The Sellout

How Three Decades of Wall Street Greed and Government Mismanagement Destroyed the Global Financial System

Charles Gasparino

• Publisher: HarperCollins e-books
• Year: 2024
• Print ISBN: 9780061697173
• eBook ISBN: 9780061892486
• Topic: Economics
• Subtopic: Economic Policy
• Index: Economics

In the spirit of Barbarians at the Gate and Liar's Poker comes The Sellout, the definitive book on the recent collapse of Wall Street, one of the most dramatic and anxiety-ridden era in national socioeconomic history. In this powerful business narrative, Charles Gasparino, the author of Blood on the Floor and King of the Club, captures how avarice, arrogance, and sheer stupidity eroded Wall Street's dominance, made many of our country's most fabled financial institutions vulnerable to significant new foreign control, and profoundly weakened the financial security of millions of poor and middle-class American families.

PART I

LET’S MAKE MONEY

1. FUN AND GAMES

Ask Pat Dunlavy to give you the defining moment of his long career at Salomon Brothers—the point in time when he started to really understand how the firm and the rest of Wall Street really works—and he’ll tell you the story about “The Great Race of 1978.”

Dunlavy was thirty years old. He was making a good living as a bond salesman in Salomon Brothers’ Cleveland office. His customers were predominantly large pension funds and other institutional investors in the Midwest that bought and traded bonds. Because of his position, he had contact with some of the firm’s power players in New York, including the firm’s legendary CEO, John Gutfreund, and some of the most savvy bond traders he’d ever met, people such as Lew Ranieri and a brilliant and charismatic trader named John Meriwether, known throughout the firm simply as “J.M.”

The Cleveland office occupied one of the largest buildings in Cleveland, fourteen stories overlooking a decaying downtown of abandoned buildings and steel mills. Like most securities firms, Salomon Brothers had its share of loudmouthed former jocks, particularly at its sales and trading desks. Daniel Benton, a salesman and former high school football player, was one of those (though certainly not the worst bloviator of the bunch). Benton was growing tired of being ribbed about his expanding waistline. At one point he made an officewide announcement. He challenged anyone in the office to a race up the building’s fourteen floors. He said he would wipe the floor with any one of them.

Dunlavy, a former college football player, had been working out regularly. One afternoon he approached Benton. “You really want to race up all fourteen stories?” Benton said he did, and if Dunlavy was man enough, he should meet him downstairs in two weeks, just before the firm’s Saint Patrick’s Day celebration, and race him to the top.

“And get ready to lose,” he added with a smirk.

But what started out as a prank between two over-the-hill football players in Salomon’s Cleveland office grew into something much bigger. The office manager invited some of the office’s biggest clients to watch. Employees brought their wives. News of the “great race” even spread to Salomon’s New York office. Traders were now laying odds on which one of the guys would win or which of them would drop dead of a heart attack before making it to the top.

It was then that Dunlavy received a call from Meriwether. In 1978, John Meriwether hadn’t yet achieved his notoriety through his depiction in Michael Lewis’s book Liar’s Poker, but his legend was growing. Most firms on the Street specialized in providing advice, to either companies or individual investors. Not Salomon Brothers. Its specialty was trading, and not just stocks but bonds as well. Because of high inflation, which eats away at the value of these so-called fixed-income investments, the bond market was a backwater during most of the 1970s. They were sold primarily to people who held them until they “matured” so they could collect regular interest payments.

But to traders at Salomon Brothers, the bond market was a big casino where they were the only real players. In the New York office, Lew Ranieri was perfecting a relatively new type of bond known as the mortgage-backed security—essentially a pool of mortgages in which the investor is paid an interest rate that flows from the mortgage payments of home owners (more on this in a bit). John Meriwether was just in his early thirties when he made his first major score on what was then considered a big gamble: buying New York City municipal bonds at the height of the city’s fiscal crisis.

Those were the years of high crime and white flight; the city nearly defaulted on its short-term debt. Real estate prices were falling. People were afraid to ride the subways. President Gerald Ford told the city to drop dead. But Meriwether saw the city’s promise and began snapping up its debt on the cheap. He took a calculated risk on New York, and his calculations were right on the money.

By the late 1970s Meriwether was taking even bigger risks. He was now part of the firm’s newly created bond arbitrage desk, a unit of the firm that he headed and grew into a money machine. Bond arbitrage is a more complex form of trading than simply buying New York City municipal bonds at depressed levels; it involves trading various types of bonds and taking advantage of price differences when market conditions change. A spike in interest rates can cause government bonds to fall because of inflation fears but corporate bonds (particularly junk bonds) to rise because inflation may spur economic growth, which in the eyes of investors may make corporate debt more appealing. The trick is to guess which markets will fall and which will rise and place your bets accordingly. It’s a high-reward but high-risk business; tens of millions of dollars can be made or destroyed in the blink of an eye.

Meriwether was one of the best arbs at Salomon, maybe on all of Wall Street. He was a math genius with a penchant for gambling, something he had been doing since he was a kid growing up on the South Side of Chicago.

When J.M. called, there wasn’t much small talk, and today’s call was no different. Meriwether said he wanted to know everything he could about the great race. He wanted precise details about Dunlavy’s weight and height and Benton’s as well. He asked questions about the building and if Dunlavy had been training for the event. Dunlavy said he had. He asked if Benton had been training. Dunlavy said he doubted it. “He’s so confident he’s going to win, he thinks he doesn’t have to train,” Dunlavy said.

“So will you beat this guy?” Meriwether asked.

“Absolutely,” Dunlavy shot back. “If I can’t drag my sorry ass up those stairs faster than Dan, I’ll shoot myself!” Dunlavy said he also had some money on the line; he’d bet Benton $50 he would win.

After a pause, Dunlavy asked, “Why do you care about any of this?”

“I might want to get involved,” Meriwether answered cryptically. “Let me think about it.”

Dunlavy wasn’t sure what the hell “get involved” meant, but a few days later Meriwether called again. He told Dunlavy he was now the official bookmaker for the great race. He was posting a “line,” laying odds on who might be the favorite to win and taking bets from anyone in the organization, from traders to back-office personnel. Meriwether said he wanted to make big money off the great race.

Dunlavy wasn’t totally surprised. He’d always viewed the typical trader as a gambler with a college degree. The best traders, however, are more like bookmakers—they use information to lay odds on favorites and underdogs. They arrange odds in their favor based on information that you can’t get anywhere else. Meriwether was the best bookmaker on Wall Street and now in the most literal sense: he had been fielding bets for days. The firm as a whole believed the race was Benton’s to lose. But based on what he’d heard from Dunlavy, Meriwether believed Benton couldn’t possibly win.

Meriwether smelled money; he knew he could make a killing by getting as many people as possible to bet on Benton. To do that, he made Dunlavy the favorite and gave Benton the “spread,” a bookmaker’s term for extra points. In other words, those who bet on Dunlavy would have to cover the spread—Dunlavy would have to win by several seconds instead of just one. The trick was finding the right spread, one that would attract enough dumb money to bet on Benton.

And that’s what Meriwether was focused on now, just as focused as he would be on figuring the odds of one of his most complex trades. “How many seconds do you think you can beat him by?” Meriwether asked.

“Well, it’s hard to say,” Dunlavy said. “I would guess ten seconds or so.”

“Really?” Meriwether fired back. “How confident are you of that number?” Dunlavy said he had run up the stairs once already and finished in 73 seconds. Benton was an overweight ex-jock with bad knees. He’d barely finish, Dunlavy assured Meriwether.

“Okay, then,” Meriwether snapped. “I’m going to let the word out that I’m taking you and giving Dan six seconds—I’ll take all comers.” After a long pause he told Dunlavy, “Don’t let me down.”

Dunlavy wasn’t sure what he’d gotten himself into. He had been working at Salomon’s Cleveland office for three years and had dreams of making it to the big time and working out of New York. Meriwether was a rising star in the company, a favorite of Gutfreund and the firm’s powerful executive committee. In other words, the last thing he wanted to do was let Meriwether down.

In the coming days, Dunlavy continued to train. He did a couple more trial runs up the fourteen flights and heard through the company grapevine that Meriwether was taking in some fairly big bucks—not the multimillion-dollar trades he made on the bond desk but enough cash to make people realize he could win or lose serious money on the outcome of the race.

Dunlavy knew Meriwether loved to win money, but he also knew that for Meriwether, winning wasn’t just about the money. Like any good trader, Meriwether was looking to make a point, and no doubt he wanted to prove to his bosses, his colleagues, and himself that he understood risk and odds better than them all.

Dunlavy remembers the day of the great race well. He wore green gym shorts and a yellow shirt with “the great race” lettered on the front. Benton wore white gym shorts and a blue-and-gray Georgetown University sweatshirt. After many photos were taken, a coin was tossed to see who would run first. Dunlavy won first dibs. At the command, he raced up the first seven floors pretty easily, and then, despite all the training, fatigue started to set in. When Dunlavy finally reached the top floor, he was gasping for air. His wife, Daryl, attended the event and stood over him as he collapsed across the finish line, worried he might have a heart attack.

Benton didn’t fare much better, collapsing as he made it across the finish line as well.

A minute later, the results were announced over the “squawk box,” the firmwide communications system where research calls and other important messages were announced. “Ladies and gentlemen, the Great Race has just concluded. The times are—Pat Dunlavy, sixty-six seconds…Dan Benton…seventy-four seconds…Happy Saint Paddy’s to you all!”

There were many groans but a few cheers all over Salomon country.

Meriwether was one of those cheering. Dunlavy had covered the spread by two seconds. Before the day was over, J.M. called Dunlavy to congratulate him. Dunlavy had now recovered, but barely; it completely slipped his mind to ask Meriwether how much money he had won.

Pat Dunlavy is now retired from Salomon Brothers. During his twenty-three years at the firm, he saw it all: scandals, massive trading losses, huge paychecks, boardroom battles, and ultimately the firm’s demise, when, in 1997, Salomon Brothers was purchased by the financier Sandy Weill on his way toward creating another fabled and ultimately troubled financial powerhouse, Citigroup. But through it all, Dunlavy looks back on the Great Race and concedes it taught him something about the culture of Salomon and Wall Street.

In a few years’ time, he would be working in New York alongside Meriwether, Ranieri, and Gutfreund. They were all legends of Wall Street—and enormously rich, earning millions of dollars a year in salary and bonuses. They were successful because they were smart, of course. But they had something else going for them: the will—or, to be more precise, the desire—to take risks and gamble.

Most of it was with other people’s money, which made the losses more palatable, although all of them had some skin in the game. But risk taking was an obsession at Salomon Brothers, particularly among the new breed of traders and managers during the late 1970s and early ’80s, people like Meriwether and Ranieri and others who would fill the trading floor of every big Wall Street firm for the next three decades.

A good case could be made that the success of Salomon Brothers and its bond traders led to a broader revolution that swept Wall Street and sowed the seeds of the financial meltdown of 2008. Historically, and continuing through the 1960s and most of the 1970s, the big firms and partnerships that dominated Wall Street employed a business model that was decidedly low risk, focused mainly on selling advice to investors and large companies.

Things started to change as several forces began to converge. One was money—to be more exact, other people’s money. As the big Wall Street firms converted from private partnerships to public companies in the 1980s, they were gambling no longer with their own money but with that of public shareholders, and literally overnight the bets got bigger and the use of borrowed funds, known as leverage, grew and grew. Another was the cost of maintaining the old business model of acting as an “agent” for customers, underwriting corporate stock and bond deals, and selling stocks to small investors. It simply didn’t pay as competition caused fees to shrink dramatically beginning in the early 1980s and continuing for the next three decades.

Yet another was technology. As soon as the first computers made their way to the Street, traders began using technology to spit out information about markets and securities, to find historical patterns in the way markets behaved and crunch data in ways that would have been impossible just a few years earlier. Armed with this information, traders for the first time seemingly had a real edge; they could process enormous amounts of information to predict trends and prices and how they repeated over time.

This is the story of how those forces, combined with the very human elements of greed and lust for power, transformed Wall Street over a quarter century and set the stage for the meltdown of 2008 that led to what many economists believe is the worst economic crisis since the Great Depression. There were other factors that contributed to the financial mayhem that reached its peak in the fall of 2008: risk takers such as Meriwether, Ranieri, and the traders they spawned would take over the management of the big financial firms; the government would entice Wall Street to innovate and create new types of debt on one hand and provide aid and comfort to the risk takers to trade these newly created bonds on the other; regulators such as Fed Chairman Alan Greenspan, as well as various chairmen of the Securities and Exchange Commission, appointed by Republicans and Democrats alike, bowed to pressure from the banking industry, made it easier to take enormous risk, and, despite periods of market unrest, never forced Wall Street to adopt more restraint.

The Ronald Reagan–era tax cuts spurred the economy and the stock market to new heights. But it was Fed Chairman Paul Volcker’s policy of squeezing inflation—one of the great economic achievements of our time—that spurred the bond market and made the taking of risk through trading various forms of debt and derivatives of debt the Wall Street business model for the next three decades.

With inflation tamed, lower interest rates in the early 1980s meant cheaper borrowing rates; risk wasn’t just made easier by technology, it was now cost effective. Lower borrowing rates meant that speculators could borrow more—a concept known as “leverage”—and put less of their own money down when trading in the open market. Because bonds had become cheaper to sell, companies would rather sell debt if they needed to raise cash than dilute current stockholders’ holdings by issuing additional shares to the public.

Wall Street began inventing new bonds—one was the junk bond, another was known as the mortgage-backed security—and the various iterations of each would reach massive proportions. Mortgage bonds would prove particularly enticing for Wall Street because of the massive fees generated in the creation of these securities and because of the alleged social good they created. In its simplest form, the mortgage-backed security is nothing more than a bond packed with mortgages; payments are funneled from the mortgage holder to the bondholder. The objective: to get banks to take the loans off their books and sell them to Wall Street, which would then sell them to investors so the banks could keep making more loans.

All the bonds could be traded. Liquidity is the lifeblood of any market, and as interest rates fell, bond trading exploded. As bonds were traded and commoditized, profit margins naturally shrank, as they had in the old-line businesses of underwriting and providing advice to small investors. That forced Wall Street to innovate further. New types of bonds were created—“derivatives” of the old bonds. The bonds became more complex and packed with riskier mortgages, for which home buyers paid higher rates of interest that were funneled through to investors, who demanded higher yields. The trades became more complex and larger, based on computer models that allegedly reduced risk to the bare minimum. Where would it all end? No one seemed to care. Money was being made, and no one seemed to think that someday it all might end. And just like that, Wall Street’s business model had shifted from giving advice to taking on risk.

Young MBAs working on Wall Street no longer wanted to advise CEOs how to run their businesses; they wanted to use leverage to take over the companies, restructure their operations, and sell them at a profit.

Evaluating and taking risk were now necessary ingredients of working on Wall Street. Brokers didn’t make big bucks by recommending to their clients some supersafe long-term investment; they made their fortunes by churning the accounts of their best customers, essentially trading shares that didn’t need trading in order to generate commissions. Bankers didn’t buy their second homes in the Hamptons simply by telling a company how to manage its cash flow; the trick was to get the typical CEO in the 1980s to grow a company by acquisitions, often by using debt to finance the deal.

Traders didn’t receive $10 million bonuses because they were completely hedged against endless losses; they made money by weighing the odds and then making decisive, and massive, bets.

And they made those bets because they were now in their comfort zone of risk taking. The randomness of events meant little to this new breed of executive on Wall Street; even as the markets grew...

Table of contents

• Cover
• Title Page
• Dedication
• Contents
• Key People
• Key Firms
• Prologue
• Part I
• Part II
• Part III
• Epilogue
• Glossary
• Acknowledgments
• Notes
• Searchable Terms
• About the Author
• Other Books by Charles Gasparino
• Credits
• Copyright
• About the Publisher