Warren Buffett: Securities Trading Investigation - Salomon Brothers Financial Scandal (1991)

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• published: 31 Jul 2013
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Salomon Brothers was a Wall Street investment bank, known as a bulge bracket company. Founded in 1910 by three brothers (Arthur, Herbert and Percy) along with a clerk named Ben Levy, it remained a partnership until the early 1980s, when it was acquired by the commodity trading firm Phibro Corporation and then became Salomon Inc. Eventually Salomon (NYSE:SB) was acquired by Travelers Group in 1998, and following the latter's merger with Citicorp that same year, Salomon became part of Citigroup. Although the Salomon name carried on as Salomon Smith Barney, which were the investment banking operations of Citigroup, the name was ultimately abandoned in October 2003 after a series of financial scandals that tarnished the bank's reputation. In this period the firm used its own capital and did not have fee-paying clients. The private company entered equities in the mid-1960s and investment banking in the early 1970s. John Gutfreund became the managing partner in 1978, taking the company public, staying on as CEO. During the 1980s, Salomon was noted for its innovation in the bond market, selling the first mortgage-backed security, a hitherto obscure species of financial instrument created by Ginnie Mae. Shortly thereafter, Salomon purchased home mortgages from thrifts throughout the United States and packaged them into mortgage-backed securities, which it sold to local and international investors. Later, it moved away from traditional investment banking (helping companies raise funds in the capital market and negotiating mergers and acquisitions) to almost exclusively proprietary trading (the buying and selling of stocks, bonds, options, etc. for the profit of the company). Salomon had expertise in fixed income securities and trading based on daily swings in the bond market. During this period, the upper management became dissatisfied with the firm's performance. Profits were small and the company's traders were paid in a way that was disconnected from true profitability. There were debates as to which direction the firm should head, whether it should prune down its activities to focus on certain areas. For example, the commercial paper business (providing short term day-to-day financing for large companies) was apparently unprofitable, although some in the firm argued that it was a good activity because it kept the company in constant contact with other businesses' key financial personnel. Finally, the firm decided to imitate Drexel Burnham Lambert, using its investment bankers and its own money to urge companies to restructure or engage in leveraged buyouts. As a result the firm competed for the leveraged buyout of RJR Nabisco and the leveraged buyout of Revco stores (which ended in failure). In 1991, U.S. Treasury Deputy Assistant Secretary Mike Basham learned that Salomon trader Paul Mozer had been submitting false bids in an attempt to purchase more Treasury bonds than permitted by one buyer during the period between December 1990 and May 1991. Salomon was fined $290 million for this infraction, the largest fine ever levied on an investment bank at the time. The firm was weakened by the scandal, which led to its acquisition by Travelers Group. CEO Gutfreund left the company in August 1991 and a U.S. Securities and Exchange Commission (SEC) settlement resulted in a fine of $100,000 and his being barred from serving as a chief executive of a brokerage firm. The scandal was then documented in the 1993 book Nightmare on Wall Street. After the acquisition, the parent company (Travelers Group, and later Citigroup) proved culturally averse to the volatile profits and losses caused by proprietary trading, instead preferring slower and more steady growth. Salomon suffered a $100 million loss when it incorrectly positioned itself for the merger of MCI Communications with British Telecom which never occurred. Subsequently, most of its proprietary trading business was disbanded. The combined investment banking operations became known as "Salomon Smith Barney" and was renamed "Citigroup Global Markets Inc." after the reorganization, because the Salomon Brothers and Smith Barney names were a division and service mark of Citigroup Global Markets. Two members of the Salomon Brothers' bond arbitrage, John Meriwether and Myron Scholes, later became a founder and a consultant for Long-Term Capital Management, a hedge fund that collapsed in 1998. The firm's top bond traders called themselves "Big Swinging Dicks," and were the inspiration for the book The Bonfire of the Vanities, by Tom Wolfe. Salomon Brothers' success and decline in the 1980s is documented in Michael Lewis' 1989 book, Liar's Poker. Lewis went through Salomon's training program and then became a bond salesman at Salomon Brothers in London. http://en.wikipedia.org/wiki/Salomon_Brothers