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that there was no way the FSA would guarantee the Lehman trading book.

"There was no way forward," recalls Paulson. "The FSA just wouldn't approve the deal."

Sources at the FSA say they were stunned that no one had called them earlier. "Why on

earth, if Paulson was serious, didn't he check with us sooner?" someone close to FSA

Chief Executive Hector Sants says.

Paulson thought Diamond had spoken to his regulator, and that he'd got them on board.

Diamond appeared to be as dismayed by the FSA's news as Paulson was, and was furious

that McCarthy had called Geithner without first coming to Barclays. He believed that he

might have been able to make headway with the U.S. Fed and was distressed to learn that

an inflammatory phone call from the FSA had seemingly killed the deal. Diamond emailed Bob Steel two damning sentences after McCarthy's phone call: "Couldn't have

gone more poorly, very frustrating. Little England."

Paulson was devastated. For the second time that weekend he placed a call to Darling,

not, he stresses, to ask the UK government for a bailout, but to gauge their mood.

He got his answer. Darling's attitude was the same. It was very bad news for everyone if

Lehman failed, but the problem was theirs, not his.

According to Treasury sources, Paulson asked his team of financiers, including Steven

Shafran and Dan Jester, both retired managing directors of Goldman Sachs, and others

from Credit Suisse, to take another look at Lehman's balance sheet.

According to someone present at the Fed meetings, one Treasury staffer estimated that

Lehman had overpriced its assets by about $100 billion (Paulson was never told it was

this bad); others said the hole was maybe $50 billion to $60 billion.

Paulson lost his cool. He was tired. He was worn out. It was time to tell the Fed and the

SEC he could not find a buyer to save Lehman Brothers. He was out of options.

By Sunday afternoon, Lehman was not Paulson's only headache. Sitting in another room

in the New York Federal Reserve was a team from American International Group Inc.

(AIG). Its stock price was down over 90 percent for the year, the company was being

forced to post more and more collateral, and its credit ratings were at risk of a

downgrade, which would in turn mean posting more collateral. AIG needed cash quickly,

or the company would default and have to file for bankruptcy.

The Lehman situation was bad; this was worse.

Paulson once again put in a call to Buffett, who told the Treasury secretary that he could

not afford to let AIG go under. "All bets are off," Treasury sources say Buffett advised

Paulson. "You must find a way to save AIG. It's too big and too global."

AIG was the world's largest insurer. It had been widely considered to be a much more

dependable counterparty than someone like Lehman or Bear Stearns. It was, after all, an

insurance company. But the reality was that it had trillions of dollars in bets on the

markets, and if its credit rating got downgraded--as most expected would happen within

days--it could be hit with collateral calls for billions upon billions it did not have.

Millions of Americans had policies with AIG.

Paulson started clearing problems off his desk. First, Lehman needed to file for

bankruptcy--a token sign, as Congressman Barney Frank would later say, mockingly, that

there was still a free market in America--for one day, at least.

After letting Lehman go, Paulson was pretty sure he would be forced to intervene to save

AIG--and God knows who else.

In his mind it wasn't right to equate AIG with Lehman--at the time, AIG looked like it

had only a liquidity problem, whereas Lehman had both a liquidity crisis and a capital

problem. It was legal for the Fed to make a loan that was secured by valuable insurance

subsidiaries; a loan to the firm would, it was hoped, avoid systemic collapse.

"Loaning against stable insurance businesses with independent credit ratings was very

different than lending to Lehman Brothers. You can't lend into a bank run