Finance: Salvaging Salomon

By THOMAS McCARROLL

When billionaire financier Warren Buffett announced he was assuming the chairmanship of Salomon Brothers on an interim basis last week, he stepped into a morass that threatened to grow worse for the 81-year-old Wall Street firm before it got better. In fact, Buffett's salvage job began even before he was able to warm his new seat. The Treasury Department, in an attempt to restore confidence in the market, barred Salomon from bidding at further auctions. In a series of telephone calls with vacationing Treasury Secretary Nicholas Brady, Buffett successfully lobbied for leniency. Salomon was permitted to trade, but for its own account only, not on behalf of clients. The decision was more than symbolic, since Salomon, one of only 40 firms designated as primary dealers in T-bonds and T-bills, directly and indirectly counts on government securities for about 25% of its business. The firm participated in last week's auction under the watchful eye of Treasury officials.

Buffett, who owns 16% of Salomon's preferred stock and a legendary reputation for his investing, if not his investment-banking, savvy, assumed Solly's chairmanship after the board forced chairman John Gutfreund and two other top executives to step down. Buffett immediately brought in Deryck C. Maughan, 43, who until recently ran Salomon's Asian operations from Tokyo, and jettisoned two bond traders. Executives admitted that the firm had violated the rules that prohibit any one bidder from buying more than 35% of a single issue at a Treasury auction, and that they had skirted regulations barring a firm from submitting bids in its customers' names without their authorization in order to conceal such illegal efforts to influence the market.

For decades, the government securities market has been considered the world's safest haven for investors. Unlike stocks and bonds, both of which were plagued by a series of insider-trading cases during the 1980s, the $2.2 trillion market for Treasury instruments was thought to be too big to rig. The Salomon scandal shook that conventional wisdom and aroused suspicion that other firms might be playing similar games. Consequently, an intimidating array of investigations by the Federal Reserve Bank, the Justice Department, the Securities and Exchange Commission -- where enforcement director William McLucas is personally heading the inquiry -- and the New York Stock Exchange were launched. Next month Representative Edward Markey, who heads a subcommittee that oversees Treasury-bond trading, will hold hearings on the Salomon scandal.

The SEC is seeking detailed information from all dealers, brokerages and commercial banks authorized to trade Treasuries, as well as from individual bond traders employed at those firms. The Treasury Department is re-examining the records of every auction since 1986, a total of more than 200, searching for evidence of collusion with customers to violate the 35% rule. Industry analysts expect only minor infractions to turn up. Still, says Howard Sirota, a New York City securities attorney, "this proves that the market isn't quite as pristine and squeaky clean as its participants would have us believe."

Salomon's more urgent problem is customer defections, which threaten the firm's liquidity. The World Bank and at least two state treasuries and four state pension funds said they would all stop buying Treasury bonds through Salomon until questions about auction violations are resolved. The British Treasury is also considering sanctions against the investment house. More desertions are expected.

Salomon already faces about a dozen lawsuits filed by investors who charge they either overpaid for securities because of artificially inflated prices or were paid less interest income because of deflated yields. In anticipation of financial damages arising out of litigation, the firm is setting aside reserves that almost certainly will exceed its profits, which have totaled $451 million so far this year. To head off a liquidity crisis, the investment house triggered its emergency financing plan, which calls for a shift from short-term IOU's to secured loans that pay higher rates.

Buffett's internal reforms, announced shortly after he and Maughan took up their posts, could cost Salomon some of its high-flying bond traders, who could bolt from the firm once they receive this year's bonuses. If individual bonuses are decoupled from the performance of business units in order to eliminate the motivation for overly aggressive trading, some traders may jump ship. Says a former Salomon trader: "People who have had deals like that know they can get them someplace else."

Despite the desertions and a plunge in stock price of more than a third since the scandal broke, few are counting Solly out. The firm still maintains substantial resources and a loyal following. Says Samuel Hayes III, a finance professor at Harvard University: "Salomon will emerge from this episode, bloodied and bruised, but just as potent a force on Wall Street."

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CAPTION: WHERE SOLLY STANDS IN THE GOVERNMENT SECURITIES MARKET*

With reporting by Elaine Shannon/Washington