The Bomb Shelter Salomon BuiltLeah Nathans Spiro
To many, it seems like Drexel all over again. This time around, the Wall Street firm caught with its hand in the cookie jar is Salomon Inc. The scandal began with the same barrage of headlines about widening federal investigations, only now, the focus is Salomon's improper efforts to dominate U. S. Treasury auctions. Drexel Burnham Lambert Inc.'s demise in February, 1990, was triggered by its inability to tap the commercial-paper market in the wake of pleading guilty to securities fraud. Salomon, too, finds itself virtually shut out of that very same market, as many investors refuse to buy its commercial paper.
But the similarities stop right there. Survival is currently not the issue for Salomon. With $134 billion in assets--and with most of that in high-quality government and other securities--the firm is in a far stronger financial position than was Drexel, whose assets consisted mainly of illiquid junk bonds. "It's the quality of our assets that gives us real liquidity," says Donald S. Howard, Salomon's chief financial officer. "We have the most liquid balance sheet of all U. S. financial institutions."
Fortunately, Salomon had developed a financial-crisis-management plan for itself two years ago. And although the plan's architects never thought it would be used to save Salomon from its own transgressions, the plan is a critical element in Salomon's efforts to stem the damage.
UNKNOWNS. The plan capitalizes on the liquidity of the firm's assets. True, now that Salomon is not issuing commercial paper, its financing options have narrowed. But it is replacing its entire $6.9 billion in outstanding commercial paper with repurchase agreements--that is, selling securities for cash with a promise to buy them back at a future date. Other backup funding sources are in place as 6ell (table).
Already, Moody's Investors Service Inc. has downgraded the firm's senior debt and its commercial paper--thereby raising its borrowing costs. But for the next few months, and possibly beyond, Salomon's deep pockets will help insulate it from financial meltdown, thus buying time to rebuild credibility in the markets.
Salomon, under its new CEO, Warren E. Buffett, is already moving aggressively on all fronts. "They're trying to get into every underwriting in town," says a senior government official. "If they can do 60 days of that--generating a lot of volume, pushing Buffett out front, and getting rid of everyone within shouting distance of the violations--maybe they can pull it off."
Longer term, however, Salomon's financial fate depends on unknown factors that lie outside the firm's balance sheet. The unknowns include the size of Salomon's legal liabilities; the extent of government fines and penalties, perhaps even revoking the firm's primary-dealer status; whether customer defections continue; and most important, whether more wrongdoings come to light.
FARSIGHTED VISION. These hair-raising problems were not what Salomon's financial staff imagined in early 1989 when they began drafting the emergency plan. It was intended to provide a backstop in a crisis--from a brokerage-industry problem, such as Drexel's bankruptcy, to a systemic breakdown, such as the 1987 stock market crash. "The last kind of problem we ever expected to meet was a Salomon-specific problem," says Howard, a 63-year-old Harvard business school alumnus who joined Salomon in 1988, after retiring as chief financial officer at Citicorp the same year.
The firm has long since diversified its sources of funding away from the short-term commercial-paper market. In 1989, Salomon began spreading its borrowings over a much wider range of instruments, currencies, and lending institutions. It reduced its dependence on short-term borrowing. From December, 1989, to June 30, 1991, Salomon's long-term debt rose from $2.9 billion to $7.2 billion. "They have worked very hard for a number of years on improving their alternative liquidity systems," says John Kriz, an analyst at Moody's.
The contingency plan was put into action on Aug. 21. Salomon was faced with commercial-paper holders who decided not to roll over the debt. "I felt it was important to protect the integrity of the state's funds," says California State Treasurer Kathleen Brown, who did not renew $230 million in maturing Salomon commercial paper.
Salomon will be able to replace its commercial paper with repurchase agreements, because it has $9 billion in Treasury and other securities available for this purpose. "If our commercial paper went away entirely, the liquidity of the firm would not be in danger," says John G. MacFarlane, Salomon's treasurer. The 37-year-old graduate of the University of Virginia business school started on Salomon's trading floor back in 1979 and still spends half his day there monitoring the firm's funding.
Bank credit lines totaling $15 billion make up Salomon's next line of defense. Since the firm pays no commitment fee, the banks could conceivably cancel their credit lines. In that case, Salomon has yet another backup: It has paid a fee for the right to draw on a $2 billion credit line from a syndicate of 46 banks, led by Bank of America and Citicorp. The loan is available for one year.
But suppose Salomon is shut out of the repurchase agreement market, uncommitted banks don't lend, and the $2 billion in bank loans is inadequate. Then, selling assets becomes the last line of defense. Since the majority of Salomon's assets are U. S. Treasuries, agency securities, and investment-grade corporate debt, "it's not like a nuclear power plant that takes a long time to sell," says analyst Philip M. Zahn of Duff & Phelps. "Salomon could sell 89% of its asset base within a month at market prices."
WIGGLE ROOM. Salomon, however, wants to avoid being forced to dump assets en masse to raise cash. And it has started to reduce assets gradually as opportunities arise. Indeed, during the Drexel crisis, which affected many brokerage firms' financing ability, Salomon shrank its assets by $11 billion--from December, 1989, to March, 1990. "We continue to do business and take positions. But given the environment, we feel it is prudent to run a smaller balance sheet," says Salomon's MacFarlane.
Ultimately, all MacFarlane and Howard can do is give Salomon flexibility. But if the investigations uncover more pervasive wrongdoing this time around, the firm, though remarkably liquid now, will find it difficult to deal with the financial shock.
HOW THE CONTINGENCY PLAN WORKS
Salomon is unable to sell its commercial paper and it is turning to alternative sources of funding to meet its huge financing needs
AGREEMENTS Selling $7 billion in securities it owns to banks with a promise to repurchase them at a set future date
BANK CREDIT Creating $15 billion in lines of credit
BANK LOANS Arranging for $2 billion in committed loans that can be borrowed from banks in the next year
ASSET SALES Reducing inventory positions and other assets, if it needs to raise cash in a liquidity crunch
DATA: SALOMON, INC, BW
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