—William Butler Yeats, The Second Coming
It was us against the world. Because we went through that
Shearson experience, it forced a group of us to be totally
together.
—Steve Lessing
T
oward the end of 1996, a Lehman proprietary trader in Japan got caught in a position that was plummeting and he was stuck there, overexposed. His department (fixed income) and his boss ( Joe Gregory) would lose all the profits they ‘d made over the year. November, as every trader knows, is the worst time to make a mistake. This one cost Lehman $100 million.
Once again, according to sources, John Cecil believed that Gregory had not kept a zealous watch over all his employees.
The loss meant that Cecil, not Gregory, was the second-highest-paid executive in the firm that year.
Cecil earned more than $5 million—nearly $2 million in cash plus $2.3 million in stock and $1.1 million in restricted stock units (RSUs) and options—earnings that, according to sources, irritated Gregory.
He would “remind” Cecil “how easy it was for someone not running a division” to do well. He had never talked like this to Cecil before, and it was this kind of bonus envy that Fuld had hoped to eliminate when he reorganized senior management.
Fuld had replaced Pettit and the operating committee with six division heads who would be paid equally, which he called the frontline committee (the title was quickly dropped, according to Cecil, in favor of executive committee). Then there was a group of 20, known as the operating committee, which included the people who ran divisions like information technology (IT) and operations.
The reason Fuld came up with this idea of a committee of (supposed) equals, according to Cecil, was that he was tired of all the friction around him. It wasn’t good for the firm. Fuld hated arguments, some of which concerned matters he was only barely familiar with, and he hated making management decisions—particularly concerning bonuses and drama between personnel.
He wanted to be left alone at the top, with the quiet and orderly Cecil behind him, but out of sight. (Cecil usually kept to his office on the 10th floor, and rarely appeared on the trading floor.)
Fuld meanwhile pushed to increase his visibility—and stature—outside the firm. The once taciturn trader suddenly and aggressively entered the New York establishment milieu: He became a member of the Council of Foreign Relations (Tom Hill was a member); he was named to the board of the New York Stock Exchange; he was a member of President Clinton’s Advisory Committee for Trade Policy and Negotiation; and he became a member of University of Colorado Business Advisory Council.
The memories of Pettit faded fast. Articles about the firm’s growing revenues (they were up 12 percent in 1997) never mentioned him, and by 2008 many people at Lehman had never heard of Chris Pettit. “We were all so relieved not to get any more memos signed
TCP
,” says one senior person. (Internal memos were signed with initials, not names—hence
TCP
for Pettit.)
As for Joe Gregory?
He swept into his new role as the head of equities, fired 27 out of the 29 people in the department, and hired a fresh team. One of those fired was Craig Schiffer.
Many of the people fired by Gregory assumed it was because of their feelings for Pettit, not because of their job performance. “If Lehman held a Lehman court, they would have all testified for Chris, and so Joe didn’t want them around,” says one person close to the situation.
Years later when Schiffer met Gregory for breakfast, Joe told him blithely: “Never pick an argument with your boss, Craig, because the bigger title will always win. You lost your job because you didn’t learn that.” (Fuld later said about Schiffer, “Why did we let him go? I always liked him, always thought he was good.”)
But some still remembered Pettit as the man who had positioned the company for its sudden rise. Jim Vinci says: “I can’t tell you how hard I laughed when I saw that
Fortune
magazine article [in April 2006] about Dick.” “So complete has Fuld’s makeover of Lehman been that he is more like a founder than a
CEO
,” it read.
“It was just ridiculous. I think a lot of us thought, ‘ How could they tell this story without Pettit? Like Dick did this all by himself?’ It was nauseating.”
Fuld, Lessing, Gregory, and the rest didn’t have time to look back.
“It was a very exciting time in the marketplace. . . . We were competing aggressively with Goldman and Salomon Brothers . . . [and had] started to build out Europe and Asia . . . becoming more of global firm,” Lessing wrote in the document commissioned by Gregory in 2003. “It was really an intense, once-in-a-lifetime opportunity to build something and bring back the Lehman Brothers name, which had a 150 -year tradition.”
The new frontline committee had Gregory (equities) and Vanderbeek (fixed income). Mel Shaftel was replaced by a banking troika—Mike Odrich’s idea—comprised of Bradley Jack from fixed income and capital markets, Steve Berger from European investment banking, and Michael “Mike” McKeever from within banking.
The firm stayed on its upward trajectory. Standard & Poor’s upgraded its outlook from “negative”—to which Lehman had sunk thanks to that $22 million first quarter—to “stable.” Moody’s had also downgraded the firm during the Mexican crisis, but by 1997 it had Lehman back up to single A.
Investment banking yielded record revenues, as did the real estate, mortgages, high yield, and emerging markets departments.
Two executives were crucial during this period.
One was Robert “Bob” Millard, an
MIT
graduate who was Lehman’s biggest earner by far throughout the 1990s. His investment business had returns of around 15 percent per year—on no leverage. One of the most successful investments was in an aerospace company called L3 Communications where Millard was appointed lead director. “We invested $60 million; we ended up with a multiple of that many times over,” he says.
Another
MVP
was Mark Walsh. Since 1991 Walsh, a very dynamic and well-liked executive, had run the principal investing activity for commercial real estate within the fixed income division’s umbrella. This meant he made loans to both developers and buyers of commercial real estate. He provided the financing for an acquisition—like the $700 million purchase of the General Motors building (now home to
FAO
Schwarz and Apple retail stores) on Fifth Avenue and 59th Street in Manhattan.
Walsh would also invest in the equity of his deals. One of his most famous trades in the early 1990s was the purchase of a building in Times Square that was considered ugly and was being sold at a relatively low price. Walsh realized that its value was its position; you could make vast profits by sticking billboards on it. He rented out the wall space and then resold the building two years later at a far higher price. According to Cecil, that deal made Lehman $80 million, and cemented Walsh’s reputation as Lehman’s King Midas.
After that deal, Walsh was awarded increasing autonomy. Fuld was so confident in him, he often put the firm’s balance sheet behind Walsh’s deals. As interest rates declined and all asset values inflated, the values of buildings he had stakes in increased. Firmwide, Walsh was a hero. He seemed to have a knack for choosing properties that could be improved and would make a killing for the firm when they sold.
The trouble was that in doing this Fuld was tying the firm’s balance sheet to illiquid assets. If something were to go wrong, the firm wouldn’t be able to reduce its exposure. But in the meantime, his unit grew until reports said it generated more than 20 percent of Lehman’s profits.
In 1997, the
New York Times
reported that Barry Sternlicht, the
CEO
of Starwood Hotels and Resorts, remembered Walsh bringing Fuld to his living room. Sternlicht was so impressed by the duo that he let them finance his $7 billion purchase of
ITT
Corporation, the parent company of the Sheraton Hotel chain, usurping a deal he’d already had in place with Goldman Sachs. From that moment on Fuld knew that Walsh was a key, if not
the
key, to Lehman’s prosperity.
On April 6, 1998, the environment on Wall Street changed forever: The $83 billion merger of Citicorp and Travelers Group, which created the world’s largest financial services company, was a watershed moment. It led to the repeal of the Glass-Steagall Act of 1933, which prevented bank holding companies from owning insurance companies and brokerage firms. And it opened the doors for a host of mergers and consolidations within the financial services industry.
Lehman’s leaders could now entertain mergers with other houses, and they looked at hundreds of potential merger targets, including the retail brokerage PaineWebber. Lehman also looked at Prudential—again, in vain. Prudential didn’t want to sell.
Lehman’s real problem, however, was that its price -to-earnings (P/E) ratio was too low--around 11--while most booming Wall Street businesses had P/Es of 14. The P/E ratio is used for valuation--the higher the P/E, the higher the stock price. In order for Lehman to make a merger, it would have had to overpay to compensate for its low P/E, which would have been detrimental to its shareholders.
But all such dreams of expansion were postponed on August 17, 1998, when the pavement suddenly crumbled beneath Wall Street’s feet, and all the securities houses heard rumblings of potential doom. Russia had devalued the ruble and defaulted on its government bonds—the first time any country had done this in the postwar era. Panicked investors sold emerging markets securities, while also selling Japanese and European bonds in favor of U.S. bonds, which were widely considered the safest currency and debt in the world. This in turn led to a drop in worldwide markets.
Cecil says, “Initially, it was a nonevent for the firm.” Fuld had always been wary of investing in Russia. He often called the place “the world’s biggest fucking crime syndicate.”
Cecil knew that Lehman had some exposure through a money management group, III (Triple I) Offshore Advisors, which managed the High Risk Opportunities Fund (HRO). Lehman, he said, had $300 million of principle in jeopardy. According to Cecil, $300 million was a headache for the firm, but not life -threatening.
Tom Russo—general counsel and head of public relations—tried to go on the offensive and organize a collaborated response to the
III
crisis rather than let individual firms try to cut deals or seize the fund’s assets.
Things were complicated, however, by the Securities and Exchange Commission (
SEC
), which decided to investigate Lehman’s marks, or pricing.
Russo says the
SEC
alleged that Lehman’s prices were higher than everyone else’s, although the General Accounting Office—later renamed the Government Accountability Office (
GAO
)—would later show that Lehman’s prices were accurate. In the meantime, the rumor mill went berserk. Lehman’s stock price fell 60 percent.
The first Cecil heard about the rumors and the subsequent shorting of Lehman stock was when Bruce Lakefield, then the head of Lehman Europe, called during the second week of September to say there was a rumor swirling that Lehman had big exposure problems. Cecil told him not to worry.
While Lehman was being buffeted by this mess, a bigger one was unfolding for all of Wall Street.
In mid-September, the hedge fund Long-Term Capital Management (
LTCM
) fell apart, throwing the entire financial system into a panic.
LTCM
was founded by John Meriwether—the former head of bond trading at Salomon Brothers—and led by a group of academics, including Nobel Prize-winning economists Robert Merton and Myron Scholes, who had, with Fischer Black, originated the Black – Scholes option pricing model. The complex mathematical equation proves, after a series of assumptions about the market, that “it is possible to create a hedged position, consisting of a long position in the stock and a short position in [calls on the same stock], whose value will not depend on the price of the stock,” according to Black ‘s paper about the topic.
LTCM
also included the highest paid trader at Salomon Brothers, Larry Hilibrand, and David Mullins Jr., a former Harvard professor and vice chairman of the Federal Reserve.
The fund was leveraged at 50 to 1, and until 1998 it had generated massive returns, supposedly because its mathematical geniuses had made these bets based on the historical relationships between various fixed income securities, such as U.S. Treasury bonds and risky corporate or emerging markets bonds. Almost every Wall Street firm was an investor, and even in a down year—1997—
LTCM
returns were 17.1 percent after fees.
But by July 1998, things had started to go wrong—and they only got worse once Russia defaulted and investors started to pull out of seemingly safe investments. On September 2,
LTCM
disclosed that the value of the fund’s holdings, once $1.8 billion, had dropped by 44 percent.
Meriwether approached Goldman Sachs co-CEO Jon Corzine for help. Could they be partners? Corzine said he’d think about it, but only if the fund would be willing to accept risk controls and oversight. Meanwhile, the stock prices of all Wall Street banks sank because the market feared that securities firms would have to close out their LTCM positions at fire -sale prices.
Lehman stock plummeted from the mid-40s in August to the low 20s in September.
Warren Buffett agreed to put up $3 billion to shore up
LTCM
, and Maurice “Hank” Greenberg, the
CEO
of insurance giant American International Group (
AIG
), put up $700 million. Corzine led the Wall Street rescue by pledging that Goldman Sachs would put up $300 million—something his co-
CEO
, Henry Paulson Jr., disagreed with.
Corzine prevailed—at least for the moment.
On September 22, while
LTCM
was organizing a bankruptcy meeting, Todd Jorn—then Lehman’s sales manager responsible for hedge funds—joined Fuld, Russo, Gregory, and Vanderbeek at the New York Federal Reserve at 33 Liberty Street in downtown New York, where each of the investment houses was asked to put in $250 million to shore up
LTCM
.