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By Lawrence G McDonald, the hard-driving Lehman Brothers trading Vice President, and the #1 New York Times bestselling author Patrick Robinson, the man who wrote Lone Survivor for the Navy SEAL Marcus Luttrell.

Direct from the heart of Lehman Brothers, the bank that smashed the world economy, comes an incredible blow-the-lid-off account of the greed, the misjudgements, the dreadful stupidity of men who should have known better. Revealed by a man who was there, the eyewitness, Larry McDonald. Anyone, laymen or expert, can understand the crucible of a Wall Street trading floor by reading “A Colossal Failure Of Common Sense.” This is a black box of secrets. And now Larry McDonald rips the lid off.

Author’s Note 

America has two distinct groups of people; Wall Street and Main Street - the financial plumbers, and those who have only the most basic notion of the ebb and flow of economics. Wall Street, with the
collapse of Lehman Brothers in 2008, was the epicenter of the worldwide financial crisis that brought the global economy to its knees.

My objective in writing “A Colossal Failure of Common Sense” was twofold. First, to show Main Street how markets really work. Second, to provide a crystal clear explanation of why the fabled merchant bank, Lehman Brothers, met with such a swift and brutal end. The lessons are important, not just to warn of such disasters in the future. But ultimately to provide a beacon, to help us serve Main Street better.

   

A Colossal Failure Of Common Sense - Jacket Copy

They stand alone – the zillion-dollar questions of the financial crisis : What the hell happened at Lehman Brothers? And why was it allowed to fail, with aftershocks that rocked the global economy? In this news-making, often astonishing book, a former Vice-President of Lehman gives us the straight answers – right from-the-belly-of-the-beast. Larry McDonald is the first senior Wall Street trader ever to write such an exposé – revealing at last the culture and unspoken rules of the game like no book has ever achieved before.

“A Colossal Failure of Common Sense” is a human story of McDonald’s rise from a Massachusetts project, to the New York headquarters of Lehman Brothers, home to one of the toughest trading floors in the world. He posed as a pizza delivery man to get past receptionists, to score interviews at brokerage firms. He peddled frozen pork chops, door to door, to hone his sales skills, desperate to realize his dream of working on Wall Street.

We get a close-up view of the other participants in the Lehman collapse, those who saw it coming with a helpless, angry certainty. We meet the Brahmins at the top, whose reckless, pedal-to-the-floor addiction to growth finally demolished the nation’s oldest investment bank. The Wall Street we encounter is a ruthless place, where brilliance, arrogance, ambition, greed, and all the human traits, combine in a potent mix that sometimes fuels prosperity, but sometimes destroys it.

McDonald’s gripping story of the firm’s death spiral is a modern-day thriller, studded with incredible, insider revelations no one else knows, or would dare reveal.

The collapse of Lehman Brothers was no surprise and didn’t have to happen. In fact, CEO Richard Fuld and President Joe Gregory were confronted with warnings on three occasions — starting as far back as 2005 — that the property market, on which they were betting the ranch, was teetering toward collapse. Fuld and Gregory turned their backs each time.

McDonald paints a vivid picture of life inside Lehman in “A Colossal Failure Of Common Sense,” where the isolated and reclusive chief executive ‘reigned’ in his sumptuous 31st floor office, accessible only by private elevator. From this Ivory Tower so much of the firm’s brightest talent was driven out of the door. The full significance of the Lehman bankruptcy remains to be measured. But this much is certain: it was a devastating blow to both America and the world beyond. And it need not have happened. This is the story of why it did.

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In 2005, when Timothy Geithner was head of the New York Fed, he ignored one of the greatest dangers our financial markets have ever faced. And that danger was buried deep inside our banks, in the unregulated market of Credit Default Swaps (CDS).

If you buy a stock from another party, the trade is forced to settle by the exchange within three days. This prevents any gray areas of ownership, which is critical for tracking the amount of risk in the financial system. Even if you bought a stock and immediately sold it to someone who then flogged it to another buyer, all these trades must be settled in the exchanges. This is the proper, regulated environment of the stock market.

But with CDS, this is not the case. It is like the Wild West, where trades are settled by hand in an over-the-counter market. Can you imagine the paperwork? And when the market exploded in 2005, during a time when traders made astronomical piles of money, the CDS paperwork piled higher and higher, until a pile the size of Mount Everest sat in the back offices of Wall Street.

With months and months of unsettled CDS trades, and with the unstoppable 300 m.p.h. gravy-train steaming forward, Timothy Geithner, our current Secretary of the United States Treasury, just stood there like a bird watcher on the side of the tracks, doing nothing about it.

The “Over-the-Counter Derivatives Markets Act of 2009”, which passed the House Financial Services Committee on a party line vote, was cleverly designed with a “trigger” to facilitate a White House takeover of the $54 trillion credit derivatives markets.

The draft legislation warns that if the “SEC and the Commodities Futures Trading Commission cannot jointly prescribe uniform rules and regulations under any provision of this act in a timely manner [60 days], the Secretary of the Treasury…shall prescribe rules and regulations under such provision.”

Considering the relationship between the SEC and CFTC has been defined by decades of territorial feuding, Secretary Geithner will quickly usurp oversight of this critical market.

But Mr. Geithner’s dubious regulatory record as President of the Federal Reserve Bank of New York from 2003 to 2008, makes him a curious candidate to become “Master of the Derivative’s Universe.”

When spectacular problems in the Credit Default Swaps (CDS) markets came to his attention following the bankruptcies of Delta and Northwest Airlines in 2005, he allowed the industry to continue to self-regulate its trading activities.

Every day billions of dollars of CDS contracts had been trading between banks, brokers and hedge funds, but contract execution to settle these transactions was often delayed by months. Literally hundreds of billions of dollars of outstanding derivative contract risk was floating off the balance sheets of the major financial institutions. This strategy allowed the derivative traders to engage in the equivalent of “check kiting” on a grand scale.

The turmoil in the markets and the size of 2005 losses made clear to the New York Fed that many banks were engaged in activities that skirted prudent banking standards. As head of trading for the world’s largest bank, Mr. Geithner could have used his authority to force the derivative industry to comply with settling all trades in three days. Instead of acting decisively to eliminate a known and growing systemic threat, he watched financial cancer quietly metastasize.

In an October 4, 2005 letter to Mr. Geithner, the ‘Major Dealers’ committed to reducing the number of confirmations outstanding longer than 30 days, by 30% over the next five months. The letter, signed by Bank of America, Barclays Capital, Bear Stearns, Citigroup, Credit Suisse, Deutsche Bank, Goldman Sachs, HSBC, JP Morgan Chase, Lehman Brothers, Merrill Lynch, Morgan Stanley, UBS and Wachovia states unequivocally that anything less than “significant progress on our backlogs…will be unacceptable.”

Over the next two and a half years, the Major Dealers spoke regularly with the New York Fed regarding the “tactical” steps they were taking to reduce the enormous number of outstanding trades. In a March 27, 2006 letter to Geithner, the Major Dealers agreed to provide only “informal updates” on their efforts to implement industry wide processing guidelines by the end of the year.

This was a critical moment in the history of the financial markets. It marked the day when the New York Fed and the US Treasury went to bed with Wall St. The grass had become too high to cut, and now they were married to this deadly mountain of unsettled CDS risk. But if Geithner had taken prudent action in 2005, forced Wall Street to settle the trades within seven days, the financial crisis might have been averted.

At a time when dangerous activities in the Credit Derivatives market demanded legal scrutiny and public disclosure, Geithner permitted the industry to avoid unpleasant intrusions into their most profitable business practices. Given confirmations should have been sent in one day, and signed contracts and collateral transferred in a maximum of three days. It is now clear the New York Fed was willing to allow the industry to self police their way back into compliance.

It took one of the Major Dealers going bankrupt to spur the necessary change. Two weeks after the collapse of Bear Stearns, in a letter dated March 27, 2008 the “Major Dealers” finally agreed to begin clearing trades electronically. By then, billions of taxpayer dollars had been put at risk, and the market was in a death spiral.

When Lehman Brothers failed on September 15, 2008, credit froze at banks around the word for the main reason that banks couldn’t determine who was exposed to Lehman. The settlement of Credit Default Swaps, an-over-the-counter market, did not keep up with the volume of trading. Our Fed and Treasury were flying blind when they let Lehman fail. And we’ll be paying the price for many years.

The mantra of the Administration has been “you never want a serious crisis to go to waste.” However, before handing the keys of the regulatory kingdom back to the deceptive Mr. Geithner, the public deserves to know about his three years of total incompetence, and they need to hear about the billowing risk in the credit derivatives markets, and how he failed to protect our nation.

By Chriss W. Street, Orange Country Treasurer
and Lawrence G. McDonald, author of “A Colossal Failure of Common Sense,” and international financial lecturer.