Liar's Poker

“Liar’s Poker – Rising Through the Wreckage on Wall Street”, Michael Lewis

P.15 – “The whole absurd situation need putting into context. John Meriwether had, in the course of his career, made hundreds of millions of dollars for Salomon Brothers. He had an ability, rare among people and treasured by traders, to hide his state of mind. Most trades divulge whether they are making or losing money by the way they speak or move. They are either overly easy or overly tense. With Meriwether you could never, ever tell. He wore the same blank half-tense expression when he won as he did when he lost. He had, I think, a profound ability to control the two emotions that commonly destroy traders – fear and greed – and it made him as noble as a man who pursues his self-interest so fiercely can be. He was thought by many within Salomon to be the best bond trader on Wall Street. Around Salomon no tone but awe was used when he was discussed. People would say, “He’s the best businessman in the place,” or “the best risk taker I have ever seen,” or “a very dangerous Liar’s Poker player.”

P.175 – “Many of the trades that Alexander suggested followed one of two patterns. First, when all investors were doing the same thing, he would actively seek to do the opposite. The word stockbrokers use for this approach is contrarian. Everyone wants to be one, but no one is, for the sad reason that most investors are scared of looking foolish. Investors do not fear losing money as much as they fear solitude, by which I mean 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. But when a market is widely regarded to be in a bad way, even if the problems are illusory, many investors get out.

“A good example of this was the crisis at the U.S. Farm Credit Corporation. It looked for a moment as if Farm Credit might go bankrupt. Investors stampeded out of Farm Credit bonds because having been warned of the possibility of accident, they couldn’t be seen in the vicinity without endangering their reputations. In an age when failure isn’t allowed, when the U.S. government had rescued firms as remote from the national interest as Chrysler and the Continental Illinois Bank, there was no chance the government would allow the Farm Credit bank to default. The thought of not bailing out an eighty-billion-dollar institution that lent money to America’s distressed farmers was absurd. Institutional investors knew this. That is the point. The people selling Farm Credit bonds for less than they were worth weren’t necessarily stupid. They simply could not be seen holding them. Since Alexander wasn’t constrained by appearances, he sought to exploit people who were. (The occupational hazard of his role was an ugly elitism; you begin to think everyone else is stupid.)

“The second pattern to Alexander’s thought was that in the event of a major dislocation, such as a stock market crash, a natural disaster, the breakdown of OPEC’s production agreements, he would look away from the initial focus of investor interest and seek secondary and tertiary effects.

“Remember Chernobyl? When news broke that the Soviet nuclear reactor had exploded, Alexander called. Only minutes before, confirmation of the disaster had blipped across our Quotron machines, yet Alexander had already bought the equivalent of two supertankers of crude oil. The focus of investor attention was on the New York Stock Exchange, he said. In particular it was on any company involved in nuclear power. The stocks of those companies were plummeting. Never mind that, he said. He had just purchased, on behalf of his clients, oil futures. Instantly in his mind less supply of nuclear power equaled more demand for oil, and he was right. His investors made a large killing. Mine made a small killing. Minutes after I had persuaded a few clients to buy some oil, Alexander called back.

“Buy potatoes,” he said. “Gotta hop.” Then he hung up.

“Of course. A cloud of fallout would threaten European food and water supplies, including the potato crop, placing a premium on uncontaminated American substitutes. Perhaps a few folks other than potato farmers think of the price of potatoes in America minutes after the explosion of a nuclear reactor in Russian, but I have never met them.

“But Chernobyl and oil are a comparatively straightforward example. There was a game we played called What if? All sorts of complications can be introduced into What if? Imagine, for example, you are an institutional investor managing several billion dollars. What if there is a massive earthquake in Tokyo? Tokyo is reduced to rubble. Investors in Japan panic. They are selling yen and trying to get their money out of the Japanese stock market. What do you do?

“Well, along the lines of pattern number one, what Alexander would do is put money into Japan on the assumption that since everyone was trying to get out, there must be some bargains. He would buy precisely those securities in Japan that appeared the least desirable to others. First, the stocks of Japanese insurance companies. the world would probably assume that ordinary insurance companies had a great deal of exposure, when in fact, the risk resides mainly with Western insures and with a special Japanese earthquake insurance company that’s been socking away premiums for decades. The shares of ordinary insurers would be cheap.

“Then Alexander would buy a couple of hundred million dollars’ worth of Japanese government bonds. With the economy in temporary disrepair, the government would lower interest rates to encourage rebuilding and simple order the banks to lend at those rates. Japanese banks would comply as usual with their government’s request. Lower interest rates would mean higher bond prices.

“Also, the short-term panic could well be overshadowed by long-term repatriation of Japanese capital. Japanese companies have massive sums invested in Europe and America. Eventually they would withdraw those investments, turn inward, lick their wounds, repair their factories, and bolster their stock. What would that mean?

“Well, to Alexander, it would suggest buying yen. The Japanese would buy yen, selling their dollars, francs, marks, and pounds to do so. The yen would appreciate not just because the Japanese were buying it but because foreign speculators would eventually see the Japanese buying it and rush to join them. If the yen collapsed immediately after the quake, it would only further encourage Alexander, who sought always to do the unexpected, that his idea was a good one. On the other hand, if the yen rose, he might sell it.”

P.196 - “There is, or was, a fundamental difference between European institutional investors and their American counterparts, noticed by every New York trader who spent any time in our office. Investment banking in America is a long-standing oligopoly. A small number of ‘name’ investment banks compete to raise capital. American investors (the lenders of money) have been trained to think that they can only do business with a handful of large investment banks. And very generally, the interests of lenders in New York take a back seat to the interests of the corporate borrowers. So, in New York, bond and stock deals are driven not by whether investors (lenders) want to buy them but by whether companies want to raise the money.

“I was never sure why this happened. I mean, you’d think that the borrower of money would be just as likely to be screwed by the middleman as the lender. But he isn’t. The Wall Street oligopoly that cost lenders so dearly doesn’t seem to affect the borrowers, perhaps because they are smart enough to play the few investment banks off against one another, perhaps because they are less dependent on Wall Street in the first place; after all, if they don’t like the terms on a bond deal, they can always take a loan from a bank. Anyway, no one dreams of trying to fool, say, IBM into issuing cheap stocks or bonds. IBM is regarded as too important to anger and therefore always issues its stocks and bonds dear. Wall Street salesmen then try to fool investors into buying the overpriced merchandise.

P. 215 – “Thinking like a bond trader, Milken completely reassessed corporate America. He made two 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 didn’t make sense. It was a stupid trade: tiny upside, huge downside. Many companies that had once been models of corporate vitality subsequently went bust. There was no such thing as a riskless loan. Even corporate giants are felled when their industries collapse under them. Witness the entire U.S. steel industry.

“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 the rating services, like the commercial banks, relied almost exclusively on the past – corporate balance sheets and track records – in rendering their opinions. The outcome of the analysis was determined by the procedure rather than by the analyst. This was a poor way to evaluate any enterprise, be it new and small, or old, large and shaky. A better method was to make subjective judgments about the character of management and the fate of their industry. Lending money to a company such as MCI, which funded most of its growth with junk bonds, could be a brilliant risk – if one could foresee the future of competitive long-distance phone services and the quality of MCI’s management. Lending money to Chrysler at extortionate rates of interest could also be a smart bet, as long as the company had enough cash flow to pay that interest.

“Milken often spoke to students at business schools. On these occasions he liked, for dramatic effect, to demonstrate how hard it actually is to put a large company into bankruptcy. The forces interested in keeping a large company afloat, he argued, are far greater than those that wish to see it perish. He’d present the students with the following hypothetical situation. First, he’d say, let’s locate our major factory in an earthquake zone. Then let’s infuriate our unions by paying the executives large sums of money while cutting wages. Third, let’s select a company on the brink of bankruptcy to supply us with an essential irreplaceable component in our production line. And fourth, just in caseour government is tempted to bail us out when we get into trouble, let’s bribe a few indiscreet foreign officials. That, Milken would conclude, is precisely what Lockheed had done in the late 1970s. Milken had purchased Lockheed had done in the late 1970s. Milken had purchased Lockheed bonds when the company looked to be heading for liquidation and had made a small fortune when it was saved in spite of itself, just as Alexander had bought Farm Credit bonds when all seemed lost but wasn’t.

“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 plugged the hole in the system. He ignored large Fortune 100 companies in favor of ones with no credit standing. To compensate the lender for the higher risk, their junk bonds bear a higher rate of interest, sometimes 4 or 5 or 6 percent higher, than the bonds of blue-chip companies. They also tend to pay the lender a big fat fee if the borrower makes enough money to repay his loans prematurely. So when the company makes money, its junk soars, in anticipation of the windfall. And when the company loses money, its junk sinks, in anticipation of default. In short, junk bonds behave much more like equity, or shares, than old-fashioned corporate bonds.

“Therein lies one of the surprisingly well-kept secrets of Milken”s market. Drexel’s research department, because of its close relationship with companies, was privy to raw inside corporate data that somehow never found its way to Salomon Brothers. When Milken trades junk bonds, he has inside information. Now it is quite illegal to trade in stocks on inside information, as former Drexel client Ivan Boesky has ably demonstrated. But there is no such law regarding bonds (who, when the law was written, ever imagined that one day there would be so many bonds that behaved like stock?)