Inside Job (6 page)

What happened first was that predatory investment firms started to use junk bonds to buy companies. This often made financial sense, for two reasons. First, the stock market had fallen so
severely, and often irrationally, that many public companies were cheap to acquire—if you had the cash, which the junk bond market provided. But the second reason for the junk bond boom was
that many companies were grotesquely
mismanaged by complacent, entrenched executives. Until junk bonds, they had nothing to fear, because they were supported by their equally
complacent, entrenched boards of directors.

But then, suddenly, there was a way to get rid of entrenched management, even if the board supported them. Someone could go to Michael Milken and, nearly instantly, raise billions of dollars on
the junk bond market to finance a hostile takeover. In some early cases, this produced real efficiencies as incompetent managers were forced out by new owners. But then the financiers noticed two
important things. The first was that once they took over a company, they could do anything they wanted. They could break the company up, sell off its pieces, cut employee benefits, pay themselves
huge fees, and, quite often, loot whatever remained. They could also “flip” the company. Early in the leveraged buyout (LBO) cycle, the stock market was severely depressed. But as the
market started to recover in the 1980s, it became almost trivial to buy a company in an LBO, cut some expenses, and take it public a few years later.

William Simon, Treasury secretary in the Nixon and Ford governments, put up $1 million of his own money and borrowed another $80 million to buy Gibson Greeting Cards in 1982. Less than a year
and a half later, with a stock market recovery under way, he took the company public at a value of $290 million. Ted Forstmann’s firm even more spectacularly bought and flipped Dr Pepper. The
simplicity and profitability of the early deals led to a bubble, one that Michael Milken and his friends then perpetuated, of which more shortly.

But the financiers’ next insight was much more fun. They realized that actually, they didn’t even need to buy the company, and then go through all the messy work of fixing it,
running it, selling it. All they needed to do instead was to
threaten
to buy the company. In response, the company’s terrified, inept executives and board of directors would pay them
enormous sums simply to go away. And thus was born “greenmail”. Michael Milken and Drexel’s junk bonds started to finance greenmail on a large scale, which was primarily conducted
through specialized firms created by the likes of business magnates T. Boone Pickens, Ronald Perelman, and Carl Icahn.

Milken and his junk bonds also financed a number of the most corrupt S&Ls, as well as the arbitrageurs, or “arbs”, who gambled on the existence and outcome of takeover battles.
Of course, making money that way was a lot easier if you actually
knew
what was about to happen, so the rise of LBOs, greenmail, and speculative arbitrage also caused an epidemic of insider
trading. People like Ivan Boesky developed networks of informants and paid serious bribe money for leaks; Boesky would then raise money through Milken, buy stock, and sell it as soon as the
takeover was initiated or completed. Boesky made a fortune, but in 1986 the SEC and government prosecutors nailed him. He pled guilty, turned informant on Milken and others, and was sentenced to
three years in prison.

The first wave of junk-bond-backed LBOs was mostly good for the economy. But it didn’t take long for the early deals, plus recovery from the second oil shock, to push up share prices. This
made the early LBOs look insanely profitable, which led to a new wave of LBOs, forcing share prices up even more. Then came greenmail and speculative arbitrage. In the rational,
“efficient” world fantasized by academic economists, buyouts should have tapered off once share prices reached reasonable levels. In the real world, junk bonds created a bubble, both in
the stock market and in the bonds themselves. The Decade of Greed, as it came to be called, lasted until the late 1980s. Once the hysteria broke, collapse rapidly followed. Milken tried to prolong
the bubble by “parking” stock through secret side agreements, and by encouraging self-dealing. His clients would buy junk bonds for their company’s employee retirement plans,
invest in junk bonds with money he raised for them, and so forth. Milken was indicted on more than ninety counts, pled guilty to six, and was sentenced to ten years in prison, fined $600 million,
and banned from the securities industry for life. The fine left him still a billionaire, and he was released from prison after two years. He has since tried to rehabilitate himself
through a series of charitable foundations, one of which is now a major source of funding for pro-business academic economists.
⁵

The junk bond–LBO-takeover-greenmail-arbitrage craze of the 1980s was a key milestone in Wall Street’s metamorphosis from a tradition-bound enclave to the cocaine-fuelled,
money-drugged, criminalized casino that wreaked global havoc in the 2000s. One major consequence of the LBO craze was to break down the traditional culture of investment banking. LBOs and related
activities required lots of capital, particularly as the size of takeover deals increased to billions, even tens of billions, of dollars. They also were inherently driven by short-term, one-time
transaction fees. So investment banks started to go public to raise capital, pay short-term cash bonuses, and abandon their quaint old notions of ethics and customer loyalty.

The LBO boom also radically changed Wall Street’s compensation structures, in both structure and size. The bankers on LBO deals soon were paid a percentage of the deal, regardless of
long-term results, and Wall Street salaries soared, as did incomes for the CEOs involved in LBOs, their law firms, their accountants, and their consulting firms. (For several years, Michael Milken
was paid over $500 million per year.) It was the beginning of the shift towards the extraordinary inequality and financial sector wealth we know today.

THE BOOM ON
Wall Street was accompanied by enormous growth in institutional stock portfolios and also by the first wave of the modern IT revolution,
driven by powerful microprocessors and personal computers. The result was the rise of sophisticated computer-driven innovations in portfolio management.

By the summer of 1987, stock indices had racked up years of spectacular gains, signs of a bubble were everywhere, and institutional
managers were nervous. But financial
innovation was there to help, with a marvellous new product called “portfolio insurance”. The idea was this: if a fund manager was worried that the market would fall, he could limit his
losses by selling stock-index futures (a form of financial derivative). If the market suddenly plunged, losses would be covered by the futures you sold.

Executing such a strategy was impossible for a mere human being, but two University of California at Berkeley finance professors, Hayne Leland and Mark Rubinstein, developed software that would
trade automatically. A portfolio manager could pick a desired price floor, and the computers took it from there. Futures selling would be minimal if the portfolio was performing well, but would
accelerate as markets fell. Fund managers loved the idea; by the autumn of 1987 some $100 billion of stock portfolios were “insured”, and the professors had made a fortune.

There was just one little problem. If this strategy was
generally
adopted, it would have exactly the opposite effect from the one intended, because any substantial market fall would
automatically generate a huge burst of futures selling. And a sudden wave of selling in the futures market would almost surely trigger panicky selling in the stock market—which could trigger
more futures selling, and so on.

And that’s more or less what happened. The effect was worsened by the fact that the stock market was in New York while the futures market was in Chicago, and the computer links between
them were extremely primitive.

It started on Wednesday, 14 October 1987, but the real carnage hit on the following Monday, 19 October, forever dubbed Black Monday. The stock market fell 23 percent, the largest one-day
percentage drop in history.
⁶
The markets eventually stabilized, with the help of a flood of new money from Alan Greenspan’s Federal
Reserve—one of the first appearances of what Wall Street came to call the “Greenspan Put”. Get into whatever trouble you may, Uncle Alan will bail you out.

The episode was a clear warning of the inherent dangers of financial “innovation”. Professors Leland and Rubinstein were obviously extremely clever men, as were the bankers using
their tools. Some of them
had to know that if enough people were using this “insurance”, any sizeable downturn would trigger large-scale selling and thereby cause
the very event they were supposedly trying to prevent. Credit default swaps and other financial derivatives often carry similar risks. Their use therefore requires
regulation
—particularly disclosure of positions to a regulator who can look across the whole market, and limitations on the total level of risk. But derivatives were too profitable for
Wall Street, which instead pushed in precisely the opposite direction.

THE 1990S WERE,
it turns out, the best of times and the worst of times. The economic outlook entering the 1990s was extremely gloomy. In the late 1980s
the LBO-takeover–stock market bubble deflated, and long-term economic problems began to bite, once again.

But in the end, America’s economic performance in the 1990s was superb. The reason was the Internet revolution, together with venture capital and start-up systems. Starting with the
invention of the World Wide Web in 1990, Internet-based innovation and entrepreneurship generated sharply higher economy-wide productivity growth for the first time since the 1960s. Even though the
Internet was globally available and the World Wide Web had been invented in Europe, America spawned every major Internet company—Amazon, eBay, Yahoo, Google, Craigslist, Facebook—and
thousands of smaller ones. Clinton administration policy helped by privatizing the Internet in 1995, reforming parts of the telecommunications sector, and taking antitrust action against
Microsoft.

At the same time, however, the Clinton government created the regulatory environment that gave us the financial bubble and crisis of the 2000s. As president, Bill Clinton let the financial
sector run wild. Economic and regulatory policy was taken over by the industry’s designated drivers—Robert Rubin, Larry Summers, and Alan Greenspan. It was during this period that
America’s financial sector assumed its current
form—highly concentrated, sometimes criminal, and systemically dangerous. Its growing fraudulence even affected the
Internet industry, via a stock market bubble that Wall Street deliberately inflated. The pervasive level of fraud in “dot-com” stocks was nakedly obvious to everyone in the industry
(including, at that time, me), but the Clinton government did nothing about it. For the first time, investment bankers were given clear signals that they could behave as they wished.

Equally dangerous, however, were several other developments in the US financial sector during the 1990s. The first was far-reaching deregulation, in both law and practice, championed by the
Clinton government, Congress, and the Federal Reserve. The second was the structural concentration of the industry, much of which would have been illegal without the deregulatory measures. With
astonishing speed, the financial sector’s major components—commercial banking, investment banking, brokerage, trading, rating, securities insurance, derivatives—consolidated
sharply into tight oligopolies of gigantic firms, which often cooperated with each other, particularly in lobbying and politics.

The third change in the industry was the rise of the “securitization food chain”, an elaborate industrywide supply chain for generating mortgages, selling them to investment banks,
and packaging them into “structured” investments for sale to pension funds, hedge funds, and other institutional investors. The result was an extremely complex, opaque process that
integrated nearly every segment of the financial system.

The fourth change in financial services was growth in unregulated, “innovative” financial instruments. Once again enabled by continued deregulation, the industry invented clever new
things like credit default swaps, collateralized debt obligations, and “synthetic” mortgage securities.

In principle, these changes created major efficiencies; but they also made the entire system more fragile, interdependent, and extremely vulnerable to both fraud and systemic crises.

But the final change in the financial sector was the most fatal. By
the end of the 1990s, at every level of the system and at every step in the securitization food chain,
all of the players—from lenders to investment banks to rating agencies to pension funds, from mortgage brokers to traders to fund managers to CEOs to boards of directors—were
compensated heavily in cash, based on short-term gains (often as short as the last transaction), with built-in conflicts of interest, and with no penalties for causing losses. Almost nobody was
risking their own money. In short, nobody had an incentive to behave ethically and prudently. By the time George W. Bush took office, the explosives had been planted; all it took was for someone to
light the fuse.

IT ALL BEGAN
with a clever, sane idea: the mortgage-backed security. In order to allow S&Ls to lend more money, banks could buy mortgages from
S&Ls—which would give the S&Ls immediate cash—and then the bank would package the mortgages into securities, which it would sell to investors.

In 1983 Larry Fink and his investment banking team at First Boston invented the CMO, or collateralized mortgage obligation. (Fink is now CEO of BlackRock, the big investment manager.)
Fink’s innovation was that his CMOs were sliced into several distinct classes, or “tranches”, with different credit ratings and yields. The top tranche had first claim on cash
flows from the mortgages, while the bottom tranche absorbed the brunt of prepayment and default risk.