In an Uncertain World

by Robert Rubin

  Ray Young represented all of the firm’s equity trading and sales activities on the Management Committee. In 1980, he retired, and I was one of three people who replaced him on the committee. Somewhat thereafter, I was asked to take on the problem of J. Aron & Company. A few years earlier, working with George Doty, I had tried to extend the arbitrage mind-set and our experience with trading in derivatives into building a commodities trading operation. Then, the year after I joined the Management Committee, Goldman bought J. Aron, its first acquisition since the 1930s. A hugely successful, family-owned commodities trading firm, Aron had sophisticated, well-established commodities operations, with connections all over the world. What neither we nor they realized, however, was that, because of various changes taking place, it didn’t have a viable business model for the future. Aron’s profits, which had been $60 million in 1981, fell to $30 million in 1982 and then to nothing in 1983.

  Doty had responsibility for J. Aron and took the first difficult step of downsizing. With that done, the two Johns and George asked me to take charge of the problem. I could have said to myself that this might not work and could upend my position at Goldman Sachs. At the very least, I might have done some probabilistic analysis. But here, as in other major career changes that strongly attracted me, I didn’t calculate. I wasn’t at all cocky about my ability to turn Aron around, but neither was I anxious. Once I had the job, I just focused on trying to do what needed to be done. And I very much wanted the responsibility, because it was interesting and would enlarge my role at the firm. Moreover, Aron was a trading business with a strong arbitrage bent, so I felt suited to the task.

  I walked around with my yellow pad for two or three months, just taking notes and trying to learn about the business before actually taking over. In the course of my inquiry, I found that the people doing the work had many thoughtful ideas about how to revise our strategy and move forward. After a while we changed the leadership, putting Mark Winkelman, who had been in the fixed-income department, in charge, reporting to me. Winkelman, who was born in Holland and worked at the World Bank before coming to Goldman, was extremely sophisticated about the developing business of relationship trading in bonds and foreign exchange. He had both the substantive background to understand Aron’s problems and the managerial skills to help set them right.

  Together Mark and I worked with the Aron people to rethink the business model. Aron had been doing classic arbitrage, buying a currency or a commodity—such as gold—in one place and selling it as close to simultaneously as possible somewhere else. Aron was imaginative in crafting opportunities for classic arbitrage, for example by maintaining open phone lines to Saudi Arabia to trade gold and silver. This kind of trading had little risk, and Aron was intensely risk averse—so much so that when it lost track of its transactions, it would close in the middle of the day, to sort everything out and make sure it wasn’t holding an extra hundred ounces of gold on its books. The only exception to this model was coffee, where Aron acted as a large importer and trader.

  One of the first conclusions others led me to see was that the relative stability of commodity prices, improved communications, and increased competition had eliminated the meaningful profit opportunity in Aron’s traditional business. Spreads were being squeezed, a reality that the Aron leadership seemed to have missed because of its great success in the past. I found over the years that the Aron experience was quite typical. Success often leads businesses and individuals to fail to notice change or to adapt to it, and so, eventually, to falter.

  Mark and I determined that Aron needed to make several basic changes. The first was to focus on relative value arbitrage, or relationship trading, which Goldman was already doing in fixed income and equities. In the Aron context, that meant looking for distortions in the price relationship between different commodities or currencies, or between them and derivatives based on them, using interest rates and other factors to estimate the appropriate relative values. For example, short-term gold futures could be traded against long-term gold futures to profit when prices that seemed out of whack converged. That meant taking risks that the Aron people had always been proud of not taking, and with the firm’s own money. We decided to abandon the sure thing that no longer existed in favor of calculated risk taking. We also decided to greatly expand Aron’s foreign exchange trading, going from a pure arbitrage operation into relative value arbitrage, outright position taking, and increased client business—for example, helping businesses and individuals hedge against currency risk, which added to the services that Goldman could offer clients. Somewhat later, we went into trading oil and petroleum products, adding a vast new arena to our business.

  These transformations at Aron required certain personnel changes, our most delicate undertaking. After extensive observation, we concluded that Aron had some extraordinarily capable people—who had already contributed greatly to rethinking the strategy—but that some others were so steeped in the old, risk-free way of doing business as to be unable to make the transition to a risk-based approach. We had to find places for those people elsewhere at Goldman or encourage them to move on. And we needed a process for recruiting. Hiring at the old Aron had been based on horse sense—somebody seemed as though he might make a good commodities trader. We formalized the process, looking for people whose experience and qualifications met our new needs. With all of these changes, we had reengineered Aron and the business started to work again—though in a very different way. We didn’t reach our ambitious $100 million goal the first year, but we exceeded it the second year and created a base from which Goldman earned enormous profits in the years after.

  Like arbitrage, commodities and currency trading was an example of a good business based on calculated risk taking and that involved living with the large losses that sometimes—and inevitably—ensue. But the Aron transformation was also an illustration of how difficult change can be at big organizations. Michael Porter, a professor at Harvard Business School, argues that great institutions fail because, once successful, they become satisfied with themselves and stop changing, and the world passes them by. That was the case with Aron, which had lost its strategic dynamism. But even with an effective business model and a dynamic, strategic mind-set, a company needs a structure that works, a system for attracting capable people and putting them in the right jobs, and a culture in which people work together in a mutually supportive way.

  But perhaps the most important management point about Aron was that the ideas for remaking its business came largely from the people who worked there, exemplifying my career’s experience that the people in the front lines of a business often have a better sense of what’s happening and what to do about it than the top executives. Our success at Aron was more evidence of Ray Young’s and Dick Menschel’s advice that to be most effective I was best off being surrounded by strong people, listening to them, and being sensitive to their concerns and quirks of personality—just as they had to be sensitive to mine.

  AT THE SUGGESTION of Bob Strauss, the Democrats asked me to chair their 1982 congressional campaign dinner in Washington. Never having done anything like it, I wondered whether I would be able to raise enough money. Instead of saying yes or no immediately, I tried to get a better idea of how much I had to raise personally to be viewed as successful. People I spoke to named a figure of $100,000. So I called a family friend in Florida who had made a lot of money from my arbitrage advice. He and his partner said they’d each put up $20,000. With the $20,000 I could contribute under the legal limits and a few other ideas about where to raise money, I felt close enough to the $100,000, and I said okay. The dinner was successful: I raised much more than $100,000 on my own, and the dinner took in more than $1 million—large numbers by the standards of that era. Bob Strauss had told me that chairing that dinner put someone in a different position in the party. He was right. Soon after, both Walter Mondale’s and John Glenn’s campaigns sought my help for the 1984 election.

  Substantively, I felt that the
Reagan administration’s budget deficits created a serious threat to future economic conditions and that sooner or later we would pay the price. I remember speaking at a House Democratic Caucus meeting in the late 1980s. Congressman Barney Frank (D-MA) said, pointedly, that although I had been concerned about deficits for some time, the economy had continued to grow reasonably well. I replied that the laws of economics hadn’t been revoked. The timing of any market impact can be complicated, but the inevitable would surely occur at some point—as, indeed, happened not much later.

  Many conservatives shared this concern. Martin Feldstein, the distinguished economist who was Ronald Reagan’s second chairman of the Council of Economic Advisers, argued strongly against large budget deficits, but his arguments were unsuccessful and he stepped down near the end of that administration’s first term. Gary Wenglowski, Goldman’s highly regarded chief economist, said he thought Reagan’s economic policy was the worst since Herbert Hoover’s. At that time, some conservatives argued that tax cuts should be accompanied by commensurate reductions in the cost of running the federal government. But that would have required program reductions that neither party was prepared to support, especially during a period when defense and entitlement spending were rising at a rapid rate. Another view was that tax cuts would generate sufficient additional growth to pay for themselves, which George H. W. Bush referred to in his 1980 presidential primary campaign against Reagan as “voodoo economics”—which seems to me about right.

  The other aspect of Reagan’s policy that most concerned me was the failure to address the country’s social problems, many of which were clearly getting worse. Around that time, I read Ken Auletta’s book The Underclass. In vivid fashion, Auletta described the replication of poverty through generations. The book crystallized a lot of my thinking on the topic—though later, when I worked in a Democratic administration, I learned that the term “underclass” is no longer politically correct. (I was told that the acceptable alternative is “people who live in distressed areas, rural and urban.”)

  I had some direct exposure to the problems of inner cities at meetings of a neighborhood group called the 28th Precinct Community Council in central Harlem in the 1970s. In searching for a way to get involved with these issues, I had met Warren Blake, an African-American police officer in charge of community relations for the precinct. Warren, a huge man with a personality to match, had strong ties to the community and cared deeply about what was happening to it. His wife’s family had run a prosperous funeral business in the neighborhood for many years, and the Blakes lived nearby in a large Victorian house that had once belonged to James A. Bailey of Barnum & Bailey Circus. When he was off duty, Warren sometimes drove a hearse. I remember a dinner Judy and I went to at their home. One of the other guests was a political activist from Papua New Guinea who proposed that Goldman Sachs finance a revolution in exchange for some of the country’s shrimp and timber concessions. I didn’t pursue this.

  What I saw and heard at the 28th Precinct Community Council gave me a more personal feeling that it is just wrong that a country as wealthy as ours does not provide the resources to successfully address poverty that passes from generation to generation. The more I learned about these issues, the more I was convinced that there were approaches that would work if adequately supported. I also came to believe that the problems of the inner cities greatly affect all of us—no matter where we may live or what our incomes may be—through crime, the deterioration of public schools, the costs of social ills, and the lost productivity of a large group of people who are not being equipped to realize their potential. The belief that affluence can insulate is illusory.

  And that helps explain why I am a Democrat. If you put all my views on public policy issues together, I wouldn’t fit neatly under any political label. In fact, many of my views, such as the importance of fiscal discipline to our country’s future growth and the centrality to our own well-being of American leadership on global issues such as trade liberalization, poverty, the environment, and terrorism, don’t really fit into any political camp. But when I look in both directions from the center, I find concerns that echo my own to a greater degree on the Democratic side, which has long seemed to me more committed to using government to meet the needs of middle- and lower-income people that markets by their nature will not adequately address.

  However, I wasn’t necessarily in full agreement even with those who shared my concerns. Roughly twenty years ago, I heard Senator Ted Kennedy (D-MA) give a speech advocating a whole host of government programs that sounded worthwhile to me. The address was powerful and well delivered. But as much as I agreed with Kennedy’s goals and respected his commitment to them, I wondered, How are we going to pay for this? The focus by some social advocates on problems and programs—but not the means to fund those programs—bothered me. My deep involvement in the 1984 presidential campaign was largely driven by the conviction that we needed a President who combined Kennedy’s social concerns with a sense of fiscal responsibility.

  Walter Mondale seemed to fit that bill. I met Mondale through his campaign chairman and former White House aide, Jim Johnson, who later became the CEO of Fannie Mae. Through Jim, I also met Mike Berman, the treasurer of Mondale’s campaign and a man wise in the ways of Washington. As I got to know Mondale better, he seemed to be very practical, with a well-known commitment to the plight of the poor, joined with a deep concern about our growing fiscal disarray. When the Mondale people asked me to be his New York State finance chairman, I accepted, after initially hesitating because once again I wanted to be sure I could raise enough money to be successful.

  Though my place at the Mondale table came from fund-raising, my conversations with Jim Johnson, Mike Berman, and others in the campaign often shaded into economic policy and politics. Some people like opera. Some like basketball. I like policy and politics. Somewhere in the back of my mind, I also knew I wanted to work in the White House if the right opportunity should ever arise.

  After Mondale’s defeat, gloom pervaded the Democrats. The party was widely seen as being in trouble and needing to reassess its direction. Some thought it was in thrall to the labor unions and interest groups, and that more centrist positions would be both better policy and more attractive to middle-class voters. Others felt just the opposite—that the focus needed to be on what they referred to as the “base.” I remember one dinner discussion at the house of Roger Altman, a fellow Wall Streeter who had served in the Carter administration and had worked with me on the Mondale campaign. Two other political strategists, Tom Donilon and the late Kirk O’Donnell, were also there, as was Jacob Goldfield, a colleague at Goldman Sachs. The focus of the discussion was that Reagan’s position was too simplistic to be serious policy but was easy to grasp and good politics: fight communism, cut taxes, and reduce government. How could views that reflected the true complexity of the issues be framed with enough political resonance to respond to such bumper-sticker simplifications? By the time dinner was over, no one had any very promising thoughts. In the years since, I’ve had many such conversations about this same conundrum.

  THE ELECTION HAD consequences inside Goldman Sachs as well. In 1985, John Whitehead resigned and soon became George Shultz’s number two at the State Department, leaving John Weinberg as the sole senior partner. That same year, Steve Friedman and I became co-heads of the fixed-income division. We were roughly the same age and each of us had moved from a law firm to Goldman Sachs at about the same time, when that was rarely done. Steve and I became partners and joined the Management Committee within two years of each other, and we worked on many client assignments and firm matters together. Steve, a former national wrestling champion, was relatively conservative and a Republican. (Curiously enough, Steve assumed the same position in the White House at the beginning of the third year of the George W. Bush administration that I had at the outset of the Clinton administration.) Despite our differences—and perhaps despite our commonalities—we worked extremely well together for
twenty-five years.

  The fixed-income division at Goldman traded all kinds of interest-bearing instruments—government debt, corporate and high-yield bonds, mortgage-backed securities, fixed-income futures, options, and other derivatives. The business was big, with a lot of risk. And shortly after we arrived, the trading operation developed serious problems. Our traders had large, highly leveraged positions, many of them illiquid, meaning that they couldn’t be sold even at generous discounts to the price of the last trade. As losses mounted, Steve and I tried to figure out what to do.

  I tend to think about fixed-income trading in three categories, although any single trade or position often involves two or even all three of them. The first is flow trading. You buy on the bid side of the market from clients and sell on the offer side, earning the spread between the two. The second is directional trading, based on judging the short-term direction of the market. You expect weaker economic numbers or a stock market dip to push bond prices higher. So you buy at $98¼, expecting to sell at $99 or even higher. The third is relative value trading, or fixed-income arbitrage. You decide that the relationship between two different securities is out of line and likely to return to form, based on valuation models, historical experience, and judgment; for example, the five-year Treasury bond is trading at an unusual discount to the ten-year. So you buy the relatively cheap bond and sell the relatively expensive bond, anticipating that their normal relationship will return.

  Relationship trading was at the heart of the trouble that developed in the fixed-income department. Bonds and derivative products began to move in unexpected ways relative to each other because traders hadn’t focused on how these securities might behave under the extremely unlikely market conditions that were now occurring. Neither Steve nor I was an expert in this area, so our confusion was not surprising. But the people who traded these instruments didn’t fully understand these developments either, and that was unsettling. You’d come to work thinking We’ve lost a lot of money, but the worst is finally behind us. Now what do we do? And then a new problem would develop. We didn’t know how to stop the process.