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

Einhorn was accustomed to companies turning hostile—anyone who wanted to be loved in the financial industry had no business selling shares short. He fired a tough e-mail right back: “I completely reject the notion that I have been disingenuous with you in any way. You had no reason to expect that our discussion was confidential in any way.” And then he finished writing his speech.

Einhorn stood in the wings of the Frederick P. Rose Hall in the Time Warner Center on May 21, waiting his turn to speak.

He had been scheduled to take the stage at 4:05 p.m., just after the markets closed—timing that had been carefully planned by the organizers of the conference. Given his stature within the industry and what he was about to say—and considering the firepower of the investors in the audience—he could easily rattle the markets, especially Lehman’s shares.

As investor events go—and there are many—this was one that genuinely mattered. The hedge fund industry is famously reclusive, but today the key players in the field were in attendance, the auditorium packed with industry titans such as Carl Icahn, Bill Miller, and Bill Ackman. By some estimates, the guests in the audience that day had more than $500 billion under management.

From the stage’s corner, Einhorn watched as his warm-up act, Richard S. Pzena, a successful value investor, was apparently finishing his speech, having run over his time allotment as he offered his big investment idea to the audience.

“Buy stock in Citigroup,” he instructed, suggesting that, at $21.06 a share, its closing price that afternoon, it was a screaming buy. “This is classic value. There is lots of stress,” he said. “When we come out of this, the upside is huge!”

If an investor had actually heeded that advice, he would have lost an enormous amount of money. But the audience applauded politely as it waited for the main event.

Beyond speaking about Lehman, Einhorn viewed his appearance today as an opportunity to promote his new book, Fooling Some of the People All of the Time , which stemmed from an earlier speech he had delivered at this very conference in 2002—a speech that had landed him in trouble with the feds. In it he had raised questions about the accounting methods used by a company called Allied Capital, a Washington-based private-equity firm that specialized in midsize companies. On the day after he criticized the firm, shares of Allied plunged nearly 11 percent, and Einhorn, at age thirty-three, immediately became an investing hero—and a villain to those he bet against.

After that talk, which happened to be the first public address he’d ever given, he had actually expected regulators to look into his accusations of fraud at Allied. Instead, the Securities and Exchange Commission started investigating him and whether he was trying to manipulate the market with his comments. For its part, Allied fought back. A private investigator working for the company obtained Einhorn’s phone records through a frowned-upon and potentially illegal approach known as pretexting—that is, pretending to be someone else in order to obtain privileged information about another person.

Einhorn’s battle with Allied had been going on for six years, but today, patient as ever, he would use his bully pulpit to take on a much larger opponent.

Einhorn finally placed his notes on the podium. As he surveyed the crowd, he noticed the glow of dozens of BlackBerrys in the first few rows alone. Investors were taking notes and shooting them back to their offices as quickly as possible.

The markets may have been closed for the day, but in the trading business, a valuable piece of information was worth its weight in gold no matter what the time. There was always a way to make money somewhere.

Einhorn opened his remarks in his slightly nasal Midwestern monotone by recounting the entire Allied story and tying that back to Lehman Brothers.

“One of the key issues I raised about Allied six years ago was its improper use of fair-value accounting, as it had been unwilling to take write-downs on investments that failed in the last recession,” he told the audience. “That issue has returned on a much larger scale in the current credit crisis.”

What he was saying was that Lehman hadn’t owned up to its losses last quarter, and the losses this time were bound to be much bigger.

After laying out his provocative thesis, Einhorn related an anecdote:

“Recently, we had the CEO of a financial institution in our office. His firm held some mortgage bonds on its books at cost. The CEO gave me the usual story: The bonds are still rated triple A, they don’t believe that they will have any permanent loss, and there is no liquid market to value these bonds.

“I responded, ‘Liar! Liar! Pants on fire!’ and proceeded to say that there was a liquid market for these bonds and they were probably worth sixty to seventy percent of face value at the time, and that only time will tell whether there will be a permanent loss.

“He surprised me by saying that I was right. He observed that if he said otherwise, the accountants would make them write the bonds down.”

From there Einhorn segued back to Lehman Brothers and made it clear that he felt the evidence suggested the firm was inflating the value of its real estate assets, that it was unwilling to recognize the true extent of its losses for fear of sending its stock plummeting.

He recounted how he had listened intently to Callan’s performance during her by now famous earnings call the day after the Bear Stearns fire sale.

“On the conference call that day, Lehman CFO Erin Callan used the word ‘great’ fourteen times; ‘challenging’ six times; ‘strong’ twenty-four times, and ‘tough’ once. She used the word ‘incredibly’ eight times,” he noted.

“I would use ‘incredible’ in a different way to describe the report.”

After that rhetorical flourish, he recounted how he had decided to call her. With a projection screen displaying the relevant figures behind him, he told how he had questioned Callan about the fact that Lehman had taken only a $200 million write-down on $6.5 billion worth of the especially toxic asset known as collateralized debt obligations in the first quarter—even though the pool of CDOs included $1.6 billion of instruments that were below investment grade.

“Ms. Callan said she understood my point and would have to get back to me,” Einhorn relayed. “In a follow-up e-mail, Ms. Callan declined to provide an explanation for the modest write-down and instead stated that, based on current price action, Lehman ‘would expect to recognize further losses’ in the second quarter. Why wasn’t there a bigger mark[down] in the first quarter?”

Einhorn explained that he had also been troubled by a discrepancy of $1.1 billion in how Lehman accounted for its so-called Level 3 assets—assets for which there are no markets and whose value is traced only by a firm’s internal models—between its earnings conference call and its quarterly filing with the SEC several weeks later.

“I asked Lehman, ‘My point-blank question is: Did you write up the Level 3 assets by over a billion dollars sometime between the press release and the filing of the 10-Q?’ They responded, ‘No, absolutely not!’ However, they could not provide another plausible explanation.”