U.S. Agencies The Top Culprits In Salomon Case

In 1989, being a primary dealer in U.S. Treasury securities was a costly proposition, according to the Federal Reserve Bank of New York. As a group, the dealers lost money in the business; individually, 65% of them did so.

In 1990 the statistics were not quite so grim. However, it appears that 10% of the primary dealers gave up their licenses and 45% of the rest continued to lose money in the business.

These statistics clearly indicated that there was a significant problem in this market. If the primary dealers, who were expected to facilitate the sales of Treasury issues, were not making money, the liquidity of the market was in danger. If the dealers kept suffering losses, at some point they would be unable to fund their portion of new debt issues.

As best I can determine, no one in the Federal Reserve system or at the Treasury thought about this problem at the time -- or since. Therefore, no one acted to stave off a developing liquidity crisis.

Shifting the Blame

A major scandal erupted in this market when it was asserted earlier this year that one of the largest primary dealers had cornered certain new-issue Treasury offerings on more than one occasion.

As might be expected, the Treasury and the New York Fed loudly disclaimed responsibility and pointed to Salomon Brothers (the branded culprit) as simply another example of morality askew on Wall Street.

This simplistic view of the event is dangerous and insulting to most Americans because it blames one aberrant actor, not problems in the system.

But systemic problems do exist. To act as if they didn't ensures that effective corrective action will not be taken.

A Surging Market

One might therefore expect further and possibly more ominous breakdowns in the U.S. Treasury market.

Unlike most securities markets, the one for U.S. Treasuries is clearly a growth business.

The Fed's flow-of-funds statistics show that issuance of U.S. government securities grew from $369 billion in 1986 to $440 billion in 1990. This year's figure is likely to be much higher.

In the same time frame, the markets for municipal securities, corporate and foreign bonds, and mortgages all shrank. And while the debt markets raised less money than they had raised earlier, funds actually flowed out of the stock markets.

Excessive Growth

Not surprisingly, anecdotal information indicates that in most of the non-Treasury markets the number of people and firms participating has declined.

There are fewer equity security houses than there were 20 years ago. The mortgage banking community has been devastated. Corporate finance divisions within security and banking firms have shrunk dramatically.

Primary dealers in government securities have not. Their numbers may have almost doubled from 1970 to 1990, according to New York Fed statistics.

One problem, therefore, is that the number of dealers was growing too fast for even the rapidly expanding Treasury markets.

Dwindling Spreads

More important, the technological revolution in the information systems portion of the markets was destroying profits as the number of dealers grew.

Twenty years ago, primary dealers in Treasury securities were able (with legal inside information from the government) to establish markets with a reasonable spread built in.

Today, the tens of thousands of machines provide traders with instantaneous quotes on Treasuries, thereby narrowing the spreads so much that there is very little profit.

|Painting the Tape'

In addition, many of the new primary dealers lack the customer base to meet the Treasury requirement that they trade at least 1% of the Treasury securities handled each year.

Failure to meet this requirement means loss of primary dealership status. Therefore the dealers with an inadequate customer base manufacture trades -- and lose money -- according to interviews that I have had with people in the profession.

Using the futures market, these dealers create the illusion of activity -- they "paint the tape" -- so the New York Fed will believe they are meeting the trading requirement.

Phony Bidding

Further, I have been told by government officials as well as industry professionals that dealers might make phony bids at the auctions -- bids at prices so far from what is acceptable that they know they are unlikely to be required to take down securities.

Finally, the problems in the banking industry also affect primary dealers. This is because the banks often lend the dealers the funds necessary to participate in the Treasury auctions.

The dealers take down broker loans, which they use to warehouse some of the securities they have bid for, before the securities are resold to customers.

Loans of this nature have shrunk by 20%, or $3.4 billion, in the past 12 months, reflecting the squeeze on bank capital and the volatility of the security dealer market.

Market Concentration

All these facts point to concentration in the primary dealer markets -- a concentration that may not have been detected because of the practice of "painting the tape."

It would therefore appear that a smaller and smaller number of firms had the profit and borrowing capacity to maintain historic levels of liquidity in the new-issue portion of the Treasury markets.

This point is hotly debated.

If the Treasury Department is correct, Salomon Brothers was able to take down 95% of a particular Treasury offering one day this year.

This point, too, is hotly debated. Probably only a mathematical genius with a Cray computer could resolve the issue.

I would argue that, logically, if a market is truly liquid, it is impossible to corner any security.

Serious Issues

There are serious problems in the functioning of the new-issue Treasury markets:

* The number and profitability of primary dealers.

* The possibility of phony bids and tape painting to create the illusion of activity.

* The possible drying up of borrowing sources for primary dealers.

These issues should be discussed in the press, in Congress, and among the appropriate regulators. The discussion should have begun years ago -- not today, because of the misdeeds of a securities house.

Why Government Fumbled

Salomon Brothers' actions were the result of a problem, not the cause of one.

Why did the New York Fed and the Treasury not understand what was going on? Why have they failed to study and deal with the critical issues?

Unfortunately, they seem not to grasp the relevant points -- and so may be inadequate to deal with them.

Richard X. Bove is a banking consultant with the Bove Group in Chatham, N.J.

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