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.”