Too Big to Fail: The Inside Story of How Wall Street and Washington Fought to Save the FinancialSystem--and Themselves

CHAPTER FIVE

Surprisingly soft-spoken when not on the air, Jim Cramer, CNBC’s blustery market guru, politely told the security guard standing outside Lehman Brothers’ headquarters on Seventh Avenue and Fiftieth Street that he was expected for a breakfast meeting with Dick Fuld. He was ushered through the revolving door, past Lehman’s bomb-sniffing Labrador, Bella, and to the reception desk, where he made his way through the familiar security procedures. Looking rumpled as usual, he was received in the waiting area of the thirty-second floor as ceremoniously as if he were a major client who had arrived to negotiate a billion-dollar deal. Erin Callan, the CFO, was present, as was Gerald Donini, the head of global equities and a neighbor of Cramer’s in Summit, New Jersey.

Fuld, who was still zealously conducting his jihad against the short-sellers, had personally invited Cramer for the meeting. By now he had come to realize that he needed an ally in his struggle against the shorts, but so far, nobody had been willing to join the battle. Not Cox. Not Geithner. And not Paulson, despite their recent conversation at Treasury. But maybe Cramer, with his huge television audience and connections deep within the hedge fund world, could somehow help sway the debate and talk up Lehman’s stock price.

Fuld had known Cramer for a decade. After Long-Term Capital Management blew up in 1998, word spread that Lehman had huge exposure to the fund and might be the next to go down. Fuld had received a major public boost from Cramer, then a new face at CNBC, when he declared on television that all Lehman needed to do was buy back its own shares to halt the downward spiral and squeeze the shorts. The following morning, Fuld, who had never met Cramer, called him at his office and told him, “I bid thirty-one dollars for one million shares of Lehman.” Shares of the company steadied soon afterward.

If Wall Street had indeed been taking on some aspects of a Shakespearean tragedy, Cramer would likely serve as the comic relief. Voluble and wild-eyed, he spoke in his TV appearances so quickly that it often seemed as if his head might explode from the sheer effort of communicating his ideas. But for all his carnival-barker antics, people on Wall Street knew Cramer was no fool. He had managed a hedge fund and founded TheStreet .com, an early and influential investing Web site, and had a keen understanding of how the market worked.

Fuld and Cramer had come to respect each other as no-nonsense street fighters, despite their pronounced differences in character. Cramer, a media star, was solidly Harvard, had once worked at Goldman, and counted as one of his best friends Eliot Spitzer, the bane of Wall Street. Fuld, for his part, tended to despise Ivy Leaguers, liked to think of himself as the anti-Goldman, and had never been much of a communicator. Still, he appreciated the fact that Cramer had always been an honest broker, willing to speak his mind, however unpopular his opinions might be.

After one of Lehman’s wait staff had taken food orders for the group, Fuld walked an attentive Cramer through his talking points. Lehman, Fuld said, was working hard to reduce the firm’s leverage and restore confidence among investors. Though they had raised $4 billion in new capital in the first quarter, Fuld was convinced that a “cabal of shorts” was preventing the stock price from being properly reflected. The franchise was undervalued.

Cramer nodded his head energetically. “Look,” he said, “I think there is definitely a problem with the shorts—they’re leaning all over you.”

Fuld was gratified to see that he had a receptive audience. As he was well aware, his short-seller predicament touched on an obscure issue near and dear to Cramer: the uptick rule—a regulation that had been introduced by the Securities and Exchange Commission in 1938 to prevent investors from continually shorting a stock that was falling. (In other words, before a stock could be shorted, the price had to rise, indicating that there were active buyers for it in the market. Theoretically, the rule would prevent stocks from spiraling straight downward, with short-sellers jumping on for the ride.) But in 2007 the commission had abolished the rule, and to critics like Cramer, its decision had been influenced by free-market ideologues who were eager to remove even the most benign speed bumps from the system. Ever since, Cramer had been warning anyone who’d listen that without this check, hedge funds were free to blitzkrieg good companies and drive down their stock.

But until the current crisis, few had been willing to listen to his admonitions. Because their hedge fund clients wanted the rule eliminated, Wall Street firms were happy to accede—right up until the time that they themselves became the target of short-sellers and had to run for cover.

“You can be a great ally to me on this uptick rule crusade,” Cramer said.

Fuld contemplated his guest’s enthusiasm as he silently weighed the advantages and disadvantages of lending his firm’s name to the cable news star’s crusade. Cramer was probably right about the rule’s removal hurting Lehman, but Fuld also knew that his firm’s own arbitrage desk had hedge fund clients who were selling short, and they made the firm a great deal of money. He certainly didn’t want to alienate them, and at the same time, he recognized that there was a legitimate debate about the issue. And however protective the restrictions may have been intended to be, Fuld knew perfectly well that investors could get around them by using options and derivatives.

Donini, skeptical that the uptick rule was Lehman’s biggest problem, interjected on behalf of Fuld. “What are you trying to accomplish, Jim?” he asked.

“The shorts are destroying great companies,” Cramer replied. “They destroyed Bear Stearns, and they’re trying to destroy Lehman,” he said, perhaps trying to play to Fuld’s ego. “I want to stop that.”

“If you’re trying to accomplish that,” Donini replied, “and you believe that shorts are causing the problem, then I don’t believe the uptick rule is the way to do it.” Donini explained to Cramer that he felt the real problem in the marketplace was “naked shorting.” Normally, when investors sell shares short, the investor first borrows the shares from a broker, sells them, and then hopes they drop in value so the investor can buy them at a lower price, replace the borrowed shares, and pocket the difference as a profit. But in naked shorting—which is illegal—the investor never borrows the underlying shares, potentially allowing them to manipulate the market.

Cramer was intrigued but also visibly taken aback by Donini’s answer. He had been invited to the meeting, had offered to help, and now his offer was being rejected. He tried changing the subject back to Lehman’s troubles. “Well, why don’t you give me ammo so that I can tell a positive story?” he suggested.

Sensing the tension rising in the room, Callan interjected, speaking up for the first time. “We just bought this unbelievable portfolio from Peloton, and it’s immediately accretive,” she said, cheerfully offering what she considered a bit of good news.

But Cramer could barely conceal a frown, for he knew a good deal about Peloton. Based in London, the hedge fund had been started by Ron Beller, a former Goldman executive whose wife was a policy adviser to Prime Minister Gordon Brown. It had once been among the top-performing hedge funds in the world but had faltered, selling its assets in a virtual fire sale. “Geez,” Cramer answered with as much tact as he could muster, “I’m surprised to hear it’s any good, given the fact that they were levered thirty to one with what I hear is a lot of bad stuff.”

“No,” Fuld said enthusiastically, “we got this for a song.”

Cramer did not look convinced. “One of the things I’m really unclear about is that, if you talk to Goldman, Goldman’s radically trying to deleverage, and what you’re saying is, ‘I’m gonna deleverage,’ but you actually are increasing your leverage.”

Fuld, who didn’t appreciate the tone of the observation, responded, “What we’re doing is, we’re buying really important portfolios that we think are worth a lot more and we’re trading out of ones that are worth less.”

Callan said that Lehman was quickly deleveraging its own balance sheet. She also said, “There are assets on the books that we have a high degree of confidence are undervalued.” She spent the next ten minutes telling Cramer about the firm’s residential real estate assets in California and Florida, two of the hardest hit markets, suggesting she expected them to rebound soon.

Having come to the conclusion that any alliance with Cramer could only be problematic, Fuld quickly changed the subject and began pumping Cramer for information. “So, what are you hearing out there? Who’s coming after us?”

Fuld said that he had become convinced that two of the nation’s most powerful financiers, Steven A. Cohen at SAC Capital Advisors in Greenwich, Connecticut, and Kenneth C. Griffin of Citadel Investment Group in Chicago, were largely responsible for both the short raid and rumormongering, though he didn’t say their names aloud.

“They are liars!” Fuld said adamantly of the shorts. “I think it’s pretty safe for you to go out and say they’re liars.”

Cramer, while sympathetic, made it clear that he wasn’t prepared to go out on a limb and back Lehman’s stock unless he had more information. “I can say that people could be skeptical of the rumors,” he offered, and then added, “why don’t you go to government? If you think this is so bad and you think that there’s a real bear raid and people are lying about it, why don’t you go tell the SEC?”

But Fuld, growing increasingly agitated, only repeated, “Why don’t you just give me the names of people telling you negative things about us?”

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 stopped everything he was doing that weekend 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 e-mailed some of his top analysts 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 big exposure to the world of securitized debt. 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. Lehman, having heard that Einhorn was critical of the firm, set up a conference call with him and made some of its top people available to him in hopes of assuaging his concerns.

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 the 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 the value of its illiquid assets—including some $9 billion in mortgages—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. Einhorn set up another call with Lehman, and again, Callan tried to answer his questions and 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 confirmed for him that he needed to make Lehman the focus of his presentation. He decided to follow up with 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 Callan 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.”

Within minutes of Einhorn’s leaving the stage, news of his speech had been broadcast throughout financial circles. Lehman was in for some serious pain when the market opened the following day; the shares would fall as much as 5 percent.

As Einhorn headed up Broadway to attend a book party being thrown for him at the restaurant Shun Lee West, he leafed through the program of the conference he had just left and saw something that made him smile ruefully.

Lehman Brothers had been one of the Patron Sponsors of the conference, having paid $25,000 so that the world could hear him publicly undermine the firm’s credibility.