Liars Poker (1989)

By Deepak Bhalla Tue 10 May 2016 4 min read

It's rare that I ever enjoy a book enough to write about it. It's even rarer that the book is published more than 25 years ago.

The book is a semi-autobiographical look at Michael Lewis foray as a bond trader in the 80s at a time when Solomon Brothers became kings of Finance. It provided an insight in to the world of bond markets in the USA. The book places a specific interest on Lewie Raneiri and his impact on mortgage bonds in the USA (This is also the opening scene to the film 'The Big Short' based off another Michael Lewis book). Raneiri's impact would set the scene for the destructive events of the 2008 crash. Although Raneiri didn't anticipate it, his CDOs (Collateral Debt Obligations) would become popular. In an attempt to remain popular CDOs would fall in to infamy. I am not going to bother reviewing the book, far be it for me to tell you what I thought of a book 25 years after its publication. I just wanted to highlight five points of interest. These aren't by any means the main points of the book, just learning points I thought it best to write down somewhere.

Rule 1: Unpredictability is Gold

It was unpredictability or risk that became the opportunity for money making. Anyone who has taken a finance course knows of course of acquiring non non-systematic risk to earn a higher yield but this type of easily quantifiable risk isn't the type of unpredictability I liken to Gold.

In the book there was mention of the USA Government's sale of loans to building developers - when the Government loaned money at favourable rates to developers building housing estates it essentially came at the cost of the bond issuer. When the government sold these bonds to the open market the market they factored in the measly returns and tagged them at a face value far below par. There was of course a catch to these bonds, when houses developed using government loans were converted or modified and sold bond holders would receive a cash windfall. The sellers paid the government first from developers wishing to pay their loan off, the Government in turn paid out the loans principal to those holding the paper.

There was an element of unpredictability that made the bonds so attractive. It was the unpredictability of the bond and purchasing them at the right time (when they were about to default or they were about to be paid off) that netted Steve Roth and Scott Brittenham profit. The bonds could be bought at very attractive rates, receive a windfall of cash and then be sold on. The unfavourable rates made the bond quantifiably unattractive while the unpredictability of cash windfalls made the bonds attractive only at the right time. Unpredictability was the golden goose.

Liars Poker

Rule 2: The only direction at the top is down

It was in the final chapter about junk bonds and Drexel Burnham that CEO at the time Michael Milken said one thing which stuck with me

First, many large and seemingly reliable companies borrowed money from banks at low rates of interest. Their creditworthiness had but one way to go: down. Why be in the business of lending money to them? It didn't make sense.

This is obvious but worth repeating. If anything, look for a company that can go up. Blue chips should never be your first choice.

Rule 3: Civil War and unrest killed Solomon Brothers

It was Solomon's inability to take up the same opportunities that Drexel Burnham did that were their ultimate undoing. They stopped being the market leader and started missing out. The reasons were probably based on in-fighting in the upper ranks of the Solomon Brothers. Goldman Sachs, Morgan Stanley and the other large established merchant banks in the meanwhile were able to profit by being fast followers. Confrontation killed Solomon Brothers.

Rule 4: The safe money is in companies too important to fail

This is a specific reference to Lockheed Martin (and after the 2008 market crash - every large bank). Large companies come and go but occasionally you find a company that it is just too against a government's interests to fail. The Lockheed's of the world aren't just the money makers, they're the gold standard of safety. They are the gilts of the equity world.

If you want safe equities look to companies so important that no-one powerful enough would like to see them go.

Rule 5: Loans have more sway

Milken claimed that Drexel and its clients, not Riklis, controlled Rapid-American. 'How can that be when I own forty percent of the stock?' asked Riklis. 'We own a hundred million dollars of your bonds,' said Milken, 'and if you miss one payment, we'll take the company away.'

This is accounting 101. Loans are paid first, why is trading risky equities so popular when you can trade their risky bonds and get first dibs?

Deepak Bhalla