Secrets behind Lehman's collapse
Posted
Sep 01 2009, 08:26 PM
by
Jon Markman
Rating:
When the century-old investment bank Lehman Brothers collapsed a year ago, it spawned not just a global financial firestorm but a cottage industry of insider accounts of where it all went wrong. Three major books have been published and more are on the way -- each proposing to tell us the darkest secrets of the world's worst-run brokerage. (My take on it: New column.)
Any endeavor that pits Type A personalities against each other in a battle for control of the public discourse is bound to be competitive, and one like this in which reputations are at stake will naturally be especially fierce. That makes the effort by Lawrence G. McDonald, a former vice president at Lehman, particularly compelling, as he was first out of the gate.
In a late-night conversation from his vacation in Paris, the former fixed-income trader told me that the book, "A Colossal Failure of Common Sense," took him and co-author Patrick Robinson one hundred and seventy-three 17-hour days to research and write -- including Christmas and New Year's. Not that anyone's counting. Because he was first off the starting line with a publishing contract and a plan, he managed to grab co-workers for interviews "at a golden moment of frustration," he says, a time when they wanted the bad apples at Lehman exposed. The bottom line is about what you'd imagine: An overmatched boss failed to listen to smarter underlings and drove the company into the ground. The details are amazing, which makes the read compelling even if you feel you know the whole story already.
Some critics have complained that a mere vice president was too low on the totem pole to judge the intent and result of decisions made by chief executive and chairman Richard Fuld. But McDonald, now a managing director at hedge fund Pangea Capital, said he managed to get access to eight members of the board's risk committee and 40 managing directors.
McDonald says his research showed that Lehman was rotten at the head, not at the core. He contends that Fuld got off track by trying to diverse the company's longtime focus on fixed-income trading into a lot of complex areas that he didn’t understand, such as credit derivatives. By the end he had created a company that was essentially a $760 billion hedge fund, after accounting for 40-1 leverage. Rather than surrounding himself with strong managers who could inform him about the risks, he favored yes men and bureaucratic hacks that brutally put down dissent among the ranks.
The author is quick with the metaphors; he's got a million of them. "Picture a rocket ship 2,000 feet high, and at top are astronauts in a capsule with 1960s computing gear and brainpower," he said. "Below the capsule is 21st century technology, power, fuel, and all the people in the firm. They had no idea how to control the incredibly powerful machine they had built -- only how to hit the gas pedal."
McDonald said the bullies around Fuld used the corporate equivalent of brass knuckles on the staff, moving people into jobs and regions that they weren't suited for in order to weaken and intimidate them. From 2004 to 2008, he says, the fixed income group -- the source of most income for the firm -- had four chiefs. "That is catastrophic," says the author. "You can get away with that in peacetime but if you do that in rough waters, it's suicidal." No one spent enough time with the teams to know where the risks lay, and how to deal with them in a responsible way as each new guy only wanted to avoid getting fired like the last guy.
In the old days, McDonald says, Lehman was in the "moving business": Let's say Campbell's Soup wants to sell $20 million in bonds to build a new soup-making facility. Lehman underwrites the debt, sells the bonds and takes a fee, such as 1% to 2%. Not much risk involved. Starting in 2004, the company got into what McDonald calls the "storage business": Buying debt itself and making directional bets. By the end, it had 35% of its net tangible assets in three gigantic real estate projects.
Why? McDonald says that Fuld was desperately jealous of two former Lehman executives, Pete Peterson and Stephen Schwarzman, who had gone on to form the private equity firm Blackstone. When Blackstone went public, the two execs became instant billionaires. The deal that captivated Fuld's greed, he says, was their purchase of Equity Office Properties; although it was done at the top of the market, the pair managed to make a bundle by reselling it in pieces. Fuld said to his commercial real estate chief: "You missed EOP, you missed MetLife Stuyvesant (another big project), don't miss the next one.' That was the beginning of the end. Fuld was jealous with a capital J."
You can read the book to read the rest of McDonald's tale of how the company toppled from the peak, but the key takeaway is this: Government regulators must take steps to ensure that board of directors are truly independent of company management, starting with a ban on chief executives becoming board chairmen.
"The board was in his back pocket, they were handpicked by Fuld and they were just blind: A navy admiral, an actress, a Broadway producer, it was just a 'yes' committee," says McDonald. "Not once did they ask risk managers for advice on whether they should allow Fuld to take the steps that led the company to ruin. They let him take all of our profits from 2003-2006 and machine-gun them around the world to buy into a global asset bubble. People inside the company begged him to stop, but he didn't allow their concerns to reach the board. He silenced them."
You might imagine that this could never happen again, but trust me: It will if the industry manages to block steps to rein in its power, as it has so far. It's a good book. Check it out.
Jon Markman is a weekly columnist at MSN Money. He also provides investment guidance to individuals and institutions through his daily Strategic Advantage and weekly Traders Advantage services, as well as through managed accounts at Markman Portfolios.
