The Go-Go Years (37 page)

Where was the S.E.C.? It seemed to have caught the night-before-Waterloo spirit itself. Its accounting department, which by statute enjoyed almost dictatorial powers over corporate accounting practices, was going its plodding, old-fashioned, and now apparently inadequate way, continuing to trust to the myopic vigilance and the checkered integrity of the accounting profession itself. And the S.E.C. staff had arrived at a state of demoralization unequalled since the Eisenhower administration. For the moment—and a short moment it would prove to be—almost anything went.

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The rise of institutional investing had brought into being a new kind of high-risk brokerage operation, the block positioner. A time had come when a large mutual or pension fund might suddenly want to buy or sell at a single stroke a block of 100,000, 500,000, or even a million shares. Traditionally, the responsibility for matching up buyers and sellers in such an order, and rounding it out by using his own capital on one side or the other when necessary, fell on the specialist on the Exchange floor; but now with such huge sums involved in mammoth transactions the specialists' capital was often ludicrously inadequate to the task. The firm that most spectacularly and successfully moved in to fill this crack in Wall Street's crumbling edifice of traditional procedure was Salomon
Brothers, formerly Salomon Brothers and Hutzler, founded in 1910, a leading institutional trader for years not in stocks but in bonds. Indeed, so great was this firm's reputation in bond trading that at one time the Wall Street definition of a marketable bond was one on which Salomon would make a bid. In the mid-sixties, when Goldman, Sachs and Bear, Stearns had the lion's share of the new and expanding business of block positioning of stocks for institutions, the partners of Salomon Brothers, headed by canny, soft-spoken William R. (Billy) Salomon, experienced a revelation. Block positioning in stocks, they mused, was not basically different from doing the same thing in bonds. In both cases, you had to know your customers, the institutional investors. Salomon Brothers knew them already from trading bonds with them for years. You had to have the resources and the nerve to assume huge capital risks. Salomon Brothers for years had been king of the plungers in the bond market; why not, then, move into the wholesale stock business?

Beginning in 1964-1965, they did, and by 1968 were the unquestioned leader in it. Their star stock trader came to be Jay Perry, a fast-talking and fiercely competitive man in his early thirties, from Hot Springs, Arkansas, who had previously been a bond trader. In Salomon Brothers' noisy trading room at 60 Wall Street, Perry would be asked by a big institution for a price on so many hundred thousand shares of a certain stock—a block worth, say, $30 or $40 million. After consulting the firm's executive committee, he would shout into the phone a bid a little under the current market, but—and here was the nub of the matter—not nearly so far under it as would be the case if the shares were thrown directly onto the mercy of a capital-weak floor specialist. Then, working at a 120-key telephone console connecting them to all the major funds in the country (an amenity denied to the floor specialist, who was forbidden to deal directly with institutions), Perry and the rest of the Salomon organization would begin trying to round up buyers for parts of the huge block available for sale. Quite often the number of shares they could find bids for would fall short of the offered block by a couple of hundred thousand shares. That was where
the positioning came in. Salomon Brothers would obligingly buy those residual shares for its own account, completing the deal, and collecting commissions from both the seller and the various buyers. Then would come the hairy part: unloading the shares Salomon had taken, and didn't really want to tie up its capital with, over a period that might drag out to as much as a couple of months, with tens of millions of capital at stake. “We'll bid for almost anything,” said Salomon blandly, “and we take many baths.” The risks his firm took through seat-of-the-pants plunges in stocks of companies it knew little about was balanced, and more than balanced, by the enormous commissions it could count on from both sides of its executed deals. In the first three months of 1969, Salomon Brothers “crossed” almost six hundred blocks, putting its own money continually at risk to the extent of many billions of dollars worth of transactions. One day it traded 374,000 shares of Control Data for $52,360,000, the largest single Stock Exchange common-stock transaction in history.

As for Salomon Brothers' “baths,” one of the wettest and most prolonged of them occurred over the first three months of 1968, in the stock of Fairchild Camera and Instrument, one of the market's most spectacular performers of 1965. On December 21, 1967, Salomon Brothers, evidently in a free-spending Yuletide mood, bought from an investing institution 52,000 shares of Fairchild at 88, for a capital commitment of about $4.5 million. Later the same day, the firm sold off 22,500 shares at 90 ⅝, thereby turning a quick profit of $58,000. That left almost 30,000 Fairchild shares in Salomon's inventory. Eight days later, on December 29, 1967, the firm bought 41,000 more Fairchild shares at 88½ from another investing institution, and on January 22, 1968—by which time the market for Fairchild had gone distinctly sour, and Salomon Brothers had decided it was a real bargain—the firm absorbed another block of 31,000 Fairchild shares at 78, thus raising its inventory to 102,000 shares at an average cost of $85, for a capital commitment of almost $9 million.

Day followed day, and Fairchild did not recover. On the
contrary, it continued dropping—quite possibly speeded on its way by hedge funds that, knowing of the huge Salomon block hanging over the market, may have made short sales to take advantage of the situation. The days stretched out to weeks, and Fairchild stock showed no signs of recovery, and at last Billy Salomon and his partners decided that they had simply been wrong. On March 1, they unloaded 2,000 Fairchild shares at 66; on March 2, 17,400 at prices down to 59 ½; on March 6 to 9, 25,500 additional shares at prices down to 55 ⅝; and finally, between March 10 and 31, the rest of the block at prices down to 52—which turned out to be just about Fairchild's low for the year. Salomon Brothers' profits on the whole series of transactions, including the December 21 capital gain and commissions, were $105,000; its losses were $2,878,000, leaving a net loss of $2,773,000.

But why worry? Next week, or next month, there would be a new block trade that would result in a
profit
of $3 million or more, as attested by Salomon Brothers' consistently gratifying annual results. Hardly a business conducive to the afternoon siesta, block trading embodied the high-rolling spirit of the time; and besides, it allowed the mutual funds and their client, the public, to lay off some of their risks onto steel-nerved professionals like Jay Perry, who always seemed to be in motion, and Billy Salomon, who never seemed to turn a hair.

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There were other, less salutary, developments. Many of the mutual funds themselves were taking advantage of the permissive climate by indulging in a form of sleight-of-hand—perfectly legal at the time—that gave their asset value the same kind of painless, instant, and essentially bogus boost as merger accounting could give to conglomerate earnings. Asset value was to a mutual fund what earnings per share were to a conglomerate: its advertisement, its bait for new capital, the formal measure
of its success or failure. The sleight-of-hand involved the use of what was called “letter stock,” and was, in the later nineteen sixties, freely indulged in by many mutual-fund magicians. The one who had the bad luck to become associated with letter stock in the public mind was Frederick S. Mates.

It may or may not be considered paradoxical that Mates, in 1968, had a well-deserved reputation as one of the most high-minded and socially concerned, as well as one of the most successful, young fund managers in Wall Street. Born in Brooklyn, a graduate of Brooklyn College with the Class of 1954, he had married a Barnard College psychology teacher, been a teacher briefly himself at a Brooklyn yeshiva, and then spent several years with the brokerage firm of Spingarn, Heine before launching his own Mates Investment Fund in August 1967. The fund was an instant success—so great a success that Mates could soon afford to integrate his social ideals into his business operations. For the Mates Fund portfolio he bought no stocks of companies manufacturing armaments, cigarettes, or products that he considered to be pollutants of the environment. He announced his ambition to use his fund to help “make poor people rich,” and to that end, he planned to cut the minimum investment in it down to $50 and to make a special selling effort in disadvantaged areas. As things turned out, his chief contribution to the welfare of the poor would seem to be the fact that he never got around to carrying out these plans, and thus spared the poor from becoming investors in the Mates Fund.

He called his office “the kibbutz on William Street” and his young staff “the flower children.” His seemed to be an operation entirely in tune with his times. Whether despite or because of these policies, objectives, and attitudes, by the summer of 1968 the Mates Fund was the new sensation of the mutual-fund industry, its asset value up almost 100 percent in its first year, and new money coming in at such a rate—a million and a half dollars a day, far exceeding the previous record set by Fred Carr's Enterprise Fund—that, in June, Mates had to close the sales window temporarily to keep his facilities from being overwhelmed.

It was in September 1968 that Mates made the investment
that he, and eventually much of the fund industry, would have cause to regret. A tiny conglomerate called Omega Equities privately sold the Mates Fund 300,000 shares of common stock at $3.25 a share. Omega was then selling on the over-the-counter market at around 24, so the price was apparently an almost unbelievable bargain. But only apparently. The Omega shares that Mates bought were not registered with the S.E.C., and therefore could not legally be resold until they had been through such registration; for practical purposes, they were unmarketable. They had been sold to Mates—legally—through an investment letter (whence the term “letter stock”) in which these terms were set forth and the buyer agreed not to resell pending registration. So now the Mates Fund had in its portfolio 300,000 shares of Omega; the question was, What value were they to be assigned in calculating the fund's assets? Under the curious rules in force at that time, Mates might technically have carried them at $24 a share, the current market price of registered Omega shares, even though they were unregistered. Or he might, more logically, have valued them at his cost—$3.25 a share. Again, an ultraconservative fund manager might have recognized the fact that they were unmarketable by valuing them at a merely nominal amount. Instead of following any of those courses, Mates did what was the common practice in accounting for letter stock: he took the market price as his base, marked it down by one-third to allow for the shares' nonregistration, and carried them at $16 a share. It will be noted that this was almost five times as much as he had just paid for them. With no change in the market price of Omega stock, then, and with no particular good news as to Omega's business prospects, the Mates Fund had made what appeared on the books it displayed proudly to the investing public to be an investment yielding an instant profit of almost 500 percent.

The layman will have no trouble recognizing this as a form of cheating. The startling thing is not that Mates did it, but that it was being done all the time in 1968, by mutual funds and hedge funds, and that not until late 1969 did the S.E.C. get around to a mild crackdown on mutual funds' letter-stock investments,
and subsequent arbitrary up-valuations of them. What made Mates a scapegoat was some untimely ill fortune that shortly overtook Omega. Early in December 1968, the Mates Fund assets, partly on the basis of the Omega deal, were up an eye-popping 168 percent for the year, making Mates, by a wide margin, the nation's leading fund performer in the greatest of all fund performance years. Then, on December 20, the S.E.C. abruptly suspended trading in all Omega stock on grounds that it was being traded “on the basis of incomplete and inaccurate information.” The immediate result was as disastrous for Mates as it was predictable. Many Mates Fund shareholders demanded redemption of their shares in cash, and this demand, because of the unmarketability of all Omega shares, was one that the fund could not possibly meet. Technically, it had failed. But the S.E.C. was in no mood to force it out of business and thus damage its 3,300 stockholders. Mates hastily applied to the S.E.C. for permission to suspend redemptions for an indefinite period, and the S.E.C. hastily and meekly complied.

The fund industry shuddered. This was purest heresy; the fundamental right of share redemption without question at any time was the cornerstone of the whole $50-billion business, analogous to the right of a bank depositor to draw from his checking account; now the cornerstone was cracked, the letter-stock deception stood suddenly exposed, and dozens of other funds came under suspicion of having similar concealed weakness. Mates, cornered, acted as bravely and honorably as he could. He immediately valued his Omega holding down to his cost of $3.25 per share, ruining Mates Fund's preeminent performance record for the year. He vowed to resume redemptions just as soon as possible. That was cold comfort to his shareholders; but a leading Wall Street fund man commented with sympathy and candor, “After all, Fred Mates is only one of many.” In February 1969, an S.E.C. official seemed to be remarkably calm about the whole matter when he said, reflectively, “The Mates situation really puts the problem in bold relief.” That July, Mates finally made good his promise to resume redemptions—
with Omega marked down to fifty cents a share. He was hoping eventually to find a way to sell his 300,000 shares for much more; early in 1972, however, the Mates Fund still had them, and was carrying them at a value of one nickel each.