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Before private equity and hedge funds started to throw their weight around, bond traders were the gunslingers of Wall Street.
In the 1980s, these “Masters of the Universe”, as Tom Wolfe dubbed them in “The Bonfire of the Vanities”, gravitated to an exclusive club of primary dealers. These are the banks and securities firms that deal directly with the Federal Reserve in its open market operations and are required to bid at Treasury auctions.
The primary dealer system was created in 1960 with eighteen members. It was a sleepy sort of club until the late 1970s, when volatility in interest rates, rising deficits and an historic bull market provided the means and opportunity to reap huge profits. Large institutional investors would only do business with primary dealers. Dealers, in turn, benefited from the information gleaned from customer flows.
The number of primary dealers peaked at 46 in 1988 before starting a steady descent, largely a result of consolidation, to sixteen today.
Even as banks swallowed up other banks, events were conspiring to reduce the allure of primary dealership. The availability of brokers’ screens to non-dealers increased transparency and chipped away at bid-ask spreads. The Japanese invasion of the 1980s disrupted the cushy franchise of dealers, who socialised with one another and were known to get together to “coup” an auction (collusion by any other name).
Electronic trading increased liquidity in the market, making it cheaper and easier to buy and sell plain-vanilla Treasuries. Customer business became a loss-leader for primary dealers, many of whom reinvented themselves as proprietary traders to justify (and underwrite) their existence. By the time the federal budget swung into surplus in the late 1990s, there were still 37 primary dealers worrying what they’d do in a world with no Treasury bonds.
Who would have guessed brokering bonds would become a lucrative business again?
In a curious twist of fate, the Treasury finds itself facing monstrous financing needs with only a handful of primary dealers to underwrite the debt.
The Congressional Budget Office is projecting a deficit for fiscal 2009, which ends September 30, of $1.85 trillion. Last month the Treasury said it expects to borrow $361bn in the April-June quarter.
Rare is the day when there isn’t a Treasury auction of some kind. Last month, the Treasury sold a record $71bn of notes and bonds to raise $18.8bn of new cash. This is happening at a time when dealers are taking less risk and are constrained by the balance sheet.
The result has been a widening of bid-ask spreads, which means an opportunity to make money the old-fashioned way. The steep yield curve is certainly an added inducement.
Dealers can buy, say, a ten-year Treasury note yielding more than three percent and finance it at the overnight repo rate of 0.2 percent. No wonder some broker-dealers are applying to the New York Fed to become a primary dealer. At least one dropout is looking for readmission.
Not only is it a good time to be a primary dealer, it’s a great time to be a bank. The Federal Reserve is practically giving money away to almost anyone that asks.
Even if private credit demand is sluggish, Uncle Sam has a huge appetite. Banks can borrow from the Fed at zero percent to 25 basis points, turn around and “lend” to Uncle Sam, with the difference going to the bottom line.
Who knows? Before long, the US may start manufacturing stuff again.
Caroline Baum is a Bloomberg News columnist. The ideas expressed are her own.
