Too Big to Fail?

Before Wall Street became universally loathed following the economic collapse of 2008, there were plenty of people who would have agreed that the high-flying financiers of days past were an integral segment of American industry, perhaps even with our best interests at the forefront of their minds. Mark Williams, in his book Uncontrolled Risk, claims that the sentiment toward investment bankers goes in cycles between them being “envied, ignored, [and] vilified.” Though companies directly involved with the 2008 Financial Crisis have had almost a decade to improve their sullied reputations, those that failed during that stretch of time have been permanently vilified. There’s no changing that.

Selecting Lehman Brothers as a point of study for ethics, risk management, and company culture was not an easy decision. Every firm on Wall Street seems to have some larger-than-life personality at the helm, perpetuating “banking is synonymous with money”, and fostering a workplace environment that makes for wildly entertaining reading. If you don’t believe me, check your local library (or my Goodreads profile).

What makes Lehman a perfect candidate to dissect is the finality and completeness of information we have. Further, the magnifying glass placed over the organization during its most tumultuous period has revealed a wealth of interesting and, frankly, hilarious, anecdotes related to how Lehman Brothers did business.

Fallen giants of Finance are romanticized more so than companies in any other industry. While failed tech companies end up being the brunt of a joke ad nauseam (pets.com et al), people feel different about financiers. This was evident in a conversation with one of my friends who I refer to as “Johnny Wall Street”. After I told him of my ongoing research of Lehman Brothers, he was quick to inform me of numerous auctions on eBay where Lehman gear was being sold at a premium. He wasn’t lying.

Why is it that people are still swapping Lehman novelties eight years after the company declared bankruptcy? Why is it that the term “Too Big to Fail” became predominantly associated with Lehman Brothers?

It all started in 1850 in Montgomery, Alabama. The Lehman Brothers Henry, Emmanuel, and Mayer, set up shop selling dry-goods. During that time period in the south, cotton was in high demand and was essentially cash equivalent. The brothers’ company accepted payments in cotton and also was able to establish a credit system where they would be guaranteed a quota from a customer’s future harvest. This turned into a full-blown cotton trading operation where they would buy cotton at low prices and warehouse it, selling it later at a higher price.

The center of cotton trading soon moved to New York and the brothers split operations between Alabama and The Big Apple. The Civil War almost destroyed the business as entire warehouses full of cotton were burned for fear of it falling into the hands of union troops. At one point Emanuel sent out a terse doomsday letter, stating: “everything is over.”

The firm was permanently moved to New York City following the war where it diversified into trading coffee and, soon after, equities. Its first “investment banking” activity came in 1899 with the underwriting of the IPO for the International Steam Pump Company (which went on to be acquired and merged many times, and is now a part of the Eaton Corporation).

The investment banking activity continued through the 20th century and into the 21st century. When the company filed for bankruptcy, it was the fourth largest investment bank in the world, claimed $639 billion in assets, and had over 25,000 employees. One of those employees was Richard Fuld.

Good luck finding a picture of Fuld not looking miserable

Hired in 1969 and named CEO in 1994, Dick Fuld ran things a bit differently than the Lehman family had. With titles ranging from “The Gorilla” to “Mr. Wall Street” to, according to Conde Nast in 2009, “The Worst American CEO of All Time”, it should come as no surprise that his Lehman Brothers was famously “Fuldcentric”.

I surmise that the shift from purely serving customers into a state of disillusion, whether it was Fuldcentricity or just plain greed and excess, has quite a bit to do with the public and government distrust of firms like Lehman, not to mention the causes of their spectacular failures. William Salomon, formerly a managing director at Salomon Brothers, a legendary investment bank that is the subject of Liar’s Poker and whose bond traders served as the inspiration for Bonfire of the Vanities, had this to say about the shift in priorities:

“In my time, the customer was God, and we would no more take advantage of him than we’d fly out the window.”

Salomon died in 2014 at the age of 100. His father and uncles’ namesake firm was absorbed by Citigroup in 2003 after its reputation was tarnished beyond repair by a series of incidents starting in the early 1990s. You can still buy memorabilia on eBay.

Profits from banking activities exploded in the 1980s. Truth be told, there were and still are quantifiable benefits for the American people. The highest rate of home ownership in the world was a direct result of Wall Street’s innovations in dealing with mortgages, notably Salomon’s Lew Ranieri. The other, broad benefit being an efficient capitalistic system, is taken for granted. As Stanley Dziedzic Jr. states in his little-known book Lehman Brothers’ Dance with Delusion: “There is little socially redeeming about investment banking.”

As the banks got bigger and Washington began to more closely scrutinize and regulate the industry, we started hearing the term “Too Big to Fail.” More accurately, it means a company is “Too big [for an authority] to [let] fail”, meaning that a company has amassed such a level of interconnectivity that its outright failure can have catastrophic consequences.

So, why did Lehman fail? Some ask- why was Lehman allowed to fail? Dick Fuld maintains that it was part of the government’s agenda. In committing $700 billion to bailing out nearly every other investment bank, AIG, and nationalizing Fannie Mae and Freddie Mac, Lehman was purposefully and intentionally skipped over.

The government maintains that, well, Lehman messed up worse than anybody else. Specifically, the company’s massively-leveraged holdings of sub-prime mortgage-backed securities and related products, coupled with a purposeful lack of risk management, brought it down. Stan Dziedzic notes how the firm’s “all for one, one for all” motto turned into “every department for itself” years before the crisis. Before his retirement, he raised serious concerns regarding risk management and lopsided performance incentives, highlighting his own feelings of isolation as the dominant attitude became: “Fuck Lehman; it’s my P&L (Profit & Loss statement used to measure performance-based compensation).”

The products that brought Lehman down are a bunch of acronyms- MBS, RMBS, CDS, NERD, CMO, REMIC, CDO, some pioneered by Lew Ranieri and understood by virtually nobody, from regular homeowners to the upper tranches of management. The eccentric “guru” who you might remember from The Big Short, Michael Burry, discovered the weaknesses of such derivative products simply by reading the entire 200+ page prospectus of a mortgage-backed security. He might have been the only person to ever do so, and he only did so because he has Aspergers, a disorder that can cause a person to become transfixed on a certain activity.

According to Mark Williams, “Often on Wall Street, as profits swell, risk management is viewed as a constraint on profit”. This is one of the most telling statements related to the perilous path Lehman and many others went down. Think about the skewed compensation model. Those taking risks are payed handsomely by way of performance bonuses, even if they have a few small failures. Meanwhile, those preventing (or at least trying their best to prevent) catastrophically risky situations from being realized get paid significantly less. Many of these positions require Ph.Ds. Which side do you want to work on?

Lehman also fell victim to the ancient greek concept of hubris. Fuld turned down a well-calculated offer from Warren Buffet that would have, in retrospect, saved the firm by providing it with much-needed capital. The firms inability to accurately calculate risk across asset classes lead to speculators shorting the stock during the twilight of Bear Sterns’ existence. Bear, a “scrappy”, smaller, younger, and less-diversified firm than Lehman, was seen as Lehman’s “little brother” and failed a full six months before Lehman. It was widely known that the two firms held similar products and rumors were abound. Dick Fuld attacked these claims by publicly saying he wanted to tear the hearts out of short sellers and “eat them”.

The fallacy of proper risk management was further exemplified by Lehman’s board of directors, which has been described as “misguided complacency”. Of the entire board, no more than one or two people were familiar with the derivatives being traded or the risks associated with them. However, Lehman maintained that the risks were managed and that their amount of leverage, at times more than 30x, was justifiable. This is similar to the claim of Long Term Capital Management (LTCM), a quantitative hedge fund that blew up in 1998: “Risk wasn’t fucking managed. Risk was bitch-slapped, risk was tamed and told what to do.” LTCM received a $3.6 billion bailout in 1998 and closed its doors soon after.

Some strategies for risk management weren’t just inaccurate, they were wrong. Lehman’s Value at Risk (VaR) figures were so bad that Williams claims VaR is like “an airbag that works all the time, except when you have a car accident.” Fuld wasn’t too keen on risk management. He had a habit of ousting people in his organization who became too powerful to the point of threatening his absolute control over the company. One of these power plays was the demotion of Madelyn Antoncic, the firm’s Chief Risk Officer. Antoncic’s role was made into a mockery as she eventually was asked to stay out of meetings were levels of risk and risk management strategies where discussed. By the time she was actually demoted it was more of a formality since Fuld couldn’t possibly deal with the backlash from firing outright such an important employee.

Toward the end of the summer before Lehman’s failure, the company was desperately looking for partners or for government intervention. Meanwhile, news organizations like CNBC were running increasingly bearish stories regarding Lehman’s top-heavy position in real estate. Fuld fired off an email, which was viewed as “a telling email, revealing that denial and anger were still a part of the Lehman culture.”

As options were completely exhausted, Lehman was forced into bankruptcy. Its assets were bought cheaply in a fire sale by some of the competitors Lehman had recently asked for help. The company clearly wasn’t all toxic- the firms that bought Lehman’s divisions and personnel were reporting record profits the very next year.

Testifying before Congress, Fuld shocked the nation with his claims of complete innocence and general aloofness. He was vilified for being paid almost half a billion dollars over the course of a decade and became the poster child for Wall Street’s excess and the scapegoat for America’s worst financial disaster since the Great Depression. In the Lehman Brothers weight room, soon after the bankruptcy filing, he was punched in the face by an employee.

In 2015, after more than seven years of exile, he made his first public appearance where he rambled, made vague references and cracked unfunny jokes. His company culture had long since been broken up, his following disbanded. When finally asked about the ultimately harmful culture he instilled at Lehman, he responded:

“It’s like Rocky says: ‘When the going gets tough, the tough get going.’”

Something like that.