Liar's Poker

by Michael Lewis

  Still, people responded. In 1979 Tom Kendall joined the desk from Wharton, with a brief intervening stop in the back office. In 1980 Mason Haupt, a fraternity brother of Kronthal’s from Wharton, and Steve Roth from Stanford signed up. In 1981 Andy Stone and Wolf Nadoolman from Harvard came on board. They viewed themselves in relation to the rest of the firm in much the same way as Lewie. As Nadoolman says, “While Tom Strauss [the emerging kingpin of the government department] and his crowd wore Hermes ties and ran triathlons, Lewie’s people were an Italian family. While the government department ate tofu and wore pleated pants, the attitude in the mortgage department was: ‘What do you mean you only had two servings, didn’t you like it?’ Did you ever see a fat government trader? Of course not. They were lean and mean. They discriminated against fat people. Look, I know what I’m talking about, I’m fat.”

  “It was clear that the rest of the firm tolerated us without approval,” says Tom Kendall. “They’d ask, ‘What do those fucking yo-brains over there in the corner do for a living?’ ” One of Andy Stone’s most vivid memories as a trainee is of pointing in the direction of Ranieri & Co. and asking a corporate bond trader who they were. “ ‘Nobody,’ said the trader. ‘Mortgages. They’re a nothing department. Nobody wants to be in mortgages.’ ” Craig Coates, the head of government trading at Salomon, asked Stone, “Why would you possibly want to be in mortgages when you can be in governments?” Even at higher levels the fat people thought the skinny people had it in for them. “The firm,” says former managing director Mortara, “was a bunch of fiefdoms. People in the other departments were more concerned with protecting their own business than with developing this new business.”

  The resentment the mortgage department felt toward those in power increased when it became known in early 1980 that those outside the department wanted it shut down. The mortgage department wasn’t making money. The other mortgage units on Wall Street—Merrill Lynch, First Boston, Goldman Sachs—were stillborn. They closed almost before they had opened. The prevailing wisdom was that mortgages were not for Wall Street.

  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 brainchild] 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 Six

  The Fat Men and Their Marvelous Money Machine

  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 h
is 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.