As an auction neared, the primary dealers would work the phones, polling customers to gauge their appetite for bonds. Mozer’s sense of how hot the market was running translated into Salomon’s bid. A few seconds before the clock struck one p.m. on the appointed day, the dealers phoned “runners,” who stood by a wall of phones at the Federal Reserve Building downtown, waiting to scribble down orders by hand and dash to the Fed clerk’s wooden box, where they jammed them inside. At the stroke of one p.m., the clerk placed his hand over the slot. That ended the auction. The government had used this antiquated system for decades.
The inherent tension of the market lay in the opposing interests of the Treasury and the dealers regarding pricing and amounts. The Treasury auctioned only a certain amount of bonds and wanted the highest price, while the dealers wanted to pay just enough in the auction to win a larger share than anyone else yet no more than necessary, for that would hurt their profit on resale. So finely calibrated were these bids that the traders used increments of 1/1,000th of a dollar. That sounds like almost nothing, but clipping off 1/1,000th of enough dollars amounted to a fortune. On $100 million, it was worth $100,000. On a billion dollars, it was worth $1 million. Because government bonds were less profitable than mortgages and corporate bonds, Treasury bonds had to be traded in blocks this size in order for the dealers and money managers to make enough money for it to be worth their while.
Dovetailing with the need for such large trades was the government’s need to work with large dealers—those who knew the market well and had the power to distribute a lot of bonds. Salomon was the largest dealer by far. In the early 1980s, the Treasury had allowed any individual firm to buy up to half of a given bond issue for its own account. Salomon commonly “couped” an auction this way, then held on to the bonds long enough to “squeeze” anybody who was “short” Treasuries—having bet that prices would fall—because there were no bonds available for short-sellers to buy to cover their positions. Prices shot up, the short-sellers screamed, the trading floor erupted in cheers, and Salomon gloated over its huge profits and swung a big stick as the King of Wall Street. Couping the auctions fattened the usually thin profits on government bonds and sent a heady mist of testosterone drifting above the formerly stodgy section where the humdrum government-bond traders sat at their desks.
In response to grumbling, the Treasury lowered the limit and said no individual dealer could buy more than thirty-five percent, which made it harder to coup the auction. Smaller squeezes still occurred, but Salomon no longer owned the market unchallenged. Naturally, the new rule was unpopular at Salomon. Since the total of bids exceeded all the bonds on offer, the Treasury also prorated everyone, which meant a firm that wanted thirty-five percent had to bid more than thirty-five percent, a juggling act.
Thus in various ways the clampdown made it harder to profit at the government desk at Salomon. The mist of testosterone did not dissipate, however. Mozer tested the Treasury’s patience twice in 1990, bidding more than one hundred percent of all the bonds to be issued. Michael Basham, who ran the auctions, told him not to do it again. Mozer was sent to an “apology breakfast” with Bob Glauber, an undersecretary of the Treasury. He squeaked out some words but did not exactly apologize. He claimed that overbidding was in the government’s best interest because it increased demand for bonds.9 Not mollified, Basham changed the rules so that no individual firm could even bid more than thirty-five percent for its own account. The limit on bids meant Salomon might not even get its full thirty-five percent limit of bonds.
Now Feuerstein read Buffett a copy of a Salomon press release to be issued the next morning, which was being explained to all board members that night. It described how Mozer had responded to this stare-down with Basham. He had proceeded to submit unauthorized bids in excess of the government’s bidding limit in the December 1990 and February 1991 auctions.
Feuerstein gave Buffett a scripted version of events and told him that he had already spoken at length with Munger, who was at his cabin in Minnesota.10 Munger had said to him something about thumb-sucking and added, “People do that all the time.”11 Buffett recognized the term “thumb-sucking” as a Mungerism for procrastination but wasn’t terribly concerned. Feuerstein did not mention anything else discussed in the lengthy conversation with Munger, and Buffett did not ponder whose thumb was being sucked. Seven or eight minutes later he got off the phone, recognizing that this wasn’t the good news for which he had been hoping but not feeling alarmed enough to call Munger immediately. He’d check in with Munger over the weekend, he decided, but for now he was going to enjoy Lake Tahoe. Then he wandered back to join Astrid and the Blumkins in the dining room, where they were having a steak before seeing Joan Rivers and Neil Sedaka perform.
While Buffett was watching the show, John Gutfreund’s plane from London finally landed. Gutfreund, Strauss, and Feuerstein had a conversation late that evening with Richard Breeden and Bill McLucas, top officials at the SEC. The three of them also placed a call to Gerald Corrigan, the beefy six-foot-four president of the New York branch of the Federal Reserve.
Using a different set of talking papers, Gutfreund and Strauss told Breeden, McLucas, and Corrigan more of the story than Salomon’s board had just heard. Mozer had not just overbid. To get around the thirty-five percent limit, at the February 1991 Treasury auction he had entered a fake bid in the name of a customer and stashed the bonds he got in Salomon’s account. In fact, he had placed more than one false bid in that auction. As to why these had not been reported earlier, they explained the delay as an oversight. Yet the SEC and the Treasury were in the midst of investigating Mozer, for he had pulled a huge squeeze in the May two-year-note auction. His actions were under intense scrutiny by regulators. That should have been true at Salomon as well. How could the delay have been an oversight? Now, the regulators had to consider whether this confession indicated some major systemic problem at Salomon.
No matter what, these admissions were going to be highly embarrassing to the Treasury and the Federal Reserve. Corrigan was shocked that the firm had not come to him saying that it had already fired Mozer and created a remedial program that involved instituting all sorts of new controls. But he expected something like that to be announced within twenty-four or forty-eight hours, after which he could “keep them on probation for a while and hope that would be the end of it.” He told Gutfreund and Strauss, “patiently and dispassionately,” as he recalls, that they had an immediate obligation to release this information to the public. Based on what he knew, he surmised that the incident could blow up into a “very, very, very significant problem.”12 It seemed to him, however, that Strauss and Gutfreund did not fully grasp this. Indeed, with hindsight, the fact that Gutfreund had gone off to London, thus placing his ability to participate in the calls with Buffett, Munger, and the other directors in the hands of an airline, was itself a telling sign.
The next day, Friday, August 9, Buffett was enjoying himself with Astrid and the Blumkins, walking along the board sidewalks of Virginia City, the old Western gold-rush town. He called in to his office. Nothing urgent was happening. Nobody at Salomon had called him. Salomon had put out the press release describing the events in fairly bland terms. The stock had fallen five percent, however, to $34.75.
Buffett called Munger on Saturday at his cabin on Star Island in Minnesota. Munger flatly told him a much more detailed and alarming story. Feuerstein, reciting from the list of “talking points,” had said that “one part of the problem has been known since last April.” While these same words had been read to the other directors, including Buffett, they had the effect of technically informing without really enlightening.13 But Munger picked up instantly on bullshit legalese and the passive voice, which irritated him. What did that mean, “has been known”? What exactly had been known? And by whom?14 When pressed, Feuerstein gave Munger a much fuller description of events, similar to what Corrigan had been told.15
As Feuerstein recounted, Mozer had gotten a le
tter from the Treasury Department in April saying they were investigating one of his bids.16 Realizing that the game was up, on April 25 he had gone to his boss, John Meriwether, and made a confession of sorts. In February, to get around the thirty-five percent limit, he had not only bid in Salomon’s name, he had also submitted phony bids under real customers’ names.17 Mozer swore to Meriwether that this was the only time, and he would never do it again.
Meriwether had recognized immediately that this was “career-threatening,” had said so to Mozer, and had reported the situation to Feuerstein and Strauss. On April 29, the three of them went to Gutfreund and told him what Mozer had confessed. Gutfreund, they said later, had been red-faced and pissed off when he heard the news.
Therefore, in April, Gutfreund knew. Strauss knew. Meriwether knew. Feuerstein, the general counsel, knew. They all knew.
Feuerstein had informed Gutfreund at the time that Mozer’s actions appeared criminal. He didn’t believe that the firm technically had a legal reporting requirement. Still, Feuerstein was sure that Salomon would run seriously afoul of the regulators if it didn’t do something, and therefore the Federal Reserve must be told. Gutfreund said it would be taken care of. Curiously, however, no specific plans were made to march down to the Federal Reserve’s ornate Italianate building and give Jerry Corrigan the news. Moreover, having concluded that the phony bid was a “one-time, aberrant act,” they had decided to leave Mozer in charge of the government desk. Hearing this, “Well, that’s just thumb-sucking,” Munger had said. “People do that all the time.” He later explained that by thumb-sucking he meant “sitting there thinking and doggling, musing, and consulting, when you should be acting.”18
Munger told Buffett that he had challenged the press release: Shouldn’t management’s prior knowledge be disclosed? Feuerstein said that, yes, it should be, but the decision had been made not to because Salomon’s management thought that disclosure would threaten the company’s funding. Salomon had tens of billions of short-term commercial paper debt that rolled over day by day. If the word got out, lenders would refuse to renew. To Munger, “funding difficulties” was shorthand for “financial panic.”19 Lacking the leverage to insist, he had given in, but he and Buffett now agreed that more disclosure was required. They mentally braced themselves for what would follow.
Two days later, on Monday morning, August 12, the Wall Street Journal reported the alleged details, with a blaring headline: “The Big Squeeze: Salomon’s Admission of T-Note Infractions Gives Market a Jolt—Firm’s Share of One Auction May Have Reached 85%; Investigations Under Way—How Much Did Bosses Know?” It mentioned the possibility of “civil charges of market manipulation, violations of the antifraud provisions of securities law, misrepresentations to federal authorities,” “books and records violations,” and “criminal charges” for committing “both wire and mail fraud.”20
Gutfreund called Buffett, sounding calm. Buffett thought that he seemed to believe the whole situation meant “a few points on the stock.” In light of the disastrous article, Buffett thought this attitude was unrealistic, a sign that Gutfreund believed the whole affair could somehow be finessed.21 It seemed of a piece with Gutfreund’s unwarranted composure the previous week. Buffett pressed for more disclosure. Salomon’s treasury division was beginning to have trouble rolling over its commercial paper, meaning the firm’s lenders were starting to show signs of nervousness.22
Meanwhile, Munger was trying to get in touch with Wachtell, Lipton’s Marty Lipton, who was John Gutfreund’s indispensable best friend as well as Salomon’s outside counsel. So entwined with Salomon was Lipton that the speed-dial buttons on Donald Feuerstein’s phone rang his wife, the Sotheby’s and Christie’s auction houses, and Marty Lipton, not necessarily in that order.23 Munger knew that Lipton and his telephone were as inseparable as Buffett and his Wall Street Journal. Cell phones still being so rare, however, that even name partners of major law firms did not use them, Munger relied on Wachtell, Lipton’s office, which, he would later observe to the SEC, had the “finest phone system for reaching Marty Lipton at any hour of the day or night that I have ever seen in the history of the world…. I think even if he was engaged in sexual intercourse, you could get through to him.”24
Whether Lipton was horizontal when reached by Munger was never specified, but Munger badgered him for a follow-up press release, saying the first had been inadequate. Lipton agreed that the board would hold a telephone meeting to discuss it on Wednesday.
Not surprisingly, Jerry Corrigan at the Federal Reserve was even less satisfied than Munger with Salomon’s muted response. On Monday, August 12, he decided to have Peter Sternlight, one of his executive vice presidents, draft a letter to Salomon Inc. stating that the firm’s actions had called into question its “continuing business relationship” with the Fed, which was “deeply troubled” by the failure to make a timely disclosure of what the firm had learned. Salomon would have ten days to report on all “irregularities, violations, and oversights” that it had discovered.
In light of Corrigan’s earlier conversation with Strauss and Gutfreund, this letter would be a death threat. If the Fed cut off Salomon’s business relationship with the government, customers and lenders would desert in droves. The consequences would be huge and immediate.
Salomon had the United States’ second-largest balance sheet—larger than Merrill Lynch, Bank of America, or American Express. Nearly all of its loans consisted of short-term debt that was callable by lenders in days or at most weeks. Only $4 billion of equity supported $146 billion of debt. Dangling off the side of the balance sheet on any given day were tens more billions, perhaps as many as $50 billion a day, of uncleared trades—transactions executed, but not yet settled. These would stall midair. Salomon also had many hundreds of billions of derivative obligations not recorded anywhere on its balance sheet—interest-rate swaps, foreign-exchange swaps, futures contracts—a massive and intricate daisy chain of obligations with counterparties all over the world, many of whom in turn had other interrelated contracts outstanding, all part of a vast entangled global financial web. If the funding disappeared, Salomon’s assets had to be sold—but while the funding could disappear in a few days, the assets would take time to liquidate. The government had no national policy to provide loans to teetering investment banks because they were “too big to fail.” The firm could melt into a puddle overnight.25
Corrigan sat back in his chair, confident that once Salomon received Sternlight’s letter, management would understand the loaded gun cocked at its head, and would respond accordingly.
Within Salomon, after the press release and the Wall Street Journal story, rumors were running wild. Late Monday afternoon, it held an all-hands-on-deck meeting in its huge auditorium on its lowest floor. Nearly five hundred people crowded in, while hundreds, maybe more, from upstairs and from Salomon offices around the world, watched on television screens. Gutfreund and Strauss walked the audience through a baked-Alaska version of events, a crisp well-done meringue of a surface that hid the chilly surprise. Afterward, Bill McIntosh, the head of the bond department, was summoned upstairs to Gutfreund’s office, where he found Gutfreund, Strauss, and Marty Lipton, “three very scared men.” Earlier in the day he had been calling for Gutfreund’s head, but unexpectedly, they asked what he thought of the situation. McIntosh demanded more explanation; he felt the all-hands version and the press release had been misleading.26 He and assistant general counsel Zach Snow ended up getting drafted to write another press release.
The next morning, McIntosh and Snow began drafting. Around midday, McIntosh went to tell Deryck Maughan, the vice chairman of investment banking, who had just come back from running the firm’s Asian operations, what was going on. Maughan knew he was hearing the harbinger of a disaster. He went to find Snow and pounced on him, saying you’d better be telling the whole truth to a vice chairman.
But Snow had no intention of hiding anything from Maughan. He started talking, and a tale unfolded
of what had transpired behind the scenes. He explained that in April, after Mozer made his first confession about the February auction, Meriwether had pleaded that Mozer not be fired, even though Feuerstein had said he believed Mozer’s actions were criminal in nature. Snow had been told—in confidence—about the situation. A month later, Mozer still ran the government desk; Feuerstein was nagging Gutfreund to come clean; Gutfreund was telling him that he would. But in fact no one had told the government. Meanwhile, Meriwether was charged with keeping an eye on Mozer, who had supposedly reformed.
Then Mozer had asked for funding to bid on more than one hundred percent of the two-year-note auction in late May. Even though some of the funding was supposedly to put in bids for customers, John Macfarlane, Salomon’s treasurer, had become alarmed. He thought it an obvious red flag and called a meeting with Snow and Meriwether. Snow had gone to Feuerstein, his boss, who agreed that it was an outrageous request. They had decided not to give Mozer the funds.27
But Mozer had secretly juggled the bids and money anyway.28 Managing to evade his overseers, he put in one suspicious bid and pulled off an enormous auction coup. Salomon wound up with eighty-seven percent of the Treasury bonds, and it and a small group of customers controlled the two-year notes afterward. The price shot up.29 Others’ losses from the “squeeze” topped $100 million, and several small firms suffered so severely that they filed for bankruptcy.30
Within Salomon, the squeeze had caused considerable angst. In the press, the firm was painted by its competitors as the pirate of Wall Street. The board members, including Buffett, had expressed outrage at a meeting that Salomon had cornered the market for two-year notes. Feuerstein had had Snow commence an internal investigation of the squeeze in June. As it turned out, Mozer had held a dinner with two hedge-fund customers right before the auction, and these customers had placed bids involved in the squeeze. With hindsight, the dinner pointed to possible collusion and market manipulation. But in the absence of proof, Mozer explained it away.31 Gutfreund had set up a meeting to see his overlords at the Treasury and the Fed to mend fences over the squeeze. When he went to see Glauber in mid-June, he sat on the sofa puffing a cigar. He offered a mea culpa to Glauber for the aftereffects of the squeeze and offered to cooperate with the Treasury—but defended Mozer against allegations of intentionally rigging the May auction. And he made no mention of what else he knew, leaving out anything about Mozer’s false bids in the earlier auction. In response to the squeeze and to the earlier run-ins with Mozer, however, unbeknownst to anyone at Salomon, the SEC and the Antitrust Division of the Justice Department began investigating the firm anyway.
The Snowball Page 74