Lehman Brothers and the crisis

On June 7, 2005, the then-new global head of fixed-income trading at Lehman Brothers launched a devastating attack on the U.S. housing market. It was "pumped up like an athlete on steroids," he said in an office meeting. Those muscles gave a "false impression of strength and in the end would not be sustained." Almost instantly the country's housing bubble began to deflate.

On Feb. 9, 2007, Lehman's global head of distressed trading publicly challenged the boss of its mortgage-securitization business, predicting that the "domino effect" of the collapsing housing market would damage the banking sector. He gave warning that Lehman, with its trillions of dollars of debt and high exposure to mortgage-backed securities, was at risk. You don't know what you are talking about, the head of mortgage securitization told him.

Both Lehman traders were right in their gloomy prophecies. Had they been heeded by the investment bank's bosses, perhaps Lehman could have been saved. But both quit, derided for their bearishness. They later returned in a last-ditch effort to rescue the ill-fated investment bank, after a coup weakened Chairman and CEO Richard Fuld and ousted his longtime crony, COO Joe Gregory. But by then it was too late: Lehman Brothers filed for bankruptcy Sept. 15 last year, becoming the best-known casualty of the financial crisis.

Many blame the sycophantic "court of King Richard" for Lehman's undoing. To feed his desire for ever-bigger bonuses, Fuld encouraged the use of borrowed money to take big bets on rising property prices. He did not help matters by riling Hank Paulson, the former boss of Goldman Sachs turned treasury secretary, at a private dinner in early 2008.

Though Paulson encouraged Lehman's boss to sell the firm, Fuld came away with a different message. "[W]e have huge brand with [T]reasury," he swiftly wrote in a now-famous memo. This smug disregard of what was more an order than advice perhaps strengthened Paulson's resolve to let Lehman go bust -- a decision that was to prove catastrophic within days as the entire financial system panicked.

That, at least, is how Lawrence G. McDonald tells it. The former Lehman trader's inside account of the investment bank's collapse has been branded by Fuld as "absolutely slanderous."

It would come as no surprise to learn that McDonald (who wrote his account with Patrick Robinson) has taken some liberties in his highly readable yarn. He provides no sources for scenes that take place after he was fired in early 2008, many of which show Fuld in a particularly bad light.

What history? The silly notion that history and precedent have no bearing on contemporary finance is at the root of what Carmen M. Reinhart and Kenneth Rogoff call "eight centuries of financial folly." The two economists' book is no page-turner, though it is much more readable than the academic research it draws from. But it is essential reading.

The authors identify several red flags that indicate a looming financial crisis (such as house prices rising in tandem with increased debt-to-income ratios), many of which were visible in the run-up to Lehman's demise and the panic that followed.

Even more worrying is their evidence of just how damaging banking crises tend to be, and how long it takes to recover from them.

Reinhart and Rogoff do not expect a quick recovery this time. Nor do they expect their proposed reforms to prevent future crises, though they could make them less frequent. As they say, "The persistent and recurrent nature of the 'this-time-is-different' syndrome is itself suggestive that we are not dealing with a challenge that can be overcome in a straightforward way."

The problem lies in the human tendency to forget the lessons of the past.