In Part 3 of a five-part series Yalman Onaran and John Helyar chronicle the demise of investment bank Lehman Brothers and the fall from grace of its leader Richard Fuld.

Key Points:

Dick Fuld is very conscious of risk. He's created a culture that's enabled us to do fine.Lehman vice-chairman Thomas Russo
Lehman used its balance sheet to finance leveraged buyouts. So did other Wall St firms forced to compete with commercial banks, which were allowed to practise investment banking after the 1999 repeal of the Glass-Steagall Act.

Leveraged loans weren't Lehman's undoing, though. Richard Fuld saw the dangers they posed and rid the firm of the riskiest ones in the fourth quarter of 2007, according to company filings.

What Fuld failed to do was take advantage of a rebound in the prices of fixed income assets at the time to sell some of Lehman's US$84 billion mortgage portfolio. He took false comfort in having hedged the firm's mortgage positions at the end of 2006.

Because of the hedges, insiders say, Lehman executives were sanguine after the July 2007 implosion of two Bear Stearns hedge funds that had invested in sub-prime securities.

Fuld even loaded up on mortgage-backed securities at the beginning of 2008, not seeing how vulnerable the firm would be when the sub-prime cancer metastasised to other asset classes.

The disconnection was on display at the World Economic Forum in Davos in January.

On the one hand, Lehman vice-chairman Thomas Russo, 65, presented a paper entitled "Credit Crunch: Where Do We Stand?" predicting the reset of interest rates on US$550 billion of sub-prime mortgages in the next 12 months would trigger foreclosures and economic woe.

On the other hand, Russo said it was no big deal for Lehman. "Dick Fuld is very conscious of risk," he said in a Bloomberg TV interview. "He's created a culture that's enabled us to do fine."

Others were not so sure. A Lehman employee of more than 20 years says she sat her subordinates down in January and told them to start considering options outside the firm.

By the end of the fiscal first quarter in February, after New York-based rivals Citigroup and Merrill had taken about US$45 billion in writedowns, Lehman's mortgage portfolio had increased by 2 per cent from the previous quarter.

Associates say Fuld had concluded the market for mortgage-backed securities had hit bottom, and he did not have people around him to warn about the spread of sub-prime troubles to so-called Alt-A mortgages - those made to borrowers without full documentation - and the commercial real estate market.

Roger Nagioff, 44, a London equities trader who succeeded Michael Gelband as fixed-income chief, was struggling to learn the business as the sub-prime rout began.

He quit in February 2008 after realising he could not get his head around Lehman's mortgage-related positions, people close to Nagioff said.

Lehman also had a rookie chief financial officer. Erin Callan, a 43-year-old investment banker, had been elevated to the job in December by chief operating officer Joseph Gregory, although she had no experience in the company's treasury, a typical training ground for CFOs. Fuld went along with the appointment and allowed her to become the public face of Lehman because he trusted Gregory and did not get involved in staffing decisions, people say.

On March 17, a day after the sale of Bear Stearns, Lehman shares fell as much as 48 per cent in New York Stock Exchange trading on concern the firm would be Wall St's next victim.

To Fuld, the idea was outrageous. The hit was a matter of wrong perceptions, not weak fundamentals. So he got on the phone with the firm's biggest clients to tell them Lehman was no Bear Stearns, and he ordered other executives to do the same.

This was pure Fuld: when bloodied, counter-punch. That's how he turned things around in 1998, when Wall St rumours had Lehman over-exposed to the Russian currency collapse and the "Asian flu". His jawboning with clients, regulators and others pulled Lehman's stock out of a spiral from $21 to $6.

This time around Fuld also reached out to Omaha billionaire Warren Buffett, the man who had ridden to the rescue of Salomon in 1987, according to two people with knowledge of the approach.

He asked investment banking chief Hugh "Skip" McGee, 49, to call David Sokol, chairman of Berkshire Hathaway-owned MidAmerican Energy Holdings, and see if Buffett might be interested in a stake in Lehman.

The answer was yes, Sokol told McGee. So Fuld called the 78-year-old Buffett. Berkshire Hathaway would buy preferred shares that would pay a dividend of 9 per cent and could be converted to common at the then-market price of US$40, the people said.

That was costlier than what other investors demanded, Fuld was told by associates, and he spurned the offer. A few days later, on April 1, Lehman sold US$4 billion of convertible preferred stock to public investors with a 7.25 per cent interest rate and a 32 per cent conversion premium.

That meant those buying the convertibles were willing to pay one-third more than the market price for Lehman's shares if and when they wanted to convert. Buffett was willing to pay only the going price at the time, which would have meant more dilution for existing shareholders. A spokeswoman for Buffett declined to comment.

Fuld had saved some money, yet he rebuffed a Buffett stake, considered to be corporate America's Good Housekeeping seal of approval. Although that might have helped Lehman in the short run, it would not have solved the firm's fundamental problem: Fuld needed to sell the entire mortgage-related portfolio at whatever price he could get and raise enough capital to cover the losses incurred in such a sale.

Six months later Goldman Sachs Group, the most profitable investment bank, agreed to even harsher terms with Buffett - paying him a 10 per cent annual return on a US$5 billion investment. Yet the market had deteriorated so much by then that even the billionaire's blessing was not enough.

Goldman's shares fell 36 per cent in the two weeks after the deal was announced, only to recover after the Government stepped in to buy stakes in the biggest US banks.

Lehman's April 1 stock sale sent a signal that the firm continued to have access to capital and the confidence of investors and the Government.

Its shares rose 26 per cent in the next three weeks. At a dinner at the Treasury Department on April 11, where Fuld chatted with Treasury Secretary Henry Paulson, he came away with the impression, as he wrote in an email to Russo that night, that we "have huge brand with Treasury" and that Paulson "loved our capital raise".

The email was later made public by US Representative Henry Waxman, chairman of the House committee on oversight and government reform.

Paulson would complain, in interviews with the New York Times and Charlie Rose after Lehman's demise, that he could not get Fuld off the dime in finding a buyer for Lehman.

Brookly McLaughlin, a Treasury spokeswoman, said Paulson "spoke to Fuld quite often" between April and September. She would not divulge the frequency or substance of their conversations.

Fuld took Paulson's request to mean he should find a strategic partner to buy a stake in Lehman, which he was already searching for, according to people close to the CEO.

Tomorrow: Why Fuld was unable to find a buyer for all or part of Lehman remains a matter of dispute. It was not for want of trying.

- BLOOMBERG