“The whole time I knew her, she was always a sharp dresser,” another colleague says. “I had heard that she would occasionally show flashes of poor judgment—see-through things, leather things . . . but the really far-out, flashy stuff really happened after she joined the hedge fund group—when she was single.”
Callan’s new look was often the subject of morning interoffice e-mails, until suddenly there were infinitely weightier matters to discuss. The markets had started to turn. For the first time in 20 years, the housing market looked like it might crash.
Since 2006, it was clear to most observers that home mortgages had become preposterously easy to get, with millions of Americans moving into luxury housing they couldn’t afford and millions more using the bubble-addled housing prices to turn their homes into personal ATMs by doing cash-back refinancings and taking out home equity loans. Yet for a full year, Wall Street continued to make mortgage-backed securities the hottest commodity around, and rating agencies in turn continued to brand them triple A.
In many ways, Lehman was no worse than any of its peers. But what was peculiar was one of its reasons for staying bullish on the housing market. A senior executive said, quite seriously, that part of Lehman’s push in the mortgage space stemmed, according to his observation, from Joe Gregory’s desire to encourage a protege, the mortgage chief Ted Janulis. Janulis had sold his New York apartment to one of Fuld’s daughters. Gregory always talked him up. (In the Myers-Briggs typology, the senior executive further explained, Janulis was the only senior manager besides Gregory who tested “F” for “feeler.” ) In 2006 Lehman’s subprime mortgage arm employed nearly 4,000 people.
As early as 2005, the so-called smart money—namely Deutsche Bank, JPMorgan, and Goldman Sachs—had started backing out of the business and scrambling to hedge its remaining exposure, while the dumb money—Bear Stearns, Lehman, Citigroup, and Merrill Lynch—all seemed to be pursuing a strategy best summed up by former Citigroup
CEO
Charles O. “Chuck” Prince in June 2007, when he told the
Financial Times
that “as long as the music is playing, you ‘ve got to get up and dance. We’ re still dancing.” (“Music” was Prince’s metaphor for liquidity—which anyone with a Bloomberg terminal could have told him by that time had dried up.)
Lehman Brothers, however, had even bigger problems on its balance sheet than subprime mortgage collateralized debt obligations (CDOs)—it had some massive mortgages of its own, leveraged loans and in 2006 Mark Walsh still wasn’t finished investing in commercial real estate.
Walsh had unparalleled access to the firm’s balance sheet, which he used to directly invest in thousands of commercial real estate deals—something that made Lehman unique among its peers. Fuld loved Walsh’s strategy, many of his former colleagues speculate, because it mirrored that of a private equity firm and put Lehman in direct competition with his old rivals at Blackstone Group—and also, obviously, because during the boom it was immensely profitable. Former colleagues estimated that Walsh’s real estate investments accounted for 20 percent of the firm’s record profits of $4 billion in 2006. But this success came at a horrible price. When the housing market began to turn at the end of 2006, and as foreclosures began to spike across southern California, investors wanted out of a partnership Walsh had previously struck with Boris Elieff, the founder of SunCal Companies, which invested in undeveloped land in southern California. Walsh returned the investors a small profit and transferred $2 billion in SunCal to Lehman’s balance sheet.
But Walsh was not yet leery of the commercial real estate sector. In 2007, when some property developers were skeptically referring to Lehman as “the lender of last resort,” Walsh spearheaded a deal—along with Barclays and Bank of America—to finance Tishman-Speyer’s $22 billion buyout of Archstone-Smith, a massive portfolio of East Coast rental properties in May 2007.
It was a controversial move. Walsh did it partly because he believed, along with leading research at the time, that a fall in the residential market can be good for rental apartments. But within the firm there was dismay at yet more billions of illiquid assets being moved onto the balance sheet to pay for it. The voices of dissent within Lehman got louder. Bart McDade, whose equity division had closed out the year with a record annual revenue of $4 billion, was scared by the large amount of debt piling onto the firm’s balance sheet. He knew that the facts behind the housing bubble were troubling, and he was deeply worried by the firm’s exposure to commercial real estate, mortgages, and loans.
So too was his former deputy, now the head of fixed income, Mike Gelband, and technically Walsh’s boss who had issued his first dire warning about the coming housing crash to “Fortress FID” almost two years previously.
Subsequently, in the summer of 2006, Gelband’s deputy, Alex Kirk, had made a presentation before 150 of the firm’s senior managers, warning that if they continued to grow their leveraged businesses, they could lose billions of dollars.
Fuld heard the presentation with Gregory, but shrugged off the warning. He believed that “the more business we can do, the better,” says Kirk.
As one attendee puts it, “Dick had this idea that for every dollar of revenue you earn in doing an
LBO
[leveraged buyout] you earn five more dollars of follow-on business—which, by the way, when you do the math, is actually two times. And you have to take a lot of risk to earn all those dollars. So Dick and Joe didn’t like being told to be risk-averse.”
Also troubling: By 2006 David Goldfarb had been moved out of the
CAO
spot and made head of strategic partnerships and principal investments, essentially giving him control over $50 billion of Lehman’s balance sheet with instructions to invest it at the very peak of the market. (Again, according to a member of the executive committee, most of them—except for Goldfarb—realized this was because Fuld was inventing a way for him to stay at the firm, while Gregory wanted him gone.)
By 2007 Treasury Secretary Hank Paulson had begun warning all the securities houses to recapitalize, by slashing dividends and scaling back their balance sheets. But Lehman ignored Paulson, too. Among Treasury staffers, Dave Goldfarb acquired the nickname “Planet Goldfarb,” because, as one of them explains, “the things he said could only be true on Planet Goldfarb, because they weren’t true on Earth.”
Lehman spent most of 2007 on an otherworldly buying spree. In May, the same month the Archstone deal closed, the firm also acquired Eagle Energy, a Houston-based energy company, for $400 million, against the advice of Mike Gelband. Sources say Fuld boasted that Eagle Energy, which was run by a friend of Skip McGee, would turn a billion-dollar profit for the firm within 12 months. But over the next 12 months, Eagle Energy would come to owe Lehman $664 million in outstanding loans. In October 2008, the French utility giant Electricite de France SA (
EDF
) bought Eagle Energy out of bankruptcy court for only $230 million, under the condition that Lehman forgive $433 million in outstanding loans. And then there was Grange Securities, an Australian
CDO
distribution house Lehman paid $100 million for on the advice of Jesse Bhattal. The acquisition happened just as “CDO” was entering the public lexicon as shorthand for the insanity that characterized the mortgage boom of the prior few years. Gelband squawked, but he was told to be quiet. Grange Securities was another bust.
The danger in buying up whole businesses this way, especially when it required Lehman to pile on billions in debt, was that if the profits failed to meet the rosy projections, Lehman could have a tough time making the payments. And unlike other firms, Lehman made few attempts to get anyone else in on the action by securitizing its deals so investors could buy in. Lehman kept all the risk for itself.
Gelband spent the year in constant conflict with Fuld and Gregory. Fixed income had made $9 billion in 2006; Gregory told Gelband that he and Fuld expected $12 billion the next year. The tension, former colleagues say, had much to do with the intellectual disconnect between them. “Mike would say something and Dick would argue with him because he didn’t understand what Mike had said,” says one observer at executive committee meetings. “A lot of people didn’t understand what Gelband said.”
In May 2007, Gregory fired Gelband. “You wanted to make changes. Well, I’m the change,” Gelband reportedly said to Gregory.
Steve Lessing e-mailed Tom Tucker to say that Gregory had fired Gelband without even giving the executive committee the opportunity to discuss it, adding that he could not believe Gregory had been so stupid and jealous as to push Gelband out. He told Tucker that everyone was now so terrified of Gregory that he feared for the survival of the firm.
Soon after Gelband left, an exasperated Alex Kirk reportedly went to Fuld and complained that he, Fuld, hadn’t been listening to Gelband properly—largely on account of the “guy down the hall” (Gregory) whom “nobody believes,” and “who just tells you what he thinks you want to hear, not what is actually going on.”
Fuld told Gregory what Kirk had said. Kirk promptly became Gregory’s next target.
In a classic Lehman maneuver, instead of replacing Gelband with Kirk, who knew the business inside out, Gregory promoted Roger Nagioff, the former head of European equity derivatives, who lived in London and who had zero expertise in fixed income, to run it. Isaacs says he saw Nagioff’s promotion as a sign that Fuld was raising the profile at the European business. In fact, many people thought Nagioff had been chosen only because Gregory liked him and didn’t think he posed a threat. Gregory did not even mind that Nagioff said he wanted to stay in London, but he told Nagioff he would have to spend two weeks per month in New York and presumed him to buy an apartment in the city.
“That was the trouble with the whole philosophy of the place,” says a former managing director and head of global recruiting, who worked at Lehman for 20 years before leaving in the late 1990s. “Instead of going out and finding the best, they’d find someone loyal.”
After the Lehman holiday party in 2007, word got around the firm that Alex Kirk had taken a company-chartered bus home and asked the driver to drop him off first, ahead of the first scheduled stop.
The man he jumped ahead of was far junior to him, but he was a member of the Gay, Lesbian, Bisexual, and Transgender (
GLBT
) Network headed by Gregory.
“Do you know who I am?” Kirk had reportedly asked the driver when he had at first demurred. When Gregory heard what had happened, he was furious, according to colleagues. He docked $1 million off Kirk’s bonus.
In early 2008, Nagioff told Gregory he was exhausted from the transatlantic commute and he was quitting. Instead of appointing the obvious successor—Kirk—Gregory chose Andrew Morton, a Canadian who had met Fuld just twice, to run the fixed income division. There are reports that Kirk either quit and was fired. Either way, he was gone.
Plenty of Lehman employees, including Tom Russo and Freidheim, gave speeches warning that a bubble was coming and how imperative it was to manage risk. At Davos in January 2008, Freidheim was quoted in the
Financial Times
saying, “We don’t have to wait to find out whether there is a recession or not. . . . We ‘re in a credit recession and we have to deal with it.”
Russo gave a speech to the G30 in November 2007, later updated for the 2008 World Economic Forum in Davos, called “Credit Crunch: Where Do We Stand?” the highlights of which were bullet points such as: “Household net worth will likely start to decline on a [year-on-year] basis in the first half of 2008”; “Signs of a softer job market are starting to emerge . . . contributing to a decline in consumer confidence”; “Meanwhile the consumer is very levered”; and “Mortgage market problems and the contagion into credit markets and banks pose an additional challenge to consumers.”
So why wasn’t Lehman taking its own advice?
By 2007, Lehman’s real estate commitments had sprung in just one month from $20 billion to $40 billion. Gregory was annoyed, executives say, that Lehman had lost out to Wachovia and Merrill Lynch for a deal financing Tishman -Speyer’ s $5.4 billion acquisition of Stuyvesant Town, a huge apartment complex in Manhattan. Fuld, too, was irked; he was close friends with Jerry Speyer, the chairman of the real estate developer, and those relationships were supposed to lead to contracts. Speyer and Kathy Fuld were board members of the Museum of Modern Art. Gregory and others urged Walsh to get the next major deal.
And so to the surprise of many on Wall Street, Walsh spearheaded a deal with Barclays and Bank of America to finance Tishman-Speyer’s $22 billion buyout of Archstone-Smith, a massive portfolio of East Coast rental properties, in May 2007.
At first Fuld and Walsh were thrilled with the deal. They agreed with a report from leading industry analysts,
Greenstreet Advisors
, that Lehman had actually
underpaid
for Archstone. They simply had not foreseen how quickly and severely the market would turn.
The timing was so atrocious that Speyer even called Fuld, according to the
New York Times
, to see if Lehman wanted out. Of course not, Fuld said. He was a man of his word. He’d put $4 billion on the Lehman balance sheet.
“Archstone would have been a good deal if there had been time to hold on to it,” says a member of the executive committee. “But the timing was terrible, especially given how Lehman funded it. The market completely collapsed right at the time when they were supposed to move all this stuff out, and so Lehman got stuck with it.”
Steve Berkenfeld, chief investment officer for private strategy and formerly one of Lehman’s attorneys, later explained why Lehman was so willing to take those risks: “How do we compete in a balance-sheet-driven business when we are half the size of Morgan, Merrill, and Goldman, and a fraction of the size of Citi? . . . We go in to a client, and they want $15 billion of financing. They don’t want to hear that $5 billion is too big for us. Do we get more active in the real estate area, which is a way for us to do it? Yes. These are our ways of competing.”