Colossal Failure Of Common Sense Part 13

Its sudden failure, so heavily linked to subprime, came hard on the heels of the New Century bankruptcy and the subprime distress signal fired skyward by HSBC and Fremont General. And now we were hearing ferocious rumors that General Motors' first-quarter profits were off 90 percent because of mortgage losses at its 49-percent-owned GMAC finance company because of subprime defaults. And anyone still standing in the brokerage game was in the process of rus.h.i.+ng for cover-but not in time to prevent the carnage.

The lawyers were on the march, with lawsuits flying around like artillery sh.e.l.ls all over the country as people swore to G.o.d they had been sold mortgages they simply did not understand. They were confused by the interest rates and the closing costs. There were allegations of unfair and discriminatory loans, reckless and predatory lending. Words like deception, high-pressure, irresponsible deception, high-pressure, irresponsible, and falsified falsified were sworn before judges. And then there were the accusations of companies deliberately altering the income and employment statements of applicants. In one courtroom, a plaintiff swore, by all that was holy, the mortgage broker had placed $5,000 in her bank account, photocopied the statement, and then removed the money, in order to qualify her for a loan. were sworn before judges. And then there were the accusations of companies deliberately altering the income and employment statements of applicants. In one courtroom, a plaintiff swore, by all that was holy, the mortgage broker had placed $5,000 in her bank account, photocopied the statement, and then removed the money, in order to qualify her for a loan.

There were continued allegations of overstatement of a.s.sets. There were legal actions, cla.s.s actions, rearguard actions, and chain reactions. The national watchdog, the Center for Responsible Lending, estimated that loans for 2.2 million people would end in foreclosure-that's one-fifth of all subprime loans made over the previous two years. In California's still-frenzied real estate markets there were now accusations of credit card offers-"platinum equity cards"-with activating phone numbers attached. When the applicant hit the b.u.t.tons, a mortgage broker was on the line, trying to sell a house. And still the bodybuilders were out there, signing people up, while their home offices just kept on loading up the mortgages and moving them in tranches to the Wall Street investment houses. By now on the trading floor we were hearing of U.S. banks flipping loans to banks in Europe and Asia-not just selling them CDOs and RMBSs but handing over the original loans.

Meanwhile, the theater door was slammed tight and locked. No one could get out. The market for CDOs was much weaker by now, and the lines had to be kept open to the foreign banks and hedge funds. But the shuddering noises from both the Alps and the Far East were growing louder. And from where I stood Larry's iceberg was getting ominously close. There were not yet lengthy stories in the national magazines, but there were some worrying reports starting to appear in the financial press, at this point mostly about court cases, with occasional charts and statistics designed to ill.u.s.trate a worsening situation. An unmistakable fear began to manifest itself on trading floors throughout the city.

This did not concern us in the distressed-bond trading division because fear, uncertainty, and falling revenues were our stock-in-trade. Right now, the stock market was refusing to go down, but it must surely be a matter of time before this changed. And one of our top guys was heavily into a plan he thought was obvious but no one else had considered. Peter Sch.e.l.lbach believed that Countrywide, the nation's number one mortgage lender, was about to go bust. That was an outlandish thought in a bank like ours, but that was Sch.e.l.l's view, and he was rockin' and rollin' his way toward proving it. Night after night he would pore over charts and reports trying to get a handle on this $26 billion giant of the mortgage industry, which operates out of Calabasas, on the north side of the Santa Monica Mountains, west of Los Angeles. Countrywide was synonymous with its founder, chairman, and CEO, Angelo Mozilo, a clever self-made man, whose father had been a butcher in the Bronx.

Angelo had taken hundreds of millions out of his mortgage business, mostly selling stock options, but Sch.e.l.l had him pegged right now, discovered him selling a hundred thousand Countrywide shares a day in the middle of the subprime crisis, in which his firm was deeply implicated.

Indeed, Countrywide was one of the true pioneers of the programs to provide financing for low-income borrowers in the 1990s, in response to the urgings of the Clinton administration and its firebrand official Roberta Achtenberg. Angelo was regarded as king of the shadow bankers, appearing on Jim Cramer's show on CNBC, and having his name linked to people in high places, like Senator Chris Dodd, for whom he provided a mortgage that saved the Connecticut Democrat around $75,000 in interest payments.

Sch.e.l.lbach was sure of his ground. A former newspaper reporter, he had a fantastic knack for the deepest kind of research, and when you add that to his wonderfully eloquent command of the language and his gifts as a musician, he was probably some kind of modern-day Renaissance man. He earned $3 million to $4 million a year, maybe more, and lived in a big, roomy apartment on the Upper West Side of Manhattan with his wife, Jackie, and two sons. Inside the firm he had a towering reputation for accuracy and judgment. Like Larry, and like me, he'd never met the chairman.

But now he was onto something. Countrywide's gigantic portfolio of subprime mortgages could not, in his opinion, permit the corporation to stay afloat, and he was recommending we take huge short positions on both the stock and the bonds. Just then Angelo Mozilo was in the process of a stock-selling program that would gross him $129 million before the summer was out. Sch.e.l.l could have lived with this. Just. But at the same time, Angelo was publicly touting the stock and using shareholder funds to buy it back and support the $45 share price. And that Sch.e.l.l could not live with. There was something very wrong with Countrywide, and the old rock guitarist did not require a consultation with S. Holmes in London's Baker Street to work out the answer.

The fact was, in the year 2000 Countrywide had had mortgage revenues of $2 billion, with net income of around $320 million. In 2006 that revenue figure was well over $10 billion, with income of $2.5 billion. Now it was plummeting, and Sch.e.l.l was detecting a $6.5 billion crash, which he thought would finish them. So far as Sch.e.l.l could predict, there was no way Countrywide, with enough subprime defaults to capsize the s.p.a.ce shuttle, could avoid losing possibly up to $700 million in the current year.

We were so busy on that first afternoon without Larry and Mike it was hard to get our bearings. And it was not until the following morning that the appalling reality set in. They weren't coming back. Right next to me, Larry's chair was empty. We had lost our fighter ace, and there was no replacing Major McCarthy, the man with the fastest cannon on Wall Street, the dive-bomber of distress, everybody's hero. Well, nearly everybody's. I still talked to him just about every day, but even so, the sight of that empty chair haunted my dreams for many, many months. To a lot of people, he was lost forever, and they still miss him.

That first day, a young trader came up to me and said, "It's not the same, is it? I mean, without him." He never even said Larry's name. He didn't need to. If he'd said the same thing six months later to anyone on the floor, he still wouldn't have needed the name.

The absence of Mike Gelband also had a terrible effect. He and Larry had represented the glue of our team. They held us together, creating that magical shared loyalty. In the opening days of May 2007, we were a bit lost without those two powerful influences, especially Mike Gelband. And for months afterward, people still wondered in their thoughts and conversations how d.i.c.k and Joe could possibly have forced him out.

The old team was still full of buddies, since many of us had been handpicked by Larry McCarthy. But there was a sadness and a feeling of disquiet about the troubles that might be lurking in the immediate future. Larry had been through three bear markets in his career, and whenever there were bullets flying, it was really comforting to see him in there with us, working along the cutting edge of the risk.

Right now I had to dismantle Larry's ledger. I had to get in and find his trades, and he had told me I'd find that a lot of fun. He was right. First thing I located was a billion dollars' worth of subprime shorts on corporations like Countrywide, Radian, MGIC Insurance, Fannie Mae, ResCap, and Was.h.i.+ngton Mutual. They were huge amounts, both shorts and puts-Larry had hit Beazer Homes and Centex, not to mention the questionable ratings agency Moody's. From what I could tell he was in for over $1 billion and was trying to jack it up to $3 billion at the time he resigned.

He'd done something extremely ambitious with Countrywide. From what I could tell, he'd bought a ma.s.sive amount of protection-a billion dollars' worth of credit default swaps at 18 basis points. That's the equivalent to shorting the bonds at slightly above 99 cents on the dollar, just a tick under par. He believed the bonds could go to 50, then bankrupt the corporation.

Some of the young traders told me later that if everything had been left in place just the way Larry had planned, he personally would have made the firm $1 billion of profit in 2007. Secretly, I took that as one h.e.l.l of a compliment, because there was no doubt in my mind that Larry had acted on everything I had told him. He'd taken my best ideas and, as it were, put his money where my mouth was. Sch.e.l.l and Hammack had helped me, but it was I who had briefed Larry on those big hitters who had somehow mislaid their bats.

Meanwhile, the Dow Jones average during May and June raged ever upward, above 13,500, battering to death those with short positions on the big subprime corporations. At the time it was hard for me to sleep. I used to walk disconsolately home from the office, worried out of my mind as those mortgage-related outfits we'd shorted powered upward. In one week I lost $8 million, and I had to report to Sch.e.l.l and Gatward, who were sympathetic, because they too were watching various corporations defy gravity. Anyway, they knew I had been $38 million up on the year, and they both believed it was merely a matter of time before there was an almighty crash.

Some people were not worried about the present market situation. One of these was Mark Walsh, who continued to do the bidding of his masters, buying ma.s.sive chunks of real estate all over the world. Right in that time frame, he pounced again, teaming with the owners of Rockefeller Center, Tishman Speyer, for a $22.2 billion leveraged buyout of the Archstone-Smith Trust, which owned 360 luxury apartment buildings from Houston to New York, Phoenix to Fairfax County. This was real estate at the highest level. Tishman Speyer was one of the top corporations in New York, with world headquarters above the ice rink at Rockefeller Plaza. This was not inappropriate, because they and Mark Walsh overpaid heavily for Archstone, probably by $3 billion, and Prince Mark was suddenly skating on very thin ice. The deal, of course, paralleled the 2006 Blackstone purchase of Equity Office Properties Trust, which was about twice the size, and which had placed the little green G.o.d of envy squarely on d.i.c.k Fuld's shoulders. When Mark Walsh sought backing from Lehman's corporate balance sheet for the Archstone deal, he received it quickly and in full. Fuld could at last see a chance to slice into the lead established by Peterson and Schwarzman in the high-prestige game of collecting enough apartment blocks to reach halfway to the stars.

But Archstone was not worth $22.2 billion. This was the top of the market, and there was a bidding war to acquire it. Goldman Sachs was in there, hot and heavy, and Fuld was determined to prove Lehman could play in this league, against the big guns of Wall Street. With the bidding already too high, Goldman pulled out, and with the greatest joy, Fuld told his blue-eyed boy to keep charging, sword drawn, and pay what he had to for a big share of Archstone's apartment empire.

There was no way Fuld was going to allow Mark Walsh to back off. Right from the start, right from the moment he had been given almost carte blanche, there could be no backing off. Because the image of the smiling, worldly Pete Peterson stood starkly before d.i.c.k Fuld, as it had done for twenty-five years.

"Thanks mostly to Blackstone, we've missed three big ones," d.i.c.k had told Mark. "Don't miss any more."

I'd never suggest that Fuld was blinded by envy or that he was a particularly vengeful man. But with d.i.c.k, it was not always about judgment. There was often something personal.

The Archstone deal was completed early in the coming October, and another honking multibillion-dollar loss was on its way to the Lehman balance sheet. But that much was not really clear in the spring of 2007, and with the stock and bond markets still blundering upward, despite incontrovertible evidence it should have been going the other way, we in the distressed division had almost nothing at which to smile. Except for an event on June 6, to which everyone was looking forward: Larry McCarthy's going-away party. It was scheduled to take place in the Red Lion, one of New York's landmark live music spots, situated south of Was.h.i.+ngton Square, a little bit west of Broadway. And there, in the richly paneled dark wood interior, with its red leather chairs and fifty-foot bar, we would all have drinks and dinner together for the last time.

Christine Daley was there, and Jane Castle, Mike Gelband, Alex Kirk, Rich Gatward, and his great friend Bart McDade. Larry's beautiful wife, Suzanne, flew up from their horse farm in Wellington, Florida. Everyone who had really mattered in Larry's life, 120 of us. It had to be everybody, because Larry was a man who always had time for the less important people, and he was generous to them with time and money, far beyond the call of duty. I guess we'll never know how many people he helped in times of trouble. But believe me, it was a whole lot. If anyone had been left out, Larry definitely would have noticed, and most definitely would have sent a chauffeur-driven limousine to pick the person up from wherever they lived. He might even have gone himself. But he would not have tolerated anyone not being invited. You have to know him as well as I do to understand that. The guy's got a heart the size of the Empire State Building.

We'd rented the whole place, and the music was great. Sch.e.l.l and his band superbly played Grateful Dead favorites right there in this cathedral of rock 'n' roll to this trading floor brotherhood, which had never been more closely knit. We were all together, standing among the pictures of musicians like Jimi Hendrix, Mick Jagger, Keith Richards, and Jerry Garcia. The speeches were hysterical, especially Larry's. He mentioned that the CDS (credit default swap) traders were currently working on bringing down the whole world. He observed that some of the women wore clothes to work his wife wouldn't wear in the bedroom. He picked out our most senior salesman and said he was the last one left who used to work for Drexel Lambert (deceased 1990). He said that Joe Beggans would take over his mantle as the world's greatest trader, and that the brand-new electric guitar Pete Sch.e.l.lbach had purchased this week, which had cost him thousands, was a stone-cold certainty to have marked the top of the market.

Despite the laughs, the evening turned out to be sadder than Larry's last day. His close friends gathered around him at the end of the evening, knowing this really was the last time, and that all the sorrow that now engulfed us could be laid at the door to the big office on the thirty-first floor. There weren't many dry eyes out there on the sidewalk as we waited for cabs on that warm June night.

But the epitaph of the evening was not written until the following day, when Bart McDade walked in at four minutes past six, instead of six o'clock sharp, as he had unfailingly done every day of his working life.

Someone called out, joking, "Hey, Bart, running a little late today?"

But our famously good-natured equity chief never smiled. And he never broke stride. He just said quietly, "We retired a legend last night."

And, in a way, that brought down the curtain on an era. The future was uncertain. The vexed question of Lehman's debt and exposure had been the subject of Mike Gelband's last stand, and he had been not just ignored but forced out of the firm, which meant, broadly, that nothing much was going to change on the thirty-first floor, where our two leaders were demanding more power from the turbines as we headed into the ice field.

Alex was now our great hope of sanity. He and Mike had implored d.i.c.k and Joe to slam on the brakes, to cut that $500 billion debt drastically. They had proposed that instead of being thirty-four times leveraged, we cut back to twenty-five times, which would bring the debt down to $380 billion. Instead of that, we were headed straight up to $660 billion, and it was driving Alex Kirk quietly nuts. Over and over he tried to issue warnings. But he was not winning. Mark Walsh was still spending money as if it had gone out of style, Lehman was still obligated to buy thunderous wads of shaky mortgages, all our short positions were going the wrong way, and the corporate bond prices were following the Dow upward. Amazingly, the Lehman Brothers high-yield bond index ground to its all-time tight credit spread of 231 basis points over U.S. Treasuries. That's under 7 percent for a high-yield bond!

Blackstone's initial public offering took place on June 22 and netted two enormous fortunes, one for Pete Peterson, and one for the CEO, Stephen Schwarzman. They received the bulk of the $4 billion raised in equity-Schwarzman sold shares worth $700 million, and the now eighty-one-year-old Peterson collected $1.8 billion in that single day. Altogether, the Blackstone IPO valued the corporation at close to $40 billion, and first-day trading saw the shares rise from $31 to between $35 and $38 on the Big Board. It was the largest IPO on Wall Street in five years, since the collapse of the dot-coms. The biggest buyer of the brand-new Blackstone public stock was a 5 percent stake in the corporation purchased for $3 billion by the enormous Jianyin Investments, owned by the Chinese government.

So while Fuld fretted and fumed at the injustice of a world that made towering heroes of such men as Peterson and Schwarzman, there were other, more advanced ways of looking at the situation. The fact was that even though Stephen Schwarzman was retaining, for the moment, 24 percent of the Blackstone stock, the two founders had essentially got out right at the top of the market. As the news broke on the trading floor, the bearish Pete Sch.e.l.lbach growled, "Look out. Schwarzman and Peterson are selling stock, and we're buying hedge funds." These Blackstone financial tartars had been early and right so often, we had almost lost count.

Since d.i.c.k's old mentor Lew Glucksman had hustled him unceremoniously out of Lehman's front door, Pete Peterson had never looked back. He and Stephen were the best, and they had both worked for Lehman. I am sure their loss was felt as keenly in another time as we felt that of Mike and Larry. And our chairman had been indirectly involved in the departure of all four of them.

By now we were approaching the halfway point in the year. And among the many hostile problems with heavy artillery ranged against us beyond our Seventh Avenue garrison, there was one that was becoming more urgent than all the rest. Because this one was already clambering halfway over the ramparts, its a.s.s pointing up toward the sun. I refer, of course, to the CDOs, which had swiftly developed into a major disaster area.

On a bright June day, we all gathered for a crisis meeting in the trading floor conference room. In the chair was Jason Schechter, senior vice president and global head of cash CDO trading, who had supervised the construction of a hybrid collateralized debt obligation comprising credit default swaps on ninety high-yield rated companies. It was perhaps the most dangerous junk bond ever invented. In attendance were Pete Sch.e.l.lbach, Joe Beggans, Pete Hammack, As.h.i.+sh Shah, Eric Felder, Jeremiah Stafford, who was a trader in high-yield indexes, and Jane Castle. I was sitting with my buddy John Gramins, a good-looking and fast-talking trader in leveraged loans, and a nine-year Lehman veteran. He was around thirty-three, and lived on the Upper West Side of Manhattan near Peter Sch.e.l.lbach. Like me, he had been handpicked for the firm by Larry McCarthy.

The overwhelming reason for the meeting was that the NINJA loans were blowing up all over the country. Poor homeowners were bailing out as the resets slammed them into a financial Guantanamo Bay, with no prospect of an early release and no escape from the crippling interest payments. Their only way out was to leave everything, write off the payments they'd already made, and get out under the cover of darkness, keys in the mailbox.

I realize I have mentioned this in a small way at various points, but this was different from what had happened in late 2006. This was nothing like a few guys in over their heads; now there was a whole scattered army on the march, getting out of their new homes and going back to the poorest areas of the cities, where they could afford to live. The s.h.i.+ning era of the $400,000-a-year bus driver was drawing to a close. There would be no more ludicrous lying on loan applications. And the days of the slick-talking bodybuilders were already numbered. In places like Stockton, there were practically traffic jams at three o'clock in the morning as the residents piled into trucks and vans and hit the road, mostly to vanish without a trace.

And as thousands of mortgages ground to a shuddering halt, the little ripples that had been slightly irritating to the financial world were now not ripples at all. They were big white-foamed breakers cras.h.i.+ng onto the beaches of Wall Street and threatening to drown anyone who was late taking cover.

The march of the NINJAs was public. There were no secrets left. There was nothing more to be hidden. The collapse of so many shadow banks had taken care of that. Any mortgage brokerages involved in subprime were in desperate trouble, and the crisis was creeping inward from its outer reaches in Iceland, Shanghai, the Swiss Alps, and London.

Everyone at the table knew that even Lehman, the biggest beast among the subprime lenders, was finding it impossible to move the CDOs. The cat was out of the bag, and we were staring at an ugly, sneering face engraved on a very hot potato-that's the big tranche of tens of thousands of mortgages for which Lehman's selling price would need to be drastically cut.

The first news to hit us was confirmation of a huge hung deal-a $2 billion CDO that we could not move at par. All over the world, big investors were starting to discover the true value of their supposed AAA mortgage-backed securities, the ones officially stamped, signed, and certified as riskless by Moody's, S&P, and Fitch. There was a kind of global cry of agony: Holy s.h.i.+t! We've been conned by one of the great scams, investment-grade bonds backed by American trailer trash Holy s.h.i.+t! We've been conned by one of the great scams, investment-grade bonds backed by American trailer trash. Lehman had been forced to drop the price, selling the CDO at a $100 million loss at 95 cents on the dollar. It was the first time we'd taken a hammering on a CDO-and the trouble was, it might not be the last. In the trade, a loss like that is known as "taking a hickey" and we'd sure taken one.

And that was only half the story. Jason Schechter explained that the SIVs, the same securitized products that had driven Mike Gelband to leave the firm, were starting to unwind in two of America's greatest banks, Citigroup and Bank of America. These two inst.i.tutions were the biggest buyers of subprime securities on the planet, and they were some of Lehman's biggest clients. They had used the lethal concoction of depositors' money, their own awesome leverage, and borrowing in the short-term commercial paper market to stuff their coffers with billions of dollars of Alt-A and subprime toxic debt. They lumped the mortgages in with other debt to create a gigantic bond, the SIV, which they believed, grotesquely, would provide a positive income stream. Like CDOs, SIVs borrow in the commercial paper market at, say, LIBOR plus 20 basis points and lend by owning a portfolio of mortgages at LIBOR plus 200. In simple terms that is like borrowing at 4 percent and lending at 6. A perpetual free money machine, they thought!

But it was as if they innately knew the terrible risks, because they hid the SIVs away, kept them off the balance sheet, stored them in offsh.o.r.e havens, away from prying eyes. There was always something distinctly underhanded about the SIVs of Citigroup and Bank of America. Neither of these mighty inst.i.tutions, which surely were big enough to have known better, had considered, in the depths of their blackest dreams, that this housing market could come unraveled and slash the value of their colossal portfolio of SIVs, perhaps bringing both banks to the verge of bankruptcy.

But now the foundations of the housing market were beginning to tremble, and the size of the two commercial banks had made them prisoners. They could run, but they couldn't hide. They could sell some, but not all, because a ma.s.sive sale of mortgage securitizations could bring down the whole edifice of Wall Street, flooding the market and sucking down the smaller investment banks in a terrible orgy of selling off cheaply.

Fear, that most terrible of Wall Street predators, was suddenly lurking in our conference room. That one big loss we'd taken could easily be repeated-and almost certainly would be repeated, now that a major AAA-rated security, issued by Lehman Brothers, had been sold cheaply, an almost unheard-of occurrence in the past five years. The moment investors find out there is greater risk involved in buying such securities, the yield rises as the bond price falls and they no longer trade at par. Once there's more risk, they want more reward.

These mortgage-backed securities had been paying only one or two hundred basis points over LIBOR, the interest rate banks charge each other for short-term loans, the lowest rate at which banks can borrow money. By June 2007, this was mostly around 5 percent, and the CDOs had hitherto been paying as little as 6 percent. But sooner or later the news would get out that Lehman had just lost $100 million, and investors would now want more for their money. They would look for six hundred basis points over LIBOR, perhaps more. The market for CDOs that contained a heavy dose of subprime mortgages would never be the same.

We were alerted that there was already a buyer's strike developing on a worldwide basis. Big investors suddenly did not feel the same about mortgage-backed securities. The CDOs, which for so long had provided a money machine for investors, now felt vulnerable. When Lehman dropped the price by $100 million, well, they'd just fired the "short" heard 'round the world. Right now it was a secret, or supposed to be, and the loss would not leak out for several weeks. But somehow there were already undercurrents. One of the important market clues delivered at that table came from Jeremiah Stafford, a thirty-two-year-old top trading operator. He was a senior vice president of credit derivative trading, but his most significant task was to trade Lehman's High Yield 9 Index (HY-9), which comprised one hundred equally weighted corporations and charted the ups and downs of their bonds. Jeremiah was, by now, very bearish. For the past three years he'd had hardly anything to do, since his markets were flat calm, with zero volatility. But now he was one of the busiest traders on the floor, because some of his biggest customers were stampeding to short the HY-9 index as a hedge against an impending credit crisis. "I'm seeing it," said Jeremiah. "Daily increasing numbers of sophisticated accounts selling the index short, as a hedge against credit spread contagion."

Everyone understood what was happening. And this was unnerving, because the near-moribund HY-9 market had been becalmed for a very long time, and the sudden explosion of activity could only have been caused by one factor: fear. Sudden dramatic protective changes, like the ones Jeremiah was reporting, manifest themselves for no other reason.

And it was not just the HY-9 they were shorting. They also wanted positions on the ABX, which tracks the value of mortgage-backed securities, and the LCDX (the leverage loan index), which tracks all the millions of dollars borrowed for hostile takeovers. (Remember the CLOs, the collateralized loan obligations, the steroids behind the buyouts?) Jeremiah was trading them all short, because that was all anyone wanted. Anyone with eyes to see could tell there was a coming sea change in the markets. This was not a s.h.i.+ft or an adjustment; this was a deep, shuddering portent.

And then Pete Hammack made it worse by revealing there was a strong rumor that Bear Stearns was considering liquidating all of the a.s.sets held by one of its two hedge funds that were long in CDOs. He'd been told this by our mortgage guys, who had just seen a very hefty block of CDOs coming through the market with Bear Stearns' paw marks all over them.

As.h.i.+sh Shah made it clear this was becoming a real marketwide problem, saying he knew that Merrill Lynch had nineteen hung CDOs that could not be moved at the right price. Those of us in this meeting were collectively beginning to recall the bitter words uttered by Mike Gelband, Larry McCarthy, and Alex Kirk in this very room three months ago: the dire quality of their warnings, the clarity of their thoughts. And those of us with longer memories could remember Mike's words of two years ago: You cannot model human behavior with mathematics You cannot model human behavior with mathematics.

We discussed the positive feedback loop-financiers' jargon for the world state of play. It means the global carousel that began on 9/11 when the Treasury dropped interest rates to 1 percent to stimulate the economy. The idea was to insert a large amount of almost free money into the economy, allowing people to borrow for cars, houses, credit cards, and store credit lines. In turn, the shadow banks were set up to lend money to prospective home buyers. With reasonable rates of repayment and a constantly rising housing market, people could use their homes like an ATM machine, taking out home equity loans and heading off on spending sprees at Sears, Home Depot, and other megastores. Awash with cash, the stores turned to China for zillions of inexpensive products, which came flooding into the United States and other Western markets. Everyone was getting rich, especially the Chinese, who proceeded to invest their profits in U.S. Treasury bonds, billions of dollars' worth. This ensured that interest rates were kept low, which triggered a thirst for higher yield among investors, and the cycle started all over again. What had begun as a friendly little zephyr of a breeze, circling cheerfully through the financial markets, was now gathering strength each time it came around, first into a good stiff blow, then into a gale, and now howling into a full-blooded hurricane, sucking up everything in its path.

It seemed that nothing could stop the loop. The population somehow could not function without cheap money. China could not function without ma.s.sive orders from the United States for consumer goods. The big Wall Street commercial banks and investment banks had become dependent on the rising real estate market and the revenues from the sales of credit derivatives. And the Treasury was counting on the Chinese to hurl money at the United States, which held down interest rates. Everyone counted on everyone else to keep this financial tornado spinning.

But now a gigantic monkey wrench had been thrown into the works. House prices were collapsing, which meant that people who could not pay their mortgages were leaping from the carousel. That left the CDO market to go to h.e.l.l as investors stopped buying. Without the easy money from the shadow banks, people were changing their spending habits, which completely screwed up the lives of Sears, Home Depot, and other retailers. They in turn stopped ordering from China in those same vast quant.i.ties. And that put a brake on the amount of Treasuries China could buy from the U.S. government, which slowed down America's ability to borrow big sums of money from Chinese banks. Everyone was now s.c.r.e.w.i.n.g up everyone else. That's known in financial circles as the negative feedback loop, the precise opposite of the first one, the positive feedback loop. For the record, for anyone who might be very slightly confused: the first one, the positive loop, is great for all concerned, although not guaranteed to last. The second one, the negative loop, is a b.i.t.c.h.

I describe it so because once the loop reverses direction, it's extremely difficult to slow down. It all starts with those CDOs backing up at the traffic light. Remember what I said when Dave Gross and I were out at New Century? That it would start right there. And indeed, New Century was one of the first to crash in flames.

Now we were hearing that Lehman had taken a haircut to the tune of $100 million on the sale of a CDO. Which meant the game was over. As night follows day, events would unfold in a gruesomely predictable order. With the housing market slowing down, many people would run out of cash, and others would find their credit lines greatly diminished; this would prevent them from spending at the same rate, affecting especially retail stores like Sears and Home Depot. But it would also affect restaurants, main street stores, and car dealers.h.i.+ps. When banks get scared, they pull back on lending. Similarly, when people get scared they just stop spending. Second homes, vacation homes, are put on the market, which drives prices down even further.

I have always been taught to be alert for the moment the pendulum stops swinging positive and turns negative. So far as I could tell, this was it. Lehman had caught a major cold with that G.o.dd.a.m.ned bond. Jeremiah could see it all happening, right before his eyes. As.h.i.+sh thought it was worse on the other side of the Street, at Merrill. Pete Hammack had heard of a potential collapse at Bear Stearns. h.e.l.l, this was was it. it.

The only voice of reason still echoing in this particular room was that of Mike Gelband, and those two comedians on the thirty-first floor had made it impossible for him to work here anymore.

At our meeting, Jason Schechter had not revealed any kind of a master plan to steer us away from potential disaster. But it had been hugely educational, and no group of people anywhere in this vast office complex understood better than we the true nature of the ice floes that lay ahead when the subprime mortgage game finally detonated worldwide rather than just stumbling along causing trouble, as it was at present. The meeting broke up after a depressing hour. And no one was more depressed than Eric Felder. He was fiddling with his BlackBerry and as we walked from the room, he said, "Guys, the lightbulb just went on for me ... in the year 2006, possibly 50 percent of the growth in the United States GDP was bogus-CDOs, CMBSs, CLOs, and MBSs. Alex's steroids. Holy s.h.i.+t!"

No one had any miracle cure for the banking industry. No one really had any idea how to jump out of the way of that razor-sharp pendulum as it began its backward path, preparing to cleave its way through our industry, traveling in a different direction. The wrong way.

Twelve working days after that CDO meeting, on Wednesday, June 20, the Dow plummeted 150 points late in the afternoon because of the uncertainty concerning those two major Bear Stearns hedge funds. Both of them were packed with subprime mortgages, and rumors were rife that they would collapse. Indeed, Merrill Lynch, one of the funds' lenders, seized $850 million worth of a.s.sets that were backing the two hedge funds, and began to auction them off. A wave of selling hit the mortgage-backed securities market and drove down the price of the bonds. Behind the scenes there had been high drama at midnight, when a rescue plan blew up and the two hedge funds were very nearly shut down right there. By the closing bell Wednesday a lot of people probably wished they had been, because the funds were in crisis and they were dragging down the whole market.

The Wall Street Journal Wall Street Journal was spooked, and reminded readers that as of a few weeks earlier, the two hedge funds had held more than $20 billion of investments, mostly in complex securities, bonds backed by subprime mortgages-"made up of the relatively risky home loans to borrowers with troubled credit histories." was spooked, and reminded readers that as of a few weeks earlier, the two hedge funds had held more than $20 billion of investments, mostly in complex securities, bonds backed by subprime mortgages-"made up of the relatively risky home loans to borrowers with troubled credit histories."

The newspaper mentioned, somewhat archly, that since 2000, Wall Street had created $1.8 trillion of securities backed by subprime mortgages. But now there was a housing slump, and the explanation for the mini-crash that day was clear: the slump was causing a spike in mortgage delinquencies, which hurt the value of the bonds. By the end of that Wednesday afternoon there were clear and obvious signs of investors becoming worried-it looked like thousands of them were trying to get out.

For the moment, the Bear Stearns funds were still breathing. Just. But we all stood back in antic.i.p.ation of a wild rush to the desk of Jeremiah Stafford to pile fortunes into short positions on the HY-9, because if those Bear Stearns funds went down, they were big enough to cause nothing short of abject chaos in the markets.

Right now we were certainly not in chaos. The Bear Stearns situation was not, for the moment, life-threatening, and the market was still quite buoyant. But Wall Street's most sinister problems occasionally arrive without the thunder of the guns and the clash of mounted cavalry on the stock exchange floor. Some deadly problems come creeping in on cat's paws, unannounced, often unnoticed. They occur when the world's banks un.o.btrusively arrive at a single conclusion-individual decisions made quite separately but at around the same time. No one says anything about collective change. The consequences just come padding in, and suddenly there's a lightning bolt of fear crackling through the market. It was happening right now in those last days of June 2007. Maybe it was the Bear Stearns hedge funds, maybe the rumors about Merrill's unsold CDOs, maybe the avalanche of investors piling into Jeremiah's short index trades. But whatever it was, the commercial paper market, the lifeblood of us all, was suddenly contracting. There was a clear and definite reluctance on the part of banks and money market funds to lend to us speculators. Both Mike and Larry would have chuckled sarcastically, No! How could anything like that possibly have happened? No! How could anything like that possibly have happened?

The signs were barely discernible, but on June 30 there was another minor hand grenade landing on the floor. Someone found out almost one in four of all Countrywide's subprime loans were delinquent-25 percent, up from 15 percent against the same period last year. In pure numbers that was hard to quantify, but Countrywide was still the biggest lender in the nation, with 62,000 employees in 900 offices financing around 200,000 loans a month, and right there we were talking thousands and thousands of homeowners not paying. And 10 percent of those were 90 days delinquent or more. It also emerged that many of these delinquencies were the direct result of savage resets, taking the homeowners' repayments from the low "teaser" levels, to double digits. Some carried prohibitive prepayment penalties, which made refinancing impossibly expensive. And it was right here that the commercial paper market finally faltered.

I'd like to explain commercial paper in a little more detail. For a start, commercial paper 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 JPMorganChase and requests 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.

Now, JPMorganChase isn't going to offer up that $500 million to any old applicant. But Bear Stearns is a highly respected bank, and they've done something similar many times before. The same would apply to Lehman, Morgan Stanley, Goldman Sachs, General Motors, or Countrywide. All of them have always paid back, with the interest, right on time. But in many cases they paid back with money from another short-term paper loan they'd borrowed from someone else. For banks with blue-chip lines of credit, it was possible to keep a huge loan rolling for months and months, paying back with borrowed money over and over. 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."

The problem was, banks tend to keep an eagle eye on charts, trends, graphs, and indices. And right now there was one chart jumping off the screens of bank a.n.a.lysts all over the world. It was the big blue tracker of the amount of United States commercial paper outstanding weekly from 2001 to mid-2007. For the first four years, it was cruising at a rock-steady $1.25 trillion to $1.5 trillion. Then it began a steep upward climb, coinciding with the advent of the credit boom in housing. In 2005 it broke $1.5 trillion. In 2006 it was well on its way to $2 trillion and reached that level by Christmas. After the first half of 2007 it was $2.25 trillion and climbing, which represented a spike of $750,000 a week. Suddenly, without warning, the biggest banks started to haul on the reins. At first they weren't saying an outright no to their best customers. But they were hesitating, referring things to committees, making it more difficult to borrow, taking longer. That evening Alex Kirk took a group of us traders out to dinner and expressed his grave concern that the modern tenets of finance were causing the systems of financial plumbing to clog.

Then, right after the July 4 vacation, they started saying a categorical no to various clients. The situation at Countrywide was probably the catalyst, spurred by the vast number of mortgage delinquencies. When Countrywide's bankers said no, instantly Angelo Mozilo and his men slammed the lid on information leaking out about this crisis. But the giant mortgage shop could no longer roll its remarketable preferreds-those 4 percent loans that needed to be paid back in seven days. The commercial paper market had frozen on them.

Terence Tucker, our ace salesman, found out. A big hedge fund tipped him off, and the rest was like a wildfire. The three-month LIBOR ripped upward from 5.36 percent to 5.95 percent. It doesn't sound like much, but this was the biggest move in years. Gatward instinctively warned his traders, "Guys, this is the biggest move in three-month LIBOR since Long-Term Capital Management bit the dust back in 1998, take down risk now. I want to see all your long positions trimmed down before the close." You could feel the tension growing. I'll never forget how much louder it was becoming on the trading floor that summer. I hadn't heard anything quite like it in my entire time with the firm up to that point. It had a distinct higher pitch to it, like a nervous crowd in the fifteenth round of a close prizefight. This move in LIBOR could only mean one thing: banks no longer trusted each other in quite the same way. Remember, Countrywide was a shadow bank, with $300 billion worth of mortgages out there, a lot of it subprime. This was the first sign of big trouble. Countrywide was under a blanket of deep white frost, with no further access to cheap, fast money.

The situation immediately worsened rather than improved. Everyone was starting to find it difficult to borrow. The roof was falling in on the carry trade. It was no longer possible to borrow at those very low rates and lend at much higher ones, a tactic that had convinced many Wall Streeters that here at last was a method of trading made in heaven. And for a very few years after Greenspan slashed the rates in 2001, "borrow short, lend long" was a license to print money.

Then, in the middle of July, Bear Stearns' two hedge funds went bust. One was their Strategies Fund, and the other was the Strategies Enhanced Leverage Fund, both under the umbrella of Bear Stearns High-Grade Structured Credit. Through January 2007 they had forty months with no declines, but in the following four months the Enhanced Fund lost 23 percent.

And that's a lot worse than it sounds. They had $638 million in invested capital and had borrowed at least $6 billion, making $11.5 billion in bullish bets on the subprime mortgage market, plus $4.5 billion in bearish wagers to hedge their position. That's ten times leverage minimum. So when it crashed 23 percent, the margin clerks at Merrill had no choice but to seize their $850 million in collateral and dump it for 85 cents on the dollar.

All of this cast a dark cloud over Wall Street, setting off a chain reaction that would shake the CDO market globally. The SEC moved in to conduct a thorough examination of the Bear Stearns fund's balance sheets. The fund immediately suspended investor redemptions. Bear Stearns itself was doing an impressive impersonation of a nerve-wracked ostrich that had planted its head straight into the sand, without the slightest intention of coming back up.

The Strategies Fund was not in such dire straits as the Enhanced, being only six times leveraged. And Bear Stearns threw it a lifeline of $1.6 billion, because they thought it had a chance to survive. But they were wrong, and on July 17 they sent out a letter to investors telling them more or less what was going on, and that the funds were essentially worthless and would be disbanded.

"There is effectively no value left for the investors" was the eloquent phraseology of the letter, which failed to add an even more eloquent phrase about their own managers' inspired strategy in loading up the funds with CDOs strictly reliant on people who had no bread. Indeed, Bear Stearns was sanguine about this mildly embarra.s.sing method of losing billions of dollars. "Our highest priority," they confirmed, "is to continue to earn your trust and confidence, each and every day, consistent with the Firm's proud history of achievement." Then they added, "Please contact us if we can be of service." This last bit was presumably aimed at specific investors who felt like dropping another $100 million in the world's worst mortgage-backed securities.

Another casualty of that black July was United Capital, a large hedge fund out of Key Biscayne, Florida, and a leading player in the a.s.set-backed securities (ABS) market. By the eleventh of the month all four of their funds were closed down with combined losses of $630 million. This was doubtless a shuddering blow to their investors, but the toughest break was to its thirty-eight-year-old founder and CEO, John Devaney, a man who had ridden the subprime wave and then crashed high and dry onto the sun-kissed but rock-hard Key Biscayne beach with a severely broken ego.

Along the way during the rampaging boom years of the subprime bonanza, John had collected a Gulfstream jet, a Renoir painting, a $6.5 million vacation home in Aspen, Colorado, and an $11 million Sikorsky corporate helicopter big enough to transport a squad of leathernecks straight into Afghanistan. There was also the world-cla.s.s 141-foot oceangoing tri-deck Trinity yacht that sported an eight-person Jacuzzi and five staterooms paneled in enough top-of-the-line cabinetmakers' cherrywood to redecorate Grand Central Station. It carried more than ten thousand gallons of fuel, was named Positive Carry Positive Carry as testimony to its owner's positive devotion to those glorious little commercial paper loans that had kept United Capital rolling along through the very best of times, and was registered-where else?-in the Cayman Islands. Housewise, John was in good shape. In Key Biscayne alone he owned seven of them, all mansions, total value of $78 million. His own residence was the $38.5 million West Matheson Drive waterfront palace that had featured prominently in the Al Pacino gangster cla.s.sic as testimony to its owner's positive devotion to those glorious little commercial paper loans that had kept United Capital rolling along through the very best of times, and was registered-where else?-in the Cayman Islands. Housewise, John was in good shape. In Key Biscayne alone he owned seven of them, all mansions, total value of $78 million. His own residence was the $38.5 million West Matheson Drive waterfront palace that had featured prominently in the Al Pacino gangster cla.s.sic Scarface Scarface. When the crunch came, and the banks suddenly slammed on the brakes that summer, it was all over for Big John. All of the above were sold, but he swore to G.o.d he would earn again the money his investors had lost. Financiers have calculated his was one of the largest hedge funds to go down in the viselike grip of the short-term credit squeeze, which forced so many to bail out and leave the market to sterner men.

Meanwhile, back on the Lehman trading floor, August brought no better news. The market was suddenly volatile, and after a strange July peak of around 14,000, it tumbled in mid-August to just above 12,800. Bank of America stepped in to save Countrywide and bought 16 percent of the ailing shadow bank for $2 billion after Countrywide's shares lost more than 66 percent of their value. In the end they went to $1. Lehman's rock 'n' roll guitarist, Pete Sch.e.l.lbach, had been right on the money. He shorted Countrywide when it was flying high and had pocketed over $10 million in profits for the firm.

It was clear, even to those accustomed to keeping their head well down at Lehman, that d.i.c.k Fuld had hit the spending gas pedal with a ferocity that would have made John Devaney's eyes water. Several days after the departure of Mike Gelband, Lehman began negotiations to buy the Houston-based energy services corporation Eagle Energy Partners for a total of $400 million. Lehman already owned one-third of it, which Mike had considered quite sufficient. And now they were going for the rest, as part of d.i.c.k Fuld's expansion plans.

Those plans were gaining ground with every pa.s.sing week. By high summer Lehman was involved in multibillion-dollar commitments with TXU and Claire's Stores. Then there was the payment services giant, First Data from Denver, Colorado, in which the firm was involved with a consortium of banks in a $26 billion takeover deal. In addition to buying Eagle Energy, Lehman was also tied up with a group of banks trying to raise billions to refinance Home Depot.

And then Dave Sherr, of all people, and his team somehow got us into the old International House of Pancakes' $1.9 billion buyout of Applebee's, a chain of almost two thousand neighborhood restaurants out of Overland Park, right on the Kansas-Missouri border. My guys, almost to a man, hated it. Steve Berkenfeld, who may have heard the rumor that d.i.c.k Fuld loved a plate of pancakes, rushed straight in and approved it. And again Lehman stepped up to the plate with financial support, this time for IHOP, boldly buying a corporation whose stock had been in steady decline. I think in the end we lost nearly half a billion dollars on this hung deal. Our salespeople couldn't move the debt at all. I'm not even sure d.i.c.k got out with a plate of secondhand pancakes. Old Dave thought securitization could save the world and even move an overpriced plate of pancake debt.

The magic of private equity was pervading the Lehman boardroom, and all of these big leveraged buyouts held immense appeal for Fuld and Joe Gregory. Both must have been aware of the firm's high-wire act with Lehman's debt. But both men were devotees, apparently, of the very suspect maxim that it's always possible to spend your way out of trouble.

In these barnstorming days, where the stock market was expressing a total disregard for reality, the private equity firms were happy to purchase a corporation at ten or eleven times its EBITDA. This is very, very high historically, especially compared to 2005 levels when the current LBO boom began, and likely to work only in a financial bubble. But d.i.c.k Fuld couldn't see this. Under him, Lehman's philosophy was akin to a golf cart, those little contraptions designed to allow golfers to zip around the course a bit more quickly than if they walked. Golf carts are all fitted with a governor, which is a device to keep the cart's top speed slow enough to be safe. Lehman's thirty-first floor was riding on a golf cart, but d.i.c.k Fuld had taken a sledgehammer to the governor and was currently making about 140 mph straight across the ninth green. Oil gushers, power stations, necklaces, handbags, home fittings, electrical goods, paintbrushes, pay slips, credit cards, wallpaper, and pancakes-d.i.c.k and Joe were in there. We were $82 billion out in leveraged mortgages, $30 billion in leveraged buyouts, $40 billion in CMBSs, $5 billion in the oil industry, $20 billion in hedge funds. G.o.d knows how many additional a.s.sets were kept off the balance sheet and currently hidden away in the middle of the Caribbean. Not to mention the fact that Lehman Brothers was well on the way to being leveraged to forty-four times our value-that's well north of $700 billion. We were somehow out there buying wildly overpriced skysc.r.a.pers with distant views to the friggin' Eiffel Tower, still buying hedge funds. And we were still up to our ears in apartments-we probably owned more than two hundred thousand of them worldwide. Sunny, south-facing two-bedroom gem. Best deal on the market. Must see. Can't last Sunny, south-facing two-bedroom gem. Best deal on the market. Must see. Can't last.

Those last two words made me shudder. I once sat down and calculated that if everything went well in terms of annual returns, Lehman could have paid back all that debt about five weeks before my 276th birthday.

Upstairs, the one deal in all the world that d.i.c.k Fuld wanted signed, sealed, and finalized was the $22 billion purchase of Archstone-Smith. Before the leaves in Central Park had turned to gold, Mark Walsh had it wrapped. Lehman's balance sheet went a slightly different color because of the ma.s.sive overpayment. But Fuld and Gregory were very happy with the price and pa.s.sed several times on the offer to exit the expensive transaction and pay the breakup fee, which would have possibly allowed Lehman to walk away from death's door. Even worse, several senior salespeople at Lehman I spoke with say they had large well-known clients that wanted to buy the Archstone debt that Lehman owned, but strangely Mark Walsh didn't seem to care about selling.

One man who did care, who cared with a ferocious inner rage, was Alex Kirk, the ranking member of the old crowd who still had the brains and the wherewithal to save us from the lunatic downhill ride we were all being forced to take.

Alex ranted about Lehman becoming a REIT with an investment bank on the side. He swore that in any other comparable organization, if indeed there was one, there would have been three men doing Walsh's job, not one. Someone should have insisted on oversight.

Using every ounce of his considerable power, he began a selling program in which he tried to unload Lehman's portfolio of leveraged loans. He put them on the market, hit bids, paid the penalty clauses, and slowly began to extricate us from both the debt and the consequences of a falling high-yield corporate bond market worldwide, not just in the United States. Alex's thinking was much like that of Mike and Larry.

But it was a tough and lonely battle for Alex to fight. In the end, I heard he took $1.5 billion worth of losses, while at the same time he was driving Joe Gregory mad, not to mention the dark, brooding figure of the increasingly remote Fuld. Again and again, Alex demanded to know if Gregory or his boss understood the risks, whether they understood what the h.e.l.l was going on, and whether they in any way comprehended that someone, somehow, somewhere, had to find a way to hit the brakes. Months later I was told if Alex had not bothered with the aggressive selling campaign, Lehman, in the end, would have lost another $10 billion, a situation perhaps best ill.u.s.trated when Coeur Defense was sold a year later for a billion-dollar loss.

By now, Alex, recently promoted to chief operating officer of fixed income, was very badly out of step with the two main powers. He was tougher and cleverer than either of them. And the prospect of his departure was too unsettling to be considered. So for the moment they just tolerated one another. But at least Alex understood precisely what he was doing.

Anyone with even low-voltage antennae could sense there was a huge sea change taking place in the corporation. Confidence was beginning to ebb away. And there were rumors of a new chief financial officer being appointed, our third in as many years-Christine Daley's cla.s.sic sign of pending trouble in any corporation.

There was a chill in the autumn evening as I emerged late one night from a restaurant on 55th Street and Broadway. I was with my beautiful girlfriend, Anabela, a New Yorkbased architect from Panama, and as we reached the south-running avenue that cuts diagonally across the west side of midtown Manhattan, I remember I paused for a moment and watched the limousines sliding through the traffic.

All around there were beautifully dressed ladies. Smartly dressed men in expensive overcoats were hailing cabs outside crowded restaurants. Doormen were blowing their piercing whistles to summon taxis. There was the sound of laughter on the night air. Huge checks for costly dinners had been paid with ease. The staff had been extravagantly tipped. A feeling of unchecked prosperity pervaded everything.

And I was suddenly seized with a deep sense of foreboding. A feeling that had been shrouding me for weeks, ever since that CDO meeting, was inexplicably upon me. I thought of Mike and Larry, away from it all now. And I thought of lonely Alex, fighting his valiant rearguard action against the paper gladiators on the thirty-first floor.

I turned to Anabela and said, with chills running down my spine, "Take a long look at all this, honey. Because it's going to end. This time next year New York will not be anything like this."

She looked at me quizzically but said nothing. Which was just as well, because I could not really have answered. Not rationally. I simply knew, that's all.