The Feds Shouldn't Compound Solly's Folly

The Salomon Brothers Inc. Treasury bond scandal has been an educational experience for everyone concerned. In the year since Solly contritely admitted to overbidding for Treasury notes, the Street has been shown that a little creative groveling can go a long way.

Even the bureaucrats have been taught a lesson: The Treasury Dept., Federal Reserve, and Securities & Exchange Commission have learned that the hands-off approach does not work. Regulators have beefed up their scrutiny of the bond auctions, improved auction procedures--and warned that they will act fast to stamp out bond-trading abuses.

Alas, the newfound regulatory activism does not end there. Treasury is moving beyond technical changes and considering a fundamental alteration in the process by which government bonds are sold at auction. And that's a shame, because it indicates that the bureaucrats haven't learned a crucial lesson of the Salomon scandal: When the Street talks, regulators should listen. If they were listening now, they would realize that no further tinkering with the auctions is necessary.

NO MORE SQUEEZES? The regulators seem to have forgotten the root cause of the Salomon scandal: the "short squeeze." By overbidding for two-year and five-year Treasury notes, Salomon wound up dominating the supply of the notes. That led to a shortage of the securities, which raised prices and thus hurt short-sellers, who were betting on a price decline. (Salomon has admitted to overbidding, but not to intentionally causing a short squeeze.)

The Treasury Dept., to its credit, has come down hard on short squeezes. The agency has stated that when an "acute, protracted shortage" of a bond or note issue develops, it will provide additional quantities of the security to the marketplace, through an auction or otherwise.

Traders who get hurt by short squeezes, and who were the first to blow the whistle on Salomon Brothers, now say that shortages in Treasury securities still occur--but as a result of natural market forces, not market manipulation. "Now you get the feeling that the feds will step in and do something about it," says one government bond arbitrageur.

By taking steps such as this, andby increasing surveillance of the market, regulators have restored investor confidence in the government bond market. Plans to automate the auctions are also a step in the right direction. That can't be said for another Treasury initiative, however. In a case of bureaucratic auto-pilot, Treasury is going an unnecessary step further by trying out a new method of auctioning bonds.

Right now, Treasury uses a "multiple price" method. Sealed bids are submitted, and the lowest interest-rate bids are accepted. Thus, different "winning" bidders wind up with disparate yields. In the months ahead, the agency will be experimenting with a kind of single-price auction--commonly known as a "Dutch auction."

Here, the auctioneer makes awards at the highest yield necessary to sell all the bonds. Let's say the Treasury has $10 billion in bonds for sale and the lowest-yielding bids are as follows: $4 billion at 5.5%, $3 billion at 5.55%, $3 billion at 5.6%, and another $3 billion at 5.65% and higher. All bidders at 5.6% or less would get 5.6%. Under the present system, only the bidders at 5.6% would get that yield, the other successful bidders would get lower yields--the so-called "winners' curse."

DUBIOUS BENEFITS. Not surprisingly, bond dealers like the idea. They note that eliminating the winner's curse would encourage more "aggressive" low-yield bids, since "bidders would never wind up with lower-yielding bonds than other bidders," says Lee Olesky, vice-president of the Public Securities Assn., the Treasury bond dealers trade group. Proponents say Dutch auctions would also reduce the possibility of bid rigging--as bidders would have less need to compare notes before the auction to avoid being awarded too low a yield.

But the advantages of this system are dubious at best. In a joint report on the Treasury market last January, the SEC, Treasury, and Federal Reserve concluded that there is little evidence to support the view that Dutch auctions present a clear financial advantage for the Treasury.

What's more, the regulators acknowledged that Dutch auctions could provide an incentive to corner the market. Right now, a bidder who wants to do so must settle for a lower yield to ensure that the bid is accepted. So it can cost big bucks to manipulate the market. In light of the Salomon scandal, you'd think the last thing regulators would want to do is make life easier for unscrupulous traders.

On balance, regulators have done a fine job of fixing the auction system. Why risk breaking it?

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