From the October 01, 2011 issue of Futures Magazine • Subscribe!

McDonald: Inside the fall of Lehman


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 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].

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