NEWS ANALYSIS : Scandal Reforms U.S. Treasury Auctions
Salomon Inc. sure took the swagger out of government-bond trading.
The firm’s fraudulent-bidding scandal, resolved this week, leaves in its wake a modernized and more effectively regulated Treasury-auction market. The atmosphere today is a sharp contrast to the antiquated old-boys club that prevailed just one year ago.
“The Salomon scandal shined the spotlight on a market that had been in the shadows,” says Samuel Hayes, a Harvard Business School management professor.
“It was a gentlemen’s club based on a code of conduct with a presumed level of ethical conduct. There was no need for formal rules because everybody understood the bounds. But it became inoperable because so many new people joined the firm.”
On Wednesday, Salomon agreed to pay $290 million to settle government charges in the biggest scandal ever in the $2-trillion U.S. Treasury securities market.
The settlement capped a 10-month investigation of Salomon, which disclosed last August that its chief government bond trader had repeatedly submitted false bids at U.S. Treasury auctions, where the government sells bonds to finance the federal budget deficit.
The admission left an indelible mark on Salomon and the industry. Salomon’s chairman, John Gutfreund, and three other top executives resigned. It resulted in congressional hearings and a major regulatory review of the Treasury bond market.
Today in the cavernous trading room at Salomon’s World Trade Center headquarters, where cigar-chomping traders once operated without fetter, a numbing array of checks and double-checks now surround the bidding process.
For instance, even though Salomon’s government-bond desk is now run by former Harvard Business School professor Eric Rosenfeld--a soft-spoken man of unimpeachable reputation--a compliance officer from Salomon’s legal department stands by his side at every single auction.
Throughout the industry, firms have instituted similar reforms in procedure and oversight.
The impetus: A roar of outrage from Capitol Hill at the informal--some would say sloppy--practices previously used to distribute government securities.
Just a few weeks ago, in fact, Securities & Exchange Commission chief Richard C. Breeden complained that his agency’s investigation of Salomon-related matters had been slowed by the incomplete records maintained by firms that dealt with Salomon.
The Treasury Department, which sets the rules for auctions, has efficiently distributed a huge amount of notes and bonds over the past decade via auctions run by the Federal Reserve Bank of New York. But the process evolved with none of the strict policing found in equity and commodities markets.
The reason: Since the public doesn’t buy directly from the Treasury, no vulnerable group required protection. Rather, bidding was carried out by a select group of “primary dealers” handpicked by the Fed. It was assumed that they were gentlemen who would follow club rules.
On auction day, their bids were called in or scribbled by hand. Auction rules, in fact, had never been codified or published. Oversight was parceled out among three regulatory agencies: the Treasury, the Fed and the Securities and Exchange Commission.
This relaxed atmosphere evaporated last summer with Salomon’s disclosures of false bids. The result has been an array of new regulatory rules:
* Broadened participation in auctions beyond primary dealers to all government securities brokers and dealers registered with the SEC.
* Beefed up enforcement of auction rules by spot-checking bids and awards greater than $500 million to make sure they are authentic.
* Improved surveillance of the trading market that develops after auctions. Authorities have announced that they will supply additional securities if a serious shortage develops.
* Stepped up the timetable to fully computerize auctions to strengthen oversight.
* Published auction rules and procedures.
* Established the SEC as the principal regulatory authority over primary dealers.
* Proposed that Congress support legislation to make misleading statements to an issuer of government securities a violation of federal securities laws.
Yet to be decided is whether to change the structure of Treasury auctions. Today, awards are granted in descending order: first to the highest bidder, then to the second highest and so on. Officials are studying the possibility of moving to an “open method” in which securities are awarded at a single price.
Wall Street traders are lukewarm about the proposal. Through the Public Securities Assn., they have suggested that it “be thoroughly studied and tested experimentally to determine that the theoretical benefits can be achieved and to measure any possible trade-offs in efficiency.”
One question, however, remains, and it affects every American: Will reforms increase the already burdensome cost of financing insatiable deficits? Such a result would be ironic, since the point of a more competitive bond market is to lower interest costs, which in turn lowers taxes.
Strangely, the elite, old club did a fine job of distributing securities, analysts say, without resorting to restrictive, bureaucratic and expensive regulation. It remains to be seen whether the post-Salomon system will carry an unacceptable price tag.
With that in mind, both the Treasury and the Fed oppose a proposal that Congress legislate authority to require audit trails of all government-securities trades.
These time-sequenced reports of trades to a self-regulatory organization are an integral part of policing the equities markets. The SEC favors their implementation, but opponents argue the cost outweighs the benefits.
