There are a number of books written about Lehman Brothers – most focus on the executive suite for very good reasons. Lawrence McDonald a former VP of distressed debt of Lehman Brothers wrote a book called A Colossal Failure of Common Sense The Inside Story of the Collapse of Lehman Brothers , Crown Publishing, NY, 2009. The perspective is interesting because Mr. McDonald’s job was to find companies whose stock should fall because of debt and other reasons and short the companies. The other part of the job was to examine the debt of companies which had declared or expected to declare bankruptcy and determine how much value is left in the company and make bids for the debt.

In the book, Mr. McDonald says his group understood what was coming in the housing market, was shorting the mortgage companies but the executive suite was driven to become the leader on Wall Street which meant they did not understand what was happening and wanted growth at any cost. While Mr. McDonald was shorting companies in the airline and real estate mortgage business, other parts of Lehman were going into overdrive to bulk up on both commercial and personal real estate mortgages bonds. They were doing it because money was inexpensive, the credit lines existed, they relied on the assumption that the real estate prices rise and people paid back mortgages (although when someone is given a mortgage with no down payments, little income and very low mortgage payments for the first two years, it is not surprising in year three and beyond thousands of people stopped paying), and the fees to bundle the mortgages or securitize and sell them as bonds was too much of an incentive not to do.

The lesson is leverage – most companies and Individuals (it seems) operate on the use of leverage. In the error of inexpensive money it is prudent for a company to buy assets which produce returns. The question is how much, is too much? In the case of Lehman Brothers when they declared bankruptcy they were leveraged 44 times their capital or for every dollar of capital, they had borrowed 44.

Prior to their downfall, Lehman bought a large commercial portfolio at the top of the market price and the securitization of individual mortgages machine was at full production, but Lehman was keeping more and more of the inventory as it was harder to sell the bonds. This was acceptable as long as the bonds kept their value, the week the bonds started to fluctuate in price, the bonds were in a free fall and billions of dollars of assets became cents on the dollar. The investment business is based on credit, the credit is based on providing assets for collateral for banks to lend money. When the mortgage bonds became to lose their value, no bank wanted the collateral. No collateral, no business.

Linking to dividend producing stocks – what is the leverage in stocks that you own?  Second lesson is the common sense one – mortgage brokers selling the no income mortgages were operating in the grey area. It was legal, but not the same as the expected standard that the mythical average person operates in. As an individual if you saw the ads or articles or participated you have to ask yourself what is the outcome of the mortgage. What are the assumptions everything is based on? Is it good?  Mr. McDonald left NYC where Lehman is based and went on a field trip to where many of the mortgages were originated to see what was happening in the field, travelling in person is often a good thing.

There are more questions than answers, till the next time – to raising questions.