Why the Bond Cartel Is Collapsing

In the understatement of the year, Salomon Inc., the nation's largest government bond dealer, disclosed on Aug. 9 that it had uncovered "irregularities and rule violations" in its operations.

The firm admitted that its traders had repeatedly tried to corner the market for newly issued Treasury securities. Subsequently, the firm withheld information about the manipulation from the government.

Since then, the Treasury market has been in turmoil. Salomon's former management resigned under fire. As you might expect, journalists have had a field day.

Drawing Wrong Conclusions

Sadly, most of the commentary - in Washington and Wall Street - missed the main point. Salomon's actions did not, contrary to assertions in The Washington Post, undermine the credit of the United States. Nor did they have any measurable impact on the level of interest rates or the costs of financing the Treasury's $300 billion deficit.

What Salomon did do, however, was provide a powerful impetus to break up a nasty little government-sponsored cartel in the world's largest securities market. Ironically, Salomon was, and is, the biggest and most profitable member of that cartel.

Both the Treasury Department and the Federal Reserve System have vested interests in the health and profits of U.S. bond-dealing community. The authorities cannot guarantee that every firm will be profitable every year.

However, they have acquiesced to ground rules that were custom-made to give the members of the so-called primary dealer club the benefit of every doubt. The key to the cartel has been control over market quotes - second-to-second real-time data about bids and offers in the inside primary market - provided on electronic screens.

While anybody with sufficient capital can trade Treasuries, access to inside prices gives members of the club a built-in operating advantage.

In theory, the primary dealers devised these restrictions (with the tacit approval of the Treasury and the Fed) to assure that the firms with which they do business are financially responsible.

A Barrier to Competition

In practice, major firms that were not primary dealers were barred from active competition. The Justice Department's Anti-trust Division began investigating this situation years ago but never pursued the case seriously - probably as a result of pressure from the Treasury and the Fed.

The motivation for the cartel is clear enough. The Treasury needs healthy bond dealers to underwrite and distribute several hundred billion dollars of securities every year.

The Federal Reserve needs healthy bond dealers to act as a conduit for monetary policy. Fed "open market operations" routinely exceed $1 trillion a year. It's no fun in the Wall Street sandbox if you don't have someone to play with.

A Clubby Atmosphere

Moreover, there are revolving doors between the Fed, the Treasury, and the Street. It is commonplace for young economists to work at the New York Fed and then seek their fortunes in the dealer community.

Many government traders believe, as one man put it, "Congress is out to get somebody. The system has worked very well. I just hope this doesn't turn into a witch hunt." In fact, the Treasury market was already under scrutiny even before the spotlight turned on Salomon.

The Government Securities Act, which gives the Treasury authority to regulate the government market, will expire on Oct. 1 unless Congress acts to extend it. Four committees - three in the House and one in the Senate - have held or planned hearings on the Treasury market.

Even with all the bad publicity, the financial community is still betting - hoping would be a better word - that Washington will be content to make only minor changes in existing legislation.

The way Wall Street sees it, big changes could undermine the efficiency of the market and escalate the cost to taxpayers of government borrowing.

To no one's surprise, self-appointed moralists in the Fourth Estate were quick to conclude that Salomon's problems reflected a major ethical scandal. Business Week magazine, whose senior editors should know better, said lawsuits stemming from the firm's disclosures could cost it more than $1 billion - fully one-third of its present capital.

A Melange of Opinions

"The logical starting point," said Business Week, is Drexel Burnham Lambert, which went bankrupt after pleading guilty to securities fraud.

Hobart Rowen of The Washington Post said, "The public can no longer be sure . . . that an investment in a U.S. government bill, note, or bond is the safest in the world."

To be charitable, such statements are pure hyperbole. Nonetheless, the cartel in the government market is breaking up for the same reason that cartels always break up. Somebody got greedy and decided to cheat.

In place of a restricted-entry club, the government market will likely evolve into a more open, arm's-length auction process. Control over price information was the glue that held the cartel together.

This, too, must go. Over the long run, taxpayers, the financial community, and the government will benefit as the fresh wind of competition blows through the canyons of lower Manhattan.

Mr. Heinemann is a chief economist at the investment banking firm of Ladenburg. Thalman & Co., New York.

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