Stiffer Rules Unlikely for ESM-Type Dealers
The recent collapse of an obscure Florida government securities firm, and the resultant temporary closure of 70 Ohio thrift institutions, has spurred calls for increased federal regulation of the risky and freewheeling government-securities market.
But the chances of major government intrusion in the largely unregulated industry are not great, some government officials say.
Partly because of the massive size and complexity of the market, no one knows for sure quite how best to regulate it, these officials say. They also question if regulation would really be effective in preventing the type of fraud that allegedly occurred at ESM Government Securities Inc., the Fort Lauderdale, Fla.-based firm whose collapse on March 4 may cost its customers more than $300 million.
Could Take Years
“I don’t know if guidelines or regulations would have made any difference in the case of ESM,” says Michael K. Wolensky, who, as the Securities and Exchange Commission’s regional administrator in Atlanta, is in charge of the agency’s investigation of the ESM debacle. “If somebody is bent on committing fraud, they’re going to do it anyway.”
In addition, a major regulatory push could take months and possibly years before becoming effective. And it would require a massive addition of money and personnel, possibly costing the government more than it would save from preventing ESM-style failures. Industry officials say they will vigorously resist any major increase in government regulation.
“The cure may be worse than the disease,” says Howard Lee, staff director for the House Banking subcommittee on domestic monetary policy. Adding new reporting requirements, he suggests, could increase dealers’ costs so much as to force the Treasury to offer higher interest rates to sell its securities.
Possible Profound Effect
An increase of as little as one-tenth of a percentage point would increase the cost of financing the deficit by $2 billion, he says.
Whatever the outcome, any change in policy toward the government-securities market could have a profound impact on U.S. economic policy. The market is the primary vehicle for the Treasury to finance the U.S. budget deficit. And by buying and selling government securities, the Federal Reserve controls the nation’s money supply.
Concern about the problem is not new. At least since the 1982 collapse of Drysdale Government Securities, which cost New York’s Chase Manhattan Bank and others more than $300 million, officials have been concerned that the market may be getting too big and risky.
The growing budget deficit has fueled unprecedented growth in the volume of trading. Overall, more than $1 trillion of marketable Treasury bills, notes and bonds are outstanding, more than double the level in 1978. This growth has fueled a proliferation in dealers.
Some 36 so-called “primary dealers”--mostly banks and brokerage firms--who deal directly with the Fed in buying and selling securities are heavily regulated. But many other secondary dealers like ESM and Drysdale are not required to register with the government or maintain minimum capital levels.
“We have no idea how many dealers there are out there,” one government regulator says.
Further adding to the risk is the high degree of leverage, which runs as high as 200 to 1, meaning that a trading firm could have as little as $5,000 in cash for each $1 million worth of securities it trades.
Thus, with only a small rise or fall in interest rates, traders can make, or lose, their own cash in a very short period.
But government and industry officials have not been enthusiastic about increasing regulation. One of the few changes since 1982 has been the Fed’s creation of a government-securities surveillance unit.
However, the unit, headed by Edmund J. Geng, a senior vice president at the Federal Reserve Bank of New York, totals only about 12 people, severely limiting its abilities.
One often-mentioned reform would be to require all dealers to register with the SEC and file financial-disclosure statements, as do brokerage firms. But, some government officials say, this would limit the number of dealers, slow the trading process and require a very costly addition in resources at the already overextended SEC.
Another suggestion is to require that dealers deliver securities to customers. ESM, the SEC alleges, often failed to deliver securities to customers and instead used them as collateral to obtain loans from other customers. But such a regulation is seen by some officials as unnecessary because the professional money managers who most commonly trade with such dealers should know better.
Minimum Capital Standards
The idea often given the greatest chance for implementation is a proposal by the Fed to establish minimum capital standards for dealers. The proposal calls for firms to voluntarily maintain capital equal to 120% of their potential risk of loss from interest-rate changes.
“The idea is that people will not do business with anyone who couldn’t show certification that it has met this standard,” New York Fed spokesman Richard Hoenig says.
The proposal, issued in revised form last February, is subject to public comment through the end of this month. The House subcommittee on domestic monetary policy has scheduled hearings this Friday on the guidelines.
However, the panel’s chairman, Rep. Walter E. Fauntroy (D-D.C.), has called for the guidelines to be implemented immediately in the wake of the ESM collapse.
But, government officials acknowledge, even those guidelines wouldn’t have prevented the ESM debacle. By transferring its losses to its parent firm, ESM managed to convince its outside auditor that it had a net worth of more than $30 million when in fact it had run out of capital years ago.
