UNCONTROLLED RISK
THE LESSONS OF LEHMAN BROTHERS AND HOW SYSTEMIC RISK CAN STILL BRING DOWN THE WORLD FINANCIAL SYSTEM
By MARK T. WILLIAMS
The McGraw-Hill Companies, Inc.
Copyright ©2010 The McGraw-Hill Companies, Inc.
All rights reserved.
ISBN: 978-0-07-163829-6
Contents
AcknowledgmentsChapter 1 The InquisitionChapter 2 From Humble Roots to Wall Street ContenderChapter 3 From Private to PublicChapter 4 History of Investment BankingChapter 5 How the Investment Banking Money Machine WorksChapter 6 The Roller-Coaster 1980sChapter 7 The 1990s: Rebuilding YearsChapter 8 Lehman’s Near-Death ExperienceChapter 9 Innovation, Imitation, and Increased RiskChapter 10 Lehman’s Risk ManagementChapter 11 The Real Estate Bet and the Race to the BottomChapter 12 The Bear MaulingChapter 13 Time Runs OutChapter 14 The Death of Lehman, Regulation, and Investment BankingChapter 15 The Enablers and the DecidersEpilogue: The Post-Lehman Financial LandscapeAppendix: Lehman Chronology, 1845–2010NotesIndex
Excerpt
CHAPTER 1
The Inquisition
After a month of financial turmoil that rocked the world, it was time foranswers. October 6, 2008, signified a dramatic change in circumstances forlegendary Wall Street firm Lehman Brothers and its once lionized leader, DickFuld. Now it was time for the disgraced former CEO to face the music as he satbefore the U.S. Congress. The American people were outraged that Wall Street hadhijacked Main Street, causing a global economic collapse and financial harm tocountless individuals. President Barack Obama characterized it as “wild risktaking” on Wall Street. Now California Congressman Henry Waxman, chairman of theU.S. House Committee on Oversight and Government Reform, was charged withexacting some form of revenge. CEO thievery from the economy would no longer bepermitted.
On this autumn day, Fuld found himself suddenly thrust into unfamiliar andunfriendly surroundings. No longer was he in the comfort of Lehman Brothers’clubby midtown headquarters in New York where his word was law. The officialpurpose of this hearing, which aired live on CSPAN, was to determine how Lehmanfailed. However, the real reason became readily apparent as soon as Waxmancommenced with his opening remarks. He wasted no time in putting Fuld on the hotseat, holding him singularly responsible for the fall of Lehman, the loss ofjobs, and the significant financial losses sustained by shareholders andbondholders. Justly or not, Fuld would be the fall guy, put on stage tosymbolize what was wrong with Wall Street.
In this unfriendly spotlight, Wall Street’s longest sitting investment-bankingCEO now appeared confused and guilty of massive wrongdoing. His hunched posture,grim-faced expressions, and defensiveness seemed like further evidence of hisguilt. Most of the public believed he deserved his comeuppance. And why not?Conventional wisdom accused Lehman of creating toxic mortgage-backed securitiesand selling enough of them to make the entire financial system sick. Someoneneeded to be held accountable. But weren’t there other firms on Wall Street thathad employed similar practices?
Proposed by a Republican senator and signed into law under a Democraticadministration, the 1999 repeal of the Glass-Steagall Act surely influenced thelevel of wild risk taking. Shouldn’t the politicians and the former FederalReserve (Fed) chairman who advocated the repeal of this Depression-eralegislation be held at least partially accountable for what happened? Where werethe financial regulators charged with protecting the safety and soundness of ourbanking system? During the last two decades “regulation-light” was the mantra.Banks overdosed on risk not overnight but over time as regulators andpolicymakers watched. There were other watchdogs that did not bark. Why wasn’tLehman’s accountant able to detect the firm’s deteriorating financial health?The bulk of financial journalists missed this growing storm cloud as well.Lobbyists played their role by doing what they do best—turning money intoinfluence. The credit rating agencies that investors depended on to provide anindependent seal of approval failed as bond ratings that appeared to be AAAquickly sank to junk.
Then there was the House Financial Services Committee, a committee whose mainresponsibility was oversight of the banking industry. Its chairman, CongressmanBarney Frank, claimed no accountability for the Great Credit Crisis of 2008. Heargued that compensation practices contributed to excessive risk and thatcompany boards and CEOs failed at their fiduciary duties because they werecombined at the hip.
Granted, there were deficiencies in corporate governance and compensation. Butwas it really so simple, or was there also political deflection? Years ofvarious congressional policies led to the conditions that made the crisispossible. Government support of the U.S. mortgage industry pumped trillions intoa market that grew out of control from a policy of greater home ownership,artificially low interest rates, lax lending standards, and securitization.Since 1984 and the multibillion-dollar bailout of Continental Illinois Bank, theU.S. government had sporadically supported a “too big to fail” doctrine that didnothing to discourage large and interconnected firms from increasing risk. Sucha policy created “moral hazard” by encouraging financial institutions to takemore risk than they would if they were not backstopped by the government. Mostpeople undoubtedly assumed that Lehman fell into this category, yet the U.S.government made the phone call to the board telling them to file for bankruptcy.And how could Lehman be held responsible for the systemic risk unleashed afterits demise? Lehman didn’t opt for bankruptcy.
Referring to the ripple effect that occurs when one institution’s failurerapidly affects counterparties, systemic risk is the very concept thatunderscores the too big to fail doctrine. The overarching theory holds that thefailure of one big bank can bring down the entire financial system. At the end,by not backstopping a Lehman partnership, the U.S. Treasury and the Fed testedthis theory, with fairly disastrous results. It turned out Lehman was a centralcog in an interconnected global financial wheel. In Fuld’s mind, Lehman was moreof a victim than a culprit.
“THE PERFECT STORM”
The hearing lasted for almost five hours, with Fuld responding to sharpcriticism from a hostile panel. As part of the public spectacle, Fuld wasallowed to read a prepared statement into the congressional records. Hisstatement was thirteen pages in length and could have been aptly titled “ThePerfect Storm.” Using a deliberately monotone voice, Fuld indicated there was a”storm of fear” on Wall Street. He implied that Lehman had been a boat in aturbulent sea with many destabilizing factors and some navigation errors hadoccurred. But in reality this storm of storms was much larger than anyone hadpredicted. Lehman was just the unfortunate investment bank that hit the rocks.As the captain, he took “full responsibility” for the wreck but spent most ofhis time listing all the maneuvers attempted to avoid the rocks.
Fuld insisted he did all he could to protect the firm, including closing downthe mortgage origination business, reducing leveraged loan exposure, decreasingcommercial and residential loan exposure, reducing firm leverage, raisingadditional capital, making management changes at senior levels, cutting backexpenses, seeking a merger partner, and encouraging regulators to clamp down onabusive short-selling practices. All this tacking and jibing was to no avail.Fuld also chastised the Fed for not responding to Lehman’s distress signalquickly enough and not launching a timely emergency rescue to shore up marketconfidence in the overall financial system.
Then Fuld placed blame on the opportunistic pirates, the naked short-sellers whospread false rumors, shorted Lehman stock, and walked away with vast profits.Additional blame was placed on the Securities and Exchange Commission (SEC) forlifting short-selling restrictions that would have provided Lehman safe harborduring the financial storm. Fuld concluded his statement by focusing on the needto revamp the existing Depression-era system of banking regulation to meet themore complex needs of today. And while many of his points were valid and worthyof further analysis, the committee was more interested in drawing attention tohis oversized compensation.
Wasting no time, Waxman quickly highlighted the approximately $500 million incompensation Fuld had pulled out of Lehman during an eight-year period. Thecongressman proceeded to zero in and pepper Fuld with such pointed questions as”Is it fair, for a CEO of a company that’s now bankrupt, to make that kind ofmoney? It’s just unimaginable to so many people.” In case the picture was notvivid enough, Waxman added, “While Mr. Fuld and other Lehman executives weregetting rich, they were steering Lehman Brothers and our economy toward aprecipice.” Although Fuld attempted to answer Waxman’s questions and those ofother committee members, on numerous occasions he was interrupted or entirelycut off. Fuld was not on stage to answer or debate important risk managementquestions—he was there only as political fodder. And why should they showdeference? Fuld was the CEO of the largest bankrupt company in U.S. history.
The fall of Lehman was complex and could not be boiled down into 30-second CSPANsound bites. In Fuld’s opinion, it was a confluence of events, a litany of badjudgment combined with bad luck—but not unbridled greed. As the hearingprogressed, Fuld responded to several questions by providing financiallytechnical and lengthy explanations. Most committee members were not in the moodto receive a lecture on the complexities of financial markets and werefrustrated by Fuld’s demeanor. John Mica, Republican congressman from Florida,injected levity to the proceedings by saying, “If you haven’t discovered yourrole, you’re the villain today, so you’ve got to act like the villain here.”
On the same day, other experts in the financial markets were wheeled in beforethe committee to opine on why Lehman failed. One expert, Luigi Zingales, aprofessor from the University of Chicago, felt the firm’s use of aggressiveleverage, emphasis on short-term debt financing, bad industry regulation, lackof transparency, and market complacency due to several years of juicy earningswere the root causes. Zingales indicated that mortgage derivatives wereevaluated on historical records, and firms had subsequently failed to factor inan ahistorical decline in lending standards and fall in real estateprices. He also pointed out that the mortgage-backed securities market in whichLehman participated was bankrolled by quasi-governmental agencies, includingFreddie Mac and Fannie Mae. In his concluding remarks, Zingales suggested that”Lehman’s bankruptcy forced the market to reassess risk.” Although only anabbreviated three-page testimony, it was a thoughtful assessment and deservedmore committee attention. But the sport of the day was roasting Fuld. A crashcourse in how risk management worked (or did not work) would have to be left forlater.
For Fuld, sitting in front of his accusers must have been a surreal experience.The circumstances leading up to and following the demise of his firm werenothing short of remarkable. Only six months prior, Lehman was one of the mainplayers that made Wall Street tick. The Lehman bond indexes were the goldstandard of the investment management industry—relied on by managersaround the world. It had been one of the country’s elite five stand-aloneinvestment banks. Yet, as Fuld spoke into the microphone that October day, noneof the elite five—Goldman Sachs, Morgan Stanley, Merrill Lynch, LehmanBrothers, or Bear Stearns—were left standing. The industry he had workedso hard to shape and nurture was gone. Goldman Sachs and Morgan Stanley, undersevere duress, had recently gained bank-holding company powers; Merrill Lynchhad been purchased by Bank of America; Lehman Brothers had failed; and BearStearns had been taken over by J.P. Morgan Chase.
To Fuld, Lehman was more than a job. Fuld had started at Lehman almost right outof college. He called himself a Lehman lifer. Fuld was proud—”damnproud”—he was not at Goldman Sachs. Lehman had its own unique culture. Whydidn’t these congressmen understand this? Yes, Fuld was once a billionaire, buthe was part of the American dream, a success story. It was true that through theyears, as Lehman’s wealth grew, so did Fuld’s. He had houses in posh places suchas Greenwich, Connecticut, West Palm Beach, Florida, and Sun Valley, Idaho, butit was customary for Wall Street titans to have trophy homes. Why didn’tWaxman’s committee look at the firm value created over Fuld’s long career?Unlike other recent well-documented failures such as Enron or Worldcom, Lehmanhad real earnings. Prior to the “Perfect Storm,” Fuld had created, rather thandestroyed, vast amounts of shareholder wealth. These billions in earnings hadresulted in multimillion-dollar payouts to bankers who in turn paid taxes andhelped fill the U.S. Treasury’s coffers.
With Fuld at the helm (prior to recent events), shareholders had been rewardedwith an impressive annual return on equity of more than 24 percent. Did thecongressmen not understand the importance of the investment banking industry?Investment banks were the gatekeepers of capital flow in our economy. Investmentbanking helped to build this country, and Lehman had played a vital role. Duringthe past 158 years, when the U.S. government needed to raise capital in times ofwar and peace, Lehman was there. And this ability to raise capital fostered thegrowth of many major corporations. Lehman helped take companies like SearsRoebuck and Campbell Soup public. What, for God’s sake, could be more apple piethan that?
FULD’S TRACK RECORD
Under Fuld’s term as CEO, Lehman’s empire stretched the globe with more thansixty offices spanning twenty-eight countries. After the spin-off from AmericanExpress in 1994, annual earnings increased from $75 million to more than $4billion. The Lehman army grew from less than nine thousand employees to morethan twenty-eight thousand strong. By 2007, Lehman’s assets exceeded $690billion with equity of more than $28 billion. Management and staff believed inLehman. Employees were the single largest shareholders, owning 30 percent of thefirm’s stock. At the apex of Fuld’s career, he was praised as an intense andcapable CEO. Regardless of market turbulence or executive infighting, he alwayslanded on top. He had proven he was a survivor.
Yet Waxman’s committee seemed to disregard these accomplishments. War wasdeclared on Wall Street on October 6, 2008. As the day progressed, Fuld becameirritated as the focus remained on his compensation, ignoring the fact that hewas the single largest shareholder. He repeatedly reminded committee membersthat he was paid heavily in stock (now worthless) and not all cash. It isestimated that when Lehman failed, Fuld lost more than $650 million. Was thisnot punishment enough? Waxman attempted to hold Fuld accountable, saying, “…you made all this money taking risks with other people’s money.”
This statement demonstrated a fundamental naiveté about investment banking.Risking other people’s money—from shareholders and bondholders—ishow investment banks have always made money. This is part of the money machinethat drives earnings. But Waxman was trying to use “other people’s money”against Fuld, as if Fuld had done something dirty with it. In essence, Waxmanwas criticizing Fuld for thinking, acting, and talking like an investmentbanker. What Fuld should have been criticized for was the leverage, type, andsize of risky bets that he allowed to be placed with insufficient capital.Lehman’s bankers took excessive risk, and they either grossly misjudged it orthey just plain ignored it in the pursuit of excessive returns. At the hearing,Fuld was not held accountable for Lehman’s state of uncontrolled risk.
After the congressional hearing, as Fuld was escorted outside to his waitingdriver, he walked by a smattering of protestors holding placards with “Greed”and “Shame” written on them. Some pelted the fallen CEO with insults, callingfor his jailing. Undoubtedly this day, combined with other not-so-distantevents, would be permanently etched in Fuld’s mind. While it was widely rumoredthat an employee punched him in the nose shortly after the September 15, 2008,bankruptcy, the pain and embarrassment he must have felt after facing Congresswould most certainly last much longer.
After all the grandstanding, the U.S. House Committee on Oversight andGovernment Reform hearings failed to provide any valuable insight into whatactually caused the Lehman bankruptcy. While it is evident that greed was acontributing factor, there were many more complicated and equally importantcausative reasons. Billions of dollars in shareholder wealth were destroyed.Although politically expedient, it is intellectually irresponsible to hold Fuldsingularly responsible. When Lehman collapsed, it had more than twenty-eightthousand employees. To suggest that a single CEO caused the entire firm to”Fuld” is a gross misrepresentation. But it does seem puzzling that a companymade up of so many intelligent and market-savvy people, a firm that was able toweather numerous calamities during its 158-year history, was unable to survivethe Great Credit Crisis of 2008.
At one point during the hearing, Waxman suggested, “[W]e need to understand whyLehman failed and who should be held accountable…. The taxpayers are beingasked to pay $700 billion to bail out Wall Street. They are entitled to know whocaused the meltdown and what reforms are needed.” Waxman was right on target. Totruly understand the events leading up to and after Lehman’s bankruptcy requiresa clear understanding of Lehman’s history, the investment banking industry, itschanging regulation, the evolving landscape of financial markets, and whatdecisions Lehman made as it defined its risk-taking culture under Dick Fuld.Only an understanding of all of these events will provide a clear view of whathappened to bring down the House of Lehman. The pages that follow are devoted toexploring the facts that led up to and caused the largest bankruptcy in WallStreet history.
CHAPTER 2
From Humble Roots to Wall Street Contender
The House of Lehman began not in the powerful financial centers of the North butin the rural agrarian South. Starting in 1844, the Lehman brothers one byone—first Henry, then Emanuel (1847), and finally Mayer(1850)—emigrated from Bavaria, Germany, to Montgomery, Alabama. They wereJewish immigrants with one simple goal: open a profitable dry goods store.Having grown up in a family where their father, Abraham, was a cattle merchant,sales and brokering was a familiar business concept.
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(Continues…)Excerpted from UNCONTROLLED RISK by MARK T. WILLIAMS. Copyright © 2010 by The McGraw-Hill Companies, Inc.. Excerpted by permission of The McGraw-Hill Companies, Inc..
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