Andrew Sorkin - Too Big to Fail - The Inside Story of How Wall Street and Washington Fought to Save the FinancialSystem--and Themselves

On Thursday, August 9, 2007, seven months before Bear went down, Einhorn had rolled out of bed in Rye, New York, a few hours before dawn to read reports and write e-mails. The headlines that day struck him as very odd. All that summer, the implosion in subprime mortgages had been reverberating through the credit markets, and two Bear Stearns hedge funds that had large positions of mortgage-backed securities had already collapsed.

Now BNP Paribas, the major French bank, had announced that it was stopping investors from withdrawing their money from three money market funds.

Like Bernanke, he stopped everything he was doing that weekend to try to better understand what was really happening. “These people are workers in France, they’ve got a money market account that they’re earning no money on. Their only goal is to have that money available to them whenever they want it; that’s what a money market account is. You can’t freeze the money market,” he told his team.

Einhorn e-mailed some of his top analysts to assign a special project: “We’re going to do something we don’t usually do, research-wise,” he announced. Instead of the usual painstaking investigation into a company or a particular idea, they were going to conduct—on both Saturday and Sunday—a crash investigation of financial companies that had big exposure to the world of securitized debt. He knew that this was where the problem had started, but what concerned him now was trying to understand where it might end. Any banks that held investments with falling real estate values—which had likely been packaged up neatly as part of securitized products that he suspected some firms didn’t even realize they owned—could be in danger. The project was code named “The Credit Basket.”

By Sunday night, his team had come up with a list of twenty-five companies for Greenlight to short, including Lehman Brothers, a firm that he had actually already taken a very small short position in just a week earlier on a hunch that its stock—then at $64.80 a share—was too high.

Over the next several weeks, names were removed from the credit basket as Greenlight closed out some short positions and focused its capital on a handful of firms, Lehman still among them.

As these banks began reporting their quarterly results in September, Einhorn paid close attention and became especially concerned by some of the things he heard in Lehman’s September 18 conference call on its third-quarter earnings.

For one, like others on Wall Street at the time, the Lehman executive on the call, Chris O’Meara, the chief financial officer, seemed overly optimistic. “It is early, and we don’t give guidance on future periods, but as I mentioned, I think the worst of this credit correction is behind us,” O’Meara announced to the analysts.

More important, Einhorn thought Lehman was not being forthcoming about a dubious accounting maneuver that had enabled it to record revenue when the value of its own debt fell, arguing that theoretically it could buy that debt back at a lower price and pocket the difference. Other Wall Street firms had also adopted the practice, but Lehman seemed cagier about it than the others, unwilling to put a precise number on the gain.

“This is crazy accounting. I don’t know why they put it in,” Einhorn told his staff. “It means that the day before you go bankrupt is the most profitable day in the history of your company, because you’ll say all the debt was worthless. You get to call it revenue. And literally they pay bonuses off this, which drives me nuts.”

Six months later, Einhorn had listened intently to Lehman’s earnings call on March 18, 2008, and was baffled to hear Erin Callan offering an equally confident prognosis. It was, in fact, the emergence of Callan as Lehman’s chief defender that had galvanized his thinking. How could a tax lawyer, who had not worked in the finance department and who had been chief financial officer for only six months, understand these complicated assessments? On what basis could she be so certain that they were valuing the firm’s assets properly?

He had suspected that Callan might be in over her head—or the firm was exaggerating its figures—ever since he had had the opportunity to speak directly to her and some of her colleagues back in November 2007. Lehman, having heard that Einhorn was critical of the firm, set up a conference call with him and made some of its top people available to him in hopes of assuaging his concerns.

But something about the call unnerved him. He had repeatedly asked how often the firm marked—or revalued—certain illiquid assets, like real estate. As a concept, mark-to-market is simple to understand, but it is a burden to deal with on a daily basis. In the past, most banks had rarely if ever bothered putting a dollar amount on illiquid investments, such as real estate or mortgages, that they planned to keep. Most banks valued their illiquid investments simply at the price they paid for them, rather than venture to estimate what they might be worth on any given day. If they later sold them for more than they paid for them, they made a profit; if they sold them for less, they recorded a loss. But in 2007 that straightforward equation changed when a new accounting rule, FAS 157, was enacted. Now if a bank owned an illiquid asset—the property on which its headquarters was located, for example—it had to account for that asset in the same way as it would a stock. If the market went up for those assets in general, it would have to record that new value in its books and “write it up,” as the traders put it. And if it fell? In that case, it was supposed to “write it down.” Of course, no one ever wanted to write down the value of his assets. While it may have been an interesting theoretical exercise—the gains and losses are not actually “realized” until the asset is sold—mark-to-market had a practical impact: A firm that had a huge write-down has less value.

What Einhorn now wanted to know was whether Lehman reassessed the value of its illiquid assets—including some $9 billion in mortgages—every day, every week, or every quarter.

To him it was a crucial question, because as values of virtually all assets continued to fall, he wanted to understand how vigilant the firm was being in reflecting those declines on its balance sheet. O’Meara suggested the firm marked the assets daily, but when the controller was brought onto the call, he indicated that the firm marked those assets on only a quarterly basis. Callan had been on the phone for the entire conversation and must have heard the contradictory answers but never stepped in to acknowledge the inconsistency. Einhorn himself didn’t remark on the discrepancy, but he counted it as one more point against the firm.

By late April, he had already begun speaking his mind publicly about the problems he saw at Lehman, suggesting during a presentation to investors that “from a balance sheet and business mix perspective, Lehman is not that materially different from Bear Stearns.”

That comment had gone largely unnoticed in the market, but it did raise the ire of Lehman. Einhorn set up another call with Lehman, and again, Callan tried to answer his questions and to turn his view of the company around. But despite her outward affability, he felt she was obfuscating.

Now, as he began preparing for his major upcoming speech in late May 2008, it was that conversation with Callan that confirmed for him that he needed to make Lehman the focus of his presentation. He decided to follow up with Callan one last time, sending her an e-mail to inform her that he planned to cite their earlier conversation in his talk at the Ira W. Sohn Investment Research Conference.

She responded immediately, skipping the niceties: “I can only feel that you set me up, and you will now cherry-pick what you like out of the conversation to suit your thesis,” she wrote back.