Furtures of Treasuries...Shorting U.S. Debt?

Date:   8/8/2005 8:51:58 AM ( 19 y ago)

Was Someone Squeezing Treasuries?

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Published: August 7, 2005
A STORM swept through the United States Treasury market in June, creating big losses at banks and brokerage firms and bringing back memories of the infamous short squeeze by Salomon Brothers in 1991 that ultimately brought the firm to its knees.


Widening GapThe recent turmoil is a troubling sign that the pools of capital at hedge funds and investment firms have grown so enormous that they can easily swamp the government securities market, one of the world's deepest, most liquid and heavily used financial markets. The upheaval also involved a short squeeze - financial-speak for what happens to short-sellers when they are forced to stanch their losses in a buying spree that sends prices higher and higher.

Back in 1991, remember, a trader at Salomon Brothers propelled the price of Treasury securities skyward by illegally buying more than the firm's allotted share at auction. That squeeze created significant losses for many other players in the market and enraged regulators. The government punished the trader, Paul W. Mozer, and the firm, which paid $290 million in fines and penalties to settle the matter. John H. Gutfreund, Salomon Brothers' chief executive at the time, resigned as a result of the mess.

This time around, the market upheaval centered on a 10-year Treasury security issued in February 2002 that pays an interest rate of 4.875 percent. The notes generated about $25 billion for the government when they were issued, but the amount of bonds changing hands regularly, known as the float, is significantly smaller than that.

It's not known who was behind the recent short squeeze and there is no indication that the activity was illegal.

But by far and away the largest holder of the 10-year Treasury in question, and therefore the one that would benefit the most from the action, is the Pacific Investment Management Company, or Pimco, the $500 billion money management firm specializing in fixed-income investments and overseen by William H. Gross.

As of June, according to data from Bloomberg News, Pimco held more than 45 percent of the outstanding 10-year security in its various funds. Pimco's percent of the daily float was unknown but would have been far larger.

James M. Keller, a managing director at Pimco and director of its government/derivatives desk, said that the company as a policy does not comment on its trades.

This particular 10-year note was also the security underlying a Treasury futures contract that expired in June. Such contracts are crucial hedging vehicles for investors and traders in mortgage-backed securities, corporate bonds and other fixed-income investments.

Problems began emerging in late May, when traders who had sold the 10-year note short suddenly found that they could no longer go into the open market and borrow the securities for delivery to their purchasers. If sellers of a security cannot deliver it to buyers, the trades cannot settle. In Wall Street parlance, this is called a "fail."

ACCORDING to traders, beginning in late May and extending into June, billions of dollars of the 10-year Treasury were failing each day. It was clear that one or more holders of the securities had stopped lending them, setting up what appeared to be a perfect short squeeze. As sellers scrambled to buy back the securities to cover their short positions, the price of the Treasury rose, creating losses for anyone who still had a short position.

Holders of securities often agree to lend them, for a fee, to traders who are short the security. If no securities are available to be borrowed, anyone who is short the security must pay the amount of the coupon or interest rate to the people who have bought them. So, those who were short this particular Treasury were losing twice: once on the coupon, and again as the security's price rose.

The June turmoil was not limited to the Treasury market, however. It also created problems for the throngs of traders at brokerage firms, hedge funds and banks that use the futures market to hedge their positions in other fixed-income securities. At one point, positions taken by investors in the Treasury futures contract that had the unborrowable 10-year note as its underlying security reached $200 billion.
Under the terms of a futures contract, any trader who has sold one must supply the underlying security to the contract's owner when it expires. If a trader fails to make the delivery, he or she may face a penalty from the Chicago Board of Trade, where Treasury futures change hands.

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Widening GapThe disruption of the Treasury market in June seemed to have prompted the Chicago Board of Trade to institute limits on the number of Treasury futures contracts a trader can buy or sell in the last 10 trading days of its cycle. For example, traders in the futures contract that corresponds to a 10-year Treasury will be limited to 50,000 contracts. The limits, announced on June 29, go into effect with the December contracts. The last limit on the 10-year Treasury was 7,500 contracts; it was in place from 1990 to 1992.

Officials at the Chicago Board of Trade declined to discuss why the changes were made. But a notice explaining the new limits said the exchange's action furthered its "interest in providing deep, liquid and transparent markets and underscores our commitment to protecting the integrity of these contracts."

And last week, Treasury officials discussed the problem of large capital pools possibly overwhelming the government securities market. In a meeting last Tuesday of the Treasury Borrowing Advisory Committee of the Bond Market Association, which meets with Treasury officials four times a year to discuss matters relating to the financial markets, Timothy S. Bitsberger, assistant secretary for financial markets at the Treasury, said it was considering creating a securities lending facility to provide an extra supply of Treasuries in emergencies when large numbers of settlement failures occur.

According to the minutes of the meeting, some people in attendance expressed support for the lending facility. Others, the minutes reported, were opposed. As is customary, the minutes did not identify which members were for or against the emergency lending facility.

The advisory committee's members are executives at brokerage firms, banks and hedge funds. One member is Mr. Keller, the Pimco managing director. He declined to discuss his view on the emergency lending facility.

In an interview on Friday, Mr. Bitsberger said that a proposal outlining how an emergency facility would work could emerge in the next six months. He said the Treasury is concerned that, as fails increase, some market participants may re-examine their reliance on government securities.

There is no doubt that supply and demand in the government securities market is becoming increasingly imbalanced. And such imbalances almost guarantee greater volatility in Treasuries and, therefore, interest rates.

From 1981 to 2004, according to government figures, Treasury securities outstanding grew 8 percent each year, on average, while annual trading volume increased 16 percent, on average. And from 2000 to 2004, Treasuries outstanding increased 4 percent a year, on average, while average trading volume rocketed 22 percent.

The futures contract expiring in September is based on a Treasury issue that is even smaller - $19.5 billion - than the $25 billion 10-year underlying the expired June contract.

In other words, fasten your seat belt. More gyrations in this market almost certainly lie ahead.





 

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