Colossal Failure Of Common Sense Part 10

They all knew one of the big attractions of New Century stock was the 10 percent dividend it paid. The stock was held up by that. It was one of the highest dividends on the New York Stock Exchange, and it was quite obviously too good to be true. If the market went down and that dividend had to be cut back, the stock would have to crash. Anyone could see that, but it did not faze the bodybuilders. Look, man, right here we got a great company and we're killing them out there in the market. Let's just fly with it. Three of our top guys have made $74 million over four years, with cash and stock. That's a goal for all of us. And New Century's gonna make that possible. Universal home ownership, right? That's our target. New Century for the new century. You gotta love it Look, man, right here we got a great company and we're killing them out there in the market. Let's just fly with it. Three of our top guys have made $74 million over four years, with cash and stock. That's a goal for all of us. And New Century's gonna make that possible. Universal home ownership, right? That's our target. New Century for the new century. You gotta love it.

They told us the corporation had taken their top salesmen to the Bahamas on a luxury liner booze cruise. Actually it had been a themed booze cruise, under the banner "The Best d.a.m.n Mortgage Company. Period." They'd even hired the railroad station in Barcelona, Spain, for another heavy-drinking junket for top employees. New Century chiefs made huge charitable contributions, and sent one high-flying exec to a Porsche-driving school.

"Guys," said our new buddy, "right here you're looking at a new shade of blue chip. That's one of our mottoes."

You couldn't dislike these New Century heroes. But their knowledge was awfully one-sided. For a start, they knew nothing of Pete Hammack's evidence of heavy stock selling among the company's three founders. Neither did they volunteer anything about some shaky accounting practices, which had caused concern to a Maryland financial research outfit, currently flagging problems with New Century's third-quarter earnings release.

Neither were they aware of the anger of a California lawyer, Alan Ramos, who was plainly infuriated that his client, an elderly lady about to be evicted from her three-bedroom home northwest of Stockton, had been made an enormous "senior citizen" loan. On checking the doc.u.ments, Mr. Ramos found that her income section had been left blank.

"Blank?" he exclaimed. "How does it even get past the first person who looks at it?"

Right there I guess we had the New Century way. Its loan originations had been $6.3 billion in the year 2000 and were expected to hit $60 billion this year. This was a corporation that unloaded thousands of mortgages, every month, onto Wall Street mortgage securitization guys who weren't anything like as smart as they should have been.

Dave Gross and I left that bar in mild amazement. That whole group of c.o.c.ky, relatively dumb bodybuilders was so pleased with their lives, so unaware of what could happen, so far behind the advanced thinkers of Wall Street. You know what they say: when it's seven o'clock in New York, it's 1991 in California. Make that 1981.

"There's something really rotten about this place," I told Dave. "We're in the Wild West of mortgage lending."

He said he agreed, and was really shaken by the totally careless way the bodybuilders wrote mortgage agreements, how they could not give a d.a.m.n whether the money was paid back or not. For one bright shining moment I decided I had seen the light. Because in that restaurant, crammed with self-satisfied know-nothings, we had gazed upon the amoral soul of this housing boom, the crux, the fulcrum, the place where so many dreams would begin, and where surely heartbreak and financial collapse must follow.

We were both struck by the curious remoteness of the guys with whom we had spoken. They acted as though the fortunes of neither the corporation nor the borrowers had anything to do with them. They were like hired guns, oblivious to the fate of their victims or the outfit that had hired them. Both in their own minds and in ours, they were men apart-for slightly different reasons, of course.

Both Grossy and I thought they were a breed, rather than a clan. They were professional salesmen who rode the waves, and when one wave petered out they would find the next one. I thought of that Philadelphia bucket shop, where high-pressure tactics were used to sell penny stocks; they would say anything, promise anything, just to get the sale done.

These guys we'd just left were the same, remote from the reality of what they were doing. They moved in a flock, migrating from one sales scam to another, probably about every five years. And they were good at it. I recognized that much, even though I'd personally have given the b.a.s.t.a.r.ds a run on a vanload of pork chops. Never forget your roots, right?

At this point in August, the New Century stock was at over $40 and rising. It would be pointless trying to persuade the mortgage guys back at the office that this market was surely heading for a very hard brick wall; Dave Sherr and his boys would surely laugh at us, as they had done before. And we flew home that night wondering what the h.e.l.l to do. The fact was, we couldn't find out the volume of subprime that had been sold to Lehman, but we had discovered much about a hardworking, hard-partying culture upon which our corporation's future might depend.

The following day, straight off the red-eye from Los Angeles, we were met at JFK and whisked into the office, where we immediately caucused with Larry and Pete Hammack, both of whom were waiting for us. We already suspected New Century had been taking wild chances with its lending, but now we needed to move fast.

Larry said the $20 puts were 50 cents each for six months, "let's buy 10,000"-which effectively meant we could make a $500,000 bet that New Century's stock would go below $20 between September and March. This was crazily cheap, we thought, but the market was calm, no volatility. We bought a pile of the puts; we bought the $20s, the $25s, and the $27.50s. Just the $20 puts we purchased made us short a million shares below $20 a share. That's not counting all the other puts we bought. If New Century went down, we'd make close to $30 million. I guess that's why Lehman stood us a couple of nights in the Beverly Wilshire.

But on the next day we wanted to up the ante on New Century-short them big-time. And with a position of this size it meant I needed the approval of Rich Gatward. By now I had a solid relationship with the old tiger of the equity trading floor, though we all had to be on our A-game in our dealings with him, and I understood he would not hesitate to bawl out anyone who wasn't. But he and I had developed excellent trust in each other, and he never once turned me down on a well-presented trade, especially against a subprime candidate. He was the toughest, but also the fairest, of the Lehman department heads that I knew. I presented him with our full plan, the complete picture of New Century, along with a sprawl of outstanding spreadsheets compiled by Pete Hammack, who came to the meeting with me. The sheets demonstrated what we could lose and what we might win depending on the price of New Century's stock, from $60 all the way down to $5. I admit I had some trepidation, because we'd been on a clandestine mission and wanted to keep it very quiet. I also had no idea whether Rich had close friends up in the mortgage department. But he never faltered, that fast a.n.a.lytical mind of his slicing up the information we presented.

Finally, after careful study, he said, "I think you've got something here. And this work is great. Put the trade on, and keep me posted." Rich was not as bearish about New Century, but he still trusted Larry and me, and he backed us every last inch of the way.

I contacted Susquehanna, an outside broker, the domain of Matt Durso, a good old buddy of Dave Gross. I told him I wanted a menu for 30,000 put contracts on New Century-that's known on Wall Street as a gorilla trade. Big.

"Jesus," he said, "what do you guys know?"

"Matt, we've done a ton of research on this," I told him. "We don't like the company. And we don't think the dividend's safe. Also, they're registered as a REIT [real estate investment trust], and we think the REITs are vulnerable in a falling housing market."

I told him we were looking to pay 55 cents per put on one of the options on his menu, and he came back wanting 65 cents. I checked with Larry, who snapped out one of his creeds: "You limit orders, you limit profits. I don't want to nickel-and-dime. I just want to get it done."

A limit order is just a way of lowballing, trying to undercut the trader's market, hoping to buy at a lower price. But when the market keeps moving away from your bid, you end up chasing it, like a Bedouin riding his camel toward a mirage. We had no time for that on a trade this hot. So I did that part of the deal and put on a $650,000 initial trade. At the end of the day, in total, we spent $5 million and bought all 30,000 put contracts. G.o.d help Matt Durso, I thought. He and Susquehanna were taking all that risk. Little did I know that in October, New Century would grind ever higher.

We were now in mid-September, and there was developing a feeling of disquiet throughout Wall Street. Yet more evidence was emerging about the stresses on the housing market. And I have to say, our trip to the West Coast was becoming more public than we antic.i.p.ated, and so were the huge short positions.

There was no word from the mortgage guys, at least no formal word, but there was a buzz about the a.s.set-Backed Securities Index, or ABX. That's the index that tracks the prices being asked and paid for the subprime mortgage bonds, the CDOs. The ABX was a system of quivering sensitivity, programmed to practically suffer a thrombosis if those bonds moved a couple of ticks downward.

And what made the situation that fall even more jumpy was that no one could remember the son of a b.i.t.c.h twitching a tendon, never mind moving a muscle. The ABX was static; the mortgage market had been dead calm for years, a graph line unlike any other. There were dead people whose heartbeats were more erratic. The index was as straight as a gun barrel, all through the entire upsurge on the U.S. housing market.

The ABX normally trades at par (100) because it's a measure of the strength and value of mortgage bonds. On Tuesday morning, September 19, the ABX slipped to 9799: the trader, who sets the market, would buy at $97 and sell to you at $99. The ABX had fallen very, very slightly, only three ticks, but in certain places that caused big consternation.

Larry and I went for a drink at a nearby sports bar, Tonic, that evening, and ran into a colleague, Eric Felder, head of our high-grade credit business-that's the traders who deal with investment-grade corporate debt. He knew as much as anyone about Lehman's credit derivative business and was highly respected all over the Street.

Eric was a real up-and-comer, a bull by nature, but as soon as we saw him, he began to tell us he was very bothered by something he had noticed that day. His question was, "Did you see that move in the ABX today?" We could see the concern on his face. "It dipped. First sign of volatility I've ever seen on that index. This, guys, is serious. If it drops one more time this week, we better short it. I guess the mortgage guys are still long. And if this keeps up, that's not gonna be good."

I asked him how this might affect New Century, and he was not optimistic. Larry said immediately he was going to double, maybe triple, our short position against the California brokerage.

The next day the ABX dropped to 9698. I increased the short on New Century yet again. Both Larry McCarthy and I understood why the CDOs were dropping. There were more sellers than buyers, more people watching that ABX, more people paying attention to slight upticks in the default charts, the repossessions, the failures on first-mortgage payments. Maybe there were even people quietly recollecting the words, months ago, of both Alex Kirk and Mike Gelband.

Larry and I did not have all the answers. But we had found out one thing: Lehman had underwritten $101 billion in mortgage-backed securities so far that year, and a whole lot of it was subprime and Alt-A. Holy s.h.i.t!

By any standards 2006 had been a ride through choppy waters for Lehman, especially with the housing market now shipping water. Short of a miracle, neither of us could see how the mortgage department could come out whole, not with the raft of CDOs they had. For all we knew, the traffic light had already malfunctioned. Which may have been what was causing the ABX to develop a nervous twitch, with everyone lining up to make an exit.

Even the Delta bonds, which seemed like a steady and reasonable bet to increase in value, had suffered a couple of diabolical moments. One of them, back in April, was so dire at the time, I couldn't bring myself to mention it in this narrative, especially as I had made the original market for the bankrupt airline.

Back on April 17, the bonds had rallied to 26 or 27 cents on the dollar. But then things went south, especially Hezbollah's missiles, which started bombarding Israel, and the world oil market, as usual, instantly wet itself. Up went the price of jet fuel. Then the pilots threatened to go on strike. We still had a boatload of the bonds, bought cheaply, but still, $425 million in face-value worth? As the hours ticked away, the strike grew more and more likely. Everyone was saying it was going to happen, and that Delta's entire fleet would be grounded, resulting in zero cash flow and a highly negative balance sheet.

Everyone, that is, except for one person. Jane Castle said, "The pilots are bluffing. Trust me. And the bonds are still worth fifty-two cents."

We were close to table max, that is, the maximum amount of money we could put on the table. After that, we couldn't buy another bond, whatever the price. And the market wasn't listening to Jane. The bond price dropped to $23, then $22. And then something truly nerve-wracking broke out.

It was two-thirty on that Monday afternoon when my direct line to the sales desk in our San Francisco office suddenly lit up. John van Oast, our man in command, was on the line with the worst possible news. T. Rowe Price, a huge mutual fund with five thousand employees out of Baltimore, Maryland, wanted to sell their Delta bonds. I knew they might have been holding about $120 million face-value worth of convertibles, and they were one of our biggest customers, with about 20 percent of Delta's entire convertible bond issue. They were a real traditional company, founded in 1937, currently with almost $400 billion under management. T. Rowe Price had to be accommodated.

"Larry," yelled John from California, "I got 'em on the wire right now, and they need a bid on Delta convertibles."

I called back, "Twenty-one, twenty-two, ten million up!"

"Hold it," replied John. "Be right back."

Seconds later he was on the line again. "They appreciate the bid, but what they really want is a cleanup bid."

Jesus Christ. They want to sell them all. The blood drained from my face. I told Larry the state of the battle. I knew he'd go low since we were already near table max.

For a moment there was silence. Then Larry called it: "Eighteen bid for the lot!"

For the first time in my life I saw a bead of sweat on his brow, and maybe even a slight tremor on his hand as he scribbled down a note.

Van Oast yelled, "They got a hundred and twenty to go. All I need to hear are the two beautiful words."

The numbers flashed through my mind: $120 million face value on bonds times 18 cents, that's $21.6 million for cash. Larry nodded curtly. "You're done!" he replied. And the deal was complete.

Larry, for once, was a bit over his skis. We were about an inch and a half from table max, which meant five bucks was a lot of money to spend. Larry had just spent more than $21 million. Somebody's budget was about to get slammed. "I'd better go see Gat," said Larry. "Jesus Christ!"

Several weeks later I took a call from the head trader at T. Rowe Price, who reminded me, "I've been in this business a long time. With that airline going down, that was probably the gutsiest call I ever heard. McCarthy?"

"Who the h.e.l.l else?" I replied.

A few days after we had bought all the bonds, the Delta pilots called off the strike, and the price went back up to 2425 cents on the dollar. Gatward was thrilled because Larry, Jane, and I had persuaded him to share the risk, and he'd taken most of it at 18 cents. So far as Jane was concerned, there was no reason to sell any of them. So we all just hung in there with our gigantic load of Delta convertibles, all through the summer of 2006.

And now we must fast-forward to a cold November day on Seventh Avenue. I was walking to work, contemplating our vast short position on New Century and our even vaster long position on the Delta bonds. The first one was probably as much my fault as anyone's; the second resulted from advice from Jane, but I had made the market. And the entire department understood the dimension of our gamble. There were not yet jokes being made about it, but we'd been in there with Delta for almost twelve months, and our corporate year ended in November.

I reached our building and stopped downstairs for a cup of coffee. It was not yet six-thirty but there were already a few people in there. First person I saw was an equity trader I knew well, Jim Everett, who turned to me with a grin and said, "Big day for you guys."

I hadn't the slightest idea what he was talking about, and I must have looked kind of blank.

"Haven't you heard?" he said.

"Heard what?"

"U.S. Air just made a hostile bid for Delta. At least fifty-five cents on the dollar for the bonds."

I think I nearly died of happiness. Chills ran up my spine, and my pulse was racing as I headed up to the trading floor. I can't remember the ride up in the elevator, can't even remember if there was anyone else sharing it. I was just running the numbers through my mind, and the key ones were that we now owned about $720 million worth, face value, of the bonds and we'd bought most them for well under 25 cents on the dollar.

I came out of that elevator like a greyhound out of a trap, running to my desk and hitting the b.u.t.ton to switch on my screen. And there it was, the hostile bid from U.S. Air. Fifty-five cents Fifty-five cents. I called Larry on his cell phone. He hadn't heard either, and said he'd be there in just a few minutes.

I could tell he was beside himself, not just with excitement but with a sense of relief, because he'd been the motor behind our enormous position. He'd relied on Jane's a.s.sessment, but he'd personally sanctioned almost the whole of Lehman's expenditure. If this had ever gone badly wrong-say, if the bonds had slipped to being worthless-Larry McCarthy would have taken the lion's share of the blame.

It was not yet seven o'clock, but by now everyone in the entire bank knew about the drama, and a lot of them knew we were about to make a colossal fortune for the firm. The atmosphere was electric, nothing less, as our group moved into gear, because trading was expected to start early, maybe around seven-thirty.

The place was packed, and every single eye was on us, especially me, the market maker. But suddenly there was a shift of focus, and we turned to the entrance to the trading floor to see Jane Castle walking in. A huge burst of applause broke out, a spontaneous cry of joy, just for her. Through all the months, through all the doubts and all the fears, she'd never wavered in her valuation of Delta Air Lines, and everyone knew it.

The smile on her face would have lit up Yankee Stadium, and she walked straight up to me and gave me a sweeping high five that darn nearly broke my wrist. Moments later Larry came in, wearing a brand-new suit and looking like the king of the world, and another burst of applause ripped into the morning air. When it died down, he looked over to Joe Beggans, who was about to start trading the Delta bonds, and, with a huge grin on his face, held out his hand and shouted, "Gimme the keys, Joe. I'm driving!" The whole place erupted.

When trading began, a lot of guys imagined we'd be selling as fast as we knew how. But not McCarthy. He crashed into the market and started buying the Delta bonds at 53 cents all over the Street. He actually chased the price up to 60 cents. And Jane was his co-conspirator, standing next to him, telling him they'd go to 65 cents.

Brent crude was crashing on the London market from $77 to $60 a barrel, jet fuel was down from $2.30 a gallon to $1.80, the pilots were flying, the aircraft were taking off, G.o.d was in His heaven, and our very own angel, Jane Castle, was telling Larry the Delta bonds could go to 70 cents.

Jane knew they'd had a positive cash build during their bankruptcy and had almost $4 billion in the can. Their last quarter's $500 million EBITDAR (earnings before interest, taxes, depreciation, amortization, and rent) was well above Street expectations. Their international flights had doubled, and there was now less compet.i.tion from the budget airlines. In addition, Delta was valued at a fabulous, only 5.6 times EBITDAR, whereas the low-cost JetBlue stock was trading at 15.5 times. In addition, Jane had always pa.s.sionately believed there would be a ma.s.sive consolidation phase coming to the U.S. airlines.

The rest remains a blur until the moment Larry McCarthy decided to get out. "Okay, guys. Let's go," he called, and, for the first time for almost a year, we began to divest ourselves of the Delta bonds. Larry launched them onto the market with consummate skill, knowing, of course, that U.S. Air was out there waiting, begging to buy. By the time he had finished, Lehman had made a $250 million profit, the largest one-day triumph in the history of Lehman Brothers bond trading.

Larry was so elated by the turn of events and by Jane's determination to maximize that he announced our whole group was invited to a dinner he would host that night at Il Mulino, one of New York's most esteemed cla.s.sic Italian restaurants. Almost everyone attended, except Jane. And there, at a meal during which no expense was spared, he proposed a toast to her. "If she was here," he shouted, "I swear to G.o.d I'd drink champagne from her shoes!" I chuckled, remembering that just before we'd all left for the restaurant, he'd actually picked up the phone and apologized profusely to the risk management department for the Delta bonds having gone up forty points. Sarcasm is supposed to be the lowest form of wit, but not on this day. How sweet it was. Why don't you shove it up your a.s.s, VaR? Why don't you shove it up your a.s.s, VaR?

And all this was happening in the shakiest quarter the mortgage business had ever had. With the mortgages crashing all over the place, we saved their a.s.ses. Their numbers were off, their profits were off, and the losses were starting to pile up. The ABX was headed for 8586, and our $250 million victory, in a way, lit up Lehman's year-end balance sheet.

The real estate boom year 2006, which had started out rich with promise, had, for those with the wits to notice, been steadily turning sour. But now, at the start of the New York winter, the landscape had turned rancid. Anywhere there had been a sign of decay, poor management, or just plain old trouble, that's what ultimately developed. Most indicators measuring the performance of the mortgage industry glowed in the darkness of disaster. Every chart that could possibly record a trend was recording a G.o.d-awful one, and getting worse. Repossessions were up, prices were down, defaults were climbing, mortgages weren't getting paid, and accountancy among the big mortgage houses was developing into sleight-of-hand as financiers struggled to hide the truth from an increasingly skeptical world.

The vastly experienced property brokers at some of the biggest investment houses in the business, Merrill Lynch, Goldman Sachs, JPMorganChase, Citigroup, Bear Stearns, and Lehman, had run headlong into the oldest, most obvious, most dangerous trap in their business: they'd gone into ma.s.sive trades, with ma.s.sively leveraged positions, without first perfecting their exit strategy, how to get out if a fire started. Right now they needed to reach the theater door, but everyone else was stampeding down the aisles, jumping over the seats, swinging on the chandeliers, and diving through the men's room window trying to reach safety.

All the signs had been out there for weeks, especially among the mergers and acquisitions. One of Larry's more graphic mottoes is that a sure signal of big trouble is when two pigs marry each other. And the pigs had been charging for the altar all year.

San Diego's Accredited Home Loans announced the purchase of Aames Financial, a Los Angeles giant with $6.75 billion in home loans, representing thousands of subprimes. Accredited must have been real at home with this, since they had $16.5 billion of their own in originations and were in worse trouble with defaults than the guys they bought.

Accredited was the outfit I'd told our guys to short just before I hit that screamer of a three-wood onto the ninth green at Cog Hill. (On reflection, it might equally well have been just after I missed the putt.) Anyhow, we'd been shorting Accredited for months, and I thought they and Miss Piggy Aames would make a perfect couple.

Wachovia Bank and Trust, out of Charlotte, North Carolina, the nation's fourth-largest bank holding company, spent a whopping $25.5 billion to buy Golden West Financial, a mortgage giant chock-full of adjustable-rate mortgages and currently shuddering from the impact of reset-led defaults.

Then in November 2006 Merrill Lynch took over San Jose-based First Franklin, one of the nation's leading originators of non-prime residential mortgage loans. Merrill somehow managed to get mixed up with a sister corporation to Franklin that went by the name of NationPoint. Online mortgage sales were its specialty, and the previous year the pair of them had lent a staggering $29 billion. They represented Subprime City. And now Merrill paid $1.3 billion for them, which under the current circ.u.mstances was tantamount to buying a nuclear bomb, fully primed, armed, and timed, with no particular destination keyed in. I hate to use up yet more of my supply of hindsight, but I can say precisely one thing that could never be disputed-if Mike Gelband or Alex Kirk had been in charge at Merrill, that merger never never would have taken place. would have taken place.

By Christmas 2006 we'd been hearing rumors for a while that MGIC, an investment corporation based in Milwaukee, would team with the Radian Group in Philadelphia to spend $259 million to buy Fieldstone Investment Corporation of Columbia, Maryland, a nationwide residential mortgage banking company with a hefty accent on nonconforming borrowers. Fieldstone wouldn't exactly enter the marriage with an appealing dowry: in the first nine months of 2006 they'd lost $28.3 million, which was not too bad for a piggy By year's end Fieldstone was the twenty-third-largest lender in the country, specializing in home buyers with the poorest credit. So we started shorting all three companies. (The deal would be announced in February 2007.) Looking back, this was an increasingly desperate attempt on our part to level up the Lehman balance sheet while this horrendous mortgage picture continued to unravel. Everywhere you looked, there was trouble. Privately Mike Gelband, Larry, and the rest of us had an unnerving instinct that this whole thing could blunder forward into unimaginable chaos.

We'd already received a shock when yet another ominous signal came ripping through cybers.p.a.ce concerning the biggest home builder in the country, the Dallas-based construction giant Centex. The previous spring Centex had missed its earnings target by a country mile, and there had been huge consternation. But then the industry somehow rallied in the summer, and it seemed the good times might be back for Centex. But in the middle of October 2006, they'd announced yet another horrific miss on their earnings sheet, making 69 cents per share instead of the forecast $1.40. It was the buzz of the trading floor. And this was not make-believe money, like our romance with the credit default swaps, the bets, and the IOUs. When Centex threw up its hands, this was real down-and-dirty cash. Centex did not gamble and scheme. Centex built homes-bricks, concrete, and wood-all over the country, thousands of them. They were bigger than Beazer. And they were not joking. They'd announced a ma.s.sive cut in their landowning options, which, to those in the trade, is a cla.s.sic sign of big problems. When a builder doesn't need land, that builder senses trouble ahead. In the third quarter Centex had orders for 6,828 homes, down 28 percent on the previous year. These were record levels of contract cancellations, and the corporation was so concerned that they were prepared to abandon huge land options at a predicted walkaway cost of $90 million. I guess that must have been tough to swallow, but, hey, in this market, a builder's gotta do what a builder's gotta do.

All the ominous signs that this endless housing funfest was about to end were sending tremors through the market. But perhaps most of all, it was attracting cruising sharks, investors and a.n.a.lysts whose business was the blood of the mighty. In a way, our group represented Lehman's private shark tank, but we were just trying to clean up the firm's act, rebalance the books, and make up for the coming losses. The real sharks were out there on the Street, circling, scenting blood, trying to spot weakness in our ancient merchant bank, weakness that would allow them to thrust forward and feed, dumping huge short positions on our stock. In some ways, they were echoing us with the mortgage houses, but these sharks were outsiders, intent on our downfall, less sympathetic, and a whole lot more ravenous.

Wall Street sharks are apt to cruise in deep waters. One of the few times they surface is at those regular conference calls when a.n.a.lysts and stockholders are free to get on the line and ask searching questions of the bank's management. Lehman's last-quarter 2006 conference took place on Thursday afternoon, December 14. In the chair was our chief financial officer, Chris O'Meara. Christine Daley and I had the phones rammed into our ears. She was really on edge, deeply troubled by the slowdown, and the subsequent buildup in our mortgage portfolio. And we were now hearing more confirmation of this, humming down the wire. "Wow," said Christine, "we're supposed to be in the moving business, not the darned storage business. I don't like the smell of this. Not one little bit."

When the discussion turned to the mortgage market, Chris admitted that Lehman's creation of CDOs was slightly slower than it had been the previous year. It did, however, "remain solid," despite what Chris stated were "the challenges from the U.S. housing market." That was a pretty economical way to describe the coming Armageddon, when the mortgage resets would do what Mike Gelband had said they would do, and bring the whole trembling edifice crashing down around our ears.

The fact was, the market was beginning to see the enormous problems that were ahead of us. Our corporate mortgage policy was revolving around the word containment containment. That word popped up again and again as the Lehman financial guys tried to explain the need for globalization in the hope of obfuscating the bald truth, instead stressing the grand world expansion strategies that set us apart from the pack. That meant unloading the CDOs all over the planet, especially to Europe and j.a.pan. And the sharks sensed the tactic.

One of the Goldman Sachs a.n.a.lysts wanted to know, "What percentage of your mortgage business is now derived from outside the U.S. versus in the U.S.?"

Chris was fighting off his back foot, but he had an answer. "It is becoming an increasing percentage. We do not disclose that. But without giving you specifics around what's outside the U.S., recognize that it's a growing proportion of what we do, and we intend to keep growing."

The fact was, the Goldman a.n.a.lyst had worked out that there were few U.S. hedge funds, pension funds, or banks that would dream of buying the CDOs, given the alarm bells now regularly sounding throughout the U.S. housing industry. And he wanted to know where these things were getting sold. Chris offered some very obscure mentions of Korea, j.a.pan, and the United Kingdom but stayed away from naming specific buyers.

The situation in places like Stockton, California, was beginning to come to a head. California newspapers were beginning to run stories of families seeing their mortgage interest rates reset and suddenly being asked for payments that came in at more than their monthly paychecks. I understand I have occasionally talked of these situations with the mild objectivity that can walk hand in hand with remoteness, when a situation seems too far from home to be real, like famine in North Africa. But these cases were were real. Here was a hardworking American man whom the bodybuilders had talked into taking out a mortgage that would cover the full price of a new house and provide some cash as well. And now, after the interest rate had reset to a much higher level, he was being asked for an astronomical repayment amount. If he paid it, his family would starve. And he didn't know the name of the person who held this mortgage, who was probably a banker in some Tokyo side street, twelve thousand miles away. So the homeowner's only alternatives were crime or the highway. real. Here was a hardworking American man whom the bodybuilders had talked into taking out a mortgage that would cover the full price of a new house and provide some cash as well. And now, after the interest rate had reset to a much higher level, he was being asked for an astronomical repayment amount. If he paid it, his family would starve. And he didn't know the name of the person who held this mortgage, who was probably a banker in some Tokyo side street, twelve thousand miles away. So the homeowner's only alternatives were crime or the highway.

Judging by the recent crime figures for Stockton, many had chosen the former route. But those figures would go down, since the population of the town was plummeting downward as people abandoned their homes in droves. In the case of this particular family, they packed up their car with their possessions, called on friends and family to help, and headed back to the poorer areas of Oakland, whence they'd come. Before finally leaving the family had ripped up the carpets, hauled out the appliances, and even cut out the copper pipes, then placed the keys in the mailbox and vanished. No one actually knew they had gone until two months had gone by without a mortgage payment being made. And then it became clear to someone: this was a subprime mortgage that was not about to get paid. In Stockton alone, there were dozens, and then hundreds.

And what about the bodybuilders? They didn't care. They were still out there, still selling, still raking in the old double commissions. Still leaving $100 tips to pretty waitresses. And still-vroom vroom- hammering those sleek, shiny 160-mph sports cars straight down the highway. hammering those sleek, shiny 160-mph sports cars straight down the highway.

By mid-December, the defaults were on the rise and beginning to show up in the national charts. The market for CDOs and all mortgage securitizations was grinding to a halt, and one h.e.l.l of a jam was developing at the theater door. It was becoming impossible for Lehman to sell these bonds in the United States. And the first people to panic, right in the middle of the Christmas holiday, were the ratings agencies, who were looking at a major credibility gap that was just beginning to spotlight them. And that was not to their liking, because these agencies, Moody's, Standard & Poor's, and Fitch, were supposed to be judging other people's credentials, not having anyone else judge their own.

But the stats were coming out and they were not looking good. In 2001, Moody's had revenues of $800.7 million; in 2005 they were up to $1.73 billion; and in 2006, $2.037 billion. The exploding profits were fees from packaging the CDOs and for granting top-cla.s.s AAA ratings, which were supposed to mean that they were as safe as U.S. government securities. But in the past few weeks things had changed drastically. Back in 2003, Moody's, S&P, and Fitch had each downgraded 113 CDOs between them, a couple every three weeks, out of all the thousands of issues. In 2005 that figure had crawled up to 172, which meant that each of the three agencies downgraded one issue every week. In the dying remnants of the year 2006, they downgraded 1,305, many of them straight from AAA to junk-BB or lower. It's also known colloquially as closing the barn door after the horses have bolted into the fields.

How on earth could a bond issue be AAA one day and junk the next unless something spectacularly stupid has taken place? But maybe it wasn't just stupid. Maybe it was something spectacularly dishonest, like taking that colossal amount of fees in return for doing what Lehman and the rest wanted, giving those CDOs an utterly undeserved rating, tantamount to the standard of the Federal Reserve, when they must have known they were dealing with a bunch of out-of-work no-hopers.

Forgive me a harsh judgment, but I think those raters were a bunch of half-a.s.sed, dishonest villains who would do anything for a fast buck. I just don't believe they were that stupid. And anyway, I believe a plea of "stupid" is probably the saddest of all defenses.

In the days surrounding Christmas 2006, there was evidence that the rating agencies were approaching panic stations. They were letting it be known that their own a.s.sessments had been wrong. And it came out publicly on December 27, on Bloomberg, that certain Lehman bonds, four of them, representing mortgages and home equity loans to some of the riskiest U.S. consumers, were about to have their ratings cut. Moody's admitted the potential for losses to investors had "rapidly increased" because consumers were facing financial difficulties. Ratings for securitizations on three other Lehman bonds, subprime home loans made the year before, were also put on Moody's list of possible downgrades. A total of thirty bond issues, with $416 million in balances, were affected.

Everywhere you looked the ratings agencies were rushing for cover. They were announcing ratings cuts all over the place, citing banks and lenders and issuing warnings, especially about subprime mortgages that were less than a year old. The truth was, all three of the big agencies could see the unexpectedly high levels of late payments and foreclosures piling up. They weren't that stupid. They could read the charts as well as we could-not as fast, but just as carefully. And now they were responding, threatening to look more closely.

The best numbers available said that defaults on subprime ARMs were running at 27 percent, the highest level for new loans for five years. About 3.2 percent of them were either delinquent by ninety days or more, or already foreclosed or repossessed. The overall rate of late payments on all subprime loans in the previous quarter rose to 12.56 percent.

A study was also issued by the Swiss bank UBS that warned of Lehman's subprime loans. They also named an Anaheim, California-based lender, Fremont General, as the issuer of the fourth-worst-performing bonds in the nation. Some of the worst had been issued by Goldman Sachs, General Electric Company's WMC Mortgage, and Morgan Stanley.

Right about then, we thought this could get really ugly. The princ.i.p.al monitoring trade group, the Securities Industry and Financial Markets a.s.sociation (SIFMA), calculated that the total value of all mortgage-backed securities issued between 2001 and 2006 had reached $13.4 trillion $13.4 trillion. CDOs now represented America's greatest export and, thanks to the bodybuilders, were still surging forward. They dwarfed the high-yield corporate bond market, which is a snazzy way of describing junk bonds, those high-risk investments that have such a checkered history but have made vast fortunes for the lucky ones.

I hate to use the word fraud fraud. But the CDO case comes very close, because its bedrock was a gigantic group of people, thousands and thousands of homeowners, who must surely default on their repayments. Even the bodybuilders knew that, despite turning a collective blind eye. And if the friggin' lugheads knew, there must have been a lot of other people who knew. My own department at Lehman was the first to know. And Alex Kirk was the first to flag it, in May 2005-one year and seven months before it started to fall apart. Mike Gelband yelled it publicly, with facts and figures, for everyone to hear, from Fuld downward, at 7:06 A.M. A.M. on June 7, 2005-one year, six months, and three weeks before. I was right there. No excuses. Many at Lehman Brothers had heard the warnings, and all through those months heard the rumors. on June 7, 2005-one year, six months, and three weeks before. I was right there. No excuses. Many at Lehman Brothers had heard the warnings, and all through those months heard the rumors.

And it wasn't just people inside Lehman. The highly respected Lawrence Lindsey former director of President George W. Bush's National Economic Council, who as president of The Lindsey Group was a highfly paid consultant to Lehman, made substantial monthly presentations to both high-level managing directors and members of the Lehman executive committee that reported directly to d.i.c.k Fuld and Joe Gregory. Lindsey was just as, if not more, bearish as Gelband and Kirk about the pending problem with mortgage resets and the impact on the economy of the growing problem of negative home equity.

Kirk, Gelband, and Lindsey had sounded the warnings. I accept there were people who honestly did not believe it. And you can never fix stupid. But our department knew beyond a shadow of a doubt that this CDO bulls.h.i.t was utterly, totally, mind-bogglingly loaded with peril. If we'd been an oceangoing liner, maritime law would have required us to fly a flag announcing: Danger: High Explosive Aboard Danger: High Explosive Aboard.