No Deal Reached Yet to Decide Lehman's Fate

By CARRICK MOLLENKAMP, DEBORAH SOLOMON, AARON LUCCHETTI, SERENA NG and SUSANNE CRAIG

The outlines of plans to determine the fate of Lehman Brothers Holdings Inc. emerged today even as it became increasingly clear that a clean sale of the entire firm to a big bank would be too difficult to execute.

A sense of optimism that a rescue could be arranged today dimmed as a growing sense of gloom descended on Wall Street. Executives from top banks in the U.S. and Europe huddled with federal regulators in an attempt to come up with plans to either buy pieces of Lehman or prepare for an orderly winding down of the firm in a manner that would minimize the collateral damage for the ailing global financial system.

After 6 p.m., the formal meeting ended for the day with no resolution, though some participants stayed behind to continue talking. "Senior representatives of major financial institutions reconvened on Saturday with U.S. officials at the New York Fed. Discussions are expected to continue tomorrow," said a spokeswoman for the Federal Reserve.

At about 8 p.m., New York Fed President Timothy Geithner was still at the bank's headquarters. Officials from the New York Fed and various banks were expected to continue working through the night.

Under one plan, either Barclays PLC or Bank of America Corp. would buy Lehman's "good assets", such as its equities business, people familiar with the matter say. Lehman's more toxic, real-estate assets would be ring-fenced into a "bad" bank that would contain about $85 billion in souring assets. Other Wall Street firms would try to inject some capital into the bad bank to keep it afloat for a period of time so that a flood of bad assets don't deluge the market, damaging the value of similar assets held by other banks and insurers. The banks are also looking for the government to somehow financially backstop the bad bank.

The problem, though, is getting enough banks to back that plan. While teams of bankers are working through structures, it's clear that only a handful of banks are in a position to provide enough funding. Many banks are inclined to preserve capital ahead of third-quarter and year-end cash preservation moves. Also, banks aren't keen to see a big rival such as Barclays or Bank of America walk away with valuable assets by only paying a pittance.

As of Saturday afternoon, Barclays, the U.K.'s third-largest bank in terms of market value, appeared to have more interest in pulling off a deal for Lehman's good assets. At about 3 p.m. on Saturday, Barclays President Robert E. Diamond Jr. was seen entering the New York Fed's employee entrance on Maiden Lane, carrying a briefcase.

Bank of America, an obvious buyer, appeared to be cooling toward a deal, people familiar with the matter. Of course, some of this could be the posturing that happens in any auction. Neither Barclays nor Bank of America wants to buy all of Lehman without some government assistance, and so far the government has been reluctant to do so.

Both Bank of America and Barclays remain fixated on the disposal of the bad real estate assets, and are less focused on evaluating Lehman's investment bank, said one person involved in the due diligence process. Things were moving so quickly Saturday that there was little time to do extensive employee interviewing that typically happens in company auctions. "It's all triage," said this person.

The real fear in the discussions, this person added, was that the fire-sale prices, or "marks" of Lehman's real estate book could set off a cascade of problems for other Wall Street firms. If those marks were made against other banks' portfolios, it could eventually force those firms to raise more capital, too. For firms' considering funding the bad bank, the calculation has thus become the price of that contribution against the price of a widescale markdown.

There could be further effects to such an event, with the banks calling in loans from hedge funds and other clients, in turn setting off more forced selling that further depresses asset and securities prices.

"Unless something is settled, it's going to be a bloodbath Monday," said this person.

In a meeting at the Federal Reserve Bank of New York in lower Manhattan, some participants also were discussing insurer American International Group Inc. and thrift-holding company Washington Mutual Inc. While those two financial firms aren't the focus of the emergency meeting, participants also are weighing the potential implications of their problems.

One person leaving the building said at least 100 people were gathered inside trying to settle the fate of Lehman, which has been staggered by its exposure to soured real-estate-related assets. By 5:15 pm, some Wall Street executives started to leave the New York Fed one at a time, getting in their cars inside a garage so they can't have their photos snapped.

Outside the Fed's downtown headquarters, a fleet of black towncars waited for bankers who were inside. At one point, the towncars blocked the narrow streets around the building, causing a traffic jam that had to be broken up by the Fed's uniformed guards. Meanwhile, bankers and Fed staffers milled around outside, smoking cigarettes and talking on their cell phones about subjects like counterparty risk.

"Everybody is hoping there will be a Wall Street solution to deal with Lehman's toxic assets," said one senior executive at a major bank. "It is a cheaper alternative than having everything unravel."

With it unclear whether the gap between the federal government and potential buyers can be bridged, a second group at the New York Fed is focusing on the possibility that there might be no alternative to liquidating Lehman and winding down its operations in an orderly fashion.

On Saturday afternoon, the credit-trading heads of major investment banks gathered at the meeting to discuss how to deal with their exposures to Lehman in the intertwined credit-default-swap market. The lack of a central clearinghouse in this market means that dealers, hedge funds and others are directly facing each other in insurance-like contracts that are tied to trillions of dollars in debt instruments.

Credit derivative traders at some firms were asked to come to work over the weekend to help quantify their exposures to Lehman and compile lists of outstanding contracts they have with the investment bank.

One person familiar with the matter said large dealers contemplated showing each other all of their credit default swap trades with Lehman. Disclosing their positions may enable dealers to find ways to offset their positions with each other wherever possible. Later in the day, some traders were told that Lehman -- with the help of Federal Reserve officials -- will try to figure out which of its counterparties have CDS trades that can be offset. Those counterparties would be informed of the offsetting positions, following which they can unwind their respective swaps with Lehman and concurrently enter into new swap contracts with each other. For example, if one dealer has bought a swap from Lehman and Lehman sold a similar swap to another bank, the two banks could agree to face each other directly.

Such moves could help prevent individual firms from scrambling to find new counterparties to rehedge their positions with when the markets reopen on Monday, potentially unleashing turmoil across the credit markets. They could also help facilitate an orderly wind-down of Lehman's derivative positions, if that becomes necessary. Still, sorting out the firm's CDS positions promises to be a difficult and time-consuming task, because many of the contracts have different terms and maturity dates.

It is not known how much in CDS contracts Lehman has. In a survey last year by Fitch Ratings, Lehman was listed among the 10 largest CDS counterparties by number of trades and the amount of debt to which the contracts were tied.

Wall Street traders poured into their offices Saturday for emergency meetings to consider the actions they would take if Lehman is forced into liquidation. They broke into teams to evaluate their positions and exposure to Lehman in everything from energy trades to equity derivatives to credit,

One trader said conditions in the credit default swap market and the short-term repo markets are more stable today than they were in March, when Bear Stearns nearly collapsed, but still, "if they go into liquidation," it is going to be a bad situation on Monday.

A disorderly unwind of Lehman's derivatives trades is only one worry. Another worry is that if Lehman collapses, its distressed assets -- such as commercial real estate -- could suddenly hit Wall Street for sale, forcing prices even lower and potentially forcing other dealers to mark down once again the value of their own holdings.

Lehman has hired law firm Weil, Gotshal & Manges LLP to prepare a potential bankruptcy filing, according to a person familiar with the situation. The New York-based Weil has a leading bankruptcy practice and advised Drexel Burnham Lambert on its 1990 bankruptcy filing.

In a Lehman bankruptcy, the firm's brokerage units would have to enter a Chapter 7 liquidation, in which a court-appointed trustee would take over, liquidate the firm's assets and get Lehman customers back their money. In general, securities that a customer holds at a brokerage firm are legally the investor's property and aren't exposed to the claims of the firm's creditors.

In trying to hold firm to their no-bailout stance even while pressing for a deal, federal officials could try to pit Bank of America and Barclays against each other. But that leverage can work only if both banks stay in the discussions.

Bank of America and Barclays know each other very well, having considered a merger several years ago. More recently, Bank of America agreed to pay $21 billion for ABN Amro Holding NV's LaSalle Bank of Chicago in 2007. That deal came at a time when Barclays was trying to buy ABN and fend off a European consortium bid. Bank of America's purchase was seen at the time as helping that Barclays bid, which ultimately failed.

At Barclays, a big question will be whether CEO John Varley and his No. 2, Mr. Diamond, both agree on buying all or part of Lehman. Mr. Diamond is eager to expand Barclays's U.S. investment bank operations. But the unit, called Barclays Capital, is also responsible for write-downs the bank has recorded.

After 5 p.m., bank executives began leaving the meeting, some getting into cars inside a garage where they couldn't be photographed. Those seen leaving included Merrill Lynch & Co. Chairman and Executive John Thain and Citigroup Inc. CEO Vikram Pandit. Bank of New York Mellon Corp. Chairman and CEO Robert Kelly declined to comment.

While some executives had left the Fed meeting, those of other firms, including three carfuls of Barclays executives, remained at the Fed office past 6 p.m.

At least 20 New York Fed staffers left from another exit. They refused to say if they were done for the night.

How J.P. Morgan steered clear of the credit crunch

By Shawn Tully, Sept 15 issue of Fortune

NEW YORK (Fortune) -- It was the second week of October 2006. William King, then J.P. Morgan's chief of securitized products, was vacationing in Rwanda. One evening CEO Jamie Dimon tracked him down to fire a red alert. "Billy, I really want you to watch out for subprime!" Dimon's voice crackled over King's hotel phone. "We need to sell a lot of our positions. I've seen it before. This stuff could go up in smoke!"

That call marked the beginning of a remarkable strategic shift that helped J.P. Morgan (JPM, Fortune 500) sidestep the worst of a historic credit crisis. J.P. Morgan mostly exited the business of securitizing subprime mortgages when it was booming. With the notable exception of Goldman Sachs (GS, Fortune 500), J.P. Morgan's main competitors - including Citigroup (C, Fortune 500), UBS (UBS), and Merrill Lynch (MER, Fortune 500) - ignored the danger signs and piled into those products in a feeding frenzy. (This is an excerpt from a story that ran in the Sept. 15 issue of Fortune. For more on Dimon and the team of talented lieutenants who helped J.P. Morgan dodge the credit crisis, read the full story)

Make no mistake: J.P. Morgan is also suffering from the credit crunch. While it largely dodged the subprime bullet, J.P. Morgan stumbled in two other areas: funding dubious deals in the LBO frenzy and jumping into the jumbo mortgage market when other banks were getting out. The third quarter is already looking tough. The company has announced that it is taking $1.5 billion in mortgage and leveraged-loan write-downs, and another $600 million to account for the decline in the value of its Fannie Mae and Freddie Mac preferred stock.

Still, J.P. Morgan is weathering the crisis far better than its rivals. From July 2007, when the cyclone began, through the second quarter of this year, J.P. Morgan took just $5 billion in losses on high-risk CDOs and leveraged loans, compared with $33 billion at Citi, $26 billion at Merrill Lynch, and $9 billion at Bank of America (BAC, Fortune 500). And in this market, losing less means winning big. Before the crisis J.P. Morgan was a middle-of-the-pack performer; today it leads in nearly every category, starting with its stock. Since early 2007, its share price has dropped 24%, to $37 (as of Aug. 27), vs. declines of 44% for Bank of America and 68% for Citigroup. Last year its market cap was far below those of Citi and BofA. Today J.P. Morgan stands in a virtual tie with BofA for first place among U.S. banks, and it towers over Citi.

That is largely thanks to J.P. Morgan's decision to shun subprime CDOs - vehicles that sell bonds backed by pools of subprime mortgage-backed securities. J.P. Morgan has long ranked among the biggest buyers of auto and credit card loans, which it turned into asset-backed securities. But even in 2005, J.P. Morgan remained a small player in the hottest business on Wall Street, securitizing mortgages. Dimon wanted to build a far bigger franchise, chiefly by securitizing the loans made by the bank itself through its Chase Home Lending division. By 2006, J.P. Morgan was growing substantially in securitizing mortgages and dabbling in subprime CDOs, a business that was generating billions in fees for other Wall Street firms.

But Dimon soon began to see reasons to pull back. One red flag came from the mortgage servicing business, the branch that sends out statements, handles escrow, and collects payments on $800 billion in home loans, its own and others'. During a regular monthly business review for the retail bank in October 2006, the chief of servicing said that late payments on subprime loans were rising at an alarming rate. The data showed that loans originated by competitors like First Franklin and American Home were performing three times worse than J.P. Morgan's subprime mortgages. "We concluded that underwriting standards were deteriorating across the industry," says Dimon.

Steve Black and Bill Winters, co-heads of the investment bank, were discovering more reasons to be cautious. CDOs issue a range of bonds, from supposedly safe AAA-rated ones with relatively low yields to lower-rated ones with higher yields. Winters and Black saw that hedge funds, insurance companies, and other customers were clamoring for the high-yielding CDO paper and were less interested in the other stuff. That meant banks like Merrill and Citi were forced to hold billions of dollars of the AAA paper on their books. What's wrong with that? Doesn't an AAA rating mean the securities are safe? Not necessarily.

In 2006, AAA-rated CDO bonds yielded only two percentage points more than supersafe Treasury bills. So the market seemed to be saying that the bonds were solid. But Black and Winters concluded otherwise. Their yardstick was credit default swaps - insurance against bond failures. By late 2006 the cost of default swaps on subprime CDOs had jumped sharply. Winters and Black saw that once they bought credit default swaps to hedge the AAA CDO paper J.P. Morgan would have to hold, the fees from creating CDOs would vanish. "We saw no profit, and lots of risk, in holding subprime paper on our balance sheet," says Winters. The combined weight of that data triggered Dimon's call to King in Africa. "It was Jamie who saw all the pieces," says Winters.

In late 2006, J.P. Morgan started slashing its holdings of subprime debt. It sold more than $12 billion in subprime mortgages that it had originated. Its trading desks dumped the loans on their books and mostly stopped making markets in subprime paper for customers. J.P. Morgan's corporate treasury under Ina Drew even starting hedging, betting that credit spreads would widen. Over the next year those hedges reportedly yielded gains of hundreds of millions of dollars.

Dimon's stance was radical: He was skirting the biggest growth business on Wall Street. J.P. Morgan sank from third to sixth in fixed-income underwriting from 2005 to 2007, and the main reason was its refusal to play in subprime CDOs, which its rivals were gorging on. "We'd get the quarterly reports from our competitors and see that they'd added $100 billion to their balance sheets," says Dimon. "And they were hardly adding any capital, so it looked like their investments were almost risk-free." But in the end, of course, the decision to shun subprime made Dimon a hero.