Salomon Treasury Scandal

The idea of pooling debt instruments and selling off tranches with varying seniority, risk, and thus interest rates began with the creation of mortgage-backed securities in the 1970s – most often associated with Louis Ranieri of Salomon Brothers – and expanded in the 1980s and ’90s. Prior to the 1990s, banks made loans – some of them to non-investment grade companies – and “syndicated” them to a handful of fellow banks. But then “broadly syndicated loans,” “leveraged loans,” or “senior loans” were developed by Wall Street.large

They sometimes command ridiculously higher prices than justified but are almost never available at bargain valuations. Unless under duress, the owner of a controlled business gives no thought to selling at a panic-type valuation. * * * * * * * * * * * * At this point, a report card from me is appropriate: In 58 years of Berkshire management, most of my capital-allocation decisions have been no better than so-so. In some cases, also, bad moves by me have been rescued by very large doses of luck. (Remember our escapes from near-disasters at USAir and Salomon? I certainly do.) Our satisfactory results have been the product of about a dozen truly good decisions – that would be about one every five years – and a sometimes-forgotten advantage that favors long-term investors such as Berkshire. Let’s take a peek behind the curtain. The Secret Sauce In August 1994 – yes, 1994 – Berkshire completed its seven-year purchase of the 400 million shares of Coca-Cola we now own. The total cost was $1.3 billion – then a very meaningful sum at Berkshire. The cash dividend we received from Coke in 1994 was $75 million. By 2022, the dividend had increased to $704 million. Growth occurred every year, just as certain as birthdays. All Charlie and I were required to do was cash Coke’s quarterly dividend checks. We expect that those checks are highly likely to grow.

© 2021 Oaktree Capital Management, L.P. All Rights Reserved Follow us: While the functioning of economies is highly variable and uncertain, economic orthodoxy considers the above process about as reliable as they come. However, I want to take a minute to highlight the uncertainty entailed in thinking about inflation. • Among the defining elements that marked my early years in investing was the 5-15% annual inflation that prevailed in the U.S. from the early 1970s through 1982. Dr. Doom and Dr. Gloom (chief economists Henry Kaufman of Salomon Brothers and Al Wojnilower of First Boston – I forget which was which) regularly admitted in their depressing speeches that they weren’t sure what was causing the inflation or how to bring it down. No one was able to make progress combatting inflation until Fed Chair Paul Volcker solved the problem by raising interest rates dramatically, bringing on a significant double-dip recession in 1980-82. • What about the more recent experience? For years, central bankers in the U.S., Europe and Japan have targeted a healthy 2% rate of inflation, but none of them have been able to produce it. This despite continuous economic growth, significant budget deficits, rapid expansion of the money supply through quantitative easing, and low interest rates – all of which are supposed to be inflationary.

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.

– and the reading of proxy material has become a mind-numbing experience. One very important improvement in corporate governance has been mandated: a regularly-scheduled “executive session” of directors at which the CEO is barred. Prior to that change, truly frank discussions of a CEO’s skills, acquisition decisions and compensation were rare. Acquisition proposals remain a particularly vexing problem for board members. The legal orchestration for making deals has been refined and expanded (a word aptly describing attendant costs as well). But I have yet to see a CEO who craves an acquisition bring in an informed and articulate critic to argue against it. And yes, include me among the guilty. Berkshire, Blue Chip Stamps, Cap Cities-ABC, Coca-Cola, Data Documents, Dempster, General Growth, Gillette, Kraft Heinz, Maracaibo Oil, Munsingwear, Omaha National Bank, Pinkerton’s, Portland Gas Light, Salomon, Sanborn Map, Tribune Oil, U.S.Financial

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%.

© 2016 Oaktree Capital Management, L.P. All Rights Reserved Follow us: However, some of his promises may test the limits of what can be accomplished under the limitations imposed by economic reality. And there are negatives, including:  Trump’s express disdain for Janet Yellen, and the resulting possibility that Fed independence will be reduced,  his stance on international trade pacts (an area in which a president has unusually broad power to take unilateral action), his threat of imposing import duties on goods made in China and Mexico, and the resulting possibility of trade wars, and  the possibility that this plus his unconventional positions on things such as climate change and defense treaties bode ill for international relations in general. That brings us to the outlook for bonds. Just as the U.S. stock market has celebrated Trump’s election, the bond markets have been discouraged. Interest rates rose very rapidly last week following Trump’s election, bringing big losses to bond holders. The FT wrote the following, citing Henry Kaufman, the Salomon Brothers chief economist who correctly called the bond bear market in the 1970s: “It’s a tectonic shift” . . . the end of a three-decade bond bull market, because of the likelihood of unfunded tax cuts, infrastructure spending and a radically reshaped Federal Reserve. “I would say the secular trend is going to be upwards now,” he told the FT.

In 1993, I made another small investment. Larry Silverstein, Salomon’s landlord when I was the company’s CEO, told me about a New York retail property adjacent to NYU that the Resolution Trust Corp. was selling. Again, a bubble had popped – this one involving commercial real estate – and the RTC had been created to dispose of the assets of failed savings institutions whose optimistic lending practices had fueled the folly. Here, too, the analysis was simple. As had been the case with the farm, the unleveraged current yield from the property was about 10%. But the property had been undermanaged by the RTC, and its income would increase when several vacant stores were leased. Even more important, the largest tenant – who occupied around 20% of the project’s space – was paying rent of about $5 per foot, whereas other tenants averaged $70. The expiration of this bargain lease in nine years was certain to provide a major boost to earnings. The property’s location was also superb: NYU wasn’t going anywhere. I joined a small group, including Larry and my friend Fred Rose, that purchased the parcel. Fred was an experienced, high-grade real estate investor who, with his family, would manage the property. And manage it they did. As old leases expired, earnings tripled. Annual distributions now exceed 35% of our original equity investment.

© Oaktree Capital Management, L.P. All Rights Reserved which inflation lifted wages, contributing further to inflation, and so forth. Rising prices frightened people into demand-pull inflation by convincing them to stock up on goods to avoid higher prices later. And people borrowed to invest in assets like land out of a belief that no matter what interest rate they paid to finance their purchase, the asset’s price would increase at a faster rate (the epitome of inflationary thinking). No one knew how to solve the problem. I used to go to hear “Dr. Gloom” and “Dr. Doom” (economists Al Wojnilower of First Boston and Henry Kaufman of Salomon Brothers) compete to be more depressing. They talked about how hard it would be to get inflation down to “an acceptable level.” One day, I heard someone ask for the definition of “an acceptable level.” He was told “one-third less than whatever it is at the time.” Finally, however, in the early 1980s Paul Volcker and the Fed implemented the painful solution of significantly higher interest rates, inflation subsided, and the stock market took off. Over the next 25 years, rising inflation and interest rates were forgotten as possible sources of risk. Today, labor in the U.S. lacks the power to demand strong wage increases or COLAs. Further, the sluggish macro picture argues against demand-pull. Strong inflation is usually associated with higher levels of prosperity and stronger demand for goods than I foresee.

There’s plenty of money to be made in the center of the court. If it’s questionable whether some action is close to the line, just assume it is outside and forget it. As a corollary, let me know promptly if there’s any significant bad news. I can handle bad news but I don’t like to deal with it after it has festered for awhile. A reluctance to face up immediately to bad news is what turned a problem at Salomon from one that could have easily been disposed of into one that almost caused the demise of a firm with 8,000 employees.

© Oaktree Capital Management, L.P. All Rights Reserved Democrats who controlled the White House for 28 of the 36 years from 1933 to 1969, and the Senate for 44 of the 48 years from 1933 to 1981. (In America, regulation is generally associated with Democrats and liberalism, and deregulation with Republicans and conservatism.) The last 28 years have been very different, however, thanks primarily to Ronald Reagan and Margaret Thatcher, bolstered by centrist Clinton and Blair administrations, and helped along by Bush, Bush and Brown. For much of that time, the Fed was under the leadership of Alan Greenspan, who is philosophically indebted to Ayn Rand, a strong believer in free markets. Free-market solutions were deemed certain to yield optimal economic decisions. Deregulation, privatization and market pricing went into full swing. Government involvement in policy making and control was disrespected. In short, it was assumed that the profit motive – Adam Smith’s “invisible hand” – would maximize capital efficiency and, therefore, societal welfare. This trend reached its apogee in the last ten years. The Glass-Steagall Act was nullified; this allowed, for example, the combination of Citibank and Salomon Brothers. Other than lowering interest rates and providing liquidity to fend off weakness, the Fed employed a hands-off approach. Investment managers and investment bankers gained fame and huge fees for performance that showed which of them were the most talented.

This and That Berkshire will pay about $4.4 billion in federal income tax on its 2006 earnings. In its last fiscal year the U.S. Government spent $2.6 trillion, or about $7 billion per day. Thus, for more than half of one day, Berkshire picked up the tab for all federal expenditures, ranging from Social Security and Medicare payments to the cost of our armed services. Had there been only 600 taxpayers like Berkshire, no one else in America would have needed to pay any federal income or payroll taxes. * * * * * * * * * * * * Our federal return last year, we should add, ran to 9,386 pages. To handle this filing, state and foreign tax returns, a myriad of SEC requirements, and all of the other matters involved in running Berkshire, we have gone all the way up to 19 employees at World Headquarters. This crew occupies 9,708 square feet of space, and Charlie – at World Headquarters West in Los Angeles – uses another 655 square feet. Our home-office payroll, including benefits and counting both locations, totaled $3,531,978 last year. We’re careful when spending your money. Corporate bigwigs often complain about government spending, criticizing bureaucrats who they say spend taxpayers’ money differently from how they would if it were their own. But sometimes the financial behavior of executives will also vary based on whose wallet is getting depleted. Here’s an illustrative tale from my days at Salomon.

Let's say there are two assets with high prospective return and risk. A portfolio consisting of the two can have high risk if they are correlated but low risk if they are not. Thus adding an uncorrelated, high-risk asset can reduce the overall riskiness of a portfolio. This understanding revolutionized investing by enabling risk-averse investors to hold high-return, high-risk assets as long as they are uncorrelated with the rest of their portfolio. Certainly Oaktree owes much of its very existence to the understanding of how assets behave in combination. Tracking error, which lately has been of increased interest, refers to a specific type of connectedness: that between a portfolio and a benchmark. More and more, clients are asking about managers' tracking error in the past and monitoring it after hiring them. A client hires managers to play specific roles in its portfolio, and it wants to be sure they will do so. In considering whether to include high yield bonds in its portfolio, for example, the client may model the performance of the portfolio incorporating the Salomon Cash-Pay Index as a proxy for the high yield bond component. Then if the client hires a manager, it wants to be sure the manager will track the Salomon Index closely (of course while outperforming!) Thus clients have reason to want low tracking error.

© Oaktree Capital Management, L.P. All Rights Reserved Memo to: Oaktree Clients and Friends From: Howard Marks Re: Genius Isn't Enough (and Other Lessons from Long-Term Capital Management) On September 24, The Wall Street Journal carried an excellent front-page article regarding the inability of the "crack team" of economic policy makers led by Messrs. Rubin and Summers to halt the slide of the emerging markets' economies and currencies. Heading the column was a quotation from David Halberstam's account of the U.S. involvement in Vietnam, The Best and The Brightest: If there was ever anything that bound men ... together, it was the belief that sheer intelligence and rationality could answer and solve everything. Across the page -- just a few columns away -- was another excellent article, this time on the subject of Long-Term Capital Management. I think the Halberstam quotation is just as relevant to this one. The saga of Long-Term Capital is well known by now. My purpose here is not to discuss the facts, although I'll do so briefly, but rather the lessons to be learned. Long-Term was the creation of former Salomon Brothers vice chairman John Meriwether, along with several other well-respected ex-Salomon Partners, a former vice chairman of the Federal Reserve, and a pair of Nobel prize winners. It was formed to engage in bond arbitrage, the systematic exploitation of bond mispricings.

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.

On the Thursday before last year's annual meeting, however, Bob Denham of Salomon told me that Melvyn Wolff, the long-time controlling shareholder and CEO of Star, wanted to talk. At our invitation, Melvyn came to the meeting and spent his time in Omaha confirming his positive feelings about Berkshire. I, meanwhile, looked at Star's financials, and liked what I saw.

Two years ago, I gave you an update on the five convertible preferreds that we purchased through private placements in the 1987-1991 period. At the time of that earlier report, we had realized a small profit on the sale of our Champion International holding. The four remaining preferred commitments included two, Gillette and First Empire State, that we had converted into common stock in which we had large unrealized gains, and two others, USAir and Salomon, that had been trouble-prone. At times, the last two had me mouthing a line from a country song: "How can I miss you if you won't go away?"

Our two laggards, meanwhile, have come to life in a very major way. In a transaction that finally rewarded its long-suffering shareholders, Salomon recently merged into Travelers Group. All of Berkshire's shareholders -- including me, very personally -- owe a huge debt to Deryck Maughan and Bob Denham for, first, playing key roles in saving Salomon from extinction following its 1991 scandal and, second, restoring the vitality of the company to a level that made it an attractive acquisition for Travelers. I have often said that I wish to work with executives that I like, trust and admire. No two fit that description better than Deryck and Bob.

Berkshire's final results from its Salomon investment won't be tallied for some time, but it is safe to say that they will be far better than I anticipated two years ago. Looking back, I think of my Salomon experience as having been both fascinating and instructional, though for a time in 1991-92 I felt like the drama critic who wrote: "I would have enjoyed the play except that I had an unfortunate seat. It faced the stage."

Fortunately, Richard had also been a long-time shareholder of FlightSafety, and it occurred to him last year that the two companies would make a good fit. He knew our acquisition criteria, and he thought that Al Ueltschi, FlightSafety's 79-year-old CEO, might want to make a deal that would both give him a home for his company and a security in payment that he would feel comfortable owning throughout his lifetime. So in July, Richard wrote Bob Denham, CEO of Salomon Inc, suggesting that he explore the possibility of a merger.

In another context, a friend once asked me: "If you're so rich, why aren't you smart?" After reviewing my sorry performance with USAir, you may conclude he had a point. We wrote four checks to Salomon Brothers last year and in each case were delighted with the work for which we were paying. I've already described one transaction: the FlightSafety purchase in which Salomon was the initiating investment banker. In a second deal, the firm placed a small debt offering for our finance subsidiary.

Additionally, we made two good-sized offerings through Salomon, both with interesting aspects. The first was our sale in May of 517,500 shares of Class B Common, which generated net proceeds of $565 million. As I have told you before, we made this sale in response to the threatened creation of unit trusts that would have marketed themselves as Berkshire look-alikes. In the process, they would have used our past, and definitely nonrepeatable, record to entice naive small investors and would have charged these innocents high fees and commissions.

Salomon could not have performed better in the handling of this unusual transaction. Its investment bankers understood perfectly what we were trying to achieve and tailored every aspect of the offering to meet these objectives. The firm would have made far more money - perhaps ten times as much - if our offering had been standard in its make-up. But the investment bankers involved made no attempt to tweak the specifics in that direction. Instead they came up with ideas that were counter to Salomon's financial interest but that made it much more certain Berkshire's goals would be reached. Terry Fitzgerald captained this effort, and we thank him for the job that he did.

Given that background, it won't surprise you to learn that we again went to Terry when we decided late in the year to sell an issue of Berkshire notes that can be exchanged for a portion of the Salomon shares that we hold. In this instance, once again, Salomon did an absolutely first-class job, selling $500 million principal amount of five-year notes for $447.1 million. Each $1,000 note is exchangeable into 17.65 shares and is callable in three years at accreted value. Counting the original issue discount and a 1% coupon, the securities will provide a yield of 3% to maturity for holders who do not exchange them for Salomon stock. But it seems quite likely that the notes will be exchanged before their maturity. If that happens, our interest cost will be about 1.1% for the period prior to exchange.

In recent years, it has been written that Charlie and I are unhappy about all investment-banking fees. That's dead wrong. We have paid a great many fees over the last 30 years - beginning with the check we wrote to Charlie Heider upon our purchase of National Indemnity in 1967 - and we are delighted to make payments that are commensurate with performance. In the case of the 1996 transactions at Salomon Brothers, we more than got our money's worth.

Our First Empire preferred will be called on March 31, 1996, the earliest date allowable. We are comfortable owning stock in well-run banks, and we will convert and keep our First Empire common shares. Bob Wilmers, CEO of the company, is an outstanding banker, and we love being associated with him. Our other two preferreds have been disappointing, though the Salomon preferred has modestly outperformed the fixed-income securities for which it was a substitute. However, the amount of management time Charlie and I have devoted to this holding has been vastly greater than its economic significance to Berkshire. Certainly I never dreamed I would take a new job at age 60 - Salomon interim chairman, that is - because of an earlier purchase of a fixed-income security.

Soon after our purchase of the Salomon preferred in 1987, I wrote that I had "no special insights regarding the direction or future profitability of investment banking." Even the most charitable commentator would conclude that I have since proved my point. To date, our option to convert into Salomon common has not proven of value. Furthermore, the Dow Industrials have doubled since I committed to buy the preferred, and the brokerage group has performed equally as well. That means my decision to go with Salomon because I saw value in the conversion option must be graded as very poor. Even so, the preferred has continued under some trying conditions to deliver as a fixed-income security, and the 9% dividend is currently quite attractive.

Last June, I stepped down as Interim Chairman of Salomon Inc after ten months in the job. You can tell from Berkshire's 1991- 92 results that the company didn't miss me while I was gone. But the reverse isn't true: I missed Berkshire and am delighted to be back full-time. There is no job in the world that is more fun than running Berkshire and I count myself lucky to be where I am.

The Salomon post, though far from fun, was interesting and worthwhile: In Fortune's annual survey of America's Most Admired Corporations, conducted last September, Salomon ranked second among 311 companies in the degree to which it improved its reputation. Additionally, Salomon Brothers, the securities subsidiary of Salomon Inc, reported record pre-tax earnings last year - 34% above the previous high.

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.

Salomon's lead lawyer in its Government matters, Ron Olson of Munger, Tolles & Olson, was also key to our success in getting through this trouble. The firm's problems were not only severe, but complex. At least five authorities - the SEC, the Federal Reserve Bank of New York, the U.S. Treasury, the U.S. Attorney for the Southern District of New York, and the Antitrust Division of the Department of Justice - had important concerns about Salomon. If we were to resolve our problems in a coordinated and prompt manner, we needed a lawyer with exceptional legal, business and human skills. Ron had them all.

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.

In 1989 when I - a happy consumer of five cans of Cherry Coke daily - announced our purchase of $1 billion worth of Coca- Cola stock, I described the move as a rather extreme example of putting our money where my mouth was. On August 18 of last year, when I was elected Interim Chairman of Salomon Inc, it was a different story: I put my mouth where our money was.

You've all read of the events that led to my appointment. My decision to take the job carried with it an implicit but important message: Berkshire's operating managers are so outstanding that I knew I could materially reduce the time I was spending at the company and yet remain confident that its economic progress would not skip a beat. The Blumkins, the Friedman family, Mike Goldberg, the Heldmans, Chuck Huggins, Stan Lipsey, Ralph Schey and Frank Rooney (CEO of H.H. Brown, our latest acquisition, which I will describe later) are all masters of their operations and need no help from me. My job is merely to treat them right and to allocate the capital they generate. Neither function is impeded by my work at Salomon.

Given the managerial stars we have at our operating units, Berkshire's performance is not affected if Charlie or I slip away from time to time. You should note, however, the "interim" in my Salomon title. Berkshire is my first love and one that will never fade: At the Harvard Business School last year, a student asked me when I planned to retire and I replied, "About five to ten years after I die."

Besides being interested in the purchase of businesses as described above, we are also interested in the negotiated purchase of large, but not controlling, blocks of stock comparable to those we hold in Capital Cities, Salomon, Gillette, USAir, Champion, and American Express. We are not interested, however, in receiving suggestions about purchases we might make in the general stock market.

Overall, our fixed-income investments have treated us well, both over the long term and recently. We have realized large capital gains from these holdings, including about $152 million in 1991. Additionally, our after-tax yields have considerably exceeded those earned by most fixed-income portfolios. Nevertheless, we have had some surprises, none greater than the need for me to involve myself personally and intensely in the Salomon situation. As I write this letter, I am also writing a letter for inclusion in Salomon's annual report and I refer you to that report for an update on the company. (Write to: Corporate Secretary, Salomon Inc, Seven World Trade Center, New York, NY 10048) Despite the company's travails, Charlie and I believe our Salomon preferred stock increased slightly in value during 1991. Lower interest rates and a higher price for Salomon's common produced this result.

Convertible Preferred Stocks We continue to hold the convertible preferred stocks described in earlier reports: $700 million of Salomon Inc, $600 million of The Gillette Company, $358 million of USAir Group, Inc. and $300 million of Champion International Corp. Our Gillette holdings will be converted into 12 million shares of common stock on April 1. Weighing interest rates, credit quality and prices of the related common stocks, we can assess our holdings in Salomon and Champion at yearend 1990 as worth about what we paid, Gillette as worth somewhat more, and USAir as worth substantially less. In making the USAir purchase, your Chairman displayed exquisite timing: I plunged into the business at almost the exact moment that it ran into severe problems. (No one pushed me; in tennis parlance, I committed an "unforced error.") The company's troubles were brought on both by industry conditions and by the post-merger difficulties it encountered in integrating Piedmont, an affliction I should have expected since almost all airline mergers have been followed by operational turmoil. In short order, Ed Colodny and Seth Schofield resolved the second problem: The airline now gets excellent marks for service. Industry-wide problems have proved to be far more serious. Since our purchase, the economics of the airline industry have deteriorated at an alarming pace, accelerated by the kamikaze pricing tactics of certain carriers.

The trouble this pricing has produced for all carriers illustrates an important truth: In a business selling a commodity-type product, it's impossible to be a lot smarter than your dumbest competitor. However, unless the industry is decimated during the next few years, our USAir investment should work out all right. Ed and Seth have decisively addressed the current turbulence by making major changes in operations. Even so, our investment is now less secure than at the time I made it. Our convertible preferred stocks are relatively simple securities, yet I should warn you that, if the past is any guide, you may from time to time read inaccurate or misleading statements about them. Last year, for example, several members of the press calculated the value of all our preferreds as equal to that of the common stock into which they are convertible. By their logic, that is, our Salomon preferred, convertible into common at $38, would be worth 60% of face value if Salomon common were selling at $22.80. But there is a small problem with this line of reasoning: Using it, one must conclude that all of the value of a convertible preferred resides in the conversion privilege and that the value of a non-convertible preferred of Salomon would be zero, no matter what its coupon or terms for redemption. The point you should keep in mind is that most of the value of our convertible preferreds is derived from their fixed-income characteristics.

We can promise complete confidentiality and a very fast answer - customarily within five minutes - as to whether we're interested. We prefer to buy for cash, but will consider issuing stock when we receive as much in intrinsic business value as we give. Our favorite form of purchase is one fitting the Blumkin- Friedman-Heldman mold. In cases like these, the company's owner- managers wish to generate significant amounts of cash, sometimes for themselves, but often for their families or inactive shareholders. At the same time, these managers wish to remain significant owners who continue to run their companies just as they have in the past. We think we offer a particularly good fit for owners with such objectives. We invite potential sellers to check us out by contacting people with whom we have done business in the past. Charlie and I frequently get approached about acquisitions that don't come close to meeting our tests: We've found that if you advertise an interest in buying collies, a lot of people will call hoping to sell you their cocker spaniels. A line from a country song expresses our feeling about new ventures, turnarounds, or auction-like sales: "When the phone don't ring, you'll know it's me." Besides being interested in the purchase of businesses as described above, we are also interested in the negotiated purchase of large, but not controlling, blocks of stock comparable to those we hold in Capital Cities, Salomon, Gillette, USAir, and Champion.

Gillette's business is very much the kind we like. Charlie and I think we understand the company's economics and therefore believe we can make a reasonably intelligent guess about its future. (If you haven't tried Gillette's new Sensor razor, go right out and get one.) However, we have no ability to forecast the economics of the investment banking business (in which we have a position through our 1987 purchase of Salomon convertible preferred), the airline industry, or the paper industry. This does not mean that we predict a negative future for these industries: we're agnostics, not atheists. Our lack of strong convictions about these businesses, however, means that we must structure our investments in them differently from what we do when we invest in a business appearing to have splendid economic characteristics.

In one major respect, however, these purchases are not different: We only want to link up with people whom we like, admire, and trust. John Gutfreund at Salomon, Colman Mockler, Jr. at Gillette, Ed Colodny at USAir, and Andy Sigler at Champion meet this test in spades. They in turn have demonstrated some confidence in us, insisting in each case that our preferreds have unrestricted voting rights on a fully-converted basis, an arrangement that is far from standard in corporate finance. In effect they are trusting us to be intelligent owners, thinking about tomorrow instead of today, just as we are trusting them to be intelligent managers, thinking about tomorrow as well as today.

In summation, Charlie and I feel that our preferred stock investments should produce returns moderately above those achieved by most fixed-income portfolios and that we can play a minor but enjoyable and constructive role in the investee companies. In September, Berkshire issued $902.6 million principal amount of Zero-Coupon Convertible Subordinated Debentures, which are now listed on the New York Stock Exchange. Salomon Brothers handled the underwriting in superb fashion, providing us helpful advice and a flawless execution.

Enter some ingenious and, in this case, highly useful investment bankers (led, I'm happy to say, by Salomon Brothers). They created the instrument desired by "stripping" the semi- annual coupons from standard Government issues. Each coupon, once detached, takes on the essential character of a Savings Bond since it represents a single sum due sometime in the future. For example, if you strip the 40 semi-annual coupons from a U. S. Government Bond due in the year 2010, you will have 40 zero- coupon bonds, with maturities from six months to 20 years, each of which can then be bundled with other coupons of like maturity and marketed. If current interest rates are, say, 10% for all maturities, the six-month issue will sell for 95.24% of maturity value and the 20-year issue will sell for 14.20%. The purchaser of any given maturity is thus guaranteed a compounded rate of 10% for his entire holding period. Stripping of government bonds has occurred on a large scale in recent years, as long-term investors, ranging from pension funds to individual IRA accounts, recognized these high-grade, zero-coupon issues to be well suited to their needs.

Besides being interested in the purchase of businesses as described above, we are also interested in the negotiated purchase of large, but not controlling, blocks of stock comparable to those we hold in Capital Cities, Salomon, Gillette, USAir and Champion. Last year we said we had a special interest in large purchases of convertible preferreds. We still have an appetite of that kind, but it is limited since we now are close to the maximum position we feel appropriate for this category of investment.

We also told you last year about our holdings of another security whose predominant characteristics are those of an intermediate fixed-income issue: our $700 million position in Salomon Inc 9% convertible preferred. This preferred has a sinking fund that will retire it in equal annual installments from 1995 to 1999. Berkshire carries this holding at cost. For reasons discussed by Charlie on page 69, the estimated market value of our holding has improved from moderately under cost at the end of last year to moderately over cost at 1988 year end.

The close association we have had with John Gutfreund, CEO of Salomon, during the past year has reinforced our admiration for him. But we continue to have no great insights about the near, intermediate or long-term economics of the investment banking business: This is not an industry in which it is easy to forecast future levels of profitability. We continue to believe that our conversion privilege could well have important value over the life of our preferred. However, the overwhelming portion of the preferred's value resides in its fixed-income characteristics, not its equity characteristics.

Earlier, another familiar face turned up in the RJR bidding contest: Jay Pritzker, who was part of a First Boston group that made a tax-oriented offer. To quote Yogi Berra; 'It was deja vu all over again.' During most of the time when we normally would have been purchasers of RJR, our activities in the stock were restricted because of Salomon's participation in a bidding group. Customarily, Charlie and I, though we are directors of Salomon, are walled off from information about its merger and acquisition work. We have asked that it be that way: The information would do us no good and could, in fact, occasionally inhibit Berkshire's arbitrage operations.

However, the unusually large commitment that Salomon proposed to make in the RJR deal required that all directors be fully informed and involved. Therefore, Berkshire's purchases of RJR were made at only two times: first, in the few days immediately following management's announcement of buyout plans, before Salomon became involved; and considerably later, after the RJR board made its decision in favor of KKR. Because we could not buy at other times, our directorships cost Berkshire significant money.

Besides being interested in the purchase of businesses as described above, we are also interested in the negotiated purchase of large, but not controlling, blocks of stock comparable to those we hold in Cap Cities and Salomon. We have a special interest in purchasing convertible preferreds as a long- term investment, as we did at Salomon. We received some good news a few weeks ago: Standard & Poor's raised our credit rating to AAA, which is the highest rating it bestows. Only 15 other U.S. industrial or property- casualty companies are rated AAA, down from 28 in 1980.

On a worst-case basis with respect to the Pennzoil litigation, we felt the bonds were likely to be worth about what we paid for them. Given a sensible settlement, which seemed likely, we expected the bonds to be worth considerably more. At yearend our Texaco bonds were carried on our books at $104 million and had a market value of $119 million. By far our largest - and most publicized - investment in 1987 was a $700 million purchase of Salomon Inc 9% preferred stock. This preferred is convertible after three years into Salomon common stock at $38 per share and, if not converted, will be redeemed ratably over five years beginning October 31, 1995. From most standpoints, this commitment fits into the medium-term fixed-income securities category. In addition, we have an interesting conversion possibility.

What we do have a strong feeling about is the ability and integrity of John Gutfreund, CEO of Salomon Inc. Charlie and I like, admire and trust John. We first got to know him in 1976 when he played a key role in GEICO's escape from near-bankruptcy. Several times since, we have seen John steer clients away from transactions that would have been unwise, but that the client clearly wanted to make - even though his advice provided no fee to Salomon and acquiescence would have delivered a large fee. Such service-above-self behavior is far from automatic in Wall Street.

For the reasons Charlie outlines on page 50, at yearend we valued our Salomon investment at 98% of par, $14 million less than our cost. However, we believe there is a reasonable likelihood that a leading, high-quality capital-raising and market-making operation can average good returns on equity. If so, our conversion right will eventually prove to be valuable.

Shortly after yearend, Berkshire sold two issues of debentures, totaling $250 million. Both issues mature in 2018 and will be retired at an even pace through sinking fund operations that begin in 1999. Our overall interest cost, after allowing for expenses of issuance, is slightly over 10%. Salomon was our investment banker, and its service was excellent.

On the other hand, we frequently get approached about acquisitions that don't come close to meeting our tests: new ventures, turnarounds, auction-like sales, and the ever-popular (among brokers) "I'm-sure-something-will-work-out-if-you-people- get-to-know-each-other." None of these attracts us in the least. Besides being interested in the purchases of entire businesses as described above, we are also interested in the negotiated purchase of large, but not controlling, blocks of stock comparable to those we hold in Cap Cities and Salomon. We have a special interest in purchasing convertible preferreds as a long-term investment, as we did at Salomon.