Lehman Brothers is becoming a historical artifact, a corporate fossil like Enron and Worldcom that we can dissect to learn about its inner decay. But as revelations mount about the degree of corruption at Lehman, we're forgetting that the failed investment bank nearly garnered a taxpayer-assisted buyout in 2008 that would have saved the firm and probably prevented public disclosure of its most abusive practices.
A new report generated as part of Lehman's bankruptcy proceedings depicts a firm so desperate to attract funding and disguise its woes that it ginned up some creative accounting maneuvers that essentially allowed it to hide nearly $50 billion worth of money-losing assets. Even on Wall Street, that's a huge sum that could easily mean the difference between solvency and collapse. Examiner Anton Valukas , appointed by the bankruptcy court, has produced an exhaustive analysis of Lehman's operations that calls the firm's representation of its finances in 2008 "materially misleading." Senior Lehman executives ignored internal warnings from their own people, the report says, and hired a British law firm to bless the firm's practices because they wouldn't pass muster under U.S. law. Lehman's auditor, Ernst & Young, never objected to any of it and now finds itself on the hot seat.
Looking back, Lehman seems like the kind of firm that deserved to fail. But it almost didn't, and efforts to bail out the firm in 2008 show how the government tried to aid any firm whose failure might have caused trouble, regardless of whether the firm itself was sound. In his recent book On the Brink, for example, former Treasury Secretary Henry Paulson describes a desperate government effort to save Lehman by brokering a private deal and possibly helping out the buyer by creating a government-backed entity that would carve off billions in toxic assets held by Lehman—similar to the deal that kept Bear Stearns out of bankruptcy earlier in 2008.
In the second week of September 2008, while Lehman was tottering, Paulson and Tim Geithner, president of the New York Federal Reserve Bank, summoned the titans of Wall Street to the New York Fed for emergency meetings on what to do about Lehman. They all worried about the havoc a Lehman bankruptcy would cause. Paulson and Geithner worked hard to interest two possible Lehman buyers: Bank of America and the British bank Barclay's. As those suitors began to look closely at Lehman's books, they both insisted separately that any deal would require billions' worth of Lehman's worst assets to be cast aside. It was up to the government to figure out what to do with them.
To their credit, Paulson and Geithner sought a private-sector solution, pleading with the big Wall Street banks to provide the financing it would take to hive off Lehman's bad assets and create a holding company that would dispose of them in due course, over a long period—similar to the arrangement made for Bear Stearns, which allowed JPMorgan Chase to buy it. But everybody knew that the Bear Stearns deal six months earlier had also entailed some government guarantees. So the assumption was that the government would do that again—as long as there were a buyer for Lehman, as there had been for Bear.
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Lehman was a competitor to all the other Wall Street firms, and in normal times they'd never help a rival. But the bankers knew that a Lehman bankruptcy could create a panic that might harm most or all of them. The drama was high as Geithner, Paulson, et al. held urgent all-nighters at the New York Fed, phoned everybody they knew, and tried to find a solution. Paulson, in his memoir, describes the fears he expressed to his wife, Wendy, should Lehman fail: " 'What if the system collapses?' I asked her. 'Everybody is looking to me, and I don't have the answer. I am really scared.' "
While poring over Lehman's books, both possible acquirers began to notice huge gaps between the value Lehman assigned to its assets and what the actual value probably was. By one estimate, Lehman had overvalued its assets by $20 billion. Bank of America raised that, saying that to get a deal done, it would have to unload up to $70 billion of Lehman's assets. At the time, Lehman's entire market capitalization was less than $30 billion. Paulson describes the gap as startling, to him and the bankers alike—yet they trudged forward, trying to get a rescue done. It's worth noting that the recent valuation gap identified by the bankruptcy examiner—determined after more than a year's worth of analysis—is in the same ballpark as the rapid-fire assessments done in less than a week in 2008.
Bank of America was more interested in acquiring Merrill Lynch (which it did, ultimately), and it backed out of the bidding for Lehman. Barclay's remained interested, and the outline of an extraordinary deal emerged. A consortium of Wall Street firms would provide $37 billion to cover Lehman's bad assets, clearing the way for Barclay's to buy the bank and prevent a bankruptcy. But there was one fatal snag: British regulators, worried about one of their banks making a deal that could strain their entire banking system, refused to give their approval. That left Lehman out of options. Without a buyer, the government had no authority to rescue an investment bank. Lehman was destined for bankruptcy.
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Paulson spoke frequently during the ordeal with Lehman CEO Richard Fuld, who has said recently that he was not aware of the accounting gimmickry highlighted by the bankruptcy examiner. That's an astonishing admission for a CEO, and it suggests one of two things: Either Fuld is lying, to protect himself from lawsuits related to Lehman's demise, or he was a terrible CEO, out of touch with his firm's most vital matter: its solvency. Paulson describes Fuld as a passionate leader who was ultimately in denial about the state of his firm, turning down earlier deals while holding out for a higher price and losing touch with the dire reality that was unfolding.
After appealing to Britain's finance minister and exhausting all appeals, Paulson met with the Wall Street CEOs. "The British screwed us," he said, according to his own account. That set the stage for Lehman's bankruptcy filing on Monday, Sept. 15, 2008, and the financial mayhem that followed. Since then, there's been an undercurrent of blame aimed at the British, as if stopping one suspect deal sent the world into a financial tailspin.
The British, however, now look rather prudent. It's chilling to consider that the stars nearly aligned for a deal that would have propped up a firm as profligate and shady as Lehman. There will be long, costly court battles over whether Lehman's financial practices were actually illegal—which is not a charge the bankruptcy examiner has made so far—or merely appalling. But what seems obvious now is that Lehman was operating way beyond standard practice. If anything, the government should be investigating firms like this, not trying to save them.
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Congress is now debating financial reform that would give the government better options for dealing with firms like Lehman that aren't ordinary banks but could still have crushing effects on the system if they failed. A top advocate for reform is Tim Geithner, now treasury secretary, who argues among other things that there needs to be a better way to wind down big failing firms like Lehman. Geithner has made some missteps, but to be fair, there is a strong case that the financial system was, in fact, on the verge of collapse in 2008 and that government action eventually calmed the markets and prevented a bona fide depression. Lehman's shenanigans made the problem worse, and the financial system is better off without it. The more we know about this sordid saga, the clearer it becomes: The Lehmans of the future must be sent to a place where wayward firms are methodically dismantled, instead of wasting government and taxpayer resources begging for a rescue they don't deserve.