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Why Did Lehman Behave So Idiotically?

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I haven't yet finished Anton Valukas' 2,200-page report into Lehman, but I feel like I could have written it for him. The Chicago-based lawyer told me recently that he was greatly looking forward to my new book The Devil's Casino: Friendship, Betrayal, and the High Stakes Games Inside Lehman Brothers, just as I was looking forward to his report. I had a feeling we'd be on the same page.

My book, due out shortly, explains the provenance and reasons behind many of Lehman's idiocies unveiled by the Examiner's $34 million report. These include: appalling risk management, accounting from the Twilight Zone (there was a reason the head of proprietary investing for Lehman, David Goldfarb, was nicknamed "Planet Goldfarb" by the U.S. Treasury staff; they felt that "what he said could not possibly be true on earth....") and pitiful misjudgments, especially concerning investments in the real estate sector at a time when the world was about to collapse.

As Valukas points out, Lehman compounded its risky real estate investments by putting them on the balance sheet from 2006 through 2008. Their competitors did not do this...a fact that U.S. Treasury Secretary Henry "Hank" Paulson was well aware of. This was why he ultimately got exasperated with Lehman. The final straw for Paulson occurred on Sunday, 14 September 2008, when a very senior executive at Credit Suisse (note: not Goldman Sachs) warned him that the illiquid hole on Lehman's balance sheet could be as big as $100 billion. According to one person in the room, Paulson said, "Screw it."

Why did Lehman behave so idiotically?

Well, you will have to wait a week to read my book, The Devil's Casino -- but what it shows you is how, historically, the Lehman culture was more like a Renaissance feudal court than a bank. Disagree with the King and you were cast out. This did not create an environment for amicable argument. Quite the reverse. As one person tells me in the book, "It became a culture of lies: It was 'what lie are we going to tell the people who work here and what lie are we going to tell the market.'"

The chief cheer-leader of this closed-off world, is not actually included in the list of people singled out by Valukas as executives who could allegedly be culpable of balance sheet manipulation: Dick Fuld, Erin Callan, Ian Lowitt and Chris O'Meara. Instead, he is the man who put them in their positions. This person is former Lehman President Joe Gregory - who many former employees now consider to be grotesquely hypocritical, telling incoming managing directors he did not want to hire "anyone who had to check their bank balance daily" - yet who himself took out over $300 million from Lehman over his 30-year tenure there and has now sued the Lehman estate for an extra $232,999,549. Dick Fuld made no claim, nor did virtually anyone else from Lehman's Executive Committee, save the former legal counsel Tom Russo, who sued for $17.3 million.

Gregory was used to fudging facts when it came to public documents. He admits as much in a journal he dictated in 2002 in which he says he's collecting the memories of other senior executives to compile an official "modern history" of Lehman that will be "sanitized."

What he wants, he says, is to give Dick Fuld more credit than he was due in resurrecting Lehman -- "for the sake of the brand."

But Gregory quickly realized that no amount of sanitizing was going to make those memoirs palatable to him, his boss - or the public. Most of the "diaries" either ignored or belittled Fuld. Nor did the various accounts tally with one another, which threatened to destroy Lehman's precious, often-pronounced motto: "One firm." So Gregory had abandoned the project, obviously not realizing the papers could fall into a journalist's hands....

Tellingly, given that Valukas labeled Lehman's financials as "materially misleading" Gregory's own dictated memories of the firm have him recalling being livid with John Cecil, Lehman's former CFO (and CAO - chief administrative officer) in 1998 because Cecil wanted to take his time releasing the firm's earnings in the immediate aftermath of the so-called Russian crisis, during which Russia had defaulted, and the small outfit of Lehman had faced a "rumor-storm" questioning whether it could survive.

Gregory says that he "could remember the conference call like it happened 'two seconds ago.'" "We needed the CFO to say the firm is financially sound...John responded that he wasn't sure he could say that for threat of being sued...we all went nuts. How could he say that? We were trying to keep the company alive - 12,000 to 13,0000 peoples' lives were at stake."

When asked about this Cecil, now running his own consultancy Eagle Knolls, replied dryly, "If only they'd applied the same caution in 2008." Yes, if only...."

But Gregory did not see Cecil's meticulousness as a plus. Quite the reverse. He made sure he was a marked man. Cecil left the firm in 2000. When asked why, Bob Genirs, Lehman's former CAO (chief administrative officer) wrote succinctly to a colleague: "Joe shot him."

Gregory, to be fair, was just a product of a system used to bending the facts.

Back in the 1970s when Lehman was run by white-shoe bankers, the traders in the commercial paper unit, Lehman Commercial Paper Inc (LCPI) used to hide their volatility from the partners. The traders used to put up their positions on five-by-seven inch cards on a wall so that everyone could see what had been bought and sold. The color of the ink indicated which type of security it was...but according to a senior person at LCPI, if the traders heard that Arthur Schulte, Lehman's partner responsible for trading, was on his way over from 1 William Street (Lehman's headquarters) to 9 Mill Lane (then the headquarters of LCPI), the cards were quickly pulled off the board. There were limits to the total value of their positions and at midday those positions might be higher. Essentially, they were hiding their volatility, how much risk they were taking on a daily basis.

As soon as Schulte left, the cards went back up. "It was a game," says Paul Newmark, Lehman's former senior vice president and treasurer of LCPI. "It was a game that was ingrained in people...Dick Fuld was very good at it."

So good at it, that once LCPI was absorbed by American Express Shearson Lehman he allegedly carried on. "Dick's reserve" was the name for what could also have been called "the Daily Fiction," which the Lehman traders hid from their bosses, Jim Robinson and Peter A. Cohen. A former managing director says it worked like this:

Every day we would report up to Shearson and American Express our P&L [profits and losses] for the day. We knew that the management upstairs, if they saw the P&L going up and down dramatically -- one day we made a lot of money, and the next day we lost a lot of money-they'd know that we were betting a lot of money, and taking a lot of risk. But if our P&L looked like a nice steady EKG kind of thing, then everything was okay. So on the days we made a lot of money, Dick didn't report all of it, and when we lost a lot of money, he took a little out of that kitty to make that day's P&L not as bad. We called that kitty (kept on a piece of paper) "Dick's reserve."

As for Gregory? He slowly rose through this culture to become head of fixed income in 1994 as Lehman got spun out. One problem: In a pre-run of what would happen in 2007 and 2008, he didn't manage risk.

In November 1994 Gregory's boss, Chris Pettit, then Lehman's president, was livid to discover that due to Gregory's carelessness, the firm had had $5 billion of gross exposure to Mexican bonds and related counterparties and it looked like Mexico could default soon. At the time, Lehman was only worth $3.5 billion. Pettit gave Gregory a public dressing down every Friday.

By the time the then Treasury Secretary Robert Rubin dived in and saved the Mexican peso, underwriting the country's debt in February 1995, Gregory and Pettit were no longer sharing the same car into work.

But the battle between the two men was won in the end by Gregory who rose to preside over Lehman's culture and day-to-day management, even though he took increasingly little interest in the firm's businesses.

"What's our China policy?" he was asked in 2008 in an Executive Committee meeting. "I have absolutely no idea," he told a horrified room. Fuld, meanwhile, was nowhere near; he was out with clients.

So, no, the Valukas report did not surprise me one iota. Lehman, I believe, was so rotten at the top, so corrupt, so unwilling to tolerate dissension, and Dick Fuld and Joe Gregory were so obsessed with clinging to their seats, that eventually it would have failed, even without a housing or asset bubble.

As one senior executive manager put it to me: "In the end a car gets pushed over a cliff, - and that guy who pushed it would be Hank Paulson - but really who are you going to blame? Him or the people who drove the car right up to the edge?"

Vicky Ward is a Contributing Editor to Vanity Fair and the author of the upcoming book The Devils Casino: Friendship Betrayal and the High Stakes Games Played Inside Lehman Brothers