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.
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What was the 1980s savings and loan crisis? How did Salomon Brothers and Lewis Ranieri navigate this crisis?
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. In Liar’s Poker, Michael 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.
Continue reading to learn more about how the investment bank took advantage of the savings and loan crisis.
Working Around the Savings and Loans Crisis
According to Lewis, Salomon’s strategy of overcoming the savings and loan crisis of the 1980s 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.
(Shortform note: The shock to the market that Lewis refers to came as a result of the newly appointed Federal Reserve chairman Paul Volker’s anti-inflationary policies. His practice of reining in the amount of money in the economy while letting interest rates vary resulted in a deep recession that didn’t abate until 1982. Interest rates topped out at 20%, but by slowing the economy, inflation came down from a peak of 14% in 1980 to an average 3.5% for the rest of the decade. Though stocks trended upward during most of this period, high inflation meant that the value of investments shrank in proportion to the diminishing value of the dollar.)
Enter: Lewis 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.
(Shortform note: Though Ranieri didn’t invent the mortgage bond, he once again received media attention during the 2008 housing bubble crisis for how he’d been the first to popularize mortgage-backed securities. Ten years after the housing bubble popped, Ranieri expressed regrets for the long-term consequences of turning home loans into instruments of speculation. However, he partially blames the US Securities and Exchange Commission (SEC) for not regulating mortgage-backed securities until it was far too late. Ranieri showed concern for homeowners as home loans became harder to come by, but during the heyday which Lewis writes about, homeowners were merely a source of uncertainty in the mortgage bond market.)
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.
(Shortform note: To avoid falling prey to the shenanigans Lewis describes, investors must properly valuate their holdings. In The Intelligent Investor, Benjamin Graham warns that stock prices and market mood swings don’t reflect an asset’s actual value and that dips and peaks in the market should be treated with caution. Graham lists specific criteria investors should consider when deciding where to put their capital, such as whether an investment’s assets are greater than its liabilities, its price-to-earnings ratio, and other factors that financial professionals should be able to research and calculate. For the casual investor, Graham recommends an even split between stocks and bonds of large companies with conservative financing.)
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.
(Shortform note: The practice of frequent trading that Lewis says drove Salomon’s profits, though disparaged by experts such as Graham and Warren Buffett, has only accelerated in the age of computers. In Lewis’s later book Flash Boys, he explains how high-frequency trading by automated computer systems negatively impacts regular investors by giving Wall Street firms an unfair, unethical advantage in the market. Beyond that, Lewis argues that high-frequency trading is dangerous. In 2010, unregulated trading algorithms triggered a “flash crash” in which the stock market dropped by 600 points and rebounded in under a minute.)
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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
