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Clearing The Wreckage



If the ongoing saga of Salomon Brothers, and its alleged effort to improperly dominate Treasury auctions, seems lifted from the pages of Liar's Poker, the events of the past few days smack instead of Destry Rides Again. Out goes the tarnished CEO, the scowling, cigar-chomping high-stakes trader John H. Gutfreund. And out of the West comes a living legend--modest, unassuming, armed with self-deprecating wit. "I was thinking of making my salary $1 a year," deadpanned Warren E. Buffett, interim chairman of Salomon Inc., at an inaugural press conference on Aug. 18. "But I could be negotiated with--downward."

Can the Sage of Omaha save Salomon Brothers--and with it, his own huge stake in the bond-trading giant? The answer to that, of course, depends largely on external forces well beyond the control of Buffett, a noted investor and chairman of Berkshire Hathaway Inc. To be sure, Buffett, whose firm holds $700 million of Salomon convertible shares, is an inspired choice for CEO. But even so, the damage-control task facing the new CEO is awesome--and potentially overwhelming. Customers are beginning to flock for the exits, led by public pension funds in California, Wisconsin, and Massachusetts.

And it is becoming increasingly clear that the transgressions allegedly committed by Salomon may be so grave that the firm is likely to face severe legal consequences. Salomon has conceded that it used customer accounts, without authority, to bid for notes and bonds in five Treasury auctions since December, 1990--thus winding up with more than the 35% share of the offering permitted to any one firm.

In recent days, yet another element of Salomon's alleged transgressions has emerged. Wall Street sources familiar with the practice say that in addition to simply jacking up the price of Treasury securities, Salomon used its dominance of Treasury auctions to demand ultralow rates of interest on cash it borrowed in return for access to Solly's hoard of Treasury securities.

STUBBORN CLOUD. Whatever the truth of such allegations, Salomon customers at home and abroad have begun to tiptoe out the door. It may become a stampede, if the scandal drags on. On Aug. 21, the World Bank suspended business dealings with the firm until at least Sept. 30. "So fundamentally have Salomon officers destroyed their credibility in our eyes, we need an independent source to verify that they have cleaned up their act," says David Shaw, fixed-income manager at Legal & General Assurance, one of Britain's largest fund managers.

In the first signs of an expected exodus of public pension funds, the giant California and Wisconsin state pension funds have put their Salomon Treasury-bond business on hold, despite Buffett's ascendancy and pleadings from Salomon executives. "The board wanted to express their outrage with the discovery of practices going on," says DeWitt Bowman, chief investment officer of the California Public Employees' Retirement System. And in Wisconsin, officials of the state pension fund were unmoved by the executive-level shakeup at Solly. "We're not certain that all steps that are necessary have been taken internally," says Kurt N. Schacht, general counsel of the State of Wisconsin Investment Board. "The violations," he maintains, "call into question the integrity of the firm and put a cloud over some very important markets."

Buffett hasn't yet been able to dispel that cloud. In its statements on the auctions, the firm has long skirted the central issue: the motivation and impact of its overbidding at auctions. Did Salomon corner the market in Treasury securities? After all, by allegedly buying or controlling--via customer accounts--more than its maximum allowable portion of bonds, Salomon would be in a position to influence bond prices improperly, particularly when short-sellers seek to buy Treasuries to cover their positions. Asked about such widely reported allegations at the press conference, Buffett replied that "anything I have seen so far at Salomon doesn't tell me about that," and "what has been uncovered is unrelated to that." And although Buffett had said earlier that he has had "48 hours to ask a lot of questions" as a board member, he would not say whether any of those questions covered allegations of market manipulation.

GOODWILL MAN. Government investigators show a lot more curiosity on that subject. Indeed, Solly's fate hinges largely on the outcome of an array of federal investigations, including inquiries by the Securities & Exchange Commission and the Justice Dept.'s Antitrust Div. The SEC and FBI are probing large purchases of Treasury notes by private investment partnerships, also known as hedge funds, through unauthorized bids submitted by Salomon. The SEC inquiry was widened in recent days with a letter to all 40 primary government-bond dealers seeking detailed information about their transactions in government securities. Justice is looking into possible bid-rigging involving other major firms, and an agency official describes its investigation as a "wide-ranging" probe into possible civil and criminal violations. "It is a very high priority," says this official, "to which substantial resources are being devoted."

So for Solly, the legal woes are only beginning. Buffett's selection has clearly mollified regulators, but in just the first few hours of his tenure as CEO, he had to dip into his reservoir of goodwill with the feds. Shortly before the board of directors met on Aug. 18, the Treasury announced that Solly was suspended from all future auctions until the firm had taken steps to clean house. In fact, the board was about to replace Gutfreund with Buffett and accept theresignation of Salomon President Thomas W. Strauss, who was replaced by Deryck C. Maughan, a Briton who was co-head of Salomon's investment banking department. After a call from Buffett to Treasury Secretary Nicholas F. Brady, during which Buffett pointed out the steps Solly had taken, the Treasury relented and the firm was allowed to continue to place bids--albeit only for its own account.

The impact of the Treasury restriction was minimized by Buffett and Maughan at a subsequent press conference. The two men also played down the transgressions committed by the firm and described them as "inexplicable" and "dumb."

SQUEEZED SHORTS? Traders and Salomon customers, however, have maintained that Salomon, by dominating auctions, was able to ratchet up the prices of Treasury securities. Another means by which the firm allegedly manipulated the market was detailed by sources familiar with the auction process. They maintain that Salomon profitably "squeezed" short-sellers by using a financing mechanism known as reverse repurchase agreements, or repos (table). In a reverse repo, a firm that owns securities loans them out for a specified time and borrows cash in return. If the security is in scarce supply, the owner can get away with paying less interest. But if the security is widely available, the holder must pay close to the going short-term interest rate.

Ordinarily, traders say, Treasury securities should be plentiful. But instead, certain issues became scarce--allegedly because of Salomon's effort to corner the market in Treasuries. As a result, Salomon is said to have insisted on paying an unduly low interest rate--as little as 1%--for the cash it borrowed in exchange for lending the securities. The firm was able to invest that cash at more than 5%, profiting handsomely. Many of the short-sellers supposedly victimized in this manner were small bond dealers, who would go short to hedge their inventory. "The larger firms have gotten away with it," beefs one Salomon customer. "If a Justice Dept. antitrust lawyer saw this, his jaw would drop to the ground." A Salomon spokesman, asked for comment, would only say that "the government is investigating the May two-year auction."

Some dealers contend that Salomon's abuses of reverse repos went one step further. They hold that Solly was able to keep securities out of the reverse repo market--thereby keeping supplies scarce and its interest payments low by squirreling them away in customer "custody accounts." Those accounts, popular with institutional investors, use government securities as collateral for customer holdings--with the choice of collateral, mainly government securities, left to the discretion of the brokerage. Dealers believe the custody accounts were essential to the operation of the squeezes, since they allow the dealer to take part of a specific issue off the market.

Treasury officials are believed to be pursuing these alleged abuses. According to a Chicago money manager and ex-Salomon customer, Robert Hickey of HickeyFinancial Services, Treasury officials were given a detailed account of such practices in the repo market and custody accounts in early June.

By one scenario being circulated on the Street, the beneficiaries included not only Salomon but also large customers who may have joined Salomon in squeezing the shorts. The federal agencies are said to be investigating the purchase of large quantities of Treasury notes by large private hedge funds, including ones controlled by renowned investors George Soros, Michael Steinhardt, and Julian Robertson. Soros and Steinhardt could not be reached for comment. A source close to the investigation said that Robertson's money-management firm, Tiger Management, was approached by investigators from the SEC and FBI a month ago, regarding the firm's $1.5 billion bid in the auction of May two-year notes. A spokesman for the firm would only say that Tiger had made a $1.5 billion bid via Salomon, received the $1.5 billion in notes, and complied with all applicable laws and rules.

MURKY DETAILS. However, investigators could be barking up the wrong tree. According to a source close to the investigation, Tiger did not loan out to short-sellers any of its $1.5 billion in two-year notes--but did quite the opposite. The source says the firm instead engaged in a perfectly legitimate trade in which it profited from the difference between the interest rate of the notes and the federal funds rate. That is known as a repurchase agreement, which is the opposite of the reverse repos allegedly used by Salomon to squeeze shorts. By doing this, Tiger and possibly other hedge funds were able to turn a quick, legitimate profit--in Tiger's case, about $15 million.

These are the kinds of murky details regulators will be sorting through. But the regulators themselves are not above the criticism of some Wall Streeters. According to a source at one brokerage, the Treasury seemed uncertain of what was going on in the market as late as the latter part of July--two months after it began receiving complaints about the May auction of two-year notes. At that time, a meeting of the Public Securities Assn. was called at the behest of the Treasury, to see if any corrective action could be taken in response to the May squeeze before the Treasury refunding scheduled for the first week of August. "Everyone knew the May short squeeze was a problem," says one attendee. "With a big refunding coming up, dealers weren't sure they wanted to participate. There was lots of concern. Why were we having a group grope in July if regulators were on top of the situation?"

That's the kind of issue that may eventually come to the fore. But first, Salomon will have to find a way off the hot seat. And as the lawsuits mount, the customers leave, and the regulators turn up the gas, Solly is likely to be roasting for a long time to come.



1 Demand is brisk for a recently issued Treasury bond. A bond dealer, whose inventory has been depleted, sells bonds that it has borrowed. It hopes to replace them at the auction at a cheaper price

2 But the auction has been `cornered,' with most of the bonds controlled by a large brokerage firm. To cover the short position, the dealer must approach the firm that engineered the corner

3 The big firm says to the dealer, `Loan me cash in return for the bons, which you must sell back to me later. ` This is known as `reverse repurchase agreement'

4 The firm has a lock on the supply of bonds, so it can dictate the terms of the loan: `The interest rate that you will charge me on the loan,' the firm may say, `is 1% a year. Take it or leave it.' The bond dealer has no choice

4 The big firm profits by investing the loan, for which it is paying just 1%, at an interest rate of at least 5 1/2%

DATA: BWGary Weiss and Leah Nathans Spiro in New York, with Dean Foust in Washington, and bureau reports

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