At the heart of the scandal that has engulfed the powerful Wall Street investment banking firm of Salomon Brothers is its manipulation in the $2.3 trillion Treasury securities market that is used to fund the U.S. debt.
By exceeding government limits on the purchase of certain Treasury securities, Salomon Brothers Inc., other dealers charged.
Wall Street speculators say they lost money as a result and the market for Treasury securities has been tainted.
Salomon chairman John Gutfreund and his deputy, Thomas Strauss, resigned Sunday. John Meriwether, the vice chairman in charge of government bond trading, also resigned.
The New York Times reports today that the scandal may be widening.
The Securities and Exchange Commission has begun requesting documents from dozens of other firms, seeking evidence of possible collusion, fraud and other illegal practices in the market for U.S. Treasury issues, people who have been briefed on the inquiry told the Times yesterday.
The far-reaching requests began to go out over the weekend, providing the first indication that government investigators suspect that illegal bidding practices of the sort disclosed at Salomon Brothers may have been more widespread than previously thought.
With the full faith and credit of the United States behind them, U.S. Treasury securities are considered the safest investment in the world.
And the interest rates on Treasury securities are used as a benchmark for other lending, ranging from business borrowing to mortgage rates. But the Salomon scandal has raised questions about the fairness of that market.
There are three types of fixed-income Treasury securities: bills, notes and bonds.
Bills mature in three months, six months or a year.
Notes are due in two to 10 years.
Bonds have the longer term, extending beyond 10 years.
Treasury bills are sold every week, and the two-year and five-year notes are sold each month. Longer-term notes and bonds are sold every three months.
The biggest buyers of these securities at government auctions are 40 large commercial and investment banks, including Salomon Brothers.
These firms are called "primary dealers" because they are the only companies authorized to trade directly with the Federal Reserve System. They in turn take orders for Treasury securities from various institutional and individual investors.
The primary dealers take orders for Treasury securities about a week before the securities are actually auctioned and these orders are traded as if they are the securities themselves, according to Kevin P. Rast, an assistant vice president for government trading in the Baltimore office of Ferris, Baker Watts Inc., a Washington-based brokerage firm.
These primary dealers are restricted from buying more than 35 percent of any particular issue so that no one firm can corner the market.
But Salomon allegedly got around this regulation by placing huge orders for itself and large clients, some without the knowledge of the clients. In this way the company allegedly could buy large chunks of the notes, corner the market and force up the price.
Other dealers and regulators became suspicious after the May 22 auction of $12.26 billion of two-year notes.
Instead of declining in value after the auction, as is sometimes the case, the price of the notes increased and stayed high for more than a month.
"There was something odd going on because you could just not buy the bonds," said Rast. "It was artificially stimulated."
This high price of the Treasury notes was particularly devastating to the "short sellers" who had bet that the price of the note would drop after the auction.
Short sellers borrow orders for the securities and then sell them with the hope of replacing them with cheaper securities when the price falls.
But the unusual price rise meant the short sellers had to replace the borrowed orders with higher-priced notes, forcing some of the smaller operations out of business, according to press reports.
The "squeeze" on short sellers also prompted them to complain to government regulators, who started an investigation that resulted in the firm's admission that it had broken bond trading regulations in the past.
The losers in the Salomon affair are the short sellers, the holders of the company's stock -- which has dropped 25 percent in value since Aug. 8 -- and the reputation of the Treasury securities market.
Some analysts have warned that this blemish might discourage investors from buying Treasury securities, thus forcing the U.S. government to pay higher interest rates on its debt.
But Rast doubts there will be any long-term effect because Treasury securities are such an important part of many investment portfolios, particularly for institutions. "I don't think it will have a huge effect on the market as a whole," he said.