the actual dollar amount rose only slightly from $15.4 million in November (63,000 applications) to $16.7 million. In January 1988, the number of applications fell to 46,000 but the dollar amount went up to $20.5 million. 15 During March and April 1988, the number of applications seemed to stabilize when the Pittsburgh Branch handled about 2,200 applications daily ($900,000 in sales). 16 The program was very cost effective, eliminating the stocks of unissued bonds held at banks, and cutting down on the time bank employees had to spend in preparing bonds for issue. At the end of fiscal 1988, this program was also considered successful by the Bureau and the decision was made to expand it nationwide in phases.

year

Innovations were also made in other areas of consumer service. The Bureau had already been making information about Savings Bonds, including the current interest rate, available to consumers by an 800-number toll-free telephone service. Starting May 3, 1988, that service was supplemented by the first telephone sales of Series EE bonds. Within the first six days of operation, 1,200 orders for bond purchases were taken; of those orders, 1,137 totalling $372,000 were approved. 17 The costs of handling those orders were so high in terms of manpower, however, it was doubtful that telemarketing would continue after 1988.

From the telemarketing of savings bonds to the TREASURY DIRECT system for selling marketable securities, the Bureau of the Public Debt came a long way during the 1980s in terms of providing service to holders of the public debt. But there was one other area in which individual purchasers of government securities needed assistance. The expansion of the public debt in the 1980s coincided with a period of deregulation and change in the financial industry. Some holders of government securities had made their purchases through many of the financial institutions that had sprung up at this time. While their bonds were backed by the "full faith and credit of the United States," it was not always clear what maintained the security of the financial institutions that purchased those bonds and held on to them. Because this system caused problems for investors in government securities, the Bureau of the Public Debt was called upon to find ways to make it safer.

10.

15 BPD, Monthly Status Report, 1/88, item 1.

16

Bureau of the Public Debt, Monthly Status Report for March 1988, BPD files, item

17 BPD, Monthly Status Report, 4/88, item 3.

Chapter Twenty-one

THE GOVERNMENT SECURITIES ACT

The market for government securities is one of the largest financial markets in existence with about $1.5 trillion in Treasury-issued bills, notes, and bonds held by the public. The main actors in the market are the Treasury Department, which authorizes and accounts for the securities, and the Federal Reserve Banks, which handle the sale of most of the issues, acting as fiscal agent for the Treasury. The Federal Reserve Bank of New York is responsible for open market operations wherein the money supply of the country is influenced by the purchase or sale of government securities.

Dealers

In the private sector there exists a variety of dealers in government securities. Foremost among them are firms designated by the Federal Reserve as primary dealers; these firms take an active part in Treasury auctions and in the Federal Reserve's open market operations. In 1985 there were 36 primary dealers. Of those, 15 were banks or subsidiaries of banks which came under the regulatory jurisdiction of the Federal Reserve and other government agencies, 11 were broker-dealers who were regulated by the Securities and Exchange Commission (SEC), and 10 were not officially regulated, but were monitored by the Federal Reserve to ensure that its dealings with them in open market operations were sound.

Secondary Security Dealers

In addition, there is a group of secondary security dealers who deal more directly with the public. In 1985 it was estimated that there were 400 to 500 of those dealers. Many of them were banks or broker-dealers, so they came under some form of regulation. But

about 100 of these secondary dealers did not come under any form of Federal regulation. 1

The problems that could be caused by these unregulated firms were brought to light by the failure of Drysdale Government Securities, Inc., in May 1982, and E.S.M. Government Securities, Inc., in March 1985. A total of six firms failed in the first half of 1985. The failure of E.S.M., which was an unregulated firm, was especially important, for it set off a domino effect by causing the bankruptcy of Home State Savings Bank, Cincinnati Ohio, which in turn set off a panic that culminated in temporary suspension of savings and loan operations throughout Ohio.

In its analysis of the situation, the Federal Reserve found that these smaller securities firms had issued misleading statements about their finances, had hidden affiliate companies that were sources of trouble, and had not maintained secure capital. A large problem concerned repurchase agreements, for under these, a securities firm would sell a government security to a bank with a promise to buy it back at a specified time. In this way the firm could gain short-term loans using securities as collateral.

These repurchase agreements caused two problems. First, the maturity dates of the securities might not match the due date of the repurchase, so the securities firm might not be able to make good on its agreement. Second, the other parties to the repurchase agreement did not always take control over their securities, which made them more susceptible to loss. As a result of these problems, many banks and municipalities were tempted into special deals by the securities firms, believing that they were involved with riskless government securities. But the situation had evolved to the point where, as Gerald Corrigan, President of the New York Federal Reserve Bank stated, "the security may be risk-free while the transaction can be quite risky." 2

In recognition of these problems, and as a result of these failures, legislation was introduced in the House and Senate in 1985 to begin Federal regulation of the government securities market. A group composed of members from the Treasury Department, the Federal Reserve Board, and the SEC was formed to consider what form the

1 "Statement by E. Gerald Corrigan, President, Federal Reserve Bank of New York, before the Subcommittee on Securities, U.S. Senate", Federal Reserve Bulletin, July 1985, 520-21.

regulation of the government securities market should take. It was agreed that the Federal Reserve would continue its monitoring of the primary security dealers. While it was desirable that self-regulation among the secondary dealers, as takes place with activities among stock brokerage firms who are members of the New York or other stock exchanges, be considered, this approach was not found feasible. Paul Volcker, Chairman of the Board of Governors of the Federal Reserve System, stated the case against self-regulation: "Developments also suggest the limitation of such a voluntary approach. The Federal Reserve has no authority over the "fringe" dealers, cannot examine them, and does not have a business relationship with them. Under those conditions, a dealer wishing to avoid official scrutiny or surveillance can do so." 3

The Bureau of the Public Debt was involved with the proposed regulations from the beginning of the problems in the government securities market. As part of the move to a full book-entry system, the Bureau's Chief Counsel, Calvin Ninomiya, had identified the importance of new rules for handling book-entry transactions. With the failure of E.S.M., the rules being set forth for book-entry were considered to see if they could be applicable in the process of protecting investors. The Bureau personnel assigned to interpreting the Government Securities Act included Van Zeck, Deputy Commissioner, Anne Meister from the Commissioner's Office, and Cynthia Langwiser and Cindy Reese (both from the Chief Counsel's Office).

5

The Government Securities Act passed both houses of Congress in October 1986 as an amendment to the Securities and Exchange Act of 1933. The basic feature of the new act was the requirement that brokers and dealers who only handled government securities had to register with an appropriate regulatory agency. The Securities and Exchange Act had previously excluded them from any registration on the grounds that their dealings were risk-free. Agencies with which firms have registered have included the SEC and the National Association of Securities Dealers. In addition, the new act carried rules requiring firms to maintain adequate capital, describing how

3 "Statement by Paul Volcker, Chairman of the Board of Governors of the Federal Reserve System, before the Subcommittee on Telecommunications, Consumer Protection and Finance, U.S. House of Representatives", Federal Reserve Bulletin, August 1985, 621.

5

Gail Schlifer, "Interview with Ellen Seidman", PD News, September 1987, 4. Bureau of the Public Debt, "Van Zeck Appointed Deputy Commissioner", PD News, June 1987, 4.