Is China losing patience with their holdings in Treasury's? It wasn't too long ago that they requested guarantees from the Treasury. I'm not too sure what the Treasury's response was to their concerns. It appears from a Wednesday, April 29, 2009 article entitled Wall Street Selling Imaginary Treasuries from EuroMoney by Eric deCarbonnel that this market may be reaching the breaking point. The main concern here is the expanding failure to make deliveries is turning potential buyers away from this market.

It seems that the greedy bankers and Wall Street firms that trade these securities want to trade in them without paying for their positions. It's all based on free financing provided with investor money. No surprise here.

The lengthly main body of the Eric deCarbonnel report, mainly consisting or a full report of this condition by the author, Helen Avery, is available at http://www.marketskeptics.com/2009/0... .

An excerpt from the closing section of the report is included below:

My reaction: The settlement system for the US government bond market broke down last September.

1) Following the collapse of Lehman Brothers, fails to deliver in the US treasury market rocketed to more than $2 trillion.

2) The number of fails is almost certainly higher than is being reported. For one, the DTCC, used by two to three hundred bond dealers for settlements, does not reveal publicly the fails to deliver there.

3) Also, the Fixed Income Clearing Corp (part of the DTCC) started netting fails in 2005/06, whereby FICC uses bonds due to a participant to offset bonds due from the same participant in the same security, making the actual amount of true fails appears to be less. (The DTCC is doing the same netting of fails in equity markets)

4) As with stocks, dealers are able to sell treasuries without owning them.

5) After selling non-existent treasuries to their clients, dealers are supposed to buy or borrow those securities. This is called “settling a trade”, and it is what dealers are failing to do.

6) The supply of treasuries available to borrow through the repo market has, in the past, been so bountiful that selling treasuries without owning them was not considered risky by most traders.

7) The lending of treasuries in the repo market has largely stopped occurring. The two main reasons are:

A) Investors in treasuries are largely risk-averse by nature and are not going to risk lending them out in this environment.
B) With interest rates so low, there is no incentive to lend out treasuries.

8) Failure to deliver treasuries is not punished. At present, failing to deliver incurs only a continued overnight interest rate, and so, with interest rate near zero, there is no incentive to deliver a bond.

9) Fails have spread across to other bond markets such as municipals, agencies, mortgage-backed and corporate bonds.

10) The US Treasury has merely asked for market participants to sort out the situation themselves (because self-regulation has worked so well so far (sarcasm)).

11) The natural balance of supply and demand has been altered and the true price of treasuries has become obscured, as is the case in equity and commodity markets.

12) If they realize they are being sold assets that do not exist, investors might become nervous.


Conclusion: If this isn’t enough to scare the hell out of you, nothing will. Below are the absolutely key passages from articles above, repeated for emphasis.

Further discouraging the supply of treasuries into the repo market is the very fact that failure to deliver has not been punished. Huther and his colleagues were never able to enforce a severe enough repercussion for failure. At present, failing to deliver incurs only a continued overnight interest rate. When that interest rate is close to zero, and the penalty for failing is zero there is little incentive to deliver a bond.

This failure to deliver also has the effect of creating phantom securities – a higher number in the system than actually exist. “In a sense, the repo market is like a Ponzi scheme,” says Jonas. “If no delivery is forced then that bond can be lent over and over again. One security can underlie a hundred trades. So the amount of securities traded is far more than exists. That is the way the world works today. If it doesn’t break, that’s great. But when one link in that system breaks, those trades have to be unwound...”

Trimbath, however, is less sanguine about the impact that phantom bonds have on the financial system. She compares the situation to musical chairs. “Who is going to get the chair when the music stops? It’s not the individual investor. I’ve seen positions just deleted from people’s statements without investors even knowing as the security they supposedly owned turns out to not exist. When push comes to shove, and the buy-ins start, who will not receive their delivery? The individual investors or the institutional clients who are more profitable for the broker/dealers?”

“These undelivered treasuries represent unfulfilled demand – demand by investors willing to lend money to the US government,” says Trimbath. “That money has been intercepted by the selling broker-dealers. By selling bonds that they cannot or will not deliver to the buyer, the dealers have been allowed to artificially inflate supply, thereby forcing prices down. These artificially low prices are forcing the US government to pay a higher rate of interest than it should in order to finance the national debt. It shouldn’t take a PhD-trained economist to tell you that prices are set where supply equals demand. If a dealer can sell an infinite supply of bonds then the price is, technically speaking, baloney. And the resulting field of play cannot be called a market.

The inaction has led to the build-up of $2 trillion in undelivered bonds. Moreover, the number of fails is almost certainly higher than is being reported, claim insiders, possibly substantially so. The $2 trillion in fails fell to $1.3 trillion at the week ending 5 November, according to the New York Fed but Trimbath points out this is only data volunteered by about 17 primary dealers. The fail rate by those dealers in US treasuries hit 30% one week in October. By 11 November it was still at 22%. “And what about the two to three hundred bond dealers who settle through the DTCC? The DTCC does not reveal publicly the fails to deliver there. Imagine the magnitude of the true amount of fails to deliver,” she says.

The former Treasury employee also explains that the Fixed Income Clearing Corp (part of the DTCC) started netting fails in 2005/06, whereby FICC uses bonds due to a participant to offset bonds due from the same participant in the same security. “The actual amount of true fails appears to be less, therefore. You can’t compare the figures now with historical fails.”

Trimbath is less optimistic that something will be done to prevent fails to deliver from continuing. “This issue has gone unanswered for years. What is going on is simple stealing. We don’t need new laws against that, we already have them. If the Fed won’t step in, then the Department of Justice has to. The problem is, however, that if delivery is forced, then the real price of treasuries will be much higher to the point where counterparties will go bust when they have to buy in. That’s when the music stops.”

Broker/dealers can't sell there bonds to their brokerage customers, so they are selling them imaginary treasuries instead. This is a sweet deal for the broker/dealers, as they are effectively borrowing at a "risk free" rate. The deal is a little less sweet for the brokerage customers, who are unknowingly picking up a lot more counterparty risk then they bargained for.