How it all began.
For financial titans, 2008 proved a slowly unfolding nightmare. In March of that year, the first major Wall Street institution—Bear Stearns—acquiesced to its demons. After weathering every type of market for 85 years, Bear Stearns was finally dragged under by a slumping housing market. On March 16, JPMorgan Chase & Co. bought it for $2 a share, about 1 percent of the value of its $170 per share price from a year prior. To catalyse the deal, the Federal Reserve agreed to facilitate the purchase of $29 billion in distressed assets from Bear Stearns. Yet disturbingly, a month after the buyout, John Mack and Lloyd Blankfein, CEOs of Morgan Stanley and Goldman Sachs Group Inc., respectively, told shareholders the housing market crisis was going to be short-lived and nearing a close.
Much of this crisis was born of irresponsible lending, known as subprime loans, to Americans who couldn’t repay their debts. Historically, when a bank issued a loan, the bank was on the hook for ensuring that the borrower repaid the funds. However, in the case of many subprime loans, once these loans were issued to borrowers, they were then packaged, or securitised, into complex instruments known as collateralised mortgage obligations (CMOs). These CMOs were then sold to other investors, effectively passing on the risk like a hot potato through the financial markets, with purchasers lured by the promise of high returns combined with low risk, due to purported diversification.
What people didn’t realise, including Wall Street executives, was how deep and interrelated the risks CMOs posed were. Part of the problem was that CMOs were complex financial instruments supported “by outdated financial architecture that blended analog and digital systems. The lack of seamless digital documentation made quantifying the risk and understanding exactly what CMOs were composed of difficult, if not impossible. Furthermore, as these CMOs were spread around the world, global investors were suddenly interconnected in a web of American mortgages. In the summer of 2008, despite the lack of financial transparency but emboldened by access to funds from the Federal Reserve in case of further distress, Richard Fuld Jr., the CEO of Lehman Brothers, eerily claimed, “We can’t fail now.”
As a storm brewed around unknowing Wall Street executives, Satoshi Nakamoto was busy fleshing out the concept of Bitcoin. On August 18, 2008, Bitcoin.org, the home website for information on Bitcoin, was registered.Whether as an individual or an entity, what’s now clear is that Satoshi was designing a technology that if existent would have likely ameliorated the toxic opacity of CMOs. Due to the distributed transparency and immutable audit log of a blockchain, each loan issued and packaged into different CMOs could have been documented on a single blockchain. This would have allowed any purchaser to view a coherent record of CMO ownership and the status of each mortgage within. Unfortunately, in 2008 multiple disparate systems—which were expensive and therefore poorly reconciled—held the system together by digital strings.
On the morning of Wednesday, September 10, 2008, Fuld and other senior management faced a different reality from Fuld’s confident summer proclamation. Management struggled to explain to a group of critical analysts $5.3 billion worth of write-downs on “toxic assets” and a quarterly loss of $3.9 billion. The call ended abruptly, and analysts signed off unconvinced of the measures Lehman was taking. The markets had already punished Lehman the day before, dropping its stock price 45 percent, and on Wednesday it dropped another 7 percent.
Two days later, on Friday afternoon, the CEOs of Merrill Lynch, Morgan Stanley, and Goldman Sachs met at the New York Federal Reserve, along with the Federal Reserve Chairman, the U.S. Treasury Secretary, and the president of the New York Federal Reserve. The afternoon’s topic was what to do about Lehman Brothers. It was clear the situation had become critical. Initially it appeared either Barclays or Bank of America would come to the rescue of Lehman Brothers, but that likelihood quickly evaporated.
On Saturday, as the same group met again at the New York Fed, John Thain, Merrill Lynch’s CEO, had an unsettling thought. During the briefing on Lehman’s situation, he realised his company might only be a few steps from the same catastrophe. “This could be me sitting here next Friday,” he said. Thain quickly moved to find suitors for Merrill, the most promising option being Bank of America, which had already been in talks to buy Lehman. With talks secretly progressing between Merrill Lynch and Bank of America, Lehman Brothers held Barclays as its only suitor hope.
By Sunday, September 14, Barclays was ready to approve a deal to buy Lehman Brothers. Lehman only needed the “U.S. or British government to back its trading balances for a couple of days, enough time for Barclays to conduct a shareholder vote for final approval. Neither government was willing to step in, and the likelihood of a deal began to melt. With only a few hours left until Asian markets opened for trading, the U.S. government questioned Lehman on its only remaining option: bankruptcy.
Harvey Miller, a well-regarded bankruptcy lawyer at Weil, Gotshal & Manges, had been working quietly since Thursday night to lay the groundwork for this worst-case bankruptcy scenario. When asked by a senior Fed official if Mr. Miller felt Lehman was ready to file for bankruptcy, he responded: “This will cause financial Armageddon.”
If Lehman filed for bankruptcy, financial firms that did business with Lehman would also lose billions, potentially triggering a domino effect of bankruptcy.
Later that evening, Bank of America inked a deal to buy Merrill Lynch for $50 billion, and a couple of hours later, in the early hours of Monday morning, Lehman Brothers filed for Chapter 11 bankruptcy protection, making it the biggest bankruptcy in U.S. history. So came to an end a 164-year-old firm born from a dry-goods store that had evolved into the fourth largest U.S. investment bank. It signaled the end of an era.
Lehman’s bankruptcy and Merrill’s buyout proved to be only the beginning. On Tuesday, the Federal Reserve Bank of New York was authorised to lend up to $85 billion to the American International Group (AIG), the biggest insurer in America, as the behemoth organisation began to teeter. It was mid- September and darker clouds loomed on the horizon for Wall Street and global financial markets.
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