Sept. 22 (Bloomberg) -- Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben S. Bernanke had been thwarted all week in their efforts to stabilize U.S. financial markets. Now, early in the evening of Sept. 18, they had a bigger fix in mind, and they went to sell it to Congress.

They sat in House Speaker Nancy Pelosi's office, at a wooden conference table adorned with pink roses and white hydrangeas, surrounded by more than a dozen congressional leaders.

In the previous four days, Lehman Brothers Holdings Inc. had gone bankrupt. Merrill Lynch & Co. and Bank of America Corp. had rushed into a shotgun wedding. The regulators had pumped $85 billion into American International Group Inc., nationalizing the world's biggest insurer, and were trying to thaw frozen credit markets and prevent economic catastrophe.

Earlier that week, lawmakers of both parties had talked about waiting until after the November election to take legislative action. Bernanke, a scholar of the Great Depression, let them have it.

``The credit lines in the American financial system, the lifeblood of the economy, are completely frozen,'' he said, according to Senator Charles Schumer of New York, a Democrat who was in the meeting. Banks had stopped lending to each other overnight, Bernanke said.

That threatened to halt all lending in the U.S., forcing businesses to close and idling workers, the Fed chief said. The Fed also was seeing money being moved out of the country.

``You could have massive failures within days,'' he told the group, and it would go beyond the banking system to ``large name- brand companies,'' according to a congressional staff member who attended the meeting and took notes.

Sobering Meeting

Politicians leaving the meeting said they were shocked at these portents of Armageddon from the usually understated Bernanke. They left the 90-minute meeting looking shaken, and resolved to act before the election.

It was ``as sobering a meeting as any of us have ever attended in our careers here,'' said Christopher Dodd, a Connecticut Democrat and chairman of the Senate Banking Committee.

Thus culminated 10 days that rattled markets worldwide and changed the structure of the U.S. financial system. Wall Street firms are shuttering or selling themselves to the most stable bidders. Regulators and lawmakers are moving toward a rescue that could cost more than $700 billion and permanently step up regulation.

`House of Cards'

President George W. Bush said as much in public remarks Sept. 20.

``At first, I thought we could deal with the problem one issue at a time,'' Bush said. ``The house of cards was much bigger and started to stretch beyond Wall Street. When one card started to go, we worried about the whole deck going down.''

The storm in the markets began with a long-deferred nod to reality by Lehman. The 158-year-old, New York-based firm had possible acquirers inspecting its books.

They discovered that Lehman hadn't yet written down its portfolio of subprime mortgages, those issued to the least creditworthy borrowers, as aggressively as some other Wall Street firms. Merrill Lynch, for instance, had reduced the value of its subprime paper to 22 cents on the dollar.

Ratings companies began to look under the hood at Lehman. They had been chastised by the Securities and Exchange Commission for issuing top, AAA grades to securities backed by subprime mortgages.

AIG Collateral Damage

When Standard & Poor's downgraded Lehman's credit rating on Tuesday, Sept. 9, its stock plummeted 45 percent to $7.79, the lowest in 11 years. The next day, Lehman reported the biggest quarterly loss in company history, $3.9 billion, and said it would restructure and sell a majority stake in its asset- management unit. The firm's stock plunged 46 percent more in the next two days.

The most immediate collateral damage was suffered by AIG. It was still valuing its subprime holdings higher than firms that had taken bigger writedowns, and investors turned on the company.

On Thursday, Sept. 11, AIG Chief Executive Officer Robert Willumstad took his own stab at a restructuring plan, saying the company would sell subsidiaries. The cost of insuring AIG debt rose 42 percent that day and 29 percent more the next.

Demands for Premium

Other companies were demanding an increased premium to do business with AIG, and investors were dumping AIG stock. Its shares declined 31 percent Sept. 12, when Standard & Poor's said it might cut AIG's credit rating.

After the close of business that day, the last chapter of Lehman as an independent entity began to be written. New York Federal Reserve Bank President Timothy Geithner summoned Wall Street leaders and Lehman executives to a meeting at his quarters in the financial district.

At 6 p.m., in a conference room there, he and Paulson got to the point quickly. Lehman wouldn't get the same treatment as Bear Stearns Cos. In March, the regulators had committed $30 billion to support the acquisition of Bear Stearns by JPMorgan Chase & Co. Now the bailout window was closed.

``The situation in March and the situation and facts around Bear Stearns were very, very different with what we were looking at in September,'' Paulson said Sept. 15.

Wall Street Executives

Paulson, a former chief executive officer of Goldman Sachs Group Inc., looked around the table. Lloyd Blankfein, his successor at Goldman; Jamie Dimon, chief executive officer of JPMorgan; John Mack, CEO of Morgan Stanley; John Thain, CEO of Merrill Lynch; and other top executives looked back.

If Lehman were to survive in some form, Paulson said, it was their responsibility. Certainly liquidating the fourth-biggest U.S. investment bank wouldn't be good for them. Volatility could unnerve investors so much that they might flee other investment banks.

``You have a responsibility to the marketplace,'' he said.

The Wall Street executives agreed to spend the weekend working on plans to carve up Lehman. The problem was that they also had to consider the interests of their own besieged firms.

On Saturday, Sept. 13, Merrill's Thain placed a call to Kenneth Lewis, chief executive officer of Bank of America. For several days, Lewis's bank had its foot firmly on Merrill's windpipe. Thain later told Merrill employees, in explaining his decision to sell, that Bank of America had ``cut our trading lines.''

Stock Plunge

Merrill managed to restore its credit lines but, like Lehman, was vulnerable. The nation's biggest brokerage had taken $52.2 billion of losses on subprime securities. Its stock had declined 36 percent the previous week, to $17.05, the lowest since 1996. When Lewis made an offer of $29 a share, or $50 billion, Thain took it.

Lehman's employees, meanwhile, were first to sense their firm's demise. Plenty of them spent the weekend in favored watering holes like Bobby Van's on West 50th Street, an unofficial office annex.

They weren't just packing bars; they were packing up office possessions. Employees began streaming into the firm's midtown headquarters the afternoon of Sunday, Sept. 14, after hearing news reports that Bank of America had been discussing a Merrill acquisition and wouldn't want both companies.

Some Lehman staff had been drinking since the market's close the previous Friday, knowing that the stock's 77 percent drop in the past week signaled its demise as an independent company. A group of them broke out champagne on the trading floor that afternoon -- not to celebrate but to mourn.

Together for News

That Sunday evening, about 70 Lehman staffers decided to move their wake about 40 blocks south, to a cavernous, glass- walled bar called Forum. They were still drinking at 2 a.m. when Bloomberg Television flashed the news: Lehman had filed for bankruptcy protection.

On Sept. 15, the Dow Jones Industrial Average fell 504 points, or 4.4 percent, the biggest one-day decline since trading resumed after the Sept. 11 terrorist attacks seven years earlier.

At 6:31 p.m., Fitch Ratings announced that it had downgraded AIG's main credit line to A from AA-. Moody's Investors Service and S&P followed within three hours.

The next day, the company's stock plunged 34 percent and its leaders began casting about for liquidity. Because of the downgrades, AIG had to immediately come up with $20 billion as collateral against subprime paper it had insured.

Record Bankruptcy

The world's biggest insurer was abruptly a candidate for the world's biggest bankruptcy, dwarfing that of Lehman.

When the values of insured securities fall, the insurer must deliver cash representing the difference between their original and current value. Of the $58 billion in contracts that AIG had written, 64 percent of the insured instruments had been downgraded and six were in default.

If AIG failed, the effects would ripple through the world financial system and damage Wall Street firms.

The regulators stepped in on the evening of Tuesday, Sept. 16, with an $85 billion loan to AIG, in exchange for an 80 percent stake. The action averted bankruptcy and, with the first $30 billion loan installment from the New York Fed, enabled the company to meet its collateral calls from customers including Goldman.

``The banks are the recipients of the Fed's largesse,'' said Christopher Whalen, managing director at Institutional Risk Analytics in Hawthorne, California, which compiles a database of bank transactions.

The action failed to stabilize the market. Stocks continued to fall the next day as the Dow lost 4.7 percent. Over three days, $3.6 trillion of market value was erased.

Libor's Jump

The meltdown reached banks on Tuesday, Sept. 16, when the London interbank offered rate jumped 3.33 percentage points to 6.44 percent. This signaled that banks didn't trust each other enough to make 24-hour loans -- except at a premium -- and overnight more than doubled the cost of borrowing in dollars. The rate was the highest since 2001.

The fear gripping the market gridlocked the financial system, including collateralized debt obligations.

``There's so much fear about the system issues engulfing the market that you can't really blame your counterparts for dotting every `I' and crossing every `T,''' said Thomas Priore, chief executive officer of Institutional Credit Partners LLC, a New York-based fixed-income advisory and investment firm.

After the market closed Tuesday, there was another eruption. A money-market concern called Reserve Primary Fund said its net asset value had fallen below $1. That's because it had taken losses of $785 million on its holdings of Lehman commercial paper, the fund told shareholders. For every dollar, a Reserve customer could redeem 97 cents.

Critic Snared

The fund was run by Bruce Bent, who created the first money- market fund 38 years ago and had been a critic of investing in mortgage-based instruments.

``Wall Street -- they don't have any brains -- all they do is market,'' Bent said in a July interview. ``They say, `If you're willing to buy it, I'm willing to sell it to you. If you're going to go out and blow up a bridge with it, that's none of my business. I just sell dynamite.'''

Now Bent's fund was caught in the Wall Street vortex and triggered a run on other money-market funds, which investors had considered as safe as cash. Account holders withdrew a record $89.2 billion on Sept. 17, according to the newsletter Money Fund Report.

Shock to Market

``This shocked our market more than anything else,'' said Deborah Cunningham, chief investment officer for $241.4 billion in Federated Investors Inc. money-market funds.

She had sensed that something like this might be coming a week earlier, Cunningham said in an interview, when Money Fund Report said investors pulled $80.7 billion from taxable money- market funds in the previous week.

During the weekend, in her Pittsburgh office overlooking center field in PNC Park's baseball stadium, she deliberated on how to calm investors' worries about the still-unresolved Lehman situation and the rest of the market.

``We didn't think Lehman was going to survive over the weekend in its then-form,'' said Cunningham. ``That's why we had everybody tuned into their BlackBerrys and news sources.''

Even when Cunningham wasn't at the office -- watching the Pennsylvania State University Nittany Lions football team beat Syracuse University, 55-13, on Saturday night, or attending her daughter's cheerleading competition Sunday night -- she was preoccupied.

``My mind wasn't really on these things,'' she said.

Merrill Debt

While Federated didn't have any Lehman notes, the firm was invested in Merrill Lynch debt. She declined to say how much. The fund manager had to prepare for an onslaught of questions and the possibility of redemptions because of that holding.

Cunningham said she thought she had good answers. Merrill's risk was mitigated by its pending merger into Bank of America. Yet it was still a challenge to calm customers and retain their funds, she said.

After the Reserve announcement, Cunningham said, ``it's been 24 hours a day, all hands on deck, nobody gets to go home.''

The market's plunge scared even seasoned pros like Laurence Fink, chief executive officer of the New York-based asset- management firm BlackRock Inc.

``We allowed leverage to reach obscene levels,'' said Fink, a pioneer in mortgage-backed securities. ``We allowed the securitization of assets that historically were never allowed to be part of the securitization package. So now we're paying the costs of all those excesses.''

Rally on `Solution'

At about 2 p.m. on Thursday, Sept. 18, New York Democrat Schumer was in the Senate. The Dow had dropped as much as 962 points, or 8 percent, since the previous Friday. Schumer, who sits on the finance and banking committees, told reporters that the Fed and Treasury were planning a ``comprehensive solution'' to the financial crisis.

That sparked a rally in the market. The Dow closed up 410 points, or 3.9 percent.

Representative Pelosi, the California Democrat, had called Paulson for an update. By 3:30 p.m., they agreed on a briefing for lawmakers and Paulson was personally calling congressional leaders and asking them to attend.

After the briefing that evening, Paulson promised he would get a proposal to legislators as soon as possible. On Saturday morning, Sept. 21, a three-page bill was delivered to members of Congress asking them to give Paulson unchecked power to buy $700 billion in bad mortgage investments from financial companies in what would be an unprecedented government intrusion into the markets.

More Debt

The plan would raise the ceiling on the national debt and spend as much as the combined annual budgets of the Departments of Defense, Education, and Health and Human Services. Paulson was asking for the power to hire asset managers and award contracts to private companies. Most provisions would expire after two years from the date of enactment.

As details of the Paulson-proposed package emerge, so do concerns that the $700 billion cure may prove worse than the disease, virulent as it has been. Reregulation of Wall Street is one thing, critics say, while redefining capitalism another.

``The recent intervention in the markets, nationalization of financial services companies and systemwide RTC-like bailout being crafted in Washington are disconcerting to say the least,'' said Christopher Low, chief economist at FTN Financial in New York. ``Unfortunately, there's not much choice.''

The two-day rally that began with Schumer's speech left the market on Friday, Sept. 19, about even with its close a week earlier.

The Dow started the week at 11,422 and finished at 11,388, and the Standard & Poor's 500 Index began at 1,252 and closed at 1,255.

If you were off on Mars for the week, you might think nothing had changed.

To contact the reporters on this story: John Helyar in Atlanta at jhelyar@bloomberg.net; Alison Fitzgerald in Washingtont ; Mark Pittman in New York at mpittman@bloomberg.net; Serena Saitto in New York at ssaitto@bloomberg.net.

Last Updated: September 22, 2008 03:19 EDT