When I say the primary broker dealers are shorting treasuries I mean that they are delaying delivery on future obligations by witholding them in order to increase the intensity of the bidding.
Their actions result in de facto shorting.
Alternately, another way of looking at it is to see that these primary broker dealers are the same charity cases that accepted TARP money in the form of Treasuries. And those Treasuries are the ONLY thing holding up their balance sheets (which should be uniformly negative by now). Given such a situation, the primary dealers have a powerful incentive to hoard the Treasuries they have in order to meet investor scrutiny.
Imagine an auctioneer being assisted by helpful agents (The Fed) in the room bidding up the price amid a crowd of frantic rubes. The way the secondary market works is that the primary dealers get to buy govt paper at a discount and then sell it on the secondary (repo) market w/a slight markup for their services. That's the way it works in normal times.
The majority of the traders in this market are institutions but remember that not all institutions are built equally. We have the primary dealers (This is the same group that I write about in my earlier article, "The Libor Cartel") and then everybody else (wealthy individuals, regional banks, credit unions, pension funds, foreign governments, state governments, charities, endowments, etc.).
Pay special attention to the regional banks. These banks are the same entities that are also feeding from the TARP trough but are STILL hemoraghing cash from: sour commercial real estate loans, sour residential mortgage loans, sour trade loans, sour CDS bets, etc. They also have an incentive to meet analyst expectations by stuffing their balance sheets w/Treasuries to offset the horrendous fiscal reality of their finances.
The best example was the fierce bidding in the 4 week paper where there was NEGATIVE interest rates earlier this week in intra-day trading.
So, why is this allowed to happen?
This arbitrage is allowed to happen because of the antiquated method of settlement.
The value and quantity of bonds traded and the value and quantity settled are not the
same because of the process known as “netting.” In netting trade obligations, the Fixed Income Clearing Corporation, or FICC, uses bonds due to a participant to offset bonds due from the same participant in the same security. In many cases, there is NO ACTUAL DELIVERY of the treasuries because in their infinite wisdom our regulators believe that this process simplifies final settlement.
The markets say otherwise. Instead it allows a group of greedy, well connected profiteers to plunder billions from institutions and accelerate the cash flow problems for the broader financial sector. It is impossible to know just how badly the secondary buyers have been cheated because propietary data identifying specific parties is hard to come by.
HOWEVER, the parlous status of state and local finances in the muni bond market reflects just how badly governments have been violated by the chosen few of Wall Street.
The promise to deliver in the secondary market is backed by very lax penalties. This is actually a gray legal area that some academics have drawn attention to in the past. The problems have only accelerated exponentially since that time.
Apparently, the Treasury and Fed believe this to be a small price to pay in their in their broader policy of quantitative easing and - gasp - dare I say it, re-capitalizing the banks at the expense of the taxpayers (again).
Friday, December 12, 2008
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