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Did Somebody Squeeze Treasury Notes?

For bond traders, it had seemed like a lead-pipe cinch. The numbers worked like magic: In the wake of every monthly auction, two-year Treasury notes would inevitably drop in price in comparison with other Treasury issues. So traders would buy longer-term bonds while selling two-year notes short just before the auction, in the fond expectation of replacing them at a lower price. But then came the May 22 auction of $12.3 billion in two-year notes--and a rude awakening.

In the days and weeks that followed, the notes broke with precedent by climbing in price (chart). It wasn't much of a gain--no more than a blip on the trading screens--but in the highly leveraged world of bond trading, a change of a few hundredths of a percentage point can translate into millions of dollars. In firm after firm, traders and bond dealers--who often take large short positions--were forced to cover their positions at huge losses. Since then, rumors have run rampant on Wall Street that the two-year notes were "cornered" at the auction by bond-trading giant Salomon Brothers Inc., which denies any wrongdoing, and by private partnerships that allegedly joined Salomon in a "short squeeze."

'SOMETHING UNUSUAL.' Were bond traders the victims of market manipulation? That's a question that has explosive implications--and is being posed at a particularly sensitive time. Congress is reconsidering the 1986 law that set up the government bond-dealership system, which relies on a network of 42 primary dealers that have an obligation to bid on every U. S. Treasury issue. Federal securities regulators appear to be taking the allegations of a corner seriously. One highly placed Bush Administration official maintains that the imbroglio gver the May auction calls into question the integrity of the dealership system. "Anything that hurts the auction process, Treasury has got to be concerned," says the official, who requested anonymity. "There is a suspicion that something unusual happened that has not happened before."

What kind of suspicion? The feds aren't talking, but scuttlebutt on the Street maintains that a few big note-buyers conspired in advance to buy up the two-year issue at the May 22 auction. One theory, advanced by a top brokerage executive who requested anonymity, is that Salomon placed bids for huge quantities of notes on behalf of itself and partnerships run by prominent money managers George Soros and Michael Steinhardt. Salomon won't comment on that, and Steinhardt and Soros were both out of the country--in Israel and Eastern Europe, respectively--and their firms said they were unreachable for comment.

Whether or not any machinations actually took place, there is no question that many bond traders were trounced by short-selling the two-year notes. Some were market-makers, who frequently sell short in the daily course of business. But many others were arbitrageurs and traders who were seeking to exploit a pattern that had been evident in recent months. "It was a consistently profitable trade, a safe arbitrage," notes Katherine G. Reed, who runs a bond-trading and research firm called Reed Curve Inc. For some traders, short-selling the two-year note had become a no-brainer, akin to betting on Secretariat. Alas, Secretariat did not win every race. "I shorted the twos two-year notes and went long the fives five-year notes," recounts one trader. "I lost a million bucks."

With so many greenbacks down the tubes, there is ample reason to suspect that the allegations are little more than scapegoating by traders who made a bad bet. "People have tossed around the word `short squeeze,' and that's simply not what happened," asserts William Brachfeld, executive vice-president of Daiwa Securities America Inc. and chairman of the Primary Dealers Committee of the Public Securities Assn. "We lost money, too--but that's because we misjudged the market, not because of a short squeeze." Indeed, one of the money managers who is alleged to have cornered the market, Steinhardt, had been previously quoted as saying that he was bullish on bonds and bearish on stocks--so buying two-year notes thereafter would hardly have been startling.

UNKIND WORDS. Salomon isn't talking for the record--but officials are privately fuming. A Salomon official maintains that the firm is the object of a vicious whispering campaign in the press by a handful of rival traders. And his view is confirmed by the bond trader who lost $1 million, who professes no great love of Salomon. "I was dumb, but I can take my medicine," this trader maintains. "Salomon can kind of irk people, so when people can really pile on them, they do it."

The bond-trading giant may simply be the victim of bad-mouthing--and if so, the firm is strong enough to take its lumps. But if Salomon turns out to have been a villain and not a victim, then the feds will have to figure out a squeeze-proof way of floating their debt.

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