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When The Lehman Brothers Fall Is All That’s Left

The government seriously erred in letting Lehman file bankruptcy the way it did.

In letting Lehman Brothers file for Chapter 11 the way it did, the Federal Reserve and the U.S. Treasury seriously erred, wiping out billions of dollars in value for bond holders that could have been saved, according to some of those close to the action when the New York-based investment bank went down on September 15 last year.

Speaking last Tuesday night at a panel discussion held at the Bank of America Building in New York City, Bryan Marsal, co-founder of the New York-based turnaround specialist Alvarz & Marsal, which is overseeing the administration of Lehman Brothers, did not mince words. “A freefall Chapter 11 was a grave miscalculation by the Treasury and the Fed,” he said, adding that such an approach destroyed $75 billion in value “in less then a week.”

Other panelists agreed. “A lot of people thought Lehman was in trouble,” prior to September 2008, said Michael Novogratz, president of New York-based $31 billion alternative investment firm Fortress Investment Group. “Very few thought the Fed and Treasury would be as crazy as to let it go bankrupt in an uncontrolled manner.” According to Novogratz, the body language coming from people in government as close as two weeks before Lehman’s Chapter 11 filling was that some solution would be found — a resolution similar, perhaps, to the government-brokered acquisition of Bear Stearns by J.P. Morgan Chase that March.

Instead, Lehman went under. “The market got caught off guard because it seemed like such an absurd thing to have done,” Novogratz said. And chaos followed.

Tuesday’s discussion was organized by the New York-based boutique bank Piper Jaffray in anticipation of its October 21st Trading Day for Kids, on which day all proceeds from equity trades directed to Piper will go to support Youth Inc., the philanthropic organization that provides support to New York-based charities that help inner-city children.

Independent survival was not an option for Lehman, Marsal pointed out. The bank, he said, had mismanaged its liquidity, particularly in the last 30 days of its existence, and was overleveraged. “It ran out of capital.”

Despite Lehman’s efforts to induce CEO Richard Fuld to find a buyer, and criticism that the firm didn’t react fast enough to save shareholder value, Rodgin Cohen, a partner with the law firm Sullivan & Cromwell who advised Lehman in those final months, recalls it was not as if a willing buyer stepped forward with an offer that was rejected. Cohen insists that the options available to Lehman and Fuld “were not as great as some people seem to think.”

Marsal believes something else could have been done. One option was for the government to more actively pursue the acquisition by Barclays Capital outside of bankruptcy. “I don’t understand why the Treasury didn’t go ahead with the Barclays transaction,” says Marsal. The London-based bank later acquired the U.S. operations of Lehman out of Chapter 11.

Marsal also suggested that the government, rather then go ahead with a traditional Chapter 11 filling, should have rewritten the law and negotiated with shareholders and bondholders to preserve some value, at least for bondholders.

And in a controlled bankruptcy the impact on the broader capital markets, the panelists agreed, would have been less dramatic. Marsal suggests that special bankruptcy laws should be written for financial institutions that fail. Novogratz points to the controversial bailout of insurance giant AIG as a better model.

Certainly this is second-day quarterbacking. And fixed-income traders like Novogratz and New York hedge fund Marathon Asset Management's Bruce Richards, who also participated in the discussion, have a vested interest in arguing for preserving value for bondholders.

But at the end of a week in which middle-market lender CIT might be getting ready to file for prepackaged bankruptcy, it is clear that lawmakers, market participants and regulators alike are only starting to work through the broader implications to the Chapter 11 process of Lehman’s fall.

The Alpha / Beta blog is devoted to news and insights about the alternative investment (Alpha) and the traditional asset management (Beta) industries. Institutional Investor staff writer Imogen Rose-Smith covers hedge funds, private equity and their investors. Julie Segal is an Institutional Investor staff writer covering money managers and pension funds, foundations and endowments.

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