naked capitalism

Submitted by Arthur Doyle, a managing director at Lehman Brothers until the summer of 2008.

When an apple has ripened and falls, why does it fall? Because of its attraction to the earth, because its stalk withers, because it is dried by the sun, because it grows heavier, because the wind shakes it, or because the boy standing below wants to eat it?

Extra points if you recognize this selection from the beginning of Tolstoy’s “War and Peace,” his critique of the “Great Man” theory of history, in which he argues that events follow organically from the circumstances of peoples rather than from the actions of kings who are “the slaves of history.” In contrast, historians such as Thomas Carlyle argued that “the history of the world is but the biography of great men.” Carlyle’s view held great sway for much of the 19th and 20th centuries, only gradually giving way after World War II with the rise of new disciplines such as social and economic history.

Some ideas, however, die more easily than others. Though the “great man” theory has lost its hold on Ivy League history departments, it lives on in popular culture. And nowhere is it stronger than in business journalism, with its breathless accounts of heroes and villains…the crazed homophobic Jimmy Cayne, the bloodless executioner Hank Paulson, the naively overreaching Ken Lewis, and so forth.

In this tradition comes “A Colossal Failure of Common Sense: The Inside Story of the Collapse of Lehman Brothers,” by former Lehman trader Lawrence McDonald and best-selling ghostwriter Patrick Robinson (Crown Brothers, New York, 2009, $27.00). McDonald traded high yield bonds for Lehman from 2004 to early 2008. He worked for, and admired, Mike Gelband and Alex Kirk who were Lehman’s heads of fixed income and high-yield trading. Gelband and Kirk were known within Lehman to be critics of CEO Dick Fuld’s strategy of aggressive expansion of the firm’s real estate business during the late stages of the credit bubble. Both men left Lehman in 2007 after losing internal political struggles over the direction of the firm (and its excessive leverage), only to return in its final days in a doomed effort to steer the Titanic away from the iceberg.

Mr. McDonald’s tale, as told by Mr. Robinson, is a thriller. However you may disagree with his premise (that Lehman was a firm filled with heroes and geniuses, lain low by the treachery of a handful of stubborn fools), it is impossible not to get caught up in the narrative. McDonald has a somewhat unorthodox rise, from community college to pork chop sales to retail stock brokerage to, finally, a coveted place on a Wall Street trading floor. And the Lehman Brothers he finds is everything he hoped it would be: razor-sharp analysts teaming with gutsy traders, taking million dollar risks and earning multi-million dollar paydays. We are, predictably, regaled with tales of wildly extravagant spending on meals and toys, huge casino wins and huger losses, all absorbed with aplomb.

Mr. McDonald and his merry band, Larry McCarthy, Rich Gatward, Alex Kirk, and the rest, move from one success to the next: at one moment shrewdly buying Delta Airlines bonds when the firm goes into bankruptcy (on the advice of researcher Jane Castle, who knows so much about the airline she “could tell you what meal they served in first class on this morning’s flight from JFK to Berlin”), the next moment shorting the bonds of Calpine, the electric utility.

But it doesn’t take long to get our first indication that all is not well at the House of Lehman. McDonald never meets the firm’s reclusive CEO, Richard Fuld. Not that unusual for a vice president…but then he reveals that his boss has never met Fuld either, and that his boss’s boss, Mr. Kirk, has only “seen” Mr. Fuld on a couple of brief occasions. McDonald has very little idea about what kind of person Mr. Fuld is, other than anecdotes retold by colleagues or clippings from the press, but what little he knows makes him nervous: Fuld is reclusive, zipping from his chauffeured Mercedes to a private elevator directly to the 31st floor executive suite, never stopping to mingle with the troops along the way. And Fuld, it seems to McDonald and his colleagues, is under the spell of the firm’s largest profit generators, the mortgage and real estate groups. Mr. McDonald doesn’t know these folks well, either, but once again what little he knows he doesn’t like: the mortgage traders are said to resemble Hollywood divas, making late entrances to meetings due to their supposed fondness for “long walks on the lake at Central Park.”

Some time in 2006, Mr. McDonald and his bosses begin to sense cracks in the housing market, and begin to worry that residential mortgage securitization will freeze up and leave Lehman Brothers holding millions of mortgages, originated by its partners, that it will be unable to sell on to hedge funds, pension funds and other clients. This could weigh down the firm’s balance sheet and profit stream, and potentially put the firm’s survival in doubt. The traders begin to take short positions in homebuilders and mortgage brokers, to try to offset this risk, but soon realize that the scale of the potential problem is too large to be addressed by their desk alone. When their attempts to persuade the mortgage guys to “slow down” are met with mockery, Gelband, head of the fixed income division, goes to Fuld himself to try to get the firm to take steps to protect itself against the downturn.

Predictable results ensue: the ignorant Fuld and his jealous deputy Joe Gregory attack the bearers of bad news and call for more and faster growth. As though determined to go to ground as spectacularly as possible, in mid-2007, a full 18 months after the beginning of the real estate downturn, Lehman buys Archstone-Smith, one of the largest residential apartment owners in the country. The rest follows inevitably: from the collapse of sub-prime, to Bear Stearns’ failure in Mar 2008, to Fannie & Freddie’s nationalization, to Lehman’s final collapse in September. Mr. McDonald’s account, though interesting, adds little to what is publicly known about Lehman’s last days. This may be because he left the firm in March of 2008, shortly after his mentor, Larry McCarthy, had resigned.

Ultimately, Mr. McDonald’s view is that Lehman’s collapse was an unfortunate and totally preventable disaster caused by a failure of leadership. Mr. Fuld, a trader from a different era, used the wrong playbook for the 21st century, and his personality defects (jealousy, arrogance, hubris) prevented him from taking counsel from those who could have helped steer him clear of trouble. He chose to listen to those who flattered him and those who delivered the largest short-term gains, and blinded himself to the risks of leverage.

This is clearly what Mr. McDonald and his colleagues believe happened to Lehman, but is it the truth?

In a narrow sense, yes, since it was Fuld’s specific decisions regarding the real estate and mortgage businesses that led the firm to fail.

But in a broader sense, Fuld is irrelevant. Given the combination of the credit bubble and the availability of cheap, plentiful leverage, along with an asymmetric reward structure (which paid out huge bonuses to managers from profits generated from that leverage but had no mechanism to punish those managers for taking risks that led to bad outcomes), wasn’t Lehman’s outcome inevitable? Doesn’t the fact that all of Lehman’s close peers–Bear Stearns, Merrill Lynch, Citigroup, Bank of America—either collapsed along with it or were saved through quasi-nationalization argue that there is something a little fishy about making Fuld, obnoxious as he was, into the lone gunman in the Lehman homicide?

To take it a step further, what might have happened had Fuld elected to sit out the latter stages of the mortgage securitization and leveraged loan booms? Lehman didn’t have Goldman’s strength in proprietary trading or Morgan’s banking franchise, so the firm’s profit and return on equity would have lagged behind peers. Gasparino and Cramer and the rest of the TV donkeys would have called for Fuld’s head instead of praising his “brilliance” and “toughness.” With a smaller bonus pool and weaker stock, Lehman’s talent would have been easy picking for hyper-aggressive peers like Deutsche Bank and UBS. So why not, in the famously ill-timed words of Citigroup’s Chuck Prince, “keep dancing until the music stops?”

The eagerness of the Street and the media to pin this meltdown, which has ruined millions of lives and cost trillions of dollars, on a couple of old guys (however greedy, vain and stupid they were), rather than on an out-of-control financial system desperately in need of reform, speaks volumes about who creates the narrative in this country, and how much those narrators feel they have to gain by retaining the status quo.

Mr. McDonald has a bit more self-awareness than the average Wall Street trader, but there is a delicious moment of unintended irony when he stops talking, for a moment, about Lehman’s excessive leverage and risk taking, and instead focuses on his own complaint that his bonus for 2007 is inadequate. Mr. McDonald’s trading book generated over $30 million in profits for the year, and, he says, that there was an unwritten rule that every $20 million in profit should generate a bonus of $1 million for the trader. At the same time, he whines, Mr. Fuld and Mr. Gregory took home bonuses of $35 million and $29 million, despite the fact that Lehman’s problems were, by then, becoming apparent (in spite of the excellent reported results for the year ending November 2007).

There is almost too much material in this thought to tease it all out properly. For one thing, where does Mr. McDonald think that all the money came from for him, a junior trader at a relatively poorly capitalized firm (compared with its peers), to generate profits of $30 million? Could it be possible that without the 30-1 or 40-1 leverage that Mr. McDonald decries, there would not have been capital available for him to put on his trades? Or that, without the leverage, the firm would have had to have been much larger for him to have made the same bets, meaning that there would be more mouths to feed besides his own?

For another thing, which is it? Was Lehman doing really well at the end of 2007, in which case Fuld and Gregory (and McDonald) should be entitled to big bonuses, or was it teetering on the brink? By McDonald’s outraged reaction to Fuld and Gregory’s payouts (which were roughly flat with their 2006 bonuses), clearly he thinks that the firm’s published financials did NOT really reflect the firm’s fiscal health, so large bonuses to EVERYONE (Mr. McDonald included) were not appropriate.

The most important questions of all are not even asked in “A Colossal Failure of Common Sense,” or in any other account I have so far seen of the Lehman failure. Simply put, how did Lehman’s published financial statements, as recently as its final 10-Q published in July of 2008, show a positive net worth of $26 billion, when the bankruptcy liquidators are saying that they are looking at a negative net worth of $130 billion?

Put another way, “Why is it that Lehman’s $660 billion balance sheet, heavily weighted in real estate and residential mortgages, experienced no writedowns whatsoever before February 2008, and writdowns of less than 1% of total assets thereafter, in the midst of the largest collapse in value of such assets in recorded history?” And why did Lehman management assert, repeatedly, through the crisis that it had no problem with liquidity or solvency, when clearly it had problems with both? How is it that the sale of preferred equity securities by the firm in April of 2008 was accomplished without revealing that the firm’s assets would soon be revealed to be worth over $100 billion less than its liabilities? Doesn’t any or all this constitute securities fraud? And shouldn’t there be criminal liability for the executives who signed the firm’s 10-K and 10-Q’s, who under Sarbanes-Oxley are responsible for material misstatements made in those documents?

All of these questions may or may not be answered in the fullness of time, once the bankruptcy is concluded. And it will be satisfying, in some sense, if those who knowingly committed securities fraud, if that is what occurred, are brought to justice.

But in a larger sense, books like Mr. McDonald’s, focusing as they do on heroes and villains, rather than on real flaws in how we conduct our financial capitalism, and how we regulate our systemically important institutions, are doing greater damage than what may have been specifically wrought by Mr. Fuld and Mr. Gregory. They promote the myth that, in the end, Lehman is a tale about a few bad apples who screwed up a great bank, rather than about a system run amok, where insiders reaped enormous rewards for creating risks borne by the society at large.