Too Big to Fail

by Andrew Ross Sorkin

  Cramer was flushed. “Look, there isn’t anybody. I do my own work, and my own work makes me feel that you’re taking down a lot of crap and you’re not selling a lot of crap, and that therefore you really need cash.”

  Fuld didn’t like being challenged.

  “I can just categorically dismiss that. We’ve been completely transparent. We don’t need cash, we have tons of cash. Our balance sheet has never been this good,” he asserted.

  But Cramer was still skeptical: “If that’s the case, why aren’t you finding some way to be able to translate that cash into a higher stock price, buying some of your bonds?”

  Fuld scoffed as he brought the meeting to an end.

  “I’m on the board of the Federal Reserve of New York,” Fuld told Cramer. “Why would I be lying to you? They see everything.”

  It was mid-May and David Einhorn had a speech to write.

  Einhorn, a hedge fund manager controlling over $6 billion of assets, was preparing to speak at the Ira W. Sohn Investment Research Conference, where each year a thousand or so people pay as much as $3,250 each to hear prominent investors tout, or thrash, stocks. The attendees get to absorb a few usually well-thought-out investment ideas while knowing that their entrance fee is going to a good cause—the Tomorrow’s Children Fund, a cancer charity.

  Einhorn, a thirty-nine-year-old who looked at least a decade younger, was sitting in his office a block from Grand Central Terminal, pondering what he would say. With only seven analysts and a handful of support staff, his firm, Greenlight Capital, was as peacefully quiet as a relaxation spa. No one was barking trade orders into a telephone; no one was high-fiving a colleague.

  Greenlight was known for its patient, cerebral approach to investing. “We start by asking why a security is likely to be misvalued in the market,” Einhorn once said. “Once we have a theory, we analyze the security to determine if it is, in fact, cheap or overvalued. In order to invest, we need to understand why the opportunity exists and believe we have a sizable analytical edge over the person on the other side of the trade.” Unlike most funds, Greenlight did not use leverage, or borrowed money, to boost its bets.

  Einhorn’s analysts spent their days studying 10-Ks in conference areas with wonky names like “The Nonrecurring Room,” a reference to the accounting term for any gain or loss not likely to occur again—a categorization sometimes used by companies to beef up their statements. For Einhorn, it was a red flag, and one that he used to spot businesses he could short. Among the companies he had identified from recent research was Lehman Brothers, which he thought might be an ideal topic for his speech. While questioning Lehman’s solidity may have become the most popular recent topic of Wall Street gossip, Einhorn had been quietly worried about the firm since the previous summer.

  On Thursday, August 9, 2007, seven months before Bear went down, Einhorn had rolled out of bed in Rye, New York, a few hours before dawn to read reports and write e-mails. The headlines that day struck him as very odd. All that summer, the implosion in subprime mortgages had been reverberating through the credit markets, and two Bear Stearns hedge funds that had large positions of mortgage-backed securities had already collapsed.

  Now BNP Paribas, the major French bank, had announced that it was stopping investors from withdrawing their money from three money market funds.

  Like Bernanke, he had canceled his weekend plans to try to better understand what was really happening. “These people are workers in France, they’ve got a money market account that they’re earning no money on. Their only goal is to have that money available to them whenever they want it; that’s what a money market account is. You can’t freeze the money market,” he told his team.

  Einhorn called in the seven analysts who worked for him to assign a special project: “We’re going to do something we don’t usually do, research-wise,” he announced. Instead of the usual painstaking investigation into a company or a particular idea, they were going to conduct—on both Saturday and Sunday—a crash investigation of financial companies that had subprime exposure. He knew that this was where the problem had started, but what concerned him now was trying to understand where it might end. Any banks that held investments with falling real estate values—which had likely been packaged up neatly as part of securitized products that he suspected some firms didn’t even realize they owned—could be in danger. The project was code named “The Credit Basket.”

  By Sunday night, his team had come up with a list of twenty-five companies for Greenlight to short, including Lehman Brothers, a firm that he had actually already taken a very small short position in just a week earlier on a hunch that its stock—then at $64.80 a share—was too high.

  Over the next several weeks, names were removed from the credit basket as Greenlight closed out some short positions and focused its capital on a handful of firms, Lehman still among them.

  As these banks began reporting their quarterly results in September, Einhorn paid close attention and became especially concerned by some of the things he heard in Lehman’s September 18 conference call on its third-quarter earnings.

  For one, like others on Wall Street at the time, the Lehman executive on the call, Chris O’Meara, the chief financial officer, seemed overly optimistic. “It is early, and we don’t give guidance on future periods, but as I mentioned, I think the worst of this credit correction is behind us,” O’Meara announced to the analysts.

  More important, Einhorn thought Lehman was not being forthcoming about a dubious accounting maneuver that had enabled it to record revenue when the value of its own debt fell, arguing that theoretically it could buy that debt back at a lower price and pocket the difference. Other Wall Street firms had also adopted the practice, but Lehman seemed cagier about it than the others, unwilling to put a precise number on the gain.

  “This is crazy accounting. I don’t know why they put it in,” Einhorn told his staff. “It means that the day before you go bankrupt is the most profitable day in the history of your company, because you’ll say all the debt was worthless. You get to call it revenue. And literally they pay bonuses off this, which drives me nuts.”

  Six months later, Einhorn had listened intently to Lehman’s earnings call on March 18, 2008, and was baffled to hear Erin Callan offering an equally confident prognosis. It was, in fact, the emergence of Callan as Lehman’s chief defender that had galvanized his thinking. How could a tax lawyer, who had not worked in the finance department and who had been chief financial officer for only six months, understand these complicated assessments? On what basis could she be so certain that they were valuing the firm’s assets properly?

  He had suspected that Callan might be in over her head—or the firm was exaggerating its figures—ever since he had had the opportunity to speak directly to her and some of her colleagues back in November 2007. He had arranged a call to Lehman to get a better handle on the company’s numbers, and like many firms do as a service to big investors, it made some of its top people available.

  But something about the call unnerved him. He had repeatedly asked how often the firm marked—or revalued—certain illiquid assets, like real estate. As a concept, mark-to-market is simple to understand, but it is a burden to deal with on a daily basis. In the past, most banks had rarely if ever bothered putting a dollar amount on illiquid investments, such as real estate or mortgages, that they planned to keep. Most banks valued their illiquid investments simply at the price they paid for them, rather than venture to estimate what they might be worth on any given day. If they later sold them for more than they paid for them, they made a profit; if they sold them for less, they recorded a loss. But in 2007 that straightforward equation changed when a new accounting rule, FAS 157, was enacted. Now if a bank owned an illiquid asset—the property on which its headquarters was located, for example—it had to account for that asset in the same way as it would a stock. If the market went up for those assets in general, it would have to record that new value in its books and “write it up,” as t
he traders put it. And if it fell? In that case, it was supposed to “write it down.” Of course, no one ever wanted to write down the value of his assets. While it may have been an interesting theoretical exercise—the gains and losses are not actually “realized” until the asset is sold—mark-to-market had a practical impact: A firm that had a huge write-down has less value.

  What Einhorn now wanted to know was whether Lehman reassessed that value every day, every week, or every quarter.

  To him it was a crucial question, because as values of virtually all assets continued to fall, he wanted to understand how vigilant the firm was being in reflecting those declines on its balance sheet. O’Meara suggested the firm marked the assets daily, but when the controller was brought onto the call, he indicated that the firm marked those assets on only a quarterly basis. Callan had been on the phone for the entire conversation and must have heard the contradictory answers but never stepped in to acknowledge the inconsistency. Einhorn himself didn’t remark on the discrepancy, but he counted it as one more point against the firm.

  By late April, he had already begun speaking his mind publicly about the problems he saw at Lehman, suggesting during a presentation to investors that “from a balance sheet and business mix perspective, Lehman is not that materially different from Bear Stearns.”

  That comment had gone largely unnoticed in the market, but it did raise the ire of Lehman and led to an hour-long phone call between Einhorn and Callan as she again tried to answer his questions to his satisfaction and to seek to turn his view of the company around. But despite her outward affability, he felt she was obfuscating.

  Now, as he began preparing for his major upcoming speech in late May 2008, it was that conversation with Callan that made him think he needed to make Lehman the focus of his presentation. He decided to reach out to Callan one last time, sending her an e-mail to inform her that he planned to cite their earlier conversation in his talk at the Ira W. Sohn Investment Research Conference.

  She responded immediately, skipping the niceties: “I can only feel that you set me up, and you will now cherry-pick what you like out of the conversation to suit your thesis,” she wrote back.

  Einhorn was accustomed to companies turning hostile—anyone who wanted to be loved in the financial industry had no business selling shares short. He fired a tough e-mail right back: “I completely reject the notion that I have been disingenuous with you in any way. You had no reason to expect that our discussion was confidential in any way.” And then he finished writing his speech.

  Einhorn stood in the wings of the Frederick P. Rose Hall in the Time Warner Center on May 21, waiting his turn to speak.

  He had been scheduled to take the stage at 4:05 p.m., just after the markets closed—timing that had been carefully planned by the organizers of the conference. Given his stature within the industry and what he was about to say—and considering the firepower of the investors in the audience—he could easily rattle the markets, especially Lehman’s shares.

  As investor events go—and there are many—this was one that genuinely mattered. The hedge fund industry is famously reclusive, but today the key players in the field were in attendance, the auditorium packed with industry titans such as Carl Icahn, Bill Miller, and Bill Ackman. By some estimates, the guests in the audience that day had more than $500 billion under management.

  From the stage’s corner, Einhorn watched as his warm-up act, Richard S. Pzena, a successful value investor, was apparently finishing his speech, having run over his time allotment as he offered his big investment idea to the audience.

  “Buy stock in Citigroup,” he instructed, suggesting that, at $21.06 a share, its closing price that afternoon, it was a screaming buy. “This is classic value. There is lots of stress,” he said. “When we come out of this, the upside is huge!”

  If an investor had actually heeded that advice, he would have lost an enormous amount of money. But the audience applauded politely as it waited for the main event.

  Beyond speaking about Lehman, Einhorn viewed his appearance today as an opportunity to promote his new book, Fooling Some of the People All of the Time, which stemmed from an earlier speech he had delivered at this very conference in 2002—a speech that had landed him in trouble with the feds. In it he had raised questions about the accounting methods used by a company called Allied Capital, a Washington-based private-equity firm that specialized in midsize companies. On the day after he criticized the firm, shares of Allied plunged nearly 11 percent, and Einhorn, at age thirty-three, immediately became an investing hero—and a villain to those he bet against.

  After that talk, which happened to be the first public address he’d ever given, he had actually expected regulators to look into his accusations of fraud at Allied. Instead, the Securities and Exchange Commission started investigating him and whether he was trying to manipulate the market with his comments. For its part, Allied fought back. A private investigator working for the company obtained Einhorn’s phone records through a frowned-upon and potentially illegal approach known as pretexting—that is, pretending to be someone else in order to obtain privileged information about another person.

  Einhorn’s battle with Allied had been going on for six years, but today, patient as ever, he would use his bully pulpit to take on a much larger opponent.

  Einhorn finally placed his notes on the podium. As he surveyed the crowd, he noticed the glow of dozens of BlackBerrys in the first few rows alone. Investors were taking notes and shooting them back to their offices as quickly as possible.

  The markets may have been closed for the day, but in the trading business, a valuable piece of information was worth its weight in gold no matter what the time. There was always a way to make money somewhere.

  Einhorn opened his remarks in his slightly nasal Midwestern monotone by recounting the entire Allied story and tying that back to Lehman Brothers.

  “One of the key issues I raised about Allied six years ago was its improper use of fair-value accounting, as it had been unwilling to take write-downs on investments that failed in the last recession,” he told the audience. “That issue has returned on a much larger scale in the current credit crisis.”

  What he was saying was that Lehman hadn’t owned up to its losses last quarter, and the losses this time were bound to be much bigger.

  After laying out his provocative thesis, Einhorn related an anecdote:

  “Recently, we had the CEO of a financial institution in our office. His firm held some mortgage bonds on its books at cost. The CEO gave me the usual story: The bonds are still rated triple A, they don’t believe that they will have any permanent loss, and there is no liquid market to value these bonds.

  “I responded, ‘Liar! Liar! Pants on fire!’ and proceeded to say that there was a liquid market for these bonds and they were probably worth sixty to seventy percent of face value at the time, and that only time will tell whether there will be a permanent loss.

  “He surprised me by saying that I was right. He observed that if he said otherwise, the accountants would make them write the bonds down.”

  From there Einhorn segued back to Lehman Brothers and made it clear that he felt the evidence suggested the firm was inflating the value of its real estate assets, that it was unwilling to recognize the true extent of its losses for fear of sending its stock plummeting.

  He recounted how he had listened intently to Callan’s performance during her by now famous earnings call the day after the Bear Stearns fire sale.

  “On the conference call that day, Lehman CFO Erin Callan used the word ‘great’ fourteen times; ‘challenging,’ six times; ‘strong,’ twenty-four times, and ‘tough,’ once. She used the word ‘incredibly’ eight times,” he noted.

  “I would use ‘incredible’ in a different way to describe the report.”

  After that rhetorical flourish, he recounted how he had decided to call her. With a projection screen displaying the relevant figures behind him, he told how he had questioned Ca
llan about the fact that Lehman had taken only a $200 million write-down on $6.5 billion worth of the especially toxic asset known as collateralized debt obligations in the first quarter—even though the pool of CDOs included $1.6 billion of instruments that were below investment grade.

  “Ms. Callan said she understood my point and would have to get back to me,” Einhorn relayed. “In a follow-up e-mail, Ms. Callan declined to provide an explanation for the modest write-down and instead stated that, based on current price action, Lehman ‘would expect to recognize further losses’ in the second quarter. Why wasn’t there a bigger mark[down] in the first quarter?”

  Einhorn explained that he had also been troubled by a discrepancy of $1.1 billion in how Lehman accounted for its so-called Level 3 assets—assets for which there are no markets and whose value is traced only by a firm’s internal models—between its earnings conference call and its quarterly filing with the SEC several weeks later.

  “I asked Lehman, ‘My point-blank question is: Did you write up the Level 3 assets by over a billion dollars sometime between the press release and the filing of the 10-Q?’ They responded, ‘No, absolutely not!’ However, they could not provide another plausible explanation.”

  Clearing his throat audibly, Einhorn ended his speech with a warning.

  “My hope is that Mr. Cox and Mr. Bernanke and Mr. Paulson will pay heed to the risks to the financial system that Lehman is creating and that they will guide Lehman toward a recapitalization and recognition of its losses—hopefully before federal taxpayer assistance is required.

  “For the last several weeks, Lehman has been complaining about short-sellers. Academic research and our experience indicate that when management teams do that, it is a sign that management is attempting to distract investors from serious problems.”