Too Big to Fail

by Andrew Ross Sorkin

  McGee had expressed his anxiety to Fuld a month earlier when he asked to be given control over the firm’s capital-raising efforts, which up until that point were being overseen primarily by management on the thirty-first floor, who he felt were not professional deal makers. “You have an investment banking division that does this for a living,” McGee told Fuld. “This is crazy. I should leave if you don’t trust the investment bank to do this.” Fuld agreed, and McGee’s “troops”—Shafir and Whitman—had been included in the Korean junket.

  But since that conversation, the firm’s situation had only worsened. They all knew that the announcement of the next big quarterly loss was only going to exacerbate the situation. Resentment was boiling up through the ranks, and it was no longer directed exclusively at Erin Callan, who, the bankers had concluded, was merely a symptom of a bigger problem.

  The person they had now come to believe was responsible for many of Lehman’s troubles—the risky bets on corporate real estate, the constant reshuffling of executives into jobs they were ill equipped to handle—was Joe Gregory, the firm’s president and Fuld’s closest associate. McGee and Gregory had never gotten along very well to begin with; each was too headstrong for the other. And in recent months, Gregory had been discussing ways to push McGee aside, by assigning him to a new commodity trading business back in Houston, the prospect of which left McGee lukewarm.

  The Sunday before preannouncing earnings report, June 8, as everyone worked over the numbers on the thirty-first floor, McGee, in a golf shirt and khakis, slipped into Fuld’s office to review the investment bank’s earnings and projections. But just as McGee had finished his summary and was getting ready to leave, he said, “When we get through this, we need to have a serious conversation.”

  “What about?” Fuld asked.

  “About a change in senior management,” McGee blurted out.

  “What?” Fuld said, distracted now from the numbers before him.

  “Well, I guess we’re having that conversation now then,” McGee said, getting up to shut the door. Gregory’s office was just a few feet away.

  When he took his seat again, he told Fuld precisely what he had meant: “You need to move on Joe.”

  Fuld was dumbstruck. “Joe Gregory is off the table,” he said, raising his voice. “He’s been my partner for twenty-five years. It’s not fair. I couldn’t look at myself in the mirror.”

  “Whether it is fair or not, you need to do something about Joe,” McGee replied. “You’ve not been well served by your COO. He’s in over his head. He’s not minding the store. He’s made some horrible personnel decisions, and he’s not watching your back on risk.”

  Reminding McGee that, as a member of the executive committee, he was responsible for making key decisions along with everyone else, Fuld said, “The entire executive committee is the risk committee.”

  McGee, realizing that he was not getting his point across, stated carefully, “You’re a wonderful leader, but when the books are written, your Achilles’ heel will be that you have a blind spot for weak people who are sycophants.”

  Fuld barely heard the last part of McGee’s comment, as he had been thinking about Gregory. “I’m not doing it,” he finally said, ending the discussion.

  McGee left the office, fairly certain that Gregory’s job was safer than his own.

  After McGee departed, Fuld sat in his office, stunned; he couldn’t conceive of the firm without Gregory. But nothing that was happening was making any sense. The firm he had rebuilt with his own two hands was falling apart everywhere he looked.

  Over at Neuberger Berman, Lehman’s asset-management arm, executives were in open revolt, trying to disentangle themselves from the mess at headquarters. Lehman had bought Neuberger in 2003, and as long as times were good, it had been a useful, relatively trouble-free contributor to the firm’s bottom line. But when Lehman stock started its swan dive, Neuberger employees panicked. They had become accustomed to the steady income generated by managing rich people’s money, but that was now in jeopardy, as a good portion of their bonuses were paid in stock.

  A week earlier, on June 3, Judith Vale, who ran a $15 billion small-cap fund for Neuberger, fired off an e-mail to the Lehman executive committee (with the exception of Fuld), demanding that top Lehman managers forego bonuses and make preparations to spin off Neuberger.

  “Morale at NB is at a dangerously low level, largely because Lehman stock is a significant portion of our compensation, and as such, our comp is not tied to anything within our control,” Vale wrote. “Many believe that a substantial portion of the problems at Lehman are structural rather than merely cyclical in nature. The ‘old’ Neuberger franchise (which resides at 605 Third) is largely intact. However, this is a people business, and the continuing health of the franchise is dependent on retaining key producers and support personnel. Don’t slam bonuses of key producers and support personnel at NB because of management mistakes made elsewhere.”

  George H. Walker IV, the head of Lehman’s investment management division and a cousin of President Bush, immediately sought to blunt Vale’s criticism.

  “Sorry, team,” Walker wrote in an e-mail to everyone who’d received Vale’s missive. “The compensation issue she raises…is a particular issue for a small handful of people at Neuberger and hardly worth the EC’s [executive committee] time now. I’m embarrassed and I apologize.”

  The correspondence was forwarded to Fuld, who wrote in reply, “Don’t worry—they are only people who think about their own pockets.” Did anyone in the firm still have any loyalty?

  Although Joe Gregory’s title was still chief operations officer, in the opinion of many Lehman executives, he had spun off into the ether years earlier. Few seemed to flaunt their personal wealth as much as he did. The helicopter commute was just the start of it. He and his wife, Niki, bought a house in Bridgehampton for some $19 million, and even though it was completely decorated, they had it redone top to bottom with their own designer. He drove a Bentley and encouraged his wife to take shopping trips to Los Angeles via a private plane. But despite an extravagant lifestyle that was estimated to cost in excess of $15 million a year, he kept most of his net worth tied up in Lehman stock. To gain access to cash, he had pledged 751,000 Lehman shares in a margin account as of January 2008, which, based on where the shares were trading, would’ve allowed him to borrow roughly $40 million.

  It wasn’t Gregory’s spending habits that people inside Lehman found objectionable, though. He had a lot of money, and he obviously wasn’t the only one who liked to throw it around. What did seem somewhat odd was his portfolio of responsibilities. Even in his prime Gregory had never brought in big deals or made many hugely successful trades himself. His job was to be Fuld’s unquestioning confidant, and as long as he was that, everything else was up to him. He loved being the in-house philosopher-king, an evangelist on the subject of workplace diversity and a devotee of the theories described in Malcolm Gladwell’s bestseller Blink. He gave out copies of the book and had even hired the author to lecture employees on trusting their instincts when making difficult decisions. In an industry based on analyzing raw data, Gregory was defiantly a gut man.

  He was also an advocate of the Myers-Briggs Type Indicator, which used Jungian psychological principles to identify people as having one of sixteen distinct personality types. (A typical question was, “Do you prefer to focus on the outer world or on your own inner world?”) Gregory used Meyer-Briggs results to help make personnel decisions. It was his conviction that individual expertise was overrated; if you had smart, talented people, you could plug them into any role, as sheer native talent and brains trumped experience. Gregory seemed to revel in moving people around, playing chess with their careers.

  His greatest experiment to date had been naming Erin Callan to be the chief financial officer. He and Callan eventually became so inseparable in the office that many were convinced, though it was never substantiated, that the two were linked romantically. Around the
time she was promoted to CFO, Callan separated from her husband, Michael Thompson, a former Lehman vice president who’d left the firm.

  Gregory loved being a mentor to younger executives like Callan, and he was fully cognizant of his role in Fuld’s hierarchy: If there was a difficult conversation to have, he considered it his responsibility to handle it. In this regard, Gregory and Fuld were total opposites. While Fuld had a gruff, tough-guy exterior, he had soft spots; he could be quite sentimental and tended to struggle when faced with difficult decisions, especially those concerning personnel. Gregory, in contrast, was much more gregarious, a leader given to championing underlings and setting lofty goals for the firm. He gave generously to charities, especially those involving breast cancer, which Niki had survived, and he had spent a full year working to establish a mentoring program between Lehman and historically black Spelman College of Atlanta, a rare effort on Wall Street.

  But when it came to judging the loyalty of Lehman employees, Gregory could be ruthless, given to angry, impetuous decisions. In the summer of 2006, Fuld had hosted a retreat for senior Lehman executives at his vacation home in Sun Valley, Idaho. Alex Kirk, who ran the global credit products group and had previously struck Gregory as a disloyal troublemaker, was due to make a presentation but was unable to make the trip because of an illness. Feeling better, Kirk decided to make the presentation via video feed, and when Gregory saw how well Kirk looked on the video, he was incensed. Kirk was clearly not sick, Gregory was convinced, and his failure to show up in person was nothing less than a personal insult to Fuld. “I want him fired,” he yelled. Kirk’s allies at the firm had to appeal to Bart McDade, Lehman’s head of equities, to intervene with Gregory and calm him down. Cooler heads eventually prevailed.

  The Lehman deal maker who had prospered most under Fuld and Gregory was Mark Walsh, a socially timid workaholic who ran Lehman’s real estate operations. An Irish American native of Yonkers, New York, Walsh made his mark in the early 1990s when he bought commercial mortgages from Resolution Trust Corporation, the outfit established by the federal government to clean up the savings and loan debacle, and packaged them into securities. A lawyer by training, Walsh seemed immune to risk, which impressed Fuld and Gregory to no end. They gave Walsh free rein, and he used it to ram through deals much more quickly than the competition. After the developer Aby Rosen closed the $375 million acquisition of the Seagram Building in only four weeks, Walsh bragged to friends about how swiftly he had been able to execute the deal.

  Each success bred hunger for more, leading to monstrous deals like Lehman’s partnership with SunCal Companies. A land speculator that bought property primarily outside Los Angeles, SunCal secured approvals for residential development and then sold them to home builders at a hefty markup. Lehman pumped $2 billion into what appeared to be its can’t-fail transactions. Walsh had virtually unlimited use of Lehman’s balance sheet and used it to turn the firm into an all-in, unhedged play on the U.S. real estate market, a giant REIT (real estate investment trust) with a little investment bank attached—a strategy that worked extraordinarily well right up until the moment that it didn’t.

  At the very height of the market, Walsh concluded his last great deal, a joint transaction with Bank of America, committing $17.1 billion in debt plus $4.6 billion in bridge equity to finance the purchase of Archstone-Smith, a collection of premium apartment complexes and other high-end real estate. The properties were excellent, but the price was sky-high, based on projections that rents could be hiked substantially. Almost immediately, the proposition started to look dubious, especially when the credit markets seized up. But given a chance to back out of the deal, Fuld declined. The firm had made a commitment and it was going to stick with it. Gregory made a circuit to rally the troops. “This is going to be temporary,” he told Lehman colleagues. “We’re going to fight through this.”

  As both Gregory and Fuld were fixed-income traders at heart, they weren’t entirely up to speed on how dramatically that world had changed since the 1980s. Both had started in commercial paper, probably the sleepiest, least risky part of the firm’s business. Fixed-income trading was nothing like Fuld and Gregory knew in their day: Banks were creating increasingly complex products many levels removed from the underlying asset. This entailed a much greater degree of risk, a reality that neither totally grasped and showed remarkably little interest in learning more about. While the firm did employ a well-regarded chief risk officer, Madelyn Antoncic, who had a PhD in economics and had worked at Goldman Sachs, her input was virtually nil. She was often asked to leave the room when issues concerning risk came up at executive committee meetings, and in late 2007, she was removed from the committee altogether.

  In the presence of the trading executives, Gregory always tried to make an impression with his market savvy, to such a degree that it became a running joke. Traders eventually came to consider his tips as contrary indicators; if Gregory declared that a rally in oil prices had much further to go, for example, they’d short oil.

  In recent years, though, a growing contingent of Lehman executives had begun to view Gregory as a menace. He just didn’t know enough about what was going on, they thought. The firm was making bigger bets than it would ever be good for and nobody in the executive office seemed to understand or care. To criticize the firm’s direction was to be branded a traitor and tossed out the door.

  Among those who tried to sound the alarm was Michael Gelband, who had been Lehman’s head of fixed-income trading for two years and had known Gregory for two decades. In late 2006, in a discussion with Fuld about his bonus, Gelband remarked that the good times were about to hit a rough patch, for which the firm was not well positioned. “We’re going to have to change a lot of things,” he warned. Fuld, looking unhappy, said little in reply.

  The fixed-income guys had been spending a lot of time talking about the train wreck that awaited the U.S. economy. In February 2007, Larry McCarthy, Lehman’s top distressed-debt trader, had delivered a presentation to his group in which he laid out a dire scenario. “There will 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.”

  McCarthy went on to conclude that “many people today believe that globalization has somehow killed off the natural business cycles of the past. They’re wrong. Globalization did not change 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.”

  Around that same time, Gregory invited Gelband to lunch “just to talk.” The two men had never seen eye-to-eye, and Gelband suspected another agenda. They met in the executive dining room on the thirty-second floor, and after chatting for a while, the conversation took a hard shift.

  “You know,” Gregory said firmly, “we’ve got to do things a little differently around here. You have to be more aggressive.”

  “Aggressive?” Gelband asked.

  “Toward risk. You’re holding back, and we’re missing deals.”

  To Gelband’s thinking, Lehman had in fact been pushing through a number of deals that didn’t make much sense. They were piling up too much leverage, taking on too much risk, and getting into businesses in which they lacked expertise. At times there appeared to be no strategy whatsoever guiding the firm. Why had Lehman paid nearly $100 million for Grange Securities, an insignificant Australian brokerage? Earlier there had been discussions about becoming a player in commodities. Had there been a sound reason for acquiring Eagle Energy, a marketer of natural gas and electricity started by Charles Watson, other than the fact that Watson had been a longtime Lehman client, as well as an old pal of Skip McGee? Meanwhile, the firm seemed willing to finance buyouts indiscrimi
nately; loans to private-equity firms were piling up on the books. Some would get securitized and sold, but the pipeline was clogging up.

  None of that seemed to bother Gregory; the deals that did concern him were the ones that Lehman had failed to get a piece of, like the blockbuster $5.4 billion acquisition of Stuyvesant Town and Peter Cooper Village, a sprawling complex of more than 11,200 apartments on the East Side of Manhattan. Lehman had joined forces with Stephen Ross’s Related Companies, the developer of the Time Warner Center, to bid on the project, but lost out to Tishman Speyer and Larry Fink’s BlackRock Realty Advisors. Adding insult to injury was the fact that Lehman considered Tishman, which it had helped buy the MetLife Building for $1.7 billion in 2005, one of its closest clients.

  Because the real estate division technically reported to fixed income, Gregory held Gelband responsible for the missed opportunity on Stuyvesant Town. “We’re going to need to make some changes,” he said, implying that Gelband should let a couple of heads roll on his staff.

  The following day, Gelband took the elevator up to see Gregory, who was in a meeting. Gelband barged in and said, “Joe, you said you wanted to make some changes? Well, the change is me.”