Book by Lawrence G. McDonald and Patrick Robinson(2009)
Review by Michael Tauberg
A Colossal Failure of Common Sense
The Inside Story of the Collapse of Lehman Brothers
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
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1.0 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.
2.0 Summary
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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 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
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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.
3.0 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 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
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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 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.
4.0 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
4.1 Easy Money
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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 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.
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4.2 Irrational 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 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 these purchases to “buying a nuclear bomb” 11.
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This bomb would eventually go off, taking down Lehman Brothers and the entire financial market.
4.3 A 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.
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
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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.
4.4 Widespread 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 of credit default swaps 16. Because these instruments were more complex and
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
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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.
4.5 A 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 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
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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.
5.0 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 refers to convertible bonds as a “last chance saloon” 22 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
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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 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 where “no one went out for lunch” since they were
working so hard 24. 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.
6.0 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 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-
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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.
7.0 Appendix A: References
1. McDonald, Lawrence, and Patrick Robinson, A Colossal Failure of Common Sense, Crown Business Inc., New York, U.S.A., 2009.
8.0 Appendix B: End Notes
1 McDonald, Lawrence. A Colossal Failure of Common Sense, 2009, Author’s Note2 McDonald, pg. 1083 McDonald, pg. 2164 McDonald, pg. 1655 McDonald, pg. 2876 McDonald, pg. 767 McDonald, pg. 1108 McDonald, pg. 1619 McDonald, pg. 11310 McDonald, pg. 11411 McDonald, pg. 19612 McDonald, pg. 19513 McDonald, pg. 21314 McDonald, pg. 23015 McDonald, pg. 9116 McDonald, pg. 22717 McDonald, pg. 17118 McDonald, pg. 21519 McDonald, pg. 22720 McDonald, pg. 10921 McDonald, pg. 20022 McDonald, pg. 7123 McDonald, pg. 8924 McDonald, pg. 8025 McDonald, pg. 17426 http://www.npr.org/blogs/money/2010/03/repo_105_lehmans_accounting_gi.html
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