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

Paulson's Decision Cost Lehman, Then the World

(page 2 of 2)

Lehman's Leverage

A similar scenario played out during that turbulent September. John Thain, CEO of Lehman's great rival, Merrill Lynch, knowing that Paulson was letting Lehman go, jumped willingly and enthusiastically into the arms of the near-bankrupt Bank of America (BAC).

In the end, the Treasury chief never forgave the Lehman chairman for ignoring that Korean offer, because in Hank's opinion that probably would have saved the world. It was here that the constantly smoldering rift between the old Wall Street rivals, Paulson and Fuld, suddenly became a chasm. Because despite everything, Fuld had an almost obsessive desire to hold on to Lehman at all costs. With the Koreans on the sidelines, he began thrashing around, investing in major hedge funds, in small hedge funds, in overseas hedge funds. He even started to form hedge funds, and Hank Paulson was appalled. Here was a Wall Street bank leveraged almost 40 times its own value at the top of the market, plainly headed for oblivion, ignoring the Korean lifeline, silencing its best risk-takers, and spending its borrowed money like a drunken sailor. Hank Paulson never got over that.

Let me clarify that 40 times leverage is the equivalent of any gambler walking into a casino with just a $100 bill in his back pocket but playing on the tables with $4,000. It doesn't take much to wipe out that old Benjamin.

Fuld and Paulson had dinner that spring of 2008. Fuld was characteristically rude to the Treasury boss. In turn Paulson was infuriated at this disrespect to his great office of state. Most of the distilled opinion suggests that it was that spring when Lehman's fate was decided. But my own new opinion is that the hasty rescue of Bear Stearns was the fulcrum upon which the entire issue swung.

Hank Paulson and then New York Fed chief Timothy Geithner have argued that Bear Stearns had to be saved because systemic defense mechanisms protecting the markets had not been set up yet. Well, a fool could tell you the adequate mechanisms were not set up when Lehman failed, either. If Hank had let Bear go, the world would have looked very different.

Lawrence G. McDonald is the co-author of A Colossal Failure of Common Sense: The Inside Story of the Collapse of Lehman Brothers and was a vice-president at Lehman from 2004 to 2008.