The three of us just stood there. And for once Larry was lost for words. He looked straight at Alex, nodded curtly, and held out his right hand. I watched them shake. I witnessed an unspoken bond forged between them. And it was not convertible. We might as well, all three of us, have cut our thumbs with a bowie knife and allowed our blood to mingle, because right there outside that conference room we three had locked our minds into a potential mutiny. And it was one I think we all sensed might one day save this organization, which to a man we believed could be heading for very serious trouble.

Larry finally found his voice. "Alex," he said, "I could not agree with you more. This property market has to be on borrowed time. And we have to get the h.e.l.l out. Couldn't you just smell the hubris in there, that mindless f.u.c.king smugness?"

Alex Kirk nodded. I had rarely seen him look this concerned. And it should be understood that he was a huge presence in the corporation. He was a fifteen-year Lehman veteran, dedicated to the cause. Deservedly, he was an extremely wealthy man. He lived in the most beautiful oak-paneled apartment, with a unique Asian theme, on the Upper West Side of Manhattan, overlooking Central Park. He had an outstanding fine art collection. He was the precise opposite of Richard Fuld, because Alex really liked all of his people, and liked to take them out to dinner, to talk and scheme. (Funny, but even over the sirloins you automatically stayed on your toes in the company of our leader.) He loved to mingle and share thoughts and plans. The 7:00 A.M. A.M. meetings were his idea. Communication was one of his many strong suits, and I was always thrilled to be taken into his confidence. Just standing there with the great man, sharing a sacred trust, wondering if perhaps we three alone stood square against the forces of evil, was an honor I still remember and treasure to this day. meetings were his idea. Communication was one of his many strong suits, and I was always thrilled to be taken into his confidence. Just standing there with the great man, sharing a sacred trust, wondering if perhaps we three alone stood square against the forces of evil, was an honor I still remember and treasure to this day.

But I cannot explain how deadly serious this was. Alex Kirk was thinking on his feet as fast as he knew how. He was developing a strategy, and he wanted it put into play right away. "Okay, guys," he told us, "get straight down to the a.n.a.lysts. Let's locate the major home builders with the highest debt leverage, plus the ones with the most exposure to first-time buyers. We need to get some huge short positions, because if this f.u.c.king thing blows, it could take everyone down with it. We have to get hedged out there."

We retreated downstairs, heading for the researchers. Jane Castle was completely preoccupied with two airlines, Northwest and Delta, both of which she believed might go bankrupt before the end of the year. And Christine Daley was up to her ears with General Motors, which she thought could not survive and might take down half of Detroit with it. So Larry and I grabbed Rich Gatward and we put a.n.a.lysts Karim Babay and Pete Hammack on the case, telling them to research the biggest home builders, particularly the ones that were active in California's Central Valley and carried hefty bank debt. In the next few hours Pete pulled them up onto his screen, scanning the building projects in the nation's property hot spots-Marin County, north of San Francisco; the vast developments in the desert outside Scottsdale, Arizona; Florida's Broward County, which sprawls to the west of Fort Lauderdale, in the southern part of the state.

I took a look at Broward County on the map and noticed it included a huge area of the Everglades. I asked Pete whether he thought the G.o.dd.a.m.ned alligators might default on their mortgages, but he treated the remark with the contempt it obviously deserved. He said he had no direct information on that, but there were a lot of stats proving that seventy thousand people a day were going to live in Florida, and so far as he could tell, none of them were alligators.

The housing boom was so widespread it was difficult to know where to start. But we kept coming back to California, and that invariably led to the central part of the state, especially along Route 99, the original old two-lane highway that starts just south of Bakersfield and runs to Sacramento, 350 miles to the north. Along the way, Route 99 snakes through the more populated eastern portion of the Central Valley, towns such as Visalia, Fresno, Merced, Modesto, and Stockton.

One name kept popping out at us: the publicly traded Beazer Homes USA, an Atlanta-based builder currently responsible for literally thousands of new houses. Beazer was operational in twenty states, with the modern specialty of selling dwellings right from the plans, complete with one of the smorgasbord of exotic mortgages, especially the no-doc. But what set this builder apart was that they had purchased a mortgage company, which slotted it into the most dangerous territory, that of vendor financing-they were both building the homes and lending people the money to buy them. Every a.n.a.lyst on Wall Street understood that this was a highly risky procedure. "If this goes wrong," said Pete, "they'll go down in flames." He pointed out their balance sheet, which was currently showing long-term debt of $1.275 billion.

In addition, Beazer was about to issue a brand-new $300 million senior unsecured bond, with a 6.875 percent coupon. This was a cla.s.sic example of a corporate bond, not secured by a.s.sets, being pushed out there to investors, just 300 bips wide of Treasuries-hardly any reward for the risk of such a bond from a corporation already in the hole for more than $1 billion, and trying to lay hands on $300 million more. Just to give you a snapshot of the amount of money involved, $1 million stacked up in $100 bills is a couple of feet high. A billion is more than three times as high as the Washington Monument.

And this was not an AAA-rated bond. Fitch Ratings had stated in the past few days that the Beazer Bond was BB+, hardly a riskless investment. And this suggested we were not the only ones wondering whether Beazer could actually handle this new $300 million debt, which was about to land like a cement mixer on their balance sheet.

But the strongest feeling I had about this construction giant involved the bodybuilders. Most home construction companies worked with the big brokerage houses and had a fairly tenuous connection with the fast-talkers out there selling mortgages. But Beazer actually owned them: it hired them, paid them, nurtured them, prepared their mortgage sales packages. And since neither I nor Larry, and certainly not Alex, trusted those sun-bronzed cowboys one inch, I was a.s.sailed by a feeling that I didn't trust their bosses much either. In my view, Beazer was surviving only because of the housing market, and if that market shifted, these guys could easily get caught with their girders around their ankles. My own view was that we should short Beazer, because it did not require a ma.s.sive stretch of the imagination to envision a sudden housing slowdown, as perhaps supply might overrun demand. At which point there might also be a hefty number of first-time buyers starting to default when the mortgage resets began to kick in. This could leave an outfit like Beazer hanging out to dry with several thousand unsellable homes in a falling market. For a company with $1.3 billion in debt, that would almost certainly prove fatal.

Larry called a meeting for the following morning, to be attended by Rich Gatward and Karim Babay Alex, if he was in the building, would very definitely sit in. The discussion would center around one of Karim's charts, which showed the Beazer sales graph climbing straight up the side of the mountain the way Yahoo's stock price had in 1999.

We checked all the data, and from where we sat it looked like Beazer was planning to pave over the entire California Delta. They were building everywhere, hundreds of people were already in their new homes, and presumably some of them were starting to pay for them. Karim understood our intentions but was uncertain whether a huge trading short on the corporation was justified. We, however, whose entire expertise was in the distressed-debt market, could see the signs, and Larry McCarthy was all set to throw a barrel at them, because Beazer was the one company that fitted all of our criteria. We decided to deploy 100,000 shares at $75 each and wait for the property market to cave in, which we thought it surely must. The only problem was, when?

Larry McCarthy took out $500 million worth of protection in the form of a five-year credit default swap. That meant he agreed to pay a 1.8 percent* carry on the $500 million, which was $9 million annually. However, if Beazer filed for bankruptcy, Lehman would be paid the $500 million, carry on the $500 million, which was $9 million annually. However, if Beazer filed for bankruptcy, Lehman would be paid the $500 million, provided the counterparty on the other side of the trade had the ability to pay. In addition, we all bought equity options-another bet that Beazer would crash, but in this case in the form of puts, which came into play if the stock went down. provided the counterparty on the other side of the trade had the ability to pay. In addition, we all bought equity options-another bet that Beazer would crash, but in this case in the form of puts, which came into play if the stock went down.

That meant we'd unleashed all our artillery at this Atlanta builder: the shorts, the swaps, and the puts. And all because each and every one of us had an instinct that the real estate bonanza would probably not continue, and we suspected those mortgage resets could bring the whole market to its knees in the not-too-distant future. In a strange way, the guys upstairs making all the money while the going was good were our Public Enemy No. 1, because their risks were gigantic, and they appeared not to sense the potential danger.

When a high-rolling market goes wrong, history tells us it happens with lightning speed, as everyone stampedes for the door at the same time. Just imagine if Lehman was caught with a half dozen of those billion-dollar mortgage securitizations, the CDOs. Imagine if suddenly the guys who walk on water were no longer able to sell those CDOs, if the market just dried up because the defaults were too great in number. Holy s.h.i.t! That really could be goodnight Vienna. Trouble is, when things have gone so right for so long, some traders tend to go soft, often failing to keep their guard up, failing to dodge the bullet that would kill them.

I'd never heard one sentence from any of the mortgage guys that would suggest they were ready to take cover in the event of a market correction. In fact, we were once more hearing rumors that Lehman was giving serious consideration to the possibility of buying New Century, the California mortgage brokerage.

I remember walking home after our meeting and reading a report Jane had given me. It actually caused me to stop dead on that summer evening and give thought to the possibility that the entire world had lost its marbles. It was an account of some Miami high-rise that had not yet been built, and there were reports of real estate speculators actually buying off the plans, holding the "apartments" until the foundation was laid, and then selling at a profit. Buying property and then turning around and selling it for a quick profit is known in the trade as flipping. But in the past, most people used to ensure there was some real estate to flip. What was going on in Miami wasn't flipping real estate. It was flipping fresh air. There was no real estate, just a 3,000-square-foot pocket of warm air twenty-three stories above the ground where one day an apartment was planned to be.

But what really caught my eye was the fact that this was apparently being done online. The deals were being conducted in cybers.p.a.ce. The buyers had never even seen the building site, probably never even been to Miami. And they were making money from some computerized selling network hundreds of miles away. This was not a raging bull market where great fortunes were being made by the shrewdest operators. This was nut country, a simple demonstration that the whole property world appeared to have gone mad. I stood there on Seventh Avenue wondering whether that empty s.p.a.ce up in the sky somewhere over South Beach had increased in value in the few minutes I'd been goofing off on a Manhattan sidewalk.

*Lehman's biggest derivative positions were in RMBS (residential mortgage-backed securities). While technically not a CDO, we will, for the sake of simplicity, refer to them as CDOs throughout the remainder of this book. (A CDO can contain many different types of financial a.s.sets, including mortgage-backed securities, corporate bonds, and credit card receivables.)*Amazingly AAA-rated CDOs yielded only 10 to 15 basis points more than U.S. Treasuries in July 2006. AA-rated CDOs yielded 20 to 25 basis points more. One hundred basis points is equal to 1 percent.*Lehman would be paid the $500 million, less the recovery rate on the bonds.Beazer Homes' five-year CDS spread in 2005 was on average 180 basis points over the London Interbank Offered Rate (LIBOR). When an investor buys $500 million of CDS on a corporation like Beazer Homes, unlike buying a bond, the CDS investor (our counterparty on the other side of the e-trade) does not have to put up $500 million in cash. We, as buyers of the CDS protection, are simply responsible for paying a premium (or cash flows above LIBOR to the counterparty) and can get paid as much as the face value if the corporation defaults. So in the Beazer example above, we were responsible for paying the 1.8 percent per year of $500 million at the time of this trade.

6.

The Day Delta Air Lines Went Bust I called the same price, 16 cents, and then we got hit again. Another five million, and then again. Instantly I dropped the price-"Fifteen, seventeen!" And our client took it. "You're done!" I yelled.

ON MONDAY, June 6, 2005, at 2:03 in the afternoon, I received one of those e-mails that June 6, 2005, at 2:03 in the afternoon, I received one of those e-mails that really really mattered. It came directly from Alex Kirk, and it announced the special nature of the next day's 7:00 mattered. It came directly from Alex Kirk, and it announced the special nature of the next day's 7:00 A.M. A.M. meeting of the traders. There would be a guest speaker: Mike Gelband, a newly promoted Lehman managing director and global head of fixed income, a man most of us hardly knew. I'd seen him only two or three times before, spoken to him once, But Mike's immense reputation had preceded him. meeting of the traders. There would be a guest speaker: Mike Gelband, a newly promoted Lehman managing director and global head of fixed income, a man most of us hardly knew. I'd seen him only two or three times before, spoken to him once, But Mike's immense reputation had preceded him.

He was a twenty-year Lehman veteran, mid-forties, with a closely shaved head and gold-rimmed gla.s.ses. Six feet tall, broad and athletic, Mike reminded me of Steve Seefeld-you did not instantly know how clever he was, but you sure as h.e.l.l knew he was a lot cleverer than you. He was one of the best and bravest traders in Treasuries and mortgages Lehman had ever had, a corporate icon. It did not matter which department you worked in, you knew precisely who Mike Gelband was. And when he spoke, people stopped what they were doing and listened.

Mike had earned his MBA in 1983 at the University of Michigan, home of the Wolverines. He graduated from the celebrated Ross School of Business, long ranked among the top five business schools nationally and considered by the Wall Street Journal Wall Street Journal to be "very probably No. 1." to be "very probably No. 1."

Mike lived out in fox-hunting country in Short Hills, New Jersey, with his wife and four children. On our floor, he occupied the northwest corner office, and was reputed to be one of the hardest, most meticulous workers in the entire building. He was an "inside man" and not naturally inclined to spend time with people socially. He played a lot of poker, which I think suited his temperament, because Mike was a studious character, somewhat like Bill Gates-not quite a financial geek, but close. To this day, I've never met anyone who could grab and comprehend a difficult new idea faster than Mike Gelband.

Anyway, he was to be our special guest speaker, and there was something about the way that e-mail was written that suggested Alex Kirk understood this was not likely to be a routine Tuesday morning gathering. Alex actually showed up at my desk in person about twenty minutes later to make sure Larry McCarthy and I understood this was a very important meeting and to make certain we would be there. Some of the guys occasionally skipped the Tuesday morning get-together because of domestic stuff like taking the kids to school. June 7 would not be one of those Tuesdays.

During the day, I was surprised how few people expressed curiosity about the Gelband meeting, believing it was just to introduce him on the heels of his new promotion. That was not quite how I read it.

It quickly became apparent that all the high-yield, distressed-debt, and high-grade traders were under orders to attend. Christine and Jane both told me they would be there, and so would almost every other research a.n.a.lyst on the floor. Alex Kirk's e-mail had stated there would be a half-hour presentation from Mike and then a fifteen-minute question-and-answer period.

And so, on that warm, clear June morning, shortly after 6:45 A.M. A.M., we gathered in the third-floor conference room. There must have been forty-five of us in there, all the traders and researchers, and anyone who could not tell this was an important briefing simply did not possess antennae. The atmosphere was charged. Alex Kirk was already seated when Larry McCarthy and I arrived. Mike Gelband was right next to him, and the two of them were in close conversation. Before them was a pile of presentations, which were immediately distributed among us. They were about thirty pages thick.

When the last person arrived and the clock clicked over to 7:00 A.M. A.M. precisely, the door was closed. It was as close to a special forces military briefing as anything I'd ever attended. I was rather surprised our cell phones were not confiscated, thus severing all connection with the outside world. precisely, the door was closed. It was as close to a special forces military briefing as anything I'd ever attended. I was rather surprised our cell phones were not confiscated, thus severing all connection with the outside world.

With the presentations now before us, virtually unread but intended to be a permanent record of the proceedings, Mike formally, and unnecessarily, introduced himself as Lehman's new global head of fixed income. There was not a soul in that room who did not understand exactly who he was.

As a hotly illuminated example of failing to beat about the friggin' bush, this one was right up there. Mike said flatly that in his opinion the U.S. real estate market was pumped up like an athlete on steroids, rippling with a set of muscles that did not naturally belong there. Those muscles gave a false impression of strength and in the end would not be sustained. He pointed accusingly to a ma.s.sive amount of leverage in the system: money that was not real money, home prices that were not real prices, mortgages that were not grounded in any definition of reality with which he was acquainted.

He cited the shadow banks, the vast complex network of mortgage brokers that were not really banks at all but managed somehow to insert themselves into the lending process, making an enormous number of mortgages possible while having to borrow the money themselves to do so. He cited outfits such as Countrywide, New Century, HBOS, and NovaStar, among others, and he accused them of creating well over $1 trillion worth of economic activity that was comprehensively false money and would never never be converted into genuine economic power. be converted into genuine economic power.

You could see by the faces around the table that many members of the gathering found this somewhat bewildering. But Mike continued relentlessly. "Many U.S. economists are completely out of touch," he said. "They do not understand derivatives in the property business and how those derivatives provide a huge and totally unacceptable stimulus to the economy. Unacceptable because they are demonstrably false. But in effect they are more powerful than a Reagan-Laffer tax cut because they make everyone feel richer; they make people believe they are richer."

He had something like twenty a.n.a.lysts led by the highly respected Shrinivas Modukuri working on this study of the causes and effects of the real estate boom and how it was being conducted out there in the market. Gelband knew all about the bodybuilders and their methods. He knew all about the exotic mortgages and the way they were being sold to the lesser intellects of the American population. He cited the interest-only loans, the no-down-payments, the no-docs, the negative amortization loans (that's the one where the loan gets bigger as you pay), and the optional ARMs, which gave you a good cheap run for a couple of years and then knocked you clean out of the box with huge rate rises on the reset. His study concluded that by the end of the current year-2005-one-third of all mortgages issued in the United States would be of the highly dicey, buy-now-pay-later variety. His a.s.sessment suggested that the number of buyers obtaining mortgages but putting down no money would almost double compared to 2003. In his view this was a nuclear-fueled catastrophe waiting to happen.

He a.s.sured us that the bodybuilders were earning double commissions on these mortgage sales and were thus operating with incentives beyond all known reason. They just needed to sell, collect their double commission, and press onward to the next victim. The consequences were relevant neither to them nor to their employers, who were merely selling the mortgage packages to Wall Street. That was us, in case anyone hadn't noticed. Not a one of them, neither the commission guys nor the mortgage brokerage houses, shared one iota of the responsibility should the homeowner, for any reason whatsoever, find himself unable to make the repayments. In Mike's opinion, this process posed the greatest threat to the U.S. economy, and it would hit home in 2007 and 2008. "You cannot," he said, "model human behavior with mathematics. There's no computer model that will ever tell you whether someone will pay their mortgage. And there never will be. The risk will always be there. You cannot calculate it. Risk and reward are beyond the intellectual limits of a computer."

In the meantime, so far as he could tell, there was already a rapid increase in the number of homeowners who were starting to draw equity out of their properties in this sensational rising market. A new phrase was creeping in: HELOC, home equity line of credit. It referred to the process of turning your home into an ATM machine, drawing out cash against its rise in value. That's the extra money not required to collateralize the mortgage. Might as well cash in, right? Mike's guys were estimating this ATM extraction against homes in 2005 would hit $200 billion, and the next year $260 billion.

His report also demonstrated an enormous amount of discretionary income going into homes over the next three years. "It's a figure that will skyrocket," he said. "And it's all leverage, essentially false money from false housing prices and false mortgages that may never be paid." Mike was plainly appalled by the research showing that ma.s.sive mortgage resets would be occurring soon: a total of probably $325 billion resetting to higher rates in the next twelve months, and $490 billion over the next thirty-six months. He wanted to know what the h.e.l.l good it was to reset a guy's mortgage rate from a repayment of, say, $400 a month, the teaser rate, to $2,000 a month if the rate shot up to 8 percent or $2,500 if it went to 10 percent. What the h.e.l.l was that all about? A G.o.dd.a.m.ned baboon could tell you the poor b.a.s.t.a.r.d couldn't pay it. I have to say, the room was stone silent, transfixed by the sound of Mike's voice.

Next he turned his firepower on the f.e.c.kless government mortgage giants Fannie Mae and Freddie Mac, which had issued their own estimates of that ATM number over the next couple of years. In a gigantic discrepancy, they were billions of dollars on the light side, and Mike plainly regarded those estimates with the same unbridled contempt we all had for Fannie's recent balance sheet, which had misstated its profits by a mere $2.7 billion-nothing serious, obviously. Mike blew their ATM estimates out of the water and declared the new financial mortgage products were masking the actual leverage debt in the U.S. economy. He pointed out that steep resets signaled some kind of death march for mortgage holders, because if they didn't meet the new minimum payment, the princ.i.p.al would go onto the back end of the mortgage and it would never be paid.

There was no one in the entire building who did not understand that a monumental fortune was being made from the CDOs and that Lehman Brothers was buying up $300,000 mortgages ten thousand at a time, parceling them out into collateralized bonds, getting them highly rated by the agencies, and moving them into the market-$1,000 bonds, sold in tranches. A 1 percent commission on a $3 billion bundle of collateralized debt like that adds up to $30 million on the Lehman revenue line while that $3 billion bundle stays on the Lehman balance sheet until they are sold. Mike Gelband's pitch was that these huge CDO numbers masked an enormous problem. That thousands of these mortgages had been issued to people who ought never to have been living in a $300,000 home anyway, and those mortgages were about to tank.

How about the market caves in and we get caught with around twenty of those big $3 billion securitizations and can't sell them? That was Mike's unspoken question. And there was, of course, another, also unspoken: That was Mike's unspoken question. And there was, of course, another, also unspoken: What happens then? When we're hanging out to dry for $60 billion and the CDOs cannot be sold because every other son of a b.i.t.c.h in America is trying to sell at the same time? How about that? What happens then? When we're hanging out to dry for $60 billion and the CDOs cannot be sold because every other son of a b.i.t.c.h in America is trying to sell at the same time? How about that? At this time the firm was leveraged to twenty-two times its net worth, and we were playing with money we didn't really have, betting on an outcome that could go wrong. At this time the firm was leveraged to twenty-two times its net worth, and we were playing with money we didn't really have, betting on an outcome that could go wrong.

Everyone could see there was not one member of Lehman's mortgage department sitting in on the meeting. This was a special briefing, and it was clear that Alex Kirk and Mike Gelband had already conferred about this perceived danger to the corporation. But this was the first time we had heard it actually put into numbers, the language we all understood. And everyone could see Mike really meant it, that it had been on his mind. We could also see that Larry McCarthy and Peter Sch.e.l.lbach agreed with every word he was saying. And it should be understood that this kind of brutal talk was being conducted in a place where the exploding real estate market was making us fortunes in profits, that our mortgage guys were riding the wave, investing and winning, risking huge amounts and coming out in front on the gamble by selling the mortgage packages to banks, funds, and investors worldwide.

The question that now stood starkly before us was, were they locked into a bubble, and was it likely to burst anytime soon? No one knew the answer to that, any more than we could know that the raging U.S. property market would make its first downturn in decades less than six weeks from now, and that this summit meeting was being conducted at the very pinnacle of the market-at a time when the mortgage guys were still able, with consummate ease, to stroll on the lake in Central Park.

No one was in any way ready for Gelband's bombsh.e.l.l. No one had ever heard anyone else in the entire organization even attempt to break down the data on the housing market, far less arrive at what appeared to be an irrefutable conclusion that it could not possibly go on like this. There were many young bulls in the room who were doing a little shrugging and rolling their eyes heavenward, kids without fear in the teeth of the gale that now blew through us. They were, nonetheless, kids. Kids who had never seen a bear market, whose antennae had not properly developed. They were kids who did not comprehend one simple truth about Wall Street: that if you cannot hone your instincts to react to big trouble when it comes stalking across the horizon, you will ultimately be ripped to shreds by the monstrous anger of the market.

The only people in this room whose expressions betrayed profound concern at the words of Mike Gelband were the proven best brains on the trading floor. I noticed Alex Kirk, Larry McCarthy, Peter Sch.e.l.lbach, Joe Beggans, Pete Hammack, Jane Castle, and Christine Daley all frowning, unmistakably concerned by the words of one of Lehman's master traders and risk takers.

And because he delivered his conclusions without interruption, Mike inevitably sounded isolated, as if he was somehow moving forward but carrying a huge burden all alone. Except, that in a sense, we all went with him-Alex, Larry, me, and the rest. Looking back, it's clear that Mike's performance was a chilling one, with him standing up there against the surge of popular opinion, in near-defiance of both the president and CEO of the corporation and their cohorts. It took a lot of courage, in my opinion, but I guess that's what you expect when you have a Wolverine standing guard at the gates.

When the meeting ended, Alex Kirk stood up and advised us to think carefully about Mike's conclusions, because they were very important. He advised discretion when the subject was raised, but informed us that Mike intended to hold a less candid meeting with d.i.c.k Fuld and possibly Joe Gregory later that afternoon.

I left the meeting with Larry, who looked about as grim-faced as I had ever seen him. "Funny," I said, "but there were so many people in there who plainly didn't agree with Mike."

"Funny?" he growled. "More like f.u.c.king tragic. Last time we had a bear market, those kids were in diapers." Larry had a way of taking a salient point and kicking it straight between the posts. I guess it was the gambler's instant acceptance of the way the cards were falling, the lightning grasp of danger. But I think in that moment we were both determined to a.s.sist Mike in any way we could. Inwardly, I vowed to keep my eyes open for any and all indications that the real estate market might be heading south sometime in the foreseeable future.

I actually promised myself more than that. I would spend some time each day searching the databases for clues that things were moving the wrong way. I understood that there would be only slender indications, and that they would be concealing mammoth consequences. But in my view, it was the duty of everyone who occupied a position of trust to act as Lehman's sentries in what we believed might be a fragile situation.

And, of course, all of us had disquieting thoughts about the reception Mike Gelband could expect when he dropped his personal hand grenade onto the floor of the mortgage and property department. The question was, would even those guys dare to cross swords with him, seeing as many people thought he would one day aspire to the highest office in the building?

The answer was not long in coming. Without even a formal e-mail or any other form of official communication, we all heard on the Lehman bush telegraph that those guys had had dared to challenge Mike. In their opinion he was too conservative. One of them had replied to his studies, "Yeah, right, Mike. Have you missed the fact that this bull market's exploding? Right now, we're carrying Lehman's balance sheet, and this kind of talk will have a bad effect on people." Someone else pointed out that real estate schools up and down the East Coast and all over California were packed, no vacancies, and working guys were stampeding out of other professions and heading for real estate offices. There were real estate guys on the television being interviewed, guys who talked about friggin' countertops and views from the G.o.dd.a.m.ned master bedroom, claiming to make a million bucks a year. dared to challenge Mike. In their opinion he was too conservative. One of them had replied to his studies, "Yeah, right, Mike. Have you missed the fact that this bull market's exploding? Right now, we're carrying Lehman's balance sheet, and this kind of talk will have a bad effect on people." Someone else pointed out that real estate schools up and down the East Coast and all over California were packed, no vacancies, and working guys were stampeding out of other professions and heading for real estate offices. There were real estate guys on the television being interviewed, guys who talked about friggin' countertops and views from the G.o.dd.a.m.ned master bedroom, claiming to make a million bucks a year.

I heard one guy that summer on television discussing his three cars: a Mercedes, a Range Rover, and a Bentley I don't know if he'd paid for them, but the pinnacle of his craft was telling some crazy lady how to work the garbage disposal. Only in real nut country could a guy like that be driving a Bentley and earning as much money as a top Wall Street trader with full honors from Harvard Business School and unbelievable responsibility involving billions of dollars every day.

Right then I seriously began to accept that the real estate market was probably a gigantic bubble. Alex and Larry were sure it would burst, but the general drift upstairs at that meeting was that Mike Gelband had developed some kind of an att.i.tude problem, and it needed to be changed, real fast. That was not, however, the way his views were perceived down here in this corner of the more hard-nosed bond-trading floor.

You probably had it in the back of your mind, but never really brought it forward, that the location of the "World Capital of Creativity" is in Hollywood. But with all due respect to the Burbank crowd, they just may pale when compared to the armies of investment banking teams on Wall Street.

Lehman Brothers had a Chinese Wall separating traders from investment bankers. Beyond that wall was the exclusive little garrison of Lehman's investment bankers, shadowy but self-satisfied folks who could come up with schemes to outwit the Holy Spirit itself. So revered was this group that they were permitted to invent, along with other Wall Street firms, a moneymaking scheme that by the middle of 2005 took off like a whirling dervish and made billions and billions of dollars before finally disappearing up its own backside, helping bankrupt half the planet.

The engine behind this mind-blowing escapade was Ros Stephenson, Lehman's global director of the financial sponsors group. She was a veteran managing director and led the LBO investment banking team. Because of the enormous size of LBO deals coming in at the time and the relatively small size of Lehman compared to big commercial banks, she and the Lehman team should have had a brain-numbingly conservative, careful philosophy, and been, by nature and declaration, highly conscious about risk. And for a long time we imagined she was the safest of managers, until she was handed the sword of the CLO (collateralized loan obligation), which was a new derivative based on the same principles of securitization that had led a hitherto unsuspecting world into the mighty CDO. Except instead of vast legions of new homeowners who might or might not be capable of paying their mortgages, the CLO represented a conglomerate of chancy takeover debts, or leveraged loans, created by people who were busily trying to buy overweight U.S. corporations. The CLO created a new powerful demand for leveraged loans globally. Ros was a beneficiary of this innovation.

CLOs can be explained by starting with the leveraged buyout companies that made it happen: private equity outfits such as Kohlberg Kravis Roberts, Bain Capital, Blackstone Group, Texas Pacific Group, Providence Equity, and Carlyle Group. All of these companies, and many others like them, share certain idiosyncrasies. None of them manufactures any product, none of them sells anything. They exist to make money for their investors. By every known standard, they are predators, but they also represent a stratum of creative genius in U.S. business that had not been matched for many years. Their business is the leveraged buyout (LBO), in which a corporation goes to Wall Street with a glittering prospectus that explains why the company needs $10 billion to buy out, say a hotel chain. Mostly the investment banks like what they hear and often are willing to make such an enormous loan because it is secured against the thriving business the LBO guys are trying to buy.

You may be among the people who find it a little odd that someone wants to buy a corporation they cannot afford when that corporation is perfectly healthy and profitable and has no need to sell itself to anyone. Which is why LBOs are often hostile takeovers, in which the buyers, armed with borrowed cash from a firm such as Lehman or Morgan Stanley, start buying up the stock in enormous quant.i.ties until they gain control of the shares. They then take the company private, start selling off the a.s.sets, and repay both the interest and the loan from the profits of the original corporation, which did not need to change ownership in the first place. Another party trick they sometimes use instead is to saddle their new acquisition with an enormous bank loan that is used both to pay back the original loan and then hand over a fat dividend to the new owners. The buyout guys ultimately pay little or nothing for the company, and then feed off its a.s.sets and reputation. As an example, in late 2004 there had been a truly spectacular example of three private-equity corporations putting together a leveraged buyout of Mervyn's department stores for $1.2 billion. But no one knew at the time they had foisted an $800 million debt on the company as soon as it was purchased, and paid $400 million of that to themselves as a dividend. (You will doubtless note I did not use the word predators predators lightly.) lightly.) In fairness, these private equity funds were filled with some of the most brilliant financiers on Wall Street. They targeted corporations that they believed were either fat, inefficient, failing to maximize profits, or being milked by bad management. They always moved in fast and began stripping a.s.sets to pay off their own debts. And then, quietly and privately, they prepared the company to go public once again, almost certainly at a better price than the original shares.

Meanwhile, Lehman, which had financed dozens of these deals, was also parceling the loans into carefully constructed CLOs. S&P, Fitch Ratings, and Moody's were in there handing out AAA ratings like candy bars, collecting huge fees and helping to organize the bonds to be sold worldwide. The difference between these CLOs and the mortgage CDOs was the difference between a raft of corporations and a raft of homeowners. Same system, different players. Same ma.s.sive fees and profits. Same level of risk-high.

The risk for an investment house such as Lehman was similar in both cases. It involved getting caught with these billions and billions of dollars' worth of bonds and being unable to sell them fast enough. The investment bankers on the other side of the Chinese Wall were honing their product into a viable market ent.i.ty, and none of them was giving the slightest thought as to how to get out-and certainly not if everyone found themselves heading for the exit at the same time.

The other similarity between the CDOs and the CLOs was the ease with which they would both continue to be sold-confirming, once again, investors' rabid desire for some decent yield on their money at a time when short-term Treasuries were still offering around 3 percent or less. Four to six percent on one of those bonds, collateralized by a public corporation, looked very, very good from where most people were standing.

In a land as innately avaricious as Wall Street, the kind of coldblooded corporate raiding involved in LBOs is simply too big a temptation for the kind of grotesque personal greed that has slithered through Wall Street for more than a century. And in the middle of 2005, determined to compete with big boys such as JPMorganChase and Citigroup, the powers that guided Lehman's destiny decided to climb in up to their eyebrows in this seamy, high-risk profit engine, which would make such a fortune but, in the end, cost the company something infinitely more precious.

However, in summer 2005, Lehman was getting more than just its feet wet in this fine new adventure. LBOs had exploded on a scale beyond anyone's imagination, and the third quarter of the year produced the best results ever for investment banks. Across the industry, stock sales and mergers and takeovers amounted to $117 billion, which allowed JPMorganChase, Citigroup, Goldman Sachs, Morgan Stanley, Lehman Brothers, and others to share $3 billion in revenue fees. The value of takeovers over three months in mid-2005 was up 41 percent on the previous year. The leveraged-buyout specialists estimated $50 billion worth of takeovers in the same three months, with a year-end figure likely to be around $180 billion.

Lehman's bankers were in a central position during the second-largest LBO in history, when the Hertz Corporation was bought out from Ford Motor Company for a total of $15 billion. There was perhaps a poetic edge to Lehman's partic.i.p.ation in this particular deal, since Bobbie Lehman had been such a close friend of his fellow racehorse owner John Hertz, who was also a partner in Lehman. But the two great financiers doubtless would have been astounded at the sheer sophistication of the deal as the Wall Street guys rustled up the cash for the world's biggest car-rental corporation to essentially buy itself for the corporate raiders from New York: Clayton Dubilier & Rice, the Carlyle Group, and Merrill Lynch. This one set the standard, as they put the debt from buying the corporation onto the balance sheet of the Hertz Corporation, repaying it with the company's own cash flow. John D. Hertz was once described by that bard of the casting couch, Louis B. Mayer, as "the toughest man who ever wore shoes." But even Hertz might have flinched from an act of such astonishing opportunism against the business that still bears his name.

But it's unlikely that anything would have made much difference in these days of reborn corporate pirates. Not since Kohlberg Kravis Roberts grabbed RJR Nabisco for $31 billion sixteen years previously had a deal of quite such audaciousness been conducted. And this was only the start. Hundreds more would follow, and Lehman would be among the leading players in the rush for leverage and the subsequent selling of the buyout CLOs on a worldwide scale.

Lehman was often not sufficiently big to join in this jamboree of the giants. But its investment bankers were ambitious, and jealous of their place in the pecking order. Thus when Morgan Stanley and Goldman Sachs started blazing trails and raising money for the buyout boys, the Lehman guys felt they had to join in, at any and all cost. And since they were world leaders in the n.o.ble art of selling corporate bonds, it did not take them long to join the top table. One of their first moves was to swoop in and hire Richard Atterbury the London-based head of Morgan Stanley's leveraged-buyout financial team. Atterbury became coglobal head of Lehman's financial sponsors, the group that advised buyout firms. Lehman was the fourth-largest U.S. securities firm, but it ranked only thirteenth among the group of advisors to buyout firms worldwide. Morgan Stanley was number two in this group, and the Atterbury move was a clear indication of Lehman's ambitions.

At that time there was nothing but optimism in the market, but as the hot New York summer continued, my own studies of the financial markets began to reveal one or two very minor but significant pointers. And then one day, during the dog days of August, I spotted two of them, presented in an interconnected mode. According to the National a.s.sociation of Realtors, sales of existing homes had fallen by 2.6 percent in July, which meant, to a reasonable person like myself, that hundreds of houses had gone on the U.S. market and failed to find a buyer, many, many more than usual. However, sales of new new homes had risen by 6.5 percent compared to June of that year and by 28 percent from July 2004, hitting an all-time high. Could this, I wondered, be where all those dicey-looking mortgages in the subprime sector were ultimately leading-to homes built by the mortgage provider? I was pretty sure something was going on. And this was confirmed by yet another number: despite the rise in sales, prices for new homes fell by more than 7 percent in July-which was not spectacularly good news for Beazer Homes in any of their endeavors. homes had risen by 6.5 percent compared to June of that year and by 28 percent from July 2004, hitting an all-time high. Could this, I wondered, be where all those dicey-looking mortgages in the subprime sector were ultimately leading-to homes built by the mortgage provider? I was pretty sure something was going on. And this was confirmed by yet another number: despite the rise in sales, prices for new homes fell by more than 7 percent in July-which was not spectacularly good news for Beazer Homes in any of their endeavors.

For me it posed one almost sinister question: had the housing market reached its peak, or would it come storming back again? The jury was still out, but on August 24, the New York Times New York Times business section came out with an article headlined "July Slowing of Home Sales Stirs Talk of Market Peak." It did not go unnoticed, but neither did it bring down the ceiling, which it probably should have. The reason was that at this time the trading floor was flooded with optimism because of the new LBOs, which surely pointed the way to the future, and Ros Stephenson seemed to grow in stature with every pa.s.sing day. business section came out with an article headlined "July Slowing of Home Sales Stirs Talk of Market Peak." It did not go unnoticed, but neither did it bring down the ceiling, which it probably should have. The reason was that at this time the trading floor was flooded with optimism because of the new LBOs, which surely pointed the way to the future, and Ros Stephenson seemed to grow in stature with every pa.s.sing day.

Whatever one may have thought about the moral issue of these buyouts, the buyout team really knew what they were doing, and seemed to be able to turn huge profits on everything they touched. They also seemed extremely reliable, and every month there was a stampede for the new bonds. In 2003 only $17 billion worth of CLOs were issued. By the end of 2005, that number had blasted off to $50 billion. This provided the rocket fuel for the leveraged buyouts. Concern that the housing market might be propelled by legions of people who might not be able to pay their mortgages was not a factor in the world of LBOs, where major corporations were standing behind the bonds. This provided confidence to hungry investors, and even those of us who thought real estate might crash were optimistic about the leveraged buyouts.

Indeed, when the investment banking department posted its profits for the third quarter of 2005, there was a round of applause. They'd made $815 million for the quarter, up 55 percent from the previous year, and up 41 percent from the second quarter. These profits were driven by an all-time record performance in debt underwriting in the buyout game, which accounted for $336 million, an increase of 39 percent over the same period the year before.

The LBOs were a bonanza, but they were someone else's. On our section of the trading floor there were three enormous situations in progress. The first was Delta Air Lines, for which we were the main bond trader and market-maker, and which might be on the verge of total collapse. The second was the ma.s.sive short position Christine Daley had led us into with Calpine, the squeaky-clean electricity giant with the smoke-screen balance sheet. The third was Beazer Homes, where we held gigantic short positions in a stock showing not the slightest interest in falling further, and Larry McCarthy became daily more likely to wring the neck of the researcher who had led him into it.

Delta was Jane Castle's bailiwick, and her plan was to play a waiting game. Generally speaking, she thought Delta would be driven into Chapter 11 bankruptcy and that the bonds would crash, at which point we should buy, buy, buy, because she, tenacious little Jane, swore to G.o.d they were worth more than 50 cents on the dollar. At the moment they stood at 3638.

Beazer was driving Larry McCarthy nuts. I'd like to say driving him quietly nuts, but that would be a lie on too grand a scale. Beazer was driving McCarthy very noisily nuts. Everything about it was getting to him, especially their profits in the boom markets of the California Delta. Karim Babay had been extremely influential in arriving at our Beazer conclusions, and he above everyone else was tuned in to the foibles of the stock market's home-building sector. On days when Beazer's shares slipped back a little, Babay would without fail come strolling by for a chat about the market, especially the Atlanta builder, which he'd say was about to go into free fall. Thus far he had not been correct, and on the much more frequent days when Beazer shares climbed higher, from our price of $75 up toward $80, Karim seemed to go missing. He doubtless understood the bath you can take chasing a short that won't go down. His absence totally infuriated Larry-Where is he? Where the h.e.l.l is he? That's all I want to know. He has to be somewhere, right? He would set off in pursuit of the elusive researcher, prowling the corridors, checking out the likely retreats for a guy who was afraid to face his accuser. Once, in a fury, Larry searched the G.o.dd.a.m.ned john, checking out the shoes under the doors in the stalls, trying to find Karim and bawl him out over the rising Beazer shares. He would set off in pursuit of the elusive researcher, prowling the corridors, checking out the likely retreats for a guy who was afraid to face his accuser. Once, in a fury, Larry searched the G.o.dd.a.m.ned john, checking out the shoes under the doors in the stalls, trying to find Karim and bawl him out over the rising Beazer shares.

With Delta kind of static for the moment and Beazer going up, the only ray of light was coming from Calpine, which suddenly reported a mediocre second quarter with growing concerns about their cash levels, the same levels Christine Daley had flagged a whole year previously. There were announcements that Calpine was mulling over the possibility of selling more a.s.sets, trying to reduce that crippling burden of debt. Privately I thought things were looking bleak for the electricity empire, because there was a ferocious battle brewing about claims on their remaining cash, even though they had not yet filed for bankruptcy. Indeed, the New York law firm Strook hosted a conference call after Calpine's first-lien debt holders tried to stop a coupon payment on the second-liens. There were lawyers everywhere, getting ready to fight over Calpine's use of their cash. And I noticed that whenever the subject came up at Lehman, there was a soft tiger-smile on the face of Christine Daley.

Calpine admitted their second-quarter net loss of $300 million was ten times worse than for the equivalent period the prior year. The reasons were reduced electricity generation as well as heavy costs related to canceled service contracts and suspended construction work on several plants. Calpine's shares had dropped a further 56 cents to $3.32, down 16 percent for the year to date. And the situation had obviously unnerved the directors, who were facing the fact that Calpine had posted losses in eight of the last eleven quarters. They'd slashed their wildly ambitious expansion program and sold off a.s.sets, but they were still sitting on a corporation with debts of $17.5 billion. That's a pile of $100 bills the height of fifty Washington Monuments-about five miles straight up. The image is useful, because one of the most irritating aspects of modern finance is that the numbers tend to be so enormous that they can't really be grasped.

Christine Daley was still smiling, for she had long ago sensed that the head honchos at Calpine operated their business along the guidelines laid down by Field of Dreams: Field of Dreams: if you build it, they will come. And while those guidelines might have been rock solid when it came to ghostly ballplayers in a cornfield, they did not apply to electricity consumption in the twenty-first century. Calpine was building it, but they weren't coming. if you build it, they will come. And while those guidelines might have been rock solid when it came to ghostly ballplayers in a cornfield, they did not apply to electricity consumption in the twenty-first century. Calpine was building it, but they weren't coming.

As summer drew to a close the Lehman trading floors remained inordinately busy. The late afternoon of September 14 was typical. People were packing up and heading home. The Yankees were fighting the dying embers of a disappointing season, and the media was in a collective fit of utter depression over the continuing conflict in Iraq. Forecasts of doom, gloom, and endless strife were everywhere, and you'd have thought George W. Bush, the beleaguered president who had rid the world of Saddam Hussein, was the devil incarnate. Gasoline was still flowing freely, but it was costing the West $50 a barrel. Prices at the pump were scaling ever upward, and since President Bush was considered directly and solely responsible for both the Iraq war and the catastrophe that had followed Hurricane Katrina, he was resolutely blamed for the rise.

Perhaps the biggest problem around that September was the price of jet fuel, because that was. .h.i.tting the airlines hard-and none harder than Delta, which was already reeling from financial blows that would have darn near leveled any airline that ever flew. The great Atlanta-based southern carrier was a.s.sailed by an $18 billion debt. In addition, it had $180 million in pension obligations, and every time jet fuel went up by one penny, it cost Delta $25 million annually. Under siege from cut-price airlines, which had slashed hundreds of dollars from basic ticket prices, Delta was consistently flying around with half-empty aircraft. Delta had its back to the wall. It had wrung a $1 billion wage and benefit concession from its pilots, and it had a plan to shed seven thousand jobs by closing down its Dallas operation, but none of it was enough.

Jane had been telling us for several months that Delta was a candidate for bankruptcy, and at eleven minutes after five o'clock on the afternoon of September 14, 2005, she was proved right. It flashed onto my screen-"Delta Air Lines Files for Bankruptcy Protection." And I swear to G.o.d, the collective heart of Lehman Brothers skipped about six beats. Larry McCarthy was not in, and as the princ.i.p.al Delta convertible bond trader, I had markets to make.

I was on my feet in an instant. Big Joe Beggans was right there next to me, armed and ready to trade Delta's straight nonconvertible bonds. Alex Kirk was walking directly toward us, fast. I opened up a line to Larry, and I could see Jane making a beeline for my desk, just when I needed her. That's what I loved about her. During any time of crisis she was always right there. Because for the next hour there was going to be pandemonium, as millions of Delta bonds, crashing through the floor, were going to be launched onto the market by people trying to get the h.e.l.l out of them. Many of those bondholders were our best clients, so we were duty-bound to purchase them, and the hits would be flying like cannonb.a.l.l.s. Millions and millions of dollars' worth of Delta Air Lines bonds that no one wanted any longer. Holy s.h.i.t! My blood was pumping.

Just for a few moments the floor was very quiet, and Alex Kirk, standing right at my shoulder, said quietly, "Steady, Larry. We're ready for this."

I looked at Jane, who was unsmiling. "Stay focused," she reminded me. "They're worth fifty-two cents each, no matter how many come up for sale." What Larry had once said about her flashed through my mind: Jane can tell you what Delta Air Lines is serving for lunch in first cla.s.s on their morning flight from JFK to Berlin, and what it cost them. There's nothing she doesn't know about that company Jane can tell you what Delta Air Lines is serving for lunch in first cla.s.s on their morning flight from JFK to Berlin, and what it cost them. There's nothing she doesn't know about that company.

I understood the position of most of the bondholders. They'd do darn near anything to get out. But I had to make the market in what would be an avalanche of selling. Millions of dollars depended on my decision, which was I guess why every eye on the entire floor was trained on us, everyone waiting for my first call on the price I'd buy at and the price I'd sell at (though to whom, G.o.d alone knew).

Vividly I remember the phones around me ringing. And then, in the middle of this opening salvo, friggin' Northwest Airlines also declared bankruptcy. There was one of those audible gasps around the floor, the noise you hear in a big ballpark when a fastball rips past the batter on a full count in the ninth. Jesus Christ, I thought the roof was going to fall in, because we could also get hit by Northwest bondholders bailing out. But it was too late for strategy. My heart was pounding.

The boss of high-yield sales, Mike Pedone, hurled his right arm into the air and snapped, "Larry, I have AIG on the wire and what do you know, they're a seller. Where are you on Delta? Gimme a bid on five million. I need a bid right now." For a split second I hesitated, and Mike yelled, "They got five million to go! Where are you?"

That's when I called it: "Sixteen, eighteen!" And the moment those words were out of my mouth, Lehman Brothers was committed to an $800,000 purchase, five million bonds at 16 cents on the dollar.

"You're done," I said, snapping out the trader's no-going-back phrase and confirming our first trade in Deltas was now cast in marble. I heard Mike fire out his own confirmation to the customer, "Okay, you're done."

Twenty seconds later, we got hit again-Terence Tucker on the line from converts. "Where are you on Delta? Five million up!" These people were desperate, trying to get rid of their holdings in the bankrupt airline. I called the same price, 16 cents, but the words were hardly out of my mouth when we got hit again for another five million, and then again. Instantly I dropped the price-"Fifteen, seventeen!"-and our client took it. "You're done!" I yelled. Maybe they'd settle at 15, I thought. But they never did.

Lisa Konrad, our distressed-bond sales diva, called out, "I got Silver Point on the line-where are you on Delta right now? Five up."