A Colossal Failure of Common Sense

Lawrence G. McDonald, “A Colossal Failure of Common Sense: The Inside Story of the Collapse of Lehman Brothers” Crown Business Group, 2009, 339 pp

For me, the most enlightening revelation in this book is just how many financial people saw the danger coming but were, at least at Lehman’s, prevented from stopping it. Lehman’s board of directors were so ineffective that they are hardly mentioned in the book.
My Notes:

Pg. 5: The Glass-Steagall Act of 1933 had prevented commercial banks from merging with investment banks, thus eliminating the opportunity for the high-rolling investment guys to get their hands on limitless supplies of depositors’ money. Major Banks wanted it abolished; they failed in 1988 but succeeded with Bill Clinton in November 1999. Citigroup had been formed by a merger that was illegal at the time it took place, but now it was legal. The old Citicorp miering with Travelers gave them ownership of Primerica, a huge commercial bank owning an investment house.

Pg. 60: Commodity Futures Modernization Act (CFMA) 2000: The major purpose of this act was to deregulate the entire business of trading a credit default swap (CDS). This is nothing more than a bet—for instance, that a mortgage company will go broke and its bond value will sink to say, 4 cents on the dollar. The lethal part of this act was the part that allowed anyone—bondholder or no—to take out the insurance, to have a bet against Countrywide, for instance, without even holding one single bond. Two centuries previously this kind of trading had been outlawed; people who had no connection with the principal were prevented from betting against it. At the end of the eighteenth century, insurance betting parlors had sprung up allowing placing wagers on whether or not ships would return from their voyage. With this came rumors of diabolical dishonesty, of ships being sunk in order for friends of the crew to collect the insurance.

Pg. 74: Credit Derivatives, also known as securitization, is a method of turning a thousand mortgages into a bond with an attractive coupon of 7 or 8 percent. One of the unintended consequences of Saranes0Oxley was the drying up of the corporate bond market. Securitization of credit derivatives helped fill the revenue gap.

Pg. 75: Greenspan began cutting interest rates to unprecedented lows. He began the process to prevent damage to the U.S. economy from the dot-com bubble, and he cut rates again to prevent a sharp recession after 9/11. He cut all the way from 6 percent in December 2000 down to 1 percent in June 30, 2003. Thus began one of the greatest consumer borrowing bonanzas since the 1920s.

Pg. 113: More than 40 percent of all U.S. subprime mortgage lenders originated in Calfornia. It was easier to finance a new house than it was to finance a new car.

Pg. 118: Tower Automotive. Tower in 2004 was a global designer and producer of structural automotive components, used by virtually every major car factory—Ford, Chrysler, General Motors, Honda, Toyota, BMW, Fiat, and Renault. They had more than eight thousand employees in thirty-nine factories in thirteen different countries spread over North America, South America, Europe, and Asia. Their specialty was the frame of the car, the steel chassis and suspension systems. In Detroit Tower was regarded as the endless heartbeat of the industry. But Jane Castle of Lehman’s thought they were going bust. She was looking at the price of steel, which was going through the roof, currently standing at around $800 a ton, having more than doubled in the past several months from $380 a ton. The problem, it seemed, was China, struggling to complete its Olympic stadiums and buying steel from anywhere they could locate it. Their appetite was ravenous, and from where we stood, it appeared half the world’s steel production was heading for Shanghai on any given day. In addition, China kept announcing plans to industrialize the entire country.

Pg. 164: In January 2006 Christine Daley, of Lehman’s, stated in a meeting that General Motors is going bankrupt. It’s not even a car company; it’s a health care provider with an auto manufacturer on the side.

Pg. 218: On February 9, 2007 Larry McCarthy of Lehman’s held a meeting of the top 45 Lehman managers (The Chairman and President did not attend) and clearly spelled out the coming mortgage crisis. In that meeting he additionally stated: “Many people today believe that globalization has somehow killed off the natural business cycles of the past. There wrong. Globalization has not changed anything, and the current risks in the Lehman balance sheet put us in a dangerous situation.”

Pg. 257: Commercial Paper: this is short-term money, loaned out for thirty to forty days or less. This market is used by the biggest and best blue chip companies. Commercial paper is the quickest, cheapest, and easiest way for them to raise a fast loan that is not regulated by the SEC. As an example, say Bear Stearns goes to JPMorgan Chase and request a $500 million loan for fourteen days. Question: would you lend bear Stearns half a billion dollars for just a couple of weeks when they were backing it with AAA-rated mortgage bonds and willing to pay 5 percent interest? Answer: probably yes, since that would mean a $959,000 profit. Most of the time these loans were paid back with money from another short-term paper loan they’d borrowed from someone else. Simply put, they were taking short-term borrowed money and investing in longer-term mortgage-backed securities that paid a higher yield. In Wall Street jargon, this was known as the “carry trade” or the “positive carry trade.”

Pg. 277: In early 2006 there was a $26 trillion worth of CDS bets outstanding in the market. By the beginning of 2008, it was $70 trillion, and throughout the world there were only seventeen banks carrying that risk. Additionally, there was another $15 to $18 trillion out there in credit derivatives, CDOs, RMBSs, CMBSs, CLOs, and ABSs, and the same seventeen banks had issued them between 2000 and 2007. If the CDSs had been called insurance, the banks would have needed $5 trillion to $10 trillion in capital loss reserves. As it was, they needed nothing and had nothing.

September 15, 2008 Lehman Brothers filed for Chapter 11 bankruptcy.