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No Bailout: Feds Made New Policy Clear in One Dramatic Weekend

Global stocks have experienced wild fluctuations this week in the wake of the U.S. government's seizure of insurance giant American International Group, the failure of Lehman Brothers, the disappearance of Merrill Lynch as an independent company and reports the U.S. government will set up a government entity to take on bad debts from financial institutions.

Through the day, Paulson, Geithner and their Fed and Treasury colleagues darted upstairs to the 13th-floor executive suites, huddling in a small conference room off of Geithner's office or in an unused office provided to Paulson for the weekend. There, they discussed their options, often with Fed Chairman Ben S. Bernanke and Vice Chairman Donald Kohn joining by phone.

Besides keeping the White House informed, Paulson began to speak privately with chief executives to evaluate their firms' exposure to a Lehman liquidation, advising what action they should take.

One of these conversations occurred Saturday afternoon between John Thain, chief executive of Merrill Lynch, and Paulson. The two talked at length alone. The conversation remained private and was not shared with other participants at the meetings. And Paulson, when later asked, would not reveal what they talked about.

Shortly after the conversation, Thain began work on the deal that would see his firm sold to Bank of America for about $50 billion. At that point, it became clear to Paulson that Bank of America was no longer a potential savior for Lehman.

The British bank Barclays remained the last hope to buy Lehman. But a flurry of conversations with Barclays' British regulator, which was concerned about whether the bank was overreaching for Lehman, suggested that the possibility was remote.

By Saturday night, it appeared all but certain to senior officials at the Treasury and the Fed that Lehman would end up in bankruptcy protection. But they waited until they heard definitively from Barclays' regulator before sharing that conclusion with the bankers who had set up shop on the first floor of the building.

Until then, the senior government officials had divided their time equally between efforts to arrange a sale of Lehman and contingency planning to prevent a market rout on Monday if Lehman were to collapse. Starting about 7 p.m. Saturday, the officials turned all their attention to dealing with the fallout of Lehman's failure, not preventing it.

Early Sunday morning, British regulators told Paulson that they had serious problems with the deal, all but killing the possibility of a Barclays buyout. At 10 a.m., Geithner and Paulson passed that information to the investment bankers who had spent the previous 24 hours trying to organize a consortium to finance an enterprise that would hold Lehman's bad assets.

The executives were stunned. The consortium wouldn't be necessary. Rather, they needed to prepare for the liquidation of Lehman and its impact on their companies.

Lehman's board made a last-ditch effort to save the firm, arguing for funding from the Fed that would give it time to find another solution. But Fed officials were firmly convinced that no one would do business with the firm come Monday morning.

Sunday evening, the firm decided to file for bankruptcy protection.

That freed Paulson to begin informing members of Congress, including Rep. Barney Frank (D-Mass.), chairman of the House Financial Services Committee, senators on both sides of the aisle and New York Mayor Michael Bloomberg. Other Treasury officials shifted gears to work on another unfolding problem at AIG, which appeared to them to be on the verge of a collapse. Some involved in this effort said discussions about AIG's troubles intensified as the weekend progressed.

As the bankruptcy of Lehman became official, someone remarked about the historic nature of the weekend.

Jim Wilkinson, Paulson's chief of staff, was within earshot of the comment and responded to the group discussing the events: "This would be extremely interesting from an analytical perspective if wasn't happening to us."

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