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A flag on the play


By William Cohan
Last Updated: December 15, 2008: 7:01 AM ET

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On Sunday morning, the executive group re-assembled at the Fed at nine o'clock. "Everything was ready to go on Sunday morning," one participant said. "People were happy with the term sheet, so there was a doable deal on the table." Steve Shafran, a senior advisor to Paulson and an ex-Goldman Sachs partner, told a group of Lehman Brothers executives at the Fed that morning, "It looks like we may have the outlines of a deal around the financing." After which, the Lehman bankers thought they had saved their firm.

The Barclays deal required the blessing of the Financial Services Authority, in London - the UK equivalent of the SEC. So Paulson spoke with his UK counterpart, Alistair Darling, the Chancellor of the Exchequer, and to the FSA. He then summoned McDade, Lehman's president, to the New York Fed and told him at around 9:45 a.m., "Deal's off. The FSA has turned it down." At roughly 10 o'clock, Paulson and Geithner briefed the bankers at the Fed.

The FSA would not comment on its decision, but a number of the participants at the Fed on Sunday morning said the reasons given to them by Paulson for the FSA's rejection ranged from "the overall size of the potential exposure that Barclays was taking on and whether Barclays was in good enough shape to do it" to the fact that the "FSA was looking for some kind of a cap to avoid U.K. contagion, and the Fed had just said, 'No assistance for Lehman.' The FSA then concluded based on the amount of diligence, the risk profile, and the lack of any assistance from the U.S. that they were not going to let it proceed."

There was also the suggestion made that Barclays "wasn't really that serious about getting FSA approval" going into the weekend knowing that there might be an opportunity to buy what it wanted from Lehman later at a lower price. (Barclays did not make its senior officials involved with the Lehman deal available for comment.)

The Lehman team was devastated by the news. "We thought we had a trade and felt good about it and thought we were in the right place," explained a Lehman banker, "and then to have the rug pulled out from under us after we were led to believe that the Street was there on the financing, it was just horrifying from our perspective." The stunned Lehman team returned to their headquarters at 745 Seventh Avenue to plot its next moves.

Paulson then told the remaining bankers, according to one, "Let's start talking about what the world will look like if Lehman goes under. Let's focus on a solution for stabilizing the markets." Among the people still present for Paulson's Sunday morning speech was John Thain. After Paulson and Geithner left the executives to contemplate what they could do as a consortium to keep the world's markets from collapsing completely, the assembled alpha males began talking about Merrill Lynch in front of Thain, as if he weren't there.

"Merrill could be the next to go," one banker said. "And Thain wasn't saying anything," a participant said. "If Thain hadn't been there that morning, the rumors really would have been flying," Shedlin said. A few minutes later, Thain got up and left the room "and he never comes back," one participant said. Thain and his team were focused on negotiating a deal with Bank of America. Merrill had planned to meet with Goldman on Sunday morning but by this time Merrill had stopped returning calls to Goldman Sachs.

After Thain, Paulson and Geithner had left the New York Fed Sunday morning, the following exchange ensued, according to several sources who were there. John Mack, the CEO of Morgan Stanley, spoke up. "Maybe we should let Merrill go down too," he said.

Aghast, JPMorgan Chase's Dimon pointed out how shortsighted that was of Mack because Morgan Stanley might be the next firm that counterparties lost faith in. "John, if we do that, how many hours do you think it would be before Fidelity would call you up and tell you it was no longer willing to roll your paper?" Dimon's comment quieted Mack. "We thought Mack said that because he might be buying Merrill," Shedlin said, and wanted to buy the firm on the cheap. (Mack denied he made the comment through a spokesman. A spokesman for Dimon said Dimon did not remember having the conversation with Mack).

The group quickly began refocusing on putting together what became an agreement that every firm in the room would continue to do business with every other firm in the room and would underwrite a multi-billion-dollar credit facility for the firms to use in an emergency in the wake of the presumed Lehman bankruptcy. "We figured all hell would break out the next day," one banker said. "And everyone else thought so too. Everyone was then focused on netting out their derivatives positions starting right then."

NEXT: SUNDAY AFTERNOON Paulson tells Lehman where to go To top of page

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