Infectious Greed

by Frank Partnoy

  Third, Salomon made money trading mortgages for its own account. Chairman John Gutfreund was not any better at managing the risks associated with mortgages than he was with any other area of trading. Neither was Lewis Ranieri, who ran the mortgage desk, and had trouble keeping tabs on the multiplicity of CMO structures. As a result, many of the firm’s mortgage risks were essentially unmanaged. On a typical day in the mid-1980s, Salomon had as much as $5 billion—more than twice its capital—tied up in mortgages it was hoping to securitize; yet, according to commentator Martin Mayer, nobody in upper management even knew it.52 Ranieri’s group made money simply by holding mortgages, which increased in value as interest rates declined.

  Meriwether’s arbitrage group had a more sophisticated approach, speculating on the relative values of different mortgage tranches. Traders in the Arbitrage Group took advantage of differences between the values of options embedded in mortgages and similar options in other bonds. These trades were huge and volatile; sometimes they lost a fortune, but generally they made money. For example, Lawrence Hilibrand lost $400 million on one mortgage bet, but he was permitted to hold on to the bet, and it eventually made money.53

  Greg Hawkins had been on Salomon’s mortgage desk before he began working in Meriwether’s Arbitrage Group. Hawkins had a Ph.D. in finance, and created computer models to assess the risk of mortgage prepayment. He found that the prepayment options in mortgages were overpriced, because investors didn’t understand prepayment risk and wouldn’t pay much for mortgages with these risks.54 As a result, certain mortgage instruments were cheap, and Hawkins could buy them, hedge their option-related risk in other markets, and pocket the difference.

  Salomon dodged a bullet when one of its newly minted star traders, Howard Rubin, left for Merrill Lynch. Ranieri had called Howard Rubin “the most innately talented trader I have ever seen.”55 Rubin’s story is a typical example of how quickly the practices within one investment bank could flow out to the rest of Wall Street. Just as Bankers Trust’s derivatives innovations spread to First Boston along with Allen Wheat, some of Salomon’s mortgage expertise flowed along with Howard Rubin, when he left Salomon for Merrill Lynch. Merrill would wish it hadn’t.

  In his first year out of Salomon’s training program in 1986, Rubin made $25 million for the firm, an astonishing amount for a novice trader.56 But that year, Salomon refused to pay first-year traders more than $90,000, including salary and bonus, regardless of how much money they had made for the firm.

  The next year, Rubin made $30 million for the firm, but Salomon also capped the overall pay of second-year employees, this time at $175,000.57 That was not enough for Rubin, and he left Salomon for Merrill Lynch, which guaranteed him $1 million a year, plus a percentage of his trading profits.58 By hiring Rubin, Merrill was hoping to buy some insight into how Salomon had been making so much money trading mortgages.

  It didn’t work out as planned. Howard Rubin’s mortgage desk at Merrill lost $377 million—all on a single day in April 1987. Rubin had been trading mortgages for less than five years at that point, and it turned out he wasn’t a wunderkind after all.

  Rubin’s loss was eerily similar to Andy Krieger’s gain that year. They had both started at Salomon. As Krieger was leaving for Bankers Trust, Rubin was off for Merrill Lynch. Both traded instruments whose value depended on the volatility estimates: currencies for Krieger, mortgages for Rubin. Rubin was just a few years older, 32, at the time of his losses. Both had placed huge bets with their firm’s capital, and their results were of the same order of magnitude. Both left their jobs soon thereafter. The main difference was that Krieger won his bet, while Rubin lost.

  How had Merrill lost the money? Principal-only bonds were the culprit. Merrill had purchased $935 million of 11 percent bonds issued by the Government National Mortgage Association (called Ginnie Mae). It split the bonds into interest and principal, and sold the interest-only portion of the mortgage (the IOs) to savings-and-loan associations. But Merrill kept the principal-only pieces (the POs).

  Meanwhile, Rubin had done an additional $800 million of a similar deal, without telling his bosses. He kept the POs of that deal, too. That left Merrill with about $1.7 billion of POs.

  An owner of POs essentially is betting that interest rates will go down. A PO is a discount instrument, meaning that its price is only a fraction—say, 20 percent—of its principal amount. If rates go down, and homeowners prepay their mortgages, the owner of the PO receives an early windfall—an extra 80 percent today, instead of several years in the future. But if rates go up, and homeowners don’t prepay, the PO might not pay anything for 30 years. POs are among the most volatile financial instruments available.

  Unfortunately for Rubin, interest rates went up. As with Bankers Trust, rumors immediately began swirling about Merrill’s trading, including reports—never confirmed—that some of the records had been hidden in desk drawers. But unlike Bankers Trust, Merrill quickly admitted the truth, and the losses were front-page news a day later.59 The firm’s press statement said the losses were due to “significant unauthorized activity by a recently discharged senior trader and subsequent market volatility.” Merrill’s stock fell about six percent.

  Surprisingly, Merrill still found a way to avoid reporting a loss for the quarter, by recognizing offsetting gains from sales of some businesses. Those sales seemed coincidental, but were far more plausible than the $80 million entry for reduced compensation at Bankers Trust. Several Merrill executives said the firm planned to record several large “one-time gains” in the quarter.60

  The Securities and Exchange Commission suspended Rubin from the securities industry for nine months in 1990, and he was soon working at another investment bank, Bear Stearns. Merrill Lynch did not face any charges relating to the way it avoided reporting a loss from Rubin’s trades. The message—as with Andy Krieger—was clear: traders involved in complex financial schemes would not be punished. Ironically, a few months after Merrill fired Rubin, Salomon also fired Rubin’s mentor, Lewis Ranieri, who no longer could compete with younger and more sophisticated traders. Difficulties with mortgages would resurface during the next several years. During the early 1990s, investors with a wide range of expertise would use mortgage instruments to place bets that interest rates would remain low, just as Gibson Greetings and P&G had used structured notes to place similar bets. Beginning in 1994, all of those bets would become losers. Salomon would suffer greatly during this period.

  But the firm’s most serious problems in 1991 related to government bonds, not mortgages. It remained unclear what regulators would do about Paul Mozer gaming the various Treasury auctions.

  By the time John Gutfreund finally imposed some controls on Mozer, telling him not to bid for too many notes in the June 1991 auction, it was too late. Nevertheless, Gutfreund seemed to believe Salomon might get away with the profits from Mozer’s “big squeeze” in the May 1991 auction. When Gutfreund met with Treasury officials in June, he brazenly suggested that Salomon had behaved properly in that auction. Gutfreund neglected to mention that he had known for months about Mozer’s false bids in the February 1991 auction.61

  When regulators began requesting documents about Salomon’s role in the auctions, Gutfreund hired lawyers from Wachtell, Lipton, Rosen & Katz, but gave them a limited mandate, to investigate only the May 1991 auction (much as Enron later would give a special committee formed to investigate its collapse a limited mandate to look only at a few questionable trades). But the lawyers soon discovered Mozer’s earlier bids, and the investigation inevitably expanded. In early August 1991, the law firm reported its conclusions to Salomon’s top brass—Gutfreund, Strauss, Meriwether, and Feuerstein. The report was damning, and Salomon was forced to issue a press release describing “irregularities” in its Treasury auction bids.

  Thomas Strauss had considered telling his friend E. Gerald Corrigan, the head of the New York Federal Reserve, about Salomon’s problems, back in April, but had not done so. Instead, Corrigan
learned about Mozer from reading the newspaper on Monday morning, August 12.62 Right away, Corrigan demanded “managerial and other changes” at Salomon. For Gutfreund, Strauss, Meriwether, and Feuerstein, the end was very sudden. A few days later, all four top officials had resigned.63

  Ironically, at precisely the same time (August 15), Michael Basham, the Treasury official who had met with Salomon officials several times as Mozer executed his scheme, also resigned, to begin working as a managing director at Smith Barney, the securities firm that soon would merge with Salomon.64 At that point, no one knew better than Basham how to deal with the Treasury’s approach to the bond markets. Before his two-year stint at the Treasury, Basham had been a junior employee in the government-bond department at Wertheim Schroeder. Basham’s moves were typical of the revolving door between government and Wall Street. Gerald Corrigan was about to leave his Fed post for a senior position at Goldman Sachs; later, Robert Rubin, co-chair of Goldman Sachs, would become a senior government official.

  Meanwhile, Warren Buffett—the Omaha-based multibillionaire—was concerned about his firm’s $700 million investment in Salomon. Buffett had invested in Salomon’s convertible preferred stock in 1987, to help the firm fend off a takeover threat from financier Ronald Perelman. Now, his investment was in danger. Buffett flew to New York, to try to save the struggling investment bank (just as years later he would consider rescuing Long-Term Capital Management, John Meriwether’s hedge fund, and, years after that, AIG). Buffett brought much-needed credibility to Salomon, and the investment bank soon recovered.

  Through September 1993, the Treasury scandal had echoed the recent changes in financial markets at other firms. Salomon had become much more technologically sophisticated, so much so that senior managers lost the ability to control key employees. The Arbitrage Group traded in deregulated markets, and took advantage of legal rules. The remaining question was whether prosecutors would punish anyone from Salomon, to send a message to financial market participants that the government would not tolerate manipulative practices.

  After a few years of negotiating with prosecutors, Mozer finally confessed to his critical mistake in the February 1991 auction, and pled guilty to submitting false bids on behalf of Warburg and Quantum. Although the criminal statutes specified a maximum prison term of 10 years—the sentence Michael Milken had received—federal sentencing guidelines allowed for departures downward from that maximum, depending on several factors, including the defendant’s cooperation. Hoping for a lighter sentence, Mozer told prosecutors about Salomon’s $100+ million tax-avoidance schemes. They appreciated this information, which they could use in their case against Salomon.

  At the sentencing hearing, Mozer—with his wife, parents, and siblings behind him—told Judge Pierre Leval he was “truly sorry” for his conduct. His lawyer asked that any time be served at home.

  Judge Leval said Mozer’s crime was an “extremely foolish, arrogant, insouciant offense,” but imposed a fine of only $30,000 and sentenced Mozer to just four months in a minimum-security prison in Florida. Judge Leval concluded the hearing by saying that “in the world of financial crimes, deterrence of others is an extremely important aspect of sentencing.” 65

  But actions spoke louder than words, and Mozer’s punishment was unlikely to deter much misconduct. Like Michael Milken (who was convicted only of books and records violations) and Al Capone (who was convicted only of tax evasion), Mozer was not convicted of the most serious allegations: manipulating the Treasury market. Instead, he pled guilty only to making false statements to the government, a serious offense, but an offense that—because it did not cover financial crimes more generally—would not likely deter financial malfeasance unless it involved lying to the government. (The same issue would arise in 2002, when prosecutors would choose to indict Arthur Andersen for obstruction of justice, for shredding documents related to the collapse of Enron, but not for any underlying fraud.) The implicit message was: go ahead and commit financial fraud, but don’t you dare lie to the U.S. Treasury.

  Regulators forced Salomon to pay a huge penalty—a $290 million fine—but that came from the firm’s shareholders (including Warren Buffett), not from any former executives. Buffett was not happy with this result. As he put it, “Mozer’s paying $30,000 and is sentenced to prison for four months. Salomon’s shareholders—including me—paid $290 million, and I got sentenced to ten months as CEO.”66

  Mozer later was fined $1.1 million and banned permanently from the finance industry in a civil action for securities fraud. Remarkably, much of this fine was for insider trading: Mozer had made $500,000 when he exercised some employee stock options, and then sold Salomon stock just three days before the firm disclosed the “irregularities” in its Treasury bids and, predictably, its stock price plunged.67 Prosecutors typically loved insider-trading cases, which were much easier to prove than complex financial fraud; but, nevertheless, they did not charge Mozer with a crime related to this conduct.

  In all, four months in a minimum-security prison seemed like a small price to pay for the millions of dollars Mozer made. In 2001, Mozer was enjoying his wealth—relaxing, and raising his eight-year-old daughter. He spent much of his time managing his own money and playing golf.68 Mozer’s treatment raised an interesting question: what would most people have done in his situation—assuming they knew in advance they would be caught and spend four months in a low-security prison—if they also knew that, afterward, they would retire as a multimillionaire, all before their fortieth birthday?

  Compared to Mozer, his supervisors received mere slaps on the wrist. Gutfreund, Strauss, and Meriwether paid fines of $100,000, $75,000, and $50,000, respectively—just a few days’ pay, at their salaries.

  Gutfreund was barred from running an investment bank for life, although he technically was permitted to work at a lower level than chairman. Of course, the “King of Wall Street” couldn’t be anywhere but the top, and, after the Treasury scandal, most highly regarded firms didn’t want Gutfreund as their leader. He became president of Gutfreund & Co.—no mean feat—and ultimately found a job as chairman of Nutrition 21, Inc., a vitamin company.69 Gutfreund also sneaked back into Wall Street in late 2001, at the age of 72, as a senior managing director of C. E. Unterberg, Towbin, a small and struggling investment firm run by Thomas Unterberg.70 Unterberg and Gutfreund had been friends for 60 years, and Unterberg returned from retirement to chair the firm, something Gutfreund was barred from doing. As Gutfreund put it, “All of the geriatrics are calling me for jobs.”71

  Thomas Strauss, the number-two person at Salomon, was suspended from the industry for six months. After that, he began running Ramius Capital, a successful multibillion-dollar hedge fund named for the renegade captain in Tom Clancy’s novel, The Hunt for Red October.72

  Meriwether was suspended for just three months. He sued Salomon for lost compensation, and received $18 million in a settlement. All things considered, Meriwether did pretty well.

  After Meriwether resigned, he worked on his golf game and thought about how he might replicate his Arbitrage Group elsewhere. Although his group had depended on Salomon for capital, it was an otherwise self-contained operation. With the right staff, he didn’t need the support of a full-service investment bank. Meriwether began recruiting former employees and talking to potential investors. To re-create the autonomy he had at Salomon, he would require that investors commit their capital for a long period of time, perhaps several years. Given this requirement, he had the perfect name for his new investment fund: Long-Term Capital Management.

  Meriwether’s loyal traders were happy to leave Salomon to join him. Their work environment would change radically: instead of sitting in the middle of Salomon’s cramped trading floor in Manhattan, they would rent offices in a relaxed, private office park in Greenwich, Connecticut.

  By August 1993, Meriwether had recruited Eric Rosenfeld, his first academic hire at Salomon, along with Victor Haghani and Greg Hawkins. Larry Hilibrand—the $23 millio
n man—joined a few months later. Meriwether persuaded the famed economists Myron Scholes and Robert Merton—who had worked as consultants at Salomon—to join Long-Term Capital as partners, along with a couple of Meriwether’s golfing friends.

  Meriwether wanted some new blood, too, especially someone who could navigate difficult regulatory issues. When David W. Mullins Jr.’s term as vice chairman of the Federal Reserve Board ended in February 1994, Mullins also agreed to join. Mullins was a perfect addition, especially given the importance of legal rules in Meriwether’s strategies. Mullins was one of the most powerful banking regulators in the world, next to Alan Greenspan. Moreover, as a past critic of derivatives markets, Mullins had credibility with other regulators, especially those outside the United States.

  The new group drafted a “confidential private placement memorandum” to give to investors interested in Long-Term Capital. The memorandum had few details. It described the on-the-run/off-the-run trade, which every smart trader on Wall Street already knew, but little else. Meriwether was selling his fund based solely on the reputation of his traders. Long-Term Capital was just as mysterious as the Arbitrage Group at Salomon had been.

  It was expensive, too. Whereas typical hedge funds at the time charged a fee of 1 percent annually, plus 20 percent of the profits, Long-Term Capital was asking for a 2 percent fee, plus 25 percent. It was outrageous, really, and numerous investors said no at first. But when a few of Salomon’s competitors agreed to invest, including the CEOs of Merrill Lynch, Bear Stearns, and PaineWebber, the money started to flow. As word spread, Long-Term Capital became known as the “hot” investment, and everyone wanted in, from movie stars and professional athletes to major university endowments and international pension funds.73 The list ranged from Hollywood agent Michael Ovitz to partners in the McKinsey consulting firm, from Nike CEO Phil Knight to Italy’s central bank.74 The initial investments topped $1 billion.