The Great Deformation (72 page)

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, specifically 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.

In point of fact, however, the five born-again investment houses didn't have much equity capital. Even by 1998, they had posted a combined net worth of only $40 billion, meaning they were levered 28 to 1. There is not a chance that the free market would have tolerated such radical leverage ratios; that is, absent the assurance that the central bank stood behind the distended balance sheets of these firms no one would have done business with them.

Indeed, that assurance was the very essence of the Fed's reprehensible bailout of Long-Term Capital Management in September 1998. By then the Wall Street house of cards was plainly evident. Notwithstanding all of the post-crisis finger-wagging by the financial establishment against LTCM's “massively leveraged” trading book, the true facts were damning: LTCM had obtained these massive borrowings from its “prime brokers” whose
“investment bank” parent firms were nearly as levered as their now infamous hedge-fund customer.

Contrary to the cover story, therefore, LTCM was not some kind of rogue outlier; it was actually one of “da boyz.” John Meriwether, the firm's chief, was not doing anything under his own shingle in Greenwich that he had not done at Salomon, and that had not been copied, replicated, and enhanced by the rest of Wall Street.

What the Fed's LTCM bailout really did was give a green light to the approximate 30 to 1 leverage ratio that already existed all around Wall Street. Indeed, in its misguided belief that the bloated stock averages of September 1998 were the linchpin to national prosperity, the Fed had authorized a cartel of dangerously leveraged gamblers—the rest of Wall Street—to bail out one of their own.

WHEN FIFTEEN GAMBLERS GOT 30X LEVERAGE BLESSED AT THE NEW YORK FED

At the end of the day, the Fed's craven sponsorship of the LTCM bailout might have been even more lethal than the panic rate cuts of 2001. The former action, in fact, amounted to a vastly upgraded Greenspan Put. As such, it surely paved the way for the final, massive growth of Wall Street balance sheets during the next decade.

As it happened, the head gambler for each of the fifteen major Wall Street banking houses had attended the crucial LTCM bailout meeting convened at the headquarters of the New York Fed. There they had duly noted the fearful perspiration and wobbly knees of officialdom and had concluded, accurately, that the Fed would prop up the casino at all hazards.

After that learning experience, it is not surprising that the five “investment banks” put their balance sheets on financial steroids. In fact, their footings quadrupled between the LTCM warning shot and the thundering meltdown of September 2008. The “financial crisis” thus arose from the vast deformations of the financial system to which the Fed's interest rate repression and “put” pandering had given rise.