The Treasury Bond Scandal--Was Anyone Really Shocked? : Finance: The more technically obsolete a market is, the bigger a target it is for corruption. The selling of U.S. debt is an antiquated process.
The moralist caught with his pants down justifiably provokes gleeful gloating. The Salomon Bros. Treasury bond scandal comes during a flurry of U.S. finger-wagging about the sorry ethical state of Japanese financial markets. Is there any difference between the U.S. and Japanese scandals, or are Americans guilty of the rankest hypocrisy?
It was recently discovered that the biggest Japanese security houses, like Nomura and Nikko, along with a host of smaller players, had been making good the losses of their largest customers during the long Japanese stock-market decline of the past year. The system operated under the noses of--and possibly with the knowledge of--officials at the Ministry of Finance. This is but the latest revelation of how Japanese markets are rigged to favor the biggest players.
Salomon was guilty of rigging the vast U.S. Treasury security market in its favor. Treasury rules forbid any of the primary dealers who buy and resell the bonds and notes issued by the Treasury to take more than 35% of a single issue. The assumption is that if any dealer owns more than that amount, it would be in a position to manipulate prices. By placing bids in other people’s names, Salomon, on several occasions throughout the first half of the year, controlled much larger shares of the market--once as much as 57%. The traders responsible for the false bids have been fired and John H. Gutfreund, Salomon’s blunt, aggressive chairman, was forced to resign along with a number of other top executives.
Nobody on Wall Street was surprised that Salomon was caught breaking rules. Gutfreund was the thinly disguised model for Eugene Lopwitz, the boorish, profane head of Pierce & Pierce, the bond-trading firm in Tom Wolfe’s “Bonfire of the Vanities.” Paul Mozer, the 36-year-old millionaire trading whiz, who wrote the fake customer orders, even looks like Wolfe’s description of Bonfire’s antihero, Sherman McCoy.
Salomon has long been famous for its jungle-warfare business ethic, and few people on Wall Street believe the top executives didn’t know what was going on. “Nobody at Salomon ever made a billion-dollar trade without Gutfreund knowing all about it,” one primary dealer said. In any case, the first rule-breaking trades were officially brought to the attention of top management in April, but the infractions were not made public until August. In the interim, Mozer executed several more corners--including a particularly egregious “squeeze” on the two-year note market in May.
It is hardly a revelation that people on Wall Street are greedy, or that people anywhere, Japanese or American, will break rules when they can make millions by doing so. The consistent lesson from the Salomon and Japanese scandals is that old-fashioned systems that operate in back rooms are ripe for abuse. The U.S. financial system is, in fact, cleaner and less easily manipulated than that of Japan--not because Americans are innately more ethical, but because the U.S. system is, on the whole, more modern, more technically advanced, and therefore more open to scrutiny.
The Treasury “primary dealer” system is a throwback to the days when government bonds were a small fraction of a normal trading portfolio, and it depends on an old-boy-type network to operate smoothly, just like so much of the Japanese financial system. Systems that work in dark corners are open to manipulation.
Treasury securities are sold through a complicated “Dutch auction” bidding system that, on the whole, has served the taxpayer well. The 40 primary dealers bid at each auction both the price they are willing to pay and the amount of the issue they are willing to take. The final price is the price that clears the entire issue, but the shares are allocated according to the sequence of the highest bids. Assume, for example, that 20 dealers bid on a $10- billion issue, with one bidding 102 for $3 billion and the rest bidding 101 for the same amount. The top bidder would get his $3 billion of securities at 101, because that was the market-clearing price, while the others would each get only one-nineteenth of what was left over.
A Dutch auction is tricky to manage. With bids and trading tickets executed by hand, it clearly makes sense to limit the number of players. The dealers claim that, in return for their privileged access, they assume an “underwriting” responsibility--in theory, they are responsible for buying Treasury securities whether or not there is any resale market. But in the modern global treasuries market, it is inconceivable that the U.S. government could not find buyers.
Salomon’s cheating made money in at least two ways. When dealers buy treasuries, they put up only 1% of the price in their own cash and borrow the rest from banks at the interbank lending rate--the lowest possible. The dealer also keeps the interest paid by the new securities before he resells them. The Federal Reserve was aggressively pushing down interest rates through most of the spring, so bank rates were far lower than interest rates paid by the treasuries. Salomon made millions more on the interest rate “spread” by taking more than their fair share.
What most outraged other dealers, however, was that Salomon could use its big share of the market to squeeze them. Dealers almost always sell treasuries on a “when-issued” basis. That is, to accommodate the planning needs of their prime customers, and to help ensure they can resell whatever they buy, they contract to sell securities they have not yet purchased--in the jargon, they take a “short” position. When Salomon locked up most of an issue with high bids, the other dealers, scrambling to cover their shorts, were at Salomon’s mercy--a classic squeeze.
It is no justification of Salomon’s trading practices to note that the taxpayer made money on the deal. Salomon was bidding up the price of treasuries. Higher Treasury prices is another way of saying lower interest rates; by getting higher prices, the Treasury, and the U.S. public, were paying less to borrow.
Over the past 20 years, Wall Street has been modernizing all its major trading systems. Modern computers eliminate the need for most of the nook-and-cranny market-smoothing functions that were the bread-and-butter of Wall Street’s professionals. The result is that financial services are perforce much more honest and, not incidentally, less profitable. Computerized tracking of major stock moves, for example, makes it far more difficult to get away with insider trading.
There’s no reason why a modern, electronic trading system, open to all comers, couldn’t provide the same minute-to-minute pricing function in the Treasury market as the primary dealers. The Treasury is the biggest issuer of securities in the world, and it should operate in the light of day.