Infectious Greed (16 page)

When Meriwether found such inefficiencies, he simply bought the cheap asset, sold the expensive one, and waited for the values to converge. They almost always did. This was proof that the University of Chicago economists had reached the wrong conclusion. They had assumed that someone would be in the markets buying the cheap assets and selling the expensive ones. But where was that someone? It seemed incredible, but there were $20 bills lying around all over the place. All Meriwether and his traders had to do was reach down and pick them up.

Traders at Bankers Trust and CSFP had learned that arbitrage opportunities didn't last long. Charlie Sanford and Allen Wheat had struggled to reinvent themselves every year, finding new ways to profit from financial innovation. The only profits that persisted for very long were those due to legal rules (as in the Japanese insurance companies buying equity derivatives) or sophistication gaps between the buyer and seller (as in the
complex deals Gibson Greetings, P&G, and others bought). Other than these two situations, mispricings disappeared quickly.

Meriwether understood this experience, and his traders exploited legal rules and sophistication gaps beautifully. The conventional wisdom about Meriwether's success is that he and his traders took advantage of market inefficiencies created by imbalances in the supply and demand for particular financial assets. In the beginning, this was true. But over time, Meriwether and his traders increasingly profited by exploiting legal rules and by taking advantage of less sophisticated clients. The more they did so, the more profitable their strategies became.

Most of Meriwether's trading strategies have remained a secret, even though the leading financial journalists of the past decade—including Michael Lewis, Roger Lowenstein, and Martin Mayer—have covered Meriwether and Salomon in great detail. All of the major business magazines and newspapers have had lengthy front-page stories about Meriwether at some point, and Meriwether and his traders have been the topic of several books. But even after years under the microscope, the details of the trading strategies are a mystery. Meriwether wanted it this way: he swore his traders to secrecy, fearing that if anyone discovered the strategies, profits would disappear.

Here, briefly, is what is known. In 1977, Meriwether's arbitrage strategies were simple. For example, he discovered that Treasury-bond futures—contracts that had just begun trading on exchanges in Chicago—were economically similar to Treasury bonds, but frequently had very different values. Meriwether bought whichever was cheaper, and sold whichever was more expensive. He made money, but—not surprisingly—these price differences didn't last long.

Meriwether also found inefficiencies among Treasury bonds of different maturities. The U.S. Treasury paid different rates on its bonds, depending on their maturity, just as a homeowner typically paid different rates for a 30-year mortgage compared to a 5-year mortgage. For example, long-term Treasury bonds would have a high yield if investors expected inflation. Short-term bonds would have a low yield if the Federal Reserve was keeping interest rates low. In such a situation, which was common, the graph of the yields for different bonds compared to their maturities—called a
yield curve
¹¹
—would slope upward from left to right.

Meriwether noticed that this yield curve was not smooth. There were kinks, where one bond had a higher yield than a bond of nearby maturity.
Where there were kinks, there were opportunities for arbitrage. As with futures, Meriwether could profit by buying the cheap bond and selling the expensive one. Meriwether made money, but when others discovered the strategy, the kinks—and the arbitrage opportunities—disappeared.

The example most frequently given of Meriwether's approach was something called the
on-the-run/off-the-run
Treasury-bond trade. The idea was that at certain times investors flocked to newly issued on-the-run Treasury bonds with a 30-year maturity, ignoring other off-the-run long-term bonds that the Treasury previously had issued, including those with a similar maturity of, say, 29¾ years. Meriwether (and many others) observed that 30-year bonds were more expensive than 29¾-year bonds, a price difference that made no sense, given the bonds' similarities. Still, some clients—particularly Japanese investors—stubbornly refused to buy anything but the most recently issued government bonds. Meriwether bought the cheap bonds, sold the expensive bonds, and waited. As the bonds aged, their prices converged, and Meriwether unwound his positions at a profit.

The on-the-run/off-the-run trade was easy to do. It wasn't complicated, and it didn't even require a computer. Traders at many investment banks made this bet, and although Meriwether was widely credited with doing the trade in substantial size, he didn't discover it. In fact, the on-the-run /off-the-run trade has been very common during the past two decades, and Meriwether wasn't even the first person to do the trade at Salomon.
¹²

Meriwether's strategies became more sophisticated in 1984, when he met Eric Rosenfeld, then a professor at the Harvard Business School. In his study of options, Rosenfeld had discovered some flaws in the assumptions of the Black-Scholes option-pricing model, which traders at both Bankers Trust and CSFP had used. For example, the model assumed the volatility of underlying financial assets was constant. It also assumed there were no costs of transacting and no market discontinuities (in other words, no
kinks
). Most important, it assumed that the distribution of returns on assets was bell-shaped, like the normal distribution of grades in the courses Rosenfeld taught. This key assumption—the gospel among most financial economists—was the source of the
random walk
hypothesis, which said that the movements of the market up and down were essentially random.

However, to anyone with experience in the options markets, these
assumptions were demonstrably false. Volatility changed over time, options were expensive to buy and sell, and there were kinks throughout the markets, where the supply and demand of particular options were unbalanced. Moreover, returns were not normally distributed; there were periods of manias and dramatic crashes, which did not fit a bell-shaped curve. Asset prices followed a random walk some of the time, but not all of the time.

Eventually, financial economists would abandon these assumptions and seek more-nuanced models of price behavior. Even Burton Malkiel, the well-respected economist and author of
A Random Walk Down Wall Street,
would conclude in a revised edition of his book that “More recent work, however, indicated that the random-walk model does not strictly hold.”
¹³
But during the late 1980s and early 1990s, economists were not focused on assumptions, and traders using flawed models routinely misvalued options.

Meriwether recognized that options were more complicated than futures. If Salomon could approach options pricing in a more sophisticated way than its competitors, it might obtain a sustainable advantage. He seized the opportunity by hiring Rosenfeld and several other academics who understood the flawed assumptions of the models. He even brought on Myron Scholes and Robert Merton as consultants. Scholes developed new models, and helped to create Salomon's AAA-rated derivatives subsidiary, known as Salomon Swapco.
¹⁴
Merton, who had been Rosenfeld's mentor, offered big-picture advice about options arbitrage.

Meriwether also hired Victor Haghani, Gregory Hawkins, and Larry Hilibrand (the aggressive trader who would receive a $23 million bonus in 1990). These three H's became the Arbitrage Group's most profitable traders. Haghani had a master's degree in finance from the London School of Economics and found arbitrage opportunities in Japan, especially in convertible bonds. (Haghani had done research for Andy Krieger when Krieger was trading currency options at Salomon a few years earlier.) The other two were Ph.D.s from MIT:
¹⁵
Hawkins was an expert in mortgages (more about them later); Hilibrand was an expert in everything. These were the people whose 1990 bonuses would enrage Mozer and other employees outside the Arbitrage Group; all of these people were closely bound to Meriwether, and they became a family.

Meriwether's “quants” put the nerds of Bankers Trust to shame. He gave them a special place in the middle of the trading floor at Salomon,
where they stood like geeks in the middle of a high school party. This group of traders was known as the best finance faculty in the world.

When currency options were introduced, Meriwether's group began trading them at the same time Andy Krieger was trading currency options at Bankers Trust. Like Krieger, Meriwether's traders looked for options that, according to the group's computer models, were mispriced relative to economically equivalent portfolios. As options traders at other firms were using sledgehammers to bludgeon each other with one-way directional bets and misdirection strategies, Meriwether and Rosenfeld were using a scalpel to dissect minor mispricings in dozens of options markets throughout the world.

The Arbitrage Group designed the first pricing systems using a highspeed network of personal computers, while other traders at Salomon were stuck waiting in line to use the firm's one, relatively slow, mainframe.
¹⁶
Meriwether set up trading desks in London and Tokyo with similar analytical firepower, to exploit opportunities in options markets abroad.
¹⁷

Victor Haghani found arbitrage opportunities in the Japanese convertible bond market. The owner of a convertible bond has the option to convert the bond into a specified number of shares of stock, and effectively has the choice between two investments—bond or stock—depending on the price of the stock. In other words, a convertible bond can be thought of as two investments: a bond plus an option to buy stock. When a company's stock price is low, a convertible bond is really just a plain-vanilla bond with fixed interest payments; the stock-option component has little or no value. But as the stock price rises, the stock-option component of the convertible bond becomes more valuable. When the stock price is high enough, the holder of the convertible bond is better off
converting
the bond into shares. At that point, the bond portion of the convertible bond evaporates, and the holder simply owns stock.

The Japanese government restricted the amount of stock companies could issue, in an attempt to limit supply and keep share prices high. There were no similar restrictions on issuing convertible bonds. However, few investors were buying Japanese convertible bonds—in part because they didn't like buying both the bond and stock components—and they were relatively cheap. That meant the options embedded in the bonds also were cheap—cheaper than they should have been in an efficient market. The legal rules restricting stock issuance in Japan, and the reluctance of
investors to buy convertible bonds, had created an arbitrage opportunity. If Haghani could somehow buy just the cheap stock-option component of the convertible bonds and then sell similar stock options to investors at a higher price, he could make virtually risk-free profits.

Haghani bought the convertible bonds, so that he effectively owned a bond plus a stock option. He then eliminated the interest-rate risks associated with the bond component of the convertible bonds, using interest-rate swaps, so that he remained exposed only to the stock-option component of the convertible bond. Then, in the over-the-counter market, Haghani sold new stock options to investors. These new stock options were designed to mimic the risk that Haghani faced in the stock-option component of the convertible bond. In other words, Haghani would simply pass along his remaining risks to investors. The beauty of this deal was that, because the convertible bonds were cheap, Haghani could buy the stock-option component for less than investors were willing to pay for the new stock options. Effectively, Haghani bought a convertible bond made of two pieces, and then sold the pieces for more than the whole—like buying a cheese sandwich for $3, and then selling the cheese and bread for $2 each.

Haghani made hundreds of millions of dollars for Salomon using this strategy. In 1992, when he was just 30 years old, Salomon paid him a $25 million bonus as a reward for finding these trades.
¹⁸

The Arbitrage Group did similar trades when the options embedded in bonds were misvalued because companies did not understand them. For example, when short-term interest rates were falling during the late 1980s, many corporate treasurers recalled high interest rates during the late Carter and early Reagan administrations, and wanted to lock in lower rates. They bought interest-rate caps—options that made money if short-term interest rates rose. But the treasurers didn't have good models for evaluating the options, and, as a result, Salomon was able to make money selling overvalued short-term options.

At the same time, companies were issuing long-term callable bonds, which they could redeem, if interest rates declined, by returning the investor's principal investment. The coupon payments of these bonds—the semi-annual interest payments investors received—were higher than those of non-callable bonds. In effect, the companies issuing the bonds were purchasing options from investors, paying them above-normal coupons instead of an upfront premium. But companies didn't necessarily want to buy these long-term options, any more than they had wanted
to be exposed to an increase in short-term interest rates. Instead of keeping the risk associated with these long-term options, the companies sold offsetting options to Salomon. Again, the companies did a poor job of assessing the value of these options, and Salomon was able to make money buying undervalued long-term options.

Salomon didn't want to keep the risk associated with the short-term options they had sold and the long-term options they had bought. Instead, traders sought to buy short-term options and sell long-term options to offset their risks; even if those options were fairly priced, Salomon could pocket the difference between buying low and selling high. Sometimes, Salomon's traders found counterparties willing to take on these risks in the over-the-counter market, just as Victor Haghani had done. When traders could not find anyone willing to take on the offsetting risk, they bought and sold options on Treasury bonds that carried roughly the same risk as their options on corporate bonds. Managing these risks was a complicated task, but Salomon's traders seemed to know what they were doing.