The Devil's Casino: A Morality Tale of the Rise and Fall of Lehman Brothers

Apres le scandale, les livres. The latest on the collapse of Lehman Brothers is Vicky Ward's The Devil's Casino. The complimentary copy sent to me for review by the publisher, John Wiley & Sons Inc., comes in a dust jacket depicting a deck of cards with the joker face up. The imagery is a propos, and the book presents a gripping, page-turner of a tale. But there's much more to this book than a story about exceedingly wealthy bankers taking undue risks in the heedless pursuit of shameless self-aggrandizement. It presents a morality tale, not just about people, but also about organizations and their life cycles.

Here's an overview of the book. In the mid-1980s, Lehman, a proud and distinguished mid-sized investment bank, sold itself to Shearson American Express. The senior management of the old Lehman mostly left. Taking over as the management of the newly acquired subsidiary were Richard Fuld and his deputy, Christopher Pettit. In the middle of their careers, these two men were suddenly dislocated and had to adjust to new bosses and a new corporate culture. Pettit, a West Point graduate and decorated Vietnam War combat vet, had built up the highly successful commercial paper operation at Lehman, instilling in it the sense of solidarity found in elite military units. Apparently driven by loyalty to his people as well as the realization that his future success likely depended on keeping them together, Pettit risked his career by insisting to his new bosses that the commercial paper operation be kept together. Noting how profitable Pettit's operation had been, Shearson's management reluctantly acquiesced.

Fuld and Pettit joined together to maintain a de facto Lehman inside Shearson (with some personnel persisting in answering their phones "Lehman"). Fuld took on the difficult task of alternately staving off and then cultivating Shearson's management, a job for which the plainspoken Pettit had no appetite. Pettit, in turn, managed "Lehman's" day-to-day operations inside Shearson, with close friends from his early days at the firm reporting to him. The division of duties played to both Fuld's and Pettit's strengths, and "Lehman" prospered.

Even as "Lehman" prospered, Fuld and Pettit began to change. Fuld, successful as a hands-on trader, became isolated as a senior executive. One vignette recounted in the book has him ordering shirts from the L.L. Bean catalog during the work day. Fuld also sought to acquire the polish and poise of Wall Street's executive elite, taking self-improvement training and, most importantly, scrutinizing and learning from the most talented men around him. He let Pettit handle daily operations; Fuld's focus was upward, geared toward advancing his career.

It's less clear how and why Pettit changed. As the firm grew, he may have been frustrated by his inability to supervise thousands of employees with the close, personal style he had previously used in successfully overseeing hundreds. His marriage to his high school sweetheart deteriorated and he took up with another woman who worked at "Lehman." This affair grated with the family-oriented culture at the "firm," which Fuld in particular sought to instill. It also marred Pettit's image, as the man who had symbolized the best in the "firm" revealed his feet of clay.

"Lehman's" pugnacious independence not surprisingly led Shearson American Express to spin it off, after ten years. But independence seemed to bring out the unattractive side of Lehman's senior executives. Fuld evidently saw the firm as the ticket, not only to wealth, but also the recognition that would come from being the CEO of a top tier Wall Street firm. He made the firm's growth a priority. He also became increasingly insecure about Pettit, whose charisma and leadership abilities Fuld could not match. Pettit was the one person in the firm who could compete with Fuld for the top job.

At the same time, Pettit's relationship with his lieutenants apparently frayed, perhaps because of his affair, and in part because of the inevitable vicissitudes of the markets. One example recounted in The Devil's Casino is the Mexican peso crisis of 1995, for which Lehman had $5 billion of exposure, a significant amount for the recently spun off firm. Pettit held Joe Gregory, then the head of fixed income, responsible for the unexpectedly large size of this exposure (Pettit had known of $1 billion). Pettit took to dressing Gregory down on a weekly basis. Gregory had previously been one of Pettit's closest friends at the firm, but the now their friendship fractured. Exactly why Pettit was so angry isn't clear; perhaps it was Pettit's military background subconsciously influencing his perception of events. For a combat unit to survive and be effective, every member must do his job. Otherwise, the entire unit may be imperiled and wiped out. Excuses and explanations don't resurrect dead soldiers; performance of one's duties is essential. Friendship is subordinated this imperative, because failure on the battlefield can be so costly. Pettit may have overreacted, from the viewpoint of a civilian dealing with a firm's misguided investments. Gregory evidently bore scars from this castigation, and, as Ward tells the story, later served as the Judas Iscariot who engineered Pettit's downfall.

Whatever Pettit's motivation, he was losing support within the firm and there were plenty of people who thought they would benefit if he departed. Fuld, although nominally the CEO, seemingly did not have the gumption to force Pettit out. He acted only when pushed by a conspiracy, comprised of Gregory and others among Pettit's lieutenants. Pettit was demoted and soon departed, tragically dying shortly thereafter in a snowmobiling accident.

As described in The Devil's Casino, Pettit's departure marked the moment when Lehman became engulfed by the atavistic impulses of lesser men than Christopher Pettit. Fuld did not immediately replace Pettit, leaving the Chief Operating Officer position open for several years. Yet, he stayed aloof from daily operations, with the firm being managed through a committee composed of the heads of the major operational units. This structure may have been conducive to promoting profitability (Fuld's uppermost goal). But it left matters crucial to the organic health of the firm as a whole, such as risk management, at a disadvantage. When Fuld eventually selected a COO, it was Joe Gregory, whom Fuld did not regard as competition for the CEO position.

The rest of the story, told in substantial and engaging detail, is well-known in its overarching features. Lehman endeavored to be David among the Goliaths of Wall Street, scoring some successes that only fueled management's hunger for more favorable headlines. Risk management came to be viewed as tiresome, and risk managers received less of management's attention.

By the early 2000s, Lehman had fallen hard for the allure of real estate, betting more and more of its balance sheet on a seemingly golden goose of an asset that kept increasing in value. Fuld's sound instincts as a trader evidently abandoned him, and Lehman piled into real estate while the smarter firms were pulling back. As the mortgage crisis unfolded in 2007 and 2008, astute players, such as short seller David Einhorn, began questioning Lehman's strategy. The firm changed CFOs, installing the attractive but not well-qualified Erin Callan as the new CFO. Although she was remarkably poised and momentarily effective in presenting the firm as solvent, her short tenure ended after a few months when the firm had to report $2.8 billion in quarterly losses, its first publicly reported losses ever. What may have been the firm's last ditch effort to substitute image for substance failed, and the die was cast. Although Fuld belatedly realized that he needed to improve the quality of the firm's management, he could not undo the firm's gargantuan real estate exposure. Lehman's new management, which included alumni previously shoved aside by the prior management, couldn't save the firm when its short term funding fled, and it was forced to seek the protection of the bankruptcy courts.

The Devil's Casino covers familiar issues, such as the dependence of Lehman and other Wall Street on short term funding to make less than liquid investments, and the federal government's decision not deploy taxpayer money to bail out Lehman. However, the longer story it tells, of the late 20th Century Lehman's origins as subsidiary and then spin-off of Shearson American Express, illustrates issues that haven't received as much coverage.

Lehman's evolution, first as a unified upstart led by a charismatic leader, and then as an increasingly dysfunctional real estate investor, exemplifies how organizations become strong, grow, prosper, but then lose focus, weaken and fracture. This is a story seen many times in many organizations. But it's a singularly important problem when it happens to financial firms with wide-ranging exposures throughout the financial system. Ward's depiction of a distant CEO who drives out the most capable man in the organization belies Wall Street's claim to believe that its people are its real capital. Wall Street firms, like so many other organizations, are susceptible to the machinations of office politics, where the well-being of the organization is subordinated to the personal interests of a few at the top. When this happens at a money center bank with worldwide exposure, the potential consequences to society and taxpayers may be painful.

What does this imply? First, boards of directors of major financial institutions have to be more proactive about the quality and style of management. It is in fact true that people are a Wall Street firm's real capital. A CEO who can't maintain the quality of personnel, or even worse forces out the best, needs encouragement to pursue other interests. While most corporate boards wouldn't regard personnel management to be within their normal duties, directors of major banks should be more assiduous. Lehman's directors scarcely manage occasional cameo appearances in The Devil's Casino. Perhaps they played a larger role than depicted in the book. But as far as a reader of The Devil's Casino can tell, there was no meaningful check or balance on the way Fuld performed his job. Thus, Lehman's viability as a firm was exposed to Fuld's individual weaknesses.

Another consideration is that federal regulators need to be more attentive to the quality of management. This is not a new problem for the Federal Reserve. The Fed has the authority to remove officers of banks under its supervision for specified statutory reasons, and from time to time has exercised this authority. Typically, the Fed informally signals its displeasure with a particular banker, and the astute bank removes the offending individual before the Fed feels the need to take formal action. Under the systemic risk monitoring responsibility that may soon rest with the Fed, regulators must recognize that risk taking is often a matter of personality and ambition, not just employee incentives and trading strategies, and they should be prepared to remove any individual executive or group of executives who might, with the enormous resources of a major bank, put the financial system in jeopardy.

Ultimately, the responsibility for maintaining the vitality of an organization rests with management. In this respect, The Devil's Casino offers an in-depth study of a failed organization for executives elsewhere to ponder. Whatever Dick Fuld intended, he didn't intend for Lehman to fail so spectacularly. CEOs everywhere should view his fate as an object lesson. To make an organization succeed, the top executive must understand that the organization is greater than he or she, and its needs and welfare supersede his or hers. If you want to be a rock star, learn to play the guitar. If you think you can use an organization to reach the klieg lights, remember Dick Fuld.

The Devil's Casino is written in a readily accessible, fast-paced style that Vicky Ward likely honed as a contributing editor of Vanity Fair. While this is a serious book that tells a serious story, those inclined to indulge, perhaps just occasionally, in voyeuristic schadenfreude will not be disappointed by vignettes about a senior executive's wife having a walk-in shoe closet larger than a store, the sartorial conformity expected of senior executives, the ruthless pecking order among management's wives, and the Prussian discipline expected of Lehman wives when it came to the firm's interests. The book synthesizes an enormous amount of information in an impressively coherent way. We offer a minor suggestion that the three references to "Robert Rubin" be clarified to distinguish Robert S. Rubin, formerly a senior partner of Lehman who is mentioned twice (the first two times), from Robert E. Rubin, former Co-Chairman of Goldman Sachs, then Secretary of the Treasury and then a director of Citigroup, who is the third reference to Robert Rubin (and correctly identified as a former Secretary of the Treasury but not distinguished from the earlier references to "Robert Rubin").