Not so lazy, after all

Is it possible that Europeans - famed for their endless vacations - work as much as we do?
By Geoff Colvin, senior editor at large
Last Updated: August 5, 2008: 9:23 AM EDT

(Fortune Magazine) -- Europeans rarely feel more superior to us Americans than at this time of year, and you can't blame them. They're taking their umpteen-week vacations, perhaps enjoying state-funded massages in Baden-Baden, while we're trying desperately to squeeze every drop of fun out of our measly two or three weeks off before returning to the salt mines.

The conventional view in Europe, held widely here also, is that they understand life better. So what if their per-capita incomes are lower than ours? They know what's really important, and it isn't slaving away like us job-crazed Yanks.

The trouble with this narrative is that it's based on a myth. Recent studies show that Europeans work much harder than most people think, and some, such as the Germans, work every bit as hard as we Americans do. An analysis of why makes it tough to say that one culture is somehow wiser than the other.

The key to the research is a simple question: What's work? The statistics we usually see focus on jobs that people get paid for, and by that measure Americans do indeed toil much more than Europeans. But that measure overlooks all the cooking, cleaning, lawn mowing, and other home-based labor that most people do. We don't get paid for it, but it's just as real as other work. When we count it as well as paid employment, the whole picture changes.

A thorough study by Richard Freeman of Harvard and Ronald Schettkat of Utrecht University found that Germans and Americans labor almost exactly the same amount. (The researchers note, "While our data deal with Germany and the U.S., our findings reflect the difference between EU and American models of capitalism more broadly.") The difference is that we do more market-based work, and Germans do more home-based work.

That simple fact holds large implications. For starters, it means we're more likely to buy various goods and services that Germans are more likely to produce at home. For example, they spend more time preparing meals, while we spend more money on restaurant meals; as a society we do more of our hamburger flipping at McDonald's, while Hamburgers do more of it at home.
Paying the price

An important result is that we create far more service jobs than Germany does, and that nation's much smaller service sector is the main reason Germans are less likely to be employed, with an unemployment rate consistently higher than ours for the past 20 years.

New research by Richard Rogerson of Arizona State University finds that "almost all of the difference [between Europe and the U.S.] in hours of [paid] work is accounted for by differences in the service sector." Some people denigrate burger flipping and the like as dead-end jobs, but for young people whose skills aren't yet highly developed, they're gateway jobs that are the best economic use of their time.

Now carry the analysis a step further. The difference between Germans and Americans in work profiles is much greater for women than men. American women are far more likely to hold paid jobs than German women, and those who do are far more likely to earn higher pay.

Each nation's economy supports those patterns. In America it's easy to buy prepared meals, child care, and such, so it's "easy for educated women to work in the market," as Freeman and Schettkat observe, whereas in Germany, "the lack of such alternatives makes full-time employment of women difficult." Thus, German women have far weaker incentives to go to college. In the U.S., 22% of working-age women hold bachelor's degrees, but in Germany only 11% do.

Bottom line, each economy runs according to powerful internal logic. Freeman and Schettkat sum up: "By working long hours and taking short vacations, Americans earn money to buy goods in the market. By working fewer hours and taking long vacations, Germans have more time to produce goods at home."

Fair enough. To each his own. But this August, as we Americans longingly imagine all those Europeans leaving their jobs behind for weeks on end, let's remember the rest of the picture - their hard work at home, unemployed youth, and less educated women - and perhaps think again about how envious we ought to be.

Electric Supercar: Tesla's wild ride

Building the world's first electric supercar was never going to be easy - even without the hubris, infighting, and mismanagement that nearly sent Tesla spinning off the road.

By Michael V. Copeland, senior writer

Last Updated: July 11, 2008: 1:16 PM EDT

(Fortune Magazine) -- For Martin Eberhard, there were many obstacles on the path to building the ultimate electric sports car. There was the scientific challenge of creating a lithium ion battery pack stable enough to power a 2,650-pound vehicle. There was the belief that Americans would stick with their gas-guzzlers, no matter what the price of oil. And there was, of course, the considerable resistance in the venture capital community to funding heavy industry.

But for Eberhard, the ultimate indignity came in early June of this year. Just days before he was finally supposed to take possession of his Tesla Roadster, a gray beauty with orange racing stripes that he had devoted the past five years of his life to building, a technician who had been driving it on the 101 freeway relayed some bad news.

The most advanced car on the planet had rear-ended a truck.

(Interactive)

Instead of sweeping triumphantly into Eberhard's driveway, the Roadster was towed back to Tesla headquarters south of San Francisco where, under the exacting eye of the company's chairman and financial backer, Elon Musk, it would be rehabilitated.

Even with its carbon-fiber front end shattered, the car was something to behold. Eberhard had named the car for Nikola Tesla, an eccentric late-19th- and early-20th-century inventor whose name has become a byword for genius tethered to otherworldly ambition. (His legacy ranges from the AC power systems we still use today to plans for a "death ray" that would help armies fight wars with electricity.)



The Tesla itself - 400 volts of electric potential wrapped in a carbon-fiber body - is as far-out as its namesake, styled like the cars you used to see only in cartoons but charged by a high-powered outlet in your garage. Stomp the accelerator, and thick cables connecting the liquid-cooled lithium ion battery pack to a printed circuit board send all that current into a series of silicon transistors the size of your little fingernail. They are capable of switching as much as 850 amps, which drive the AC motor as high as 14,000 rpm and send the rear-wheel-drive Roadster screeching off the line, with a range of 220 miles on a single charge. Acceleration is so fast (0 to 60 in 3.9 seconds) that you get pushed back in your seat for as long as you dare to keep your foot on the aluminum pedal.

That the Tesla exists at all is a small miracle. For car geeks it has long seemed that electric vehicles are the car of the future - and always will be. First tinkered with in the 1800s, the electric vehicle (or EV) had its fate sealed with the invention by 1900 of the internal-combustion engine, which was cheaper and could travel much farther than any battery-powered model. There was another flurry of EV development during the energy crisis of the 1970s, and again in the early '90s because of a series of regulatory guidelines governing emissions. But by the late '90s, California had defanged the electric-vehicle portion of its zero-emissions mandate and soon after, GM (GM, Fortune 500), Toyota (TM), Honda (HMC), and Ford (F, Fortune 500) all shut down their EV programs. The most dramatic end would come for GM's EV1, when the Detroit automaker famously ripped the cars away from ecstatic owners and sent them to the crusher, as detailed in the film Who Killed the Electric Car?

That backdrop makes the story of the Tesla all the more remarkable. The car was conceived by Eberhard, an engineer, serial entrepreneur, and inventor (his name is on battery-cooling, electric motor, and power electronics patents filed by Tesla Motors). He was convinced that if he could outfit an existing sports car chassis with loads of laptop batteries, it would be feasible to build and he'd find plenty of buyers among the speed-loving, planet-conscious Silicon Valley set and beyond. But given that he had zero experience in the auto world and that gas was at a relatively cheap $1.50 a gallon, Eberhard, 48, couldn't find a VC firm willing to give him enough to build the car. Which is how he came to Elon Musk.

The 37-year-old Musk had co-founded PayPal, was forced out of the online-payment company, but cashed in when it was sold to eBay (EBAY, Fortune 500), giving him more than enough money to launch SpaceX, a private rocket company that aims to start shuttling people to the International Space Station by 2011. Big ideas, in other words, are Musk's specialty. After a two-hour meeting in February 2004, Musk agreed to plow $6.3 million into Tesla. He would become the company's chairman; Eberhard would be CEO.

In one sense, the duo's timing couldn't have been better. Tesla has begun delivering cars just as gas prices and fears about global warming have shot to all-time highs. All those automakers that shelved plans have since restarted them. Nissan (NSANY), Mitsubishi, Daimler, Subaru, and boutique firms like Fisker Automotive are furiously working on new models - some all-electric, others range-extended EVs - but won't get to market till 2009-13. GM's Bob Lutz even credited his company's relaunch to Tesla. "If some Silicon Valley startup can solve this equation," he told Newsweek, "no one is going to tell me anymore that it's unfeasible."

Telsa first customers

But somewhere between the elegant plan and the rear-ender on the 101, things went terribly wrong. Says Eberhard, looking back: "I should have been more careful. I shouldn't have let [Musk] take a disproportionate control of the board." He adds, "I have no issues with Tesla Motors as a company. I do have problems with Elon and the way he treats people." Indeed, it was poetic that Eberhard wasn't behind the wheel when his Tesla crashed - he had been booted from the driver's seat and forced out of the company seven months earlier. Musk has kept silent until now about what happened. "I was too busy trying to fix the fucking mess he left. I haven't had time to tell my story," he says. "I will say, I have never met someone who is as capable of creating such a disinformation campaign as Martin Eberhard."

In the past four years, Musk has sunk $55 million of his personal fortune into the company, the ousted Eberhard has started a tell-all blog to air his grievances, and 1,000 customers - many of whom long ago laid out nearly $100,000 - are still waiting for cars that are unquestionably cool but now a year overdue. The only thing anyone can agree on is that men, not machines, are largely to blame for Tesla's struggles. (See Eberhard's response to this story.)

***

You need to be a little nuts to start a car company. And by most accounts Martin Eberhard always was. In his early career, he launched a series of startups, including an electronic-book company he co-founded called NuvoMedia, which he sold to Gemstar in a deal valued at $187 million in 2000. By 2003 he was looking for his next project. Driving the streets of Palo Alto that year, he began to notice that the same driveways that held a Prius (or "dork mobile," as he liked to call it) often also had a Porsche 911 or other luxury sports car.

"It was clear that people weren't buying a Prius to save money on gas - gas was selling close to inflation-adjusted all-time lows," says Eberhard, a tall, thin man with a mop of graying hair and a nervous, foot-tapping energy. "They were buying them to make a statement about the environment." So why not, he reasoned, allow this deep-pocketed clientele to make that statement driving a car that exceeded the performance of a Porsche?

Eberhard, who has an undergraduate degree in computer engineering and a master's in electrical engineering from the University of Illinois at Urbana-Champaign, spent almost a year doing an analysis of what energy source was most efficient for his imagined eco-supercar. He examined and dismissed hydrogen fuel cells, natural-gas-powered cars, hybrid technologies, and diesel. The energy source that offered the highest efficiency and performance, he concluded, was pure electric.

As it turned out, EV pioneer Al Cocconi (one of the original engineers of the prototype for GM's EV-1 and founder of an EV shop called AC Propulsion in San Dimas, Calif.) had concluded the same thing and produced a one-off he called the tzero. Though the tzero could go 0 to 60 mph in 4.1 seconds, it was loaded to the gills with 1,000 pounds of lead-acid batteries, so its range was limited to 60 or so miles of driving.

At the time, AC Propulsion was struggling to keep its lights on, so Eberhard proposed a deal: In exchange for a $150,000 investment, he wanted Cocconi to try powering the tzero with thousands of lithium ion laptop batteries, which were lighter and had six times more energy per pound than the lead-acid variety. (It was an easy sell: Cocconi was already experimenting with lithium ion.) The lighter batteries worked. The souped-up tzero accelerated from 0 to 60 in 3.6 seconds and had a range of more than 300 miles. Eberhard had found his supercar. He persuaded AC Propulsion to build him one and tried to convince Cocconi that he should put the tzero into production. But Cocconi had no interest in building a car company.

So Eberhard decided to build a car by licensing electric-drive-train technology from AC Propulsion and using an existing carmaker to do the manufacturing, just as semiconductor manufacturers had done with their "fab-less" model. In Eberhard's view, that would make building the car better, cheaper, and faster. After persuading Marc Tarpenning, a software jockey and Eberhard's business partner in his previous companies, to join him, they incorporated Tesla Motors in July 2003. Eberhard didn't know it at the time, but someone else was itching to see tzeros hit the road in large numbers, and that someone had far deeper pockets than he did.

After eBay bought PayPal for $1.5 billion in 2002, Elon Musk, an imposing South African with a yen for high-tech gadgets and designer clothes, had taken his sizable fortune and set up SpaceX in Hawthorne, Calif. Shuttles to space were the first goal, but Musk's really big idea was that by making space travel cheap, people could start moving off earth and onto other planets. His terrestrial plans were equally ambitious. Like Eberhard, Musk had long thought EVs were the logical way to kick our oil addiction. "During undergrad at the University of Pennsylvania, I used to harangue my dates about electric cars," says Musk. Before the Internet piqued his interest, he had even started a Ph.D. at Stanford focused on advanced capacitor technology.

So when JB Straubel, a hotshot engineer out of Stanford who is now Tesla's CTO, mentioned the tzero to Musk, he immediately arranged for a test drive. Musk tried to buy the car, but Cocconi wouldn't sell, nor would he take the $250,000 Musk offered to convert his Porsche 911 Turbo to electric. Then Tom Gage, AC Propulsion's CEO, had an idea. "That's when I suggested that Martin and Elon should talk," he says.

***

It took Eberhard and Ian Wright, VP of vehicle development, only two hours during a February 2004 meeting to get Musk onboard. The meeting ended with Musk saying simply, "Okay, I'll do it." On the street outside SpaceX, Eberhard and Wright high-fived. "I think we just got our funding," Eberhard said.

There were, however, a few catches. Musk saw the franchise-dealership arrangements that U.S. car companies had tangled themselves up in as an increasingly expensive, margin-killing model. He wanted to own and operate Tesla dealerships rather than franchise them. He wanted final say over all decisions - which he would get by naming himself chairman. And finally, Musk demanded that they close the deal in two weeks. His wife was expecting twins, and he needed everything buttoned up by then. Though Musk had a reputation for outsized thinking and an ego to match, Eberhard wasn't in a position to be picky. As he puts it, "You take money from the people who offer it to you."

Tesla now had funding, a business plan, and even a chassis. The first prototype of Tesla's car, dubbed the Roadster, would be based on a $45,000 fiberglass-skinned sports car that Lotus sold, called the Elise. Lotus made fast, light cars and also had the virtue of being the only sports car manufacturer that would give Tesla management the time of day. While Eberhard was thrilled to have a viable plan to build the Roadster, Musk had even bigger ideas. "Eberhard's initial stimulus for starting Tesla was to build the EV he wanted to buy," says Wright. "Musk had a much grander vision: He wanted to be the next General Motors."

Despite their differences, the two men initially worked well together. Both are technical guys who attack problems relentlessly. Eberhard's style is to question every engineering assumption. He'd corner people in the hall and debate them on the merits of air-cooled vs. liquid-cooled battery packs. "Technically he is just brilliant, and he has a tenacity that is unbelievable," says Laurie Yoler, a venture capitalist and an early Tesla board member and investor. "He is the guy you want around in those early days when you have naysayers all around." The team was solving huge technical problems, from battery cooling and load balancing to the power electronics. But if he didn't like an idea, Eberhard could also be very insulting. When an early member of the marketing team suggested putting solar panels on the roof of Tesla's new headquarters in San Carlos, Calif., Eberhard's response was, "Why the fuck would we do that?" (Eberhard says now that the company simply couldn't afford it.)

At the time, Musk's primary job was running SpaceX, but he and Eberhard talked practically every day. On some weekends both men would continue the conversation over dinner at one or the other's home with their families. Using what he was learning about rockets, Musk would constantly suggest materials that could shave a few pounds from the chassis or the body. Says Wright: "There were signs that he wanted to fiddle in the details, but it wasn't enough to make me run screaming. Musk is a technically savvy guy who wanted to help."

The highlight of board meetings for the tech-obsessed group were the show-and-tell portions, with little focus on the bottom line. "Martin would come in all excited and talk about one breakthrough or another," Yoler says. "Then we would go out to the shop and look at the latest electric motor or battery pack prototype." In his role as chairman, Musk would ask technical questions and then offer his own suggestions. As the car progressed, staffers began to realize that a green light from Eberhard was not sufficient. "The question always had to be asked," says Tarpenning, "'What will Elon think of that?'"

As time went on, Musk became more and more comfortable pulling rank. Jessica Switzer, who ran marketing at Tesla until the car's official launch in 2006, recalls persuading Eberhard to spend $30,000 on focus groups to test the car's logo, look, and feel. A few weeks later Musk killed the project without explanation. With Eberhard's approval, Switzer hired people from a PR firm in Detroit to drum up publicity in the automotive press before the car's launch. Musk promptly fired them. She later learned that Musk didn't want to spend money on marketing before the car was finished and figured his own involvement and the car itself would drum up more than enough PR.

When it came to design, Musk's vision - building the Next Great American Car Company - soon came into conflict with Eberhard's goal of getting a cool electric sports car to market quickly and relatively cheaply. The Lotus Elise chassis on which the Roadster was based had a high doorsill, a feature that makes entering the car tricky if you are not careful. Getting out is even harder. It took several attempts for Musk's wife to get out of an early Roadster prototype while wearing a dress. So Musk ordered the engineers to lower the doorsill two inches, thereby losing much of the cost savings that come from using a crash-tested off-the-rack chassis. "Have you tried getting out of an Elise?" asks Musk. "It's like you have to be a contortionist."

And rather than use the fiberglass body panels from the Elise that Eberhard had suggested, Musk insisted on carbon fiber, a lighter, stronger, and "cooler" material, in his opinion. He then went on to redesign the headlights and the door latches. After riding for a weekend in an early Roadster model and taking a beating in the standard Lotus seats, he insisted that custom seats be developed. Every change meant additional cost and time. "I always argued that we would sell exactly as many cars whether the door latches were push-button or electronic, whether the body panels were carbon fiber or fiberglass," Eberhard says. "All the nicer, cooler, faster stuff increased risk."

But Musk got his way, in large part because he was putting more and more of his own money into Tesla. He led Tesla's $12 million second round of financing in the fall of 2005, and also convinced some of his high-powered friends, including Google founders Sergey Brin and Larry Page and eBay employee No. 2, Jeff Skoll, to invest in later rounds. To date, he has personally put in $55 million of the $145 million Tesla has raised.

Musk, who is precise in his sentences, laughs easily, and if fired up will literally leap from his chair to punctuate a comment, admits he poked his nose into everything. "I was very insistent on things during the design phase, and it is true those things cost money," he says, "but you can't sell a $100,000 car that looks like crap." Unfortunately, while the exterior of the Tesla was designed and redesigned to meet Musk's exacting specifications, there was one very big problem: Two months before the car was set to debut in the summer of 2006, it still didn't have a production-ready transmission.

***

As Hollywood heavy hitters like Michael Eisner and Governor Arnold Schwarzenegger mingled with well-heeled car buffs at the Roadster's public unveiling at the Santa Monica Airport in July 2006, it looked like a slam-dunk for Tesla. But behind the scenes company execs were sweating. Electric motors have the advantage of being lightning fast from a standing start. But to get to the top speed that Tesla had promised (125 mph), they needed either a more powerful drive train or a second gear that could send the car speeding beyond 100 mph.

Problem was, Tesla's engineering team didn't yet have the experience to build a more powerful drive train, and no one had come up with a two-speed transmission that could go from 13,000 rpm to 7,000 rpm and survive for more than a few thousand miles before it wore out. Eberhard was inclined to stay on schedule, get cars on the road by sticking with one gear, and offer a Roadster that topped out at 110 mph.

Instead Musk launched the search for a supplier that could deliver a two-speed transmission. "Why did DeLorean fail?" Musk asks. "Because it was a shitty sports car. It may have looked cool, but it had the acceleration of a Honda Civic. That's what our car would have been with the motor we had and the power electronics we had connected to a single speed."

Meanwhile Eberhard was spending more and more time basking in the glow of the clean-tech crowd. He was the face of Tesla, the voice on its blog. He became a regular on the conference circuit and even starred in his own BlackBerry "innovators" ad. But at least four board members, including Musk, were growing concerned that Eberhard didn't have a firm grasp of the company's increasingly complex finances and supply chain. At an executive staff meeting at Tesla's San Carlos headquarters in June 2007, Eberhard grew visibly agitated, according to Straubel and others, as Tom Colson, head of manufacturing, went through a cost analysis of the Roadster put together by one of the company's VC backers.

In Tesla's own prospectus for its most recent round of funding, dated April 12, 2007, it had estimated the cost of building the car at $65,000, dropping as production ramped up. But just two months later, the VCs now believed the average cost was going to be well north of $100,000 for the first 50 cars and would decrease only slightly as more cars were built. "If this is true," Eberhard told Colson and the room, "you and I are both fired."

Eberhard doesn't dispute that things seemed to be heading south, but he says that for months he had been asking the board to hire a CFO and a COO and it wouldn't approve his choices. "I raised my hand and said, 'I am drowning, please help me,'" he recalls. Board member Yoler says that Eberhard could have hired anyone he liked but was holding out for Elon's approval, which never came.

In fact, there was another search going on at the same time. Tesla was moving from its development stage to an operational stage, where costs and schedules were taking precedence. According to board members (all venture capitalists at the time, except for Musk's brother), that wasn't a good fit for Eberhard. Even his old friend Tarpenning saw the problem. "You reach a point where the same people who are running the company when it has three people are not the same people who are running the company when it has 300," he says. "Both of us had been around the Valley long enough where we knew that to be the case." Eberhard himself agreed to join a board subcommittee to search for his own replacement. Dozens of candidates were interviewed and rejected; in the meantime Eberhard remained optimistic that Tesla would be able to hit its Aug. 27 production date.

But according to Darryl Siry, Tesla's head of sales, marketing and service, that wasn't going to happen. In June, he says, Lotus factory officials began warning that the late-August launch wasn't realistic. Eberhard persisted, saying in staff meetings that "we're dead if we miss that launch," Siry says. Yet Tesla hadn't even released all the car's specs to the parts suppliers. Two suppliers, Xtrac and then Magna, failed to get the two-speed transmission to work. Still, Tesla was ramping up spending as if it was going to start production in late August, putting $469,696, for example, into stereo and navigation gear that never made it into the cars and instead was sold back to the distributors at a loss. "Elon was pushing for early shipping all the time - it wasn't me," says Eberhard. "I resisted that spending, but Elon insisted."

Even though the Roadster project was wildly off course, between January and June 2007 there were monthly board meetings about designs for showrooms and a parallel project to find a site - they picked Albuquerque - to build a factory for Tesla's second model car, a $59,000 sedan code-named Whitestar. "Either senior management just wasn't paying attention, or they were hoping it would work itself out and they could fix it later," says one board member. "They were running line items on cost, irrespective of where milestones were on development of the car and the supply chain, as if they were not related."

With more-financially-minded investors like Valor Equity Partners and Technology Partners now backing the company, board meetings became focused on the numbers, and according to Musk and three other board members, Eberhard simply didn't have the answers. "In any other company it's the CFO that provides those numbers," Eberhard says in his defense. "I'm an engineer, not a finance guy." During the July 2007 board meeting, Eberhard took a grilling. "You can't tell me the car is going to cost $65,000 to make when just the battery pack is well over $20,000," recalls the board member. "This CEO would not admit the problems and ask for help. You must develop commitments from data and set them in reality, not just hope it works out. We did not believe that this registered with him, and the board felt compelled to take action." A month later Eberhard was removed as CEO and demoted to president of technology.

****

In August 2007, Tesla finally got its priorities straight with what became known as the "Marks list." It was put together by Michael Marks, former CEO of Flextronics and a minority investor in Tesla, whom Musk handpicked as interim CEO to replace Eberhard. It contained about a dozen items in order of importance, each of which had the potential to delay the car. At the top: battery pack, battery cooling, and transmission.

Whereas Eberhard was the high-concept visionary, Marks was a manufacturing whiz with no tolerance for any gray areas in schedule or cost. He quickly realized there was no way to hit the late-August launch and ordered a minimum six-month delay. "I postponed anything that wasn't aimed directly at getting the Roadster out the door," Marks says. That meant mothballing plans for the factory in Albuquerque and shuttering a side business that would have produced battery packs in Thailand for other automotive customers. "If we didn't get that car out," he says, "there wasn't going to be a business."

Eberhard had cut a deal with Lotus for production of the Roadsters that included penalties if production didn't begin on schedule. It didn't. In October, Lotus hit Tesla with a bill for $4 million. That was just the start of the company's cash-flow problems. "We had bought 80% of the parts for hundreds of cars, but since we didn't have the remaining 20% of the parts (including a working transmission), we couldn't ship [the cars] and get paid for it," said Musk.

Marks had been keeping Eberhard temporarily busy on power-supply electronics problems and public appearances, but in December 2007, Musk orchestrated his ouster from the board. Over the next month 10% of Tesla's employees, most considered Eberhard loyalists, were also let go.

Eberhard was furious, believing he had just been following Musk's orders. "Either he was a passive investor or he was involved," says Eberhard, "and I can tell you, Elon was involved every step of the way." Though he had lost control of the company, Eberhard could still fight a PR war. He launched "The Tesla's Founders Blog" detailing what he called the "Stealth Bloodbath" and soliciting comments from current and ex-employees. A typical post: "The company has changed so tremendously since I started. It's very secretive and cold now. It's like they're trying to root out and destroy any of its heart that might still be beating."

The board went nuts, and Yoler pleaded with Eberhard to stop (he eventually toned it down). Nancy Pfund, who sits in on board meetings on behalf of Tesla backer J.P. Morgan, says that Eberhard's "bloodbath" was really just getting costs under control. "We had to reduce the burn rate of the company," she says. "It's always painful, but that doesn't mean we didn't have to do it."

Morale plummeted for those who remained, especially since the car was still nowhere near ready. "We knew things were not going to get better until we had cars out there, so that is what we focused on," says CTO Straubel. Musk began spending two to three days a week at headquarters. The board found a permanent replacement for interim CEO Marks in Ze'ev Drori, an operations-focused Silicon Valley veteran who came out of retirement. Meanwhile CTO Straubel took the car apart on the shop floor in San Carlos, looking at every printed circuit board and every bracket to see where the company could cut costs. Since no supplier could provide the two-speed transmission Tesla wanted, Straubel's team continued to work on the one-speed version, seeing whether it could eke more power from the motor and the electric drive. In March 2008, with a clear path to costs below the sticker price by the end of the year, Tesla decided it could wait no longer and began production of the Roadster. The transmission on the first 40 Teslas, however, will need to be replaced by the end of the year to get the promised performance.

***

Seven Teslas - part of the so-called Founder's Series - have been completed. (The lucky owners: Musk, his brother, board member Antonio Gracias, investor Skoll, Google's Larry Page and Sergey Brin, and of course Eberhard.) The company hopes to ship several hundred more by the end of the year. Musk has set his sights on delivering Tesla's next car sometime in 2010. Called the Model S, it's an all-electric $60,000 family sedan with four doors and a hatchback, which he now plans to build in the Bay Area. He'll need to raise $250 million to $300 million, and he knows it's a long shot that Tesla can grow up and become a real car company. For all the difficulty of getting a few cars built, scaling to thousands and tens of thousands of cars is exponentially harder. Tesla is turning to automotive veterans like former Chrysler executive Mike Donoughe, recently hired as executive vice president of vehicle engineering and manufacturing, to help crack that code. But before it can get to the next car, Tesla needs to make sure the Roadster is a success.

And there are a whole lot of auto buffs and professionals waiting to see what will happen when these cars hit the road for real. Though you can get insurance for a Tesla, a big concern is the amount of heat generated by 6,831 battery cells lashed together. "Never mind whether they will burst into flames," says Bruce Belzowski, assistant research scientist at the University of Michigan's Transportation Research Institute, of the Tesla batteries. "What if they plain don't work? There is real uncertainty about these battery technologies, because there is nothing to compare it with - it's so new there aren't even regulations in place yet." Tesla says the batteries have been tested for an equivalent of 40,000 miles with no safety or durability issues.

Tesla's customers don't seem particularly concerned. During all the turmoil, only about 30 of almost 1,000 asked for their deposits back, and those spots were quickly filled. Engineer Earl Cox (who is buying a Tesla, as is his dad, Stanford professor Don Cox) says he has a great deal of respect for Eberhard. "But I would still love Tesla to win," he says. "I would love if Elon Musk went down in history alongside Henry Ford for doing this thing. It is a great car - I don't have any hesitancy about that - and I can't get it soon enough."

Same goes for Stephen Casner, a software engineer who worked with Eberhard and Tarpenning at networking technology company Packet Design. It was because he trusted and believed in his two former colleagues that he put down $100,000 for his radiant red Roadster. What he didn't do is ask for his money back after Eberhard was shown the door and Tarpenning quit. "I guess I just want the car too much," Casner says.

Startups, after all, are always chaotic. The people who found them are often arrogant or overbearing or both. But in a way Musk was right: The bumps along the road are forgettable, as long as the car isn't.

First Published: July 10, 2008: 7:41 AM EDT

Inside job

This story reads like a corporate coup.The writer says it is more like the (in)famous 'barbarians at the gate'. But I relate it to more of a coup attempt from Pakistan or Congo. It has everything in it - double agent, ambition, greedy financiers, innocent and ignorant management.


A every detailed and commendable article. What amazes me is the speed at which the article has come out with so many details. The events happened just two months ago. The dust is settled and the event has been archived. Read on.

The extraordinary story of two Dow Chemical officials who plotted an LBO of their company - and forgot to tell the CEO or board.

Roger Parloff, senior editor

Last Updated: July 1, 2008: 11:05 AM EDT

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(Fortune Magazine) -- On Jan. 18, 2007, the Financial Times reported "talk in the market" that "a consortium of private equity groups are working on a breakup bid" for Dow Chemical. Dow's share price was spiking; its shareholders, employees, and joint venture partners were demanding more information; yet its CEO, Andrew Liveris, was totally in the dark about what, if anything, lay behind the rumor.

The next morning he e-mailed Dow director and former chief financial officer J. Pedro Reinhard, whom he knew to be plugged in to the financial community. "Can you sniff around your contacts?" he asked. "Let me know if this has any basis?"

About two hours later Reinhard replied dismissively, "This rumor was in the market for about over six months."

"Anything new?" pressed Liveris.

"Not that I am aware," Reinhard responded.

Reinhard was not being candid with his CEO. A few hours before tapping out his responses, he had been meeting in London's plush Carlton Tower Hotel with two advisors working for an Omani sovereign wealth fund. The fund was trying to form a consortium with U.S. private equity firms to launch a leveraged buyout of Dow. According to later statements by the advisors, Reinhard and one of Dow's highest-ranking executives, Romeo Kreinberg - then responsible for about half of Dow's global operations - had been in a hotel room flipping through a 100-page booklet prepared by a London affiliate of J.P. Morgan Chase outlining how the Omani-led LBO would proceed. They were also discussing the compensation Reinhard and Kreinberg might expect if the deal went through as planned - Reinhard would be chairman of the new entity and Kreinberg chief executive.On April 12, 2007, Dow (DOW, Fortune 500) fired the two executives, two days after learning from J.P. Morgan CEO Jamie Dimon that his bank had been advising the Omanis on the bid and that Dow's Reinhard and Kreinberg had participated in the discussions. Dow invoked punitive clauses in their contracts, cutting off roughly $45 million in vested equity and other compensation. Reinhard and Kreinberg responded with outraged protestations of innocence and filed defamation suits against Dow for $25 million and $100 million, respectively.

The bitter litigation came to a morally unsatisfying conclusion last month. On the one hand, Reinhard and Kreinberg admitted that, well, yes, they had in fact participated in unauthorized LBO discussions, and yes, Dow's board had been fully within its rights in imposing the draconian penalties on them. At the same time, however, Dow made major financial concessions. Though the settlement terms are confidential, it's clear that the former officers will have restored to them much of the lucre that Dow tried to yank. In other words, the bogus defamation suits had just been a cynical negotiating tool, and in the end, a shrewd one.

Still, the lawsuits will have one lasting adverse consequence for the plaintiffs: articles like this one. During the course of the litigation, thousands of e-mails and other documents surfaced, as did several key deposition transcripts. From them it is possible to piece together much of what happened, and what emerges is that Kreinberg and Reinhard - the latter still a director in good standing at Colgate-Palmolive (CL, Fortune 500), Royal Bank of Canada, and Sigma-Aldrich - were actually engaging in conduct that was even worse than Dow realized when it fired them.

Kreinberg and Reinhard declined through their attorneys to be interviewed for this story. From the day they were fired, each adopted a maddeningly peekaboo stance, in which their attorneys asserted that their accusers were mistaken or incredible, but their clients refused to come forward with their own account.

Extraordinary business drama

The documents obtained by Fortune, however, provide the most complete picture to date of an extraordinary business drama - a rare, riveting look inside the world of private equity dealmaking intrigue at the height of its frenzy. There are cameo appearances by Henry Kravis of KKR, David Bonderman of TPG (formerly Texas Pacific Group), Chinh Chu of the Blackstone Group, and a walk-on by the richest, youngest industrialist you may never have heard of: 51-year-old Russian immigrant, U.S. citizen, and multibillionaire Len Blavatnik.

Reinhard & Kreinberg

Though the story of the abortive Dow LBO inevitably evokes comparisons to Barbarians at the Gate, it actually teaches very different lessons from that archetypal narrative of 1980s deal intoxication. Notwithstanding that a Dow LBO valued at $50 billion to $60 billion would probably have been the largest ever, in this tale glory and ego ultimately took a back seat to reason and pragmatism. To the chagrin of the coup plotters, the moneymen were loath to go hostile and coldly skeptical about whether the numbers made sense. Dow's fate was determined neither by a self-dealing CEO nor by swashbuckling corporate raiders, but rather by a board that was majority-controlled by independent directors. Alas, there may be no movie in this one.

As their ethnically hybrid names suggest, Pedro Reinhard and Romeo (accent on the second syllable) Kreinberg are truly worldly men. Reinhard, 62, grew up in Brazil and was schooled in Germany and the U.S. Kreinberg, 57, was born in Croatia and raised in Argentina, has lived in nine countries, and speaks six languages. Each spent his 30-plus-year career at Dow crisscrossing the globe, from Germany to Italy to Switzerland to the U.S., with frequent excursions to the Middle East. Stellar performers, each was once a leading contender for the CEO spot: Reinhard in 2000 (when Michael Parker got the nod) and Kreinberg in 2004 (when Liveris prevailed).

Reinhard was respected for his keen financial acumen and vast knowledge of the chemical industry. At the same time, independent Dow director James Ringler testified in November that Reinhard's "emotionalism at times would about drive you nuts," and that "he had ... a delivery ... that would irritate the Pope."

Kreinberg was a superb executive within his operational silo, according to three independent directors, but they also say he was "autocratic" and "close-minded" and had a "my way or the highway" attitude that was abrasive to peers. He was a "very, very difficult individual to manage," a fourth director noted in his deposition, and he liked to live large on his Dow expense account.

In late 2005, Reinhard and Kreinberg were the two point men supervising Dow's joint venture with the government-owned Oman Oil Co. Reinhard and Kreinberg handled all dealings with the Omanis, according to director Arnold Allemang, a former head of operations at Dow, and they jealously protected their turf. Their attitude, said Allemang, was, "If you want to talk to [the Omanis], you'll do it through us."

While the executives' Oman connection was key to their eventual expulsion, Reinhard had a troublesome second connection that Dow scarcely understood until months after his termination: his role at Len Blavatnik's massive private holding company, Access Industries. Blavatnik, who made his fortune in Russian oil assets, is now one of the world's richest men, with a personal net worth estimated at $7 billion to $8 billion. Access holds interests in telecommunications, media, real estate, oil, metals, and - since August 2005, when Access closed on its purchase of the Netherlands-based Basell Polyolefins - the chemicals arena.

Upon buying Basell, Access hired Reinhard as an advisor. Having turned 60, Reinhard was phasing out his operational duties at Dow, though he was staying on as a director. Dow told him he could work for Access as long as he confined himself to matters that wouldn't conflict with Dow's interests. He was also advised that because Access now had the Basell unit, he couldn't sit on the Access board, since that might violate antitrust laws barring directors from sitting on the boards of competitors.

Reinhard's conception of what constituted a conflict proved vastly narrower than Dow's. By early 2006 he was not only a member of Access's investment committee - which some Access officials referred to as its "de facto board" - but also sitting as an "observer" on board meetings of Basell itself. Reinhard assured Access that Dow was comfortable with his roles.

In March 2006, Access's Blavatnik sent Dow's Liveris a letter formally offering to acquire Dow's commodities (or "basics") divisions. Unbeknownst to Dow, Reinhard had "edited and signed off" on Blavatnik's letter before it was sent, according to Access e-mails. Liveris, who was not receptive to the overture, made no response. Reinhard, however, again without Dow's knowledge, informed Access of Dow's reaction. "Spoke briefly to Pedro," an Access official reported to Blavatnik. "Later learned that Dow approached both Kuwait and Saudi Aramco with the assets we want.... He told me/us to sit tight."

In April, when Liveris became chairman of Dow's board, he directed Dow's general counsel to write Reinhard a stern two-page letter spelling out that Dow would consider it a conflict of interest for Reinhard, when advising Access, to discuss or receive any "information about Basell." Reinhard argued with Dow's chief counsel and tried to negotiate, but Dow wouldn't budge.

Reinhard told Access nothing about the letter and disregarded its dictates. In the ensuing months, Reinhard attended Access and Basell board meetings as Basell bid for and ultimately acquired Lyondell Chemical Co., forming LyondellBasell Industries, the third-largest industrial-chemical company in the world.

During the first half of 2006, Dow's share price was languishing, and the company was regularly being approached by investment banks with unsolicited presentations proposing deals to increase shareholder value, including breakup LBOs. A common view was that Dow was undervalued because it was seen as a commodities business. If it sold its commodities segments while focusing on its higher-margin "performance chemicals" units, the share price would soar, some predicted.

In July the company's senior management and board held a weeklong strategy retreat in Newport, R.I., where they debated six strategic "optionalities," including a breakup of the company. Liveris argued that Dow's commodities and performance segments were so interdependent that it was best to maintain the company's integrated structure. Instead of a breakup, he favored an "asset light" strategy, in which Dow would "monetize" its commodities assets by, for instance, selling joint venture interests in them while keeping operational control. The proceeds would be used to expand the performance units.

The board backed Liveris's asset light strategy and rejected breakup strategies. The only dissenter was Reinhard.

A tempting target

That same month an Omani-led LBO bid for Dow was in gestation. A freelance consultant and wheeler-dealer named Terry Ruane approached chemical industry consultant Eddie Wilson, asking him to do a breakup valuation of Dow. Ruane and Wilson both were based in Jersey, in the Channel Islands, and both were business consultants in Oman. Ruane worked for Dow on its Omani joint venture, the Oman Petrochemical Industry Co. (OPIC), reporting to Kreinberg and Reinhard. Wilson, who had spent 25 years at Dow earlier in his career, was also a consultant to OPIC, but for the Omanis. To help with the valuation, Ruane showed Wilson a short profile of Dow that had been prepared by J.P. Morgan Cazenove, a joint venture of J.P. Morgan Chase (JPM, Fortune 500) and the British investment bank Cazenove. Wilson did the valuation but didn't hear back from Ruane for several months.

In late July, when Dow announced disappointing second-quarter results, its stock plummeted 10%, making the company an even more alluring target for a breakup bid. Officials inside Blavatnik's Access - unaware of the nascent parallel activity in Oman - began mulling an LBO of Dow as an indirect means of capturing Dow's commodities assets. In August and September they prepared a breakup analysis for Dow using the code name Achilles (because Dow's commodities unit was its "Achilles' heel" as far as share price was concerned). Remarkably, Reinhard played a key role in preparing Access's breakup analysis of Dow, according to both internal Access e-mails and the later deposition testimony of Access's mergers and acquisitions chief, Philip Kassin. Reinhard identified appropriate comparable companies for each of Dow's business segments - information not provided in Dow's 10-K - and extrapolated appropriate earnings multiples.

By mid-September, Access officials had completed their analysis. The draft noted that the "deal would most likely have to be 'hostile.'" On Sept. 18, 2006, after a Basell board meeting at its laboratory in Ferrara, Italy, Kassin, Reinhard, Blavatnik, and Basell's CEO met in a small private office, and Kassin presented his LBO proposal. When he was just minutes into it, Kassin later testified, Blavatnik cut him off, saying the deal was "too big, probably not doable," and that he had "no desire to do anything hostile." Shortly after the meeting, Kassin e-mailed a colleague about the debacle, noting, "Pedro very very very pissed."

Someone - Dow hypothesizes Reinhard - wouldn't let the idea die. In October, Terry Ruane, the same consultant who had asked Ed Wilson to do a breakup evaluation of Dow in July, contacted Kassin at Access and described an Omani-led bid to do a Dow LBO, advised by J.P. Morgan Cazenove and to be sponsored by U.S. private equity players. He urged Access to participate. Ruane told Kassin not to tell Reinhard about the Omani bid at this point, acting as if it were a secret, but in an affidavit later submitted in the litigation, Ruane says it had actually been Reinhard who told Ruane to contact Kassin in the first place. (Reinhard's and Kreinberg's lawyers have sharply challenged Ruane's credibility, with some basis: Kassin and Wilson testified that he sometimes "exaggerates" or "spins" to get deals done, and Kassin added that he sometimes works multiple sides of a deal. Ruane also has ongoing consulting contracts with Dow.)

After having coffee with Ruane in London, Kassin e-mailed Blavatnik: "The consortium preference is to have Pedro as chairman and Romeo Kreinberg as CEO." Kassin stressed that the deal might not be hostile, after all. "[Ruane] said most of the management is supportive and involved - except, obviously, Liveris." Once an LBO bid is made, a board has a fiduciary obligation to shareholders to assess it on its merits, regardless of what the CEO may think of it. If a majority of the board approves, the deal would technically be considered friendly.

Kassin set up a meeting in London between Blavatnik and Ruane to discuss an LBO of Dow that would be led by the State General Reserve Fund of the Sultanate of Oman (SGRF), an Omani sovereign wealth fund, which was prepared to ante up at least $5 billion of equity. Ruane brought with him Ian Hannam, co-head of equity capital markets at London's J.P. Morgan Cazenove, who was advising the Omanis. Again, however, Blavatnik was noncommittal at best, and Access never went forward.

On Oct. 30, Ruane and Hannam met with Reinhard and Kreinberg for the first of two meetings at the Carlton Tower in London. Some OPIC business was discussed, but the purpose of the meeting, Ruane maintained in his later affidavit, "was to discuss what a typical leveraged buyout would mean for the resulting management," with "special reference to a potential buyout of Dow."

Two Omani government ministers wanted a face-to-face with Reinhard and Kreinberg before proceeding, so Ruane arranged a meeting in Muscat. At one point the Omanis leaned across the table and asked if Reinhard and Kreinberg thought Dow would be a good investment and if they would be willing to stay in their positions to manage it. They answered yes to both questions, according to statements Ruane made to his lawyers.

Thereafter the bid moved forward in earnest. In anticipation of signing a formal engagement letter with the Omanis, the JPM Cazenove bankers notified key officials at their parent, JPM Chase, and initiated a conflicts check. The conflicts memo stated, "Buyout team led by former CFO. Not all members of current senior Dow management team are involved." Accompanying internal JPM e-mails identified Reinhard as the "former CFO." Another e-mail said, "I understand that D mgmt deliberately keeping low profile until further down track ... i.e., aiming very much for plausible deniability at this stage."

Since JPM Chase did a lot of business with Dow, the prospect of a hostile bid made some of its bankers extremely uncomfortable. But others stressed that the deal might yet win Dow board consensus. The issue then appears to have been tabled, and the signing of the engagement letter was put off pending clarification on these points.

In mid-December, Ruane brought consultant Ed Wilson, the former Dow official, back into the picture to help the bankers draw up a 100-page business plan for what was now code-named "Project Door." (The coding was half-hearted; Dow was "Door," Oman was "Oryx," and one of the Door units slated for early sale was "Door Corning.") On Jan. 19, Ruane, Hannam, Wilson, Reinhard, and Kreinberg met at the Carlton Tower again, and Wilson took the executives through the business plan.

Wilson remembered the meeting well, since he got some bad news there, he later recounted in his deposition. He had previously been told by Ruane that the two of them would be sharing a 25% slice of JPM's banking fees as their compensation on the deal. Reinhard and Ruane now informed him that the new plan was for the 25% piece to be split three ways - among Ruane, Reinhard, and Kreinberg. Wilson would just get a lump sum. Since JPM's advisory fees were then being ballparked in the $200 million range, 25% would have been about $50 million. Wilson was steamed. (Reinhard's and Kreinberg's attorneys have attacked Wilson's credibility, as they did Ruane's - and again, with some basis. After the post-termination litigation began, Wilson struck a highly unusual "cooperation" agreement with Dow under which Dow agreed not to sue him over his role in the affair, to pay him his usual consulting fee - about $4,500 a day - for time spent responding to litigation demands, and to reimburse his attorneys fees. Ruane and Wilson had some bargaining leverage because they were outside the jurisdiction of the U.S. courts.)

Media attention

It was after or during this second Carlton Tower meeting that Dow CEO Liveris sent Reinhard the previously mentioned e-mail asking him what was behind the buyout talk reported in the Financial Times, only to be told that it was a stale rumor.

Kreinberg also kept mum, according to Liveris's later testimony, when the Financial Times item came up for discussion at regular meetings of Dow's top executives. "He was there," Liveris recounted, "sitting there all the time, looking very mute and unresponsive." The item was even discussed informally at Dow's next board meeting, according to the testimony of Liveris and other directors. Reinhard was present but volunteered nothing.

By this time the Omanis and JPM Cazenove bankers were almost ready to make their formal presentations to American private equity groups. Before doing so, however, they needed to tie up crucial loose ends. The head of Oman's SGRF needed to meet Reinhard and Kreinberg personally and make sure they were okay with a stingier management-incentive package than had been originally proposed. Rather than allowing top management to come away with 10% of the surviving company if it met performance targets, SGRF was scaling that back to 6%. Second, the JPM Chase bankers needed to know how many Dow board members and executives were really backing Reinhard and Kreinberg - i.e., was there really any hope of this becoming a friendly deal.

To resolve these issues, Hannam scheduled two meetings for Reinhard and Kreinberg in London on Feb. 27. At one they would meet the head of the Omani fund and at the other, JPM Chase vice chairman Bill Winters.

Two days before the critical meetings a second, more detailed newspaper story described an impending LBO bid for Dow. It predicted a "$54 billion approach ... likely to include powerful players such as KKR, Blackstone, and Carlyle Group." Upon learning of the item, Chinh Chu of Blackstone called Liveris to assure him that Blackstone was not involved. Liveris called Kravis, who said he didn't know of anything underway, but he assured him that it was highly unlikely his firm would be involved in anything hostile.

Still, Liveris took the rumors seriously. He launched "Project Fort," by asking Dow's two primary investment banks, Citigroup (C, Fortune 500) and Merrill Lynch (MER, Fortune 500), to perform LBO analyses of Dow in anticipation of an unsolicited bid. He also hired the nation's premier takeover-defense lawyer, Marty Lipton of Wachtell Lipton Rosen & Katz.

Meantime, the LBO planners decided that the press leaks made it too risky to meet in London. Hannam moved them to the Compleat Angler, a gorgeous inn on the Thames, about 35 miles to the west. To ensure secrecy, he didn't reveal the name of the hotel and just sent cars to Heathrow to pick up the participants. He also rented the hotel's entire residents' lounge so that the congregants could meet unobserved.

According to Dow, Kreinberg created a cover story for his trip that day. He had the OPIC chairman write a bogus letter summoning him to London to discuss an invoice reimbursement dispute.

Neither meeting went well. Reinhard and Kreinberg did not commit to the Omanis' incentives package. In fact, in an internal JPM Cazenove e-mail later that day, a banker wrote that Reinhard now saw "no compelling reason for [an] Omani link" for the deal. (Dow speculates that Reinhard objected to the stingier compensation package.) At the second meeting Winters, from JPM Chase, learned for the first time that Reinhard and Kreinberg actually had no known supporters on the board, but were acting alone. Winters was "surprise[d] that only 2 individuals in loop at this stage," a JPM Chase banker wrote to Hannam. "Any approach likely to be perceived as unfriendly/hostile.... Much of above may make JPM commitment to SGRF more difficult at this stage."

Still, Winters did not call off the deal. He instructed Hannam to tell the Omanis it might yet be possible to win Dow board approval if the board were approached in the right way. Hannam was to tell the Omanis, "We remain committed to helping you get this asset."

Reinhard's and Kreinberg's lawyers claimed in court papers that their clients were surprised by the talk of an LBO at the Angler and that they "rebuffed" such proposals, telling JPM bankers that if an overture were made, Dow would "circle the wagons." Kreinberg even claimed that he had gone to the hotel expecting to meet only Ruane and discuss mundane OPIC business. But this account strains credulity. Though Wilson did not attend either meeting, he was at the Compleat Angler and had tea with Reinhard and Kreinberg after the meetings. Neither expressed any shock or surprise at the time, Wilson testified, nor any desire to drop out of the project or have it come to a halt.

On March 1, Dow CFO Geoffrey Merszei was told at a meeting in New York with Citigroup bankers that JPM Chase was involved in the LBO bid for Dow that was spurring newspaper reports. On March 5, Liveris called JPM Chase CEO Jamie Dimon, who promised to look into the question and get back to him.

Also on March 5, Wilson met with Reinhard in Zurich, according to Wilson. The meeting focused on the 25% of JPM's banking fees that Reinhard still hoped to get a piece of and that Wilson was still angry about being cut out of. "Reinhard was trying to assure me that the payment of some of the banking fees to himself and Mr. Kreinberg would not be problematic [legally or ethically]," Wilson testified. Reinhard had invited officials from a Swiss bank to the meeting, and they were arguing that "ways could be found to structure it ... without giving rise to problems." The arrangement allegedly would have involved having Reinhard and Kreinberg's shares of the banking fees sent to Wilson, who would then forward the money to them in Switzerland. Wilson refused.

On March 7, Liveris and Dimon spoke again by phone. Dimon confirmed that his bank's Cazenove unit was working on something, but he was still trying to find out more.

On March 12, yet another newspaper item appeared, the most detailed and accurate yet. The London tabloid Evening Standard, was heralding a "$60 billion deal ... masterminded by Ian Hannam out of J.P. Morgan in London," in which "the usual suspects," including KKR, were among the likely sponsors. Furious, Dow CFO Merszei called JPM Chase's Dow account representative, Christopher Iannaccone, and told him to stop work immediately. Iannaccone promised to relay the message to higher-ups.

More cold water was poured on the deal when it was formally pitched to KKR and TPG on March 13 and 14. "We don't think the numbers work," wrote one KKR banker. At TPG, David Bonderman was likewise "underwhelmed," according to a JPM e-mail.

On March 15, JPM Chase's Winters recommended pulling out of the deal in an e-mail copied to Dimon. "Based on this feedback, we should go back to Dow now with an 'all pencils down' message. I'm happy to help with damage control if needed." It appears that Dimon called Liveris that same day to convey the message (though Liveris is not certain of the date). JPM Chase also notified the Omanis and Hannam. JPM was out of the hunt.

But Reinhard may not yet have given up. Two days after JPM withdrew, he urged Kassin, the mergers and acquisitions chief at Access, to solicit more approaches to Dow. "Had long talk with Pedro last night," Kassin wrote Blavatnik. "He is in very weird position. He is playing on too many teams in my opinion."

The last newspaper leak came on April 8 and proved to be the coup de grâce for Reinhard and Kreinberg. The story reported that "a consortium of Middle Eastern investors and American buyout firms" was putting the "finishing touches" on a bid and identified JPM Chase in London as its advisor. As it happened, Dimon was scheduled to have dinner with Liveris at Dow's headquarters in Midland, Mich., the next evening. Dimon sarcastically e-mailed Winters and two others the next morning: "Considering that I am having dinner tonight with the CEO of Dow, can I get briefed about what is going on?" The bankers assured Dimon that JPM had been "tools down" since March 15.

Upon seeing the latest press account, KKR's Kravis called Liveris. According to Liveris's notes, Kravis told him his London office had been approached, but they had stopped when they found out it was hostile. He also said the Omanis were working with people "who know a lot about Dow."

'Double agent' Reinhard

Dimon's dinner with Liveris on April 9 - the "mea culpa meeting," as one JPM Chase banker referred to it - was amicable. "Mr. Dimon was very forthcoming," Liveris later testified. Dimon's "demeanor" communicated that "this was a man who had clearly found out that his company was involved in something that he ... did not support," Liveris said. "[Dimon] made reference to ... parties very, very close to Dow, and ... went on to more than insinuate that there were people that were really in the middle of this deal and that really I had to know about." Liveris pressed him for details, and Dimon promised to get back to him. Iannaccone, who had been present, reported afterward in an e-mail, "Clearly we have been dinged by this episode, but if Jamie is able to provide some color over the next couple days, we might not be in as bad a position as I thought."

Dimon fingered Reinhard and Kreinberg in a phone call to Liveris the next day. Reinhard in particular, Dimon said, was acting like a "double agent," according to Liveris's notes. "Jamie recommended I do my own homework, but if he were me, he would get these guys 'out' and off the [board of directors] asap."

Liveris broke the shocking news to the board the next day. It unanimously authorized Liveris to terminate Reinhard and Kreinberg after giving each man an opportunity to be heard. On the morning of April 12, each man offered only a lawyerly, blanket denial of wrongdoing. They were fired later that day.

The lawsuits and countersuits were filed on May 8, 2007, and settled on June 2, 2008. In addition to the confidential financial terms, Reinhard and Kreinberg publicly admitted their unauthorized LBO discussions, while the company acknowledged the men's "substantial contributions to Dow over their lengthy and illustrious careers at Dow."

"Pedro Reinhard is pleased with the settlement," his attorney Gary Naftalis said in a statement. "He greatly appreciates the company's public recognition and kind words about his illustrious career at the company." Kreinberg's attorney Stanley Arkin declined comment for this article.

"The defendants' acknowledgment that the board was right was key," says Dow's attorney David Bernick. "Once that was agreed, the only remaining question was whether to continue the litigation for the sake of getting back the last dollar of earned equity compensation. [Dow] decided that was not the appropriate path to take."

Obviously, mysteries still abound. Who misled whom into thinking the Dow board would be receptive to an LBO? Who leaked to the press? And what in God's name were these two guys thinking? Can't help you there.

To read Roger Parloff on legal affairs, go to fortune.com/legalpad.

How Lehman lost its way

The venerable Wall Street firm once looked like it would escape the worst of the credit crisis. Now there's talk of a Bear Stearns-like collapse - or a sale.

By Allan Sloan and Roddy Boyd

Last Updated: July 2, 2008: 8:45 PM EDT
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NEW YORK (Fortune) -- To understand what went wrong at Lehman Brothers, leave the canyons of Wall Street and head to the flatlands of Bakersfield, 120 miles northeast of Los Angeles.

That's where you'll find McAllister Ranch, envisioned as a 6,000-home, multibillion-dollar recreational community built around a Greg Norman-designed golf course, boating and fishing waters and a beach club. Now McAllister is three-square miles of fenced-off, almost lunar landscape punctuated by a half-finished clubhouse and a golf course gone to weeds.

So far Lehman's bets on McAllister and other real estate plays in Southern California's Inland Empire have cost Lehman at least $350 million.

None of Lehman's investment bank peers have this kind of exposure to the burst real estate bubble. Then there's the exposure all of them have: problems with collateralized loan obligations, leveraged buyouts, and mortgage-related securities. But Lehman insisted it was only minimally exposed to this kind of stuff.

Turns out, it wasn't. As a result, the bank and its shareholders have endured big losses; messy public demotions of the chief operating officer and chief financial officer; battles with short-sellers, who are betting that Lehman's share price, down about 70% on the year, will decline further; rumblings that the firm will be sold; and rumors (which we consider unfounded) that it will pull a financial El Foldo the way the late Bear Stearns did.

How has Lehman (LEH, Fortune 500) come to this? Read on, and we'll tell you Lehman's true history - and how management miscues, combined with historical forces outside Lehman's control, have put the firm in a world of hurt. We'll also tell you how we think the drama will play out.

Deals gone bad

McAllister Ranch is an apt symbol for Lehman's problems on several counts.

First, Lehman's commercial paper unit is on the hook for a $235 million loan it made to the development. Good luck trying to collect that debt. Worse, in 2006 - the height of the housing bubble - Lehman invested a total of $2 billion in deals with McAllister's developer, SunCal Cos., a Southern California firm severely spattered by the bursting of the real estate bubble. The $350 million McAllister loss looks increasingly like only a down payment.

Because it prided itself on real estate expertise - it helped popularize real estate-backed securities in the early 1970s - and investment prowess, Lehman risked far bigger proportions of its own capital doing deals than its major competitors did. Brad Hintz, a former Lehman chief financial officer who now follows the firm as an analyst at Alliance Bernstein, wrote recently that Lehman has more than 2.5 times its entire net worth tied up in complex, hard-to-value securitized products.

Only Merrill Lynch (MER, Fortune 500), among Lehman's peers, has a higher ratio, Hintz said - and Merrill is vastly larger than Lehman. What's more, Merrill has multibillion-dollar assets, such as stakes in Bloomberg LP and BlackRock, that it can sell quickly without interfering with its core businesses. Lehman has nothing similar.

Lehman's high-risk, high-reward strategy produced cash gushers during the good days - the firm reported almost $16 billion of profits from 2003 through 2007 - but those days are gone. Lehman recently reported a $2.8 billion second-quarter loss, which probably won't be its last unprofitable quarter. Two years ago Fortune lauded Lehman and its chief executive, Dick Fuld, because the firm was the best-performing investment-banking stock in the country. That was then.

Now Lehman finds itself stuck with all sorts of hard-to-sell assets and securities worth far less than what it has invested in them. For example, last October - with the credit crunch and real estate meltdown well underway - Lehman (in partnership with the Tishman Speyer real estate firm) paid $22.2 billion to do a leveraged buyout of Archstone, a big apartment developer. Lehman decided to go through with the deal rather than walk and risk paying a $1 billion breakup fee (which could presumably have been negotiated down, as happened in subsequent busted LBOs).

Lehman's Archstone losses could ultimately exceed what a breakup fee would have cost. The firm disclosed a $350 million Archstone charge to earnings last month, and that could be only the start.

"Archstone is the preeminent apartment developer, but the timing was off," says Craig Leupold, president of Green Street Advisors, a real estate consulting firm. "I'm looking at a decline of 10% to 15% in value for apartment complex values, which amounts to $2 billion to $3 billion off the purchase price."

That would be a staggering hit for Lehman, whose total capital is only $19 billion ($36.9 billion if you count its recent preferred-stock issues and subordinated debt). Founded in 1850 as a cotton trading firm in Montgomery, Ala., Lehman Bros. had a storied reputation for prudence and sound management.

So how did it end up in this pickle?

In part because, irony of ironies, CEO Fuld, who prevailed in a decades-long battle for Lehman's soul, adopted the policies of the people that he and his trading floor allies fought so bitterly in Wall Street's most famous civil war of the 1980s.

The trading faction, which included Fuld and was led by his then-boss, Lew Glucksman, wanted the firm to stick to its traditional knitting of trading and underwriting securities. The banking faction, led by Steve Schwarzman and Pete Peterson, wanted to use the firm's capital aggressively to do risky deals.

The traders prevailed then - but Fuld ultimately adopted large elements of the bankers' proposed strategy. It's as if Jack Welch had decided during his GE days that the touchy-feely school of management was right after all and began walking the halls to ensure that people were happy. Lehman eventually sold itself to American Express in 1984. Schwarzman and Peterson left to start Blackstone Group and become multibillionaires. Fuld stayed at Lehman.

After ten mediocre-to-awful years as part of American Express's failed financial supermarket strategy, an undercapitalized, independent company called Lehman Brothers emerged in 1994 with Fuld as CEO.

Neither Fuld, a passionate Lehman lifer, Schwarzman or Peterson would speak with Fortune. A Lehman spokesman said the firm wouldn't cooperate either, because our questions were "unfair and biased."

It's tempting to blame Fuld for everything that's gone wrong at Lehman. After all, the man took credit for the firm's successes (while throwing the occasional victim under the bus when there were problems) and got a corporate rock star compensation package.

By Fortune's math, Fuld has realized almost half-a-billion dollars in cash - $489.7 million, to be precise - by cashing in stock options and restricted stock that he was granted. (That's a pretax number.) He's also knocked down wads and wads of regular old money.

Done in by a financial arms race

But a significant part of Lehman's problem doesn't stem from Fuld's management - it's because the firm suffered collateral damage from Washington's decision a decade ago to repeal the Glass-Steagall Act, adopted during the Great Depression to separate investment banking from commercial banking.

Until Glass-Steagall disappeared, one of the attractions of owning a piece of an investment bank was that it was asset-lite. The major asset - the firm's people - went home at night. The financial assets were generally liquid (which means easily sellable at the market price). And because they weren't burdened with multibillion-dollar investments in real estate or corporations, investment banks had staying power and could wait for bad markets to recover.

The repeal of Glass-Steagall would change that. Ask Chris Andersen, chief executive of investment boutique Andersen Partners and, at 70, one of Wall Street's grand old men. When Glass-Steagall was adopted in 1999 to let Citi and Travelers (which have since split apart) combine, Andersen notes, commercial banks promised not to use their balance sheet to compete with investment banks, which traditionally had far smaller capitalizations.

"Of course, the minute Glass-Steagall was repealed, the commercial banks began using their balance sheets to compete, offering loans if they also got to do equity offerings as well as arranging public debt financials for transactions," says Andersen.

So investment banks like Lehman bulked up to compete with the Citis and J.P. Morgan Chases (JPM, Fortune 500) of the world, setting off a financial arms race to compete on size and scope.

The arms race - and the associated risk for Lehman - has grown exponentially more intense since 2004, when the world began to find itself awash in cheap short-term money, and globalization and dealmaking increased the call on Lehman's capital for things such as leveraged buyouts-and real estate.

At the end of 2003, Lehman had $11.9 billion of tangible capital and $308.5 billion of assets on its balance sheet. The ratio: just under 26 to 1. As of the first quarter of this year, it showed $786 billion of assets and less than $18 billion of capital. Ratio: around 44 to 1, leaving relatively little cushion to absorb losses.

Lehman also has self-inflicted wounds.

When firms like Citi (C, Fortune 500) and Merrill and Morgan Stanley (MS, Fortune 500) began fessing up to big problems related to the real estate bubble popping and the ensuing worldwide credit squeeze, Lehman insisted all was well. It even managed to show a $489 million profit for its first quarter, but only with accounting so aggressive and bizarre (albeit legal) that it undercut faith in Lehman's numbers.

Lehman took a $722 million paper profit in the value of its so-called Level 3 equity holdings - stocks that don't trade publicly and for which there aren't liquid markets. This means that Lehman claimed a 9% profit on its private-market stocks during the same period the Standard & Poor's 500 index of publicly traded stocks fell by 10%. Hmmmm.

David Einhorn, a short-seller whose questions about Lehman's balance sheet have confounded its management, says the firm's since-deposed chief financial officer, Erin Callan, told him $400 million to $600 million came from writing up the value of electric generating plants in India - Einhorn feels that only about $65 million was justified. (Lehman, as we've said, declined comment.)

Lehman also showed a $600 million profit because of the decline in the market value of its own debt obligations, whose price was falling because of perceptions that the company was in trouble. That's permissible accounting - but these are ugly, low-grade earnings, not unlike the "profit" you make when your house is foreclosed at a value lower than your mortgage.

And finally, we found that Lehman created another $176 million by almost doubling (to $365 million) the value it ascribed to certain mortgage servicing rights. Servicers get paid by mortgage holders for collecting payments and handling paperwork, and valuing servicing rights is notoriously tricky.

Until recently Lehman managed to raise capital without getting its stock price killed. The neatest move came on April 1, when Lehman sold $4 billion of preferred stock convertible into common stock. For arcane reasons we won't bore you with, when a company sells a big convert issue, convertible arbitragers - who make money exploiting differences between the prices of convertible issues and their underlying common stock - short the common like mad, driving down its price.

But Lehman kept the arbs at bay by placing the vast majority of the issue with large, long-term holders of its common. This helped precipitate a short squeeze, and Lehman's stock rose 18% (to $44.17 from $37.50) the day of the issue, rather than declining as the market expected.

But in a second sale last month Lehman seemed to have lost its touch - or gotten desperate. It sold $4 billion of common stock and $2 billion of convertible preferred, but seems to have placed much of the preferred with hedge funds and arbs that shorted the common, which promptly plummeted. That bummed out investors who bought the common, and the declining price increased the talk about Lehman's problems.

While we won't get bogged down in the minutiae of collateralized debt obligation exposures - which Lehman has done a better job of avoiding than Merrill, Citi or UBS (UBS) - the exposure it does have poses serious potential problems.

Lehman's filings indicate it has about $6 billion of CDO exposure. About a quarter of them are rated BB+ or below. These low-rated arcane, illiquid bonds-made-from-other-bonds are worth maybe 10 cents on the dollar. That indicates a loss of at least $1 billion. There are likely additional losses looming in the other three quarters of the portfolio.

What's next for Lehman

We're not predicting that Lehman will fail - it won't because of the Federal Reserve Board, which has let it be known that it will lend Lehman (and any other investment bank it deems worthy) enough money to avoid collapsing, the way Bear Stearns did.

Lehman has been in trouble before - the collapse of the Long Term Capital Management hedge fund in 1998 started rumors it was insolvent, the 9/11 terrorist attacks traumatized employees and made its headquarters near Ground Zero unusable - and it somehow managed to escape and prosper and stay independent.

But this time we suspect that because of pressures we foresee both from the capital markets and regulators, Lehman will ultimately end up owned, once again, by a much larger institution.

So let's close by going back to where we started: McAllister Ranch. An official with SunCal, the project's developer, says the company "remains committed to seeing that this community becomes a reality." When we tried to get a tour of the property, a man in a Hawaiian shirt and shorts, who clearly isn't an investment banker, emerged from deep inside the development's darkened sales office.

His final words as he shooed us off: "This is not a public business." Which may be said of Lehman soon.

Enron suit: A new tempest for Citi?

twist twist

A $20 billion claim charges the bank helped the firm manufacture financial statements. Bethany McLean investigates.

By Bethany McLean, Fortune editor-at-large

(Fortune Magazine) -- "When Enron blows up, will it be worse than Long-Term Capital?"

So wrote one Citigroup banker to another in April 2001, some seven months before Enron's bankruptcy. That e-mail is, of course, a vivid reminder of two big blowups that rocked the capital markets. But -- surprise! -- it's not just a remembrance of things past.

The e-mail is also part of a series of lawsuits filed against Citi after Enron's bankruptcy, one of which is supposed to go to trial this spring, in which Enron -- or what remains of it -- is seeking more than $20 billion from Citi. In the inflated numbers, the aggressive posturing, and the mind-numbing complexity, the lawsuit itself is totally Enronesque. The funny thing, though, is that this time around it's not clear which actor is playing Enron.

Let's get this out of the way first: Yes, Enron still exists! But it's called Enron Creditors Recovery Corp., it has just 36 employees, and it exists for one reason: to pay creditors. To date, those creditors have gotten 36 cents on the dollar, double the original estimate, which Enron has paid by selling assets such as pipelines and power plants -- and extracting money from Wall Street banks that, like Citi, helped Enron fool the world.

The 'Mega Claims' suit

This campaign against Wall Street began in 2003, when Enron filed a suit that it aptly called Mega Claims against 11 banks, alleging that they helped manufacture its financial statements. Nine of the 11 settled, paying what Enron says is $1.7 billion in cash (some of this was payment for claims the banks took back) and giving up almost $1 billion more in claims. A small case remains against Deutsche Bank -- and a big one remains against Citi. "We believe the suit is without merit, and we intend to defend against it vigorously through the courts," says Citi.

The Mega Claims case is separate from the lawsuit by Enron's shareholders that Citi settled in 2005 for $2 billion to "put a difficult chapter in our history behind us," as then-CEO Chuck Prince put it. Oops. It appears that Citi may have settled the wrong case, because last spring an appeals court sidelined the shareholders' suit. It is currently awaiting a relevant Supreme Court decision.

But Enron itself has a shot against Citi, thanks partly to provisions in bankruptcy law. Mega Claims has its genesis in the 4,235 pages of analysis produced by the Enron bankruptcy examiner, who concluded that Citi helped Enron "produce materially misleading financial statements."

For instance, Citi, which averaged a stunning deal a month with Enron from 1997 through the company's bankruptcy, helped Enron improperly record more than $5 billion in cash flow from operations and understate its debt by billions. As a result, Enron alleges that Citi knew the company's real condition ("When Enron blows up ...").

Karma on Wall Street?

And so Enron argues that Citi should return what it says were $3 billion of payments from Enron to Citi in the years before Enron's bankruptcy. Enron also argues that Citi should have to fill the $18 billion gap between what other innocent creditors are being paid and what they are owed. (This number is obviously out of whack with what the other banks paid.)

The most Enronesque part of the lawsuit has to do with the billions that Citi lent Enron. In the late 1990s, Citi began to get nervous about its exposure to Enron. So Citi crafted some fiendish structures under which, in the event of an Enron bankruptcy, third-party investors -- who believed such a thing was highly unlikely -- would step into its shoes as Enron's creditors.

Not only did those investors end up with Enron's debt, but they wound up with Enron debt that may be worthless because of a concept known as "equitable subordination," under which a bankruptcy court can penalize a creditor's misconduct by making sure that the creditor is paid last.

It appears that Citi knew that was a possibility. A few days before Enron's bankruptcy, one Citi executive wrote, "Remember the risk is equitable subordination.... Think 'jammed to the bottom of the pile.'"

Today Enron argues that what it says are $5 billion of original Citigroup claims can indeed be jammed to the bottom of the pile. Citi says that because third parties now hold the claims, those claims have been cleansed of any bad acts that may have occurred. (Call it claims laundering.) But Citi still has to care, because it's also being sued by those third parties, who want to force Citi to pay if Enron doesn't.

This issue is at the cutting edge of bankruptcy law. Judge Arthur Gonzalez, who is overseeing Enron's bankruptcy, ruled that the claims should be subordinated. Citigroup and a current holder of a small claim appealed Gonzalez's decision to the district court, and in August, in a closely watched decision, Judge Shira Scheindlin ruled that claims were subject to different sorts of treatment based on how the holders acquired them. It's still unclear what her decision means for the bulk of the original Citi claims.

Of course, all this couldn't come at a worse time for Citi (Charts, Fortune 500). Maybe the real question is, Could there be such a thing as karma, even on Wall Street?

Fannie Mae's fuzzy math

somebody's cooking again!

The mortgage lender has quietly changed the way it calculates its bad loans -- and it could be camouflaging steep credit losses, writes Fortune's Peter Eavis.

By Peter Eavis, Fortune senior writer

November 14 2007: 1:03 PM EST

(Fortune) -- Investors might want to take a closer look at Fannie Mae's latest earnings report. Lost in the unsurprising news of the mortgage lender's heavy losses was a critical change in the way the company discloses its bad loans -- a move that could mask that credit losses that are rising above levels that the company predicted just three months ago.

Without the change in disclosure, an important yardstick for credit losses that Fannie Mae (Charts) provides to investors would have looked much worse than it did in financials filed last week.

Fannie Mae's potentially misleading disclosure comes at a crucial time for the company. Fannie Mae was severely penalized last year for overstating earnings and for a lack of oversight. As part of its punishment, the amount of home loans that Fannie Mae can make was limited.

But now influential members of Congress, including Senator Charles Schumer, want Fannie Mae's watchdog, the Office of Federal Housing Enterprise Oversight (OFHEO), to temporarily lift the portfolio limits on the company and its rival Freddie Mac. Legislators want both lenders to buy more subprime mortgages to help stave off foreclosures.

Fannie Mae already holds a substantial amount of risky mortgages in its $2.4 trillion mortgage book -- and the recent shift in how it discloses a much-watched credit yardstick disguises just how quickly bad loans may be rising.

If that's the case, Fannie Mae will face a new barrage of questions about its bookkeeping.

Fannie Mae controller David Hisey responds that the change in how its loss numbers were presented makes them "more transparent, not misleading."

How the Wall Street money machine broke down

But Fannie Mae's numbers effectively make its credit look better than it is.

It all comes down to what's known as the credit loss ratio -- a measure that Fannie Mae has consistently provided to investors to help them assess the credit quality of its mortgages. The credit loss ratio expresses bad loan losses as a percentage of Fannie Mae's loans.

In August, Fannie Mae predicted its credit loss ratio would be 0.04-0.06 of a percentage point for all of 2007. (Wall Street generally refers to percentages in basis points, which each equal one hundredth of a percentage point. In Fannie Mae's terminology, then, its 2007 loss ratio estimate is four to six basis points.)

A range of four to six basis points may not sound like a big deal for an institution involved in mortgages, but for Fannie Mae it is the norm.

What matters is if Fannie Mae goes above that range. And Fannie Mae appears to have already done that this year. But its disclosure change makes that worrying development very hard to see.

Here's why: Last week, as part of its earnings report, Fannie Mae revealed that the company had changed the way it calculates the credit loss ratio. Under the new method, Fannie Mae's annualized credit loss ratio was just 4 basis points in the first nine months of the year.

At first glance, four basis points looks to be at the low-end of Fannie Mae's full-year forecast. Problem is, because the company is using a new methodology, the previous estimate no longer makes sense to use.

So what would have happened if the company had compared apples to apples -- and stuck with the old method of calculating its loss ratio?

Under the previous method, Fannie Mae would have been well outside of its range. The company would have reported an annualized loss ratio of 7.5 basis points in the first nine months of this year.

Uh-oh. It's Enron all over again

What exactly caused the change -- and how did it lead to a reduction in the credit loss ratio?

In its third quarter financial statements, Fannie Mae started to break out credit losses taken to fulfill an accounting treatment called SOP 03-3, which the company said it adopted at the start of 2005.

These SOP 03-3 losses were previously included in its credit loss ratio calculation, but Fannie Mae last week removed them from that calculation, causing its loss ratio to look much lower.

The company said it made the change to add transparency to its loss numbers and to show a more cash-based reflection of credit losses.

In a statement, Fannie Mae spokesman Brian Faith said that the forecast of four to six basis points was "predicated on our estimation of what our realized losses would be for the year."

What does realized losses mean? When asked that, Faith referred to Fannie Mae's most recent quarterly filing. There, realized losses appear to be defined as losses calculated under the new method. In other words, Faith appears to be suggesting that the 2007 forecast was always based on the new method of calculation.

Why is that hard to believe? When the company issued that range in August, it expressed all its published credit loss ratios under the old method. And on an August conference call, when discussing the full-year range of four to six basis points, Fannie Mae executives did not mention any change in calculation of the ratio.

Management acknowledges that credit losses are mounting. During an analyst call last week, Fannie Mae CEO Daniel Mudd warned that the company's loss ratio could rise to eight to 10 basis points in 2008, due to a worsening housing market. It's not clear whether that forecast is based on the old or new methodology.

The company may already be exceeding that 2008 guidance. Based on the old methodology for calculating the loss ratio for the third-quarter alone, the company's annualized loss ratio is already at 14 basis points.

If so, Fannie Mae's mounting losses are disturbing.

So what could a soaring loss ratio mean for Fannie Mae? Consider these numbers: At Sept. 30, Fannie Mae had exposure to $74 billion of loans with a FICO credit score below 620. Loans scored below 620 are generally classified as subprime. In addition, Fannie Mae has exposure to $196 billion of Alt-A mortgages, home loans for which the borrower doesn't have to submit complete documentation for basic criteria like income.

At the same time, Fannie Mae has only $40 billion of capital.

Worst-case, credit losses from high-risk loans like subprime and Alt-A could eat away at that capital and leave the mortgage giant on an extremely weak financial footing.