In an Uncertain World (14 page)

What I saw and heard at the 28th Precinct Community Council gave me a more personal feeling that it is just wrong that a country as wealthy as ours does not provide the resources to successfully address poverty that passes from generation to generation. The more I learned about these issues, the more I was convinced that there were approaches that would work if adequately supported. I also came to believe that the problems of the inner cities greatly affect all of us—no matter where we may live or what our incomes may be—through crime, the deterioration of public schools, the costs of social ills, and the lost productivity of a large group of people who are not being equipped to realize their potential. The belief that affluence can insulate is illusory.

And that helps explain why I am a Democrat. If you put all my views on public policy issues together, I wouldn't fit neatly under any political label. In fact, many of my views, such as the importance of fiscal discipline to our country's future growth and the centrality to our own well-being of American leadership on global issues such as trade liberalization, poverty, the environment, and terrorism, don't really fit into any political camp. But when I look in both directions from the center, I find concerns that echo my own to a greater degree on the Democratic side, which has long seemed to me more committed to using government to meet the needs of middle- and lower-income people that markets by their nature will not adequately address.

However, I wasn't necessarily in full agreement even with those who shared my concerns. Roughly twenty years ago, I heard Senator Ted Kennedy (D-MA) give a speech advocating a whole host of government programs that sounded worthwhile to me. The address was powerful and well delivered. But as much as I agreed with Kennedy's goals and respected his commitment to them, I wondered,
How are we going to pay for this
? The focus by some social advocates on problems and programs—but not the means to fund those programs—bothered me. My deep involvement in the 1984 presidential campaign was largely driven by the conviction that we needed a President who combined Kennedy's social concerns with a sense of fiscal responsibility.

Walter Mondale seemed to fit that bill. I met Mondale through his campaign chairman and former White House aide, Jim Johnson, who later became the CEO of Fannie Mae. Through Jim, I also met Mike Berman, the treasurer of Mondale's campaign and a man wise in the ways of Washington. As I got to know Mondale better, he seemed to be very practical, with a well-known commitment to the plight of the poor, joined with a deep concern about our growing fiscal disarray. When the Mondale people asked me to be his New York State finance chairman, I accepted, after initially hesitating because once again I wanted to be sure I could raise enough money to be successful.

Though my place at the Mondale table came from fund-raising, my conversations with Jim Johnson, Mike Berman, and others in the campaign often shaded into economic policy and politics. Some people like opera. Some like basketball. I like policy and politics. Somewhere in the back of my mind, I also knew I wanted to work in the White House if the right opportunity should ever arise.

After Mondale's defeat, gloom pervaded the Democrats. The party was widely seen as being in trouble and needing to reassess its direction. Some thought it was in thrall to the labor unions and interest groups, and that more centrist positions would be both better policy and more attractive to middle-class voters. Others felt just the opposite—that the focus needed to be on what they referred to as the “base.” I remember one dinner discussion at the house of Roger Altman, a fellow Wall Streeter who had served in the Carter administration and had worked with me on the Mondale campaign. Two other political strategists, Tom Donilon and the late Kirk O'Donnell, were also there, as was Jacob Goldfield, a colleague at Goldman Sachs. The focus of the discussion was that Reagan's position was too simplistic to be serious policy but was easy to grasp and good politics: fight communism, cut taxes, and reduce government. How could views that reflected the true complexity of the issues be framed with enough political resonance to respond to such bumper-sticker simplifications? By the time dinner was over, no one had any very promising thoughts. In the years since, I've had many such conversations about this same conundrum.

   

THE ELECTION HAD consequences inside Goldman Sachs as well. In 1985, John Whitehead resigned and soon became George Shultz's number two at the State Department, leaving John Weinberg as the sole senior partner. That same year, Steve Friedman and I became co-heads of the fixed-income division. We were roughly the same age and each of us had moved from a law firm to Goldman Sachs at about the same time, when that was rarely done. Steve and I became partners and joined the Management Committee within two years of each other, and we worked on many client assignments and firm matters together. Steve, a former national wrestling champion, was relatively conservative and a Republican. (Curiously enough, Steve assumed the same position in the White House at the beginning of the third year of the George W. Bush administration that I had at the outset of the Clinton administration.) Despite our differences—and perhaps despite our commonalities—we worked extremely well together for twenty-five years.

The fixed-income division at Goldman traded all kinds of interest-bearing instruments—government debt, corporate and high-yield bonds, mortgage-backed securities, fixed-income futures, options, and other derivatives. The business was big, with a lot of risk. And shortly after we arrived, the trading operation developed serious problems. Our traders had large, highly leveraged positions, many of them illiquid, meaning that they couldn't be sold even at generous discounts to the price of the last trade. As losses mounted, Steve and I tried to figure out what to do.

I tend to think about fixed-income trading in three categories, although any single trade or position often involves two or even all three of them. The first is flow trading. You buy on the bid side of the market from clients and sell on the offer side, earning the spread between the two. The second is directional trading, based on judging the short-term direction of the market. You expect weaker economic numbers or a stock market dip to push bond prices higher. So you buy at $98¼, expecting to sell at $99 or even higher. The third is relative value trading, or fixed-income arbitrage. You decide that the relationship between two different securities is out of line and likely to return to form, based on valuation models, historical experience, and judgment; for example, the five-year Treasury bond is trading at an unusual discount to the ten-year. So you buy the relatively cheap bond and sell the relatively expensive bond, anticipating that their normal relationship will return.

Relationship trading was at the heart of the trouble that developed in the fixed-income department. Bonds and derivative products began to move in unexpected ways relative to each other because traders hadn't focused on how these securities might behave under the extremely unlikely market conditions that were now occurring. Neither Steve nor I was an expert in this area, so our confusion was not surprising. But the people who traded these instruments didn't fully understand these developments either, and that was unsettling. You'd come to work thinking
We've lost a lot of money, but the worst is finally behind us. Now what do we do?
And then a new problem would develop. We didn't know how to stop the process.

We had lost about $100 million. Today that wouldn't mean much, but in that world at that time, it was very meaningful. And it wasn't just the losses to date but also a question of what those losses portended for the future. You have no way of knowing when a downward spiral will end or if the next period will be even worse. The fixed-income division had contributed greatly to Goldman's overall profitability. Suddenly, our biggest trading operation had gone sour, and we didn't understand why or what the future might bring.

Steve and I went into the trading room and said, “Let's all sit down and try to understand what we're holding. If we have positions we shouldn't have, let's get rid of them.” Leaving aside the psychological factors that incline most traders to resist taking losses, what soon became clear was that they hadn't fully anticipated the behavioral characteristics these securities could have when conditions changed substantially. Many of these bonds had embedded or implicit options. As a simple example, the firm was trading mortgage-backed securities that represented the loans people take out to finance homes. As interest rates declined, people refinanced 13 and 14 percent mortgages at 9 and 10 percent. That meant that our bonds didn't rise in line with the fall in interest rates and in some cases were paid off early—creating a loss on a position that had been hedged with Treasury bonds. A similar problem affected corporate bonds. As interest rates declined, bond prices rose to a point where the corporate issuers might exercise call provisions—the right to pay off an outstanding bond, usually to refinance at lower rates. When a bond was at $80, the borrower's right to redeem at $102 was often ignored. Then, when the bond market had a massive rally, the call provisions did begin to reduce the otherwise expected premium, while the short position rose and created a net loss. What happened to us represents a seeming tendency in human nature not to give appropriate weight to what might occur under remote, but potentially very damaging, circumstances.

Another lesson in these 1986 bond market losses—which I had learned through mistakes made in arbitrage years earlier—was to think not only about the odds of making a profit on each trade, but the limits on tolerance for loss in the event market conditions became much worse then expected. The issue wasn't simply financial staying power. A trader and his firm had to know the outer limits of what they were willing to lose relative to their earnings and balance sheet. A related problem was liquidity. Traders tend to assume that their positions will always be salable at very close to the last market price. When markets are doing reasonably well, they say, “Well, if I don't like something I've bought, I'll just kick it back out.” But when conditions deteriorate severely, liquidity diminishes enormously. Traders often can't sell bad positions except at enormous discounts, and sometimes not at all. Then they may be forced to sell good positions to raise money. Thus, during periods of great market duress, investments can react in unexpected ways. Securities that have no logical relationship may suddenly move in tandem while securities that do have a logical relationship may diverge. Unexpected losses can develop rapidly and be huge.

Dealing with the 1986 meltdown in fixed income probably helped reinforce the position Steve and I had acquired as heirs apparent, and in 1987, John Weinberg appointed us co–chief operating officers of Goldman Sachs. Even after we assumed our new positions, however, I remained co-head of trading and arbitrage and the Management Committee member responsible for J. Aron—albeit with many fewer day-to-day responsibilities in each of those areas. Steve, on the other hand, chose to relinquish his position as co-head of the investment banking division, although he remained very involved in it.

Beginning in early 1987, we became embroiled in a crisis which—painfully—prepared me to help manage several other high-profile crises in subsequent years. A partner of ours, along with two people from another firm, was arrested for insider trading in a highly controversial case. Based on our counsel's investigations, we believed our partner was innocent, and we stood by him through the entire ordeal. All the original charges were dropped. No new charges were ever brought against the other two. Our partner ultimately pled guilty to a single count unrelated to the original charges. His counsel advised him that he shouldn't be found guilty but that, with a wealthy defendant in a jury trial in a matter of this sort, there were no guarantees.

For almost two years, Steve and I were engaged with this case and the issues it created for the firm. In dealing with this problem, we learned a number of important lessons. First, in managing a crisis, it is crucial that you not allow it to interfere significantly with conducting your business. One way to minimize this risk is to designate a small team to deal with the crisis. Steve and I told everyone else at Goldman that we'd keep them posted, but that their responsibility was to remain focused on their work. Second, we learned the importance of getting out and seeing your clients during a crisis. Clients have a lot of questions and the firm has to answer them. Third, you have to communicate with your own people frequently, especially since the media is likely to emphasize the negative. Fourth, regarding the media, my own experience over many years, in a number of crisis situations in both the public and private sectors, has convinced me that you simply have to grit your teeth and live through the rough early coverage—you ordinarily can't affect the initial firestorm. What you can do is be candid about whatever the situation may be, affirmative with respect to your commitment to address your problems—if that is relevant in the particular situation—and confident about the future. Over time, your answers should begin to get more attention and the coverage should become more balanced. Finally, in all of this, you need to resist the tendency to become a little paranoid, thinking that people are looking at you differently when, in most cases, they're not. It's important not to be oversensitive, and to treat everyone normally. With all of the potential for something to go wrong in any big company, no matter how well run, and with the attendant media and political firestorms that can erupt in short order, knowing how to cope with a crisis can quickly become critically important for any senior manager.

At the end of 1990, John Weinberg stepped down, and Steve and I were named co-chairmen. Following the Weinberg-Whitehead example, we didn't try to divide up responsibilities or subject areas. We told everyone to assume that either of us could speak for both and that touching one base was sufficient. This worked because we shared the same fundamental views about the firm, trusted each other totally, kept in close touch, and were both analytically minded in our approach to problems. When this structure does work—and that is a rarity—the advantages are substantial: there are two senior partners to call on clients and two people who can work together on issues with no hierarchical baggage, and who can reinforce each other in discussions with the rest of the organization. Also, when difficulties arise, having a partner reduces the feeling of loneliness at the top.