Fed in Talks to Add Primary Dealers as Sales Rise to Record

By Daniel Kruger

Feb. 12 (Bloomberg) -- The Federal Reserve Bank of New York is in talks with at least four firms to expand the network of dealers that underwrite government-bond auctions as the U.S. prepares to sell more than $2 trillion in debt this year.

MF Global Ltd. and Nomura Securities International Inc. are in discussions to join the 16 so-called primary dealers that trade directly with the central bank and are required to bid at auctions, officials at the companies said. RBC Capital Markets, the investment-banking arm of Canada’s biggest bank, and Jefferies & Co., a brokerage for institutional investors, are in negotiations, according to people familiar with the process.

Treasury Department and Fed officials want to ensure there are enough firms bidding at auctions to keep borrowing costs low after the total number of dealers dropped last year to the lowest amount since the network was formalized in 1960. The Treasury Borrowing Advisory Committee, a market group that works with the central bank, wrote in a memo released Feb. 4 that more dealers would reduce “the possibility of an undersubscribed auction.”

“With the contraction in primary dealers in the marketplace over the past year, clearly there’s a need to replace some of them, especially with the increased issuance coming out of the Treasury,” said Donald Galante, a senior vice president in New York at MF Global, which he said is in talks with the central bank about a dealership position.

Nomura, a unit of Japan’s largest securities firm, has applied to the Fed, said Ralph Piscitelli, a New York-based spokesman for the firm.

Christopher Bury, co-head of fixed-income rates at Jefferies, RBC spokesman Kevin Foster New York Fed spokesman Calvin Mitchell declined to comment.

Auction Tails

The collapse of Lehman Brothers Holdings Inc. and the disappearance of Bear Stearns Cos. and Countrywide Securities Corp. in mergers in the past year has reduced liquidity and removed bidders as some auctions have doubled in size. The Fed said yesterday that Merrill Lynch & Co. was no longer a dealer.

Data from Stone & McCarthy Research Associates in Skillman, New Jersey, show that yields on 10-year notes sold in 2008 through August averaged 1 basis point higher than in pre-auction trading, compared with no difference in 2007. 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 $2.5 trillion represents $250 million in annual interest.

Open Market Operations

U.S. lawmakers are cutting a proposed economic stimulus package to $789 billion and may be able to send it to President Barack Obama’s desk by the end of this week, Senate Finance Committee Chairman Max Baucus said yesterday.

To help pay for the plan the Treasury will likely borrow a record $2.5 trillion this fiscal year ending Sept. 30, almost triple the $892 billion in notes and bonds sold in fiscal 2008, according to Goldman Sachs Group Inc. The New York-based firm is one of the 16 primary dealers.

This week, the Treasury is selling $187 billion of bills, notes and bonds.

Primary dealers serve as counterparties in open market operations, the central bank’s mechanism for maintaining its target rate for overnight loans between banks. Primary dealers also are expected to bid when the Treasury sells bills, notes and bonds. The designation is coveted by some firms because central banks and certain pension and endowment funds will only do business with operations that have it.

Dealer Departures

Firms exited the dealership business beginning in the 1990s as the large number of dealers and the increased transparency of electronic trading reduced the spread between offers to buy and sell debt, curtailing the profitability of trading. The number of dealers peaked at 46 in 1988.

Nomura was a primary dealer from 1986 through November 2007, when it cut 400 jobs in the U.S. after its first quarterly pretax loss in four years, following a $656 million loss on U.S. home loans.

Lehman Brothers filed for bankruptcy on Sept. 15, and shareholders of Bear Stearns were nearly wiped out when the firm agreed to be acquired by JPMorgan Chase & Co. on March 16 after the Fed committed $29 billion in financing to facilitate the transaction.

With the departure of those firms, and Merrill Lynch’s purchase by Bank of America Corp. on Sept. 14, the Treasury market began to suffer from more frequent and persistent episodes of illiquidity, traders and investors said.

That has produced “a wider bid-offer” spread, said Tom di Galoma, managing director of U.S. government bonds at Jefferies. “There’s money to be made in Treasuries. There’s dislocations in the government bond market that we probably haven’t seen since probably the early 1980s.”

Budget Deficit

The last time the government added more than one firm to its roster of primary dealers was 1988, when three firms joined. Cantor Fitzgerald & Co. was the last new dealer in August 2006.

From 1970 through 1988, as the U.S. budget deficit increased to $155.2 billion from $2.8 billion, the number of primary dealers also rose, to 46 from 20. Obama has projected a deficit of more than $1 trillion this fiscal year.

To contact the reporter on this story: Daniel Kruger in New York at dkruger1@bloomberg.net