Understanding the Subprime Crisis: A Narrative, Part Two

Part Two: John Meriwether and the rise of Arbitrage

In the first entry of this narrative, we paid attention to the story of Lewis Ranieri and the Salomon Brothers mortgage desk in the 1980s.  We will now focus on another major player at Salomon in the 1980s, one whose fame and influence is even greater than Ranieri’s, and who is as different from Ranieri as could possibly be.  That man is John Meriwether.

Ranieri was a loud, fat, New York-born Italian who started in the Salomon mail room and had never gone to college.  Meriwether, on the other hand, was famous for his quiet and reserve.  Michael Lewis, in his book Liar’s Poker, opens with a famous story about Meriwether that even he has admitted is probably apocryphal: the game of Liar’s Poker, a modified game of poker played using the serial numbers on dollar bills, was vastly popular at Salomon at the time, and the inscrutable Meriwether was the firm’s best player.  The story goes that Salomon’s managing partner, John Gutfreund, challenged Meriwether to a single hand of liar’s poker for the sum of one million dollars, and Meriwether responded that he would only play if the sum for the hand was ten million (Gutfreund turned him down, which Lewis says was the intent).  

His first notable trade at Salomon was a classic bit of arbitrage; a trader named J.F. Eckstein’s firm was failing in 1979, and tried to get Meriwether to buy out his position.  Eckstein had sold millions in US Treasury bills, while buying millions in Treasury bill futures (futures are a contract where two parties agree to the sale of a commodity at a set price at a predetermined moment in the future).  At the time, treasury futures were selling at a discount compared to the actual bills.  What Eckstein had done was place a two hundred million dollar bet that the prices of the bills and the futures would eventually converge, but the longer that took, the more his equity value was disappearing.  If he didn’t sell his position, he would be ruined long before the prices converged.

Meriwether agreed with Eckstein’s reasoning, and bought his position.  He was only thirty-one, new to Salomon, and was told that his job was on the line if he was wrong.  His buyout of Eckstein put tens of millions of Salomon’s capital at risk, which in 1979 only totaled two hundred million.  The prices did converge, and made a fortune for Salomon.  In 1980, Salomon made Meriwether a partner, and the head of the newly formed Domestic Fixed Income Arbitrage Group, and gave him permission to make large trades using the firms capital.

At this point, it is important to explain what arbitrage trading is.  Few concepts are as essential to modern economics yet so poorly understood.  The broadest definition is that arbitrage is a form of trading which takes advantage of price discrepancies.  These discrepancies exist in part because of one of the foundational rules of modern economics: the theory of Comparative Advantage.  Advanced by economist David Ricardo in his 1817 book, On the Principles of Political Economy and Taxation, he used the example of wine and cloth production in England and Portugal.  Both nations can produce both wine and cloth, but it is cheap to produce wine in Portugal and cheap to produce cloth in England.  Therefore, it makes sense for Portugal to produce excess wine, and to trade its excess to England for their excess cloth.  But what if, for any number of reasons, people chose to trade in ways that do not maximize their comparative advantages?  That is where arbitrageurs step in.

In his book The Undercover Economist, economist Tim Harford demonstrates that Tropicana orange juice is actually less expensive at Whole Foods than at less upscale grocery stores.  He uses this to explain price discrimination; at Whole Foods, Tropicana is the least expensive orange juice option, and therefore the people purchasing it are very sensitive to its price, while at most downmarket groceries, Tropicana is the most expensive option, and those purchasing it are being prince insensitive.  But this is also a very good example of how arbitrage works.  What if you could purchase millions of gallons of Tropicana at Whole Foods’ price and sell it at the price of downmarket groceries?  Each transaction would net you only a few pennies, but multiplied by thousands or millions, you’d make a killing.  And while you made a killing, the price of Tropicana at different groceries would converge, until there was a single price for Tropicana at all groceries.  And finally and most importantly, this sort of trade could isolate only the difference in cost between Tropicana at Whole Foods and other supermarkets; if the real cost of orange juice rose or fell, this trade would be unaffected, because it only concerned the difference in the two prices.

What Meriwether did was to take that idea and apply it to the domestic fixed income (meaning fixed interest rate) bond market, which was the market where Salomon had a significant information advantage over their competitors.  That alone would have made his department profitable for Salomon, but was not how he became their most valuable partner.  That was achieved because of something Ranieri lacked, but Meriwether had in spades: intellectual curiosity.

At a time when Wall Street trading desks were stocked primarily with gut-based traders, Meriwether, who had an MBA from the University of Chicago (where he had been a classmate of future rival Jon Corzine), and had been a high school math teacher before joining Salomon, was an anomaly.  And in 1983, he began to staff his group with people even more anomalous than he was.  He hired people such as Eric Rosenfeld, a M.I.T.-trained assistant professor at Harvard Business School; Greg Hawkins, who had been one of the campaign managers for Bill Clinton’s campaign for Arkansas Attorney General and then got his Ph.D. in Financial Economics from M.I.T.; Victor Haghani, who had just received his master’s in finance at the London School of Business; and his jewel, Lawrence Hilibrand, who had two doctorates from M.I.T. and was an assistant professor there as well.  Through Rosenfeld, Meriwether became friendly with Columbia University professor Robert C. Merton, who had made one of the most profound breakthroughs in economics while studying with famed economist Paul Samuelson at M.I.T. in the 1960s: continuous time finance modeling.  In the 1970s, Merton had solved mathematical problems in the work of economists Fischer Black and Myron Scholes to develop a model for the price of stock options; the Black-Scholes model is famous, and eventually won Merton and Scholes the Nobel Prize in economics (Black had passed away, and Nobel Prizes cannot be awarded posthumously).

Meriwether’s hiring of academics was so far outside the norm for Salomon that the group fit in poorly with the rest of the firm.  This fitted Meriwether well; he was so private that he forced Salomon to remove his picture from their annual report, and at the height of his infamy, the New York Times wasn’t even able to ascertain whether or not he had siblings.  The group mirrored his private and secretive nature, sharing no information with other departments of Salomon and going so far as to refuse to eat in the company cafeteria.  When one member of the group left, Meriwether ordered the others to stop playing golf with him.

Arbitrage began as the academic solution to a theoretical problem.  If in an ideal marketplace, the price of a product was representative of its actual value, then what to make of price discrepancies?  How would the market deal with them, and validate the underlying concept?  The solution was via arbitrage.  In this manner, neoclassical economics can demonstrate that despite the lack of the existence of rational “homo economicus” – people who make all their economic decisions rationally – by showing that arbitrageurs will spot price discrepancies, pile on, and that by their actions they will rectify the discrepancy.  This solution is conveniently self-fulfilling; by pointing out that there is an advantage to piling on to price discrepancies, and predicting that they will narrow, actual arbitrageurs will make the prices converge based on their own actions rather than waiting for outside factors.

And so Meriwether and his group of academics began to search the domestic bond market for price discrepancies.  Initially, they found many upon many – they had the field to themselves.  And they made millions; tens and hundreds of millions.  The main reason for this was not merely the theory of arbitrage, but the group’s own confidence in it.  The discrepancies they were targeting were in actual terms quite small, measured in basis points (hundredths of a percent).  But their confidence in their models was so great that they were eager to make their trades larger and larger – putting hundreds of millions of dollars in leveraged capital at risk to maximize the profit from gains of single basis points.  And as their wagers paid off, they pushed themselves and Salomon to take even larger positions.  

By doing this, Meriwether was ignoring the lesson of his first major trade.  The trade Eckstein had sold Meriwether was one where Eckstein had made the right call.  But he couldn’t afford to keep it; he was forced to sell his holdings before the spread contracted.  The models could predict with high accuracy that the prices would eventually converge, but in the meantime, an increase in the spread of prices of minuscule amounts could cause the value of their holdings to decrease by millions.  In 1987, in fact, the arbitrage group lost $120 million in a single day.  But this did not change the fact that Meriwether’s group was earning gobs of money for Salomon, and that this was happening right as their previous cash cow, Ranieri’s mortgage group, was falling apart.  Meriwether’s group was given even greater access to capital, and Meriwether was given control over not just domestic fixed-income arbitrage, but mortgages, high-yield corporate bonds, and European and Japanese government bonds.  

Fully aware of the fact that they were making the bulk of Salomon’s profits, Meriwether’s group began to agitate for greater rewards.  They instinctively disliked the sharing of their gains with other, less profitable departments (Hilibrand was so strongly opposed to this that he once campaigned to have the group exempted from paying the costs of the cafeteria, since they did not choose to use it).  Salomon’s management, remembering the defections from Ranieri’s mortgage group to other firms for more money, and how that killed their golden goose of mortgage bongs, cut a deal in 1989 to pay the members of the arbitrage group a fixed 15% of their group’s profits.  That year, Hilibrand’s share alone was $23 million – an unheard of sum which gives an idea of how much money this group was making.

This deal, however, which was made in secret, tore Salomon apart.  No other department had such a deal.  Resentments grew, and in 1991, Paul Mozer, who had been forced out of the arbitrage group to run the government desk at Salomon, made a confession to Meriwether: he had submitted a false bid to the US Treasury to gain an unauthorized share of a bond auction.  Meriwether took this information to John Gutfreund, the managing partner of Salomon, but also defended Mozer and encouraged the firm to keep him as the head of the government desk.  Gutfreund followed Meriwether’s advice, but in a couple months the firm discovered that Mozer had committed many other infractions.  This time, they immediately informed the Treasury and the Federal Reserve, who were furious.  Gutfreund was forced to step down, and Warren Buffet, who had purchased Salomon two years earlier, came to take over.  Buffet reportedly tried to save Meriwether from being tainted by the scandal, but eventually Meriwether was asked to resign for the good of the firm, which he did.  Meriwether was the target then of a civil complaint by the SEC, which he settled without admitting any wrongdoing for a three-month suspension from the securities industry and a $50,000 fine.  Salomon fared much worse; they were fined a record $290 million by the government.

Outraged at the perceived sell-out of Meriwether, his group revolted.  Hilibrand made a disastrous trade which led to a temporary loss of $400 million.  This led to a dispute where management wanted Hilibrand to sell the trade before it lost more, and Hilibrand wanted the firm to double its investment.  The trade was kept, but not doubled, and did eventually earn a profit for Salomon, but the writing for the arbitrage group was on the wall.  In the next two years, nearly every member of Meriwether’s group at Salomon would leave to join him in a new venture, one which became one of the most famous investment funds of modern finance: Long Term Capital Management.

As for Salomon, this marked the end of a meteoric rise beginning in 1980 which inspired fame and envy so great as to inspire best-sellers like Liar’s Poker and Bonfire of the Vanities.  Having lost both their astronomical earners, Ranieri and his mortgage department, and Meriwether’s arbitrage group, and fatally weakened by the $290 million dollar fine (nearly 150% of their total capital at the time of Meriwether’s hiring), Salomon floundered and was acquired by Travelers Group in 1997, which then merged with Citicorp in 1998, forming the financial giant of Citigroup.  Salomon Brothers is now no more than a division and service mark of Citigroup Global Markets.  But the innovations of Salomon partners and traders in the 1980s, as well as the windfall profits the firm attained when it proved willing to risk the bulk of its own capital rather than selling its services to investors, had, as we can and have seen, permanent effects on Wall Street and financial markets.

These effects were evidence of the individuals who produced them.  Only someone whose financial expertise was in finding methods of profiting by single basis points such as Hilibrand would care about the expense of his share of a cafeteria he didn’t eat at while drawing a salary of $23 million.  Only a form of making money which disregarded the absolute value of an asset such as arbitrage could have allowed and encouraged Wall Street firms to ignore the effect of their trades on their customers.  Michael Lewis, while working as a bond salesman in London for Salomon, wrote of the firm pushing him to make sales to clients which he knew would hurt the client.  This was counter to the established business model of investment banks; they traditionally earned their profits by charging commissions, known as “haircuts” on each transaction.  But, when the wagers were representing money which dwarfed all the haircuts combined, whether the trades helped or hurt the customers stopped having meaning.  Hilibrand, after the firing of Meriwether, indeed tried to convince Salomon to shut down the investment banking department entirely.  What had been a business of salesmen working for wealthy customers became a business of mathmeticians and economists trying to derive methods by which to gain themselves advantage, where the only value the customers had was in providing the capital needed to test the theories.

Meriwether was a major engine of that development as well.  Having inspired an investment bank to put its own capital behind his trades, and having had his success inspire every other investment bank on the street to do the same, he was going to take his model directly to investors, and usher in the era of the modern hedge fund.

This post includes information from several sources not available online.  The major sources are: