Chapter OneThe Inquisition
After a month of financial turmoil that rocked the world, it was time for answers. October 6, 2008, signified a dramatic change in circumstances for legendary Wall Street firm Lehman Brothers and its once lionized leader, Dick Fuld. Now it was time for the disgraced former CEO to face the music as he sat before the U.S. Congress. The American people were outraged that Wall Street had hijacked Main Street, causing a global economic collapse and financial harm to countless individuals. President Barack Obama characterized it as "wild risk taking" on Wall Street. Now California Congressman Henry Waxman, chairman of the U.S. House Committee on Oversight and Government Reform, was charged with exacting some form of revenge. CEO thievery from the economy would no longer be permitted.
On this autumn day, Fuld found himself suddenly thrust into unfamiliar and unfriendly surroundings. No longer was he in the comfort of Lehman Brothers' clubby midtown headquarters in New York where his word was law. The official purpose of this hearing, which aired live on CSPAN, was to determine how Lehman failed. However, the real reason became readily apparent as soon as Waxman commenced with his opening remarks. He wasted no time in putting Fuld on the hot seat, holding him singularly responsible for the fall of Lehman, the loss of jobs, and the significant financial losses sustained by shareholders and bondholders. Justly or not, Fuld would be the fall guy, put on stage to symbolize what was wrong with Wall Street.
In this unfriendly spotlight, Wall Street's longest sitting investment-banking CEO now appeared confused and guilty of massive wrongdoing. His hunched posture, grim-faced expressions, and defensiveness seemed like further evidence of his guilt. Most of the public believed he deserved his comeuppance. And why not? Conventional wisdom accused Lehman of creating toxic mortgage-backed securities and selling enough of them to make the entire financial system sick. Someone needed to be held accountable. But weren't there other firms on Wall Street that had employed similar practices?
Proposed by a Republican senator and signed into law under a Democratic administration, the 1999 repeal of the Glass-Steagall Act surely influenced the level of wild risk taking. Shouldn't the politicians and the former Federal Reserve (Fed) chairman who advocated the repeal of this Depression-era legislation be held at least partially accountable for what happened? Where were the financial regulators charged with protecting the safety and soundness of our banking system? During the last two decades "regulation-light" was the mantra. Banks overdosed on risk not overnight but over time as regulators and policymakers watched. There were other watchdogs that did not bark. Why wasn't Lehman'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 into influence. The credit rating agencies that investors depended on to provide an independent seal of approval failed as bond ratings that appeared to be AAA quickly sank to junk.
Then there was the House Financial Services Committee, a committee whose main responsibility was oversight of the banking industry. Its chairman, Congressman Barney Frank, claimed no accountability for the Great Credit Crisis of 2008. He argued that compensation practices contributed to excessive risk and that company boards and CEOs failed at their fiduciary duties because they were combined at the hip.
Granted, there were deficiencies in corporate governance and compensation. But was it really so simple, or was there also political deflection? Years of various congressional policies led to the conditions that made the crisis possible. Government support of the U.S. mortgage industry pumped trillions into a 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, the U.S. government had sporadically supported a "too big to fail" doctrine that did nothing to discourage large and interconnected firms from increasing risk. Such a policy created "moral hazard" by encouraging financial institutions to take more risk than they would if they were not backstopped by the government. Most people 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 after its demise? Lehman didn't opt for bankruptcy.
Referring to the ripple effect that occurs when one institution's failure rapidly affects counterparties, systemic risk is the very concept that underscores the too big to fail doctrine. The overarching theory holds that the failure 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 tested this theory, with fairly disastrous results. It turned out Lehman was a central cog in an interconnected global financial wheel. In Fuld's mind, Lehman was more of a victim than a culprit.
"THE PERFECT STORM"
The hearing lasted for almost five hours, with Fuld responding to sharp criticism from a hostile panel. As part of the public spectacle, Fuld was allowed to read a prepared statement into the congressional records. His statement was thirteen pages in length and could have been aptly titled "The Perfect 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 a turbulent sea with many destabilizing factors and some navigation errors had occurred. But in reality this storm of storms was much larger than anyone had predicted. Lehman was just the unfortunate investment bank that hit the rocks. As the captain, he took "full responsibility" for the wreck but spent most of his time listing all the maneuvers attempted to avoid the rocks.
Fuld insisted he did all he could to protect the firm, including closing down the mortgage origination business, reducing leveraged loan exposure, decreasing commercial and residential loan exposure, reducing firm leverage, raising additional capital, making management changes at senior levels, cutting back expenses, seeking a merger partner, and encouraging regulators to clamp down on abusive short-selling practices. All this tacking and jibing was to no avail. Fuld also chastised the Fed for not responding to Lehman's distress signal quickly enough and not launching a timely emergency rescue to shore up market confidence in the overall financial system.
Then Fuld placed blame on the opportunistic pirates, the naked short-sellers who spread false rumors, shorted Lehman stock, and walked away with vast profits. Additional blame was placed on the Securities and Exchange Commission (SEC) for lifting short-selling restrictions that would have provided Lehman safe harbor during the financial storm. Fuld concluded his statement by focusing on the need to revamp the existing Depression-era system of banking regulation to meet the more complex needs of today. And while many of his points were valid and worthy of further analysis, the committee was more interested in drawing attention to his oversized compensation.
Wasting no time, Waxman quickly highlighted the approximately $500 million in compensation Fuld had pulled out of Lehman during an eight-year period. The congressman 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 of money? It's just unimaginable to so many people." In case the picture was not vivid enough, Waxman added, "While Mr. Fuld and other Lehman executives were getting rich, they were steering Lehman Brothers and our economy toward a precipice." Although Fuld attempted to answer Waxman's questions and those of other committee members, on numerous occasions he was interrupted or entirely cut off. Fuld was not on stage to answer or debate important risk management questions—he was there only as political fodder. And why should they show deference? 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 CSPAN sound bites. In Fuld's opinion, it was a confluence of events, a litany of bad judgment combined with bad luck—but not unbridled greed. As the hearing progressed, Fuld responded to several questions by providing financially technical and lengthy explanations. Most committee members were not in the mood to receive a lecture on the complexities of financial markets and were frustrated by Fuld's demeanor. John Mica, Republican congressman from Florida, injected levity to the proceedings by saying, "If you haven't discovered your role, 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 before the committee to opine on why Lehman failed. One expert, Luigi Zingales, a professor from the University of Chicago, felt the firm's use of aggressive leverage, emphasis on short-term debt financing, bad industry regulation, lack of transparency, and market complacency due to several years of juicy earnings were the root causes. Zingales indicated that mortgage derivatives were evaluated on historical records, and firms had subsequently failed to factor in an ahistorical decline in lending standards and fall in real estate prices. He also pointed out that the mortgage-backed securities market in which Lehman participated was bankrolled by quasi-governmental agencies, including Freddie Mac and Fannie Mae. In his concluding remarks, Zingales suggested that "Lehman's bankruptcy forced the market to reassess risk." Although only an abbreviated three-page testimony, it was a thoughtful assessment and deserved more committee attention. But the sport of the day was roasting Fuld. A crash course in how risk management worked (or did not work) would have to be left for later.
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 were nothing short of remarkable. Only six months prior, Lehman was one of the main players that made Wall Street tick. The Lehman bond indexes were the gold standard of the investment management industry—relied on by managers around the world. It had been one of the country's elite five stand-alone investment banks. Yet, as Fuld spoke into the microphone that October day, none of the elite five—Goldman Sachs, Morgan Stanley, Merrill Lynch, Lehman Brothers, or Bear Stearns—were left standing. The industry he had worked so hard to shape and nurture was gone. Goldman Sachs and Morgan Stanley, under severe duress, had recently gained bank-holding company powers; Merrill Lynch had been purchased by Bank of America; Lehman Brothers had failed; and Bear Stearns had been taken over by J.P. Morgan Chase.
To Fuld, Lehman was more than a job. Fuld had started at Lehman almost right out of college. He called himself a Lehman lifer. Fuld was proud—"damn proud"—he was not at Goldman Sachs. Lehman had its own unique culture. Why didn't these congressmen understand this? Yes, Fuld was once a billionaire, but he was part of the American dream, a success story. It was true that through the years, as Lehman's wealth grew, so did Fuld's. He had houses in posh places such as Greenwich, Connecticut, West Palm Beach, Florida, and Sun Valley, Idaho, but it was customary for Wall Street titans to have trophy homes. Why didn't Waxman's committee look at the firm value created over Fuld's long career? Unlike other recent well-documented failures such as Enron or Worldcom, Lehman had real earnings. Prior to the "Perfect Storm," Fuld had created, rather than destroyed, vast amounts of shareholder wealth. These billions in earnings had resulted in multimillion-dollar payouts to bankers who in turn paid taxes and helped fill the U.S. Treasury's coffers.
With Fuld at the helm (prior to recent events), shareholders had been rewarded with an impressive annual return on equity of more than 24 percent. Did the congressmen not understand the importance of the investment banking industry? Investment banks were the gatekeepers of capital flow in our economy. Investment banking helped to build this country, and Lehman had played a vital role. During the past 158 years, when the U.S. government needed to raise capital in times of war and peace, Lehman was there. And this ability to raise capital fostered the growth of many major corporations. Lehman helped take companies like Sears Roebuck and Campbell Soup public. What, for God's sake, could be more apple pie than that?
FULD'S TRACK RECORD
Under Fuld's term as CEO, Lehman's empire stretched the globe with more than sixty offices spanning twenty-eight countries. After the spin-off from American Express in 1994, annual earnings increased from $75 million to more than $4 billion. The Lehman army grew from less than nine thousand employees to more than twenty-eight thousand strong. By 2007, Lehman's assets exceeded $690 billion with equity of more than $28 billion. Management and staff believed in Lehman. Employees were the single largest shareholders, owning 30 percent of the firm's stock. At the apex of Fuld's career, he was praised as an intense and capable CEO. Regardless of market turbulence or executive infighting, he always landed on top. He had proven he was a survivor.
Yet Waxman's committee seemed to disregard these accomplishments. War was declared on Wall Street on October 6, 2008. As the day progressed, Fuld became irritated as the focus remained on his compensation, ignoring the fact that he was the single largest shareholder. He repeatedly reminded committee members that he was paid heavily in stock (now worthless) and not all cash. It is estimated that when Lehman failed, Fuld lost more than $650 million. Was this not 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—is how investment banks have always made money. This is part of the money machine that 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, Waxman was criticizing Fuld for thinking, acting, and talking like an investment banker. What Fuld should have been criticized for was the leverage, type, and size of risky bets that he allowed to be placed with insufficient capital. Lehman's bankers took excessive risk, and they either grossly misjudged it or they 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 waiting driver, he walked by a smattering of protestors holding placards with "Greed" and "Shame" written on them. Some pelted the fallen CEO with insults, calling for his jailing. Undoubtedly this day, combined with other not-so-distant events, would be permanently etched in Fuld's mind. While it was widely rumored that an employee punched him in the nose shortly after the September 15, 2008, bankruptcy, the pain and embarrassment he must have felt after facing Congress would most certainly last much longer.
After all the grandstanding, the U.S. House Committee on Oversight and Government Reform hearings failed to provide any valuable insight into what actually caused the Lehman bankruptcy. While it is evident that greed was a contributing factor, there were many more complicated and equally important causative reasons. Billions of dollars in shareholder wealth were destroyed. Although politically expedient, it is intellectually irresponsible to hold Fuld singularly responsible. When Lehman collapsed, it had more than twenty-eight thousand employees. To suggest that a single CEO caused the entire firm to "Fuld" is a gross misrepresentation. But it does seem puzzling that a company made up of so many intelligent and market-savvy people, a firm that was able to weather numerous calamities during its 158-year history, was unable to survive the Great Credit Crisis of 2008.
At one point during the hearing, Waxman suggested, "[W]e need to understand why Lehman failed and who should be held accountable.... The taxpayers are being asked to pay $700 billion to bail out Wall Street. They are entitled to know who caused the meltdown and what reforms are needed." Waxman was right on target. To truly understand the events leading up to and after Lehman's bankruptcy requires a clear understanding of Lehman's history, the investment banking industry, its changing regulation, the evolving landscape of financial markets, and what decisions 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 what happened to bring down the House of Lehman. The pages that follow are devoted to exploring the facts that led up to and caused the largest bankruptcy in Wall Street history.
Chapter TwoFrom Humble Roots to Wall Street Contender
The House of Lehman began not in the powerful financial centers of the North but in the rural agrarian South. Starting in 1844, the Lehman brothers one by one—first Henry, then Emanuel (1847), and finally Mayer (1850)—emigrated from Bavaria, Germany, to Montgomery, Alabama. They were Jewish 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.