Liar's Poker

Michael Lewis, “Liar’s Poker”, Penguin Books, 1989, 249 Pages

Checking my records, I notice that I have read 32 books in the past year that concern finances. This 32nd book on that list would have been an excellent place to start. Lewis description of Wall Street investment banks and the government’s failure to regulate them in the 1980’s has, of course, resulted in continued escalation of problems up to the present, and probably beyond. I highly recommend this book as very entertaining as well as important in that it clearly shows that blow-ups of past risky behavior on Wall Street never really seems to correct future behaviors. I think the simple answer for this is that the rewards are too great; the worst that can happen is you are fired—but not until you have enough to retire on. None of these 32 books seems to really focus in on this possibility as a main cause. Ever since Wall Street got rid of partnerships, we have privatized the earnings and socialized the risks. Oh well…just keep reading on.

My Notes:
Pg. 35: “Making profits on Wall Street is a bit like eating the stuffing from a turkey. Some higher authority must first put the stuffing into the turkey. The turkey was stuffed more generously in the 1980s than ever before. And Salomon Brothers, because of its expertise, had second and third helpings before other firms even know that supper was on.

One of the benevolent hands doing the stuffing belonged to the Federal Reserve. That is ironic, since no one disapproved of the excesses of Wall Street in the 1980s so much as the chairman of the Fed, Paul Volcker. On October 6, 1979, Volcker announced that the money supply would cease to fluctuate with the business cycle; money supply would be fixed, and interest rates would float. In practice, the shift in the focus of monetary policy meant that interest rates would swing wildly. Bond prices move inversely, lockstep, to rates of interest. Allowing interest rates to swing wildly meant allowing bond prices to swing wildly (like stocks). Bonds were no longer conservative investments.”

Pg. 60: Henry Kaufman, the head of bond research at Salomon, wrote in the Institutional Investor of July 1987:
“One of the most remarkable things that happened in the 1980s was the sharp explosion in debt, way beyond any historical benchmark. It was way beyond anything you would have expected relative to GNP, relative to monetary expansion that was taking place. But it came about, I think, as a result of freeing the financial system, putting into being financial entrepreneurship and not putting into being adequate disciplines and safeguards.”

Of course he was whistling in the dark and living up to his nickname: Dr. Gloom. He could have wrote this same article in July of 2006.

Pg. 83: Nudged by a friendly public policy, savings and loans grew, and the volume of outstanding mortgages loans swelled to $55 billion in 1950 to $700 billion in 1976. In January 1980 that figure became $1.2 trillion and the mortgage market surpassed the combined U.S. stock markets as the largest capital market in the world.

Pg. 136: Collaterized Mortgage Obligation (CMO). The CMO is thought by many to be one of the most impo0rtan financial innovations of the 1980s along with junk bonds. 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. Who wants to lend money not knowing when he will get it back?

To create a CMO, one gathered hundreds of millions of dollars of ordinary mortgage bonds—Ginne Maes, Fannie Maes, 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 investors had some certainty about the length of their loans. Now you could sell a third tranche of a CMO to pension funds, etc…

Pg. 175: Investors do not fear losing money as much as they fear solitude, i.e., taking risks that others avoid. When they are caught losing money alone, they have no excuse for their mistake, and most investors, like most people, need excuses. They are, strangely enough, happy to stand on the edge of a precipice as long as they are joined by a few thousand others. They also stampede in herds.

Pg. 215: Milken made two critical observations. First, many large and seemingly reliable companies borrowed money from banks at low rates of interest. Their creditworthiness had but one way to go: down. Why be in the business of lending money to them? It was a stupid trade: tiny upside, huge downside. Second, two sorts of companies could not persuade risk-averse commercial bankers and money managers to lend them so much as the time of day: small new companies and large old companies with problems. Money managers relied on the debt-rating agencies to tell them what was safe (or, rather, to sanction their investments so they did not appear imprudent). But rating agencies relied almost exclusively on the past in rendering their opinions. The outcome of the analysis was determined by the procedure rather than by the analyst.

What Milken was saying was that the entire American credit-rating system was flawed. It focused on the past when it should have focused on the future, and it was burdened by a phony sense of prudence. Milken had another useful secret. Drexel’s research department, because of its close relationship with companies, was privy to raw inside corporate data. When Milken traded junk bonds, he has inside information. Now it is quite illegal to trade in stocks on inside information, but there is no such law regarding bonds. When the law was written no-one imagined the day when so many bonds behaved like a stock (remember, Volcker fixed that).

The biggest thing going in the 80s was the buying and selling of corporate America using junk bonds and thus loading companies up with debt. It was not then, and still isn’t, a good idea to have things like a fully funded pension fund.