In early fall 1991, shortly after the revelation of Salomon Brothers' hanky-panky in the Treasury notes market, the staff of the House Banking Committee held an exploratory meeting with some officers of the Federal Reserve Bank of New York to discuss what Congress could do to avoid a repetition of this scandal.

The tenor of the talk grew to be too much for one of the senior Fed people present, who shouted at the staffers, "You don't understand. People don't lie to the Federal Reserve Bank of New York" - which drew the astonished reply, "Why not? They lie to us all the time."

In fact, a degree of innocence or neglect at the Fed was a precondition for the manipulated squeeze that Steinhardt Partners, Caxton Corp., Quantum Fund, and Salomon Brothers pulled off in the Treasury note auctions of the spring 1991.

Big Short Positions

Sophisticated observers understood that the customs of investors in these notes - and the use of "on the run" Treasury issues as hedging instruments - encouraged the creation of large short positions in the when-issued market that precedes each auction.

But even those who knew why a lot of arbitragers shorted the when-issued market found it hard to see how the hedge funds and Solly could squeeze them.

The primary dealers who buy and distribute these new issues are funded through repurchase agreements, and the "lender" in each such agreement becomes the owner of the notes for the period of the agreement.

Daisy Chain of Repos

Over the course of a single day, the notes that the short-sellers need can be circulated repeatedly through the Fed Wire in a daisy chain of repurchase agreements, permitting the sellers to deliver to purchasers and avoid the penalties associated with a failure to deliver.

A relatively small fraction of an issue circulating through this system of repurchase agreements should guarantee that short-sellers can continue to put their hands on the notes or bonds they need until investors sell last month's issue and "roll" into next month's paper.

The exercise has to be repeated every day, but it can be repeated every day, provided nobody interferes with the willingness of those who hold the notes (as buyers or holders under repurchase agreements) to lend them.

Cheap Funding Is Key

The profits that market manipulators can make on a squeeze in the Treasuries market are generated not so much by selling the notes at a higher price as by borrowing money at low interest rates through "reverse repurchase" agreements.

The lender will agree to a sale-and-repurchase agreement at a low interest rate because he needs just these notes to cover his short position.

The more difficult the holders of the notes can make it for the shorts to find them, the lower the rate at which they can borrow on the repurchase chassis. Such notes are said to be "on special," and notes on special are a comfort and a joy for the noteholders.

Market Truism

As the uses-and-sources committees of all financial institutions will be the first to say, the money you can save on your cost of funds is the most certain source of profits in all the world.

Dealers know and hedge fund operators can learn the highways and byways of the Treasuries markets. They can find out which of the many pension funds, mutual funds, and insurance companies may not by law, or will not by policy, use today's portfolio of bonds held under a repurchase agreement as tomorrow's source of short-term cash.

Notes or bonds sold to these large investors under repurchase agreements are thus frozen out of the repo market and will not become available to the short-sellers.

Dealers also know and hedge funds can learn which of these institutional investors maintain third-party repo arrangements at the money-center banks, standing arrangements to sweep their cash positions into short-term purchases of Treasuries every night after the Fed Wire closes, virtually eliminating the possibility of another repo for the same notes on the same day.

The Steinhardt Deal

The Wall Street houses that supply these notes to these overnight buyers use the proceeds to reduce their overnight debt to the banks that, for a very small fee, operate the system.

In the squeeze of the spring 1991 note auctions, Mike Steinhardt of Steinhardt Partners, protecting and enhancing the profits in the very large positions he had taken originally in the when-issued market, made a deal with Salomon under which Salomon purchased the notes not only subject to Steinhardt's repurchase under contract, but also subject to Steinhardt's control over any interim repurchase agreement that Salomon might wish to make to fund its own positions.

This was big money. On May 29, 1991, according to documents "discovered" by counsel for Three Crown Limited Partnership, one of the plaintiffs in the civil suits growing out the 1991 squeeze, Salomon was funding no less than $8.4 billion of Steinhardt's Treasury holdings.

There were, in short, various devices that could be used by people gaming in the Treasuries market to make their games a sure thing. But there is still a missing piece, and increasingly both private and public investigators are beginning to look for it at the Fed itself.

Not for Repurchase

One of the institutions that doesn't put its portfolio out for repurchase is the Federal Reserve Bank of New York, which accumulates a grab bag of short-term and medium-term paper as part of the open market operations it conducts for the system as a whole.

In December, the House Subcommittee on Telecommunications and Finance asked the Fed to report its own purchases subject to repurchase of notes "on special" in the repo market.

And eventually the Fed did report relatively small holdings of such notes - defined for the purpose of the response as notes that could be financed at rates less than half the prevailing rates for notes that were not on special.

As Salomon was known to have adopted a policy of making its holdings of the May 1993 notes available for reverse repurchase at two percentage points below a prevailing rate of more than 5% in June 1991, the Fed's response in effect defined away what might have been evidence that it had been holding the notes that the victims of the squeeze desperately needed.

Small Yield on Vast Sum

Subcommittee Chairman Edward J. Markey, D-Mass., therefore came back and asked for the Fed's portfolio holdings of all notes and bonds that were "on special" with interest rate reductions of 25 basis points or more, because cheating is worthwhile at a yield as small as 25 basis points when the nut is $8.4 billion.

On June 3, Fed Vice Chairman David Mullins responded to Rep. Markey with some aggregate figures. Of $508 billion taken by the Fed in repurchase agreements in 1991, Mullins reported, $24 billion had been securities that were being borrowed elsewhere "at rates below the general collateral rate."

There was no breakdown of the duration of the securities in these repos, or the extent to which they were on-the-run or seasoned issues, or the length of time the Fed held them. As to whether or not the Fed was keeping off the market the notes Salomon and George Soros and Steinardt Partners and Caxton Partners were squeezing in April and May 1991, well, the Fed could not provide any information at all: "The Reserve bank began to maintain a formal data base of repo rates," Mullins writes, "in mid-September 1991."

Skimpy Testimony

In other words, after Mullins and E. Gerald Corrigan of the Federal Reserve Bank of New York had testified in the congressional investigations of the Salomon scandal and were embarrassed by their lack of information about what had been going on.

The Federal Reserve Bank of New York once supervised in detail the government bond market and all the important dealers, meeting regularly one on one with responsible officers of the larger houses - both Billy Salomon and Bill Simon (who was chief of Salomon's bond traders before he became secretary of the Treasury) remember going to 33 Liberty Street and undressing completely before Alan Holmes and his successor, Peter Sternlight.

In those days, too, the Fed had a staff of trained market people who examined the collateral offered for repos, to make sure it was eligible and clean.

Fed Shrinks from Supervision

But because of the belief that people don't lie to the Fed, the bank retreated from its supervisory role. Under the Government Securities Act of 1986, supervision of virtually all the dealers was turned over to the Securities and Exchange Commission, though the Fed retained its oversight power.

But the SEC (and its surrogates the New York Stock Exchange and Nasdaq) can't supervise government bond dealers because there are no rules of fair practice to enforce or audit trails to examine.

Recently, the Fed has certified to the Congress that the fairly frequent squeezes in the market in 1992 were "natural," with no one holder owning enough to make a squeeze work.

But the Fed doesn't in fact know who controls these notes and bonds, because it doesn't even try to find out who is selling what notes to whom under repurchase agreements,-or what notes and bonds are being purchased and repurchased from whom in the third-party repo market at the banks.

No |Prescreening'

Nor does the Fed, in Mullins' words, "prescreen the securities that are presented" for repurchase in connection with its own open market operations.

"We have made our preferences not to receive securities that are deeply on special plain to the dealer community," Mullins added, "effectively making it unnecessary to prescreen collateral."

In other words, people don't lie to the New York Fed - at least, not unless they can make money by doing so.

Rein In the Dealers

Nobody can supervise any market without supervising the dealers, and in the Treasuries market - where much of the business is done through blind brokers so the dealers themselves don't know their counterparties - regulators who don't police the dealers cannot possibly distinguish between "natural" and manipulative squeezes.

Indeed, the Federal Reserve Bank of New York was still telling callers that the squeezes in the notes auctioned in April and May 1991 were natural," after the Treasury Department and the SEC had sent the FBI out to gumshoe what was obviously a manipulated market.

We do not and probably never will know for a fact that the Fed unwittingly facilitated the market manipulation by Salomon and the hedge funds in spring 1991, but it does seem likely.

The improvement in vigilance since then seems to be paying off, By Mullins' reply to Markey, the proportion of Treasury securities on special in the Fed's repurchase portfolio dropped from 4.8% in 1991 to 1.5% in 1992.

But there's still too much the Fed doesn't want to know. Regulation is a business where nonfeasance is as bad as malfeasance. The time has come to turn over the regulation of the government securities markets to the SEC.

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