Stephen Foley: No means no – the words that doomed a Wall Street legend

No. Hank Paulson said no. The US Treasury Secretary said it several times before people realised it wasn't just a negotiating tactic. No, there will be no government money to bail out Lehman Brothers, he said, telephoning all of Wall Street's top chief executives last week as the investment bank's shares were in freefall.

He said it again when he gathered them all together at the Federal Reserve's fortress-like grey building in the heart of Manhattan's financial district after close of business last Friday. One after another, they pleaded for some sort of loan, some sort of government guarantee to backstop Lehman's enormous liabilities, any sort of help. Come on Hank, they told him, you know how it works, you ran Goldman Sachs, the mightiest investment bank of them all until just a couple of years ago. Lehman is simply too big to fail. We don't know what happens if it goes under, but we can all agree it will be ugly for Wall Street, and potentially disastrous for the economy, too.

And yet, as the crisis intensified with alarming speed over the weekend, the message was consistent and firm. No, no, no.

And so the world's finance industry woke up yesterday to a changed landscape, with no map on what happens next. Not only has Lehman Brothers, a bank with a history stretching back to its creation as a little cotton trading business 158 years ago, been snuffed out. At the same time, Merrill Lynch has sold itself, a desperate move to avoid becoming the next victim of a conflagration that just keeps burning more intensely.

The finest minds on Wall Street combined could not come up with a way to save Lehman, and heaven knows they tried. With journalists camped outside from early on Friday, a parade of black limousines ferried the most powerful men on Wall Street to and from the crisis meetings going on inside the Fed building.

They were all involved: Lloyd Blankfein, Mr Paulson's successor at Goldman Sachs; Vikram Pandit, head of Citigroup, the largest bank in the US; John Thain, head of Merrill Lynch, the famous broker; the JPMorgan Chase chief executive, Jamie Dimon, the man who stepped in back in March to buy Bear Stearns as it teetered – when he was given a $30bn loan from the Fed to cover Bear's losses.

They used to call these people the masters of the universe, now they are imploding stars, called to deal with the collapse of a bubble of their own making.

A sense of unreality pervaded that first meeting. Mr Paulson and the head of the Fed in New York, Tim Geithner, delivered their message that there would be no government bail-out. The 30 executives in the room listened, but didn't believe them.

When they reconvened at 9am the next morning, to begin brainstorming some of the complex deals that might be arranged to keep Lehman from going bust – most probably a takeover by Bank of America or the ambitious British upstart Barclays – almost all of them factored in a Federal Reserve guarantee as part of their plans. Barclays, whose US investment banking chief, Bob Diamond, was snapped going into the Fed on Saturday, was confident enough that the government would blink first that it instructed advisers in London to begin drawing up documents outlining a deal for its shareholders.

Most of the work on Saturday was on a plan for them all, as one, to inject large sums into the bad half of Lehman (filled with the toxic mortgage investments that are at the root of this global crisis), while Bank of America or Barclays walked away with the good half. But John Mack, the belligerent chief executive of Morgan Stanley, was among the vocal opponents, saying the whole idea was unfair. As time went by, each new bright idea dimmed. Wall Street's banks have been stretched very thin indeed by the credit crisis. Their aim now is to slim down, not to take on gigantic new liabilities.

Uptown, in Lehman Brothers' garish, iconic Times Square headquarters, many employees were working overtime to provide regulators with details of millions of trades that the company has outstanding, as the giant effort began to understand what exactly might happen if the company was forced suddenly out of business.

By the end of Saturday, it was clear that something much larger than Lehman Brothers was at stake. The entire edifice of global financial markets seemed suddenly at risk, built as it is on mutual trust and on a confidence that what has been promised will be paid.

No one knew this more acutely than John Thain of Merrill Lynch, who knew his bank would be next in the line of fire if Lehman folded. Since the credit crisis began in August 2007, share traders have continually asked the question: who is next? Merrill had the next worst balance sheet, and a further collapse in the share price would only do to Merrill what had been done to Lehman, an erosion of confidence ending in disaster.

Quietly, Mr Thain placed a call to Ken Lewis, the straight-talking boss of Bank of America. Hey, Ken, would you be interested in buying us? The answer came back: yes. Do the deal.

Meanwhile, a brewing crisis at another big firm, AIG, was also weighing heavily on participants' minds. That insurance giant huddled with its advisers elsewhere in the city to plan a financial restructuring to stave off a credit rating downgrade that could destroy the company. Bob Willumstad, just a couple of months into his post as chief executive, had no choice but to contemplate a fire sale of assets.

Sunday, 14 September 2008, was one of the most dramatic days ever seen on Wall Street, a day that changed the landscape for ever. With the Financial Service Authority, its regulator in London, expressing concern about the potential liabilities it would take on, with doubts about whether Barclays could win shareholder support for a purchase of Lehman without knowing exactly what they were becoming liable for, and with no sign of Mr Paulson and the Fed changing their hardline stance, Mr Diamond faced up to the inevitable. Around noon, it was over. Barclays was out. Lehman was dead. The shockwaves were immediate.

Inside the Fed, matters were crystallising fast. They had to. Trading would begin to restart in some Asian markets around midnight, New York-time, and a resolution of some kind would have to be announced by then. The bankers quickly agreed to put together a pot of money that could be used to fight fires if the Lehman unwind caused losses elsewhere in the system. Going around the room, the sum agreed was $7bn apiece. Ten of them went in, among them Barclays, Goldman Sachs, Deutsche Bank and UBS. The details of how that $70bn will be put to use, if it has to be, will be worked out on the hoof.

A bare-bones announcement was rushed out after 10pm. The Fed finally relaxed its position and agreed to looser rules for its own programme of lending to the markets, which could also help with any firefighting. Its announcement came out at the same time.

Meanwhile, a shocked Merrill Lynch board, which had been meeting in emergency session through the evening to agree a $44bn takeover, signed their own death certificate. It is one of the most momentous deals in the finance industry for years. That, too, was reported as the midnight deadline loomed. A Lehman bankruptcy filing wouldfollow within hours.

Nothing similar has happened on Wall Street in living memory. Never has so much been decided by so few in such a short time. What happens next? None of those involved would dare to predict.