Liar's Poker - content

Liar’s Poker

by Michael Lewis

Overview

Chapter 6 is a case in study about how mortgage bonds industry came about and how it works.

Chapter 10 is a case in study about how junk bonds industry came about and how it works and the role Wall Street plays in taking over companies in America.

Chapter 2

I had recently read John Gutfreund’s now legendary comment that to succeed on the Salomon Brothers trading floor a person had to wake up each morning “ready to bite the ass off a bear.” That, I said, didn’t sound like much fun. I explained to her my notion of what life should be like inside an investment bank. (The description included a big glass office, a secretary, a large expense account, and lots of meetings with captains of industry. This occupation does exist within Salomon Brothers, but it is not respected. It is called corporate finance. It is different from sales and trading, though both are generally referred to as investment banking. Gutfreund’s trading floor, where stocks and bonds are bought and sold, is the rough-and-tumble center of moneymaking and risk taking. Traders have no secretaries, offices, or meetings with captains of industry. Corporate finance, which services the corporations and governments that borrow money, and that are known as “clients,” is, by comparison, a refined and unworldly place. Because they don’t risk money, corporate financiers are considered wimps by traders. By any standards other than those of Wall Street, however, corporate finance is still a jungle full of chest-pounding males). ======== The lady from Salomon fell silent at the end of my little speech. Then, in a breath, she said limp-wristed, overly groomed fellows on small salaries worked in corporate finance. ======== How do I become a Wall Street analyst? Over time this question had fantastic consequences. The first and most obvious was a logjam at the point of entry. Any one of a number of hard statistics cam be enlisted to illustrate the point. Here’s one. Forty percent of the thirteen hundred members of Yale’s graduating class of 1986 applied to one investment bank, First Boston, alone. There was, I think, a sense of safety in the numbers. The larger the number of people involved, the easier it was for them to delude themselves that what they were doing must be smart. The first thing you learn on the trading floor is that when large numbers of people are after the same commodity, be it a sstock, a bond, or a job, the commodity quickly becomes overvalued. Unfortunately, at the time, I had never seen a trading floor. ======== Investment bankers also wanted to believe, like members of any exclusive club, that the logic to their recruiting techniques was airtight. No one who didn’t belong was admitted. This conceit went hand in glove with the investment bankers’ belief that they could control their destiny, something, as we shall see, they couldn’t do. Economics allowed investment banking recruiters to compare directly the academic records of recruits. The only inexplicable aspect of the process was that economic theory (which is, after all, what economics students were supposed to know) served almost no function in an investment bank. The bankers used economics as a sort of standardized test of general intelligence. ======== Glass-Steagall was an act of the U.S. Congress, but it worked more like an act of God. It cleaved mankind in two. With it, in 1934, American lawmakers had stripped investment banking off from commercial banking. Investment bankers now underwrote securities, such as stocks and bonds. Commercial bankers, like Citibank, took deposits and made loans. The act, in effect, created the investment banking profession, the single most important event in the history of the world, or so I was led to believe.

It worked by exclusion. After Glass-Steagall most people became commercial bankers. Now I didn’t actually know any commercial bankers, but a commercial banker was reputed to be just an ordinary American businessman with ordinary American ambitions. He lent a few hundred million dollars each day to South American countries. But really, he meant no harm. He was only doing what he was told by someone higher up in an endless chain of command. A commercial banker wasn’t any more a troublemaker than Dagwood Bumstead. He had a wife, a station wagon, 2.2 children, and a dog that brought him his slippers when he returned home from work at six. We all knew never to admit to an investment banker that we were also applying for jobs with commercial banks, though many of us were. Commercial banking was a safety net.

The investment banker was a breed apart, a member of a master race of deal makers. He possessed vast, almost unimaginable talent and ambition. If he had a dog, it snarled. He had two little red sports cars yet wanted four. To get them, he was, for a man in a suit, surprisingly willing to cause trouble. For example, he enjoyed harassing college seniors like me. Investment bankers had a technique known as the stress interview. If you were invited to Lehman’s New York offices, your first interview might begin with the interviewer asking you to open the window. You were on the forty-third floor overlooking Water Street. The window was sealed shut. That was, of course, the point. The interviewer just wanted to see whether your inability to comply with his request led you to yank, pull, and sweat until finally you melted into a puddle of foiled ambition. Or, as one sad applicant was rumored to have done, threw a chair through the window.

Another stress-inducing trick was the silent treatment. You’d walk into the interview chamber. The man in the chair would say nothing. You’d say hello. He’d stare. You’d say that you’d come for a job interview. He’d stare some more. You’d make a stupid joke. He’d stare ana snajce nis nead. You were on tenterhooks. Then he’d pick up a newspaper (or, worse, your resume) and begin to read. He was testing your ability to take control of a meeting. In this case, presumably, it was acceptable to throw a chair through a window. ======== Investment bankers underwrite securities. You know, stocks and bonds. Commercial bankers just make loans. ======== “When they ask you why you want to be an investment banker, you’re supposed to talk about the challenges, and the thrill of doing deals, and the excitement of working with such high-caliber people, but never, ever mention money.” ========

Chapter 3

He who makes a beast of himself gets rid of the pain of being a man. —Samuel Johnson ======== Salomon Brothers knew more about bonds than any firm on Wall Street: how to value them, how to trade them, and how to sell them. ======== The biggest myth about bond traders, and therefore the greatest misunderstanding about the unprecedented prosperity on Wall Street in the 1980s, are that they make their money by taking large risks. A few do. And all traders take small risks. But most traders act simply as toll takers. The source of their fortune has been nicely summarized by Kurt Vonnegut (who, oddly, was describing lawyers): “There is a magic moment, during which a man has surrendered a treasure, and daring which the man who is about to receive it has not yet done so. An alert lawyer [read bond trader] will make that moment his own, possessing the treasure for a magic microsecond, taking a little of it, passing it on.”

In other words, Salomon carved a tiny fraction out of each financial transaction. This adds up. The Salomon salesman sells $50 million worth of new IBM bonds to pension fund X. The Salomon trader, who provides the salesman with the bonds, takes for himself an eighth (of a percentage point), or $62,500. He may, if he wishes, take more. In the bond market, unlike in the stock market, commissions are not openly stated.

(0.125% of 50,000,000 is $62,500) Because 0.125% = 0.125/100 And (0.125/100) x 50000000 = (0.00125) x 50000000 = 62500

Now the fun begins. Once the trader knows the location of the IBM bonds and the temperament of their owner, he doesn’t have to be outstandingly clever to make the bonds (the treasure) move again. He can generate his own magic microseconds. He can, for example, pressure one of his salesmen to persuade insurance company Y that the IBM bonds are worth more than pension fund X paid for them initially. Whether it is true is irrelevant. The trader buys the bonds from X and sells them to Y and takes out another eighth, and the pension fund is happy to make a small profit in such a short time.

In this process, it helps if neither of the parties on either side of the middleman knows the value of the treasure. The men on the trading floor may not have been to school, but they have Ph.D.’s in man’s ignorance. In any market, as in any poker game, there is a fool. The astute investor Warren Buffett is fond of saying that any player unaware of the fool in the market probably is the fool in the market. In 1980, when the bond market emerged from a long dormancy, many investors and even Wall Street banks did not have a clue who was the fool in the new game. Salomon bond traders knew about fools because that was their job. Knowing about markets is knowing about other people’s weaknesses. And a fool, they would say, was a person who was willing to sell a bond for less or buy a bond for more than it was worth. A bond was worth only as much as the person who valued it properly was willing to pay. And Salomon, to complete the circle, was the firm that valued the bonds properly.

But none of this explains why Salomon Brothers was particularly profitable in the 1980s. Making profits on Wall Street is a bit like eating the stuffing from a turkey. Some higher authority must first put the stuffing into the turkey. The turkey was stuffed more generously in the 1980s than ever before. And Salomon Brothers, because of its expertise, had second and third helpings before other firms even knew that supper was on.

One of the benevolent hands doing the stuffing belonged to the Federal Reserve. That is ironic, since no one disapproved of the excesses of Wall Street in the 1980s so much as the chairman of the Fed, Paul Volcker. At a rare Saturday press conference, on October 6, 1979, Volcker announced that the money supply would cease to fluctuate with the business cycle; money supply would be fixed, and interest rates would float. The event, I think, marks the beginning of the golden age of the bond man. Had Volcker never pushed through his radical charge in policy, the world would be many bond traders and one memoir the poorer. For in practice, the shift in the focus of monetary policy meant that interest rates would swing wildly. Bond prices move inversely, lockstep, to rates of interest. Allowing interest rates to swing wildly meant allowing bond prices to swing wildly. Before Volcker’s speech, bonds had been conservative investments, into which investors put their savings when they didn’t fancy a gamble in the stock market. After Volcker’s speech, bonds became objects of speculation, a means of creating wealth rather than merely storing it.

Once Volcker had set interest rates free, the other hand stuffing the turkey went to work: America’s borrowers. American governments, consumers, and corporations borrowed money at a faster clip during the 1980s than ever before; this meant the volume of bonds exploded (another way to look at this is that investors were lending money more freely than ever before). The combined indebtedness of the three groups in 1977 was $323 billion, much of which wasn’t bonds but loans made by commercial banks. By 1985 the three groups had borrowed $7 trillion. What is more, thanks to financial entrepreneurs at places like Salomon and the shakiness of commercial banks, a much greater percentage of the debt was cast in the form of bonds than before.

So not only were bond prices more volatile, but the number of bonds to trade increased. Trades exploded in both size and frequency. A Salomon salesman who had in the past moved five million dollars’ worth of merchandise through the traders’ books each week was now moving three hundred million dollars through each day. He, the trader, and the firm began to get rich. ======== Ask any astute trader and he’ll tell you that his best work cuts against the conventional wisdom. Good traders tend to do the unexpected. ======== That the back row was more like a postgame shower than a repository for the future leadership of Wall Street’s most profitable investment bank troubled and puzzled the more thoughtful executives who appeared before the training class. As much time and effort had gone into recruiting the back row as the front, and the class, in theory, should have been uniformly attentive and well behaved, like an army. The curious feature of the breakdown in discipline was that it was random, uncorrelated with anything outside itself and, therefore, uncontrollable. ======== The movements of the trading floor respond to the movements of the markets as if roped together. The American bond market, for example, lurches whenever important economic data are released by the U. S. Department of Commerce. The bond trading floor lurches with it. The markets decide what are important data and what are not. One month it is the U.S. trade deficit, the next month the consumer price index. The point is that the traders know what economic number is the flavor of the month and the trainees don’t. ======== There were many bad places your name could land on the job placement blackboard in 1985, but the absolute worst was in the slot marked “Equities in Dallas.” We could not imagine anything less successful in our small world than an equity salesman in Dallas; the equity department was powerless in our firm, and Dallas was, well, a long way from New York. Thus, “Equities in Dallas” became training program shorthand for “Just bury that lowest form of human scum where it will never be seen again.” Bury Sally, they shouted from the back of the room.

Chapter 4

If you are a self-possessed man with a healthy sense of detachment from your bank account and someone writes you a check for tens of millions of dollars, you probably behave as if you have won a sweepstakes, kicking your feet in the air and laughing yourself to sleep at night at the miracle of your good fortune. But if your sense of self-worth is morbidly wrapped up in your financial success, you probably believe you deserve everything you get. You take it as a reflection of something grand inside you. You acquire gravitas and project it like a cologne whenever you discuss the singular and laudable Salomon Brothers culture. ======== Best of all, he gave us a rule of thumb about information in the markets that I later found useful: “Those who say don’t know, and those who know don’t say.” ======== The stock market had once been Wall Street’s greatest source of revenues. Commissions were fat, fixed, and nonnegotiable. Each time a share changed hands, some broker somewhere took out a handsome fee for himself, without necessarily doing much work. A broker was paid twice as much for executing a two-hundred-share order as for a one-hundred-share order, even though the amount of work in either case was the same. The end of fixed stock brokerage commissions had come on May 1, 1975—called Mayday by stockbrokers—after which, predictably, commissions collapsed. Investors switched to whichever stockbroker charged them the least. As a result, in 1976, revenues across Wall Street fell by some six hundred million dollars. The dependable money machine broke down. ======== To get the best job, you had to weather the most abuse. ======== Bond trading had captured the imaginations of more than half the men in the class. Instead of saying “buy” and “sell” like normal human beings, they said “bid” and “offer.” ======== A trader placed bets in the markets on behalf of Salomon Brothers. A salesman was the trader’s mouthpiece to the most of the outside world. The salesmen spoke with institutional investors such as pension funds, insurance companies, and savings and loans. The minimum skills required for the two jobs were quite differemt. Traders required market savvy. Salesmen required interpersonal skills. But the very best traders were also superb salesmen, for they had to persuade a salesman to persuade his customers to buy bond X or sell bond Y. And the very best salesmen were superb traders and found customers virtually giving their portfolios over to them to manage.

The difference between a trader and a salesman was more than a matter of mere function. The traders ruled the shop, and it wasn’t hard to see why. A salesman’s year-end bonus was determined by traders. A trader’s bonus was determined by the profits on his trading books. A salesman had no purchase on a trader, while a trader had complete control over a salesman. Not surprisingly, young salesmen dashed around the place looking cowed and frightened, while young traders smoked cigars. That the tyranny of the trader was institutionalized shouldn’t surprise anyone. Traders were the people closest to the money. The firm’s top executives were traders. Gutfreuntd himself had been a trader. There were even occasional rumors, probably started by the traders, that all the salespeople were going to be fired, and the firm would simply trade in a blissful vacuum. Who needed the fucking customers anyway?

Good bond traders had fast brains and enormous stamina. They watched the markets twelve and sometimess sixteen hours a day—and not just the market in bonds. They watched dozens of financial and commodity markets: stocks, oil, natural gass, currencies, and anything else that might in some way influence the bond market. They sat down in their chairs at 7:00 A.M. and stayed put until dark. Few of them cared to talk about their jobs; they were as reticent as veterans of an unpopular war. They valued profits. And money. Especially money, and all the things that money could buy, and all the kudos that attached to the person with the most of it. ======== More different types of people succeeded on the trading floor than I initially supposed. Some of the men who spoke to us were truly awful human beings. They sacked others to promote themselves. They harassed women. They humiliated trainees. They didn’t have customers. They had victims. Others were naturally extremely admirable characters. They inspired those around them. They treated their customers almost fairly. They were kind to trainees. The point is not that a Big Swinging Dick was intrinsically evil. The point is that it didn’t matter one bit whether he was good or evil as long as he continued to swing that big bat of his. Bad guys did not suffer their comeuppance in Act V on the forty-first floor. They flourished (though whether they succeeded because they were bad people, whether there was something about the business that naturally favored them over the virtuous are separate questions). Goodness was not taken into account on the trading floor. It was neither rewarded nor punished. It just was. Or it wasn’t.

Because the forty-first floor was the chosen home of the firm’s most ambitious people, and because there were no rules governing the pursuit of profit and glory, the men who worked there, including the more bloodthirsty, had a hunted look about them. The place was governed by the simple understanding that the unbridled pursuit of perceived self-interest was healthy. Eat or be eaten. The men of 41 worked with one eye cast over their shoulders to see whether someone was trying to do them in, for there was no telling what manner of man had levered himself to the rung below you and was now hungry for your job. The range of acceptable conduct within Salomon Brothers was wide indeed. It said something about the ability of the free marketplace to mold people’s behavior into a socially acceptable pattern. For this was capitalism at its most raw, and it was self-destructive. ======== There are three bond groups: governments, corporates, and mortgages ======== LIBOR? LIBOR? What the fuck is LIBOR? LIBOR is an acronym for London interbank offered rate; it is the interest rate in London at which one bank lends to another; and it is available at 8:00 A.M. London time, or 3:00 A.M. New York time.

The TED spread was the difference between the LIBOR rate and the interest rate on three-month U.S. treasury bills. ======== The only thing history teaches us, a wise man once said, is that history doesn’t teach us anything. ======== With the possible exception of John Meriwether, the mortgage traders were the firm’s Biggest Swinging Dicks. The mortgage department was the most profitable area of the firm, and the place trainees most desperately wanted to work. It could afford to be nasty. It concluded the classroom stage of our training. ======== In spite of my craven panic in the presence of mortgage traders I was curious about their business and their boss, Lewie Ranieri. All Salomon trainees were curious about Ranieri. Lewie Ranieri was the wild and woolly genius, the Salomon legend who began in the mail-room, worked his way onto the trading floor, and created a market in America (and was starting a similar one in Britain) for mortgage bonds. Ranieri was Salomon, and Salomon was Ranieri. He was constantly being held out as an example of all that was special about our firm. He was evidence that the trading floor was a meritocracy. At Salomon Brothers, because of what Ranieri had achieved, a great deal seemed possible that otherwise might have not. I had never seen the great man himself. But I had read about him.

Here it is time to follow the story of the mortgage traders, for not only were they the soul of the firm, they were a microcosm of Wall Street in the 1980s. The mortgage market was one of two or three textbook cases that illustrated the change sweeping the world of finance. I followed our mortgage traders closely from my seat in London, mostly because I was intrigued that such awful-looking people could do so well for themselves. I was fascinated by Ranieri. For several years running, he and his traders made more money than anyone on Wall Street. I didn’t like them one bit, but that was probably a point in their favor. Their presence was a sign of the health of the firm, just as mine was a sign of the illness. If the mortgage traders left Salomon, I figured, we’d had it. There would be nothing remaining but a bunch of nice guys. ========

Chapter 5

I don’t do favors. I accumulate debts. —Ancient Sicilian motto ======== The senior mortgage traders maintained that abuse led to enlightenment. It purged trainees of pretension and made them realize they were the lowest of all God’s creations. ======== Just as some people are mean drunks, mortgage traders were mean gluttons. Nothing angered them more than being without food, unless it was being interrupted while they ate. ======== Wall Street brings together borrowers of money with lenders. Until the spring of 1978, when Salomon Brothers formed Wall Street’s first mortgage security department, the term borrower referred to large corporations and to federal, state, and local governments. It did not include homeowners. A Salomon Brothers partner named Robert Dall thought this strange. The fastest-growing group of borrowers was neither governments nor corporations but homeowners. From the early 1930s, legislators had created a portfolio of incentives for Americans to borrow money to buy their homes. The most obvious of these was the tax deductibility of mortgage interest payments. The next most obvious was the savings and loan industry.

The savings and loan industry made the majority of home loans to average Americans and received layers of government support and protection. The breaks given savings and loans, such as deposit insurance and tax loopholes, indirectly lowered the interest cost on mortgages, by lowering the cost of funds to the savings and loans. The savings and loan lobbyists in Washington invoked democracy, the flag, and apple pie when shepherding one of these breaks through Congress. They stood for homeownership, they’d say, and homeownership was the American way. To stand up in Congress and speak against homeownership would have been as politically astute as to campaign against motherhood. Nudged by a friendly public policy, savings and loans grew, and the volume of outstanding mortgages loans swelled from $55 billion in 1950 to $700 billion in 1976. In January 1980 that figure became $1.2 trillion, and the mortgage market surpassed the combined United States stock markets as the largest capital market in the world.

Nevertheless, in 1978 on Wall Street it was flaky to think that home mortgages could be big business. Everything about them seemed small and insignificant, at least to people who routinely advised CEOs and heads of state. The CEOs of home mortgages were savings and loan presidents. The typical savings and loan president was a leader in a tiny community. He belonged to the Lions or Rotary Club and also to a less formal group known within the thrift industry as the 3-6-3 Club: He borrowed money at 3 percent, lent money at 6 percent, and arrived on the golf course by three in the afternoon.

That was the sort of person who dealt in home mortgages, a mere sheep rancher next to the hotshot cowboys on Wall Street. The cowboys traded bonds, corporate and government bonds. And when a cowboy traded bonds, he whipped ’em and drove ’em. He stood up and shouted across the trading floor, “I got ten million IBM eight and a halfs [8.5 percent bonds] to go [for sale] at one-oh-one, and I want these fuckers moved out the door now.” Never in a million years could he imagine himself shouting, “I got the sixty-two-thousand-dollar home mortgage of Mervin K. Finkleberger at one-oh-one. It has twenty years left on it; he’s paying a nine percent interest; and it’s a nice little three-bedroom affair just outside Norwalk. Good buy, too.” A trader couldn’t whip and drive a homeowner.

The problem was more fundamental than a disdain for Middle America. Mortgages were not tradable pieces of paper; they were not bonds. They were loans made by savings banks that were never supposed to leave the savings banks. A single home mortgage was a messy investment for Wall Street, which was used to dealing in bigger numbers. No trader or investor wanted to poke around suburbs to find out whether the homeowner to whom he had just lent money was creditworthy. For the home mortgage to become a bond, it had to be depersonalized.

At the very least, a mortgage had to be pooled with other mortgages of other homeowners. Traders and investors would trust statistics and buy into a pool of several thousand mortgage loans made by a savings and loan, of which, by the laws of probability, 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, a guaranteed slice of a fixed pie. There could be millions of pools, each of which held mortgages with particular characteristics, each pool in itself homogeneous. It would hold, for example, home mortgages of less than $110,000 paying an interest rate of 12 percent. The holder of the piece of paper from the pool would earn 12 percent a year on his money plus his share of the prepayments of principal from the homeowners.

Thus standardized, the pieces of paper could be sold to an American pension fund, to a Tokyo trust company, to a Swiss bank, to a tax-evading Greek shipping tycoon living in a yacht in the harbor of Monte Carlo, to anyone with money to invest. Thus standardized, the pieces of paper could be traded. All the trader would see was the bond. All the trader wanted to see was the bond. A bond he could whip and drive. A line which would never be crossed could be drawn down the center of the market. On one side would be the homeowner; on the other, investors and traders. The two groups would never meet; this is curious in view of how personal it seems to lend a fellowman the money to buy his home. The homeowner would see only his local savings and loan manager, from whom the money came and to whom it was, over time, returned. Investors and traders would see paper.

Bob Dall first became curious about mortgages while working for a Salomon partner named William Simon, who later became secretary of the U.S. Treasury under Gerald Ford (and even later made a billion dollars buying savings and loans cheaply from the U.S. government). Simon was supposed to monitor developments in the mortgage market, but as Dall says, “He could not have cared less.”

Simon’s distaste for the home mortgage market stemmed from a dispute he had with the Government National Mortgage Association (known as Ginnie Mae) in 1970. Ginnie Mae guaranteed the home mortgages of less affluent citizens, thereby imbuing them with the full faith and credit of the U.S. Treasury. Any homeowner who qualified for a Federal Housing and Veterans Administration (FHA / YA) mortgage (about 15 percent of home buyers in America) received a Ginnie Mae stamp. Ginnie Mae sought to pool its loans and sell them as bonds. Here is where Simon came in. As the adviser to the U.S. government most knowledgeable about bonds, he was the natural man to nurture the mortgage market.

Like most mortgages, Ginnie Mae-backed loans required a gradual repayment of principal over time. Also like most mortgages, the loan could be prepaid in full at any time. This was the crippling flaw of the proposed Ginnie Mae mortgage bonds as Simon saw them. Whoever bought the bonds was, in one crucial respect, worse off than buyers of corporate and government bonds: He couldn’t be certain how long the loan lasted. If an entire neighborhood moved (paying off its mortgages), the bondholder, who had thought he owned a thirty-year mortgage bond, found himself sitting on a pile of cash instead.

More likely, interest rates fell, and the entire neighborhood refinanced its thirty-year fixed rate mortgages at the lower rates. This left the mortgage bondholder holding cash. Cash was no problem if the investor could reinvest it at the same rate of interest as the original loan, or at a higher rate. But if interest rates had fallen, the investor lost out, for his money would not earn the same rate of return as before. Not surprisingly, homeowners prefer to prepay their mortgages when interest rates fall, for then they may refinance the house at the lower rate of interest. In other words, money invested in mortgage bonds is normally returned at the worst possible time for the lender.

Bill Simon tried to persuade Ginnie Mae to protect the buyer of mortgage bonds (the lender). Instead of simply passing whatever cash came from the homeowners through to the bondholders, he argued, the pool should be made to simulate a normal bond with a definite maturity. Otherwise, he asked, who’d buy the bonds? Who wanted to own a bond of unknown maturity? Who wanted to live with the uncertainty of not knowing when he’d get their money back? ======== Trading money was nonetheless trading. It required at least one iron testicle and the same peculiar logic as bond trading. Witness: One day earlier in his career Dall was in the market to buy (borrow) fifty million dollars. He checked around and found the money market was 4 to 4.25 percent, which meant he could buy (borrow) at 4.25 percent or sell (lend) at 4 percent. When he actually tried to buy fifty million dollars at 4.25 percent, however, the market moved to 4.25 to 4.5 percent. The sellers were scared off by a large buyer. Dall bid 4.5. The market moved again, to 4.5 to 4.75 percent. He raised his bid several more times with the same result, then went to Bill Simon’s office to tell him he couldn’t buy money. All the sellers were running like chickens.

“Then you be the seller,” said Simon. So Dall became the seller, although he actually needed to buy. He sold fifty million dollars at 5.5 percent. He sold another fifty million dollars at 5.5 percent. Then, as Simon had guessed, the market collapsed. Everyone wanted to sell. There were no buyers. “Buy them back now,” said Simon when the market reached 4 percent. So Dall not only got his fifty million dollars at 4 percent but took a profit on the money he had sold at higher rates. That was how a Salomon bond trader thought: He forgot whatever it was that he wanted to do for a minute and put his finger on the pulse of the market. If the market felt fidgety, if people were scared or desperate, he herded them like sheep into a corner, then made them pay for their uncertainty. He sat on the market until it puked gold coins. Then he worried about what he wanted to do. ======== Bob Dall loved to trade. And though he did not have official responsibility for Ginnie Macs, he began to trade them. Someone had to. Dall established himself as the Salomon Brothers authority on mortgage securities in September 1977. Together with Stephen Joseph, the brother of Drexel CEO Fred Joseph, he created the first private issue of mortgage securities. They persuaded the Bank of America to sell the home loans it had made—in the form of bonds. They persuaded investors, such as insurance companies, to buy the new mortgage bonds. When they did, the Bank of America received the cash it had originally lent the homeowners, which it could then relend. The homeowner continued to write his mortgage payment checks to the Bank of America, but the money was passed on to the Salomon Brothers clients who had purchased the Bank of America bonds.

Dall felt sure this was the wave of the future. He thought the boom in demand for housing would outstretch the sources of funding. The population was aging. Fewer Americans occupied each house. The nation was wealthier, and more people wanted to purchase second homes. Savings and loans could not grow fast enough to make the required loans. He also saw an imbalance in the system caused by the steady drift of people from the Rust Belt to the Sun Belt. Thrifts in the Sun Belt had small deposits and a lot of demand for money from home buyers. Thrifts in the Rust Belt held massive deposits for which they had no demand. Dall saw a solution. Rust Belt thrifts could effectively lend to Sun Belt homeowners by buying the mortgage bonds of Sun Belt thrifts.

At the request of the Salomon Brothers executive committee Dall produced a three-page memo summarizing his belief in the market, which convinced John Gutfreund to remove the trading of Ginnie Macs from the government bond trading department and establish a mortgage department.

Dall stopped trading money, moved to a seat a few feet away from his old desk, and began to think thoughts years into the future. He realized he needed a financier to negotiate with banks and thrifts, to persuade them to sell their loans as the Bank of America had done. These loans would be transformed into mortgage bonds. The obvious choice for the job was Steve Joseph since Joseph had worked closely with Dall on the Bank of America deal.

Dall also needed a trader to make markets in the bonds that Joseph created, and that was a bigger problem. The trader was absolutely crucial. The trader bought and sold the bonds. A big-name trader inspired confidence in investors, and his presence alone could make a market grow. The trader also made the money for Salomon Brothers. Because of this, the trader was the person whom people admired, watched, and attended. Dall had always been the mortgage trader. Now he would be the manager. He had to borrow a proven winner from either the corporate or the government bond-trading desks. It presented a problem. At Salomon, if a department allowed someone to leave, it was for the good reason that it wanted to get rid of him; when you took people from other departments, you got only the ones you didn’t want.

Lewis Ranieri, a thirty-year-old utility bond trader (a utility bond trader is not, like a utility infielder, a trader who steps in when the first stringers are injured; a utility bond trader trades the bonds of public utilities, such as Louisiana Power & Light). Ranieri’s move to the mortgage department was a seminal event on the eve of the golden age of the bond trader. With his appointment in mid-1978, the story of the mortgage market as it is conventionally told within Salomon Brothers commences.

Dall knows precisely why he selected Ranieri. “I needed a good strong trader. Lewie was not just a trader, though: He had the mentality and the will to create a market. He was tough-minded. He didn’t mind hiding a million-dollar loss from a manager, if that’s what it took. He didn’t let morality get in the way. Well, morality is not the right word, but you know what I mean. I have never seen anyone, educated or uneducated, with a quicker mind. And best of all, he was a dreamer.”

When John Gutfreund told him he would join Dall as head trader in the embryonic mortgage security department, Lewie panicked. Utility bonds were making big money. And while it was true a person didn’t get paid on commission, one nevertheless climbed through the ranks at Salomon Brothers by pointing to a chunk of money at the end of each year and saying, “That’s mine, I did that.” Revenues meant power. In Lewie’s view, there would be no chunk of money at the end of the year in the mortgage department. There would be no more climbing through the ranks. In retrospect, his fears look laughably absurd. Six years later, in 1984, on the back of an envelope, Ranieri would argue, plausibly, that his mortgage trading department made more money that year than the rest of Wall Street combined in all their businesses. He would swell with pride as he discussed his department’s achievements. He would be named vice-chairman of Salomon Brothers, second only to Gutfreund. Gutfreund would regularly mention Ranieri as a possible successor. Yet Ranieri envisioned none of it in 1978. At the time of his appointment he felt cheated.

Like Bill Simon, Ranieri thought mortgages an ugly stepchild of the bond market. Who’d buy the bonds? Who wanted to lend money to a homeowner who could repay at any time? Besides, there wasn’t much to trade. “There were nothing but a few Ginnie Maes (and one Bank of America deal), and nobody cared about those; I tried to figure out what else there was to do.” ======== He took a part-time job on the night shift in the Salomon Brothers mailroom in 1968. The Salomon paycheck was seventy dollars a week. Several months into his new job he ran into money problems. He had no financial support from his parents (his father had died when he was thirteen). His wife lay ill in the hospital, and the bills simply accumulated. Ranieri needed ten thousand dollars. He was nineteen years old, and all he had to his name was his weekly paycheck.

He was finally forced to request a loan from the one Salomon Brothers partner he knew vaguely. “You gotta remember,” he says now, “I was convinced, really convinced, he was going to fire me.” Instead the partner told Ranieri that the hospital bill would be taken care of. Ranieri thought that meant it would be deducted from his weekly paycheck, which he couldn’t afford, and he began to protest. “It will be taken care of,” the partner repeated. Salomon Brothers paid the ten-thousand-dollar bill racked up by the wife of its mailroom clerk with three months’ tenure. There was no committee meeting to discuss whether this was appropriate. The partner to whom Ranieri had addressed his request hadn’t even paused before giving his answer. It was understood that the bill would be paid, for no reason other than it was the right thing to do.

One cannot be certain of the exact words spoken by a Salomon Brothers partner long since gone, but it is clear what Ranieri heard: Lewie Ranieri would always be taken care of. The act moved Ranieri deeply. When he speaks of loyalty, of the “covenant” between Salomon Brothers and the people who worked for Salomon Brothers, it is that single act of generosity he remembers. “From that point on,” says one of his mortgage traders, “Lewie loved the firm. He couldn’t understand it was only a business.” “The firm took care of its people,” says Ranieri. “There used to be all these expressions, like ‘It’s more important to be a good man than a good manager.’ And people really meant them. We were a band of brothers. There was, as the people say, a covenant.” ======== Up to the point of his transfer to the mortgage department, Ranieri had dominated every department he had joined. The firm encouraged both aggression and ability; it made a point never to interfere with natural jungle forces. In a matter of months after his appointment power over the new mortgage department consolidated in Ranieri’s hands. In view of Ranieri’s ambition, even Dall concedes a coup was inevitable. Dall fell ill and was often away. In his absence Ranieri started a research department (“Mortgages are about math,” he, the college dropout, insisted) by asking Michael Waldman, a top mathematician, to join him. The request came, Waldman recalls, “in Lewie’s usual forceful manner.”

Then Ranieri persuaded the firm to give him a sales force to sell the godforsaken mortgages he was being asked to trade. All of a sudden a dozen salesmen learned they had to please Lew Ranieri, rather than whomever they had been pleasing before. Rich Shuster, who had been a thrift salesman in the Salomon Brothers Chicago office, now found himself a mortgage salesman working for Lewie Ranieri. “Once I mis-dialed the commercial paper department and got mortgages instead. Lewie happened to answer the phone and immediately realized what had happened. He started to shout at me, ‘What the fuck are you doing selling commercial paper? You are paid to sell mortgages!’ ” Salesmen began to focus on mortgages. ======== Bob Dall disappeared, although he didn’t leave Salomon until 1984. He found himself out of a job. He was squeezed out by Ranieri months after he had hired him. This sort of thing went on continually at Salomon. The challenger took, over by being a little more energetic, a little more popular with clients, a little more influential with colleagues until the man whom he was quietly challenging seemed to evaporate. He became almost quaintly obsolete, like the handle crank on the automobile. Management did not intervene. The loser eventually left. ======== The business was reeling from what appeared to have been the knockout punch. Paul Volcker had made his historic speech on October 6, 1979. Short-term interest rates had skyrocketed. For a thrift manager to make a thirty-year home loan, he had to accept a rate of interest of 10 percent. Meanwhile, to get the money, he was paying 12 percent. He ceased, therefore to make new loans, which suited the purpose of the Federal Reserve, which was trying to slow the economy. New housing starts dropped to postwar lows. Before Volcker’s speech, Steve Joseph’s mortgage finance department had created roughly two billion dollars in mortgage securities. It was a laughably small amount—less than two-tenths of a percent of outstanding American home mortgages. But it was a start. After Volcker’s speech the deals stopped. For Ranieri & Co. to create bonds, the thrifts had to want to make loans. They didn’t. The industry that held most of America’s home mortgages on its books was collapsing. In 1980 there were 4,002 savings and loans in America. Over the next three years 962 of those would collapse. As Tom Kendall put it, “Everybody hunkered down and licked their wounds.”

Everybody but Ranieri. Ranieri expanded. Why? Who knows. Perhaps he had a crystal ball. Perhaps he figured that the larger his department grew, the harder it would be to dismantle. For whatever reason, Ranieri hired the fired mortgage salesmen from other firms, built his research department, doubled the number of traders, and left the dormant mortgage finance department in place. He hired a phalanx of lawyers and lobbyists in Washington to work on legislation to increase the number of potential buyers of mortgage securities. “I’ll tell you a fact,” says Ranieri. “The Bank of America deal [Bob Dall’s first brain-child] was a legal investment in only three states. I had a team of lawyers trying to change the law on a state-by-state basis. It would have taken two thousand years. That’s why I went to Washington. To go over the heads of the states.”

“If Lewie didn’t like a law, he’d just have it changed,” explains one of his traders. Even if Ranieri had secured a change in the law, however, investors would have stayed clear of mortgage bonds. Tom Kendall remembers visiting Ranieri’s top salesman, Rick Borden, in Salomon Brothers’ San Francisco office in 1979. Borden was reading a self-help book. “I remember him saying over and over, These Ginnie Macs suck. They get longer [in maturity] when rates go up, and shorter when rates go down, and nobody wants them,’ ” says Kendall.

To make matter worse, the Salomon Brothers credit committee was growing reluctant to deal with the collapsing savings and loans industry. Stupid customers (the fools in the market) were a wonderful asset, but at some level of ignorance they became a liability: They went broke. And somehow, thrifts weren’t like normal stupid customers. One thrift in California, Beneficial Standard, reneged on a purchase of bonds from Salomon that had been confirmed—as are all bond trades—by phone. The thrift claimed in the subsequent lawsuit that the mortgage bond business should be governed by real estate law, rather than securities law, and that in real estate law an oral contract wasn’t binding (years later it lost its case). This very nearly was the final straw.

The executive committee members of Salomon Brothers decided the mortgage market was bad news. They didn’t understand it; they didn’t want to understand it; they just wanted out of it. They planned to start by severing ties with the thrift industry. The entire thrift industry looked shaky. Lines of credit were to be cut. Cutting off thrifts was the same as shutting down the mortgage department since thrifts were the only buyers of mortgage bonds. “I basically threw my body between the credit committee and the thrift industry,” says Lewie. In all his decisions Ranieri had the support of only one man on the Salomon Brothers executive committee, but his was the important vote: John Gutfreund. “John protected me,” says Ranieri.

The upshot of the hostilities between the mortgage department and the two real powers of Salomon, corporate and government bond trading, was that everything in the mortgage department was separate: mortgage sales, mortgage finance, mortgage research, mortgage operations, and mortgage trading. “The reason everything was separate is that no one would help us,” says Ranieri.

It was slightly more complicated than that, however. To a degree they were separate by choice. Ranieri didn’t exactly go out of his way to build bridges to the rest of the firm. And Bob Dall had insisted in his original three-page memo to the Salomon executive committee that the mortgage department stand alone. He remembered the way the old boss, Bill Simon, had treated the first mortgage securities. If the mortgage department were forced to work with the government department, he said, “the mortgage market would never get off the ground; it would be subjugated.” If the few financiers at Salomon Brothers, whose job it was to call on the CEOs of large corporations, were given mortgage finance, “they would never have done the deals. Corporate finance people feel mortgage deals are beneath them,” Dall explained.

But in Ranieri’s mind, the mortgage department stood alone for the very simple reason that it had no friends. He built high walls to protect his people from hostile forces. The enemy was no longer his Wall Street competitors, for they had mostly disappeared. The enemy was Salomon Brothers. “The irony,” says Ranieri, “is that the firm would always point to the mortgage department and say, ‘Look, see how innovative we are!’ But the truth is that the firm said no to everything we did. This department got built in spite of the firm, not because of the firm.” ========

Chapter 6

1981-1986

CTS began to flash on the mortgage trading desk in October 1981, and at first no one knew why. On the other end of the telephones were nervous savings and loan presidents from across America wanting to speak to a Salomon mortgage trader. They were desperate to sell their loans. Every home mortgage in America, one trillion dollars’ worth of debt, seemed to be for sale. There were a thousand sellers, and no buyers. Correction. One buyer. Lewie Ranieri and his traders. The force of the imbalance between supply and demand was stunning. It was as if a fire hydrant burst directly upon a group of thirsty street urchins. One trillion dollars came barreling through the phone lines, and all the traders had to do was open their mouths and swallow as much as they could.

What was going on? From the moment the Federal Reserve lifted interest rates in October 1979, thrifts hemorrhaged money. The entire structure of home lending was on the verge of collapse. There was a time when it seemed that if nothing were done, all thrifts would go bankrupt. So on September 30, 1981, Congress passed a nifty tax break for its beloved thrift industry. It provided massive relief for thrifts. To take advantage of it, however, the thrifts had to sell their mortgage loans. They did. And it led to hundreds of billions of dollars in turnover on Wall Street. Wall Street hadn’t suggested the tax breaks, and indeed, Ranieri’s traders hadn’t known about the legislation until after it happened. Still, it amounted to a massive subsidy to Wall Street from Congress. Long live motherhood and home ownership! The United States Congress had just rescued Ranieri & Co. The only fully staffed mortgage department on Wall Street was no longer awkward and expensive; it was a thriving monopoly.

It was all a great mistake. The market wasn’t exploding because of the megatrends that Bob Dall had listed in his memo to Gutfreund (growth in housing, movement from Rust Belt to Sun Belt, etc.) although those later became factors. The market took off because of a simple tax break. It was as if Steven Jobs had bought office space, built an assembly line, hired two hundred thousand salesmen, and written brochures before he had anything to sell. Then someone else creates the personal computer, and seeing this, Jobs leaps into action, calling his previously useless infrastructure Apple Computer.

Bond traders tend to treat each day of trading as if it were their last. This short-term outlook enables them to exploit the weakness of their customers without worrying about the long-term effects on customer relations. They get away with whatever they can. A desperate seller is in a weak position. He’s less concerned about how much he is paid than when he is paid. Thrift presidents were desperate. They arrived at the Salomon Brothers mortgage trading desk hat in hand. If they were going to be so obvious about their weakness, they might as well have written a check to Salomon Brothers.

The situation was aggravated by the ignorance of the thrifts. The 3-6-3 Club members had not been stress-tested for the bond market; they didn’t know how to play Liar’s Poker. They didn’t know the mentality be hidden. A new accounting standard allowed the thrifts to amortize the losses over the life of the loans. For example, the loss the thrift would show on its books in the first year from the sale of a thirty-year loan that had fallen 35 percent in value was a little over 1 percent: 35 / 30. But what was even better is that the loss could be offset against any taxes the thrift had paid over the previous ten years. Shown losses, the Internal Revenue Service (IRS) returned old tax dollars to the thrifts. For the thrifts, the name of the game was to generate lots of losses to show to the IRS; that was now easy. All they had to do to claw back old taxes was sell off their bad loans; that’s why thrifts were dying to sell their mortgages to the people they were up against. They didn’t know the value of what they were selling. In some cases, they didn’t even know the terms (years to maturity, rates of interest) of their own loans. The only thing the thrift managers knew was how much they wanted to sell. The truly incredible thing about them, noted by all the Salomon traders, was that no matter how roughly they were treated, they kept coming back for more. They were like ducks I once saw on a corporate hunt that were trained to fly repeatedly over the same field of hunters until shot dead. You didn’t have to be Charles Darwin to see that this breed was doomed.

Trader Tom DiNapoli fondly remembers a call from one thrift president. “He wanted to sell a hundred million dollars’ worth of his thirty-year loans [bearing the same rate of interest], and buy a hundred million dollars of some other loans with the cash from the sale. I told him I’d bid [buy] his loans at seventy-five [cents on the dollar] and offer him the others at eighty-five.” The thrift president scratched his head at the numbers. He was selling loans nearly identical to those he was buying, but the difference in yield would leave him out of pocket an unheard-of ten million dollars. Or, to put it another way, the thrift was being asked to pay a transaction fee of ten million dollars to Salomon Brothers. “That doesn’t sound like a very good trade for me,” he said. DiNapoli was ready for that one. “It isn’t, from an economic point of view,” he said, “but look at it this way, if you don’t do it, you’re out of a job.” A fellow trader talking to another thrift president on another line overheard DiNapoli and cracked up. It was the funniest thing he had heard all day. He could picture the man on the other end of the phone, just oozing desperation.

“October 1981 was the most irresponsible period in the history of the capital markets,” says Larry Fink, a partner with Steven Schwartzman, Peter Peterson, and David Stockman in the Blackstone Group. In October 1981 Fink was head of the small mortgage trading department at First Boston, which would soon grow large and become Lewie Ranieri’s major competitor. “The thrifts that did the best did nothing. The ones that did the big trades got raped.”

Perhaps. However, like all trades in the bond market, these were negotiable transactions between consenting adults, and the sole rule of engagement was: Buyer beware. Had this been a boxing match, it would have been canceled to prevent the weaker fighter from being killed. But it wasn’t. In any case, the abuse could have been even worse. Ranieri had a sense of mercy and, where he could, stepped in to redress the balance of power between the thrift presidents and his traders. Mortgage trader Andy Stone recalls having bought $70 million of mortgage bonds at a price of eighty (again, cents on the dollar). At Stone’s insistence, a bond salesman in California sold them immediately to Ben Franklin Savings & Loan for a price of eighty-three. In minutes Stone had made $2.1 million (3 percent of $70 million). After the customary slapping of palms and the praising of the salesman over the firm loudspeaker, Stone informed Ranieri.

Now $2.1 million was a good day’s work. Stone had been a trader for just eight months, and he was eager to show the boss how well he was doing. The boss wasn’t pleased. “Lewie said, ‘If you weren’t young, I’d fire you right now. Call the customer and tell him you’re the asshole who ripped him off. Tell him you bought the bonds at eighty, and the price is therefore not eighty-three, but eighty-point-two-five,’ ” says Stone. “Imagine how it feels to call up a customer and say, ‘Hi, I’m the asshole who ripped you off.’”

It wasn’t just the dummies who queued to trade with Salomon Brothers. Even knowledgeable thrift presidents felt they faced a choice between rape and slow suicide. To do nothing spelled bankruptcy for many. Paying out 14 percent on deposits while taking in 5 percent on old home mortgage loans was a poor way to live, but this is precisely the position thrifts were in. By late 1982 the thrifts were attempting to grow their way out of catastrophe. By that time, short-term interest rates had fallen below long-term interest rates. The thrift could make new mortgage loans at 14 percent while taking in money at 12 percent.

Many thrifts layered a billion dollars of brand-new loans on top of their existing, disastrous hundred million dollars of old loss-making loans, in a hope that the new would offset the old. Each new purchase of mortgage bonds (which was identical to making a loan) was like the last act of a desperate man. The strategy was wildly irresponsible, for the fundamental problem (borrowing short term and lending long term) hadn’t been remedied. The hypergrowth only meant that the next thrift crisis would be larger. But the thrift managers were not thinking that far in advance. They were simply trying to keep the door to the shop open. That explains why thrifts continued to buy mortgage bonds even as they sold their loans.

The tax and accounting breaks, designed to rescue the savings and loan industry, seemed, in the end, to be tailor-made for Lewie Ranieri’s mortgage department. It rained gold on Salomon Brothers’ mortgage traders. Or at least that is how it appeared to the rest of envious Wall Street. Ranieri allowed his boys to assume a carefree buy now, worry later attitude in the midst of the upheaval in the thrift industry. And the Salomon traders found themselves in a weird new role. They were no longer trading mortgage bonds, but the raw material for mortgage bonds: home loans. Salomon Brothers was all of a sudden playing the role of a thrift. Nothing—not Ginnie Mae, not the Bank of America—stood between Wall Street investment banker and homeowner; Salomon was exposed to the homeowners’ ability to repay. A cautious man would have inspected the properties he was lending against, for nothing but property underpinned the loans.

But if you planned to run with this new market, you did not have time to check every last property in a package of loans. Buying whole loans (that is what the traders called home loans, to distinguish them from mortgage bonds) was an act of faith, like eating bologna. Leaps of faith were Ranieri’s specialty. A quick mental calculation told him that whatever the cost of buying bad loans, it couldn’t possibly match the profits he would make by trading the things. He turned out to be right. Once he ended up with loans that had been made to a string of Baptist churches in Texas, but generally the loans were for housing, just is the thrift managers who sold them had claimed.

However, as I have said, the notion of trusting the thrifts gave Salomon’s top brass the willies. (And Salomon wasn’t alone. Most other Wall Street firms had severed ties with the thrifts.) As Ranieri recalls, “The executive committee said I couldn’t trade whole loans. So I just went out and did it anyway. Everyone insisted I shouldn’t have done it. They told me I was going to go to jail. But whole loans were ninety-nine-point-nine percent of the entire mortgage market. How could you not trade whole loans?” How indeed. “We bought them,” says Tom Kendall, “and then found out you had to have an eagle before you buy them.” An eagle was Federal Housing Administration approval to trade in whole loans. “So then we went and got the eagle.”

Ranieri & Co. intended to transform the “whole loans” into bonds as soon as possible by taking them for stamping to the U.S. government. Then they could sell the bonds to Salomon’s institutional investors as, in effect, U.S. government bonds. For that purpose, partly as the result of Ranieri’s persistent lobbying, two new facilities had sprung up in the federal government alongside Ginnie Mae. They guaranteed the mortgages that did not qualify for the Ginnie Mae stamp. The Federal Home Loan Mortgage Corporation (called Freddie Mac) and the Federal National Mortgage Association (called Fannie Mae) between them, by giving their guarantees, were able to transform most home mortgages into government-backed bonds. The thrifts paid a fee to have their mortgages guaranteed. The shakier the loans, the larger the fee a thrift had to pay to get its mortgages stamped by one of the agencies. Once they were stamped, however, nobody cared about the quality of the loans. Defaulting homeowners became the government’s problem. The principle underlying the programs was that these agencies could better assess and charge for credit quality than individual investors.

The wonderfully spontaneous mortgage department was the place to be if your philosophy of life was: Ready, fire, aim. The payoff to the swashbuckling traders, by the standards of the time, was shockingly large. In 1982, coming off two and a half lean years, Lewie Ranieri’s mortgage department made $150 million. In 1984 a mortgage trader named Steve Baum shattered a Salomon Brothers record, by making $100 million in a single year trading whole loans. Although there are no official numbers, it was widely accepted at Salomon that Ranieri’s traders made $200 million in 1983, $175 million in 1984, and $275 million in 1985.

Lewie Ranieri was the right man at the right place at the right time. “Lewie was willing to take positions in things he didn’t fully understand. He had a trader’s instinct that he trusted. That was important,” says one of his senior traders. “The attitude at Salomon was always, ‘If you believe in it, go with it, but if it doesn’t work, you’re fucked.’ And Lewie responded to this. At other places management says, ‘Well, gee, fellas, do we really want to bet the ranch on this deal?’ Lewie was not only willing to bet the ranch. He was willing to hire people and let them bet the ranch, too. His attitude was: ‘Sure, what the fuck, it’s only a ranch.’ In other shops, he’d have had to write a two-hundred-page memo for a committee that wanted to be sure that what he was doing was safe. He would have had to prove he knew what he was doing. He could never have done that. He knew what he was doing, but he could never have proved it. Had Lewie been assigned to look at the mortgage market at other firms, it wouldn’t have gone anywhere.”

The Salomon trading floor was unique. It had minimal supervision, minimal controls, and no position limits. A trader could buy or sell as many bonds as he thought appropriate without asking. The trading floor was, in other words, a CEO’s nightmare. “If Salomon’s trading floor was a business school case study,” says mortgage trader Wolf Nadoolman, “the guy pretending to be the CEO would say, ‘That is shocking!’ But you know what? He’d be wrong. Sometimes you lose some dough, but sometimes you make a fortune. Salomon was right.”

Salomon’s loose management style had its downside. Salomon Brothers was the only major firm on Wall Street in the early 1980s with no system for allocating costs. As unbelievable as it seems, no measure was taken of the bottom line; people were judged by the sum total of the revenues on their trading books irrespective of what those cost to generate. When the firm was a partnership (1910-1981) and managers had their own money in the till, loose controls sufficed. Now, however, the money didn’t belong to them but to the shareholders. And what worked for a partnership proved disastrous in a publicly owned corporation.

Instead of focusing on profits, trading managers focused on revenues. They were rewarded for indiscriminate growth. Gross revenues meant raw power. Ranieri had finally been made partner in 1978. His influence waned with his revenues until the end of 1981, but when the mortgage market exploded, he began a rapid rise to the top of Salomon Brothers. In 1983, with his department generating 40 percent of the firm’s revenues while no other department generated more than 10 percent, he was placed on the Salomon Brothers executive committee. He expanded by hiring more traders and moving into real estate mortgages.

In December 1985 John Gutfreund told a reporter, “Lewie is very definitely on the short list of potential future chairmen.” Ranieri expanded by purchasing a mortgage banker, who made loans directly to home buyers and supplied Ranieri with the raw material for mortgage bonds. In 1986 Ranieri was named to the office of the chairman directly beneath Gutfreund. In that year Ranieri expanded overseas, creating the Mortgage Corporation in London to reshape the British mortgage market in the image of America’s. Joining him in the office of the chairman was one representative each of the government and corporate bond trading desks, Tom Strauss and Bill Voute. Both were also on the short list of potential future chairman. Both were expanding their departments as well, though not so fast as Ranieri. By mid-1987, though it has proved impossible to confirm the assertion, a Salomon managing director claimed that 40 percent of the seven thousand-odd Salomon employees reported, in one way or another, to Ranieri.

With trading revenues came glory and advancement at every level of the company. The numbers on a neighbor’s trading book became known within Salomon Brothers in the same manner as the size of a neighbor’s bonus. Though trainees were the last to hear anything, word eventually reached them of the opportunity created by the massive change in the capital markets over which Salomon presided. “All you had to do was sit in the classroom, find out how many mortgages there were in the country, figure out what would happen if they securitized, say, ten percent of them, and you realized this was going to be big,” says former Salomon trader Mark Freed, a member of the Salomon Class of 1982.

By 1984 Salomon Brothers could plausibly assert to a U.S. congressional subcommittee that the nation would require four trillion dollars in new housing finance before 1994. Ranieri the conquering hero, the Salomon legend, the incarnation of the concept of success, appeared before the training class to describe how he had just flown in from California, and how he had looked down from his airplane and seen all those little houses, and how all those little houses were mortgaged, and how all those mortgages would eventually make their way onto the trading floor of Salomon Brothers (no one questioned his ability to see the houses from thirty thousand feet; if anyone could, it was Lewie). By 1984 the mortgage desk would be the place to work in the eyes of young M.B.A.’s emerging from the Salomon Brothers training program. People wanted to trade mortgages, to be Salomon Brother mortgage traders, to be a part of a money machine that by this time was earning more than half of the firm’s revenues.

Salomon Brothers mortgage traders rode roughshod over both the largest capital market in the world and their own firm, which was far and away the most profitable on Wall Street. They felt lucky. “It was an accepted fact,” says a mortgage trader, “that mortgage traders had iron balls. It was an accepted fact that as a mortgage trader you didn’t make a lot of money in your market, you made all the money in your market. It was an accepted fact that you didn’t do some of the trades in your market, you didn’t do most of the trades in your market, you did all of the trades in your market.”

To do all the trades in your market, you had to have buyers as well as sellers, and these, in October 1981, were thin on the ground. Ranieri, along with the guru of junk bonds, Mike Milken of Drexel Burnham, became one of the great bond missionaries of the 1980s. Crisscrossing the country, trying to persuade institutional investors to buy mortgage securities, Ranieri bumped into Milken. They visited the same accounts on the same day. “My product took off first,” says Ranieri. “Investors started to buy the gospel according to Ranieri.” The gospel according to Ranieri was, in simple terms, “that mortgages were so cheap your teeth hurt.” Ranieri’s initial pitch focused on how much higher the yield on mortgage bonds was than the yield on corporate and government bonds of similar credit quality. Most mortgage bonds were accorded the highest rating, triple A, by the two major rating agencies, Moody’s and Standard & Poor’s. Most mortgage bonds were backed by the United States government, either explicitly, as in the case of Ginnie Mae bonds, or implicitly, as in the case of Freddie Mac and Fannie Mae.

No one thought the U.S. government would default. Investors nevertheless wanted no truck with Ranieri or Ranieri’s growing army of salesmen. In spite of the upheaval in the mortgage market, the initial objection expressed by Bill Simon to Ginnie Mae remained valid: You couldn’t predict the life of a mortgage bond. It wasn’t that prepayments were bad in themselves. It was that you couldn’t predict when they would arrive. And if you didn’t know when the cash would come back to you, you couldn’t calculate the yield. All you could surmise was that the bond would tend to maintain its stated maturity as rates rose and homeowners ceased to prepay, and would shorten as rates fell and homeowners refinanced. This was bad. Though the conditions of supply had changed overnight in October 1981, the conditions of demand for mortgage securities had not. Mortgages indeed were cheap; they were plentiful, yet no one wanted to buy them.

Worse, in several states mortgage securities were still illegal investments, a condition Ranieri didn’t fully accept. In a meeting he screamed at a lawyer whom he had never met, “I don’t want to hear what lawyers say, I want to do what I want to do.” He sought a federal preemption of state laws. And he began to look for a way to make mortgages resemble other bonds, a way to give mortgage securities a definite maturity.

Ultimately he wanted to change the way Americans borrowed money to buy their homes. “I ought at least be allowed the right,” he said, “to go to the consumer and say, here are two identical mortgages, one at 13 percent, and one at 12.5 percent. You can have either one you want. You can refinance the one at 13 percent anytime you want for whatever reason you want. The one at 12.5 percent, if you move or die or trade up, has no penalty. But if you just want to refinance it for savings and debt service, you pay me [a fee].” Congress gave him permission to sell his mortgage securities in every state, but to his more radical proposition it said no. The homeowner kept his right to prepay his mortgage at any time, and Ranieri was forced to find another way to persuade institutional investors to buy his godforsaken mortgage securities.

So he did. “Lewie Ranieri could sell ice to an Eskimo,” says Scott Brittenham, who accompanied him on many of the sales calls. “He was so good with customers you couldn’t keep him on the trading desk,” says Bob Dall, who was coming to the end of his days at Salomon. Says Ranieri: “I stopped trying to argue with customers about prepayments and finally started talking price. At what price were they attractive? There had to be some price where the customers would buy. A hundred basis points over treasuries [meaning one percentage point yield greater than U.S. treasury bonds]? Two hundred basis points? I mean, these things were three hundred and fifty basis points off the [U.S. treasury yield] curve!”

All American homeowners had a feel for the value of the right to repay their mortgage at any time. They knew if they borrowed money when interest rates were high that they could pay it back once rates fell and reborrow at the lower rates. They liked having that option. Presumably they would be willing to pay for the option. But no one even on Wall Street could put a price on the homeowners’ option (and people still can’t, though they’re getting closer). Being a trader, Ranieri figured, and argued, that since no one was buying mortgages and everyone was selling them, they must be cheap. More exactly, he claimed that the rate of interest paid by a mortgage bond over and above the government, or risk-free, rate more than compensated the mortgage bondholder for the option he was granting to the horneowner.

Ranieri cast himself in an odd role for a Wall Street salesman. He personified mortgage bonds. When people didn’t buy them, he appeared wounded. It was as if Ranieri himself were being sold short. He told The United States Banker in 1985: “Those of us in housing felt the market was charging us more of a premium for the prepayment risks than the real value.” Think about the way that sentence is put. Who are “those of us, in housing”? Ranieri himself wasn’t charged a premium. It was the homeowner who was charged. Lewie Ranieri, formerly of the Salomon Brothers mailroom and utility bond trading desk, had become the champion of the American homeowner. It was a far more appealing persona than that of the slick, profiteering Wall Street trader. “Lewie had this spiel about building homes for America,” says Bob Dall. “When we’d come out of those meetings, I’d say, ‘C’mon, you don’t think anyone believes that crap, do you?’ ” But that was what made Ranieri so convincing. He believed that crap.

Ranieri was perhaps the first populist in the history of Wall Street. The great Louisiana politician Huey P. Long campaigned on the slogan “A chicken in every pot!” Lewie Ranieri moved bonds off his trading books with the slogan “A mortgage on every home!” It helped that Ranieri looked the part of the common man. “It was a great act,” admits his protege Kronthal. To work Ranieri wore black Johnny Unitas-style ankle-high boots and six-inch-wide neckties. Every Friday he arrived on the trading floor in a tan polyester jacket and black chinos. He owned exactly four-suits, all polyester.

As he grew wealthy, earning between two and five million in each of the golden years between 1982 and 1986, he continued to own four suits. Jeffeny Kronthal recalls, “We used to kid him that he stood in line at The Male: Shop in Brooklyn to get his suits. They used to sell you a suit, with a trip to Florida, a bottle of champagne, and food stamps, all for ninety-nine bucks.” With his money Ranieri bought five powerboats. “Then I had more boats than suits,” he says. Other than that he lived modestly, without flashy cars or new homes. The clothes made the man, and everyone noticed the clothes. The suits said, “I haven’t forgotten that I came from the back office, and don’t you fucking forget it either.” They also said, “I’m Lewie, not some schmuck rich investment bankeir. There’s no artifice here. You can trust me, and I’ll take care of you.’”

Under due weight of Ranieri and his traders, investor mistrust eroded. And slowly investors began to buy mortgages. “Andy Carter of Genesson [money managers] in Boston was the first to buy the gospel according to Ranieri,” says Ranieri. More important, Ranieri was the guru of the thrift incdustry. Dozens of the largest thrifts in America wouldn’t budge without first seeking Ranieri’s advice. They trusted him: He looked like them, dressed like them, and sounded like them. As a result, thrift managers who could have bought Mike Milken’s junk bonds when they sold their loans stayed heavily concentrated in mortgage bonds. Between 1977 and 1986 the holdings of mortgage bonds by American savings and loans grew from $12.6 billion to $150 billion.

But that number dramatically understates the importance of the thrifts to the fortunes of Ranieri & Co. Ranieri’s sales force persuaded the thrift managers to trade their bonds actively. A good salesman could transform a shy, nervous thrift president into a maniacal gambler. Formerly sleepy thrifts became some of the biggest swingers in the bond markets. Despite their dwindling numbers, the thrifts as a group nearly doubled in assets size, from $650 billion to $1.2 trillion between 1981 and 1986. Salomon trader Mark Freed recalls a visit he paid on a large California thrift manager who had been overexposed to Wall Street influence. Freed actually tried to convince the thrift manager to calm down, to take fewer outright gambles on the market, to reduce the size of his positions, and instead hedge his bets in the bond market. “You know what he told me,” says Freed, “he said hedging was for sissies.” Various Salomon mortgage traders estimate that between 50 and 90 percent of their profits derived from simply taking the other side of thrifts’ trades. Why, you might wonder, did thrift presidents tolerate Salomon’s huge profit margins? Well, for a start, they didn’t know any better. Salomon’s margins were invisible. And since there was no competition on Wall Street, there was no one to inform them that they were making Salomon Brothers rich. What was happening—and is still happening—is that the guy who sponsored the float in the town parade, the 3-6-3 Club member and golfing man, had become America’s biggest bond trader. He was also America’s worst bond trader. He was the market’s fool.

Despite their frenetic growth, savings and loans, as Bob Dall had predicted, could not absorb the volume of home mortgages created in the early 1980s. Being a mortgage trader at Salomon more often meant being a mortgage buyer than a mortgage seller. “Steve Baurn [the whole loan trader] was running a two-billion-dollar thrift,” says one of his former colleagues. Like a thrift, Baum found himself sitting on loans for long periods. (Unlike a thrift, he prospered.) This completed the curious reversal in roles that occurred in the early 1980s, when thrifts became traders and traders thrifts. (What was happening is that Wall Street was making the entire savings and loan industry redundant. One day someone brave will ask: “Why don’t we just do away with S and Ls entirely?”) Michael Mortara nicknamed Baum “I Buy Baum” since he seemed never to sell anything. That, it turned out, was a stroke of luck. The bond market was on the verge of a record rally. As Henry Kaufman recalled in Institutional Investor:

We reached about 21.5 percent on the prime rate and we reached 17.5 percent on the bill rate in the early 1980’s. The peak of long term interest rates was reached in October 1981, when long governments hit about 15.25 percent. I only sensed that in the third quarter of 1982 that the economy was not about to get back on its feet very quickly, and so, finally, in August ‘82 I became bullish. And, of course, that day when I turned bullish, the stock market had the biggest gain in history; on that day the bonds rallied dramatically.

Ranieri & Co. had been forced by the glut into owning billions of dollars of mortgage bonds. Because of conditions of supply and demand in their market, they had no choice but to bet on the bond market going up. They watched with glee, therefore, the biggest bond market rally in the history of Wall Street. They had Kaufman to thank at first. When Henry said it was going up, it went up. But then the Federal Reserve allowed interest rates to fall. Policy in Washington, as anticipated by Kaufman, had taken a second fortunate turn for Ranieri and his band of traders. “We’re talking off to the races, bond futures up sixteen points in a week, unreal,” recalls Wolf Nadoolman. The mortgage department was the envy of the firm.

The hundreds of millions of dollars of trading profits realized by the handful of mortgage traders derived in large part from a combination of the market going up and the blessed ignorance of America’s savings and loans. Yet there were other, more intriguing ways Ranieri made money.

Ranieri’s traders found that their counterparts at other firms could be easily duped. Salomon’s was the only mortgage trading desk without direct phone lines to other Wall Street investment banks, preferring instead to work through intermediaries, called interbroker dealers. “We dominated the street,” says Andy Stone. “You’d buy bonds at twelve, even when they were trading at ten, to control the flow. The [Salomon Brothers] research department would then produce a piece saying the bonds you had just bought at twelve were really worth twenty. Or we’d buy six billion more of the things at twelve. The rest of the Street would see them trading up on the screens and figure, ‘Hey, retail buying, better buy, too,’ and take us out of our position.” Translation: Salomon could dictate the rules of the mortgage bond trading game as it went along.

As time passed, Ranieri grew less involved with the day-to-day decisions made on the trading desk. “Lewie was a brilliant big-picture guy,” says Andy Stone. “He’d say that mortgage bonds were going to do better than treasury bonds over the next two weeks, and he was right ninety-five percent of the time. And if he wasn’t, he could always call up nineteen thrifts and persuade them to buy our position in mortgages.” Ranieri was not, however, a brilliant detail guy, and the traders were beginning to delve into the minutiae of the mortgage market. “The nature of the trader changed,” says longtime mortgage bond salesman Samuel Sachs. “They wheeled in the rocket scientists, who started to carve up mortgage securities into itty-bitty pieces. The market became more than the five things that Lewie could hold in his brain at any one time.”

The young traders had M.B.A.’s and Ph.D.’s. The first of the breed was Kronthal, after whom came Haupt, Roth, Stone, Brittenham, Nadoolman, Baum, Kendall, and Howie Rubin. One trick the new young traders exploited was the tendency of borrowers to prepay their loans when they should not. In a nice example of Wall Street benefiting from confusion in Washington, Steve Roth and Scott Brittenham made tens of millions of dollars trading federal project loans—the loans made to the builders of housing projects, guaranteed by the federal government. By 1981 the federal government was running a deficit. It embarked on a program of asset sales. One group of assets it sold were loans that it had made to the developers of low-cost housing in the 1960s and 1970s.

The loans had been made at below market rates in the first place, as a form of subsidy. On the open market, because of their low coupons, they were worth far less than par (one hundred cents on the dollar); a typical loan was worth about sixty cents on the dollar. So, for example, a thirty-year hundred-million-dollar loan, paying the lender 4 percent a year in interest (when he could earn, say, 13 percent in U.S. treasuries), might be worth sixty million dollars.

On the occasion of the government sale of a loan a tiny announcement appeared in the Wall Street Journal. It seemed only two people read it: Roth and Brittenham. Brittenham now says, “We dominated the market for years. When I came on board in 1981, we were really the only people buying them.” The market was more of a game than most. The trick was to determine beforehand 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, the lender. This arose because project loans traded below a hundred cents on the dollar. When Roth and Brittenham bought loans at sixty cents on the dollar that prepaid immediately, they realized a fast forty cents on the dollar profit. To win the money, you had to know how to identify situations in which the lender would get his money back prematurely. These, it turned out, were of two sorts.

The first were the financially distressed. Where there was distress, there was always opportunity. “It was great if you could find a government housing project that was about to default on its mortgage,” says Brittenham. It was great because the government guaranteed the loan and, in the event of a default, paid off the loan in full. The windfall could be in the millions of dollars.

The other kind of project likely to prepay its mortgage was the cushy upmarket property. Brittenham recalls, “You’d look for a nice property—not a slum—something with a nice pool, tennis court, microwave ovens. When you found it, you’d say to yourself, That’s a likely conversion.” To convert, the occupants bought out the owner-developer, who would, in turn, repay the loan to the government. Once the government had received its money, it repaid Roth and Brittenham a hundred cents on the dollar for a piece of paper they had just bought at sixty. The thought of two young M.B.A.’s from Wall Street roaming the nation’s housing projects in search of swimming pools and bankrupt tenants seems ridiculous until you have done it and made ten million dollars.

The wonder is that the people in Washington who sold the loans did not do the same. But they didn’t understand the value of the loans. Instead they trusted the market to pay them the right price. The market, however, was inefficient.

Even larger windfalls came from exploiting the inefficient behavior of the American homeowner. In deciding when to pay off his debts, the homeowner wasn’t much craftier than the federal government. All across the country citizens with 4, 6, and 8 percent home mortgages were irrationally insisting on paying down their home loans when the prevailing mortgage rate was 16 percent; even in the age of leverage there were still many people who simply didn’t like the idea of being in hock. This created a situation identical to the federal project loan bonanza. The home loans underpinned mortgage bonds. The bonds were priced below their face value. The trick was to buy them below face value just before the homeowners repaid their loans. The mortgage trader who could predict the behavior of the homeowners made huge profits. Any prepayments were profits to the owner of the mortgage bond. He had bought the bond at sixty; now he was being paid off at a hundred.

A young Salomon Brothers trader named Howie Rubin began to calculate the probability of homeowners’ prepaying their mortgages. He discovered that the probability varied according to where they lived, the length of time their loans had been outstanding, and the sizes of their loans. He used historical data collected by Lew Ranieri’s research department. The researchers were meant to be used like scientific advisers at an arms talk. More often, however, they were treated like the water boys on the football team. But the best traders knew how to use the researchers well. The American homeowner became, to Rubin and the research department, a sort of laboratory rat. The researchers charted how previously sedentary homeowners jumped and started in response to the shock of changes in the rate of interest. Once a researcher was satisfied that one group of homeowners was more likely than another to behave irrationally, and pay off low-interest-rate mortgages, he would inform Rubin, who then bought their mortgages. The homeowners, of course, never knew that their behavior was so closely monitored by Wall Street.

The money made in the early years was as easy as any money ever made at Salomon. Still, mortgages were acknowledged to be the most mathematically complex securities in the marketplace. The complexity arose entirely out of the option the homeowner has to prepay his loan; it was poetic that the single financial complexity contributed to the marketplace by the common man was the Gordian knot giving the best brains on Wall Street a run for their money. Ranieri’s instinct that had led him to build an enormous research department had been right: Mortgages were about math.

Chapter 7

The deterioration of Ranieri & Co. was so rapid and complete that one is reluctant to attribute it to a single factor, such as the defection of traders. And it is clear that several forces at once eroded its supremacy. One of these forces was the market itself; the market began to right the imbalance between Ranieri & Co. and the rest of the bond trading world. The beautiful inefficiency of mortgage bonds was spoiled for Salomon by one of its own creations, called the collateralized mortgage obligation (CMO). It was invented in June 1983, but not until 1986 did it dominate the mortgage market. The irony is that it achieved precisely what Ranieri had hoped: It made home mortgages look more like other bonds. But making mortgage bonds conform in appearance had the effect, in the end, of making them only as profitable as other kinds of bonds.

Larry Fink, the head of mortgage trading at First Boston who helped create the first CMO, lists it along with junk bonds as the most important financial innovation of the 1980s. That is only a slight overstatement. The CMO burst the dam between several trillion investable dollars looking for a home and nearly two trillion dollars of home mortgages looking for an investor. The CMO addressed the chief objection to buying mortgage securities, still voiced by everyone but thrifts and a handful of adventurous money managers. Who wants to lend money not knowing when he’ll get it back?

To create a CMO, one gathered hundreds of millions of dollars of ordinary mortgage bonds—Ginnie Macs, Fannie Macs, and Freddie Macs. These bonds were placed in a trust. The trust paid a rate of interest to its owners. The owners had certificates to prove their ownership. These certificates were CMOs. The certificates, however, were not all the same. Take a typical three-hundred-million-dollar CMO. It would be divided into three tranches, or slices of a hundred million dollars each. Investors in each tranche received interest payments. But the owners of the first tranche received all principal repayments from all three hundred million dollars of mortgage bonds held in trust. Not until first tranche holders were entirely paid off did second tranche investors receive any prepayments. Not until both first and second tranche investors had been entirely paid off did the holder of a third tranche certificate receive prepayments.

The effect was to reduce the life of the first tranche and lengthen the life of the third tranche in relation to the old-style mortgage bonds. One could say with some degree of certainty that the maturity of the first tranche would be no more than five years, that the maturity of the second tranche would fall somewhere between seven and fifteen years, and that the maturity of the third tranche would be between fifteen and thirty years.

Now, at last, investors had a degree of certainty about the length of their loans. As a result of CMOs, there was a dramatic increase in the number of investors and volume of trading in the market. For though there was no chance of persuading a pension fund manager looking to make a longer-term loan to buy a Freddie Mac bond that could evaporate tomorrow, one could easily sell him the third tranche of a CMO. He slept more easily at night knowing that before he received a single principal repayment from the trust, two hundred million dollars of home mortgage loans had to be prepaid to first and second tranche investors. The effect was astonishing. American pension funds controlled about six hundred billion dollars’ worth of assets in June 1983, when the first CMO was issued by Freddie Mac. None of the money was invested in home mortgages. By the middle of 1986 they held about thirty billion dollars’ worth of CMOs, and that number was growing fast.

CMOs also opened the way for international investors who thought American homeowners were a good bet. In 1987 the London office of Salomon Brothers sold two billion dollars of the first tranche of CMOs to international banks looking for higher-yielding short-term investments. The money that flowed into CMOs came from investors new to mortgage bonds, who would normally have purchased corporate or treasury bonds instead. Sixty billion dollars of CMOs were sold by Wall Street investment banks between June 1983 and January 1988. That means that sixty billion dollars of new money were channeled into American home finance between June 1983 and January 1988.

As with any innovation, the CMO generated massive profits for its creators, Salomon Brothers and First Boston. But at the same time, CMOs redressed the imbalance of supply and demand in mortgages that had created so much opportunity for the bond traders. A trader could no longer bank on mortgages’ being cheap because of a dearth of buyers. By 1986, thanks to CMOs, there were plenty of buyers. The new buyers drove down the returns paid to the investor by mortgage bonds. Mortgages, for the first time, became expensive.

The market settled on a fair value for CMOs by comparing them with corporate and treasury bonds. Though this wasn’t precisely rational, as there was still no theoretical basis for pricing the homeowner’s option to repay his mortgage, the market was growing large enough to impose its own sense of fairness. No longer were the prices of ordinary mortgage bonds allowed to roam inefficiently, for they were now linked to the CMO market, in much the same way that flour is linked to the market for bread. Fair value for CMOs (the finished product) implied a fair value for conventional mortgage bonds (the raw materials). Investors now had a new, firm idea of what the price of a mortgage bond should be. This reduced the amount of money to be made exploiting their ignorance. The world had changed. No longer did Salomon Brothers traders buy bonds at twelve and then make the market believe they were worth twenty. The market dictated the price, and Salomon Brothers’ traders learned to cope.

After the first CMO the Young Turks of mortgage research and trading found a seemingly limitless number of ways to slice and dice home mortgages. They created CMOs with five tranches and CMOs with ten tranches. They split a pool of home mortgages into a pool of interest payments and a pool of principal payments, then sold the rights to the cash flows from each pool (known as IOs and POs, after interest only and principal only) as separate investments. The homeowner didn’t know it, but his interest payments might be destined for a French speculator, and his principal repayments to an insurance company in Milwaukee. In perhaps the strangest alchemy, Wall Street shuffled the IOs and POs around and glued them back together to create home mortgages that could never exist in the real world. Thus the 11 percent interest payment from condominium dwellers in California could be glued to the principal repayments from homeowners in a Louisiana ghetto, and voila, a new kind of bond, a New Age Creole, was born.

The mortgage trading desk evolved from corner shop to supermarket. By increasing the number of products, they increased the number of shoppers. The biggest shoppers, the thrifts, often had a very particular need. They wanted to grow beyond the limits imposed by the Federal Home Loan Bank Board in Washington. It was a constant struggle to stay one step ahead of thrift regulators in Washington. Many “new products” invented by Salomon Brothers were outside the rules of the regulatory game; they were not required to be listed on thrift balance sheets and therefore offered a way for thrifts to grow. In some cases, the sole virtue of a new product was its classification as “off-balance sheet.”

To attract new investors and to dodge new regulations, the market became ever more arcane and complex. There was always something new to know, and inevitably Ranieri fell out of touch. The rest of the ozone layer of management at Salomon Brothers had never really been in touch. Therefore, the trading risks were managed by mere tykes, a few months out of a training program, who happened to know more about Ginnie Mae 8 percent IOs than anyone else in the firm. That a newcomer to Wall Street should all of a sudden be an expert wasn’t particularly surprising, since the bonds in question might have been invented only a month before. In a period of constant financial innovation, the youngest people assumed power (and part of the reason young people got rich was that the 1980s was a period of constant change). A young brain leaped at the chance to know something his superiors did not. The older people were too busy clearing their desktops to stay at the frontiers of innovation. ======== “Wall Street makes its best producers into managers. The reward for being a good producer is to be made a manager. The best producers are cutthroat, competitive, and often neurotic and paranoid. You turn those people into managers, and they go after each other. They no longer have the outlet for their instincts that producing gave them. They usually aren’t well suited to be managers. Half of them get thrown out because they are bad. Another quarter get muscled out because of politics. The guys left behind are just the most ruthless of the bunch. That’s why there are cycles on Wall Street—why Salomon Brothers is getting crunched now—because the ruthless people are bad for the business but can only be washed out by proven failure.” ======== Ranieri had accomplished what he set out to do: put the mortgage department on equal footing with corporate and government bonds. The U.S. mortgage market is now the largest credit market in the world and may one day be the single largest bond market in the world. Ranieri’s creation signaled a shift in the focus of Wall Street. Wall Street, historically, had dealt with only one side of the balance sheet: liabilities. Mortgages are assets. If home mortgages could be packaged and sold, so could credit card receivables, car loans, and any other kind of loan you can imagine. ========

Chapter 8

Men in general judge more by the sense of sight than by the sense of touch, because everyone can see but only a few can test by feeling. Everyone sees what you seem to be, few know what you really are; and those few do not dare take a stand against the general opinion. —Niccolo Machiavelli, The Prince ======== John Gutfreund and Tom Strauss (who oversaw our international operations) shared the conventional wisdom of Wall Street that there would one day be just a few truly global investment banks and that the losers would, presumably, stay home. Those few global banks would form an oligopoly that could lift the price of its capital raising services and prosper. The firms regularly mentioned as likely to form the global club were the Japanese investment bank Nomura, the American commercial bank Citicorp, and the American investment banks First Boston, Goldman Sachs, and Salomon Brothers. And the European banks? I don’t think we even knew their names.

Tokyo was the obvious site for our rapid expansion because Japan’s trade surplus left it gorged with dollars it had either to sell or to invest. The Japanese were the Arabs of the 1980s. But because American firms felt unwelcomed by Japan’s financial establishment, and because financial regulation was labyrinthine in Japan, the Japanese offices of Wall Street firms tended to be small and tentative.

Meanwhile, there was no obvious barrier to entry in Europe. There was little financial regulation. And the Atlantic cultural divide seemed less daunting than the Pacific to native New Yorkers. ======== To sell short, or to short, is to sell a security that you don’t own, hoping that it will decline in price and you can buy it back later at a lower price. To short our own stock would be to bet on its taking a nose dive. ======== Once you knew the truth about the firm, you realized it was far better to disinform than to inform. And if our leaders were going to lie about their methods, they were almost by necessity going to tell a whopper. ======== The markets in the long run are no doubt driven by fundamental economic laws—if the United States runs a persistent trade deficit, the dollar will eventually plummet—but in the short run money flows less rationally. Fear and, to a lesser extent, greed are what make money move. ======== If there was a single lesson I took away from Salomon Brothers, it is that rarely do all parties win. The nature of the game is zero sum. A dollar out of my customer’s pocket was a dollar in ours, and vice versa. ========

Chapter 9

The supreme art of war is to subdue the enemy without fighting. —Sun-tzu ======== There are no copyright laws in investment banking and no way to patent a good idea. Pride of authorship is superseded by pride of profits. If Salomon Brothers creates a new kind of bond or stock, within twenty-four hours Morgan Stanley, Goldman Sachs, and the rest will have figured out how it worked and will be trying to make one just like it. I understand this as part of the game. I recall that one of the first investment bankers I met taught me a poem.

God gave you eyes, plagiarize. ======== The plain fact was that a combination of market forces and gross mismanagement had thrown Salomon Brothers into deep trouble. At times it was as if we had no management at all. No one put a stop to the infighting; no one gave us a sense of direction; no one put a halt to our rapid growth; no one wanted to make the hard decisions that businessmen, like generals, simply have to make. ======== “You don’t get rich in this business,” said Alexander when I complained privately to him. “You only attain new levels of relative poverty. ======== He had, however, put his finger on the insatiable hunger for more felt by anyone who had succeeded at Salomon Brothers and probably at any Wall Street firm. The hunger or, if you will, the greed took different forms, some of which were healthier for Salomon Brothers than others. The most poisonous was the desire to have more now: short-term greed rather than long-term greed. People who are short-term greedy aren’t loyal. Salomon Brothers people in 1986 wanted their money now because it looked as if the firm were heading for disaster. Who knew what 1987 would bring? ========

Chapter 10

How Can We Make you Happier?

On one day late in the second year, September 24, 1987, the pattern was unexpectedly broken. Someone shouted, “We’re in play!”

I checked my news screens. If people still rubbed their eyes when they didn’t believe what they were seeing, that’s what I would have done. News was flashing across that Ronald O. Perelman, the five-foot-four-inch husband of a New York gossip columnist, the notorious hostile raider who had lately conquered the cosmetic firm Revlon, was making a bid to buy a large chunk of Salomon Brothers. His financial backer was Drexel Burnham, and his advisers were Joseph Perella and Bruce Wasserstein from First Boston. It was the first time Wall Street had turned and attacked its own.

All of a sudden my telephone board looked like a clear night in the Rockies; lights twinkled and pulsed. The customers were calling, ostensibly to express their condolences that our firm was about to be stormed and mutilated by a heartless predator. Theirs was a hollow-sounding concern, however. They only wanted to gawk, the way people do who gather around the scene of an accident and stare at the twisted metal and trembling victims. More than a few were thinking that big, bad Salomon Brothers had finally met a force in the market that was bigger and badder still, amused that that force happened to be a leading purveyor of ladies’ cosmetics.

Why was a lipstick merchant coming after us? The most intriguing answer was that it wasn’t his idea. Perelman’s bid could easily be seen as a hate bomb lobbed at John Gutfreund by Drexel’s junk bond king, and Perelman’s true backer, Michael Milken. Milken often lobbed hate bombs at people who treated him badly. And Gutfreund had treated him badly. In early 1985 Milken had visited our offices for a breakfast meeting with Gutfreund. It started with Milken growing angry because Gutfreund refused to speak to him as an equal. It ended in a shouting match, with Milken being escorted from the building by a security guard. Gutfreund subsequently cut Drexel out of all Salomon Brothers bond deals.

Then Drexel found itself at the center of the largest SEC investigation ever. Rather than send flowers, a Salomon Brothers managing director mailed to Milken’s clients copies of legal complaints (for extortion and racketeering) filed against Milken by three other clients. The relationship between Salomon Brothers and Drexel Burnham was, in September 1987, rightly regarded as the worst between any two firms on Wall Street.

Milken spooked Gutfreund. For all of his worldly ambition, Gutfreund remained remarkably parochial and introverted. That’s why, for example, it never occurred to him that anyone would manage his London office but Americans. We weren’t businesspeople, and we hadn’t seized the opportunity to diversify when we were strong. We really never knew how to do anything more than trade bonds. No one at Salomon had ever created a substantial new business with the exception of Lewie Ranieri, and he had eventually been buried for his troubles. Milken, on the other hand, had built the biggest new business on Wall Street directly adjacent to our own, and his goal was to usurp Salomon’s position in the bond markets.

“Whatever Gutfreund said,” said one of my colleagues much nearer to Gutfreund than I, “he always thought just one firm was capable of deballing Salomon Brothers, of taking over our franchise: Drexel. He wasn’t worried about the white shoes at Morgan Stanley because he thought our competitive drive was that much stronger. But Drexel is tough like us. And Henry [Kaufman] was predicting a long-term decline in the credit quality of corporate America. They were all turning to junk. That meant our client base was drifting toward Drexel.”

But it wasn’t only our clients. Our employees defected to Drexel at an alarming rate. At least a dozen former Salomon Brothers traders and salespeople staffed Milken’s eighty-five-man Beverly Hills junk bond trading floor, and many more worked for Drexel in New York. Every month or so another bond trader, salesman, or research analyst walked off the side of the New York trading floor and announced to management he was leaving for Drexel. How did Salomon management respond? “Put it this way,” says one who did, “you weren’t allowed back out on the trading floor to collect your jacket.”

The defections to Drexel were, not surprisingly, self-perpetuating. Reports of the magical sums of money to be made working for Michael Milken trickled back into Salomon and made us drool. One Salomon middle executive left to join Milken in Beverly Hills in 1986. In his third month on the new job he found an extra hundred thousand dollars in his weekly paycheck. He knew it wasn’t bonus time. He assumed Drexel’s accountants had made a mistake. He told Milken.

“No,” said Milken, “it is no mistake. We just want to let you know how happy we are with the job you are doing.”

Another former Salomonite told of his first bonus with Michael Milken. Milken handed him several million dollars more than he expected. He had grown accustomed to Salomon Brothers’ bonus sessions, where he had rarely got more than he expected. Now he was staring at a bonus that was bigger than John Gutfreund’s entire compensation package. He sat in his chair, stunned, like a character from the old television show “The Millionaire.” Someone had just handed him enough money to retire on, and he didn’t know how to express his gratitude. Milken watched him, then asked, “Are you happy?” The former Salomon employee nodded. Milken leaned forward in his chair and asked, “How can we make you happier?”

Milken drowned his people in money. The magnificent stories had many of us at Salomon hoping for a phone call from Milken. It also bred loyalty on his Beverly Hills trading floor. Milken, at times, seemed to preside over a cult. “We owe it all to one man,” one Drexel trader told author Connie Bruck. “And we are all extraneous. Michael has denuded us of ego.” Every ego has its price. One of my former fellow trainees who had gone to work for Milken told me that, of the eighty-five who staffed the Beverly Hills Office, “Twenty to thirty are worth ten million dollars or more, and five or six have made more than a hundred million.” Whenever a newspaper printed an estimate of Milken’s paycheck, apparently, the entire Beverly Hills office of Drexel had a chuckle at how low it was. My friend and others with him told me that Milken was worth more than a billion dollars. Still, you had to wonder what gave Michael Milken greater pleasure, making a billion dollars or watching Gutfreund squirm as one of his biggest clients, Ronald Perelman, stalked Salomon Brothers. “I know Michael, and I like Michael,” says Lewie Ranieri, who had been fired by Gutfreund two months before (and now appeared like the Ghost of Christmas Past). “His epitaph should read: He never betrayed a friend, and he never showed mercy towards an enemy.”

The second way to see Perelman’s bid was as retribution for the sins of our management. Dash and I decided that a take-over of our firm was not such a bad idea, not that anyone sought our views. We knew that Ronald Perelman, lipstick mogul, swashbuckler, and rogue, had no clue how to run an investment bank. But we also knew that if he succeeded in conquering Gutfreund, the first thing he would do would be to examine the firm as a business, instead of as an empire, which would be a new and refreshing approach to running Salomon Brothers. No question, a lot of corporate take-overs are shams, thinly disguised. The raiders claim that they are going to oust lazy, stupid managers when what they really want is to strip the assets from the company. But our take-over was a heartwarming exception. Our assets were our people; we had no land, no overfunded pension plan, no brand names to strip. Salomon Brothers was an honest target. Our management deserved the ax.

The only business plan on Wall Street more sensationally wrong than the one Salomon had already devised was the one Salomon was charting for the coming months. We had the temperament and wisdom of a Lebanese taxi driver: We had our foot slammed down either on the accelerator or on the brake; we knew no moderation and had no judgment. When we had decided we needed more space in New York, did we, like mortals, slip quietly across the street into larger offices? No. We began construction, with real estate developer Mort Zuckerman, of Columbus Circle, of the biggest, most expensive real estate project to date in Manhattan. Susan Gutfreund ordered a box of glass ashtrays with the design of our future palace etched into the bottoms. We would eventually bail out of the project at a cost of $107 million; she kept the ashtrays.

We had also set our sites on global domination and built the largest trading floor in the world above a London train station. Now London was a glorious bust and overdue for consolidation, at an estimated loss of a hundred million dollars. The wits in the English press were referring to us as “Smoked Salomon.” We had built a giant and omnipotent mortgage department; then we let half of it leave and fired the rest. Lewie and his monopoly were gone, a loss of at least a few hundred million dollars more. We had unleashed some of the world’s largest egos to struggle for power on the forty-first floor. Now, New York was plagued with internecine strife; the price of this mistake might well be the loss of the firm. On or off. Buy or sell. In or out. Consistency was for little minds, not for us.

Still, our most severe misjudgments were not steps we had taken but steps we had neglected to take. It wasn’t as though investment banking in 1987 were no longer a profitable business. On the contrary, it was more profitable than ever before. Open any newspaper and you saw investment bankers raking in fees of $50 million and more for a few weeks of work. For the first time in many years other firms, not Salomon, were making the money. Ironically, the new winners were just those men helping Ronald Perelman in his bid to buy us: Milken, Wasserstein, and Perella. Drexel Burnham, thanks to Michael Milken, had replaced us as Wall Street’s most profitable investment bank in 1986. It had cleared $545.5 million on revenues of $4 billion, more than we had made at our best.

Drexel was making its fortune in junk bonds, and that stung. We were supposed to be Wall Street’s bond traders. We were in danger of losing that distinction, however, for our managers had failed to see how important junk bonds would become. They thought junk was a passing fad. That was easily their single most expensive oversight, for it precipitated not only a revolution in corporate America, and a giddy free-for-all Wall Street, but the take-over attempt of my firm, and for that final effect it is worth pausing for a moment to examine. I did.

Junk bonds are bonds issued by corporations deemed by the two chief credit-rating agencies, Moody’s and Standard & Poor’s, to be unlikely to repay their debts. “Junk” is an arbitrary but important distinction. The spectrum of creditworthiness that has IBM at 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; they have been much in the news.

But they are not, it should be emphasized, new. Companies, like people, have always borrowed money to buy things they haven’t had the cash to afford. They also borrow money because, in America at least, it is the most efficient way to finance an enterprise; interest payments on debt are tax-deductible. And shaky enterprises have always wanted to borrow money. At times, as when the turn of the century robber barons built their empires on mountains of paper, lenders have been surprisingly indulgent. But never as indulgent as today. What is new, therefore, is the size of the junk bond market, the array of rickety companies deeply in hock, and the number of investors willing to risk their principal (and perhaps also their principles) by lending to these companies.

Michael Milken at Drexel created that market, by persuading investors that junk bonds were a smart bet, in much the same fashion that Lewie Ranieri persuaded investors mortgage bonds were a smart bet. Throughout the late 1970s and early 1980s Milken crisscrossed the nation and pounded on dinner tables until people began to listen to him. Mortgages and junk made it easier to borrow money for people and companies previously thought unworthy of the funds. Or, to put it the other way around, the new bonds made it possible for the first time for investors to lend money directly to homeowners and shaky companies. And the more investors lent, the more others owed. The consequent leverage is the most distinctive feature of our financial era.

In her book The Predators’ Ball, Connie Bruck traced the rise of Drexel’s junk bond department (Milken reportedly tried to pay the author not to publish). The story she tells begins in 1970, when Michael Milken studied bonds at the University of Pennsylvania’s Wharton School of Finance. He was blessed with an unconventional mind, which overcame his conventional middle-class upbringing (his father had been an accountant). At Wharton he examined fallen angels, the bonds of one-time blue-chip corporations now in trouble. At the time fallen angels were the only junk bonds around. Milken noticed that they were cheap compared with the bonds of blue-chip corporations even considering the additional risk they carried. The owner of a portfolio of fallen angels, by Milken’s analysis, almost always outperformed the owner of a portfolio of blue-chip bonds. There was a reason: Investors shunned fallen angels out of a fear of seeming imprudent. It is a remarkably simple observation. Milken noticed that investors were constrained by appearances and, as a result, had left a window of opportunity open for a trader who was not. Thus the herd instinct, the basis for so much human behavior, laid the foundation for a revolution in the world of money.

Milken began his career that same year, 1970, in Drexel’s back office. He pushed his way onto the trading floor and became a bond trader. He wore a toupee. Even his friends said it didn’t fit him properly; his enemies said it looked as if a small mammal had died on his head. The parallels between Milken and Ranieri are striking. Like Ranieri, Milken lacked both tact and couth, but not confidence. He was perfectly happy to stand apart from his colleagues. Milken sat in a corner of the trading floor while he created his market, ostracized until he made too much money to be anything but the boss. Also like Ranieri, he built a team of devoted employees.

Milken shared Ranieri’s zeal. “Mike’s difficulty was that he simply didn’t have the patience to listen to another point of view,” a former Drexel executive told Bruck. “He was terribly arrogant. He would assume he had conquered a problem and go forward. He was useless in a committee, in any situation that called for a group decision. He only cared about bringing the truth. If Mike hadn’t gone into the securities business, he could have led a religious revival movement.”

Milken is Jewish, and Drexel, when he joined, was an old-line WASP investment bank with, he felt, an anti-Semitic streak. Milken considered himself an outsider. That was a point in his favor. In 1979 a good guess at who would revolutionize finance in the coming decade would have been made as follows: Search the unfashionable corner of Wall Street; eliminate everyone who appears to have just emerged from a Brooks Brothers catalog, everyone who belongs or claims to belong to exclusive clubs, and everyone who comes from a good WASP family. (Among the leftovers would have been not only Milken and Ranieri but Joseph Perella and Bruce Wasserstein of First Boston, the leaders in corporate take-overs and, coincidentally, the other two men who helped Ronald Perelman chase Salomon Brothers.)

Here the similarity ends. For unlike Ranieri, Michael Milken took complete control of his firm. He moved his junk bond operation from New York to Beverly Hills and eventually paid himself $550 million a year, 180 times what Ranieri made at his peak. When Milken opened his Wilshire Boulevard office (which he owns), he let it be known who was in charge by putting his name on the door instead of Drexel’s. And he created a working environment that was different from Salomon Brothers in one crucial respect: Success was measured strictly by how many deals you brought in, rather than by how many people worked for you, whether you had a seat on the board of directors, and how many gossip columns you appeared in.

It is always hard to say what it is about a man that makes him suited to overturn the conventions by which the rest of the world has been living for ages. In Milken’s case, it is especially difficult because he’s almost neurotically private and offers no helpful insights into his character to would-be biographers, other than the business he does. My view is that he combined two qualities that were, at the time of his ascendancy, regarded as mutually exclusive. They certainly did not coexist within Salomon Brothers in the early 1980s. Milken possessed both raw bond-trading skills and patience with ideas. He had an attention span.

Here Milken overcame great odds. Loss of concentration, a complete lack of ability to focus, was the chief occupational hazard of the trading floor. Dash Riprock was an excellent and typical case in point. Watching Dash was as disconcerting as watching a music video. There were brief moments, for example, when Dash was glum. On occasion, usually when his business had momentarily waned, he dropped his telephone with a thud and explained to me how one day he planned to quit investment banking and go back to school. He was going to bury himself in a library for a few years, then become a history professor. Or maybe a writer. The idea of Dash locked in quiet contemplation, even for five minutes, struck me as uniquely improbable, and these conversations of ours would end with my trying to say so and his not listening because he was bored and wanted to change the topic. “I don’t mean I want to study now,” he’d say “I mean when I’m thirty-five and have a few million dollars in the bank,” as if, after years of jamming bonds, a few million dollars in the bank would make him more likely to pay attention.

After three years of bond sales Dash couldn’t concentrate sufficiently to enjoy a decent period of moodiness. Almost as soon as it had occurred to him to sulk (“Don’t fuck with me, I’m in a bad mad mood,” he’d warn traders) he would have forgotten about it, for somehow, in the throes of his gloom, he’d sell a few hundred million dollars’ worth of government bonds and grow bright again. “Yeah, Mikey!” he’d shout, as he scribbled a sales ticket. “The nippers, they love me. And I’m whipping and driving them. OOOOhhhhhhh yeaahhhh.” Most of his thoughts were entirely devoted to finding the next trade. His was a never-ending search for a fix.

Michael Milken, who began in a job not dissimilar to Dash’s, was building a business, rather than making an endless series of trades. He was willing to look up from the blips on his trading screen and think clear and complete thoughts years into the future. Would a certain microchip company survive for twenty years to meet its semiannual interest payments? Would the U.S. steel industry survive in any form? Fred Joseph, who became CEO of Drexel, listened to Milken on the subject of corporations and thought he “understood credit better than anyone in the country.” As a by-product, Milken came to understand companies.

Companies had long been the domain of commercial bankers and the corporate finance and equity departments of investment banks. They hadn’t been subjected to the mental processes of a bond trader. We at Salomon, as I have said, relegated the equity department to a corner in our basement. Many of our bond traders thought of our corporate financiers as administrative assistants; their pet name for the corporate finance department was Team Xerox. Anyone who might have seen what Milken saw never reached a position to do anything about it. That was a great shame, because it left us blind to a prize within our reach.

Thinking like a bond trader, Milken completely reassessed corporate America. He made two observations. First, many large and seemingly reliable companies borrowed money from banks at low rates of interest. Their creditworthiness had but one way to go: down. Why be in the business of lending money to them? It didn’t make sense. It was a stupid trade: tiny upside, huge downside. Many companies that had once been models of corporate vitality subsequently went bust. There was no such thing as a riskless loan. Even corporate giants are felled when their industries collapse under them. Witness the entire U.S. steel industry.

Second, two sorts of companies could not persuade risk-averse commercial bankers and money managers to lend them so much as the time of day: small new companies and large old companies with problems. Money managers relied on the debt-rating agencies to tell them what was safe (or, rather, to sanction their investments so they did not appear imprudent). But the rating services, like the commercial banks, relied almost exclusively on the past-corporate balance sheets and track records in rendering their opinions. The outcome of the analysis was determined by the procedure rather than by the analyst. This was a poor way to evaluate any enterprise, be it new and small, or old, large and shaky. A better method was to make subjective judgments about the character of management and the fate of their industry. Lending money to a company such as MCI, which funded most of its growth with junk bonds, could be a brilliant risk if one could foresee the future of competitive long-distance phone services and the quality of MCI’s management. Lending money to Chrysler at extortionate rates of interest could also be a smart bet, as long as the company had enough cash flow to pay that interest.

Milken often spoke to students at business schools. On these occasions he liked, for dramatic effect, to demonstrate how hard it actually is to put a large company into bankruptcy. The forces interested in keeping a large company afloat, he argued, are far greater than those that wish to see it perish. He’d present the students with the following hypothetical situation. First, he’d say, let’s locate our major factory in an earthquake zone. Then let’s infuriate our unions by paying the executives large sums of money while cutting wages. Third, let’s select a company on the brink of bankruptcy to supply us with an essential irreplaceable component in our production line. And fourth, just in case our government is tempted to bail us out when we get into trouble, let’s bribe a few indiscreet foreign officials. That, Milken would conclude, is precisely what Lockheed had done in the late 1970s. Milken had purchased Lockheed bonds when the company looked to be heading for liquidation and had made a small fortune when it was saved in spite of itself.

What Milken was saying was that the entire American credit-rating system was flawed. It focused on the past when it should have focused on the future, and it was burdened by a phony sense of prudence. Milken plugged the hole in the system. He ignored large Fortune 100 companies in favor of ones with no credit standing. To compensate the lender for the higher risk, their junk bonds bear a higher rate of interest, sometimes 4 or 5 or 6 percent higher, than the bonds of blue-chip companies. They also tend to pay the lender a big fat fee if the borrower makes enough money to repay his loans prematurely. So when the company makes money, its junk soars, in anticipation of the windfall. And when the company loses money, its junk sinks, in anticipation of default. In short, junk bonds behave much more like equity, or shares, than old-fashioned corporate bonds.

Therein lies one of the surprisingly well-kept secrets of Milken’s market. Drexel’s research department, because of its close relationship with companies, was privy to raw inside corporate data that somehow never found its way to Salomon Brothers. When Milken trades junk bonds, he has inside information. Now it is quite illegal to trade in stocks on inside information, as former Drexel client Ivan Boesky has ably demonstrated. But there is no such law regarding bonds (who, when the law was written, ever imagined that one day there would be so many bonds that behaved like stock?).

Not surprisingly, the line between debt and equity, so sharply drawn in the mind of a Salomon bond trader (Equities in Dallas!), becomes blurred in the mind of a Drexel bond trader. Debt ownership in a shaky enterprise means control, for when a company fails to meet its interest payments, a bondholder can foreclose and liquidate the company. Michael Milken explained this more succinctly to Meshulam Riklis, the de facto owner of Rapid-American Corporation, at a breakfast meeting in the late 1970s. Milken claimed that Drexel and its clients, not Riklis, controlled Rapid-American. “How can that be when I own forty percent of the stock?” asked Riklis.

“We own a hundred million dollars of your bonds,” said Milken, “and if you miss one payment, we’ll take the company away.”

Those words are balm for the conscience of any bond salesman, like me, weary of screwing investors on behalf of corporate borrowers. If you miss one payment, we’ll take the company away. “Michael Milken,” Dash Riprock said, “has turned the business inside out. He screws the corporate borrower on behalf of investors.” Borrowers were squeezed because they had nowhere else to go but to Milken for money. What Milken offered was access to lenders. The lenders, along with Milken, made money. The gist of Milken’s pitch to them was this: Build a huge portfolio of junk bonds, and it does not matter if a few turn out to be lemons, the higher payoff on the winners should more than offset the losses on the losers. Drexel was prepared to gamble on companies, said Milken to institutional investors. Join us. Invest in the future of America, the small-growth companies that make us great. It was a populist message. The early junk bond investors, like mortgage investors, could make money and feel good about themselves. “You should have heard Mike’s speech each year at the junk bond seminar in Beverly Hills” (known as the Predators’ Ball, for the carnivores, like Ronald Perelman, in attendance), says a Drexel executive in New York. “It would have brought tears to your eyes.”

It’s impossible to say exactly how much money Milken converted to his cause. Many investors simply gave over their portfolios to him. Tom Spiegel of Columbia Savings & Loan, for example, responded to Milken’s message by inflating his balance sheet from $370 million in assets to $10.4 billion, much of it junk. A company that in sweet theory made loans to homeowners was simply taking billions of dollars in savings deposits and buying junk bonds with it. Before 1981 savings and loans did, almost exclusively, lend money to homeowners. Since the deposits were insured by the federal government—giving thrift managers cheap funds—the investments were restricted by the federal authorities. In 1981, when they began to flounder, the U.S. Congress decided to let the savings and loans try to speculate their way out of trouble. And though it meant, effectively, gambling with the government’s money, they were allowed to buy junk bonds. Spiegel has spent some of the profits from his junk bond portfolio on television advertisements that say what a prudent place the Columbia Savings & Loan really is, in spite of what you might hear. A little man in a blue suit climbs a bar graph to demonstrate how quickly Columbia’s assets are growing.

By 1986 Columbia Savings & Loan was one of Drexel’s biggest customers. Tom Spiegel’s salary was ten million dollars, making him the highest paid of America’s 3,264 thrift managers. Other S&L managers thought Spiegel a genius and followed his lead. “Zillions of little S and Ls all over the country now own junk bonds,” one of my former training program classmates told me as he rubbed his hands together in glee. He had left Salomon in the middle of 1987 and, like many other Salomon bond experts, had gone to work with Michael Milken in Beverly Hills.

Herein, funnily enough, lies one of the chief reasons why Salomon Brothers did not rush into the junk bond market when the opening presented itself in the early 1980s or succeed in it later on. As it stood, the entire savings and loan industry was, within Salomon, Lewie Ranieri’s captive customer. Had Salomon become big dealers in junk bonds, Bill Voute, the head of corporate bonds, would have demanded equal access to savings and loans. Lewie Ranieri feared losing his grip on Salomon Brothers’ savings and loan customers and found a couple of ways to foil the small, fledgling junk bond department created by Voute in 1981.

In 1984 our two-man junk bond department spoke at a Salomon Brothers seminar for several hundred savings and loan managers. They had been invited to address the thrifts by the mortgage department. But after their three-hour presentation, Ranieri rose to deliver the closing address. The customers, of course, hung on his every word; as I’ve said, they viewed Lewie as their savior. “There are two things you absolutely should never do,” said Ranieri. “And the first is buy junk bonds. Junk bonds are dangerous.” Of course, he might have believed it. In the end, however, the thrifts did not, and Ranieri’s objection served only to discredit Salomon’s junk bond department and drive the thrifts into the arms of Drexel. And Bill Voute’s people were livid about being humiliated before such an important audience. “It was sort of like being invited to dinner and finding out you’re the dinner,” says one former Salomon junk bond man.

The same two-man team of junk bond specialists spent six months crossing America making presentations to individual S&L managers. “It was a crackerjack presentation, and we were getting a great response, but no one was calling up to buy bonds,” says one of the Salomon former junk bond specialists. They expected that the orders to buy junk bonds would soon follow their road show. But not one savings and loan manager ever called. “We found out why later, when a member of the team quit Salomon and went to Drexel to work for Milken,” says this man. “The customers told him that one of Lewie’s salesmen had been right behind us telling the thrifts not to believe us.” It says a great deal about the lack of leadership on the forty-first floor that the mortgage department got away with this little stunt. But such was the state of our corporation.

Meanwhile, the new market was exploding. One indication of Milken’s success was the number of new junk bonds issued. From virtually zero in the 1970s, new junk bond issuance grew to $839 million in 1981, to $8.5 billion in 1985, and to $12 billion in 1987. By then junk bonds were 25 percent of the corporate bond market. Between 1980 and 1987, according to IDD information services, $53 billion worth of junk bonds came to market. That is only a fraction of the market, however, because it neglects the billions of dollars worth of new, man-made fallen angels. Milken devised a way to transform the bonds of the most stable companies to junk: leveraged corporate take-overs.

Having attracted tens of billions of dollars to his new speculative market, Michael Milken, by 1985, was faced with more money than places to put it. It must have been awkward for him. He simply could not find enough worthy small-growth companies and old fallen angels to absorb the cash. He needed to create junk bonds to satisfy the demand for them. His original premise—that junk bonds are cheap because lenders are too chicken to buy them—was shot to hell. Demand now exceeded natural supply. Huge pools of funds across America were dedicated to the unbridled pursuit of risk. Milken and his Drexel colleagues fell upon the solution: They’d use junk bonds to finance raids on undervalued corporations, by simply pledging the assets of the corporations as collateral to the junk bond buyers. (The mechanics are identical to the purchase of a house, when the property is pledged against a mortgage.) A take-over of a large corporation could generate billions of dollars’ worth of junk bonds, for not only would new junk be issued, but the increased leverage transformed the outstanding bonds of a former blue-chip corporation to junk. To raid corporations, however, Milken needed a few hit men.

The new and exciting job of invading corporate boardrooms appealed mainly to men of modest experience in business and a great deal of interest in becoming rich. Milken funded the dreams of every corporate raider of note: Ronald Perelman, Boone Pickens, Carl Icahn, Marvin Davis, Irwin Jacobs, Sir James Goldsmith, Nelson Peltz, Samuel Heyman, Saul Steinberg, and Asher Edelman. “If you don’t inherit it, you have to borrow it,” says one. Most sold junk bonds through Drexel to raise money to storm such hitherto unassailable fortresses as Revlon, Phillips Petroleum, Unocal, TWA, Disney, AFC, Crown Zellerbach, National Can, and Union Carbide. It was an unexpected opportunity, not just for them but for Milken, for he certainly did not have the overhaul of corporate America in mind when he envisioned his junk bond market in 1970. He couldn’t have. When he stumbled upon the idea, no one imagined that corporations could be undervalued.

As a graduate student at the London School of Economics I was taught that stock markets were efficient. Broadly this means that all outstanding information about companies is built into their share prices—i.e., they are always fairly valued. This sad fact was hammered home to students with a series of studies demonstrating that stock market brokers and analysts, people with the very best information, fared no better in their stock market picks than a monkey drawing a name from a hat or a man throwing darts at the pages of the Wall Street Journal. The first implication of the so-called efficient markets theory is that there is no sure way to make money in the stock market other than trading on inside information. Milken, and others on Wall Street, saw that this simply was not true. The market, which may have been quick to digest earnings data, was grossly inefficient in valuing everything from the land a company owns to the pension fund it creates.

There is no easy explanation why this should be so, not that anyone on Wall Street wasted any time trying to explain it. To the men in Wall Street’s small mergers and acquisitions departments, Michael Milken was a godsend, a vindication of their choice of careers. Joe Perella at First Boston, having started the M&A department in 1973 and hired Bruce Wasserstein in 1978, had devoted resources to take-overs merely “on a hunch,” he says. “There was this huge opportunity,” says Perella, “and it was lying under the dirt. You had a steady supply of companies whose assets were undervalued. But there was a paucity of buyers. People who wanted to buy these companies couldn’t monetize their desire. Someone-Milken-came along and kicked away the dirt. Now anyone with a twenty-two-cent stamp can make a bid for a company.’’

Perella, Wasserstein, and countless others apart from Drexel relished the turn of events. Each take-over required a minimum of two advisers: one for the raider and another for his prey. So Drexel couldn’t keep all the business it created for itself. Most deals involved four or more investment bankers, as several buyers competed for the prize. The raiders were the stone dropped into the still pond, and they sent ripples shooting across the surface of corporate America. The process they began took on a life of its own. Managers running public companies with cheap assets began to consider buying the companies from their shareholders for themselves (what is known in Europe as management buyout, or MBO, and in America as a leveraged buyout, or LBO). They put themselves in play. Then, finally, Wall Street investment bankers became involved in what Milken had been quietly doing all along: taking big stakes in the companies for themselves. The assets were cheap. Why let other people make the money? So the take-over advisory business was all of a sudden shot through with the same conflict of interest I faced every day selling bonds: If it was a good deal, the bankers kept it for themselves; if it was a bad deal, they’d try to sell it to their customers.

There was, in other words, plenty of work to go around. Mergers and acquisitions departments mushroomed across Wall Street in the mid-1980s, just as bond trading departments had mushroomed a few years before. There was a deep financial connection between the two: Both drew heavily on the willingness of investors to speculate in bonds. Both also drew on the willingness of people to borrow more than they could easily repay. Both, in short, depended on a whole new attitude toward debt. “Every company has got people sitting around who do nothing for what they get paid,” says Joe Perella. “If they take on a lot of debt, it forces them to cut fat.” The take-over specialists did for debt what Ivan Boesky did for greed. Debt is good, they said. Debt works.

There was a deep behavioral connection between bond trading and take-overs as well: Both were driven by a new pushy financial entrepreneurship that smelled fishy to many who had made their living on Wall Street in the past. There are those who would have you think that a great deal of thought and wisdom is invested in each take-over. Not so. Wall Street’s take-over salesmen are not so different from Wall Street’s bond salesmen. They spend far more time plotting strategy than they do wondering whether they should do the deals. They basically assume that anything that enables them to get rich must also be good for the world. The embodiment of the take-over market is a high-strung, hyperambitious twenty-six-year-old, employed by a large American investment bank, smiling and dialing for companies.

And the process by which a take-over occurs is frighteningly simple—in view of its effects on community, workers, shareholders, and management. A paper manufacturer in Oregon appears cheap to the twenty-six-year-old playing with his computer late one night in New York or London. He writes his calculations on a telex, which he send to any party remotely interested in paper, in Oregon, or in buying cheap companies. Like the organizer of a debutante party, the twenty-six-year-old keeps a file on his desk of who is keen on whom. But he isn’t particularly discriminating in issuing invitations. Anyone can buy because anyone can borrow using junk bonds. The papermaker in Oregon is now a target.

The next day the papermaker reads about himself in the “Heard on the Street” column of the Wall Street Journal. His stock price is convulsing like a hanged man because arbitrageurs like Ivan Boesky have begun to buy his company’s shares in hopes of making a quick buck by selling out to the raider. The papermaker panics and hires an investment banker to defend him, perhaps even the same twenty-six-year-old responsible for his misery. Five other twenty-six-year-olds at five hitherto unoccupied investment banks read the rumors and begin to scourge the landscape for a buyer of the paper company. Once a buyer is found, the company is officially “in play.” At the same time the army of young overachievers check their computers to see if other paper companies in America might not also be cheap. Before long the entire paper industry is up for grabs.

The money to be made from defending and attacking large companies makes bond trading look like a pauper’s game. Drexel has netted fees in excess of $100 million for single take-overs. Wasserstein and Perella, in 1987, generated $385 million in fees for their employer, First Boston. Goldman Sachs, Morgan Stanley, Shearson Lehman, and others wasted no time in establishing themselves as advisers, and though none had the fund-raising power of Salomon, all made great sums of money. Salomon Brothers, slow to learn about take-overs and largely absent from the junk bond market, missed the bonanza. There was no reason for this other than a certain unwillingness to emerge from our bond trading shell. We were well positioned to enter the business; what with our access to the nation’s lenders we should have been a leader in the financing of take-overs. Of course, we had an excuse; we had to have an excuse for missing such a huge opportunity. Our excuse was that junk bonds were evil. Henry Kaufman made speech after speech arguing that corporate America was overborrowing and that junk bond mania would end in ruin. He may have been right, but that’s not why we didn’t leap into junk bonds. We didn’t underwrite junk bonds because our senior management didn’t understand them, and in the midst of the civil war on the forty-first floor, no one had the time or the energy to learn.

John Gutfreund could pretend that he had avoided the business because he disapproved of its consequences, highly leveraged companies. But that excuse wore thin when he later plunged like a kamikaze pilot into the business of leveraging companies and brought ruin upon us and a few of our clients. (It also didn’t help that both he and Henry Kaufman purchased junk bonds for their personal accounts at the same time they were preaching corporate austerity.) In any case, whether Salomon Brothers participated or Salomon Brothers abstained, every company was by now a potential target for Milken’s raiders, including Salomon Brothers Inc. That was the final irony of Ronald Perelman’s bid. We were being raided by a man financing himself with junk bonds because we had neglected to enter the business of raiding companies and financing the raids with junk bonds.

Soon after the news broke of Perelman’s ambitions, Gutfreund made a speech to the firm saying that he didn’t approve of hostile raiders and that he intended to shun Perelman, but apart from that, which we could have guessed on our own, we were left, as usual, uninformed. We relied on the investigative reporting of James Sterngold of The New York Times and the staff of the Wall Street Journal to learn the blow-by-blow of the event.

The story was this: The tears had first flowed on Saturday morning, September 19, a few days before the news broke. On that morning John Gutfreund received a telephone call at his apartment from his friend and lawyer Martin Lipton, the man whose office he had used two months before to sack Lewie Ranieri. Lipton knew that Salomon’s largest shareholder, Minorco, had found a buyer for its 14 percent stake in the company. The identity of the buyer, however, was still a mystery. Gutfreund must have been badly embarrassed. He had known for months that Minorco wanted to sell its holdings but had been slow to accommodate it. This was bad judgment; as a result, he lost control of the process. Fed up with Gutfreund, Minorco advertised its Salomon shares through other Wall Street bankers.

On Wednesday, September 23, Gutfreund learned from the president of Minorco the bad news that the buyer was Revlon Inc. It was clearly the beginning of a take-over attempt. Revlon’s Perelman said that in addition to Minorco’s shares, he wanted to buy a further 11 percent stake in Salomon, which would bring his stake to 25 percent. If Perelman succeeded, Gutfreund, for the first time, would lose his grip on the firm.

Gutfreund scrambled to find an alternative to Revlon for Minorco.

He called his friend Warren Buffett, the shrewd money manager. Buffett, of course, expected to be paid to rescue Gutfreund, and Gutfreund offered him a surprisingly sweet deal. Instead of Buffett’s purchasing our shares outright, Gutfreund proposed only that Buffett lend us money. We, Salomon, would buy in our own shares. We needed $809 million. Buffett said he’d lend us $700 million of that, by purchasing what was in effect a Salomon Brothers bond. That was just enough. Gutfreund could tap $109 million of our capital to make up the difference.

Investors around the world envied Warren Buffett, for he had it both ways. His security, known as a convertible preferred, bore an interest rate of 9 percent which was in itself a good return on his investment. But in addition, he could trade it in at any time before 1996 for Salomon common stock at thirty-eight dollars a share. In other words, Buffett got a free play, over the next nine years, in the shares of Salomon. If Salomon Brothers continued to falter, Buffett would take his 9 percent interest and be content. If somehow Salomon Brothers recovered, Buffett could convert his bond into shares and make as much money as if he had stuck his neck out and bought our stock in the first place. Unlike Ronald Perelman, who was willing to commit himself to the future of Salomon Brothers by buying a large chunk of equity, Buffett was making only the safe bet that Salomon would not go bankrupt.

The arrangement had two consequences: It preserved Gutfreund’s job, and it cost us, or, rather, our shareholders, a great deal of money. Our shareholders, after all, would pay for Buffett’s gift. The simplest way to determine its cost to them was to value Buffett’s bond. Buffett paid Salomon Brothers 100, or par. I punched a few numbers into my Hewlett-Packard calculator. I reckoned (very conservatively) that Buffett could sell it immediately for 118. The difference between 100 and 118, or 18 percent of Buffett’s total investment, was pure windfall. That comes to $126 million. Why should Salomon Brothers shareholders (and employees, if we assume some of it at least might well come out of our bonuses) foot the bill to save a group of men who had taken their eyes off the ball? That was the first question that crossed my mind and the minds of many of our managing directors.

For the good of Salomon Brothers, explained Gutfreund. “I was shocked,” Gutfreund said of Perelman’s bid. “Perelman was just a name to me, but I felt that the structure of Salomon Brothers, in terms of our relationships with clients, their trust and confidence, would not do well with someone deemed to be a corporate raider.”

Except for the first sentence, this statement rings false from the beginning to end. Let’s take the last part first. Our relationship with clients hadn’t suffered from having a South African as a shareholder; why should it suffer from an association with a hostile raider? I don’t care to dwell on the morality of either apartheid or hostile take-overs. But at the very minimum, it must be agreed, the former is at least as dangerous to be associated with as the latter. Our business may even have benefited from an association with a hostile raider. Corporations fearing raids, when they saw our backers, might well have kept us on retainer, just as they kept Drexel Burnham on retainer, as a sort of protection fee. Once Perelman was a major shareholder, we could credibly promise to keep him (and his friends) off the backs of others. Perelman, I am sure, was perfectly aware of this synergy when he contemplated buying into an investment bank.

Second, for a man on Wall Street to refer to Ronald Perelman in September 1987 as “just a name to me” is absurd. Everyone knew who Ronald Perelman was. Christ, I knew who Ronald Perelman was before I started work at Salomon Brothers. From virtually nothing, he had amassed a fortune of five hundred million dollars. And he had done it by raiding companies with borrowed money and firing bad management. Gutfreund no doubt knew that his days were numbered if Perelman gained control of Salomon Brothers. And if by some miracle of oversight he did not, he learned quickly when he met with Perelman at the Plaza Athenee Hotel in New York on September 26. The amazing rumor circulated in the managing directors’ dining room on the forty-second floor that Gutfreund’s replacement would be Bruce Wasserstein.

In view of the circumstances, the way John Gutfreund persuaded the Salomon Brothers board to pay Warren Buffett a large sum of money to serve as our white knight appears marvelously shrewd. The board, by law, had to consider the interests of shareholders. On September 28, Gutfreund told the board that if it rejected the Buffett plan in favor of Ronald Perelman, he (together with Tom Strauss and a few others) would resign. “I never stated it as a threat,” Gutfreund later told Stern-gold. “I was stating a fact.”

An aspect of the genius of Gutfreund was his ability to cloak his own self-interest in the guise of high principle. The two could be, on rare occasions, indistinguishable. (If there is one thing I learned on Wall Street, it’s that when an investment banker starts talking about principles, he is usually also defending his interests and that he rarely stakes out the moral high ground unless he believes there is gold under his campsite.) It is possible, even probable, that John Gutfreund felt genuinely appalled by the financial tactics of Ronald Perelman—he is a feeling man—and no doubt he delivered his statement with the conviction of a preacher. He was magnificently persuasive. But he was risking nothing by laying his job on the line; he had nothing to lose and everything to gain; once Perelman acquired his stake, Gutfreund would have been fired before he had a chance to resign.

There was ample evidence in Gutfreund’s past to justify a cynical interpretation of his offer of resignation. Years before, in a similar situation, Gutfreund had made a similar move. In a partnership meeting in the mid-1970s a strange exchange occurred. William Simon (who was neck and neck with Gutfreund to succeed Billy Salomon as chairman) mentioned how rich Salomon Brothers partners could become if they sold their stakes and transformed Salomon from a privately held concern into a publicly held corporation.

Billy Salomon thought the partnership was the key to the health of the firm and the sole mechanism for securing the loyalty of its employees (“It locked them in, like family,” he says). When Simon quit talking, Gutfreund rose and bravely echoed the opinion of his boss. He said that if the firm were ever sold, the partners could have his resignation; he, John Gutfreund, would quit because the key to the success of Salomon Brothers was its partnership. “That’s one of the main reasons I picked him to succeed me,” says William Salomon, “because he said he deeply believed in the partnership.”

Once he gained control and had the largest stake in the company, however, Gutfreund had a change of heart. In October 1981, three years after the reins had passed into his hands, he sold the firm for $554 million to the commodity dealer Phibro. As he was chairman, he made the most money from the sale, about $40 million. He said the firm needed the capital. William Salomon disagrees. “The firm had more than enough capital,” he says. “His materialism was disgraceful.” (In a way, Gutfreund was now paying for it. Had Salomon remained a partnership, there could have been no possibility of a take-over.)

Nevertheless, Gutfreund’s threat to resign swayed the board members of Salomon Inc. It diverted their attention from the simple economics of the situation, which weighed overwhelmingly in Perelman’s favor, and toward the social responsibility of Salomon Brothers. Besides, most of them had been appointed to their posts by Gutfreund and were his friends. After two hours they decided to accept Gutfreund’s proposal. Warren Buffett made his investment, Gutfreund kept his job, and Perelman kept his money in his pocket.

Life in our firm almost returned to normal, for a few weeks. But a fundamental question about Salomon Brothers had been raised. We all knew our firm was badly managed. But was it so badly managed that even a buccaneer like Perelman could hope to improve its condition? Actually, another question was more likely on the minds of the Big Swinging Dicks of the forty-first floor. People who for so long had viewed money as the measure of success were bound to envy not only Perelman but Wasserstein, Perella, and Milken. Especially Michael Milken. The question of the day on 41 was: How come he makes a billion dollars and I don’t?

This question drives us right to the center of what has happened in financial America over the past few years. For Milken, not Salomon Brothers, had made the biggest trade of the era. That trade was, of course, the buying and selling of corporate America. Salomon had missed the grand shift in its own business from trading bonds to trading entire industries.

Chapter 11

The prevailing reasoning in the bond market went like this: Stock prices were lower; therefore, people were less wealthy; therefore, people would consume less; therefore, the economy would slow down; therefore, inflation would fall (maybe there’d even be depression and deflation); therefore, interest rates would fall; therefore, bond prices should rise. ======== the money game rewarded disloyalty. The people who hopped from firm to firm and, in the process, secured large pay guarantees did much better financially than people who stayed in one place. ========

Notes:

In the interest of variety, the word “thrift” is used interchangeably with “savings and loans” throughout the text, as it is on Wall Street.

Books:

In her book The Predators’ Ball, Connie Bruck traced the rise of Drexel’s junk bond department (Milken reportedly tried to pay the author not to publish).

One of Alexander’s financial heroics found its distorted way to the center of Tom Wolfe’s Bonfire of the Vanities Wolfe describes his protagonist, Sherman McCoy, getting himself in trouble with the gold-backed French government bonds, the so-called Giscard bonds It was Alexander who had first discovered the Giscard was mispriced, and far from getting himself in trouble he made many millions of dollars exploiting the mispricing.