NEW YORK -- A new system to distribute government debt, instituted in the wake of the Salomon Brothers scandal, began yesterday with a "disastrous" auction of $14 billion worth of three-year Treasury notes that left higher interest rates in its wake and losses for every firm that bought securities.
The new rules opened up critical aspects of the auction to as many as 1,550 broker-dealers registered with the Securities and Exchange Commission, up from 39 primary dealers. But participation by the newly permitted entrants at the New York Federal Reserve Bank, the key central bank branch for debt financing, was extremely limited.
Meanwhile, some disgruntled primary dealers shunned the auction in protest of the new rules, said John Lonski, senior economist at Moody's Investors Service. This resulted in the worst bidding for any Treasury financing this year.
After the auction, yields rose and prices fell for Treasury securities of all maturities, setting a grim tone for today's auction of 10-year notes and tomorrow's auction of 30-year Treasury bonds.
"In a word, you can call these results disastrous," said Peter Greenbaum, an economist with Smith Barney. "Especially in this environment, with accommodative monetary policy and the security of short maturity, the auction should go off without a hitch."
During trading early yesterday before the auction, three-year notes were yielding about 5.98 percent, but the average winning bid was 6 percent. Some some winning bids were high enough to produce a yield of 5.97 percent, and others were low enough to mean a 6.03 percent yield, an extraordinarily wide spread. Following the auction, rates moved up to 6.05 percent. Since bond prices move inversely to yields, the auction stuck any firm that acquired the notes with losses.
For the $14 billion in three-year notes issued, total bidding was only $21 billion. Typically, the volume of bids will be double or even triple the amount available.
A restraining element, said one trader who requested anonymity, was the recent crackdown on government securities dealers in the wake of Salomon's admission that it had faked customer order to bypass participation limits in the auction.
Questions have been raised concerning the amount of communication between primary dealers prior to auctions and whether it constitutes illicit or inappropriate inside information.
Many of the dealers argue communication is vital for generating confidence in the market.
"The problem is no one is talking to one another, and therefore no one can gauge the depth of demand," the trader said. "There's no price discovery, so everyone is bidding blindly" or not bidding at all.
Because of the difficulty of assessing market conditions even under the best circumstances, most brokers were expected to shun their newfound privilege to make competitive bids for customers, at least for now. Instead, many are likely to continue to use primary dealers for Treasury purchases, or take advantage of another change in the rules and enter non-competitive bids, whereby they receive the average price for up to the $5 million in Treasury securities.
In addition to expressing concern about new rules surrounding the auction, traders also were worried about more fundamental conditions affecting the market. A discount rate cut had been widely expected to occur early this week, but the Federal Reserve Board held back, shifting expectation until late next week, after the auction and the release of new information on inflation.