In 2007, at the height of the global economic boom, the chief risk officer at Lehman Brothers continued to express her concerns over the increasing risk the company was taking in some of its deals.
The deal to acquire Texas power company TXU Corp. in the largest leveraged buyout in history was particularly troubling. But rather than heed the chief risk officer’s warnings, Lehman CEO Richard Fuld apparently told her to “shut up.”
The story told by former Lehman executive Lawrence McDonald illustrates the recklessness of the investment bank’s executives.
“This bank was an out-of-control reckless monarchy,” McDonald said at a recent CFA Vancouver event at the Vancouver Four Seasons Hotel. “One of the problems with Lehman Brothers was that it wasn’t rotten at the core. It was rotten at the head. We had people who thoroughly understood credit derivatives, thoroughly understood 21st-century financial products, but they never had any access to the board.”
McDonald has become an outspoken advocate for change in the financial system, which he says continues to suffer from the same corporate governance problems that led to Lehman Brothers’ downfall on September 15, 2008, when it initiated the largest bankruptcy ever filed in the U.S. at the time.
Business in Vancouver spoke with McDonald prior to his presentation.
Corporate governance as a cause for Lehman Brothers’ downfall appears to be the focus of your presentation and your book. Are those issues still relevant two years later?
If you listen to hedge fund managers David Einhorn of Greenlight Capital or Dan Loeb, founder at Third Point LLC, or asset managers and activist investors like Carl Icahn, they’re very passionate about this point, and it still bothers a lot of investors. We still have systemically risky banks that don’t have proper board governance. They’re livid that some of these banks are still sitting on a substantial amount of risk and have not fixed their balance sheets or fixed their board. Some boards have improved, like Bank of America, but you still have boards of directors that leave much to be desired.
What still needs to be done about this?
In the case of Lehman, the board didn’t have anybody that had any type of 21st-century financial expertise. We had an actress on our board that was in motion pictures with Spencer Tracy. We had an admiral of the navy on the board. And the average age of the board was 70. This board was handpicked, strategically picked to be massagable. One member was on the board for 22 years. So, one of the things that needs to happen is putting term limits on boards of directors. The SEC or the Federal Reserve can mandate that publicly traded companies, or those in finance, must have board members that have a certain level of financial experience. They should also have direct reporting lines to the trading desk. I worked with our head of global credit derivatives, one of the smartest guys on the street, but he never spoke to the board. The board didn’t want to be exposed to anything they didn’t understand.
So the problem remains widespread among the banks?
In May, I attended the Berkshire Hathaway annual general meeting, and I have to say, these two men [Warren Buffet and Charles Munger] are something to behold. They answered questions in front of 30,000 people for six-and-a-half hours. They had 25 stations for microphones where you could answer questions. That’s transparency. That’s corporate governance. None of the people at Lehman Brothers would do something like that, because they don’t want to answer the tough questions.
Citigroup, for example, doesn’t want to talk about their balance sheet. There’s this guy, Mike Mayo, who was complaining because Citigroup’s management would not sit with him, even after all this. It appalls me that two years after Lehman, you have a major bank sitting on a lot of risk, but won’t sit down with an analyst because he’s critical of some of their accounting. That’s a problem. And that’s why I think the banks need to be broken up. They’re too much like hedge funds. Today, there is so much directional betting on the market that they try to protect themselves and don’t want to show a lot of what they’re doing. The problem is, they don’t even show it to the board.
The other banks on the street could be more transparent and have better corporate governance. At the end of the day, there are a lot of things that brought down Lehman: horrible, horrible management, risk-taking, leverage, but the board approved it all. This can’t happen at a systemically important bank.
So you do believe some banks are too big to fail?
I do, but I think they have to be broken up. Years ago, when Drexel Burnham [the fifth-largest investment banking firms in the U.S.] failed or Continental Illinois [the seventh-largest bank in the U.S.] fell, it didn’t bring down the global economy. But the assets of Lehman were 100-times larger than Drexel and Continental combined. If we have another 100-times increase in 10 years and another bank fails, there won’t be enough printing presses to print the money needed.
Do you think enough will be done at the policy level to try to prevent something similar again?
The issues are being addressed, but it’s slow. Some banks still haven’t addressed it. It’s up to the Federal Reserve to fix things, but one of the things Charlie Munger pointed out was that the Fed was created in 1913 as a result of the panic of 1907, and the Fed’s powers were increased again after the crash of ’29. Now they’re increasing yet again. But each time, they haven’t gotten far enough to fix the corporate governance stuff. That’s the biggest concern I hear: that it’s still an old boys’ club. And a lot of these board members are on five boards. If you’re in your 70s and on five boards making 300-grand each, that’s really good Christmas-present money for the grandkids. If you’re sitting on $700 billion of risk, you shouldn’t be on five boards. There should be rules around this.