Cantor: 'Getting between the wall and the wallpaper'

Forbes.com

By Thomas Jaffe,

October 20, 1997

At 36, Howard Lutnick is the youngest chief executive of a major Wall Street firm. From his lofty perch on the 105th floor of New York's One World Trade Center, the managing general partner of Cantor Fitzgerald, L.P., can peer down on the lesser skyscrapers that house far bigger and better-known brokerages. Though it dominates the brokering of U.S. government bonds, Cantor is no Merrill Lynch or Morgan Stanley, Dean Witter Discover or Goldman, Sachs. But never mind; Lutnick has ambitions as towering as the aerie he occupies.

Cantor has come up as a niche player. In a single day, on average, $100 billion in U.S. government debt is traded through brokers like Cantor, which reigns supreme in brokering long bonds; 30-year maturities. It also is a major broker for other segments of the Treasury market. Not least, it supplies the Treasury bond pricing data that are the bread and butter of Dow Jones & Co.'s electronic information service.

Though the Cantor partnership's capital of $185 million is only a pittance compared with Morgan's $13 billion or Goldman's $5.8 billion or, soon, the $9 billion of Travelers' Salomon Smith Barney, Lutnick is expanding Cantor into a supermarket of wholesale brokerage services in all kinds of fixed-income paper, foreign exchange, derivatives, futures and interest rate swaps. And it is in equities with institutional sales and trading. Cantor already employs over 2,300 people; more than half of them at its New York headquarters, about 675 in London.

A nondescript man of average height with thinning black hair, Howard Lutnick has come a long way from the modest home on Long Island, where he grew up as one of three children of a college professor. With his 40th birthday still nearly four years away, Lutnick already boasts membership on the executive board of the Nasdaq stock market and sits on the board of managers of his alma mater, Haverford College. Lutnick, his lawyer wife and their 18-month-old son live in Manhattan's showy Trump Palace, where they are served by an English butler.

His social ambitions match his business ambitions. This summer the Lutnicks vacationed at the ritzy Grand Hôtel du Cap Ferrat on the French Riviera, in a $42,000-a-week villa.

His mentor

Lutnick bootstrapped himself from obscurity by being useful to now-legendary Wall Streeter B. Gerald Cantor. When Bernie Cantor died last summer, at 79, he was buried in the small Los Angeles cemetery in which Marilyn Monroe lies. His fortune was estimated at $500 million, and his art collection was world-famous for its hundreds of Rodin sculptures.

Cantor's was a classic rags-to-riches tale. As a poor teenager in the Bronx he hawked hot dogs at Yankee Stadium. He quit New York University to become a broker, served as a paratrooper during World War II and in 1945 founded his own securities firm in New York. But it was in Los Angeles, the entertainment capital of the world, that he made his mark, numbering Kirk Douglas and Zsa Zsa Gabor among the clients of his Cantor Fitzgerald & Co. (Fitzgerald, long gone, was an early associate.)

Long term wasn't Cantor's style. He kept moving around, looking for an edge. Arbitrage was his real love; small, quick profits with little or no risk. Cantor knew his way around the convoluted tax code, and his interpretation of its finer points made him a master of tax shelters, straddles and other such schemes. Besides collecting Rodins, Cantor collected politicians. He and his wife, Iris, were among those to rent a room for the night at the Clinton White House.

Many in the securities industry are like Bernie Cantor, prowling about for an edge, but Cantor broke from the pack of edge-seekers in 1972. The equities business was crowded, and, save for the Nifty Fifty, equities were drooping. The government bond market was less crowded and; handily; less tightly regulated.

Sensing opportunity, Cantor invested about $3 million in Telerate, an electronic data service that disseminated commercial paper interest-rate information. He also opened Cantor Fitzgerald Securities Corp., a wholesale broker-dealer of government securities now registered separately from his Cantor Fitzgerald & Co.

The way the government securities market had worked until that point was that wholesale brokers like Cantor arranged trades between primary dealers. The primary dealers dealt with retail customers; retail being in this case not the general public but big institutions, financial houses, large hedge funds and the like.

There are currently around 35 primary dealers, mostly huge firms like Salomon, Merrill Lynch and Lehman Brothers. Why do they need wholesale brokers? To cover their tracks. The lion's share of the volume in government securities comes from the primary dealers trading amongst themselves. If a primary dealer is liquidating a huge position, it doesn't want that fact known, lest others, smelling a huge sell order, try to crowd ahead of it. By going through a wholesale broker, the primary dealer expects anonymity.

Enter Cantor. As a wholesale broker, Bernie did what his rivals hadn't thought of: He made the market more efficient by putting the bids and offers from primary dealers on Telerate's screen network. This made the market more transparent but preserved anonymity.

Today there are plenty of other bond quot screens. But when Cantor first got into it, Telerate was an innovation. It filled a gap. Through the Telerate network of screens everyone could see; more or less in real time; what was going on in the Treasury market, though they couldn't see the names of the players. Cantor's timing was exquisite. Stocks were soon to turn dull, and they were to remain so for a decade. But as the federal deficit swelled, the government bond market boomed. Cantor moved in deeper, soon doing business directly with larger retail customers as well. He sold his controlling stake in Telerate for a huge profit in the early 1980s, but continued to milk it by charging it for the data Cantor supplied. Though the operation turned into a disaster for Dow Jones, it was one of the best things that ever happened to Cantor.

Bernie's boy

Into this lucrative setup stepped young Howard Lutnick in 1983. Whereas Bernie had dropped out of college, Lutnick had a degree in economics from prestigious Haverford. But just a bit underneath the patina the young man and the old man were much alike. Cantor liked the kid. When he was just 24, an age when many young people are still in graduate school, Lutnick was trading for some of Cantor's personal clients. That was in 1985.

That same year Cantor let Lutnick start the Investment Strategies Group division of Cantor Fitzgerald & Co. Cantor was moving further down the distribution chain in the Treasury market, now dealing directly with retail customers such as regional banks, medium-size businesses, wealthy individuals and others.

In December 1990, when Lutnick was only 29, Cantor named him his second-in-command and designated successor. "Bernie wouldn't hear a bad word about the kid," says an ex-Cantor executive. "If you presented him with evidence that Howard had crossed the line, he'd say, 'Don't worry. He's young. He'll learn.'"

If he himself had not been the victim, Bernie Cantor might well have admired the way Lutnick grabbed control of Cantor Fitzgerald as his mentor lay dying.

In 1990 Cantor, in his 70s, went on dialysis. By 1994 he had been declared legally blind. Lutnick convinced him to change the firm from a corporation into a partnership, to avoid double taxation. The deal closed in September 1992.

Cantor had started with a 73% stake, but he and his stylish wife, Iris, took out profits to finance their high living. (By the time Cantor died, he owned just 47%.) The partnership structure still gave him absolute power; though Bernie's days were numbered, Lutnick apparently was getting antsy. He made an ally of Stuart Fraser, Iris Cantor's nephew, naming him head of the firm's government securities brokerage. In 1995 Lutnick, Fraser and a third partner tried to buy out the Cantors, but Bernie was still able to say no.

But on Jan. 2, 1996, when Bernie Cantor had been put on life support, Lutnick made his move. He activated the five-member incapacity committee provided for in the partnership agreement. Three members voted to take the reins from Cantor's failing hands; Iris Cantor and the fifth member abstained. Howard Lutnick, though he held just 14% of the partnership, was now the boss.

Iris Cantor, newly in charge of the holding company through which Bernie owned his partnership units, was furious. Lutnick has claimed she wanted to sell the firm. Iris claimed that she merely wanted a say in operating it. In May 1996 they went to Chancery Court in Delaware to have it out. After two days they settled. Lutnick won: Iris Cantor would get a lot of money but have no voice in running the firm. When Bernie was buried two months later, Iris barred Lutnick from the cemetery.

A master of the universe

If Lutnick grieved, it wasn't for long. The weekend after his mentor's death, Lutnick and a crowd of guests celebrated his 35th birthday by gambling for charity at New York's Metropolitan Club.

Lutnick was by now; in novelist Tom Wolfe's felicitous phrase; a master of the universe.

What gives Lutnick and the firm clout in an investment world dominated by far bigger and more respected firms? Certainly not prestige. Its clout derives from its highly specialized position. This is a business in which margins are so thin that it takes real expertise to make money on them. Lutnick likes to refer to it as "getting between the wall and the wallpaper."

The wholesale market in government securities operates in price increments as small as 1/256 of a point, which translates to $39.06 on $1 million worth of bonds. In the retail market, increments typically are in 1/32 of a point, translating to $312.50 per million. Commissions? A primary dealer that trades through Cantor's wholesale government securities brokerage operation normally pays a commission of $30 per $1 million. The customers of Cantor's retail arm would pay a minimum commission on their trades of $39 per million. There's not a lot of paste between that wallpaper and that wall.

There is, however, a hell of a lot of wall and wallpaper. These tiny margins are worth pursuing because the market is so huge. In a market where $100 billion a day is traded, even $30 per $1 million comes to $3 million.

If you can wring a few extra pennies on a business in the billions, you've got real money. Think of it as highly sophisticated coin-clipping; a clip here, a clip there, often so tiny as to be unnoticed across trillions of coins.

Lutnick's critics say he has not always been scrupulous in getting between the wall and the wallpaper. Here's one episode about which Forbes has seen the relevant documents: In the late 1980s a U.S./German outfit, International Participation Corp., was running investment money for 6,000 European investors, mainly Germans. Indianapolis-based Vancorp Financial Services took on the management of $29 million of the capital. Vancorp opened an account at, among others, Cantor Fitzgerald & Co., trading mostly in Treasury bonds and over-the-counter options on Treasurys.

From late May to September 1989 the Cantor account lost $3.1 million and, elsewhere, futures accounts lost $1.1 million, yet Vancorp collected over $4 million in commissions and fees. When Vancorp returned the IPC funds to Germany that fall, only about $17 million of the $29 million was left.

So complex was the bookkeeping; and so convoluted the trail; that it took until May 1994 for the Commodity Futures Trading Commission to file a complaint. In January 1997 Cantor agreed to pay a $500,000 fine to settle CFTC charges that it had assisted in fraud.

But the German investors are still suing Cantor Fitzgerald & Co. for fraud and asking for more than $7 million in damages, plus three times that in punitive damages. The case is scheduled to go to trial Nov. 18 in federal district court in Los Angeles.

Extracurricular gains?

Where was the alleged fraud? The suit alleges Cantor agreed to broker Vancorp's trades for $156.25 per $1 million face value of Treasury bonds but in most cases collected almost three times that. It also alleges that Cantor acted not as a broker but as a dealer, without disclosing it to the client. Cantor denies the charges.

Howard Lutnick personally executed Vancorp's orders. His trading was conducted through three inventories; H, W and L; the initials for Howard William Lutnick.

FORBES has reviewed trading records relevant to the case. On Aug. 4, 1989 for instance, Cantor made a $150,000 profit (before commission) on a trade involving $20 million of long bonds that it purchased from Vancorp on the same day. In a trade this size the straight brokerage commission due Cantor at the agreed-upon $156.25-per-million rate would have been just $3,125. Did Vancorp's customers get full value for their bonds?

FORBES examined hundreds of transactions in which securities were traded between Vancorp and Cantor Fitzgerald & Co.'s Investment Strategies Group, and between ISG and other entities, most typically Cantor Fitzgerald Securities' government securities brokerage. They involved some $4.75 billion worth of positions and included over 80% of Vancorp's trades with Cantor.

Cantor defends its outsized gains on these transactions as simple reward-for-risk. But in the transactions reviewed by FORBES Lutnick lost money only about one time in ten. Cantor's take from the trades we examined was around $2.8 million. Close to half of that was rung up in four house inventories, almost all of it by H, W and L. Lutnick has admitted to a 30%-to-40% interest in the trading profits of those inventories. The other $1.5 million or so was credited as gross commissions to the salesman who covered the Vancorp account. After the salesman took his cut of that $l.5 million, Lutnick got a big chunk of what was left over.

The Vancorp account yielded profits in other ways. Cantor collected over $1.2 million of net interest. There were foreign exchange consulting fees. Commissions were rung up when house inventories sold positions acquired from Vancorp. Getting between the wallpaper and the wall? Cantor seems to have made quite a bit of space for itself in these transactions.

There are many, many ways to play the Treasury bond market. Howard Lutnick was well-versed in "rolls." What are rolls? A roll trade takes place between the day the Treasury announces it will auction off a new issue of a government security and the day the auction occurs.

Bond traders thrive on playing the spreads between existing securities of comparable yield and maturity and the forthcoming issues. Lutnick needed to figure out how to use Cantor's edge. According to a number of ex-Cantorites, for a time Lutnick and his Investment Strategies Group traders had access to the internal screens that the wholesale brokers used in Cantor's government securities brokerage rooms. At the bottom of those screens is a data crawl known as a waterfall that shows, by account number, which customers have been the buyers and sellers in the last few trades in a given security.

The brokers use the waterfall to keep track of the order flow. But knowing who is doing the trading is a clue to how big or well-informed the buying may be. Is it a primary dealer like Lehman? Is it a smart hedge fund like George Soros' Quantum? Or just a large company investing surplus cash? The customers are not supposed to have this information.

Cantor denies that the traders in Investment Strategies Group ever had access to the waterfall, but that is flatly contradicted by several former Cantorites. James Avena is now the president of New York-based Tullett & Tokyo Securities, but from 1982 to 1990 he ran Cantor Fitzgerald Securities. Avena says he told Bernie Cantor that Lutnick and his crew were peeking at the waterfall while trading. Cantor put a stop to it, Avena says.

First Nevada first

Howard Lutnick kept looking for other ways to leverage the franchise. In the late 1980s Bernie Cantor did not want to use his firm's scarce capital for trading, but he was willing to let Lutnick trade on his own. So Lutnick set up Solomon Partners, a private trading partnership named for his father. It was open from 1988 to 1990. He must have done well, because Cantor soon wanted a bigger piece of the action. In 1990 Lutnick created a better-capitalized private partnership, First Nevada Associates, with most of the capital coming from Bernie Cantor.

Though in theory First Nevada was a separate entity, it functioned like a house inventory for Cantor Fitzgerald & Co.'s Investment Strategies Group. When it was inconvenient for Cantor Fitzgerald to carry a position on Cantor's books, it might be carried on First Nevada's. Or First Nevada might be used to process a transaction or book a profit. First Nevada was active from October 1990 through December 1992. Between its founding and mid-March 1992, the account generated over 1,000 pages of transactions, nearly all of them in U.S. government securities.

Was First Nevada a sham account, a way for the house at times to covertly trade for itself against customers? Cantor Fitzgerald has always maintained that First Nevada was an independent customer of the firm. Yet several times in January and February 1992 First Nevada's profit-and-loss position was noted in the margin of Cantor Fitzgerald & Co. blotters exactly the same way that such notations were regularly made for the house's alphabetical inventories. On many days First Nevada's trading easily made it Investment Strategies Group's biggest customer.

On Mar. 11, 1992 the Wall Street Journal broke the story that the Securities & Exchange Commission was investigating Cantor. A month earlier the brokerage statement covering First Nevada's trading was a record 191 pages long. The day after the story broke, First Nevada abruptly stopped trading on margin. Over the rest of 1992 the account was wound down.

In 1994 the SEC made Cantor Fitzgerald & Co. cough up $90,000 in profits and interest and fined it $100,000 for poor record-keeping in connection with a complex scheme to accumulate risk-free positions at Treasury bond auctions.

Gary Lutnick, 32, Howard's younger brother, joined the firm in 1991. He has run the trading team of Cantor's Global Trading Strategies group, the renamed Investment Strategies Group. According to people who worked with him over the years, Gary developed a clever way of squeezing a bit extra for the franchise. A retail customer would make an offer to buy long bonds. If there was a flurry of buying in the bond, Gary would sometimes grab bonds on the screen in front of the customer and then sell the customer his newly purchased bonds at a slightly higher price; again getting between the wall and the wallpaper. He could do that because customers see the trading screen, but don't see who bought the bonds ahead of them.

Anxious to dispel rumors that Cantor's government securities brokerage was giving Gary Lutnick better execution for his trading than it gave to its other wholesale customers, the firm this year hired Richard Breeden, a former chairman of the SEC, to investigate. Breeden told FORBES that the electronic trade-matching system Cantor installed in its government securities brokerage rooms last year made the possibility of such preferential treatment remote.

But Breeden admits his inquiry was "fairly narrowly focused." He says: "We came in and looked at the way things run today. We did not go back and look at the last two years, five years, ten years, to inquire."

All that Breeden's "fairly narrowly focused" probing proves is that nothing fishy was going on while he was looking. A half-dozen former staffers of Cantor's renamed Global Trading Strategies Group have told Forbes that over the years the firm frequently traded ahead of its retail customers.

A Japanese bank gets a hosing

Howard Lutnick's efforts to win respect for Cantor Fitzgerald keep hitting the wall. In early 1996 there was the case of Cantor and Tokyo-based Norinchukin Bank, Japan's leading financial institution for agricultural cooperatives. The Japanese bank took a real hosing on some overnight orders it left with Cantor to fill. Did Gary Lutnick wield the hose? Sources tell us he did.

In its trading of U.S. Treasurys, Norinchukin favored what is called a scale trade. This means you buy a bit at a time, hoping that the market will be temporarily weak and let you lower your average cost. You can do this by putting in an overnight buy order on a descending scale. That can be dangerous on a volatile day.

Apr. 5, 1996 was such a day. It was Good Friday, when the market was open only half a day, and unemployment numbers were due out that morning. As it turned out, unemployment had dropped, which was bad for bonds. The long bond slumped sharply, losing around two points.

Gary Lutnick, our source says, had an order to buy nearly $1 billion worth of long bonds for Norinchukin on scale-down. Instead of filling the order as the price fell, the source says, Gary waited until the bond had dropped considerably, then bought bonds and sold them to Norinchukin at the higher prices specified in the scale order. Our source says he made the house roughly $800,000 in a matter of hours.

The Norinchukin Bank won't say much about the April 5th episode, but in mid-1996 it quit trading Treasurys in limit orders; and sharply cut back its business with Cantor.

Cantor Fitzgerald won't comment on the Norinchukin trading, but it did provide Forbes with a copy of an interoffice memo on its trade execution policy for customer level/limit orders. It was dated May 9, 1996, just a month after the alleged Good Friday incident. Personnel of the then Investment Strategies Group were instructed to explain the policy to their customers.

In the letter, after the usual boilerplate Cantor clearly warned: ". . . while holding your unexecuted order, we may trade for our own account at prices that are equal to, or better than, your level/limit." Isn't that a frank admission that it reserved the right to front-run customers? Front-running is of course illegal in stocks: In Treasury bonds it's a gray area.

Has Cantor Fitzgerald cleaned up its act, as Richard Breeden's findings would suggest? In a June 24, 1997 letter to FORBES, Cantor said that its policies and procedures forbid brokers in its government securities brokerage to take positions. Yet on June 6 of this year, according to sources, Timothy Coughlin, a star Cantor broker of ten-year notes, took a large position on which Cantor wound up losing an estimated $1.5 million.

We could go on and on with examples of transgressions and alleged transgressions we have uncovered in more than a year of research on Cantor Fitzgerald.

Since Lutnick took over Cantor's daily management in 1991, its revenues have tripled, to nearly $600 million last year, due in part to all the new businesses he's gone into. Keep this in mind, however: The growth was financed from profits from government bond brokerage, the equities business and income received from the sale of pricing data (a revenue flow the firm shares with an outfit now controlled by Iris Cantor). Many of those new businesses lose money or don't make much. European operations, led by the huge London office, gush red ink.

In short, Lutnick has yet to prove that he can turn Bernie Cantor's specialized money machine into a profitable full-service Wall Street house.

Skating on thin equity

Net profits rose during Lutnick's first years in charge, but from 1994 to 1996 they dropped from around $80 million to under $60 million. This year so far has seen another drop in profits, in part because of Lutnick's breakneck expansion.

Howard Lutnick's ambitions are huge but thinly capitalized. As of Mar. 27, 1997, there were $7.9 billion of assets but only $185 million of partners' capital.

The equity base looks even thinner when you realize that much of it is borrowed money. Last year the partnership retired a big chunk of Iris Cantor's partnership units and then it reoffered units to Lutnick and other partners; Lutnick's share is now 25%. Financing for the deal was provided by a Chase Manhattan-led syndicate. Thus Lutnick's partnership units; as well as those belonging to many other partners; are pledged as security for the loan.

Just as we were preparing to go to press, after months of reporting on the story, we received a press release from Cantor Fitzgerald. It announced the firm was, among other changes, shutting its fixed-income trading unit, Global Trading Strategies, Howard Lutnick's old stamping ground and more recently Gary Lutnick's. The announcement said the firm would concentrate on executing trades for customers. We note the irony without comment.