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Salomon Scandal Could End Cartel

NO matter how big the profits a cartel generates, sooner or later it will always get in trouble. Somebody will get greedy and try to cheat.In essence, that's what happened in the market for United States government securities, the world's largest financial market. A month ago, Salomon Brothers Inc., the biggest US bond dealer, disclosed that it had uncovered "irregularities and rule violations" in its operations. The firm admitted that its traders had repeatedly tried to corner the market for newly issued Treasury securities. Subsequently, the firm withheld information about the manipulation from the government. Since then, the Treasury market has been in turmoil. Salomon's former management resigned under fire. Journalists have had a field day. Sadly, the bulk of the commentary missed the main point. Salomon's actions did not undermine US credit. Nor did they have a measurable impact on interest rates or the cost of financing the Treasury's $300 billion deficit. What Salomon did do was provide a powerful impetus to break up a nasty little government-sponsored cartel. Ironically, Salomon was, and is, the most profitable member of that cartel. Both the Treasury Department and the Federal Reserve System have vested interests in the health of US bond dealers. The authorities cannot guarantee that every firm will be profitable every year. However, by awarding special status to an inner circle of only 40 (now 39) primary dealers, they created a system that gives members of this club the benefit of every doubt. Control over the electronic screens that provide real-time market quotes is the glue that holds the cartel together. Anybody with adequate capital can trade Treasuries. However, instant access to true inside prices gives club members a built-in advantage. Primary dealers restrict access to price data (with the tacit approval of the Treasury and the Fed) to ensure, in theory, that firms with which they do business, outside the primary dealer club, are financially responsible. In practice, the rules bar major outside firms from active competition. The Justice Department began looking at these arrangements years ago, but never pursued the case seriously. The government's motivation for the cartel is clear. The Treasury needs healthy dealers to underwrite and distribute several hundred billion dollars of securities every year. The Fed needs healthy bond dealers to act as a conduit for policy. Fed "open market operations" exceed $1 trillion a year. It's no fun in the Wall Street sandbox if you don't have someone to play with. Moreover, there is a revolving door between the Fed, the Treasury and Wall Street. It is commonplace for young economists to work at the New York Fed and then seek their fortunes in the dealer community. Treasury secretaries William Simon, Donald Regan, and Nicholas Brady - among others - all came from primary dealer firms. In fact, the Treasury market was under scrutiny long before the spotlight turned on Salomon. The Government Securities Act, which gives the Treasury authority to regulate the governme nt market, will expire on Oct. 1 unless Congress acts to extend it. Some journalists have been quick to conclude that Salomon's problems reflected a major ethical scandal. One major business magazine, whose senior editors should know better, claimed that lawsuits stemming from the firm's disclosures could cost Salomon upwards of $1 billion - fully one-third of its present capital. Hobart Rowen of the Washington Post said that the Salomon Brothers lesson is that the present system of regulation is not good enough, "the public can no longer be sure ... that an investment i n a US government bill, note or bond is the safest in the world." Such statements are pure hyperbole. Nonetheless, the cartel is breaking up. In place of a restricted club, the Treasury market should evolve into an open auction process with free access to price information. In the long run, taxpayers, Wall Street, and Washington will all benefit as the fresh wind of competition blows through the canyons of lower Manhattan.