse into bankruptcy back in March 2008?
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My new book, A Colossal Failure of Common Sense, moves to a stark and irrevocable conclusion, that Henry Merritt Paulson, the former U.S. Treasury Secretary, made a fateful decision that within two weeks brought the world's economy to its knees.

He decided to let Lehman Brothers, the 158-year-old Wall Street institution, go bankrupt. He need not have done so. But on that fateful weekend, Sept. 13-15, 2008, he made the decision with which he must live for the rest of his life. He would not save Lehman Brothers. As one senior Lehman managing director told me, "They put Lehman's head underwater and watched for the bubbles." And that did it, globally, as first the U.S. and then the rest of the world swooned.

Since last winter, I have had many hundreds of hours to ponder Paulson's history-making decision, and while I cannot revise the truth, nor in any way let him off the hook, I am drawn to the conclusion that the Treasury boss did not lose the war on that final weekend. He lost it the previous March when he stepped forward and saved the much smaller Bear Stearns, which was in the same leaking boat as Lehman with far worse debt and no hope. Hank Paulson could have let them go, but he did not. He practically frog-marched JPMorgan Chase (JPM) into the arena and ordered it first to loan Bear Stearns a large amount of cash, and then five days later to buy the 86-year-old Wall Street bank.

When Paulson gave the lifeboat to Bear Stearns, it gave Lehman's CEO Richard S. Fuld a deadly, false sense of confidence.

JPMorgan's Behavior Change

Even today, the most clever Lehman minds tell me about a form of schizophrenia that JPMorgan displayed in its dealings with Bear Stearns and later Lehman. Bear was an investment bank almost half the size of Lehman. Yet the Fed and Treasury commissioned JPMorgan and its CEO Jamie Dimon to provide cash infusions to Bear the week before the bank's bailout. JPMorgan became a new tool in Hank Paulson's chest of creative innovations.

Fast-forward to September 2008--and oh how things had changed. Most senior traders and bankers I spoke to from Lehman were shocked at the new demeanor of JPMorgan, the split personality that Lehman was now experiencing like a bayonet in the back. JPMorgan was in a foul mood of sorts. Injecting aid, a cash infusion for Lehman? No, JPMorgan was now demanding weekly increases in the collateral that Lehman would have to put up in order to secure short-term loans to run its businesses. This suffocated the 158-year-old investment bank. It put her to sleep.

But what, I ask, would have happened if Paulson had simply stepped aside and let Bear Stearns collapse into bankruptcy back in March? I'll tell you the first thing: Dick Fuld would probably have had a heart attack. "If he can let Bear Stearns go, he can let us go."

And what would have been the natural progression? Fuld would have had no options. Mired in debt, holding billions and billions of unsellable assets, already entering its death throes, Lehman would then have had only one way out: to accept the offer about to be made by the Korea Development Bank, which when it materialized was around $23 a share. Fuld might have been way out of his depth in 21st century finance. But he was nobody's fool, and he had a sense of self-preservation second to none. He would have accepted the Korean money in seven seconds, particularly since Paulson himself never stopped urging him to do so right until the men from the Far East withdrew as Labor Day arrived.

Lehman's Leverage

A similar scenario played out during that turbulent September. John Thain, CEO of Lehman's great rival, Merrill Lynch, knowing that Paulson was letting Lehman go, jumped willingly and enthusiastically into the arms of the near-bankrupt Bank of America (BAC).

In the end, the Treasury chief never forgave the Lehman chairman for ignoring that Korean offer, because in Hank's opinion that probably would have saved the world. It was here that the constantly smoldering rift between the old Wall Street rivals, Paulson and Fuld, suddenly became a chasm. Because despite everything, Fuld had an almost obsessive desire to hold on to Lehman at all costs. With the Koreans on the sidelines, he began thrashing around, investing in major hedge funds, in small hedge funds, in overseas hedge funds. He even started to form hedge funds, and Hank Paulson was appalled. Here was a Wall Street bank leveraged almost 40 times its own value at the top of the market, plainly headed for oblivion, ignoring the Korean lifeline, silencing its best risk-takers, and spending its borrowed money like a drunken sailor. Hank Paulson never got over that.

Let me clarify that 40 times leverage is the equivalent of any gambler walking into a casino with just a $100 bill in his back pocket but playing on the tables with $4,000. It doesn't take much to wipe out that old Benjamin.

Fuld and Paulson had dinner that spring of 2008. Fuld was characteristically rude to the Treasury boss. In turn Paulson was infuriated at this disrespect to his great office of state. Most of the distilled opinion suggests that it was that spring when Lehman's fate was decided. But my own new opinion is that the hasty rescue of Bear Stearns was the fulcrum upon which the entire issue swung.

Hank Paulson and then New York Fed chief Timothy Geithner have argued that Bear Stearns had to be saved because systemic defense mechanisms protecting the markets had not been set up yet. Well, a fool could tell you the adequate mechanisms were not set up when Lehman failed, either. If Hank had let Bear go, the world would have looked very different.

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