Wall Street Follies

Liar’s Poker Revisited: Why Investment Banks Deserve to Die

By Jonathan Weber , 2-02-09

I recently took the opportunity to read a seminal business book that I’d never read before, Michael Lewis’ Liar’s Poker. I thought the book, widely lauded as capturing the go-go times on Wall Street in the 1980s, would be a little dated. Bond trading and corporate takeovers and Michael Milken - it’s been a while since those topics had much glamour.

But I was shocked at how relevant Liar’s Poker remains today. The book, which draws on Lewis’ post-graduate days as a bond salesman at Salomon Brothers, is a hilarious send-up of the perverse culture of Salomon in particular and the Wall Street trading world in general. What jumped out at me, though, was the way it exposes a fundamental - and, as we see today, highly dangerous - problem with the business model of investment banking.

Unlike almost any other business, investment banks make money at the expense of their customers. Indeed, a core element of their operations is built on a conflict of interest that they manipulate to their own advantage. It’s a business model that deserves to die, and with any luck the Panic of ‘08 will bury it.

I first became suspicious of the investment banking model simply by noticing - as a business reporter, and, for a short time, as an employee of a financial research firm that also had a trading desk - that in recent years investment banks made most of their money by trading for their own account. Sure, there are the lucrative corporate advisory services, and the money-raising (via stock and bond issues) for corporate clients, and the trading commissions. But while these activities might once have been the raison d’etre of investment banks, they are now much less profitable than they used to be, and are (or were) far outstripped by the money the banks made placing their own bets in the stock and bond and commodities markets.

Trading, of course, is a zero-sum game. If you make money on a trade, somebody else loses money, by definition. The investment banks, also by definition, have the most information on what’s happening in the markets, and thus are in the best position to come out on the right side of the trade. If they’re trading stocks, the person who gets the short end might be the individual investor, who is the equivalent of the weekend poker player sitting down at a Las Vegas table filled with professional gamblers. The chances of victory aren’t zero, but they’re close to it.

In many other trades though, the entity on the other side is actually a client of the bank, an institutional investor who is looking to the investment bank to bring them good deals and help them make money. Lewis comically describes how this played out: less important customers were deliberately sold crappy, money-losing deals, so that the bank gained from being on the other side of the trade. In fact, his job as a junior bond salesman was to unload the junk nobody wanted onto a naive customer.

To put it another way, if a particular trade was a good one, the bank kept the position for itself and took the profits. If it was a bad one, the bank dumped it on an unsuspecting customer.

Salomon could get away with this because it had such a dominant position in the then-obscure world of bond trading. Bonds, unlike stocks, don’t have officially listed prices, and the trading in them is run by the dealers. If you wanted in on bond investing, you more or less had to go to Salomon or one of its competitors, who were all doing the same thing. Lack of transparency in the market served the bankers’ interests very well.

In recent years, one of the ways this evolved was that the investment banks cooked up all kinds of deals based on new financial instruments (mainly derivatives such as mortgage-backed securities), and sold them to their customers without any regard for the soundness of the investments. If the bank thought they were good investments they held them, and if they were bad investments they sold them (but still took big fees for coming up with them in the first place).

That in turn led to absurd spectacles such as the Yellowstone Club here in Montana, where investment bank Credit Suisse made a $375 million loan without any due-diligence, permitted the loan recipient to pocket most of the money rather than invest it in the project, and then sold the loan to its own customers (who are now likely to lose most if not all of their money). This could happen only when the interest of the seller of the securities was diametrically opposed to the interests of the buyer.

As it happens, the near-total collapse of the investment banking industry over the past year is partly a result of a market meltdown so dramatic that even the banks’ own positions were way underwater (albeit not as far underwater as most of their customers’ investments). But their most profitable activities, and the creation of the giant house of cards that has now collapsed, were ultimately enabled by the fundamentally corrupt structure that Michael Lewis illustrated so pungently 20 years ago. It’s amazing that it took this long for it to all fall down.

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