The financial crises and scandals of the 1980s offer more than simple parallels--they offer explanatory continuity. In this case, Salomon Brothers are like the Bear Stearns, and Drexel-Burnham-Lambert become, at least for a while, the Goldman Sachs. We even have the lowly 'Italian types' running the dirty business and taking the role of scapegoats. So the recent meltdown (notwithstanding the much larger socio-economic crisis America faced and still faces from 2000-to now) is really just JUNKBOND CAPITALISM DEJA VU. And for continuity's sake, we also have Salomon employees going on to give us a late 1990s crisis in the Long term Capital Management fiasco (which follows from the Russian crisis, which follows from the Asian crisis). All we need now is for things to come full circle and a China crisis and (well at least we can go back to Nixon in China and reminisce).
http://en.wikipedia.org/wiki/Savings_and_loan_crisis#Imprudent_real_estate_lending Imprudent real estate lending In an effort to take advantage of the real estate boom (outstanding US mortgage loans: 1976 $700 billion; 1980 $1.2 trillion)[4] and high interest rates of the late 1970s and early 1980s, many S&Ls lent far more money than was prudent, and to risky ventures which many S&Ls were not qualified to assess, especially regarding commercial real estate. L. William Seidman, former chairman of both the Federal Deposit Insurance Corporation (FDIC) and the Resolution Trust Corporation, stated, "The banking problems of the '80s and '90s came primarily, but not exclusively, from unsound real estate lending."[5] http://en.wikipedia.org/wiki/Drexel_Burnham_Lambert The threat of a RICO indictment unnerved many at Drexel. A RICO indictment would have required the firm to put up a performance bond of as much as $1 billion in lieu of having its assets frozen. This provision was put in the law because organized crime had a habit of absconding with the funds of indicted companies, and the writers of RICO wanted to make sure there was something to seize or forfeit in the event of a guilty verdict. Unfortunately, most of Drexel's capital was borrowed money, as is common with most Wall Street firms (in Drexel's case, 96 percent—by far the most of any firm). This debt would have to take second place to this performance bond. Additionally, if the bond ever had to be paid, Drexel's stockholders would have been all but wiped out. Due to this, banks will not extend credit to a firm under a RICO indictment.[4] By this time, several Drexel executives—including Joseph—concluded that Drexel could not survive a RICO indictment and would have to seek a settlement with Giuliani. Senior Drexel executives became particularly nervous after Princeton Newport Partners, a small investment partnership, was forced to close its doors in the summer of 1988. Princeton Newport had been indicted under RICO, and the prospect of having to post a huge performance bond forced its shutdown well before the trial. Joseph said years later that he'd been told that if Drexel were indicted under RICO, it would only survive a month at most.[5] Nonetheless, negotiations for a possible plea agreement collapsed on December 19 when Giuliani made several demands that were far too draconian even for those who advocated a settlement. Giuliani demanded that Drexel waive its attorney-client privilege, and also wanted the right to arbitrarily decide that the firm had violated the terms of any plea agreement. He also demanded that Milken leave the firm if the government ever indicted him. Drexel's board unanimously rejected the terms. For a time, it looked like Drexel was going to fight.[4] http://www.sjsu.edu/faculty/watkins/junkbonds.htm excerpt 1 The Savings and Loan Industry The Savings and Loans were in difficulty long before Michael Milken came onto the American financial scene. Originally S&L's were restricted to holding mortgages on real estate. This restricted S&L's competitiveness with respect to bank which were not so restricted. But the interest rates that banks and S&L's could pay on deposits were regulated so S&L's did not have to match banks in a bidding contest on interest rates. During the 1970's inflation rates went up and interest rates followed. This was especially hard on S&L's, which had their assets tied up in long term mortgages paying low interest rates but had to pay high current rates to keep depositors. Fundamentally at that stage the S&L's became bankrupt, but every one wanted to postpone the inevitable. The government's actions in trying to stave off the bankruptcy of the S&L's turned a bad situation into a disasterous one. The Garn-St. Germain Act of 1982 removed most of the restrictions on what S&L's could hold. From 1982 they could hold stocks, bonds, real estate, and commercial loans as well as mortgages. But at the same time that the restrictions on what S&L's could hold were removed, the interest rates restrictions for banks were also removed. Nevertheless the Federal Government continued to insure S&L deposits. Depositors did not have to concern themselves about the safety of an S&L. S&L's were another financial institution, like insurance companies, where a relatively small investment in equity gave the buyer control over a much larger amount of investible assets. The purchase of an S&L with a billion dollars worth of assets might require only $30 million to buy up its equity. Within months of the passage of Garn-St. Germain members of Milken's circle were taking over S&L's using Drexel junk bond money. The S&L's then became major markets for junk bonds. A $30 million outlay for a S&L could easily lead to the sale of $500 million of junk bonds by Drexel for which it would charge a commission of $20 million. Some of the S&L's taken over by friends of Milken were: excerpt 2 The junk bonds market could have collapsed in the mid-1980's under the burden of the defaults and effective defaults, but Milken got a lucky break. Edward Altman of the Business School of New York University was hired by Morgan Stanley, the most pretigious investment bank in the U.S., to do research on the default rate on junk bonds. Morgan Stanley wanted to enter the obviously lucrative field of marketing original issue junk bonds. It made the mistaken presumption that Drexel's position in the field was based upon knowledge and research when, in fact, it was, in Benjamin Stein's words, based "upon years of mutual backscratching in the back alleys of finance." Altman computed the ratio of the face value of the bonds that actually defaulted in a given year to the total face value of bonds in existence in that year. Although this procedure might seem reasonable, it did not allow for the tremendous growth in junk bonds over the period. Suppose all of the junk bond issues default after five years. This would be a 100 percent default rate. But if the first year there is $100 million issued and the amount doubles each year then this would be the record Altman's method would show: http://www.nytimes.com/1990/02/14/business/collapse-drexel-burnham-lambert-drexel-symbol-wall-st-era-dismantling-bankruptcy.html?pagewanted=1 Pioneer in Junk Bonds Yesterday's developments underline the stunning turnaround at Drexel, which was one of Wall Street's most powerful firms until last year, when it settled criminal and civil charges of securities law violations. Drexel rose from being a Wall Street also-ran in the late 1970's to become one of the nation's most profitable investment banks in the late 1980's as a creator of the modern junk bond market. Under the guidance of Michael R. Milken, former head of its junk bond division, Drexel became a primary player in the takeover battles that swept corporate America during the last decade. With Drexel's bonds, smaller companies that never before could have obtained financing were able to make bids for some of America's largest corporations. http://en.wikipedia.org/wiki/Salomon_Brothers Period of Innovation At the beginning Salomon had to provide rapid service and to maintain a reputation for honesty and integrity. In this period the firm risked its own capital to make money because it did not have fee-paying clients. The private company entered equities in the mid- 1960s and investment banking in the early 1970s. Partners were highly motivated to put the firm’s health before their own activities. John Gutfreund became managing partner in 1978 and took the company public, staying on as CEO. During its time of greatest prominence in the 1980s, Salomon became noted for its innovation in the bond market, selling the first mortgage-backed security, a hitherto obscure species of financial instrument created by Ginnie Mae. Shortly thereafter, Salomon purchased home mortgages from thrifts throughout the United States and packaged them into mortgage-backed securities, which it sold to local and international investors. Later, it moved away from traditional investment banking (helping companies raise funds in the capital market and negotiating mergers and acquisitions) to almost exclusively proprietary trading (the buying and selling of stocks, bonds, options, etc. for the profit of the company). Salomon had an expertise in fixed income trading, betting large amounts of money on certain swings in the bond market on a daily basis. The top bond traders called themselves "Big Swinging Dicks", and were the inspiration for the books The Bonfire of the Vanities and Liar's Poker (see below). During this period however the performance of the firm was not to the satisfaction of its upper management. The amount of money being made relative to the amount being invested was small, and the company's traders were paid in a flawed way which was disconnected from their true profitability (fully accounting for both the amount of money they used and the risk they took). There were debates as to which direction the firm should head in, whether it should prune down its activities to focus on certain areas. For example, the commercial paper business (providing short term day to day financing for large companies), was apparently unprofitable, although some in the firm argued that it was a good activity because it kept the company in constant contact with other businesses' key financial personnel. It was decided that the firm should try to imitate Drexel Burnham Lambert, using its investment bankers and its own money to urge companies to restructure or engage in leveraged buyouts which would result in financing business for Salomon Brothers. The first moves in this direction were for the firm to compete on the leveraged buyout of RJR Nabisco, followed by the leveraged buyout of Revco stores (which ended in failure). http://en.wikipedia.org/wiki/Government_National_Mortgage_Association Salomon Brothers' success and then decline in the 1980s is documented in Michael Lewis' 1989 book, Liar's Poker. Lewis went through Salomon's training program and then became a bond salesman at Salomon Brothers in London. In the work, Lewis portrays the 1980s as an era where government deregulation allowed unscrupulous people on Wall Street to take advantage of others' ignorance, and thus grow extremely wealthy. He traces the rise of Salomon Brothers through mortgage trading, when deregulation by the U.S. Congress suddenly allowed Savings and Loans managers to start selling mortgages as bonds. Lewis Ranieri, a Salomon Brothers' employee, had created the only viable mortgage trading section, so when the law passed, it became a windfall for the firm. However, Lewis believed that Salomon Brothers became too complacent in their new-found wealth and took to unwise expansion and massive displays of conspicuous consumption. When the rest of Wall Street wised up to the market, the firm lost its advantage. Likewise, Lewis argued that Salomon Brothers improperly tried to "professionalize" itself. As he notes, Ranieri and his fellow traders lacked college degrees; one of the traders only had an eighth-grade education. Despite this lack of credentials, the group was extremely successful financially. However, the firm, in order to improve its "image," began to hire graduates of prestigious business and economics programs (a group which included Lewis himself). Because of his uncouth manners, Ranieri (along with many of his Italian colleagues) was eventually fired. By relying more on diplomas than on raw trading skill, Lewis argued, Salomon crumbled. After mortgage bonds, Lewis examined junk bonds and how Michael Milken built junk bonds from nothing to a multi-trillion-dollar market. Because the demand for junk bonds was higher than its supply, Lewis argues that corporate raiders began to attack otherwise sound companies in order to create more junk bonds. Lewis remarked in his conclusion that the 1980s marked a time where anyone could make millions, provided they were at the right place at the right time, as exemplified by Ranieri's success. [edit] Long Term Capital Management Salomon Brothers' bond arbitrage group was also the breeding ground for the core group of founders and traders (led by, among others, John Meriwether and Myron Scholes) for Long Term Capital Management, the hedge fund that collapsed in 1998.[5] _______________________________________________ Marxism-Thaxis mailing list Marxism-Thaxis@lists.econ.utah.edu To change your options or unsubscribe go to: http://lists.econ.utah.edu/mailman/listinfo/marxism-thaxis
