House of Cards, page 30
THE JOY OF MORTGAGE-
BACKED SECURITIES
ne of the ways Bear Stearns began to increase its return on equity was through the growth of its mortgage-backed securities department. Tommy Marano started full-time at Bear Stearns in May 1983, after graduating from Columbia College. A history major, Marano started at the firm on the equity syndicate desk, working on the basic underwriting of equity offerings for Fannie Mae, Freddie Mac, and Ginnie Mae. He liked reading and writing the boring prospectuses. Then fate intervened. “I got paid a really lousy bonus one year by the head of the syndicate at that point, and I talked to my immediate boss and he said, ‘You ought to go talk to John Sites'”—who founded the mortgage department at Bear Stearns in 1981 and later became co-head of fixed income— “‘and ask John Sites if he has a role for you in the mortgage area because you like to read these books and they're complicated deals.’”
Bear's mortgage-backed securities business rose from the ashes of the savings-and-loans crisis of the mid to late 1980s, when failed thrifts were desperately trying to get illiquid assets off their balance sheets. At that time, the margins on trading the bonds of Fannie Mae and Freddie Mac were huge, generally $2 to $3 on a trade and sometimes $5. In other words, the difference between what a bond was bought for and what it could be sold for could be as much as five points. (Today that spread is calculated in thirty-seconds of a point.) “There were very few types of securities trading,” Marano said. “You didn't have the technology or analytics we have today.” Bear Stearns followed the lead of Salomon Brothers in trying to help the thrifts solve their balance sheet problems, with all those nonperforming mortgages. “The play we made in that area was following what Salomon was trying to do with the thrifts,” he continued. “That was the birth of securitization, really, and what you were trying to do was get the assets off the thrifts' balance sheets to basically get them some liquidity to keep operating. And it was Bear, through John Sites, that really got the market to change in 1987 by allowing Fannie and Freddie to issue these REMICs”—real estate mortgage investment contracts— “directly, as opposed to only issuing pass-throughs or mortgage-backed bonds. Bear Stearns and Sites were key to that, as was Lehman. I actually priced and traded the very first REMIC Fannie Maes 87-1 (for $500 million). It was a new market. It was a growing market. You had none of the technology we had today, and you had [a] very wide bid-offered spread. That's really why the firm went after it, and we spent a lot of money on risk analytics and banking. We did deals for all the failed thrifts, among them American Savings and Loan and California Federal.” The business took off. “It became kind of a real race between us, Salomon Brothers, Merrill, First Boston, Lehman Brothers, and DLJ,” Marano said, “with Bear Stearns and Lehman taking the lead.”
While Sites, with the help of Marano and others, had been building a powerful engine in the firm's mortgage securities department, the rocket fuel for it came in November 1987 when the firm hired a well-known trader named Howie Rubin. Rubin was plenty controversial. Until 1985, he had been a mortgage trader at Salomon Brothers, working for Lew Ranieri, who is generally acknowledged to be the godfather of the mortgage-backed securities business on Wall Steet and the man who coined the word “securitization” to describe buying bundles of home mortgages, slicing and dicing them into different tranches, and selling them off to investors around the world. He realized mortgages were nothing more than “math” and hired a team of Ph.D.'s to do the structuring. Ranieri once called Rubin, a Harvard MBA and onetime professional gambler, “the most gifted trader I have ever seen.” In 1985, Merrill Lynch hired Rubin away from Salomon Brothers by tripling his compensation to $1 million. A year later, Rubin supposedly “exceeded his trading limits” in his mortgage-backed securities portfolio, causing Merrill to lose $37 million. As his punishment, he was promoted to chief mortgage securities trader. On April 29, 1987, the Wall Street Journal reported Merrill had lost $250 million—later increased to $275 million and then $337 million, and then reduced to $85 million—as a result of unauthorized trading in mortgage securities. Merrill blamed Rubin, then thirty-six, for the loss, which at the time was the largest on a single trade in Wall Street history. Merrill executives told the Journal that Rubin “had far exceeded his limits in acquiring mortgages that were packaged into a particularly risky form of securities. The package involves splitting off the interest payments on the mortgages from the principal and selling each separately.”
It turned out that a few weeks earlier, Rubin had sold the stream of interest payments on $500 million of mortgage bonds to Ernie Fleischer at Franklin Savings & Loan, in Ottawa, Kansas, and kept the stream of principal payments on the same bonds. Rubin tried to sell what he still owned through Merrill's vaunted sales force, but for technical reasons the strip of principal payments was plenty risky in a rising-interest-rate environment, and no buyers could be found. Some said Merrill had overpriced the securities. In any event, with his losses mounting daily, Rubin “just put them in his drawer,” an unnamed Merrill executive told the Journal. “We didn't know he owned them.” From there, the facts of the matter get murky. Supposedly, Rubin then went on vacation and locked his desk. To get into the drawer, Merrill's maintenance staff took a chain-saw and cut open the desk and found the confirmation slips for the trade. Then Merrill fired Rubin, insisting he had misled them. Rubin's ex-buddies at Salomon, including Ranieri, defended him and said it was preposterous that Rubin could have created and sold these securities— which had to be registered with the SEC, after all—without his bosses at Merrill Lynch being aware of what he was doing. (Rubin declined repeated requests to be interviewed; in 1990 he settled SEC charges brought against him, and Merrill ended up paying him deferred compensation said to total around $1 million.)
About the time Merrill fired Rubin, executives at Bear Stearns reached out to hire him. In November 1987, Bear named him one of its fourteen mortgage securities traders at a salary reported to be $100,000 a year plus 10 percent of the profits he generated, a 90 percent reduction in his compensation. Cayne said he was involved directly in the decision to hire Rubin. Sites went to Cayne and told him he wanted Rubin. At first, Cayne was skeptical of hiring someone who had been accused of unauthorized trading and appeared to be in trouble with the SEC. Cayne told Sites he wanted to meet Rubin. As Cayne recalled, “The guy looked me in the eye and said, ‘You really honestly think I did this?' I said, ‘No, I don't.’” Cayne said he thought Merrill Lynch made Rubin its “fall guy.” The hiring of Rubin was a perfect example of Cayne relying on his gut instinct when interviewing a prospective employee.
Tommy Marano believed the hiring of Rubin reflected the firm's opportunistic streak. “It was a demonstration of the firm's propensity to be comfortable taking risks even with people who might be colorful,” he said. Marano was one of Rubin's fellow traders, and while he was a little wary of him at first, he quickly became impressed. “Howie, first of all, has the calmest demeanor of any trader I ever interacted with, so very few situations can freak him out,” Marano continued. “He also has an amazing mind for math. He's just very, very quick with math. He's very organized, very creative, and I think his strongest feature is that he has this way of putting customers at ease.” The Bear traders used to joke that even when Rubin was screwing a customer, the customer enjoyed every minute of it.
Marano said that Rubin—along with Sites, Chuck Ramsey, who was in charge of the company's small mortgage bond desk, and others— helped to get the executive committee of the firm “plugged into” the “revenue potential” of the mortgage securities business. “It was Howie's risk-taking propensity,” Marano said, “as well as all the money we invested in research and technology that let us really run the first really big position” in mortgage securities on the firm's balance sheet. In short order, under the leadership of Sites, Ramsey, Rubin, and others, the firm became a major underwriter of mortgage-backed securities. Bear was a “negligible force” in the market in 1986, the Wall Street Journal reported, was seventh in the closely watched league tables in 1988, and by the first half of 1989 was in first place, having underwritten $7.1 billion in mortgage-backed securities, $2 billion more than Salomon Brothers, the perennial market leader.
THE BULL MARKET was raging into the fall of 1987, but on October 19 the Dow Jones Industrial Average suffered its largest one-day crash, in percentage terms, in history, losing 22.6 percent of its value, or some $500 billion. Around Wall Street, a near-panic ensued as fortunes were lost instantly, and nerves were more than a little frayed. Bear Stearns stock lost about a third of its value that day and was trading at around $8 a share, almost two-thirds less than it had on October 1. “I was catatonic,” recalled Bobby Steinberg, the head of arbitrage. “I'd never lost so much money in my life. Ace says, ‘Bobby? What action are you taking?' Action? I'm sitting there helpless. He says, ‘I think now's the time to start buying.' Then he gets up—everyone on the trading floor's watching—and he starts practicing his golf swing. He says, ‘I think maybe I won't come in tomorrow. I think I'll play golf.’”
The image of Greenberg swinging his golf club on the trading floor in the midst of a collective panic became one of the firm's enduring legends. “It is amazing how history keeps repeating itself,” Greenberg wrote the troops during the crash. “The market in stocks and bonds has taken a precipitous drop, but I am far from depressed. Why? Because once again, we are seeing and we will be seeing great opportunities in all areas, particularly in personnel. I can assure you we are pursuing every lead at this very moment. Our move to Park Avenue will start shortly, and I truly believe that the timing is perfect. Just keep in mind it was just a few years ago that two of our competitors left the clearing business. Eleven months ago several large firms closed their Arbitrage Departments”—and here he said he wished he had forced the firm's arbitrage department to go on vacation two weeks ago, because Steinberg's positions alone cost the firm around $50 million on October 19. “We will be a winner.”
The firm lost $100 million on October 19. That money was simply removed from the accrual that had built up during the year in the discretionary bonus pool. That meant that unless things turned around before the end of the firm's fiscal year, the managing directors were likely to get smaller bonuses that year because of the loss. But the crash did cause a Hong Kong investment firm, Jardine Matheson, to renege on a $23-a-share tender offer for 20 percent of Bear Stearns—an offer that valued the whole firm at about $2 billion. The executive committee debated whether to sue Jardine, and the final vote was nine to one in favor of the suit, with Greenberg being the lone dissenter. Eventually, the case went to trial before a jury, and Jardine's lawyers realized they were losing and folded. Bear Stearns won a $60 million settlement from Jardine (which, ironically, is also now part of JPMorgan) for the firm's shareholders. That worked out to $3.53 per share, most of which went to the senior management of the firm, since they owned close to half of the firm. Greenberg, who had never wanted to litigate the matter, had thought the firm might get at most a $12 million settlement and probably less.
“BULLIES ALWAYS CAVE”
ith the repercussions from the crash and Jardine's withdrawn offer still fresh in the minds of the executive committee—a committee that had supported Cayne against Greenberg in deciding to file a lawsuit against Jardine—Cayne decided that his co-president arrangement with John Rosenwald had become untenable. Bear Stearns needed a sole president, Cayne realized. It was time for another power play. “I go to Johnny Rosenwald, who happens to be a really nice guy,” Cayne said. “He's not devious at all. He's like a dwarf. He's like five foot one or something. But he tells great stories and he's a gentleman. I said to him, ‘We are the laughingstock of Wall Street. We don't have a president. We're the only company in the world that doesn't have a president. Now, you're a big shareholder and I'm a big shareholder. We should together go to Greenberg and say you want to be the president. You're the president. I don't care. We have to have a president. We can't have simply a vice chairman and a president turned into co-presidents. That's just ridiculous.' He agrees.”
Cayne and Rosenwald went to see Greenberg with the plan that one of the two of them would be named president of the firm. “Greenberg goes completely crazy,” Cayne said. “He throws his jacket on the floor.” Greenberg refused to deal with his partners' request. But Cayne would not take that for an answer. “‘This is a fill or kill,’” he told Greenberg after his tantrum. “‘This doesn't happen, I'm out of here.' No anger. I told him, ‘It's your firm. I don't doubt that it's your firm. But I won't be here getting coffee in the morning and the other guys' coffee in the afternoon.’” He won from Greenberg an agreement that he would make a decision in ninety days about who would be president, even though Cayne couldn't figure out why Greenberg wanted to wait other than as a stalling tactic. “Ninety days go by,” Cayne said. “I walk in his office that Monday morning and say, ‘Today's D-Day.' He says, ‘For what?' I said, ‘Don't you remember that little thing ninety days? Well, ninety days are up.' He says, ‘Jimmy, we can't do that, that's not fair to Johnny.' I said, ‘Tonight is the executive committee meeting. It will be announced at the executive committee,' and I walked out. Executive [committee] meeting was at 4:15. I get there at 4:10. Rosenwald and Greenberg are standing there. ‘We've got to talk to you,' they say. I walk over. ‘Look, Jimmy, at the end of the year we'll make the change.' I said, ‘Wait a second. We just had a ninety-day period. Now, there's another four months, five months.' ‘Yeah,' they said. I said, ‘It's simple. We're going to go back in that room. Either you make the announcement or I'll make the announcement that I'm leaving.' Then I just walked out of the room to go to the executive committee meeting.”
Of course, ever the tactician, Cayne figured he had the executive committee in his pocket. “I've got the executive committee,” he said. “I've got a six-vote preference there. I walk in and I wink at everybody. This is it. It's D-Day. I don't know what the fuck he's going to do. But as far as I'm concerned, this is it. Decision. I was pretty sure what was going to happen, but it was no cinch. Greenberg said, ‘It seems that Johnny wants to do a little something different, so he's going to move into the ivory tower, which leaves only one person in the presidency, and that's Jimmy. He's the president, the only president.' That's how he addresses it. Then he turns to the guy at his right and says, ‘Okay. What have you got?' Like we're having a meeting and all of a sudden he's made an announcement that's earth-shaking. Rosenwald has been at the firm for thirty years. He's just been told he's going somewhere else. He calls on somebody to continue going around the table with ‘What do you got?' Rosenwald says, ‘Well, wait a second. I've been here for thirty years and I deserve a little more than simply “John is moving into something else.” I really don't think that I was treated right.' Greenberg says, ‘Yeah, well, okay, well, so what?' And he goes on.”
Even the thick-skinned Cayne found Greenberg's cavalier treatment of Rosenwald appalling. “Rosenwald was not a friend of mine,” Cayne said. “He was not a compadre at all. On Monday night, I'm out to dinner with Patricia and friends and I said to them, ‘You know what? I got to call this guy, because what happened was so embarrassing to him.' She said, ‘Well, you don't even like him.' I said, ‘I know, but it's just like there's a rawness that existed, that Greenberg was a meatpacker who was treating him like he was a piece of dirt.’” When Cayne got home that night, he called Rosenwald. “I said, ‘Johnny, you've given a lot to the firm and I apologize for the way this all came down.' And he said, ‘I can't tell you how much this call really means. I thank you.' Even though I may be rough and tough and grew up scrambling and clawing my way, there's a basic niceness and a basic humanity. I ran the firm with an idea. The idea was be nice to everybody. It works. Pretend you're running for mayor, over and over. Have the quote boys like you. Have the clerks like you. Have the traders like you. It's better. That's what pervaded the organization—the idea that working and playing well with others is equally rewarded with production. You get rewarded for working and playing well with others. And that becomes part of the culture. That is the culture.”
AND YET THERE were legendary stories within the firm about the vicious-ness with which Cayne could publicly dress down subordinates. In fact, many new senior-level employees considered getting chewed out by Cayne to be both a rite of passage and an intoduction of sorts to the ways of the firm. One senior managing director recalled how within a month of taking over the running of an important business line, he got a call from Cayne. “He says, ‘Come down to my office right now.' Not hello. ‘Come down to my office right now.' I open up the door to his black-walled chamber, all done in black ebony wood. Between the door and the chair, if I hadn't had almost thirty years of experience on Wall Street, I probably would have shit in my pants. Because he barked at me the moment I set foot in that office.” After a fulsome, expletive-filled discussion of the managing director's supposed error in judgment—carved out in front of Alan Schwartz and Sam Molinaro, who were there, too—“he just sort of said, ‘Dismissed.’”
On May 4, 1988, Bear Stearns announced that Cayne would be the sole president and Rosenwald would become a vice chairman. The consensus seemed to be that Cayne, then fifty-four, was in position to take over running the firm from Greenberg, then sixty. “It's not a big change,” Cayne told the Times. “People will be doing the same thing they always have. It's business as usual.” Greenberg made no mention of Cayne's appointment in any of his numerous internal memoranda.
