Photographs by Natalie Brasington Photography
From an early age Larry McDonald wanted to be a Wall Street trader and through chutzpah, hard work and sheer determination he reached this pinnacle. He sold meat out of his car, he bamboozled his way into corporate offices by pretending to deliver pizzas and, once he found a trading position, he worked harder than anyone else. He also had the foresight to watch the horizon. He co-founded ConvertBond.com when it was clear there was a need for more transparency in convertible bond pricing and sold it at the right time. He was skeptical of the endless housing boom and the mortgage lenders who where growing exponentially from it. McDonald and his team of traders earned Lehman Brothers millions on their skepticism of the subprime lending bubble, but could not convince the big boys to get off the ride. His book, "A Colossal Failure of Common Sense: The Inside Story of the Collapse of Lehman Brothers" tells his story and explains what went wrong at Lehman. We spoke with McDonald about how Lehman was allowed to implode.
Futures Magazine: In less than 100 words tell us why Lehman Brothers failed.
Larry McDonald: Three words: leverage, leverage, leverage.
FM: Care to elaborate?
LM: Over-concentration of risk in one asset class, commercial real estate, [which violated] the age-old banking principle: Never fund a concentrated position in an illiquid asset in the short-term financing market. In other words if you are trying to fund something that is very illiquid with a liquid cash market, what happens is the cash dries up in the liquid cash market then you can't fund yourself. It is an age-old banking principle that banks should always have enough liquidity relative to their illiquid assets. That pretty much sums it up. In 2006-07 the money markets were 20,000 feet deep and in 2008 they became 20 feet deep.
FM: What trouble did you see and how did you try and relate that to the leadership at Lehman?
LM: When you are going to warn a senior executive, you have to leave it up to the most senior executives. The leaders of our part of the firm, [Managing Directors] Mike Gelband, Alex Kirk, Madelyn Antoncic and, to some extent, Larry Lindsey [former Fed governor], warned senior management about what was wrong with the balance sheet, what was wrong with the risk taking.
FM: Was it just not received?
LM: We were in the middle of a global asset bubble, we were in the middle an amazing renaissance in commodities and the BRIC countries (Brazil, Russia, India and China) were making up a larger portion of global GDP. The perception was that that this was a new world that would be led higher by [these factors]. The perception back then was even if the U.S. slowed down, the emerging markets and the U.S. were decoupling and therefore the emerging markets would catapult us much higher. There were a lot of reasons to ignore the warning signs.
FM: But wasn't Lehman's concentration in mortgaged backed securities?
LM: Yeah, but the most deadly part was commercial — the commercial mortgage backed securities. That is commercial real estate. David Einhorn (head of Greenlight Capital) is on record stating that 35% of [Lehman's] net tangible equity was in three commercial real estate investments. The theory was there was a decoupling in that part of the world and the growth was so strong that it would give us a soft landing in the U.S. even if we slowed down.
FM: Were these non-U.S. assets?
LM: Partially. There were three big ones. There were two big U.S. ones: Archstone and Suncal, Suncal was a very large commerical real-estate project in California. Coeur Defense, which was the largest transaction in Europe. So we had two big U.S. [commercial real-estate deals] and one big European [project].
FM: How is it that you were able to earn significant profits for Lehman Brothers by realizing the extent of the housing and subprime bubble yet the firm was so tied to it?
LM: By no means was it me, I was just part of a wonderful group of people and our group made a lot of money in '07 and a lot of money in '08. We were short a lot of things like Countrywide, like New Century, a lot of these mortgage brokers. The problem with some banks is they become like silos; one part of the firm is not communicating with another and you have very serious franchises around the firm that are just immense powerful franchises that are not very easily challenged. If you picture a massive bank like Lehman [as] a 767 with 16 engines, we were just one engine. For every dollar we were making some of the guys upstairs were losing five.
FM: What has been the feedback by former colleagues?
LM: When the Valukas report came back — a wonderfully done examiners' report written by Anton Valukas — many of my findings were consistent with his report. The feedback has been incredibly supportive over the years.
FM: Did you hear from any of the people who resisted your warnings?
LM: I have not. Not in any meaningful way. People just want to move on. It is just a bad trade.
FM: You blame the credit crisis directly on the repeal of Glass-Steagall. How is it responsible? Have we gone far enough in restoring those protections?
LM: I don't think [the repeal] of Glass-Steagall was 100% responsible. In a perfect world we could make a matrix of responsibility for the financial crisis and give a certain weighting to each part of the matrix and the Glass-Steagall dismantling by the Gramm-Leach-Bliley Act would have a substantial weighting in that matrix. I would say that the problem with Gramm-Leach-Bliley is that it put banks like Lehman and Bear into the ring with giant colossal opponents. It is like taking a middle-weight fighter and all of a sudden he is fighting a heavy-weight for the first time. The deposits that the big banks have and had in this country [are huge]. It made firms like Lehman [use] leverage to compete against the colossal giants.
FM: Glass-Steagall wasn't completed reinstated by the Volker Rule and many experts believe it was watered down. What would you like to see?
LM: The best thing that I see in financial reform is what is being done by the banks themselves. The invisible hand of Adam Smith is actually working through the system as we speak. Even without a Glass-Steagall, many banks are reducing leverage, they are reducing proprietary trading. Now banks know that Glass-Steagall and Basel III are out there in the future and they know the blades are coming. There has been an amazing job by a lot of U.S. banks. What they have done is remarkable in terms of deleveraging, in terms of selling off proprietary trading units, in terms of downsizing. The U.S. banking system is in a [very] healthy spot. Where we are being challenged is in Europe.
FM: But has the problem of too big to fail been alleviated?
LM: The banks are definitely deleveraging but some of [them] have merged and too big to fail has not been solved yet, but there are mechanisms in the wings — this living will, this resolution authority that is part of Dodd-Frank that would allow the FDIC to come in and take over an institution — we are not done with that yet. We are getting closer to ending too big to fail but we are not there yet.
FM: To what extent did all the major investment banks know — or think they knew — that they were too big to fail? That they made decisions knowing the government would bail them out?
LM: I will leave that up to the book.
FM: Did Lehman believe this?
LM: Just look at the credit default swap levels on banks then vs. now. Credit default swaps on banks in '06-'07; the big banks were trading 30-65 basis points above Libor and today the big banks are trading at hundreds and hundreds of basis points wider. So there is no question that the market, not just the banks, everybody viewed them as too big to fail. It was an entire all-encompassing market belief. I can't begin to stress the importance of this. If you looked at the biggest banks, their credit spreads over Libor, their bond yields were so low, everybody was swept up in this too big to fail.
FM: Talk a little about convertBond.com and how that prepared you as a trader?
LM: The vision there was that with convertible bonds and all bonds, there was a thirst for getting more and more information up on the web. Luckily we were out in front of that. I think we were the first web site in the world to get information up on the web for investors globally that they could digest.
FM: Your timing was good.
LM: We were very lucky. In the last 15 years you have seen a steady commoditization of financial products. Stocks that used to trade in 30¢-40¢ spreads are trading in pennies, bonds that used to trade [several] points wide are trading much thinner. Our theory was to get out in front of it. Technology is marching forward and you want to be out in front of it. There was a need for more transparency. Back then if you wanted to get bond prices you had to wait until they got published and it would take weeks.
FM: Do you think the crisis would have been less severe if Bear Stearns would have been allowed to fail in March 2008? Would it have scared others straight or was it already too late at that point?
LM: It would have made things more swift, it would have accelerated prices somewhat. The [Bear Stearns] balance sheet was about half the size but it still would have been very disruptive and caught the market off guard. Hank Paulson and his team felt the market needed a speed bump at that point and that was their decision.
FM: Did the Fed's sweetheart deal for Bear Stearns convince others, Richard Fuld in particular, that Treasury and the Fed would not allow a major investment bank to fail?
LM: It wasn't just Mr. Fuld, it was the entire marketplace. When you look at when Lehman failed, the credit default swaps were only 770 basis points wide (roughly a 7.7% chance of default), so the market wasn't really pricing in a failure. Today, for example, Greece is trading at 2500 basis points. The entire market was under the impression that there would be some type of deal. The [only] question was price.
FM: From the point that Bear Stearns collapsed, many analysts pointed to Lehman as the next most likely investment bank to fail. How was this received at Lehman?
LM: There was a lot of denial.
FM: Did the leadership at Lehman think that short-sellers were out to get them?
LM: That was part of it, there definitely were some people in the firm with the belief that there was a posse [out to get them], but 40X leverage knocks you out of business, not short-sellers.
FM: Did that help those of you who where trying to steer the company in another direction or did it further ostracize you?
LM: They didn't start to turn the ship around until it was too late. They tried in the second quarter of '08. There was a big theory back then that you could hedge risk — it wasn't just Lehman. One of the most deadly trades in the history of the world is when you are long the illiquid but you are short the liquid. A lot of banks around the street felt that they could hold on to illiquid assets and hedge them with 21st century index products (like the S&P 500 and leveraged loan products). That theory was turned upside down because you had these market rallies — after Bear Stearns failed the market was up substantially from March of 2008 through June. Lehman's hedges cost them billions. If you are long an illiquid asset like real estate in massive size and you short liquid indexes like the S&P 500, when the market rallies your hedges go up substantially so you lose money on [them] and you have to take them off. When the market rolled over in July and August, Lehman and other firms were left naked.
FM: Former FDIC Chairman Bill Isaac says the biggest problem during the credit crisis was the dysfunctional way the Fed and Treasury operated. There was no consistency on who would be saved and who would be allowed to fail, which fostered greater panic. Do you agree?
LM: That is true. There was a tremendous inconsistency and that is what confused the market.
FM: You strongly criticized the senior management at Lehman yet you have said the government should have saved the company. Why?
LM: [Letting] Lehman fail made all the other bailouts after that more expensive. Some people in government made the case that other firms had the collateral to justify saving them and Lehman didn't, but it just made the other bailouts after it much more expensive. Letting Lehman fail accelerated the other failures after it.
FM: Treasury Secretary Paulson said they did not have the authority to save Lehman though they saved AIG, Fannie Mae and Freddie Mac. Did that make sense to you?
LM: McDonald refers to his book.
FM: Compare what was going on in 2007 and 2008 with the investment banks and the current crisis of sovereign debt.
LM: It is a fascinating dichotomy because back then, banks were holding bad real estate assets and bad loans; today banks are holding very good assets for the most part but the safe part of a bank's balance sheet is typically government securities, so the regulators look at government securities as [less risky]. If you look at the way a regulator will analyze a bank's balance sheets, [you'll see that] they give certain points of risk to different types of assets and many banks have a lot more government bonds on their balance sheets than risk assets, which would be loans. But in this part of the crisis vs. '08 it is bizarre that some of the risky assets are the sovereign bond side which makes this serious because those assets make up a large portion of bank balance sheets.
FM: TARP as it was passed was never executed. It seems odd that the Treasury Secretary could say, "never mind what was voted on I am going to do something different with it."
LW: Well he did have a clause, he didn't break any laws. He brilliantly left a clause in there that gave them the ability to [fund the banks directly]. During the S&L crisis the FDIC created a vehicle that held bad assets and TARP gave Hank Paulson and his team the ability to do a resolution trust type bailout or an investment bailout and they chose to do the latter.
FM: Was that a good call?
LM: We will let the history books decide.
FM: Aren't the banks still holding on to all this toxic stuff?
LM: Yeah, but the assets are in a lot better shape right now. The banks in the United States have had three years to heal their balance sheets and the steep yield curve has been a godsend for these banks. They are able to borrow at 25 basis points from the Fed and lend money out at 4% or 5%. It has been three wonderful years of powerful healing of bank balance sheets.
FM: Which is wonderful for the banks but bad for everyone else.
LM: It is good for everyone else in the sense that it helps prevent a double dip recession. You don’t want the banks collapsing, that’s good for nobody but the bad part is it hurts savers that live off of fixed incomes, retirees.
FM: In the book you talk about the great history of Lehman. They obviously were too leveraged, but wasn't it the contrarian approach at the time to believe that there was a housing bubble?
LM: That is what happens with every bubble. Every bubble is a new phenomenon. Bubbles are intoxicating. The thing about bubbles is that they go on much longer than people think. There people who were bearish on real estate back in '05. Famous investors were bearish in '04 and '05 and got killed. Look at the dot com crisis. There were many short sellers that got killed in '97 and '98. A bubble takes on a life of its own. There where a lot of people who were negative the stock market in '95 and it went up [much higher]. When Greenspan said "irrational exuberance" it was three years before the crash.
FM: You just took a position with Newedge. Tell us what you are involved in currently.
LM: It is customer-facing business that has a platform in high-yield, high-grade convertible securities and structured products. I am trading in those areas representing Newedge to [the] buy-side. Newedge has a robust balance sheet and brand globally, and I want to build that brand up in the United States.