What happened next resembles the fate of any profitable employee who dallies before leaving Salomon Brothers for a competitor. The employee is hauled before a series of bigwigs. The bigwigs attempt to persuade him, using a variety of arguments, that he is making the mistake of his life. The first line of argument is usually that without Salomon Brothers one would end one’s days in misery. As one trader put it, “You were made to think anyone who worked at another firm must be an idiot or an asshole, so if you went to work for another firm, you must be an idiot or an asshole.” The members of the executive committee must have realized that, because the traders who had left were smart. And they were Stone’s pals, SKD he would resist the notion that they were either idiots or assholes. As the mortgage trader says, “A friend leaves for Merrill Lynch, and you say, ‘Wait a minute, he’s not an idiot or an asshole.’ Then another friend leaves. Then it dawns on you…”
On Monday morning Stone saw the same three men, in the same order, as had appeared before our training class: Jim Massey, Dale Horowitz, and John Gutfreund. Massey came first. Massey, as he had made clear to our training program, operated on the level of fear and intimidation. “Massey laid a guilt trip on me,” says Stone. “He said, ‘You owe us, we made you, you can’t leave.’ ” Stone already distrusted anyone outside the mortgage department. He quickly put Massey behind him. He pointed to the seventy million dollars he had made for the firm and said, “I think we are at least even.” Massey passed Stone to Horowitz.
Dale Horowitz was the member of the executive committee who played the role of human being. Uncle Dale. “He started out,” says Stone, “by saying, ‘I’ve watched you closely since you’ve joined us. I’ve been following your career. You may not have realized it, but I’ve taken a special interest in your development.’ ” It was the usual line. But it took an unusual and pitiful turn when Horowitz said, “I had a hand in the move you made from junk bonds to corporates and corporates to mortgages… ” Wait a second. Stone had never been in junk bonds or corporates. Stone realized that Horowitz was describing Andy Astrachan, not him. Stone had been in mortgage trading from the start. “He must have asked his secretary for the file on Andy, and she got the wrong one. I was so embarrassed for him I almost didn’t tell him.” Almost. Horowitz passed Stone to Gutfreund.
“John Gutfreund and I were not exactly good buddies,” says Stone. “I walked into his office, and he says, first thing, I guess you’re here to discuss puny problems. You probably want to talk about you and how much you are paid, instead of big questions like the direction of the firm.” Exactly what this approach was designed to achieve is not clear. Stone stiffened. He asked Gutfreund if he would sell the mortgage department for ten million dollars, to which Gutfreund responded, “Of course not.’” Stone said, “You might as well, ‘cause we’re all going to quit. Every one of us will leave for a total increase of ten million dollars.” Gutfreund said, “You’re as difficult as your reputation.” But before Stone could leave the office, Gutfreund asked him how much money he would require to stay. Stone said, “I’ll stay here for less money, but I won’t let you rape me.” Gutfreund agreed to pay Stone “eighty percent of what Merrill had offered.”
It was the first and last time that management capitulated in the face of a departing mortgage trader. When news spread at the end of 1985 that Andy Stone had been paid nine hundred thousand dollars—unheard of for a fourth-year Salomon trader—the corporate and government departments expressed extreme displeasure. The other mortgage traders had to be paid hundreds of thousands of dollars more than they otherwise would, to bring them into line with Stone. But corporates and governments had been excluded from the bonanza. Salomon etiquette had been violated. Such things were just not done. “From that point on,” says Stone, “I was never treated well at the firm. Whenever I lost money on a trade, they’d say, ‘We should have let him go.’”
The firm decided quickly enough that it was a mistake to have met Stone’s demands. A single large paycheck had thrown into doubt not only the compensation system but also the long-standing pecking order within Salomon Brothers. Money was the absolute measure of one’s value to the firm. Paying a mortgage trader much more than a treasury trader made the treasury trader feel unwanted. It wasn’t going to happen again. To stanch the flow of his young mortgage trading talent out the door, Mike Mortara was forced to resort to diplomacy, which never worked as well as cash, especially with traders. He arranged two dinners at the end of 1985 between his traders and John Gutfreund.
The first was held at Gutfreund’s favorite Manhattan restaurant, Le Perigord, where, according to one gourmand, “the man in the kitchen has a way with birds.” Among those present were Mortara, Kronthal, Stone, and trader Nathan Cornfeld. “Gutfreund was impressive, totally dominant,” says one of the men present. “I left thinking how pleased I was that he ran the firm.” Otherwise the meal was a disaster. It is doubtful anyone tasted the food. Gutfreund took control, in the way only Gutfreund can. He embarrassed Mortara, who was by that time a managing director, by referring to how much money Mortara had made on his Salomon stock when the firm went public. No doubt Gutfreund had dug those data out of a file especially for the dinner. “Mike turned bright red,” says one of the traders present. Then Gutfreund raised the issue of compensation.
Stone, as usual, spoke his mind. He told Gutfreund that since mortgages were the most profitable area of the firm, the traders should be paid more than the rest of the firm. “That’s when Gutfreund blew up,” recalls one of the traders. “He went on about how it was an honor to work at Salomon Brothers and how the firm, not the people, created the wealth.” Anyway, Gutfreund said, the mortgage department overrated its importance; it wasn’t even as profitable as the government department.
The traders knew this was a bold-faced lie, but no one contradicted him. “No one wanted to see John any angrier,” says Stone. The evening ended on a strained note. The second dinner between Gutfreund and the traders was canceled. It was clear to everyone that it would only aggravate the festering wound. Young traders continued to depart Salomon Brothers. And at the end of 1986 Andy Stone joined Prudential-Bache as head of mortgage trading.
Chapter Seven
The Salomon Diet
1986-1988
HE BOND MARKET and the people market sought their respective equilibriums, and in the two years following the dinner at Le Perigord the mortgage department of Salomon Brothers disintegrated. A departing trader could indeed be replaced by other bright young men from the nation’s leading business schools. With the million dollars Salomon saved by not meeting Howie Rubin’s demands, it bought a dozen new Rubins. The replacements looked pretty much like the original. However, they didn’t make nearly as much money for Salomon Brothers. For, unlike their predecessor, they had to compete with the best. Shearson Lehman, Goldman Sachs, Morgan Stanley, Drexel Burnham, First Boston, and Merrill Lynch employed former Salomon traders. There was a growing club of men on Wall Street who said with a smile that Salomon Brothers was a great place to be from. By allowing dozens of able mortgage traders to fertilize the mortgage departments of other firms, Salomon Brothers let slip through its fingers the rarest and most valuable asset a Wall Street firm can possess: a monopoly.
Ranieri & Co. had been a more airtight monopoly than even the people at Salomon Brothers knew. Between 1981 and 1985 the only noticeable competition had been First Boston, and even it, early on, wasn’t a serious threat. Marvin Williamson, a Salomon Brothers mortgage salesman who moved to First Boston in late 1982, recalls that “at the time at Salomon we thought First Boston was behind every rock. Not only were they not behind every rock, [but] they didn’t even know where the rocks were.” Yet by the middle of 1986 First Boston could boast about the same market share in mortgage securities as Salomon Brothers. Ranieri didn’t like what he saw, and he let Gutfreund know. He says, “I kept telling him, ‘John, you’re selling the technology for a hill of magic beans.’”
There is no chance th
at the rest of Wall Street would have permitted Salomon Brothers to maintain its hammerlock on the mortgage market. Eventually other firms would have caught on to our tricks because mortgages were too profitable to ignore, but the process was accelerated by our policies. The traders who left Salomon Brothers provided Wall Street not only with trading skills and market understanding but also with a complete list of Salomon Brothers’ customers. Now the traders had a short-term incentive to educate the fool; show the fool how much he was paying to Salomon Brothers, and perhaps he’d give his business to you.
The transfer of skills and information probably cost Salomon Brothers hundreds of millions of dollars. In the early days of trading, mortgage bonds were profitable because the traders could buy them at one price and sell them almost instantly at a much higher price. A trader would pay a thrift in Kansas 94 for a bond, then sell it to a thrift in Texas at 95. By early 1986 margins had narrowed. A trader paid 94.5 for a bond which he might just possibly, on a good day, sell at 94.55. Michael Mortara says, “We’d see them [former Salomon traders] at work on the screens. Or the customers would tell us that they had dealt with them. We started to miss trades, and we finally had to cut our spreads.”
Toward the end of 1985 the mortgage trading departments of other firms began to advertise in the Wall Street Journal. Drexel Burnham ran one showing two men on a tandem bicycle. The one in front was hugely fat and slumped in exhaustion. The one in back looked over the shoulder of the one in front and pedaled furiously. Could it be? “Yes,” says Steve Joseph, who keeps a copy of the ad on his office wall at Drexel, “the fat guy was supposed to be Lewie.” Merrill Lynch’s ad showed two rowing crews, one obese, the other fit and muscular. The fit crew was just inches behind the fat crew and looked about to pass. The fit crew was meant to be Merrill Lynch. The fat crew, as everyone on Wall Street knew, was the Salomon Brothers mortgage trading department. Looking back on his tenure at Salomon from his office at Goldman Sachs, Mortara says, “The peak in profitability was 1985.”
The deterioration of Ranieri & Co. was so rapid and complete that one is reluctant to attribute it to a single factor, such as the defection of traders. And it is clear that several forces at once eroded its supremacy. One of these forces was the market itself; the market began to right the imbalance between Ranieri & Co. and the rest of the bond trading world. 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 objection 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?
To create a CMO, one gathered hundreds of millions of dollars of ordinary mortgage bonds—Ginnie Macs, Fannie Macs, and Freddie Macs. These bonds were placed in a trust. The trust paid a rate of interest to its owners. The owners had certificates to prove their ownership. These certificates were CMOs. The certificates, however, were not all the same. Take a typical three-hundred-million-dollar CMO. It would be divided into three tranches, or slices of a hundred million dollars each. Investors in each tranche received interest payments. But the owners of the first tranche received all principal repayments from all three hundred million dollars of mortgage bonds held in trust. Not until 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 that 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 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, two hundred million dollars of home mortgage loans had to be prepaid to first and second tranche investors. The effect was astonishing. American pension funds controlled about six hundred billion dollars’ 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 thirty billion dollars’ worth 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 two billion dollars 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. Sixty billion dollars of CMOs were sold by Wall Street investment banks between June 1983 and January 1988. That means that sixty billion dollars of new money were 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 be 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 comp
any in Milwaukee. In perhaps the strangest alchemy, Wall Street shuffled the IOs and POs around and glued them back together to create home mortgages that could never exist in the real world. Thus the 11 percent interest payment from condominium dwellers in California could be glued to the principal repayments from homeowners in a Louisiana ghetto, and voila, a new kind of bond, a New Age Creole, was born.
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. There was always something new to know, and inevitably Ranieri fell out of touch. The rest of the ozone layer of management at Salomon Brothers had never really been in touch. Therefore, the trading risks were managed by mere tykes, a few months out of a training program, who happened to know more about Ginnie Mae 8 percent IOs than anyone else in the firm. That a newcomer to Wall Street should all of a sudden be an expert wasn’t particularly surprising, since the bonds in question might have been invented only a month before. In a period of constant financial innovation, the youngest people assumed power (and part of the reason young people got rich was that the 1980s was a period of constant change). A young brain leaped at the chance to know something his superiors did not. The older people were too busy clearing their desktops to stay at the frontiers of innovation.
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