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.