The Salomon Brothers Treasury Auction Scandal

John Macfarlane was Salomon Brothers’ treasurer when his firm became embroiled in scandal. Salomon’s traders had submitted unauthorized bids in the names of customers in US Treasury security auctions. Using customer names allowed the traders to purchase more securities than Treasury Department rules allowed. Salomon’s senior management learned about these violations, but failed to take timely action. John and his team were responsible for financing the firm during the ensuing crisis to prevent it from defaulting on its debt.

18 August 1991

Harvard Business School’s case study of the Salomon Brothers Treasury auction scandal begins with a picturesque vignette. It’s 18 August 1991, a Sunday afternoon, so the vast trading floor at Seven World Trade Center is empty of traders and salespeople. The last remnant of Hurricane Bob is pelting the windows with rain. Deryck Maughan and I are alone on the floor, waiting to be called to the boardroom to describe the effect of the prior nine days on our respective businesses. What the case study doesn’t describe is the extreme uncertainty under which we and our respective teams were operating.

Nine days earlier, senior management issued a press release admitting that the head of Salomon’s US Treasury Trading Department, Paul Mozer, had submitted unauthorized bids in the names of customers in three US Treasury security auctions. The purpose was to surreptitiously violate Treasury Department rules prohibiting any single entity from bidding for more than 35% of a new-issue Treasury security. He and Tom Murphy, who worked for Mozer as Treasury department manager, were trying to accumulate large positions in individual Treasury issues which might allow them to manipulate prices in their favor. Salomon suspended them both while investigating their actions further. Neither Deryck nor I knew if the investigation would find additional unauthorized bids or whether more employees were involved in the scheme.

Five days after the initial press release, a more fulsome press release contained the bombshell admission that Salomon’s three most senior executives had known about the unauthorized bids for five months. But in that time, Chairman and CEO John Gutfreund, President Thomas Strauss, and Vice Chairman John Meriwether had failed to act or inform authorities.

With knowledge of their complicity, the market punished Salomon’s stock on the next trading day and the Finance Department, which I managed, was inundated with customer requests to buy back our debt and terminate repurchase agreements (repos), which were the primary tool we used to fund our securities trading inventory. Initially, we purchased $700 million of our debt at prices discounted from par but, seeing that the discount was not an adequate deterrent to sellers, we suspended purchases. Furthermore, we were encountering reduced demand for our repos, which were fully secured and presented virtually no credit risk, indicating that the taint of senior management’s impropriety was enough to chase away customers, even if their transactions with us presented little or no risk of loss.

Deryck and I also did not know that the Federal Reserve had sent a letter to Gutfreund demanding a full accounting of Salomon’s Treasury auction violations. The Fed expected that letter to be conveyed to Salomon’s board of directors and, once received, the Fed expected the board to remove Salomon’s top management. But Gutfreund had not given the letter to Salomon’s board and Fed officials thought that the board was being defiant.

The events of the prior nine days had shaken my confidence in the ability of our balance sheet to withstand the storm, but not as much as the news I learned upon entering the boardroom. The US Treasury was considering barring Salomon from Treasury debt auctions. Meanwhile, the Federal Reserve Bank was considering removing our primary dealership status, which would eliminate our ability to participate in Fed open market operations. My advice to the board was that the former might be manageable, under certain conditions, but the latter would be fatal to the firm.

Mitigating my alarm was the news that the board had accepted the resignations of Gutfreund, Strauss, and Meriwether and that Warren Buffett, the Chairman of Berkshire Hathaway, Salomon’s largest stakeholder, had been appointed interim chairman. Clearly, Salomon’s clients, customers, and employees had lost confidence in senior management and Warren’s willingness to assume leadership was reassuring.

No doubt, Berkshire Hathaway’s $700 million ownership interest in Salomon incented Warren to try to save us and protect his investment. However, he made it clear he was not going to risk his reputation defending Salomon if it proved to be rotten to the core. If further investigations revealed that wrongdoing at Salomon was pervasive, Warren was prepared to walk away from Salomon. His commitment to a just outcome, at the risk of his financial interest, was evidenced by his pledge that outside counsel would conduct a thorough investigation of Salomon and report its findings to the Treasury Department. This was persuasive enough to earn a stay of execution from Treasury Secretary Nicholas Brady and Salomon was allowed, for now, to keep its primary dealership status. It could also continue to participate in US Treasury auctions for its own account, although not on behalf of customers.

At the conclusion of the board meeting, Warren congratulated Deryck on his appointment as Salomon’s Chief Operating Officer and took him to a press conference in the firm’s 300-person auditorium, filled to capacity with reporters and photographers, to announce the new leadership team.

It has been 30 years since those remarkable events and it seems appropriate now to share the story of the tumultuous days of 1991 and 1992 and the factors that influenced the eventual outcome. This is a story about the extraordinary leadership demonstrated by Salomon’s new management, co-workers who dutifully toiled tirelessly into the nights, and mentors who helped shape my career and character.

At Salomon Before the Treasury Auction Scandal

Graduating from the University of Virginia’s Darden School of Business with an MBA, I entered Salomon Brother’s Sales and Trading Training Program in July 1979 at the age of 25. After three months of classroom instruction and desk rotations, I joined the Finance Department, which was responsible both for the liability side of Salomon’s balance sheet and for managing matched books consisting of repos and reverse repos, i.e., collateralized loans.

The Finance Department had evolved just a few years earlier out of security clearing operations in the “back office,” affectionately known as “the cage.” The cage was literally a barred-in area like a jail cell where securities were received and distributed by foot messengers to other security firms located in lower Manhattan. Salomon’s traders would buy and sell securities and the securities would be received and dispatched until at the end of the day, those securities that remained, called “the box,” were added up. Then, cage personnel would call Bankers Trust or Manufacturers Hanover or Irving Trust (all those names have disappeared from the financial landscape through mergers) to finance the box at the broker loan rate.

By 1979, when I joined the Finance Department, Salomon had taken steps to lower its cost of funds by using repos to reduce its bank loan borrowings. Each repo was the legal and financial equivalent of a secured borrowing, backed by an individual security. The cash amount borrowed was less than the market value of the security by a small percentage of market value. The difference between the security’s market value and the loan amount was margin, commonly called “the haircut.” The size of the haircut was determined by the daily volatility of the underlying security. A Treasury bill might have a 0.5% haircut, whereas a Treasury bond might have a 2% haircut. Instead of borrowing at the broker loan rate, repo allowed Salomon to borrow at something closer to the Fed funds rate, which was considerably cheaper.

Salomon’s Finance Department also pioneered an innovation that made repo safer and more efficient for both lender and borrower: tri-party repo. Salomon established custody accounts at a third-party bank which held the securities on behalf of the lender and verified that the repos were properly collateralized. Instead of messengering securities back and forth with our repo counterparties, the securities stayed at the custody bank and the bank credited and debited the accounts of counterparties. The bank also made sure the transfer of securities was contemporaneous with the transfer of funds, reducing credit and operational risks.

When I started in the Finance Department, the mortgage market was growing and I worked closely with Lew Ranieri and the mortgage traders to repo US government agency debt; Ginnie Mae, Freddie Mac, and Fannie Mae securities; and then, ultimately, portfolios of un-securitized mortgage loans. From two early mentors, Mark Rein and Miles Slater, I learned about Fed policy and open market operations, about money market technicals, and about security inventory finance. Mark was Salomon’s Treasurer and Miles managed the Finance Department.

In early 1984, after we had worked together for three years, Miles approached me with a proposition: “John, there’s this interesting product called interest rate swaps that the investment bankers are doing on an agency basis.” He meant that Salomon’s bankers matched clients wanting to pay a fixed interest rate and receive a floating interest rate with other clients wanting the opposite payment stream. It was an awkward process, lining up both sides of the swap before either party could execute their half of the transaction. “The bankers are asking if we could position one side of the trade while they find the other side.” Miles meant the bankers wanted to execute one side of the trade and have us hedge its risk until the bankers found an off-setting swap counterparty.

It sounds laughably antiquated now, but back in 1984 there were no swap dealers standing by to instantly quote prices. There was no standardized swap documentation either; that was not created until 1987. The logical place to start positioning swaps was the Finance Department, because we knew how to hedge the long-term interest rate embedded in swaps. Activity grew and we spun the business out onto its own trading desk. Pat Dunlevy was recruited from Mortgage Sales to run the department and I ran the trading side while Tom Jasper, who was recruited from the investment bank, ran marketing. We hired Dan Ross from Cravath to manage the legal side of the business and Pat Kelly joined the sales team. Approximately two years later, Miles was promoted to run Salomon’s London operations and the firm asked me to return to the Finance Department to run my old department which, at the time, was a larger and more profitable business.

Back at the Finance Department, everything was going smoothly until one fateful day in October 1987. It was Columbus Day, a bank holiday, and our department was closed. I received an early morning call at home from a colleague who recommended I grab a Wall Street Journal and get into the office ASAP. According to the Journal, which I read on the Metro North express train to Grand Central Terminal, Salomon management had decided, over the preceding weekend, to exit the money market business, firing the departments which traded and sold corporate commercial paper and bank certificates of deposit. Management had also decided to exit the municipal bond business. The reason for the urgent trip was that senior management, in their infinite wisdom, had failed to realize the critical role the money market sales force played in distributing the Finance Department’s repos and the firm’s commercial paper.

Hope Woodhouse, who was Product Manager for the Finance Department, and I selected several of the top money market salespeople to pull from the firing list. Hope subsequently ran that sales team along with performing her duties as product manager for the department. She was an invaluable partner, both then and four years later when we dealt with another self-inflicted wound. That October 1987 day was an omen of senior management’s future missteps.

When our Treasurer, Mark Rein, tragically died in the terrorist bombing of Pan Am flight 103 over Lockerbie, Scotland, the firm asked me, at the age of 33, to assume the role of Treasurer while maintaining oversight of the Finance Department. A few months later, our CFO resigned and in June of 1988 senior management made one of their best decisions by hiring a gifted CFO, Don Howard, from Citibank. Don had multiple decades of experience running large balance sheets and, having lived through the volatility of the Volker Fed, taught me more than I would have learned over a lifetime on my own about the vicissitudes of corporate liquidity. He was a fountain of wisdom, and I will never forget him saying “John, the time to borrow money is when you can because when you need to, no one will lend to you.” No sooner had he taught me that valuable lesson, then Drexel Burnham defaulted for that very reason.

Over the subsequent two years, we took the lessons from Drexel’s default to heart and used our relatively strong earnings and balance sheet to extend the maturities of our unsecured borrowings via a medium-term note program and several underwritten long-term bond issues. We combined Don’s capital markets expertise with my swap and financing markets expertise to construct a portfolio of hedges, primarily consisting of interest rate swaps, converting our fixed-rate term debt to floating-rate obligations. The resulting net interest cost was Fed funds plus 5-10 basis points, which was marginally higher than our repo rate, but below the cost of the bank loans previously used to fund less-liquid, hard-to-repo trading inventory such as equities and corporate bonds. Securing long-term liquidity at that time proved invaluable in the 1991 crisis.

The late 1980s and early 90s were Salomon’s heyday. We expanded internationally and exported financial technologies we had developed, such as OTC derivatives and asset securitization, to Asia and Europe. Our proprietary trading, run by John Meriwether until his 1991 resignation, did business from New York, London, and Tokyo. Our banking and equity businesses were also growing and the number of employees increased from 2,300 in 1981 to 9,000 in 1991. Our balance sheet grew to $150 billion, seemingly small today but, at the time, a giant in the industry.

Managing Through the 1991 Crisis

Our customers and creditors were outraged by the falsification of Treasury auction bids and the coverup by the firm’s most senior executives. Many firms stopped doing business with us. Embarrassingly, California Public Employees Retirement System (CALPERS), Pacific Investment Management Company (PIMCO), and the World Bank announced their decisions to stop dealing with us publicly. The British Treasury dropped our bankers from a public offering of British Telecommunications equity. There was a risk that Salomon would be criminally charged. If we were charged, we knew we would not be able to roll our unsecured debt. In fact, counterparties were already reluctant to execute repos with us, and demanded an increased haircut and higher interest rate as compensation for the perceived risk.

In late August 1991, we faced the maturity by yearend of $7.9 billion of commercial paper and $3.7 billion of other short-term unsecured obligations. Hope Woodhouse, along with Finance Department Head of Trading Gordon Tanner, Assistant Treasurer Jeff Smith, and I worked with our sales force to develop new repo structures for securities that had not before been financed via repos, such as Japanese government bonds.

During the first two months of the crisis, we made multiple presentations to a standing-room-only audience of our bankers, debt holders, and other creditors in Salomon’s auditorium. Typically, Warren would provide a corporate overview, Deryck would review business developments, Don would discuss financial performance, and I would discuss liquidity management and our funding plan, walking through our schedule of debt maturities.

Jeff, who had developed the trust of our commercial bankers over multiple decades of managing relationships, and I spent a lot of time holding hands, talking to note holders, talking to commercial paper holders and to our other creditors. Many called saying, “You need to buy back your commercial paper from us.” Of course, we did not have the liquidity to accelerate the maturity of all our unsecured debt. But we did have enough liquidity to retire a modest amount and we rationed our repurchases by applying significant discounts to par, even for one- and two-month obligations. Once presented with the economics of an expeditious sale, most investors decided to hold on, but there were those who accepted our offer and appreciated our accommodation.

We also reduced the balance sheet. The fairest, easiest, and most effective tool was to increase the internal rate the Finance Department charged each trader for the unsecured capital required to fund his positions. This had less of an effect on US Treasury traders because 98.0% to 99.5% of their funding cost was at the secured repo rate, which had not changed materially, and the remaining 0.5% to 2.0% was at the unsecured rate which went up by 400 basis points, adding between 2 bp and 8 bp to their overall cost. However, for certain mortgage, corporate bond, and equity securities that required higher repo margin, or for securities we could not fund with repo agreements, the cost was significantly higher, in some cases 200 bp to 400 bp higher.

This forced traders to sell positions on which profitability was eroded by the higher financing charge. It was an even-handed and objective way to apply the same economic pressure throughout the firm, without going from trader to trader to negotiate reductions. In certain instances, where traders were not responding to the increased cost, the firm’s Asset/Liability Management Committee mandated a selective culling of positions, often to the chagrin of our equity traders. As a result of these initiatives, we shrank the balance sheet from $150 billion in mid-August to $97 billion by 30 September 1991.

Over the last four months of 1991, Hope, Jeff, Gordon, and I worked so closely together we could finish each other’s sentences. We met every day at the market’s open and close, the second meeting often extending late into the evening, to review our strategies. I am indebted to their professionalism, creativity, and commitment as well as that of the teams of people who worked with us. Many in our sales force were able to preserve a core of loyal clients who stayed with the firm when it was unpopular to do so. As I think about those clients who stayed and those who fled, the common denominator among the former was their tenure of business with Salomon and the extent to which they had spent time getting to know our salespeople and traders.

Through those early months of the crisis, I did not go home during the week, instead spending nights near our 7 World Trade Center offices at the Downtown Athletic Club. Often leaving the office at midnight, after strings of calls with our Asian clients, I would rise at 5 am and jump in the club’s pool for 2,500 head-clearing yards of freestyle before showering and walking to the office at 7 am. My route took me past the Marriott Hotel in the World Trade Center complex and several times Warren would exit as I walked by and we would share the three-block walk talking about a wide range of topics. Those morning strolls produced some of my fondest memories of the crisis.

Warren was perhaps the only person who could have successfully led Salomon through the scandal. His credibility, his track record of success, his pursuit of the truth, and his remarkable business insights gave employees and our clients confidence that the firm was being managed in an ethical and prudent manner. He also had a keen eye for talent, having hired Bob Denham, who was, at the time, Managing Partner of the Los Angeles-based law firm, Munger, Tolles. Initially, Bob replaced chief legal officer Donald Feuerstein, who was forced to resign because of his role in the Treasury auction cover-up. Later, Bob became Salomon’s Chairman when Warren returned to Berkshire Hathaway and Omaha, Nebraska, after resolution of the crisis. Bob was one of the smartest people I have ever worked with and a source of great counsel throughout the crisis and after.

Gradually, Salomon’s prospects improved and so did our funding outlook. By January 1992, we could issue small amounts of commercial paper and medium-term notes, although at significant premiums. Most of our repo counterparties returned to transact at normal haircuts and interest rates.

In May 1992, just nine months after the auction bidding violations became public, Salomon settled with various regulatory and law enforcement agencies, agreeing to pay $290 million in fines and restitution. Nine months was a remarkably short period of time to negotiate a settlement with seven law enforcement and regulatory entities, ranging from the US Treasury Department to the New York Stock Exchange. By contrast, the probe of Drexel had lasted two-and-a-half years. Achieving that quick settlement was a tribute to Warren and Bob and to the unique approach they took to accelerate the process. Notably, they waived attorney-client privilege, which facilitated regulatory discovery and underscored their commitment to avoid any attempt to cover up additional wrong-doing. In the end, there were no material findings beyond those announced in August 1991 and no criminal charges against Salomon were filed.

In Virginia

I mentioned the events at Salomon Brothers that prepared me, as well as one could be prepared, for the Treasury auction scandal. But as the years have passed, I realize how my life before Salomon also influenced and prepared me.

I grew up in Southwestern Virginia in the blue-collar railroad town of Roanoke, went to public schools, and then to Hampden-Sydney College, an all-male liberal arts college in Virginia, founded in 1775. The total enrollment was 600 at the time. At the beginning of every year, we publicly signed the school’s honor code and code of conduct. “I will behave as a gentleman at all times and in all places.” “I will not lie, cheat, or steal, nor tolerate those who do.” The student-run Honor Court reinforced the lessons of responsible citizenship.

Inspired by my professors Wayne Tucker, Graves Thompson, and John Brinkley, I majored in classics, studying Latin, philosophy, and history, and was impressed by the Roman stoics. During summers I returned to Roanoke to work for a local construction company. The most challenging summer was spent behind a road paving machine, spreading asphalt. It was hot and physically demanding work, but the learnings from my coworkers, most of whom were minorities, taught me the narrowness of my perspective and trained me to seek diverse opinions in the evolution of my worldview.

At Hampden-Sydney, I was awarded a scholarship in my sophomore year from the George F. Baker Trust that paid full college tuition and would pay for graduate business school, if I was accepted. So, at the urging of my then fiancé and now wife of 45 years, Dudley Wood, I applied to the University of Virginia’s Darden School of Business. To pay for what the scholarship did not, I worked for one year between college and Darden at the construction company. That year I also took accounting courses at a local community college in order to help fill the gap between my classics education and the experience of my prospective Darden classmates, most of whom had business degrees and/or four-plus years of banking experience.

By the end of my first year at Darden, I knew I wanted to work in finance, ideally with a New York investment bank. My thesis adviser, Ray Smith, encouraged me to study a capital markets topic so I wrote a case about the initial public offering of a Virginia-based convenience store chain. It helped me get an interview at Salomon and, shortly thereafter, I was offered a job.

Nothing had a more profound effect on my life’s path than the intensive commitment to character of my parents, Granger and Anne, who rarely had time or interest in lecturing, but instead taught through their service to the community. Dad served in the Virginia State Senate and was often ridiculed by establishment politicians and local power brokers for his apolitical approach. Witnessing his courage to speak his mind gave me the backbone to do the same, several years later. Had I not observed the long-term effectiveness of his approach, albeit often with short-term adverse consequences, I might not have had the courage to tell Paul Mozer “No” when, in May 1991, he asked me to fund an unusually large Treasury position that I knew was on the edge of propriety. I immediately reported his request to Salomon’s Assistant General Counsel, Zack Snow, and to our boss, John Meriwether. Thankfully, my recommendation to Merriweather to not provide the funding Mozer requested was accepted.

Two and half months passed until the full extent of Mozer’s schemes were exposed. It was then I learned that, had I not taken my action, I would have been accused of abetting Mozer and extending his scheme to the manipulation of the Treasury repo and reverse repo markets. I would likely have been among the senior management casualties of August 1991. It was my father’s apolitical example, along with a patchwork of other learnings, from Eagle Scouts, Hampden-Sydney, working summers side-by-side with my “asphalt brothers,” and having wonderful mentors that prepared me for a career at Salomon and beyond.

In Berkshire Hathaway’s 1992 annual report to shareholders, Warren Buffett wrote “Many people helped in the resolution of Salomon’s problems and the righting of the firm, but a few clearly deserve special mention. It is no exaggeration to say that without the combined efforts of Salomon executives Deryck Maughan, Bob Denham, Don Howard and John Macfarlane, the firm very probably would not have survived. In their work, these men were tireless, effective, supportive and selfless, and I will forever be grateful to them.”

John left Salomon in January 1998 to join Tudor Investment Corporation as Partner and Chief Operating Officer, where he worked until 2011. Today, he is managing member of Arrochar Management LLC and serves or has served on several for-profit and not-for-profit boards, including the University of Virginia Board of Visitors, the University of Virginia Darden School, the University of Virginia Investment Management Company, Hampden-Sydney College, Brunswick School, Nantucket Conservation Foundation, the US Olympic and Paralympic Foundation, and the Foreign Policy Council at Brookings.

To comment on a story or offer a story of your own, email Doug.Lucas@Stories.Finance

Copyright © 2022 John Macfarlane. All rights reserved. Used here with permission. Short excerpts may be republished if Stories.Finance is credited or linked.