Special Report September 15, 2009, 3:29PM EST

Paulson's Decision Cost Lehman, Then the World

The former Treasury boss arranged a Bear Stearns rescue but let Lehman go under. A Bear bankruptcy would've alarmed Fuld, thus averting the global upheaval

My new book, A Colossal Failure of Common Sense, moves to a stark and irrevocable conclusion, that Henry Merritt Paulson, the former U.S. Treasury Secretary, made a fateful decision that within two weeks brought the world's economy to its knees.

He decided to let Lehman Brothers, the 158-year-old Wall Street institution, go bankrupt. He need not have done so. But on that fateful weekend, Sept. 13-15, 2008, he made the decision with which he must live for the rest of his life. He would not save Lehman Brothers. As one senior Lehman managing director told me, "They put Lehman's head underwater and watched for the bubbles." And that did it, globally, as first the U.S. and then the rest of the world swooned.

Since last winter, I have had many hundreds of hours to ponder Paulson's history-making decision, and while I cannot revise the truth, nor in any way let him off the hook, I am drawn to the conclusion that the Treasury boss did not lose the war on that final weekend. He lost it the previous March when he stepped forward and saved the much smaller Bear Stearns, which was in the same leaking boat as Lehman with far worse debt and no hope. Hank Paulson could have let them go, but he did not. He practically frog-marched JPMorgan Chase (JPM) into the arena and ordered it first to loan Bear Stearns a large amount of cash, and then five days later to buy the 86-year-old Wall Street bank.

When Paulson gave the lifeboat to Bear Stearns, it gave Lehman's CEO Richard S. Fuld a deadly, false sense of confidence.

JPMorgan's Behavior Change

Even today, the most clever Lehman minds tell me about a form of schizophrenia that JPMorgan displayed in its dealings with Bear Stearns and later Lehman. Bear was an investment bank almost half the size of Lehman. Yet the Fed and Treasury commissioned JPMorgan and its CEO Jamie Dimon to provide cash infusions to Bear the week before the bank's bailout. JPMorgan became a new tool in Hank Paulson's chest of creative innovations.

Fast-forward to September 2008—and oh how things had changed. Most senior traders and bankers I spoke to from Lehman were shocked at the new demeanor of JPMorgan, the split personality that Lehman was now experiencing like a bayonet in the back. JPMorgan was in a foul mood of sorts. Injecting aid, a cash infusion for Lehman? No, JPMorgan was now demanding weekly increases in the collateral that Lehman would have to put up in order to secure short-term loans to run its businesses. This suffocated the 158-year-old investment bank. It put her to sleep.

But what, I ask, would have happened if Paulson had simply stepped aside and let Bear Stearns collapse into bankruptcy back in March? I'll tell you the first thing: Dick Fuld would probably have had a heart attack. "If he can let Bear Stearns go, he can let us go."

And what would have been the natural progression? Fuld would have had no options. Mired in debt, holding billions and billions of unsellable assets, already entering its death throes, Lehman would then have had only one way out: to accept the offer about to be made by the Korea Development Bank, which when it materialized was around $23 a share. Fuld might have been way out of his depth in 21st century finance. But he was nobody's fool, and he had a sense of self-preservation second to none. He would have accepted the Korean money in seven seconds, particularly since Paulson himself never stopped urging him to do so right until the men from the Far East withdrew as Labor Day arrived.