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Treasury-Federal Reserve Study of the
U. S. Government Securities Market
DEALER PROFITS AND CAPITAL AVAILABILITY IN THE
U. S. GOVERNMENT SECURITIES INDUSTRY, 1955-1965
Staff study prepared by
William G. Colby, Jr.
Economist
Federal Reserve Bank of New York
May 5, 1967
THE
FEDERAL
RESERVE
BANK of
ST. LOllS
Research Library
TABLE OF CONTENTS
Page
Summary and Conclusions
I.
Introduction
1.
1
Income data
III. Dealer Profit Performance
A.
B.
The income equation
Trading profits
1. Spread
2. Transactions
3- Price (rate) changes; positions
C. Net carry
D. Trends in trading profits (plus carry)
E. Operating expenses
F. Regression results
1. Rate changes
2. Spread
3- Carry rates
k. Transactions
5- Positions
IV. Dealer Capital:
Capacity in the Industry
A.
Invested capital
1. Sources of change in invested capital
2. Changes in invested capital, 1948-1955
3. Changes in invested capital, 1955-1960
Changes in invested capital, 1960-1965
B. Margin requirements
1. Margin rates
2. Minimum capital requirements
C. Capital adequacy
7. Rate of Return on Capital
APPENDIX A - Summary of dealer income and expenses, 1964 and 1965
APPENDIX B - Regression equations
APPENDIX C - Dealer capital measurement
iii
2
3
6
8
8
13
17
22
25
29
33
35
%
37
38
39
kO
b3
45
46
47
50
50
54
57
59
62
65
67
iii
Summary and Conclusions
Profits
The sharply deteriorating trend in earnings of U. S. Government securities dealers from 1961 through late 1966, following on the heels of several
extremely successful years, has been offered as evidence that public and private
innovations in financial markets have been detrimental to the profitability
of the industry.
This development has raised some concern about the future
effectiveness of the industry in accommodating public ("official") and private
activity in the market.
This study examined the effects of these innovations,
as well as the impact of the economic and institutional environment of the past
decade, on the level of aggregate dealer profits and reached several conclusions.
These are:
1. A longer view of dealer profit performance, from the late 19^-0T s,
reveals a strong cyclical pattern of earnings, suggesting that the recent low
levels were not abnormally below other periods at the same stage in the business cycle.
Profits in 1950; 1955j and 1956 were virtually zero or negative,
and less than net income in 1961, 1962, and 1964.
The principal feature of
the early sixties was the extended and uninterrupted interval of economic
expansion which was accompanied by a generally rising and perhaps more importantly, non-volatile level of interest rates.
2.
The sharp reduction in dealer profits, for I96I-I965 inclusive,
can be attributed in great measure to the negative effects of cyclically declining security prices on dealer positions, and tightening monetary conditions
in general.
Treasury bill yields rose in each of the five years (1961 through
1965) and long-term bond yields moved higher in every year but 1962.
(in
that year, there was some improvement in earnings.) Furthermore, with trading
activity in long-term securities observed to move inversely with monetary
tightness, a declining volume of coupon transactions after 19^3 led to reduced
opportunities for profits on turnover.
Finally, as the differential between
long- and short-term rates narrowed with higher rate levels, the tendency for
profitable carry was minimized and eventually eliminated.
While sufficient
data are not yet available for a complete analysis, early reports indicate
that 1966, with the abrupt drop in security yields late in the year, was a
very profitable period for dealers, lending support to the hypothesis that
cyclical monetary conditions have dominated dealer profit performance.
3.
In assessing long-term profitability in the dealer industry,
the effects of public and private innovations in financial markets become
relatively more important.
Both sectors may have contributed to the most
notable change, namely the nature of the business cycle itself.
The well-
defined and relatively short cycle of the fifties was supplanted by a new
pattern, not perhaps as yet entirely visible or identifiable.
If this pattern
persists, it represents a changed environment for dealer operations and one to
which dealers must attempt to adjust.
This may mean, for example, longer
periods of meager returns followed by a relatively short but highly profitable
interval, with the need for catching the turn in the market taking on even
greater significance.
One aspect of the changed cyclical environment, attributed to both
sectors, which was apparently harmful to dealer earnings though unquestionably
valuable on broader grounds, was the stability of interest rates. Not only
should bid-asked spreads narrow with diminished volatility, making transactions
less profitable, but potential gains from intracyclical price fluctuations
(through appropriate, well-timed position adjustments) may decline.
The extent to which public innovation, in the broad sense of
new and evolving fiscal and monetary action and debt management, guided the
prolonged expansion and in doing so affected dealer expectations and perceived
market risks, is difficult to measure. As a result, it is unclear whether
these essentially exogenous decisions produced greater or less uncertainty
about rate movements and thus were a hindrance or help to profitable dealer
behavior.
Some evidence suggests that dealers may have been less successful
in adjusting positions in anticipation of price changes in the 1960ls than in
the late 1950's. Still, when a major rate reversal occurred in late 1966, dealers
reacted swiftly and accurately, expanding their positions accordingly.
5• Developments in the private sector tended to affect dealer profits
adversely.
Increased access to the Federal fund market, and the advent of
negotiable commercial bank
certificates of deposit provided short-term lenders
with more competitive alternatives to dealer loans and thus contributed to
relatively higher financing costs. Both uses competed directly for funds that
otherwise might have been more cheaply available to finance dealer positions.
Furthermore, the increased competition of these instruments for short-term
funds undoubtedly aggravated the pressure on dealers to reduce quoted spreads
for short-maturity U. S. Government securities.
During the early 1960!s, there was an apparent increase in competition
among dealers, arising from the entry of three new bank dealers and the addition
of one sizable nonbank dealer.
Constrained by an exogenously determined level
of aggregate transactions, this expansion in numbers may also have brought
increased pressure on spreads, and retarded existing dealers1 shares of rising
transactions.
vi
B.
Capital
This study also investigated the prospects for adequate capital
being available to accommodate future market operations,in light of the past
deterioration in profits.
Insufficient capital would act as a constraint on
the desired expansion of positions and concomitant willingness to assume the
risks associated with large positions.
A circumstance of insufficient capital
is presumably detrimental to efficient and effective market performance in
accommodating public and private operations.
This study found that the amount
of capital possessed by nonbank dealers (sufficiently liquid to satisfy margin
requirements) plus potentially available bank dealer funds is far in excess
of any possible needs in the foreseeable future.
Estimated minimum capital requirements (for positioning average
daily gross long positions of $4.6 billion in 1965) were between $40 million
and $45 million.
$29 million.
Of this total, nonbank dealer positions "required"
These same dealers reported aggregate invested capital of
$26l million in 1965 and specifically allocated $86 million to their operations in U. S. Government securities.
It is reasonable to assume that the
amount of nonbank dealer capital which could conceivably be employed as
margins approaches $100 million.
Bank dealers, who accounted for one-third
of estimated minimum margin requirements, in fact are not actually subject
to such capital requirements since the bulk of their positions is financed
with their own funds.
These funds may be augmented readily through borrowing
in the Federal funds market and issuing certificates of deposit.
In short,
the amount of capital potentially available for margining securities is
enormous and, for the industry as a whole, is not a realistic constraint on
the expandibility of these positions.
The adverse trend in earnings in the early sixties certainly had
no perceptible effect on capital investment except to the extent that low
vii
profits slowed the capital growth of existing dealers.
and two nonbank firms entered the industry.
In fact, three new banks
The two recorded nonbank dealer
departures were for reasons unrelated to market performance.
The willingness
of both old and new dealers to actually commit available capital to expand
positions, however, is largely unrelated to the amount available.
With the
mobile or liquid nature of these funds, at diversified nonbank dealers as
well as bank dealers, such resources may be shifted readily to activities which
provide greater opportunities for profitable employment.
If expected profits
in U. S. Government securities operations are exceeded by potential gains in
other activities or at least are not sufficient to adequately compensate
for the risks of making markets, dealers are unlikely to commit capital
to positioning Government securities.
Nevertheless, there is no doubt that
capital will be forthcoming if expected profits justify its utilization.
II.
Introduction
For the five years 1961 to 1965* average annual profits from dealer
operations in U. S. Government securities fell substantially below the level
attained in the previous five year period.^
The decline in the sixties cul-
minated in a net loss of over $14 million in 19^5> when only three of twenty
dealers were able to report a profit from these operations.
This deterioration
has caused some concern about the maintenance of a strong dealer industry and
brought into question the effects of increased competition resulting from the
entrance of additional dealers over the past few years as well as of recent innovations in official policies and operations.
twofold:
The task of this paper is
(l) to specify and evaluate the factors bearing on dealer profit-
ability, such as changing economic circumstances, industry structure, and
operating techniques utilized by the Federal Reserve and Treasury, and
(2) to ascertain the sufficiency of dealer capital under current market
conditions, with a view to judging, in light of the profit situation,
whether adequate capital will continue to be available to the industry so
that its capacity to assume risk (and thus continue as a dealer market) and
to absorb large official operations will not be impaired.
The discussion in this paper is derived largely from the operations
of nonbank dealers due to the more straightforward nature of their activities
and the existence of more reliable profit data for these firms; known or suspected variations in bank dealer operations or behavior are noted.
The de-
scription and evaluation of dealer profit performance is severely constrained
by the fragmentation and inadequacies of the data and by the absence of welldefined concepts underlying the data compilation. Much of the dealer data
1. In this paper, virtually all references to operations in U. S.
Government securities also include dealer activities in Federal Agency securities and, commencing in 1961, certificates of deposit. Where data include
operations in bankers'acceptances and municipal and corporate securities,
which are undertaken by many dealer firms, specific note is made.
2+
presented here is meant to impart to the reader merely some awareness of the
magnitude and direction of certain measurable aspects of dealer profits and
related variables.
The limitations of the data are numerous, and to avoid
excessive details, only the more important qualifications are described.
1.
Income data
Data on dealer income have been gathered from three separate
sources.
Differing in their construction and coverage, these disparate
series present the most serious constraint to meaningful inter-period income
analysis.
The earliest series on dealer earnings is found in the study of
the Government securities market made by Meltzer and von der Linde for the
eleven years from 19^8 to 1958,
Annual gross income and expense figures
are shown for "all reporting dealers" (bank and nonbank) along with several
subcategories of income and expense, including net profits.
This series
incorporates total earnings and expenses of the diversified nonbank dealers
but only the U. S. Government securities operations of the banks.
Details
on reporting procedures and methods of allocating income and expenses are
unfortunately absent.
The series includes the five bank dealers and twelve
3
nonbank dealers trading with the System Open Market Account in 1958, although this was not the exact composition of "authorized" dealers in each
of the eleven years, as is noted in the discussion of dealer capital.
The second series on dealer profits (hereafter the FEB--NY series)
was assembled by the Federal Reserve Bank of New York for the six years prior
2. Meltzer, Allan H., and Gert von der Linde, A Study of
the Dealer Market for Federal Securities, Joint Economic Committee, 86th
Congress, 2nd Session, (Washington, D. C.; Government Printing Office,
i960).
3. The seventeen dealers were: Bankers Trust; Chemical Bank
New York Trust; Continental Illinois National Bank and Trust; First
National Bank of Chicago; Morgan Guaranty Trust; Bartow Leeds & Co.; Briggs,
Schaedle & Co., Inc.; C. F. Childs & Co., Inc.; C. J. Devine & Co.; Discount
Corp.; First Boston Corp.; Aubrey G. Lanston & Co.; New York Hanseatic
Corp.; Wm. E. Pollock & Co., Inc.; Chas. E. Quincey & Co.; D. W. Rich & Co.,
Inc.; and Salomon Bros. & Hutzler. (See ibid, p.2)
3
to the regular reporting program initiated in 1964.
In this series, data for
the Government securities operations of individual firms were collected on a
monthly basis from 1958 "to 1963; procedural and allocative details are again
missing.
This series was the only one with sufficient observations to permit
statistical analysis, which was undertaken despite known shortcomings in the
data. Due to the inability of most dealers to separate trading profits from
interest income on Treasury bills, and differences among dealers in classifying
a number of income and expense components, the series used for measuring profits
is that of trading profits plus carry. Of course, use of this combined profit
concept, and the absence of a trading profit or carry breakdown between bills
and coupon securities, may mask or distort relationships between each component
and other variables.
Finally, partially disaggregated data on individual dealers are
available from the reporting program initiated for nonbank dealers in 1964
and bank dealers in 19^5 by the Market Statistics Division of the Federal
Reserve Bank of New York.
These figures cannot be directly related to the
earlier series but are, nevertheless, a more reliable and detailed statement
of actual profit performance. A short analysis of aggregate income statements
for these two years is presented in Appendix A. Again, the inability to segregate bill trading profits from interest accrual, plus diverse allocative
practices, preclude exact inter-firm comparisons of trading profits or carry.
III. Dealer Profit Performance
This section schematically describes the elements of dealer income
and expense, and then explores the impact of postulated relationships between
selected exogenous variables and observed profit performance.
The testing of
these relationships utilizes both visual and regression analyses; naturally,
evaluation of the results must be interpreted as more suggestive than
clusive
evidence that the perceived effects are valid.
con-
1+
Briefly, the behavior of net income and its broader contributing
components (trading profits, carry, and operating expenses) may be reviewed.
The data, presented in Chart I (and Table i) are linked for the three successive series despite several discrepancies.
The Meltzer-von der Linde data
cover, as previously noted, all operations of participating nonbank dealers
while the other two series reflect only the Government securities operations.
Net carry, in the FRB--NY figures, had to be combined with trading profits
because several dealers reported their bill income with trading profits while
others included it with interest earned.
In any event, valid estimates of
annual net carry throughout the entire 19^8-1965 interval were impossible due
to the aforementioned problem of separating trading profits from accrued discount on bills.
For both the Meltzer-von der Linde and FRB--NY series, gaps in
the figures submitted by individual dealers, particularly with regard to
operating expenses, necessitated some interpolation from subgroups of dealers
in arriving at aggregate income and expense levels.
In I96U, as noted earlier,
statistics on the bank dealer operations were not collected at all; the industry figures shown in Table I include bank dealer income and expense estimates
based on nonbank dealer results and data obtained informally from several dealer
banks.
Several conclusions may be drawn from the linked series, however,
despite these shortcomings. First, it is quite evident that trading profits
have been the primary determinant of net income and that the extreme volatility
il
of the former has led to wide fluctuations in the level of net income.
The
movement of trading profits, in turn,appears to coincide (inversely) with the
business cycle.
Years of high trading profits were generally associated with
Data on the relative contributions of capital gains or losses
and spreads ("turnaround" prices) to these swings in trading profits are not
available. However, the behavior of these two components are examined
in later sections.
Chart I
INCOME AND EXPENSES OF U. S. GOVERNMENT SECURITIES DEALERS, 1948-1965*
Millions of dollars
Millions of dollars
* See note accompanying Table I for a further description of the data.
1. Figures are for i l l operations of nonbank dealers and for the U. S. Government and related securities operations of bank dealers.
2. Figures are for operations in II. S. Government and related securities. Trading profit and carry figures were not available separately.
3. Figures are for operations in U. S. Government and related securities. In 1964, bank dealer income and expense data were not collected.
Estimates for the industry in that year were based on nonbank dealer data.
5
Table I
Income and Expenses of U. S. Government
Securities Dealers, 19^8-1965
(in millions of dollars)
Trading
profits
(i7~
Net
carry
" W
Trading profits
plus carry
(3)
Operating
expenses
i)
Net income
(before taxes)
ttr
Meltzer-von der Linde data*
1948
1949
1950
1951
1952
1953
1954
1955
1956
1957
1958
3,796
11,127
5A53
9,721
11,715
23,392
23,215
9,200
15,7^6
52,125
64,288
2,687
4,264
2,125
99
1,177
1>549
5 , ^
1,293
-1,315
-9,151
-3,827
6,483
15,391
7,278
9,820
12,892
24,941
28,629
10,493
14,431
42,974
6o,46l
5,689
7,992
8,039
8,449
7,374
11,574
14,680
13,491
15,333
17,893
22,960
1,051
7,710
319
1,829
3,713
14,060
14,924
- 1,881
639
27,043
38,840
19,909
16,602
20,609
24,324
21,024
20,773
31,815
16,850
41,022
5,713
13,675
1,898
23,300
24,238
4,300
-14,346
FRB—NY data#
51,724
33,452
61,631
30,037
34,699
22,671
1958
1959
i960
1961
1962
1963
Market Statistics datat
1964
1965
*
21,100
7,304
6,4oo
2,333
27,500
9,637
Data are for all operations of the 12 nonbank dealers and the U. S. Government
securities operations of the 5 bank dealers authorized to trade with SOMA in
1958* "Gross earnings" (not shown) were reported by all dealers; items in the
table were extrapolated from complete reports submitted by from 8 to 13 dealers.
Trading profits plus carry minus operating expenses do not equal net income due
to the omission of "other earnings". Trading profits on Treasury bills were
reported with interest income by most, if not all, dealers. The data are derived from the regular dealer financial statements. Since most have different
fiscal years, the data for individual dealers do not cover a common time period.
(Continued on next page.)
6
recessions and declining interest rates and years of low returns with expansion
and rising rates.
Furthermore, poor years have often meant net aggregate losses
for the industry, as in 1950, 1955, 1965, and perhaps 1948 and 1956 if profits
for the Government securities operation alone are considered.
Second, the peak profit years, 1957> 1958, and i960, appear as a hump
in the earnings picture rather than as the culmination of a well-defined and
subsequently reversed trend.
It may thus be quite misleading to compare and
contrast profits in only the two halves of the decade from 1956 to 1965. Rather
than characterizing the 1961 to 1965 period as unusually poor, it would seem
just as valid to view average earnings in the earlier five years as abnormally
swollen.
A.
The income "equation"
Broadly speaking, the net income (before taxes) accruing to dealers
from their Government securities operations represents the sum of trading profits
and carry minus operating expenses.^
In order to identify the exogenous variables
influencing dealer earnings and to diagnose their effect on earnings over the
past decade, the elements of income and expense can be viewed as the products of
independent (or possibly interdependent) components.
(Footnote continued from preceding page.)
#
Data are for U S. Government securities operations of all dealers. Trading
profits plus carry were reported by all dealers; operating expenses and net
income were extrapolated from complete reports of 5-8 dealers. "Other income"
is included in trading profits plus carry. The data are based on calendaryear reports.
t Data are for U. S. Government securities operations of all dealers. Bank
dealer income and expenses were estimated for 1964, based on nonbank dealer
data in 1964 and 1965, and bank dealer data in 1965. Trading profits on
Treasury bills are included in interest earned. "Other income" is not
shown. Data on trading profits are adjusted for unrealized capital gains
and losses at year-end. The data are based on calendar-year reports.
5. Hereafter, the terns "dealer" and "dealer function" refer only
to the Government securities operations of participating firms.
7
Trading profits, to take the primary element, are the sum of
differences between the sale and purchase price of each security sold. The
sale-purchase price differential can be conceptually split into two separate
facets:
(l) the "spread", which represents the bid-offer quotations at
which a dealer would simultaneously buy and sell a security; (2) the capital
gain or loss associated with the movement of security prices, that is, a
shift in both bid and offer quotations while securities are held in position.
The contribution of spread to trading profits depends upon sales volume
while the effect of price change is contingent on the size and composition
of positions at the moment such change
occurs.
The second element of dealer income is carry, the difference
between interest earned on securities held in position and the interest
cost of financing them. Again, carry income (or loss) is the product of
the yield-cost differential and the amount of securities financed, summed
over time. At this point, no account is taken of the variation in cost
among different types of financing.
The final broad element of net income is operating expenses,
which consist of fixed and variable components.
Fixed expenses include
wages, rent, etc., while variable expenses include among others the
clearing costs associated with the delivery and safekeeping of securities.
The variable component is a function of per-unit sales costs and the
volume of sales. Charges are generally attached only to the sale side
of transactions.
A dealer profit identity can be constructed to bring these
elements into clearer focus.
The first two factors relate to trading
profits, the third to carry, and the fourth to operating expenses:
n
t
n
t
n
t
NI
- L
L
i=l k=l
L E ^ ^ + L L
(Y
i=l k=l
i=l
i=l
ik " E k)
—
n
^
a S
i=l
i
-
F
8
Where:
net income (before taxes)
NI
s
bid-offer spread, in dollars per bond
S
number of bonds sold (assumed equal to purchases)
i
security issues, n separate issues
k
units of time, arbitrarily small
^p
-
price change, in dollars per bond
P
-
positions, number of bonds held (net of gross long and
short positions)
Y
-
interest earned from positions, in dollars
E
-
interest expense on borrowed funds, in dollars
a
-
constant of variable expenses associated with trading,
in dollars per complete transaction per bond
F
-
fixed operating expenses, in dollars
Each of these components can now be investigated separately in
measuring the impact of changing exogenous variables.
B*
Trading profits
1. Spread
The bid-asked spread encompasses both compensation for performing
the intermediary "broker" service and a reward for assuming the risks of
making markets.
Trends in quoted security spreads for several maturity
categories since 1950 are presented in Table II.
It is evident that quoted
bill spreads narrowed throughout the late fifties and early sixties while
spreads on coupon securities exhibited mixed behavior over the decade. It
should be emphasized that the spreads recorded here are announced quotations
which often vary considerably from the actual or "inside" spreads at which
trades are effected. Naturally, the possibility of a discrepancy between
announced and inside spreads increases as spreads widen, as with longer-term
issues.
9
Table II
Spread Between Dealers1 Quoted Bid and Asked Prices
on U. S. Government Securities*
Year
3-month
Treasury bills
(in basis points)
Coupon securities
6-13
3-5
5-10
After
months
years
years
10 years
(Most typical spread, in 32nds)
1950
1951
1952
1953
4-5
5-5
5.25
n .a.
n .a.
n.a.
2
1-5
2.25
2
5
2
k
k
5
2
3.5
k
6-5
1954
1955
1956
1957
3-5
3-5
3-75
3-5
2
2
2
2
2.75
2-75
3-5
5
4.5
k
b
5
5
k
k
5
1958
1959
i960
1961
3-5
3-75
2.75
2
2
4-5
2-5
4-5
k
k
7
6
8
8
8
8
8
8
1962
1963
196k
1965
2.25
2
2.25
2.25
2
2
2
2
k
2.5
3-5
k
8
6
k
k
8
8
8
8
1950-195U
1955-1960
1961-1965
4-55
3.67
2.30
2.00
2.1*1
2.10
2.70
3.96
3.60
3.90
5.67
6.00
4.20
6.17
8
*
Source: Summarization of quarterly data in Ahearn, Louise F., and Janice
Peskin, "Market Performance as Reflected in Aggregative Indicators",
Treasury-Federal Reserve Study of the U. S. Government Securities Market,
1967, Appendix Table 7.
If price changes and carry rates are presumed to be, for the
moment, primarily cyclical phenomena, the long-term profitability of Government securities dealers should depend in some measure on the behavior
of spreads.
While much detailed empirical analysis remains to be done, it
is possible to suggest and tentatively evaluate several factors influencing
the width of security spreads.
10
The service component of spread may intuitively be expected to
vary inversely with the degree of competition and the level of variable
costs.
The behavior of variable costs is examined in the section on op-
erating expenses.
Competition, in this case, refers to both the substitu-
tability of alternative instruments and to the degree of competition among
dealers for business.
It is difficult to assess the impact of either type
since competing instruments or new firms rarely spring forth full grown at
a particular point in time.
Coincident with the narrowing of bill spreads
in the sixties, nevertheless, was both a rise in the number of dealers and
vastly expanded usage of Federal funds and certificates of deposits as
short-term investment instruments.
Theoretically, both events should have
increased the demand and supply elasticities in the market for U. S. Government securities, thereby narrowing spreads.
The fact that some coupon spreads widened while others narrowed
as the early sixties progressed is ascribed primarily to altered supply
conditions in various maturity categories, as noted by Mrs. Peskin in her
discussion of spread behavior.
The net effect of these diverse movements
on aggregate dealer income can be evaluated only in the context of the
trend in sales volume for each category, however; this exercise is undertaken in the next section.
The second element influencing the width of spread quotations
is the risk associated with making markets and maintaining positions under
conditions of potential price decline and capital loss.7 Although risk
Many of the firms now trading with SOMA were active in the
Government securities market prior to such participation. It is a matter
of conjecture whether the competitive effect of new firms is felt upon
"recognition" or prior to it.
7* Risk, as used here, is of the Markowitz^Tobin variety, the
standard deviation of expected returns, accompanied by the usual assumption
of risk-averting behavior.
Chart II
CHANGE IN MONTHLY AVERAGES OF DAILY TREASURY BILL RATES, JANUARY 1948-DECEMBER1966
Basis points
1948
49
Basis points
50
51
52
53
54
55
Source: Board of Governors of the Federal Reserve System.
56
57
58
59
60
61
62
63
64
65
66
11
cannot be measured directly, it should be reflected in the volatility of
short-run rate or price changes over time.
The pattern of rate volatility
is shown in Chart II, as month-end to month-end changes in the three month
bill rate.
Clearly, volatility dropped considerably in the 1961-65 period
from the late fifties.
The primary effect of reduced price fluctuation
should be to lower the risks inherent in holding positions and therefore to
contract the risk component of spread.
This will depress profitability,
even though the expected value of price changes, or the actual net price
change, for either a stable or unstable period might be zero.
According to many dealers, the cause of rate stability in the
early sixties was the relatively greater control of interest rates exerted
by the FOMC in conjunction with "Operation Twist".
It is evident in Chart
II that the month-to-month fluctuation in average daily three-month bill
rates declined sharply in 1961, when the program was initiated, and remained relatively stable through most of 1965*
The only period of com-
mensurate stability (shown on the chart) was from 19^8 to 1950* when the
Federal Reserve pegged interest rates.
Indeed, bill spreads were widest
in the years immediately following removal of the pegs.
Reduced volatility
in the sixties is also evident in Tables 4 and 5 of the Ahearn and Peskin
paper; these tables record the frequency of large and small daily price
changes.
In examining the financial environment of the sixties, Mr. Ettin
concludes that "... more aggressive and flexible response to short-run rate
movements by the Treasury and Federal Reserve contributed to a greater
o
stability of yields". As evidence, he notes the increased use of repurchase
8. Ettin, Edward, "The Financial and Economic Environment of the
1960fs in Relation to the U. S. Government Securities Market",
Treasury-Federal Reserve Study of the U. S. Government Securities Market,
January 1967.
12
agreements by the Federal Reserve in the sixties, which had the effect of
eliminating sharp short-term pressures stemming from outright purchases
and sales, and the greater care taken by the Treasury in the pattern and
timing of its actions.
At the same time, Mr. Ettin attributes a good portion of shortterm rate stability during the period to events and innovations in the
private sector. Most important "was the steady and balanced growth in
output with relatively constant prices and costs, which led to stable
expectations about interest rates.
In addition, substantially expanded
usage of Federal funds and certificates of deposit as short-term money
market instruments raised the elasticities of supply and demand for
Treasury securities, tending to smooth over short-run supply-demand
imbalances.
It remains to be seen whether behavior in the public or private
sector contributed most to rate stability.
Heightened Treasury-Federal
Reserve sensitivity to rate volatility, assuming that short-term stability
is a continuing policy goal, and the increased mobility of funds and substitutability of instruments in the private sector should permanently
lower the risks associated with short-term rate movements.
The circumstance
of balanced growth and steady rate expectations could well have dominated
the observed effect on rates, however, and this situation may not be permanent.
If not, the reduction in risk, which implies lower spreads and
profits, would be only transitory.
13
2.
Transactions^
Juxtaposed to spread in the income equation is the volume of sales .
Ceteris paribus, profits should be positively related to sales volume; however,
the interplay of changes in spreads and sales in various maturity categories
complicate the quantification of each contributing component.
Spreads were
observed to have declined for bills but widened for some longer term coupon
issues; sales alternatively have climbed steeply in bills but behaved erratic10
ally for coupon securities.
Further clouding the picturespread profits
per unit of sales are many (perhaps 20 or 30) times higher for long-term
coupon issues than for bills.
To assess the overall trends in gross spread-
sales revenues ("spread profits"), sales of Uo S. Government securities were
multiplied by quoted spreads in each maturity category.11
The
results
9« The data on dealer transactions and positions are those
utilized in other papers prepared for this study. Hence, they are subject
to the same qualifications. Of particular importance are the revisions of
reporting procedures and coverage in i960 which essentially preclude detailed inter-period (1950's versus 1960'fs) comparisons of transactions and
position effects on profits. Where such comparative analysis is attempted,
the effect of these revisions must be kept in mind.
10. It is possible that shifting customer trading patterns may
have led to a net reduction in average spreads per unit of observed volume,
all other factors constant. In particular, professional (inter-dealer)
trading is known to be conducted "close-up", i.e., at minimal spreads.
Transactions with "dealers and brokers in U.S. Government securities" has
not, however, increased over the past six years, (in terms of all maturity
categories, transactions among dealers and brokers as a per cent of total
dealer transactions averaged about 30 per cent in each year from 1961-65,
inclusive.) Hence, lacking more detailed figures on maturity categories,
shifting trading patterns by customer type do not appear to have been a
factor leading to narrower average spreads.
11. Spread profits for Federal Agency securities were not
computed annually due to the absence of specific spread quotations. A
rough estimate of such profits in 1965 would be on the order of $10-15
million.
14
12
are presented in Chart III.
For additional reference, a summary of daily
average transactions is included in Table III.
Sales figures used for the
spread profit calculation were one-half of transactions (inflated to a gross
TO
annual basis).
Table III
Dealers1 Daily Average Gross Transactions
by Maturity Category, 1955 to 1965*
(in millions of dollars)
Coupon securities
5-10
1-5
years
years
Treasurybills
Less than
1 year
1955
1956
1957
520.7
572.6
66b. 8
168.8
164.6
177.0
159.7
152.2
123.8
1958
1959
i960
1961
682.8
829.3
817.5
1,036.3
238.2
164.4
152.1
167.5
1962
1963
1964
1965
1,230.3
1,199-6
1,302.5
1,400.3
170.7
119.6
85.8
78.8
*
Source:
After
10 years
Total
93-5
74.8
30.3
39-3
18.4
18.0
982.0
982.6
1,013-9
186.6
225.5
236.2
265.I
95.6
49-5
4o.o
53.3
43.3
21.9
22.2
29.6
1,246.3
1,290.6
1,268.0
1,552.3
225.1
215.8
219.2
194.7
120.9
l4l.l
126.1
102.0
36.3
4 9.9
41.3
49.6
1,782.4
1,726.1
1,775-0
1,825.4
Summarization of quarterly data in Ahearn and Peskin paper.
Over the 1955-65 interval, gross spread profits exhibited several
distinct trends. From 1955 to 1958, spread profits rose from $64 million to
$98 million, or by slightly more than 5° per cent, as increased volume in
all maturity categories combined with widening spreads on coupon securities
12. These computations are biased upward, perhaps by as much as
50 per cent in coupon categories. The bias stems from the difference between
quoted and actual spreads and the narrower spreads encountered in inter-dealer
transactions. As noted earlier, as quoted spreads widen, the possibility of
a gap between quoted and actual spreads increases; thus, this bias may have
become more pronounced in the sixties.
13. Sales figures alone were not
year period. Sales exceed one-half of total
are not included with purchases. Allotments
during i960 to 1965 amounted to an estimated
available for the entire 11transactions since allotments
in auctions and underwritings
5-10 per cent of reported sales.
Chart III
ESTIMATED DEALER "SPREAD PROFITS"* ON U. S. GOVERNMENT SECURITIES
* "Spread profits" represent the product of security sales and the difference between bid and asked spread quotations. Dealer sales were computed
as sae half daily average transactions (Table III), inflated to a gross annual basis.
26
(see Table Il)li+.
During the next three years, 1959 to 1961, spread profits
dipped to an average $92 million before jumping to $106 million in 1962. Both
movements stemmed largely from fluctuations in sales of 5-10 year maturities.
Following 1962, spread profits turned down, due on the one hand to narrowing
spreads on $-10 year securities (and 1-5 year issues in 1963), and on the
other to declining sales in all coupon maturities after 1963•
(From 1963
to 1965^ aggregate coupon volume fell 20 per cent).
Contracting spread profits after 19&3 clearly depressed dealer
income in 196^ and 1965 • At the same time, one can hardly conclude from
the foregoing analysis that gross spread profits contributed significantly
to the reduced level of net income experienced from 1961 to 1965, relative
to the preceding five years . Not only did spread profits reach a peak in
1961, but also the average level of spread profits from 1961 to 19&5 was
million, or nearly 5 P e r cent, above the earlier five-year period.
Furthermore, spread profits on Federal Agency securities were undoubtedly
higher in the later period due to expanded sales.
Dealers sales of Agency
securities generally paralleled the trend in issues outstanding, which
grew from $2-9 billion in 1955 to $7-9 billion in i960 and $13.8 billion
in 1965. Dealers' sales of Agency securities doubled in the 1960-65 period
alone. Narrower spreads did offset much of the 150 per cent expansion in
bill volume from 1955 to 1965-
Nevertheless, bill spread profits were a
minor component of the total; had spreads been the same in 1965 as in
i960 (the peak year for net income), bill spread profits would have been
increased by only $7 million, a small increment to aggregate spread profits.
IIT The year-to-year volatility in estimated spread profits
observed in Chart III for individual coupon maturity categories is a
function primarily of sales, which in turn may be strongly influenced
by variations in the volume of new issues offered by the Treasury. The
passage of particular issues from one maturity category to another may
also account for some of the annual fluctuations.
27
Future growth in spread profits will depend, of course, on the
trends in spreads and sales of U. S. Government securities.
Increased com-
petition from other money market instruments and added dealers is likely to
remain.
Rate volatility, somewhat greater since late 1965, is difficult to
predict, having been based in the early sixties on a peculiar combination
of public and private factors.
Spreads on Treasury bills widened to about
3 basis points in 1966, although other quoted spreads were generally unchanged .
Sales volume is a function primarily of the level and maturity
composition of outstanding marketable debt.^
Since the turnover of se-
curities (dealers sales/debt outstanding) diminishes as the time to
maturity lengthens, future sales growth will be contingent not only on
fiscal policy but on debt management policy as well. A $1 billion rise
in Treasury bills outstanding during the 1955-65 period led to a $20 million rise in daily average bill transactions, whereas a $1 billion rise in
coupon securities stimulated a $3-4 million expansion in coupon trading.
Nevertheless, before concluding that growth in short-term issues will benefit dealers more, differences in the profitability of sales in various
maturity classes must be considered, along with the effect of debt increases
in each class on spreads themselves.
Thus, in 1962 for example, a sharp
increase in 5-10 year issues initially resulted in enhanced spread profits.
Subsequently, however, this expansion is believed to have led to narrower
spreads due to the greater availability or liquidity of these securities.
At this stage, it is impossible to predict the future aggregate outcome
for spread profits resulting from this apparent tradeoff between sales or
debt outstanding and spreads.
15. Ahearn and Peskin, oj>. cit., p. 11.
28
Sales volume, particularly in longer-term securities, also varies
inversely with the degree of monetary tightness, often represented by the
level of interest rates. As the early 1960's progressed, coupon sales
1 £>
turned down in all maturity categories, except over twenty-year issues;
from 1963 to 1965^ aggregate coupon sales declined almost 20 per cent. In
late 1966 and early 19^7, when interest rates turned down, coupon sales
expanded appreciably above the average level of the preceding two and
one-half years.
3-
Price (rate) changes; positions
The second, and by far more volatile component of trading profits
is the gain or loss associated with price changes of positioned securities.
Trading profits vary directly with price changes and are a function of the
size and rapidity of such changes, the size and composition of dealer positions, and the success of dealers in anticipating price movements.
Generally, interest rates are a function of economic activity
and monetary policy, and it is clear that cyclical swings in rates, hence
in trading profits, are accepted as part of the dealers' environment.
Rate
levels, per se, have possibly an indirect effect on trading profits, via
their derivative impact on spreads, transactions, and carry; rate movements,
however, have a strong direct effect.
The close relationship between rate changes and dealer revenues
is apparent in Chart IV, which presents the year-end to year-end changes
in the three-month bill rate (plotted inversely) and the annual level of
trading profits plus carry.
In years that movements in the bill rate
reversed direction (19^9, 1950, 1953, 1955. 1957, 1959. i960, and 1961),
Sales of Federal Agency securities rose in every year
from i960 to 1965.
29
the level of gross profits changed in accordance with (but inversely to)
the rate movement.
For all other years (except 1958)* when the bill rate
continued its prior yearfs direction, the "wrong" movement in gross profits
can be largely attributed to a "rebound" effect, since capital gains and
losses were not in this sense cumulative from year to year and the magni17
tude of the rate change was usually diminished.
Of course, the size
and direction of long-term rate movements in certain years modified the
observed bill rate-gross1 profits relationship.
In 19^2, for example, the
rise in gross profits undoubtedly derived in part from falling long-term
bond rates over the year.
The size and composition of dealer positions determine the
impact of a given price change on trading profits.
Large positions,
particularly in long-term coupon securities, will naturally affect profits
more than small positions and in the same direction as prices.
The net
contribution to profits of capital gains or losses on positions depends
on the success of dealers in correctly anticipating the direction and
extent of long- and/or short-term price movements and thus adjusting position levels for alternatively increasing and decreasing prices. As the
professionals in the market and, in fact, the mechanism for effecting
price changes, dealers may be expected to do better than break even in
the ebb and flows of prices.
Dealer capital gains from a unit price
rise should exceed capital losses from a comparable downturn.
The year 1958 offers one clear example of how dealers were
able to profit from timely position adjustments during a sharp intrayear fluctuation in security prices.
In that year, annual trading
profits soared despite a sharp rise in bond rates and a very small net
17. Implicit in the rebound effect is the underlying "normal"
contribution of spread profits.
Chart III
DEALER TRADING PROFITS PLUS NET CARRY AND ANNUAL CHANGES IN THE TREASURY BILL RATE,
19
decline in bill rates.
Table IV presents average daily positions for all
dealers in each quarter of 1958 along with changes in bill and long-term
bond rates and quarterly trading profits plus carry for all nonbank dealers.
Table IV
Dealers' Average Net Positions in U. S. Government Securities
Interest Rate Changes, and Nonbank Dealer Trading Profits
plus Net Carry, Quarterly 1958
(Dollar amounts in millions)
Quarter
I
II
III
iv
Dealer positions
Rate change (in percentage pts.) Nonbank dealer
All
Coupon
3-month bill Long-term bond Trading profits
maturities securities
rate
rate
plus carry
1,932.0
2,198.3
1,017.9
839.5
1,063.6
1,248.5
397.9
373.4
- I.69
- .29
+ 1-91
- .03
- .03
+ .07
+ .57
.00
$21,078
15,016
2,202
4,165
Note: Position data from Ahearn and Peskin paper; rate changes are based
on daily average rates for the week beginning and ending each quarter;
trading profit plus net carry data from FRB--NY.
In the first half of the year, nonbank dealers had trading profits plus
carry of $36.1 million, compared with $6.4 million in the second half.
With estimated operating expenses of about $17 million for the year as a
whole, it is apparent that, as a group, nonbank dealers suffered net
losses in the third and fourth quarters.
Yet, they were able to post
the second highest level of annual net income in the entire 1948-1965
period.
The sharp dip and recovery of bill rates in 195^ was, to be
sure, a cyclical phenomenon.
Examination of dealers relative positions
before, during, and after the 1953-5^ a^d i960 recessions indicate that
dealers were able at those times also to reap net capital gains.
It is,
of course, impossible with the data available to measure the net contribution
20
of these "cycle profits" to the overall long-term level of dealer income.
Nor can we begin to explain, in the context of dealer expectations, particular position levels after peaks and troughs or why they were not more
or less extreme.
Nevertheless, these factors have a crucial bearing on
future profitability.
The emergence of an apparently new pattern of economic expansion,
of much longer duration than in the fifties and followed by short, sharp, rate
retrenchments, has altered the flow of profits to dealers.
effect on earnings, still, is indeterminate.
The implied
Less frequent cycles,
prima facie, would tend to indicate a drop in long-term profitability and,
at the same time, magnify the importance of "catching" the peaks and
troughs in rate movements.
Greater control of economic growth should
also imply decreased amplitude in rate movements which, despite the
ability to adjust relative positions correctly at alternate stages of
the business cycle, would mean diminished earning o p p o r t u n i t i e s P o tentially offsetting these factors is the extent to which dealers expand
and contract positions, particularly in the longer maturity categories,
and the timing of these changes.
Two examples of position adjustment are cited to illustrate
the role of absolute position levels when rates are changing.
In both
examples, average position levels are compared for roughly equal but
opposite movements in the three-month bill rate around a major turning
p o i n t . I n the first half of 1958, dealers1 daily positions averaged
18. The idea of a reduced amplitude in rate swings would
seem thus far to have been discredited by rate behavior in the summer
and fall of 1966. It is indeed apparent that future fluctuations will
depend on the relative emphases on monetary and fiscal policy and the
type of expectations generated by these policies.
19* Rates used for computing changes are daily averages for
the weeks at the beginning and end of each period described.
21
$2.1 billion, during which time the bill rate dropped approximately 2
percentage points.
During the following six months, when rates rose
almost 2 percentage points, positions averaged $0.9 billion per day.
Thus, dealers had on average $1.2 billion (net) of securities "working"
for them when rates were falling, which were not in position (incurring
20
capital losses) when rates subsequently rose.
In the third quarter
of 1966 dealers1 positions averaged $2.0 billion. During this period,
the bill rate rose about 1 percentage point. After peaking out at 5.52
per cent at the end of September, the bill rate subsequently declined
approximately 1 percentage point by the end of February 1967*
Over
this second interval, average daily positions were $3*9 billion.
In
this case, dealers had an "extra" $1.9 billion of securities accruing
capital gains during the period of declining rates, or almost 60 per
cent more than in the 1958 period.
Per unit of rate change, the net
capital gains were clearly larger in the 1966-67 sequence than in 1958.
Thus, it is by no means certain what overall effect changing cyclical
21
patterns will have on profits in future years.
20. A closer examination of monthly data reveals that dealers
were not as accurate in timing their position changes as the text may
imply. In addition, of course, position composition and changes in
longer-term rates also have an important bearing on aggregate gains and
losses.
21. Obviously, the timing of position changes in relation to
weekly or monthly rate fluctuations, that is, intra-cyclical position levels,
can also lead to net capital gains or losses (with no net change in rates).
22
C. Net carry
The magnitude of net carry (and its variation over time) is a
function of: (l) the structure of interest rates, (2) the size and composition of dealer positions, (3) financing sources, and (b) the variety
and substitutability of instruments competing with U. S. Government
securities.
The contribution of net carry to earnings throughout the
period of discussion is impossible to measure accurately, due primarily
to the aforementioned inability of many dealers to segregate discount
00
earned (interest) from trading profits on Treasury bills.
Despite
these shortcomings, it is nevertheless useful to examine the behavior
over the past decade of those factors mentioned above.
Since loans to dealers compete with other money market instruments
as a source of short-term investment, the cost should be closely associated
with rates on these substitutes.
Indeed, bank dealers have typically
applied the Federal funds or 3-month bill rate in computing the total
cost of own bank funds used.
Nonbank dealers, for their part, have also
financed securities at interest costs approximate to these money market
rates, as is apparent in Chart V.
Interest costs for different types
22. In the Meltzer-von der Linde data, dealers apparently included all bill income in interest earned. In the FRB--NY data for 19581963, several dealers placed bill income with trading profits while others
combined it with interest earned; for those years, therefore, it was not
feasible to record a series on net carry. Market Statistics data has all
bill income incorporated with interest earned. In none of these series did
dealers include in interest earned the price appreciation on coupon securities purchased at a discount that represented interest accrual (or make
the opposite adjustment for premium prices).
Chart V
COMPARISON OF RATES ON U. S. TREASURY BILLS AND LONG TERM BONDS WITH SELECTED DEALER BORROWING COSTS
Percent
1960-1965 *
Percent
Note: The borrowing rates were selected from special reports submitted by a number of nonbank dealers and are believed to be representative of all
nonbank dealer borrowing costs. "Repurchase agreements" represent the cost of short-term borrowing from sources other than New York City banks.
"All borrowing" is the overall cost of financing reported by one dealer. Overall financing costs of other dealers may vary slightly depending on the
particular mix of borrowing from New York City banks and other sources.
* Treasury bill rates are monthly averages of daily rates on the outstanding bill closest to 3-months maturity; the II. S. Government long term bond rate
http://fraser.stlouisfed.org/ series is the index computed by the Board of Governors.
Federal Reserve Bank of St. Louis
23
of dealersrfinancing (as reported by selected dealers) are shown along
with the 3-month bill rate and the F.R.B. long-term bond index.
In the
absence of direct data on net carry, the difference between the 3-month
bill and longer-term bond rates should provide a suitable proxy for
tracing relative carry profitability over time for such maturities.
Differences between the 3-month bill rate and both 3-5 year
and long-term bond rates (F.R.B. indexes) are plotted in Chart VI.
In
general, the carry differential widened during recessions (1953-5^ 195^,
and I96O-61) when interest rate levels were low, and narrowed as rates
23 ,
rose.
(During boom periods, the 3-5 year security rate had a tendency
to rise above the long-term bond rate, making intermediate term issues
relatively less costly to position.) Thus, it is evident that the behavior of aggregate net carry over the past
2k decade has usually compounded
the impact on profits of changing prices.
In 1961,when security prices
declined, carry profits are estimated to have comprised a large part of
net income (perhaps $3 million out of total net income of $6 million).
In most other boom years, however, such as 1956, 1957, and 1965* it is
23. Volatile bill rates, of course, caused most of the
fluctuation in the differentials.
2k. In 1961, when the difference between short and long-term
rates was quite high, net carry profits were estimated roughly to have been
on the order of about $5 million. This estimate was based on average annual
interest rates and net dealer positions for several maturity categories of
securities, with the assumption that carrying costs were equal to the
three-month bill rate.
24
likely that negative carry profits aggravated already diminished levels
of trading profits and net income.
The potential for profitable carry declined steadily from 1961
to 1965.
To the extent that public policies brought about this narrowing
of rate differentials, it was certainly detrimental to carry profits. In
the early part of the period, the Treasury and Federal Reserve did work
jointly to increase the relative supply of bills in an attempt to shore up
short-term rates for balance of payments reasons.
However, it must be noted
that these rate differentials have historically narrowed during periods of
economic expansion. As a result, it is impossible to accurately assess
the relative impact of these two factors.
Position size and composition naturally helped or hindered
earnings, depending on whether financing costs were higher or lower than
security yields.
While there may have been some tendency for positions
to vary with the sign of the differential, Mrs. Peskin found neither
strong nor consistent relationships of the type to be expected.
It is
probable that the inventory motive and expectations about prices have
largely outweighed carry considerations.
The fact that significant
relationships were found between dealer short positions and carry suggests that dealers may have preferred to use short sales to meet customer
25
needs rather than hold securities with negative carry. '
Dealer carry profits (or losses) have also varied with the
type and source of borrowed funds.
Referring back to Chart V, the
cost of repurchase agreements, such as those made with corporations,
25. This observed relationship may be spurious, however, since
short sales may be more directly related to the behavior of interest rates.
Chart VI
ESTIMATES OF RELATIVE NET CARRY PROFITS ON U. S. GOVERNMENT INTERMEDIATE AND LONG-TERM BONDS, 1955-1965*
Per cent
Kite: Tbi 3-itath bill rate is vsei as a priiy for tbe rate charged for financing dealers' positions.
* Kates in U. S. Government securities are nonthly averages of daily figures computed by the Board of Governors of the Federal Reserve System.
25
was noticeably lower than the rate paid for bank loans. Among bank
loans, "out-of-town" rates during most of the late
fifties
were l/2 point or more below New York City bank rates.
These rate
differentials, however, narrowed substantially during the early 1960fs
and much of this shrinkage has been attributed to the broader usage of
competing instruments, notably Federal funds and certificates of deposit.
Greater mobility of bank reserves has meant that rates on "out-of-town"
bank funds have become more sensitive to and thus moved closer to rates
prevailing at New York banks.
Likewise, the development of certificates
of deposit, which can be tailored to meet specific corporate needs and
have rates slightly above short-term bill rates, has virtually eliminated
the advantageous position previously held by dealers* repurchase agreements as an outlet for short-term funds.
D.
Trends in trading profits plus carry, by type and size of dealer
In order to evaluate relative dealer performance as well as
the impact of changing market conditions, trading profits plus carry
were deflated by gross annual sales; the results appear in Table V.
Ideally, it would have been desirable to segregate trading profits from
carry and to examine each of these sources of income for bills and coupons
securities individually. As pointed out previously, however, most dealers
have been unable to isolate trading profits from accrued discount (interest)
on Treasury bills, and only in 1964 and 1965 were dealers asked to separate
bill and coupon revenues. Lack of separate data for bill and coupon
trading profits has presumably led to an increasing downward bias in
aggregate profits per unit of sales due to the relative shift in trading
composition over the past decade from coupon securities to bills; in terms
of spread, bill transactions are less profitable per unit than coupon transactions .
26
Table V
U. S. Government Securities Dealers: Trading Profits
plus Carry per Million Dollars of Sales, I948-I965
(In dollars)
Trading profits
plus carry
Year
Trading profits
plus carry
Year
19^8
19^9
1950*
104
212
65
1957
195 8+
1959
1951
1952
1953
105
123
228
i960
1961
1962
Ikl
iko
195^
1955*
1956#
188
82
107
1963
1964*
1965*
92
112
43
305
332/297
181
343
*
*
Loss years.
Despite operating expenses of $112 per million dollars of sales in 1956,
a profit vas realized due to "other earnings" of $11 per million dollars
of sales.
t Three hundred thirty-two and prior figures are from Meltzer-von der Linde;
297 and subsequent figures through 1963 are from FRB--NY. Data for 196k
and 1965 are from Market Statistics.
* Nonbank dealers only.
The trading profits plus carry data in the table correspond
fairly closely with the aggregate profit trend in Chart I.
Discrepancies
can be attributed largely to sales behavior and the aforementioned billcoupon mix.
To gain insight into differences in performance among types
of dealers, trading profits plus carry per unit of sales were computed
from 1958 to 1965 for three separate dealer groups: bank dealers, large
nonbank and small nonbank dealers with five firms in each group. The results
are shown in Table VI.
From 1958 to 1963, the large nonbank dealers were generally
the most profitable of the three groups and had the greatest intern-dealer
consistency in performance.
Not until 1965 did a large nonbank dealer
incur a loss in its Government securities operation.
Small nonbank dealers,
27
nevertheless, were not far behind in I96O-6I, and in 19^2, 19^4, and 1965 their
gross earnings per unit exceeded those of the larger nonbank dealers.
Judging
from an examination of individual dealer performance, it appears that, since
i960, the small dealers were as profitable per unit of sales, or more so, than
the large firms but at the same time were more vulnerable to changing conditions . One important source of the enhanced profitability has presumably
been the increasing proportion of Federal Agency activity to total transactions
of the smaller firms.
Bank dealer gross earnings per million dollars of sales lagged
behind the nonbank dealers in every year.
This result, and differences be-
tween the large and small nonbank dealers, does not necessarily imply varying
levels of efficiency or expertise.
Bank dealers, rather, have concentrated
Table VI
Trading Profits plus Carry per Million Dollars of Sales
1958-1965, by Dealer Groups
(in dollars)
Dealer Group
1958
1959
I960
1961
1962
1963
196^ 1965
ll+9
95
15k
139
525
320
-109 - 81
212
251
505
20
10k
119
261
36
103
118
271
55
88
9k
160
23
kl8 181
183
183
216
lk8
111
116
168
20
125
130
163
91
1+5
56
121
- 57
198
205
301+
111
52
26
133
-113
160
193
455
101
109
133
I+29
- 97
Five bank dealers*
Weighted average
Unweighted averages
Range - High
Low
32
3k
66
3
Five large nonbank dealers
Weighted average
Unweighted average
Range - High
Low
1+00
380
508
279
23^
237
31k
117
k±9
567
285
182
201+
162
213
119
184
58
1+21 176
-221+ -219
bOk
377
667
96
148
157
270
85
Five small nonbank dealers
Weighted average
Unweighted average
Range - High
Low
*
Interest expense based on the average rate on Federal funds.
28
their activity in the bill market, where profits per unit of sales are lowest.
Since bill positions require correspondingly less capital than coupon positions,
it is difficult to judge at this stage which group in fact was the most profitable, as between bank and nonbank dealers.
In I96U and 1965, all nonbank dealers reported trading profits (ex
carry) on coupon securities separately and five submitted trading
profit data for bills. Bank dealers reported coupon profits in 1965, with
four of them supplying bill trading profits in addition.
of sales, are presented in Table VII.
These data, per unit
The pattern is much as anticipated.
Table VII
Ratios of Selected Income and Expense Items to
Dollars per million dollars of' gross sales
1964
1965
Nonbank
Bank
Nonbank
Income or expense item
Unweighted average
Median
Weighted average
4o
37
27
30
17
17
-
-
-
Trading profit on
other securities^
Unweighted average
Median
Weighted average
253
271
252
- 26
99
109
88
77
121
Operating expenses
Unweighted average
Median
Weighted average
122
91
97
86
66
77
126
96
96
Trading profit on
Treasury bills*
*
Based on five nonbank and four bank dealers.
=H=
Includes Government coupon issues, Federal Agency securities, and c/D's.
Per-unit coupon profits are substantially higher than bill profits, and trading
profits (not including carry) declined from 1964 to 1965 for both bills and
coupons, in line with falling prices.
What is perhaps surprising is the higher
level of bill profits for banks than for nonbank dealers in 1965 • Nonbank
dealers have claimed that banks are willing to trade bills less profitably
29
because of the derivative correspondent benefits.
Pending additional dealer
data, however, this claim cannot be substantiated by the available information.
It is possible, for example, that merely variations in computational methods
have led to this observed difference.
E
-
Operating expenses
Aggregate dealer operating expenses maintained a fairly stable but
definitely rising trend throughout the fifties and early sixties (see Chart i).
Growth in aggregate expenses, however, was paralleled by an expansion in
Government securities transactions, with the result that dealer expenses per
million dollars of sales appear to have actually declined slightly over the
past decade.
Data on expenses, expressed in dollars per million dollars of
26
sales, are presented in Table VIII.
The deflation of dealer expenses by sales substantially eliminates
variations in costs stemming from sales volume; what remains are changes in
per-unit variable costs over time and per-unit fixed expenses.
charges constitute the principal element of variable costs.
Clearing
Typically, these
charges range from $5 to $10 per million of bills to $10 to $35 per million
27
of coupon securities.
The higher costs for clearing coupon securities are
due to the extra handling efforts involved in checking coupons and the
28
smaller typical size of transaction.
Unfortunately, there are no data on
26. As noted in the introduction, neither item definitions nor reporting
procedures are known for the Meltzer-von der Linde and FRB--NY series. Due
to obvious discrepancies in and between dealer reports to Market Statistics
in 1965(110 expense itemization was requested in 196U), a breakdown of expenses was not attempted. Judging from this latter experience, little weight
should be attached to the absolute figures in the two earlier studies.
27• Clearing charges are proportional to dollar value and are assessed
only on sales. Bank dealers do their own clearing while virtually all nonbank dealers clear through a bank. Most bank dealers, nevertheless, allocate a portion of general clearing expenses to their Government securities
operations.
28. The latter determinant suggests that there is, in fact, a fixed plus
variable charge for clearing.
30
Table VIII
Operating Expenses per Million Dollars of Sales,
U. S. Government Securities Dealers, 1946-1965*
(In dollars)
Meltzer-von der Linde Data#
Salaries
Other current
expenses
49
60
34
44
46
50
44
46
51
61
59
40
45
37
45
48
53
51
58
61
63
63
19^8
1949
1950
1951
1952
1953
1954
1955
1956
1957
1958
Total operating
expenses
88
105
71
89
93
104
95
104
112
123
122
FRB--NY Datat
Salaries
Clearing
charges
Telephone
expense
Other operating
expenses
40
40
50
43
40
37
27
24
20
18
20
19
7
8
9
8
8
8
26
26
39
28
28
38
1958
1959
i960
I96I
1962
1963
Total operating
expenses
100
97
117
96
95
92
Market Statistics Data*
Total operating
expenses
1964
Nonbank dealers
97
1965
Nonbank dealers
Bank dealers
96
77
*
Because of rounding, figures may not add to totals. Figures are weighted
averages for Market Statistics data and it is believed that the Meltzer-von
der Linde and FRB--NY data were computed in a similar manner. In all three
series, there were variations among dealers in the treatment of specific
(Continued on next page.)
31
the trend in unit clearing charges over the last ten years, primarily because
such charges are negotiated between clearing agents and individual customers,
and depend largely on the volume or profitability of each customer's business.
The concensus of several dealers, however, is that such charges have not changed
to any noticeable degree.
While the fixed expenses of Government securities operations have
undoubtedly risen since 1955> the rapid expansion of dealer sales appears to
have offset these increased costs on a per-unit basis, as suggested in Table
VIII.
This conclusion may be misleading, however.
In the first place, trans-
actions growth has been largely in Treasury bills (entirely so since i960)
where gross spread profits are lowest.
In this sense, unit fixed expenses
have increased as a proportion of overall spread profits per unit of sales.
Second, it is apparent from comparing Table VIII with Table I
that total unit operating expenses are closely related to net income. In
(Footnotes continued from preceding page.)
expenses. Items included in operating expenses by some may have been
charged against trading profits or interest earned (or added to interest
paid) by others. Furthermore, in the FRB--NY and Market Statistics data,
there may have been considerable error on the part of some diversified
dealers in the allocation of overhead expenses to the various firm
functions.
#
These data cover all operations of the nonbank dealers and only the activities in U. S. Government and related securities of bank dealers.
Nevertheless, these figures have been deflated only by sales of U. S.
Government securities for nonbank and bank dealers. Data are extrapolated from complete income statements of from 7 to 13 dealers. The
bank-nonbank composition of this group is not known.
t
These data pertain to operations in U. S. Government and related securities only of both nonbank and bank dealers . Details are extrapolated from a varying number of dealers' reports.
*
Operating expenses are for activities in U. S. Government and related
securities for all dealers in the groups shown.
32
most years when profits rose--19^9> 1953, 1957, 1958, and i960--total operating
expenses (per unit) advanced also, paced by increases in salaries and "other
operating expenses".
This flexibility in unit expenses presumably derived from
profit-oriented bonuses granted to both officers and employees.
The relatively
low level of costs per unit of sales in the sixties may thus have been achieved
largely at the expense of bonuses.
Of course, it it a matter of conjecture
whether these salary and wage levels are competitively sustainable; if not, the
trend in long-term operating expenses (both aggregate and per unit of sales)
has been understated.
The 196^- and 1965 expense data submitted to the Market Statistics
Division, as shown in Table VII, displayed marked stability between years (for
nonbank dealers) and among dealers in each y e a r r p h e lower (weighted) average
level of unit expenses reported by bank dealers for their Government securities
operations in 1965 ($77 versus $96 for nonbank dealers) may derive from certain
operating economies inherent in sharing overhead expenses with other related
bank activities.
Unit operating expenses of the five large nonbank dealers,
discussed in the previous section but not shown, averaged $90 and $95 in 1964
and 1965, respectively, while corresponding costs for the five small nonbank
dealers were $166 and $165.^°
The large differences in both years between the two groups of
nonbank dealers may be partially explained by economies of diversification,
as suggested for bank dealers, since on balance the large dealers were
considerably more diversified.
Such a finding would have important impli-
cations for long-term dealer profitability, as would definite signs of
29. Data for individual dealers are not shown. In 1964 and 1965,
seven and nine of twelve nonbank dealers, respectively, had operating expenses
between $73 and $105 per million of sales.
30. Unweighted averages.
33
economies of scale with respect to the volume of transactions.
Rank corre-
lation analysis was employed to test for the latter relationship, in terms
of both levels and changes (from 1964 to 1965) in transactions and unit
operating expenses, but no significant relationships were found.
This
result casts considerable doubt on the meaningfulness of the described cost
differences between large and small dealers.
It is very likely that much
of these differences may have in effect stemmed from the sales "denominator",
wherein varying sales .mixes entailed dissimilar unit expenses.
dealers with the highest unit expenses in 1965*
The two
example, also had the
highest Agency/total transactions ratios, and both were small dealers.
F.
Regression results
Multiple regression analysis was employed to test some of the
assumed relationships in the net income equation, and to estimate the relative importance of the contributing components.
The reader is reminded,
however, that the observed relationships are in terms of realized profits,
although with certain variables, particularly positions, it is the dealers'
adjustments to expectations, and the resultant discrepancy between expected
and realized profits that should be of crucial concern.
Equations were estimated using the monthly data on dealer
earnings furnished for the FRB--NY study.
These data encompass the six
years from 1958 "to 19^3 and thus were conveniently divisible into two subintervals, essentially coinciding with the two broad periods under investigation.
The general model tested here differs basically from the equation
set forth in Section m - A in ihat: (l) it deals with gross rather than net
earnings before taxes, (2) trading and carry profits are lumped together
as the dependent variable, and (3) gross earnings are deflated by sales.31
31. Only nonbank dealer data were used since bank dealers
submitted no figures on interest expense.
34
A gross earnings concept was substituted for net income due to the
unreliability and incompleteness of monthly operating expense data.
Judging
from the allocative problems associated with preparing the annual dealer reports
for the Market Statistics Division for 1964 and 19^5, it
is
doubtful that dealers
were able to allocate to their Government securities operations little more than
clearing charges on a monthly basis.
In addition, two nonbank dealers submitted
no expense data at all.
The dependent variable includes both reported trading profits and
net carry, since some dealers (as noted earlier) reported aggregate bill income
as trading profits while others included it -with interest earned.
This was
unfortunate because the combined figure may obscure certain relationships, particularly with regard to positions.
Trading profits plus carry was, furthermore,
deflated by monthly aggregate nonbank dealer sales to eliminate the effects of
market growth
it is expressed as dollars of trading profits plus carry per
million dollars of sales (Xq). The independent variables tested were as follows:
I. Spread
II.
Quoted bid-asked spread on three-month bills
Transactions
-
Sales, all securities, nonbank dealers
X3 - Bill transactions, all dealers
X^ - Coupon transactions, all dealers
III. Rates, rate changes
X^ - Change in end-of-month three-month bill rate
Xg - Change in the monthly average long-term bond rate (FRB index)
Xj - Change in bill rate, last three days of preceding month
XQ - Three-month bill rate
35
IV-
Positions
X9 - Bill positions, all dealers
X10 -
Coupon positions, all dealers
X n - Total positions, all dealers
V.
Others
X12 - Dummy variable for i960 data revision
X13 - Dummy variable for advance refunding months
In all, seventeen equations were estimated for each of three time
periods--1958-63, 1958-April i960 and 1961-63--using the same dependent variable and many of the same independent variables. Differences in specification
mainly entailed alternative transactions, positions, and rate differential or
level variables, due to substantial multicollinearity among variables. Five
"representative" equations are presented in Appendix B.
In the earlier sub-
period, observations were used only through April i960 due to the discontinuity in the data created by the reporting revisions in the following month.
1. Rate changes
Interest rate change variables (a proxy for realized changes in
the value of positions) proved to have the greatest impact on monthly trading
profits plus carry.
Two such variables were employed in every equation, the
month-end change in the 3-month Treasury bill rate (X5) and the change in the
monthly average level of long-term U. S. Government bond rates (Xg), using
the FRB Government bond index.
These two series were not highly inter-
correlated and each contributed substantially to the total explained variation.
Experimentation with various rate change variables indicated that this particular
pair yielded the-best results.
A third rate change variable was used concurrently, but for a
slightly different purpose. Dealers, in calculating monthly income figures
36
for FEB--NY, may not have included the unrealized appreciation or depreciation
on month-end positions.
succeeding month.
These gains or losses would usually be realized in the
On the assumption that dealers turn over their positions every
few days, only rate changes occurring at month end would lead to unrealized gains
or losses.
The change in the 3-month bill rate over the last three days of the
preceding month (Xy) was therefore included.
It proved to be highly significant
for the 1958-April i960 period (and for the full six years), due no doubt to the
greater rate volatility in that period, and to the aforementioned reporting
procedure.
Several tentative observations may be drawn from the examination of
the rate change coefficients.
The bond yield coefficient (Xg) was consistently
larger than the bill yield coefficient (X^), often by a factor of two or more.
Bond rate changes were undoubtedly more representative of broad changes in
security yields than were variations in the bill rate, and given changes in
long-term yields have a greater effect on prices. Second, the rate change
coefficients were always larger in the early sixties than the late fifties.
This suggests that dealers carried larger positions relative to transactions
in the later period.
2.
Spread32
The spread on Treasury bills (X^) was positively related to gross
earnings in all periods tested, although the coefficients were significant only
for regressions covering the full six years and were much smaller -than the rate
32. The variable serving as a measure of spread was the bid-asked
differential on the new 3-month bill, as reported in the Securities Departments
"Composite Closing Quotations" for the Thursday following each new auction.
Spreads on new bills were typically smaller during the week of auction than in
succeeding weeks. The new 91-day bill, for example, might have had a 3 basis
point spread on Thursday while the 98-day bill (issued as a 6-month bill) a
quoted 6 point spread, reflecting in part the greater dispersion and scarcity
of the older issue. The Thursday quoted spread on the new 3-month bill was
considered more representative of actual spreads, more sensitive to changing
competitive and risk cosditions, and less a function of scarcity, than bills
which had been fully digested in the market. The monthly spread figure is an
arithmetic average of the weekly Thursday figures.
37
change coefficients.
might be expected.
There are several reasons why these two results
First, the spread on bills may not have been a valid
proxy for all spreads; for example, while bill spreads narrowed throughout
much of the 1955-65 period, spreads on some coupon issues widened.
A
coupon spread variable was not introduced because of the difficulty in
selecting a meaningful proxy and the fact that trading profits were not
segregated for bills and coupons.
The second reason may be the lack of month-to-month variation
of bill spreads, particularly in the '6l-'63 period.
(Quoted coupon spreads
varied even less.) As a result, much of the importance of spread contributions to income may have showed up in the constant terms, which were
typically similar in magnitude to the rate change coefficients.
In
addition, use of monthly data, as opposed, say, to annual data, has undoubtedly led to an underestimation of spread influence relative to
33
changes in interest rates.
3•
Carry rates
In pilot regression runs, the spread between the FRB index of
long-term bond rates and the 3-month bill rate was tested as a proxy for
net carry.
The variable coefficients were never significant and occasion-
ally had the wrong sign. Furthermore, due to the relative stability of the
bond rate, the rate spread variable was found to be very highly correlated
with the 3-month bill rate itself. Hence, in the final set of regressions,
the bill rate (XQ) was substituted for the rate differential, representing
not only carry but general monetary conditions as well.
The results were
33- On a monthly basis, interest rates fluctuated more widely
than did quoted spreads. Were annual data used, the relative magnitude of
spread changes would increase while the gains and losses associated with
monthly rate changes would cancel out to some degree. The annual "net"
of monthly changes in trading profits plus carry would therefore be more
sensitive to variations in spread.
38
occasionally significant, with the expected sign; however, the variable
contributed very little to the explanatory power of the set of independent
variables.
Transactions
Trading profits plus carry per unit of sales were regressed
against three transactions variables--bill and coupon transactions of all
dealers and total sales of nonbank dealers--to estimate the effect of
trading volume on profitability.^
With gross earnings already deflated
by sales, these variables might be expected to reflect changes in bidasked spreads not "picked up" by the spread variable itself.^
The
coefficient for coupon transactions (X^) was found to be positive in all
periods, significantly so for the six-year and initial three-year intervals.
The coefficients for total sales (X2) and bill transactions (X3) turned
out to be negative and significant, for the same periods.
The results may be interpreted in several ways.
One hypothesis
is that higher transactions, ceteris paribus, imply wider spreads. Alternatively, higher volume may tend to reduce spreads as liquidity increases,
particularly during periods of Treasury financings.
The observed behavior
of coupon and bill transactions in the regressions could be, indeed, intuitively "fitted" to these two hypotheses but the association is rather
tenuous.
It is more likely that the observed effect stemmed rather from
the nature of the data involved.
The dependent variable incorporates
profits and transactions of both bills and coupon securities.
Neither bill-coupon sales breakdowns nor transactions data
were readily available for nonbank dealers alone.
35.
36 and 37.
Shortcomings in the spread variable are discussed on pages
39
Since coupon transactions are considerably more profitable than bills (per
million of transactions), the dependent variable should vary with the billcoupon composition of total sales. As the proportion of "low profit" bill
transactions rises, the numerator may therefore not rise in the same proportion as total sales. Since coupon transactions were observed to be
more sensitive to interest rates than bills, it is quite likely that changes
in transactions composition over time led to the particular regression
results at hand.
A dummy variable (X13) was introduced for the eight months in
which advance refundings occurred in the 1958-1963 period.
The coefficient
was consistently positive and significant for regressions covering the sixyear period but neither consistently positive nor significant for the 19611963 interval, in which six refundings were conducted.
With coupon activity
substantially heightened during refunding months, higher profits per unit
of total sales might be expected on the basis of the foregoing argument.
The fact that the coefficients for the I96I-I963 period were not significantly
different from zero suggests, assuming that the number of refunding observations
was not inadequate, lower coupon spreads during refunding months.
5•
Positions
Dealer position variables were inserted alternately with the
bill rate (Xg ) as proxies for net carry profits, with the assumption that
all capital gain or loss effects associated with position levels had been
"removed" by the rate change variables .
generally insignificant.
The results were mixed and
The bill position coefficient (X9) was negative, and
the coupon position coefficient (X10) positive for the six-year period, as might
Position data were for all dealers since nonbank dealer
figures alone were not readily available for 1958-60.
40
be expected, with a positively sloping yield curve.37 ^
the same time,
however, both coefficients were positive in the late fifties (1958-April i960)
and negative in the early sixties (1961-63)*
Examination of spreads between
dealer loan rates at banks (New York City and "out-of-town1') suggests that the
average excess of these over the 3-month bill rate was greater in the earlier
period, implying higher negative carry on bills at that time.
In light of
these results, there is a strong possibility that coefficients in the two
sub-intervals may have in fact been influenced by factors other than relative
rates, such as capital gains and losses associated with position levels.3®
IV. Dealer Capital;
Capacity in the Industry
The term "capital" most commonly refers to the total net worth
of a firm, that is, to the accounting residual of dollar assets and liabilities. This residual is often employed as a base for calculating the
profitability of equity capital which, in turn, may serve as a rough guide
for allocating capital among different enterprises.39
Broadly speaking,
it also functions as a measure of and constraint on a firm's ability to
borrow. Unfortunately, conceptual and statistical difficulties prevent
a valid application of accounting capital either for assessing profitability
37* Although the 3-month bill rate was used as a proxy for
financing costs in the discussion of net carry, financing costs have
typically exceeded that rate. See footnote 24.
38. Revisions in data coverage and reporting procedures may
also have affected the results.
39- Marginal profitability is a more valid parameter for
allocating capital but it is impossible to measure in most instances.
41
or for estimating the potential asset expansion of dealer operations in
U. S. Government and related securities.
The appropriate measurement of capital for either purpose is
complicated largely by the type of firms operating as primary dealers and
the way they employ capital. All but one or two of the nonbank dealers
and, of course, all bank dealers are engaged in a variety of other
activities.
Each of these additional operations requires some capital
underpinning.
For nonbank dealers, difficulties in segregating capital
for the Government dealer function arise both because of the intermingling of activities in an operational sense and because capital
often "flows" from one activity to another depending on the relative
profitability of each at any point in time. Bank dealers, for their
part, would present similar complications but, as a rule, they regard
capital (i.e., some portion of net worth) as neither a relevant operational constraint on positions nor a suitable standard for assessing
the dealer functionfs profitability.
Historical data on nonbank dealer capital are available
only for aggregate net worth, i.e., accounting capital, and, in the
subsequent analysis of the trend in invested capital over the past two
40
At
decades, it is therefore, necessary to use this broad concept5 o T Nonbank dealer "capital" includes not only capital
and surplus as stated in the balance sheet but also permanent-type
reserves, long-term debt, and unrealized appreciation i^or depreciation) on securities in position. This rather broad interpretation
of net worth was selected for two reasons. First, permanent-type
reserves and long-term debt are incorporated in net worth by the
Federal Reserve Bank of New York for credit purposes. Dealers may
be awarded securities in regular auctions or other offerings to the
value of fifty times net worth, in lieu of the two per cent deposit
required of all other (nonbank) bidders. Second, discrepancies
among dealer financial statements in the treatment of the above
items, particularly unrealized gains and losses, necessitated the
broad definition to attain greater uniformity.
b2
the same time, the specification of more meaningful measures of capacity
and profitability, in terms of capital for nonbank dealers and alternative
criteria for banks, may lend some perspective to the analysis and point up
the potential shortcomings in the data surveyed.
A discussion of nonbank
dealer capital measures and the arguments for the inapplicability of
such formulations to bank dealers is presented in Appendix C.
In brief,
the concepts of capital available and capital in use are developed for
estimating nonbank dealer expandability and deriving a meaningful rate of
return on equity, respectively.
Capital available is essentially the
maximum amount of net worth available to cover margins.
The portion of
net worth representing the book value of furniture or stock exchange memberships, for example, is not eligible.
Capital in use is that portion
of net worth actually in use as margins, the excess of the purchase price
of positions in U. S. Government and Agency securities and c/D's over
borrowing.
The primary defect in using accounting capital to gauge industry
size is the inability to detect secular shifts among competing firm functions.
To the extent that these possible shifts represent permanent or semi-permanent
commitments, inhibiting fluidity, the trends in capacity growth will be misstated. Nevertheless, for nonbank dealers active prior to i960, the dealer
function constituted an important part (if not the most important part) of
these firms' activities suggesting that observed trends in accounting capital
should validly reflect the behavior of capital available.
For those firms
"recognized" since 19^0, including two very large firms having net worth far
in excess of the amounts needed to maintain their dealer operations, sufficient
information is available to roughly estimate capital available.
43
In the subsequent discussion, aggregate capital investment in the
industry since 19^9 is reviewed, along with an examination of the sources of
and trends in capital growth.
For this purpose, estimates of capital available
are used for incorporating the bank dealers.
Then a schedule of margin rates
for various types of securities and maturity categories is constructed and
applied to aggregate dealer positions for i960 to 19&5 to derive a measure of
capital in use,
Following this section, relative levels and trends in available
capital and required capital are appraised in the context of expected profit
performance.
A.
In the final section, the rate of return on capital is discussed.
Invested capital
The expansion of assets through borrowing is a function of the amount
of capital available and the nature of assets which may serve as financing collateral.^
The Government securities industry represents an extreme in this
utilization of borrowed funds or leverage, typically maintaining a capital/asset
ratio of less than 5 Per cent.
The ability to operate with this exaggerated
leverage is based, of course, on the highly liquid and minimum risk characteristics
of the dealers' collateral assets, namely U. S. Government securities.
Expansion
is limited, nevertheless, since nonbank dealers are required to provide margins
to the lender as a protection against potential price declines on collateral
s e c u r i t i e s T h e s e capital (or margin) requirements vary according to type and
maturity of collateral, with higher margins on longer term securities due to
the greater price risk incurred by the lender.
In sum, the expandability
of dealer positions depends on the amount of capital available for margins,
the size of required margins, and, in conjunction with the latter, the
maturity composition (and types) of securities held by dealers.
hi.
Assuming sufficient funds for desired financing are available.
42. Collateral securities are necessary for long positions or
short positions. Of course, for short positions the margin provides protection
against price increases in the loaned securities. Bank dealers also have exhttp://fraser.stlouisfed.org/
pansion
constraints but not of exactly the same nature. See Appendix C.
Federal Reserve Bank of St. Louis
1. Sources of change in invested capital
Distinctive changes in the level of capital invested in nonbank dealer
firms over the past two decades have resulted from varying profit performance,
the entry and exit of firms, and, in regard to capital accumulation, decisions
about the retention or disbursement of earnings. Marginal factors include the
addition or withdrawal of capital by individual officers or partners, the issue
of long term debt, and unrealized appreciation or depreciation.
Table IX shows
the year-end level of aggregate nonbank dealer net worth from 1948 to 19^5 > based
on two overlapping series.
The first series, from 1948 to 1958, was compiled by Meltzer and von
der Linde, largely on the basis of annual financial statements, and includes
what appeals to be net worth plus recognizable reserves.
to 1965>
lwas
The second series, 1955
compiled by the author from both financial statements and supple-
mentary data available on a confidential basis to the Credit Department of the
Federal Reserve Bank of New York. Much of the discrepancy between the two
series (note 1955 to 1958) stems from the broader coverage of permanent-type
reserves in the second series.
In addition, some variation may be due to dif-
ferent treatment of unrealized gains or losses in each case.
The figures on net worth generated by Meltzer and von der Linde
cover the twelve nonbank dealers "designated for handling transactions in U. S.
securities (with SOMA.)" in 1959*
Only five of these dealers were so designated
in the 1948 to 1952 period, while more than twelve were trading with the Federal
Reserve at one time or another from 1952 to 1955i thus, net worth, according to
our definition of the industry, was overstated in the Meltzer-von der Linde series
for 19^9 to 1952 and perhaps slightly understated for 1953 and 1954. The discrepancy would probably be on the order of 10 per cent or less, however. For the two
periods examined more thoroughly, 1955"60 and 1960-65, the net worth figures (from
the Federal Reserve Bank of New York) reflect all "authorized" nonbank dealers.
45
Table IX
Total Net Worth of Nonbank Government Securities Dealers
(in millions of dollars)
Year
Meltzervon der Linde
FRB of
New York*
1948
1949
1950
54.6
58.1
53-1
_
1951
1952
1953
51-9
53.8
59-2
-
1954
1955
1956
64.2
69.3
61.4
72.1
67.2
*
-
-
-
-
Meltzervon der Linde
FRB of
New York*
1957
1958
1959
67.3
73-8
74.1
84.4
88.7
I960
1961
1962
-
Year
1963
1964
1965
-
-
-
-
95.7
110.4
137.0
127.6
237.3
260.9
Includes capital, undivided profits, long-term debt, permanent-type reserves,
and unrealized appreciation or depreciation on securities.
2.
Changes in invested capital, 1948 to 1955
From 1948 to 1952, 3 there were ten "recognized" dealers, five
nonbank firms and five dealer departments of commercial banks.
The net worth
of the five nonbank dealers at the end of 1952 was an estimated $45 million,
and in each firm a considerable portion of activity was devoted to the Government
securities operation.
Judging from their participation in sales and positions at
that time, the five bank dealers probably "contributed" an additional $10 to $15
million of capital.^
In 1953, capital and other requirements for trading with SOMA were
eased, and nine additional nonbank dealers received such authorization.
firms added an estimated $10 million of capital.
These
Three firms, each with net worth
under $500 thousand, lasted three years or less; two departures resulted from
the death of a principal officer and a subsequent withdrawal of capital
43. The end of the calendar year is used as the reference for inclusion or exclusion of ''authorized" firms.
44. This and subsequent estimates of bank dealer "capital" are in
effect capital available, approximately the amount that would have been necessary
http://fraser.stlouisfed.org/to conduct the operation on an independent basis.
Federal Reserve Bank of St. Louis
46
from the firm.
The six other firms have remained in the industry to this day.
One bank dealer commenced trading with SOMA in 1954 but ceased at the end of
1955
"to a lack of interest. With the addition of a small nonbank dealer
in the middle of 1955, the industry at year-end was represented by five bank
and twelve nonbank dealers with aggregate capital of perhaps $85 to $90 million,
including an estimated $15 to $l8 million for bank dealers.
3.
Changes in invested capital, 1955 to i960
From 1955 to i960, the membership of "authorized" firms remained
unchanged.
Total nonbank dealer net worth rose from $72 million to almost
$96 million, a gain of 33 per cent. During the period, about $1.3 million of
new capital was invested in dealer firms. Several million, perhaps $6 or $7 million, was withdrawn, the bulk of which represented the death or retirement of
participating partners and officers. With long-term debt declining about $2 million, from $3-3 million to $1.4 million, it is apparent that between $25 and
$30 million of earnings was retained in the industry.
This implies an annual
growth rate of about 5 P e ^ cent. However, while annual earnings figures are
not available for most of the firms for this period, total earnings were considerably larger, perhaps double the amount of retained earnings.
Dividend or disbursement policies clearly differed among nonbank
dealers. First Boston Corporation alone earned $20 million from 1955 to i960
but paid out 88 per cent in dividends. Discount Corporation similarly paid
out 80 per cent of $6.4 million in net profits.
Largely as a result of this
policy, the net worth of these two firais grew only 7 and 8 per cent, respectively.
Other firms, however, expanded their net worth considerably, six by 50 per cent
or more.
Perhaps significantly, First Boston and Discount are the only publicly
owned firms.
Size per se does not appear to have been a factor in the decision
to retain earnings and expand capital, except to the extent that many of the
bl
smaller firms were more likely dominated by a few individuals who, perhaps for
reasons of prestige, or potential growth in earnings, wished to expand their
firm's capital and operations. As a result, the growth in capital from 1955
to i960 might be characterized as passive. New capital was not immediately
attracted to the industry by virtue of a high rate of return.
Long-term debt was outstanding at only four firms during the period,
all of whom were in the middle-to-small size category. At three of these firms,
such debt declined from 1955 to i960, leaving a total of only $1.4 million for
the industry in the latter year. While there may be a variety of reasons for
not issuing long-term debt, it is apparent that it has not played a significant
role in underwriting the market.
4.
Changes in invested capital, I96O-65
Between i960 and 1965* the dealer industry experienced several mem-
bership changes, resulting in a substantial net addition to accounting capital.
Three bank and two nonbank dealers joined the industry, one nonbank dealer
merged with a large brokerage firm, and two nonbank dealers withdrew. Both
withdrawals from the industry were for reasons totally unrelated to firm performance in the Government securities market. By 1965, the number of bank
dealers had risen from five to eight while nonbank dealer membership stood
unchanged at twelve.
Total net worth of all "recognized" nonbank dealers jumped from
$96 million in i960 to $26l million in 1965.
Of the net $165 million increase,
$148 million represented the entry of two dealers plus the merging brokerage
firm, $25 million came from the increase in net worth of these three firms,
and $12 million represented capital accumulation at the nine previously existing firms.
Partially offsetting this rise was a drop of $20 million in
net worth from the two departures and partial capital withdrawal from the
merged dealer.
48
Examining the nine previously active dealers alone, net worth advanced
from $71.7 million to $83.6 million from i960 to 1965, an increase of l6.6 per cent.
This growth compares with a $17-5 million (32 per cent) rise during the earlier period.
Three of the nine firms experienced a net decline in net worth from i960 to
1965, however/ and $10.4 million of the $11.9 million gross increase was concentrated
at two dealers. Again, there is no way to determine either the amount of earnings
generated over the period or the withdrawal policy for most firms. The(FKB--NY data,
are incomplete with regard to five of the nine dealers for 1961 to 19^3 • For the
final two years, 1964 and 1965, these nine firms reported to the Market Statistics
Division a combined net income of $20.1 million from all activities before taxes.
Dealer capital could presumably have grown faster had dealers retained
a greater share.
At the same time, fragmentary evidence suggests that in the
1960ts a substantially smaller proportion of total earnings generated by the nonbank dealers accrued from the Government securities operation.
For 1964 and 1965
combined, for example, Government securities operations of nonbank dealers resulted
in a net loss of $6.8 million whereas aggregate income from all sources (before
taxes) amounted to $128 million ($100 million of which was earned at Merrill Lynch).
It is thus quite possible that capital available could have contracted during the
period; at the very least, earnings performance provided little incentive for
dealers to expand capital in their Government securities operation.
As previously noted, five banks were primary dealers from 1955 to I960;
between 1961 and 1965? three additional banks became primary dealers and were
"authorized" to trade with SOMA.
Using gross transactions as a measure of size,
the five older bank dealers grew approximately 23 per cent from 1955 to i960 and
45. For 1961 through 1965* First Boston Corporation earned $l6.0 million, of which 90 per cent was paid out in dividends; Discount Corporation earned
$2.2 million, paying out 113 per cent in dividends.
49
34 per cent from i960 to 1965-
Since transactions growth was primarily in the
bill sector, where margin requirements are minimal, estimates of "capital" expansion need not be as large; thus, bank dealer capital available, estimated at
$15-18 million in 1955* was perhaps $20 million in i960 and, for the same previously existing five bank dealers, $25 to $27 million in 1965-
In 19&5; the
three new bank dealers accounted for 27 per cent of total transactions by bank
dealers, implying an additional $8 million of employed "capital".
This combined
bank dealer "capital" investment of $33 to $35 million is close to the figure
of $35 million, estimated by the banks themselves in 19&5 as necessary for their
operations.
Summarizing these trends in dealer capital, the total net worth of
active nonbank dealers plus the assumed "capital" investment of the bank dealers
rose from $85 to $90 million in 1955 to about $115 million in i960. Using
capital available figures for the entering nonbank dealers, the 1965 figure for
capital funds employed in Government securities operations by bank and nonbank
dealers was about $140 million.
This represents an approximate increase of
60 per cent over the decade. For perspective, over the same interval, net
positions and gross transactions for all dealers (after some adjustment for
reporting revisions) are estimated to have expanded on the order of 67 per cent
and 100 per cent, respectively.
The two increases stemmed largely from changes
in Treasury bills.
Capital growth in the industry, 1955 "to i960, came about almost
entirely through the retention of earnings.
In the later period, the major
share (perhaps two-thirds) of new capital devolved from new entrants, as growth
in the older firms slowed due to declining earnings.
While observed capital
appears to have risen in line with market activity (in terms of positions and
transactions), it is not as certain, even with the additional firms, that
50
capital available has expanded at a comparable pace, particularly in the i960
to 1965 period.
B. Margin requirements
The adequacy of dealer capital depends on the relationship between
available capital and required capital.
The latter is a function of the size
and composition of dealer positions as well as the cost, in terms of capital
margins, per dollar of securities held.
How large can positions grow before
margin requirements exhaust the available capital, assuming a desire on the
part of dealers to expand inventories to that point?
The assumption of dealers' desire to expand positions is crucial.
Capital available operates as a broad constraint on position levels, as evidenced by the strong positive relationship between the size of individual
dealer's capital and positions.
The level of positions held at any particular
time, however, is a function of expected profits or profitability, as determined by transaction volume, spreads, expected price changes, and other factors.
Expected profits involve both return and risk. Unless expected returns are
high and/or risks low, dealers may not be induced to expand positions to what
might be considered, on other criteria, the most efficient level.
In this
investigation, we are limited to an estimate of the degree to which positions
could be expanded, given favorable conditions, before encountering the absolute capital constraint. As noted in Appendix C, this exercise is valid for
nonbank dealers, but a different set of criteria must be developed for judging
the expandability of bank dealer positions.
1. Margin Rates
The most striking feature about quoted margin rates for Government
securities dealers is the diversity of quotations for each of the various
maturity categories and the apparent flexibility in their application.
Schedules
of approximate rates, as reported in earlier studies and more recently by three
dealers and two clearing banks, are presented in Table X.
They are approximate
because in many instances individuals were quite vague about minimum requirements.
The concensus of persons interviewed was that margin requirements had, if anything,
narrowed over the past decade. Several noted that current requirements were in
practice below the "official" margins set a number of years ago.
Of course, there
is some tendency for margins to narrow or be less strictly enforced during periods
of relatively stable rates, as in the early 1960's.
The maturity of the collateral (U. S. Government securities) was easily
the overriding factor in the determination of margin requirements, and despite
variations among lenders, "advertised" margins seemed to be granted to all Government securities dealers without discrimination. At the same time, there was
some indication from discussions with dealers and clearing banks that preferential
treatment, in the form of borrowers not always meeting minimum requirements, was
extended by some lenders on the basis of business received or the size of the
borrower (in terms of capital). Size was a factor in that lenders were typically
more careful in checking, on a day-to-day basis, the adequacy of margins provided
by small dealers.
Large dealers might be under-margined one day, and simply asked
to provide more coverage the next.
It is doubtful, nevertheless, that large
dealers were able to operate on continuously narrower margins than small dealers
over any extended period of time.
In order to estimate minimum aggregate capital requirements for past
position levels, it is necessary to assign margin rates to each maturity category or type of position activity. Margin rates against Treasury bills, certificates of deposit, and other securities maturing in less than 1 year ranged from
Table X
Margin Requirements on Collateral Loans and Repurchase Agreements*
(in per cents or points)#
Type of security
used as collateral
New York
Clearing
House Assn.
(1957)
Mr. Girard
Spencer"Hearings"
(1958)
Source of Margin Quotation
Meltzervon der
Linde
(1966)
(1959)
(1966)
Long
Collateral loans
Discount
accrual
Treasury bills
i
0
0-1 pt
0-1 pt
(I555T
Short
1 pt
0
0
0
Certificates of deposit
Certificates of indebtness
E
D
(1966)
(1966)
1/2*
1 pt
Notes and bonds
Under 1 year
or
Under 5 years
Accrued
interest
1 pt
1 pt
1 Pt
2 pts
2 pts
0
1 pt
One to 5 years
5 - 1 0 years
or
(<18 mo. )
2 pts
2 pts
1 pt
(>l8 mo.) 2 pts
2 pts
2 pts
-
1-2 pts
2 pts
(<3 yr, )l/2pts
(>3 yr.) 1 pt
2 pts
3 pts
Over 5 years
3 pts
3 pts
3 pts
3 pts
2 pts
2 pts
5 pts
3 pts
Over 10 years
Federal Agency
2-3 pts
One year or less
5 pts
2-3 pts
Same
as
U.S. Gov'ts.
Over 1 year
Repurchase agreements
(3 mo.) $25/mil.
(6 mo. ) $50/mil.
One year or less
*
#
t
The sources for the quotations identified by letters would prefer not to be disclosed publicly
Per cent denoted by
points by pts".
Federal Agency securities have not been used as a rule as collateral for borrowing securities.
Same
as
U.S. Gov'ts.
Same
as
U.S. Gov'ts.
t
0
2-5 pts
53
46
zero to as much as 1 point.
Typically, bill margins are set by taking the
current market value of the bills (in terms of their bid price) and rounding
47
down to the nearest convenient number.
The margin on CD's is computed sim-
ilarly, although the requirement may vary with the source of the CD, that is,
the issuing bank. For coupon securities maturing in less than one year, accrued
interest in effect serves as a margin, since it is rarely counted as part of the
collateral value.
In order to reflect the "convenience" factor in financing
bills and CD's and the addition of accrued interest on under 1 year coupon
securities, l/4 of 1 per cent was applied to bills and CD's and l/2 of 1 per
cent to the coupon securities.
For coupon securities maturing after one year, financing is again
handled on a "flat" basis (excluding accrued interest). For one-to-five year
issues, margins ranged from l/2 point to 2 points, with the more frequent quotation nearer one point. To make some provision for accrued interest, 1 l/2
per cent was selected for our computations.
For issues maturing in 5-1° years,
quotations ranged from 2 to 5 points but were generally on the lower side. Again,
allowing for convenience and accrued interest, 3 per cent was applied to this
category.
points.
In the over-10-year issues, margin rates were quoted from 3 to 5
In this case, 4 per cent was used for 10-20 and 5 Pe** cent for over
20 year issues.
46. Zero margin generally means that the loan is covered by an
equivalent dollar amount of collateral securities, valued at the bid price.
While a computational distinction between points ($10,000 per million par value)
and per cents exists, the overriding convenience factor has rendered the distinction virtually irrelevant; in this memorandum, there need be no computational
distinction because position totals used to compute dollar margin requirements
wetfe reported on the basis of par value. Because bill positions were reported
at par value, however, aggregate margin requirements for bills may be slightly
overstated. In Congressional hearings in 1958, a survey indicated that initial
margins for loans at commercial banks against collateral (U. S. Government securities) maturing in 1 year or less were as follows: of $1.95 billion of financing, 47 per cent was financed at zero initial margin, 23 per cent at l/k point
or less, 24 per cent at 1 point, 10 per cent at 2 points, and 6 per cent at 3
points or more.
http://fraser.stlouisfed.org/98.250
Federal Reserve Bank of St. Louis
47- For example, a 180-day bill bid at 98.321 might be valued at
for collateral purposes.
54
Federal Agency securities, having become much more actively traded and
widely held, appear to have- experienced declining margin requirements over the
past decade.
In the Meltzer-von der Linde study, 5
to all types and maturities.
cent was applied uniformly
Today, several sources said Agencies were accorded
the same margins as comparable-maturity Governments. For Agency securities maturing in less than one year, a 1 per cent margin was used, while 3 per cent was
applied to all Agencies maturing in more than one year.
Margin rates for borrowed securities again depend on the maturity of
the collateral, although they are slightly lower in the longer maturity sectors
than margins for straight financing.
Less risk of adverse price movements is
involved in covering securities borrowed because the prices of these securities
move in the same direction as the collateral prices.
(The dollar value of a
loan, of course, does not change with security prices.) Margins range from
virtually zero on bills to 3 points for securities maturing in over ten years.
Typically, however, a rule-of-thumb 2 points is applied to the total "collection"
of securities submitted as collateral against borrowed securities, largely because of the inconvenience
vidual issues.
entailed in calculating margin allowances for indi-
Two points was therefore applied when estimating aggregate
margins on dealers' short positions.
2 • Minimum capital requirements
Applying the margin rates selected in the last section, minimum
capital requirements were estimated for average dealer positions from i960 to
1965, and for the week of highest average daily positions, August 17-21, 19
Data for years prior to i960 were available only on a net ba^is,
precluding meaningful analysis or inter-period comparisons. Reported on a commitment basis, the position data lead to some overstatement of capital requirements since new security issues are typically taken into position several days
(or more) prior to actual issue and payment. This practice occurs largely in
bills, however, where the impact on capital is relatively small.
55
Position data are for all dealers, even though bank dealers financed the bulk
of their positions themselves and hence were not subject to margin requirements;
the importance of this procedure will be noted later.
Two methods of calculation
were employed, the primary one being based on dealers1 gross long positions and
the second, used as a comparative check, on the gross short plus net long positions. The results of the first method are presented in detail in Table XI, as
are the summary figures for the second method.
A necessary assumption for minimum capital utilization is that dealers
borrow to the fullest extent possible.
This entails using the entire gross long
positions as collateral against either direct loans or borrowed securities.
Aggregate margins required on the gross long position, then, are a first approximation of the minimum amount of dealer capital needed to support the observed
level (and composition) of positions, without regard for the relative size of the
short position.
Using this method, dealer capital requirements rose from over
$23 million in i960 to over $4-0 million in 1965* or by 74 per cent. When net
long positions were at their peak during this period, in the week ended August
21, 1964, requirements were $57 million.
When dealers borrow securities to sell short, the proceeds of the
short sales can be used to repay outstanding loans, and the released collateral
can, in effect, be shifted to collateralize the borrowed securities.
Several
aspects of providing collateral for borrowed securities may alter aggregate
margin requirements.
On the other hand, as noted earlier, margin rates on long-
term collateral securities are lower than when applied to borrowed securities
than to direct loans. Also, bills sold short are often financed by "due bills",
which are unsecured borrowings requiring no margins at all.
On the other hand,
49. Minimization of capital used does not necessarily imply the
least-cost combination of capital and borrowing.
56
Table XI
Minimum Aggregate Capital Requirements for
Financing Dealer Positions, I96O-I965
and August 17-213 1964, by Maturity
Category. Based on Average Daily
Position Figures
(in millions of dollars)
i960
1961
1962
1963
1964
1965
August 17-21,
1964
4.l4
5.09
6.50
6.31
7.02
7.17
7 .21
1.68
10.04
3.14
1.15
1.24
2.42
7-72
2.66
1.29
1.16
2.70
6.24
4.73
1.45
1.94
1.80
8.20
7.15
1.24
3.14
1.48
7.52
8.39
.44
6.00
1.31
5.29
8.30
.75
10.86
.92
10 • 93
15 .62
•79
16 .30
1.04
.88
1.72
1.24
2.16
1.49
2.23
1.51
2.54
3.85
2 • 51
2 .50
-
-
.10
.53
.56
• 55
31.59
35.12
40.63
57 • 33
Method of Gross Long
Positions (including
long-term RP'sJ
Treasury "bills
Coupon securities
Under 1 year
1-5 years
5-10 years
10-20 years
Over 20 years
Agency securities
Under 1 year
Over 1 year
Certificates of deposit
Total
1.19
• 77
-
23.35
22.26
26.52
5.07
9.13
9.88
11 • 51 12.39
13.79
9.20
Net long position
20.04
15.56
19-36
21 • 97 24.49
31.20
49.74
Total
25.11
24.69
29.24
33 .48
44.99
58.94
Method of Gross Short
plus Net Long Positions
Iincluding long-term
RP's)*
Gross short position
*
36.88
A margin of 2 points was applied to the entire short position; then selected
margins were applied to net long positions in each category.
57
there are greater risks involved in using bills as collateral against longer term
securities borrowed because of potential price rises; this would imply higher
margins for bills than in the case of direct loans. Arjplying the straight 2 point
margin (frequently used as a rule of thumb by lenders of securities)to dealers'
gross short positions and then the previously selected margins to net long positions in each maturity category, aggregate minimum capital requirements were again
estimated.
The results, shown in Table XI, were consistently above the totals
computed from gross long positions but not by very large amounts; the differences
ranged from 5 "to 11 per cent.
The higher margins "imposed" on short positions in
bills weighed more heavily than reduced margins on long-term collateral securities
but the variation between the two methods is certainly not sufficient to consider
the relative size of the short positions an important determinant of capital requirements
C.
Capital adequacy
A primary task of this study was to ascertain the sufficiency of dealer
capital under current market conditions and to judge its expected availability for
accommodating the near-term requirements of public and private market participants.
The foregoing analysis of invested capital and minimum requirements surely indicates
that adequate capital was available in 19^5 for positioning securities. Although
capital requirements grew at a faster rate during the sixties than did the proxies
for capital available, the absolute gap between them widened.
Far from seeing a
withdrawal of invested capital in dealer firms, most firms grew in size from i960
to 1965 and six firms entered the industry.
Furthermore, since bank dealers finance
50. Both techniques are subject to similar types of error, not only
with regard to the validity of margin rates applied, but also in terms of the
practical, problems of daily financing activities. In the latter sense, both
methods probably underestimate needed capital by implicitly assuming a degree of
flexibility and efficiency in the distribution of collateral among lenders not
practically feasible under current clearing arrangements. In part, however, the
"generous" estimates of margin rates may offset this bias.
58
the bulk of their positions with their own funds, the potential capacity of the
industry grew substantially with the addition of three new bank dealers.
Indeed,
of the $18 million increase in required capital from i960 to 1965, bank dealers
accounted for $9 million.
In 1965, the actual amount of capital required, i.e.,
the requirements of nonbank dealers, was just under $29 million.
This can be
compared roughly with total nonbank dealer capital of $261 million and capital
allocated to Government securities activities of $86 million.
With the mobility
of funds among firm functions, there is little doubt that there is sufficient
capital available to meet any foreseeable needs in the near future.
The crucial factor, as mentioned earlier, in determining whether public
and private operations will be accommodated efficiently is the expected profitability of such accommodation.
When profit expectations are favorable, resources
can be shifted to Government securities operations by dealers, even to the point
of bank dealers raising additional funds in the CD and Federal funds markets.
Alternatively, when prices are expected to decline or bid-asked spreads narrow
to the point where they do not cover the risks of holding securities, dealers
may be unwilling to expand their positions to accommodate official or private
operations and may divert resources to other, more profitable uses.
Nothing
in the analysis of profits in the early sixties, however, indicated that dealer
net income (and return on capital) would remain at permanently low levels, so
it is likely that future dealer behavior will continue to respond to profit
opportunities as they arise.
Nevertheless, efforts to prevent deterioration in
market performance, however defined, can succeed only if there is reasonable
assurance of adequate profits.
occurs.
Capital will be more than sufficient if this
59
V.
Rate of Return on Capital
Computing a meaningful rate of return for capital employed by dealers
in their U. S. Government securities operations is severely hampered by the problems inherent in specifying and measuring the appropriate capital base and in
properly allocating income and expenses among this and closely related firm functions.
Additionally, it is virtually impossible to assess the intangible returns
which may accrue to the diversified dealers by virtue of their making markets in
U. S. Government securities.
Nevertheless, to comply with the request of this
study1s prospectus to discuss the magnitude of returns to firms having U. S.
Government securities operations, the rates of return reported by Meltzer-von
der Linde for 1948 to 1958 are presented in Table XII and additional material
appears below for later years.
(The Meltzer-von der Linde data refer to income
from all operations of nonbank dealers, however.)
Table XII
Ratio of Aggregate Net Income (before taxes) to
Net Worth (including long-term financing), Nonbank
Dealers, 1948-1958*
(in per cents)
1948
1949
1950
1951
*
1.2
17.O
- .8
4.3
1952
1953
1954
1955
7.8
25.6
24.2
2.3
1956
1957
1958
.2
42.4
58.1
Ratios are based on complete reports from 7 to 10 dealers. Net income is
after special charges or gains. In 1955, bank dealers had a net loss in
their Government securities operations, which led to a loss for the whole
industry.
Source: Meltzer-von der Linde, p. 133The FRB--NY study did not provide sufficiently detailed figures to
permit meaningful calculations of return on capital from 1959 to 1963.
Capital
data were for nonbank dealers only while income data were for all dealers.
Clearly, the return was very high in i960 and quite low in 1963.
60
For 1964 and 1965, nonbank dealers estimated capital allocated to
their Government securities operations of $82.2 and $85.5 million, respectively.
Based on these figures, the rates of return were 3.7 per cent in 1964 and -12.3
per cent in 1965 before taxes.
Examining the combined operations of each nonbank
dealer, however, the rates of return on accounting capital averaged 26 per cent
(196k) and 27 per cent (1965).
In both years, the highest rates of return were,
as might be expected, achieved primarily by the larger, diversified firms.
In
1965, when 10 of the 12 nonbank dealers reported losses in the Government securities operations, five had overall profits, and four of these were the large
diversified dealers.
The study prospectus also requested some comparison of rates of return
in similar fields such as among brokerage or investment firms.
Any comparison of
this nature, however, suffers from more extensive difficulties than simply capital
and income allocation.
Foremost are the problems of average versus marginal mea-
surement, and the specification of a risk differential.
Currently available data
on income and capital allow computation only of average rates of return for extended periods of time.
The crux of efficient capital allocation, however, is
the marginal rate of return, i.e., the change in income per marginal change in
capital.
In a diversified dealer firm, where considerable portions of capital
are mobile, average rates of return to various functions may differ while marginal rates are equal.
Similarly, average rates may differ among firms yet
marginal rates be equal.
provide no
Thus, differences in observed average
rates of return
predictable clue about potential capital movements.
The second and perhaps more important constraint to inter-industry
comparisons is the problem of assigning a risk component to rates of return in
order to reflect the riskiness of various types of enterprise.
It may be rea-
sonable that U. S. Government securities dealers should receive
greater risk
61
compensation per unit of invested capital (given the risks associated with highly
leveraged positions and volatile prices) than, say, brokerage firms with minimal
capital risk exposure; how much greater the compensation, nevertheless, is a
matter of conjecture.
Indeed, given the very wide cyclical earnings swings, and
the difficulties in quantifying nonmarket factors (Federal Reserve support of
rates immediately following World War II, for example), it is impossible at this
stage even to generate a reliable long-run rate of return for the U. S. Government
securities industry alone.
62
Appendix A
Summary of Dealers'Income and Expenses, 1964 and 19&5
Aggregate income statements covering the U. S. Government securities
operations of the twelve nonbank dealers in 1964 and 1965 and the eight bank
dealers in 1965 are presented in Table A-l.
In 1965? nonbank dealers incurred
an aggregate loss of $9*9 million (before allowance for income taxes) from these
operations with only two of the twelve dealers realizing a profit.
In contrast,
nine firms showed a profit in 1964 and combined pretax net income totaled $3.1
million.
Bank dealers had similar difficulties in 1965? losing $4,5 million in
the aggregate with but one bank reporting a net gain.
The primary cause of net losses in 1965 was the extremely low level
of trading profits, particularly on coupon securities.
Spread profits, based on
annual sales and quoted spreads of the several coupon maturity categories, were
estimated at $68 million for total coupon sales, although substantial downward
adjustment, perhaps by about one-half, is necessary to account for the fact
that actual spreads were well inside the announced quotations.
Still, all dealers
had combined coupon trading profits of only $9-4 million, or little more than
one-fourth of potential gross revenues had there been no capital losses; declining
prices of securities held in position in effect wiped out three-quarters of the
estimated spread profits.
Trading profits on Treasury bills, included in interest income in
these figures, were not separated from accrued discount (interest) by most firms.
Based on the performance of five nonbank dealers and four bank dealers who were
able to segregate trading profits from discount (interest) earned on bills,
aggregate bill trading profits in 1965 were estimated to be about $6 million.
63
Table A-l
Dealers' Income and Expenses on Government Securities Operations* and
Nonbank Dealer Net Income from All Other Activities, 1964 and 1965
(in thousands of dollars)
Nonbank
Government securities operations
Income
Trading profits on coupon securities
Unrealized appreciation or
depreciation on securities owned
Interest, dividends, and
discount earned
(income from Treasury bills)
Other income
Total Income
Expenses
Interest on borrowed funds
All other expenses
Total expenses
Net income before taxes
Net income before taxes from
all other activities
1965
1
Bank
w
l4,6oo
6,762
2,645
493
910
- 1,193
102,590
113,569
35,9^1
(67,859)
(-75,091)
(20,183)
46
173
82
117,728
118,59^
37,475
98,023
16,630
112,286
16,169
33,891
114,653
128,455
3,076
- '9,862
8,069
41,960
4,484
56,611
78,615
Note: Figures may not add to totals due to rounding.
Includes Federal Agency securities and certificates of deposit.
*
1
This compares with potential spread profits of $10 million.
The relatively
smaller contraction of trading profits on bills vis a vis coupon securities
presumably stemmed in part from the smaller impact on bill "prices" of a given
change in interest rates.
Based on the estimated $6 million of bill trading profits, $4 million for
nonbank dealers and $2 million for bank dealers, net carry for all dealers was
approximately $-3-7 million.
1. The
http://fraser.stlouisfed.org/
are
Federal Reserve Bank of St. Louis
Nonbank dealers sustained the entire loss while
quoted spreads on Treasury bills, used for estimating spread profits
probably quite close to actual spreads.
64
bank dealers were estimated to have broken even on the financing of their positions. Bank dealers typically employed as the cost of carry the Federal funds
or three-month bill rates which in 1965 were somewhat below nonbank dealers1
borrowing rates.
65
Appendix A
Table B-l
List of Independent Variables for Multiple
Regressions
Variable
Unit
Quoted bid-asked spread on the new threemonth Treasury bill, monthly averages of
Thursday observations
Basis points
Total sales, nonbank dealers, monthly
averages of daily data1
Millions of
dollars
Bill transactions, all dealers, monthly
averages of daily data
Millions of
dollars
Coupon transactions, all dealers, monthly
averages of daily data1
Millions of
dollars
Change in end-of-month three-month bill
rate
Percentage
points
Monthly change in long-term U. S.
Government bond rate (FRB index),
monthly averages of daily data
Percentage
points
Change in three-month bill rate, last
three days of preceding month
Percentage
points
Three-month bill rate, monthly averages
of daily data
Percentage
points
Bill positions, all dealers, monthly
averages of daily data
Millions of
dollars
Coupon positions, all dealers, monthly
averages of daily data1
Millions of
dollars
Total positions, all dealers, monthly
averages of daily data1
Millions of
dollars
Dummy variable , +1 for all months,
January 1958 - April i960
Dummy variable , +1 for refunding months
in 1960-1963
Includes Federal Agency securities and certificates of deposit.
Table B-l
Multiple Regression Results Explaining Nonbank Dealer Trading Profits Plus Carry
Ret regression coefficients and standard errors
Equation
I
II
III
iy
V
*
§
t
ft
Period
2
R
ad.1.
Watson
ratio
(Standard
error of Xf)
-250.65t
(43.23)
- 776.54ft
(192.82)
-598.85ft
(153.33)
48.26tt
(21.51)
*6
X7
X
X 2*
1
1958-1963
.69
1-95
465.41
(116.78)
1958-4/1960
.61
1.32#
492.63
(144.95)
-258.13ft
(65.07)
- 491.46t
(323.54)
-719.87ft
(224.83)
42.87
(34.89)
1961-1963
•31
2.42
374.71
(91.64)
-308.03ft
(158.310
- 890.66ft
(311.39)
- 9.75
(479.69)
12.29
(56.08)
1958-1963
.6?
1.91
380.12
(120.26)
-257.54ft
(44.38)
- 715.82ft
(200.45)
-689.59ft
(149.16)
44.00tt
(22.14)
1958-4/1960
.64
1.43
411.59
(140.24)
-249.71+t
(63.34)
_ 434.47t
(309.55)
-725.59tt
(205.40)
37.84
(33.33)
1961-1963
.44
2.61
387.54
(82.63)
-350.20ft
(141.37)
-1176.46ft
(279.90)
-101.88
(428.77)
2.45
(49-75)
x
Xi2
ll*
-0.027
(0.021)
-31.66
(29.10)
50.56
(45.50)
o.oo4
(0.011)
-73-o4t
(49.03)
100.03ft
(49.69)
-0.033ft
(0.010)
0.036
(0.036)
-0.04t
(o.oe)
o.oiot
(0.06)
4.38
(44.87)
0.01
(0.01)
(8:sr
89-74t
(49.85)
-0.031ft
(0.010)
-0.005
(0.046)
0.112t
(O.O65)
-0.04t
(0.02)
0.13
(0.13)
0.08
(0.11)
0.01
(0.01)
-0.14ft
(0.04)
-0.04
(0.10)
-
-
.68
2.02
374.60 •
(119.3*0
-248.54ft
(44.50)
- 656.25ft
(203.38)
-626.64ft
(156.61)
38.19ft
(22.36)
1958-4/1960
.62
1.39
402.86
(143.46)
-251.47ft
(65.15)
- 452.69t
(324.42)
-744.58tt
(222.60)
37.57
(34.11)
1961-1963
.44
2.69
358.73
(82.65)
-322.93+t
(144.03)
-1068.24tf
(300.34)
-145.28
(431.07)
2.63
(49.76)
4,63
(44.88)
1958-1963
• TO
2.02
449.57
(115.19)
-246.31ft
(42.32)
- 730.90ft
(191.60)
-607.54ft
(151.22)
39.07tt
(22.06)
8o.l9t
(46.66)
1958-4/1960
.67
1.40
716.72
(133.06)
-249.l8tt
(56.08)
- 483.40t
(296.47)
-757.6ltt
(205.23)
28.45
(32.01)
1961-1963
• 31
2.37
350.59
(91.87)
-313.68ft
(159.28)
- 872.43tt
(309.47)
49.41
(479.77)
11.38
(58.39)
48.49
(45.28)
1958-1963
.68
2.01
^53.97
(118.41)
-263.86ft
(43-77)
- 697.21ft
(197.08)
-607.34tt
(158.69)
4o.6ott
(21.50)
57.25
(51.12)
1 9 5 8-4/1960
.63
1.49
496.73
(141.18)
-269.72ft
(62.89)
- 411.41
(312.11)
-604.12 ft
(244.06)
38.69
(33-57)
-
1961-1963
.26
2.44
216.56
(94.91)
-351.06ft
(164.01)
- 954.67ft
(329.71)
-101.79
0+92.53)
31.43
(56.75)
35.54
(59.61)
XQ*
-45.71tt
(20.76)
1958-1963
IVo-tailed test for significance. All other variables have one-tailed test.
Low Durbin-Watson ratio indicative of significant positive serial correction at .05 confidence level,
.10 level of significance for Student's t value,
.05 level of significance for Student's t value.
Xu
-o.023ft
(.009)
88.70t
(47.04)
-
X,
-
-
43.43
(58.44)
28.34
(58.98)
-0.505ft
(0.169)
-11.41
(25.72)
-o.8ott
(0.33)
-35.94
(40.39)
-0.02
(0.24)
-79«7ltt
0*6.73)
-0.039ft
(0.010)
0.23tt
(0.13)
-0.052ft
(0.024)
0.348t
(0.225)
-0.014
(0.013)
0.087
(0.21)
13.51
(47-99)
129.97tt
(54.07)
-30.58
(54.66)
67
Appendix
1.
A
Nonbank dealer capital measures
The broadest measure of nonbank dealer capital is the accounting
capital concept discussed previously.
It has the advantage of being easily
calculated and does provide an indication of risk protection afforded creditors and size of firms having dealer operations.
Furthermore, it is the
only measure of dealer capital available for the 19^8 to 1963 period.
In seeking a more definitive and meaningful measure, we must narrow
the capital concept to bring out the allocative feature.
A second approach to
the specification of dealer capital is the notion of capital available. This
conceptually represents the amount of capital which management is able or
willing to commit to the financing of Government securities positions.
Capital
available, if not formally allocated by management, is essentially accounting
capital minus all assets not serviceable as loan collateral to finance securities positions, such as furniture and fixtures, good faith deposits, stock
exchange memberships and minimum capital requirements for such memberships
and for other firm activities.
In essence, capital available is a yardstick
of funds suitable for satisfying margin requirements.
Finally, a third potential measure, capital in use, is the amount
of firm capital actually committed to the financing of positions in the form
of collateral margins.
In practice, it is the excess of market value of
securities positions (including accrued interest) over the value of loans
against which these securities have been pledged.
There is considerable evidence, as will be specified shortly, that
all three concepts were used in the most recent figures on allocated capital
collected by the Federal Reserve Bank of New York.
Some dealers, lacking al-
locative guidelines, presented figures unrelated to any of these concepts.
68
Capital available is undoubtedly the appropriate measure for position
expandability, unless there is a policy limit set by management on the amount of
capital which may be devoted to Government securities financing.
As for
calculation, it should not be difficult for management to provide a realistic
estimate of the amount of capital which is potentially available. A serious
drawback to the use of such a figure as a guideline to expandability, however,
is that capital available may not be stable but be a function of the perceived
profitability of a particular situation and of the relative profitability of
alternative uses of funds at any particular time.
For example, a lucrative
corporate underwriting may pre-empt capital normally committed to financing
a Treasury refunding operation.
In specifying the most meaningful base which could be applied uniformly
to all dealers to measure profitability, potential biases exist in both the
capital available and capital in use concepts.
(Accounting capital is clearly
unrealistic for computing a rate of return on just one firm activity.) With
capital in use, any capital not efficiently employed in other activities (i.e.,
some additional amount of capital available) due to its being held in reserve
for financing Government securities, will not be incorporated in the base.
In
this case, profitability would be overstated. Alternatively, a capital figure
for diversified firms will certainly include funds which are normally used for
other purposes, leading to an overstated base and understated profitability
figure. At nondiversified firms, of course, both concepts result in the same
capital figure.
Dealers with other activities may not necessarily squeeze borrowings
to the limit, that is, always borrow with minimal margins, siphoning off or
adding capital as the level of positions requires.
In questioning whether or
how much capital in excess of the minimum required is included in observed captal in use by diversified dealers, a feasible normative assumption is suggested,
69
namely that dealers, faced with alternative applications of limited capital,
1
equate the marginal benefits of allocating funds to each activity.
Thus,
capital will be committed to maintaining Governmert securities positions when
it is profitable to do so. When competing needs for capital are slack, presumably borrowings will be minimized, but this will be a function of financing
charges.
2. Measuring bank dealer profitability and position expansion
The selection of a capital measure for bank dealers is not only
difficult but virtually meaningless.
Capital does not function as a constraint
on position expansion nor is it used for calculating profitability.
In sum,
the concepts of capital available and capital in use have no useful interpretation in the bank dealer situation.
The expansion of Government securities positions in the dealer
operations of banks is constrained in the extreme by formal or informal position limits set by management, usually for several maturity categories. Under
certain conditions, these maximum levels may be exceeded at the discretion of
management; alternatively, dealer position expansion may be restrained by
factors not directly related to the "dealer" role.
In particular, several
bank dealers provide considerable assistance to their banks1 reserve adjustment
needs, often through short sales or the placing of repurchase agreements.
Even
though the dealer operation is theoretically divorced from management of the
investment portfolio, it is often integrated both physically and operationallywith the money management centers.
In short, no matter what the formal maximums
may be, expandability may be determined in large part by bank liquidity needs,
which may run counter to securities market considerations, even when profitability of the latter is adequate.
1. Dynamically , capital flows are "created" by shifts in the marginal
revenue functions of various activities arising from changing market conditions,
expectations, and opportunities for capital use in each activity.
70
In trying to estimate bank dealer profitability, we are confronted
with several difficulties.
In the first place, bank dealers may borrow more
heavily in the Federal funds market purely to support dealer positions, on
the theory that the larger borrowings are offset by the liquidity of these
positions.
To this extent, no bank capital is committed at all; the "margin"
in this case is simply the good name of the bank.
Secondly, there is the
problem of defining an appropriate opportunity cost for that amount of funds
in use, be it deposits (and capital) or borrowing, which would have been
2
allocated to other bank activities.
This is perhaps one reason why bankers,
only recently experimenting with functional cost analysis, have not developed
standards for judging dealer profitability.
To quote one banker,
... a black
figure is good; the bigger, the better."
Finally, banks differed in their use of the dealer operation for
servicing customers and, as previously noted, in their assistances in adjusting
reserve positions.
Since many dealers are operationally integrated with other
money management functions, the difficulties of properly allocating expenses,
combined with the tangible costs and intangible returns from servicing customers and assisting reserve adjustment, render any statement of profitability
tenuous at best.
2. Differences in risk between U. S. Government securities operations
and other uses of funds would also have to be taken into account in comparing
returns on funds in use.
@FedFRASER