The Snowball

by Alice Schroeder

  6. The Standard & Poor’s 500 index was used as a proxy for the market.

  7. Bertie would never make this bet. Since childhood, Warren had beaten her at every game they ever played; never once had he let her win. She would have known that he would eat a potato chip just so she would have had to pay up.

  8. Letter from Warren E. Buffett to the Honorable John Dingell, U.S. House of Representatives, March 5, 1982.

  9. In the interest of brevity, the history of portfolio insurance has been shortened considerably. The rout began as the Federal Reserve raised the discount rate over Labor Day weekend 1987. Over the next month, the market wavered and showed signs that investors were nervous. On October 6, the Dow broke a one-day record when it fell 91.55 points. Interest rates continued to climb. The Dow dropped another 108 points on Friday, October 16. Professional money managers spent the weekend pondering. On Black Monday, October 19, many stocks failed to open at all in the early hours of trading and the Dow fell a record-breaking 508 points. The exact cause of the crash remains in dispute. Program trading and equity index futures accelerated the decline, but economic factors, military tensions, comments by Federal Reserve Chairman Alan Greenspan about the dollar, a slowing economy, and other factors have been blamed.

  10. Interviews with Ed Anderson, Bill and Ruth Scott, Marshall Weinberg, Fred Stanback, Tom Knapp.

  11. Interview with Walter Scott Jr.

  12. In this case, the way to be hedged would be to short a broad group or index of stocks.

  13. This account is based on both Doris’s and Warren’s versions of the story.

  14. James Sterngold, “Too Far, Too Fast: Salomon Brothers’ John Gutfreund,” New York Times, January 10, 1988.

  15. Salomon supplied its clients’ debt needs along all points of the maturity ladder. For a bond shop to eliminate its commercial paper department was a baffling decision.

  16. Four past option grants to Gutfreund were about to expire worthless and a fifth would have yielded only a trivial gain. The revised exercise price reaped Gutfreund an estimated $3 million. The impact of swapping all stock options for new options affected 2.9% of outstanding shares. Salomon’s 1987 proxy did not disclose the repricing and instead contained an additional $4.5 million or 3.4% stock-option grant (Graef Crystal, “The Bad Seed,” Financial World, October 15, 1991).

  17. Interview with Bob Zeller.

  18. Ibid. Zeller says that Buffett represented the shareholders’ interests on the compensation committee with integrity, while trying to determine which employees genuinely deserved reward.

  19. John Taylor, “Hard to Be Rich: The Rise and Wobble of the Gutfreunds,” New York, January 11, 1988.

  20. Interviews with John Gutfreund, Gedale Horowitz.

  21. Interview with Tom Strauss.

  22. While technically the terms of the preferred stock didn’t work that way, if Buffett wanted to, he could have found a way to get out.

  23. Carol Loomis, “The Inside Story of Warren Buffett,” Fortune, April 11, 1988. Buffett stated these rumors were false in the article.

  24. Katharine Graham letter to the members of the Buffett Group, December 14, 1987. She added a personal note to Warren’s copy: “Here is what I sent out. Hope it is ok and I don’t get lynched.”

  25. Investors use different periods to estimate cash flows—from ten years to forever (“perpetuity”)—as well as different interest rates. Buffett’s margin of safety, however, was big enough to essentially eliminate the differences in methods; his view was that debating such precision mattered less than applying a big haircut. The key assumption is what growth rate the business is assumed to have—and for how long.

  26. Robert L. Rose, “We Should All Have an Audience This Receptive Once in Our Lives,” Wall Street Journal, May 25, 1988.

  27. Or 14,172,500 KO shares costing $593 million at an average price of $41.81 (or $5.23 split adjusted for the three 2-for-1 stock splits that occurred between 1988 and 2007). All shares and prices are adjusted for subsequent stock splits.

  28. Interview with Walter Schloss.

  29. At that point, KO’s market value represented 21% of the total market capitalization of Berkshire Hathaway—by far the biggest bet, in dollar terms, that Buffett had ever made on a single stock. Yet in percentage terms, this fit his past pattern.

  30. Interview with Howie Buffett.

  31. Michael Lewis, Liar’s Poker: Rising Through the Wreckage on Wall Street. New York: W. W. Norton, 1989.

  32. BRK received a 9.25% coupon from the Champion preferred, above the going rate of 7%, and raised debt at 5.5% to fund this $300 million purchase. Champion called the preferred early, but Berkshire was able to convert its shares prior to the call and sell them back to the company at a small discount. Berkshire booked a 19% after-tax capital gain over the six years it held Champion.

  33. Linda Sandler, “Heard on the Street: Buffett’s Special Role Lands Him Deals Other Holders Can’t Get,” Wall Street Journal, August 14, 1989.

  34. From an interview with a friend who said this to Munger.

  35. Speech at Terry College of Business, the University of Georgia, July 2001.

  36. Interview with John Macfarlane.

  37. Interview with Paula Orlowski Blair; Michael Lewis, Liar’s Poker.

  38. Many contracts required posting of collateral or margin, but this did not compensate for the risk of mismarking in the model.

  39. Buffett and Munger, 1999 Berkshire Hathaway annual shareholder meeting.

  40. Salomon held on for eight years. Phibro sold its share in the JV in 1998. Alan A. Block, “Reflections on resource expropriation and capital flight in the Confederation,” Crime, Law and Social Change, October 2003.

  41. Roger Lowenstein, When Genius Failed: The Rise and Fall of Long-Term Capital Management. New York: Random House, 2000.

  42. Interview with Eric Rosenfeld.

  43. Meriwether characteristically exempted himself from this lucrative deal.

  44. Report to the Salomon Inc. Compensation & Employee Benefits Committee, “Securities Segment Proposed 1990, Compensation for Current Managing Directors.”

  45. This pay deal was still one-sided; the arbs could only break even or win. Buffett’s partnership had exposed him to unlimited liability to share in losses if he performed poorly—i.e., his incentives were truly aligned with his partners.

  46. Michael Siconolfi, “These Days, Biggest Paychecks on Wall Street Don’t Go to Chiefs,” Wall Street Journal, March 26, 1991.

  47. Interview with Deryck Maughan.

  48. Using different terms. The casino/restaurant analogy was Buffett’s. Even if the customer businesses had become profitable, they would have demanded even larger amounts of capital in later years, despite bigger scale and market share, and it is questionable whether their returns would ever have satisfied Buffett.

  49. Interview with Eric Rosenfeld.

  Chapter 48

  1. Michael Lewis, Liar’s Poker: Rising Through the Wreckage on Wall Street. New York: W. W. Norton, 1989.

  2. Feuerstein had worked in several senior roles at the SEC, including acting as counsel on Texas Gulf Sulfur, a landmark insider-trading case.

  3. Interview with Donald Feuerstein and many others, who confirmed his role and the POD nickname.

  4. Interviews with Donald Feuerstein, Tom Strauss, Deryck Maughan, Bill McIntosh, John Macfarlane, Zach Snow, Eric Rosenfeld.

  5. Interview with Bill McIntosh.

  6. Interview with John Macfarlane.

  7. Roger Lowenstein, Buffett: The Making of an American Capitalist. New York: Doubleday, 1996, quoting Eric Rosenfeld.

  8. Lowenstein, Buffett, quoting John McDonough.

  9. Interview with Eric Rosenfeld.

  10. Interview with Donald Feuerstein.

  11. Feuerstein went back into the conference room after talking to Munger and repeated the “thumb-sucking” comment to another lawyer, Zach Snow, without further context. He did not seem to have grasped its significance
, according to Snow in an interview. Feuerstein says Munger said, “Warren and I do that all the time.” Whatever the wording, neither Feuerstein nor Buffett took alarm at Munger’s remark.

  12. Interview with Gerald Corrigan.

  13. Feuerstein had had breakfast with one director, Gedale Horowitz, and told him much the same story, slightly more informatively, on the morning of August 8. But Horowitz says he also felt misled.

  14. Carol Loomis, “Warren Buffett’s Wild Ride at Salomon,” Fortune, October 27, 1997.

  15. Munger’s later statement that he dragged this out of Feuerstein differs from Feuerstein’s recollection. Both agree that Munger was given a clear description. There is no question that Buffett and Munger’s overall interpretation of the actions of both Feuerstein and Gutfreund grew harsher as more information came to light.

  16. Statement of Salomon Inc., submitted in conjunction with the Testimony of Warren E. Buffett, Chairman and CEO of Salomon, before the Securities Subcommittee, Committee of Banking, Housing and Urban Affairs, U.S. Senate, September 10, 1991.

  17. Mercury Asset Management (an affiliate of S.G. Warburg) and the Quantum Fund. When the Federal Reserve contacted Salomon, it was initially because S.G. Warburg had bid in its own name as a primary dealer (Statement of Salomon Inc., September 10, 1991).

  18. Charles T. Munger testimony before U.S. Securities & Exchange Commission, “In the Matter of Certain Treasury Notes and Other Government Securities,” File No. HO-2513, February 6, 1992.

  19. Ibid.

  20. Michael Siconolfi, Constance Mitchell, Tom Herman, Michael R. Sesit, David Wessel, “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?” Wall Street Journal, August 12, 1991.

  21. Buffett later said Wachtell, Lipton shared some blame, noting that Wachtell declared effective on August 8 a shelf registration for $5 billion of medium-term notes using a prospectus that was “purporting to state all material facts about Salomon” as of that date but contained no reference to Mozer’s activities or management’s inaction. “If this relaxed position was one that Wachtell, Lipton was conveying to the government and the public through official filings, it is not unlikely that they were conveying something similar to John, although I don’t know what,” Buffett said.

  22. Interview with John Macfarlane.

  23. Interview with Bob Denham, who discovered this when he moved into Feuerstein’s old office.

  24. Charles T. Munger testimony before U.S. Securities & Exchange Commission, “In the Matter of Certain Treasury Notes and Other Government Securities,” File No. HO-2513, February 6, 1992.

  25. If its lenders failed to renew the firm’s loans, Salomon would be forced to liquidate its assets almost overnight. In such a fire sale, assets would sell for a fraction of their carrying value. The apparently invincible balance sheet of Salomon would melt into bankruptcy’s black hole immediately.

  26. Interview with Bill McIntosh.

  27. Interviews with Donald Feuerstein, John Macfarlane.

  28. Mozer didn’t report an existing net “long,” “when-issued” position in Treasury bonds that put it over the limit, and he also submitted another false bid in the name of Tiger Management Company.

  29. Mozer denied intentionally manipulating the market. He was suspected of “repo-ing out” the bonds by borrowing cash from customers with the bonds as collateral and making verbal side agreements with these customers that they would not relend the bonds to anyone. That froze the supply of bonds, squeezing the short-sellers. Suspicions of price-fixing dogged Salomon long afterward. There was little doubt that Mozer and his customers had cornered the bonds and created a squeeze. According to Eric Rosenfeld, Salomon’s own arb desk was short Treasuries and got burned.

  30. Constance Mitchell, “Market Mayhem: Salomon’s ‘Squeeze’ in May Auction Left Many Players Reeling—In St. Louis, One Bond Arb Saw $400,000 Vanish and His Job Go with It—From Confidence to Panic,” Wall Street Journal, October 31, 1991.

  31. Feuerstein didn’t find this out right away, even though it was known internally. He blames this omission for his failure to press for a more thorough investigation of the squeeze. Several people, including Meriwether, apparently knew about the “Tiger dinner” (named after one of the hedge-fund customers). However, the “Tiger dinner” did not prove collusion.

  32. Interview with John Gutfreund.

  33. Or whatever the price was; this is Buffett’s general recollection.

  34. While this was taking place, Salomon filed a shelf registration statement in connection with a $5 billion senior debt offering, which the directors signed. The filing of a registration statement under these circumstances potentially put the firm in violation of securities laws.

  35. Some thought the squeeze may have been simply a matter of timing to make a bet that the Fed was about to ease interest rates, according to Eric Rosenfeld, rather than defiance of the Treasury.

  36. Various viewpoints within the firm are drawn from interviews with a number of the principals.

  37. Interviews with Donald Feuerstein, Zachary Snow. Feuerstein says he happened to be taking his son on a college visit at Cornell University that day and was “furious” when he found out later what happened.

  38. Interview with Donald Feuerstein. Feuerstein referred to his failure to influence Gutfreund as the result of Gutfreund’s yessing him to death, saying, “It is difficult to have an argument with someone who purports to agree with you” (Donald M. Feuerstein letter to William F. May, Charles T. Munger, Robert G. Zeller, and Simon M. Lorne, Munger, Tolles & Olson, January 31, 1993).

  39. Interview with Zach Snow. Snow says that the dream haunted him long afterward. Feuerstein does not recall this incident but says that if something like this happened it did not come across this way to him.

  40. Philip Howard, Gutfreund’s lawyer, speaking to Ron Insana on CNBC Inside Opinion, April 20, 1995.

  41. John Gutfreund speaking to Ron Insana, CNBC Inside Opinion, April 20, 1995.

  42. The auctions of December 27, 1990 (4-year notes), February 7, 1991 (the so-called “billion-dollar practical joke”), and February 21, 1991 (5-year notes) contained false bids. The April 25, 1991, auction included a bid in excess of the amount authorized by a customer. In the May 22, 1991 (2-year-notes) auction, Salomon (Mozer) failed to report a net “long” position to the government, as required, which fueled suspicions of a cover-up of market manipulation, but proof of market manipulation was never found.

  43. Interview with Zach Snow, who also testified to this under oath in 1994.

  44. Interview with Deryck Maughan.

  45. Interview with Jerry Corrigan.

  46. Even though he was Mozer’s boss, Meriwether did not have the authority to fire him; one managing director could not fire another. Only Gutfreund could do that.

  47. Interview with Bill McIntosh.

  48. Interviews with John Macfarlane, Deryck Maughan.

  49. McIntosh, by his own admission, had been no fan of Gutfreund’s prior to this event.

  50. Interview with Bill McIntosh.

  51. Spread-widening of ten to twenty basis points only attracted more sellers. As the afternoon wore on, the traders widened the spread until finally they were offering only ninety cents on the dollar for the notes. The price implied a reasonably high probability of default.

  52. The firm would still do business as an “agent,” which meant it would buy only if it had another buyer in hand to which it could resell the notes.

  53. Kurt Eichenwald, “Wall Street Sees a Serious Threat to Salomon Bros.—ILLEGAL BIDDING FALLOUT—High-Level Resignations and Client Defections Feared—Firm’s Stock Drops,” New York Times, August 16, 1991.

  54. Interview with Jerry Corrigan.

  55. Strauss later related this to Buffett.

  56. Interview with Jerry Corrigan.

  57. Interview with Jerry Cor
rigan.

  58. Interview with Jerry Corrigan. He says that Strauss and Gutfreund had had more than one routine conversation with him between April and June without mentioning anything, and he no longer trusted them.

  59. Buffett arrived in New York between 2:30 and 3:00 p.m., during which time the press release would have been drafted and ready to go.

  60. From Salomon press release dated August 16, 1991: “In order to give the Salomon Inc., board of directors maximum flexibility, they are prepared to submit their resignations at a special meeting of the board.”

  61. Interview with Eric Rosenfeld.

  62. Interview with Bill McIntosh, Tom Strauss, Deryck Maughan.

  63. Interview with Tom Strauss.

  64. Interview with Jerry Corrigan.

  65. Interview with Ron Olson.

  66. Warren Buffett testimony, “In the Matter of Arbitration Between John H. Gutfreund against Salomon Inc., and Salomon Brothers Inc.” Sessions 13 & 14, November 29, 1993.

  67. This is Buffett’s recollection of Gutfreund’s remarks. (From Warren Buffett testimony, “In the Matter of Arbitration Between John H. Gutfreund against Salomon Inc., and Salomon Brothers Inc.,” Sessions 13 & 14, November 29, 1993.

  68. Interview with Tom Strauss.

  69. On October 8, 1991, he was displaced when the Walton family, owners of Wal-Mart stock, took over spots 3-7; Buffett became number 8. Entertainment mogul John Kluge and Bill Gates occupied the top two spots.

  70. Through a routine letter to Mercury Asset Management when the Treasury Department discovered that Mercury, together with its affiliate S. G. Warburg & Co., had submitted bids for greater than the 35% limit rule for the auction. Mozer had submitted one of these bids without Mercury’s authority. Mozer was copied on this letter and covered it up by telling Mercury that Salomon had mistakenly submitted this bid in its name—and was going to correct it, so no need to bother responding to the Treasury. (Statement of Salomon Inc., submitted in conjunction with the Testimony of Warren E. Buffett, Chairman and CEO of Salomon. Before the Securities Subcommittee, Committee of Banking, Housing and Urban Affairs, U.S. Senate, September 10, 1991.)