In September 2008, Lehman Brothers' bankruptcy roiled markets worldwide, with catastrophic results. Credit markets froze, and the S&P 500 lost 40% before the year was out. Could this happen again? In a paper released yesterday, the FDIC prepared a case study in which regulators manage Lehman's failure with the tools and mandate they have under the Dodd-Frank Act on financial reform. Here's how things might have gone.

Will they, won't they?
What happened
: In July, Treasury Secretary Hank Paulson told Lehman CEO Dick Fuld that the bank would receive no federal assistance. However, Fuld claims that Paulson never ruled this out. The government certainly sent mixed signals concerning the possibility of assistance: As late as Sept. 10 -- five days prior to the bankruptcy filing -- the Federal Reserve Bank of New York was using a presentation that discussed the option of federal financial support for Lehman.

Lehman executives and board members believed that the government would ultimately step in to help the bank -- and so did the senior management of other top Wall Street firms.

How it could have gone: In the spring of 2008, the FDIC meets with Lehman, along with the SEC and the Federal Reserve. Regulators quash any hint of ambiguity by firmly asserting that:

  • No rescue will be forthcoming;
  • Lehman has a July deadline to sell itself or raise adequate capital.
  • Failing that, the alternative to a sale or an capital raising is receivership (i.e., the government takes responsibility for the firm and oversees its resolution). Shareholders should expect to be wiped out under this scenario.

The following tables show two timeline of events leading up to Lehman's bankruptcy -- first what actually happened, and then a hypothetical "Dodd-Frank" timeline:

Actual events


Near collapse of Bear Stearns, before it is acquired by JPMorgan Chase (NYSE: JPM)

Lehman holds discussions with Warren Buffett concerning a strategic investment by Berkshire Hathaway (NYSE: BRK-B). Talks end without a result.


Korean bank KDB is the only potential strategic investor left


Rumors that Lehman is "done" become widespread.


Sept. 10: Lehman pre-announces Q3 earnings and a restructuring plan in which it hives off its commercial real estate assets.

Sept. 15: Lehman Brothers files for bankruptcy, causing significant disruption in markets worldwide.

Alternative scenario under Dodd-Frank


The FDIC establishes an on-site presence at Lehman to perform due diligence.

FDIC and other regulators hold joint meeting to inform Lehman that there will no bailout or assistance.

FDIC starts planning for a sale.

FDIC identifies and values 'problem' assets that could block an acquisition, in order to determine the best way to structure the sale.


Lehman is unable to sell itself. The FDIC starts to market Lehman to potential acquirers. Potential buyers are invited to submit bids that are consistent with the deal structure.

The FDIC evaluates bids.

Source: FDIC, Examiner's Report – Lehman Brothers Holdings.

The acquisition
What happened
: Barclays purchased Lehman's North American activities post-bankruptcy against the backdrop of chaotic global markets. Given these conditions and the timing, it was impossible for Lehman to realize full value on the sale of its assets.

How it could have gone: Lehman Brothers is placed in receivership, but Barclays is able to purchase the entire company, with a loss-sharing agreement on problem assets identified by the FDIC. This is the same sort of arrangement that the FDIC typically puts together in the context of a failed commercial banks. Consistent with the planned deal structure, Lehman's assets and certain liabilities are transferred to Barclays, with limited disruption to financial markets. Lehman obtains better bids for its assets, and creditors recover a higher proportion of what they are owed.  

Messy and expensive
What happened
: Lehman's estate sued Barclays, claiming it structured the sale agreement in a manner that produced "an immediate and enormous windfall profit." Lehman's bankruptcy fees to law firms, consultants, and other advisors topped $1 billion, including at least $370 million to restructuring firm Alvarez & Marsal. The bankruptcy became the costliest in U.S. history

How it could have gone: The sale takes place in an orderly, transparent manner, reducing any risk of litigation. Fees for professional services are much lower.

Too big to fail: Alive and well in America
Sheila Bair, the head of the FDIC, is one of the few regulators who has advanced the notion that "too-big-to-fail" institutions should be broken up. Regulators now have the authority to require banks to do so under Dodd-Frank. Should it happen? Yes. Will it happen? No.

With Bair entering her last few weeks at the head of the FDIC, I don't see anyone taking up her banner to push for banks to break themselves up. Citigroup (NYSE: C), JPMorgan Chase, and Bank of America (NYSE: BAC) must be breathing a sigh of relief. Taxpayers, on the other hand, should be sorry to see her go.