Feds probe $4 trillion bond market

NEW YORK (Fortune) -- The U.S. banks that are the nation's primary Treasury bond dealers came away from Monday afternoon's chat with Federal regulators saying they are happy to cooperate with an investigation into shady practices in the $4 trillion government bond market, the world's deepest and most liquid securities market.

But it seemed that acquiescence as much as cooperation was the watchword in the industry's first wide scale probe of the industry in 15 years, as watchdogs extended a probe into whether some banks squeezed notes to boost profits.

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"The Federal Reserve Bank of New York met today with the senior management and senior compliance officers of its 22 primary dealers to discuss practices to strengthen market integrity in the U.S. Treasury market. Representatives from the U.S. Department of the Treasury were in attendance," the New York Fed said in a statement released after the 4 p.m. EST meeting adjourned.

"We look forward to further discussion with the primary dealers and other interested market participants and will continue to promote and encourage ways to improve industry practices and strengthen market integrity."

Does that sound like a reason for the big banks to panic? So far, the Interagency Working Group on Market Surveillance, which includes officials from the Securities and Exchange Commission, the Treasury Department, the Federal Reserve and the Commodity Futures Trading Commission has yet to file formal charges against any of the primary bond dealers that trade directly with the Federal Reserve Bank of New York.

However, the investigation is far from over and at least one firm, UBS AG (Charts), is under a cloud of speculation that it has been manipulating prices in the market that sees about $530 billion change hands everyday.

Two UBS traders, Phillip Smith and Robert Fischetti, are on leave due to their connection to alleged bond market manipulation, according to the Wall Street Journal. UBS said it "is cooperating in the government's investigation."

Under such circumstances, knowing the rules is helpful. "[The banks] need to work out these trading inconsistencies because if they happen too often the Fed will just step in and make them sorry that they are primary dealers," says Steve Bohlin, a portfolio manager with Thornburg Investment Management.

"The advantages of being a primary dealer include access and liquidity and being able to see what's going on in the market place," Bohlin added. "But the disadvantage, as we saw this afternoon, is that you've got to show up all the time when you're given a special invitation like this. They're going to look at 22 dealers."

Distinctly bad behavior in the $4 trillion-plus market is sure to be taken seriously, since Treasury issuance keeps cash flowing into the U.S.'s debt-laden coffers, helps set consumer interest rates and generally keeps the economy humming; the appearance of transparency is essential if foreign investors are to keep buying U.S. debt.

Specifically, regulators are looking into the bond repurchasing market. Borrowing bonds to be used in other deals, a so-called repurchase agreement, is legal. But regulators are concerned that the practice is being abused, with banks snapping up scarce securities to artificially inflate prices.

If a Treasury dealer borrows a lot of a single scarce bond and then ties those securities up in a deal, this keeps them off the market, away from other traders. The value of the bonds then rises in the repurchase market, benefiting the bank that holds them. The firm that has control over those securities can also profit by lending some of the bonds to other market participants.

Bond traders say that leverage will be the key word going forward, and regulators will have to draw some clear lines when it comes to how much leverage is too much.

"This isn't too unusual... it's part of review about practices in the market place," says Ernest Patrikis, a former Federal Reserve Bank of New York general counsel and now a partner at Pillsbury Winthrop Shaw Pittman LLP. "Regulators are saying to these guys 'Let's all get our acts together and behave and do the right thing'."

Patrikis said that whether or not the probe turns into a full-blown scandal, it will be used as a way for the Fed to force bankers and primary dealers to keep their noses clean.

"I can't tell if this will lead to more housecleaning, but my instincts are that if they're bringing people in, this is a prophylactic sort of measure. What's being done is being done already and it's time for some protection."

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