This article is an excerpt from the Shortform book guide to "Liar's Poker" by Michael Lewis. Shortform has the world's best summaries and analyses of books you should be reading.
Like this article? Sign up for a free trial here.
What is Liar’s Poker by Michael Lewis about? How did the Salomon Brothers fall from grace on Wall Street?
The cynical view of the financial world says that Wall Street is run by a special breed of traders who exploit investors’ collective fear and greed to enrich themselves. In Liar’s Poker, Michael Lewis backs up this opinion with a first-hand account of the pursuit of ill-gotten riches at the Salomon Brothers investment firm during the 1980s.
Read below for a brief Liar’s Poker book overview.
Liar’s Poker by Michael Lewis
Many business experts would have you believe that investing is a rational, thoughtful, and mathematical process. Others think the economics of high finance are much like the weather, subject to forces beyond anyone’s control. There’s a third view that’s a little more cynical—that much of the behavior of the investment marketplace is driven by a special breed of Wall Street traders who exploit investors’ collective fear and greed to enrich themselves however they can, without any sense of ethics, moderation, or care for the potential havoc they might wreak.
In the Liar’s Poker book, published in 1989, Michael Lewis gives a first-hand account of the unchecked pursuit of ill-gotten riches on the trading floor of Salomon Brothers, which for a brief time was the world’s most profitable investment banking firm. How it rose and fell from those heights is a story of financial swindles, high-stakes speculation, toxic machismo, and unfettered excess.
Before becoming a best-selling author, Lewis was a seller of bonds at Salomon Brothers’ London office. As a member of the firm, he was subjected to Salomon Brothers’ financial indoctrination, took part in its culture of chasing wealth at any cost, and witnessed the start of its downward spiral. After leaving Salomon Brothers to pursue a career in journalism, Lewis became known for his books on sports and finance, including Moneyball (2003), The Blind Side (2006), The Big Short (2010), and Flash Boys (2014).
Wall Street in the 1980s
The 1970s were a turbulent time of high unemployment and crippling inflation, and in the financial boom that followed, people dove into investing as a means to get rich quickly. This created a fertile hunting ground for unscrupulous traders looking to take advantage of investors. Lewis discusses the events that led to a boom in the bond market around 1980, how the Salomon Brothers investment firm was ideally poised to make the most of that market, and what the internal culture of Salomon was like.
Lewis traces the roots of Wall Street’s financial trading culture to the Glass-Steagall Act of 1934, which separated investing and commercial banking. A firm could do one or the other, but not both. This created investment banking as its own profession, and investment brokers became the superstars of finance and were often characterized by the scale of their ambitions. For a long time, their profits came from trading stocks, until the practice of charging fixed commissions for each trade was halted in 1975. Stock brokers dropped their rates to undercut each other, and profits bled out of the stock trading business. Traders had to find a new way to make money off of the investors in the market.
An opportunity appeared in 1979 when the Federal Reserve announced that it would let interest rates fluctuate in an attempt to curb the dollar’s inflation. Lewis says this had an unintended side effect—if interest rates were no longer stable, then bonds would also go up and down in value. Bonds (loans made to governments or corporations) are normally considered a safe, boring, and timid investment compared to more volatile stocks. However, when unmoored from fixed interest rates, bonds suddenly became ripe tools for speculation. Combined with corporate America’s newfound willingness to incur debt as a means to funnel growth, the market for bonds went through the roof, and the firm of Salomon Brothers was positioned to exploit it.
Enter: Salomon Brothers
Originally founded as a private partnership, Salomon Brothers became a publicly traded corporation in the ’70s before being acquired by Phibro in 1981, with chairman John Gutfreund personally making $40 million on the deal. Lewis writes that Salomon Brothers’ profits weren’t as important to Gutfreund as the power and prestige he received as CEO. Under Gutfreund’s leadership (or lack thereof) there was absolutely no oversight of what the company’s traders were doing or how they did it. All that mattered was that they made the firm money. Neither was there any sense of moderation from Gutfreund or his fellow executives. According to Lewis, every action they took was either full-throttle or nothing at all.
At the start of the ’80s, the all-or-nothing approach paid dividends, because when the bond market began to take off, Salomon Brothers had already fought for a controlling monopoly of bond trades on Wall Street. They’d been allowed to do so because other trading firms had always disparaged bonds as second-class investments. Once the tide turned, Salomon cornered the market, and its dealers encouraged all of their clients to leverage debt in the form of more bonds, which they’d trade from investor to investor while charging a fee on every transaction. Bond traders used every sales trick in the book to hike up the number of transactions their clients made, always increasing Salomon’s cut of the pie.
Salomon’s bond traders saw themselves as financial entrepreneurs and viewed everyone else in the banking world as timid, cowardly sheep. The trading floor was very much a boys’ club. Women were allowed to sell products to clients, but only men were allowed to join the upper echelons where trading took place. Lewis recounts that bond traders constantly fought to prove their alpha-male status by aggressive trading, excessive self-indulgence, and elaborate pranks that bordered on abuse. Their chief entertainment was a game called “Liar’s Poker”—a version of “I Doubt It” played with dollar bills instead of cards. The point of the game was to read other people, call out bluffs, and learn how to lie—all useful skills in the world of high finance.
Lewis’s Front Row Seat
If Lewis’s appraisal of Wall Street seems harsh, it can’t be said that it’s unearned. Lewis’s knowledge of Salomon Brothers comes from firsthand experience. Fresh out of college in the mid-1980s, Lewis joined the Salomon team, was trained in their philosophy of investing, and then became part of its culture.
Lewis writes that along with the stock market, the number of students pursuing economics boomed in the 1980s, despite the fact that—as he would find out—economic theory has nothing to do with the actual work done by investment firms, which focus more on spotting and exploiting opportunities that arise from brief market fluctuations or investor gullibility. His experience applying for jobs in investing also highlights the industry’s hypocrisy, since he learned early on that in order to succeed, he had to pretend that making money didn’t matter. Instead, he had to claim that he was in it for the challenge.
Once Lewis was hired as a Salomon trainee, he was promised a salary twice as large as what his business professors made. The year was 1985, and Salomon Brothers was rapidly expanding to keep up with the increased demand for their services. Though none of their new hires were loyal to the firm, Salomon’s training did everything it could to indoctrinate recruits into the firm’s way of thinking—that trading was a cutthroat business, the best investment traders were tantamount to sharks, and rank and seniority mattered far less than how much money you could bring in for the business.
Lewis explains that the cutthroat trading culture was baked into Salomon Brothers’ training process. Trainees were pitted against each other in competition for prime work assignments. They were all expected to find mentors in the company—who would either abuse them or else ignore them—and to find ways to make themselves attractive to any departmental managers who might hire them. Humiliation was the point of the process, as was teaching new recruits to be aggressive and conniving in how they landed plum positions in the business. Lewis points out that not all the traders were as awful as the overall culture would suggest—just that concepts such as right and wrong were irrelevant on the trading floor.
After training, Lewis was assigned to the London office where the focus was more on customer relationships and less on the dog-eat-dog tactics of New York. Nevertheless, European investors had their own brand of fiscal gullibility that Lewis was expected to exploit—in particular, the belief that the future of individual stocks and bonds could be predicted by mapping their past. By the end of the ’80s, Lewis became disabused of the notion that how much money you make reflects your personal worth. He would leave the business of investing entirely, but only after witnessing some of its most dramatic ups and downs.
The Mortgage Bond Era
The trends that led to Salomon Brothers’ meteoric rise in the ’80s began long before Lewis joined the firm. Salomon’s embarrassment of riches didn’t come from traditional government or corporate bonds but from its willingness to experiment in the fledgling mortgage bond market. Lewis explains how mortgage bonds work, how Salomon Brothers capitalized on the market, and how they turned the mortgage lenders—the savings and loan industry—into the primary customers of the mortgage bonds they created.
Lewis writes that in the 1970s, the largest and most rapidly expanding group of borrowers were homebuyers, not investors. What’s more, since home loans were insured by the government, they were safe bets for lenders to make since the risk was deferred to the American taxpayer. By 1980, the mortgage industry was handling over $1 trillion in loans, more money than in the entire US stock market, but from Wall Street’s perspective home loans were viewed as worthless. They were tiny compared to the huge transactions Wall Street banks dealt in, and on an individual basis, they were logistically difficult to trade. Instead, home loans were the bailiwick of small, local bankers whom Wall Street institutions thought of as ignorant country bumpkins.
To make home loans worth Wall Street’s time and energy, bankers had to find a way to trade and profit from them in bulk. The solution is to bundle large groups of mortgages into pools. Within each pool, only a fraction of the loans should default while the pool as a whole remains a net positive investment. That pool can then be converted into a bond through which dealers can buy and sell mortgages in bulk. The bondholder receives the interest payments homeowners make on their loans while he’s also able to shop the bond around like any other financial equity. Lewis points out that all through this process, the bondholder and the homeowners are completely blind to each other’s existence—all that matters is the financial product.
The main problem with mortgage bonds (as compared to corporate or government bonds) is that they don’t have a fixed maturity date. Homeowners have the option to pay off their loans early, which they usually do via refinancing when interest rates are low. When homeowners pay out, the bond turns to cash at what is generally the worst time (because of low interest rates) for the bondholder to reinvest his money. Despite this, Lewis recounts that Salomon Brothers believed the mortgage bond market would be hot in the 1980s. The housing business was expanding too quickly, and local banks didn’t have enough money to finance all the loans they wanted to make. Mortgage bonds would act as a tool for Wall Street to provide that funding.
Target: Savings and Loans
Right on the cusp of the 1980s, the savings and loan industry suffered a shock that threatened to stop the housing market in its tracks. Lewis says that instead of backing out of the mortgage bond business, Salomon Brothers dove head-first into the market, turning the US government’s plan to bail out local banks into a way to funnel money to itself. According to Lewis, Salomon’s strategy revolved around exploiting the fears of small-town bankers, taking advantage of a crucial tax break meant to help those struggling banks, and turning those banks into the buyers of the bonds created by other banks’ loans.
The ’70s were a time of great inflation. To slow it, the Federal Reserve Bank announced in 1979 that instead of controlling interest rates, it would allow them to fluctuate according to the dictates of the market. The result was that interest rates went up. The housing market faltered since no one wanted to take out home loans at high rates of interest. Lewis explains that savings and loans were suddenly in trouble, since the interest they were paying to savings accounts was greater than the interest they were making on their mortgages that had been written on previous, lower interest rates. These banks needed to sell their mortgages in a hurry, and since it had cornered the mortgage bond market, Salomon was the only buyer.
Enter: Ranieri
Enter Lewis Ranieri, head of Salomon Brothers’ mortgage bond trading desk, whom Lewis depicts as the sharkiest shark on Wall Street. Ranieri and his traders took advantage of the fact that most owners of savings and loans had shockingly little understanding of their financial positions or the value of their holdings. Another wrinkle that turned into a pot of gold for Salomon was a tax break passed by Congress in 1981 that would refund savings and loans for their losses. The catch was that those losses had to be on paper, so to prove the amount of their losses, banks had to sell their loans and buy someone else’s. At the time, mortgage bonds were the only way to do this quickly, so Ranieri and his cohorts swooped in like hawks.
Lewis describes a typical mortgage bond trade like this: A Salomon trader would call Kansas Bank A and offer to buy $1 million in loans for the price of 70 cents on the dollar ($700,000 total). After making the buy, he’d call Georgia Bank B and offer to sell that bundle of loans for 75 cents per dollar ($750,000 total, with a profit of $50,000). Since neither bank knew about the other bank’s transaction, Salomon Brothers’ profits from facilitating the deal were invisible. Salomon traders were schooled in the art of tricking sellers to undervalue their assets while convincing buyers to rate the same products higher. Thanks to the tax break, banks valued their losses and Salomon Brothers reaped the reward.
As savings and loans got a taste of trading bonds, Ranieri started convincing banks to trade their bonds more frequently, giving them a way to gamble on the market and turn their losses into even greater profits. Whether the banks made money or not wasn’t of any concern to Ranieri, since Salomon skimmed profits off of every transaction. Lewis implies that in essence, mortgage bond traders were like carnival hucksters, convincing every gullible passerby to bet one more dollar on a rigged ring toss game. And it worked—by the middle of the ’80s, Ranieri’s traders were raking in higher profits than anyone else on Wall Street.
Mortgage Bonds Decline
Despite Salomon Brothers’ roaring success with the mortgage bond market in the first half of the ’80s, no gravy train runs forever. Beginning in 1986, Salomon’s Wall Street dominance declined. Lewis recounts three separate ways that Salomon Brothers eroded their standing in the mortgage bond market—they allowed other banks to snatch away their best traders, they developed a new financial product that undercut the value of traditional mortgage bonds, and the leaders of Salomon’s mortgage bond department indulged in so much personal excess that Salomon’s executives had to take a stand against them.
As Lewis stated earlier, Salomon Brothers recruited many new traders from the legions of economics students in the 1980s, none of whom had any loyalty to the business. More than that, Salomon restricted their pay for the first two years of employment, regardless of how much money they brought in. This allowed other Wall Street banks to lure them away with higher salaries and bonuses. For young traders, Salomon simply became the place where they went to receive on-the-job training before sailing off to more lucrative positions. Not only did this drain Salomon’s talent, but it also gave away the firm’s advantage by transferring its trading strategies and techniques—along with its monopoly in the bond market—into the hands of its rivals.
Lewis writes that besides the steady loss of talent at Salomon, new financial products called Collateralized Mortgage Obligations (CMOs) defused the mortgage bond market by removing the bonds’ volatility that had made them ripe for speculation. Salomon had actually devised these tools themselves to make mortgage bonds attractive to traditional investors. A CMO divided a bundle of mortgages into three or more “tranches” that matured at different rates. Money from homeowners who paid their loans early would go to the holders of tranche #1 until their investment was paid back in full, before rolling payments to tranches #2 and #3. Therefore, tranche #1 was a short-term investment, and tranche #3 was long-term.
Lewis explains that by bringing predictability to mortgage bond payouts, CMOs attracted new investors such as pension funds who wouldn’t have touched unpredictable mortgage bonds in the past. CMOs made mortgage bonds as respectable as corporate and government bonds, but they also normalized the value of those bonds. Because of CMOs, investors now had a better understanding of what mortgage bonds were worth, making it harder for Salomon Brothers’ bond traders to bamboozle their clients as they had in the past. To stay on top of the market, Salomon’s traders kept inventing even more complex and mystifying products that they could hawk to buyers as their next “get rich quick” scheme.
Exit: Ranieri
Despite their efforts, Salomon’s mortgage bond profits steadily dropped from 1986 to 1987. Lewis writes that because of this, Salomon’s board took a harder, closer look at the behavior of Ranieri’s bond traders. A faction within Salomon’s upper management had a growing distaste for the drunken schoolboy antics of Ranieri’s inner circle and would no longer ignore the way Ranieri and his friends misused company resources. In July 1987, Gutfreund fired Ranieri for reasons that have never been specifically disclosed, and Ranieri’s closest colleagues were also let go over the next several months.
Even with Ranieri gone, his legacy remained. Lewis asserts that because of Ranieri, mortgage bonds had risen from obscurity to become a major source of business on Wall Street. Because of the way Ranieri’s mortgage department had reshaped the culture of Salomon Brothers, and because the firm had let its talent slip away to every other major bank on Wall Street, the cutthroat tactics and backhanded dealings that epitomized Salomon Brothers’ trading floor were now the norm for investment banking in general. Salomon Brothers’ Wall Street dominance continued in spirit, if not in financial fact.
The Rise of the Junk Bond
The next investment trend to sweep Wall Street wouldn’t arise from Salomon Brothers but would instead be used against it. These were so-called “junk bonds” that had existed for decades but would be pushed to new heights by Michael Milken, head of the bond department at rival firm Drexel Burnham. Lewis describes how Milken fostered the junk bond craze of the late 1980s and how he used it to fund a wave of hostile corporate takeovers, including one directed at Salomon Brothers.
Junk bonds are issued by companies in poor financial standing as a means to raise capital and keep themselves afloat. These bonds are “junk” because of their high default risk—if the issuing company goes bankrupt, the bondholders are left with nothing. Nevertheless, junk bonds can be attractive because of the high interest rates they offer. Investors who place a lot of money in junk bonds are betting that the profits from the bonds that pay off will be greater than the losses from the bonds that go bust.
According to Lewis, mortgage bonds and junk bonds were alike in that Wall Street looked down on them as second-rate investments. Like Ranieri with mortgage bonds, Milken ignored Wall Street convention and grabbed as much of the junk bond market as he could. However, unlike Ranieri, Milken saw corporations as businesses, not just customers to be swindled. Using a team of financial researchers, Milken would calculate whether a struggling company was undervalued. If its assets were worth more than its stock price suggested, Milken could argue that its junk bonds weren’t risky and trade them to investors who often made a killing.
By 1987, the junk bond market soared to over $12 billion in transactions as the mortgage bond market continued to falter. Lewis says that Milken needed more junk bonds to sell, so he partnered with a new breed of investor—the hostile takeover king. By identifying businesses whose stock was undervalued, Milken marked targets for potential takeover. He’d finance the purchase of a controlling stake in the company by selling junk bonds to pay for the stock, then when the target company was bought and its leadership ousted, its stock would plummet and its bonds became junk that Milken would trade to finance the next takeover.
Takeover Target: Salomon Brothers
As its profits teetered, Salomon Brothers came within a hair of falling victim to a hostile takeover bid. In September 1987, takeover magnate Ron Perelman (with funding from Milken) moved to grab control of Salomon. Lewis explains why Salomon was vulnerable, the threat Perelman posed to Salomon’s management, and how Warren Buffett came to their rescue.
When junk bonds took off in the latter 1980s, Salomon Brothers kept out of the market, but not for any well-thought-out reason. Lewis says it was mostly because Ranieri sabotaged any attempt by Salomon Brothers to join the junk bond business. Ranieri felt that bonds were his kingdom and that his power would be threatened by any attempt to steer the company away from his mortgage bond turf. As a result, Salomon missed out on participating in the takeover business, and after Ranieri’s firing, the firm was blindsided by Perelman and Milken turning the market against them.
Buffett to the Rescue
When one of Salomon’s chief investors wanted to sell their shares, Perelman swooped in and made an offer to buy them with funding provided by Milken. Perelman usually fired the managers of the companies he took over, so Gutfreund scrambled to find another buyer to keep his position in the firm. The buyer he found was investor Warren Buffett, but Buffett saved Salomon to make a profit for himself, and he didn’t want shares in the business. Instead, Lewis writes that Buffett loaned Salomon Brothers $800 million so it could buy back its stock, a loan that Salomon would have to repay at 9% interest. Gutfreund’s job as CEO was secure, but the price would be paid by the firm’s shareholders until their debt to Buffett was cleared.
Perelman’s takeover attempt may have been motivated by more than simple greed. Lewis suggests that Milken may have urged the takeover because of his animosity toward Salomon’s CEO Gutfreund, a dislike that Gutfreund reciprocated. Milken’s Drexel Burnham had lured away many of Gutfreund’s former employees, and the rivalry between their two firms was one of the biggest on Wall Street.
The 1987 “Black Monday” Crash
No sooner had Salomon Brothers evaded one catastrophe when it and the rest of the financial world felt a shock unmatched since the Great Depression. On Monday, October 19, 1987, the global stock market crashed, wiping out trillions of dollars in investments. Lewis explains that the crash occurred at a particularly bad time for Salomon Brothers, how the firm missed its chance to turn losses into gains because of some questionable business decisions, and how some individuals did well in the misfortune.
Lewis writes that in the week before what would become known as the “Black Monday” stock market crash, Salomon chose to leap into junk bonds while simultaneously laying off 1,000 employees. Some entire departments were let go, including those in charge of money markets and municipal bonds, with no apparent rhyme or reason. Distrust within the company was at an all-time high, especially since the rank-and-file workers knew that the executives sitting on the board wouldn’t feel any negative effects from the layoffs.
Before Salomon had a chance to find its new footing, the stock market crash hit like a tsunami. Here, Lewis mentions a curious fact about stocks—when the stock market goes down, the bond market goes up. By firing so many of its bond trading experts, Salomon was left with very few people in a position to take advantage of this flip. One Salomon trader had happened to short the S&P index just before the crash, which luckily recovered a big chunk of wealth, but otherwise Salomon and most of its clients lost entire fortunes in the debacle.
There was one silver lining as Salomon Brothers’ stock dropped. Gutfreund, Lewis, and many other staff recognized that their stock was deeply undervalued (just as Milken had known the month before) and took the opportunity to buy their own company’s stock when it was selling at an all-time low. Lewis says that for him, his investment didn’t represent any faith or goodwill toward Salomon Brothers. It was simply a cold calculation toward wealth, which would surely follow when the stock price rebounded. In his heart, Lewis was ready to leave, and though he’d wonder if quitting was a wise decision, he had faith (as of his writing) that the business would do well and continue to make money for years to come.
———End of Preview———
Like what you just read? Read the rest of the world's best book summary and analysis of Michael Lewis's "Liar's Poker" at Shortform.
Here's what you'll find in our full Liar's Poker summary:
- A first-hand account of the pursuit of ill-gotten riches at the Salomon Brothers
- The boom and burst of the mortgage bond market
- Where there is room for ethics and level-headed investing
