Steve spoke with Mike Offit, Wall Street veteran and author of the literary financial thriller, Nothing Personal: A Novel of Wall Street, that follows the path of a young gun from business school to Wall Street, where his meteoric rise is boosted by a series of sudden and brutal murders. Mike spent 20 years on Wall Street. He was a senior trader for commercial mortgages and asset-backed securities at Goldman Sachs and founded and ran the commercial mortgage and real estate department for Deutsche Bank. He also, notably, in April of 2007, wrote an article that warned that the problems at Bear Stearns were the beginning of a massive bank crisis.
A Life In The Investment Banking World
Mike was working on Wall Street during the creation of the first mortgage-backed securities—collateralized mortgage obligations—CMOs. He noted that even those first structured and mortgage-backed securities had their cycle of boom and then a gigantic bust in 1987 when they suffered enormous losses because interest rates dropped and refinancing rapidly accelerated.
Mike retired from the Street in 1999, shortly after another crisis, the long-term capital management crisis, where a big, heavily leveraged hedge fund failed. That eventually led to a liquidity crisis when the failure spilled over, affecting other hedge funds. Mike believes that Lehman Brothers, which had a huge exposure to the failed hedge fund, would have failed back then had the Fed not intervened. It’s worth noting that the regulators assured everyone at the time that they would keep a closer eye on leverage so that a similar event would never happen again. Despite that reassurance, a very similar circumstance arose in 2006-2007 when Bear Stearns had exposure to two hedge funds that were heavily invested in what came to be known as “subprime mortgages.” Mike had been privy to the close relationship between the banks and the bond-rating agencies, where the banks would cajole the raters into giving triple-A ratings to bonds even when those bonds contained underlying loans that were third-rate quality.
By 2007, Mike saw the danger posed by the two hedge funds that were teetering on the brink of insolvency despite an injection of $3-$4 billion in cash from Bear Stearns. That’s when he wrote an article pointing out the danger to Bear Stearns, as well as the possibility of a Bear Stearns collapse snowballing across the rest of the investment banking industry.
A Novel Of Wall Street
Mike explained that his goal in writing his novel was two-fold: one, to give readers an inside look at the high-dollar world of investment banks and two, to convey the effects that entering that world can have on young, naive people fresh out of college. He sought to include the four main themes commonly found in people’s lives and in literature: romance, family, money and power, and spirituality and morality.
The novel takes the reader inside the vulgar world of Wall Street and portrays the insidious forces of greed, sex, and power that rule there. It offers details on how major financial firms operate and take advantage of markets, regulators, and their clients, and pulls you into a world of money and murder, where morality collides with greed.
Check out Mike’s novel, Nothing Personal: A Novel of Wall Street.
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Steve Pomeranz: My next guest is Mike Offit. He was a senior trader for commercial mortgages and asset-backed securities at Goldman Sachs and founded and ran the commercial mortgage and real estate department for industry leader, Deutsche Bank. In April, 2007 he wrote an article that warned that the problems at Bear Stearns were the beginning of a massive bank crisis. Shortly thereafter, he wrote a piece that predicted the failure of the brokerage and banking system and advised investors to get their money into safe custody banks. He was dead on on all of this. I want to ask him to fill us in on that situation and also to talk about his book called Nothing Personal: A Novel of Wall Street. Welcome to the show, Mike.
Mike Offit: Thanks very much. I’m very happy to be here.
Steve Pomeranz: You think of your book as a bit of a parable, a coming of age story wrapped in a white color crime novel and you’ve had all these years living in the center of the vortex of the big trading desks on Wall Street. So tell us the story.
Mike Offit: Well, the novel was obviously inspired by my years on the street and running a couple of big trading desks at Goldman and Deutsche Bank. I also spent years at First Boston. I was inspired to write a story that reflected my experience but also, would hopefully be something of an educational book for readers where they could get a sense of what this inside world of the really big powerful investment banks really it was like and also, the effect that it would have and does have on young people who go into that business.
So in doing that, I was inspired to sort of carry the narrative with a white-collar crime story and a murder mystery because those things always do tend to come together. If you look at the sort of the four main themes in people’s lives and also in literature, there is romance, family, money and power, and spirituality and morality. So I tried to bring all of that together into an effective narrative that, after having read it, hopefully, the reader would be entertained and also have learned something and gotten something of a flavor for how all of this comes together and why we see on Wall Street these cycles of boom and bust. Really, that does lead into sort of an analysis of the financial system and these cyclical crises that we go through.
Steve Pomeranz: Well, let’s get into that. I don’t know if you’ve seen, The Wolf of Wall Street.
Mike Offit: I have. Yeah.
Steve Pomeranz: You have, yeah. I know I ask that question to a lot of people. They have not seen it. It’s definitely something that is way over the top, something you do want to see, but to the degree that it’s really just all about how much money you can make at any cost to the end client. When you were managing these trading desks and you were putting together packages of mortgages, for the most part, were these good investments, were half of them bad investments? What was the general thinking about the investments themselves?
Mike Offit: Well, sort of, fortunately and also unfortunately, I’m old enough that when I started doing this originally, the mortgage-backed securities business was relatively new. So I was, therefore, the creation of sort of the first structured mortgage securities-
Steve Pomeranz: You’re talking about Ginnie Maes way back when?
Mike Offit: Ginnie Mae, Fannie Mae, Freddie Mac, single families. Those were the earliest-
Steve Pomeranz: Right.
Mike Offit: … but then Wall Street started to figure out ways to package and structure those-
Steve Pomeranz: Yeah.
Mike Offit: … into bonds.
Steve Pomeranz: CMOs.
Mike Offit: CMOs, exactly. Interestingly enough, that first mortgage-backed, security-structured, the CMO, had its crisis in late 1986 until 1987, where those bonds suffered enormous losses because interest rates dropped and refinancings really accelerated. This affected bonds and those securities that were very sensitive to prepayments. Even the first structured mortgage-backed security had its cycle of boom and then a gigantic bust.
Steve Pomeranz: Folks, the idea here is that if you’re packaging a bunch of mortgages and you’re looking at the cash flow that’s being paid to you as a bondholder, part of that has to do with the number of people that are actually either refinancing, so you’re getting your money back or moving you getting your money back because they’re paying off their mortgages. So the rate at which you get your money back really determines your overall rate of return.
Mike Offit: Exactly. With mortgages, in particular, their sensitivity to interest rates is heightened because, in effect, if you go and invest your money at, say at one time, you could buy 9% or 10%-
Steve Pomeranz: Yeah.
Mike Offit: … mortgage-backed securities, you didn’t control how long you could hold that bond. If the owners of the, say, 10,000 individuals, single-family homes in that pool of mortgages that you bought all went out and refinanced, your bond would get paid off instead of in 30 years, it could be in a month or two months very quickly. So mortgages had a sort of typical bond structure of a sensitivity to interest rates, but it was really magnified by the fact that there was no call protection—is the technical word for it—they could be taken away from you at any time.
Steve Pomeranz: And I guess one of the problems with Wall Street firms is they were trading these; they were holding onto them in inventory and they were using just excessive amounts of borrowed capital or leverage to do it with.
Mike Offit: Exactly. This really began during my career in the mid-to-late eighties where firms began to hold big proprietary trading positions. Sometimes it was voluntary because you decided that they were cheap and you wanted to hold onto them. Sometimes it was involuntary because you just couldn’t sell them to anybody. And in ’86-’87, it was more of the involuntary type. It was-
Steve Pomeranz: Yeah.
Mike Offit: They couldn’t sell them and build up these big inventories. So we’ve seen a cycle of this on the street. There was the ’86-’87 mortgage bust and then shortly after that, we had the savings and loan crisis, which was also in large part fueled by commercial real estate lending.
The savings and loan industry suddenly had access to a vast amount of capital and because they were given federal insurance for their deposits. As people put their money into these banks completely protected by the federal government, the banks had a lot of money they needed to invest very quickly, and one of the things they did was they lent aggressively to commercial developers, put up buildings that wound up being empty, they defaulted, the banks started to lose an awful lot of money, and then we had the S&L crisis and bailout in the late 1980s.
Steve Pomeranz: Yeah, the government had to come in and bail them out just like they did in ’08.
Mike Offit: Right. Little bit different in that they actually let them fail, and they took over all of these assets-
Steve Pomeranz: The bad debts, mm-hmm (affirmative).
Mike Offit: … and sold them off at a deep discount to guess who? Wall Street, the very same entities that has helped these banks grow and cause the problem to begin with.
Steve Pomeranz: Where does that put us when we get up to 2007? Now describe very quickly, the state of the world that you saw before the bust began.
Mike Offit: Right. Well, I retired in 1998, ’99 after another crisis, which was the long-term capital management crisis where a big hedge fund failed, and it was operating on 40 or 50 to one leverage number. Wall Street was lending at $50 for every dollar of capital that it had, so a control of these enormous positions, and there was an Asian banking crisis followed by Russia defaulting, and suddenly this huge hedge fund had losses and needed to sell these securities to meet margin calls. There wasn’t that good at market for them. They were very leveraged and toxic securities to begin with and as they began to sell them off, the prices declined. Then other hedge funds had to meet margin calls and it snowballed into a big liquidity crisis, not quite on the scale of 2008, but enormous enough that the Fed had to intervene. Had they not intervened in 1998, Lehman Brothers likely would’ve failed because they had a huge exposure to this hedge fund. So at that time, the regulators assured everybody that this would never happen again.
They would carefully control leverage. In 2003, there was another sort of the issue that came up where Congress got involved was that all of the big insurance companies that backed larger accounts at brokerage firms stopped offering, it was called excess civic insurance-
Steve Pomeranz: I remember that.
Mike Offit: … for people with larger accounts. The reason they left the market was they said that the investment banks, the brokerage firms’ balance sheets had gotten so big and complex that even these sophisticated insurance companies like Travelers and AXA, Radiant, they couldn’t understand Wall Street balance sheets. So if they were going to insure them against failure, they needed to really understand what those risks were and they couldn’t.
Steve Pomeranz: So for once, the insurance company’s got something right.
Mike Offit: They got that one dead right.
Steve Pomeranz: Yeah.
Mike Offit: I mean, dead right.
Steve Pomeranz: Yeah.
Mike Offit: So they left. The brokerage industry was left with this sort of image crisis. If these big, sophisticated third-party insurance companies said that they were taking too much risk, what could they possibly do? And the general accounting office in Congress got very stern with them and said, “You need to solve this problem.” They sort of went into a very unique solution, which was 14 of the biggest brokerage firms quickly formed a captive insurance company to offer this excess civic insurance. The problem with it was is they put it in the beautiful state of Vermont, not New York or Washington DC, but in a remote state because that state didn’t require any financial disclosure at all for that insurance company.
I got concerned about that in 2006, 2007. I said, “Gee, if you have an account at a brokerage firm, you’ve got the SITC insuring up to $500,000 of your money and this excess of becoming from this company that you don’t know anything about.” SIPOC itself only had about a billion dollars in capital and was insuring trillions of dollars of brokerage accounts. This excess civic insurer had maybe no money or maybe a hundred million dollars. So that led me to be very concerned about the brokerage industry at that moment. Then there was a crisis in two Bear Stearns hedge funds and it was very similar to what had happened with long-term capital management. They had bought with enormous leverage, complicated mortgage-backed securities, and those would become the subprime mortgages, had begun to underperform. The other sort of irony and this and that, these things were called subprime mortgages for a reason. They’re borrowers where people who couldn’t get normal mortgages, they were risky borrowers.
Steve Pomeranz: You know, but the way the brokerage firms were doing the math then, they were looking at historic rates of default and modeling that out so they could kind of get a sense for how to price it with this idea that a certain amount would not work out. Right?
Mike Offit: Exactly. They would structure a security where the lower-rated classes would absorb all of the first losses-
Steve Pomeranz: Yeah.
Mike Offit: … and then the very top of, what we call the capital structure, the best bonds would have this protection and those bonds could be rated triple-A even if all of the underlying loans were really third-rate quality, and this was done together with the rating agencies. In my career, I spent an awful lot of time with the rating agencies always trying to convince them to be more flexible and give us more triple-A bonds on every deal that we did because that would make us more money.
Steve Pomeranz: So it’s like alchemy, how do you take-
Mike Offit: Exactly.
Steve Pomeranz: … a base metal and turn it into gold?
Mike Offit: Well, fool’s gold is really the right name. It could be the name of another novel.
Steve Pomeranz: I remember doing a show or a segment on my show when I actually went in and looked at the balance sheet of these brokerage firms and I saw a leverage of 33 to one.
Mike Offit: Yeah. That’s what you could see. I can tell you when I was at Deutsche Bank, for example, in 1998, we had hit sort of our capital limits. So we couldn’t grow our trading position anymore and we really wanted to. We were very profitable and my boss wanted us to. The clever fellows down in the financing desk figured out a way to get us billions of dollars more leverage by issuing through an offshore lending conduit. So this wouldn’t go on the balance sheet of the bank, it would sort of be disappearing money that didn’t show up anywhere. Our leverage numbers were actually much greater than what was reported. It was perfectly legal. It was within the regulations, but even the numbers that you see when you look at the reports they issued, don’t really give you the full picture.
Steve Pomeranz: What happens to your money if you have $100 and your leverage, you’ve only put down 3%, so your leverage is 33 times, what happens if that $100 loses a dollar?
Mike Offit: Well, generally you’re hit with what’s called a margin call, and that means your broker or your lender asks you to put up that dollar so that you maintain that 3% cushion. Of course, if you can’t meet that margin call, they have the right to start liquidating funds.
Steve Pomeranz: And they do liquidate.
Mike Offit: Oh, they certainly do liquidate.
Steve Pomeranz: They don’t care what your financial situation is. That money is going to get liquidated by two o’clock if you don’t come in with [crosstalk 00:13:21]
Mike Offit: Exactly. It’s very strict. In fact, I had a consulting client a few years ago who had a margin call and had several hundred-millions of dollars of municipal bonds liquidated into the market. They didn’t give him any time and this is a billionaire-
Steve Pomeranz: Yeah.
Mike Offit: A big hitter, as the saying goes. So it’s very strict and it’s very carefully enforced, but interestingly, within the firms themselves and lending to each other, the rules are a little bit more flexible and how it’s enforced is more flexible. But this became a huge area of concern for me in 2007. I saw these Bear Stearns hedge funds looking, leveraged on, teetering on the brink of insolvency. Bear Stearns was forced by the rest of the industry to lend these two hedge funds, $3 or $4 billion to keep them afloat, but it was a flea in a tornado.
Steve Pomeranz: Yeah. I don’t know. The difference here though is when I would see reports like this, I would go, what situation is contained and what situation is the beginning of a contagion?
Mike Offit: Exactly.
Steve Pomeranz: How do you tell the difference? And that’s the difference.
Mike Offit: And contagion is a good word because even the name of the piece I wrote was, “virus.” When you see a situation where, particularly, a market of highly structured illiquid securities that are… there’s not a ready market to liquidate this stuff, they’re not like US treasury bonds or high-quality corporate bonds. They’re very structured. They’re very sensitive to any credit changes, and then you look across the balance sheets of the trading houses themselves and other hedge funds and you see large amounts of these and you see that the prices on them are beginning to suffer. You know that this is going to most likely become something that accelerates because if Bear Stearns hedge fund has to sell and brokerage firms lower their bids by three or four points, that’s where the bonds trade will now, all of the bonds across the market, have to be marked down.
Steve Pomeranz: Marked down.
Mike Offit: Those traders have to mark their inventory to market and suddenly, they lose money, that affects the capital of their bank or their fund, and now they have to come up with margin calls, they have to come up with money, which means they have to start selling those securities too.
Steve Pomeranz: There’s a lot to talk about here, but first let me just re-introduce you here. Mike Offit, the author of, Nothing Personal: A Novel of Wall Street, describing his experiences at the trading desks that he ran some years ago.
Well, unfortunately, we’re going to have to stop it there. My guest is Mike Offit, his book, Nothing Personal: A Novel of Wall Street. I recommend that you get it. Mike, thank you so much for joining us. I’d love to have you back sometime.
Mike Offit: Thank you.