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

CHAPTER SIX

“Who talked?” Dick Fuld demanded, scarcely able to control his fury and looking as if he might leap across the table and strangle someone.

Lehman’s executive committee—the firm’s top managers—were arrayed around a conference room table on Tuesday, June 3, awkwardly sitting in absolute silence.

Fuld held a copy of that day’s Wall Street Journal in his hand. There, on the front page, was what he described to them as “the greatest betrayal of my career.” He had practically choked that morning when he read the headline—“Losses Push Lehman to Weigh Raising New Capital”—with the story adding the damning details: “Wall Street executives estimate it is likely to be $3 billion to $4 billion. They said Lehman would probably announce the capital raising in conjunction with its quarterly results.”

There it was, the morning’s news, the secret plan he had been working on for the past month to counter the critics and demonstrate strength, exposed for the entire world to read. He had been working frantically to shore up the firm, and now, he thought, the leak put all that effort in jeopardy.

Fuld had spoken to the reporter Susanne Craig on and off the record many times over the last few months. But he’d certainly never breathed a word of this. Fuld could only take solace in the fact that she didn’t have all the facts of his plan just yet: Lehman was in discussions with the Korea Development Bank, a state-owned policy bank in South Korea. The talks, which were being orchestrated by Kunho Cho, Lehman’s top executive in Seoul, could lead to a major cash infusion of more than $4 billion. Still, Fuld knew that the only way Craig could have learned that the firm was considering seeking new capital was if someone in the know—someone at the table in the conference room that morning, in fact—had leaked the story.

Coming on the heels of David Einhorn’s campaign against the firm—Lehman’s stock had fallen 22.6 percent since his speech in May—it was yet another public relations disaster. Fuld knew perfectly well that bankers were occasionally prone to being loose-lipped about their clients, but this concerned the firm he had given his entire life to and was about its very survival. The breach of loyalty stung him deeply.

Already that morning rumors were circulating that Lehman was so desperate for liquidity that it had tapped the Federal Reserve’s discount window. That was untrue, but Lehman’s stock was pummeled anyway, falling 15 percent.

For the past two weeks Fuld had been forced to respond to such rumors on an almost daily basis, as Einhorn’s comments had taken on enough credibility to sow seeds of doubt about Lehman’s own. To Fuld’s thinking, that was precisely Einhorn’s objective. Fuld’s co-chief administrative officer, Scott Freidheim, had been in touch with nearly half the public relations flacks in the city, desperately attempting to formulate a counterattack against Einhorn and the shorts. “How does this guy have any credibility coming after us?” Freidheim asked Joele Frank and Steve Frankel, two crisis specialists. “We can’t go tit for tat with everyone who makes a claim,” he’d said to another PR executive, Steven Lipin. In the meantime, the firm had established a clear script for all discussions with the media: There would be no more winging it; they couldn’t afford any mistakes.

Fuld thought Craig’s coverage had crossed the line, even if it was a legitimate scoop. To him, in his fit of rage, it was as if she had knowingly set out to undermine the firm, just like Einhorn. The article made Lehman seem like a collection of petty high school cliques, a gossip mill. He had always considered her one of only a handful of trustworthy reporters. The week before she’d even asked to sit in on one of Lehman’s management meetings, a request he thought was ludicrous, but he’d declined the request politely. “I’d like to be helpful,” he explained. “But I can’t allow that.”

When Craig phoned Fuld that afternoon to follow up on her story, he lit into her mercilessly. “You pose as a responsible journalist but you’re just like the rest of them!” he said. “Your seat at the table has been removed,” he shouted, then slammed down the receiver. There would be a new rule in effect at Lehman, he subsequently decreed: Nobody, not even the PR department, was allowed to speak to the Wall Street Journal ever again.

When he learned of Fuld’s diktat, Andrew Gowers, Lehman’s head of communications, was beside himself. “I don’t understand how on earth this policy is supposed to help us communicate in the middle of all this if we’re going to shut out the biggest financial paper in the country,” he complained to Freidheim.

“I don’t know,” Freidheim replied with a shrug. “It’s between Dick and the paper.”

Scott Freidheim knew who the leaker was, or so he believed.

At forty-two years old, Freidheim was the youngest member of Fuld’s inner circle. The son of the former CEO of Chiquita, he was the ideal Fuld operative: a get-it-done loyalist with a killer instinct. As the firm’s co-chief administrative officer, he wasn’t so much a banker as he was a highly paid strategist. To Fuld’s detractors, he was one of the chairman’s pets, a know-nothing protector of the throne who shielded Fuld from any number of ugly truths. Freidheim was an executive in the Joe Gregory mold: He owned an enormous home in Greenwich and a constantly rotating fleet of cars; he had recently bought the “mobile office” once owned by one of his friends, hedge fund mogul Eddie Lampert—a black GMC Denali outfitted with Internet access that he had chauffeur him to Manhattan each day. “Isn’t this awesome!” he once announced excitedly when he showed off the vehicle to colleagues as it blasted the theme song to Mission: Impossible.

After the tense meeting with Fuld about the Journal story, Freidheim was determined to find the leaker for his boss. He had in fact sensed that something was amiss the night before, after he’d had a flurry of confusing phone calls with Craig and with Lehman’s spokesperson, Kerrie Cohen. He had been frustrated because he couldn’t get a straight answer about the coming story.

Early the next morning, Erin Callan had dropped by his office, which she rarely did, and innocently asked about the story, “Do you think it will make the stock go up?”

With that it became clear to Freidheim that the leak had been her idea. Like a growing group of executives up and down the organization, Freidheim had come to the conclusion that Callan was in the wrong job, and he had grown tired of her perky self-assurance. She performed for the media as though she were on some kind of reality show. She might have pulled off the earnings call back in March, but now he questioned Gregory’s decision to put her in the job, referring to her as a “diversity hire.” He couldn’t believe she had gone off and talked to Einhorn before his speech without first consulting anyone—he’d been trying to put that fire out for a week now. And he had been furious back in April when Craig, in another Journal story, had crowned her “Lehman’s straight shooter,” as if the rest of them were a pack of untrustworthy liars. Callan just didn’t know where the line was drawn. She kept a model of a private jet on her desk and revealed details about her personal shopper to the press, blithely unaware of the resentment it inspired. The worst was when she framed a photograph of herself getting out of a limousine, from a gushy profile in the Condé Nast Portfolio magazine that pronounced her “The Most Powerful Woman on Wall Street,” and hung it on her office wall; Gregory had had to tell her to take it down.

Freidheim, now on the warpath, called security and ordered the company’s phone records searched. He soon discovered what he regarded as all the proof he needed: Callan had indeed spoken to Craig the day before. Whether that meant she had actually informed the reporter about the capital raise plans was yet to be determined. Had she revealed that the Koreans were a potential suitor? Freidheim did not know, but the phone record gave him an excuse to talk to Fuld about her.

When Freidheim arrived at Fuld’s office, he found Gregory there and proceeded to present his findings to both men. He concluded by saying that he wanted to approach Callan about the call himself, and added, “We can’t rule out firing her.”

Gregory, her mentor, was aghast at the accusation. Nobody was getting fired, and as far as he was concerned, nobody was even going to mention the matter to Callan. “She has too much on her plate,” Gregory insisted, and Fuld nodded his agreement. He simply could not afford to lose his CFO, not in the current climate, and not even if she had done the unthinkable and leaked the information.

In his heart, Fuld knew that his Korean gambit was a Hail Mary pass. Lehman’s own banking operation in Seoul was effectively a mirage; it had never produced any business significant enough even to warrant Fuld’s attention. He had also been warned repeatedly by just about everyone in the office that there were some serious doubts about the players involved. The whole success of the effort hinged on two individuals: Kunho, a well-connected banker with impeccable manners who, as far as anybody could tell, was simply unable to close any deal; and Min Euoo Sung, a former Lehman Brothers banker based in South Korea who had left the firm and had managed to snag a prestigious new appointment as the head of the Korea Development Bank. While Fuld had always liked Min—years earlier, when Min was working for Woori Financial Group, he had brought Lehman in on a joint $8.4 billion purchase of a troubled loan portfolio—some of Min’s other colleagues at Lehman were stunned by the appointment, as were a number of KDB’s staff, who, having judged his credentials inadequate, had tried unsuccessfully to stop it.

Min, however, was undeterred; he had grandiose visions. At a dinner with his new colleagues, he sang a song called “Leopard in Mt. Kilimanjaro” as an expression of his desire to be a powerful force in the world of finance. The Lehman situation presented the first major opportunity to achieve that goal. Before he had even formally started his job, Min had approached his friend Kunho about doing a deal. Kunho had in turn brought Jesse Bhattal, the debonair head of Lehman’s Asia-Pacific operations, based in Tokyo, into the talks, and the idea started to gain momentum.

What choice did Fuld have but to play this situation out? In less than a week, on June 9, the firm would be announcing its first quarterly loss—a staggering $2.8 billion—since American Express spun it off. The stock was already down 18 percent in three days. Fuld had to find capital, and at this point, he would try any avenue he could. He had been pressing his old friend Hank Greenberg, the former chairman of AIG, to put money into the company, as well as trying to get an investment from General Electric, but he couldn’t be certain that either would come through.

Certainly, Fuld did have some reason to believe that a constructive agreement might be negotiated with the Koreans. The Monday before the Lehman team had left for Asia, David Goldfarb, Fuld’s chief strategy officer, had raised his boss’s expectations.

“Korea situation sounds promising,” Goldfarb wrote in an e-mail that he also sent to Gregory. “They really are looking to restructure and open up financial services and seem to want anchor event to initiate the effort, which could be us. I still prefer a Hank [Greenberg] or GE solution, but if that is not there, we could make this strategically based as well.

“Between Kunho and ES’s [Min’s] relationship it feels this could become real. If we did raise $5 billion, I like the idea of aggressively going into the market and spending 2 of the 5 in buying back lots of stock (and hurting Einhorn bad!!). Lots to do on this, been speaking to Jesse and Kunho. Sounds like the Koreans are serious on this and are looking to do something aggressive. Could be interesting timing for them, to get some attention away from faster growth Asian economies. Could be interesting, but as we know these thing often don’t go further then the rhetoric.”

On June 1 a small team of Lehman bankers had headed to New Jersey’s Teterboro Airport and set off for Korea in the firm’s Gulfstream. The senior person aboard, Tom Russo, Lehman’s chief legal officer, had little deal-making experience, but as one of Fuld’s confidants, he could serve as a trusted pair of eyes and ears. Mark Shafir, the firm’s head of global mergers and acquisitions (and the brother of Robert Shafir, whom Gregory had unceremoniously forced to quit), was the lead deal banker, along with Brad Whitman, a talented acquisitions expert who had spent most of his career merging the nation’s far-flung telecommunications firms into a handful of powerful players. Completing the group were Larry Wieseneck, the firm’s head of global finance, and lawyer Jay Clayton of Sullivan & Cromwell. They would meet Kunho and Bhattal when they got there.

With a stop for refueling in Anchorage, the jet made the trip in nineteen hours, and on arrival the exhausted Lehman contingent took a fleet of cars to their hotel on the outskirts of Seoul. The Shilla was a peculiar place with a lobby that looked like a spaceship, but at least it had a bar.

The first meeting in Seoul involved only lower-level officials of KDB and Hana Financial, which was also considering an investment. Shafir and Whitman could tell immediately that this was not a deal that was likely to happen. Neither Korean firm had brought along lawyers or hired its own U.S. advisers. And Min, who had not yet officially started as chief executive of KDB, could not even take part in the talks.

“This is bullshit,” Wieseneck exclaimed after the initial session ended, having served little purpose other than to make introductions. Even as the talks progressed, the Lehman team could hardly tell to whom they were speaking. At one point Russo engaged in what he thought was a productive exchange with an individual who turned out to be an outside accountant. “Relying on Kunho is like bottom of the ninth, two outs, in the World Series,” Shafir complained to his American colleagues the first night in the bar, “and you send up a guy to the plate who hasn’t gotten a hit all year.”

Lehman had wanted to start discussions at $40 a share, but by the end of the first day the stock was at $30. Nobody—not even this group of deal-hungry Koreans—was going to pay a 33 percent premium. The whole affair became increasingly unreal.

No food was served at the meetings, so the Lehman bankers were starving by the time they got back to their hotel, where the meals were generally dreadful. The only palatable item they could find on the menu was tuna, which most of them ate every day of their stay.

But neither the subpar accommodations nor the Koreans’ erratic behavior could dent Russo’s enthusiasm: He was going to make this happen. “They’re going to do this deal,” he told his colleagues, supported by Kunho and Bhattal. “They’re going to put in $10 billion. They’re going to make their balance sheet available for loans.”

No, they aren’t, thought Shafir. They aren’t going to do anything of the kind.

Sitting on a hotel room bed crowded around the speakerphone, the group called Fuld back in New York, with Russo leading the conversation. “Dick, I’m feeling very good about it,” Russo enthused. “I think we have a 70 percent chance of getting something done with these guys.”

Fuld’s delight at the news, however, was short-lived. The group returned to New York empty-handed on June 5; efforts to come up with even a rudimentary term sheet had completely failed. The Koreans had obviously been deterred by Lehman’s cratering stock and simply may not have had the wherewithal to bring about such a major piece of business. Even Russo had lost confidence. “We’re not going to get a deal with these yoyos,” he told Fuld.

Moments after hearing the news, Fuld, frustrated as ever, screamed down the hall at Steven Berkenfeld, a member of the firm’s executive committee.

“Were you the one who said you can’t trust the Koreans?” he asked.

“I don’t think I phrased it that way,” Berkenfeld said.

“Yes, you did,” Fuld said. “And you were right.”

The Korean deal wouldn’t go away quietly, though. A few days later, Min called Fuld and insisted he still wanted to get something done. Fuld figured the only way it was remotely possible was if the Koreans hired a real adviser. So he called up Joseph Perella, the mergers and acquisitions guru who had recently started a new firm, Perella Weinberg Partners.

“Listen, I’ve got something for you,” Fuld told Perella. “You’re going to get a call from ES. Do you know him? He used to work for me.”

Fuld was explicit about what he needed out of the deal. “We’re trading at about $25. Our book value is $32. We need a premium, so we’d take $35 to $40.”

Perella, who assigned the project to his colleague Gary Barancik, didn’t think the odds were good. KDB was a national institution with what seemed to him to be a local charter. They had no business branching out with a risky international deal. “It’s like the Long Island energy utility trying to buy something in Russia,” he told Barancik.

But they promised to do the best they could.

Fuld was also dealing with another problem: a potential whistle-blower.

One of Lehman’s employees, Matthew Lee, a senior vice president in the finance division whom Fuld scarcely even knew existed, had just weeks earlier sent a letter to the company’s senior management in which he claimed to have uncovered a series of accounting and management problems at the firm.

Fuld’s inner circle dutifully forwarded the letter to the firm’s auditors and the board, but weren’t overly concerned by it. To them, Lee had always been something of a troublemaker. Because they had recently demoted him and were planning to fire him, they viewed the letter as more of an extortion attempt by a disgruntled employee looking for a severance agreement than anything they should worry about.

However, during a meeting with the firm’s auditors, Ernst & Young, Lee raised a serious red flag about one of the firm’s practices that was also quietly being questioned in other parts of company: an accounting trick known as Repo 105.

What the public did not know—nor did some of Lehman’s top executives, including Fuld—was that Lehman had been artificially lowering its quarterly leverage ratio by using an accounting sleight of hand. At the end of every quarter, Lehman’s government securities business would “sell” securities to a counterparty in exchange for cash, which they’d use to pay down debt. But days after the quarter ended, Lehman would turn around and take the securities back onto their balance sheet and return the cash.

Instead of accounting for these deals in the traditional manner as “repurchase agreements” or “repos,” in which the firm would lend securities in exchange for cash, classifying them as “sales” had the effect of making the firm’s leverage look lower in than it really was: Lehman had managed to move $49 billion off of its books in the first quarter of 2008 and $50 billion in the second quarter.

Within certain parts of the firm, Repo 105 was an open secret. In early June Michael McGarvey, a finance controller, sent an e-mail to his colleague Jormen Vallecillo explaining the accounting practice as “basically window dressing. We are calling repos true sales based on legal technicalities.” Vallecillo replied, “I see … so it is legally doable but doesn’t look good when we actually do it?”

Lehman’s London-based law firm, Linklaters, had blessed the practice, but that didn’t keep other senior executives from being anxious about it. Back in April Hyung Lee, global cohead of fixed income, e-mailed Bart McDade, “Not sure you are familiar with Repo 105,” he began. McDade shot back, “I am very aware… . It is another drug we r on.” In early June McDade issued an edict that the firm would cut its use of Repo 105 by half.

Lee, as expected, was dismissed and was paid $300,000 in cash to leave the firm. As part of his severance agreement, he agreed “not to make any remarks now or at any time in the future to any third party, such as a client, a competitor, or the media, that could be detrimental or adverse in any way to Lehman.”

With Lee gone, Fuld and the firm had bigger things to agonize about, or so they thought.

Skip McGee, a forty-eight-year-old Texan, commuted to New York every week from Houston to run Lehman’s investment banking operations. He’d board a private plane using the firm’s NetJets account every Sunday evening around 7:30, land in New York around midnight, and take a car to his rental on the Upper West Side. Come Thursday night he’d be on a first-class flight back to Houston on Continental.

McGee, a classic, old-school, back-slapping banker, was clearly ambitious. After graduating summa cum laude from Princeton and getting a law degree, he had spent nearly two decades at Lehman, first as a banker for wildcatters in the oil patch of his backyard and then moving up the ranks until he became the head of the entire investment banking division and joined Fuld’s vaunted executive committee.

For some time, McGee and his team had been having deep misgivings about the way the firm was being managed. His unit, which advised corporate clients on mergers and stock offerings, had its best year ever in 2007, bringing in $3.9 billion in revenue, and yet the firm’s stock, which was used to pay a large portion of everyone’s bonuses, was being decimated by anxiety about what was happening on the other side of the house—namely, the firm’s investments in real estate assets. Even worse, the constant rumors and headlines about Lehman’s health were beginning to affect his team’s ability to sign up new clients, who were reasonably worried about hiring them. It had gotten so bad that some clients had asked to include a “key man” provision in their engagement letters that would guarantee that the banker assigned to them would continue working with them if Lehman was sold or went bankrupt.

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 the 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 forgo 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 Myers-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 indiscriminately; 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.”

“What are you talking about?” Gregory asked.

“Me. I’m done. I’m leaving the firm.”

“I am very disappointed” was Dick Fuld’s characterization of his personal reaction to Lehman’s second-quarter earnings in a report released at 6:30 a.m., Monday, June 9. The loss was $2.8 billion, or $5.12 a share. A conference call was scheduled at 10:00 a.m. to discuss the result, but by then the blood sport was already well under way on CNBC.

“Dick Fuld is Lehman. Lehman is Dick Fuld,” said George Ball of Sanders Morris Harris Group. “You’ve got a management that wears the corporate logo on its heart… . It’s got to hurt enormously.”

Fuld and Gregory were watching the coverage in Fuld’s office when David Einhorn of Greenlight Capital appeared on the screen.

“Are you saying ‘I told you so’ this morning?” the CNBC interviewer asked him.

“Well, it does seem that a lot of the things I’ve raised over the last while seem to have been borne out by today’s news,” he said, apparently trying to sound as humble as possible, under the circumstances.

Einhorn discussed his concerns about the extent of SunCal and Archstone’s write-downs, and why they hadn’t come sooner, and then delivered a strongly worded admonition: “It’s time to dispense with the ad-hominem attacks and get down to an analysis of what’s really going on with this business.”

That afternoon, Charlie Gasparino, a tenacious reporter on CNBC, began hectoring Kerrie Cohen, Lehman’s spokesperson, to confirm a tip he had received that Gregory and Callan were about to be fired. Off the record, Cohen dismissed his tip as a useless rumor.

But Gasparino, still skeptical, pressed her to go to her boss, Freidheim. “I’ve got it that Joe and Erin are leaving the firm,” he said. “Unless you go on record, I’m going with it.”

When Gasparino threatens to go on the air with market-moving information—a reporting tactic for extracting information from sources—most executives, however much they might resent it, try to comply. Freidheim didn’t think any personnel changes were imminent, but before he officially denied it, he marched into Fuld’s office.

“I’m going to have to use my name,” Freidheim told Fuld, making it clear that his own credibility was on the line. “I have to know if you’re even thinking about it.”

“No,” Fuld replied, “it’s not under consideration.”

“Well, I’m going to have to talk to Joe,” Freidheim said, “ because I need to know he’s not thinking about it, either. I’m not using my name unless I know it can’t happen.”

“Absolutely not,” Gregory stated when Freidheim put the question to him. “You can tell Gasparino you talked to me, and the answer is no.”

Keeping the lid on Gasparino was a relatively easy task compared to that of containing the pressure building within the firm. Bankers and traders were alternately restless, nervous, and angry.

Late that afternoon, Skip McGee forwarded an e-mail to Fuld from Benoît D’Angelin, once his longtime counterpart—the former co-head of investment banking—in Lehman’s London office; he had left the firm to start a hedge fund. McGee was clearly trying to send Fuld a not-so-subtle hint.

Many, many bankers have been calling me in the last few days. The mood has become truly awful … and for the first time I am really worried that all the hard work we have put in over the last 6-7 years could unravel very quickly. In my view two things need to happen very quickly.

1. Some senior managers have to be much less arrogant and internally admit that some major mistakes have been made. Can’t continue to say “We are great and the market doesn’t understand.”

2. Some changes at senior management need to happen very soon. People are not and WILL not understand that nobody pays for that mess and that it is “business as usual.”

Fuld read the note somberly and wrote back to McGee with a promise that he’d have lunch with the top investment bankers to give them a chance to air their grievances.

What Fuld did not know was that a palace revolt was already in the offing. The week before a group of fifteen traders had gone to dinner at the private Links Club, on East Sixty-second Street, right off Madison. The purpose of the dinner was to discuss how Fuld could be pressured into firing Joe Gregory. If Fuld wouldn’t do it, they agreed, they’d threaten to resign en masse.

Jeff Weiss, the head of financial services banking, was not at the dinner, nor was Gerald Donini, but both were patched in for the key discussions on speakerphone. Weiss advised against a confrontation. “Dick is not gonna react well,” he said. “You’re not going to get him to move by trying to corner him. Slow down. Things are moving in the right direction. Let this thing out over the next couple of days.”

At the executive committee meeting the following morning, Fuld looked exhausted, like a boxer gone one round too far. The fight had not gone out of him, but he knew that he had to try another approach. To keep the firm together, he was going to have to be more conciliatory.

“There’s a lot of unrest,” he acknowledged. “We haven’t been together. We made some mistakes.” Then he suggested they go around the table and get everyone’s take on the question: How do we restore confidence?

Everyone was in attendance—Joe Gregory, Tom Russo, Skip McGee, Bart McDade, Steven Berkenfeld, and a handful by phone. Everyone except Erin Callan, who was still making calls to investors.

Fuld pointedly asked Skip McGee to go first. “Morale has never been worse,” McGee told the committee. “We have to admit publicly we made some mistakes. We continue to spin like we’ve done nothing wrong. We’re better than this.”

McGee paused and then added quietly: “We need to make a senior management change.”

“What do you mean?” Fuld snapped.

“We need to hold ourselves accountable—that’s what the market wants, and that’s what our troops want.”

While McGee did not mention Gregory by name, everyone at the table understood whom he was talking about. Indeed, just a month earlier, at another executive committee meeting, Gregory had actually offered to resign. “If there’s a bullet to be taken, I’ll be the one to take the bullet,” he said stoically. At the time everyone had dismissed the comment as a rhetorical flourish, an easy thing to propose when there was little chance of its happening.

Fuld continued around the table. As each executive took his turn, making various suggestions, nobody seconded McGee’s call for change.

Russo, looking at McGee the entire time, chose to make a statement about the importance of teamwork, a sentiment that was then taken up by Gregory. “We’ve got to stop all the Monday-morning quarter backing,” he insisted. “We’re all in this together. We’ve made a lot of decisions over the years—all together. Some have been better than others, but we can work through this together.”

As the others spoke, McGee, his BlackBerry hidden under the table, typed a two-word message to his colleague Jeff Weiss: “I’m dead.”

Returning to his office, McGee called his wife, Susie, in Houston, and told her bluntly, “I may be out of here by the end of the week.”

That afternoon the thirty-first floor had become a gossip mill, a collection of various cliques assembling and reassembling to try to divine what might happen next. Even though Erin Callan had missed the executive meeting, she had certainly heard about what had transpired there. She was convinced that it was she, not Gregory, who might be on the firing line, and if she had to step down as CFO, she hoped to be able to keep a job of some sort at the firm. So she sent Fuld a two-sentence e-mail without a subject line: “Just to be clear I am very willing to be part of the accountability of management. Think I have become so closely tied with the performance and the public face of the firm that it may be helpful to put someone else in my role.”

He didn’t reply.

By the time Fuld met with the investment bankers for lunch on Wednesday, June 11, in the wood-paneled private dining room on the thirty-second floor, Lehman’s stock price had fallen another 21 percent. This was McGee’s show, Fuld knew, and that meant he was going to get tested.

He was right. It was five on one. McGee, Ros Stephenson, Mark Shafir, Jeffrey Weiss, and Paul Parker. They jumped at the chance to tell their boss why he needed to make management changes. The real estate investments were killing the firm. Good people had been let go, while novices, like Erin Callan, had been promoted to positions out of their depth. Joe Gregory had become distracted and knew nothing about risk. If there was a single problem, he was it.

“Look, the answer is, somebody’s gotta pay,” Mark Shafir said.

“Joe’s been with me for thirty years,” Fuld shot back. “He’s great at what he does, he has a great career, he’s done so much for this place. You’re asking me to throw him over the side just because we have one bad quarter?”

“It’s not just a bad quarter,” McGee replied. “It’s more deep-seated than that.”

Fuld paused and looked down at the food that he had not touched. “Are you telling me that you want me to—”

“No, no!” the bankers cried out. They certainly did not want his resignation; his departure would be a death knell for the firm. But the status quo could not continue; Fuld had to break out of the inner circle that was buffering him from the firm and get more involved with its operations.

Fuld was willing to accept that criticism. “I get that, that’s the feedback I’ve been getting,” he said. “I’m going to do it. I will do the right thing.” Still, he would not commit to firing Gregory.

“What are you going to say when you leave this meeting?” he asked the bankers.

“That the guy doesn’t get it,” said Weiss, laying it right out on the table.

“I got it,” Fuld replied.

As the bankers rose from the table and headed back to the elevator bank, no one was quite certain what Fuld intended to do. It seemed unlikely that he was going to fire Gregory; nothing he’d said indicated that he was ready to take that drastic a step. Still, McGee and the bankers were relieved to have finally had an audience with Fuld and said their piece.

While that lunch had been going on, Gregory was stirring downstairs in his office. He knew the rumors—he could see the sentiment quickly building up against him. Fuld had made enough comments about the morale problem inside the building for him to understand that he was under fire. He wasn’t blind to the snippy comments and office rumor mill about him. Indeed, if there was one thing Gregory focused on—what he called “culture”—he could now see it fraying.

His own power, he knew, had started eroding months earlier. Fuld had increasingly leaned on Bart McDade, the firm’s head of equities and one of the most popular guys at the firm—honest, disciplined, and bright, maybe too much for his own good. Indeed, following Bear Stearns’ near-failure, Fuld had made McDade his de facto “risk guy.”

McDade had long been a fixed-income man, successfully running that division, only to be shunted over to the less profitable equities desk in 2005 in what many in the firm viewed as a classic Joe Gregory disposal of a potential rival. Or maybe, as others saw it, that decision had just been Joe being Joe, playing a hunch that a talent like McDade could be utilized wherever the need was greatest.

Though McDade was too polite to have ever said anything in front of the executive committee, he had spoken privately to Gregory about Gregory’s role at Lehman, making some not so subtle comments about “doing the right thing for the firm.” And while not as forceful as McGee, McDade had made it clear to Fuld that Gregory had lost his credibility, but by now that had become obvious to almost all the employees.

Minutes after Fuld returned to his office, Gregory came by.

“I think I should step down,” he said uncertainly.

“What’s going on here?” Fuld said, waving him away. “Go back in your office. I get 51 percent of the vote, and that’s not happening.”

Five minutes later, Fuld came to speak with Gregory, who was now talking to Russo, discussing what he had just told Fuld.

Gregory said that he was convinced the market wanted the firm to take action. “They want heads,” he insisted. “Heads have to roll. And it can’t be you,” Gregory told Fuld. “I have to do it.”

“It’s not your call,” Fuld told him. “This is a disease, every firm has it. It’s not your fault.”

Russo, who hadn’t said anything up until now, chimed in. “Dick, I think Joe’s right.” Under the circumstances, this was best for the firm.

As Fuld began to resign himself to what everyone had come to regard as inevitable, he fought back tears, muttering, “I don’t like it, I don’t like it, I don’t like it.”

Erin Callan was in her office when Gregory came in to break the news. He was leaving, he said, out of loyalty to the firm. And as her mentor, he had one last request: He asked her to step down as well, arguing that while his departure might affect morale internally, her brand name was the one that mattered to Wall Street. “We should do it together,” he said.

Though she had sent the e-mail to Fuld, Callan felt stricken, unable to believe it had come to this.

Minutes later, she went to see Fuld. “I lost credibility with our investors and I think I have to step down,” she said, her voice quivering.

Again Fuld felt overwhelmed, the tears rising to his eyes. But he had been here before. He could go on. Left alone in his office, he started to put the new pieces in place. He called Jeff Weiss.

“I’m listening,” he told Weiss.

“Uh, okay,” Weiss replied, not entirely certain what Fuld was driving at.

“I’m listening,” Fuld repeated, as if to suggest that Weiss’s comments at lunch were being heeded.

“Do I have to tell you how I feel about Bart McDade?” Weiss said, essentially endorsing him for Gregory’s job.

“No,” Fuld said, “you do not.”

That night, McGee was dining with a college friend at Maloney & Porcelli, a steak house on Fiftieth Street, when his mobile phone rang. It was Fuld. McGee stepped outside under the restaurant’s green awning to take the call.

“Okay. I just want you to know that I heard you,” Fuld said, “and I’ve got the ball.”

“What?” McGee asked.

Fuld didn’t answer.

“I may be a dumbass from Texas,” McGee said, “but can you be a bit more explicit?”

“I heard you,” Fuld said, “I’ve got the ball.”

He told McGee to be at a special executive committee board meeting the following morning at 8:00 sharp.

Now McGee understood.

On Thursday morning, Kerrie Cohen began receiving voice mails from Charlie Gasparino at 6:00.

“Hey, Kerrie. You better call me back right now, because this is a problem… . [Y]ou guys specifically denied something that I heard, and now it sounds to me like it’s true. So you better call me back now! Now means now. I better not get scooped on this—you’re going to have a huge credibility problem, and so will Lehman. So call me now.” Twenty minutes later, he followed up: “I better get a call back from you before this hits the tape. I am not kidding!”

Cohen had in fact been called in at 5:30 a.m. to work with Scott Freidheim on drafting the press release announcing Gregory’s resignation and Callan’s decision to step down; Callan had worked a deal with Fuld to remain at the firm in another role. Though it was not detailed in the release, Gregory would also be staying on, allowed by Fuld to remain on the Lehman payroll as an out-of-the-way consultant, so that he could continue to qualify for his pension and deferred compensation. Gregory’s career was over, but his old friend never did quite pull the trigger on him. In the press statement, Fuld said of Gregory, “Joe has been my partner for thirty years and has been a driving force behind where we are today and what we have achieved as a firm. This has been one of the most difficult decisions either of us has ever had to make.”

Freidheim also helped prepare a note to the staff from Fuld. “Our credibility has eroded,” Fuld said. “The current market environment is forcing us to take a number of measures to regain the confidence of all our constituents.”

For a change, that morning, the newspapers had nothing new on Lehman.

When Fuld arrived in the office, Freidheim handed him a draft of the press release to review, and then they started the executive committee meeting. Fuld looked distraught.

“This is the hardest thing I’ve ever done,” he said as he went on to describe Gregory’s role as a friend and business partner. “Joe is taking one for the team.”

“I always said that if anyone should take a bullet, it should be me,” Gregory said. “Let’s not let this be wasted.”

As Fuld again looked as if he were about to well up, Gregory grabbed his hand and said quietly, “It’s okay.”

“Do you want to say anything?” Fuld asked Callan.

“No, no,” she replied, wiping away a tear.

Announcing that he planned to name Bart McDade as Gregory’s successor, Fuld said, “He’s the best operator we have.”

But this was no time to celebrate McDade’s appointment. As the meeting came to an end, Fuld gave Gregory one final, heartfelt hug and then watched as he slowly left the conference room.