Salomon Scandal May Take Toll On Bond Prices, GFOA Cautions
WASHINGTON - The Salomon Brothers bond scandal is driving state and local governments to rely more on banks than on brokers and primary dealers to buy Treasury securities and may be indirectly affecting municipal bond prices, the Government Finance Officers Association warned yesterday.
Richard B. Dixon, GFOA president and chief administrative officer for Los Angeles County, delivered the warning at a hearing of the House Ways and Means Committee's oversight subcommittee in the ongoing congressional inquiry into Salomon's bidding abuses in the government bond market.
The panel, chaired by Rep. J.J. Pickle, D-Tex., also heard testimony from senior Salomon Brothers executives who pledged to take a leading industry role in helping to strengthen federal oversight of the bond market.
The Salomon officials cautioned that any government move to strip the firm of its status as a primary dealer in government securities could cause collateral damage to others in the market, a view that was challenged by Michael Basham, former Treasury deputy assistant secretary for domestic finance.
Mr. Dixon warned that Salomon's abuses are of "acute concern to GFOA," particularly since the group has placed U.S. government securities at the top of the list of recommended safe investments for its members.
"Some [GFOA] members who had been trading exclusively through primary dealers are now reexamining that practice," Mr. Dixon said.
"Many GFOA members had already begun using sources other than brokers or dealers, particularly banks, to purchase government securities," he noted.
He said as of the third quarter of 1990, state and local governments held $344 billion out of the $3.2 trillion of outstanding U.S. Treasury debt. That represents about 20% of federal securities that are not held by foreign investors or federal agencies, he said.
Texas, for example, keeps roughly 66% of its investment portfolio, or $3 billion, in government securities. In its local government investment fund, Texas has 60%, or $1.6 billion, invested in U.S. government securities, he added. And the percentage of holdings is even greater for Austin, Texas, where $650 million of its $700 million operating assets portfolio is held in U.S. obligations, Mr. Dixon said.
He said Salomon's attempts to corner the Treasury market have had several effects on state and local governments. He charged that state and local revenues have decreased because those governments have had to pay more in the secondary market for securities whose prices were driven up by Salomon's actions. Also, less sophisticated buyers of governments who cannot trade the securities in the "when-issued" market - the period between announcement of an auction and the auction itself - have had to pay higher prices when they placed noncompetitive bids for securities as a result of Salomon's actions, the GFOA official said.
Salomon's actions also have an important indirect effect on the municipal market, which uses Treasury prices as a benchmark of sorts, he said. "Although the prices of Treasury securities and tax-exempt municipals do not fluctuate in exactly the same manner, they tend to move in the same direction."
"The Treasury market remains an indicator of trends in the municipal market. In addition, many jurisdictions borrow money through bank loans and not by issuance of municipal tax-exempt debt, so any factor affecting bank interest rates will have an impact on state and local government bank borrowing as well," Mr. Dixon said.
He said an informal survey of key GFOA members found that many state and local governments have suspended trading with Salomon Brothers indefinitely in some or all investments. He said one GFOA member reported for the first time that it could not obtain Federal National Mortgage Association and Federal Home Loan Bank notes, because many brokers and dealers have reduced their own purchases.
In addition, Pennsylvania Treasurer Catherine Baker Knoll has filed a class action suit against Salomon on behalf of her office and "all persons damaged by illegal trading," said Mr. Dixon. The suit alleges that Salomon's misconduct artifically inflated and/or distorted the price of two issues of Treasury notes, of which $175 million were purchased by Pennsylvania, he said.
Mr. Dixon added that most finance officers surveyed were confident that ongoing investigations into Salomon's trading irregularities will lead to changes in the system. "Because of this, they indicated that they expect to continue trading in federal obligations in the near term," he said.
He said the GFOA also surveyed pension fund managers and their overwhelming reaction to the scandal was to suspend trading with Salomon Brothers. He said managers in Los Angeles County, however, have not stopped doing business with the firm. But fixed-income managers have indicated they are leery about doing business with the large dealers because the managers are unwilling to reveal their positions, he said. As a result, the Los Angeles County pension fund works more often with second-tier dealers when executing major portfolio shifts, he said.
Mr. Dixon said the Salomon affair has heightened the GFOA's concerns over proposals to give the Treasury authority to regulate sales practices of government securities broker dealers when the Government Securities Act of 1986 is reauthorized this year. The group says such agencies as the Securities and Exchange Commission may be more appropriate.
The Senate late Wednesday passed a one-year extension of the 1986 law, in a move that gives federal regulators the 90-day period they requested to study what major changes may be needed in the government securities auction process.
During the Ways and Means hearing, Deryck Maughan, Salomon's chief operating officer, stressed the firm's internal reforms and apologized again for the past bidding abuses. "We want to be part of the solution, not part of the problem," Mr. Maughan said. "We want to be part of the future of the securities market."
"We have new people, we have new policies, and we have new procedures," he said. "Not only have the people changed, but I can assure you, Mr. chairman, the tone at the top has changed."
Salomon, Mr. Maughan said, now believes it has "an opportunity, and a mandate, to become a leader in developing innovative, effective, and comprehensive compliance procedures."
But Rep. Pickle and other subcommittee members remained skeptical after testimony by Mr. Maughan and Salomon's chief legal counsel, Robert Denham, and said the panel members remain interested in legislation to tighten federal controls over the bond market.
"To preach that you want to become a role model seems to me to be a rather nervy thing to do," said Rep. Pickle. "I don't want to say, ~We forgive you,' and want you to be the role model. It seems to me that's asking a bit much."
Committee members said they were impressed by the willingness of Salomon officials to step up internal controls on their bidding procedures. At the same time, there was skepticism about Salomon's contention that much of the blame lay with deposed government bond trader Paul Mozer.
"It seems to me there must be more than simple behavior aberration of one person," said Rep. Ed Jenkins, D-Ga. But, he added, "if that's all you're dealing with, it may not be as troublesome as I perhaps think it is."
Mr. Maughan appealed for Salomon Brothers to be allowed to continue to serve as one of the 39 licensed primary dealers in government securities, warning that if the firm goes down, others might as well. "If you fell this tree, what other trees fall?" he asked rhetorically.
But Mr. Basham, now a managing director for Smith Barney, Harris Upham & Co., indirectly disagreed. He noted that with the collapse of Drexel Burnham Lambert Inc., formerly a large primary dealer, the bond market did not suffer and the government continued to distribute bonds with success.