What if the Treasury Had Bailed Out Lehman Brothers?

My background is in finance as a trader and I continue to remain fascinated by the turbulent events of Late Summer/Fall 2008 when the global markets entered a freefall.

As some readers may remember, September 2008 - March 2009 was an EXTREMELY volatile period. The fate of the global financial system was in doubt. Bank runs were beginning to form and a note of panic had entered the normally optimistic financial media. While we have survived (so far), what if things had gone a little differently?

NOTE- some background in economics and finance are required but I will attempt to simplify things into layman's language.

September 10, 2008
New York Federal Reserve

"Sir?"

A junior aide knocked on the office door. Hank Paulson, the former CEO of Goldman Sachs and current Secretary of the Treasury, glanced up from his place at the head of the table. The dark oak paneled room reflected the tense mood of the room's occupants. Virtually the entire pantheon of senior Wall Street leadership was present.

"What is it?! Can't you see we're busy?" he barked.

The staffer shrinked from the vehement tone of his boss' voice but gathered the courage to respond. "Dick Fuld is on the line. He requests an immediate audience."

Paulson swore softly. He had read the news. In fact so had everyone here. The media was having a field day with its apocalyptic headlines. But in fact, as everyone present knew, things were a lot worse.

Dick Fuld, CEO of Lehman Brothers, had just reported a massive loss for Q3 earnings of over $3.9 billion. The announcement had come a day after Lehman shares ALREADY lost 45%. Shares of his own former company, Goldman Sachs, had suffered a major decline, as had the share prices of the other present and former CEO's in the room. And that was just based off the publicly available information.

"I think we should hear him out." everyone's heads glanced towards the other end of the table. The speaker was a slight, bearded man but commanded an air of respect and calm. Ben Bernanke, Chairman of the Federal Reserve, spoke again, "Hank, I know we spoke before about not bailing out Lehman, but just think of it as another Bear Sterns."

"Another Bear Sterns?" rasped another speaker. Jamie Dimon, CEO of JP Morgan Chase expressed his incredulity. "Ben, you rammed that deal down my throat and now you want us to do it again with Lehman? Are you out of your fricking mind?!"

He turned to address the other occupants. "This man," he pointed at Bernanke, "is more responsible for the current mess than anyone else present. Your policy of cutting interest rates when you should've been raising them is now blowing up in our faces. Because of you we have Starbucks workers making $10/hour unable to pay off million dollar condo mortgages in Florida. And now you want the rest of us to pay for your mistakes?"

Ben sighed, "And your trading of naked CDS (credit default swaps) had nothing to do with that either I suppose? Or the naked shorting of each others' stocks? The fact is, as much as I hate to say it, Lehman is too big to fail."

"Too big to fail?" The next speaker turned to address those around him. Bill Gross, CEO of PIMCO, spoke, "AIG is the next problem and more might come. How much more funds can the Federal Reserve inject? They certainly have a limit and cannot be a saviour everytime. We should focus our attention on saving the Fannie and Freddie mortgages directly."

"You're just saying that because your fund holds millions in mortgage bonds," said the next speaker, John Mack, CEO of Morgan Stanley.

"Gentlemen, today is Thursday evening. Trading ends tomorrow. The fact is if we don't act now, Lehman will be declaring bankruptcy on Monday." Bernanke's voice cut through the quiet murmuring around the corners of the room. "The fact is, everyone here has an agenda, but together we hold the collective interest of America. In fact, we ARE America. Hank, I can't force you to do anything but I strongly suggest you drop old rivalries and step in to do something about Lehman."

Hank Paulson nodded to the staffer waiting patiently at his side, "Tell Fuld I will see him in exactly 1 hour. We need to draw something up by this weekend."

Thoughts anyone?
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I love how you take a complicated subject, put it into layman's language, then work it into a narrative style so seamlessly. So certainly well written.

I think the million dollar question here is, Does bailing out Lehman stop the financial meltdown?
 
The Market Reacts: mid-September - early October 2008

September 20, 2008
New York Stock Exchange (NYSE) trading floor
9:15 AM EST

From his perch on the 2nd floor balcony Hank Paulson looked down at the activity below. Nervous traders milled around the trading floor awaiting the start of the opening bell at 9:30 AM EST.

The past few days had seen momentous changes come out of multiple US regulators. The Federal Reserve acting in conjunction with the Treasury Department had rescued Lehman Brothers in an action that the press had been snidely dubbing Bailout 4.0 (Bear Sterns was the first, Fannie/Freddie Mac the second, and AIG the third - all in 2008 under his watch).

Jamie Dimon of JP Morgan Chase had flatly refused to have anything to do with Lehman. And with good reason. After meeting with its CEO, Dick Fuld, Paulson had been shocked at the extent of subprime garbage hiding on its balance sheets. After a quick conference with the Federal Reserve, it was decided that Citigroup would buy out Lehman Bros. and the most toxic assets would go on the Fed's balance sheets. While no one present at the meeting - least of all the Citi board of directors - had liked the deal, they had ultimately bowed to pressure from Ben Bernanke, Chairman of the Fed, who stressed the need to preserve the money markets.

"Gentlemen, without this action, we ARE going to see a run on the banks. Short term interest bearing deposits, or money markets, will suffer as a result. Money-market funds are typically a safe investment popular with American consumers and companies alike, but redemptions have gone through the roof. But now, both foreign and domestic investors are SELLING everything. We face a full blown panic." the bespectacled former academic addressed the room in a sober tone. No one had disagreed with him although there had been some nagging questions from the President.

Hank sighed. How that lame duck managed to graduate with an MBA and STILL not know anything about the stock market was beyond him. He had tasked several junior staffers with the unenviable task of explaining basic economics to his boss.


But Paulson didn't care about any of that right now. While the press always made him nervous and prone to stuttering, his thoughts were focusing on the next crisis.

Without consulting him, Christopher Cox, Chairman of the SEC (Securities and Exchange Commission, the regulator in charge of the stock and bond markets) had instituted a sweeping ban of nearly all stocks. Paulson was aghast at this latest action. Didn't that idiot know anything about finance?

While short sellers had been villified for much of the financial turmoil, they were a necessary element for market liquidity. By selling stocks they didn't own, short sellers were also required to buy back the stocks - ideally at a lower price to make their profit, otherwise they faced unlimited losses. Removing them from the market would result in a lack of buyers in an otherwise very nervous market.

The markets had immediately rallied by over 900 points on the Dow after the news release. While the newspapers had gloated over a return to confidence, Paulson knew better. This was nothing more than a short squeeze. Short squeezes occur when there is a rapid increase in the price of a stock and are typified by a lack of supply and an excess of demand for the stock. After the short sellers had bought back their positions - at massive losses - they would be out of the market.

Apparently, the traders on the floor realized this too when the opening bell rang. The indices almost immediately dropped into the double digits. Before the day was over, the Dow Jones had fallen by over 400 points.

******************************************************

October 6th 2008
US Congress
House of Representatives

"In conclusion, we are facing a very bleak period before us. I urge the rest of Congress to VOTE NO to the proposed TARP (Toxic Asset Relief Program) bill. This is a thinly disguised transfer of wealth from the rest of the country to support a small group of fat cats. I yield the floor, Mr. Speaker." The Congressman who left the podium was a thin, elderly man but possessed a vitality and passion that was evident in his words.

Ben Bernanke sighed from his seat on the floor. Ron Paul, the Congressman from Texas had long been a thorn in his side with is speeches railing against the Federal Reserve and its collusion with the financial elite. For most of his tenure, the rest of Congress had tended to dismiss his speeches as that of a fringe lunatic. But the events of the past year had seen his popularity grow enormously. Even other Congressmen were beginning to listen to him now. Ron Paul had spearheaded a grass roots campaign against the latest rescue project. Constituents were flooding their representatives' offices with faxes, emails, and letters.

Ben was growing tired of the constant questions from the rest of Congress. Along with Hank Paulson, the two men had quickly drafted a bill called the Toxic Asset Relief Program, or TARP for short, that would grant the Treasury sweeping powers to handle the financial crisis. The Lehman bailout had not been enough. In fact, recent events showed that virtually every single bank in the US had enormous amounts of sub-prime garbage on their balance sheets. Enough to bankrupt them several times over.

He needed to convince these blockheads to vote for the bill before they adjourned for Fall recess.

"All those in favor, say Aye. All those against, Nay." As the Speaker announced the results, Ben fought back a growing sense of alarm.

The vote for TARP had failed. Congress would adjourn for the next few weeks.

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