Lehman Trader Bares ‘Dark Secret,’ Hits the Road, Mimics Munger

Lawrence G. McDonald, the bond trader who wrote the inside story on Lehman Brothers Holdings Inc., twists his face into a curmudgeonly grimace to imitate Charles Munger of Berkshire Hathaway Inc.

“I’ve seen you on CNBC, Larry, and you’re hard on all this proprietary trading on Wall Street,” he growls. “But that’s what you were doing at Lehman.”

It’s 10 a.m. at the Hotel Amigo off the Grand Place in Brussels, and McDonald, 44, is dropping names and laughing at a friendly ribbing that he says Munger gave him about “A Colossal Failure of Common Sense.”

Since the book came out last July, McDonald has taken to the lecture circuit. He arrived from Monaco in the wee hours and has now folded his lanky frame into a leather banquette and ordered tea and croissants. He has come to the humid capital of Europe for a panel on the future of finance, where he doesn’t hesitate to plug his book and website.

Looking crisp in a dark suit and aqua tie, he discusses Barack Obama’s regulatory setbacks, John Paulson’s bets against the bubble, and Lehman’s “dark secret.” Munger declined to comment on their meeting.

Pressley: What happened to Obama’s regulatory overhaul?

McDonald: Obama had Wall Street in a full nelson -- face on the mat, grinding it in. And Wall Street has just done the kind of incredible reversal you see in Olympic wrestling.

One of two things happened: Either Wall Street’s $400 million in lobbying is paying off. Or maybe the banking system is in much worse shape than they’ve led people to believe.

‘Tale of the Tape’

If you did the tale of the tape for Wall Street, here’s what you’d get. Rating agencies: a massive loss for Obama. Proprietary trading: another loss. The original Volcker rule would have forbidden banks to trade for their own accounts. Now they’re saying, “OK, you can prop trade so long as your original trades are with a customer.”

Pressley: Why not just bring back Glass-Steagall?

McDonald: That’s what I wanted. This came up when I sat down with Munger during Berkshire’s annual meeting. He read the book, but ribbed me because it shows Larry McCarthy and me prop trading.

But we were prop trading small. We had a position in Delta Air Lines bonds with a face value of $700 million, but the bonds were at 20 cents on the dollar. It was 0.20 times 700 million. These were little ant trades compared with what our mortgage traders were doing. Their hedges were 10 times ours. That’s what took down Wall Street.

Lehman’s Derivatives

Pressley: What about the derivatives legislation?

McDonald: The original plan was to spin derivatives off into a separate company. That’s not happening. And there’s no clear language on how much capital they’ll have to put up against the derivative book.

Lehman had about $6 trillion, notionally, in derivatives. We didn’t have anywhere near the reserves necessary to protect ourselves. If John Paulson came to us and wanted to buy $1 billion worth of credit-default swaps on Washington Mutual, our guy had to find the other side of the trade.

But you can’t always find the other side. So out of the $6 trillion book, a certain amount was offset and a certain amount wasn’t. The question is: Did we have the reserves for the part that wasn’t? This legislation doesn’t address that.

Pressley: Tell me about Paulson.

McDonald: The first time I heard his name was in late 2006 or so. We were putting on these short trades against the housing bubble. Our department would go to our derivatives trader and say, “We want to buy protection on a basket of names -- say $1 billion on Washington Mutual and $500 million on Countrywide for a start.”

Paulson’s Truck

He did the first $200 million or so, but then he said, “There’s an elephant in front of you.”

“Who?”

“This guy Paulson is backing up the truck on a lot of these names.”

We didn’t have the sophistication to do what the great traders were doing. They were buying default swaps on CDOs.

Pressley: Like Michael Burry.

McDonald: Brilliant. We were throwing spears; he had a Gatling gun.

Pressley: What did you think when the German government banned naked short selling?

German Panic

McDonald: It was a knee-jerk reaction, almost a panic.

Think about it. Lehman had a $660 billion balance sheet; $300 billion of it was in Treasuries, commercial paper and agency paper. Imagine if those went down 10 points. It would’ve made Lehman’s losses on commercial real estate look like chicken feed. Now imagine if all the euro zone government bonds went to 85 cents on the dollar. The losses in banks would be unfathomable. That’s why they did that ban.

Pressley: What was Richard Fuld’s gravest error?

McDonald: His gravest error was sticking by Joe Gregory and not aligning himself with more talent.

They had a deep, dark secret on the 31st floor: They didn’t want to be exposed for all they didn’t understand. Sun Tzu says in “The Art of War” that if an emperor lives in fear of his own men it’s a sign of supreme incompetence.

“A Colossal Failure of Common Sense: The Inside Story of the Collapse of Lehman Brothers” was written with Patrick Robinson and published by Crown Business (351 pages, $27). Also available in paperback from Three Rivers in the U.S. and from Ebury in the U.K. ($16, 7.99 pounds). To buy this book in North America, click here.

(James Pressley writes for Muse, the arts and leisure section of Bloomberg News. The opinions expressed are his own. This interview was condensed from a longer conversation.)

To contact the writer on the story: James Pressley in Brussels at jpressley@bloomberg.net.

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