The initial substantive residual equity investment should be comparable to that expected for a substantive business involved in similar [leasing] transactions with similar risks and rewards. The SEC staff understands from discussions with Working Group members that those members believe that three percent is the minimum acceptable investment. The SEC staff believes a greater investment may be necessary depending on the facts and circumstances, including the credit risk associated with the lessee and the market risk factors associated with the leased property.
This letter—which came to be known as the three-percent rule—stuck like glue, even though it wasn’t a rule at all, and some securities regulators had opposed it at the time. Ultimately, companies would do mind-boggling numbers of structured deals—trillions of dollars in all—assuming that if they found an outside investor to buy three percent, they could keep the details off their balance sheets. The deals ranged from basic structured-finance transactions (credit-card and car-loan deals) to CBOs to more complex off-balance-sheet partnership structures, including the infamous deals at Enron. As more companies relied on the three-percent rule, it became more difficult to change it.
In January 1992, E. Gerald Corrigan, president of the New York Federal Reserve Bank, expressed concern about these deals in a closely followed speech: “If this sounds like a warning, that is because it is. The growth and complexity of off-balance sheet activities and the nature of the credit, price, and settlement risk they entail should give us all cause for concern.” Wheat pooh-poohed Corrigan’s remarks at a Paris conference of derivatives dealers, and instead warned of a “credit gridlock,” in which regulated dealers would fill up all of their credit lines and find themselves unable to transact, unless they could do substantial off-balance-sheet financing.44 He argued that regulations needed to be loosened, not strengthened.
In fall 1993, Allen Wheat took over as president and chief operating officer of CS First Boston. As one of the firm’s senior bankers put it at the time, “I think this is now really Wheat’s baby. We’ll either fly with Wheat or we’ll go down with Wheat.”45
Wheat flew to London to give a 45-minute address to the firm’s management committee. According to one former colleague, “He told us that he had accepted the job, because he saw it as a great way to vastly increase his personal wealth and that he would make us all incredibly rich. He never once mentioned the clients.”46
Perhaps he should have. The clients’ fees already had made Wheat incredibly rich. CSFP had earned about $125 million per year in 1991 and 1992.47 The London bank’s return on equity was reported to be 40 percent, double that of Bankers Trust, then the most profitable bank in the United States.48 CSFP employees reportedly earned twice as much as their counterparts at other banks, and by 1992 there were nearly 500 of them.49 Wheat made $9 million a year, leading many competitors to rebrand First Boston as Wheat First Securities, the name of a small regional brokerage firm headquartered in Richmond, Virginia.
But a chill wind blew through the firm. Infighting continued and morale ebbed. Even in good years, employees reportedly were tearing up million-dollar bonus checks and tossing the confetti in their bosses’ faces.50 Wheat didn’t seem optimistic that the firm’s culture would change anytime soon. After his promotion, he compared First Boston to a patient emerging from heart surgery who “then gets up and tries to run a marathon.”51
Wheat’s inner circle was small and the key positions were held by former Bankers Trust employees.52 Wheat maintained only superficial relationships with outsiders, many of whom felt jilted, especially around bonus time. One former colleague said, “He appears to be a nice guy. You talk to him, joke with him and feel close to him. Then he blows you away.” Wheat wasn’t sympathetic about employee bonus complaints. He told an interviewer, “At bonus time, I look at people and think, ‘Why are you upset?’ They can’t really answer. They constantly look at the next guy and say, ‘I am better than him, I am worth more than him.’”53
In 1994, CSFP made $240 million in profits, whereas the entirety of First Boston—with thousands of employees—made just $155 million.54 Wheat was underwhelmed by the riffraff outside of CSFP. That year, First Boston made a controversial decision not to give many of its employees any bonus at all, even though they had worked for the entire year. The bank fired hundreds of employees and asked departing personnel to sign a sweeping release that barred them from disclosing confidential or proprietary information “to anyone,” including their own lawyers.55
Wheat’s seeming disdain for some employees was consistent with his overall view that the “skills” of most investment bankers were vastly overvalued. Wheat frequently derided the benefits of financial sophistication, noting at one point that “it has tended to be the very sophisticated guys in very sophisticated instruments who have been burned.”56 A few years later, Wheat would finally bare his soul, in a candid interview with Helen Dunne of the Daily Telegraph: “OK. If I am being honest with you then yes, let’s whisper it, but the truth of the matter is that all of us are overpaid. There is nothing magical about what we do. Anybody can do it.”57
Chris Goekjian, one of Wheat’s inner circle from Bankers Trust, described him as “looking for arbitrage in the widest sense of the word. He responds to inefficiencies in the market by responding to client needs.”58 Clients valued Wheat’s approach to structured notes, Quantos, structured finance, and other derivatives, because CSFP enabled them to place bets they otherwise could not have made, thereby creating new products to profit from limits in the markets.
But there wasn’t as much magic at First Boston and some other banks, which were limited by their lack of vision and—believe it or not—by their managers’ relatively conservative approaches. In contrast, at Salomon Brothers, another investment bank, there were no limits, and one enigmatic trader approached the recent wave of financial innovation from a radically different perspective. Whereas Wheat profited from arbitrage by selling risk to clients, this unobtrusive man exploited the risks on his own. His small group of traders bet more than anyone else and they made a lot more, too. Their bosses at Salomon gave them absolute freedom and virtually unlimited capital, and their performance was—well—magical. The man’s name was John Meriwether and his traders were known as the Arbitrage Group. For many years, they were the highest-paid people on Wall Street.
4
UNRECONCILED BALANCES
John Meriwether could have been Andy Krieger’s older brother. They were similar in appearance, with floppy hair and wiry builds. Meriwether was a superb golfer and won a scholarship to Northwestern University; Krieger played professional tennis. Their first jobs out of business school were at the same firm—Salomon Brothers. At Salomon, they sat just two seats apart.
Meriwether’s father was an accountant, like Krieger’s.1 Both worked during business school at a Chicago financial firm. For business school, Meriwether attended the University of Chicago, not Wharton, but that was simply because Meriwether, like Krieger, chose to attend a school close to home. If Meriwether had grown up in Philadelphia, not on Chicago’s South Side, he likely would have attended Wharton, too.
But in business, the similarities ended. Krieger lasted barely a few years at Salomon and Bankers Trust, and ran a modest, if profitable, trading operation after that. Meriwether, for the better part of two decades at Salomon, was arguably the best performing trader in the world.
Meriwether joined Salomon Brothers in 1973, twelve years before Krieger, the same year Black, Scholes, and Merton published their famous options-valuation formulas. By 1977, Meriwether had created a small team at Salomon called the Domestic Fixed Income Arbitrage Group, known as just the Arbitrage Group.
During the next several years, Meriwether and his group of about a dozen other traders were responsible for much of Salomon’s bottom line. In 1981, the Arbitrage Group made $100 million, one-third of Salomon’s profit.2 By the late 1980s, Meriwether’s group was consistently making more than half a billion dollars a year.3
In early 1990, at about the same time Allen Wheat was leaving Bankers Trust for CSFP, the executive committee of Salomon Brothers was meeting to discuss bonuses for the year. Committee members did not know that Meriwether secretly had persuaded Salomon’s chairman, John Gutfreund—who had been dubbed the “King of Wall Street” in a BusinessWeek cover story—to set aside 15 percent of the Arbitrage Group’s profits as bonuses. The committee members were paging through a document listing Gutfreund’s recommended compensation for each group, as they did every year at bonus time.
When they turned to the Arbitrage Group’s page, they were stunned. It listed bonuses ranging from $3 million at the low end to $23 million for Lawrence Hilibrand, who had a Ph.D. from the Massachusetts Institute of Technology and was one of the most mathematically astute and aggressive traders in the group. (Hilibrand was the trader who sat next to Andy Krieger a few years earlier, before Krieger left Salomon for Bankers Trust.) Meriwether, who by this time was the number-three person at Salomon, was to receive $10 million. The bonuses would dwarf the money anyone previously had made at any Wall Street firm. By comparison, Gutfreund, Salomon’s chairman, would be paid a mere $2.3 million,4 exactly one-tenth of what Hilibrand would make.
The fact that Meriwether had secretly negotiated such lucrative bonuses enraged many bankers at Salomon, especially young Paul Mozer, who had been in the Arbitrage Group until Meriwether asked him to leave to head government bond trading in 1988.5 Meriwether remained Mozer’s boss, and they kept a close relationship, but Meriwether had not included Mozer in the secret bonus deal. Mozer was irate, and realized that he was now on his own. For him to compete with Lawrence Hilibrand, he would have to find a new and spectacular way to make money trading government bonds.
Mozer wasn’t the only one who resented the special treatment for the Arbitrage Group. A selfish culture was spreading throughout Salomon, along with word about the 1990 bonuses. Chairman Gutfreund announced that the Arbitrage Group’s deal was a model for the rest of the firm, and that compensation would be tied more directly to profits. One executive recalled, “After that, it was every man for himself.”6
Like Bankers Trust and CSFP, Salomon developed new products and practices in a rapidly evolving, unmanageable, and unregulated marketplace. Whereas Bankers Trust developed over-the-counter options and complex swaps, and CSFP created structured notes and Collateralized Bond Obligations, Salomon was a pioneer in complex arbitrage strategies and mortgage instruments. Beginning in the mid-1980s, Salomon’s Arbitrage Group invented new ways of buying low and selling high, supposedly with little or no risk.
A close examination of Salomon’s practices from the mid-1980s until 1994 reveals that the firm was completely out of control. Paul Mozer was engaged in a hugely profitable scheme to rig the government’s billion-dollar Treasury-bond auctions. Salomon’s blunders in valuing its own derivatives made Bankers Trust’s mistakes look like rounding errors. Salomon’s mortgage inventions led to huge losses, at Salomon and elsewhere. Chairman John Gutfreund’s only control over John Meriwether was an occasional, “If this doesn’t work, you’re fired.”7 Meriwether had a modicum of control over his subordinates, but rarely exercised it. When one trader asked Meriwether for permission to double the size of a losing mortgage trade, Meriwether waved away the details, saying, “My trade was when I hired you.”8
Meriwether’s Arbitrage Group consistently made money from 1977 until the early 1990s, when the group totally dominated Salomon, generating 87 percent of the firm’s profits.9 In 1991, Meriwether was forced to resign from Salomon—along with chairman John Gutfreund—for failing to supervise Paul Mozer’s activities in Treasury-bond auctions. But Meriwether’s traders continued to prosper. In 1991 and 1992, the Arbitrage Group made over a billion dollars a year,10 more than the entire profits of many Wall Street banks. A few years later, Meriwether would persuade the traders to join him at a new firm, called Long-Term Capital Management, where they would carry on the Arbitrage Group’s legacy.
John Meriwether attended the University of Chicago in the early 1970s, just as efficient-market theory was taking over the study of financial markets. So-called Chicago School economists were almost religious in their belief that markets were efficient. (The economist in the joke about the $20 bill was always from the University of Chicago.) The Chicago faculty included Eugene Fama, whose empirical research corroborated efficient-market theory, and Merton Miller, who argued that financial innovation was driven by a desire to reduce regulatory costs.
Miller had the greatest impact on Meriwether, with his arguments that economically equivalent financial assets should have the same value. Financial economists following Miller took his argument a step further, concluding not only that similar assets should have the same value, but that they would have the same value. This conclusion was the proposition known generally as the Law of One Price.
Meriwether accepted Miller’s premise, but rejected the conclusion. Sure, markets should be efficient. Everyone knew, for example, that if gasoline at one station was too expensive, people would buy cheaper gas at the station next door. But when Meriwether began working at Salomon, he found that many markets were not even close to efficient. Similar assets had radically different values, and it seemed to stay that way for long periods of time. People were foolishly buying the expensive gasoline, and continuing to do so for months and months. Of course, similar assets should be worth similar amounts. But they were not.
When Meriwether found such inefficiencies, he simply bought the cheap asset, sold the expensive one, and waited for the values to converge. They almost always did. This was proof that the University of Chicago economists had reached the wrong conclusion. They had assumed that someone would be in the markets buying the cheap assets and selling the expensive ones. But where was that someone? It seemed incredible, but there were $20 bills lying around all over the place. All Meriwether and his traders had to do was reach down and pick them up.
Traders at Bankers Trust and CSFP had learned that arbitrage opportunities didn’t last long. Charlie Sanford and Allen Wheat had struggled to reinvent themselves every year, finding new ways to profit from financial innovation. The only profits that persisted for very long were those due to legal rules (as in the Japanese insurance companies buying equity derivatives) or sophistication gaps between the buyer and seller (as in the complex deals Gibson Greetings, P&G, and others bought). Other than these two situations, mispricings disappeared quickly.
Meriwether understood this experience, and his traders exploited legal rules and sophistication gaps beautifully. The conventional wisdom about Meriwether’s success is that he and his traders took advantage of market inefficiencies created by imbalances in the supply and demand for particular financial assets. In the beginning, this was true. But over time, Meriwether and his traders increasingly profited by exploiting legal rules and by taking advantage of less sophisticated clients. The more they did so, the more profitable their strategies became.
Most of Meriwether’s trading strategies have remained a secret, even though the leading financial journalists of the past decade—including Michael Lewis, Roger Lowenstein, and Martin Mayer—have covered Meriwether and Salomon in great detail. All of the major business magazines and newspapers have had lengthy front-page stories about Meriwether at some point, and Meriwether and his traders have been the topic of several books. But even after years under the microscope, t
he details of the trading strategies are a mystery. Meriwether wanted it this way: he swore his traders to secrecy, fearing that if anyone discovered the strategies, profits would disappear.
Here, briefly, is what is known. In 1977, Meriwether’s arbitrage strategies were simple. For example, he discovered that Treasury-bond futures—contracts that had just begun trading on exchanges in Chicago—were economically similar to Treasury bonds, but frequently had very different values. Meriwether bought whichever was cheaper, and sold whichever was more expensive. He made money, but—not surprisingly—these price differences didn’t last long.
Meriwether also found inefficiencies among Treasury bonds of different maturities. The U.S. Treasury paid different rates on its bonds, depending on their maturity, just as a homeowner typically paid different rates for a 30-year mortgage compared to a 5-year mortgage. For example, long-term Treasury bonds would have a high yield if investors expected inflation. Short-term bonds would have a low yield if the Federal Reserve was keeping interest rates low. In such a situation, which was common, the graph of the yields for different bonds compared to their maturities—called a yield curve11—would slope upward from left to right.
Meriwether noticed that this yield curve was not smooth. There were kinks, where one bond had a higher yield than a bond of nearby maturity. Where there were kinks, there were opportunities for arbitrage. As with futures, Meriwether could profit by buying the cheap bond and selling the expensive one. Meriwether made money, but when others discovered the strategy, the kinks—and the arbitrage opportunities—disappeared.
The example most frequently given of Meriwether’s approach was something called the on-the-run/off-the-run Treasury-bond trade. The idea was that at certain times investors flocked to newly issued on-the-run Treasury bonds with a 30-year maturity, ignoring other off-the-run long-term bonds that the Treasury previously had issued, including those with a similar maturity of, say, 29¾ years. Meriwether (and many others) observed that 30-year bonds were more expensive than 29¾-year bonds, a price difference that made no sense, given the bonds’ similarities. Still, some clients—particularly Japanese investors—stubbornly refused to buy anything but the most recently issued government bonds. Meriwether bought the cheap bonds, sold the expensive bonds, and waited. As the bonds aged, their prices converged, and Meriwether unwound his positions at a profit.
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