naked capitalism

By Arthur Doyle, a former managing director of Lehman Brothers who now manages a hedge fund.

I didn’t come to Joseph Tibman’s The Murder of Lehman Brothers expecting a blow-by-blow insider’s account of the financial meltdown of 2008. That ground has been covered adequately by, among others, Andrew Ross Sorkin in Too Big To Fail.

Frankly, I didn’t really even expect a blow-by-blow of what led Lehman to fail. That may seem a surprisingly low expectation for a book subtitled “An Insider’s Look at the Global Meltdown,” which has been authored by a senior banker who spent his career at the firm. But I myself was a managing director at Lehman Brothers until the summer of 2008, and yet if you asked me to tell you what really happened, I couldn’t.

Of course, plenty of people at Lehman, if you asked them “what happened?” would give you an answer. They’d say, “Paulson hated Fuld’s guts,” or “Fuld ran the company into the wall,” or “Mark Walsh made a bad real estate bet.”

But while each of those statements may be true, none of them, at least to me, really answers the question: “What happened?” Or, at least, what I mean when I ask the question, which is really: “Trace for me the series of events that led a profitable investment banking and trading franchise to become so overleveraged and loaded with bad assets that, at the end, the bankruptcy specialists estimate that it had a negative net worth far in excess of $100 billion. Who OK’d the decisions that led to that outcome? How many people were privy to the bank’s disastrous situation, and what did they do once they learned of it? Who was complicit in the decisions that were made in Lehman’s final months regarding the representation of the company’s financial position to investors, regulators and trading partners, some of which (given the disparity between the firm’s published statements and ultimate worth in liquidation) surely amounted to outright fraud?

I was pretty senior at Lehman, and yet I have no idea how to even begin to answer any of these questions. And neither does Mr. Tibman, who, unlike me, worked in investment banking rather than trading. Nor would I expect him to.

What I did expect to find in Mr. Tibman’s narrative was a human drama, an account of how it felt to work at Lehman as the unthinkable happened. Mr. Tibman, at Lehman since the dark days under ownership by American Express, and through the harrowing days following 9/11, seemed well positioned to tell that story.

Unfortunately, except for a few brief glimpses, that is not the story we get. Tibman, with the innate caution of a veteran I-banker, feels that “maintaining his viability for future employment” requires him to use a pseudonym. It also requires him to omit most of the personal details of the people with whom he worked and what, if anything, he witnessed personally of the events related to Lehman’s fall

Of course, this is Tibman’s prerogative, and you can’t blame a man for trying to avoid pissing off people who might be future employers. But you have to ask yourself… why exactly did Tibman choose to write this book? It certainly wasn’t to settle any scores. With a (very) few exceptions, Tibman treats all the principal characters in the drama with kid gloves. The shots he takes (at Fuld, for being out of touch; at COO Gregory, for being obsessed with growth; at Paulson, for being inconsistent in his bailout strategy) are gentle, and have been, by now, taken by dozens of others. Girl-wonder Erin Callan is revealed to be, though brilliant, perhaps a tad out of her depth as CFO. Gee, d’ya think? More than a year after hedge fund manager David Einhorn turned Callan into mincemeat over discrepancies between statements she made in the March 2008 conference and details which appeared weeks later in the firm’s 10-Q, this hardly counts as news.

Tibman does seem interested in making sure we know that Lehman’s investment banking division was, and I’m paraphrasing here, “totally awesome.” They were smarter and more creative and faster and harder working than everyone else’s investment banking division. And, unlike their competitors, they had high ethical standards. Sure, Tibman knows that he and his colleagues weren’t performing charity work, but “Lehman was not Bear. Bear (were) aggressive, messy bankers without any sort of standard. All investment bankers are whores. But they were the cheapest of streetwalkers…when we poached Bear bankers, well, we had to bring them to heel like junkyard dogs that did not know how to behave.” In contrast, at Lehman, “at least in the context of investment banking, we wanted…to behave with a meaningful semblance of ethics and good corporate citizenship.”

Cue the gag reflex, though I’ve never worked in investment banking so for all I know this could be true. And Tibman seems genuine, on this one subject. In a passage describing that awful weekend when it became clear that Lehman was going to file for bankruptcy, he conveys a sliver of what it must have felt like to walk in his wing-tipped shoes. Speaking to those of us who think of investment bankers as “a hoard of spoiled, greedy assholes,” he asks us to suspend all predispositions and “think only of what it means to be marginalized, a laughed-about underdog…then you experience something of great magnitude, like 9/11…and from that experience a bond develops that propels you with purpose. You (then) succeed beyond all expectation. Once maligned, you are now…surpassing all goals that you have set for yourselves. And then a very few make some very poor decisions, and the glorious landscape that…you have worked at for a very many years simply falls like light timber through a backyard chipper.”

OK, so now that I read the last bit over, it is perhaps a bit more cringe-worthy than it originally seemed, particularly the part about the transformative effect of 9/11 on Lehman’s place in the I-banking Lead Tables. Then again, as Tibman says, if you weren’t there, you couldn’t possibly understand.

My real objection to Mr. Tibman’s line of thinking—and this applies equally to the thinking of Lawrence McDonald, whose book, A Colossal Failure of Common Sense, I reviewed several months ago—is that the idea that Lehman was made up of a great collection of businesses but was ruined by a few stupid actors is nonsense. You cannot separate one part from the whole. Without Lehman’s highly leveraged, hugely risk-taking trading operation, Mr. Tibman’s investment banking business could never have existed—certainly not on the scale it grew to in its last several years of existence. Leaving aside the fact that Lehman’s costly distribution (trading) and research operations was a primary reason Tibman and his friends were able to win so much business, there’s also the fact that without the profits from the trading business (well over $4 billion per year in LEH’s last several years, more than 5x the profits of the investment banking business), the company couldn’t have gone on the spending spree which enabled it to poach top bankers from its competition.

And where did the trading operation’s huge profits come from? Was it from brokerage commissions on stock and bond trades executed on behalf of customers? Ha. Principal transactions (aka “proprietary trading”), that is, trading for the firm’s own account, accounted for nearly 75% of the trading division’s revenues during the firm’s last three full years of operation. Brokerage commissions accounted for just over 12%, while net interest margin accounted for the rest.

So Lehman Brothers, with a $691 billion balance sheet, sitting atop a $22.5 billion capital base (both figures from the 2007 10-K) was essentially running a giant proprietary trading operation with a decent-sized investment banking operation attached. I’ll resist the easy comparison to the Soprano family’s use of Satrialli’s Pork Store to distract attention from where the real action was, but you get the point. You could call Lehman a $22.5 billion hedge fund, except that very few hedge funds of that size (or any size) operate at a leverage ratio of greater than 30-1—and certainly not hedge funds whose balance sheets were loaded with massive, risky and illiquid assets.

So, yes, it is unfortunate that Mssrs. Fuld & Gregory, who were the primary managers of the Lehman hedge fund, made so many bets that turned sour in 2008. But those bets weren’t some afterthought that ruined an otherwise great firm. By 2008 (actually, by several years earlier than 2008), those bets essentially WERE the firm. They were the life blood that generated the revenue for the $9 billion of annual compensation that Lehman paid out to its professionals. And, like any hedge fund, the managers took their cut (49.3% of revenue went toward compensation, typical for Wall Street) every year—but never had to pay any back in years when returns when negative. At least traditional hedge funds have high water marks (provisions that require managers to earn back any losses from prior years for limited partners before paying incentive fees to themselves). On Wall Street, after a bad year, the firm starts fresh. In fact, it pays out billions in bonuses even in a losing year, so as not to “lose talent to the competition.”

It has now been over a year since the Lehman implosion. In the intervening period, the capital markets have come roaring back. Meanwhile, the real economy, though it is getting worse at a slower pace, is still in its worst shape in a generation. The economic and psychic toll on the country from the crisis has been vast. The recapitalization of the financial system, whose costs are being overwhelmingly borne by the public through bailouts as well as by the steepest yield curve in decades, will take years and extract a continued price from consumers and businesses throughout the economy. Despite this, it appears increasingly unlikely as time goes on that any meaningful reform will be instituted to protect the public from what Simon Johnson so aptly refers to as the “rent-seeking behavior of the financial sector.”

Mr. Tibman’s book, like so many of the books written about the crisis in 2009, bears its share of responsibility for this state of affairs. By spinning narratives that deflect attention from the activities and circumstances most responsible for the crisis, and by indulging the human instinct to blame the failure of complex systems on individual bad actors rather than on the rottenness of the whole, we increase the likelihood that similar crises will return sooner and with greater severity than would otherwise be the case.