$6 Trillion Bond Fraud Foiled ?

$6 Trillion Bond Fraud Foiled

By RANDALL W. FORSYTH | MORE ARTICLES BY AUTHOR

Italian authorities foil fraud in U.S. Treasuries; €14.4 billion of Greek bonds will be harder to retire.

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One of the biggest-ever bond "deals" hit a snag Friday when some $6 trillion of U.S. Treasury securities were seized by Italian authorities. A trunk full of what appeared to be paper Treasury bonds in denominations of $1 billion was intercepted en route to Zurich from Hong Kong in what the U.S. embassy in Rome said was part of an alleged scheme to defraud Swiss banks.

The implausibly large denomination of the securities was an obvious tip-off the bonds were bogus. They were dated 1934 and still had paper coupons attached, which would be clipped and deposited every six months back in the days before electronic book-entry securities. And the $6 trillion total would equal about 40% of the current amount of U.S. Treasury securities in the public's hands, and multiples of the total of American debt in the 1930s. All of which made the scam laughable.

At the same time, some investors in real European sovereign-debt securities were less than amused about how their holdings of Greek bonds were being treated in comparison to those held by the European Central Bank. In a deal expected to facilitate an eagerly awaited bailout to prevent a default by Greece on 14.4 billion euros of bonds coming due in March, the ECB will swap bonds it purchased since 2010 for new securities that are identical—except that they effectively will be shielded from losses.

As part of the so-called PSI, or private sector involvement, holders of Greek debt are supposed to accept big haircuts on their bonds as part of the plan to reduce Greece's debt burden to 120% of its gross domestic product by 2020. But as a result of the ECB's exchange, €50 billion of Greek bonds purchased as part of the ECB's monetary-policy operations apparently won't be subject to such haircuts. The ECB swap also doesn't apply to the €12 billion of Greek bonds held by the national central banks of Europe separate from the ECB.

In other words, some holders of Greek debt will be more equal than others, as in Orwell'sAnimal Farm, with the ECB getting "more equal" treatment than the private sector. That's sparked outrage among bond-market veterans.

Mark J. Grant, managing director for corporate syndicate and structured products at Southwest Securities—and among the first to warn of Greece's debt crisis two years ago—says the ECB now effectively is senior to other bond holders, who are in a subordinated position. The precedent would then apply to all sovereign credits. That puts European sovereign debt in a "severely negative position" vis-à-vis the security afforded by U.S. Treasury obligations, he contends.

Even so, Treasury notes and bonds sold off at the end of the week in reaction to the steady flow of positive economic news, which lifted the stock market within a percent of its highest levels since 2008. That gave investors less reason to stick with the safe harbor of low-yielding government paper, which they sold in favor of risk assets despite the uncertainty about a Greek-debt deal ahead of the three-day weekend for the Presidents Day holiday Monday.

Either the markets have become sufficiently confident the bailout deal would emerge after the weekend or they have become complacent, inured to the continuing crisis in Europe.

MEANWHILE, THE MARKET also has to confront the task of absorbing $99 billion of real (as opposed to bogus) Treasury notes during the holiday-shortened week. The benchmark 10-year Treasury yield ended the week just above the 2% mark, at 2.009%, up about five basis points (hundredths of a percentage point) on the week. On the long end, the 30-year bond yield was up about four basis points, at 3.155%. 

E-mail: randall.forsyth@barrons.com