The end of Lehman, part 1

Introduction

Two weeks ago, with another dismal anniversary looming, Mr. Fuld went to Washington.

On Sept. 1, former Lehman Brothers CEO Richard Fuld Jr. testified about the failure of his Wall Street firm, painting himself and his company as victims of “uncontrollable market forces” and unsympathetic government banking officials.

Afterward, The New York Times said the seemingly “tragic and solitary figure” had gained a “fairly sympathetic hearing” from the federal Financial Crisis Inquiry Commission as he gave his version of the chaotic days before Lehman’s massive bankruptcy filing on Sept. 15, 2008 — two years ago today.

Fuld said little, though, about the decisions that Lehman had made over a period of years that had helped put it in a position in which it was desperately seeking a lifeline from other banks or the government — acknowledging simply that the firm had “made some poorly timed business decisions and investments.”

It would be easy to get the impression from Fuld’s testimony that Lehman had been destroyed, more or less, by an Act of Nature — those “uncontrollable forces” of investor panic and market turmoil. Even back in 2008, at the moment of Lehman’s fall, The Associated Press called it a casualty of a “financial hurricane.”

But any fair reading of the facts indicates that the nation’s mortgage meltdown was a man-made disaster. And Lehman Brothers wouldn’t have been in desperate straits two Septembers ago if it hadn’t immersed itself in risky bets on real estate, gambling on commercial real estate and bankrolling many of America’s worst subprime home-loan sharks.

No Wall Street player did more than Lehman to bring the subprime mortgage boom to life. It began its push into subprime in the mid-1990s, helping what was then a niche business begin its dramatic expansion. Ten times over a span of 11 years, Lehman ranked first or second on the list of Wall Street’s top packagers of subprime mortgage-backed securities. In 2005, at the height of the subprime boom, the firm put together $54 billion in subprime mortgage-backed bonds — more than any investment bank had ever packaged.

Ethics at the door

I know something about Lehman’s methods because I spent much of the last three years investigating the company’s mortgage empire for a book, called The Monster, about the rise and fall of the subprime industry. My reporting revealed many highlights and lowlights that illustrate how Lehman helped fuel the growth of subprime — and how it enabled the questionable practices that came to dominate the market.

For example:

• One of the subprime lenders Lehman financed in the 1990s was First Alliance Mortgage Company, known as FAMCO for short. Lehman got involved with FAMCO even though one of Lehman’s own vice presidents warned that the lender was the kind of place where you “leave your ethics at the door,” and that it specialized in “high-pressure sales to people in a weak state.” The lender frequently charged borrowers as many as 20 upfront points on their loans — $20,000 in initial fees on a $100,000 loan.
• Lehman helped steer hundreds of millions of dollars in funding FAMCO’s way. In 1999 and 2000, it kept FAMCO afloat after other investment banks, spooked by a series of government investigations of the lender, refused to provide it financing.

• Lehman denied wrongdoing. A federal jury later concluded that FAMCO had engaged in fraud, and that Lehman had knowingly “aided and abetted” the fraud. An appeals-court panel upheld the jury’s conclusion, writing: “Lehman admits that it knowingly provided ‘significant assistance’ to First Alliance’s business, but distinguishes that from providing substantial assistance to fraud. In a situation where a company’s whole business is built like a house of cards on a fraudulent enterprise, this is a distinction without a difference.”

• Along with raising money to support independent lenders, Lehman also owned two subprime lenders outright, BNC Mortgage and Finance America. In 2007, I interviewed 25 former employees of these two companies who said that workers and managers at the lenders engaged in a variety of shady practices to put borrowers into deals they couldn’t afford; in some instances, several former employees alleged, workers used scissors, tape and Wite-Out to create fake tax forms and pay stubs and make loan applicants’ financial profiles look better. One ex-employee told me staffers who tried to “take a stand” against such practices “were reprimanded for not being cooperative — not wanting to be creative about making deals work.”
• Lehman officials told me that any such instances were not representative of the company’s practices. They said the firm had tough antifraud controls and it went to great lengths to screen out dicey loans.
• Another Lehman subsidiary that funded significant numbers of questionable loans during the boom years was Aurora Loan Services. Aurora focused on “Alt-A” loans, which fit somewhere between subprime and A-credit loans. An in-house special investigations team reviewed a sample of mortgages packaged into securitizations by Lehman’s structured finance experts, and found that 40 to 50 percent of them had misrepresentations in the loan documents, according to a witness in a securities fraud lawsuit later filed by Lehman investors. Another sample, the witness said, showed even worse numbers — more than 70 percent of those loan files showed signs of fraud, such as inflated property appraisals.
• According to the securities suit, however, top Lehman managers were more concerned with pushing Aurora’s loans through the firm’s securitization pipeline than with screening out bad loans. One of the Lehman-installed managers, the suit alleged, “stormed out of a meeting and yelled at the vice president for special investigations, loud enough for everyone in the vicinity to hear: ‘Your people find too much fraud!’”

Profit and loss

Lehman Brothers’ high-wire business strategy in subprime and other markets helped it post records profits of $3.2 billion in 2005, then eclipse that mark with profits of $4 billion in 2006 and nearly $4.2 billion in 2007. But by the middle of 2008, Lehman’s risky bets began to catch up with the investment bank. It reported losses of nearly $7 billion over just six months, setting the stage for the firm’s Sept. 15, 2008, failure.

By Fuld’s reckoning, the largest corporate bankruptcy in U.S. history was simply the result of a misunderstanding. A swirl of incorrect perceptions and rumors, he told the financial crisis commission earlier this month, produced a loss of market confidence. Then, he said, federal officials operating on “flawed information” refused to provide a bailout that could have saved one of the nation’s most powerful financial institutions.