Suit Alleges Misdeeds by Salomon Smith Barney During LTCM Panic

Meanwhile, Salomon Smith Barney may be helping set up a former arbitrager to minimize its hedge fund risk.
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Eager to rid its books of hedge-fund-related risk,

Salomon Smith Barney

may help one of its key London arbitragers set up his own operation with $750 million in assets that were once under the firm's umbrella, according to two people close to the firm.

The fact that an in-house hedge fund manager is getting the red-carpet treatment shouldn't surprise anyone, but it does point out how Salomon Smith Barney allegedly mistreated some of its clients in the outside hedge fund community. One left fuming on the wrong side of the equation is Patrick McMahon, head of

MKP Capital Management

, a hedge fund based in Manhattan.

MKP is suing Salomon for $250 million in damages, alleging Salomon forced the mortgage-backed securities hedge fund to liquidate roughly $1 billion in bonds in a bad market. The suit also alleges that the prime broker then snapped up some of the liquidated securities at bargain prices, essentially using its position as MKP's lender to get a sweet deal on those securities.

Salomon Smith Barney was unable to provide comment on the lawsuit. And the firm's lawyers have yet to file a response to the complaint.

Not all of Wall Street thinks the suit has merit. "Hard to say. It's easy to sue when there's money coming back into the market," says Gary Pzegeo, a fixed-income specialist with

Evergreen Funds

, the mutual fund subsidiary of

First Union

(FTU)

.

Meanwhile, Salomon Smith Barney is in the midst of helping set up one of its own guys, Paul Matthews, who in December took over the firm's global bond arbitrage desk in London. Matthews may now be in line to become a top-flight hedge fund manager, starting with a cool $750 million in seed capital from Salomon Smith Barney's parent,

Citigroup

(C) - Get Report

, say the two people close to the firm. But Citigroup doesn't want the lending risk exposure to show up on the books, so it may quietly spin off the London global-arb desk into a hedge fund managed by Matthews. Matthews didn't return phone calls seeking comment. Salomon Smith Barney declined to comment on what it's doing in London, citing the firm's policy of not commenting on rumors.

Funny how the same aversion to risk that is apparently prompting Solly to launch Matthews' hedge fund business allegedly put MKP in a world of pain.

Last fall, when

Long-Term Capital Management's

near-collapse set off a global credit crunch, plenty of hedge funds got margin calls that forced them to sell at depressed prices. Lenders got scared, and the hedge funds got squeezed. Bloomington, Minn.-based

Eagle Capital Management

, run by veteran trader Paul Upcraft, was said to have cratered the same week a major Wall Street brokerage house yanked its credit line. Michael Vranos'

Ellington Management Group

and Andrew Fisher's

Convergence Asset Management

got hit as well. An attorney for both Convergence and Ellington didn't return calls seeking comment. An official with Eagle Capital declined to comment.

Indeed, almost everyone panicked when they saw Long-Term shaken to its foundation, but MKP alleges that Solly actually took advantage of the situation to force MKP's hand.

MKP maintains in its suit that Salomon Smith Barney forced the bond sale, then profited from the auction by buying some of its inventory at low-ball bids. "

Salomon Smith Barney then saw an opportunity to profit from its wrongdoing by purchasing these undervalued bonds when it knew there would be little, if any, competition," the complaint says.

Ironically, MKP's McMahon, 36, is an alumnus of Salomon Brothers from the 1980s, as are his partners, Eric Keiter and Maurice "Chip" Perkins. McMahon's mortgage-backed division fell under the purview of (but didn't report directly to) John Meriwether, the Long-Term managing partner who was then the master of Salomon's arbitrage universe.

McMahon declined to comment beyond the complaint, which was filed in March in New York Supreme Court.

What does all this mean for current hedge fund clients of Salomon Smith Barney? Following the perilous days last fall, Sandy Weill, Citigroup's risk-averse patriarch, urged his managers to play it safe. Weill, according to the suit, "made it clear the heads of the various departments would be held responsible for any losses incurred in lending to

Salomon Smith Barney's prime brokerage clients." Hence the possible global-arb desk spinoff.

MKP claims in its suit that Weill wanted out at all costs. Weill and

Travelers

had a lot to lose by disclosing a heavy hedge fund exposure in Salomon Smith Barney's prime brokerage business. They were busy completing Travelers' mega-merger with Citicorp in the midst of a market meltdown, the very week it stopped lending to MKP, the suit says.

"To protect that deal, which represented the capstone achievement of

Weill's long Wall Street career, Travelers' senior management issued various decrees intended to insulate

Salomon Smith Barney from all risk, whether real or imagined," the complaint maintains.

"When things got hairy last year ... there were some awful counter-parties and some good ones," says one investor in another fixed-income arbitrage hedge fund,

III Offshore Advisors

. The investor reserved praise for

Morgan Stanley Dean Witter

(MWD)

and

J.P. Morgan

(JPM) - Get Report

.

MKP, which has returned 12% this year, according to an investor in the fund, figures its claim of $250 million just about totals the 1998 compensation for Weill and John Reed, Citigroup's co-chief executives.

Ultimately, however, Salomon Smith Barney may have changed the rules by cutting off lending to hedge funds, but MKP had to play, says a rival hedge fund manager in mortgage-backed bonds. "They were leveraged up the wazoo," says the manager. "They knew what they were doing."