EPILOGUE

Everything Is Correlated

Around the time Eisman and his partners sat on the steps of the midtown cathedral, I sat on a banquette on the east side, waiting for John Gutfreund, my old boss, to arrive for lunch, and wondering, among other things, why any restaurant would seat, side by side, two men without the slightest interest in touching each other.

When I published my book about the financial 1980s, the financial 1980s were supposed to be ending. I received a lot of undeserved credit for my timing. The social disruption caused by the collapse of the savings and loan industry and the rise of hostile takeovers and leveraged buyouts had given way to a brief period of recriminations. Just as most students at Ohio State University read Liar's Poker as a how-to manual, most TV and radio interviewers read me as a whistle-blower. (Geraldo Rivera was the big exception. He included me in a show, along with some child actors who'd gone on to become drug addicts, called "People Who Succeed Too Early in Life.") Anti-Wall Street feelings then ran high enough for Rudolph Giuliani to float a political career upon them, but the result felt more like a witch hunt than an honest reappraisal of the financial order. The public lynching of Michael Milken, and then of Salomon Brothers CEO Gutfreund, were excuses for not dealing with the disturbing forces underpinning their rise. Ditto the cleaning up of Wall Street trading culture. Wall Street firms would soon be frowning upon profanity, forcing their male employees to treat women almost as equals, and firing traders for so much as glancing at a lap dancer. Bear Stearns and Lehman Brothers in 2008 more closely resembled normal corporations with solid, Middle American values than did any Wall Street firm circa 1985.

The changes were camouflage. They helped to distract outsiders from the truly profane event: the growing misalignment of interests between the people who trafficked in financial risk and the wider culture. The surface rippled, but down below, in the depths, the bonus pool remained undisturbed.

The reason that American financial culture was so difficult to change--the reason the political process would prove so slow to force change upon it, even after the subprime mortgage catastrophe--was that it had taken so long to create, and its assumptions had become so deeply embedded. There was an umbilical cord running from the belly of the exploded beast back to the financial 1980s. The crisis of 2008 had its roots not just in the subprime loans made in 2005 but in ideas that had hatched in 1985. A friend of mine in my Salomon Brothers training program created the first mortgage derivative in 1986, the year after we left the program. ("Derivatives are like guns," he still likes to say. "The problem isn't the tools. It's who is using the tools.") The mezzanine CDO was invented by Michael Milken's junk bond department at Drexel Burnham in 1987. The first mortgage-backed CDO was created at Credit Suisse in 2000 by a trader who had spent his formative years, in the 1980s and early 1990s, in the Salomon Brothers mortgage department. His name was Andy Stone, and along with his intellectual connection to the subprime crisis came a personal one: He was Greg Lippmann's first boss on Wall Street.

I'd not seen Gutfreund since I quit Wall Street. I'd met him, nervously, a couple of times on the trading floor. A few months before I quit, my bosses asked me to explain to our CEO what at the time seemed like exotic trades in derivatives I'd done with a European hedge fund, and I'd tried. He claimed not to be smart enough to understand any of it, and I assumed that was how a Wall Street CEO showed he was the boss, by rising above the details. There was no reason for him to remember any of these encounters, and he didn't: When my book came out, and became a public relations nuisance to him, he'd told reporters we'd never met. Over the years, I'd heard bits and pieces about him. I knew that after he'd been forced to resign from Salomon Brothers, he'd fallen on harder times. I heard, later, that a few years before our lunch, he'd sat on a panel about Wall Street at the Columbia Business School. When his turn came to speak, he advised the students to find some more meaningful thing to do with their lives than go to work on Wall Street. As he began to describe his career, he'd broken down and wept.

When I e-mailed Gutfreund to invite him to lunch, he could not have been more polite, or more gracious. That attitude persisted as he was escorted to the table, made chitchat with the owner, and ordered his food. He'd lost a half-step, and was more deliberate in his movements, but otherwise he was completely recognizable. The same veneer of courtliness masked the same animal impulse to see the world as it is, rather than as it should be.

We spent twenty minutes or so determining that our presence at the same lunch table was not going to cause the earth to explode. We discovered a mutual friend. We agreed that the Wall Street CEO had no real ability to keep track of the frantic innovation occurring inside his firm. ("I didn't understand all the product lines and they don't either.") We agreed, further, that the CEO of the Wall Street investment bank had shockingly little control over his subordinates. ("They're buttering you up and then doing whatever the fuck they want to do.") He thought the cause of the financial crisis was "simple. Greed on both sides--greed of investors and the greed of the bankers." I thought it was more complicated. Greed on Wall Street was a given--almost an obligation. The problem was the system of incentives that channeled the greed.

The line between gambling and investing is artificial and thin. The soundest investment has the defining trait of a bet (you losing all of your money in hopes of making a bit more), and the wildest speculation has the salient characteristic of an investment (you might get your money back with interest). Maybe the best definition of "investing" is "gambling with the odds in your favor." The people on the short side of the subprime mortgage market had gambled with the odds in their favor. The people on the other side--the entire financial system, essentially--had gambled with the odds against them. Up to this point, the story of the big short could not be simpler. What's strange and complicated about it, however, is that pretty much all the important people on both sides of the gamble left the table rich. Steve Eisman and Michael Burry and the young men at Cornwall Capital each made tens of millions of dollars for themselves, of course. Greg Lippmann was paid $47 million in 2007, although $24 million of it was in restricted stock that he could not collect unless he hung around Deutsche Bank for a few more years. But all of these people had been right; they'd been on the winning end of the bet. Wing Chau's CDO managing business went bust, but he, too, left with tens of millions of dollars--and had the nerve to attempt to create a business that would buy up, cheaply, the very same subprime mortgage bonds in which he had lost billions of dollars' worth of other people's money. Howie Hubler lost more money than any single trader in the history of Wall Street--and yet he was permitted to keep the tens of millions of dollars he had made. The CEOs of every major Wall Street firm were also on the wrong end of the gamble. All of them, without exception, either ran their public corporations into bankruptcy or were saved from bankruptcy by the United States government. They all got rich, too.

What are the odds that people will make smart decisions about money if they don't need to make smart decisions--if they can get rich making dumb decisions? The incentives on Wall Street were all wrong; they're still all wrong. But I didn't argue with John Gutfreund. Just as you revert to being about nine years old when you go home to visit your parents, you revert to total subordination when you are in the presence of your former CEO. John Gutfreund was still the King of Wall Street and I was still a geek. He spoke in declarative statements, I spoke in questions. But as he spoke, my eyes kept drifting to his hands. His alarmingly thick and meaty hands. They weren't the hands of a soft Wall Street banker but of a boxer. I looked up. The boxer was smiling--though it was less a smile than a placeholder expression. And he was saying, very deliberately, "Your...fucking...book."

I smiled back, though it wasn't quite a smile.

"Why did you ask me to lunch?" he asked, though pleasantly. He was genuinely curious.

You can't really tell someone that you asked him to lunch to let him know that you didn't think of him as evil. Nor can you tell him that you asked him to lunch because you thought you could trace the biggest financial crisis in the history of the world back to a decision he had made. John Gutfreund had done violence to the Wall Street social order--and got himself dubbed the King of Wall Street--when, in 1981, he'd turned Salomon Brothers from a private partnership into Wall Street's first public corporation. He'd ignored the outrage of Salomon's retired partners. ("I was disgusted by his materialism," William Salomon, the son of one of the firm's founders, who had made Gutfreund CEO only after he'd promised never to sell the firm, had told me.) He'd lifted a giant middle finger in the direction of the moral disapproval of his fellow Wall Street CEOs. And he'd seized the day. He and the other partners not only made a quick killing; they transferred the ultimate financial risk from themselves to their shareholders. It didn't, in the end, make a great deal of sense for the shareholders. (One share of Salomon Brothers, purchased when I arrived on the trading floor, in 1986, at a then market price of $42, would be worth 2.26 shares of Citigroup today, which, on the first day of trading in 2010, had a combined market value of $7.48.) But it made fantastic sense for the bond traders.

But from that moment, the Wall Street firm became a black box. The shareholders who financed the risk taking had no real understanding of what the risk takers were doing, and, as the risk taking grew ever more complex, their understanding diminished. All that was clear was that the profits to be had from smart people making complicated bets overwhelmed anything that could be had from servicing customers, or allocating capital to productive enterprise. The customers became, oddly, beside the point. (Is it any wonder that mistrust of the sellers by the buyers in the bond market had reached the point where the buyers could not see a get-rich-quick scheme when a seller, Greg Lippmann, offered it to them?) In the late 1980s and early 1990s Salomon Brothers had entire years--great years!--in which five proprietary traders, the intellectual forefathers of Howie Hubler, generated more than the firm's annual profits. Which is to say that the firm's ten thousand or so other employees, as a group, lost money.

The moment Salomon Brothers demonstrated the potential gains to be had from turning an investment bank into a public corporation and leveraging its balance sheet with exotic risks, the psychological foundations of Wall Street shifted, from trust to blind faith. No investment bank owned by its employees would have leveraged itself 35:1, or bought and held $50 billion in mezzanine CDOs. I doubt any partnership would have sought to game the rating agencies, or leapt into bed with loan sharks, or even allowed mezzanine CDOs to be sold to its customers. The short-term expected gain would not have justified the long-term expected loss.

No partnership, for that matter, would have hired me, or anyone remotely like me. Was there ever any correlation between an ability to get into, and out of, Princeton, and a talent for taking financial risk?

At the top of Charlie Ledley's list of concerns, after Cornwall Capital had laid its bets against subprime loans, was that the powers that be might step in at any time to prevent individual American subprime mortgage borrowers from failing. The powers that be never did that, of course. Instead they stepped in to prevent the failure of the big Wall Street firms that had contrived to bankrupt themselves by making a lot of dumb bets on subprime borrowers.

After Bear Stearns failed, the government encouraged J.P. Morgan to buy it by offering a knockdown price and guaranteeing Bear Stearns's shakiest assets. Bear Stearns bondholders were made whole and its stockholders lost most of their money. Then came the collapse of the government-sponsored entities, Fannie Mae and Freddie Mac, both promptly nationalized. Management was replaced, shareholders badly diluted, and creditors left intact but with some uncertainty. Next came Lehman Brothers, which was simply allowed to go bankrupt--whereupon things became even more complicated. At first, the Treasury and the Federal Reserve claimed they allowed Lehman to fail to send the signal that recklessly managed Wall Street firms did not all come with government guarantees; but then, when all hell broke loose, and the market froze, and people started saying that letting Lehman fail was a dumb thing to have done, they changed their story and claimed they lacked the legal authority to rescue Lehman. But then AIG failed a few days later, or tried to, before the Federal Reserve extended it a loan of $85 billion--soon increased to $180 billion--to cover the losses from its bets on subprime mortgage bonds. This time the Treasury charged a lot for the loans and took most of the equity. Washington Mutual followed, and was unceremoniously seized by the Treasury, wiping out both its creditors and its shareholders entirely. And then Wachovia failed, and the Treasury and FDIC encouraged Citigroup to buy it--again at a knockdown price and with a guarantee of the bad assets.

The people in a position to resolve the financial crisis were, of course, the very same people who had failed to foresee it: Treasury Secretary Henry Paulson, future Treasury Secretary Timothy Geithner, Fed Chairman Ben Bernanke, Goldman Sachs CEO Lloyd Blankfein, Morgan Stanley CEO John Mack, Citigroup CEO Vikram Pandit, and so on. A few Wall Street CEOs had been fired for their roles in the subprime mortgage catastrophe, but most remained in their jobs, and they, of all people, became important characters operating behind the closed doors, trying to figure out what to do next. With them were a handful of government officials--the same government officials who should have known a lot more about what Wall Street firms were doing, back when they were doing it. All shared a distinction: They had proven far less capable of grasping basic truths in the heart of the U.S. financial system than a one-eyed money manager with Asperger's syndrome.

By late September 2008 the nation's highest financial official, U.S. Treasury Secretary Henry Paulson, persuaded the U.S. Congress that he needed $700 billion to buy subprime mortgage assets from banks. Thus was born TARP, which stood for Troubled Asset Relief Program. Once handed the money, Paulson abandoned his promised strategy and instead essentially began giving away billions of dollars to Citigroup, Morgan Stanley, Goldman Sachs, and a few others unnaturally selected for survival. For instance, the $13 billion AIG owed to Goldman Sachs, as a result of its bet on subprime mortgage loans, was paid off in full by the U.S. government: 100 cents on the dollar. These fantastic handouts--plus the implicit government guarantee that came with them--not only prevented Wall Street firms from failing but spared them from recognizing the losses in their subprime mortgage portfolios. Even so, just weeks after receiving its first $25 billion taxpayer investment, Citigroup returned to the Treasury to confess that--lo!--the markets still didn't trust Citigroup to survive. In response, on November 24, the Treasury granted another $20 billion from TARP and simply guaranteed $306 billion of Citigroup's assets. Treasury didn't ask for a piece of the action, or management changes, or for that matter anything at all except for a teaspoon of out-of-the-money warrants and preferred stock. The $306 billion guarantee--nearly 2 percent of U.S. gross domestic product, and roughly the combined budgets of the departments of Agriculture, Education, Energy, Homeland Security, Housing and Urban Development, and Transportation--was presented undisguised, as a gift. The Treasury didn't ever actually get around to explaining what the crisis was, just that the action was taken in response to Citigroup's "declining stock price."

By then it was clear that $700 billion was a sum insufficient to grapple with the troubled assets acquired over the previous few years by Wall Street bond traders. That's when the U.S. Federal Reserve took the shocking and unprecedented step of buying bad subprime mortgage bonds directly from the banks. By early 2009 the risks and losses associated with more than a trillion dollars' worth of bad investments were transferred from big Wall Street firms to the U.S. taxpayer. Henry Paulson and Timothy Geithner both claimed that the chaos and panic caused by the failure of Lehman Brothers proved to them that the system could not tolerate the chaotic failure of another big financial firm. They further claimed, albeit not until months after the fact, that they had lacked the legal authority to wind down giant financial firms in an orderly manner--that is, to put a bankrupt bank out of business. Yet even a year later they would have done very little to acquire that power. This was curious, as they obviously weren't shy about asking for power.

The events on Wall Street in 2008 were soon reframed, not just by Wall Street leaders but also by both the U.S. Treasury and the Federal Reserve, as a "crisis in confidence." A simple, old-fashioned financial panic, triggered by the failure of Lehman Brothers. By August 2009 the president of Goldman Sachs, Gary Cohn, even claimed, publicly, that Goldman Sachs had never actually needed government help, as Goldman had been strong enough to withstand any temporary panic. But there's a difference between an old-fashioned financial panic and what had happened on Wall Street in 2008. In an old-fashioned panic, perception creates its own reality: Someone shouts "Fire!" in a crowded theater and the audience crushes each other to death in its rush for the exits. On Wall Street in 2008 the reality finally overwhelmed perceptions: A crowded theater burned down with a lot of people still in their seats. Every major firm on Wall Street was either bankrupt or fatally intertwined with a bankrupt system. The problem wasn't that Lehman Brothers had been allowed to fail. The problem was that Lehman Brothers had been allowed to succeed.

This new regime--free money for capitalists, free markets for everyone else--plus the more or less instant rewriting of financial history vexed all sorts of people, but few were as enthusiastically vexed as Steve Eisman. The world's most powerful and most highly paid financiers had been entirely discredited; without government intervention every single one of them would have lost his job; and yet those same financiers were using the government to enrich themselves. "I can understand why Goldman Sachs would want to be included in the conversation about what to do about Wall Street," he said. "What I can't understand is why anyone would listen to them." In Eisman's view, the unwillingness of the U.S. government to allow the bankers to fail was less a solution than a symptom of a still deeply dysfunctional financial system. The problem wasn't that the banks were, in and of themselves, critical to the success of the U.S. economy. The problem, he felt certain, was that some gargantuan, unknown dollar amount of credit default swaps had been bought and sold on every one of them. "There's no limit to the risk in the market," he said. "A bank with a market capitalization of one billion dollars might have one trillion dollars' worth of credit default swaps outstanding. No one knows how many there are! And no one knows where they are!" The failure of, say, Citigroup might be economically tolerable. It would trigger losses to Citigroup's shareholders, bondholders, and employees--but the sums involved were known to all. Citigroup's failure, however, would also trigger the payoff of a massive bet of unknown dimensions: from people who had sold credit default swaps on Citigroup to those who had bought them.

This was yet another consequence of turning Wall Street partnerships into public corporations: It turned them into objects of speculation. It was no longer the social and economic relevance of a bank that rendered it too big to fail, but the number of side bets that had been made upon it.

At some point I could not help but ask John Gutfreund about his biggest and most fateful act: Combing through the rubble of the avalanche, the decision to turn the Wall Street partnership into a public corporation looked a lot like the first pebble kicked off the top of the hill. "Yes," he said. "They--the heads of the other Wall Street firms--all said what an awful thing it was to go public and how could you do such a thing. But when the temptation rose, they all gave in to it." He agreed, though: The main effect of turning a partnership into a corporation was to transfer the financial risk to the shareholders. "When things go wrong it's their problem," he said--and obviously not theirs alone. When the Wall Street investment bank screwed up badly enough, its risks became the problem of the United States government. "It's laissez-faire until you get in deep shit," he said, with a half chuckle. He was out of the game. It was now all someone else's fault.

He watched me curiously as I scribbled down his words. "What's this for?" he asked.

I told him that I thought it might be worth revisiting the world I'd described in Liar's Poker, now that it was finally dying. Maybe bring out a twentieth anniversary edition.

"That's nauseating," he said.

Hard as it was for him to enjoy my company, it was harder for me not to enjoy his: He was still tough, straight, and blunt as a butcher. He'd helped to create a monster but he still had in him a lot of the old Wall Street, where people said things like "a man's word is his bond." On that Wall Street people didn't walk out of their firms and cause trouble for their former bosses by writing a book about them. "No," he said, "I think we can agree about this: Your fucking book destroyed my career and it made yours." With that, the former king of a former Wall Street lifted the plate that held his appetizer and asked, sweetly, "Would you like a deviled egg?"

Until that moment I hadn't paid much attention to what he'd been eating. Now I saw he'd ordered the best thing in the house, this gorgeous, frothy confection of an earlier age. Who ever dreamed up the deviled egg? Who knew that a simple egg could be made so complicated, and yet so appealing? I reached over and took one. Something for nothing. It never loses its charm.