Salomon Brothers

James Tobin, and William Brainard, who both convinced David Swensen to run the Endowment. nomics) and William Brainard as his advisers, he completed his Ph.D. dis- sertation, “A Model for the Valuation of Corporate Bonds,” in !"#$. Even before obtaining his doctorate, however, he began his professional career, in !"%%, as an economist at the International Monetary Fund. He was active at the &'( in the preparation of a new publication, "Government Finance Statistics Yearbook." In !"%" he started a six-year Wall Street career, first as an associate in corporate finance for Salomon Brothers. “At age twenty-seven he earned a permanent place in Wall Street his- tory,” Forbes reported in )$$*, “by inventing the derivative instrument known as the swap. While working at Salomon Brothers, he spearheaded a deal that allowed &+' to reverse currency exposure on some foreign bonds by arranging to have the World Bank issue dollar-denominated bonds with matching terms.” He next spent three years as senior vice president at Lehman Brothers, engineering the firm's currency swap oper- ations and developing new financial products. In !"#*, at the age of thirty-one, Swensen received a surprising offer from Yale—to head investment operations for its then ,! billion endow- ment. A pay cut of #$ percent was one of the unusual aspects of this Yale position. Another was his lack of direct experience managing an institu- tional endowment portfolio.

River Falls High School, Class of !"#! University Wisconsin River Falls, $.%., $.&., Class of !"#' Yale University Graduate School of Arts & Sciences, Ph.D. !"() Department of Economics International Monetary Fund, !"## Salomon Brothers, !"#" Lehman Brothers, !"(* Swensen’s educational and career timeline lectual debate.” He had lived campus life to the hilt, participating in sports and other extracurricular activities and forming strong friendships with everyone from undergraduates like his freshman advisee, Dean Takahashi ($.%. !"(), +,,+ !"(-), to Nobel laureate Tobin. In his men- tor’s later years, friends observed Swensen shoveling snow from Tobin’s driveway and delivering his Christmas tree. Still, in !"(' the job as Yale’s Chief Investment Officer looked daunt- ing. "I was dumbfounded about what to do," he recalled twenty years later. He promptly hired his friend Takahashi, who remained the Yale Investments Office second-in-command until his retirement in *)!" to work on Yale-based environmental projects (the two colleagues also col- laborated as teachers of classes on investment in Yale College and the School of Management). In the acknowledgments section of his first book, in *))), Swensen would write: “The ideas and influence of Dean Takahashi, my friend for twenty-three years and my colleague for twelve years, touch every page of this book.

Note that the confiscation of income is as high as 60% for the 529 C class. Also note that some of the convoluted mathematics involved in deciding which of the 16(!) classes the broker will offer clients from a single sponsor of the same fund with such different costs. Some classes have front-end loads, some have deferred loads, 11(!) have hidden loads paid by the investor in the form of 12b-1 fees for fund distribution. As a result, the net dividend yields received by investors in the 16 classes vary—in this case, from a low of 1% for the 529 C class to high of 2.16% for R6 class of this intermediate-term bond fund. Since the gross (pre-expense) yield of this fund was 2.4%—43% of the yield has been effectively confiscated. If that table tells us anything, it is that the salesmen must be paid. That’s fine for a particular firm, I guess, but investors should make sure that they receive commensurate value in return. The Metamorphosis of an Index Let me close with a few broad thoughts about how the world of bonds might change in the years ahead. As the driver of Vanguard’s dominant 23% share of bond fund assets, Vanguard Total Bond Market Index Fund offers an interesting case study of how bond market indexing works. In 1986, when I first considered the creation of a bond index fund, the sole broad bond index was the Salomon Brothers Investment Grade Bond Index. Then, U.S. Treasury bonds accounted for 50% of its weight, government agency obligations 32%, and corporate bonds 18%.

Net Securities Gains and Losses Wesco's earnings contained securities gains of $33,609,000, after income taxes, for 1998, versus $62,697,000, after taxes, for 1997. The entire 1998 Ñgure resulted from sales of marketable securities. Of the 1997 Ñgure, only $93,000 was realized through the sale of securities; the balance, $62,604,000, resulted from the exchange of the preferred and common shares of Salomon Inc (""Salomon'') owned by Wesco for preferred and common shares of The Travelers Group Inc. (""Travelers'') late in 1997 in connection with the merger of Salomon with a subsidiary of Travelers. Accounting standards require that the fair (market) value of shares received in such an exchange be recorded as the new cost basis as of the date of the exchange, with the diÅerence, after appropriate reserves for future income tax on the gain, recog- nized in the Ñnancial statements as a realized after-tax gain. For income tax purposes the exchange is recorded at the original cost of the securities exchanged; no gain is reported on the tax return until the securities are sold. Although the realized gains materially impacted Wesco's reported earnings for each year, they had a very minor impact on Wesco's shareholders' equity.

Convertible Preferred Stockholdings At the end of 1998, Wesco and its subsidiaries owned $20,000,000, at original cost, in convertible preferred stock which by merger of Travelers and Citicorp late in 1998 became convertible preferred stock of Citigroup. The Travelers preferred stock, itself, was received in 1997 (see the preceding section) in exchange for the Wesco group's remaining shares of Salomon preferred stock, which originally cost $20,000,000, and whose cost was adjusted upwards to $45,000,000 as of the date of the exchange. The issue requires redemption at par value of $20,000,000 on October 31, 1999, if not converted to 892,105 shares of common stock before that date. The investment is carried on Wesco's consolidated balance sheet at fair value of $44,000,000 as of December 31, 1998, the approximate market value of the common shares at that date, with the $1,000,000 diÅerence between its adjusted cost and market value deducted from shareholders' equity, net of income tax eÅect, without aÅecting reported net income, according to accounting convention. The convertible preferred stock was obtained at the same time Wesco's parent corpora- tion, Berkshire Hathaway, obtained additional amounts of the same stock at the same price per share. Through yearend 1997, Wesco's consolidated Ñnancial statements reÖected an investment in 9.25% convertible preferred stock of US Airways Group, Inc.

liquidating tag-end foreclosed real estate. In 1997, reversals of reserves for possible losses on sales of such tag-end real estate, expensed in prior years, beneÑted this category of earnings by about $1.1 million, after income tax eÅect. The 1997 and 1996 ""other 'normal' net operating income'' Ñgures also include intercompany charges for interest expense ($172,000 and $298,000 after taxes, respectively) on borrowings from Wes-FIC principally made late in 1993 to facilitate the transfer of loans and foreclosed properties to MS Property Company. This intercompany interest expense does not aÅect Wesco's consolidated net income inasmuch as the same amount is included as interest income in Wes-FIC's ""normal'' net operating income. Net Securities Gains and Losses Wesco's earnings for 1997 contained securities gains of $62,697,000, after income taxes, versus losses of $115,000, after income taxes, in 1996. Of the 1997 Ñgure, only $93,000 was realized through the sale of securities; the balance, $62,604,000, resulted from the exchange of the preferred and common shares of Salomon Inc (""Salomon'') owned by Wesco for preferred and common shares of Travelers Group Inc. (""Travelers'') late in 1997 in connection with the merger of Salomon with a subsidiary of Travelers.

Accounting standards promulgated by the Financial Accounting Standards Board require that the fair (market) value of shares received in such an exchange be recorded as the new cost basis as of the date of the exchange, with the diÅerence, after appropriate reserves for future income tax on the gain, recognized in the Ñnancial statements as a realized after-tax gain. For income tax purposes the exchange is recorded at the original cost of the securities ex- changed; no gain is reported on the tax return, and no taxes are yet due. Although the realized gain had a material impact on Wesco's reported earnings, it had a very minor impact on Wesco's shareholders' equity. Inasmuch as $48,504,000 of the after-tax gain had previously been reÖected in the unrealized gain component of Wesco's shareholders' equity as of September 30, 1997, that amount was merely switched from unrealized gains to retained earnings, another component of share- holders' equity. Convertible Preferred Stockholdings At the end of 1997, Wesco and its subsidiaries owned $52 million, at original cost, in convertible preferred stocks of Travelers Group Inc. (""Travelers'') and US Airways Group, Inc. (""US Air''). The Travelers preferred stock was received in late 1997 (see the preceding section) in exchange for the Wesco group's remaining shares of Salomon Inc preferred stock, which originally cost $40 million, and whose cost was adjusted upwards to $90 million as of the date of the exchange.

The investments are carried on Wesco's consolidated balance sheet at fair value, with any diÅerence between adjusted cost and market value included in sharehold- ers' equity, net of income tax eÅect, without aÅecting reported net income, accord- ing to accounting convention. Following is a summary of these investments in convertible preferred stocks at yearend 1997: Conversion Price 12/31/97 at Which Par Market Price Yearend Preferred Par Value Value May Be of Common Carrying Dividend of Exchanged for Stock on Value of Security Rate Holding Common Stock 12/31/97 Holding Travelers Group Inc. ÏÏÏ 9.00% $40 Million $22.42 $53.875 $ 96 Million US Airways Group, Inc. 9.25% 12 Million 38.74 62.50 19.2 Million These convertible preferred stocks were obtained at the same time Wesco's parent corporation, Berkshire Hathaway, obtained additional amounts of the same stocks at the same price per share. The preferred stock of Travelers was obtained in exchange for the remaining shares of preferred stock of Salomon Inc which Wesco and its subsidiaries had acquired in 1987. On October 31, 1995, in accordance with the terms of its convertible preferred stock, Salomon redeemed $20 million par value of its preferred shares owned by Wesco at cost plus accrued dividends.

On October 31, 1996 and October 31, 1997, Wesco converted an aggregate of $40 mil- lion par value of its remaining preferred shares of Salomon to 1,052,628 shares of Salomon common stock, with Wesco continuing to hold par value of $40 million of Salomon preferred stock. On November 28, 1997, Wesco and its subsidiaries received $40 million par value of Travelers 9% preferred stock plus 1,784,204 shares of Travelers common stock, in exchange for the Salomon holdings, in connection with a merger of Salomon into Travelers. Fair value of the Travelers preferred and common shares, carried on Wesco's consolidated balance sheet in the categories ""securities with Ñxed maturities'' and ""marketable equity securities,'' were $96.0 million and $96.1 million, respectively, at yearend 1997, versus the adjusted costs of $90.0 and $90.8 million, respectively, at which they were carried. US Air has called its convertible preferred stock for redemption on March 15, 1998. On March 13, 1998, Wesco converted its shares, acquired for $12 million in 1989 and written down to an adjusted cost of $3 million in 1994, to 309,718 shares of US Air common. In previous years we noted that ""few, if any, investors have ever prospered mightily from investing in convertible preferred stocks of leading corporations.'' Our experience proves, yet again, what poor prognosticators we are.

We estimate that (1) our investment in preferred and common stock of Travelers, acquired in 1997 through its merger with Salomon, in which we originally invested $80 million, net, was worth about $112.1 million more than we paid, and (2) our $12 million US Air holding was at yearend 1997 worth about $7.2 million more than we paid. These Ñgures when combined created $119.3 million more than actual cost. In addition, Wesco's investment in convertible preferred stock of The Gillette Company, made in 1989 at cost of $40 million, and converted into Gillette common stock in 1991 is carried at a $321.4 million yearend market value in Wesco's consolidated 1997 balance sheet.This

is $281.4 million more than the investment cost. Also, in 1995, Wesco realized a gain of $6.9 million, before taxes ($4.2 million after taxes), on sale of its $23 million investment in preferred stock of Champion International Corporation. Consolidated Balance Sheet And Related Discussion As indicated in the accompanying Ñnancial statements, Wesco's net worth increased, as accountants compute it under their conventions, to $1.76 billion ($248 per Wesco share) at yearend 1997 from $1.25 billion ($176 per Wesco share) at yearend 1996. The $513 million increase in reported net worth in 1997 was the result of three factors: (1) $419 million resulting from continued net appreciation of investments after provision for future taxes on capital gains; plus (2) $94 million from retention of 1997 net income, including $63 million realized on the exchange of Salomon stock for Travelers stock, discussed above; less (3) dividends paid. The foregoing $248-per-share book value approximates liquidation value assum- ing that all Wesco's non-security assets would liquidate, after taxes, at book value. Probably, this assumption is too conservative.

But our computation of liquidation value is unlikely to be too low by more than two or three dollars per Wesco share, because (1) the liquidation value of Wesco's consolidated real estate holdings (where interesting potential now lies almost entirely in Wesco's equity in its oÇce property in Pasadena) containing only 125,000 net rentable square feet, and (2) unrealized appreciation in other assets (primarily Precision Steel) cannot be large enough, in relation to Wesco's overall size, to change very much the overall computation of after-tax liquidating value. Of course, so long as Wesco does not liquidate, and does not sell any appreciated assets, it has, in eÅect, an interest-free ""loan'' from the government equal to its deferred income taxes on both the unrealized gains and gains deferred from the merger of Salomon into Travelers in 1997, subtracted in determining its net worth. This interest-free ""loan'' from the government is at this moment working for Wesco shareholders and amounted to about $102 per Wesco share at yearend 1997. However, some day, perhaps soon, major parts of the interest-free ""loan'' must be paid as assets are sold. Therefore, Wesco's shareholders have no perpetual advantage creating value for them of $102 per Wesco share. Instead, the present value of Wesco's shareholders' advantage must logically be much lower than $102 per Wesco share.

Buffett described the principle he conveyed to Salomon employees during the 1991 Treasury-auction scandal: that losing money could be tolerated, but losing even a shred of the firm's reputation could not. He framed the standard as asking not merely whether conduct was legal but whether it would survive the next day's front page written by a smart but unfriendly reporter.

The reputation principle Buffett delivered as interim Salomon chairman.

Buffett wrote that he could not promise that Berkshire's managers would never make mistakes, but that he could promise that the firm would never knowingly tolerate conduct intended to mislead regulators, customers, or the public. He argued that an institution's culture is set by what its leadership tolerates, and that the single most reliable predictor of future conduct is the conduct leadership has already excused.

On the standard for institutional culture.