The Crony Capitalist Pretense Behind Warren Buffett's Banking Buys

When Warren Buffet put $5 billion in Berkshire Hathaway funds into Goldman Sachs the week after Lehman failed, amidst total turmoil and panic, it appeared from the outside a high risk bet. Buffet had long tried to portray himself as a folksy engine of traditional stability, investing only in things he could understand, so jumping into a wholesale run of chained liabilities may have seemed more than slightly out of character. Some of that was explained later via Buffet's apparent hands on TARP, particularly version 1, but also later investments in Wells Fargo and US Bancorp.

I have no particular issue with Buffet making those investments, only the pretense of intentional mysticism that surrounds them. The reason the criticism of crony-capitalism sticks is because this was not Buffet's first intervention to "save" a famed institution on Wall Street. If Buffet's convention is to stick with "things you know" then he has been right there through the whole of the full-scale wholesale/eurodollar revolution.

On August 21, 1991, Calpers announced that it was cutting ties with Salomon Brothers, explicit in its condemnation, saying it was "outraged and disappointed" that the investment house would knowingly try to circumvent securities rules. There was a Congressional investigation and SEC threats, even criminal beyond the typical slappish fines that are used now. It was so outrageous that even Treasury Secretary Nicholas Brady, purportedly with Alan Greenspan on board, considered yanking Salomon's primary dealer privilege - which would have meant the end of Salomon right then and there.

With almost a quarter century having passed, Solly, as the firm used to be known, has faded from memory in its more detailed contributions. It was the Wall Street firm that epitomized the 1980's far more than any others, being famously written up in Michael Lewis' Liar's Poker and Tom Wolfe's The Bonfire of the Vanities and giving rise to the colloquialism Masters of the Universe (and another, far less family-friendly description). Gordon Gekko may have been a corporate raider in the movie version of Wall Street, but it was the bond traders who made bank (and still do).

The heart of Solly's business was arbitrage, an unusual term as in pure English the word's definition suggests something like no risk. You find a couple of related securities that aren't what they "should" be and trade into that gap until prices converge to where they were supposed to be in the first place. That meant, of course, you had to find out what "shouldn't" be before anyone else, which further meant being right about prices before, during and after. What set Salomon apart during the 1980's was their high-level willingness to bring on the finance professors, the early quants that were so sure they could find the "right" prices and thus identify the fattest, and cleanest, arb spreads.

What happened in late 1990 and 1991 is still a matter of conjecture, even on the government side. What is not in doubt is that Solly's chief government securities trader, Paul Mozer, was openly flaunting US Treasury rules about the federal government's debt auctions. Treasury had never restricted how much any particular dealer could bid for debt at auction, but would from time to time make individual and ad hoc efforts to ensure orderly and "fair" operation. During the December 27, 1990, treasury auction, Mozer via Salomon's own account bid for $2.975 billion of the $8.5 billion total four-year note, or 35%, and also what would later be uncovered as an unauthorized use of a customer account for an additional $1 billion bid.

In April 1991, Salomon bid for $3 billion of a $9 billion five-year note auction, being awarded that full allotment plus an overbid on a customer account which was not again authorized (Mozer placed $2.5 billion in bids for a customer that claimed it only approved $1.5 billion, which placed $600 million into Salomon's account and thus more than 35%). But it was the May 22, 1991, auction that went not just too far, causing more than a little consternation and attention. All told, Salomon placed bids for its accounts and those of customers, plus an undisclosed existing long position, for more than 100% of available two-year notes. Further, these bids were highly aggressive, priced a full 2 bps through the when-issued price.

What was most egregious about all of this was that only months before these auctions (and a few others that were uncovered) a 35% limitation on bid amounts was put in place specifically to stop Paul Mozer. Deputy Assistant Treasury Secretary Michael Bansham had called Mozer in June of 1990 after Salomon had bid more than 100% for $8 billion notes auctioned then. Bansham later testified that he told Mozer not to do it again during that call, but just a week later Mozer did (along with another, undisclosed dealer). That led to the 35% restriction being adopted as a rule by Treasury, which carried the name Mozer-Bansham Rule!

For Salomon's part as the offending firm, Treasury was incensed that management, including CEO John Gutfreund, found out after that May 1991 auction but told no one about it, even after several official contacts between the government and Salomon. For several weeks, the firm kept mostly silent while Treasury, the Fed and the SEC all went about investigating. That led to, on August 18, Treasury announcing (to whom is not clear) that it would suspend Salomon from its auctions, again a virtual death penalty for the bank - until Buffet intervened that afternoon personally with Secretary Brady. He even testified before both houses of Congress that the bank was completely contrite and reflective, the guilty parties included management had been expunged from the operations, and that there would be no more absurdity going forward. He went so far as to publish a two-page letter to shareholders that October in the Wall Street Journal, Washington Post, New York Times and even the Financial Times of London.

Buffet had already been a large shareholder in the firm, dating back to 1987 (and leading to, coincidentally, Salomon shutting down its muni desk just one week before the crash, but that is a whole other story) and his friendship with John Gutfreund. When Treasury came to shut down Solly in the middle of 1991, Buffet promised to clean house and take over himself in order to save the firm; Treasury modified its ruling to allow Salomon to continue operating as a dealer in treasury auctions but only for its own account. More firings soon followed, including, obviously (then, as different from now), Paul Mozer.

There is a lot more here than just one bank looking to circumvent what may seem arbitrary rules and restrictions. The government has an indisputable duty to ensure good function of its debt issuance processes, but what few people then could understand was why Mozer was going to all the trouble. From the outside, convention saw very little, if any, upside to these activities and actions. Instead, it was largely left as a matter of ego, the Masters of the Universe simply flexing their muscles in a game of power.

Contemporarily, that was how it was described, as the LA Times wrote in an extensive article only a few months after that hot summer:

"Investigations are continuing, but findings so far indicate that the crisis escalated far out of proportion to the money involved. Mozer's inept little scam had netted the firm only a pittance, between $3.3 million and $4.6 million, and cost taxpayers nothing in interest. Contrasted with the billion-dollar looting of the stock market by convicted felons Ivan F. Boesky and Michael Milken, Mozer's crime was small potatoes--but it was enough to bring his swaggering company to the brink of ruin."

To the unfamiliar, it did seem an "inept little scam" that brought minimal actual profit - at least as far as what could be easily seen. Repo markets were, sadly, largely unknown and unexplored at that time, but already the bedrock of Salomon and then its competitors as the 1990's dawned. The term "corner the market" had been around for as long as Wall Street had, a conceptual strategy carried out time and again. The Hunt brothers had endeavored something very similar in 1979 in silver, but it was beyond comprehension in 1990 and 1991 how that might apply in treasury notes.

Even the official Treasury Department report on the affair, which runs to 197 pages http://www.treasury.gov/resource-center/fin-mkts/Documents/gsr92rpt.pdf, is non-committal. However, they make it quite clear, implicitly, as to why they believe Mozer was acting infelicitously; the section immediately following the factual descriptions of Salomon's actions was all about short squeezes. Even Section B-1, beginning Section B, which goes into great detail about how the auction process works, was a narrative of the short squeeze process.

Though they never put the two directly together, it isn't much left apart either. The report states clearly in describing the May 1991 auction, "Even before the May two-year notes were settled on May 31, 1991, rumors began to surface of a short squeeze in the market for those notes. On May 29, 1991, Treasury staff called the SEC's Divisions of Market Regulation and Enforcement to notify them of possible problems stemming from the auction."

As troubling as all that might have been what becomes clear was this was not a rogue operation, either. What has been left buried under decade's old history is another part of that Treasury Report that quietly uncovered what I think is a pivotal turning point in monetary evolution. Not only was Solly likely after repo collateral, controlling the supply and thus rates and downstream "liquidity" through other mathematical factors, this extended deep into agency debt. Through its investigation into Paul Mozer's actions at treasury auctions, the Department also found widespread and often serious over-bidding in GSE issuance (GSE debt was not issued via auction, it was subscribed via an allotment process of what would now seem to be dinosaur technology - phone calls between GSE handlers and dealers).

"As described below, a number of selling group members reported to GSEs inaccurate information concerning customer orders during the pre-allocation period and nearly all selling group members reported inaccurate information concerning their sales of the securities after settlement. In providing such inaccurate information, selling group members prepared and maintained books and records reflecting the inaccurate information."

In total, the joint investigation, which included the SEC and Treasury, but also OCC, FRBNY, the NYSE and NASD, found ninety-eight dealers, again, nearly all that were investigated were involved in flagrantly overbidding for agency securities.

"Some traders added random amounts to their actual customer orders. Others increased the number and amount of customer orders reported to the GSEs to include "anticipated" or "historic" sales, i.e., an amount that the trader believed, based on past experience, the selling group member would be able to sell after the GSE announced the price. Even in those instances where a selling group member had identifiable customers for the number and amount of the customer orders reported to the GSEs, the trader would not indicate to the GSEs that many of the orders were subject to significant conditions."

It is easier today to see this with much greater clarity, as the wholesale banking system is now fully revealed (to those that want to make even slight inquiry), but the contemporary haze should not excuse lack of appreciation then. There is great significance of government and agency debt at auction and issuance, as it is on-the-run securities that control the repo environment. A bond, note or bill just auctioned is the most liquid because it contains the most direct and quantifiable characteristics; once a security is replaced by the next auction in the series, that security becomes highly liquid OTR and the previous fades into trading obscurity (off-the-run). In short, the frenzy over OTR is repo at a time when collateral wasn't as widely available and the limited OTR's were quite limited (a shortage the bubbles, greater sovereign issuance and securitizations would eventually but temporarily overcome).

Banking was still believed to be of the S&L model at that moment, but even they, or a good many of them as Resolution Trust and the FDIC would describe, had already transformed into the shadow visions that presaged everything that has come after. In other words, it was only being closed-minded about what was taking place in "money" that hid what Mozer and so many others were up to - collateral had become currency, maybe even at that early date the currency, and had thus attained "value" far beyond what was thought to be an "inept little scam." Rehypothecation and leverage, and the legal and accounting structures surrounding and abiding them, made that so.

Salomon Brothers, for its part, didn't last the decade. By the middle 1990's, the math professors were all over Wall Street and the firm had lost whatever "informational" advantage it used to rule the 80's. By 1997, the bank was taken over by Travelers and folded into Smith Barney, thus largely lost to further experience of it even if we still feel its evolutionary reverberations throughout this eurodollar age.

What Solly had pioneered, in the end, was not just expanding the envelope of financial processes and engineering, but how this wholesale system could obliterate that envelope altogether. In other words, the prior restraints that acted upon banking were no longer restraints, and that what lay ahead, if you could get there, was an entirely new framework of money and currency that was to be written as they went. That dream was realized fully by 1995 when JP Morgan ended the last vestiges of traditional banking as a marginal experience, fusing math with money and currency into traded liabilities of all kinds.

By the late 1990's, Wall Street was using derivatives, funded by repo as well as treasury and agency collateral, to "engineer" trades that were previously far, far out of reach. JP Morgan, for example, "helped" in 1996 Italy get its official budget numbers in line with a currency swap. More infamous than that, now, Goldman Sachs in 2000 and 2001 arranged swaps with Greece to ensure that country could remain within the euro and the EU's Maastricht restrictions on deficits.

Aeolos was the legal entity that pushed "debt", loosely defined, off balance sheet as that entity swapped airport landing fees for initial cash payments. That was preceded by Ariadne in 2000 where the national government in Greece gave up a significant portion of national lottery proceeds in exchange for, again, up-front cash. Greece could not have cared less about where that cash came from or even what exactly it was, since all that mattered was a positive number on a bank balance sheet in its name; the balancing liability was and remained the bank's problem. Though these were infusions of cash-like assets to be paid back over time from specific cash streams, all of which sound indistinguishable from debt or loans, it wasn't specifically treated that way because doors previously closed were now opened as money and banking left behind actual money and banking.

It was Margaret Thatcher in a TV interview in 1976 who now famously said, "...and Socialist governments traditionally do make a financial mess. They always run out of other people's money." And that was true, except insofar as it pertained to what I have called the second age of economic socialism, dominated by general government redistribution and taxation. The distinction with the third age, which was just coming into view and finding itself, was exactly what Thatcher had described as intent, though I doubt she could have conceived how restraint would no longer be true. Socialists had indeed run out of "other people's money", but the eurodollar/wholesale system that was to follow simply removed those ideas of money in the first place.

If a socialist impulse and intention could not tax toward what goals it wanted to achieve, the wholesale banking system would instead simply ignore money and conjure liabilities that functioned equivalently. Any socialist government could then never run out of "money" so long as there was a wholesale bank willing to trade. Even interest costs were no longer much impediment, as balance sheet expansion and incestuous Basel thinking ensured interest rates would always (so it was thought) be on the "whatever you want" side. It was more than symbioses between especially wholesale banks and government bonds, as Salomon was just starting to show, it was the operational union of banking and government deficits.

In short, wholesale banking evolution "financed" the next socialist age, and not just in Europe. Profligacy was no longer a negative factor, indeed it was a signal of an engaging counterparty. An entire strain of "economics" roared back to life from the dead, the disastrous results of the same efforts put to real monetary limits in the Great Inflation; the very same that Mrs. Thatcher was correctly railing against at the very same moment the eurodollar system was starting, if very slowly at first, to bring it all back to life.

Officially, none of the socialists ever seemed to care about how, exactly, all this magic worked. This included Alan Greenspan and all those setting out to control economic direction through "stimulating" debt. It was one episode after another where the FOMC, in particular, demonstrated time and again their unconditional un-interest in what was actually occurring at these banks. Not only was there Solly's rigging toward repo, which followed closely the S&L disaster, there was Orange County in 1994, LTCM in 1997, the entire dot-com mania and, the big finale, Greenspan's "conundrum" of the housing bubble catastrophe. Through it all, these same economists that had convinced themselves they could run the global economy viewed money and banking as if it were still 1929.

It was, after all, Milton Friedman's intellectual framework that they were following. He had viewed the great crash and then the Great Depression as being of limited money expansion, but in that case real currency. That has never been questioned seriously by orthodox treatment of any smaller variety, just accepted. Whether or not that explanation is even valid is no longer really relevant, as the banking system no longer uses money and currency. It has instead moved to traded liabilities and wholesale leverage (and more dimensions of leverage which call into question not just Friedman's explanation for the depression, but whether anything Friedman suggested about how a "free" market might work even applies now.

It left open the interdependence by which banking and government could eventually combine, to conspire of common interests in control and power. Real money is anathema to central control because it allows an exogenous removal, a very real open door for the people to withdraw in total from the exercise of debasing power. The wholesale model does not, especially when government sanction is really traded for bank-funded "liquidity."

Maybe that was the point upon which Warren Buffet could maintain his timely investment in Goldman Sachs as consistent with his stated mantra of invest in what you understand. I cannot speak for the man as to his familiarity with wholesale banking, but all that the rest of the regulatory framework knew was that at that moment government and banking were inseparable; and thus the former would not fail without blowing apart the latter. Wall Street was not bailed out specifically to save the economy, but rather to save the economy as it would continue to be under the socialist and elitist doctrine.

What is most relevant about what we are seeing in Greece now is, contrary to "expert" opinion, there are actually limits upon wholesale evolution; that there does exist restraint long thought absent. I call it innate value, but whatever it is it really suggests that what happened in the past few decades was indeed inflation, not just in prices, mostly assets, but in redefinition of all of finance and money. That "fooled" value but only for a time, and that the more organic, human characteristics that lay dormant trying to comprehend all the vast changes and misdirections has finally, inevitably re-emerged to deny much further. These redefinitions and true inflation, though far beyond what was imaginable in 1991, let alone 1976, are now just as flawed stagnation as they were once thought flawless advance. In other words, the "world" may not have quite grasped where money is absent, but has awoken sufficiently to finally notice the discrepancy and how that is, contra economics, fatally misguided.

We have reached the outlines of another Thatcher moment, where socialism still makes quite the financial mess, this time, though, not running out of other people's money but rather finding an end to the total deference by which inflationary redefinition and redistribution can operate.

The Crony Pretense Behind Warren Buffett's Banking Buys

Jeffrey Snider is the Chief Investment Strategist of Alhambra Investment Partners,

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