Lehman in retrospect

A Colossal Failure of Common Sense:  The Inside Story of the Collapse of Lehman Brothers
by Lawrence G. McDonald
(Crown Business, 2009, 368 pages)

With the Lehman Brothers remembrance show having just passed, there has been a flood of books on the global financial crisis, largely falling into two camps.  In the first camp are books written mainly by academic economists that provide a rigorous and systematic look into the causes and consequences of the crisis.  In the second are the more journalistic accounts that provide a narrative with a strong emphasis on the personalities, meetings, and decisions made during the crisis.

Like William Cohan's House of Cards and David Wessel's In Fed We Trust, Lawrence G. McDonald's Colossal Failure of Common Sense falls into the second camp, turning the complex sub-prime shenanigans of Wall Street investment banks into high drama.  McDonald was a vice president of high-yield debt and convertible securities trading at Lehman from 2004 until March 2008 when he was summarily executed by Lehman's corporate firing squad.

McDonald begins his book with a prologue outlining the government interventions he believes to have been primarily responsible for the financial chaos of 2008.

The first being the various policies initiated by the Clinton administration and continued under George Bush to increase home ownership amongst low-income folks by "threatening, sometimes berating, sometimes bullying" lenders to provide mortgages to people with traditionally poor credit histories.  McDonald specifically mentions the Community Reinvestment Act as a culprit and remarks that "Easy mortgages were the invention of Bill Clinton's Democrats".

The second is repeal of the Glass-Steagall Act of 1933, the depression-era legislation that separated commercial banking from investment banking.  McDonald argues that Glass-Steagall was crucial in preventing "some diabolical investment house from plunging in big on a corporation like Enron and going down with a zillion dollars of small depositors' cash".  And that its repeal was "directly responsible for bringing the entire world to the brink of financial ruin".

Whilst I am sympathetic of the first point, I am less so of the second which seems to be a common view held by economic commentators.  The major financial institutions that failed during the crisis were pure investment banks, such as Bear Stearns, Merrill Lynch and Lehman Brothers;  or they were pure commercial banks, like IndyMac, Washington Mutual and Wachovia.  The only exception is Citigroup, which was formed from a merger between Citicorp and Travelers Insurance (a large company that owned the investment bank Smith Barney) that happened before the repeal of Glass-Steagall due to a special exemption.

Not to mention the fact that JP Morgan and Bank of America would not have been able to save Bear Stearns and Merrill Lynch respectively had it not been for the repeal of Glass-Steagall.  Further, the economic research on Glass-Steagall doesn't support McDonald's view either.

Nonetheless, the book does not pretend to be an academic text on the crisis.  Its subtitle promises "the incredible inside story of the collapse of Lehman Brothers."  But it should really be called "An Autobiography of Larry McDonald", as the first three chapters are devoted to his life story, including his pre-Lehman days.  We learn, for example, that he was once a pork chop salesman, that his mother was a fashion model and that his father liked to play golf.

When McDonald finally gets around to Lehman, we are introduced to the likes of Mike Gelband, Alex Kirk and Larry McCarthy who were Lehman's global heads of fixed income, high-yield trading, and distressed-debt trading respectively.  (McDonald worked for, and admired these men greatly, painting them as geniuses and heroes who foresaw the impending subprime crash.)  McDonald writes:

Each and every one of them laid it out, from way back in 2005, that the real estate market was living on borrowed time and that Lehman Brothers was headed directly for the biggest subprime iceberg ever seen, and with the wrong men on the bridge

The "wrong men" of course refer to Richard Fuld, Lehman's CEO and Chairman, and Fuld's right-hand-man, Lehman's President, Joseph Gregory.

McDonald portrays Fuld and Gregory as out-of-touch, the two of them closeted up in their own little world on the 31st floor.  McDonald admits that he has never actually met the reclusive Fuld, which is not so uncommon for a vice president, but he then reveals that his boss, a managing director, has not once met Fuld either.  Inevitably what readers are fed are mainly second-hand anecdotes from uncited sources, presumably colleagues.  And the picture that McDonald paints is not a pretty one:  Fuld comes across as reckless, aggressive, arrogant, and wilfully ignorant.  Although he was not so ignorant of McDonald's book.  Speaking with a Reuters reporter, Richard Fuld called the book "absolutely slanderous".  In Fuld's defence, McDonald's writing can often be melodramatic and over-the-top.  At one point, McDonald wondered "if we three [McDonald, McCarthy and Kirk] alone stood square against the forces of evil."

In a telling scene, reminiscent of Bud Fox's "How much is enough speech" in Oliver Stone's Wall Street, Kirk engages in a heated exchange in Gregory's office.  Gregory was eager to take on more risks while the subprime crisis was well underway in 2007.  "Where's the number?" Kirk roared, "We tried twenty times leverage that didn't work.  So we tried thirty times leverage and that didn't work either.  Now we've tried forty times and that won't work.  Well what's the number?  What will make you happy?  One hundred times?  One thousand times?  Where does it end?"  Shortly after, Kirk resigned.

According to McDonald, Fuld once told Madelyn Antoncic, Lehman's chief risk officer who was internationally voted the 2005 Risk Manager of the Year to "shut up" at a meeting.  And it was custom at executive committee meetings for the risk chief to be asked to leave the room when there was a major deal being discussed.

McDonald's book, like so many other journalistic accounts, focuses on the people and the personalities, the heroes and the villains.  Sure one could say that Lehman's collapse was caused by reckless risk-taking and a failure of common sense.  But that doesn't get us very far.

What's more telling is that on being asked by Representative Peter Welsh at a congressional hearing:  "Why were you allowed to fail?"  Fuld replied:  "Until the day they put me in the ground, I will wonder.  I do not know why we were the only one".

Fuld was expecting that "in the end, come what may Hank would save both him and Lehman Brothers" -- as if his firm were too big to fail.

The press assemble in front of Lehman Brothers on 16
September 2008, the day the bankruptcy filing was announced.