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Pencil, paper, billion-dollar deals Low-tech bidding for Treasury debt under scrutiny


New York--The gathering place is merely a corner in the lobby of a lower Manhattan building, though the building is hardly ordinary by the glass-and-steel standards of a modern financial hub. The low, block-long stone edifice, inspired by palazzos of great Italian banking families of the Renaissance, was built in the early 1920s as New York was emerging as a global financial power.

Furnishings in the corner are stark: a few dozen cubicles, phone jacks (without phones), a cabinet, and two common pressed-wood boxes, one dead center and another near a gate separating the corner from the rest of the lobby.

Despite such austerity and antiquity, this is the digestion point for the richest diet of money in the world. In this corner of the Federal Reserve Bank of New York, up to 90 percent of the trillions of dollars of debt annually issued by the U.S. government is sold.

Several times a week, the corner becomes crowded with representatives of a group known as primary dealers -- currently 39 banks and brokerage firms pledged to purchase the debt. Using pencil and paper and a pressed-wood deposit box, they provide the crucial bids that determine how much the federal government must pay on its massive borrowing.

In the wake of Salomon Brothers scandal, some have questioned whether a system relying on scribbled bids from such a small group of participants is still appropriate. Salomon, the Wall Street giant, forged customer orders to skirt limitations on how much of the bonds it could purchase, setting the stage for what, in essence, was price-fixing of government debt.

"It strikes me as absurd to have orders for purchases of billions of dollars of Treasury securities scribbled onto scraps of paper and stuffed into wooden boxes in the last seconds before an auction deadline," Sen. Donald W. Riegel Jr., D-Mich., complained last week in congressional hearings.

The system is "by no means state of the art," added Richard Breeden, chairman of the Securities and Exchange Commission. The SEC supervises almost all financial markets, with the notable exception of the Treasury market, which is under the joint supervision of the Treasury Department and the Federal Reserve system.

Proposals being broached in Congress concern broadening the number of direct bidders through the use of computerized ordering, and changing the auction system itself.

Others, however, defend a system considered for years to be above reproach. After all, until the Salomon episode, there has not even been a hint of scandal, in sharp contrast to the monthly announcements of improprieties stemming from the all-electronic market for stocks.

Moreover, the current auction process has allocated trillions of dollars worth of federal debt to global investors without prompting the precipitous interest rate shifts that a poor system could trigger.

In view of the Treasury's need to finance debt, and the Federal Reserve's desire to influence monetary policy, E. Gerald Corrigan, president of the New York Federal Reserve Bank, says there must be a finite group of private firms doing business directly with the government. And some large firms will pay a central role.

Today, bids are based on interest rates that firms are willing to accept. The firms willing to accept the lowest rates can buy the most debt from the government, limited only by a rule (which Salomon broke) stating no firm may purchase more than 35 percent of the securities offered at an auction. High bidders may receive only part of their order, or none.

The most frequently mentioned new bidding structure would be a "Dutch Auction," in which all the securities are sold at a single price high enough to satisfy the entire supply. This would theoretically hurt the seller -- the federal government -- by knocking out the lowest bids. But it could encourage the notion of a fairer, safer market, and thus prompt better prices in the long run.

The most radical change would be to decentralize the entire bidding process, by allowing orders to come in through a vast, computerized, network. Rather than 39 competitive bids, there might be thousands.

To see how different such an electronic market could be, contrast the prospect of flickering computer screens with the current system.

Typically, representatives for the primary dealers gather about noon on the day of an auction at their allotted space at the New York Fed.

From a locked cabinet they receive their own, special phones: odd-looking models lacking a dial. Plugging the phones into pre-assigned wall jacks with dedicated lines to home office trading floors, they begin grunted conversations to determine how many million dollars they should bid for, and how much they should pay.

Not bidding, or bidding ludicrous prices, is not permissible. And in this system, unlike many used throughout the financial markets, no computer can be switched, or telephone unplugged.

Minutes pass. On a special form, the dealers write tentative interest rate offers, extending out to a fraction of a percent. At 12:58 p.m., a fed official begins counting down the seconds, just as in the closing moments of a ball game. In the final moments, a last digit is scribbled onto the sheet and the form is crammed into a box. The 12:59.59 deadline is sacrosanct.

That concludes the first, most critical, facet of the circuitous process. Fortunes can be made and lost in the early moments, and interest rates set during these brief meetings influence everything from the cost of a home to the global standing of the U.S. dollar.

Following the submission of the bids, they are relayed to a special room eight floors above the bidders where a half dozen officials quickly check for improprieties. It was at this point that a Fed employee in February noted an bidding overlap that, months later, resulted in Salomon confessing to forged customer orders.

Within an hour the results are sent to the Treasury in Washington, where they are consolidated with other, far smaller orders received by the 11 other Federal Reserve banks and by the Treasury itself. Winning bidders, or those willing to assume government debt at the lowest interest rate, are then notified by wire.

The primary dealers then resell the debt on the vast secondary market for government bonds. Or, if they were placing orders for customers, they transfer the securities to special accounts. Through this extended path, even the smallest investor can buy Treasury securities.

A person can also simply write a check to the Fed: The interest rate received is determined by the average price paid by winning competitive bidders.

By the end of the year, the Fed expects to have at least this facet of the business automated. Automating the rest of the system is under study, yet despite congressional ire, change may come slowly.

"All this high-tech stuff isn't all it's cooked up to be," said E. Gerald Corrigan, president of the New York Fed. "If you really want to invite shenanigans, just keep automating."

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