Tuesday, August 09, 2011

When Salomon Brothers Was King

I had the occasion to reread Michael Lewis' 1989 classic book about investment banking and the first mortgage crisis, Liar's Poker.

A good friend had recently finished Lewis' Moneyball, the book he wrote about baseball team managements' use of key statistics to select and pay players. Somehow we got onto the subject of his first book, and I lent him my copy.

Upon his returning it to me last Thursday, I began to selectively reread it. Not being the sort of book that I reread often, I hadn't actually opened it, to my knowledge, in 22 years. Thus, many of the passages were quite surprising.

To give some perspective regarding some of what I recalled, thanks to the aid of Lewis' book, let me recount a story from my business youth. Back when I was in Corporate Planning at Chase Manhattan Bank, troubleshooting businesses as one of a few elite internal consultants working for Gerry Weiss, I would often be immersed in a project for months. After its completion, I'd tackle the mountain of BusinessWeeks, Fortunes and Forbes magazines which were routed through the group. What I found typical at that time was that headline issues and stories, read several months later, invariably had developed almost completely opposite of the then-breaking stories. Headlines, read 3-4 months later, often seemed ridiculous.

And so it is with the recent mortgage-originated financial debacle, thanks to Lewis' book.

First, it surprised me to relearn that Lew Ranieri's mortgage research department at Salomon was novel at the time. And that, given the prepayment option embedded in every mortgage, they had been shunned by investment banks for their unreliable duration characteristic.

Second, there had been just one CMO originated and sold before the guy who actually authored the mortgage-backed origination and trading business, Bob Dall, got the green light from Gutfreund & Co. to open for business.

Third, Salomon spent large sums on lobbyists to get Congress to enact federal legislation, overriding state laws, making it legal to issue bonds collateralized by mortgages. Further, Salomon persuaded Congress to allow government-backed mortgages to be so used. This was supremely important, because with FNMA insurance, buyers were assured that defaulted mortgages would be made good by the federal government.

Reading the evolution of the mortgage-backed business, the first time, through Lewis' telling, it's stunning to recall that from 1981-86, now approaching 30 years ago, the first mortgage boom was largely missed by First Boston (where current BlackRock CEO and founder Larry Fink was merely the head of its mortgage-backed business), Morgan Stanley, Kidder Peabody, Goldman Sachs, et. al. Most of the investment banks which did play a role poached Salomon traders in the latter years of the boom.

Fourth, the sums of money then paid to rising mortgage-backed trading superstars seems laughable now. None of the original trading wunderkinds broke $1MM in compensation for their first few years.

But perhaps the most amazing piece of history is to read Lewis' description of Salomon at its peak. With (don't laugh) a huge equity base of $3B, Salomon was unrivaled among investment banks for its scale, profits and influence. In one of the latter years of its mortgage trading dominance, Salomon's mortgage business had profits which were roughly equal to the rest of Wall Street's investment banks in total!

Here's the funniest part. I mentioned that to a friend on Friday, asking him to guess how much that profit was? He guessed, of course, in the tens of billions. In fact, at the time, around 1985-86, it was about $750-800M.

Since Lewis' book is really about himself, and not just the Salomon mortgage-backed business, it relates much of the story historically. By the time Lewis arrived as a trainee, Ranieri's operation had reached its obese, swaggering, arrogant apogee.

It took Lewis' recounting of the affair to remember how Warren Buffett became involved with Salomon, and the almost perfect parallel with his rescue of Goldman Sachs just a few years ago.

Ronald Perelman, with the backing of Drexel Burnham's Michael Milken, put Salomon into play in September, 1987. Lewis provides an extensive discussion of how Milken's junk bond empire would soon eclipse Salomon's focus on mere mortgage-backed bonds. How Salomon's corporate infighting and inept senior management allowed it to completely miss the junk bond market development until it was too late.

Also woven through the tale is Lewis' explanation of why Bill Simon was passed over for CEO of Salomon when the last family member, Billy Salomon, retired, in favor of Gutfreund, because Gutfreund sided with Billy on never taking the private partnership public. Then Gutfreund sold the firm to Phillips Brothers, a commodity giant, within just a few years. Bill Simon went on to found the LBO movement with a little deal involving Gibson Greeting Cards.

However, back to Buffett. Buffett lent Salmon a large sum to buy out most of the share that Perelman sought from then-holder Minorco, along the same lines as his recent Goldman Sachs loan- a high coupon rate and convertibility to equity at a rather attractive strike price.

That's how Buffett ended up temporarily running Salomon after the Treasury bid-rigging scandal a few years later.

There are many fascinating parallels from investment banking in the early 1980s with the runup to the financial crisis of 2007-08. But there are some important differences, too. Specifically, back in its day, Salomon managed to tower over its less-capable competitors for years as it dominated the first incarnation of the mortgage-banking market. Some twenty-five or so years later, the other investment banks had learned a thing or two, and were much quicker to jump on a developing bandwagon. As were commercial banks.

Thus the wholesale economic disaster that arrived when the federal government, led by Fannie Mae and Freddie Mac, whose involvement in mortgage-backed bonds had been engineered by Lew Ranieri back in the early 1980s, insured the bulk of mortgages, with ever-declining quality standards, which backed bonds sold to investors around the globe.

And, finally, one recalls, after (re)reading Lewis' book, that Goldman Sachs isn't the first and only investment (now commercial) bank which people love to hate. First, there was Salomon. And at the time, nobody could envision Salomon not dominating global investment banking for decades.

It's an instructive and fun reread, or, if you're too young to know of the book, first time read.

Heck, it's only August 9th. Still time to quickly step through Liar's Poker on the beach before Labor Day arrives.


PaulC said...

Thanks for the post, it was well written. I'm 21 and really interested in investment banking as I look for a job next summer so I stopped in to the local Barnes and Noble (yes, I prefer hard, tangible books) and picked up a copy of Liar's Poker.

I'm too young to know first hand about Solomon, but upon finishing the book I was intrigued by some of the things you mentioned including the relatively small profits Solomon had that led Wall Street in those days and how such a huge, global company could be run by a group of children. I thought the book was great for a slightly higher level explanation of bond trading and how markets affect them, while providing less quantitative insight about an investment bank.

In any event, thanks a lot for the post, it was nice to read a recap of the book.

C Neul said...


Thanks for your comment. I'm slightly surprised that B&N had it in stock, being such an old book. Or was it a softcover?

The two things you mention went hand in hand. Being smaller fiefdoms, all of the then-recently public IBs (Morgan Stanley, First Boston, etc.) and private ones were long on infighting. Except probably Goldman. With smaller kitties over which to squabble, and, as Lewis notes, trading being the supreme skill in many of the firms, like Lehman, MS and Salomon, strategic development of businesses and companies was non-existent.

As he noted, Milken basically invented his separate empire totally out of sight of Joseph's NY HQ.

Suffice to say, it's a totally different world now. The modern equivalent of the old Salomon would, of course, be hedge funds, or private equity shops with large trading desks. For the former, you could read my posts regarding the recent book entitled The Quants.


PaulC said...

Would you also suggest The Big Short? I was considering picking that one up as well if, for no other reason, to get some insight into the '08 meltdown and a more recent account by Mr. Lewis.

C Neul said...

I would. Haven't read it myself, but I am sure it is well worth reading, especially in your situation.

Now I think I know what I'll take with me later this month.