Too Big to Fail [59]
Einhorn called in the seven analysts who worked for him 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 subprime exposure. 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. He had arranged a call to Lehman to get a better handle on the company’s numbers, and like many firms do as a service to big investors, it made some of its top people available.
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