A Colossal Failure Of Common Sense Part 11

Whichever way you examine it, $13.4 trillion is a very decent amount of cash, enough to carpet the earth. But the money was not real, nor would it materialize. Right now, even as we contemplated the reality during the Christmas holidays in 2006, there were families bailing out of houses that were about to be repossessed, running for their lives, without even the slightest intention or the wherewithal ever to repay their mortgages. If things continued to get worse, the amount of cash that the mortgage holders might actually collect out of that $13.4 trillion might not reach even the top of the Cape Canaveral launch pad, never mind anywhere near the moon.

And speaking of the moon, I should mention that at precisely this time, this Christmas, I reached out and touched its glowing outer edges with my own fingertips, like ET just before he went home. Seventeen years had pa.s.sed since I graduated from UMa.s.s and set my sights on a seat at one of Wall Street's top tables. Seventeen years since my high school buddy Jack Corbett had informed me that my chances of achieving this hovered somewhere between slim and none. It had also been almost seventeen years since a succession of New England finance hotshots had evicted me from more offices than any other applicant since records began.

These had been years of barnstorming commotion, years of desperate aims and objectives and what I considered to be t.i.tanic effort. My own single-minded quest had, for me personally, demolished all before it, including a marriage that lasted only a year before being swept away in the fiery wake of my own ambitions.

Step by step, through the little bond company above the dry cleaner, I had reached for the moon. Up into the stratosphere to Morgan Stanley, and then the break for which I had prayed for so long: a coveted place on the trading desk at Lehman Brothers. This was a place where, for the first time in my life, I seemed to matter. It was a place where mighty weights of responsibility had been rested on my shoulders, where great men finally treated me as an equal. It was a place where, in my mind, I once had stood alone, making the market for the foundation of the biggest trading victory in the 156-year history of Lehman Brothers; a place where I had helped to forecast both the coming Armageddon and what to do to protect ourselves. It was a place where I had the effrontery to believe I belonged, and where I profoundly hoped I would always be received with respect.

And now I was being invited up to the suite of rooms on the twenty-seventh floor where the annual bonus hearings were held, where Rich Gatward and Larry McCarthy presided over meetings with all of their people, reminding them of their strengths and weaknesses, and handing them their annual bonus package. When it was my turn to go in, they both stood up and shook my hand. It was then, and still is, the proudest moment of my entire life. In the two years I had been there I had made the firm just shy of $50 million hard cash. In 2006 alone, with the Delta bonds and subprime shorts, I had been responsible for $35 million of trading profits.

They both treated me as if they were aware of every last dollar I'd made. Neither of them sought any credit for anything they had contributed. They never did, no matter what the circ.u.mstances. They made me feel as if I had done it all on my own. And when they gave me my piece of paper, my eyes raced down it to find the number that mattered. And there it was, a glistening seven-figure bonus.

"You're hitting two-ninety" said Larry. "Nice going, buddy."

In those fleeting seconds I considered I had achieved my life's ambitions. I was in the majors and suited up, my name was on the lineup card, and I was ready to swing the bat with the best of them. I'd come from so far back. I'd started so darned late. But somehow I'd made it. Even my dad might admit I'd proved some people wrong.

No day ever pa.s.ses when I do not think with profound grat.i.tude of those moments when I stood up there with Rich and Larry and received my million-dollar reward. No day. No night.

How d'you like them apples, Corbett?

It was no surprise that Larry and Rich had been wearing such broad smiles, because the year-end results for Lehman, despite the mounting problems in the real estate market, were extremely good. The firm had $46 billion in revenues, with profits of around $4 billion, or $6.73 per share. Generally speaking, that was good enough to keep us patronizing bars and restaurants like Il Mulino, Ben Benson's, Tonic, n.o.bu 57, Rue 57, Felix, Pink Elephant, Frederick's, and Ono at the Hotel Gansevoort.

Life was exquisite that winter. Quarter by quarter, Lehman had been coining money. In 2005, Q1 revenues were $7.39 billion, Q2 $7.33 billion, Q3 $8.6 billion, and Q4 $9.05 billion. In 2006, the revenue breakdown was Q1 $10.3 billion, Q2 $11.5 billion, Q3 $11.7 billion, and Q4 $13.1 billion. As gravy trains go, this was not half bad.

No one, however, was looking very hard at the dark side to this magnificent state of affairs. And that dark side was leverage, the amount Lehman Brothers had borrowed in order to lever up their balance sheet, taking bigger and bigger positions, which they could afford only if they used someone else's money. It made the profits look fabulous. But in order to appreciate the shining fabulousness of the profits, you had to ignore the fact that in order to attain them, Lehman had actually borrowed by now thirty-two times their own worth, or more simply, around $480 billion, mostly to cover purchases of mortgages from places like New Century. Some of us thought that was probably a bit steep, especially since the number in 2004, a mere twenty-four months earlier, had been only twenty times Lehman's own worth.

I always found the numbers to be mind-blowing and so did Larry, Alex, Rich, and Mike. But we were in a minuscule minority. Even the SEC, which is supposed to keep a sharp weather eye out for situations of obvious danger, paid not the slightest attention to the condition of Lehman, any more than they did to the other banks with highly leveraged positions, like Merrill Lynch and, more important, Bear Stearns, which were leveraged even higher than we were.

The House Financial Services Committee held fifty-six hearings in 2006, and they covered every possible unforeseen happening that could befall the western part of planet Earth. They discussed everything, from flood insurance to transparency in financial reporting. As a matter of fact, they spent hours and hours on those subjects, and even longer talking about the obfuscations that had brought down Enron so many years ago. That was the tactic of spreading out wider and wider until the truth is forever obscured. Not one of those fifty-six gatherings of the U.S. government's financial watchdogs touched directly upon the issues that were in danger of bringing the entire world economy to its knees-the off-balance-sheet securitizations, the RMBSs, CDOs and CLOs, the deadly leverage in the system.

Indeed, the Securities and Exchange Commission chairman, the fifty-four-year-old Harvard-educated Christopher c.o.x, was summoned before that committee in September, just as the credit bubble was reaching its peak. This was by any standards a momentous brain to face the congressmen. Chris c.o.x not only had earned his MBA at the Harvard Business School but also had earned a doctorate in law from Harvard, where he edited the law review. He served in the White House as a senior a.s.sociate counsel to President Reagan starting in 1986, at the age of thirty-four.

If he couldn't get it, who could? Answer: no one. Because c.o.x, speaking at a session to celebrate the Sarbanes-Oxley Act, the signature legislation of the post-Enron era, felt compelled to observe: "We have come a long way since 2002. Investor confidence has recovered. There is greater corporate accountability. Financial reporting is more reliable and transparent." Sometimes, Mr. c.o.x. Not always. And there were at least ten people in my department at Lehman who on that very same September day could have put you straight.

Right now there seemed to be a local, statewide, and nationwide policy to ignore the encroaching truth. Uncle Sam had removed his top hat and put on his ostrich suit in order to bury his head in the sand, or perhaps somewhere with even less sun. However, there was one new set of numbers that came sidling out of the darkness, like Caliban slouching sideways: there was an increase of 35 percent in U.S. house foreclosures for December. More than a hundred thousand properties were taken away from owners who were unable to pay their mortgages. Merry Christmas, New Century.

Meantime, on the other side of the Atlantic, the oldest and third-largest banking corporation in the world was facing up to a burgeoning wave of shocking news that seemed to be growing worse by the day. The global mammoth HSBC was putting together a warning that its bad-debt charges would be 20 percent larger than forecast.

HSBC, a major player in the low-quality-mortgage game, made no attempt to disguise the ominous trend that was emerging throughout its North American mortgage operation. The 140-year-old London-based bank was by far the largest so far to specify this obvious forthcoming problem, and its directors were prepared to go on the record, saying that the current slump in U.S. real estate prices had made it more difficult for strapped homeowners to refinance in the traditional way. They had but one chance. And that was to run.

HSBC had a global payroll of almost sixty thousand and in 2003 laid out $15.5 billion to purchase Household International, the disgraced predatory lender from Chicago. This allowed HSBC to break swiftly out of the blocks and into the shaky mortgage business before most banks were organized. It now looked as if they might be first in, first out, because they were citing a $10.56 billion charge and squarely admitting that their predictions about defaults and repossessions were way off target.

The truth was, a vast operation like HSBC could ride out a storm like this. A lot of much smaller shadow banks really did not have a prayer without some serious federal help. And one of these was none other than New Century, whose black-gla.s.s house of cards was about to cave in.

In the days before HSBC made its formal warning, New Century admitted its third-quarter earnings would have to be revised. They accurately forecast a resounding fourth-quarter loss, as the early payment defaults. .h.i.t home. They further said they would restate results for the previous three quarters in order to correct accounting errors. The glossy mortgage provider slashed its forecasts for loan production in 2007, and in one day its stock crashed 29 percent. When it hit $15 I went down to discuss the situation with Rich Gatward. He said: "Double our short position. You're right, these guys are crooked." We'd stuck to our guns for almost six months, holding on to the shorts-and now the cards had turned, and we were on our way to a $28 million profit.

In a sense, we were not yet tuned in to a dark subterranean move along the deep tectonic plates of Wall Street. That stern warning from HSBC had not gone unnoticed. The market did not react, but there must have been an underlying seam of fear, unspoken but present, because on February 27, 2007, there was a major hiccup on the Chinese stock market, and on the following afternoon, Wednesday, just before 3:00 P.M. P.M. the Dow Jones Industrial Average suddenly and for no apparent reason dropped 178 points in a single minute and then kept falling. Alex Kirk, heading into a meeting, exclaimed, "Holy s.h.i.t!" as he walked past my desk. Ten minutes later, when he came out of the meeting, it was down 546, its biggest single-day rout in five years. "What the h.e.l.l's going on?" he asked. But no one knew, and there was an aura of quiet unease right through the trading floor. I could see some of the younger traders, looking worried, some of them scared. Alex Kirk, frowning, said, "It doesn't add up. Markets don't drop like that in sixty seconds. There's something wrong here." the Dow Jones Industrial Average suddenly and for no apparent reason dropped 178 points in a single minute and then kept falling. Alex Kirk, heading into a meeting, exclaimed, "Holy s.h.i.t!" as he walked past my desk. Ten minutes later, when he came out of the meeting, it was down 546, its biggest single-day rout in five years. "What the h.e.l.l's going on?" he asked. But no one knew, and there was an aura of quiet unease right through the trading floor. I could see some of the younger traders, looking worried, some of them scared. Alex Kirk, frowning, said, "It doesn't add up. Markets don't drop like that in sixty seconds. There's something wrong here."

Larry didn't believe it either, and in the middle of the drama, in the middle of what was a stupendous freeze of pure terror throughout the floor, he was the only man who moved. With people all around him paralyzed with indecision, he waded into the churning market all on his own, to buy three million shares of SPYs (an exchange-traded fund that tracks the S&P 500) in the hole, that is, at the low point as the market plummeted. Alex, standing next to him, ordered a tight stoploss on the trade (i.e., he limited the amount that could be lost). But he allowed Larry to put over $400 million on the line, waiting for the numbers to climb back up.

In the end they did recover, and Larry made $6 million in something like twenty minutes. Some people later put the plunge down to a mysterious high-tech computer glitch, and maybe it was. But the S&P hadn't suffered more than a 10 percent correction in four years. And glitch or no glitch, that sudden crash frightened the life out of many traders, a lot of whom suspected it could have been a tremor before the real earthquake.

Well, the home of all earthquakes is reputedly California, and just a few days later, right up the street from the San Andreas Fault, we had a real good one. New Century admitted it was going to be late filing its annual report with the SEC. The following day the company disclosed there were U.S. Attorney's Office and New York Stock Exchange investigations into trading on its stock. Immediately federal bank regulators announced a crackdown on loose lending standards on subprime mortgages.

Seven days later-six months since Dave Gross and I had shared a couple of beers with the bodybuilders-New Century stopped making new loans, and the stock price collapsed totally. They went straight to bankruptcy.

And what now for the lugheads? I supposed they would just move on to the next scam. They were a breed, and the collapse of New Century would not unduly concern them. Guys like that understand innately there are almost certainly hidden problems with all the products they carry into the market.

I wondered if those salesmen in the restaurant would ever remember Dave Gross and me, a couple of guys in from New York who asked a lot of questions, most of them negative, some of them almost accusatory. Would our presence out there, sitting in that bar, ever ring a bell with the hotshots who had told us how great it was to be a part of the New Century family? How fast the cars and the women were? How rich they would all become, how perfect life would be out there on the road, moving the poor from semi-ghettos onto the lush banks of the Delta and the sprawling new developments in Nevada?

To them, when it all went wrong, none of it would matter. Nothing would be laid at their door. But for us in the financial world it would surely come home to roost. If this went the way we thought it was going, lives would be ruined. Men who had worked brilliantly and faithfully for decades could get wiped out in a crashing stock market, with its attendant bankruptcies. People whose wealth is tied up in corporations so often leave their private stock options behind, unable to claim their rightful rewards after a lifetime of work.

And there were other aspects, stuff that only some of us could ever understand. Not just the sadness of ruin, the undeserved sword of Damocles slashing down on a family or a small business. Some people have no difficulty grasping the sorrow and heartbreak that may lie ahead. And I am one of those. I don't usually admit to such sad deliberations, but I am nonetheless aware that I harbor them. I suppose it's a weakness. But I am not ashamed of it. And it's why I despise the bodybuilders. Because the anguish of other people will always matter to me.

9.

King Richard Thunders Forward And they summoned Prince Mark and told him to saddle up his white battle charger and go to it-storm the boardrooms, lay siege to the world's most grandiose commercial real estate, and the h.e.l.l with the expense. And the risk.

ASIDE FROM THE subprime mortgage market, where the lunatics were now in total command of the nuthouse, there was another kind of craziness lurching around on Wall Street in the winter of 2007. It wore a merry smile and there was bright optimism in its eyes. However, when it was exposed to a harsh light, it would become the face of bleak stupidity. subprime mortgage market, where the lunatics were now in total command of the nuthouse, there was another kind of craziness lurching around on Wall Street in the winter of 2007. It wore a merry smile and there was bright optimism in its eyes. However, when it was exposed to a harsh light, it would become the face of bleak stupidity.

I refer to the Apparition of Plenty, a grinning wraith, wandering around a market awash with cash, with billions of dollars from China still flooding in for U.S. Treasuries, still making money a very cheap commodity. Generally speaking, it was impossible to go out of business in the United States in the first half of 2007. On the same subject, I should confirm it was still pretty tough to fail in the second half. Huge corporations could borrow limitless amounts anytime they wished. So could medium ones. The little ones? No problem. Bankers could borrow with impunity; investment bankers could have anything they needed. My great-aunt Matilda probably could have hit Bear Stearns for a couple of billion to open a Cuban cigar shop, despite the fact that (a) importing anything from Cuba was illegal and (b) she had pa.s.sed away in 1954. Even General Motors, under a preposterous weight of debt and liability, could borrow. So help me, bankrupt Calpine could, and did, still borrow.

Logic had flown the coop. Rolling loans, short-term thinking, and easy-come money dominated the landscape. Secure a billion-dollar loan for thirty days, borrow again to pay it back, then again, then again. Just keep borrowing and paying back. It could go on forever. It was a physical impossibility to go bust. In the entire year, major bankruptcies in the United States were few and far between. Globally, the default rate was at an all-time low. In 2009 there will be probably five thousand in the United States alone.

Of course, most people never gave the matter much serious thought-probably they were too busy filling out loan applications. But there was one person in our organization who was giving the matter profound consideration. And that person happened to be the one a.n.a.lyst in all of Wall Street who had called the Calpine bankruptcy first, and also the insurmountable problems of General Motors: Christine Daley.

As one of Lehman's top two a.n.a.lysts of distressed debt, she was gazing at a market that was defying gravity. Calpine was on the floor with gigantic debt, and I had bought the bonds for as low as 10 cents on the dollar when they filed for Chapter 11 protection. Insanely, the bonds went above par to 120 cents on the dollar! General Motors, which, logically, should have tumbled into the Detroit River, had its stock selling at $32 when it should have been about 27 cents. The truth was, in this pumped-up credit bubble, Christine's market in distressed bonds had ceased to exist. There wasn't any distress, but Christine could see no real reason why there shouldn't be. Which was right and proper, since there wasn't a reason, or at least not a logical one. It was just the way things were. The very brilliant Christine Daley was in an intellectual dilemma, a situation to which she was unused.

Slowly, over the long dark weeks of midwinter, she ran into the same recurring problem: recommending short positions, spotting real live trouble, and then watching the bonds go up, rising on a flood tide, as people with money to spend continued their desperate search for some value, some return, on their cash. They were buying corporate bonds because of the insatiable thirst for yield above the low rates being paid for Treasuries.

In her view we were looking at weeds-priced not as flowers, as Warren Buffett had observed, but as emeralds. And over the weeks I watched Christine become ever more gloomy and frustrated. We talked often, and she would ask the unanswerable question, "What the h.e.l.l am I supposed to do? I locate a corporation that cannot possibly survive, crippled by debt, floundering around, losing market share, with a future that adds up to zero, and the stock goes up. And then the bonds."

And every day the Dow Jones kept chugging along at around 12,700, not much volatility, and very few scares. Christine still looked as beautiful as ever and arrived every day immaculately turned out, but I often caught her looking somewhat reflective, and I could see she had much on her mind. She was the lonely vulture with nothing to buy.

I knew she believed the bonus pool in the distressed-debt department was going to h.e.l.l, and one late afternoon she said, "We're never going to make a lot of money this year. So what's the point of working?" It was a pretty good question, but my trading world was wider than her researcher's domain, and her position was much worse than mine. I could still operate. She couldn't.

Together we sat and stared at new tables that had just been released showing the main players packaging lower-quality mortgage-backed securities. Right at the top of the 2006 table was Lehman Brothers, with over $50 billion worth of subprime on the market, up there ahead of the giant RBS Greenwich Capital, the U.S. fixed-income investment arm of the Royal Bank of Scotland (founded 1727). The Scots were $4 billion behind Lehman. And behind both of them came two more Wall Street behemoths, Morgan Stanley and then Merrill Lynch, which was over $16 billion behind. In fifth position was Countrywide Securities. Between them these five had over $200 billion out there swinging in the warm breezes of the Sunbelt, all five hoping fervently the poor were going to keep writing checks even though they could not prevent them from growing bigger and bigger with each pa.s.sing month.

Both Christine and I had heard the rumors that the mortgage guys were having trouble moving the CDOs, those securitizations of mortgages. Actually, we'd probably heard more than that, but in the strictest confidence, since this wasn't the kind of stuff you want to make a great deal of noise about. As bad news goes, that hovers somewhere between chilling and terminal. Because if our guys couldn't move them, neither could anyone else, and that theater door was getting real jammed up.

Maintaining these rolling loans, which were acquired to buy the mortgages in the first place, was plainly becoming very difficult and very pressured. The idea was to repackage these mortgage-backed securities and get them turned around and sold in the fastest possible time, before the original loan money had to be paid back. But now it was just possible Lehman was getting stuck with them, these red-hot potatoes, which can so seriously damage your hands.

I remember mentioning to Christine that the engine of this business was the bodybuilders, who were still out there, working for whoever was still in the game-not New Century-and they were still selling mortgages. It was not like turning off a faucet. You couldn't shoot them. And Lehman had obligations to the brokerage houses. If they could no longer move the CDOs, this was a shocking problem.

Remember, when it came to a.s.sessing trouble, Christine Daley was widely considered not just the best on Wall Street but one of the best there had ever been. And she was worried. I could see that. With her own field of operations temporarily in shreds, I sensed she was losing heart, becoming engulfed by the blind illogic of the market and of some of the people with whom she shared this enormous building.

One of these was our corporate president, Joe Gregory, the right-hand man of the reclusive CEO, d.i.c.k Fuld. Now, d.i.c.k had either been born or had somehow evolved into a very strange character, remote from his key people, apparently allergic to the engine room of the business, and obsessively jealous of his hold on power. But Joe Gregory was a regular, run-of-the-mill, ho-hum financial sycophant, devoted to his master, Richard Fuld, but with few of the necessary tools and instincts to serve as president of Lehman Brothers. He suited the boss fine, however, since he posed not even the semblance of a threat and would do anything in the world for the chief.

Joe's fixation was a subject called diversity. He was consumed with it. His aim was the mission of inclusion. He had an entire department devoted to it, headed up by a managing director. Great rallies were staged in New York's auditoriums, with free c.o.c.ktails and hors d'oeuvres served for up to six hundred people, all listening to Joe or one of his henchmen pontificating. "Inclusion! That must be our aim!" he would yell, as if we were running a friggin' prayer meeting.

In Joe's view, it was the culture of the corporation that mattered. Joe believed that inclusiveness would carry us to victory. If the culture was right, then all would be right. Which was all very well, but down in the trenches, where a trader might sweat blood to make a couple of million dollars, most of us were a bit tetchy about Joe Gregory going off and spending it on a c.o.c.ktail party for six hundred people.

That might not have been fair to him, but that's the way it seemed to us. Especially when it emerged that the top dog in diversity was earning well over $2 million a year and that the diversity division had a bigger budget and more people than risk management! Which was unusual for a hard-driving merchant bank with billions on the line every day, and where control of financial risk was absolutely paramount. The whole scenario really bothered a lot of people, especially hard-nosed traders who, after hours of real stressful work out there fighting the world, were then being marched off to these meetings and rallies to support Joe's trumpet call for equality. People who spend all day long concentrating, making big decisions, dealing in millions, are sometimes a bit tired after a 6:00 A.M. A.M. start. start.

This included Christine, who, with a husband, two small children, and a gorgeous apartment to maintain down in the Tribeca area of the city, was really not ready for this sideshow at the conclusion of her working day. Joe's mission for diversity drove her mad. She had no time for any of it, but Joe Gregory had us all over a barrel: he had major control over our bonus compensation, and he made it clear there would be extra money for those who rallied to his cause. Most of us did not care about the cause, but the prospect of this thirty-first-floor sycophant lopping a couple of hundred thousand off our annual check because we weren't in there pitching for the cause of the day was seriously irritating. Harsher judges than I considered Joe hid behind his unusual fixation, appearing to fight the world's woes while staying well clear of the gundeck.

Christine's view of the market was it was behaving irrationally and almost certainly showing cla.s.sic signs of a top, with dozens of corporations trading at values far, far beyond reality. She also believed that when the president of a trading investment bank was spending his time staging hugely expensive rallies for minority groups, that might have been the ultimate demonstration of a market peak. There was too much undeserved cash flying around, it was all too easy, and there was too much time to find oddball ways to spend it. The essential weirdness of the situation-a bankrupt Calpine still borrowing, GM stock priced way above where it should be, and then the rallies on top of it all-might have been the last straw for Christine. She just could not deal with it. Also, she was permanently concerned about the coming catastrophe in the mortgage game, and certain in her own mind that Lehman had to get out of CDOs, downsize their risks, and stay out. So one morning in February she came to me and said, "Larry, how are we going to make any money this year? There's zero value in this marketplace. But I've probably got enough to live out my life. And I'm quitting. Maybe I'll come back when these idiots start to blow up. But right now there's nothing here for me."

I ought not to have been surprised. And perhaps I wasn't. But the awful truth of her words drove right through me. Christine, my friend, my buddy, my ally, my kindred spirit, always there, always ready to help. You don't find many people like that, not in one lifetime. And now I was losing her. I do not recall ever feeling that sad at any other moment in my career. Not even when Steve Seefeld and I parted on the rainy sidewalk of Greenwich Avenue seven years earlier.

There was nothing I could say. And nothing more she wanted to hear. Her logic was impeccable. She needed to go. And she knew how I felt about her. Nothing more needed to be said. Except before she left my desk she said, "Just so you know, Larry: I didn't really believe you about the subprime crisis last year. But you called it."

I muttered something about blind luck, and gave her a hug. She was wrong, of course. Alex Kirk had called it in May 2005, when he made the steroid comment to Larry and me right outside that 7:00 A.M. A.M. meeting. All I can say is, I knew Alex had hit it right on the b.u.t.ton, and I had acted ever since to try to contain the coming disaster. Christine had not been party to that somewhat historic moment, and neither Larry nor I had ever revealed the ident.i.ty of the true prophet. meeting. All I can say is, I knew Alex had hit it right on the b.u.t.ton, and I had acted ever since to try to contain the coming disaster. Christine had not been party to that somewhat historic moment, and neither Larry nor I had ever revealed the ident.i.ty of the true prophet.

Meanwhile, Joe Gregory was out there on various stages, facing the television cameras, waving his arms in the air like some kind of a messiah, blathering on about the culture, basking in his gigantic earnings, getting to and from his $32 million beachfront home in the Hamptons via private helicopter, limousine, and G.o.d knows what else. When he did settle down to some real work, he was there only to do the bidding of his boss, Fuld: keep those derivatives going, those CDOs, the lethal swaps, and the highly leveraged commercial real estate deals. That way the stock stayed high, the balance sheet looked great, and the personal bonus checks for the two men at the top of the tower would keep them in a style to which they had undoubtedly become accustomed.

It was, however, blindingly obvious to the big brains in the organization that the two top guys were living in Delusion City. Both of them were devoted to the commercial mortgage-backed securities-CMBS-another gigantic securitized debt portfolio, this one based on huge buildings not yet paid for with real money. Again, Lehman was slicing them up and packaging them, getting them rated AAA, and selling the bonds to banks, hedge funds, and sovereign wealth funds all over the world.

Instead of the vast army of struggling homeowners, this derivative, the CMBS, offered the backing of major corporations in the form of cash flow paid by rents to those who owned the buildings. And so far as d.i.c.k and Joe were concerned, this was perfect: a hedge against the residential real estate, a safe diversification. Except that in the current global a.s.set bubble, no one was diversified, nothing was safe. They simply did not understand that Lehman was concentrated, that commercial real estate was equally as vulnerable as residential property. Just another top-of-the market illusion of solidarity.

Christine Daley understood this, understood we were heading for trouble. And now she was leaving. The rest of us were caught in a trap, because Lehman had us in golden handcuffs. Our equity holdings in the firm were growing, but even if we left, it would be months, maybe years, before we could get our hands on the money. Each year we left behind enormous sums payable only in the firm's stock sometime in the future. This had unquestionably played on Christine's mind. She had been with the firm eight years, and by leaving when she did, she was able to sell some of her stock, which must have given her a substantial sum.

She had, however, decided not to remain in New York. It might be the city that never sleeps, but it is also the city that never stops swallowing people's money. And she set about finding a new, more economical place for her family to live, utilizing the same kind of research program she had applied in her quest to expose Calpine. Everything was considered-climate, schools, universities, housing costs, taxes, and the surrounding countryside.

Eventually she chose Nashville-Music City, the fast-growing capital of Tennessee, situated on the banks of the wide and winding c.u.mberland River, home to the Country Music Hall of Fame, and the stamping ground of Hank Williams, Loretta Lynn, Barbara Mandrell, and Emmylou Harris. Nashville is also a place of learning, with sixteen colleges and universities, including Vanderbilt, and six graduate business schools. Nonetheless, the image of this consummate, clued-up New Yorker, Wall Street's soignee diva of distress, strutting around that warm, slow, and easy southern city is one that escapes me still.

We gave her a farewell dinner within a few days of her departure, since Nashville was beckoning. Twenty of us gathered in the Blue Fin, a cla.s.sy Times Square restaurant at Broadway and 46th-Larry McCarthy, Alex, Sch.e.l.l, Joe, Jane, and the rest-and there were no attempts to persuade her to change her mind. We all knew Calpine's CFO had tried that for months before he realized he was still dancing through raindrops.

But there was something else at that dinner. Amidst all the jokes and laughter, I think we all knew Christine was onto something. She was getting out with as much of her bonus money as possible, and Larry told me he was sure she was making the right decision. It was as if we all sensed there was a death wish about the Lehman top management, that something was so wrong we might not survive. I mean that. I was thinking the unthinkable: that our ship might go down unless we, the experts on distress, could get hold of the helm and correct our course.

Everyone knew that Christine's market had, temporarily at least, dried up. And we wished her well, trying to hide a nagging feeling that she was at least two steps ahead of the game. Alex, typically and generously, picked up the tab, and Larry and I escorted her down to find a cab. We stood on the sidewalk for a few minutes, finally kissed her good-bye, and then she was gone, heading south down Broadway, toward another, calmer world. I felt desolate as I watched the taillights of her cab speeding away down the Great White Way.

Back at the factory, I had a team of a.n.a.lysts burning the midnight oil, poring over charts and statistics, locating photographs and converting them into slides. Larry and I were preparing the mother of all presentations, to convince the top Lehman executives that this ship must swerve away from the course set by d.i.c.k Fuld and Joe Gregory, who had not personally been on the bridge for about five years. And, in the opinion of the growling McCarthy, their chosen lookouts were a sight worse than those two comedians who missed the giant iceberg from the crow's nest of the t.i.tanic t.i.tanic. Those guys didn't have binoculars. The Lehman lookouts couldn't see at all.

Around this time I could see Larry becoming extremely irritated with the situation. Every time I spoke to him, he snapped out some thought that had been preying on his mind: "Subprime is already spreading to Alt-A, and then it's going to spread to the banks. And then it will spread to our high-yield market. d.i.c.k and Joe think it's 'contained'-well, it's not, it's contagious."

Occasionally he walked around the mortgage floor, and he could smell they were losing money. He could sense they were saying as little as possible, like a bunch of nervous rabbits frozen in the headlights, their links to the trading floor long gone.

Our a.n.a.lysts Pete Hammack and Ashish Shah kept coming up with startling truths, especially the huge increase in homeowner-ship since 2002. It had climbed to an all-time high of 66 percent as the shadow banks and mortgage companies shoehorned people into homes, persuading them to go into heavy debt. Now, suddenly, I unearthed a horrific fact: in February 2007 the total dollar value in real estate in the United States was worth approximately $20 trillion. Which seemed like a big number, except that in 2005 it had been about $23 trillion, before everyone started bailing out of subprime. In Larry's opinion, underwriting standards were being totally compromised. The bodybuilders had done their worst. And now we faced a gathering storm. Larry said as much to Dave Sherr, the global head of the mortgage securitization business, who rounded on him and retorted, "You don't know what you're talking about. You're an idiot."

Larry fired back with a favorite expression of his: "And you're a high kite," meaning someone who is essentially drifting around the stratosphere, s.p.a.ced out, high on their own importance. I doubt Sherr understood precisely what McCarthy meant, but I am certain he got the drift. For drift, read rift. The two hardly ever spoke to each other again.

On Friday morning, February 9, 2007, in a third-floor conference room, the senior managing directors gathered to hear Larry's findings. He's worth listening to when he's studied something for about one-hundredth of a second, never mind a couple of months. And no one wanted to miss it, except for the two chowderheads up on the thirty-first floor, who once more demonstrated their limitations by ignoring the entire proceedings. But forty-five of the top Lehman operators crowded into that room to hear a thirty-page presentation.

Larry, characteristically steamed straight in, citing the crashing figures for home equity values, pinpointing the uptick in residential mortgage defaults, and railing about the standards of underwriting and the ma.s.sive exposure so many Wall Street firms now had to subprime mortgages. He declared the warning by HSBC to be more important than any other issue, and he lambasted our own management for believing the problem was somehow "contained."

He scorned the latest unemployment figures, which were indeed moving lower, because there was hard evidence the subprime problem was already spreading to Alt-A mortgages and to construction corporations, not to mention the biggest brokers. "There'll be a domino effect," he said. "And the very next domino to fall sideways will be the commercial banks, who will swiftly become scared and start deleveraging, causing consumer borrowing to contract, which will push out the credit spreads. The present situation, where no one thinks there is any risk whatsoever, in anything, cannot possibly last."

In that room, he did not need to elaborate. But I'll explain what he meant. The credit spread refers to the difference between Treasuries, which were paying around 4.5 percent, and the yields of corporate bonds and the mortgage-backed securities, which were probably around 7 to 8 percent. Larry felt that these yields may suddenly spike up to 9 or 10 percent, which is known in the trade as widening the spread. It happens when the market senses higher risk and it becomes necessary to lower the price and up the yield in order to move the bonds. Larry McCarthy could see this coming, clear as daylight.

"That contraction in consumer borrowing," he said, "will strip the steroids out of the market. And there will swiftly be a very big correction, which will lead to higher unemployment." He added that the Fed would surely move to cut interest rates, but there would still be a very hard landing. "Many people today believe that globalization has somehow killed off the natural business cycles of the past," he said. "They're wrong. Globalization has not changed anything, and the current risks in the Lehman balance sheet put us in a dangerous situation. Because they're too high, and we're too vulnerable. We don't have the firepower to withstand a serious turnaround."

At this point Dave Sherr offered a short speech for the defense. He said that the mortgage market and the corporate bond market were not correlated. He reb.u.t.ted Larry in short, terse sentences, reiterating once more that, in his opinion, the ace distressed-bond trader did not know what he was talking about.

"Dave," snapped back Larry, "you mortgage guys have been giving us the mushroom treatment for months, keeping us in the pitch dark and feeding us s.h.i.t." He added that we were not being told the whole truth, and that as a company, we were not moving nearly fast enough. "These derivatives and all the leverage in the system are giving everyone a false sense of security," he said.

He pointed out that our risks were enormous in so many fields, not just in the CDOs but also in commercial real estate, in leveraged buyouts, and especially in credit default swaps, the voodoo section where people could bet against a corporation or a bond without having a princ.i.p.al interest in the operation.

"I know a little about gambling," he confirmed, with awesome understatement, "and I know a lot about risk. We have too much. Far, far too much. And we need to cut it right back, and start a counteroffensive, with the heaviest short positions we've had for years, before this whole insane market goes straight down the tubes."

Aside from those who were already singing from the same hymn-book-including Alex Kirk, Mike Gelband, Rich Gatward, Joe Beggans, Pete Sch.e.l.lbach, and Jane Castle-there were many worried faces in that room when Larry concluded. A few of the younger guys may have been skeptical, but the majority took his conclusions seriously.

After the meeting Sch.e.l.l told Larry he was glad it had all finally been said. But he did wonder why it had to be right now. Larry turned somewhat theatrically to the window and pointed at some imaginary horizon. "You see that right out there?" he demanded hypothetically "That's a f.u.c.king iceberg, and we're headed straight for it, flank speed. Even the G.o.dd.a.m.ned t.i.tanic t.i.tanic tried to swerve." tried to swerve."

Pete commented on how Dave Sherr had reacted with such anger, calling Larry to task. But the old stock market high roller just grinned slyly and commented, "As you go through life, old buddy, you'll probably find that empty cans usually make the most noise."

Right then Lehman Brothers needed noise-anything to drown out the forthcoming cacophony of the corporate conference call that would take place on March 14, because there were surely numbers and stats, obvious to McCarthy and his tribe but perhaps not quite so obvious to the a.n.a.lysts, who were currently circling the coral reefs of Wall Street and probably tearing at the shattered carca.s.s of New Century.

On the appointed day we opened the lines with Chris O'Meara, our slick-talking chief financial officer, in the chair. It turned out to be one of the longest conference calls in the history of Lehman, as Chris parried the polite cut-and-thrust of the sharks with long-winded, convoluted, barely comprehensible explanations that might have baffled Einstein in his prime.

The first point that caused a ripple of consternation throughout the vast network of shareholders and researchers who were listening in was Chris's revelation that mortgage-based securitization volumes had decreased to $22 billion from $40 billion the year before. He stopped short of the shining truth that the U.S. market for questionable mortgages had collapsed. He also never mentioned that not only were the mortgage holders running for their lives but U.S. investors were finally saying no-and that finance houses appeared to have no alternative but to start moving those toxic loans abroad in ever-greater volume. That way they could cripple the entire globe, instead of just America. Chris attempted to belittle the importance of this development by mentioning, somewhat loftily, that subprime mortgage securitization accounted for less than 3 percent of Lehman's total revenues. What he did not say was there was a growing mountain of these things piling up, not sold, unloved, ma.s.sive potential liabilities, yet deftly removed from the balance sheet by means of the qualified special-purpose ent.i.ties. In other words, accounting sleight-of-hand, witchery, trickery, sorcery, or skulduggery. Now you see it, now you don't.

Just read this outrageous mangling of the language to conceal the truth at any price. O'Meara's antagonist was Michael Mayo, a hard-eyed a.n.a.lyst from the Prudential Equity Group.

MAYO: You said under 3 percent. But that's still a possible domino effect from subprime to other areas. What other exposure do you have to the subprime market?O'MEARA (an air of pure incredulousness in his voice): To the subprime market?MAYO: That's what I had in mind.O'MEARA: Okay. So there's-the situation you're talking about, warehouse lending, or ...?MAYO: More generally, what's your total balance sheet exposure to subprime mortgage, either direct or indirect?O'MEARA: We have a fair amount of sort of exposure. We talked about the residual interests, which represent sort of a levered exposure. We also have whole loans, but all of it is subject to the same hedging principles we talked about earlier. And it's been working quite effectively.MAYO: But when you said the hedging offset the losses, the hedging offset the losses in which areas?O'MEARA: Essentially everything. Our objective is to offset the risks as we are moving these instruments, and holding the instruments, in what we'll call our client warehouse, as we're moving them from raw product into securitization.

Listening as a stockholder on the line, you could have wondered whether he worked for the New York Philharmonic or a meatpacking factory. And even Chris felt the need to have another stab at clarification.

"Mike," he said, "if we're making secondary markets and taking positions that we're distributing and sponsoring client activity while that's in the warehouse and on the balance sheet, we're trying to hedge the components of risk that exist: the interest rate risk, the prepayment risk, the various risks that exist. We're actively, dynamically trying to risk mitigate."

I'm not sure what a coast-to-coast "Huh?" sounds like. But I guess it would be very much like a dull thudding sound, like a lead balloon landing in a bottomless dollop of bulls.h.i.t.

From where I sat, it seemed that the Lehman rear guard was growing weaker. All around me there were more critics of the direction the company was headed. And the mood among the a.n.a.lysts on that conference call was one of unmistakable skepticism, audible in the tone of the questions, the barely suppressed disbelief in the voices. What had been, a year previously, a small group of Lehman personnel crying out in the wilderness was now a growing army of mutineers, both inside and outside the firm.

The trouble was, the corporate direction was created at the very top, on the thirty-first floor, at the steel whim of the old commercial-paper lughead d.i.c.k Fuld and the thirty-year Lehman veteran trader Joe Gregory. These two men controlled many things way beyond Seventh Avenue: thousands of families, mortgages, college educations, second homes, alimonies, vacations. Indeed, they controlled lives. And to risk upsetting either of them was more than most people could afford.