The Death Sentence of an Empire
September 2008.
"IndyMac and Freddie Mac have been nationalized."
Danny's phone call began with that single line.
Six months had passed since Bear Stearns collapsed. A great deal had happened in the meantime. The market had breathed a brief sigh of relief, but the subprime crisis was far from over. IndyMac Bank had gone under, and home prices kept falling. Wall Street's investment banks were announcing losses day after day, and Lehman Brothers' stock had plunged more than 80% from its peak.
And just yesterday, the U.S. government had announced it would nationalize IndyMac and Freddie Mac.
"So it played out exactly the way Danny said it would, based on what he got from his old colleague."
A while back, Danny had mentioned — claiming it came from a former coworker — that the federal government would step in and rescue Freddie Mac.
"And honestly, it's surreal. The United States — the very heart of capitalism — nationalizing corporations."
"There was no other choice. IndyMac and Freddie Mac aren't banks — they're government-sponsored enterprises, GSEs."
The companies the government had decided to save were not the investment banks. When investment banks like Bear Stearns — recently sold off for pennies on the dollar — or Lehman Brothers, soon to collapse, extended home mortgage loans to their customers, Freddie Mac bought those loan bonds from the banks.
The banks, flush with cash from selling their loan bonds to Freddie Mac, lent that money out again and raked in the profits. As of now, the two companies held $6 trillion — fully half of the roughly $12 trillion in outstanding U.S. home mortgage debt.
If they went bankrupt, the American housing market would collapse, and home transactions would grind to a halt. That was why the government had fought so hard to keep them alive.
"That said, the executives are probably going to pay the price for this."
"It must have been bad, then?"
"From what I've been hearing from all over lately, these companies were originally supposed to handle only prime loans — borrowers with high credit. But once the investment banks started eating their market share, they began issuing loans without even verifying income."
NINJA loans. No Income, No Job, No Asset.
Lending money to people who had no income, no job, and no assets. It was a loan built on a single belief — that home prices would keep rising forever — and the moment that belief shattered, the rot exploded into the open.
"Thinking about the housing market, the U.S. government really did have to save them."
"But there's an even bigger reason than that."
I quietly focused on Danny's words.
"It could escalate into a diplomatic problem."
"A diplomatic problem?"
"Like I said, those two companies are government-sponsored enterprises. Which means the bonds they issue are effectively guaranteed by the U.S. government."
"The People's Bank of China, the Bank of Japan, even Korea's National Pension Fund where you're sitting. Think about how much of the bonds they've issued those institutions are holding."
They had bought bonds issued by IndyMac and Freddie Mac as a way of building up their foreign exchange reserves. After all, with the U.S. government standing behind them, those bonds were as good as dollars.
"The plan announced alongside the nationalization: all shares are wiped out, but creditors get their money 100% guaranteed. Why do you think that is?"
"They were watching how foreign governments would react."
"Exactly. The state seized the company. The shareholders' stakes turned into waste paper."
Nationalization — in capitalist America, of all places.
But they must have judged it the lesser evil compared to a full-blown diplomatic crisis.
"Anyway, that's America right now. What do you want to do with our idle cash?"
At Danny's question, I thought for a moment. The $135 million we had pulled out of Bear Stearns was still sitting in cash.
"What's the return on our current positions?"
"Lehman CDS is up 250% from March, Merrill Lynch is at 180%, AIG is around 200%."
The existing positions alone were already generating substantial returns.
But it wasn't over yet.
"Now's the timing. The mortgage market can't hold out much longer."
"Good. So the money from Bear Stearns — you want all of it into Lehman?"
I fell silent.
In one week, Lehman Brothers would file for bankruptcy. The day a 158-year-old investment bank vanished overnight was fast approaching.
"Yes. Put the entire amount into Lehman CDS."
Lehman Brothers' situation right now was the worst it had ever been. The stock had crashed more than 90% from its peak, and the third quarter was expected to post a $3.9 billion loss. The CEO had spent days shouting to investors that the firm had plenty of capital, but the market didn't believe a word of it. Talk of a credit rating downgrade was circulating, and trading counterparties were beginning, one by one, to shy away from dealing with Lehman.
They were walking the exact path Bear Stearns had.
"Are you sure about this?"
Danny pushed back.
"There's talk that Barclays and Korea Development Bank are going to acquire Lehman. Board members are in negotiations in Korea and the UK right now."
I laughed inwardly.
In my previous life, there had been a moment when Korea's state-owned policy bank, KDB, had come within a hair's breadth of acquiring Lehman Brothers. If the acquisition had gone through, history might have turned out differently. But in the end, the two sides could never agree on the per-share price, and the deal was ultimately abandoned.
The same went for Barclays in Britain.
Even now, Lehman's management cared less about saving the company than about how much more money they could walk away with once it was sold. Greed wrecked the negotiations.
That was the ultimate reason Lehman failed.
"It's fine. Neither deal is going to work out."
"...You're that certain?"
"Yes. Just wait one week."
"All right. This time too, I'm putting my faith in you and you alone, Kang."
The afternoon of September 14, 2008.
Conference room at the Federal Reserve Bank of New York. It was a Sunday, but this room was filled with formidable names: the Treasury Secretary, the President of the New York Fed.
And the CEOs and chairmen of the most storied investment banks on Wall Street — Goldman Sachs, Morgan Stanley, Merrill Lynch, Citigroup, and more. The very heart of the American financial world, gathered in a single room.
"..."
The atmosphere was suffocating. As of Friday, Barclays and Bank of America had both been weighing an acquisition of Lehman. But on Saturday night, Bank of America had abruptly swerved toward acquiring Merrill Lynch instead.
All that remained was Barclays.
And Barclays' negotiations had not yet reached a conclusion.
"I'll be blunt."
The Treasury Secretary opened his mouth, and the room fell quiet.
"In the Bear Stearns case, the government helped. The Fed extended emergency funding to JP Morgan and took the toxic assets onto its own books."
The Secretary's gaze swept slowly across the table.
"But not this time. The government, the Fed — neither of us will put anything on the table."
Silence settled over the conference room, and the faces of several CEOs hardened.
"If Lehman falls, none of you walk away unscathed. I trust every one of you knows exactly how enormous your derivatives exposure to Lehman is."
The Secretary gestured to the aide beside him. The aide moved around the table, distributing documents one by one.
"These are Lehman's actual books."
The CEOs opened the documents. With every page they turned, their expressions changed.
Total assets of $639 billion.
Of that, $85 billion in real-estate-related assets.
Level 3 assets — assets that could not be priced by the market — alone totaled $41 billion.
A leverage ratio exceeding 30 times equity.
"What in the..."
For an outsider, the numbers alone might not have meant much. But the men seated in this room understood precisely what those figures signified.
$41 billion in Level 3 assets. If the market couldn't assign them a price, it meant they couldn't be sold. And assets that couldn't be sold were, for all practical purposes, waste paper.
"We cannot acquire them."
The CEO of Goldman Sachs spoke first, his voice resolute. He was the man with the most to say about this entire subprime disaster. Goldman had exited the subprime mortgage products early and had, in fact, bet on the decline — and profited handsomely.
"The same goes for us."
The CEO of Morgan Stanley, the second-largest firm in the room, likewise distanced himself.
"Who would take on this company after seeing these books? Level 3 assets alone are $41 billion. Nobody knows what they're actually worth."
"What about forming a consortium to carve out the toxic assets separately?"
The President of the New York Fed offered the suggestion.
"We could set up a special purpose vehicle, as we did with Bear Stearns—"
"Back then, the Fed stood behind the guarantee."
Another investment bank chairman cut in.
"Now you're asking us to do it with our own money, with no guarantee at all. That's impossible."
The argument raged on. Not a single person was willing to shoulder Lehman's rot.
"I'm told Lehman is in acquisition talks with Barclays as we speak."
One CEO spoke up.
"Perhaps we should wait and see how that turns out?"
The Treasury Secretary considered it for a moment, then nodded. The others agreed as well. For now, that was the only hope they had.
"Mr. Secretary."
Then it happened.
The door to the conference room burst open, and an aide came rushing in. He approached the Treasury Secretary and whispered in his ear.
"It's the British Chancellor of the Exchequer."
The Secretary's eyes narrowed. He nodded and took the phone.
"Tony, it's me."
"Henry, I'm sorry, but we have no intention of importing America's cancer into Britain."
"...What is that supposed to mean?"
"If Barclays takes on Lehman's toxic assets, the British financial system collapses with it. Our authorities will block Barclays' acquisition of Lehman. That's all."
Click.
The line went dead.
The Treasury Secretary slammed the phone down onto the table. Gasping for breath, he looked around the room.
"There will be no Barclays acquisition of Lehman."
The conference room went silent, as if doused in ice water.
Barclays had been the only ship that could save Lehman — and every single person seated in this room. And that ship had just sailed away.
The Secretary closed his eyes briefly.
He had to make a decision.
"Bring me that phone back."
The aide handed over the phone. The Secretary dialed a number and pressed the receiver to his ear. After several rings, the other end picked up.
"It's me. Prepare to file Lehman for bankruptcy."
"...What are you saying?"
The voice on the other end belonged to Lehman Brothers' CEO. Desperation was soaked into every syllable.
"The negotiations are still underway. Barclays—"
"Barclays is out. The British government blocked it."
"Then if the Fed lends us some money, we can hold on. If we just had cash right now—"
"The Fed is out too."
"There must be another buyer somewhere. It's too early to give up—"
"There is no money to save Lehman — not in the government, not at the New York Fed, and not on Wall Street."
The Treasury Secretary's voice was unwavering.
"Mr. Secretary, please—"
"Submit the bankruptcy petition before midnight tonight."
With those words, the Treasury Secretary hung up.
A strange silence swallowed the conference room.
It was the moment a death sentence was pronounced upon an empire with 158 years of history.