Wall Street

Michael Lewis’s Liars’ Poker
Burrough and Helyar’s Barbarians at the Gate
Theodore Forstmann’s “Violating Our Rules of Prudence”
William D. Cohan’s House of Cards
Simon Johnson’s “The Quiet Coup”
Michael Lewis’s The Big Short
Michael Lewis’s “Shorting Reform”
Nouriel Roubini and Stephen Mihm’s Crisis Economics
Miscellaneous articles

Recommended reading:
Den of Thieves by James B. Stewart, for the 1980 scandals (Boesky, Milken, et al.)
No One Would Listen by Harry Markopolos et al., for his exposé of the Madoff scandal
and especially
13 Bankers by Simon Johnson and James Kwak, 2010

A muckraking web site:

Michael Lewis’s Liars’ Poker

Michael Lewis wrote the best-selling book
Liar’s Poker: Rising Through the Wreckage on Wall Street
in 1989.
I am in no position to judge how accurate the picture that he paints is.
he certainly gives a colorful and often entertaining picture
of his view of the world around him at Salomon Brothers.

Below are some excerpts.
Some, but not all, of the emphasis is added.
As an experiment, perhaps as an eccentricity, but certainly to save space,
I frequently use SI suffixes and prefixes for large numbers:

T = tera = trillion = 1012 = 1,000,000,000,000
G = giga = billion = 109 = 1,000,000,000
M = mega = million = 106 = 1,000,000

[pages 34–36]
The biggest myth about bond traders,
and therefore the greatest misunderstanding about
the unprecedented prosperity on Wall Street in the 1980s,
is that
they make their money by taking large risks.
A few do.
And all traders take small risks.
But most traders act simply as toll takers.
The source of their fortune has been nicely summarized by Kurt Vonnegut
(who, oddly, was describing lawyers):
“There is a magic moment, during which a man has surrendered a treasure,
and during which the man who is about to receive it has not yet done so.
An alert lawyer [read bond trader] will make that moment his own,
possessing the treasure for a magic microsecond, taking a little of it,
passing it on.”

In other words,
Salomon carved a tiny fraction out of each financial transaction.
This adds up.
The Salomon salesman sells $50M worth of new IBM bonds to pension fund X.
The Salomon trader, who provides the salesman with the bonds,
takes for himself an eighth (of a percentage point), or $62.5K.
He may, if he wishes, take more.
In the bond market, unlike in the stock market,
commissions are not openly stated.

Now the fun begins.
Once the trader knows the location of the IBM bonds
and the temperament of their owner,
he doesn’t have to be outstandingly clever to make the bonds (the treasure)
move again.
He can generate his own magic microseconds.
He can, for example,
pressure one of his salesmen to persuade insurance company Y
that the IBM bonds are worth more than pension fund X paid for them initially.
Whether it is true is irrelevant.
The trader buys the bonds from X and sells them to Y
and takes out another eighth,
and the pension fund is happy to make a small profit in such a short time.

In this process,
it helps if neither of the parties on either side of the middleman
knows the value of the treasure.

The men on the trading floor may not have been to school,
but they have Ph.D.’s in man’s ignorance.

In any market, as in any poker game, there is a fool.
The astute investor Warren Buffet is fond of saying that
any player unaware of the fool in the market
probably is the fool in the market.

In 1980, when the bond market emerged from a long dormancy,
many investers and even Wall Street banks
did not have a clue who was the fool in the new game.

Salomon bond traders knew about fools because that was their job.
Knowing about markets is knowing about other people’s weaknesses.
And a fool, they would say, was a person
who was willing to sell a bond for less or buy a bond for more
than it was worth.
A bond was worth only as much as
the person who valued it properly was willing to pay.

And Salomon, to complete the circle,
was the firm that valued the bonds properly.

But none of this explains
why Salomon Brothers was particularly profitable in the 1980s.
Making profits on Wall Street is a bit like eating the stuffing from a turkey.
Some higher authority must first put the stuffing into the turkey.
The turkey was stuffed more generously in the 1980s than ever before.
And Salomon Brothers, because of its expertise,
had second and third helpings before other firms even knew that supper was on.

One of the benevolent hands doing the stuffing belonged to the Federal Reserve.
That is ironic, since
no one disapproved of the excesses of Wall Street in the 1980s so much as
the chairman of the Fed, Paul Volcker.
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,
interest rates would float.

The event, I think, marks the beginning of the golden age of the bond man.
Had Volcker never pushed through his radical change in policy,
the world would be many bond traders and one memoir the poorer.
For in practice, the shift in the focus of monetary policy meant that
interest rates would swing wildly.

[For confirmation, see this,
which asserts
[G]iven the Fed’s efforts to control money quantity rather than rates,
the Fed funds rate bounced around on a daily basis such that
businesses faced an impossible task of raising capital
owing to uncertainty about the rate at which they could raise capital.

Bond prices move inversely, lockstep, to rates of interest.
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.
[That is a common characterization,
but some draw a distinction between paper wealth and real wealth.]

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 $48K.
[Lewis earlier informed us that was his starting salary.]

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).
The combined indebtedness of the three groups in 1977 was $323G,
much of which wasn’t bonds but loans made by commercial banks.
By 1985 the three groups had borrowed $7T ( = $7,000G).
[That’s a 20-fold expansion.]
What is more,
thanks to financial entrepreneurs at places like Salomon
and the shakiness of commercial banks,
a much greater percentage of the debt was cast in the form of bonds than before.

So not only were bond prices more volatile,
but the number of bonds to trade increased.
Nothing changed within Salomon Brothers that made the traders more able.
Now, however, trades exploded in both size and frequency.
A Salomon salesman who had in the past
moved $5M worth of merchandise through the traders’ books each week
was now moving $300M through each day.
He, the trader, and the firm began to get rich.

[page 60]
[A] few of the old hands within Salomon Brothers ... were uneasy
with the explosion of debt in America.
(In general, the better they recalled the Great Depression,
the more suspicious they were of the leveraging of America.)
The head of bond research at Salomon, Henry Kaufman, was, when I arrived,
our most acute case of cognitive dissonance.
He was the guru of the bond market and also the conscience of our firm.
He told investors whether their fast-moving bonds were going up or down.
He was so often right that the markets made him famous
if not throughout the English-speaking world
then at least among the sort of people who read the Wall Street Journal.
Yet Kaufman was known as Dr. Gloom.
The party had been thrown in his honor, but he seemed to want it to end.
As he wrote in the Institutional Investor of July 1987:
One of the most remarkable things that happened in the 1980’s was
[the] sharp explosion in debt,
way beyond any historical benchmark.

It was way beyond anything you would have expected relative to GNP,
relative to monetary expansion that was taking place.
But it came about, I think, as a result of freeing the financial system,
putting into being financial entrepreneurship
and not putting into being adequate disciplines and safeguards.
So that’s where we are.
[Emphasis added.]

[pages 69–70]
Because the forty-first floor [the trading floor]
was the home of the firm’s most ambitious people,
and because there were no rules governing the pursuit of profit and glory,
the men who worked there, including the more bloodthirsty,
had a hunted look about them.
The place was governed by the simple understanding that
the unbridled pursuit of perceived self-interest was healthy.
Eat or be eaten.
The men of 41 worked with one eye cast over their shoulders
to see whether someone was trying to do them in,
for there was no telling what manner of men had levered himself
to the rung below you and was now hungry for your job.
The range of acceptable conduct within Salomon Brothers was wide indeed.
It said something about the ability of the free marketplace
to mold people’s behavior into a socially acceptable pattern.
For this was capitalism at its most raw, and it was self-destructive.

At a Salomon Brothers trainee, of course,
you didn’t worry too much about ethics.
You were just trying to stay alive.
You felt flattered to be on the same team with the people
who kicked everyone’s ass all the time.
Like a kid mysteriously befriended by schoolyard bully,
you tended to overlook the flaws of bond people
in exchange for their protection.
I sat wide-eyed when these people came to speak to us [Salomon’s trainee class]
and observed a behavioral smorgasbord the likes of which
I had never before encountered, except in fiction.
As a student you had to start from the premise that
each of these characters was immensely successful,
then try to figure out why....

[pages 83–86]
Wall Street brings together borrowers of money with lenders.
Until the spring of 1978,
when Salomon Brothers formed Wall Street’s first mortgage security department,
the term borrower referred to
large corporations and to federal, state, and local governments.
It did not include homeowners.
A Salomon Brothers partner named Robert Dall thought this strange.
The fastest-growing group of borrowers
was neither governments nor corporations but homeowners.
From the early 1930s
legislators had created a portfolio of incentives
for Americans to borrow money to buy their homes.
The most obvious of these was
the tax deductibility of mortgage interest payments.
The next most obvious was the savings and loan industry.

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 mortgages swelled
from $55G in 1950
to $700G in 1976.
In January 1980 that figure became $1.2T ( = $1,200G),
and the mortgage market surpassed the combined United States stock markets
as the largest capital market in the world.

Nevertheless, in 1978 on Wall Street
it was flaky to think that home mortgages could be big business.
Everything about them seemed small and insignificant,
at least to people who routinely advised CEOs and heads of state.
The CEOs of home mortgages were savings and loan presidents.
The typical savings and loan president was a leader in a tiny community.
He was the sort of fellow who sponsored a float in the town parade;
that said it all, didn’t it?
He wore polyester suits,
made a five-figure income,
and worked one-figure hours.
He belonged to the Lions or Rotary Club
and also to a less formal group known within the thrift industry
as the 3-6-3 Club:
He borrowed money at 3 percent,
lent money at 6 percent, and
arrived on the golf course by three in the afternoon.

Each year four salesmen who sold bonds to Texas thrifts
[In the interest of variety,
thrift will be used interchangeably with savings and loan throughout the text,
as it is on Wall Street.]

performed a skit before the Salomon training class.
[Salomon had an annual training class for its new professional employees.]
Two played Salomon salesmen; two played the managers of a thrift.
The plot ran as follows:

The Salomon salesmen enter the thrift just as the thrift managers are leaving,
tennis racket in one hand and a bag of golf clubs in the other.
The thrift men wear absurd combinations of
checkered pants and checkered polyester jackets with wide lapels.
The Salomon salesmen fawn over the thrift men.
They go so far as to admire the lapels on the jacket of one thrift manager.
At this, the second thrift manager gets huffy.
“You call those doodads lapels?
Those tawny thangs?”
he says in a broad Lone Star accent.
“Lapels ain’t lapels unless you can see them from the back.”
Then he turns around, and sure enough,
the lapels jut like wings from his shoulders.

The Salomon salesmen, having schmoozed their client, move in to finish him off.
They recommend that
the thrift managers buy a billion dollars’ worth of interest rate swaps.
The thrift managers clearly don’t know what an interest rate swap is;
they look at each other and shrug.
One of the Salomon salesmen tries to explain.
The thrift men don’t want to hear; they want to play golf.
But the Salomon salesmen have them by the short hairs and won’t let go.
“Just give us a billion of them thar interest rate swaps, so we can be off,”
the thrift managers finally say.
End of skit.

That was the sort of person who dealt in home mortgages,
a mere sheep rancher next to the hotshot cowboys on Wall Street.
The cowboys traded bonds, corporate and government bonds.
And when a cowboy traded bonds, he whipped ’em and drove ’em.
He stood up and shouted across the trading floor,
“I got ten million IBM eight and a halfs [8.5 percent bonds] to go [for sale]
at one-oh-one,
and I want these fuckers moved out the door now.”
Never in a million years could he imagine himself shouting,
“I got the sixty-two-thousand-dollar home mortgage of Mervin K. Finkleberger at on-oh-one.
It has twenty years left on it; he’s paying a nine percent interest;
and it’s a nice little three-bedroom affair just outside Norwalk.
Good buy, too.”
A trader couldn’t whip and drive a homeowner.

The problem was more fundamental than a disdain for Middle America.
Mortgages were not tradable piece 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 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 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 $110K 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 ...
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.
A line which would never be crossed
could be drawn down the center of the market.
On one side would be the homeowner;
on the other, investors and traders.
The two groups would never meet;
this is curious in view of how personal it seems to lend a fellowman
the money to buy his home.
The homeowner would see only his local savings and loan manager,
from whom the money came and to whom it was, over time, returned.
Investors and traders would see paper.


[pages 88–89]

Bob Dall loved to trade.
And though he did not have official responsibility for Ginnie Maes
[from the Government National Mortgage Association],
he began to trade them.
Someone had to.
Dall established himself as
the Salomon Brothers authority on mortgage securities
in September 1977.
Together with Stephen Joseph, the brother of Drexel CEO Fred Joseph,
he created the first private issue of mortgage securities.
They persuaded the Bank of America to sell the home loans it had made—
in the form of bonds.
They persuaded investors, such as insurance companies,
to buy the new mortgage bonds.
When they did,
the Bank of America received the cash it had originally lent the homeowners,
which it could then relend.
The homeowner
continued to write his mortgage payment checks to the Bank of America,
but the money was passed on to the Salomon Brothers clients
who had purchased the Bank of America’s bonds.


[pages 100–101]
[In 1980, the] mortgage department [at Salomon Brothers]
wasn’t making much money.
The other mortgage units on Wall Street—
Merrill Lynch, First Boston, Goldman Sachs—
were stillborn.
They closed almost before they had opened.
The prevailing wisdom was that mortgages were not for Wall Street.

The business was reeling from what appeared to have been the knockout punch.
Paul Volcker had made his historic speech on October 6, 1979.
Short-term interest rates had skyrocketed.
For a thrift manager to make a thirty-year home loan,
he had to accept a rate of interest of 10 percent.
Meanwhile, to get the money, he was paying 12 percent.

He ceased, therefore, to make new loans,
which suited the purpose of the Federal Reserve,
which was trying to slow the economy.
New housing starts dropped to postwar lows.

[Man, were those guys backward back then.
Slow the economy?
What a retarded, non-growth-oriented thought.
Just imagine, placing stability ahead of growth.]

Before Volcker’s speech,
Steve Joseph’s mortgage finance department
had created roughly $2G in mortgage securities.
It was a laughably small amount—
less than two-tenths of a percent of outstanding American home mortgages
[evidently then around $1T, or $1,000G;
in 2008 I believe mortgages are around $12T]
But it was a start.
After Volcker’s speech the deals stopped.
For Ranieri & Co. to create bonds,
the thrifts had to want to make loans.
They didn’t.
The industry that held most of America’s home mortgages on its books
was collapsing.
In 1980 there were 4,002 savings and loans in America.
Over the next three years 962 of those would collapse.
As Tom Kendall put it,
“Everybody hunkered down and licked their wounds.”
[See pages 103–106 for some details.]

Everybody but Ranieri. Ranieri expanded....
[Lewie Ranieri] hired a phalanx of lawyers and lobbyists in Washington
to work on legislation
to increase the number of potential buyers of mortgage securities.
“I’ll tell you a fact,” says Ranieri.
The Bank of America deal [Bob Dall’s first brainchild]
was a legal investment in only three states.
I had a team of lawyers trying to change the law on a state-by-state basis.
It would have taken two thousand years.
That’s why I went to Washington.
To go over the heads of the states.”

“If Lewie didn’t like a law, he’d just have it changed,”
explains one of his traders.
Even if Ranieri had secured a change in the law, however,
investors would have stayed clear of mortgage bonds.
Tom Kendall remembers visiting Ranieri’s top salesman, Rick Borden,
in Salomon Brothers’ San Francisco office in 1979….
“I remember him saying over and over,
‘These Ginnie Maes suck.
They get longer [in maturity] when rates go up,
and shorter when rates go down,
and nobody wants them,’ ”
says Kendall.

To make matters worse,
the Salomon Brothers credit committee was growing reluctant
to deal with the collapsing savings and loan industry.
Stupid customers (the fools in the market) were a wonderful asset,
but at some level of ignorance they became a liability.
They went broke.

[pages 103–115]
Lights began to flash on the mortgage trading desk [at Salomon Brothers]
in October 1981,
and at first no one knew why.
On the other end of the telephones were
nervous savings and loan presidents from across America
wanting to speak to a Salomon mortgage trader.
They were desperate to sell their loans.
Every home mortgage in America, one trillion dollars’ ($1T) worth of debt,
seemed to be for sale.
There were a thousand sellers, and no buyers.
Correction. One buyer. Lewie Ranieri and his traders.
The force of the imbalance between supply and demand was stunning.

What was going on?
From the moment the Federal Reserve lifted interest rates in October 1979,
thrifts hemorrhaged money.
The entire structure of home lending was on the verge of collapse.
There was a time when it seemed that if nothing were done,
all thrifts would go bankrupt.
So on September 30, 1981,
Congress passed a nifty tax break for its beloved thrift industry.

[The tax break allowed thrifts to sell all their mortgage loans
and put their cash to work for higher returns,
often by purchasing the cheap loans disgorged by other thrifts.
[This sounds like a version of churning.]
The thrifts were simply swapping portfolios of loans.
The huge losses on the sale
(the thrifts were selling loans for sixty-five cents on the dollar
they had originally made at par, or a hundred cents on the dollar)
could now be hidden.
A new accounting standard allowed the thrifts to
amortize the losses over the life of the loans.
For example,
the loss the thrift would show on its books in the first year
from the sale of a thirty-year loan that had fallen 35 percent in value
was a little over 1 percent: 35 / 30.
But what was even better is that
the loss could be offset against
any taxes the thrift had paid over the previous ten years.

Shown losses,
the Internal Revenue Service (IRS) returned old tax dollars to the thrifts.
For the thrifts,
the name of the game was to generate lots of losses to show to the IRS;
that was now easy.
All they had to do to claw back old taxes was sell off their bad loans;
that’s why thrifts were dying to sell their mortgages.]

It [the tax break] provided massive relief for thrifts.
To take advantage of it, however,
the thrifts had to sell their mortgage loans.
They did.
And it led to hundreds of billions of dollars in turnover on Wall Street.
Wall Street hadn’t suggested the tax breaks, and indeed
Ranieri’s traders hadn’t known about the legislation until after it happened.
Still, it amounted to a massive subsidy to Wall Street from Congress….
The United States Congress had just rescued Ranieri & Co.
The only fully staffed mortgage department
was no longer awkward and expensive;
it was a thriving monopoly.

The market took off because of a simple tax break.

Bond traders tend to treat each day of trading as if it were their last.
This short-term outlook enables them
to exploit the weakness of their customers
without worrying about the long-term effects on customer relations.
They get away with whatever they can.
A desperate seller is in a weak position.
He’s less concerned about how much he is paid
than when he is paid.
Thrift presidents were desperate.
They arrived at the Salomon Brothers mortgage trading desk hat in hand.
If they were going to be so obvious about their weakness,
they might as well have written a check to Salomon Brothers.

The situation was aggravated by the ignorance of the thrifts.
The 3-6-3 Club members had not been stress-tested for the bond market;
they didn’t know how to play Liar’s Poker.
They didn’t know the mentality of the people they were up against.
They didn’t know the value of what they were selling.
In some cases, they didn’t even know the terms
(years to maturity, rates of interest)
of their own loans.
They only thing the thrift managers knew was how much they wanted to sell.

Trader Tom DiNapoli fondly remembers a call from one thrift president.
“He wanted to sell $100M worth of his thirty-year loans
[bearing the same rate of interest],
and buy $100M of some other loans with the cash from the sale.
[A classic case of churning, in this case customer-originated.]
I told him I’d bid [buy] his loans at seventy-five [cents on the dollar]
and offer him the others at eight-five.”
The thrift president scratched his head at the numbers.
He was selling loans nearly identical to those he was buying,
but the difference in yield would leave him out of pocket an unheard-of $10M.
Or to put it another way,
the thrift was being asked to pay a transaction fee of $10M [~ 13 percent]
to Salomon Brothers.
“That doesn’t sound like a very good trade for me,” he said.
DiNapoli was ready for that one.
“It isn’t, from an economic point of view,” he said
“but look at it this way, if you don’t do it, you’re out of a job.”
A fellow trader talking to another thrift president on another line
overheard DiNapoli and cracked up.
It was the funnies thing he had heard all day.
He could picture the man on the other end of the phone, just oozing desperation.
[Where was the competition between investment bankers
for the business of these desperate thrift presidents?]

“October 1981
was the most irresponsible period in the history of the capital markets.”
says Larry Fink,
a partner with Steven Schwartzman, Peter Peterson, and David Stockman
in the Blackstone Group.
In October 1981
Fink was head of the small mortgage trading department at First Boston,
which would soon grow large and become Lewie Ranieri’s main competitor.
“The thrifts that did the best did nothing.
The ones that did the big trades got raped.”

However, like all trades in the bond market,
these were negotiable transactions between consenting adults,
and the sole rule of engagement was:
Buyer beware.

It wasn’t just the dummies who queued to trade with Salomon Brothers.
Even knowledgeable thrift presidents felt they faced a choice between
rape and slow suicide.
To do nothing spelled bankruptcy for many
Paying out 14 percent on deposits
while taking in 5 percent on old home mortgage loans
was a poor way to live,
but this is precisely the position thrifts were in.
By late 1982 the thrifts were attempting to grow their way out of catastrophe.
By that time, short-term interest rates had fallen below long-term interest rates.
[I.e., long-term mortgage rates had skyrocketed.]
The thrift could make new mortgage loans at 14 percent
while taking in money at 12 percent.

Many thrifts layered $1G of brand-new loans
on top of their existing, disastrous $100M of old loss-making loans,
in a hope that the new would offset the old.
Each new purchase of mortgage bonds (which was identical to making a loan)
was like the last act of a desperate man.
The strategy was wildly irresponsible, for
the fundamental problem (borrowing short term and lending long term)
hadn’t been remedied.
The hypergrowth only meant that the next thrift crisis would be larger.
But the thrift managers were not thinking that far in advance.
They were simply trying to keep the door to the shop open.
That explains why thrifts continued to buy mortgage bonds
even as they sold their loans.

The tax and accounting breaks,
designed to rescue the savings and loan industry,
seemed, in the end,
to be tailor-made for Lewie Ranieri’s mortgage department.
It rained gold on Salomon Brothers’ mortgage traders.
Or at least that is how it appeared to the rest of envious Wall Street.

Ranieri allowed his boys to assume a carefree buy-now, worry-later attitude
in the midst of the upheaval in the thrift industry.
And the Salomon traders found themselves in a weird new role.
They were no longer trading mortgage bonds,
but the raw material for mortgage bonds:
home loans.
Salomon Brothers was all of a sudden playing the role of a thrift.
Nothing—not Ginnie Mae, not the Bank of America—
stood between Wall Street investment banker and homeowner.
Salomon was exposed to the homeowner’s ability to repay.
A cautious man would have inspected the properties he was lending against,
for nothing but property underpinned the loans.

But if you planned to run with this new 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.
Leaps of faith were Ranieri’s specialty.
A quick mental calculation told him that whatever the cost of buying bad loans,
it couldn’t possibly match the profits he would make by trading the things.
He turned out to be right [for two decades, anyhow].

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
the 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 these 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 $150M.
In 1984
a mortgage trader named Steve Baum shattered a Salomon Brothers record,
by making $100M in a single year trading whole loans [that’s a lot of loans].
Although there are no official numbers,
it was widely accepted at Salomon that Ranieri’s traders made
$200M in 1983,
$175M in 1984, and
$275M in 1985.


To do all the trades in you 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 [more] 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 it 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 homeowner securities had not.
Mortgages were indeed 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 taking 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 like having that option.
But no one even on Wall Street could put a price on the homeowner’s 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 bond-holder
for the option he was granting to the homeowner.


Under the weight of Ranieri and his traders, investment mistrust eroded.
And slowly investors began to buy mortgages....
Ranieri was the guru of the thrift industry.
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 $12G to $150G.

But that number dramatically understates
the importance of the thrifts to 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 $650G go $1.2T 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.
Freed 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 hugh 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 ...
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 Baum [the whole loan trader] was running a $2G 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 was that
Wall Street was making the entire savings and loans industry redundant.
One day someone brave will ask:
“Why don’t we just do away with S & Ls entirely?”)

[pages 127–28]
[Salomon Brothers Chairman John] Gutfreund especially seemed to revel
in the ... growth [of his domain].
He loved to point out that
Salomon was the world’s most powerful investment bank,
with $3G in capital.
He took obvious pleasure from the concept of being a “global” investment bank.
Offices opened and expanded in London, Tokyo, Frankfurt, and Zurich.
The firm, which had employed two thousand people in 1982,
had six thousand people by 1987.

All this can be attributed, one supposes,
to a healthy desire to remain competitive.
However, many of the mortgage traders argue that
growth for growth’s sake reflected glory upon John Gutfreund.
Often he would point out that
Salomon Brothers carried $80G of securities on its books overnight, every night.
He would follow this observation by saying that, in asset size,
Salomon Brothers was
“the largest commercial bank in the world” and
“one of the forty largest countries in the world.”
As one (Jewish) mortgage trader said in response,
“C’mon, John, you’re not talking about the Netherlands;
you’re talking about a bunch of Jews who are leveraged.”

The concept that he presided over no more than Jews with leverage
was as alien to Gutfreund as the Netherlands.
Salomon Brothers, where he was boss, was bigger than that.
By the commutative property of executive grandeur,
John Gutfreund was bigger than that....

[pages 136–39]
The beautiful inefficiency of mortgage bonds
was spoiled for Salomon by one of its own creations,
called the collateralized mortgage obligation (CMO).
It was invented in June 1983,
but not until 1986 did it dominate the mortgage market.
The irony is that it achieved precisely what Ranieri had hoped:
It made home mortgages look more like other bonds.
But making mortgage bonds conform in appearance had the effect, in the end,
of making them only as profitable as other kinds of bonds.

Larry Fink,
the head of mortgage trading at First Boston who helped create the first CMO,
lists it along with junk bonds as
the most important financial innovation of the 1980s.
That is only a slight overstatement.
The CMO burst the dam between
several trillion investable dollars looking for a home and
nearly two trillion dollars of home mortgages looking for an investor.
The CMO addressed the chief objections to buying mortgage securities,
still voiced by everyone but thrifts and a handful of adventurous money managers.
Who wants to lend money not knowing when he’ll get it back?
[Preceding sections of the book have made it very clear that
the problem that worried investors back then
was not the risk that homeowners would default,
but that they would prepay the mortgage,
meaning that the investor would not get the revenue stream,
with its guaranteed rate of interest, that he had anticipated.]

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 drawer.
[Just kidding, the real word Lewis used was:] trust
The trust paid a rate of interest to its owners.
The owners had certificates to prove their ownership.
These certificates were CMOs.
The certificates, however, were not all the same.
Take a typical $300M CMO.
It would be divided into three tranches, or slices of $100M each.
Investors in each tranche received interest payments.
But the owners of the first tranche
received all principal repayments
from all $300M of mortgage bonds held in trust.
Not until 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.

The effect was to reduce the life of the first tranche
and lengthen the life of the third tranche
in relation to the old-style mortgage bonds.
One could say with some degree of certainty that
the maturity of the first tranche would be no more than five years, that
the maturity of the second tranche would fall somewhere between
seven and fifteen years, and
the maturity of the third tranche would be between fifteen and thirty years.

Now, at last,
investors had a degree of certainty about the length of their loans.
As a result of CMOs,
there was a dramatic increase in the number of investors
and volume of trading in the market.
For though there was no chance of persuading
a pension fund manager looking to make a longer-term loan
to buy a Freddie Mac bond that could evaporate [be prepaid] tomorrow,
one could easily sell him the third tranche of a CMO.
He slept more easily at night knowing that
before he received a single principal repayment from the trust,
$200M of home mortgage loans had to be prepaid
to first and second tranche investors.
The effect was astonishing.
American pension funds controlled about $600G worth of assets in June 1983,
when the first CMO was issued by Freddie Mac.
None of the money was invested in home mortgages.
By the middle of 1986 they held about $30G of CMOs,
and that number was growing fast.

CMOs also opened the way for international investors
who thought American homeowners were a good bet.
In 1987 the London office of Salomon Brothers
sold $2G of the first tranche of CMOs
to international banks looking for higher-yielding short-term investments.
The money that flowed into CMOs came from investors new to mortgage bonds,
who would normally have purchased corporate or treasury bonds instead.
$60G of CMOs were sold by Wall Street investment banks
between June 1983 and January 1988.
That means that
$60G of new money was channeled into American home finance
between June 1983 and January 1988.

As with any innovation, the CMO generated massive profits for its creators, Salomon Brothers and First Boston.
But at the same time CMOs
redressed the imbalance of supply and demand in mortgages
that had created so much opportunity for the bond traders.
A trader could no longer bank on mortgages’ being cheap
because of a dearth of buyers.
By 1986, thanks to CMOs, there were plenty of buyers.
The new buyers drove down the returns paid to the investor by mortgage bonds.
Mortgages, for the first time, became expensive.

The market settled on a fair value for CMOs
by comparing them with corporate and treasury bonds.
Though this wasn’t precisely rational,
as there was still no theoretical basis
for pricing the homeowner’s option to repay his mortgage,
the market was growing large enough to impose its own sense of fairness. [??]
No longer were the prices of ordinary mortgage bonds
allowed to roam inefficiently,
for they were now linked to the CMO market,
in much the same way that flour is linked to the market for bread.
Fair value for CMOs (the finished product) implied
a fair value for conventional mortgage bonds (the raw materials).
Investors now had a new, firm idea
of what the price of a mortgage bond should be.
This reduced the amount of money to made exploiting their ignorance.
The world had changed.
No longer did Salomon Brothers traders buy bonds at twelve
and then make the market believe they were worth twenty.
The market dictated the price, and Salomon Brothers’ traders learned to cope.

After the first CMO the Young Turks of mortgage research and trading
found a 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 owners in California
could be glued to
the principal repayments from homeowners in a Louisiana ghetto,
and voilà, a new kind of bond, a New Age Creole, was born.

The mortgage trading desk evolved from corner shop to supermarket.
By increasing the number of products, they increased the number of shoppers.
The biggest shoppers, the thrifts, often had a very particular need.
They wanted to grow beyond
the limits imposed by the Federal Home Loan Bank Board in Washington.
It was a constant struggle to stay one step ahead of
thrift regulators in Washington.
Many “new products” invented by Salomon Brothers
were outside the rules of the regulatory game;
they were not required to be listed on thrift balance sheets

and therefore offered a way for thrifts to grow.
In some cases,
the sole virtue of a new product was
its classification as “off-balance sheet.”

To attract new investors and to dodge new regulations,
the market became ever more arcane and complex.

[pages 186–87]

[A personal tale by Lewis.]
At 10:00 a.m. [one] day in London,
Alexander [a colleague and friend of Lewis] telephoned.
He, of course, was in New York, where it was 5:00 a.m.
He had been sleeping in his study, beside his Reuters machine,
and rousing himself every hour to check prices.
He wanted to know why the dollar was plunging.
When the dollar moved, it was usually because
some other central banker or politician somewhere had made a statement....
But there was no such news.
I told Alexander that
several Arabs had sold massive amounts 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 inventing logical lies like this.
Most of the time when markets move, no one has any ideal 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 be refuted.
So if you didn’t know why the dollar was falling,
you shouted out something about Arabs.
Alexander, of course, had a keen sense of the value of my commentary.
He just laughed.

Burrough and Helyar’s Barbarians at the Gate

The following are some excerpts from
(the 2003 paperback edition of) the 1990 book
Barbarians at the Gate: The Fall of RJR Nabisco
by Bryan Burrough and John Helyar.
All emphasis is added.

[pages 233–4]
Wall Street had been taken over by a cartel, [Ted] Forstmann believed.
A junk-bond cartel.
A cartel whose guru was Michael Milken of Drexel Burnham Lambert
and whose most powerful member was Henry Kravis of Kohlberg Kravis.
A cartel that now had the upper hand in the looming battle for RJR Nabisco.

The cartel’s product, the high-yield, or “junk,” bond,
was by 1988 being used to raise money—usually for takeovers—
by virtually every major investor, brokerage house, and leveraged buyout firm.
Ted Forstmann fervently believed
junk bonds had perverted not only the LBO industry,
but Wall Street itself.
Almost alone among major acquirers, Forstmann Little refused to use them.

To Forstmann the junk bond was a drug
that enabled the puniest acquisitors to take on the titans of industry,
and he held it responsible for twisting the buyout world’s priorities
until they were unrecognizable.
No longer, Forstmann believed,
did buyout firms buy companies to
work side-by-side with management,
grow their businesses, and
sell out in five to seven years,
as Forstmann Little did.
All that mattered now was
keeping up a steady flow of transactions
that produced an even steadier flow of fees—
management fees for the buyout firms,
advisory fees for the investment banks,
junk-bond fees for the bond specialists.

As far as Ted Forstmann was concerned,
the entire LBO industry had become the province of quick-buck artists.

The junk bond itself wasn’t to blame, Forstmann held.
In its normal form it could be a useful financing tool.
What he objected to were
the mutant strains that seemed to crop up with each new transaction:
securities that paid interest only in other bonds
(called pay-in-kind, or PIKs),
stocks that were crammed down shareholders’ throats
(known artlessly as “cram downs”), and
bonds whose interest rates escalated until
debt service choked a company to death.
Forstmann derided these securities as
“funny money,” “play dough,”, and his personal favorite, “wampum.”
In speeches to institutional investors,
he took to waving a piece of Indian jewelry to make his point.

Sooner or later, Forstmann knew,

the economy would turn down and
all the junk-bond junkies would go belly-up
when they couldn’t make their mountainous debt payments.

They were like those “no-money-down” real estate investors
with no money in their pockets when their debts came due.
When that happened, Forstmann feared,
the use of junk-bond debt would be so widespread that
the entire U.S. economy might be dragged into a depression.

[pages 372–4]
[Unlike the above excerpt,
there is no macroeconomic significance to this excerpt,
rather it is a look at the tactics, goals, and values of some Wall Street players.]

The computer runs on Ted Forstmann’s desk told the grim story.
At $85 a share,
Forstmann was comfortable bidding for RJR Nabisco.
The deal could be financed the Forstmann Little way,
with cash and no junk bonds.
At ninety, it was still doable,
though the returns to his investors fell sharply.
Institutions put their money with Forstmann Little
to get the 35 percent minimum return it promised.
To pay much above ninety, Forstmann could see,
he could give investors no more than 20 percent.
Hell, he joked, T-bills paid 11 percent [in 1988].
It was mortifying.

There was only one way to boost the returns enough to justify a bid.
North of ninety, Forstmann could see,
they could bid with the aid of a Goldman Sachs bridge loan,
which would be refinanced through the sale of junk bonds.
Forstmann cringed at the thought,
but Geoff Boisi [an investment banker with Goldman Sachs]
was pushing the idea hard.
All week Forstmann, at Boisi’s behest,
had suffered a crash course in junk bonds.
Half the time he couldn’t understand
what the young Goldman bankers were telling him.
“I’m speaking English, and it’s like they’re speaking Turkish,”
he complained.

But Forstmann understood enough to realize the risks such a loan entailed.
For each quarter Goldman couldn’t sell the bonds to refinance the loan,
the loan’s interest rate rose.
And rose.
If everything went well,
Forstmann could repay the load through RJR Nabisco’s cash flow.
But if for any reason Goldman couldn’t sell the bonds,
Forstmann Little was liable for the entire amount.
In effect, Forstmann was forced to bet the entire deal
on whether Goldman could unload the bonds,
a risky wager given the firm’s spotty track record.

Boisi was practically feverish, he wanted the bridge so bad.
He assured Forstmann it was safe.
There was no more than a one in a thousand chance
that Goldman couldn’t sell the bonds.

“Sure,” Forstmann said, “so write that in there,” meaning, in the contract.

“No, Teddy,” Boisi explained.
“We have to have the right to get out of this thing
in the event of an emergency.”

It was the worst part of a process with which
Forstmann had become increasingly uncomfortable.

In the end, it always came back to junk bonds.
They went round and round.
At one point, Boisi threw up his hands.

“What are you, a priest?” he asked Forstmann.
“Have you got some kind of religious conviction about this stuff?”

Forstmann tried to explain.
“Geoff, there’s no place to go.
I’m a fighter, but I just can’t do this stuff.”
He pulled a copy of the article he had written for The Wall Street Journal
and shook it at Boisi.
“I really believe this stuff, you know.”

They were in the thick of debate Tuesday afternoon
when [his partner] Brian Little took Forstmann aside.
“I think you and Nicky [Forstmann’s younger brother] and I ought to talk.”
The two men collared the younger Forstmann
and retreated to Little’s office.

The three partners knew their position was bleak.
The returns simply weren’t adequate unless they used junk bonds.
None of them wanted to do that.
But the simple truth was that, even if they had, they couldn’t.
Forstmann’s antijunk diatribes had painted them into a corner.
To go with a junk-bond-financed bridge loan at this point
would invite public ridicule.
“The reality is, it can’t be done without junk,” Little said.

Their mood was somber.
“I guess we should just end this,” [their attempt to buy RJR Nabisco],
Ted Forstmann said.

He broke the news to Boisi and his three corporate partners.
After the initial furor subsided,
he wrote out a long press release citing in detail
Forstmann Little’s reasons for backing out of the deal.
It amounted to an attack on the auction process and on junk bonds;
he planned to issue it the following morning.
That evening he called Peter Atkins
[the lawyer who guided the RJR Nabisco board
though its deliberations over the bidding process]
and read it to him.

Atkins immediately realized he couldn’t let Forstmann issue the release.
It sent the wrong message to junk-bond buyers
and to a banking industry already jittery about LBO debt
and the possibility of anti-LBO legislation.
With just three days until the bidding deadline,
this was no time to scare the banks.
Forstmann could bow out,
but Atkins simply couldn’t allow his departure
to hinder the two remaining bidders.

Forstmann stuck to his guns, insisting that he had to let the world know
he was bowing out on principle.
Frustrated, Atkins pulled Hugel from a Combustion Engineering board meeting.
“We have to get them to change this press release,” the lawyer said.
“It looks really bad.”

[Charles] Hugel
[chairman of the special committee of RJR Nabisco board members
that selected the winning bidder]
felt he had bent the rules
to allow Forstmann into the bidding in the first place,
and, like Atkins,
was embarrassed to find him withdrawing.
“Our horse was dying,” Hugel would say later.
“And,” Atkins added, “it was dying in public.”

Now Hugel himself locked horns with Forstmann.
For hours they argued about the release.
“I have to put it out,” Forstmann kept insisting.
Forstmann Little had a reputation to protect, he repeated.
Hugel laid down the gauntlet.
If Forstmann wouldn’t bend to persuasion, maybe blackmail would work.

“What if I put out my own press release?” Hugel suggested.
“What do you mean? What would it say?”
“It’ll say you acted in a hostile and unethical way.”
“You wouldn’t do that.”
“Try me,” Hugel said. “I guarantee it’ll be in the newspapers the next day.”

The next morning Forstmann Little & Co.
issued a terse, one-sentence press release,
bowing out of the bidding for RJR Nabisco
with nary a peep of explanation.

Theodore Forstmann’s
“Violating Our Rules of Prudence”

Violating Our Rules of Prudence
By Theodore J. Forstmann
Wall Street Journal Op-Ed, 1988-10-25

[Emphasis is added.]


Today’s financial age has become a period of unbridled excess with
accepted risk soaring out of proportion to possible rewards.
Every week, with ever-increasing levels of irresponsibility,
many billions of dollars in American assets are being saddled with
debt that has virtually no chance of being repaid.
Most of this is happening
for the short-term benefit of Wall Street’s
investment bankers, lawyers,
leveraged buyout firms and junk-bond dealers
at the long-term expense of Main Street’s
employees, communities, companies and investors.

[In the 2008 et seq. financial crisis
Wall Street, with the energetic and enthusiastic support of the main-stream media,
of course sidestepped the risk problem by
unloading the risk on the American taxpayer,
so “taxpayers” should be added to Forstmann’s list of Main Street victims.]

As an active acquirer of corporations,
I have had a ringside view of the market’s deterioration over the past decade.
My partners and I founded Forstmann Little & Co.,
one of the nation’s first leveraged-buyout firms, in 1978.
Since that time, without ever using junk securities,
we have acquired 14 companies for an aggregate price of almost $7 billion.
Ten of those companies subsequently have been sold.
All have proven successful.

Leveraged buyouts can provide high returns at low risks
if the right company is purchased at the right price and with real money.
Ten years ago [circa 1978],
acquisitions were limited to
a small group of leveraged-buyout specialists,
generally working with the mentalities of owners and
subject to the constraints of
prudently skeptical bank and subordinated debt lenders.
Acquisitions were made on the basis of modest growth projections and
with the expectation that
debt interest would be safely serviced and
the debt fully repaid in the near future.

Today [circa 1988], however,
the rules of prudent investing are being violated again and again.
The financial risk inherent in using leverage is being applied to companies,
such as those in the oil and lumber industries,
already burdened with commodity risk.
It is being applied
to single-product companies facing the risk of technological obsolescence,
to recession-sensitive concerns, and
to companies with low and vulnerable operating margins.
When high-quality candidates are found,
the prices paid are often so extreme that
even if projections are successfully met,
the companies cannot service their interest expense on a current basis
or repay their acquisition debt as it comes due.

Watching these deals get done is like watching
a herd of drunk drivers take to the highway on New Year’s Eve.
You cannot tell who will hit whom, but you know it is dangerous.

Too often, today’s “owner” is merely
an investment banker, with an agent’s mentality,
who is underwriting the acquisition’s junk bonds for fees,
or an LBO fund willing to risk a small amount of equity
under a mountain of high-yield debt
in return for its own fees.
Adam Smith’s quaint notion of
market prices set by buyers who care what price they pay
has been evaporated.

Of course, the bigger the deal, the bigger the fees.
The company at stake and its employees
often have all the importance of
an insignificant “post-closing adjustment.”
And the trusting lenders, strapped tightly into their coach cabin seats,
may one day wake up to a bump, look out the window
and see their smiling captain and crew waving to them from the ground below.

The ingredient that makes these overleveraged transactions possible is
the excessive use of junk securities:
the fake “wampum” of 1980s finance.
The steady breakdown of market discipline has occurred as
advances in wampum technology have multiplied.
Ten years ago [circa 1978],
the “high-yield bond” was
a socially productive corporate finance instrument of limited scope,
intended as a funding vehicle for young, growing companies.
Use of these securities was then extended to mergers and acquisitions,
and in the early stages this application was also constructive.

Pandora’s box opened, however,
when investment banks began to dream up new types of junk securities,
viewing buyouts and corporate acquisitions
as vehicles for high-margin agency business.
This emphasis on fees began
the decoupling of buyouts from buyers and
the generation of investment principals without investment principles
that threatens us today.

Fees, of course, are paid only when transactions are completed.
And so the participants had to invent
new types of securities designed solely for the purpose of getting deals done,
often at extreme risk.
First, cautious institutional lenders were replaced by
junk bonds bearing high interest rates
and paying underwriting fees of up to 3% to 5%.
(Traditional corporate quality-debt underwriting fees are less than 1%.)
Next, when even optimistic acquisition projections showed that
this debt principal could not be paid back,
loan-repayment schedules were lengthened so that problems could be deferred.

Next, when this proved insufficient,
the “zero-coupon” debenture was invented in which
interest payments were deferred and compounded for as long as five years.
Finally, when all of this wasn’t enough, PIK securities were invented.
PIK, which stands for “payment-in-kind,” is based on the notion that
when a borrower is too broke to pay his interest in cash,
he can “pay” by issuing an additional note,
which he also can’t afford to service.
This is the intellectual equivalent of
doubling your money by folding it in half.
But not to worry, for when the two notes come due,
the “buyer” expects to refinance the whole package
with new junk securities paying new fees and start the clock again.

If the roles of the junk bond issuer and underwriter can be explained by fees,
what motivates the buyers of these securities—
typically insurance companies, S&Ls and mutual funds set up for the purpose—
to leap into the abyss between risk and reward?
In return for only a few hundred basis points of higher yield,
these speculators take on virtually all of a transaction’s equity risks
with none of the corresponding rewards.
They forgo all significant covenant protection
and ignore all warnings of caveat emptor.
Boom-time optimism, not thoughtful credit analysis, is their guiding light.
And in a bankruptcy, their holdings will almost certainly be wiped out.

The argument is made that
such risk is justified by the low default rate of junk bonds to date.
But buyerless buyouts are a recent phenomenon,
and wampum (zero-coupons, PIKs, et al.)
let even a doomed acquisition avoid final sentence for several years.
Surely, when the history books are written,
the reason so many investors bought these bonds
will be the financial riddle of our age.

Lured by the promise of high fees,
the commercial banks have now also begun to leap.
The banks have traditionally protected themselves by
lending only at the most senior, or safest, level
of the acquisition’s capital structure
and by rarely lending more than 60% of the acquisition price.
This has started to change for the worse in recent months, however,
and commercial banks are now competing for their own junk-bond fees
by providing risky bridge loans.
Moreover, some acquisition prices have gotten so high that
even the bank’s fraction of the purchase price
exceeds the company’s true value.
Indeed, in one recent multibillion-dollar transaction,
the highest bid was so high
the bank portion of its financing
exceeded the seller’s original asking price for the whole company.

What can be done to solve this problem?
Legislation is not the answer because
it will create more problems than it cures.
Markets and their participants must correct their own inefficiencies.

Many Americans are concerned with the market’s massive excesses.
These people include
a significant number of leaders in the financial community who, to date,
have not been outspoken in their opposition.
In fact, the managing partner of a major investment banking firm
confided to me recently that
he was appalled by the current financing environment but that
“all of us have been somewhat corrupted by
the potential for short-term gain.”

The financial press may be able to help by accurate reporting.
It can report that
buying a company at too high a price is not “winning”;
investment profits are made by creating values after the company is acquired;
there is a large difference between fee income to a transaction’s agents
and capital income to a transaction’s investors.
It can investigate and report the investment returns of buyout firms
and can skeptically review these firms’ inflated claims
for their companies that later prove unsalable.

In any case, a return to market discipline is inevitable.
Financial history has witnessed a thousand booms and busts.
Within recent memory, we have seen
the junk equities of the 60s,
the heated Third World lending of the 70s, and
the thrift crisis of the 80s.
These problems of the recent past pale in scope next to
the pervasiveness and total dollars involved in the current craze.
If the participants in this craze awaken now,
the correction may still be within tolerable limits for the country.
If not,

all of America will pay the penalty,
the debt is huge and widely held
the banking structure’s integrity would be at stake.

[So wrote Theodore Forstmann in October 1988.]

Simon Johnson’s “The Quiet Coup”

The Quiet Coup
by Simon Johnson
The Atlantic, May 2009

The crash has laid bare many unpleasant truths about the United States.
One of the most alarming,
says a former chief economist of the International Monetary Fund,
is that
the finance industry has effectively captured our government—
a state of affairs that more typically describes emerging markets,
and is at the center of many emerging-market crises.
If the IMF’s staff could speak freely about the U.S.,
it would tell us what it tells all countries in this situation:
recovery will fail
we break the financial oligarchy that is blocking essential reform.

And if we are to prevent a true depression,
we’re running out of time.

[For the (14 page) body of the article, follow the link above.]

Stewart's Den of Thieves

Here is a passage from a book published in 1992,
James B. Stewart’s Den of Thieves:

[page 404]
[Bruce] Baird was imediately struck by
the similarities between the insider-trading investigations
and the Mafia cases he’d worked on.
Like organized crime, the Wall Street suspects prized silence and loyalty
over any duty to tell the truth and root out corruption.
He assumed that a Goldman Sachs partner, for example, would go to jail
rather than implicate another partner at the firm.
Also, as in organized crime investigations,
there were numerous interlocking cases,
and not enough investigators to pursue all the leads.

William D. Cohan’s House of Cards

Here are some excerpts from William D. Cohan’s House of Cards.

[pages 19–20]
The number of put options sold on Monday [2008-03-10]—
short term bets made by investors that Bear’s stock would decline quickly—
rose to 158,599, some seven times the twenty-day average,
with the bets that the stock would fall outnumbering by 2.6 times
those that it would rise.

More startling, though,
was what bets investors were actually making.
The most active contract sold on March 10
gave investors the right but not the obligation
to sell Bear Stearns stock for $30 a share
anytime before the options expired on March 21, in eight trading days.
In other words, for the buyers of these puts to make money,
Bear’s stock, which closed at $62.30 on Monday,
would have to fall a stunning 52 percent in eight sessions.

Equally as startling as these bets was the fact that
some investors wanted to make even more of them.
On and around March 10,
requests poured into the Chicago Board of Options
to open up additional put options for Bear Stearns.
The CBOE, where options are traded, has guidelines to determine
when to open up a series of options
and usually avoids doing so
if the strike price is either way in or way out of the money.
But in this case, investors demanded that the CBOE make available
a new March series of puts with an exercise price of $25 per share—
a bet that the price of Bear’s stock
would fall below $25 in seven trading sessions—
and a new April series with strike prices of $20 and $22.50.
The CBOE agreed to accommodate the demand
and opened up the new options for trading the next day,
but will not say who asked that the new series be opened.
These were major negative bets on Bear’s short and immediate-term prospects.
Where were all these large and seemingly highly improbable bets coming from?
Nobody seemed to know for sure.

[As events played out, the following Sunday, March 16,
Bear Stearns entered into a forced merger with JPMorgan Chase,
which valued its stock at only $2 per share.
Vehement protest from Bear’s shareholders
and some sloppy drafting of that initial agreement
finally pushed the sell price up to $10 per share,
still well below those strike prices of $30, etc.
Obviously, those who purchased those seemingly highly speculative puts
made out like bandits.]

[page 187]
All of these events [in the late 1970s] conspired together
to make [Bear Stearns chairman Cy] Lewis a broken man.
What happened to Lewis was all of a piece
with what was happening at other predominantly Jewish Wall Street firms
after World War II.
A force of nature—whether it was
Cy Lewis at Bear Stearns,
Gus Levy at Goldman Sachs, or
André Meyer at Lazard
maneuvered to the top of a firm and succeeded beyond his wildest dreams.
These men had everything they could have ever wanted.
But in their successful climb,
they lost the ability to help others get to the top.
They wanted to be King of the Hill forever.
“That doesn’t work in nature and that doesn’t work on Wall Street,”
[Cy Lewis’s son] Sandy Lewis said.
“So as they get weaker, they get tougher.
On the way up, they gather friends, they gather momentum,
and they gather power.
But when they get to the top and they realize they can’t go on forever,
there is only one way to go, and that is down.”

[pages 206–7]
[Helpful tips about how the rich became rich.]

In [April 1986] ...
[Bear Stearns chairman Alan [Ace]] Greenberg’s memo writing
was positively manic
and focused almost exclusively on his favorite theme,
reducing expenses.
He even bemoaned
the firm’s increasing cost of using Scotch tape on the interoffice envelopes.
“From this day on,” he wrote on April 18,
“instruct your secretary to lick only the left side of the flap
when sending the envelope.
The reason for this will amaze you,
and make you wonder why you didn’t think of this yourself.
If the envelope is gently opened by the recipient,
it can be used again and sealed, without using scotch tape,
by your secretary licking the right side of the flap and then sealing it.
After all of us have become accustomed to accurate and precise licking,
a further extension of this will be to lick only the left third,
and then the middle for the next trip,
and the right side for the penultimate voyage.
If one has a small tongue and good coordination,
an envelope could be opened and resealed ten times.”

Accurate! Precise!
Anyone needing further instruction
should consult the departmental secretary, Ms. U. Lickem,
who will be happy to evaluate your technique and provide guidance as needed.]

[page 450]
[This quotation, from Bear Stearns’ last chairman Alan Schwartz,
is the very last text in the book.]

“I’m sure we’ll figure out
how to prevent something like this from happening again.
Wall Street is always good at fighting the last war.
But these things happen and they’re big,
and when they happen
everybody tries to look at what happened in the previous six months
to find someone or something to blame it on.
But, in truth, it was a team effort.
We all fucked up.
Government. Rating agencies. Wall Street.
Commercial banks. Regulators. Investors.

Michael Lewis’s The Big Short

[Here is an excerpt from Michael Lewis’s 2010 book The Big Short.
This is from the epilogue, “Everything Is Correlated.”
Emphasis has been added, and the SI notation is used for large numbers.
Thus, for example,

$700 billion = $700G = 700 G$


The public lynching [in the 1980s] of Michael Milken,
and then of Salomon Brothers CEO John Gutfreund,
were excuses for not dealing with
the disturbing forces underpinning their rise.

The changes [that were made] were camouflage.
They helped to distract outsiders from the truly profane event:
the growing misalignment of interests between
the people who trafficked in financial risk and the wider culture.


[Michael Lewis and John Gutfreund met for lunch in September 2008,
at the peak of the financial crisis.
The following interweaves Lewis’s summary of the discussion at that lunch
with some general thoughts of his on the causes of the crisis.]

We agreed that the Wall Street CEO had no real ability
to keep track of the frantic innovation occurring inside his firm.
(“I didn’t understand all the product lines and they don’t either.”)

We agreed, further, that the CEO of the Wall Street investment bank
had shockingly little control over his subordinates.
(“They’re buttering you up and then doing whatever the fuck they want to do.”)
[The answer to that is that
the Wall Street CEO gets to decide who those subordinates are,
and to set the priorities for the firm.
Further he can set up control mechanisms
to ensure that those priorities are followed.
For example, he can determine the power and sophistication
of his companies risk management department.]

He thought the cause of the financial crisis was “simple.
Greed on both sides—greed of investors and the greed of the bankers.”
[A point I raised in October 2008.]
I thought it was more complicated.
Greed on Wall Street was a given—almost an obligation.
[Not so.
The members of the old WASP ruling class,
whose intelligence Jews have had so much fun deriding (e.g.),
in fact were brought up with an obligation of service to the nation as a whole
(“noblesse oblige”),
an obligation which all too frequently is absent from the new “meritocracy,”
with its common emphasis on a global outlook.]

The problem was the system of incentives that channeled the greed.

The line between gambling and investing is artificial and thin.
The soundest investment has the defining trait of a bet
(you losing all of your money in hopes of making a bit more),
and the wildest speculation has the salient characteristic of an investment
(you might get your money back with interest).
Maybe the best definition of “investing” is
“gambling with the odds in your favor.”
The people one the short side of the subprime mortgage market
had gambled with the odds in their favor.
The people on the other side—the entire financial system, essentially—
had gambled with the odds against them.
Up this point, the story of the big short could not be simpler.
What’s strange and complicated about it, however, is that
pretty much all the important people on both sides of the gamble
left the table rich.
The CEOs of every major Wall Street firm were on the wrong end of the gamble.
All of them, without exception,
either ran their public corporations into bankruptcy
or were saved from bankruptcy by the United States government.
They all got rich, too.

What are the odds that people will make smart decisions about money
if they don’t need to make smart decisions—
if they can get rich making dumb decisions?
The incentives on Wall Street were all wrong; they’re still all wrong.

[Lewis] thought you could trace
the biggest financial crisis in the history of the world
back to a decision [Gutfreund] had made.
John Gutfreund had done violence to the Wall Street social order—
and got himself dubbed the King of Wall Street—
when, in 1981, he’d turned Salomon Brothers from a private partnership
into Wall Street’s first public corporation.
He’d ignored the outrage of Salomon’s retired partners.
(“I was disgusted by his materialism,” William Salomon,
the son of one of the firm’s founders,
who had made Gutfreund CEO only after he’d promised never to sell the firm,
had told me.)
He’d lifted a giant middle finger in the direction of
the moral disapproval of his fellow Wall Street CEOs.
And he’d seized the day.
He and the other partners not only made a quick killing;
they transferred the ultimate financial risk
from themselves to their shareholders.
It didn’t, in the end, make a great deal of sense for the shareholders.
(One share of Salomon Brothers, purchased in 1986,
at a then market price of $42,
would be worth 2.26 shares of Citigroup today,
which, on the first day of trading in 2010,
had a combined market value of $7.48.)
But it made fantastic sense for the bond traders.

But from that moment, the Wall Street firm became a black box.
The shareholders who financed the risk taking
had no real understanding of what the risk takers were doing,
and, as the risk taking grew ever more complex,
their understanding diminished.
All that was clear was that

the profits to be had from smart people making complicated bets
overwhelmed anything that could be had
from servicing customers,
or allocating capital to productive enterprise.

The customers became, oddly, beside the point.

The moment Salomon Brothers demonstrated the potential gains to be had
from turning an investment bank into a public corporation
and leveraging its balance sheet with exotic risks,
the psychological foundations of Wall Street
shifted, from trust to blind faith.
No investment bank owned by its employees would have leveraged itself 35:1,
or bought and held $50G in mezzanine CDOs.
I doubt any partnership would have sought to game the rating agencies,
or leapt into bed with load sharks,
or even allowed mezzanine CDOs to be sold to its customers.
The short-term expected gain would not have justified
the long-term expected loss.


[J]ust weeks after receiving its first $25G taxpayer investment,
Citigroup returned to the Treasury to confess that—lo!—
the markets still didn’t trust Citigroup to survive.
In response, on November 24 [2008],
the Treasury granted another $20G from TARP
and simply guaranteed $306G of Citigroup’s assets.
Treasury didn’t ask for a piece of the action, or management changes,
or for that matter anything at all
except for a teaspoon of out-of-the-money warrants and preferred stock.
The $306G guarantee—nearly 2 percent of U.S. gross domestic product,
and roughly the combined budgets of the departments of
Agriculture, Education, Energy,
Homeland Security, Housing and Urban Development, and Transportation—
was presented undisguised, as a gift.
The Treasury didn’t ever actually get around to explaining what the crisis was,
just that the action was taken in response to
Citigroup’s “declining stock price.”

By then it was clear that
$700G was a sum insufficient to grapple with
the troubled assets acquired over the previous few years
by Wall Street bond traders.
That’s when the U.S. Federal Reserve took
the shocking and unprecedented step of
buying bad subprime mortgage bonds directly from the banks.
By early 2009 the risks and losses associated with
more than a trillion dollars’ worth of bad investments
were transferred from big Wall Street firms to the U.S. taxpayer.
Henry Paulson and Timothy Geithner both claimed that
the chaos and panic caused by the failure of Lehman Brothers
proved to them that
the system could not tolerate the chaotic failure of another big financial firm.
They further claimed, albeit not until months after the fact,
that they had lacked the legal authority
to wind down giant financial firms in an orderly manner—
that is, to put a bankrupt bank out of business.
Yet even a year later they would have done very little to acquire that power.
This was curious, as they obviously weren’t shy about asking for power.

The events on Wall Street in 2008 were soon reframed,
not just by Wall Street leaders
but also by both the U.S. Treasury and the Federal Reserve, as
a “crisis in confidence.”
A simple old-fashioned panic, triggered by the failure of Lehman Brothers.
By August 2009 the president of Goldman Sachs, Gary Cohn,
even claimed, publicly, that
Goldman Sachs had never actually needed government help,
as Goldman had been strong enough to withstand any temporary panic.
But there’s a difference between an old-fashioned financial panic
and what happened on Wall Street in 2008.
In an old-fashioned panic, perception creates its own reality:
Someone shouts “Fire!” in a crowded theater
and the audience crushes each other to death in its rush for the exits.
On Wall Street in 2008 the reality finally overwhelmed perceptions:
A crowded theater burned down with a lot of people still in their seats.
Every major firm on Wall Street was either bankrupt
or fatally intertwined with a bankrupt system.
The problem wasn’t that Lehman Brothers had been allowed to fail.
The problem as that Lehman Brothers had been allowed to succeed.

This new regime—
free money for capitalists, free markets for everyone else—
plus the more or less instant rewriting of financial history
vexed all sorts of people,
but few were
as enthusiastically vexed
as Steve Eisman
[one of the protagonists
of Lewis’s book]
The world’s most powerful and most highly paid financiers
had been entirely discredited;
without government intervention
every single one of them would have lost his job;
and yet those same financiers were using the government to enrich themselves.
“I can understand why Goldman Sachs would want to be included in
the conversation about what to do about Wall Street,” he said.
“What I can’t understand is why anyone would listen to them.”
In Eisman’s view,
the unwillingness of the U.S. government to allow the bankers to fail
was less a solution than a symptom of
a still deeply dysfunctional financial system.
The problem wasn’t that the banks were, in and of themselves,
critical to the success of the U.S. economy.
The problem, he felt certain, was that

some gargantuan, unknown dollar amount of credit default swaps
had been bought and sold on every one of them.
“There’s no limit to the risk in the market,” he said.
“A bank with a market capitalization of $1G
might have $1T worth of credit default swaps outstanding.
No one knows how many there are!
And no one knows where they are!”

The failure of, say, Citigroup, might be economically tolerable.
It would trigger loses to Citigroup’s shareholders, bondholders, and employees—
but the sums involved were known to all.
Citigroup’s failure, however,
would also trigger the payoff of a massive bet of unknown dimensions:
from people who had sold credit default swaps on Citigroup
to those who had bought them.

This was yet another consequence of
turning Wall Street partnerships into public corporations:
It turned them into objects of speculation.
It was no longer the social and economic relevance of a bank
that rendered it too big to fail,
the number of side bets that had been made upon it.

At some point I could not help but ask John Gutfreund
about his biggest and most fateful act:
Combing through the rubble of the avalanche,
the decision to turn
the [Salomon Brothers] Wall Street partnership
into a public corporation
looked a lot like the first pebble kicked off the top of the hill.
“Yes,” he said.
“”They—the heads of the other Wall Street firms—
all said what an awful thing it was to go public
and how could you do such a thing.
But when the temptation arose, they all gave in to it.”
He agreed, though:
The main effect of turning a partnership into a corporation
was to
transfer the financial risk to the shareholders.

“When things go wrong, it’s their problem,” he said—
and obviously not theirs alone.
When the Wall Street investment bank screwed up badly enough,
its risks became the problem of the United States government.
“It’s laissez-faire until you get in deep shit,”
he said, with a half chuckle.

[That’s the last part of the book of general interest.
The remaining half page consists of
personal anecdotes involving Lewis and Gutfreund.]

Michael Lewis’s “Shorting Reform”

Shorting Reform
New York Times Op-Ed, 2010-05-30

To: Wall Street chief executives

From: Your man in Washington

Re: Embracing the status quo

Our earnings are robust,
our compensation has returned to its naturally high levels
and, as a result,
we have very nearly regained our grip on the imaginations of
the most ambitious students at the finest universities —
and from that single fact many desirable outcomes follow.

Thus, we have almost fully recovered from
what we have agreed to call The Great Misfortune.
In the next few weeks, however,
ill-informed senators will meet with ill-paid representatives
to reconcile their ill-conceived financial reform bills.
This process cannot and should not be stopped.
The American people require at least the illusion of change.
But it can be rendered harmless to our interests.

To this point, we have succeeded in keeping the public focused on
the single issue that will have very little effect on how we do business:
the quest to prevent taxpayer money from ever again being used to
(as they put it) “bail out Wall Street.”

As we know, we never needed their money in the first place,
and by the time we need it again, we’ll be long gone.
If we can keep the public, and its putative representatives,
fixated on the question of
whether their bill does, or does not, ensure there will be no more bailouts,
we may entirely avoid a discussion of our relationship to the broader society.

Working together as a team

we have already suppressed debate on many dangerous ideas:
that those of us deemed too big to fail
are too big and should be broken up,

for instance, or
that credit default swaps and collateralized debt obligations
and other financial inventions
should simply be banned.

We are now at leisure to address the few remaining threats to our way of life.
To wit:

1. Washington will attempt to limit our ability to exploit the idiocy of institutional investors a k a our “customers.”
The Senate appears intent on
forcing our most lucrative derivatives business onto open exchanges,
where investors can, for the first time, observe the prices we give them.
This measure — which I’ve come to call
the “Making the World Safe for Germans With Money Act” —
will prove difficult to defeat.
Our public strategy here, as elsewhere, must be to complicate the issue.

To the mere mention of open, public exchanges for derivatives,
you should always respond,
“That will destroy liquidity in these fragile and complex markets.”
Most people don’t even know what “liquidity” means,
or what causes it or why they actually need to have more rather than less of it —
or what, even, the point is of a market that requires privacy to operate.
They will assume that you must understand it better than they do.
For that reason alone it is useful.

The other point you should make to our elected officials
(privately, please) is that
our profits function as a fixed point in an uncertain universe.
If they curtail our ability to shaft German investors in one way,
we will simply find some other way to do it.

Shockingly, the Senate version of the bill more or less
would require us to cease to trade derivatives entirely.
This unpleasant idea was introduced by Senator Blanche Lincoln of Arkansas,
and it leads me to a point that is worth underscoring:
We do not have a problem with the American people,
we have a problem with American women.
Elizabeth Warren, our TARP supervisor,
continues to ask questions about what we did with our government money;
Mary Schapiro has used her authority at the S.E.C. to sue Goldman Sachs.
Of the four Republican senators who crossed over to vote with the Democrats,
two were women — and one of the guys posed naked for Cosmopolitan magazine.

Going forward, we should discourage women from seeking higher office —
or indeed, any position in which they might exert influence over our activities.
More immediately, in your private conversations
with Larry Summers, Tim Geithner and male Republican senators,
you should simply refer to Blanche Lincoln as “unhinged.”
They’ll get it.

2. Our slow cousins at Moody’s and Standard & Poor’s
are likely to suffer a blow to their already lowly status.
They are virtually certain to be stripped of their designation as
Nationally Recognized Statistical Ratings Organizations.
Whatever that means, it presents no threat to our way of life.
Just the reverse: the more miserable it is to work at Moody’s,
the less capable (and more manipulable) Moody’s employees will be.

The lone remaining risk to the status quo is the Franken amendment —
introduced by Senator Al Franken of Minnesota —
which would prevent us from personally selecting
the ratings agencies that offer opinions on our offerings.
It creates a board inside the Securities and Exchange Commission
to assign ratings agencies,
thereby removing the direct incentive the raters have to please us.
(Of course, it preserves their indirect incentive:
that is, that we might one day offer them jobs.)

The Franken amendment thus gums up what has been heretofore
a very cleanly rigged system.
In addition to encouraging public references to Stuart Smalley

and Mr. Franken’s other theatrical embarrassments,
we should remind our friends on Capitol Hill and in the press that
the Franken amendment will give the federal government
the same control over finance it has seized in health care.”

3. There is a slight, but real, risk that
public opinion will yank us in some unexpected direction.
Over the past few months, a curious pattern has emerged:
the more open the debate, the more radical the outcome.

In private, reasonable discussions
we were able to persuade our friends in the Senate
to prevent votes on amendments hostile to our interests —
the worst of which, I might add, was dreamed up by yet another female senator.
But the minute a vote was held, and senators sensed the cameras watching,
even our friends abandoned us to the mob.
All of these people are continually engaged in the same mental calculation:
are the votes I might gain with this remark or this idea or this position
greater than
the votes I can buy with the money given to me by Wall Street firms?
With each uptick in the level of public scrutiny —
with every minute of televised debate — our money means less.

In the short term,
we must do whatever we can to dissuade Representative Barney Frank
from allowing any part of
these discussions between senators and representatives
to be televised.
In the longer term we must return to the shadows.
Do your work in private; allow your money to speak for you; and remember,
the only way we’ll get the financial reform we need is if we pay for it.
No one else can afford it.

[The emphasis and, needless to say, the photo
were added by the author of the current blog.]

Roubini and Mihm’s Crisis Economics

Here is a very brief excerpt from the 2010 book
Crisis Economics: A Crash Course in the Future of Finance
by Noriel Roubini and Stephen Mihm.
The emphasis is added.

Chapter 8
First Steps

Section 8.1
Curing Compensation

In recent years, the financial services industry—and compensation within it—has undergone exorbitant and utterly unwarranted growth, driven by financial liberalization, financial innovation, elimination of capital controls, and the globalization of finance.

In the process, finance’s “contribution” —if that’s the word—
to the U.S. gross domestic product has soared
from 2.5 percent in 1947
to 4.4 percent in 1977
to 7.7 percent in 2005.
By that time financial firms accounted for upwards of 40 percent
of the earnings of the companies listed in the S&P 500,
and these firms’ share of the total S&P 500 market capitalization
doubled to approximately 25 percent.
Even more startling,
the combined income of the nation’s top twenty-five hedge fund managers
exceeded the compensation of the combined income of the CEOs
of all companies listed in the S&P 500.
In 2008
no less than one in every thirteen dollars in compensation in the United States
went to people working in finance.
By contrast, after World War II
a mere one in forty dollars in compensation went to finance workers.

This outsize and excessive growth of the financial system did little to create any “added value” for investors.
While many hedge funds, investment banks, private equity funds, and other asset managers claimed that they could provide investors with superior “alpha” returns
(in other words, bigger returns than those provided by more traditional asset managers),
“schmalpha,” not “alpha,” became the norm.
These high-flying asset managers often got higher returns, but investors saw little of it, because the managers charged higher fees for their allegedly superior services.

The various players in the financial system parted investors from their money in other ways too.
Take securitization: at every step of the process, someone—a mortgage broker, an originating bank, a home appraiser, a broker dealer, a bond insurer, a ratings agency—charged high fees for its “services” and transferred the credit risk down the chain.
But it was an oligopoly of investment banks that profited the most from this arrangement, exploiting the lack of transparency about these operations to extract profits from credulous investors, most of which ended up in the pockets of these firms’ employees rther than those of the shareholders of the firms.

The cancerous growth of finance has arguably had significant social costs too, as innovation and creativity have fled from manufacturing and other old-fashioned industries in favor of Wall Street.
Indeed, since the 1970s, as our colleague Thomas Philippon has revealed, finance has attracted an ever-growing number of intelligent, highly educated workers.
As compensation soared, graduates of elite schools increasingly went to Wall Street.
In fact, among Harvard seniors surveyed in 2007, a whopping 58 percent of the men joining the workforce were bound for jobs in finance or consulting.
In a curious paradox, the United States now has too many financial engineers and not enough mechanical or computer engineers.

Not coincidentally, the last time the United States saw comparable growth in the financial sector was in the years leading up to … 1929.
In the 1930s, compensation in the financial sector plummeted, a victim of regulatory crackdowns that made banking a boring, if more respectable, profession.
Reforming today’s warped compensation structure is a necessary first step toward making banking boring once again.

[Cf. Thomas Philippon, Ariell Reshef:
“Wages and Human Capital in the U.S. Financial Industry: 1909-2006”,
“Skill Biased Financial Development:
Education, Wages and Occupations in the U.S. Financial Sector”

Miscellaneous Articles


Huge Profit at Goldman Brings Big Bonuses
New York Times, 2006-12-12

[This is the preliminary Web version of
the published article “Visions of Bonus Heaven in Goldman Sachs Profit” below.]

The Goldman Sachs Group reported today that
it earned $9.34 billion this year,
the most in Wall Street history, and that
it would set aside
$16.5 billion for salaries, bonuses and benefits for employees.

That figure works out to an average of $622,000 for each employee,
although the payouts will be far from uniform:
the investment bankers at Goldman
who arrange mergers and acquisitions or sell corporate stock to investors
will receive much more,
and support staff and other kinds of employees much less.

In the company’s fourth fiscal quarter, which ended Nov. 24,
profits increased 93 percent over the year before,
to $3.16 billion, or $6.59 a share,
exceeding the forecasts of most analysts.

Most other major Wall Street investment banks
will report their results later this week or next week,
and analysts expect robust figures across the industry.

The bonuses at Goldman, the leading merger advisor in the industry,
and elsewhere on Wall Street
are expected to give the New York area’s economy a substantial boost,
particularly in sales of high-end residential real estate,
luxury cars and other pricey goods.
“When these guys learn what their bonuses are,
we are among the first people they call,”
said Pamela Liebman,
the chief executive of the Corcoran Group, a residential brokerage.
“They call their mothers, and then their real estate brokers.”

Ms. Liebman said that investment bankers “work hard and want to live well,”
and that they are usually interested in buying
a luxury apartment in Manhattan or
a second or third residence elsewhere.

She said her agency is already getting calls
in advance of the bonus announcements this year,
and that the interest is not limited to the top executives of Wall Street firms.
“Even the junior guys want to spend their bonuses on residential real estate.”

Two years ago, BMW of Manhattan opened a showroom at 67 Wall Street,
so that investment bankers would not have to take the time to travel uptown
to its main sales and service operation at 57th Street and 11th Avenue.

At the time, Jeffrey A. Falk, the president of the dealership,
said the intention was to get physically closer to potential customers.

“This is part of a strategy we have been developing over the past two years
to make it more convenient for our demographic.”

Speaking today, he said there has been an increased level of
what he called “pre-shopping” at the Wall Street showroom,
based on anticipated bonuses.

“They are shopping now,
and talking to salesmen based on what they think their bonus will be,”
Mr. Falk said.
“Then in January and February, we’ll get the orders.”

Spouses and the high-end retailers that cater to them
feel the effect of the bonus payment,
said Faith H. Consolo, vice chair of Prudential Douglas Elliman,
a commercial brokerage.

“The luxury market is very dramatically affected by bonuses,”
Ms. Consolo said.
“We are talking
furs, jewelry, apparel and beauty items like $250 jars of face cream.
Anything that makes them look good or feel good.”

Luxury spas are likely to see an influx of business as well, she side [sic: said],
as executives use part of their bonuses to send their spouses on spa vacations.

2006 is the third consecutive year of record-breaking earnings for Goldman,
which is the world’s largest securities company
as measured by the total market value of its stock.
And the company appears positioned to continue growing
in its crucial investment banking business.

The company said its backlog of merger and underwriting deals
was larger at the end of November than it was at the end of August.

Rising stock prices generally,
an active market in fee-generating business deals and
gains on investments, many of them in Asia,
are expected to make this year exceptionally profitable
for many other Wall Street companies as well.

Visions of Bonus Heaven in Goldman Sachs Profit
New York Times, 2006-12-13

[This is the as-published version of the preliminary report
Huge Profit at Goldman Brings Big Bonuses” above,
which goes more into
the luxury goods on which the bonuses will be spent.]

Money is not supposed to grow on trees.
Unless you happen to work at Goldman Sachs.

The investment bank reported earnings yesterday
that left jaws agape on Wall Street.
Quarterly profits soared 93 percent.
The bank earned nearly as much per share in 2006
as it had in the last two years combined,
both of which were also record years.

Immediately after the results were released, they were labeled
the best ever by an American investment bank.

The figures were certainly good news
to the scores of Goldman bankers and traders
who will find out, starting today, what their bonuses will be.
Chances are good they will be impressive:
the bank is paying $16.5 billion in compensation this year, or
roughly $623,418 for every employee.

Wealth on Wall Street is not distributed evenly, of course.
Rainmakers in investment banking
can expect to see $20 million to $25 million each
while traders who booked big profits
will take home a chunk of those profits, up to $50 million apiece,

according to senior executives at leading Wall Street banks.
[See “Goldman Chairman Gets a Bonus of $53.4 Million”.]

“Anyone at the bonus line at Goldman Sachs died and went to bonus heaven,”
said Michael Holland, chairman of Holland & Company,
a New York-based investment firm.
“It doesn’t get any better than this.”

The bonuses at Goldman, the leading merger adviser in the industry,
and elsewhere on Wall Street
(Lehman Brothers and Bear Stearns report earnings later this week,
and their earnings are expected to be robust as well)
are expected to give the New York area’s economy a substantial boost,
particularly in sales of
high-end residential real estate, luxury cars and other pricey goods.

“When these guys learn what their bonuses are,
we are among the first people they call,”
said Pamela Liebman,
the chief executive of the Corcoran Group, a residential brokerage.
“They call their mothers, and then their real estate brokers.”


Investment banking earnings are often proxies for
the health of the American and global economy.

[I don’t think many economists who are not in the pay of Wall Street
would agree with that.]

And conditions have been ripe for Goldman and its competitors
to mint money.

[The reality is that they were, and are, a kleptocracy,
skimming vast sums from the financial system
which they did little of real value to merit.
Wall Street did not “mint money”;
it took for itself, in an orgy of greed,
money meant for investment,
not enriching the lifestyles and wealth
of investment bankers.]

Stock markets have been on a tear for months,
while credit markets — far bigger than the equity markets —
have continued to be robust.
Credit derivatives continue to grow at a geometric pace,
with $27 trillion outstanding.

Opportunities abound to
invest in companies, trade securities or advise clients
in markets around the world, including China, Russia and the Middle East.

Private equity firms continue to buy increasingly large companies —
witness the Blackstone Group’s $36 billion acquisition of
Equity Office Properties Trust,
the nation’s largest office-building owner and manager,
a deal Goldman advised on.
And hedge funds,
which account for 40 to 80 percent of trading in certain markets,
represent significant profit-making potential for Wall Street —
and, of course, for Wall Street’s persistent leader.

For the year, Goldman produced
record revenue of $37.7 billion and
a record profit of $9.5 billion, or $19.69 a share.

In the fourth quarter,
the bank earned $3.15 billion, or $6.59 a share,
on revenue of $9.41 billion.
Investment banking revenue climbed 42 percent, to $1.3 billion,
and trading and principal investments rose 57 percent, to $6.6 billion.

Even David Viniar, Goldman Sach’s cautious chief financial officer,
sounded vaguely optimistic.

“Our economists’ view is that
we will continue to have good economic growth,
somewhat slower in the U.S.,
somewhat better in Europe and
very good in Asia,”
Mr. Viniar said.
“our business tends to be tied to economic growth more than anything else.”

Fueling Mr. Viniar’s optimism is
the breadth of Goldman’s business as well as
the number of deals the bank has in the pipeline, the so-called backlog.
That pipeline is more robust than it has been at any point since 2000,
Mr. Viniar said.

Like many universal and investment banks,
Goldman Sachs has transformed its business to capitalize on
sea changes in the capital markets,
particularly new opportunities in far-flung markets and
a shift from issuing and trading plain-vanilla stocks and bonds
to building and trading complex derivative products.

That shift is apparent in the makeup of Goldman’s revenue.

In 1997,
investment banking and trading and principal investments
produced roughly the same revenue
($2.6 billion and $2.9 billion, respectively),
for total net revenue of $7.4 billion.

In 2006,
investment banking earned $5.6 billion while
trading and principal investments produced $25.6 billion
almost 70 percent of the total $37.7 billion in net revenue.

Goldman derives significant profits from acting as an investor,
deploying the firm’s capital to buy and sell companies.
In the second quarter,
the bank spent $2.6 billion for a 5 percent stake in
the Industrial and Commercial Bank of China, China’s largest state-owned bank
($1.6 billion came from Goldman Sachs’s private equity funds
and the remainder was financed off Goldman’s balance sheet).
When the giant Chinese bank went public in October
in the largest initial public offering ever,
Goldman’s stake soared in value.
For the fourth quarter,
Goldman earned $949 million in profits from the investment.

It made another half a billion dollars on the sale of the Accordia Golf Company,
a portfolio of Japanese golf courses that Goldman began to acquire in 2001.

Investors seemed to question whether the good times could continue.
Goldman’s stock traded down $2.52, or 1.2 percent, to $200.
“The stock being down almost shows they are victims of their own success,”
said Jeffrey Harte, a securities industry analyst at Sandler O’Neill.
“Ninety-seven percent year-on-year earnings growth is spectacular,”
referring to earnings per share.

Goldman’s returns do not come without significant risk.
Banks use “value at risk” to calibrate
how much money they could potentially lose in particular trading strategies
over a set period of time.
Goldman’s average value at risk soared 33 percent in the fourth quarter,
to $106 million this year from $80 million at the end of November 2005.
For the year, value at risk totaled $101 million,
compared with $70 million in 2005.

And yet
Goldman’s size seems to insulate it from downturns
in some of its businesses.
For example,
the firm has aggressively developed internal hedge funds for wealthy investors,
which generate high fees for Goldman.
The bank’s flagship hedge fund, Global Alpha,
is down more than 11 percent from a year,
a drastic change from 2005
when the fund returned more than 40 percent after fees.
The impact of the fund’s poor performance will be booked in January,
but fees from smaller accounts that match the strategies of Global Alpha
were down 78 percent in the fourth quarter, to $23 million.

Mr. Viniar acknowledged that
the fund’s returns would adversely impact first quarter earnings
but expressed optimism about the growth of the hedge fund industry.

“The hedge fund asset class is a growing asset class,” he said.
“It is one that is sensible.
It is one that a lot of people with money to invest are interested in.
It will continue to grow at a reasonable pace moving forward.”

His unusual optimism did not completely outweigh his characteristic caution,
Asked about the quality of deals in the backlog,
Mr. Viniar was quick to point out,
“Conditions in the capital markets can change quickly
and no backlog is ever guaranteed.”

John Holusha contributed reporting.


Wages and bonuses in investment banking (PDF)
Summary 07-07,
Bureau of Labor Statistics, U.S. Department of Labor, August 2007

[This is a short (one and a half pages) but most informative and interesting report
with a most informative graph and table presenting the numbers.
Its lead paragraph:]

For people working in investment banking,
especially those in and around Wall Street,
it’s hard to deny that late 2005 and early 2006
was very, very good to them.
With steady employment totals,
very handsome bonuses being handed out in fourth quarter 2005,
and even larger ones awarded in first quarter 2006,
it would seem to be an understatement
to say that investment banking was thriving.
In first quarter 2006,
private sector investment banking and securities dealing
recorded average weekly wages of $8,367 [$435K/year],
well above that of any industry with the exception of
the other Wall Street bonus giant, securities brokerage.
The investment banking industry’s quarterly total wages
ranged from $6 billion to $18.9 billion in late 2005 and early 2006
the industry’s average weekly wage was nearly 10 times the national average.

Pay at Investment Banks Eclipses All Private Jobs
New York Times, 2007-09-01
(Note also the graphic showing
investment banker weekly wages in ten counties;
the data in the graphic is contained in
a table on the second page of the BLS report.)

[The relevant part of the article; emphasis is added.]


Top money managers earn such huge incomes that
even when their compensation is mixed with
the much lower pay of clerks, secretaries and others,
the average pay in investment banking is
10 times that of all private sector jobs,

new government data shows.

Investment banking paid an average weekly wage of $8,367 [$435K/year],
compared with $841 per week [$44K/year] for all private sector jobs,
the Bureau of Labor Statistics said in a routine report issued Thursday.

The report also showed
how far ahead hedge fund managers are of other investment bankers
in making money.

In Fairfield County, Conn., home to many hedge funds,
the average pay was $23,846 a week [$1.24M/year].
In Manhattan, with a much broader mix of investment banking firms
and seven times the number of employees,
pay was much less,
averaging $16,849 a week [$876K/year] in the first quarter of 2006.
[Is 70% “much less”?]

investment banking accounted for just 0.1 percent of all private sector jobs,
but it accounts for 1.3 percent of all wages, the bureau said.
Of the nation’s 132.5 million private sector jobs,
173,340 were in investment banking in the first three months of 2006,
the report stated.

The bureau said that 4 of the top 10 counties in average industry pay
were in the New York City market.

Almost 72 percent of all investment banking earnings were in just five counties:
New York (Manhattan) [$16,849/week, $876K/year],
Fairfield [$23,846/week, $1.24M/year],
San Francisco [$14,177/week, $737K/year],
Los Angeles [$7,231/week, $376K/year], and
Cook County, Ill., which envelops Chicago [$7,943/week, $413K/year].

“With steady employment totals, very handsome bonuses,” the report said,
“it would seem to be an understatement
to say that investment banking was thriving.”

The bureau regularly issues reports highlighting incomes in different industries. This was the first on investment banking.

The growth of hedge funds has had
a significant effect on jobs and income growth
in Fairfield County, which includes Greenwich, Conn.

A decade earlier, in the first quarter of 1996,
there were slightly fewer than 1,500 jobs in investment banking and securities,
a slightly broader definition of jobs that the bureau used then.

By the first quarter of 2006,
Fairfield County had more than four times the jobs, 6,137,
just in investment banking.

Average weekly pay more than doubled in real terms,
from $10,220 [$531K/year] in 1996
to $23,846 [$1.24M/year] in the same period last year.
The average pay for all 363,000 jobs in Fairfield, including investment banking,
was $1,949 weekly [$101K/year].

Investment banking accounted for
more than a fifth of all private sector wages in Fairfield County
and more than a seventh in Manhattan,
the bureau said.



The Credit Crisis Is Going to Get Worse

Behind Insurer’s Crisis, Blind Eye to a Web of Risk
New York Times, 2008-09-27

“It is hard for us, without being flippant,
to even see a scenario within any kind of realm of reason
that would see us losing one dollar
in any of those transactions.”

— Joseph J. Cassano, a former A.I.G. executive, August 2007


A Mountain, Overlooked
How Risk Models Failed Wall St. and Washington
By James G. Rickards
Washington Post Op-Ed, 2008-10-02

[An excerpt; emphasis is added.]

Crooked mortgage brokers,
greedy investment bankers,
oblivious rating agencies and
gullible investors
have all been faulted in the financial crisis,
and there is bipartisan agreement that
regulators were asleep at the switch.
It’s all well and good to call for substantial new oversight.
But if regulators were oblivious to the danger, the question is why.

The problem is that Wall Street and regulators
relied on complex mathematical models
that told financial institutions
how much risk they were taking at any given time.
Since the 1990s,
risk management on Wall Street has been dominated by
a model called “value at risk” (VaR).
VaR attributes risk factors to every security
and aggregates these factors across an entire portfolio,
identifying those risks that cancel out.
What’s left is “net” risk
that is then considered in light of historical patterns.
The model predicts with 99 percent probability that
institutions cannot lose more than a certain amount of money.
Institutions compare this “worst case” with their actual capital
and, if the amount of capital is greater, sleep soundly at night.
[“Worst case” is a misnomer: 99 percent is not 100 percent.]
Regulators, knowing that the institutions used these models, also slept soundly.
As long as capital was greater than the value at risk,
institutions were considered sound --
and there was no need for hands-on regulation.

Lurking behind the models, however, was a colossal conceptual error:
the belief that
risk is randomly distributed and that
each event has no bearing on the next event in a sequence.
[This last is called (statistical) independence.]
This is typically explained with a coin-toss analogy.
If you flip a coin and get “heads” and then do it again,
the first heads has no bearing on
whether the second toss will be heads or tails.
It’s a common fallacy that if you get three heads in a row,
there’s a better-than-even chance that the next toss will be tails.
That’s simply not true.
Each toss has a 50-50 chance of being heads or tails.
Such systems are represented in the bell curve [normal distribution],
which makes clear that events of the type we have witnessed lately
are so statistically improbable as to be practically impossible.
This is why markets are taken by surprise when they occur.

But what if markets are not like coin tosses?
What if risk is not shaped like a bell curve?
What if new events are profoundly affected by what went before?

The more enlightened among the value-at-risk practitioners understand that
extreme events occur more frequently than their models predict.
So they embellish their models with “fat tails”
(upward bends on the wings of the bell curve)
and model these tails on historical extremes
such as the post-Sept. 11 market reaction.
But complex systems are not confined to historical experience.
Events of any size are possible,
and limited only by the scale of the system itself.
Since we have scaled the system to unprecedented size,
we should expect catastrophes of unprecedented size as well.
We’re in the middle of one such catastrophe, and
complexity theory says it will get much worse.

Financial systems overall have emergent properties
that are not conspicuous in their individual components
and that traditional risk management does not account for.
When it comes to the markets,
the aggregate risk is far greater than the sum of the individual risks;
this is something that Long-Term Capital Management
did not understand in the 1990s
and that Wall Street seems not to comprehend now.
As long as Wall Street and regulators keep using the wrong paradigm,
there’s no hope they will appreciate just how bad things can become.
And the new paradigm of risk must be understood
if we are to avoid lurching from one bank failure to the next.

The writer was general counsel of Long-Term Capital Management
from 1994 to 1999.
He works for Omnis Inc.,
a McLean consultant on national security and capital markets.

Fund Chiefs Back Oversight:
Managers Tell Lawmakers They Would Give Data to Regulators

By Amit R. Paley
Washington Post, 2008-11-14

Five of the world's wealthiest billionaire hedge-fund managers
said yesterday that
they would support greater oversight of their secretive $2 trillion industry,
as momentum grows in Congress for
stricter control of an essentially unregulated corner of the financial world.


The five managers ...
were paid an average of more than $1 billion last year,
according to the committee.

How to Ground The Street
The Former 'Enforcer' On the Best Way to Keep Financial Markets in Check.
By Eliot L. Spitzer
Washington Post Outlook, 2008-11-16

[An excerpt.]

The new president’s team must soon get to the root causes
of the mistakes that have brought us to the economic precipice.
Yes, we have all derided
the explosion of leverage,
the failure to regulate derivatives,
the flood of subprime lending that was bound to default and
the excesses of CEO compensation.
But these are all mere manifestations of three deeper structural problems that require greater attention:
  1. misconceptions about what a “free market” really is,
  2. a continuing breakdown in corporate governance and
  3. an antiquated and incoherent federal financial regulatory framework.

we must confront head-on
the pervasive misunderstanding
of what constitutes a “free market.”

For long stretches of the past 30 years, too many Americans fell prey to the ideology that a free market requires nearly complete deregulation of banks and other financial institutions and a government with a hands-off approach to enforcement. “We can regulate ourselves,” the mantra went.


our corporate governance system has failed.
We need to reexamine each of the links in its chain. Boards of directors, compensation and audit committees, the trio of facilitators (lawyers, investment bankers and auditors) whose job it is to create the impression of legal compliance, and shareholders themselves -- all abdicated their responsibilities.

Institutional shareholders, in particular mutual funds, pension funds and endowments, must reengage in corporate governance. Over the past decade, arguably the sole challenge to corporate mismanagement and poor corporate strategies has come from private-equity firms or activist hedge funds. These firms were among the few shareholders or pools of capital willing to purchase and revamp encrusted corporate machines. So it shouldn’t be surprising that the corporate world has taken a skeptical view of them -- especially short-selling hedge funds, which have often been a rare voice raising the alarm.

Boards of directors were also missing in action over the past decade; not only did they not provide answers, they all too often failed even to ask the appropriate questions. And the roles of compensation committees, of course, must be totally rethought. No longer can Garrison Keillor‘s brilliant observation about our kids -- that they are all above average -- apply to CEOs and propel failed leaders’ paychecks through the roof. Today’s momentary public oversight and outrage over executive compensation, while long overdue, is no substitute over the long term for firm standards set by compensation committees and boards of directors.

we need to completely overhaul
the federal financial regulatory framework.

On Wall Street, Bonuses, Not Profits, Were Real
New York Times, 2008-12-18

Seeing Through Wall Street
Restoring trust to the economy will require
bringing transparency to the markets.

By Eliot Spitzer
Slate.com, 2008-12-23

[Emphasis has been added.]

There is an odd symmetry to a year that began with a subprime meltdown—
initially affecting those at the lower end of the economic spectrum,
before it lit the fuse that burned down the entire house—
and ended with the Bernard Madoff scandal,
an old-fashioned Ponzi scheme
whose victims were nominally sophisticated investors.
Clearly, nobody has been immune to this now-global plague.
Every effort to rebuild an economy in free fall
has been one moment too late or one step too short,
and the remedies, though expensive, have so far at least
failed to address underlying structural issues.

Yet certain truisms have continued to prove their validity.
As Justice Brandeis observed, sunlight is the best disinfectant.
The transparency that comes with the glare of sunlight
is hard for companies and government to deal with—and so is resisted.

But transparency could begin to remedy
one of the great costs of our current crisis:
the public’s monumental loss of confidence in the markets.
One of the great accomplishments of the past 50 years has been
the so-called “democratization” of the markets—
the successful effort to get Americans of all economic levels
to invest in our process of capital formation.
Not only did this create greater liquidity, but more important,
it gave a much larger piece of America
the opportunity to benefit from economic growth.
The rise of the “ownership society”
became a noted part of our politics as well as our sense of well-being.

Now, many of these investors are rightly concluding that
the market has become nothing more than a casino on steroids
with Wall Street and corporate CEOs playing the role of the house,
swinging the odds against the investors at every turn.
Trust will be regained
only if there is a fundamental change in the rules of transparency
and only if those rules are enforced.
Such transparency could have prevented
many of the cataclysms of the past year.
So it is all the more troubling that
we continue to fail to require
anything close to the information flow that we should—
either about the behavior that brought us to where we are
or about the transactions and efforts that are now being funded by taxpayers.

No doubt we all have our favorite questions that have not been answered.
But here are a few year-ending queries
to the players who have been central to the unfolding events of the past months.
Some of these questions are retrospective in nature; some are prospective.
  1. First, for our Treasury Department—and the Federal Reserve—
    which seem able to lend or guarantee at a scale unheard of until now:
    Where is all the money going, and
    how is it decided who gets it?
    Many of the investments appear to be much less critical
    than an investment in Lehman Bros. would have been, for example.
    If this reflects learning, wonderful.
    But what is the current metric for evaluation?
  2. Speaking of Lehman,
    what precisely was the conversation at the Fed among the various bankers
    that led to the conclusion not to give Lehman assistance
    but to give AIG an almost unlimited Fed pipeline?
    What, exactly, did each bank tell the government about
    its exposure to Lehman or AIG, and when?
  3. What did the government tell the banks about their obligation to lend,
    once they had received
    the infusion of billions to restore their balance sheets?
    As we have seen,
    the banks are holding onto an enormous amount of the cash,
    failing to inject needed oil into a system whose gears have ground to a halt.
    It defies common sense that
    the banks have been permitted to receive this capital
    and yet have not been required to lend
    in any significantly greater volume.
    As a result, the economy continues to fall like a rock.
  4. When did the Fed, Treasury, or the Office of the Controller of the Currency
    begin to evaluate the credit risk of the subprime debt pipeline,
    and what did any of them do about it?
    This is the old what-did-they-know-and-when-did-they-know-it question.
  5. Have these government entities begun to think through
    the possibility of requiring banks that securitize debt
    to maintain an ownership of some significant percentage of this debt?
    That would begin to address the risks that result when
    those who originate debt
    really have no concerns or accountability for
    the long-term capacity of borrowers to pay.
  6. For the banks,
    which have received an unceasing supply of credit and guarantees:
    We have heard too often from those at the top that
    “we didn’t have operational responsibility;
    we relied on our risk managers.”

    We are now major equity investors in these banks.
    Our capital is now at risk.
    So let’s get—right now—
    all the analysis of the subprime debt
    that was originated, securitized, or bought.
    If the credit departments got it so wrong,
    we deserve to know that
    so we can remedy the situation by bringing in analysts with greater skills.
    If the credit analysis was correct
    and the risk managers were sending warnings up the chain,
    we deserve to know that as well.
    Because then the senior managers—despite their disclaimers—
    have some questions to answer.
    There are few things more essential for a bank than
    knowing that its loans will be paid back.
    We had better figure out how the banks got it so wrong.
    Any bank unwilling to release these documents
    should not get public funding.
  7. Also for the banks:
    What would it cost to modify meaningfully all the subprime mortgages
    such that delinquencies and defaults can be brought back into line?
    Have they calculated this figure?
    Loan modification is a necessary step
    to resolving the underlying housing crisis,
    and one way or another, it has to get done.
    Why loan modification
    wasn’t a condition of the banks’ receipt of capital
    is a mystery that remains unresolved.
  8. For the rating agencies, we should also require public disclosure—
    of their subprime analysis.
    Let them withstand the public scrutiny of
    the process that generated AAA ratings on debt
    that so soon became toxic.
    Perhaps they will be vindicated.
    Perhaps there really was no way to see around the corner.
    Or perhaps we will conclude that
    the agencies simply do not have the analytical tools
    to sense inflection points,
    in which case their ratings really are not worth a great deal.

As we struggle through the difficult process of rebuilding,
many errors will be made in good faith
by those trying to deal with an unprecedented situation.
But it will almost always be the case that
transparency will assist in the long term,
uncomfortable though it may be in the near term.
Until we get comfortable with that notion,
we will continue to sink deeper and deeper into
the crisis of confidence gripping our economy.

Eliot Spitzer is the former governor of the state of New York.
The Spitzer family had an indirect investment with Bernard Madoff.


Risk Mismanagement
New York Times Magazine, 2009-01-04

A Page From the Hoover Playbook
By Harold Meyerson
Washington Post Op-Ed, 2009-01-07

[An excerpt; emphasis is added.]

In Sunday’s New York Times magazine,
economics columnist Joe Nocera reported on
the intricate mathematical models
that Wall Street banks and brokerages used to assess their exposure to risk --
models, it’s now painfully clear, that failed to alert our financial titans
that they were parading off a cliff.
Devised by the quants
(Wall Street’s name for the gifted mathematicians it employed),
the models factored in an immense number of variables,
including market behavior going back a quarter-century,
in coming up with daily quantifications of risk.

But in addition to all their quants,
Wall Street should have hired a handful of hists
(my version of Wall Streetese for economic historians).

Those hists might have insisted that the risk models
include data from
the late 1920s, the last time that America’s financial institutions were
as highly leveraged and as lightly regulated
as they were last year.

Those hists might have noted that
even as U.S. households bought more and more on credit,
their median annual income had flat-lined

($50,557 in 2000, $50,233 in 2007)
and that this was a story that could only end badly --
much as it did at the end of the ‘20s,
when the purchasing power of American farmers and workers tanked.

Obama's SEC Pick Is No Joe Kennedy
By Steven Pearlstein
Washington Post, 2009-01-07

[The main interest in this column is Pearlstein’s general critique of Wall Street,
for example, the following (emphasis is added):]

What I didn’t know until I read through some of her speeches this week is that
Schapiro also gets the fundamental problem with Wall Street’s scummy culture.
She understands that it is a culture that
  • rests on a barely disguised contempt for customers;
  • is dominated by short-term thinking; and
  • glorifies risk-taking, games-playing and corner-cutting.
It is, as she put it in a speech last October at Dominican University,
a culture in which
“individuals have allowed the pursuit of wealth to become mere sport,
devoid of any ethical meaning or moral obligation to others.”

[Good point.
In my view that result is, to a large extent, the result of
the drive of the secularists to de-Christianize out country.
notwithstanding the historical hostility many (but not all) Jews have held toward it,
has been at the center of what has made our country great.
Its being pushed out of public life
has had and will have many negative consequences,
among them the loss of its ability to persuade people to be better people.]

Obama Calls Wall Street Bonuses ‘Shameful’
New York Times, 2009-01-30

[Its beginning.]

WASHINGTON — President Obama fired a warning shot at Wall Street on Thursday, branding bankers “shameful” for giving themselves $18.4 billion in bonuses as the economy was spinning out of control and the government was spending billions to bail out many of the nation’s most prominent financial firms.

Speaking from the Oval Office with Treasury Secretary Timothy F. Geithner by his side, Mr. Obama lashed out at the industry over a report, compiled by the New York State comptroller, Thomas P. DiNapoli, which found that over all, financial executives received the same level of bonuses as they had in 2004, when times were more flush.

It was a pointed and unusual flash of anger — if a premeditated one — from the president, and it suggested that he intended to use his platform to take a hard line against excesses in executive compensation.

“That is the height of irresponsibility,” Mr. Obama said angrily. “It is shameful, and part of what we’re going to need is for folks on Wall Street who are asking for help to show some restraint and show some discipline and show some sense of responsibility.

“The American people understand that we’ve got a big hole that we’ve got to dig ourselves out of, but they don’t like the idea that people are digging a bigger hole even as they’re being asked to fill it up,” Mr. Obama said, adding that “there will be time for them to make profits and there will be time for them to make bonuses. Now is not that time.”

[I think Obama is absolutely right about this.
It seems a shame that President Bush, so far as I am aware,
seemed to neither investigate nor condemn
the unconscionable actions on Wall Street
that have been so instrumental in bringing financial disaster to America.
Yes, his term was almost over,
but even so his judgment,
while he still had the bully pulpit of the presidency,
would have made it clear that
it is not just Democrats who condemn Wall Street’s behavior,
and where he stood on these issues.

If the GOP wants to get back in power,
it needs to squarely address its role in the financial disaster.
It needs to take its share of responsibility for the economic situation.
How can any self-respecting conservative
call for restraint and discipline from the underclass,
while failing to criticize Wall Street for its actions?
A bonus, in the general understanding,
was to be given for exceptionally meritorious work.
What happened on Wall Street was anything but that
(as indicated by multi-billion dollar losses).]

“Eat what you kill”
The next few articles expose the “Eat what you kill” ethos on Wall Street.

It’s Not the Bonus Money. It’s the Principle.
New York Times, 2009-01-31

[An excerpt; emphasis is added.]

Wall Street traders are also extremely reluctant to give up the
eat what you kill mentality
that has dominated their profession these past two decades.
There is no sense of shared enterprise at most firms,
and no belief among the rank and file
that they should have to pay a price
if the firm is drowning in losses and needs government support.
That is why they are so blind to how they appear to the rest of us.
They just want theirs.
That is the culture they have created.

Indeed, Ira Kay, a top executive consultant with Watson Wyatt,
told me that
this bonus season has been akin to “war” inside many Wall Street firms.
“It is a small group of people who caused the problems,” he said.
But other bankers had very good years —
and all over New York they are now complaining about their smaller bonuses,
completely tone-deaf to how this sounds outside their Wall Street silos.
You can make a pretty convincing argument that that culture —
and the bonuses that flowed from it —
had a lot to do with creating the financial crisis.
If Wall Street can’t bring itself to admit as much,
the new administration and the Democratic Congress
are going to be more than happy to point it out.

Getting Theirs Cuts Both Ways on Wall Street
New York Times, 2009-01-31

It’s Theirs and They’re Not Apologizing
New York Times, 2009-01-31

[End of "Eat what you kill" articles.]

Wall St., a Financial Epithet, Stirs Outrage
New York Times, 2009-02-03

The Tsunami That Buried a Wall Street Giant
New York Times, 2009-03-10

Review of:
A Tale of Hubris and Wretched Excess on Wall Street

By William D. Cohan
468 pages. Doubleday. $27.95.

[An excerpt; emphasis is added.]

As many reporters have observed,
Bear Stearns was known for its sharp-elbowed, opportunistic culture;
even in a notoriously aggressive business,
it had a distinctly scrappy, results-oriented approach.
Building upon many newspaper and magazine depictions of the firm,
Mr. Cohan creates vivid portraits
of the personalities who came to define Bear Stearns:
the brilliant, authoritarian Cy Lewis, who pushed the firm into the limelight;
his successor, Ace Greenberg, who put his imprimatur on the firm by
looking for “people with PSD degrees,”
that is non-M.B.A.’s who were poor and smart
and had a deep desire to become rich


A Tsunami of Excuses
New York Times Op-Ed, 2009-03-12

IT’S been a year since Bear Stearns collapsed, kicking off Wall Street’s meltdown, and it’s more than time to debunk the myths that many Wall Street executives have perpetrated about what has happened and why. These tall tales — which tend to take the form of how their firms were the “victims” of a “once-in-a-lifetime tsunami” that nothing could have prevented — not only insult our collective intelligence but also do nothing to restore the confidence in the banking system that these executives’ actions helped to destroy.


Is It Time to Retrain B-Schools?
New York Times, 2009-03-15

Paying Workers More to Fix Their Own Mess
New York Times, 2009-03-18

[An excerpt; emphasis is added.]

Ah, retention pay.
It has been one of the great rationales
for showering money on chief executives and bankers
regardless of how well they are doing their jobs.
It’s just that the specific rationale keeps changing.


Throughout this crisis, policy makers,
starting with President George W. Bush [43] and Ben Bernanke
and now including President Obama [44],
have been a bit too deferential to Wall Street.


Today’s tax code makes no distinction between
income above $373,000 and income above, say, $5 million.
Both are taxed at 35 percent.

That is a legacy of the tax changes of the early 1990s,
when far less of the nation’s income went to millionaires.
you can make a good argument for
a new, higher tax bracket on the very largest incomes.

[You bet.
That’s really the way to go.
Those Wall Street salaries and compensation packages have gotten so outlandish,
and as we have seen have not produced
executives who have exactly been stunningly successful at helping the overall economy,
that the old arguments about how
a higher tax bracket would not provide adequate incentive
to get the best and brightest people
in positions where they could help the overall economy,
has been empirically diminished.]

In the past, the economist Thomas Piketty says,
higher marginal tax rates tended to hold down salaries and bonuses,
because executives had less incentive to angle for multimillion-dollar pay.

Administration Seeks Increase in Oversight of Executive Pay
New York Times, 2009-03-22

[An excerpt.]


The Obama administration will call for
increased oversight of executive pay
at all banks, Wall Street firms and possibly other companies
as part of a sweeping plan to overhaul financial regulation,
government officials said.


[T]he hedge fund industry has significant influence on Capitol Hill
and has shown that
it can defeat proposals it finds onerous.

While a growing number of hedge fund advisers
have voluntarily agreed to register with the S.E.C.,
many of the most prominent ones are expected to oppose efforts to require them
to provide what they consider proprietary information
about their holdings and trading practices,
even on a confidential basis.

Battles Over Reform Plan Lie Ahead
New York Times, 2009-03-27

The Market Mystique
New York Times, 2009-03-27

[Emphasis is added.]

On Monday, Lawrence Summers, the head of the National Economic Council,
responded to criticisms of
the Obama administration’s plan to subsidize private purchases of toxic assets.
“I don’t know of any economist,” he declared, “who doesn’t believe that
better functioning capital markets in which assets can be traded
are a good idea.”

Leave aside for a moment the question of whether
a market in which buyers have to be bribed to participate
can really be described as “better functioning.”
Even so, Mr. Summers needs to get out more.
Quite a few economists
have reconsidered their favorable opinion of capital markets and asset trading
in the light of the current crisis.

But it has become increasingly clear over the past few days that
top officials in the Obama administration
are still in the grip of the market mystique.
They still believe in the magic of the financial marketplace
and in the prowess of the wizards who perform that magic.

The market mystique didn’t always rule financial policy.
America emerged from the Great Depression
with a tightly regulated banking system,
which made finance a staid, even boring business.
Banks attracted depositors
by providing convenient branch locations and maybe a free toaster or two;
they used the money thus attracted to make loans, and that was that.

And the financial system wasn’t just boring.
It was also, by today’s standards, small.
Even during the “go-go years,” the bull market of the 1960s,
finance and insurance together accounted for less than 4 percent of G.D.P.
The relative unimportance of finance was reflected in
the list of stocks making up the Dow Jones Industrial Average,
which until 1982 contained not a single financial company.

It all sounds primitive by today’s standards.
Yet that boring, primitive financial system serviced an economy that
doubled living standards over the course of a generation.

After 1980, of course, a very different financial system emerged.
In the deregulation-minded Reagan [40] era,
old-fashioned banking was increasingly replaced by
wheeling and dealing on a grand scale.
The new system was much bigger than the old regime:
On the eve of the current crisis,
finance and insurance accounted for 8 percent of G.D.P.,
more than twice their share in the 1960s.
By early last year, the Dow contained five financial companies —
giants like A.I.G., Citigroup and Bank of America.

And finance became anything but boring.
It attracted many of our sharpest minds and made a select few immensely rich.

Underlying the glamorous new world of finance was
the process of securitization.
Loans no longer stayed with the lender.
Instead, they were sold on to others,
who sliced, diced and puréed individual debts to synthesize new assets.
Subprime mortgages, credit card debts, car loans —
all went into the financial system’s juicer.
Out the other end, supposedly, came sweet-tasting AAA investments.
And financial wizards were lavishly rewarded for overseeing the process.

But the wizards were frauds, whether they knew it or not, and
their magic turned out to be no more than a collection of cheap stage tricks.
Above all,

the key promise of securitization —
that it would make the financial system more robust
by spreading risk more widely —
turned out to be a lie.

Banks used securitization to increase their risk, not reduce it,
and in the process they made the economy more, not less,
vulnerable to financial disruption.

Sooner or later, things were bound to go wrong, and eventually they did.
Bear Stearns failed; Lehman failed; but most of all,
securitization failed.

Which brings us back to
the Obama administration’s approach to the financial crisis.

Much discussion of the toxic-asset plan has focused on the details and the arithmetic, and rightly so.
Beyond that, however, what’s striking is
the vision expressed both
in the content of the financial plan and
in statements by administration officials.
In essence, the administration seems to believe that
once investors calm down,
securitization — and the business of finance —
can resume where it left off a year or two ago.

To be fair, officials are calling for more regulation.
Indeed, on Thursday Tim Geithner, the Treasury secretary,
laid out plans for enhanced regulation
that would have been considered radical not long ago.

But the underlying vision remains that of
a financial system more or less the same as it was two years ago,
albeit somewhat tamed by new rules.

As you can guess, I don’t share that vision.
I don’t think this is just a financial panic;
I believe that it represents

the failure of a whole model of banking,
an overgrown financial sector
that did more harm than good.

I don’t think the Obama administration can bring securitization back to life,
and I don’t believe it should try.

A Rich Education for Summers (After Harvard)
New York Times, 2009-04-06

Lawrence H. Summers plays down his stint in the hedge fund business as a mere part-time job — but the financial and intellectual rewards that he gained there would make even most full-time workers envious.

Mr. Summers, the former Treasury secretary and Harvard president who is now the chief economic adviser to President Obama, earned nearly $5.2 million in just the last of his two years at one of the world’s largest funds, according to financial records released Friday by the White House.

Impressive as that might sound, it is all the more considering that Mr. Summers worked there just one day a week.

Much is known about Mr. Summers’s days in Washington and Cambridge, but little attention has been paid to his two years in New York, from late 2006 to late 2008, advising an elite corps of math wizards and scientists devising investment strategies for D. E. Shaw & Company.


After Off Year, Wall Street Pay Is Bouncing Back
New York Times, 2009-04-26

The rest of the nation may be getting back to basics,
but on Wall Street,
paychecks still come with a golden promise.

Workers at the largest financial institutions are on track
to earn as much money this year
as they did before the financial crisis began,
because of the strong start of the year for bank profits.

Even as the industry’s compensation has been put in the spotlight
for being so high at a time when many banks have received taxpayer help,
six of the biggest banks set aside over $36 billion in the first quarter
to pay their employees,
according to a review of financial statements.

If that pace continues all year,
the money set aside for compensation suggests that
workers at many banks will see their pay — much of it in bonuses —
recover from the lows of last year.

“I just haven’t seen huge changes in the way people are talking about compensation,” said Sandy Gross, managing partner of Pinetum Partners, a financial recruiting firm. “Wall Street is being realistic. You have to retain your human capital.”

Brad Hintz, an analyst at Sanford C. Bernstein, was more critical.
“Like everything on Wall Street, they’re starting to sin again,” he said.
“As you see a recovery, you’ll see everybody’s compensation beginning to rise.”

In total, the banks are not necessarily spending more on compensation,
because their work forces have shrunk sharply in the last 18 months.
Still, the average pay for those who remain —
rank-and-file workers whose earnings are not affected by government-imposed limits —
appears to be rebounding.

Of the large banks receiving federal help,
Goldman Sachs stands out for setting aside the most per person for compensation.
The bank, which nearly halved its compensation last year,
set aside $4.7 billion for worker pay in the quarter.
If that level continues all year,
it would add up to average pay of $569,220 per worker
almost as much as the pay in 2007, a record year.


Money for Nothing
New York Times, 2009-04-27

[W]e should be disturbed by an article in Sunday’s Times reporting that
pay at investment banks, after dipping last year, is soaring again —
right back up to 2007 levels.

Why is this disturbing? Let me count the ways.

there’s no longer any reason to believe that
the wizards of Wall Street
actually contribute anything positive to society,
let alone enough to justify those humongous paychecks.

Remember that the gilded Wall Street of 2007 was a fairly new phenomenon.
From the 1930s until around 1980 banking was a staid, rather boring business
that paid no better, on average, than other industries,
yet kept the economy’s wheels turning.

So why did some bankers suddenly begin making vast fortunes?
It was, we were told, a reward for their creativity — for financial innovation.
At this point, however,
it’s hard to think of any major recent financial innovations
that actually aided society,
as opposed to being new, improved ways to
blow bubbles, evade regulations and implement de facto Ponzi schemes.

Consider a recent speech by Ben Bernanke, the Federal Reserve chairman,
in which he tried to defend financial innovation.
His examples of “good” financial innovations were
(1) credit cards — not exactly a new idea;
(2) overdraft protection; and
(3) subprime mortgages.
(I am not making this up.)
These were the things for which bankers got paid the big bucks?

Still, you might argue that we have a free-market economy,
and it’s up to the private sector to decide how much its employees are worth.

But this brings me to my second point:
Wall Street is no longer, in any real sense, part of the private sector.
It’s a ward of the state, every bit as dependent on government aid
as recipients of Temporary Assistance for Needy Families, a k a “welfare.”

I’m not just talking about the $600 billion or so
already committed under the TARP.
There are also
the huge credit lines extended by the Federal Reserve;
large-scale lending by Federal Home Loan Banks;
the taxpayer-financed payoffs of A.I.G. contracts;
the vast expansion of F.D.I.C. guarantees; and, more broadly,
the implicit backing provided
to every financial firm considered too big, or too strategic, to fail.

One can argue that it’s necessary to rescue Wall Street
to protect the economy as a whole — and in fact I agree.
But given all that taxpayer money on the line,
financial firms should be acting like public utilities,
not returning to the practices and paychecks of 2007.

Furthermore, paying vast sums to wheeler-dealers isn’t just outrageous;
it’s dangerous.
Why, after all, did bankers take such huge risks?
Because success — or even the temporary appearance of success —
offered such gigantic rewards:
even executives who blew up their companies
could and did walk away with hundreds of millions.
Now we’re seeing similar rewards
offered to people who can play their risky games with federal backing.

So what’s going on here?
Why are paychecks heading for the stratosphere again?
Claims that firms have to pay these salaries to retain their best people
aren’t plausible:
with employment in the financial sector plunging,
where are those people going to go?

No, the real reason financial firms are paying big again
is simply because they can.
They’re making money again (although not as much as they claim), and why not?
After all, they can borrow cheaply, thanks to all those federal guarantees,
and lend at much higher rates.
So it’s eat, drink and be merry, for tomorrow you may be regulated.

Or maybe not.
There’s a palpable sense in the financial press that the storm has passed:
stocks are up,
the economy’s nose-dive may be leveling off, and
the Obama administration will probably let the bankers off
with nothing more than a few stern speeches.
Rightly or wrongly, the bankers seem to believe that
a return to business as usual is just around the corner.

In 2008, overpaid bankers taking big risks with other people’s money
brought the world economy to its knees.
The last thing we need is to give them a chance to do it all over again.

Obama Proposes a First Overhaul of Finance Rules
New York Times, 2009-05-14


In its first detailed effort to overhaul financial regulations, the Obama administration on Wednesday sought new authority over the complex financial instruments, known as derivatives, that were a major cause of the financial crisis and have gone largely unregulated for decades.

The administration asked Congress to move quickly on legislation that would allow federal oversight of many kinds of exotic instruments, including credit-default swaps, the insurance contracts that caused the near-collapse of the American International Group.

The Treasury secretary, Timothy F. Geithner, said the measure should require swaps and other types of derivatives to be traded on exchanges or clearinghouses and backed by capital reserves, much like the capital cushions that banks must set aside in case a borrower defaults on a loan. Taken together, the rules would probably make it more expensive for issuers, dealers and buyers alike to participate in the derivatives markets.

The proposal will probably force many types of derivatives into the open, reducing the role of the so-called shadow banking system that has arisen around them.

“This financial crisis was caused in large part by significant gaps in the oversight of the markets,” Mr. Geithner said in a briefing. He said the proposal was intended to make the trading of derivatives more transparent and give regulators the ability to limit the amount of derivatives that any company can sell, or that any institution can hold.


Derivatives are hard to value.
They are virtually hidden from investors, analysts and regulators,
even though they are one of Wall Street’s biggest profit engines.
They do not trade openly on public exchanges,
and financial services firms disclose few details about them.

The new rules are meant to change most, but not all, of that opacity.

[Okay, let’s stop and ask a question.
“Who are those profits at the expense of?”
Money doesn’t come from nowhere
(even though we often heard Wall Streeters claiming that they had “created wealth”)
or grow on trees;
if Wall Street earned commissions on those derivatives,
that means, inevitably, that someone paid those commissions.
Again, who are those profits and commissions at the expense of?]

Used properly, they can
reduce or transfer risk,
limit the damage from market uncertainty and
make global trade easier.
Airlines, food companies, insurers, exporters and many other companies
use derivatives to protect themselves from
sudden and unpredictable changes in financial markets
like interest rate or currency movements.
Used poorly,
derivatives can backfire and spread risk rather than contain it.

The administration plan would not require that
custom-made derivative instruments —
those with unique characteristics negotiated between companies —
be traded on exchanges or through clearinghouses,
though standardized ones would.
The plan would require the development of timely reports of trades,
similar to the system for corporate bonds.

Inside The Great American Bubble Machine
How Goldman Sachs has engineered
every major market manipulation since the Great Depression

by Matt Taibbi
Rolling Stone, 2009-10-08

In Rolling Stone Issue 1082-83,
Matt Taibbi takes on “the Wall Street Bubble Mafia” —
investment bank Goldman Sachs (click here to read the whole story).
The piece has generated controversy,
with Goldman Sachs firing back that Taibbi’s piece is
“an hysterical compilation of conspiracy theories”
and a spokesman adding,
“We reject the assertion that we are
inflators of bubbles and profiteers in busts,
and we are painfully conscious of the importance in being a force for good.”
Taibbi shot back:
“Goldman has its alumni pushing its views from the pulpit of
the U.S. Treasury, the NYSE, the World Bank,
and numerous other important posts;
it also has former players fronting major TV shows.
They have the ear of the president if they want it.”
Here, now, are excerpts from Matt Taibbi’s piece
and video of Taibbi exploring the key issues.

From Matt Taibbi’s “The Great American Bubble Machine”
in Rolling Stone Issue 1082-83:

The first thing you need to know about Goldman Sachs is that it’s everywhere.
The world’s most powerful investment bank is
a great vampire squid wrapped around the face of humanity,
relentlessly jamming its blood funnel into anything that smells like money.

Any attempt to construct a narrative around
all the former Goldmanites in influential positions
quickly becomes an absurd and pointless exercise,
like trying to make a list of everything.
What you need to know is the big picture:
If America is circling the drain,
Goldman Sachs has found a way to be that drain —
an extremely unfortunate loophole
in the system of Western democratic capitalism,
which never foresaw that
in a society governed passively by free markets and free elections,
organized greed always defeats disorganized democracy.

[Actually I think that was foreseen;
the problem is that
today's political class is too in bed with
those manipulating the system for the private advantage of their in-group.]

They achieve this using the same playbook over and over again.
The formula is relatively simple:
Goldman positions itself in the middle of a speculative bubble,
selling investments they know are crap.
Then they hoover up vast sums from the middle and lower floors of society
with the aid of a crippled and corrupt state that allows it to rewrite the rules
in exchange for the relative pennies the bank throws at political patronage.
Finally, when it all goes bust,
leaving millions of ordinary citizens broke and starving,
they begin the entire process over again,
riding in to rescue us all by lending us back our own money at interest,
selling themselves as men above greed,
just a bunch of really smart guys keeping the wheels greased.
They’ve been pulling this same stunt over and over since the 1920s —
and now they’re preparing to do it again,
creating what may be the biggest and most audacious bubble yet.


Whiz Kids, Wall Street Division
By Harold Meyerson
Washington Post Op-Ed, 2009-07-15

Our time is no stranger to the hubris of the brilliant, though.
To find it, we need to look not to Washington but to Wall Street.
The real successors to McNamara’s whiz kids
are the economic geniuses, the “quants,”
who figured out how to build a tower of investment
on a dot of assets,
arbitrage everything,
and hedge any risk,
except, of course, the ones that plunged us into a depression.

The devastation they wrought
may not have reached the level of the Vietnam War,
which embittered this nation for decades
and cost the lives of tens of thousands of Americans
and many times more Vietnamese.
But considering that they were merely economists, bankers and their ideologues,
the damage is impressive enough.
It’s not just the millions of jobs lost,
the retirement savings wiped out,
the homes foreclosed on.
It’s also
the offshoring of American manufacturing and
the concomitant creation of mountains of consumer debt
(which the American people owed to Wall Street)
so that their compatriots could continue to consume
even though their incomes had stagnated.
It’s the transformation of
a nation that once invested in productive enterprise into
a nation sustained by asset bubbles.

The Joy of Sachs
New York Times Op-Ed, 2009-07-17

The American economy remains in dire straits, with one worker in six unemployed or underemployed. Yet Goldman Sachs just reported record quarterly profits — and it’s preparing to hand out huge bonuses, comparable to what it was paying before the crisis. What does this contrast tell us?

First, it tells us that Goldman is very good at what it does. Unfortunately, what it does is bad for America.

Second, it shows that Wall Street’s bad habits — above all, the system of compensation that helped cause the financial crisis — have not gone away.

Third, it shows that by rescuing the financial system without reforming it, Washington has done nothing to protect us from a new crisis, and, in fact, has made another crisis more likely.

Let’s start by talking about how Goldman makes money.

Over the past generation — ever since the banking deregulation of the Reagan years — the U.S. economy has been “financialized.” The business of moving money around, of slicing, dicing and repackaging financial claims, has soared in importance compared with the actual production of useful stuff. The sector officially labeled “securities, commodity contracts and investments” has grown especially fast, from only 0.3 percent of G.D.P. in the late 1970s to 1.7 percent of G.D.P. in 2007.

Such growth would be fine if financialization really delivered on its promises — if financial firms made money by directing capital to its most productive uses, by developing innovative ways to spread and reduce risk. But can anyone, at this point, make those claims with a straight face? Financial firms, we now know, directed vast quantities of capital into the construction of unsellable houses and empty shopping malls. They increased risk rather than reducing it, and concentrated risk rather than spreading it. In effect, the industry was selling dangerous patent medicine to gullible consumers.

Goldman’s role in the financialization of America was similar to that of other players, except for one thing: Goldman didn’t believe its own hype. Other banks invested heavily in the same toxic waste they were selling to the public at large. Goldman, famously, made a lot of money selling securities backed by subprime mortgages — then made a lot more money by selling mortgage-backed securities short, just before their value crashed. All of this was perfectly legal, but the net effect was that Goldman made profits by playing the rest of us for suckers.

And Wall Streeters have every incentive to keep playing that kind of game.

The huge bonuses Goldman will soon hand out show that financial-industry highfliers are still operating under a system of heads they win, tails other people lose. If you’re a banker, and you generate big short-term profits, you get lavishly rewarded — and you don’t have to give the money back if and when those profits turn out to have been a mirage. You have every reason, then, to steer investors into taking risks they don’t understand.

And the events of the past year have skewed those incentives even more, by putting taxpayers as well as investors on the hook if things go wrong.

I won’t try to parse the competing claims about how much direct benefit Goldman received from recent financial bailouts, especially the government’s assumption of A.I.G.’s liabilities. What’s clear is that Wall Street in general, Goldman very much included, benefited hugely from the government’s provision of a financial backstop — an assurance that it will rescue major financial players whenever things go wrong.

You can argue that such rescues are necessary if we’re to avoid a replay of the Great Depression. In fact, I agree. But the result is that the financial system’s liabilities are now backed by an implicit government guarantee.

Now the last time there was a comparable expansion of the financial safety net, the creation of federal deposit insurance in the 1930s, it was accompanied by much tighter regulation, to ensure that banks didn’t abuse their privileges. This time, new regulations are still in the drawing-board stage — and the finance lobby is already fighting against even the most basic protections for consumers.

If these lobbying efforts succeed, we’ll have set the stage for an even bigger financial disaster a few years down the road. The next crisis could look something like the savings-and-loan mess of the 1980s, in which deregulated banks gambled with, or in some cases stole, taxpayers’ money — except that it would involve the financial industry as a whole.

The bottom line is that Goldman’s blowout quarter is good news for Goldman and the people who work there. It’s good news for financial superstars in general, whose paychecks are rapidly climbing back to precrisis levels. But it’s bad news for almost everyone else.

The Dust Hasn't Settled on Wall Street,
but History's Already Repeating Itself

By Steven Pearlstein
Washington Post, 2009-07-31

A Year Later, Little Change on Wall St.
New York Times, 2009-09-12

Wall Street lives on.

One year after the collapse of Lehman Brothers, the surprise is not how much has changed in the financial industry, but how little.

Backstopped by huge federal guarantees, the biggest banks have restructured only around the edges. Employment in the industry has fallen just 8 percent since last September. Only a handful of big hedge funds have closed. Pay is already returning to precrash levels, topped by the 30,000 employees of Goldman Sachs, who are on track to earn an average of $700,000 this year. Nor are major pay cuts likely, according to a report last week from J.P. Morgan Securities. Executives at most big banks have kept their jobs. Financial stocks have soared since their winter lows.

The Obama administration has proposed regulatory changes, but even their backers say they face a difficult road in Congress. For now, banks still sell and trade unregulated derivatives, despite their role in last fall’s chaos. Radical changes like pay caps or restrictions on bank size face overwhelming resistance. Even minor changes, like requiring banks to disclose more about the derivatives they own, are far from certain.


Lehman Had to Die So Global Finance Could Live
New York Times, 2009-09-12

Wall Street Follies: The Next Act
New York Times, 2009-10-25

[This is a status report on the attempt to prevent future disasters like the last one.]

It certainly sounded good.

Hoping, perhaps, to persuade a dubious public that curbing reckless business practices is indeed a Washington priority, the Obama administration and Congress produced a hat trick of financial reforms last week. The outlines of a consumer financial protection agency emerged from the House Financial Services Committee. The House Agriculture Committee spelled out ways to regulate risky derivatives trading, and the United States Treasury’s compensation czar announced his plan to rein in runaway executive pay at seven companies that, in total, have received hundreds of billions of dollars in taxpayer help within the past year.

Not to be outdone, the Federal Reserve announced plans late Thursday to review pay practices at the nation’s largest banks. It all left the question, would it make Wall Street safe for America?

For all the apparent action in Washington, some acute observers say that it was much ado about little. Last week’s moves, they say, were tinkering around the edges and did nothing to prevent another disaster like the one that unfolded a year ago.

The white-hot focus on pay, for example, looks like a way for the government to reassure an angry public that they are making genuine changes. But compensation is a trifling matter compared to, say, true reform of derivatives trading.

“The American public understands the immorality of paying people huge bonuses for failures that damaged the economy,” said Michael Greenberger, a law professor at the University of Maryland and a former commodities regulator. “What they don’t understand is that those payments are only a small fraction of the irregularities that took place and that, in essence, the compensation problems, as bad as they are, are a sideshow to the casino-like nature of the economy as it existed, pre-Lehman Brothers, and as it exists today.”

It is difficult enough for seasoned regulators or market professionals to assess whether various reform proposals will close pernicious loopholes and make the financial system safer. But for a crisis-weary public, such an analysis is almost impossible. Much easier to grasp are the cuts to executive pay announced by Kenneth R. Feinberg, the Treasury official in charge of setting compensation at bailed-out companies.

Mr. Feinberg reduced compensation across the board at American International Group, Citigroup, Bank of America, Chrysler, General Motors, GMAC and Chrysler Financial, the companies that received the most government help. He cut average cash payments by more than 90 percent and overall pay by around 50 percent. Trying to discourage the instant-gratification mindset that permeates trading desks and executive suites, Mr. Feinberg also required that the majority of the salaries he oversees be paid in stock that must be held for the long term.

It is certainly worthwhile to reduce outsize pay at companies receiving taxpayer support. But regulating derivatives is far more important to those interested in eliminating the possibility of future billion-dollar bailouts. These financial instruments, which trade privately and beyond the prying eyes of regulators, are central to the interconnectedness among companies that required some of the costliest rescues. American International Group, for example, had to be rescued to cover the costs of insurance it had written for customers intending to protect their mortgage holdings from default. The insurance is a derivative called a credit-default swap. The company has received $170 billion in taxpayer aid.

But the derivatives bill generated by the House Agriculture Committee contains a sizable loophole. It is designed to push the trading of these opaque instruments onto exchanges or clearinghouses where regulators and participants can better assess who is at risk. But the bill would let transactions remain private if they involve nonfinancial companies that are trying to protect against fluctuations in their costs of doing business, a practice known as hedging. For example, when Exxon buys or sells derivatives to hedge against shifts in the price of oil, those transactions would be exempt from having to be traded on an exchange or clearinghouse. Thus, many derivatives would not trade in the light of day.

Such companies argue that trading on an exchange will make their costs rise. But critics of the exemption say that if protecting the system from a meltdown costs participants a bit more, so be it. This last go-round has certainly been expensive for taxpayers, after all.

The consumer financial protection agency moving through Congress would also carve out an exemption that disturbs advocates for borrowers. It means that the agency will not oversee loans provided by auto dealerships.

Travis Plunkett, legislative director at the Consumer Federation of America, said this is akin to exempting mortgage brokers from oversight in real estate finance. “It’s crazy to us not to cover the people who are offering the loans, who benefit from the loans and who sometimes have been found to participate in unfair lending,” he said.

None of this, mind you, addresses
the most significant issue of all:
how to make sure that companies do not grow to a point
where they become too big or interconnected to be allowed to fail.

The man with a plan to resolve that crucial problem is Paul A. Volcker,
the former chairman of the Federal Reserve who is revered
for crushing the ruinous inflation of the early 1980s.

In an interview last week with The New York Times,
Mr. Volcker said
the nation’s commercial banks
should not be allowed to hold and trade risky securities,

a practice that generated deep losses for many of them in the credit crunch.
The governor of the Bank of England made the same point last week.
Separating these operations
was the response the United States government took after the Crash of 1929,
but today,
the administration says it has no plan to break up the banks again
in the manner Mr. Volcker suggests.

The former Fed chairman is certainly not alone in his fears about
the threat that large institutions still pose.
Neil Barofsky,
special inspector general of Treasury’s Troubled Asset Relief Program,
was asked last Wednesday by CNN about the changes being made
to ensure that a disaster like the one starting last year would not recur.


“I think actually what’s changed is in the other direction,”
the refreshingly candid Mr. Barofsky said.
“These banks that were too big to fail, are now bigger.
Government has sponsored and supported
several mergers that made them larger.
that guaranteed that implicit guarantee of moral hazard.
The idea that the government is not going to let these banks fail,
which was implicit a year ago,
its now explicit.”

Then he added,
“So, if anything,
not only have there not been any meaningful regulatory reform
to make it less likely, in a lot of ways,
the governments have made such problems more likely.
we could be in more danger now than we were a year ago.”

To Rein In Pay, Rein In Wall St.
New York Times, 2009-10-30

Why are financial industry paychecks so big?

The answer is simple,
and it is the one Willie Sutton is supposed to have offered
when asked why he robbed banks:
“Because that’s where the money is.”

Those who want to do something about bringing that pay down
ought to focus on
why there has been so much money in the financial sector in recent years.
It should be no surprise that people in that business wanted to be paid a lot;
the surprise should be that there was so much money to go around.

For whatever reason,
the money was there in recent years as never before.

The government estimates total financial industry profits each year,
and it is easy to compare them to the size of the economy.
In the six decades from 1929 through 1988,
those profits averaged 1.2 percent of gross domestic product —
and never went above 1.7 percent.

Then they shot up in the 1990s and went up further in the current decade,
peaking at 3.3 percent in 2005.
Even now, the figure is higher than it ever was before 1990.

Why were those profits so high?
And did society get its money’s worth out of them?
If those surging profits
reflected the financial industry’s success in helping the real economy,
we might be jealous but not contemptuous.
You don’t hear a lot of carping
about how Bill Gates and Steve Jobs became so wealthy.

There is no doubt that the allocation of credit —
a primary function of the financial industry —
is a crucial function, particularly in an economy undergoing change.
If the finance business has done a great job of that,
of directing money to where the new opportunities are,
then there is no reason to begrudge them their wealth.

Unfortunately, there is little evidence that the financial industry’s success
has done much for the rest of us.
Capital was not well allocated during the recent bubbles, to say the least.
The fact we had bubbles testifies to that.

Moreover, Robert Barbera, the chief economist of ITG,
points out that in the middle of this decade
there was a surge in borrowing by the rest of us — households and nonfinancial businesses —
that was much larger than the simultaneous growth in the economy.

The last time that happened, he points out, was in the late 1980s,
just before the previous banking crisis.
Perhaps he has found an indicator
that a systemic risk regulator could use in a coming cycle.

But saying the success of the financial sector
has not been a godsend to society
does nothing to explain why it occurred.

Let me suggest a few contributors to that success:

It is not just all those fees you have noticed
on your credit cards and checking accounts.
Much more important is the growth of the hedge fund industry.

The people who managed money for institutions a generation ago
charged fees that seem tiny by today’s standards.
Now hedge funds normally charge a management fee of 1 percent of total assets,
plus 20 percent of profits.
Those fees swell financial industry profits.
To generate investment returns high enough to justify those fees,
hedge funds use a lot of leverage.
That borrowed money creates financial industry revenue.

“In 1990, the 10 largest financial institutions
had 10 percent of financial assets in the United States,”
says Henry Kaufman, an economist and author of a new book,
“The Road to Financial Reformation.”
“Last year, the figure went over 60 percent.”
He points out that bid-asked spreads are rising in some markets,
which will raise profits for the market makers,
and that fees for underwriting securities are also rising.

Richard Bookstaber, a former hedge fund manager and risk manager
whose 2007 book “A Demon of Our Own Design”
warned of the crisis that soon erupted,
suggested in his blog last week that
banks profited from
“constructing informational asymmetries between themselves and their clients.
This gets into those pages of small print
that you see in various investment and loan contracts.
What we might call gotcha clauses and what the banks call revenue enhancers.
And it also gets into
the use of complex derivatives and other innovative products
that are hard for the clients to understand, much less price.”

Many of the financial innovations of recent years
were not designed to increase operating profits for customers.
Instead, they sought to avoid taxes,
or make accounting statements look prettier,
or get around regulations seeking financial safety.
At their worst, they boiled down to
an offer to charge a customer a dime
for letting him evade 20 cents in taxes.
Such transfers do nothing for the larger society.

The banks took more and more risks in recent years.
Some they pushed out to others via derivatives that often were badly priced.
But others were kept.
When things went well, the profits rolled in.
When they went badly, we got to bail them out.

(The profit numbers the government uses, by the way,
are a version of operating profits.
They don’t count big write-offs, which would seem quite unreasonable
if it did not turn out that bankers did not need to count them either.
Bailed out, they could return to collecting big paychecks.)

If those are the reasons for the profits,
perhaps regulatory attention should focus on the causes,
not the effect.

Rather than have a pay czar
try to determine fair compensation for bailed-out banks
while others can do as they please,
Congress could look at changing the environment that produced this mess.

One way to do that is to encourage more competition.
The impulse last year to have bigger banks take over failing big banks
now looks exactly wrong,
even before remembering that
the regulators thought Citigroup and Bank of America were good acquirers
with solid balance sheets.

The new regulatory system also needs to force banks to hold a lot more capital,
and it needs to keep them from using tricks to take the same risks
while appearing to need less capital.
If the regulators can do that,
it would reduce bank profits by tying up capital.
One Wall Street executive I know suggests that would, in turn,
bring down compensation
by stimulating shareholders to demand more of the profits for themselves.

Mr. Kaufman argues that
to prevent further socialization of the financial system,
there simply have to be fewer banks that are too big to fail.
He thinks such institutions should face more stringent regulation,
and be barred from certain activities.
If they want to do those things,
they can find ways to split up or shrink.

Customers can also be empowered.
Forcing most derivatives onto exchanges
would increase the number of people
who would be in a position to trade them,
and probably bring better pricing for customers.
One reason there are so many custom derivatives is that
banks have persuaded customers they are cheaper, which is absurd.
They can argue that because
the banks do not force companies to put up cash
when the value of a position declines.
That should change.
The banks could still lend the needed margin, or course,
but by separating the credit and pricing functions
customers would know more,
and possibly get better deals.

Some such ideas were in the Obama proposals,
but they are being watered down by intense bank lobbying.
Some legislators who loudly denounce bank pay
seem unwilling to do anything about the actual causes.

If policy makers want to bring down bank pay,
they should do something to make the industry more competitive,
and to assure that no one expects the taxpayer to again
pay all the costs if the industry blows up again.

This Wall Street fairy tale doesn't have a happy ending
By Steven Pearlstein
Washington Post, 2009-10-30

Once upon a time, there was a magical kingdom
whose capital markets were ruled by two firms known as Goldman and Morgan.
Each firm earned $1 billion a year in trading profits.
By custom, 25 percent of these profits were shared with the employees,
according to their needs and talents.
The markets worked remarkably well
in allocating capital to the realm’s most productive enterprises,
and the kingdom prospered.

Goldman had a clever trader named Peter,
who in one year produced $50 million in trading profits,
which earned him $10 million in salary and bonus.
Eyeing those profits,
Morgan offered Peter $15 million to switch firms.
He quickly accepted.
Not to be outdone, Goldman responded by luring Paul, Morgan’s top trader,
for something more than $15 million.
A general bidding war for talent ensued.

After several years of this competition,
neither Morgan nor Goldman was able to gain a competitive advantage.
The industry was still earning the same $1 billion in trading profits,
but now nearly half of those profits were distributed to employees.
Although every employee benefited,
most of the gains went to Peter, Paul and a handful of other top performers.

Before long, the students at the kingdom’s universities noticed that
they could make much more money going into finance
and began to alter their career choices.
Some professions, such as law and management consulting,
were able to continue attracting top students
by matching the starting pay at Goldman and Morgan.
Many others were forced to settle for less-talented graduates
or to try to attract graduates from other kingdoms.

Meanwhile, the owners of Goldman and Morgan
began looking for new sources of revenue and profit
to finance this never-ending bidding war for talent.
The firms gathered all their financial wizards --
mathematicians, engineers and economists --
and set them to inventing
whole new categories of securities that could be traded,
in addition to sophisticated new trading strategies
that would increase the number of times each security changed hands.

[A version of churning.]

These innovations did little to improve the efficiency or output
of the rest of the kingdom’s economy,
but over time,
they allowed Goldman, Morgan and their employees
to capture a greater share of the realm’s income and wealth.

The people of the kingdom
rushed to embrace these new securities and trading strategies,
even if most did not understand them.
Because of them,
just about any commoner could get loans for any purpose,
with no questions asked and no money down.

Businesses discovered that
they could make more money buying and selling other businesses
than doing the hard work of
inventing new products or better ways to make them.
And investors calculated that they could earn outsized returns
by placing their bets with
large amounts of money borrowed from each other or residents of other kingdoms.

There were some at the castle who warned that
all this borrowing and trading of financial assets was too good to be true
and needed to be restrained.
But the king’s ministers would not listen.
They were blinded by the glitter of all the gold pouring in from tax collectors,
along with the silver generously sent their way by the Morgan and Goldman traders.
They professed shock when it was finally revealed that
few of the new securities were worth anything close to what people thought.

Today, the people of the kingdom are angry.
Their income and wealth are lower than when our story began.
Most of the gains of the era of riches
have long since been siphoned off by the Goldman and Morgan traders.

Businesses are saddled with capacity they cannot use and debt they cannot repay.
A generation of top talent has been squandered,
and the gap between rich and poor has widened.

If there is a moral to this tale,
it is that finance alone cannot make a kingdom thrive and prosper.

Trading assets is largely a zero-sum game:
The buyers’ gains are the sellers’ losses, or vice versa.

Economies benefit to the degree that
financial markets efficiently allocate capital
from those who have it to those who can make the most of it.

Surely, one measure of that efficiency is
how little is skimmed off by the financial middlemen.
So the next time someone tells you that
it’s no concern of yours if Wall Street traders are earning a king’s ransom,
remind him of the story of Goldman and Morgan
and the financial wizards who thought they could spin capital out of straw.

The words on the 'Street'
By Simon Johnson
Washington Post Outlook Book Review, 2009-12-27


You can blame the bankers all you want, but

it is the government’s job
to prevent the financial sector (and anyone else)
from holding or exercising this kind of power over us.
Where was the government?

By 2008,
our executive and legislative branches had long been deep in bipartisan slumber,
allowing vulnerabilities to build up in the form of
rising consumer debt levels and
lax (or nonexistent) protection for consumers [and taxpayers]
against outrageous practices by the financial sector.
This bigger picture is missing from
Sorkin’s and McDonald’s blow-by-blow accounts,
but it is a recurrent theme in “Past Due,” by journalist Peter S. Goodman.

We can quibble about the relative importance of some details --
such as the role of China’s high savings rate
in lowering global interest rates and feeding the American credit boom --
in Goodman’s highly informative account.
But there is no question that
politicians either
believed that crazy “financial engineering”
created a sound basis for sustainable growth
just loved what the financial system could do for them at election time.

And, as Sorkin relates, it is hard to escape the conclusion that
the rhetoric regarding
our supposedly free markets without government intervention
just masks the reality --
that there is a revolving door between Wall Street and Washington,
and powerful people bend the rules to help each other out.
In an illustration of Wall Street clubbiness,
Sorkin documents a meeting in Moscow between Hank Paulson,
secretary of the treasury (and former head of Goldman Sachs),
and the board of Goldman Sachs.
As the storm clouds gathered at the end of June 2008,
Paulson spent an evening talking substance with the board —
while agreeing not to record this “social” meeting in his official calendar.
We do not know the content of the conversation,
but the appearance of this kind of exclusive interaction
shows how little our top officials care about public perceptions of favoritism.

In saner times, this would constitute a major scandal.
At moments of deep crisis,
understanding what influences policymakers and having access to them
can help a firm survive on advantageous terms.
Goldman Sachs was saved, in large part,
by suddenly being allowed to become a bank holding company on Sept. 21, 2008.
Our most senior government officials determined that
the United States must allow Goldman to keep its risky portfolio of assets,
while offering it essentially unfettered access to
cheap credit from the Federal Reserve.
In rescuing a crippled investment bank,
the Treasury created the world’s largest government-backed hedge fund.

In the face of these developments,
Andrew Haldane, head of financial stability at the Bank of England,
has become blunt about
the way our banking system interacts with (and rips off) taxpayers.
In a recent paper that represents
the straightest talk heard from the official sector in a long while,
Haldane puts it this way:
The government may say “never again” to bailouts,
but when faced with the choice to either “rescue big banks
or allow the world economy to collapse,”
it will reasonably choose the route of rescue.
[Comment from KHarbaugh:
Am I the only person who is getting tired of hearing these
“the world economy will collapse” arguments
with hardly a shred of proof for it?]

But, knowing this,
the people running our biggest banks have an incentive to take more risk --
if things go well, bank executives get the upside,
and if there’s a problem, the taxpayer will pick up the check.
[As I’ve said before, Wall Street and the government have rigged the system so that
“Heads, Wall Street wins; tails, the taxpayers lose.”
The only analogous situation is what the feminists have arranged:
“Heads, women win; tail, men lose.”
My opinion on the common cause of these two situations:
the feminist/Jewish alliance.]

If a financial sector boss wants greater assurance of a bailout,
he or she should make bigger and potentially more dangerous bets --
so the government simply cannot afford to let that bank fail.

This, Haldane argues, is our “doom loop” --
big banks know they can get away with the same behavior (and more) again,
and we are doomed to repeat the same boom-bust-bailout cycle.
A long time ago,
President Andrew Jackson [7]’s private secretary, Nicholas Trist [nice beard :-)],
described the Second Bank of the United States,
the last financial institution to seriously challenge the power of the president, thus:
“Independently of its misdeeds,
the mere power, -- the bare existence of such a power --
is a thing irreconcilable with the nature and spirit of our institutions.”
Unless and until we break the political power of our largest banks,
the middle class will be hammered down.
Whose taxes do you think will be raised
to reflect the costs of repeated financial shenanigans?
[Answer: those of future generations.]
The financial sector will become even richer and more powerful.
If you didn’t like where inequality in the United States was already heading,
wait until you see the effects of this recession.

The most significant result of the financial crisis is
the emergence of six large banks that are undoubtedly too big to fail
and therefore enjoy a strengthened government guarantee;
Goldman, JPMorgan, Citigroup, Bank of America, Wells Fargo
and Morgan Stanley
are the beneficiaries of the doom loop.
The most significant non-result is the fact that
no comprehensive legislation has yet been passed to reform the financial sector.
Without really serious reform,
we have every reason to start counting down to the next financial crisis,
and to the next fleet of Mercedes lining up before the New York Fed.

Simon Johnson is co-founder of the blog BaselineScenario,
co-author of “13 Bankers,” to be published in April,
and a professor at MIT’s Sloan School of Management.


A Wall Street pay puzzle
By Robert J. Samuelson
Washington Post, 2010-01-18

Why does Wall Street make the big bucks?
A nation with 10 percent unemployment is understandably puzzled and outraged
when the very people at the center of the financial crisis
seem to be the first to recover and are pulling down fabulous pay packages.
At Goldman Sachs, the average pay for 2009
has been estimated at nearly $600,000;
at J.P. Morgan Chase’s investment bank,
it’s been reckoned at slightly below $400,000.
These averages conceal
multimillion-dollar bonuses for top traders and investment bankers;
underlings get smaller sums.
Are Wall Street’s leaders that much smarter and more industrious
than everyone else?

By their own admission, they’re not.
Testifying last week to a congressionally created commission,
Wall Street chief executives conceded that
their errors directly contributed to the crisis.
Wall Street money moguls may be bright and diligent, but they’re not unique.
It’s where they work -- not who they are -- that’s so enriching.
A study of Harvard graduates found that
those who went into finance “earned three times the income of
other graduates with the same grade point average, demographics and college major,”
reports Harvard economist Lawrence Katz, the study’s co-author.

Is it possible that what Wall Street does
is three times more valuable to society than other well-paid occupations?
That’s hard to believe.
It’s not that Wall Street is just the vast casino of popular imagination.
It helps allocate capital, which -- done well -- promotes a vibrant economy.
In 2007, Wall Street firms enabled businesses to raise $2.7 trillion
from the sale of stocks, bonds and other securities.
[One may surmise that raising that $2.7T could have been done at far less cost.]
But Wall Street sometimes misallocates capital,
as the 1990s “tech bubble” and today’s crisis painfully remind.
The huge social costs (high unemployment, lost income) refute the notion that
Wall Street consistently creates exceptional economic value
that justifies exceptional compensation.

The explanation for Wall Street’s high pay lies elsewhere.
Most of us are paid based on what we produce
or, more realistically, what our employers produce.
By contrast,
Wall Street compensation levels are tied to the nation’s overall wealth.
Investment banks, hedge funds, private equity firms
and many other financial institutions
trade stocks, bonds and other securities for their own profit.
They also advise
mutual funds, pension funds, endowments and wealthy individuals
on how to invest and trade.

There’s a big difference between annual production and national wealth.
In 2007, the year before the crisis,
annual production (gross domestic product) equaled almost $14 trillion.
In the same year,
household wealth was $77 trillion (5.5 times production);
that covered the value of homes, vehicles, stocks, bonds and the like.
Eliminating nonfinancial assets (mainly homes)
cut wealth to about $50 trillion (3.5 times).
Deducting household debts from financial wealth
pushed net worth to $35 trillion (2.5 times income).

People who are trying to protect or expand existing wealth
are playing for much higher money stakes
than even hardworking and highly skilled producers.
That’s the main reason they’re paid more.
Similar percentage changes in production and wealth translate into
much larger gains or losses in wealth --
up to five times as much based on the crude math above.
Many lawyers enjoy the same envious position
of being paid on the basis of wealth enhancement or protection.
They’re involved in high-stakes mergers and acquisitions,
estate planning, divorces and tax planning.
On average,
partners in the top 25 law firms earned $1.3 million to $4 million in 2008,
reports the American Lawyer magazine.

All this provides context to today’s pay controversies.
Wall Street may be greedy -- who isn’t?
[What happened to the old virtue, of Christian or Greek origin,
of moderation in all things?]
but the explanation for its high compensation
is its economic base (wealth, not production).
That’s why it’s so hard to control or regulate.
Since the 1960s, the industry has changed dramatically.
revenue came mainly from commissions on buying stocks and bonds for others.
In 1966, commissions were 62 percent of revenue.
Now, firms mostly make and manage investments for themselves and others.
In 2007, commissions provided only 8 percent of revenue.

The transformation has made Wall Street
a greater source of potential economic instability.
Some compensation packages exacerbated the crisis
by offering big bonuses if big risks paid off.
Because government provided a safety net for the whole system,
it’s justified in taxing the industry -- as President Obama proposed last week --
to cover the costs, as Douglas Elliott,
a former investment banker now at the Brookings Institution, correctly argues.

A larger issue is:
How much should society concentrate on existing wealth
as opposed to creating new wealth?
[I would suggest American society has focused too much on wealth
and not enough on production, i.e., honest toil, of goods and infrastructure.
I would like to have added personal growth there as well,
but our society already spends enormous amounts on that,
just not on what I would view as the most desirable definition of personal growth.]

Wall Street’s lavish pay packages may attract too many of
America’s best and brightest.
“It’s bad for the rest of the economy,”
says economist Thomas Philippon of New York University,
a student of the financial sector.
“We also need smart brains outside finance.”
If that somehow happens, the crisis may yet have a silver lining.

Ailing Banks Favor Salaries Over Shareholders
New York Times, 2010-01-27

Finding the winners on Wall Street is usually as simple as looking at pay.
Rarely are bankers who lose money paid as generously as those who make it.

But this year is unusual.

A handful of big banks that are struggling in the postbailout world
are, by some measures,
the industry’s most magnanimous employers.
Roughly 90 cents out of every dollar that these banks earned in 2009 —
and sometimes more —
is going toward employee salaries, bonuses and benefits,

according to company filings.


Wall Street's Bailout Hustle
Rolling Stone, 2010-02-17

Goldman Sachs and other big banks
aren’t just pocketing the trillions we gave them to rescue the economy -
they're re-creating the conditions for another crash

It’s Time for Swaps to Lose Their Swagger
New York Times, 2010-02-18


DERIVATIVES are responsible for
much of the interconnectedness between banks and other institutions
that made the financial collapse accelerate in the way that it did,
costing taxpayers hundreds of billions in bailouts.
Yet credit default swaps have been largely untouched
by financial reform efforts.


Buffett Casts a Wary Eye on Bankers
New York Times, 2010-03-02

Mr. Buffett’s letter made a bold suggestion
that isn’t sitting well with the establishment.

“When stock is the currency being contemplated in an acquisition
and when directors are hearing from an advisor,
it appears to me that
there is only one way to get a rational and balanced discussion,”
he wrote.
“Directors should hire a second advisor
to make the case against the proposed acquisition,
with its fee contingent on the deal not going through.”

The Swaps That Swallowed Your Town
New York Times, 2010-03-07

[What swaps may have done to your local government’s finances.]

AS more details surface about
how derivatives helped Greece and perhaps other countries
mask their debt loads,
let’s not forget that the wonders of these complex products
aren’t on display only overseas.
Across our very own country,
municipalities, school districts, sewer systems
and other tax-exempt debt issuers
are ensnared in the derivatives mess.

Like the credit default swaps that hid Greece’s obligations,
the instruments weighing on our municipalities
were brought to us by the creative minds of Wall Street.
The rocket scientists crafting the products got backup from swap advisers,
a group of conflicted promoters who consulted municipalities and other issuers.
Both of these camps peddled swaps as a way for tax-exempt debt issuers
to reduce their financing costs.


Wall Street's role in Greek crisis should be no surprise
By Allan Sloan
Washington Post Opinion, 2010-03-10


Wall Street makes most of its money these days by speculating.
It doesn’t care about the collateral damage
that its activities can inflict on people, companies and entire countries --
unless the result is
embarrassment, punishment, regulation or some combination of these.

Once upon a time, big investment houses’ major profits came from
underwriting deals for companies that wanted to raise capital
and from
helping customers buy and sell securities.
But that’s so ‘70s.
Increasingly, the Street makes its real money by
creating, peddling, trading and sometimes owning
high-profit-margin instruments

such as the Trojan-horse securities that helped Greece
obscure its true financial situation for a while
but now are costing the country dearly,
on both the image and financial fronts.

Learning From Lehman
New York Times Editorial, 2010-03-14

On top of everything Lehman Brothers did before it collapsed in 2008,
nearly toppling the financial system,
it now seems that it was aggressively massaging its books.

Of course, many colossal bankruptcies involve bad accounting.
But a new report on the Lehman collapse,
released last week and described in an article in Friday’s Times,
would leave anyone dumbstruck by the firm’s audacity —
and reminded of the crying need for adult supervision of Wall Street.

The 2,200-page report was written by Anton R. Valukas,
a former federal prosecutor who was appointed by the Justice Department
as an examiner for the Lehman bankruptcy case.
According to the report, Lehman engaged in transactions
that let it temporarily shift assets off its books
and in so doing, hide its reliance on borrowed money.

The maneuvers, which Mr. Valukas said were “materially misleading,”
made the firm appear healthier than it was.
He wrote that Richard S. Fuld Jr., Lehman’s former chief executive,
was “at least grossly negligent,” and that Lehman executives engaged in
“actionable balance sheet manipulation.”

At the time, one Lehman executive sent e-mail to a colleague
describing the accounting ploys as “basically window dressing.”

Window dressing? Shortly before Lehman’s failure,
$50 billion in liquid assets were shed from its balance sheet.

The executive who got the e-mail almost manages a question:
“So it’s legally do-able but doesn’t look good when we actually do it?” —
followed by that familiar dodge:
“Does the rest of the street do it?”

Surely those whose job it is to analyze and supervise were alarmed,
weren’t they?
According to the report,
rating agencies, government regulators and Lehman’s board of directors
had no clue about the gimmicks.
The result is that we were all blindsided.
And we could be blindsided again.
Congress is not even close to passing meaningful regulatory reform.
The surviving banks have only gotten bigger and more politically powerful.
If the Valukas report is not a wake-up call, what would be?

Gambling With the Economy
New York Times Op-Ed, 2010-04-20

WHILE the Securities and Exchange Commission’s allegations
that Goldman Sachs defrauded clients is certainly big news,
the case also raises a far broader issue
that goes to the heart
of how Wall Street has strayed from its intended mission.

Wall Street’s purpose, you will recall, is to raise money for industry:
to finance steel mills and technology companies and, yes, even mortgages.
But the collateralized debt obligations involved in the Goldman trades,
like billions of dollars of similar trades
sponsored by most every Wall Street firm,
raised nothing for nobody.
In essence, they were simply a side bet — like those in a casino —
that allowed speculators to increase society’s mortgage wager
without financing a single house.


Financial Debate Renews Scrutiny on Banks’ Size
New York Times, 2010-04-21

[The conclusion of the article:]

Simon Johnson, an M.I.T. professor,
has been leading the intellectual charge to break up banks.
In his book “13 Bankers,” he urged that
no financial institution be permitted to control more than 4 percent of G.D.P.
and no investment bank more than 2 percent.
All six of the big financial institutions exceed those limits.

Forbidding taxpayer bailouts, as the Senate bill proposes,
is worth little more than the paper it is on, Mr. Johnson argues.
“When push comes to shove, will the government save these guys?”
he asked.

“I don’t know anybody who doesn’t think they’d save Goldman
if Goldman were to suddenly run into trouble.”

Uncertainty Is Not Ending With Summer
New York Times, 2010-09-07

Wall Street is accustomed to topsy-turvy markets. But with public opprobrium constraining bonuses, the likes of JPMorgan and Goldman Sachs have limited their employees’ compensation to around 40 percent of revenue. If the robust showing in August proves inauspicious, banks may find they have too small a fee pie from which too many slices will need to be cut.
It might not take much of a slowdown before
they soon start slashing jobs.

[Whereas, the compensation schedule on Wall Street
is already astronomical with respect to
that of the nation in which Wall Street exists and might be presumed to serve
would it not make sense for Wall Street to use reduced income
as a chance to bring its compensation schedule
back more into line with the normal?]


Why I Am Leaving Goldman Sachs
New York Times Op-Ed, 2012-03-14


The Hidden Cost of Trading Stocks
‘Best Execution’ and Rebates for Brokers

New York Times Editorial, 2014-06-23

There’s no escaping the conclusion that the stock market is not a level playing field where all investors, large and small, have an equal shot at a fair deal.

A recent groundbreaking study found that undetected insider trading occurs in a stunning one-fourth of public-company deals. Experts have long debated the pros and cons of high-frequency trading, another pervasive practice, but there is no doubt that it gives superfast traders the jump on others in trading stocks. And the very idea of trading on a public exchange, where stock prices and trading volumes are visible to all, is being eclipsed by private trading of public stocks in off-exchange venues, called dark pools, usually operated by banks.

These are not the only ways in which big market players make money at the expense of other investors. The Senate Permanent Subcommittee on Investigations recently held a hearing on “maker-taker” pricing in which stock exchanges pay rebates to brokers for sending them buy-and-sell orders. The practice has been around for years, as a growing number of exchanges — there are now 11 public exchanges in the United States — have battled for business. What is new is the compelling evidence that the rebates are corrupting.

Under federal trading rules, brokers must provide “best execution,” which usually means finding the best stock prices for clients who pay them to buy and sell shares. But the rules also recognize that for some trades, getting the best price is only one part of best execution; the speed, size and cost of a trade must also be considered.

Research presented at the Senate hearing showed that under the guise of making subjective judgments about best execution, brokers were routinely sending orders to venues that paid the highest rebates.

In the last quarter of 2012, for example, the brokerage TD Ameritrade sent all nonmarketable customer orders — those that can’t be completed immediately based on the market price — to the one exchange that paid the highest rebate. In the first quarter of 2014, it sent nonmarketable orders to two venues that paid the highest rebates.

Senator Carl Levin, the subcommittee chairman, rightly called it “a frankly pretty incredible coincidence” that the firm’s judgment on best execution for tens of millions of customers had invariably led it to use the venues that paid the highest rebates. Under questioning, Steven Quirk, an executive of TD Ameritrade, conceded that in the trades cited by Mr. Levin the firm had virtually always used exchanges that paid the most. He also estimated that the firm made $80 million last year from maker-taker rebates.

Meanwhile, many brokerages promote their low trading costs. But the fees to trade stocks do not include the hidden costs that are incurred when investors don’t get the best price. A study from 2012 estimated that rebates cost individual investors, mutual funds and pension funds as much as $5 billion a year.

Securities regulators clearly need to better enforce the best execution requirements on brokers, and require better disclosure on brokers’ routing decisions and the rebates they earn. If Congress won’t provide more resources for enforcement, rebates need to be passed along to the customer or eliminated altogether.

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