Liar's Poker

by Michael Lewis

  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 was the sort of fellow who sponsored a float in the town parade; that said it all, didn’t it? He wore polyester suits, made a five-figure income, and worked one-figure hours. 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.

  Each year four salesmen who sold bonds to Texas thrifts performed a skit before the Salomon training class. Two played Salomon salesmen; two played the managers of a thrift. The plot ran as follows: The Salomon salesmen enter the thrift just as the thrift managers are leaving, tennis racket in one hand and a bag of golf clubs in the other. The thrift men wear absurd combinations of checkered pants and checkered polyester jackets with wide lapels. The Salomon salesmen fawn over the thrift men. They go so far as to admire the lapels on the jacket of one thrift manager. At this, the second thrift manager gets huffy. “You call those doodads lapels? Those tany thangs?” he says in a broad Lone Star accent. “Lapels ain’t lapels unless you can see them from the back.” Then he turns around, and sure enough, the lapels jut like wings from his shoulders.

  The Salomon salesmen, having schmoozed their client, move in to finish him off. They recommend that the thrift managers buy a billion dollars’ worth of interest rate swaps. The thrift managers clearly don’t know what an interest rate swap is; they look at each other and shrug. One of the Salomon salesmen tries to explain. The thrift men don’t want to hear; they want to play golf. But the Salomon salesmen have them by the short hairs and won’t let go. “Just give us a billion of them interest rate swaps, so we can be off,” the thrift managers finally say. End of skit.

  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.” In the early 1970s Simon traded United States treasury bonds for Salomon Brothers. He liked to do this on his feet, drinking jug after jug of ice water. Shouting bids and offers for bonds was not then a fashionable occupation outside Salomon Brothers. “When I first came into the business, trading was not a respectable profession,” he later told the writer L. J. Davis. “I never hired a B-school guy on my desk in my life. I used to tell my traders, ‘If you guys weren’t trading bonds, you’d be driving a truck. Don’t try to get intellectual in the marketplace. Just trade.’”

  Simon was not a Harvard graduate but a Lafayette College dropout who had elbowed his way to the top. He didn’t attract crowds of aspiring traders on his visits to college or business school campuses because there weren’t any crowds of aspiring traders. What he said or did was of no interest to The New York Times or the Wall Street Journal. Who in the 1970s cared about treasury bonds? Still, he felt and acted big. Salomon was where opinion mattered, and inside Salomon the treasury trader was king. U.S. treasuries were the benchmark for all bonds; the man who could whip and drive them was the benchmark for all traders.

  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 inves
ted 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? When Ginnie Mae ignored the objection, Bill Simon ignored Ginnie Mae. He assigned what is known at Salomon Brothers as a grunt—an analyst in the corporate finance department—to lead the charge on the new mortgage securities markets. Grunts don’t lead charges. In other words, there would be no charge.

  Bob Dall spent his day borrowing money to finance Bill Simon’s bets in the U.S. government bond market. Dall was effectively trading money; he sought to borrow each day at the cheapest rates and lend at the highest. But he was borrowing and lending for only that one day.

  He’d come in the next day and start all over again. Trading money, unlike trading bonds, was never fashionable, even within Salomon Brothers. Money was the least volatile commodity traded by Salomon Brothers and therefore the least risky.

  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. It was the spring of 1978, and Gutfreund had just been appointed chairman of the firm by his predecessor, William Salomon, the son of one of the firm’s three founding fathers. 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.

  But with the help of John Gutfreund Dall got his first choice: 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. “I was the hottest talent in the corporate department,” he says. “I didn’t understand.” The move plucked him from the fray. 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.

  “I felt like they were saying, ‘Congratulations, we
want to exile you to Siberia.’ I didn’t try to foil the move because that wasn’t my style. I just kept asking John, ‘Why do you want me to do this?’ Even after the move friends came up to ask what I had done to piss off John: Had I lost money or broken the law or what?” 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.”

  Ranieri’s boyhood ambition had been to become a chef in an Italian kitchen. That ended when a head-on automobile accident on Brooklyn’s Snake Hill rekindled an asthmatic condition that didn’t tolerate kitchen fumes. He was a sophomore English major at St. John’s College when 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.