A Colossal Failure of Common

Sense

Book by Lawrence G. McDonald and

Patrick Robinson(2009)

Review by Michael Tauberg

Table of Contents

1.0 Introduction......................................................................................................3
2.0 Summary..........................................................................................................3
3.0 General Concepts.............................................................................................5
4.0 Causes of the Crisis..........................................................................................6
4.1 Easy Money......................................................................................................7
4.2 Irrational Exuberance.......................................................................................8
4.3 A Failure of Management.................................................................................9
4.4 Widespread Securitization..............................................................................10
4.5 A Failure of the Ratings Agencies...................................................................11
5.0 Critique..........................................................................................................12
6.0 Conclusion......................................................................................................14
7.0 Appendix End Notes.......................................................................................15
Appendix B: End Notes

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10 Introduction

A Colossal Failure of Common Sense was one of many books to be published in the

aftermath of the Financial Crisis of 2007. After seeing the global economy stall in

the face of massive losses in world financial markets, many Americans sought to

better understand the crisis and its causes. This book, written from the perspective

of a financial market insider, provides a glimpse into the world of global finance and

also seeks to explain how the players in this world were involved in the crisis. In the

words of the author Lawrence McDonald, “My objective in writing A Colossal Failure

of Common Sense was twofold. First, to provide … a close-up, inside view of how

markets really work…..And, second, to give… as crystal clear an explanation as

possible about the real reasons why the legendary Lehman Brothers met with such

a swift end”1. By writing about his personal experience at Lehman Brothers and

recounting stories from within the famous investment banking firm, Mr. McDonald

largely succeeds at his first goal. However, the elements of personal biography and

the chronological order of the book make it difficult for the reader to fully appreciate

all of the varied causes of the financial crash. I believe that the main value of

reading this book is in understanding these causes, with Lehman Brothers acting as

a microcosm of the greater financial universe. As such, in this review I have isolated

elements from Mr. McDonald’s book which highlight how the crisis happened. I

collect these elements, and present the author’s ideas about the causes of the

crisis, highlighting how these forces were at work within Lehman Brothers. Finally, I

critique A Colossal Failure of Commons Sense with regards to its shortcomings, and

assess how well it achieved its two stated goals.

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20 Summary

A Colossal Failure of Common Sense is written from the perspective of the author

Lawrence G. McDonald, who worked as a trader in the distressed debt division of

Lehman Brothers investment bank. He writes in the style of a biography, mixing

elements of his own personal life with events that took place within the Lehman

Brothers firm from 2004 to 2009. Throughout the book, the author provides

analyses of these events in the context of the global financial crisis and includes

other facts and information about the US and global economy.

McDonald spends the early chapters of the book describing his ambition to work on

Wall Street and goes on to detail his rise in the financial services industry. During

this time he worked first as an investments salesman for Merrill Lynch, then as a

cofounder of the internet startup Convertbond.com which specialized in the analysis

of convertible bond issuances. He uses these chapters to introduce the reader to

the concepts of bonds and debt in financial markets.

Later, McDonald describes how he was hired as a trader at Lehman Brothers and

tells stories about his early days there. He discusses major events, such as his

trades involving large American corporations like Delta Airlines and General Motors.

These chapters introduce us to McDonald’s colleagues as well as to the higher level

players within the Lehman organization.

Next, McDonald discusses his involvement in the US subprime mortgage market on

behalf of Lehman Brothers. He discusses the early warnings of a subprime market

crash from Lehman employees such as Michael Gelband, the company’s global head

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of fixed income. McDonald also explains what was happening in the US sub-prime

mortgage market at this time and highlights the factors that led to its growth,

especially unscrupulous sales tactics being employed by mortgage originators.

After explaining the subprime mortgage market, the author describes how risk

within Lehman was not limited to residential real estate but extended to commercial

real estate. He discusses several major purchases of commercial real estate by the

firm, always using vast sums of borrowed money. He uses these chapters to

disparage Lehman CEO Dick Fuld and explains how Fuld pushed for these risky

deals without truly understanding them. It is the commercial real estate

investments described in these chapters that would eventually be a major cause of

the firm’s bankruptcy.

Finally, McDonald details the last days of Lehman Brothers. He describes second-

hand accounts of events within the company, when Lehman executives realized

how large the losses on their investments were. McDonald also describes the events

surrounding the decision of the US Treasury not to bail out Lehman Brothers as it

had done with the investment bank Bear Stearns.

30 General Concepts

Throughout the book, McDonald introduces some important financial concepts.

Among these are credit default swaps (CDS), collateralized debt obligations (CDOs),

and collateralized loan obligations (CLOs). Of particular importance in the book are

CDOs which are explained to be at the root of the global financial crisis. The CDO is

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described in great detail on page 107 of the book and this explanation forms the

basis for much of the book’s subsequent material. The CDO is described as a

security which is comprised of many individual home mortgages. These mortgages

are packaged together much like a bond so that the owner of the CDO holds these

individual mortgages and derives payment from the interest paid on them. So for

example, a CDO comprising 1000 mortgages sold at $300,000 each would be worth

a total of $300 million2. If these mortgages carried an interest rate of 2 percent, the

CDO would pay $500,000 per month (coming from homeowners) on this $300

million base. This $300 million CDO would then be broken up into smaller pieces

and sold around the globe to various investors.

Since a single CDO is comprised of many different mortgages, and mortgage default

rates in the US were historically low, ratings agencies who assessed the riskiness of

these securities often gave them the highest possible rating of AAA, meaning that

they were considered as safe as US Treasuries. McDonald sums up this process

within Lehman stating “Lehman was slicing them (CDOs) up and packaging them,

getting them rated AAA, and selling the bonds to banks, hedge funds, and sovereign

wealth funds all over the world” 3.

Of course, McDonald also highlights the catch involved with these CDOs. They were

sold to the so-called subprime home buyers who had little cash and low credit

ratings. This meant that to account for the risk of lending to these borrowers, the

real interest rates on these mortgages had to be much higher than the initial 2%

described above. In fact, after 2 years, the interest on these mortgages would climb

upwards of 10%. At this level, the subprime borrowers would be unable to make

their interest payments and the CDOs that were built on these borrowers would lose

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much of their value. It is this process, the reader is told, which precipitated the

financial crisis. Subsequent sections of this report expand upon the process of

creating and selling CDOs and other securities as well describing the other factors

that contributed to the financial crisis.

40 Causes of the Crisis

Below, I outline what that author presents as the main causes of the financial crisis.

I provide examples from the book of how these causes related to both Lehman

Brothers and the broader financial market

4.1Easy Money

One of the main themes of A Colossal Failure of Common Sense is ease with which

money was

borrowed in the early to mid 2000s. The author tells stories of home owners who

borrowed via large mortgages, investments banks and hedge funds who borrowed

money to buy derivatives, and private equity companies who borrowed huge sums

to execute leveraged buyouts of corporations. As a member of the distressed debt

trading group at Lehman Brothers, the author notes with amazement the ease with

which money could be borrowed at remarkably low interest rates. Companies like

General Motors could continue to finance their operations through debt even as it

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was clear to the author and his colleagues that that they could never meet all of

their obligations 4. Investments banks like Lehman Brothers borrowed so much

money that they were able to buy assets with very little real capital. By the time the

firm collapsed, the ratio of Lehman’s total assets to real capital was 44:15. The

author suggests repeatedly throughout the book that all of these actors were able

to borrow so much money because interest rates were cut to all time lows by US

Federal Reserve Chairman Alan Greenspan. According to McDonald

“He(Greenspan) cut and cut (interest rates) , all the way from 6 in December 2000

down to 1 percent on June 30, 2003”6. Besides allowing companies and individuals

to borrow beyond their means, these low interest rates had another pernicious

effect. Since traditionally safe investments like treasury bonds offered such low

rates of return, investors were forced to turn to riskier investments to achieve

higher yields. The author notes that “The ten-year Treasury (bond) yield in 2004

was only 4.05 percent”7. With such a low rate of return, investors “flooded into …

mortage-backed securities to get a higher yield on their money” 7. In other words,

the giant amounts of leverage and the huge appetite for risk that eventually undid

many Wall Street investment firms was a direct result of their ability to borrow

money cheaply.

4.2Irrational Exuberance

As an insider of one of the major Wall Street investment banks, the author is able to

describe the nearly unlimited optimism in the financial markets before the 2008

Market Crash. During this time, financial firms such as Lehman Brothers were

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making record profits, driven largely by the growth in the US residential mortgage

market8. These profits, the author maintains, were largely illusory. The CDO, which

was the foundation of these returns, was a much riskier asset than many believed it

to be, and would quickly lose money as soon as the “teaser” rates (described in

section 3 of this document) on home mortgages expired. As interest payments

dramatically rose, homeowners would be forced to default on mortgages that they

could no longer afford. Nevertheless, as more and more money was being made

from these CDOs, the players in this market grew in influence and had an even

greater incentive to ignore the risk involved. McDonald relates how the mortgage

traders within Lehman produced “miraculous” profits and grew in status within the

organization9. With so much money being made, it was difficult for opposing voices

to be heard. McDonald states that he always had reservations about the source of

these returns but that “I didn’t dare mention even a semblance of doubt, not to

anyone. That would have been tantamount to high treason…”10.

This trend of unwarranted optimism was present throughout the industry even after

the residential mortgage market began to show signs of weakness. The author

describes how in 2006, Merrill Lynch bought San Jose based First Franklin, one of

the nation’s biggest originators of non prime residential mortgages despite the fact

that First Franklin had 29 billion in risky loans outstanding11. He also relates how

other players like Wachovia Bank and Trust, based in Charlotte, North Carolina

participated in this buying frenzy, spending 25.5 billion dollars to buy Golden West

Financial12 which carried many sub-prime mortgages on its books. The author likens

11
these purchases to “buying a nuclear bomb” .

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This bomb would eventually go off, taking down Lehman Brothers and the entire

financial market.

4.3A Failure of Management

After the author outlines the huge amount of risk that Lehman Brothers and other

financial players were taking with their holdings of residential and commercial

backed securities, a natural question arises. How did the management of these

firms fail to understand the huge consequences of this risk? While he does not have

inside knowledge of the management at other organizations, Mr. McDonald’s does

provide an answer to this question with regards to Lehman Brothers, and this

answer is an indictment of Lehman Brothers CEO Richard Fuld, its President Joe

Gregory and the Lehman Board of Directors. McDonald suggests that CEO Richard

Fuld was a poor leader who was “removed from his key people” 13 and who thus did

not really understand very much of Lehman’s operations or obligations. In addition

to his distance from the inner workings of his firm, Fuld was avaricious, and jealous

of industry rivals Goldman Sachs and the Blackstone Group14. He constantly

promoted risky deals to grow the firm so that it could compete with these rivals and

show similar profit levels. When voices of dissent arose within the Lehman ranks

with regards to these deals, Dick Fuld would browbeat or simply fire anyone who

got in his way. As the author notes “Stories about long-departed commanders were

legion. There were mind blowing tales of Fuld’s temper” 15.

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If Dick Fuld was the engine behind the enormous risk taking at Lehman, then

President Joe Gregory and the Lehman Board of Directors were Fuld’s enablers. The

author calls Gregory a “run of the mill, ho-hum financial sycophant” 14 who acted

only to back up the CEO. According to the author, the board of directors were

composed largely of aging veterans of other industries who were not “tuned into

the massive securitization of the modern economy” 16. Without the board or the

president acting as checks on the power of CEO Dick Fuld, Lehman Brothers was

able to take on huge debts and expose itself to enormous risks. This combination of

risk and debt in financial markets would eventually create the conditions of the

great financial crash that would bankrupt Lehman Brothers and many other

companies.

4.4Widespread Securitization

Although the author levels some serious criticisms at the management of Lehman

Brothers, he makes it clear that they were not solely to blame for the downfall of

the firm. Throughout the book, McDonald notes that the financial world was growing

increasingly complex, so that it was much harder to understand the many risks

underlying investments in traditionally safe areas like residential and commercial

real estate. This was due largely to the rapid growth of securitization in financial

markets. These securities, including CDOs, CLOs and other derivatives like CDS,

“exploded” 8 in the 2000s. By 2006 there were $15 to $18 trillion worth of credit

derivatives (CDOs, CLO) in the global market and another $70 trillion dollars worth

16
of credit default swaps . Because these instruments were more complex and

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harder to value than traditional debt like home mortgages or corporate bonds, they

served to hide risk from investors who did not fully understand them. McDonald

notes how some market participants such as famed investor Warren Buffet noticed

that the true risks of these instruments were not reflected in their prices calling

them “weeds priced as flowers” 8. In regards to their potential to become

destabilizing to the entire financial system, Buffet referred to them as “financial

weapons of mass destruction” 8.

If these securitized investments were more complex and difficult to price than

traditional investments, then they proved much easier to sell. McDonald sites a

figure which claims that in 2005 “23 percent of all Wall Street revenue stream for

the last 3 years flowed out of securitization sales” 8. With this kind of incentives to

sell these risky instruments, Wall Street became home of what the author calls

“casino capitalism” 17, and investing increasingly took the form of risky gambling.

The author implies that widespread gambling based on risky instruments such as

CDOs and CDS (called by McDonald “those lethal swaps” 18) was unsustainable and

would eventually lead to a crisis.

4.5A Failure of the Ratings Agencies

As stated above, the complex securities being traded by firms like Lehman Brothers

carried substantially more risk than most expected. According to the author,

investors were falsely led to believe that these investments were safe7. The party

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responsible for this misrepresentation of risk was the credit rating agencies. The

agencies: Moody’s Investors Service, Fitch Ratings, and Standard & Poor’s, were

responsible for assessing the risk of debt securities such as CDOs and assigning

them a rating. A high rating such as triple-A meant that the security was very safe

and unlikely to default and lose money. By assigning these CDOs very high ratings,

these agencies enabled banks to sell them very easily and led investors to take on

much more risk than they realized. As McDonald writes, “they gave the banks

credence, allowing them to issue CDOs with triple-A ratings signed and certified by

the three biggest names in the business” 20. However, it eventually became clear

that these ratings were not accurate. The author states that at the end of 2006,

1305 CDOs had their ratings downgraded from AAA to BB or lower (junk bond

status)21.

The author posits that it may have been more than laziness or stupidity that led to

these inaccurate ratings. He notes that the agencies charged three times more

money to rate CDOs than other forms of debt and had an incentive to ensure that

these CDOs were popular in the market20. Apparently the business of rating these

instruments was very profitable. For example, McDonald states that Moody’s had

revenues of $2.037 in 2006 billion up from 800.7 million in 200021. With incentives

to hide risk, McDonald implies that the ratings agencies were intentionally dishonest

and that they are largely to blame for the spectacular growth of CDOs and other

risky investments which would cause the financial crisis.

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50 Critique

In A Colossal Failure of Common Sense, The author does a good job of presenting

the story of the global financial crisis, centered on his experiences at Lehman

Brothers investment bank. However, there are certain limitations in McDonald’s

approach to telling this story that make it difficult for the reader to gain a complete

and accurate picture of the crisis. His informal writing, his closeness to the material,

his need to cater to the financial layperson, and the early release date of the book

are all factors that prevent the author from providing a complete picture of the

financial crisis.

The author uses a very personal style of writing that succeeds at making the reader

feel very close to the events described. However, this informal style, full of

colloquialisms and other casual turns of phrase, is often imprecise. When McDonald
22
refers to convertible bonds as a “last chance saloon” for distressed companies

such as Enron to receive badly needed capital, the reader has to puzzle over

western film imagery before understanding the idea behind these bonds. In

addition, this style does not allow for the use of many supporting facts or figures to

be presented in a detailed manner. While discussing Enron’s convertible bonds, no

concrete information is given on how many of these bonds were issued or to whom

they were being sold. The reader must accept McDonald’s reasoning for the events

he describes, where supporting data would greatly strengthen his case

The casual style of writing employed by the author also serves to highlight his

potential biases as a witness to the events in the book. The author is clearly

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sympathetic to his close colleagues at Lehman Brothers, specifically in the trading

operations of the company. McDonald never utters a single negative word about the

people with whom he worked closely such Larry McCarthy, Michael Gelband and

Alex Kirk. However, he spends much of the book attacking Lehman CEO Dick Fuld

and blaming him for the company’s woes. As a trader, it seems as if McDonald may

not have been close enough to Lehman management to make an accurate

assessment of their performance. In fact, McDonald admits to having never

personally met CEO Fuld23. Besides being removed from many of the management

decisions that he criticizes, the author’s trader mentality has the potential to color

his views on the larger crisis. He describes the trading world as being very insular
24
where “no one went out for lunch” since they were working so hard . Being a

trader who was so close to the events of the financial crisis, it is possible that the

author misses some of the larger themes and patterns behind what happened on

his trading floor

Furthermore, it is very likely that the author simplified much of his subject matter of

this book to reach a wider audience, composed largely of financial laypeople. While

this approach makes the book approachable, it prevents a deeper analysis of the

material. So, while the author mentions the value at risk (VaR) model that is used to

assess the risk on various investments, he does not go into a great deal of detail on

how this model failed to show the high risk in CDOs and other derivatives. Other

matters of accounting which would require that the reader have a greater

background in finance are also neglected. The actual methods used to price

instruments like bonds, CDOs and CDS are never discussed, so the reader does not

get a complete picture about how these investments lost so much money.

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Finally, since the book was published so soon after the events described, some key

information was missing from it. A question that is never fully answered in the book

is how Lehman Brothers managed to survive so long with major losses piling up on

its books. The answer to this question was eventually answered in SEC filings that

showed that Lehman had engaged in various accounting tricks to cover its losses.

This became known as the Repo105 scandal 26

. Knowledge of this scandal would

have made it clear to the reader that many practices within Lehman Brothers and

other Wall Street firms bordered on accounting fraud. No doubt this information

would help the reader to get a broader view of the financial crisis and its causes.

60 Conclusion

A Colossal Failure of Common sense looks back at the events of the global financial

crisis of 2007 and presents stories, information and analysis that are intended to

shed light on those events. By describing his experiences within Lehman Brothers,

that author, Lawrence McDonald, is able to present the reader with possible reasons

for why Lehman Brothers collapsed along with so much of the greater financial

market.

McDonald faces many challenges in presenting such a broad range of complex

material. In most cases, he succinctly explains the various causes of the crash

including the role of low interest rates in spurring risky investments, the bubble

mentality that took hold in financial markets, the failure of Lehman management to

predict or prevent the crisis within the firm, the proliferation of credit derivatives

that facilitated the spread of risk, and the failure of ratings agencies to warn against

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this risk. Although he describes these factors clearly, he is hampered by certain

choices made when writing the book. By choosing to target a broad audience with

little financial knowledge and by avoiding in-depth and data-backed analysis of

events, the author only partially succeeds in educating the reader. In addition, his

biases are evident throughout, making it more difficult for the reader to trust that

the author is providing an accurate account of the crisis. Still, the anecdotes and

inside stories from within Lehman Brothers make for an interesting read. A Colossal

Failure of Common Sense is an entertaining portrait of one man’s experience inside

the financial crisis and viewed from that perspective, it is a success.

70 Appendix A: References

1. McDonald, Lawrence, and Patrick Robinson, A Colossal Failure of Common

Sense, Crown Business Inc., New York, U.S.A., 2009.

80 Appendix B: End Notes

1
McDonald, Lawrence. A Colossal Failure of Common Sense, 2009, Author’s Note
2
McDonald, pg. 108
3
McDonald, pg. 216
4
McDonald, pg. 165
5
McDonald, pg. 287
6
McDonald, pg. 76
7
McDonald, pg. 110
8
McDonald, pg. 161
9
McDonald, pg. 113
10
McDonald, pg. 114
11
McDonald, pg. 196
12
McDonald, pg. 195
13
McDonald, pg. 213
14
McDonald, pg. 230
15
McDonald, pg. 91
16
McDonald, pg. 227
17
McDonald, pg. 171
18
McDonald, pg. 215
19
McDonald, pg. 227

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20
McDonald, pg. 109
21
McDonald, pg. 200
22
McDonald, pg. 71
23
McDonald, pg. 89
24
McDonald, pg. 80
25
McDonald, pg. 174
26
http://www.npr.org/blogs/money/2010/03/repo_105_lehmans_accounting_gi.html

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