Thirty years ago, Salomon Brothers and Goldman Sachs were two of the "bulge bracket" underwriting firms that dominated Wall Street. Both firms with partnerships with trading cultures that characterized their organizations. It was a time when Wall Street firms were looking far and wide for ways to increase their access to capital. Trading firms make money by making bets. More capital meant bigger bets. Bigger bets meant more money.
In 1980, in pursuit of a bigger balance sheet, Salomon CEO John Gutfreund negotiated the sale of his firm to Philipp Brothers, then the largest commodity trading firm in the world. The sale was not without controversy. Within Salomon, bond traders--led by Salomon family member William Salomon--opposed the sale. How, they asked, would traders be paid their due in the event the new firm lost money in other far-flung commodity businesses? As partners, they had a reason to be concerned by over-expansion into business lines that they neither understood nor controlled. They did not yet appreciate the benefits of trading with Other People's Money.
But the sale of Salomon went through--John Gutfreund pocketed his $30 million bonus--and over the next few years, the new firm, Phibro-Salomon was acquired by Travelers Insurance. Travelers, in turn, was acquired by Citibank, to create the financial supermarket that was supposed to give American banking a global dominance to match the well-capitalized Asian and European counterparts.
The Salomon story was part of the evolution of Wall Street over the past thirty years, as the storied Wall Street firms succumbed to the lure of capital to give up their partnership status and merge into commercial banks and to become publicly traded corporations. And while these firms did achieve their goals of increasing their access to capital--and ultimately won back their access to the massive pools of depositor money insured by the FDIC--the cost to the rest of us has been significant.
Where, after all, was William Salomon when Lehman Brothers decided to bet the ranch on collateralized mortgage securities that would ultimately bankrupt the firm. Where was William Salomon when Bear Stearns increased its leverage to thirty times, based on financial models that few in the firm really understood. And where was William Salomon when Joseph Cassano, the head of AIG Financial Products took the insurance giant headlong into the credit default swap business.
There was a moment when Cassano made his case to the AIG Board of Directors. The credit default swap contracts that AIGFP was providing to financial giants such as Goldman Sachs had no risk to AIGFP, argued Cassano, and therefore all of the annual receipts paid to AIGFP under those credit default swap contracts could be taken as current income--and used to pay very large bonuses--rather than held as reserves against future risk. CDS contracts are essentially insurance contracts provided to guarantee against defaults on corporate bonds, but Cassano argued that the bonds were so strong that there was no credit risk, and therefore the money paid to AIGFP was essentially free money.
But there was no William Salomon on the AIG Board of Directors. Unlike the old Wall Street partnerships, directors of corporations are largely insulated from the financial consequences of their decisions. Had AIG been a partnership like the old Salomon Brothers, a William Salomon would likely have asked the logical question of Joseph Cassano:
Goldman Sachs is paying us tens of millions of dollars a year, but you are telling us there is zero risk. One of us is wrong. This is a game of poker, and there is an idiot at the table. And you are telling me that Goldman Sachs is the idiot? I don't think so. I think we are the idiots at this table. If Goldman Sachs is paying us tens of millions of dollars a year, we are taking risk, and we sure better know what that risk is, because we are betting our future on it.
But, of course, AIG was not a partnership, and the rest is history.
But the Phibro-Salomon story had one chapter left. This summer, Citibank--the failed financial supermarket that is now a ward of the State--sought approval from the US Treasury to pay bonuses in order to keep a group of highly profitable traders from leaving the bank. The bonuses--the most famous being the $100 million for Andrew Hall--were to be for traders in its Phibro commodity trading subsidiary.
William Salomon saw the writing on the wall. The partnership trading culture that was critical to Salomon Brothers success--a culture that combined incentives and accountability--would not survive an evolution into a corporate model. What we have learned is that the incentives to make big bets and take big risks has survived, but without the accountability. Andrew Hall made $2 billion for Citigroup placing energy bets, and was due to be paid $100 million. But what of those whose bets lost Citigroup $2 billion? They have not even lost their jobs.
The trading firms gained the access to the capital that they sought in the 1980s, and they found the joy of playing with Other People's Money. And for twenty years, the game has gone on.
Heads I win, tails you lose. Or in David Einhorn's more elegant formulation, Private Profits, Socialized Risk.
Today, the US Treasury and the Fed are trying to hold the pieces together. AIG. Citi. Bank of America. GMAC. Fannie Mae. CIT Financial. But why? Where is the evidence that large financial corporations are more efficient at allocating capital than smaller banks? Surely, they have not been sound custodians of depositor funds or of the public trust. Neither have they proven they can deliver more predictable returns on shareholder equity than smaller, more nimble financial institutions, who themselves are increasingly disadvantaged by each bailout. Whose interest has conglomeration served but that of insiders seeking greater compensation with less risk?
One central question to all of this is whether the fundamental corporate model is not central to the problem. Today, absent prosecution for fraud, the CEOs and directors of all of these failed firms will walk away with much of their wealth intact, insulated from the consequences of the decisions they made. For years now, they have been playing with our money.
New regulatory regimes will not be adequate to control this systemic risk. Controlling banker compensation might have a populist appeal, but no one should imagine it constitutes systemic reform. Regulatory bureaucracies cannot control systemic risk in massive financial corporations, because the systemic risk is the massive financial corporation.
Thirty years ago. William Salomon was suggesting a simple truth: Sound decision-making, incentives and accountability require that those who are making decisions and placing bets have their own capital at risk.