How Bad Will It Get?

In the minds of many employees of Salomon Inc., it's safe to say the ghostly visages of E. F. Hutton & Co. and Drexel Burnham Lambert Inc. loom large. Both were powerful firms. But after being forced to admit serious wrongdoing, Drexel went bankrupt and Hutton sold itself. Can Salomon, which has admitted rigging its bids in Treasury auctions, avoid a similar fate?

That's not easy to predict. Unlike industrial companies with lots of fixed assets and relatively secure markets, investment firms are very perishable. Psychology plays an important role, and when perceptions shift, customers and top employees can vanish overnight. So can the billions of dollars of short-term credit that the firms need to function.

Interviews with numerous Wall Street executives, regulators, and other observers suggest, though, that Salomon has a good chance of making it. "I personally predict Salomon will survive and recover," says Samuel L. Hayes III, professor of investment banking at Harvard business school. The main reasons are new Chief Executive Warren E. Buffett's quick moves to remove implicated employees and fess up to the firm's wrongful activities, the desire of regulators to keep it in business, and the firm's immense financial resources. Salomon, with some success, has been busily trying to reassure clients, bankers, and employees that it will weather its troubles.

Despite its efforts, Salomon seems likely to emerge from the crisis as a smaller, less profitable, less powerful firm. Between late June and late September, the firm sold $40 billion in securities, dramatically reducing its assets to $105 billion. First of Michigan Corp. analyst Perrin Long predicts that it may shrink to half its size. "They won't have the ability to borrow as they have in the past. And they'll have less revenues and less profits," says Long. One key to the damage will emerge in the third week in October when the firm releases third-quarter results. It has already announced it will be taking a reserve against litigation costs. According to a BUSINESS WEEK estimate (Sept. 16), those costs could total as much as $1 billion.

NIBBLING AWAY. Surviving even as a shrunken entity is far from a sure thing. For one thing, new transgressions keep dribbling out. The firm itself admitted on Sept. 20 that "it seems to us likely that still other instances of similar behavior will be uncovered in the future through our internal review by the investigating authorities." Criminal charges may well be filed against the firm and its current and former executives. "The negative effect is incremental and cumulative," says a government lawyer. "Each time there's another hit, Salomon's credibility and reputation is damaged further."

Salomon's customer base is wary. American Telephone & Telegraph CEO Robert Allen undoubtedly spoke for many major companies on Sept. 23 when he chastised Salomon at a press conference for its "arrogant disregard for moral standards." He added: "I'm not inclined to go to Salomon Brothers to do business now." And public institutions, such as the World Bank, British Telecommunications, and state pension funds have already suspended dealings with Salomon. Criminal charges may exacerbate matters, since many states and customers might shy away from dealing with potential felons.

Although there have been no widespread employee defections--possibly because of Wall Street's slump--the firm has lost a few key individuals. More may depart at the start of 1992, after bonuses are distributed. One dilemma management faces is how to compensate its high-priced proprietary traders and thus protect the firm's most profitable stream of earnings without angering regulators.

CREDIT WOES. Salomon executives fear that financing sources may evaporate. The firm is no longer able to sell commercial paper, leaving it with repurchase agreements and bank lines of credit to meet its short-term financing needs. Yet, some jittery commercial banks have withdrawn unsecured lines of credit, whittling down Salomon's $15 billion in bank lines. And it has reduced its secured bank credit line backing its commercial paper from $2 billion to $1.5 billion. Efforts to arrange a new credit facility with Citicorp and J. P. Morgan & Co., have so far been fruitless.

Yet Salomon's strengths should go a long way toward overcoming these negatives. Buffett has been a big plus. While Hutton CEO Robert M. Fomon lingered on long after the firm pleaded guilty to criminal charges, Buffett cleaned house immediately. While Drexel professed its innocence for years, Buffett quickly admitted wrongdoing. And Salomon has been relatively successful in convincing customers that though CEO John H. Gutfreund was slow in reporting infractions, the actual wrongdoing was the responsibility of Paul W. Mozer, the head of the government bond department. By contrast, Michael R. Milken, Drexel's key employee, was at the center of its illegalities. "It's the difference between herrings and whales," says former SEC Commissioner Joseph Grundfest.

Drexel's violations, furthermore, tainted junk-bond operations, virtually its only profit center. The Treasury market is important to Salomon. But the firm also has one of the biggest equity businesses, is a major player in junk bonds, and has a respected investment-banking operation. Nor has its extremely profitable proprietary trading activities so far been tarnished by the scandal. However, with less capital, higher borrowing costs, lower inventories, and fewer clients, Salomon will find it harder to earn the lucrative trading profits.

Salomon has made fewer enemies on Wall Street than Drexel. While Drexel had a very loyal client base, it was reviled for funding hostile takeovers. "Drexel was an upstart trying to elbow their way in," says Harvard's Hayes. "Salomon is a member of the established leadership of Wall Street."

And Salomon has backers in Washington. When Drexel was near bankruptcy, regulators calmly stood aside and let it fail. Due in part to Salomon's key role in Treasury auctions, some regulators feel very differently about it. Federal Reserve Board Chairman Alan Greenspan told a congressional committee on Sept. 24 that the firm's violations were "an extremely serious matter" and that Salomon's status as a primary dealer in Treasury securities was under review. But, he added, "the new management of Salomon Brothers has demonstrated an acute sensitivity to the need for absolute integrity in the government securities market and is taking steps to assure compliance with applicable laws and regulations."

Most important, Salomon's balance sheet is much stronger than Hutton's and Drexel's. Much of Drexel's net worth was locked in junk bonds that, after Milken left, fell sharply in price and became virtually illiquid. Salomon's assets are mostly highly marketable securities. In extremis, it could quickly liquidate itself and pay off its liabilities.

Liquidation, though, is highly unlikely. If the pressure on Salomon became untenable, the firm would probably follow the lead of E. F. Hutton, which sold out to Shearson Lehman Brothers Inc. Salomon might be an attractive purchase for a big foreign bank, despite its legal liabilities. Certainly, losing its independence would be considered a defeat. But a sale might start to look like a pretty good deal, especially to its most important shareholder, who just happens to be running the show.