In 1989 Michael Lewis released his first book, “Liar’s Poker“.
It tells the story of Michael’s entry into Wall Street and his experiences as a bond salesman at Salomon Brothers in the late 1980s. The rise of Mortgage-backed securities from this era eventually leads to the story of the “The Big Short” and the bets placed against the US housing market. However the focus of Liar’s Poker is on 1980s Wall Street and the leading bond trading firm, Salomon Brothers.
Here are some highlights.
1979 Interest Rate Fluctuations
At a rare Saturday press conference, on October 6, 1979, Volcker announced that the money supply would cease to fluctuate with the business cycle; money supply would be fixed, and interest rates would float.
Allowing interest rates to swing wildly meant allowing bond prices to swing wildly. Before Volcker’s speech, bonds had been conservative investments, into which investors put their savings when they didn’t fancy a gamble in the stock market. After Volcker’s speech, bonds became objects of speculation, a means of creating wealth rather than merely storing it. Overnight the bond market was transformed from a backwater into a casino. Turnover boomed at Salomon. Many more people were hired to handle the new business, on starting salaries of forty-eight grand.
Once Volcker had set interest rates free, the other hand stuffing the turkey went to work: America’s borrowers. American governments, consumers, and corporations borrowed money at a faster clip during the 1980s than ever before: this meant the volume of bonds exploded (another way to look at this is that investors were lending money more freely than ever before).
Rise of Mortgage Bonds
The savings and loan industry made the majority of home loans to average Americans and received layers of government support and protection. The breaks given savings and loans, such as deposit insurance and tax loopholes, indirectly lowered the interest cost on mortgages, by lowering the cost of funds to the savings and loans. The savings and loan lobbyists in Washington invoked democracy, the flag, and apple pie when shepherding one of these breaks through Congress. They stood for homeownership, they’d say, and homeownership was the American way. To stand up in Congress and speak against homeownership would have been as politically astute as to campaign against motherhood. Nudged by a friendly public policy, savings and loans grew, and the volume of outstanding mortgage loans swelled from $55 billion in 1950 to $700 billion in 1976. In January 1980 that figure became $1.2 trillion, and the mortgage market surpassed the combined United States stock markets as the largest capital market in the world.
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 homeowners 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.
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.
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.”
Life Lessons from Alexander the Trader
Early on Alexander taught me the importance of a strong exterior. “I learned awhile ago that there was no point to showing weakness,” he said. “When you arrive at six-thirty a.m., having had no sleep the night before, and having lost your best friend in a car accident, and some Big Swinging Dick walks over to your desk, slaps you on the back, and says, ‘How the hell are you?’ you don’t say, ‘I’m really tired and really upset.’ You say, ‘I’m great, how the hell are you?’”
Alexander insisted at our farewell dinner that I was making a great move. The best decisions he has made in his life, he said, were completely unexpected, the ones that cut against convention. Then he went even further. He said that every decision he has forced himself to make because it was unexpected has been a good one. It was refreshing to hear a case for unpredictability in this age of careful career planning. It would be nice if it were true.
Falling Price of Gold
The world of money was in upheaval. Funds were rushing out of the stock market and into safe havens. The conventional safe haven for money is gold, but this was not a conventional moment. The price of gold was falling fast. Two creative theories made their happy way around the trading floor, both explaining the fall in gold. The first was that investors were being forced to sell their gold to meet margin calls in the stock market. The second was that in the depression that followed the crash, investors would have no need to fear inflation, and since for many gold was protection against inflation, it was less in demand.