Don't Overreact in Freddie, Fannie Bidding Case
According to recent congressional testimony, 18 out of the first 21 dealers to respond in inquiries by the Federal Home Loan Mortgage Corp. conceded that they had inflated customer orders for bonds that the government-sponsored enterprise was about to issue.
The thrust of the congressional exchange was surprise at how widespread the practice appeared to be.
However, knowledgeable observers found it remarkable that there were actually three firms that had not exaggerated the data.
|The Way Business Was Done'
By most accounts, Freddie Mac, the Federal National Mortgage Association, and the Treasury were fully aware that it was custom for dealers to overstate customer orders.
As one former Treasury official was quoted, "It was the way business was done."
The Securities and Exchange Commission and the government-sponsored enterprises have begun a massive investigation of these practices.
The dealers have been asked to assist, by investigating their own activities. They have also been asked to provide the government with documents and information on past practices and steps taken to prevent their recurrence.
The government and the dealers have a mutual interest in ensuring that policies and procedures provide accurate data.
Severe Penalties Possible
Each dealer and bank should be developing a compliance program that the issuing authorities could review periodically. Such an approach would tend to restore public confidence in the integrity of this market.
Dealers need to recognize that they may have violated a number of federal statutes and consequently could face large criminal sanctions, civil penalties, and administrative remedies.
If their practices are found to be in violation of the general securities-fraud provisions or other, more particularized statutes in the federal criminal code, the broker-dealers could be facing multimillion-dollar fines and license revocation.
Other statutes and regulations could be invoked, such as the SEC's books and record-keeping provisions, which carry lesser sanctions.
Anything about past practices that the issuing authorities are told by dealers can be used against them in enforcement proceedings.
But regulators and prosecutors should resist the public outcry and congressional posturing. They must act sensibly and with restraint.
Overreaction could damage the ability of many government-sponsored enterprises to secure necessary funds for important public programs.
It could also work an injustice on companies and individuals who had no intent to deceive, but who simply believed they were participating in a long-standing, well-recognized system.
How the Bonds Are Sold
Government-sponsored enterprises are not a part of the government. They are privately owned corporations operating for profit. Special charters granted by Congress allow them to raise funds for specialized types of lending to areas such as agriculture, education, or home mortgages.
Bonds issued by these enterprises are designated "government securities" under federal law. This designation avoids the costly registration process that other private corporations must endure.
Nevertheless, these bonds are not backed by the full faith and credit of the United States.
The monthly issuance of bonds by the government-sponsored enterprises is run in a different manner from the weekly Treasury bond auction.
The enterprises do not sell their bonds at auction to the highest bidder. Issue prices are based on a spread from treasuries. The bonds are then allocated to the many dealers who make up the "selling group." They re-sell the bonds to their own customers.
Poorly Kept Secret
For years, apparently, the dealers routinely overstated their customer orders in reports filed with the enterprises.
As noted, a number of former Treasury officials conceded that the government has known of the practice for many years.
Some agency officials were in bond brokerage firms before taking their government jobs.
They may have had first-hand experience - or, a least, knowledge - of the practice from their days in industry.
No Harm Done
It is difficult to attribute fraud or intent to deceive in these practices - or to discern any party injured. An exception might be bond dealers who reported accurately in all instances (or who, more likely, exaggerated less than their competitors).
There has been no suggestion that either the issuing authorities or the ultimate purchasers suffered any financial harm. There has been no claim that any ultimate customer paid too much or too little as a result of these practices. The bidding practice could not affect the pricing, as the enterprises base the prices on a spread from Treasury bonds. The bonds were sold at the prices and interest rates that the enterprises set.
Coming down too hard on the dealers might harm the ability of the Treasury and the government-sponsored enterprises to raise needed funds.
An Essential Service
To put it simply, the government and the enterprises need viable bond dealers to remain in the business of buying and selling government securities.
This year, the U.S. Treasury will need to borrow over $300 billion in new money to fund the federal budget deficit. In addition, it must continue to roll over, as it matures, its existing debt of $3.5 trillion.
Separately, the enterprise issue bonds to raise money for politically popular programs such as home mortgage lending and farm lending.
The enterprises have outstanding over $850 billion in bonds. The U.S. government clearly needs the bond dealers in order to stay afloat.
What is less clear is to what extent securities dealers need the business from the U.S. government.
Source of Liquidity
Many of the same bond dealers who underwrite new bonds for the enterprises also provide the secondary market for resale of their bonds and of the Treasury's. They "make a market" in government bonds by continuously publishing price quotes to other market participants and buying and selling government bonds.
Thus, the larged bond dealers make it simple and inexpensive for anyone to unload large position in Treasury or enterprise bonds on a moment's notice.
Profits and Prestige
Liquidity in the government bond market makes investors more willing to purchase the bonds and reduces government borrowing costs. It also money-market funds, insurance companies, and banks - which hold large positions in government bonds - much more efficient.
According to some accounts, the business of underwriting government securities is not very profitable.
With razor-thin margins and massive exposure to the risk of price changes caused by shifts in interest rates, many dealers have been unable to make a profit and have quit the business.
Some of those who remain say their motive is not profit but ot accommodate clients who want to buy newly issued U.S. bonds - or for the prestige associated with being one of the government's investment bankers.
Danger of an Exodus
If many bond dealers left the business, the U.S. government and the government-sponsored enterprises could ultimately bear the cost.
Fewer dealers would mean less competition and higher spreads in the primary and secondary markets for government bonds.
This would increase the cost of funds to the enterprises and the government - and drive the federal budget deficit still further into the stratosphere.
Departure of a significant number of brokers would result in considerable disarray in the financial markets for some time.
Freddie Mac's Solution
It remains to be seen how the government and the enterprises will react to the information developed by their investigations and the voluntary reform efforts underway in the industry.
To date, only Freddie Mac has announced its action.
Early this month, Freddie Mac required members of its selling group to refund 20% of the commissions they earned in 1990 and 1991 from selling Freddie Mac securities. This approach represents an effort to treat the problem as a contractual dispute, resolving it quickly with a relatively modest penalty and a warning to the dealers.
Press accounts suggest that the SEC may be inclined to take a more punitive approach as a result of its ongoing investigation of the matter. The Wall Street Journal recently quoted an unnamed senior SEC official as saying: "If you have to hit them all, you have to hit them all. That's our job."
Part of the job of the SEC and the Justice Department, however, is to exercise regulatory and prosecutorial discretion and common sense.
A focus on harsh penalties would be inappropriate. The government should focus on making the market work better.
Such an approach could involve specific rules addressing the issue. Also, the banking regulators and the self-regulatory organizations that supervise the bond dealers could expand their audit routines, adding a review of underwriting procedures for securities of the government-sponsored enterprises.
The Case for Civil Remedies
Dealers who have voluntarily provide information to the SEC on past practices and who take steps to ensure they will not recur should not face criminal prosecution. At most, such dealers should face modest, future-oriented civil remedies.
The SEC should consider issuing a public report on its investigation and making sure that the dealers and the enterprises adopt appropriate mechanisms to assure future compliance.
Such a course would be in line with previous voluntary disclosure programs.
It would not satisfy the righteously indignant. However, it would produce a just result - and might prevent a widespread exodus of banks and broker-dealer firms from the business of underwriting government bonds.
Mr. Nathan, a former deputy assistant U.S. attorney general, is a partner at the Washington law firm of Arnold & Porter. Mr. Freeman is an associate at the firm.