Friday, September 19, 2014

Book Review #14: Liar's Poker: Author: Michael Lewis

1980s was a decade of financial innovation in the US. The bond markets had exploded. Bonds, that were once considered to be boring and sedate products fit only for Pension Funds and retirees, suddenly became volatile and highly risky. It all started in 1979 when then US Treasury secretary, Paul Volker, announced that the monetary policy will be defined by fixed money supply with the interest rates being the only monetary policy tool that the US Fed will use to stabilize US Economy. This policy change lead to wildly fluctuating interest rates. Bond prices which behave inversely to interest rates suddenly became highly volatile as a result.

Where there is volatility, there is money to be made. The volatility in bond markets led to investment banks setting up their bond trading desk. The biggest of them all was Solomon Brothers, the wall street firm which specialized in Bonds. With bonds no longer remaining a sedate product and transitioning into a vast money making opportunity, the demands for bonds exploded. Business started booming and huge amount of money was to be made.

Innovation was the name of the game. The greatest innovation was the realization that there was a huge market for innovatively packaged mortgages. Prior to this, mortgage loans were never a flavour of the market due to two reasons. First, the size of the individual mortgage (ticket size) was very small and did not interest a serious investor. Second was that while mortgages had a well defined cash flow pattern, the borrowers were allowed to prepay their mortgage in full without any penalty for prepayment. This second factor meant that an investor in mortgage loan market faced unpredictable cash flows. After all, it is not happy situation if you buy a mortgage backed bond expecting a steady cash flow and suddenly find that the mortgage has been prepaid and the cash flow will stop from the next month.

These two factors, small ticket size of mortgages and prepayment risk ensured that the demand of mortgage based bonds remained low. Solomon saw a huge potential for anyone who can resolve these challenges. They were the leaders in bond trade and here was an untapped opportunity. Solomon set up a mortgage bond desk and over a period of two years, this team came up with a series of path-breaking innovations (which were the scourge of any MBA student studying Finance in the next 20 years !) that redefined the mortgage based markets. The first innovation was what is known as 'Asset Securitization', where Solomon bought over the mortgage loans from the banks. They got a very good rate since Banks were keen on offloading these loans from their books and receive the cash flow that they converted to more mortgages.

What did Solomon do with these bonds that they purchased? They mixed and matched these loans to various bond offerings that could meet the expectations of different class of investors. For example, they stripped the interest component of these loans and packaged them as 'Interest Only' securities that produced regular cash flow. They sold these to investors whose primary objective was steady cash flow. They packed the principal component to 'Principal Only' bonds  and sold them to Pension Funds which did not care for regular cash flows and were interested in Capital Appreciation. Wall Street was raining innovative products and the innovation was limited only by the imagination of the Bond Trader. Young bond traders became multi-millionaires overnight.  It helped that the regulatory authority was behind this rapid innovation and could not provide the required oversight.

Suddenly bond trading organizations found that they did not have enough hands to trade and sell bonds. Non-availability of man power became the limiting factor to increasing business. Firms started going to campuses to pick the best of the lot. Solomon Brothers recruited a set of trainees for its batch of 1985. The author of the book 'Liar's Poker' was a member of that batch of '85.

He remained with Solomon for three years till he left the company in 1988. In this book, he provides a ringside view of the Bond Market, Wall Street, European Markets, Bond Innovations dotting the book with descriptions of interesting personalities and path-breaking events that defined the glorious decade for the bond traders, the years from 1980 till the collapse in 1988.

Arrival of Mortgage backed securities was one such path breaker. Another was the arrival of Junk Bonds. This was initiated by Mike Milken, the master of them all. He understood that the bonds issued by financially weak companies with good managements can provide high yield to the investors. This is because the market prices these bonds cheap considering the poor financials of the company. This increases the yield of the bonds. By packing a set of similar bonds Milken was able to spread the interest rate risk significantly. This led to bonds with high yield and relatively low interest rate risk. There was a vast demand for such bonds and Milken and the company he represented Drexel Burnham Lambert.

This was also the decade of 'Leveraged Buy Outs (LBO)' and 'Managed Buy Out (MBO)'. In both these Debt, in the form of Junk Bonds was used to buy out the company. In LBO, outsiders used Leverage to overthrow the management and buy out the companies. Critics of these allege that the ultimate objective of both these innovations is to take the company private and then strip the assets. Many giants became a victim of LBOs. In MBO, the management used the Debt financing route to buy out the companies from the market and make it private.

Solomon Brothers was one of the victims of an attempted LBO. In this case Milken, in association with another Wall Street investor, attempted to buy out the stake of the company. The company brought in Warren Buffet as a 'White Knight' to foil the takeover bid. Buffet used an innovative approach called 'Convertible Preferred' at 9% interest with an Option to buy the shares of Solomon at 38 Dollars a share any time within the next 10 years. As mentioned in THIS BOOK, Buffet later converted the same to Solomon Shares and made a tidy profit.

Towards the end of the 80's bond market started losing its sheen. It will not come back to its original glory (with new derivative products) till the next Mortgage Boom in the early 2000. Many of the key players in the Bond Boom of the eighties either lost their jobs or were investigated for misdeeds and punished. In addition, the regulators learned their lessons well and the arc of the law started catching up. Fortunes were lost in this period.

Michael Lewis, the author of the book, had 'Been there and Done that'. His Wall Street experience comes out very clearly in each page of this book. This book provides a spell bounding ride through the great bond boom of the 80's. There are thrills, there are characters and there is fun. And money.

Lots of it.

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