Liar's Poker

by Michael Lewis

  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. F
reed 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: