Infectious Greed (17 page)

Salomon's options arbitrage extended outside the United States. When German investors were interested in buying call options on Boeing Co., the American airplane manufacturer, Salomon simply sold the options on its own, instead of asking Boeing to issue the options—which would have required extensive negotiations.
¹⁹
Boeing didn't even need to know about the trade. Salomon hedged its risks from the sale by buying Boeing stock—on the New York Stock Exchange—and by buying put options on Boeing stock—in the over-the-counter markets. As Andy Krieger's misdirection-play showed, a call option was roughly equivalent to an investment in an asset—in this case, stock—plus a put option. That meant Salomon was hedged, and could pocket a riskless fee.

Salomon also found a new way to arbitrage Nikkei 225 options, trading on the difference between the stock market in Tokyo and the stock-index future market in Osaka, Japan. Investors were so bullish on stock-index futures—contracts to buy and sell all of the stocks in the Nikkei 225 index, traded in Osaka—that those futures were worth more than the underlying stocks in Tokyo. Salomon could buy the stocks in Tokyo, sell the Osaka index, pocket the difference, and wait for the two to converge.
²⁰
If Osaka investors were too pessimistic, Salomon would take the opposite positions. (This trade utilized the same strategy Nick Leeson later would tell his bosses he was employing in the Singapore office of Barings Bank.)

A final example of a non-U.S. strategy was when Salomon's traders learned that, although the German tax system rewarded German companies for buying German stocks, foreigners actually wanted to buy those stocks more than Germans did. Salomon created a trade whereby the German companies bought the stocks, but entered into a swap agreement to pay out the stock returns to the foreigners. No one paid tax, and everyone was better off (except German citizens, who lost out on tax revenue, but that wasn't Salomon's concern).
²¹

The “magic” behind these various, complex trades was that they made money even though Salomon was neither selling deals to clients nor taking on much risk. The trades were driven by legal rules or by the actions of unsophisticated parties, or by both. Unlike previous methods of arbitrage, these innovations generated profits for Salomon that were sustainable over a period of years.

 

 

A
s the Arbitrage Group's profits increased, Salomon's top managers were unable to monitor the risks the firm's traders were taking, especially in derivatives, and the reports they received about trading risks were inaccurate and incomplete. Although it was not widely known at the time, Salomon's supposedly sophisticated risk-management systems could not accurately value the firm's trading positions. Salomon had the same problem as Bankers Trust: its own employees could not assess the firm's risks. Bankers Trust and Salomon were two of the most sophisticated participants in the derivatives markets, yet during the late 1980s and early 1990s, those banks were not able to figure out what their own derivatives were worth.

In 1993, Salomon's managers decided to overhaul the firm's internal risk-management systems, just as many Wall Street firms were doing the same. As employees in New York began reviewing these systems, they discovered tens of millions of dollars of mistakes. Forty Salomon employees spent the next eighteen months, full-time, trying to track down the firm's hidden losses. Ultimately, Salomon found $87 million of “unreconciled balances” in New York, and another $194 million of errors in London.
²²
The losses had been building up undetected in an outdated accounting system since 1989. The mistakes resembled those Bankers Trust made during the Andy Krieger incident, but over a much longer period of time, with more than double the losses.

Salomon's accounting firm at the time was Arthur Andersen, the prestigious
firm that would be involved in numerous accounting scandals later in the decade, including Enron, Waste Management, and others. If Bankers Trust, with Arthur Young, and Salomon Brothers, with Arthur Andersen, couldn't control and understand these financial risks, how could anyone else be expected to do so? As one well-respected stock analyst, Perrin Long of Brown Brothers Harriman, said after Salomon finally announced the losses in 1995, “You have to ask, ‘What the hell is going on?' ” Another analyst asked, “When does it end?”
²³

Ironically, it turned out that poor supervision and controls were the Arbitrage Group's major advantages over its competitors. Meriwether's traders could allocate more capital to their bets when they spotted arbitrage opportunities, because no one above Meriwether was carefully monitoring the group's risks and use of capital.

Meriwether had a close and informal relationship with Salomon's chairman, John Gutfreund. Unlike Charlie Sanford of Bankers Trust, Gutfreund did not impose controls on employees based on RAROC (the risk-adjusted return on capital). Instead, Gutfreund kept track only of revenues, not costs, even with respect to new products.
²⁴
If Sanford had permitted Andy Krieger to place billion-dollar currency bets, imagine what Gutfreund would permit Meriwether to do.

Fortunately, Meriwether was a sophisticated risk manager, and while Gutfreund was ignoring the details about risk and cost of capital for Salomon as a firm, Meriwether was setting profit targets based on these factors within the Arbitrage Group. In rough terms, each of Meriwether's traders needed to make at least $60 million a year for the firm; otherwise, the trader would need to find a job somewhere else.
²⁵
In other words, Meriwether recognized that the Arbitrage Group's traders were taking such large positions, and potentially putting so much of Salomon's capital at risk, that if a trader couldn't make at least $60 million doing so, it wasn't worth it for Salomon as a firm.

Gutfreund's laissez-faire approach had one other advantage. Because Meriwether was not subject to strict controls, he could leave his trading positions in place for long periods of time, long enough for price discrepancies to converge. At other banks, senior managers became nervous when trades turned bad, and forced traders to liquidate positions that eventually might have become profitable. In contrast, Meriwether could “let his bets ride.” The result was counterintuitive: the more out of control the Arbitrage Group became, the more money it could make.

One example was Meriwether's response to the stock market crash of
1987. For the first ten months of 1987, the Arbitrage Group had been up $200 million. After losses from the crash, they were suddenly back to even for the year.
²⁶
Many of the traders were terrified. Their computer models, which looked at
standard deviation
as a measure of the likelihood of particular events, had failed. (A one-standard-deviation event happened about a third of the time. A two-standard-deviation event happened only about five percent of the time. And so on.) According to the computer models, the 1987 stock market crash was a vastly improbable
twenty-
standard-deviation event,
²⁷
less likely than a hundred perfect storms.

But Meriwether kept his cool, and turned to the reliable on-the-run/ off-the-run trade. In the panic, investors had rushed to the safety of 30-year Treasury bonds, making them more expensive than off-the-run bonds with similar maturities. The arbitrage opportunity—previously competed away—suddenly reappeared. Unlike his peers at other banks (who were panicking over losses, worried their firms might not survive), Meriwether didn't need special approval to do this trade “in size.” Meriwether bet that the gap between bonds would close, and made $50 million on that trade alone.
²⁸

Gutfreund's hands-off approach also encouraged traders to engage in strategies designed to skirt legal rules. In addition to the strategies already mentioned, the Arbitrage Group structured trades to profit from regulations, such as those that encouraged European banks to invest money in government bonds, rather than lend money to companies. Meriwether's traders also structured deals in Italian government bonds to convert government tax subsidies into trading profits. When Paul Mozer had worked in the Arbitrage Group, he did several trades designed to reduce Salomon's own tax obligations. These opportunities to avoid legal rules persisted so long as the legal rules persisted.

One commentator described Mozer's tax-avoidance trades as “dirty jobs.”
²⁹
In one example, Mozer created sham transactions to minimize Salomon's taxable earnings. In these transactions, Salomon bought and sold bonds at artificial prices to generate what appeared to be losses—thereby concealing more than a hundred million dollars of taxable earnings—when in reality the trades had no economic effect. (By the late 1990s, there would be billions of dollars of such tax-avoidance trades—especially among energy and telecommunications companies such as Enron and Global Crossing—with no economic purpose other than avoiding legal rules, including taxes.)

Not surprisingly, traders who were consistently designing transactions to avoid legal rules—and who were paid millions of dollars for doing so—developed a culture of supremacy and disdain. Mozer and other traders began to disparage other firms in the same way salesmen from Bankers Trust had derided their clients. Salomon's customers were important to the Arbitrage Group, because they provided precious information about supply and demand that traders needed to spot inefficiencies. But many of Meriwether's traders began to take that information for granted, and to view their customers as fools. Paul Mozer was said to “turn on the charm on sales calls. But then he'd turn around and say something about what a moron the person was.”
³⁰

Although Mozer rankled some of his colleagues and their clients, he was a consistent source of trading profits. When Mozer's predecessor on the government-bond desk was involved in a Treasury-bond auction, dozens of people would stand behind and watch. But when Mozer took over, anyone who tried to watch him—even Chairman John Gutfreund—was castigated with “get away from here” or “get out of here.”
³¹
Salomon's chief legal counsel, Donald Feuerstein, thought Mozer had an “attitudinal problem.”
³²
Nevertheless, Meriwether and Gutfreund strongly supported Mozer, and the fact that he was abrasive didn't matter much. Mozer made $3 million in 1988, $4 million in 1989, and $4.75 million in 1990.
³³

When Mozer learned that Salomon had paid Hilibrand $23 million in 1990—five times Mozer's compensation—something snapped. As one executive described it, “Mozer looked at Larry Hilibrand and thought, he got 23 million; I want to get 23.”
³⁴
In a bank full of bonus-obsessed traders, Mozer was unusually neurotic about his pay.

For his plan to “get 23,” Mozer returned to the on-the-run/off-the-run trade idea. Again, the original idea was that many clients—particularly foreign insurance companies—always wanted to hold the most liquid Treasury bonds. As a result, the newest bonds often were worth more than slightly older bonds. That was the arbitrage opportunity: a trader could buy the cheap bonds, sell the expensive ones, and wait for the prices to converge. In Mozer's case, the bonds that fit into his new plan were 2-year notes, not 30-year bonds, but the idea was the same.

A group of investment banks had created a
when-issued
market, in which traders could buy and sell future rights to the newest 2-year notes. In this market, Mozer could agree today to sell notes that did not yet exist but would be created in a few weeks “when issued” by the
Treasury in its next auction. The Treasury approved of this market, for the same reason regulators allowed
price talk
for new issues of stock: the early market minimized surprises and gave traders more confidence in bidding for the actual notes at auction.

Because companies were eager to buy new notes, prices tended to rise during the when-issued period, and then fall when the Treasury auctioned the notes (companies then would begin looking forward to the next auction and a fresh batch of notes). That predictable price decline presented an arbitrage opportunity: traders could sell in the when-issued market, and then buy a few days later at the Treasury auction. The major government-bond dealers all did this trade, selling billions of dollars of when-issued notes and buying at auction to cover their positions.

Mozer had a diabolical idea: if he could control the Treasury auction, he could
squeeze
the other dealers doing the arbitrage, who were counting on the new notes to satisfy their obligations to sell in the when-issued market, forcing them to pay a premium to buy the precious, recently auctioned bonds. Mozer wasn't the first person to think of this manipulative scheme: some of the clients Mozer so disdained—including Japanese insurance companies—had attempted to squeeze the Treasury market several years earlier. But Salomon was the largest of the handful of dealers approved to participate in Treasury auctions, so Mozer would be in a much better position to execute a big squeeze.

Nevertheless, Mozer's first attempts failed. In May 1990, he tried to corner a Treasury auction by boldly bidding for more than 100 percent of the notes. By submitting more bids than there were bonds for sale, Mozer improved the chances that he would receive most, if not all, of the bonds being auctioned, just as some Wall Street traders placed reservations to buy, say, twelve cars when they learned that a dealership was receiving a shipment of ten of the latest model. (When the Mazda Miata was introduced, traders held the rights to buy many of the new cars—rights they were able to sell at a profit, even if they had no interest in buying a Miata.)

The U.S. government frowned on traders submitting such large bids, because they didn't want one investment bank to be able to control the price of recently auctioned bonds. Michael E. Basham, a deputy assistant secretary of the Treasury, called Mozer immediately after receiving Mozer's bid and reminded him of a “gentleman's agreement” between the Treasury and Wall Street that no firm would bid for more than 35 percent of a Treasury auction. The Treasury wanted the dealers to compete,
so that the government could borrow at lower rates. Although the auctions were only loosely regulated, the Treasury did not want to encourage anti-competitive behavior by dealers. Basham said the Treasury wouldn't discipline Salomon this time, but cautioned that Mozer should take care to comply with the informal 35 percent agreement in future auctions.