Liar's Poker

by Michael Lewis

  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.

  We were going into an executive committee meeting for the firm at the Waldorf. I had written the night before a two-pager, indicating that I thought yields would go down quite sharply and my rationale for it. And I’d given it to my driver to deliver to my secretary, so she could type it up and put it into our machine, on our screens, to be shown to our traders and salespeople at the same time—oh, around 8:45 or 9:00 in the morning, before the markets opened. I then went to the Waldorf where we had eight people from the executive committee. I got a call from my secretary asking me to explain something that I had written because she was typing it up—I had written in longhand—and I think it was John Gutfreund who said, “What are you on the telephone for?” And I said, “Oh, I just dictated a memo.” Somebody said, “What about?” and I said, “Well, I’ve just changed my view on the [bond] market.” And they said, “You’ve changed your view on the market?” Well, by that time it was going on the screen, and then the markets went wild.

  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 wer
e 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.

  The money was made, therefore, with ever more refined tools of analysis. But the traders did not become correspondingly more refined in their behavior. For each step forward in market technology they took a step backward in human evolution. As their number grew from six to twenty-five, they became louder, ruder, fatter, and less concerned with their relations with the rest of the firm. Their culture was based on food, and as strange as that sounds, it was stranger still to those who watched mortgage traders eat. “You don’t diet on Christmas Day, and you didn’t diet in the mortgage department. Every day was a holiday. We made money no matter what we looked like,” says a former trader. They began with a round of onion cheeseburgers fetched by a trainee from the Trinity Deli at 8:00 A.M. “I mean you didn’t really want to eat them,” recalls trader Gary Kilberg, who joined the trading desk in 1985. “You were hung over. You were sipping coffee. But you’d get wind of that smell. Everyone else was eating them. So you grabbed one of the suckers.”

  The traders performed astonishing feats of gluttony never before seen at Salomon. Mortara made enormous cartons of malted milk balls disappear in two gulps. D’Antona sent trainees to buy twenty dollars’ worth of candy for him every afternoon. Haupt, Jesselson, and Arnold swallowed small pizzas whole. Each Friday was “Food Frenzy” day, during which all trading ceased, and eating commenced. “We’d order four hundred dollars of Mexican food,” says a former trader. “You can’t buy four hundred dollars of Mexican food. But we’d try—guacamole in five-gallon drums, for a start. A customer would call in and ask us to bid or offer bonds, and you’d have to say, ‘I’m sorry, but we’re in the middle of the feeding frenzy. I’ll have to call you back.’”

  And the fatter they became, the more they seemed to loathe skinny people. “No hypocrisy here! We are proud to look precisely as we are!” They joked how the thin government traders who ran triathlons on weekends still couldn’t make any money during the week, which was not entirely accurate. But it was true that no one made as much money as mortgage bond traders. The market for mortgage trading had turned. At the end of each month, remembers Andy Stone, “we’d have department dinners. We’d say we made twice as much as corporates and governments combined. We’re the best. Fuck ‘em; and when Mike Mortara wasn’t made a partner at the end of 1983 and all the other heads of trading desks did, it really united us. We said, ‘We don’t work for Salomon Brothers, we work for the mortgage department.’”

  Ranieri preserved the culture in spite of its growing numbers with group functions. If it wasn’t dinner at the end of each month, it was the trip to Atlantic City, from which government and corporate traders were strictly excluded. The mortgage traders hopped into helicopters, spent the night gambling, and flew back to Salomon Brothers in time to trade the next morning. That’s the sort of thing you were meant to do—if you were a trader with iron balls.

  Some goofs had genealogies. The suitcase goof had started in 1982, with one trader getting hold of another trader’s weekend bag and replacing the clothes with pink lace panties. There were at least four goofs and regoofs of this sort between 1982 and 1985. The goof finally stopped spawning more goofs when John D’Antona arrived late one Friday morning with suitcase in hand. He’d planned a weekend trip to Puerto Rico. He began to lord his good fortune over the other traders: “Hey, guys, sorry you can’t come along, ha-ha-ha.” Et cetera.

  Finally it was too much for Peter Marro and Greg Erardi (often imagined by telephone callers to be two people: Greg or Artie). When D’Antona’s attention drifted, the two traders slipped away with his suitcase. They removed the clothes and inserted about ten pounds of wet paper towels instead. D’Antona didn’t discover the switcheroo until he emerged from a hotel shower in Puerto Rico that evening. Dripping wet, he made his first call to his prime suspect: Marro. Marro confessed. This, said D’Antona, was not a funny joke. He called Marro seven more times over the weekend to remind him just how unfunny it was. He plotted revenge. Marro awoke to one of D’Antona’s calls, early Sunday morning, that apparently began: “I don’t know how, I don’t know when, I don’t know where, but one day…”

  Revenge came shortly thereafter, but not upon Marro. As usual, the blame shifted to the trainee who worked for the culprit. The trainee who worked for Marro was Gary Kilberg, a member of my training class.

  Kilberg had lugged his own suitcase to work one day. That evening he would take the Eastern shuttle to Washington to meet with, among others, two U.S. senators. Suspecting he was D’Antona’s target, he hid his suitcase in a closet in Henry Kaufman’s office. Just as he was about to leave for the airport, his phone rang. It was Marro. Marro was sitting about eight feet away, but when two traders wished to speak privately, even at close proximity, they used the phones.

  Marro warned Kilberg. “Don’t tell anyone I warned you,” he said, “but you better check your suitcase.” So, making sure no one followed him, Kilberg checked his suitcase. All was in order.

  Kilberg caught his flight. His trip was uneventful. Yet when he walked onto the trading floor two days later, all the traders were laughing, D’Antona the most visibly. “What’s so funny?” asked Kilberg.

  “Did you have a good trip, Killer?” said D’Antona.

  “Yeah,” said Kilberg.

  “What do you mean, ‘yeah’?” asked D’Antona.

  Then it occurred to about six people at once what had happened. D’Antona had, on the day of Kilberg’s trip, found a suitcase full of clothes somewhere in the vicinity of the Salomon trading floor. The suitcase had had a large gold K stuck on it. K stood for Kilberg, right? Wrong.

  It hadn’t been Kilberg’s suitcase. “Then whose suits and shirts are these?” asked a trader, pulling some very expensive-looking threads from under a desk. “You could see everyone thinking,” recalls Kilberg. “And they weren’t thinking small fry. They were thinking big fry. They were thinking Kaufman [Henry] or Kimmel [Lee] or, since they had panicked and were not being rational, Coates [Craig, the head of government bond trading]. All at once they said, ‘Oh, shit! What do we do?’”

  Well, when you thought about it, that wasn’t a bad question. Whoever didn’t have the suits had the soggy toilet paper. Whoever had the toilet paper to wear over the weekend must be steamed. Since the goof had been internal to the mortgage department all along, and there were no K’s in the mortgage de
partment unaccounted for, who, of emotional importance, would be the wiser if the suits simply disappeared? No one. So one of the traders bundled the suits in a green Glad bag, like a dead body, and dumped them into the construction wreckage across the street from Salomon—in front of the New York Health and Racquet Club.

  The traders agreed, like Tom Sawyer and Huck Finn, never to tell a soul what had happened. “To this day,” says Kilberg, “they don’t know whose suits those were.”

  The department, in short, looked far more like a fraternity than it did a division of a large corporation. The boss was at least partly responsible for the adolescent nature of his department. He wasn’t just one of the boys; he was the ringleader. Mere winning was not as important to Ranieri as winning with style. Skewered by the mail spear on Ranieri’s trading desk were an orange pair of stripper’s panties. It was enjoyable to make more money than the rest of the firm, but it was sheer delight to make more money than the rest of the firm at the same time you spent half your day playing practical jokes on your employees and smoking big fat cigars.

  A trader recalls Ranieri marching out from his office onto the floor to talk to one of his young traders, Andrew Friedwald. “He had this big smile on his face. He was standing real close to Andy and asking him how a deal was going. Andy was saying how he hoped to sell some bonds in Japan and London, and Lewie just stood there nodding with this weird smile. Andy said something else, and all Lewie did was stand there and smile. Then Andy felt the joke. Lewie was holding a Bic lighter right under Andy’s balls. His pants were about to catch fire. Andy hit the roof.”

  Another Andy, Andy Stone, recalls having a bottle of Bailey’s Irish Cream poured into his jacket pockets by Ranieri. When he complained that it was his favorite suit, Ranieri whipped out four soiled hundred-dollar bills and said, “Don’t complain, buy a new one.”