Fewest Treasury Traders Since 1960 Hit Taxpayers

By Sandra Hernandez

Aug. 4 (Bloomberg) -- For the first time since 1960, when it created the network of securities firms obligated to buy and sell Treasury bonds, the U.S. government has the fewest bond traders making markets in its debt and a bigger burden for American taxpayers financing record federal deficits.

The number of so-called primary government securities dealers declined to 19 last month when Bank of America Corp., based in Charlotte, North Carolina, acquired the troubled Countrywide Financial Corp. The sale was the climax of dozens of bank failures, triggered by the biggest decline in residential real estate since the Great Depression and the seizing up of credit markets from New York to London. The Federal Reserve Bank of New York, the agent of the U.S. Treasury, plans to shrink the dealers again when JPMorgan Chase & Co. completes its takeover of Bear Stearns Cos.

Fewer firms bidding for U.S. bonds means ``you're going to have sloppier auctions,'' said Mark MacQueen, a money manager in Austin, Texas, at Sage Advisory Services, who traded Treasuries at dealer Merrill Lynch & Co. in the 1980s. ``The taxpayer and the government are paying more no matter what happens.''

The paucity of primary dealers coincides with the largest borrowing requirement in American history and the acknowledgment by the administration of President George W. Bush that the U.S. will finance a budget deficit totaling a record $482 billion next year. When the dealer system began 48 years ago with 18 firms, the U.S. had a $300 million surplus. The group has shrunk from a peak of 46 in 1988.

Auction Tail

While the interest rate on the benchmark 10-year Treasury note today is less than half the 9.14 percent yield of 20 years ago, the dwindling number of dealers and contraction of credit markets means that yields on 10-year notes sold this year have averaged 1 basis point higher than in pre-auction trading, compared with no difference in 2007, data from Stone & McCarthy Research Associates in Skillman, New Jersey, show. In the three years before 2007, such sales drew a yield just below the pre- auction rate. One basis point, or 0.01 percentage point, spread over $171 billion -- the amount of debt the Treasury said it may sell this quarter -- represents $17.1 million in interest.

Traders refer to yields that are higher at auction than typically forecast as a tail. The Treasury's July 22 sale of 20- year Treasury Inflation Protected Securities, for example, drew a tail of 5 basis points, or 0.05 percentage point, according to RBS Greenwich Capital in Greenwich, Connecticut.

Credit Market Losses

Taxpayers already are reeling from the highest unemployment rate since 2004 and the worst economy since 2001, a slump that was caused partly by the collapse of confidence in the fixed- income market. Bond investors who readily provided financing for everything from subprime mortgages to high-yield, high-risk companies 18 months ago, cut their credit lines last summer in a relentless reduction of money lending.

Four of the five firms reporting the biggest credit-market losses since the start of 2007 -- Citigroup Inc., Merrill Lynch, UBS AG, and Bank of America -- are dealers. Sixteen have lost a total of $266.9 billion as the U.S. housing slump roiled financial markets, according to data compiled by Bloomberg.

Yields on the current benchmark 10-year note fell 17 basis points last week to 3.93 percent, the most since the week ended June 27, according to New York-based BGCantor Market Data. The 3.875 percent security due in May 2018 gained 1 10/32, or $13.13 per $1,000 face amount, to 99 17/32.

Almost all of the firms that were dealers when the Fed formalized rules in 1960 have changed their names, been acquired by other securities companies or gone out of business. First Boston is now part of Zurich-based Credit Suisse Group; Salomon Brothers is now owned by Citigroup in New York; and PaineWebber Inc. is owned by UBS AG, also in Zurich.

Opportunity or Headache

A common way for traders to profit is to sell the securities before the auction -- a strategy made possible by the government, which allows trading of bonds as if they were already sold. If the auction draws a yield higher than in the so-called when- issued market, traders can buy the new debt at a lower price, pocketing the difference as profit. Bond prices move inversely to yields.

``Larger auctions simply mean that each primary dealer probably has to buy and distribute more,'' said Raymond Remy, 48, the head of fixed income in New York at Daiwa Securities America Inc., one of the dealers. ``And that could be an opportunity or that could be a giant, giant headache.''

The Treasury this week will sell $17 billion of 10-year notes in its quarterly sale of the securities, the most since 2003. It will also auction $10 billion of 30-year bonds, the most in two years. The government said July 30 that it's considering more frequent auctions of both securities, and will announce a decision in November.

Indirect Bidders

Dealers are just one category of participants at auction and a smaller number doesn't automatically doom the government to higher rates or guarantee profits for firms.

Indirect bidders, a class of investors that includes foreign central banks, bought 27 percent of the two-year notes that sold in the past year. That compares with an average of 34 percent in the preceding 12 months.

Indicators of economic growth and world events have a bigger impact on demand at auctions than the number of dealers, said Craig Coats Jr., who co-headed Salomon's fixed-income desk during the 1980s, when it was the world's biggest bond trader.

``The auction process is really going to be dependent upon what is going on in the market at the time,'' said Coats, who began trading bonds in 1969.

So far this year, four dealers traded at least 41 percent of Treasury bills and notes, while the least active four traded as little as 0.8 percent, according to Fed data.

Good For Dealers

While more than 800 financial institutions were set up to bid directly in Treasury auctions, dealers bought 71 percent of the bonds in the 576 sales between May 2003 and December 2005, according to a 2007 paper by Michael Fleming, a researcher at the Federal Reserve Bank of New York.

``The Fed and the Treasury will be nervous if the dealer community fell to too-low of a number because somebody's got to underwrite more of this debt,'' said Charles Comiskey, the head of Treasury trading in New York at dealer HSBC Securities USA Inc. ``It's pretty obvious it would be good for the dealers. If there's less competitors, it's more of a share of the pie for less people.''

To contact the reporters on this story: Sandra Hernandez in New York at Shernandez4@bloomberg.net.