Salomon and the Treasury Securities Auction

Questions to Address in Memorandum for Case

“Salomon and the Treasury Securities Auction”

Group 7: Yucheng Jiang (yucheng7), Hefei Wang (hefeiw2), Yali Zhang (yaliz3)

1. Why does the U.S. Treasury auction its securities rather than issue them using the underwriting process that corporations or municipal governments employ when issuing bonds?  Hint: think about the economic benefits that underwriters provide to corporations or state and local governments that might not be applicable to the U.S. (federal) government.

No credit risk and more liquid.

Solomon is different from other dealers that it is younger and will buy back securities.

Top underwriters get better prices from customers, because customers believe these established firms and reputation. Solomon didn’t have that reputation when it wanted to break in, so it entered in an area where reputation was not necessary, which is Treasury.

Solomon had a large inventory, facing downside risk.

How they finance the inventory? Commercial paper and repurchase agreement of Treasury (repo borrowing using Treasury as a collateral, but could not borrow as much as you can).

In the underwriting for corporate and municipal bonds, underwriters, in exchange for a guarantee to buy any new securities that outside investors were unwilling to buy, receive an underwriting fee. “At the time of Salomon's founding, only the reigning investment banks had the connections and reputations necessary to approach potential investors and assure them of the quality of the new securities.” While, the U.S. government debt market is the largest securities market in the world and has the most liquidity and demand, so it doesn’t need the exclusive sales right, or guarantee, provided by corporate or municipal debt underwriters. Also, underwriting process will increase the borrowing cost for U.S. government, which is not necessary.

2. Why did bidders in the Treasury’s multiple-price, sealed-bid auction try to bluff each other and sometimes start false rumors?

100 million-10m (noncompetitive bids) = 90m for competitive bids

Suppose:

2.00% 40m(pay higher price); 2.01% 100m(pay lower price); 2.02% 30m

90m-40m=50m

2.01% is the stop out yield and bidders get 50% of their bids.

Make fewer bidders at the stop-out yield. Bluffing makes the demand increase and bidders can buy securities at the secondary market. Solomon has an advantage of market information. It can submit bids for their customers and Solomon has many customers.