Liars Poker

In 1979, chairman of the Federal Reserve Paul Volcker announced that the money supply would cease to fluctuate with the business cycle; money supply would be fixed, and interest rates would float. This marked the beginning of the golden age of the bond man. It allowed interest rates to swing wildly and bond prices move inversely, lockstep, to rates of interest, meaning bond prices began to swing wildly.

Before Volcker's announcement, bonds were conservative investments for those who didn't want to gamble in the stock market. After, they became objects of speculation, a means of creating wealth rather than merely storing it. It turned the bond market into a casino.

America also began borrowing more, meaning the volume of bonds exploded. By 1985, commercial banks were shakier and a greater percentage of debt was cast in the form of bonds. Trades exploded in both size and frequency, so a trader who used to move $5M in merchandise a week could now be moving $300M a day.

Salomon Brothers traders take a small fraction of each financial transaction, an eighth of a percentage point. So selling $50M in IBM bonds translates to $62,500 in the trader's pocket. As long as those bonds keep trading places, the trader makes money.

Salomon Brothers pounded into the trainees' heads the singular and laudable culture of Salomon Brothers. They were lower than whale shit at the bottom of the ocean, but that was rolling in clovers compared to not being at Salomon.

Cognitive dissonance: feeling one way but acting another, and feeling guilty for your actions.

Salomon always had superior bond trading skills, so when borrowing exploded in the 80s, they all got filthy rich. SB was the leading underwriter of new-stock issues on Wall Street and one of the top two or three equity traders, but inside SB the men from equities were second-class citizens. Equities, comparatively speaking, made no money.

May 1, 1975 is called Mayday by stockbrokers. It was the end of fixed stock brokerage commissions. A broker was paid twice as much for executing a 200 share order as for a 100 share order, even though the amount of work was the same. That all changed on Mayday and investors switched to whichever stockbroker charged them the least. Revenues fell.

The mortgage traders were the biggest dicks at Salomon. They made the most money and were all flaming assholes.

From 1978 to 1981 the fastest growing group of borrowers was neither governments nor corporations but homeowners. From the early 1930s legislators created a portfolio of incentives for Americans to borrow money. Interest payments on mortgages are tax-deductible. The savings and loans industry received government support and protection, campaigning homeownership as the American way. The volume of outstanding loans swelled from $55B in 1950 to $700B in 1976 to $1.2T in 1980. The mortgage market surpassed the US stock market as the largest capital market in the world.

Mortgages were pooled with other mortgages. Traders and investors would buy into a pool of several thousand mortgage loans, trusting statistics that only a small fraction should default. Pieces of paper could be issued that entitled the bearer to a pro rata share of the cash flows from the pool. Pools tended to hold mortgages with particular characteristics, such as less than $110k paying a 12% interest rate. These standardized pieces of paper could then be sold to anyone with money to invest, who would receive a 12% return.

Bob Dall and Stephen Joseph created the first private issue of mortgage securities. They persuaded Bank of America to sell the home loans it made in the form of bonds. They persuaded investors, such as insurance companies, to buy the new mortgage bonds. Bank of America received the cash it originally lent the homeowners, which it could then relend. The homeowner continued to write mortgage payment checks to BoA, but the money was passed on to the Salomon Brothers clients who purchased the BoA bonds. Lewis Ranieri was asked to be the lead trader and took over. He prevented it from being shut down in 79/80 when they were making no money because nobody wanted to buy mortgage bonds.

In October 1981, Congress passed a tax break that made all the thrifts incentivized to sell the mortgage loans to take advantage of it. They sold them at discounted prices and got fucked by Salomon's team of mortgage traders. Nobody wanted to buy them because you couldn't predict their lifespan. If interest rates dropped and everyone refinanced, they'd be paid off instantly. Uncertainty made them unattractive. Traders could still buy them for cheap and sell them for more. Thrifts felt like they had to sell. "October 1981 was the most irresponsible period in the history of capital markets. The thrifts that did the best did nothing. The ones that did the big trades got raped." - Larry Fink.

Ranieri campaigned for homeownership and convinced people to buy mortgage bonds.

In 1981 the federal government was running at a deficit so it sold assets including loans to developers of low-cost housing in the 1960s and 70s. The loans were made at below market rate in the first place, as a form of subsidy. In the open market, they were worth far less than par due to their low coupons. A typical loan was worth about sixty cents on the dollar since the buyer could put their money in Treasury bonds instead and get a better rate. Pretty much only two people bought these: Roth and Brittenham, two traders at Salomon. The trick was to determine which of the government project loans was likely to prepay, for when it did, there was an enormous windfall to the owner of the loan because project loans were trading below par.

The two situations where prepay would happen were housing projects about to default, because government guaranteed loans would be paid in full if they defaulted, and cushy upmarket projects likely to buy out the developer and prepay. These two traders were the only ones doing this, so they'd buy them at low prices because the people in Washington weren't doing the same work.

Predicting when people would prepay was the trick. Buy the bond at sixty, get paid off at a hundred. Using the research team at Salomon, a smart trader named Howie Rubin put together a model to predict when homeowners would prepay.

The mortgage bond traders were also notoriously gluttonous, fat, loud, and rude. They were like a fraternity and played practical jokes on each other. They also made more money than all other departments in the firm.

Salomon didn't give traders a percentage of what they brought in, which felt unfair considering the best first-years earned $30M for the company and were paid $95k. Other companies poached the best traders by paying them $1M salaries plus profit sharing. Three of the top mortgage traders were poached by Merrill Lynch. When a fourth top trader, Andy Stone, was offered four times his Salomon salary, he agreed to leave but talked to execs at SB first who tried to convince him to stay. He had made them $70M alone last year as a fourth-year trader. He asked Gutfreund if he would sell the mortgage department for ten million dollars, to which Gutfreund responded, "Of course not." Stone said, "You might as well, 'cause we're all going to quit. Every one of us will leave for a total increase of ten million dollars." Gutfreund agreed to pay Stone 80% of the Merrill offer.

Word spread of his huge salary and everyone demanded to be paid more. It fucked up the whole pecking order and culture at the firm. It was a mistake. Young traders were taken and by 1986 Salomon lost its monopoly on mortgage bonds.

The defection of traders is one reason for the disintegration of Ranieri & Co. The other was collateralized mortgage obligations, which took hundreds of millions of dollars of ordinary mortgage bonds, put them in a trust which paid a rate of interest to its owners, and then owners would have certificates to prove ownership. Those certificates were CMOs, and they could be first tranche, second tranche, or third tranche, or as many tranches as you want. The first tranche had its principal paid first, and the second and third respectively after that. So a $300M CMO would reliably have the first $100M prepaid in less than 5 years, the second $100M in 7-15, and the third $100M in 15-30. The earlier tranches have higher interest rates in exchange for being hit with the earlier wave of prepayments. This gave investors more certain maturities and made mortgage bonds more popular, and thus more buyers led to smaller margins for traders and smaller returns. CMOs were invented in 1983 and dominated by 1986. Larry Fink created the first one.

Mortgage bonds were sometimes split up into interest-only and principal-only strips as well. Howie Rubin, former Salomon trader and the first to defect to Merrill, lost $250M in one trade of IOPOs.

15-year mortgages were called Midgets, Gnomes, and Dwarfs because of their short maturity. Ranieri had made his way up from the mailroom and as a low-level employee, an anonymous partner paid for his wife's medical bills. He loved Salomon.

In 1987, Ranieri was fired and the majority of his team as well. They all became leaders of mortgage trading at other firms. Michael Mortara became the head of mortgage trading at Goldman Sachs, the leader in mortgage trading in the first half of 1988.

Michael Lewis started in the London office of SB. Culture difference: the notion that a person should subordinate himself to a corporation was laughable to the Europeans.

The Japanese were the Arabs of the 1980s. Their trade surplus left them gorged with dollars it had to either sell or invest.

One of Michael Lewis's mentors at Salomon was a salesman on the 41st floor who was the closest thing to a master of the markets. He could interpret events around him instantly. He was a contrarian who picked winners when everyone else was against him. When news of the nuclear reactor in Chernobyl broke, he instantly bought tons of futures in crude oil and American potatoes. Why potatoes? He realized the cloud of nuclear fallout would threaten European food and water supplies, placing a premium on uncontaminated American substitutes.

Chernobyl and oil is a straightforward example, but Alexander, the mentor, could react to events better than anyone. Alexander would explain something to Michael Lewis and he would parrot it to his own customers and make them a handsome profit.

Poem from investment bankers: God gave you eyes, plagiarize.

In 1986, Drexel Burnham passed Salomon Brothers as the most profitable investment bank. They made their fortune with junk bonds, which stung because SB was supposed to be Wall Street's bond traders. Them failing to see how important junk bonds would become was their single most expensive oversight.

What are junk bonds? Bonds issued by corporations that are deemed to be unlikely to repay their debts by the two chief credit rating agencies, Moody's and Standard & Poor's. "Junk" is arbitrary. The spectrum of creditworthiness that had IBM on one end and a Beirut cotton trading firm on the other has a break somewhere in the middle. At some point the bonds of a company cease to be investments and become wild gambles. Junk bonds are easily the most controversial financial tool of the 1980s.

Rickety companies borrowing money. Interest payments are tax-deductible so borrowing money is the go-to way to finance an enterprise. Michael Milken at Drexel created the junk bond market; he persuaded investors that junk bonds were a smart bet, in much the same fashion Lewie Ranieri persuaded investors mortgage bonds were a smart bet.

Junk bonds paid a higher rate of interest because they were higher risk. They also pay the lender a fee if the borrower makes enough money to repay prematurely. This causes them to behave like stocks because if the company makes a bunch of money, the anticipation for a windfall causes the price to soar and if they lose money, the price would drop in anticipation of default.

Drexel's research department had close relationships with companies and was privy to raw inside corporate data. It's insider trading, but insider trading is only illegal for stocks, not bonds. Nobody imagined that bonds would behave like stocks.

Milken created so much demand for junk bonds that he had more money than places to put it. There weren't enough small-growth companies and old fallen angels to absorb the cash. He needed to create junk bonds to satisfy demand for them. His solution was to use junk bonds to finance raids on undervalued corporations, by simply pledging the assets of the corporation as collateral to the junk bond buyers. A takeover of a large corporation could generate billions of dollars worth of junk bonds. A new job of invading corporate boardrooms was born.

Mergers and acquisitions departments mushroomed across Wall Street in the mid 1980s, just as bond trading mushroomed a few years before. Everyone wanted to raid these undervalued companies. Managers running public companies with cheap assets began to consider buying the companies from their shareholders for themselves through leveraged buyouts. Other investment banks followed Drexel's lead and started taking large stakes in companies. The assets were cheap, why not? Takeover advisory business blossomed.

Ronald Perelman attempted a hostile takeover of Salomon Brothers. Gutfreund would have almost certainly been fired since 25% of the company was being taken over. He struck a deal with Warren Buffett to lend Salomon $700M so they could buy enough of their own shares. It was essentially selling Buffett a Salomon bond: 9% interest and an option to buy the stock at $38 for the next 10 years. Great deal for Buffett.

The shift from trading bonds to trading companies was one that Salomon missed. Corporate America was being bought and sold.

Monday, October 19, 1987: the stock market fell. This caused the bond market to shoot through the roof. Stocks down, people poorer, consumption down, economy down, inflation decreases, interest rates fall, bond prices rise.