Bailout Nation (30 page)

A
fter Bear's bailout, the question of who might be next was on all of Wall Street's minds. What other overleveraged firm might also be in trouble?

The obvious answer was Lehman Brothers. Just two months after Bear's demise, hedge fund manager David Einhorn explained at the Ira Sohn Investment Research Conference, an annual charity event, why he believed Lehman Brothers was the next candidate for problems. Einhorn questioned Lehman's accounting, its Level 3 (“mark-to-make-believe”) assets, and its solvency. There were suggestions the firm was being evasive in terms of hard numbers for its liabilities.
⁴

Why was Lehman Brothers allowed to fail when Bear Stearns was rescued? Why the nonbailout? Lehman was both older and larger than Bear Stearns. It had 25,000 employees at its peak, and the two firms were involved in similar businesses.

Unfortunately for Lehman, it seemed as if the team of Paulson and Bernanke were desperately hoping to avoid moral hazard. Bear was a one-off, they noted. Referring to the Fed's funding of JPMorgan Chase's takeover of Bear, Ben Bernanke said: “That was an extraordinary thing to do. I thought about it long and hard.
...
I hope this is a rare event. I hope this is something we never have to do again.”
⁵

Rare? Hardly. History would repeat itself again and again as the year unfolded.

A
fter Bear's implosion, Lehman's management considered their options. Its senior team—longtime, entrenched employees—were contemplating raising capital. Unfortunately, their loyalty and closeness to the company prevented them from fully grasping the firm's dire circumstances—at least, not until it was too late. Selling a few billion dollars in preferred stock was the plan. By engineering JPMorgan's takeover of Bear Stearns, the Fed may have lulled Lehman's executives into a false sense of bravado regarding the urgency of their need to raise capital. Similarly, Lehman's prime brokerage clients kept more funds with the struggling firm than they surely would have if they had seriously thought the Fed would let Lehman go under.
⁶

In April 2008, less than a month after Bear Stearns' demise, Lehman's annual meeting took place. CEO Richard Fuld was pugnacious, and seemed not at all worried about the situation. He was rumored to have told Lehman Brothers employees: “I will hurt the shorts, and that is my goal.”

Talk about your misplaced efforts. Six months later, Lehman Brothers filed the biggest bankruptcy in American history. (Full disclosure: My firm was one of the shorts that was decidedly unhurt by Fuld's efforts.)

Warren Buffett made an offer to Lehman, one that turned out to be more generous than the offer later accepted by Goldman Sachs.
⁷
As noted in our discussion of moral hazard, one can surmise Lehman's rejection of Buffett's bid was the last straw as far as the Fed and Treasury were concerned.
If they were unwilling to help themselves,
went the thinking,
then we'll be damned if we'll write another $30 billion check.

With Buffett spurned and an irritated Fed and Treasury, there were fewer and fewer options. Potential suitors kicked the tires at Lehman, but there were simply too many toxic assets on the books to attract a serious buyer.

Once Lehman filed for bankruptcy, Barclays scooped up most of the U.S. and U.K. operations—without any troubling bad paper to worry about. Neuberger Berman's management—who had sold to Lehman Brothers a decade earlier—bought the wealth management unit post bankruptcy. They essentially bought themselves back. Nomura Securities took over Lehman's Asian operations.

After 158 years, Lehman Brothers was no more.

—Ralph Waldo Emerson

 

 

 

 

 

W
hat took down the grand financial icons of Wall Street?

Why did a veritable conga line of storied names and legendary firms follow Bear Stearns and go the way of the dodo?

There are no hard-and-fast answers, but if you will indulge me, I have a theory. It may surprise and even shock you, given the stunning irresponsibility involved. But it is the only explanation that makes any logical sense, from either an economic perspective or a behavioral one.

No, it wasn't a conspiracy of short sellers. Mark-to-market accounting rules had nothing to do with it. And in the recent era of radical deregulation, you can be sure that excess supervision and regulatory compliance were not the root cause.

The question before us is simply this: Why did these profitable, well-run companies insist on embracing ever greater amounts of risk? What was it that compelled formerly conservative, low-risk business models to throw caution to the winds, and shoot the moon?

The most cogent explanation is tied to misplaced incentives and the overcompensation of senior executives, especially the C-level execs. Much of it can be traced back to the glory days of the tech boom.

I call it the “dot-com stock option penis envy” theory of financial mismanagement.

Got a better theory? I'm all ears. But before you dismiss this one, let's try it on for size:

In the bull market boom of 1982 to 2000, employees at Silicon Valley start-ups received huge pools of stock options. These were wildly risky companies whose potentials for success were quite slim. Indeed, the typical start-up eventually fails via conception or execution. Once the venture capitalist money is exhausted, it is on to the next start-up. Those few who made it really hit the big time: first Intel, then Microsoft, then Cisco, Apple, Dell, Oracle, AOL, and EMC. Each of these firms' founders became billionaires, and many of their early hires became multimillionaires.

That alone wasn't what did it. These were storied names, famously started in garages and dorm rooms. It wasn't even the second wave of technology firms that went public that caused the problem. Netscape, Rambus, Microstrategy, Global Crossing, Research in Motion, Yahoo!, and others all grew rapidly, had enormous revenue, and were real businesses (well, maybe not Netscape, but the others did).

I suspect it was the third wave of technology initial public offerings (IPOs)—whisper-thin business models, zero profitability—that really got under the bankers' skin. These were the merest wisps of companies, put together over the course of a semester or two by college kids. The bankers watched as companies like WebMD, CMGI, eToys, Investor Village, Excite, and InfoSpace went public, creating vast paper wealth; perhaps
Pets.com
was the last straw. When the pubescent founders/CEOs/dudes-in-chief became billionaires after their IPOs, one can only imagine what the bank executives thought.

I'd bet the East Coast CEOs turned green with envy. The big investment houses, banks, and insurers saw this from 3,000 miles away—and started losing their minds. It was going on right in the backyards of West Coast banks like Washington Mutual and IndyMac and Countrywide Financial. They witnessed this, and it got to be too much for their dopamine-addled brains. Soon they were scheming to get some of that sweet stock option lucre for themselves. They created a system of incentives that gave themselves huge stock options bonuses. Sauce for the goose is sauce for the gander indeed.

Unfortunately, there were two major flaws in the plan. When technology creates what has become known as “the killer app”—the hockey stick portion of growth—it catches a wave. These were new product lines, groundbreaking ecosystems, vast changes in consumer habits. E-mail! Mobile phones! Online retail! iPods! Game-changing booms like these were most likely to come from technology. The companies that developed these were awesome wealth producers. As these products became widely adopted, a natural sweet spot for cashing in stock options was created.

The major finance businesses—banking, lending, insurance, investing—did not lend themselves to the sort of explosive growth that created overnight billionaires. Sure, you could get wildly wealthy, but you had to be somewhat patient. But that wouldn't do; these were the sort of folks who couldn't be bothered even to wait for immediate gratification. The bankers needed some way to get to that next level
now
, to embrace the sort of models that would be game changers immediately.

They needed a Viagra.

The 100-year-old financial houses could never compete with that sort of growth. Well, at least not with their relatively staid old business models, their conservative approach to risk. Slow growth and modest profit margin was not how you got rich quick. So they leveraged up, embraced risk, and reinvented themselves as newfangled quants.
“We're engineers, too—financial engineers! We design derivatives and securitize debt! We have access to massive leverage! Hey, everybody, we're all gonna get laid!”