The warning was ominous: ''Massive global wealth destruction.''
That's what Lehman Brothers Holdings executives predicted in a confidential memo prepared for government officials before they filed the biggest bankruptcy in US history.
The message didn't get through. Two dozen of the world's most powerful bankers, brought together by Treasury Secretary Henry M. Paulson Jr. and Federal Reserve Bank of New York President Timothy F. Geithner the weekend of Sept. 13, 2008, to devise a rescue plan for Lehman, were too busy saving themselves to see the larger threat.
''The discussion among the CEOs was `How do we prevent the next firm from going under?''' former Merrill Lynch & Co. Chief Executive Officer John A. Thain, who cut a deal to sell his company that weekend, said in an interview. ''There should have been much more discussion about the impact directly on the markets if Lehman went bankrupt.''
Of all the quakes of 2008 - the fall of Bear Stearns in March, the takeover of mortgage buyers Fannie Mae and Freddie Mac and the salvaging of American International Group in September - the failure to account for the effects of Lehman's demise was the most critical because its aftershocks came closest to wrecking the world economy.
The financial chieftains spent the weekend unwinding derivatives trades - bets made on whether companies will pay their debts - and trying to keep bank-to-bank loans flowing. They ignored the market for commercial paper, short-term loans used by businesses worldwide to cover everyday expenses, including payroll and utilities.
Lehman's downfall on Monday, Sept. 15, sparked a run on the $US3.6 trillion ($4.2 trillion) money market industry, which provides those loans. The panic left companies stranded with insufficient cash and ravaged the accounts of millions of people.
Within a week, the US stepped in with a $US1.6 trillion program to halt withdrawals from money market funds, part of $US13.2 trillion it has committed to beating back the worst financial crisis since the Great Depression.
''They put the entire financial system at risk, and they didn't have to,'' said Harvey R. Miller, a partner at Weil Gotshal & Manges in New York who represented Lehman in the bankruptcy, referring to government officials. ''They were warned. I told them, 'Armageddon is coming. You don't know what the consequences will be.' Their response was, 'We have it covered.'''
Paulson and Geithner, who succeeded him as Treasury secretary, both declined to comment.
One year later, policy makers haven't learned the lesson of the bankruptcy, said Richard Bernstein, CEO of Richard Bernstein Capital Management LLC in New York and former chief investment strategist for Merrill Lynch.
The system was freezing in front of our eyes
Rather than break up institutions such as Bank of America and Citigroup, or limit their expansion, the US has given them billions of dollars in tax incentives and loan guarantees that enabled them to grow even bigger. To protect against a bank collapse touching off another freefall, President Barack Obama has proposed regulatory changes that rely on the wisdom of bankers and government overseers - the same people who created the conditions that led to Lehman's bankruptcy and were unable to foresee its consequences.
''Designating certain institutions as too big to fail, and not having a thorough regulatory process to match, practically invites another catastrophe,'' Bernstein said.
Rescue efforts exposed a financial system with so many moving parts that US regulators and the world's top bankers couldn't keep track of them all. Like the fictitious substance ice-nine in Kurt Vonnegut Jr.'s 1963 novel ''Cat's Cradle,'' a seed of which set off a chain reaction that transformed all the world's water into ice, Lehman's failure froze credit markets.
''I remember at the end of the week calling up my wife and saying, 'Jamie, go to the ATM, go to the cash machine, and take cash out,''' Mohamed El-Erian, CEO of Pacific Investment Management, the world's largest bond-fund manager, said. ''She said, 'Why?' I said, 'I don't know whether the banks are going to open tomorrow.' The system was freezing in front of our eyes.''
As with other financial institutions, Lehman's problems stemmed from borrowing too much to finance too many hard-to-sell investments, such as mortgage-backed securities, that were declining in value as a result of the deteriorating real estate market. Lehman was different because the government let it declare bankruptcy, meaning the company's creditors were wiped out as well as its stockholders.
The ensuing panic doomed the oldest US money market fund, the $US62.5 billion Reserve Primary Fund, started in 1971 by Bruce R. Bent. Reserve Primary had lent Lehman $US785 million, about 1.3 per cent of its assets, some of it in short-term loans that Lehman was now unable to repay. In a two-day run on the fund, more than 60 per cent of its money was withdrawn. Its net asset value fell below $US1 a share, or ''broke the buck,'' on Sept. 16, making investors vulnerable to losses and triggering withdrawals at other funds.
The run on money market funds, considered the safest investments after bank deposits and the major buyers of commercial paper, sent shivers through the global economy. World stock markets lost $US2.85 trillion, or more than 6 per cent of their value, in three days.
''We did not expect how the Lehman Brothers bankruptcy would transmit through the commercial-paper market and cause all the stress in the money funds,'' said David Nason, a former assistant Treasury secretary under Paulson.
The oversight may have had something to do with who was at the meetings, said Joshua H. Rosner, managing director at New York investment research company Graham Fisher & Co. They were all bankers.
''It wasn't a mistake to let Lehman fail; it was a mistake to let them go without putting foam on the tarmac,'' Rosner said. ''If they had a variety of stakeholders in the room, those stakeholders would've told the regulators they needed to do something about commercial paper.''