The Great Deformation

by David Stockman

  It instilled in Wall Street the utterly false lesson that fortunes can be made in the carry trade, an illusion that is possible only when the Treasury bond price keeps rising, rising, and rising. Yet under a régime of sound money it is not possible for public debt to appreciate for long stretches of time, and most certainly not for thirty years.

  THE GLORIOUS REIGN OF THE BRITISH CONSOL: GOVERNMENT BONDS IN THE ERA OF SOUND MONEY

  This truth is illustrated by the glorious reign of the 3 percent British consol, a perpetual bond of the British government. First issued in 1757, it remained in circulation until 1888. Other than temporary wartime fluctuations, the price of the 3 percent consol did not change for 131 years. Accordingly, no punter got rich riding the consol on leverage, yet no saver lost his shirt by owning it for its yield. The consol was a sound public bond denominated and payable in sound money.

  After August 1971, by contrast, the US Treasury bond became the “anti-consol”; that is, the poker chip of speculators, not the solid redoubt of savers. The thing to do was to short it during the 1970s when the Great Inflation crushed its value; own it during the 1980s and 1990s when disinflation lifted its price; and rent it after December 2000 when well-telegraphed bond-buying campaigns by the central bank made holding the bond a front runner’s dream.

  The crucial difference between the stable era of the consol and the volatile era of the anti-consol, of course, is the monetary standard. The gold content of the pound sterling did not change for 131 years; in fact, not for 212 years. By contrast, for the last forty years the dollar has had no content at all, aside from the whim of the FOMC. Needless to say, what is implicated here is far more than “fun facts” about the classical gold standard.

  The era of the anti-consol demonstrates that capital markets eventually lose their capacity to honestly price securities under a régime of unsound money; they end up dancing to the tune of the central bank; that is, pricing the trading value of financial assets based on expected central bank interventions, not the intrinsic value of their cash flows, rights, and risks.

  This profound deformation of capital markets during the last forty years shaped the evolution of present-day Wall Street. These financial institutions had a near-death experience during the Great Inflation, when the value of stock and bond inventories was pummeled and activity rates in brokerage, underwriting, and mergers and acquisitions (M&A) advisory withered. But Wall Street was born again when Paul Volcker broke the back of wage and commodity inflation, thereby triggering the thirty-year ascent of the Treasury bond.

  During this long upward march, Wall Street progressively learned that the Fed was operating much more than a disinflation cycle that would run its course. Instead, it had set in motion an asset inflation scheme that it would nurture and backstop at all hazards. The thing to do, therefore, was to accumulate financial assets, fund them with short-term debt, and harvest the positive spread.

  More or less continuously over thirty years, bond prices rose and the cost of carry in the wholesale money markets fell. At length, this fundamental yield curve arbitrage, along with a plethora of variations on that trade, generated stupendous profits.

  Some profits filtered down to the bottom line of Wall Street profit and loss statements (P&Ls), but much of the windfall was corseted in the salary and bonus accounts of the major Wall Street houses. In either case, the signal was unmistakable: the Fed’s deformation of the financial markets was turning Wall Street balance sheets into money machines: the bigger the balance sheet, the better the money.

  WHEN WALL STREET TRADING DESKS AWOKE IN SPECULATORS’ HEAVEN

  The crucial first step in fostering the carry trade bonanza was bringing money market interest rates down to ground level after they had erupted into double digits during the Great Inflation. At the peak of the Volcker monetary crunch in mid-1981, open market commercial paper rates reached 16 percent before receding to a 6–8 percent range during the following decade and a half. In this period the Fed steadily reduced the trend levels of short-term rates, but usually with a decent regard for the state of the business cycle and the rate of progress on disinflation.

  An inflection point was reached at the time of the dot-com bust, however, and this cautionary approach was abruptly jettisoned. Indeed, soon after the Fed commenced its manic interest rate–cutting campaign in December 2000, Wall Street trading desks thought they had died and gone to speculator’s heaven.

  The interest rate on AA-rated financial commercial paper, the benchmark for Wall Street wholesale funding, then stood at 6.5 percent. By the end of the following year, unsecured financial paper rates had dropped to 4 percent and then to 2 percent by the end of 2002 and eventually to 1 percent by the spring of 2003. Moreover, repo financing, which was secured by collateral, dropped even more sharply.

  In the face of an 85 percent plunge in Wall Street’s cost of production—that is, the cost of funding its assets—there was hardly an asset class imaginable that did not generate gushers of positive cash flow. When financed with this 1 percent wholesale money, the much bigger yields of Treasuries, corporates, GSEs, real estate loans, junk bonds, and junk mortgages all produced fat profit spreads. Indeed, given standard leverage in excess of 90 percent on most of these asset classes, the huge “spread” gifted to Wall Street by the Fed was equivalent to handing dealers their very own printing press.

  HOW FIVE WALL STREET “INVESTMENT BANKS” GREW 200X

  It thus happened that the Keynesian prosperity managers at the Fed took aim at levitating the GDP, but instead unleashed the assembled genius of Wall Street in hot pursuit of balance sheet growth at all hazards. The most spectacular case was the five so-called investment banking houses—Goldman, Morgan Stanley, Merrill Lynch, Lehman, and Bear Stearns. On the eve of the 2008 crisis, these five Wall Street houses had combined balance sheet footings of $5 trillion, meaning that their girth exceeded the GDP of Japan at the time.

  As recently as 1998, however, the combined balance sheet of these firms or their predecessors was only $1 trillion. And back in 1980, before these “investment banking” houses were reborn as hedge funds, their footings had totaled only a few ten billions. The five behemoths thus started their thirty-year ride on the rising bond market when they were less than 1 percent of the size where they ended.

  As previously indicated, there was a good reason for this historic modesty. The old-time Wall Street businesses of securities underwriting, merger advisory, and stock brokerage didn’t require much capital; they made money providing value-added financial services, not by scalping the yield curve and trading swaps.

  Furthermore, the devastation of financial markets by the Great Inflation so sharply diminished demand for investment banking services that Wall Street had been virtually drawn and quartered. Two-thirds of all firms doing business in August 1971 had been carried off the field or merged by the time Chairman Volcker had finished his bleeding cure. So, when the market hit its July 1982 bottom, Wall Street didn’t have much of a balance sheet or much of a business.

  What remained was born again during the next thirty years, but in an entirely new financial body. Salomon Brothers was the prototype, and by 1985 it was the undisputed king of Wall Street, enjoying a prosperity not seen among financial houses since 1929. Perhaps that’s why there was a berth for me when I arrived there in early 1986, a fugitive from the government budget business and clueless about corporate balance sheets.

  I soon learned while hanging around the partners’ dining room, however, that a singular fact explained what the born-again Wall Street firms were really all about; namely, on days that interest rates went down (and bond prices therefore rose), Salomon’s P&L was in the black. Conversely, when bond prices fell, its P&L was in the red. It rarely happened otherwise.

  The moguls behind the screen, of course, could not acknowledge that the way to make big money was to stand around catching falling interest rates in a Wall Street rain barrel. So Salomon’s unrivaled profitability was attributed to wizardry, sp
ecifically to the mathematical trading alchemy of John Meriwether and his team of quants who themselves would one day be reborn as Long-Term Capital Management.

  It was true that Meriwether had discovered that tiny pricing discrepancies in the government bond market could be profitably arbitraged by means of computerized trading technology. But in building up a huge proprietary trading book, at least by the standards of the day, he had also discovered an even more important truth; namely, that being “leveraged and long” was even better. In fact, it was almost guaranteed to yield a perennial winning hand. In a fixed-income world rebounding from double-digit inflation, bond prices were almost always going up.

  The roots of that aberration, however, went way back to the generation of bond investors who had been destroyed in the monetary hell of double-digit bond yields during the 1970s. The Great Inflation scourge was not quite the wheelbarrow inflation of Weimar Germany, but it still left investors deeply traumatized.

  So, when they finally stopped dumping their bonds and cursing the very idea of fixed-coupon debt in the early 1980s, they had actually overdone it. At its 15 percent peak in July 1981, the long-term Treasury bond yield reflected not merely compensation for CPI inflation, which had averaged about 9 percent during the prior four years, but also a deep distrust of the reckless post–Camp David monetary policies which had brought so much carnage to the fixed-income markets.

  In short, there was a fiat money penalty in the government bond rate which would take three decades to dissolve. Yet dissolve it did—slowly, steadily, ineluctably. Except for brief cyclic gyrations, the ten-year treasury yield never strayed from its long march downhill, breaking back under the double-digit line in 1985, tracking into the 6–7 percent range during the mid-1990s, crossing through 5 percent by the turn of the century, and eventually finding a bottom at 1.5 percent thirty-one years later.

  This meant that had a modestly leveraged Rip Van Winkle put on the long-bond trade in 1982, he could have quadrupled his money while sleeping peacefully for three decades, and made many times more than that with the heavy leverage employed by the big trading houses. At the end of the day, there is no secular trend in modern financial history that is even remotely comparable in protean power and transcendent significance.

  Surfing the long descent of the bond yield became the pathway to money making in the born-again Wall Street. In due course, traders learned that the odds were strikingly large that bond prices would be higher (reflecting the falling yield) month after month. This also meant that the risk of owning the bond on high leverage was small, and that the amplification of returns on the reduced amount of capital deployed in a leveraged trade was huge.

  After the Fed settled into the Greenspan Put and Bernanke’s Great Moderation, traders were not only confirmed in their directional bet, but now they had an official safety net, too. Owing to the central bank’s incrementalism with respect to changes in its pegged federal funds rate and its continuous emission of smoke signals and verbal cues about future policy, traders who stayed even partially sober during market hours had no reason to fear owning the Treasury bond on 95 percent short-term borrowings.

  If their cost of carry was going to rise, they would get plenty of warning from the Fed. Meanwhile, harvesting the spread on larger and larger positions that required only tiny amounts of permanent capital, they proved that money could be legally coined, even outside of the US mints.

  INSIDE THE BOND ARB AT SALOMON BROTHERS

  It wasn’t so automatic in the initial years, however. In the summer of 1987 Salomon began to wobble badly, so John Gutfreund, the firm’s legendary CEO, appointed a high-level task force to come up with a plan to fix the firm’s faltering profit machine.

  Part of the problem was the usual Wall Street warfare between investment bankers and traders. Qualified as neither, I was apparently added to the task force in order to occupy the fire field between the warring factions. There were three memorable facets to the circumstances at hand.

  First, the ten-year Treasury bond had reached a low of 7 percent in early 1987 and then had been steadily backing up for most of the year; it eventually flared up to 9.5 percent during the initial Greenspan tightening scare of late August and September 1987. So, if you were standing around with a financial rain barrel trying to catch falling interest rates, it wasn’t working out at the moment: the market value of the long bond suffered an abrupt 30 percent loss in nine months.

  Secondly, duly noting that Salomon’s giant government and municipal bond trading operation had incurred deep losses during the recent several quarters, the investment bankers on the task force pronounced it a “bad business.” Their “restructuring” plan therefore proposed to get out of “flow” trading for customer accounts and refocus the firm’s giant bond operation on the immensely profitable “prop” trading business run by Meriwether.

  But even though his proprietary trading unit had its own P&L, staff, computers, and fame, John Meriwether wanted nothing to do with dumping the government bond operation. How would his traders get “market intelligence” about client portfolios?

  Thereupon, the Salomon investment bankers were made to understand that “flow” trading—that is, front-running clients—was essential to the firm’s “prop” trading riches, and so the government bond operation lived for another day. Likewise, after Greenspan flinched on Black Monday, bond yields resumed their fall and Salomon’s P&L began to rebound smartly. Soon the task force was disbanded, nothing at the firm was “restructured,” and the thirty-year run of bond price appreciation resumed its course.

  Thereafter, Salomon Brothers grew fulsomely in the “leveraged and long” modality of born-again Wall Street, and was eventually swallowed up by Sandy Weil’s serial acquisition machine. The highly leveraged trading model Salomon had pioneered in the 1980s thus metastasized in the underbelly of Travelers Smith Barney at first, and then ultimately in the behemoth known as “Citi.”

  Given an ever more reliable and compliant central bank policy, the route to elephantine profits at the Citigroup trading colossus was pretty much a no-brainer. The formula was to accumulate financial assets aggressively, fund them largely in the low-cost commercial paper and repo markets, and then book the profit spread in a manner that proclaimed the streets of Golconda were once again paved with gold. Moreover, after enough profit had been booked to satisfy a 20 percent return on equity objective, the vast remainder of trading gains flowed into bonuses and employee profit sharing.

  As the years and mergers rolled on, the true financial dimensions of this corpulent son of Salomon faded into in the fog of Citigroup’s undecipherable financial reporting. But success invariably has its imitators on Wall Street and before the 1990s ended, the five former investment banks had all been reborn, reshaped, and remodeled on the Salomon template.

  HEDGE FUNDS IN INVESTMENT BANKER DRAG

  The $1 trillion, or thirty-five-fold, growth in combined balance sheet footings of the five investment banking houses between 1980 and 2000 had nothing whatsoever to do with “investment banking” or regulated securities “underwriting.” M&A bankers and corporate advisory services still didn’t need a dime of capital.

  They got paid on account of the “regulatory brand equity” of the major houses; that is, the safe harbor value at the SEC and plaintiff’s bar that Morgan Stanley’s blessing, for example, conferred on the typical economically dubious M&A deals undertaken by CEOs and their boards. Likewise, standard equity and bond underwritings were essentially a “best efforts” placement of securities in the public market by dealer cartels.

  They almost never underpriced these distributions, meaning that the risk of loss was small. Their investment banking departments thus were operated on a “capital lite” basis. The huge underwriting spreads, as high as 7 percent on equity deals, reflected returns to regulatory brand equity, not capital risk-taking.

  By contrast, what had grown by leaps and bounds were the sales and trading operations of the five “investment banking
” houses and especially the units they were pleased to label as their “prime broker” divisions. Obviously, these units were not anything like what the name implied; they did not resemble in the slightest an institutional market version of Merrill Lynch’s doctors’ and dentists’ stock brokerage. The latter, at least in theory, were in the customer service business.

  The truth was that the five broker-dealers had become hedge funds. While they still dressed up like investment banks, their old white-shoe businesses had actually become a sideline. Instead, they were now deep into the balance sheet businesses, positioning large-scale inventories of securities for active counterparty trading against their external hedge fund “customers.”

  Likewise, the “underwriting” that was really of interest to them, outside of the SEC-chaperoned IPO bubble, was OTC underwriting. That, too, was a form of trading which involved slicing and dicing existing securities so that the pieces and parts could be swapped into custom-tailored (bespoke) trades.

  This financial alchemy took place through a private-dealer venue where whole loans, securitized loan pools, and derivatives of these pools could be traded on a bilateral basis outside of the regulated exchanges. In most instances, the “hedges” they sold on an underlying security or index basket were not against positions actually owned by their so-called customer. In fact, both parties to these trades were usually just gambling during working hours.

  All of these new-style trading and OTC product activities were balance sheet intensive. This breakneck growth, therefore, should have encountered a formidable barrier on the free market; namely, the requirement for large dollops of equity and other risk capital to fund these mushrooming (and risky) balance sheets.