michael tauberg - lehman bros review

Book by Lawrence G. McDonald and Patrick Robinson(2009)

Review by Michael Tauberg

A Colossal Failure of Common Sense

The Inside Story of the Collapse of Lehman Brothers

Table of Contents

1.0 Introduction....................................................................................................................................3

2.0 Summary........................................................................................................................................3

3.0 General Concepts...........................................................................................................................5

4.0 Causes of the Crisis.........................................................................................................................6

4.1 Easy Money....................................................................................................................................7

4.2 Irrational Exuberance.....................................................................................................................8

4.3 A Failure of Management...............................................................................................................9

4.4 Widespread Securitization............................................................................................................10

4.5 A Failure of the Ratings Agencies..................................................................................................11

5.0 Critique.........................................................................................................................................12

6.0 Conclusion....................................................................................................................................14

7.0 Appendix End Notes.....................................................................................................................15

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1.0 Introduction

A Colossal Failure of Common Sense was one of many books to be published in the aftermath of the

Financial Crisis of 2007. After seeing the global economy stall in the face of massive losses in world

financial markets, many Americans sought to better understand the crisis and its causes. This book,

written from the perspective of a financial market insider, provides a glimpse into the world of global

finance and also seeks to explain how the players in this world were involved in the crisis. In the words

of the author Lawrence McDonald, “My objective in writing A Colossal Failure of Common Sense was

twofold. First, to provide … a close-up, inside view of how markets really work…..And, second, to give…

as crystal clear an explanation as possible about the real reasons why the legendary Lehman Brothers

met with such a swift end”1. By writing about his personal experience at Lehman Brothers and

recounting stories from within the famous investment banking firm, Mr. McDonald largely succeeds at

his first goal. However, the elements of personal biography and the chronological order of the book

make it difficult for the reader to fully appreciate all of the varied causes of the financial crash. I believe

that the main value of reading this book is in understanding these causes, with Lehman Brothers acting

as a microcosm of the greater financial universe. As such, in this review I have isolated elements from

Mr. McDonald’s book which highlight how the crisis happened. I collect these elements, and present the

author’s ideas about the causes of the crisis, highlighting how these forces were at work within Lehman

Brothers. Finally, I critique A Colossal Failure of Commons Sense with regards to its shortcomings, and

assess how well it achieved its two stated goals.

2.0 Summary

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A Colossal Failure of Common Sense is written from the perspective of the author Lawrence G.

McDonald, who worked as a trader in the distressed debt division of Lehman Brothers investment bank.

He writes in the style of a biography, mixing elements of his own personal life with events that took

place within the Lehman Brothers firm from 2004 to 2009. Throughout the book, the author provides

analyses of these events in the context of the global financial crisis and includes other facts and

information about the US and global economy.

McDonald spends the early chapters of the book describing his ambition to work on Wall Street and

goes on to detail his rise in the financial services industry. During this time he worked first as an

investments salesman for Merrill Lynch, then as a cofounder of the internet startup Convertbond.com

which specialized in the analysis of convertible bond issuances. He uses these chapters to introduce the

reader to the concepts of bonds and debt in financial markets.

Later, McDonald describes how he was hired as a trader at Lehman Brothers and tells stories about his

early days there. He discusses major events, such as his trades involving large American corporations like

Delta Airlines and General Motors. These chapters introduce us to McDonald’s colleagues as well as to

the higher level players within the Lehman organization.

Next, McDonald discusses his involvement in the US subprime mortgage market on behalf of Lehman

Brothers. He discusses the early warnings of a subprime market crash from Lehman employees such as

Michael Gelband, the company’s global head of fixed income. McDonald also explains what was

happening in the US sub-prime mortgage market at this time and highlights the factors that led to its

growth, especially unscrupulous sales tactics being employed by mortgage originators.

After explaining the subprime mortgage market, the author describes how risk within Lehman was not

limited to residential real estate but extended to commercial real estate. He discusses several major

purchases of commercial real estate by the firm, always using vast sums of borrowed money. He uses

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these chapters to disparage Lehman CEO Dick Fuld and explains how Fuld pushed for these risky deals

without truly understanding them. It is the commercial real estate investments described in these

chapters that would eventually be a major cause of the firm’s bankruptcy.

Finally, McDonald details the last days of Lehman Brothers. He describes second-hand accounts of

events within the company, when Lehman executives realized how large the losses on their investments

were. McDonald also describes the events surrounding the decision of the US Treasury not to bail out

Lehman Brothers as it had done with the investment bank Bear Stearns.

3.0 General Concepts

Throughout the book, McDonald introduces some important financial concepts. Among these are credit

default swaps (CDS), collateralized debt obligations (CDOs), and collateralized loan obligations (CLOs). Of

particular importance in the book are CDOs which are explained to be at the root of the global financial

crisis. The CDO is described in great detail on page 107 of the book and this explanation forms the basis

for much of the book’s subsequent material. The CDO is described as a security which is comprised of

many individual home mortgages. These mortgages are packaged together much like a bond so that the

owner of the CDO holds these individual mortgages and derives payment from the interest paid on

them. So for example, a CDO comprising 1000 mortgages sold at $300,000 each would be worth a total

of $300 million2. If these mortgages carried an interest rate of 2 percent, the CDO would pay $500,000

per month (coming from homeowners) on this $300 million base. This $300 million CDO would then be

broken up into smaller pieces and sold around the globe to various investors.

Since a single CDO is comprised of many different mortgages, and mortgage default rates in the US were

historically low, ratings agencies who assessed the riskiness of these securities often gave them the

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highest possible rating of AAA, meaning that they were considered as safe as US Treasuries. McDonald

sums up this process within Lehman stating “Lehman was slicing them (CDOs) up and packaging them,

getting them rated AAA, and selling the bonds to banks, hedge funds, and sovereign wealth funds all

over the world” 3.

Of course, McDonald also highlights the catch involved with these CDOs. They were sold to the so-called

subprime home buyers who had little cash and low credit ratings. This meant that to account for the

risk of lending to these borrowers, the real interest rates on these mortgages had to be much higher

than the initial 2% described above. In fact, after 2 years, the interest on these mortgages would climb

upwards of 10%. At this level, the subprime borrowers would be unable to make their interest payments

and the CDOs that were built on these borrowers would lose much of their value. It is this process, the

reader is told, which precipitated the financial crisis. Subsequent sections of this report expand upon the

process of creating and selling CDOs and other securities as well describing the other factors that

contributed to the financial crisis.

4.0 Causes of the Crisis

Below, I outline what that author presents as the main causes of the financial crisis. I provide examples

from the book of how these causes related to both Lehman Brothers and the broader financial market

4.1 Easy Money

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One of the main themes of A Colossal Failure of Common Sense is ease with which money was

borrowed in the early to mid 2000s. The author tells stories of home owners who borrowed via large

mortgages, investments banks and hedge funds who borrowed money to buy derivatives, and private

equity companies who borrowed huge sums to execute leveraged buyouts of corporations. As a

member of the distressed debt trading group at Lehman Brothers, the author notes with amazement the

ease with which money could be borrowed at remarkably low interest rates. Companies like General

Motors could continue to finance their operations through debt even as it was clear to the author and

his colleagues that that they could never meet all of their obligations 4. Investments banks like Lehman

Brothers borrowed so much money that they were able to buy assets with very little real capital. By the

time the firm collapsed, the ratio of Lehman’s total assets to real capital was 44:15. The author suggests

repeatedly throughout the book that all of these actors were able to borrow so much money because

interest rates were cut to all time lows by US Federal Reserve Chairman Alan Greenspan. According to

McDonald “He(Greenspan) cut and cut (interest rates) , all the way from 6 in December 2000 down to 1

percent on June 30, 2003”6. Besides allowing companies and individuals to borrow beyond their means,

these low interest rates had another pernicious effect. Since traditionally safe investments like treasury

bonds offered such low rates of return, investors were forced to turn to riskier investments to achieve

higher yields. The author notes that “The ten-year Treasury (bond) yield in 2004 was only 4.05

percent”7. With such a low rate of return, investors “flooded into … mortage-backed securities to get a

higher yield on their money” 7. In other words, the giant amounts of leverage and the huge appetite for

risk that eventually undid many Wall Street investment firms was a direct result of their ability to

borrow money cheaply.

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4.2 Irrational Exuberance

As an insider of one of the major Wall Street investment banks, the author is able to describe the nearly

unlimited optimism in the financial markets before the 2008 Market Crash. During this time, financial

firms such as Lehman Brothers were making record profits, driven largely by the growth in the US

residential mortgage market8. These profits, the author maintains, were largely illusory. The CDO, which

was the foundation of these returns, was a much riskier asset than many believed it to be, and would

quickly lose money as soon as the “teaser” rates (described in section 3 of this document) on home

mortgages expired. As interest payments dramatically rose, homeowners would be forced to default on

mortgages that they could no longer afford. Nevertheless, as more and more money was being made

from these CDOs, the players in this market grew in influence and had an even greater incentive to

ignore the risk involved. McDonald relates how the mortgage traders within Lehman produced

“miraculous” profits and grew in status within the organization9. With so much money being made, it

was difficult for opposing voices to be heard. McDonald states that he always had reservations about

the source of these returns but that “I didn’t dare mention even a semblance of doubt, not to anyone.

That would have been tantamount to high treason…”10.

This trend of unwarranted optimism was present throughout the industry even after the residential

mortgage market began to show signs of weakness. The author describes how in 2006, Merrill Lynch

bought San Jose based First Franklin, one of the nation’s biggest originators of non prime residential

mortgages despite the fact that First Franklin had 29 billion in risky loans outstanding11. He also relates

how other players like Wachovia Bank and Trust, based in Charlotte, North Carolina participated in this

buying frenzy, spending 25.5 billion dollars to buy Golden West Financial12 which carried many sub-

prime mortgages on its books. The author likens these purchases to “buying a nuclear bomb” 11.

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This bomb would eventually go off, taking down Lehman Brothers and the entire financial market.

4.3 A Failure of Management

After the author outlines the huge amount of risk that Lehman Brothers and other financial players were

taking with their holdings of residential and commercial backed securities, a natural question arises.

How did the management of these firms fail to understand the huge consequences of this risk? While he

does not have inside knowledge of the management at other organizations, Mr. McDonald’s does

provide an answer to this question with regards to Lehman Brothers, and this answer is an indictment of

Lehman Brothers CEO Richard Fuld, its President Joe Gregory and the Lehman Board of Directors.

McDonald suggests that CEO Richard Fuld was a poor leader who was “removed from his key people” 13

and who thus did not really understand very much of Lehman’s operations or obligations. In addition to

his distance from the inner workings of his firm, Fuld was avaricious, and jealous of industry rivals

Goldman Sachs and the Blackstone Group14. He constantly promoted risky deals to grow the firm so that

it could compete with these rivals and show similar profit levels. When voices of dissent arose within the

Lehman ranks with regards to these deals, Dick Fuld would browbeat or simply fire anyone who got in

his way. As the author notes “Stories about long-departed commanders were legion. There were mind

blowing tales of Fuld’s temper” 15.

If Dick Fuld was the engine behind the enormous risk taking at Lehman, then President Joe Gregory and

the Lehman Board of Directors were Fuld’s enablers. The author calls Gregory a “run of the mill, ho-hum

financial sycophant” 14 who acted only to back up the CEO. According to the author, the board of

directors were composed largely of aging veterans of other industries who were not “tuned into the

massive securitization of the modern economy” 16. Without the board or the president acting as checks

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on the power of CEO Dick Fuld, Lehman Brothers was able to take on huge debts and expose itself to

enormous risks. This combination of risk and debt in financial markets would eventually create the

conditions of the great financial crash that would bankrupt Lehman Brothers and many other

companies.

4.4 Widespread Securitization

Although the author levels some serious criticisms at the management of Lehman Brothers, he makes it

clear that they were not solely to blame for the downfall of the firm. Throughout the book, McDonald

notes that the financial world was growing increasingly complex, so that it was much harder to

understand the many risks underlying investments in traditionally safe areas like residential and

commercial real estate. This was due largely to the rapid growth of securitization in financial markets.

These securities, including CDOs, CLOs and other derivatives like CDS, “exploded” 8 in the 2000s. By 2006

there were $15 to $18 trillion worth of credit derivatives (CDOs, CLO) in the global market and another

$70 trillion dollars worth of credit default swaps 16. Because these instruments were more complex and

harder to value than traditional debt like home mortgages or corporate bonds, they served to hide risk

from investors who did not fully understand them. McDonald notes how some market participants such

as famed investor Warren Buffet noticed that the true risks of these instruments were not reflected in

their prices calling them “weeds priced as flowers” 8. In regards to their potential to become

destabilizing to the entire financial system, Buffet referred to them as “financial weapons of mass

destruction” 8.

If these securitized investments were more complex and difficult to price than traditional investments,

then they proved much easier to sell. McDonald sites a figure which claims that in 2005 “23 percent of

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all Wall Street revenue stream for the last 3 years flowed out of securitization sales” 8. With this kind of

incentives to sell these risky instruments, Wall Street became home of what the author calls “casino

capitalism” 17, and investing increasingly took the form of risky gambling. The author implies that

widespread gambling based on risky instruments such as CDOs and CDS (called by McDonald “those

lethal swaps” 18) was unsustainable and would eventually lead to a crisis.

4.5 A Failure of the Ratings Agencies

As stated above, the complex securities being traded by firms like Lehman Brothers carried substantially

more risk than most expected. According to the author, investors were falsely led to believe that these

investments were safe7. The party responsible for this misrepresentation of risk was the credit rating

agencies. The agencies: Moody’s Investors Service, Fitch Ratings, and Standard & Poor’s, were

responsible for assessing the risk of debt securities such as CDOs and assigning them a rating. A high

rating such as triple-A meant that the security was very safe and unlikely to default and lose money. By

assigning these CDOs very high ratings, these agencies enabled banks to sell them very easily and led

investors to take on much more risk than they realized. As McDonald writes, “they gave the banks

credence, allowing them to issue CDOs with triple-A ratings signed and certified by the three biggest

names in the business” 20. However, it eventually became clear that these ratings were not accurate. The

author states that at the end of 2006, 1305 CDOs had their ratings downgraded from AAA to BB or lower

(junk bond status)21.

The author posits that it may have been more than laziness or stupidity that led to these inaccurate

ratings. He notes that the agencies charged three times more money to rate CDOs than other forms of

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debt and had an incentive to ensure that these CDOs were popular in the market20. Apparently the

business of rating these instruments was very profitable. For example, McDonald states that Moody’s

had revenues of $2.037 in 2006 billion up from 800.7 million in 200021. With incentives to hide risk,

McDonald implies that the ratings agencies were intentionally dishonest and that they are largely to

blame for the spectacular growth of CDOs and other risky investments which would cause the financial

crisis.

5.0 Critique

In A Colossal Failure of Common Sense, The author does a good job of presenting the story of the global

financial crisis, centered on his experiences at Lehman Brothers investment bank. However, there are

certain limitations in McDonald’s approach to telling this story that make it difficult for the reader to

gain a complete and accurate picture of the crisis. His informal writing, his closeness to the material, his

need to cater to the financial layperson, and the early release date of the book are all factors that

prevent the author from providing a complete picture of the financial crisis.

The author uses a very personal style of writing that succeeds at making the reader feel very close to the

events described. However, this informal style, full of colloquialisms and other casual turns of phrase, is

often imprecise. When McDonald refers to convertible bonds as a “last chance saloon” 22 for distressed

companies such as Enron to receive badly needed capital, the reader has to puzzle over western film

imagery before understanding the idea behind these bonds. In addition, this style does not allow for the

use of many supporting facts or figures to be presented in a detailed manner. While discussing Enron’s

convertible bonds, no concrete information is given on how many of these bonds were issued or to

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whom they were being sold. The reader must accept McDonald’s reasoning for the events he describes,

where supporting data would greatly strengthen his case

The casual style of writing employed by the author also serves to highlight his potential biases as a

witness to the events in the book. The author is clearly sympathetic to his close colleagues at Lehman

Brothers, specifically in the trading operations of the company. McDonald never utters a single negative

word about the people with whom he worked closely such Larry McCarthy, Michael Gelband and Alex

Kirk. However, he spends much of the book attacking Lehman CEO Dick Fuld and blaming him for the

company’s woes. As a trader, it seems as if McDonald may not have been close enough to Lehman

management to make an accurate assessment of their performance. In fact, McDonald admits to having

never personally met CEO Fuld23. Besides being removed from many of the management decisions that

he criticizes, the author’s trader mentality has the potential to color his views on the larger crisis. He

describes the trading world as being very insular where “no one went out for lunch” since they were

working so hard 24. Being a trader who was so close to the events of the financial crisis, it is possible that

the author misses some of the larger themes and patterns behind what happened on his trading floor

Furthermore, it is very likely that the author simplified much of his subject matter of this book to reach a

wider audience, composed largely of financial laypeople. While this approach makes the book

approachable, it prevents a deeper analysis of the material. So, while the author mentions the value at

risk (VaR) model that is used to assess the risk on various investments, he does not go into a great deal

of detail on how this model failed to show the high risk in CDOs and other derivatives. Other matters of

accounting which would require that the reader have a greater background in finance are also

neglected. The actual methods used to price instruments like bonds, CDOs and CDS are never discussed,

so the reader does not get a complete picture about how these investments lost so much money.

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Finally, since the book was published so soon after the events described, some key information was

missing from it. A question that is never fully answered in the book is how Lehman Brothers managed to

survive so long with major losses piling up on its books. The answer to this question was eventually

answered in SEC filings that showed that Lehman had engaged in various accounting tricks to cover its

losses. This became known as the Repo105 scandal 26. Knowledge of this scandal would have made it

clear to the reader that many practices within Lehman Brothers and other Wall Street firms bordered on

accounting fraud. No doubt this information would help the reader to get a broader view of the financial

crisis and its causes.

6.0 Conclusion

A Colossal Failure of Common sense looks back at the events of the global financial crisis of 2007 and

presents stories, information and analysis that are intended to shed light on those events. By describing

his experiences within Lehman Brothers, that author, Lawrence McDonald, is able to present the reader

with possible reasons for why Lehman Brothers collapsed along with so much of the greater financial

market.

McDonald faces many challenges in presenting such a broad range of complex material. In most cases,

he succinctly explains the various causes of the crash including the role of low interest rates in spurring

risky investments, the bubble mentality that took hold in financial markets, the failure of Lehman

management to predict or prevent the crisis within the firm, the proliferation of credit derivatives that

facilitated the spread of risk, and the failure of ratings agencies to warn against this risk. Although he

describes these factors clearly, he is hampered by certain choices made when writing the book. By

choosing to target a broad audience with little financial knowledge and by avoiding in-depth and data-

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backed analysis of events, the author only partially succeeds in educating the reader. In addition, his

biases are evident throughout, making it more difficult for the reader to trust that the author is

providing an accurate account of the crisis. Still, the anecdotes and inside stories from within Lehman

Brothers make for an interesting read. A Colossal Failure of Common Sense is an entertaining portrait of

one man’s experience inside the financial crisis and viewed from that perspective, it is a success.

7.0 Appendix A: References

1. McDonald, Lawrence, and Patrick Robinson, A Colossal Failure of Common Sense, Crown Business Inc., New York, U.S.A., 2009.

8.0 Appendix B: End Notes

1 McDonald, Lawrence. A Colossal Failure of Common Sense, 2009, Author’s Note2 McDonald, pg. 1083 McDonald, pg. 2164 McDonald, pg. 1655 McDonald, pg. 2876 McDonald, pg. 767 McDonald, pg. 1108 McDonald, pg. 1619 McDonald, pg. 11310 McDonald, pg. 11411 McDonald, pg. 19612 McDonald, pg. 19513 McDonald, pg. 21314 McDonald, pg. 23015 McDonald, pg. 9116 McDonald, pg. 22717 McDonald, pg. 17118 McDonald, pg. 21519 McDonald, pg. 22720 McDonald, pg. 10921 McDonald, pg. 20022 McDonald, pg. 7123 McDonald, pg. 8924 McDonald, pg. 8025 McDonald, pg. 17426 http://www.npr.org/blogs/money/2010/03/repo_105_lehmans_accounting_gi.html

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http://www.npr.org/blogs/money/2010/03/repo_105_lehmans_accounting_gi.html

michael tauberg - lehman bros review

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