Liar’s Poker is a book about Michael Lewis’s (author of the book) experience working in the once prestigious Salomon Brothers investment bank. He gave an insight into the internal workings, tension and ugly side of the firm. I shall pick out the useful and amusing things from the book.
I found the description of the interview interesting. I do not know if this is true. “Investment bankers had a technique known as the stress interview. If you were invited to Lehman’s New York offices, your first interview might begin with the interviewer asking you to open the window. You were on the forty-third floor overlooking Wall Street. The window was sealed shut.”
“Another stress-inducing trick was the silent treatment. You’d walk into the interview chamber. The man in the chair would say nothing. You’d say hello. He’d stare. You’d say that you’d come for a job interview. He’d stare some more. You’d made a stupid joke. He’d stare and shake his head. You were on tenterhooks. Then he’d pick up a newspaper (or, worse, your resume) and begin to read. He was testing your ability to take control of a meeting.”
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Trading bonds and taking an eighth of it
He described how the Salomon trader would earn commissions through the sale of bonds. The trader will probably offer $50 million worth of IBM bonds to pension fund X through the Salomon salesman. He will take an eighth of a percentage point or $62,500 in this case. Thereafter he will convince insurance company Y through another salesman that the bonds are worth more than $50 million and this may not be true. The trader will buy back the bonds from X and resell it to Y at a higher price, and pocket another eighth of a percentage point in quick succession.
The rise of the mortgage department
Salomon Brothers was the first to form a mortgage security department in 1978. This was probably the genesis of our securitization of our mortgage loans and eventually escalate into the crisis in 2008. The fastest group of borrowers were the homeowners and “the volume of outstanding mortgages 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.”
Securitization of mortgage loans
“Mortgages were not tradable pieces of paper… No trader and investor wanted to poke around suburbs to find out whether the homeowner 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 law of probability, only a small fraction should default.”
“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.”
Frenzy selling of mortgage loans
When the Fed increased interest rates in 1979, the saving and loans industry was on the verge of collapse. A tax break was passed whereby the thrifts were able to enjoy if they sell their loans. Salomon Brothers, the only firm on Wall Street to have a mortgage department, was the sole buyer of cheap loans. Naturally, it monopolized the mortgage 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, …”
Freddie Mac and Fannie Mae were created during this period and offered to “transform most home mortgages into government-backed bonds.” “Once they were stamped, however, nobody cared about the quality of the loans. Defaulting homeowners became the government’s problem.”
Brain drain and rise in competition
As Salomon refused to reward the mortgage traders enough to make them stay, many of the traders left for other Wall Street banks, bringing along their knowledge, skills, experience and lists of clients. This allowed other banks to catch up on the mortgage trading business and challenge Salomon’s monopoly. The spread has narrowed and profitability began to decrease.
Creation of the Collaterized Mortgage Obligations (CMOs)
“It was invented in June 1983, not not until 1986 did it dominate the mortgage market.”
“To create a CMO, one gathered hundreds of millions of dollars of ordinary mortgage bonds – Ginnie Maes, Fannie Maes, and Freddie Macs. These bonds were placed in a trust. The trust paid a rate of interest to its owners. The owners had certificates to prove their ownership. These certificates were CMOs. The certficates, however, were not all the same. Take a typical three-hundred-million-dollar CMO. It would be divided into three tranches, or slices of a hundred million dollars each. Investors in each tranche received interest payments. But the owners of the first tranche received all principal repayments from all three hundred million dollars of mortgage bonds held in trust. Not until the first tranche holders were entirely paid off did second tranche investors receive any prepayments. Not until both first and second tranche investors had been entirely paid off did the holder of a third tranche certificate receive prepayments.”
“…seemingly limitless number of ways to slice and dice home mortgages. They created CMOs with five tranches and CMOs with ten tranches. They split a pool of home mortgages into a pool of interest payments and a pool of principal payments, then sold the rights to the cash flows from each pool (known as IOs and POs, after interest only and principal only) as separate investments. The homeowner didn’t know it, but his interest payments might be destined for a French speculator, and his principal repayments to an insurance company in Milwaukee. In perhaps the strangest alchemy, Wall Street shuffled the IOs and POs around and glued them back together to create home mortgages that could never exist in the real world. Thus the 11 percent interest payment from condominium dwellers in California could be glued to the principal repayments from homeowners in a Louisiana ghetto, and voila, a new kind of bond, a New Age Creole, was born.”
Unethical business practice
Salomon was said to dump shares of a collapsing company to clients. “There was a phenomenon known at Salomon as a priority. A priority was a huge number of bonds or stocks that had to be sold, either because selling them would make us rich or because not selling them would make us poor. When Texaco teetered on the brink of bankruptcy, for example, Salmon Brothers owned about one hundred million dollars’ worth of bonds in the company. There was a real danger that these bonds would become worthless. Unless sold to customers, they could cost Salomon a great deal of money. Sold to customers, of course, they would cost the customers a great deal of money. That, it was decided, was the best thing to do.”
“He [Alexander] wanted to know why the dollar was plunging… I told Alexander that several Arabs had sold massive holdings of gold, for which they received dollars. They were selling those dollars for marks and thereby driving the dollar lower.”
“I spent much of my working life investing logical lies like this. Most of the time when markets move, no one has any idea why. A man who can tell a good story can make a good living as a broker. It was the job of people like me to make up reasons, to spin a plausible yarn. And it’s amazing what people will believe. Heavy selling out of the Middle East was an old standby. Since no one ever had any clue what the Arabs were doing with their money or why, no story involving Arabs could ever be refuted.”
Create warrants to transfer risks
“Risk, I had learned, was a commodity in itself. Risk could be canned and sold like tomatoes.”
“My client wanted to take a big risk by wagering a large sum of money on German bonds rising. He was therefore the “buyer” of risk. Alexander and I created a security, called a warrant of a call option, which was a means of transferring risk from one party to another. In buying our warrant, risk-averse investors from around the world (meaning most investors) would be, in effect, selling us risk… The difference between what we paid cautious investors for the risk and what we sold it to my customer for would be our profits. We estimated these would come to about seven hundred thousand dollars.”
Investment strategy – Seek secondary and tertiary effects
There was one useful strategy described in the book. A trader named Alexander whom Michael Lewis followed.
“… in the event of a major dislocation, such as a stock market crash, a natural disaster, the breakdown of OPEC’s production agreements, he would look away from the initial focus of investor interest and seek secondary and tertiary effects.”
“Remember Chernobyl? When news broke that the Soviet nuclear reactor had exploded, Alexander called. Only minutes before, confirmation of the disasater had blipped across our Quotron machines, yet Alexander had already bought the equivalent of two supertankers of crude oil. The focus of investor attention was on the New York Stock Exchange, he said. In particular it was on any company involved in nuclear power. The stocks of those companies were plummeting. Never mind that, he said. He had just purchased on behalf of his clients, oil futures. Instantly in his mind less supply of nuclear power equaled more demand for oil, and he was right.”
After he made a killing in oil, he shifted his attention to potatoes.
“Buy potatoes,” he said. “Gotta hop.” Then he hung up.”
“Of course. A cloud of fallout would threaten European food and water supplies, including the potato crop, placing a premium on uncontaminated American substitutes.”
One more example, what if Tokyo had a major earthquake? What are the secondary effects?
“…what Alexander would do is put money into Japan on the assumption that since everyone was trying to get out, there must be some bargains. He would buy precisely those securities in Japan that appeared the least desirable to others. First, the stocks of Japanese insurance companies. The world would probably assume that ordinary insurance companies had a great deal of exposure, when in fact, the risk resides mainly with Western insurers and with a special Japanese earthquake insurance company that’s been socking away premiums for decades. The shares of ordinary insurers would be cheap.”
“Then Alexander would buy a couple of hundred million dollars’ worth of Japanese government bonds. With the economy in temporary disrepair, the government would lower interest rates to encourage rebuilding and simply order the banks to lend at those rates. Japanese banks would comply as usual with their government’s request. Lower interest rates would mean higher bond prices.”
“Also, the short-term panic could well be overshadowed by the long-term repatriation of Japanese capital. Japanese companies have massive sums invested in Europe and America. Eventually they would withdraw those investments, turn inward, lick their wounds, repair their factories, and bolster their stock. What would that mean?”
“…to Alexander, it would suggest buying yen.”
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