Liar’s Poker

In 1981 Congress rescues the dying savings and loan industry with tax breaks, but in return the thrifts must sell off their mortgages. Suddenly Salomon traders are swamped with offers: “The only fully staffed mortgage department on Wall Street was no longer awkward and expensive; it was a thriving monopoly” (130). Thrift officers are so desperate to sell, and so ignorant of the value of their holdings, that they take bad offers from Salomon in stride: “[N]o matter how roughly they were treated, they kept coming back for more” (131).

Many thrifts lose big on these transactions. A Salomon competitor says, “‘The thrifts that did the best did nothing. The ones that did the big trades got raped’” (132). Ranieri tries to tone down the worst of it, now and then forcing a trader to revise a deal to make it less bad for the client. The thrifts then purchase other mortgage bonds, hoping a higher rate of return will get them out of their hole.

Salomon begins to trade in home loans as well. These they call “whole loans” and package them into bonds sanctioned by the government. Under Ranieri, in 1983 the mortgage department generates 40% of Salomon’s revenues; by 1984 it produces more than half. Between 1984 and 1986, mortgage traders earn $650 million for Salomon.

Trading is fast and loose; controls are few. The focus is on revenues, not profits. Ranieri, now vice-chairman, expands the mortgage business, and by 1987 as much as “40 percent of the seven thousand-odd Salomon employees reported, in one way or another, to Ranieri” (137).

The problem with mortgages is that it’s hard to predict when a homeowner might suddenly pay off the entire loan. This makes a mortgage bond problematic, since the correct payout at maturity can’t be calculated. Ranieri solves this simply by lowering the offering price. That, and Ranieri’s everyman mannerisms and enthusiasm for home ownership, endears him to investors. The new market flourishes: “Between 1977 and 1986 the holdings of mortgage bonds by American savings and loans grew from $12.6 billion to $150 billion” (142).

Salomon’s traders hold huge advantages: They know the bond market better than anyone, their profit margins are invisible to outsiders, and theirs is virtually the only trading floor on Wall Street. Thrifts, desperate to repair their portfolios, become the overeager “fools” in this game. Ironically, “thrifts became traders and traders thrifts” (143): Salomon holds so many mortgages that it acts as a sort of thrift institution, if an extremely profitable one. The firm’s power is enormous: “Salomon could dictate the rules of the mortgage bond trading game as it went along” (145). Buying and selling in huge amounts, Salomon can make bond prices rise or fall.

Two Salomon traders discover that certain housing developers are more likely to pay off their federally backed mortgages ahead of schedule and that “[o]nce the government had received its money, it repaid [Salomon traders] a hundred cents on the dollar for a piece of paper they had just bought at sixty” (147). Individual homeowners also might pay off their loans quickly: “The trick was to buy them below face value just before the homeowners repaid their loans” (148).

As mortgage revenues grow, so do the traders’ girths due to their gluttonous eating habits. They consume cheeseburgers for breakfast, eat candy all day, order pizzas, and consume Mexican food with five-gallon drums of guacamole. What’s more, “[e]ach Friday was ‘Food Frenzy’ day” (149). There are monthly dinners, not to mention gambling trips to Atlantic City. Encouraged by Ranieri, the traders play practical jokes, or “goofs,” on one another—for example, replacing someone’s suitcase of weekend clothing with pink panties, wet towels, or wet toilet paper: “The department, in short, looked far more like a fraternity than it did a division of a large corporation” (152).

Between 1982 and 1987, Salomon triples in size to 6,000 employees, with offices in London, Tokyo, Zurich, and Frankfurt. Bond traders, though, take home a mere fraction of the profits they generate. One of the best traders is Howie Rubin, a chemical engineer and Harvard MBA who previously figured out how to make a killing at blackjack: “Rubin found the prepayment game he played with discount mortgage securities similar to counting cards” (156). To him, the noise and distractions of the trading floor are like a casino. In his two years at Salomon, Rubin makes $55 million for the firm but is paid $165,000. He wants more.

Gutfreund, rich from the 1981 sale of Salomon to a commodities firm, disdains the traders’ desire for a bigger cut. Rubin moves to Merrill Lynch, who guarantee him “a minimum of $1 million a year, plus a percentage of his trading profits” (157). Others follow him out the door. Salomon increases compensation for a few balky stars, which sows dissent among the rest. The firm continues to leak traders.

After 1985, with its compensation system in tatters and many of its best traders hired away, Salomon has “let slip through its fingers the rarest and most valuable asset a Wall Street firm can possess: a monopoly” (168). Eventually, the “transfer of skills and information probably cost Salomon Brothers hundreds of millions of dollars” (168). The best days are behind them, as “[t]he peak in profitability was 1985” (169).

Another problem of Salomon’s own making is its 1983 co-invention, with First Boston bank, of the Collateralized Mortgage Obligation (CMO), which divides mortgage bonds into, for example, three groups, or tranches, that get paid off at five years from early prepayments, then at seven to fifteen years from later prepayments, and at fifteen to thirty years from the final prepayments and mortgages paid at maturity. The last tranche is largely exempt from the uncertainty about borrowers who might pay off their entire mortgages too soon, reducing the interest paid to the bond, and “[i]t made home mortgages look more like other bonds” (169). CMOs can be subdivided in any number of ways to appeal to a wide variety of investors, and they prove wildly popular: By 1988 $60 billion in CMOs have been sold. They also have the effect of making mortgage securities no more profitable than other types, to Salomon’s dismay.

Thrift institutions, still looking for ways to grow, like the way CMOs sidestep federal limits on a savings and loan’s balance sheet. Salomon mortgage traders sometimes lose large sums in the newly competitive market, but they hide this from managers “with profits they had squirreled away for a rainy day” (175). Beyond that, the traders prefer to be left to themselves, and when Ranieri or managing director Michael Mortara show up to backseat drive them, they play pranks until the two give up and leave them alone.

1987 is a difficult year for Salomon, and Gutfreund responds by creating a new level of management, appointing traders to executive positions. This doesn’t help much; as trader Andy Stone puts it, “‘The best producers are cutthroat, competitive, and often neurotic and paranoid. You turn those people into managers, and they go after each other’” (176). The three main bond department heads—Tom Strauss at government, Bill Voute in corporate, and Ranieri at mortgages—vie for power.

Mortgage traders, feeling underpaid, use expense accounts to pad their lifestyles, hiring limos for friends or, in one case, filing enough phony expense reports to pay for a new car.

Strauss and Voute gang up on Ranieri, wrangling one of their corporate managers, Mark Smith, a transfer into the mortgage desk. Smith acts as a spy and saboteur, getting good traders transferred or fired.

In April of 1987, a Merrill Lynch mortgage trader, Howie Rubin (formerly at Salomon), is let go because he has “lost more money on a single trade than anyone in the history of Wall Street” (180). Rubin makes an unauthorized mortgage “IOPO” sale that splits interest (“IO”) and principal (“PO”) payments into different bonds, selling the IO part and keeping the PO bonds for later sale. When the price of bonds suddenly plummets, Rubin can’t find buyers.

Shortly before this story breaks, a Salomon mortgage team, copying Rubin’s approach, arranges a similar but smarter deal, selling off the principal bonds early: “[T]he Salomon sales force managed to move the dreaded things out the door to investors before the market collapsed” (182). Mark Smith, however, has made a trade similar to Rubin’s, and when the market drops, he also loses a fortune while the mortgage team profits. Smith convinces Salomon that his trades are supposed to be bundled with the team’s trades, thus balancing his losses with their profits. The other traders consider it a theft of their own work; three quit the firm.

In July 1987, Gutfreund, who previously wanted to disband the mortgage department and move Ranieri upstairs, instead abruptly fires him, calling him “a disruptive force” and “too big for Salomon Brothers” (184). Ranieri believes he is the victim of a palace coup engineered by Strauss and Voute. Within two months, most of Ranieri’s mortgage traders have been let go, and many become directors of trading at competitors’ mortgage departments: “Salomon Brothers expertise fertilized the rest of Wall Street” (186). Voute assumes control of the mortgage department, but neither he nor the remaining employees know much about mortgage trading.

Despite his record loss, Howie Rubin is promptly hired by Bear Stearns. Ranieri “opened his own company half a mile north of Salomon Brothers” but mourns for the old Salomon, “when the firm was run by men who said, ‘It is more important to be a good man than a good manager,’ and meant it” (187).