Too Big To Fail

Timothy Geithner, the president of the New York Federal Reserve, had helped put together the Bear Stearns deal, and on April 3, 2008, he was going to explain this to the Senate Banking Committee and the world. He planned to stress that Bear Stearns “was a symptom of a much larger problem confronting the nation’s financial system” (58). For years, Geithner had expressed his concerns:

Geithner […] warned that the explosive growth in credit derivatives—various forms of insurance that investors could buy to protect themselves against the default of a training partner—could actually make them ultimately more vulnerable, not less, because of the potential for a domino effect of defaults (60).

However, “no amount of studying or preparation could have equipped him to deal with the events that began in early March 2008” (65).

Paulson’s deputy, Robert Steel, was also going to testify before the Senate Banking Committee on April 3. He knew he would be asked about the government’s role in the Bear Stearns negotiations, and he knew he “had to dodge that issue” (67). He also expected Senators Richard Shelby and Jim Bunning to be difficult. Sure enough, the “fireworks started almost immediately” (69), with a question from Senator Christopher Dodd about whether the government had bailed out Wall Street insiders while those on Main Street struggled. Bernanke explained that the idea was to protect the American economy, not anyone on Wall Street. Steel then responded to the expected question about the negotiation of the $2/share price for Bear Stearns. Although the questioning did not prove immediately successful, the event set the stage for the public:

In the end, the day’s testimony produced no smoking guns, no legendary exchanges, no heroic moments. But it introduced to the American public a cast of characters it would come to know very well over the next six months, and it provided a rare glimpse into the small circle of players that sits atop the world of high finance, wobbly though it may have been at the time (77-78).

Those testifying at the hearing held their own “largely by defending the Bear bailout as a once-in-a-lifetime act of extreme desperation, not as the expression of nascent policy” (70). They also painted it as something they “had to do for the good of the entire country, if not the world” (70). Dimon decided to have an analogy ready: “Buying a house is not the same as buying a house on fire” (71). His job was to protect his shareholders, not the US taxpayer. He was asked whether JP Morgan had, “realizing the leverage it had, driven an excessively hard bargain with the government, at taxpayer expense” (77). He responded that if the “private and public parties before you today had not acted in a remarkable collaboration to prevent the fall of Bear Stearns, we would all be facing a far more dire set of challenges” (77). However, Senator Bunning, who the hearing attendees expected to be critical, was “prescient” in his criticism of the deal, which he characterized as “socialism” (78). He asked what would happen “if a Merrill or a Lehman or someone like that is next” (78).

At a dinner with Paulson marking the end of the G7 summit, Fuld wanted to “impress upon the secretary the seriousness of his efforts and to gauge where Lehman really stood with Washington” (79). Before the dinner, Paulson told Fuld he was worried about a “new IMF report estimating that mortgage- and real estate-related write-downs could total $945 billion in the next two years” (81). He was also worried about the “staggering amount of leverage” investment banks were “using to juice their returns” (81). In fact, at a dinner the previous year, the CEO of Citigroup had asked him, “Isn’t there something you can do to order us not to take all of these risks?” (81). Fuld told Paulson that something should be done about short-sellers. At the same time, Paulson hinted that Fuld might want to start thinking about selling the entire firm. Later, as each dinner guest spoke, “the perilous state of the economy became ever clearer” (82).

The next Tuesday, former investment banker Neel Kashkari and former academic Phillip Swagel met with Paulson and Ben Bernanke about a plan they had developed for “what to do in the event of a total financial meltdown” (83). They presented the pros and cons of the plan and several other alternatives: “The meeting ended with no resolution except to take the plan and put it on the shelf until—or unless—it was needed” (92).

Meanwhile, Bob Diamond, the chief executive of Barclays Capital in London, who had attended the Treasury dinner, heard from another attendee, Bob Steel. Steel asked if he might consider buying Lehman, which left Diamond “momentarily speechless” (94). Barclays was looking to increase its US presence, so this could present a good opportunity. Barclays had already been in talks with UBS to purchase its investment banking franchise, but Lehman was in a “different league” (95). Diamond considered this “something to think about” (95).

Fuld called CNBC’s “blustery market guru” Jim Cramer to a meeting, hoping that Cramer might be “an ally in his struggle against the shorts” (96). He found Cramer to be “a receptive audience” (97). However, Cramer wanted to take an approach contrary to what Fuld thought was best, so he decided “any alliance with Cramer could only be problematic” (99). Cramer, too, “made it clear that he wasn’t prepared to go out on a limb and back Lehman’s stock unless he had more information” (99-100). He suggested that Lehman go to the SEC, but Fuld grew “increasingly agitated” (100) and asked Cramer who was telling him negative things about Lehman. Cramer told him, “I do my own work” (100), and that his work told him that Lehman needed cash.

In mid-May, hedge fund manager David Einhorn, known for his “patient, cerebral approach to investing” (100), was about to give a speech at an investment conference. His firm, Greenlight Capital, “did not use leverage, or borrowed money, to boost its bets” (100). He had identified Lehman as a business he could potentially short, and he decided to speak about that. He had already been worried about Lehman the previous summer, when he saw that a major French bank had frozen its money market funds. He had his analysts do a “crash investigation of financial companies that had big exposure to the world of securitized debt” (101), and they came up with 25 companies, including Lehman. He thought Lehman was “overly optimistic” in its September earnings conference call and that it was “not being forthcoming about a dubious accounting maneuver that had enabled it to record revenue when the value of its own debt fell” (102). Six months later, in the March earnings call, he was “baffled” to hear Lehman offer an “equally confident prognosis” (103). A new accounting rule in 2007 required banks to “write down” illiquid assets when the market in those assets went down, but “no one ever wanted to write down the value of his assets” (103). Einhorn wanted to know how often Lehman wrote down its assets, but Lehman gave conflicting answers, with one person suggesting daily and another suggesting quarterly. Einhorn counted this discrepancy as “one more point against the firm” (104). By late April, he was criticizing Lehman publicly, with Lehman staff becoming increasingly hostile to him.

Einhorn’s speech at the conference in May was scheduled for after the markets closed because he had enough influence to “easily rattle the markets, especially Lehman’s shares” (105). He had previously come under SEC scrutiny after he gave a speech critical of the accounting methods used by private-equity firm Allied Capital, and its stock fell 11 percent the next day. In his speech, he compared Lehman’s accounting to that of Allied. He “made it clear that he felt the evidence suggested the firm was inflating the value of its real estate assets” and that it was “unwilling to recognize the true extent of its losses for fear of sending its stock plummeting” (107). He ended his speech by saying he hoped that Cox, Bernanke, and Paulson would “pay heed to the risks to the financial system that Lehman is creating and that they will guide Lehman toward a recapitalization and recognition of its losses—hopefully before federal taxpayer assistance is required” (107). “Within minutes” (108) of the end of his speech, news of it had spread, and Lehman shares took a hit the next day. Ironically, Lehman had been a patron sponsor of the conference.

On June 3, Fuld was furious that the Wall Street Journal headline read “Losses Push Lehman to Weigh Raising New Capital” (109). His “secret plan” to shore up the firm had leaked, putting “all that effort in jeopardy” (109). Following Einhorn’s speech, this was “yet another public relations disaster” (109). Fuld forbade anyone at the firm to speak to the Wall Street Journal. Erin Callan was believed to be the leak, but Fuld was unwilling to consider firing her.

Fuld’s secret plan involved an investment by a Korean bank, but the talks did not go well from Lehman’s perspective. They left without a deal. Meanwhile, Matthew Lee, a senior vice president in Lehman’s finance division, had written a letter to senior management claiming to have “uncovered a series of accounting and management problems at the firm” (116). This potential “whistle-blower” had uncovered something even Fuld did not know: Lehman was “artificially lowering its quarterly leverage ratio by using an accounting sleight of hand” (116). The company was essentially classifying repurchase agreements as sales, making it appear that their leverage was lower than it was. This was an “open secret” (116) in some parts of the company, but others were uncomfortable with it. The company fired Lee, who had agreed to a gag order.

At the same time, Lehman’s head of operations, Skip McGee, had been having “deep misgivings about the way the firm was being managed” (117). He viewed Joe Gregory as a liability, but Fuld refused to consider getting rid of him. Others, however, found Gregory’s “portfolio of responsibilities” (121) objectionable. He was Fuld’s “unquestioning confidant” and the firm’s “in-house philosopher king” (121). He also seemed to “revel in moving people around, playing chess with their careers” (122). Moving Erin Callan to CFO had been his “greatest experiment to date” (122). However, Gregory could also be “ruthless, given to angry, impetuous decisions” (122), and a “growing contingent of Lehman executives had begun to view Gregory as a menace” (124). Gregory was also pressuring others to take on more risk, when they thought Lehman was already taking on too much. Michael Gelband, the head of fixed-income training, left the firm over it.

Lehman had a well-regarded chief risk officer, Madelyn Antoncic, but “her input was virtually nil” (124), and she was often excluded from executive committee meetings and eventually removed from the committee completely, in late 2007.

After Lehman reported a loss of $2.8 billion in the second quarter of 2008, rumors began to spread that Gregory and Callan were going to be fired. And, in fact, 15 traders had recently met to discuss how they could pressure Fuld to fire Gregory. At a meeting with Fuld that included Gregory, McGee again said that the firm needed to “make a management change,” but no one backed him up, and others stressed the importance of “teamwork,” with Gregory saying that they needed to “stop all the Monday-morning quarterbacking” (128-29). McGee expected to lose his job. Having heard about the meeting, Callan thought she might be the one to lose her job.

On June 11, Fuld met with McGee and the investment bankers, who again called for management changes. Fuld would not commit to firing Gregory, but when Fuld returned from the meeting, Gregory offered to step down. Gregory also asked Callan to step down, and she agreed (though both Gregory and Callan stayed on Lehman’s payroll in other roles). Of course, Lehman had previously denied the rumors that they would be fired, so its credibility took a hit.