    Debt Management: Backup Funding Options Would Enhance Treasury's
    Resilience to a Financial Market Disruption (26-SEP-06,
    GAO-06-1007).

    The September 11, 2001, attacks significantly affected the
    financial markets that the U.S. Treasury (Treasury) relies on. To
    understand how Treasury could obtain funds during a future
    potential wide-scale financial market disruption GAO examined (1)
    steps Treasury and others took during the September 11 attacks
    and after to assure required debt obligations and payments were
    made on time and ensure liquidity in the markets, (2) major
    actions Treasury and others have taken since the attacks to
    increase the resiliency of the auction process, and (3) the
    opinions of relevant parties on the main design features of any
    backup funding options. We conducted interviews with Treasury
    officials and others and reviewed appropriate documents.
    -------------------------Indexing Terms-------------------------
    REPORTNUM:   GAO-06-1007
        ACCNO:   A61427
      TITLE:     Debt Management: Backup Funding Options Would Enhance
    Treasury's Resilience to a Financial Market Disruption
         DATE:   09/26/2006
      SUBJECT:   Cash management
    	     Credit
    	     Debt
    	     Federal funds
    	     Federal reserve banks
    	     Financial institutions
    	     Financial management
    	     Funds management
    	     Policy evaluation
    	     Sales
    	     Securities
    	     US Treasury securities

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    GAO-06-1007

         * Results in Brief
         * Background
         * Objectives, Scope, and Methodology
         * Treasury Canceled an Auction and Used Certain Cash Balances
              * Treasury Canceled a 4-week Bill Auction in Response to the
              * Treasury Relied on Compensating Balances to Help Meet Its De
              * Treasury Met Its Debt Obligations on Time, Resumed Auctions
         * Compensating Balances Are No Longer Used
         * The Federal Reserve Used a Number of Methods to Provide Liqu
              * Some Federal Reserve Actions and Financial Market Behavior A
         * Since the Attacks, Treasury and the Federal Reserve Have Add
              * Treasury and the Federal Reserve Have Added Sites for All Fo
              * Treasury Alternates Sites to Process Auctions and Conducts M
              * Treasury Has Adopted a Flexible Contingency Policy for Aucti
         * Primary Dealers Have Taken Actions Intended to Increase Thei
         * Despite Actions Intended to Increase Auction Resilience, Exp
         * Relevant Parties Validated Design Features and a Potential T
              * Obtain a Line of Credit with Financial Institutions
              * Private Placement of a Cash Management Bill
              * Explicitly Authorize a Treasury Draw Authority with the Fede
         * Conclusion
         * Recommendations for Executive Action
         * Matters for Congressional Consideration
         * Agency Comments
         * Appendix I: Cost and Complexity Rule Out Other Options That
              * Holding Additional Cash Balances Would Not Be Cost Efficient
                   * Foreign Central Banks Add Complexity to Obtaining Funds
         * Appendix II: Background on Previous Treasury Draw Authoritie
              * Situations When Treasury Used Previous Draw Authorities
                   * Source of Funding
                   * Collateral Used
                   * Type of Financial Transaction
                   * Approvals on Use of Draw Authority
                   * The Cost of the Draw Authorities
                   * Amount and Time Limits for Use of Draw Authorities
                   * The Inclusion of Draw Authorities in the Debt Ceiling
                   * Disclosure of the Use of the Draw Authorities
                   * Expiration of Draw Authorities
         * Appendix III: Comments from the Department of the Treasury
         * Appendix IV: Comments from the Board of Governors of the Fed
         * Appendix V: GAO Contact and Staff Acknowledgments
              * GAO Contact
              * Acknowledgments
                   * Order by Mail or Phone

    Report to the Chairman, Committee on Ways and Means, House of
    Representatives

    United States Government Accountability Office

    GAO

    September 2006

    DEBT MANAGEMENT

    Backup Funding Options Would Enhance Treasury's Resilience to a Financial
    Market Disruption

    GAO-06-1007

    Contents

    Letter 1

    Results in Brief 2
    Background 5
    Objectives, Scope, and Methodology 8
    Treasury Canceled an Auction and Used Certain Cash Balances to Help Meet
    Its Obligations during the Week of September 11, 2001 10
    Compensating Balances Are No Longer Used 13
    The Federal Reserve Used a Number of Methods to Provide Liquidity to
    Domestic and Foreign Financial Institutions 14
    Since the Attacks, Treasury and the Federal Reserve Have Added Staffed
    Locations and Data System Capability Intended to Increase Auction
    Resilience 18
    Primary Dealers Have Taken Actions Intended to Increase Their Resilience
    and Treasury Has Suggested Additional Improvements 23
    Despite Actions Intended to Increase Auction Resilience, Exploring Funding
    Alternatives Outside of the Auction Process Is Appropriate 25
    Relevant Parties Validated Design Features and a Potential Tiered Approach
    to Treasury Funding Options Has Emerged from Discussions 25
    Conclusion 31
    Recommendations for Executive Action 32
    Matters for Congressional Consideration 33
    Agency Comments 33
    Appendix I Cost and Complexity Rule Out Other Options That Were Discussed
    35
    Appendix II Background on Previous Treasury Draw Authorities 37
    Appendix III Comments from the Department of the Treasury 47
    Appendix IV Comments from the Board of Governors of the Federal Reserve
    System 49
    Appendix V GAO Contact and Staff Acknowledgments 51

    Tables

    Table 1: Matrix Treasury Presented to Dealers on Potential Responses to
    Contingencies 22
    Table 2: Design Features of 1979 Cash and Securities Draw Authorities 38

    Figures

    Figure 1: Treasury Acted to Ensure Funding after the September 11 Attacks
    10
    Figure 2: Four Major Processes Must Be Performed for Treasury to Receive
    Its Cash After Announcement 19
    Figure 3: Current Operations of the Auction and Issuance of Marketable
    Treasury Securities 20
    Figure 4: Concentrated Use of Cash Draw Authority 1942-1981 (Days Federal
    Reserve Held Special Short-Term Treasury Certificates) 40
    Figure 5: Borrowing Concentrated Around Tax Payment Months 1942-1981 (Days
    Federal Reserve Held Special Short-Term Treasury Certificates) 41
    Figure 6: Cash and Securities Draw Authority Transactions 43

    This is a work of the U.S. government and is not subject to copyright
    protection in the United States. It may be reproduced and distributed in
    its entirety without further permission from GAO. However, because this
    work may contain copyrighted images or other material, permission from the
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    separately.

    United States Government Accountability Office

    Washington, DC 20548

    September 26, 2006

    The Honorable William M. Thomas Chairman Committee on Ways and Means House
    of Representatives

    Dear Mr. Chairman:

    The massive destruction caused by the September 11, 2001, attacks on the
    World Trade Center and the resulting loss of life, facilities,
    telecommunications, and power significantly affected U.S. financial
    markets, including the markets for U.S. Treasury (Treasury) securities.
    The attacks exposed the vulnerability to a serious wide-scale disruption1
    of the markets that Treasury relies on as a regular source for financing
    government operations and large, regularly occurring payments such as
    Social Security benefits. In response to the attacks, Treasury canceled a
    scheduled auction of 4-week bills on September 11 and used compensating
    balances-noninterest-bearing cash balances used to compensate banks for
    various services-to help meet its obligations on time.

    However, compensating balances are no longer used. In addition, Treasury's
    cash management policy is to maintain minimal cash balances in order to
    lower borrowing costs. We reported earlier this year that the combination
    of a minimal cash balance policy and the unavailability of previous
    methods for accessing cash warrant closer attention to Treasury's ability
    to raise cash-and ultimately meet federal payment obligations-should
    normal auctions be unavailable in the event of another wide-scale
    disruption to financial markets.2

    In your continuing interest in how Treasury borrows the money required to
    finance the federal government and in recognition of the risks of a
    wide-scale financial market disruption, you asked us how Treasury might
    obtain funds should normal financial market operations be significantly
    degraded or closed due to a catastrophic emergency. Specifically, we
    examined (1) steps Treasury and the Federal Reserve took during the week
    of the September 11, 2001, attacks and during the weeks following the
    attacks to assure required debt obligations and payments were made on time
    and ensure liquidity in the financial markets, (2) major actions Treasury,
    the Federal Reserve, and primary dealers have taken since the September 11
    attacks to increase the resiliency of Treasury's auction process and
    participation, and (3) the opinions of relevant parties3 on the main
    design features of any cash draw authority and how the features would
    affect accountability and congressional oversight, enhance Treasury's
    operations, affect Federal Reserve operations, and influence the views of
    capital market participants.

    1 We broadly refer to a wide-scale disruption as an event that causes a
    severe disruption or destruction of critical infrastructure components
    across a geographic area or that results in a wide-scale evacuation or
    inaccessibility of certain areas.

    2 GAO, Debt Management: Treasury Has Refined Its Use of Cash Management
    Bills but Should Explore Options That May Reduce Cost Further, GAO-06-269
    (Washington, D.C.: Mar. 30, 2006).

                                    Results in Brief

    Treasury canceled a 4-week bill auction and used certain cash balances to
    help meet its obligations during the week of the September 11, 2001,
    attacks. Also in response to the attacks' financial effects, the Federal
    Reserve provided large amounts of liquidity4 to financial institutions.
    Since the attacks, Treasury and the Federal Reserve have added staffed
    locations and data systems capability for critical auction functions.
    Primary dealers-who are awarded a large proportion of Treasury securities
    at auction-have also taken actions intended to increase their resiliency.
    Regardless of actions taken to increase resiliency, exploring other
    funding options is appropriate and a promising two-tiered approach that
    would provide Treasury additional access to cash during a wide-scale
    disruption has emerged.

    To make up for the cash shortfall associated with the cancellation of the
    4-week bill auction in 2001, Treasury used compensating balances, which
    were subsequently eliminated in 2004,5 to help meet its obligations on
    time. It resumed auctions within a week and replaced compensating balances
    within 10 business days of the attacks.

    3 Relevant parties include Treasury and Federal Reserve officials and
    staff, and capital market participants such as traders, senior executives
    of financial institutions, and trade association executives. We also had
    discussions with congressional staff regarding oversight.

    4 The term liquidity is used broadly here to encompass cash and credit in
    hand and promises of credit to meet needs for cash.

    5 Although Treasury's authority to use compensating balances has not been
    eliminated, it no longer uses compensating balances to pay for financial
    agent services. It now directly pays for services, which it says improves
    cash management.

    In the days following the attacks, the Federal Reserve expanded liquidity,
    providing billions of dollars to domestic and foreign financial
    institutions through open market operations, securities lending
    transactions, discount window lending, and other actions.6 As Treasury
    considers an alternative source of cash during a possible future
    wide-scale disruption, it should be cognizant that the Federal Reserve
    was, is, and potentially will be a significant source of liquidity for
    many financial institutions in a crisis.

    Since the September 11 attacks, Treasury and the Federal Reserve, acting
    as Treasury's fiscal agent, have staffed additional operational locations7
    and added data systems capability intended to increase auction resilience.
    Treasury and the Federal Reserve have added locations in different
    geographic regions from their primary locations for all four critical
    auction functions. Treasury periodically tests sites during live auctions,
    conducts mock auctions, and stipulates that if it cannot conduct any
    disrupted auction within an hour of the originally scheduled time it will
    communicate information to market participants as it becomes available.

    Primary dealers have also taken actions to increase resiliency. All
    primary dealers have contingency sites and most have systems that link
    directly to Treasury's auction systems at their contingency sites. Because
    of the nature of financial markets, almost all primary dealer contingency
    locations are well within the same geographic regions as their primary
    sites and most dealers plan on staff relocating to their contingency
    sites.

    Regardless of the progress of resiliency efforts, the nature and impact of
    a potential future wide-scale disruption remain unknown. In addition,
    since compensating balances were eliminated in 2004, Treasury has at least
    one less source of funds on which to rely. Finally, Treasury's cash
    management policy of minimal cash balances to lower borrowing costs
    further limits Treasury's access to cash during a wide-scale disruption.
    The combination of these factors makes it prudent for Treasury to explore
    other funding alternatives to use during a wide-scale disruption. Relevant
    parties with whom we spoke, including primary dealers, agreed.

    6 The discount window is the lending mechanism used by Federal Reserve
    banks to lend funds to depository institutions on a short-term basis to
    cover temporary liquidity needs or reserve deficiencies.

    7 An operational location is a site that is staffed and has systems
    operating during the routine performance of the function.

    These parties also generally agreed that the main design features that
    should be considered when weighing alternative funding options include
    situations for use, type of collateral, transaction type, approvals,
    costs, amount limit, time limit, inclusion under the debt ceiling,
    disclosure, and length of authority (if required). However, the specifics
    would depend on the proposed options.

    Discussions with Treasury and Federal Reserve officials and other relevant
    parties have led us to conclude that a two-tiered approach could enhance
    Treasury's ability to obtain funds during a wide-scale disruption. The
    first tier consists of two funding options involving a range of
    appropriate financial institutions, namely a credit line and a private
    placement of a cash management (CM) bill. The second tier involves a
    direct draw from the Federal Reserve that would provide Treasury a last
    resort source of funds when other options are not viable.

    We recommend that the Secretary of the Treasury determine the main design
    features and examine any implementation requirements for establishing a
    line of credit and a private placement of a CM bill with a range of
    appropriate private sector financial institutions for use during a
    wide-scale disruption, and select the most appropriate option(s). In
    addition, Congress should consider establishing an explicit, carefully
    crafted, last resort draw authority to permit the Federal Reserve to lend
    directly to the Treasury. This authority should be limited to situations
    in which all other funding options are not viable during a wide-scale
    disruption.

    In written comments on a draft of this report, both Treasury and the
    Federal Reserve agreed that Treasury should examine the first-tier funding
    options described in this report. Although neither took a position on our
    suggestion that Congress should consider permitting the Federal Reserve to
    lend directly to the Treasury, both emphasized the importance of
    maintaining the independence of the central bank. For example, Treasury
    stated that it, "is generally opposed to arrangements in which
    governments, at their discretion, can borrow directly from their central
    bank as such arrangements compromise the independence of the central
    bank." As our report notes, we also recognize the importance of
    maintaining the independence of the central bank and suggest an approach
    that we believe provides both flexibility and reduces the vulnerability to
    abuse. Both Treasury and Federal Reserve Board staff also provided
    technical comments which we incorporated as appropriate. Their letters are
    reprinted in appendix III and appendix IV respectively.

                                       Background

    The September 2001 terrorist attacks and the subsequent collapse of the
    twin World Trade Center towers damaged more than 400 structures across a
    16-acre area, and claimed almost 2,800 lives. Financial services industry
    employees accounted for about 74 percent of the victims. Dust and debris
    blanketed the area, creating difficult and hazardous conditions that
    complicated recovery efforts. Many financial organizations lost
    telecommunications service when the 7 World Trade Center building
    collapsed and debris struck a major Verizon central switching office that
    served approximately 34,000 businesses and residences.8 Over 13,000
    customers also lost power. To accommodate the rescue and recovery efforts
    and maintain order, pedestrian and vehicle access to the area encompassing
    the financial district was restricted through September 13, 2001.9

    The attacks severely disrupted the secondary markets for government
    securities and money market instruments primarily because of the impact on
    the brokers that facilitate trading among dealers (broker-dealers) and on
    one of the clearing banks for those trades. Two banks-the Bank of New York
    (BONY) and JPMorganChase-provided clearing and settlement services (and
    still do) for many major broker-dealers in the government securities
    market. Clearing banks transferred funds and securities for their
    customers that purchased or sold government securities based on
    instructions received by the Government Securities Clearing Corporation
    (GSCC).10 As a result of the attacks, BONY had difficulty reestablishing
    its connections with GSCC and its own account at the Federal Reserve, and
    its customers had difficulties connecting with BONY. These problems
    contributed to the disruption of the secondary government securities
    market. BONY had to evacuate four facilities, including its primary
    telecommunications data center and over 8,300 staff, because they were
    located near the World Trade Center. By September 14 BONY reestablished
    connectivity with GSCC and began receiving and transmitting instructions
    for securities transfers.11

    8 When this Verizon facility was damaged, about 182,000 voice circuits,
    more than 1.6 million data circuits, and more than 11,000 lines serving
    Internet service providers were lost.

    9 GAO, Potential Terrorist Attacks: Additional Actions Needed to Better
    Prepare Critical Financial Market Participants, GAO-03-414 (Washington,
    D.C.: Feb. 12, 2003).

    10 Broker-dealers submitted trade information to GSCC, which compared and
    netted this information and sent settlement information to clearing banks,
    such as BONY and JPMorganChase. In 2003, GSCC merged into the Fixed Income
    Clearing Corporation, which now handles the clearing and settlement of
    U.S. government securities for its member firms.

    Both the Federal Reserve's Fedwire Securities Service, which provides
    safekeeping, transfer, and settlement services for securities issued by
    Treasury and other federal agencies, and its Fedwire Funds Service, which
    provides payments services associated with securities sales and other
    large-value transactions, continued processing transactions without
    interruption. Although the Federal Reserve Bank of New York (FRBNY), which
    manages the Fedwire services, sustained damage to some communication
    lines, the Fedwire services were not interrupted because the facilities
    that process transactions were not located in lower Manhattan. Over 30
    banks initially lost connectivity to Fedwire services, but most were able
    to reestablish connections through backup systems, and most payment system
    operations continued with minimal disruption.

    The Federal Reserve, Treasury, and primary dealers all play important
    roles in Treasury auctions. The Federal Reserve and its associated Federal
    Reserve banks function as the United States government's fiscal agent and
    perform a variety of services for the Treasury including handling Treasury
    auctions, accepting bids, communicating bids to Treasury, issuing Treasury
    securities to winning bidders, and collecting payment for securities.

    Treasury borrows the money needed to operate the federal government and
    manages the government's outstanding debt subject to a statutory limit.12
    Treasury's primary debt management goal is to finance the government's
    borrowing needs at the lowest cost over time. To meet this objective,
    Treasury issues debt through auctions in a "regular and predictable"
    pattern across a wide range of securities. Treasury publishes a schedule
    with tentative announcement,13 auction, and settlement (issue) dates up to
    6 months in advance of regular security auctions. Depending on the type of
    security, Treasury typically auctions and then issues a security within a
    week or less. Treasury generally issues short-term regular bills with 4-,
    13-, and 26-week maturities every Thursday and issues 2- and 5-year notes
    at the end of each month. Three- and 10- year notes are issued in the
    middle of each quarter. Treasury reopens 10-year notes-or increases the
    amount outstanding for these notes-1 month after their initial issuance.
    In addition, Treasury issues Treasury Inflation-Protected Securities
    (TIPS) in 5-, 10-, and 20-year maturities in certain months according to
    the TIPS' maturity. 14 Finally, Treasury issues 30-year bonds in February
    and August and reopens these issues in May and November, respectively.

    11 GAO-03-414 .

    12 Treasury's authorities are codified in chapter 31 of title 31 of the
    United States Code.

    13 The tentative auction schedule provides the date but not the actual
    amount of an auction, which Treasury provides in an announcement generally
    a few days prior to auction.

    Treasury supplements its regular and predictable schedule with flexible
    securities called cash management (CM) bills. Unlike for other securities,
    Treasury does not publish information on CM bills on its auction schedule.
    Instead, Treasury generally announces CM bill auctions anywhere from 1 to
    4 days ahead of the auction. The term to maturity-the length of time the
    bill is outstanding-varies according to Treasury's cash needs. CM bills
    allow Treasury to finance very short-term cash needs-for as little as 1
    day-while providing short notice to market participants.15

    As of the end of fiscal year 2005, about 46 percent of marketable Treasury
    securities held by the public will mature during the next 24 months. As
    these securities mature and are replaced by new debt, the cost to finance
    the federal government's debt will vary with changing interest rates.

    The bidders in Treasury auctions include depository institutions,
    individuals, dealers and brokers, pension and retirement funds, insurance
    companies, investment funds, foreign and international entities, the
    Federal Reserve, and others. In recent years the percentage of U.S.
    Treasury securities held internationally has increased. Although the
    categories of bidders are diverse, primary dealers, other commercial bank
    dealer departments, and other nonbank dealers and brokers received almost
    60 percent of auction awards of marketable securities between August 2001
    and May 2006. Federal Reserve banks received almost 21 percent during that
    same time period for their own accounts. Primary dealers are banks and
    securities brokers that trade in U.S. government securities with the
    Federal Reserve. Primary dealers have functioned for over 40 years as the
    distribution and support system for Treasury debt and play a "vital"
    role16 in the price discovery process.17 The FRBNY designates primary
    dealers based on certain capital requirements, and requires primary
    dealers to participate meaningfully in both Federal Reserve open market
    operations and Treasury auctions to maintain their designation. However,
    the Federal Reserve does not have regulatory authority over dealers acting
    in the primary dealer role.

    14 GAO-06-269 .

    15 For more information on CM bills see GAO-06-269 .

    In the past, outside of the auction process, Treasury had access to a cash
    draw authority intended for emergencies. Intermittently between 1942 and
    1981, Treasury was able to directly sell (and purchase) certain short-term
    obligations to (and from) the Federal Reserve in exchange for cash.
    Treasury used the cash draw authority infrequently and mostly in times of
    war or armed conflict. Congress last granted the authority in 1979 and
    limited the amount Treasury could draw to $5 billion. Congress allowed
    this authority to expire in 1981 (see app. II for more background
    information). Although the existence of a previous draw authority is
    relevant, we are not suggesting restoration of this authority in its
    previous form due to certain limitations.

                           Objectives, Scope, and Methodology

    To understand the steps that Treasury and the Federal Reserve took during
    the week of the September 11 attacks and during the following weeks to
    assure required debt obligations and payments were made on time and ensure
    liquidity in the financial market, we conducted interviews with
    knowledgeable Treasury and Federal Reserve officials and staff. We also
    reviewed prior audit reports and other documentation from GAO, the Federal
    Reserve, and Treasury. We analyzed and examined these sources to develop a
    time line with key actions and to determine actions and financial market
    behavior that are informative when considering alternative funding sources
    for Treasury.

    To understand major actions Treasury, the Federal Reserve, and primary
    dealers have taken since the September 11 attacks to increase the
    resiliency of Treasury's auction process and participation, we interviewed
    Treasury and Federal Reserve officials and staff involved in conducting
    primary dealer visits, the auction process, and systems. We reviewed
    Treasury contingency and continuity of operations (COOP) plans and other
    documents that described contingency sites, staff training topics,
    contingency exercise results, and other Treasury summaries. We also
    interviewed executives and staff involved and familiar with resiliency
    efforts at 14 primary dealers and executives involved with emergency
    planning at The Bond Market Association, the industry association
    representing participants in the government securities and other debt
    markets. In addition, some of our work was based on internal knowledge
    derived from Treasury audits we have conducted in the past.

    16 See Remarks of the Under Secretary Brian C. Roseboro before The Bond
    Market Association's Annual Meeting, April 22, 2004, js-1454.

    17 Price discovery is the process that primary dealers undertake that
    determines an appropriate clearing price at auction.

    To describe the opinions of relevant parties on the main design features
    of any cash draw authority and how the features affect accountability and
    congressional oversight, enhance Treasury's operations, affect Federal
    Reserve operations, and influence the views of capital market
    participants, we interviewed Treasury officials involved with debt
    management, policy, operations, fiscal management, auctions, and legal
    matters. Further, we interviewed Federal Reserve officials involved with
    monetary affairs, open market and discount window operations, and Treasury
    auction staff and researchers. In addition, we communicated with foreign
    debt management officials, and conducted interviews with executives and
    staff involved with Treasury auctions at 14 primary dealers and senior
    executives at two major commercial banks. We also spoke with other capital
    market participants, and had discussions with senior congressional staff
    concerned with oversight. We analyzed relevant Treasury, Federal Reserve,
    and capital market documentation to obtain government and capital market
    perspectives. We validated, with relevant parties, main design features
    for consideration when structuring an alternative cash draw arrangement
    and looked for emerging funding options based on discussion with relevant
    parties.

    We conducted our review in Washington, D.C., and New York, N.Y., from
    March 2006 through September 2006 in accordance with generally accepted
    government auditing standards.

      Treasury Canceled an Auction and Used Certain Cash Balances to Help Meet Its
                   Obligations during the Week of September 11, 2001

    Treasury took a number of steps in reaction to the September 11 attacks to
    ensure it met its obligations during a time of disrupted financial
    markets, as summarized in figure 1. It canceled an auction scheduled for
    September 11, withdrew compensating balances held in depository
    institutions across the country, communicated with the FRBNY about the
    status of markets, and resumed its normal auction schedule within 1 week
    of the attacks.

    Figure 1: Treasury Acted to Ensure Funding after the September 11 Attacks

    Treasury Canceled a 4-week Bill Auction in Response to the Attacks' Effects

    Treasury decided to postpone and then cancel a planned auction of $10
    billion worth of 4-week bills because of financial market degradation due
    to the September 11 attacks. In addition, various infrastructure concerns
    at the FRBNY made it unclear whether it could have conducted an auction.18
    Following its normal borrowing schedule, on September 10 Treasury
    announced its intention to auction $10 billion worth of 4-week bills on
    September 11 to help pay off $11 billion worth of 4-week bills that were
    about to mature on September 13.

    According to a senior Treasury debt management official, after the
    September 11 attacks, Treasury initially wanted to postpone but not cancel
    the auction. Treasury officials consulted with the FRBNY about market
    conditions and learned that some primary dealers had evacuated their
    office buildings that morning.

    As the magnitude of the attacks became clearer Treasury decided to cancel
    the auction. A markets officer in charge of Treasury auction staff located
    at the FRBNY told us that it was unclear if they could have executed the
    auction because of evacuations, structural integrity, and other concerns
    at the time. Treasury issued a press release on September 12 confirming
    the cancellation of the 4-week bill auction and that Treasury had no plans
    for rescheduling the auction. Treasury officials determined that canceling
    the auction would not damage Treasury's reputation for "regular and
    predictable" auctions, given the nature of the attacks.

    Treasury Relied on Compensating Balances to Help Meet Its Debt Obligations

    Treasury decided on September 11 to initiate procedures to withdraw almost
    $13 billion of compensating balances-noninterest-bearing cash balances
    that Treasury used to compensate banks for various services-to make up for
    the cash shortfall associated with the cancellation of the $10 billion
    4-week bill.19 Treasury officials told us that they wanted to pull back as
    much cash as possible and as quickly as possible without harming the
    financial position of the banks. Treasury's ending operating cash balance
    on September 11 was just a little over $11 billion, which would have been
    insufficient to pay off maturing 4-week bills on September 13, meet
    Treasury's other obligations, and maintain the $5 billion target in its
    Federal Reserve account.

    18 According to Treasury, the Bureau of Public Debt-a bureau of the
    Treasury--could have conducted the auction since its systems were
    available and operational.

    19 The total impact on Treasury's cash balance resulting from the
    cancellation of the auction was a shortfall of $11.5 billion, including
    $1.5 billion of Federal Reserve holdings scheduled to be rolled into the
    4-week bill. So, other things being equal, Treasury would have had to pull
    $11.5 billion in compensating balances to make up for the cancellation of
    the 4-week bill.

    Treasury contacted banks across the country holding compensating balances
    on September 11 and asked them to confer with other bank executives and
    consider whether withdrawing a total of $12.6 billion on September 13
    would cause any harm to the banks' operations. The banks responded that
    the withdrawals would not, and according to senior Treasury officials,
    also offered to help Treasury in any way during the crisis. Treasury
    transmitted formal letters on September 12 specifying amounts to be
    withdrawn on September 13. On that date Treasury received the $12.6
    billion from compensating balances and returned posted collateral to
    applicable banks. Treasury did not pay any penalties because compensating
    balances could be withdrawn by Treasury at any time, and no
    telecommunications problems were encountered in completing the transfers.

    Treasury Met Its Debt Obligations on Time, Resumed Auctions within a Week, and
    Replaced Compensating Balances within 10 Business Days of the Attacks

    Treasury paid almost $43 billion in maturing bills (including about $11
    billion of maturing 4-week bills) and received about $35 billion from
    issuing bills on September 13. Additionally, on September 13 Treasury
    announced its intention to auction 13- and 26- week bills and executed the
    auction on September 17, 2001, awarding almost $35 billion, resuming its
    normal auction schedule. In deciding to resume auctions, Treasury held
    conversations with market participants and the FRBNY who conveyed that the
    market was ready to bid on auctions. The September 17 auction proceeded
    normally according to one senior debt management official and bid-to-cover
    ratios20-a commonly cited measure of auction performance and market demand
    for securities-were similar to the 13- and 26-week bill auctions held just
    before September 11.

    20 The bid-to-cover ratio is the ratio of the amount of bids received in a
    Treasury security auction compared with the amount of awarded bids. The
    13-week bill auction on September 10, 2001, resulted in a bid-to-cover
    ratio of 2.06, and the September 17, 2001, auction resulted in a ratio of
    2.31. The 26-week bill auction on September 10, 2001, resulted in a
    bid-to-cover ratio of 2.29, and the September 17, 2001, auction resulted
    in a ratio of 2.19.

    Finally, Treasury replaced $11.2 billion of compensating balances on
    September 21 and another $2 billion on September 24.21 Banks were required
    to pledge certain types of collateral to secure compensating balances and
    one bank could not pledge enough collateral until September 24.

                        Compensating Balances Are No Longer Used

    Treasury replaced compensating balances with direct payments to banks for
    certain services in 2004.22 This effectively eliminated the alternative
    source of funds Treasury had drawn on during the September 11 attacks.
    Compensating balances were-as the name implies-noninterest-bearing
    balances deposited in banks to compensate them for collecting tax and
    nontax receipts. Banks could make loans or buy investments with the
    compensating balances, which were fully collateralized.

    The amount of any compensating balance was determined by Treasury based on
    specified interest rates.23 Current Treasury officials told us that they
    did not view compensating balances as a substitute cash backup source
    except in extraordinary circumstances. Further, a combination of
    circumstances starting in 2002 made compensating balances "inefficient and
    disruptive" for Treasury.24 Declining interest rates required increases in
    balances while the need to stay under the debt-limit25 required decreases
    in balances, which later had to be reversed and increased to unusually
    high levels. For example, September end-of-month compensating balances
    increased from about $6 billion, to $13 billion, and then to $27 billion
    in fiscal years 2000, 2001, and 2002, respectively. Treasury began to
    phase out compensating balances in 2003 and drew down the compensating
    balances to zero in 2004.

    21 Treasury replaced $12.6 billion in compensating balances and deposited
    an additional $0.6 billion in compensating balances based on certain
    requirements that determined the amount.

    22 Section 218 of the Transportation, Treasury, and Independent Agencies
    Appropriations Act, 2004, Pub. L. No. 108-199, Div. F, 118 Stat. 279, 321
    (Jan. 23, 2004), established a permanent, indefinite, appropriation for
    Treasury to reimburse financial institutions for depository and financial
    services previously reimbursed by means of compensating balances.

    23 The banks' compensation for performing these services was based on the
    imputed earnings from the compensating balances calculated at the 91-day
    Treasury bill rate. Treasury determined the amount to deposit by comparing
    the value of services provided with the imputed earnings on the
    compensating balances.

    24 U.S. Office of Management and Budget, Budget of the U.S. Government,
    Analytical Perspectives, Fiscal Year 2006 (Washington, D.C.: 2005), p.
    249.

    25 The debt limit is a legal ceiling on the amount of gross federal debt
    (excluding some minor adjustments), which must be raised periodically by
    Congress to accommodate additional federal borrowing.

     The Federal Reserve Used a Number of Methods to Provide Liquidity to Domestic
                           and Foreign Financial Institutions

    Consistent with its goal of maintaining the stability of the financial
    system and containing systemic risks, the Federal Reserve took action in
    response to the attacks' financial effects. The Federal Reserve
    communicated that it was available as a source of liquidity and provided
    billions of dollars through various means to banks and financial market
    participants experiencing liquidity problems as a result of the September
    11 attacks.

    The Federal Reserve announced its willingness to provide liquidity on
    September 11 several times via systems and official statements. For
    example, soon after the attacks the Federal Reserve broadcast that it was
    fully operational on the Fedwire system-the Federal Reserve's large-value
    electronic payment system. In a second broadcast message it announced that
    it was available to meet liquidity needs. Around noon, the Federal Reserve
    Board of Governors issued a press release stating that "The Federal
    Reserve System is open and operating. The discount window is available to
    meet liquidity needs." These statements along with others by a Federal
    Reserve governor and a Federal Reserve bank president on that day26 were
    intended to reassure financial markets that the Federal Reserve System was
    functioning normally and to encourage banks to view the discount window as
    a source of liquidity. According to a then Director of Research at the
    Federal Reserve Bank of Richmond who has since become that bank's
    President, the statements also signaled to banks a "distinct" shift in how
    the Federal Reserve would view discount window borrowing.27

    The Federal Reserve provided liquidity through discount window and open
    market operations. We previously reported that banking regulatory staff
    told us that the attacks largely resulted in a funding liquidity problem
    rather than a solvency crisis for banks.28 Thus, the challenge the Federal
    Reserve faced was ensuring that banks had adequate funds to meet their
    financial obligations. Settlement problems also prevented broker-dealers
    and others from using the repo markets29 to fund their daily operations.
    In 4 days after the attacks, the Federal Reserve provided billions of
    dollars to banks through various means to overcome the problems resulting
    from unsettled government securities trades and financial market
    dislocations. For example, the Federal Reserve provided $37 billion in
    overnight credit through its discount window on September 11, $46 billion
    on September 12, and $8 billion on September 13. In contrast, no overnight
    discount window credit was provided on September 10 and September 14. It
    also conducted securities purchase transactions and other open market
    operations to provide needed funds to illiquid institutions. For example,
    the Federal Reserve held a zero end-of-day balance in overnight repos on
    September 10 and September 11, but end-of-day balances increased to $38
    billion on September 12 and peaked at $81 billion on September 14 during
    the 4 days following the attacks. In addition, the Federal Reserve waived
    daylight overdraft fees for all account holders and eliminated the penalty
    on overnight overdrafts for depository institutions from September 11
    through September 21. Had these actions not been taken, some firms unable
    to receive payments may not have had sufficient liquidity to meet their
    other financial obligations, which could have produced other defaults and
    magnified the effects of September 11 into a systemic solvency crisis.

    26 See statements by Federal Reserve Governor Edward Gramlich and Federal
    Reserve Bank of New York President William McDonough in Jeffrey M. Lacker,
    "Payment System Disruptions and the Federal Reserve Following September
    11, 2001," Journal of Monetary Economics, vol. 51, issue 5 (July 2004),
    935-965.

    27 See Jeffrey M. Lacker, "Payment System Disruptions and the Federal
    Reserve Following September 11, 2001," Journal of Monetary Economics, vol.
    51, issue 5 (July 2004), 935-965.

    The Federal Reserve provided additional liquidity by continuing its normal
    check crediting schedule despite delays in transportation. The grounding
    of air transportation complicated and delayed some check clearing, since
    both the Federal Reserve and private providers relied on overnight air
    delivery to transport checks between banks in which they are deposited and
    banks on which they are drawn. The Federal Reserve continued to credit the
    value of deposits to banks even when it could not present checks and debit
    the accounts of paying banks. The Federal Reserve decided to not offset
    this float through open market operations to continue providing liquidity.
    Crediting banks for deposited checks before receiving the corresponding
    credit from banks on which the checks were drawn causes float. This
    additional liquidity-normally less than $1 billion outstanding at any one
    time-peaked at over $47 billion on September 13, 2001.

    28 GAO, Potential Terrorist Attacks: Additional Actions Needed to Better
    Prepare Critical Financial Market Participants, GAO-03-414 (Washington,
    D.C.: Feb. 12, 2003).

    29 Repo or a repurchase agreement is a form of short-term collateralized
    borrowing used by dealers in government securities. See GAO-06-269 for
    more information on repurchase agreements.

    To provide dollars needed by foreign institutions, the Federal Reserve
    also arranged new or expanded swap lines with the Bank of Canada, the
    European Central Bank, and the Bank of England. The swap lines involved
    exchanging dollars for the foreign currencies of these jurisdictions,30
    with agreements to re-exchange amounts later. These temporary arrangements
    provided funds to settle dollar-denominated obligations of foreign banks
    whose operations were affected by the attacks.

    According to a Federal Reserve official, the large injections of liquidity
    were also necessary in part to offset large reserve drains from other
    autonomous factors-factors that affect the supply of balances but are
    generally outside the control of the Federal Reserve. For example, as
    previously noted, the level of check float peaked at $47 billion on
    September 13 and a foreign currency swap added $20 billion of balances on
    that same day, but another autonomous factor reduced balances by over $30
    billion on that day, which was between $15 billion and $20 billion more
    than prior levels.

    To further increase liquidity, the Federal Open Market Committee (FOMC)31
    announced on September 17 that it would lower its federal funds target
    rate by 50 basis points32 to 3 percent and the Federal Reserve Board of
    Governors approved a 50 basis point reduction in the discount rate to
    2-1/2 percent.33 In its announcement the Federal Reserve stated that it
    would "continue to supply unusually large volumes of liquidity to the
    financial markets, as needed, until normal market functioning is
    restored." The FOMC acknowledged that the actual federal funds rate might
    fall below its target in this situation. According to a then Director of
    Research at the Federal Reserve Bank of Richmond, who has since become
    that bank's President, market participants expected a decline in the
    federal funds rate driven perhaps by the large amount of liquidity
    injected by the Federal Reserve, creating excess reserve balances.34

    30 Although swap lines permitted up to a total of $90 billion to be
    exchanged, the maximum foreign currency swap during this period was about
    $20 billion on September 13, 2001.

    31 As part of the Federal Reserve, the Federal Open Market Committee
    oversees open market operations, which are used to implement monetary
    policy on a day-to-day basis.

    32 One basis point is equal to 1/100th of a percent. Thus, 50 basis points
    are .50 percentage points.

    33 The Federal Reserve Board of Governors exercises general supervision
    over the operations of the Federal Reserve banks. The Federal Reserve
    banks establish the discount rates subject to review and determination of
    the Federal Reserve Board of Governors.

    Market participants typically use government securities as collateral for
    financing or to meet settlement obligations. When some broker and bank
    facilities were destroyed or lost connectivity, the results of trading
    information, such as amounts of securities or funds to transfer and the
    ability to transfer funds, were lost or degraded for days. If trade
    information is not correct and funds and securities are not properly
    transferred, the trade will be considered a "fail." To help alleviate
    failed trades resulting from the attacks, the Federal Reserve and Treasury
    loaned and auctioned securities respectively. From September 11 through
    September 13, the Federal Reserve loaned $22 billion of securities from
    its portfolio to broker-dealers that needed securities to complete
    settlements of failed trades. The Federal Reserve also reduced
    restrictions on its securities lending, leading to a sharp increase in
    borrowing at the end of September 2001.35

    Treasury also conducted an unplanned, special issuance of 10-year notes in
    order to prevent a possible financial crisis.36 According to current and
    former Treasury officials involved with this decision, on September 17 it
    became evident that the stopped and incomplete trading on September 11
    resulted in increasing fails in the secondary market. Treasury officials
    described how a rapid rise in fails at the end of September and beginning
    of October was based on demand for the 5- and 10-year notes. After
    conferring with capital market participants who recommended a reopening,
    or increasing the amount outstanding, of the 5- or 10-year notes, Treasury
    officials decided to reopen the 10-year note. They reasoned that since the
    note was already scheduled to reopen in November, investors--who were
    anticipating the November reopening--would be better prepared for the
    issuance than for a 5-year note. Treasury officials concluded that the
    additional supply of the 10-year note produced a positive "psychological"
    effect on markets by providing increased confidence about the certainty of
    supply helping to decrease fails in the 5- and 10-year notes trades.

    34 See Jeffrey M. Lacker, "Payment System Disruptions and the Federal
    Reserve Following September 11, 2001," Journal of Monetary Economics, vol.
    51, issue 5 (July 2004), 935-965.

    35 The Federal Reserve loans out securities from its System Open Market
    Account (SOMA) subject to certain limits. The Federal Reserve suspended
    per dealer limits on SOMA holdings on September 11 and further loosened
    terms on September 13.

    36 GAO-03-414 .

    Some Federal Reserve Actions and Financial Market Behavior Are Informative When
    Considering Alternative Funding Sources for Treasury

    Immediately after the September 11 attacks, many financial institutions,
    including some foreign central banks, looked to the Federal Reserve to
    provide liquidity through various methods. As Treasury considers potential
    financial institutions for funding sources during a wide-scale disruption,
    it will need to remain cognizant of the fact that the Federal Reserve was,
    is, and potentially will be, the provider of liquidity for many financial
    institutions in a crisis. Further, the amount and terms of the liquidity
    provided by the Federal Reserve to financial institutions will likely
    affect the characteristics of any funding alternatives available to
    Treasury. As discussed previously, the Federal Reserve eased restrictions
    and lowered interest rate targets to provide expanded liquidity to
    financial institutions. Finally, the market fails and other collateral
    issues in the secondary market may affect the type of security Treasury
    will want to issue in a crisis. Treasury officials recognize that during a
    crisis, investors tend to exhibit a "flight-to-quality" behavior, moving
    their capital away from riskier investments to safer investment vehicles,
    such as U.S. Treasury securities. These considerations are discussed later
    in this report.

    Since the Attacks, Treasury and the Federal Reserve Have Added Staffed Locations
           and Data System Capability Intended to Increase Auction Resilience

    After an auction is announced, the critical functions that must occur
    without interruption for Treasury to raise the required funds from the
    issuance of Treasury securities are (1) auction, (2) prepare issue file,
    (3) issue securities, and (4) cash transfer (see fig. 2). If any of these
    functions are disrupted, Treasury would not be able to obtain the cash
    needed from an auction. During the September 11 attacks, Treasury and the
    Federal Reserve, acting as Treasury's fiscal agent, had two operational
    locations to conduct auctions, one operational location to prepare files
    with important issuance information, one operational location to issue
    securities, and one operational location with a secondary location-which
    could be activated if necessary-to transfer cash. Since then, Treasury and
    the Federal Reserve have added locations for all of Treasury's critical
    auction process functions.

    Treasury depends on certain systems to auction and issue its securities.
    The critical systems that must be operational for an auction to occur and
    for Treasury to receive the funds from that auction are (1) the auction
    system which receives and processes bids for securities, (2) the funds and
    securities transfer system, (3) the book-entry accounting system, and (4)
    the cash reporting system. In addition, since the September 11 attacks the
    Federal Reserve has strengthened its out-of-region data system capability.
    Figure 2 describes each of these processes and associated systems.

    Figure 2: Four Major Processes Must Be Performed for Treasury to Receive
    Its Cash After Announcement

    Treasury and the Federal Reserve Have Added Sites for All Four Critical
    Functions Since the September 11 Attacks

    Treasury and the Federal Reserve have added sites that are geographically
    separated from each other for all four of Treasury's critical auction
    functions, as seen in figure 3. Contingency sites are located in different
    geographic regions and do not require staff to relocate from the primary
    site, while backup facilities are generally located in the same region as
    the sites they are intended to backup. For example, staff would relocate
    from a primary site, like site A in figure 3, to the cold backup facility
    listed under site A in a contingency.

    Figure 3: Current Operations of the Auction and Issuance of Marketable
    Treasury Securities

    Notes: Gray sites have been added since the September 11 attacks.

    A hot site is generally staffed and has systems operating during the
    routine performance of the function. Hot sites simultaneously perform the
    function.

    A warm site is generally staffed and has systems operating on a periodic
    basis (i.e., bi-weekly) or is aware and ready to take over when necessary
    during the operations of the function.

    A cold site is generally not staffed to perform its associated function on
    a routine or nonroutine basis until the organization deems it necessary
    due to some contingency.

    Auctions can now be performed at three operational locations with one
    backup facility. All three locations are fully operational for every
    auction.

    Issuance files can now be prepared at one operational location with a
    backup facility and one semi-operational location. Site D is
    geographically separated from site A, periodically performs the functions
    for specific auctions, and can be immediately activated to perform the
    tasks of this function. Further, site A has trained staff at its backup
    facility that can perform the tasks of this function after being notified
    of a contingency situation or event.

    Securities can now be issued at one operational location with a backup
    facility and one semi-operational location. Site E periodically performs
    the function of issuing securities for specific auctions approximately
    once every 2 weeks. This site is also geographically located in another
    region.

    The cash transfer function has added two cold contingency locations since
    September 11, 2001. Site B is the primary location and sites G and H are
    the secondary locations, which are geographically separated from site B
    and can be activated in the case of a contingency event. Site C is now a
    third contingency location that was a secondary location at the time of
    the September 11 attacks.

    Treasury Alternates Sites to Process Auctions and Conducts Mock Auction Tests

    Treasury periodically switches auction processing between sites during
    live auctions to test their readiness and conducts mock auctions. For
    example, in one exercise, Treasury directed one site to take over the
    auction processing from another site during a live auction. Treasury
    reported the test a success since staff demonstrated their ability to
    "seamlessly" take over and perform auction closing procedures, release
    auction results, and complete other normal post-auction activities. In
    another exercise, Treasury conducted a manual mock auction to expose staff
    to an atypical situation and reported achieving its objective of
    calculating auction results within 2 hours.37

    Treasury Has Adopted a Flexible Contingency Policy for Auction Disruptions

    In April 2003, Treasury began discussing options for postponing a
    scheduled auction "when the market is operating in a contingency or
    extraordinary environment" with dealers. In July of that year, Treasury
    presented dealers with a matrix of contingencies and Treasury responses,
    shown in table 1.

    37 Calculating results within 2 hours assumes all bids have been received
    and processed.

    Table 1: Matrix Treasury Presented to Dealers on Potential Responses to
    Contingencies

    Contingency                          Treasury response
    Treasury/Fed operational/technical   Delay auction.a Notify market of
    problems                             specific length of delay (e.g., 1
                                            hour).
    Treasury/Fed systems failure         Reschedule auction.

                                            Notify market of rescheduling with
                                            specific date and time if possible.
                                            If not immediately possible, provide
                                            follow-up with specific date and time
                                            as soon as feasible.
    Bidder connectivity disrupted (some  Response will depend on strength of
    participants affected, auction still auction coverage. If delay is
    covered)                             necessary, then notify market of
                                            specific length of delay (e.g., 1
                                            hour).
    Bidder connectivity disrupted (many  Delay auction.a Notify market of
    participants affected, auction not   specific length of delay (e.g., 1
    covered)                             hour).
    Independent of connectivity auction  Delay auction.a Notify market of
    not covered                          specific length of delay (e.g., 1
                                            hour).

    Source: U.S. Treasury.

    aIf an auction is delayed for any reason, Treasury will notify the market
    of the delay and the new closing time. In all cases, a delay will cause
    Treasury to reject all competitive bids already tendered and participants
    will need to resubmit competitive bids when the auction resumes.

    Treasury gathered feedback from participants and concluded a more flexible
    contingency approach would be appropriate. Treasury told us that some
    dealers suggested that writing rules for various contingencies may be too
    burdensome and that it may be to Treasury's advantage to remain discreet
    on how certain auction fails will be handled. For example, in the case
    where one or two dealers have missed the auction, and if the auction was
    covered sufficiently, then Treasury may want to complete the auction
    without the missing parties. Treasury told us that it needs a flexible
    approach because there are an "infinite number of possible situations" to
    which it might have to respond, so the best it can do is provide general
    guidelines about how it will respond. According to Treasury, the matrix of
    Treasury responses to a number of possible contingencies was generally
    considered comprehensive and reasonable by the dealers they interviewed.

    The Bond Market Association (TBMA)38 commended Treasury for developing the
    matrix of possible circumstances, but encouraged Treasury to expand its
    list of contingencies to include actions Treasury would take in the face
    of extraordinary circumstances such as natural disasters, terrorist
    attacks, suspension of trading, or a disruption to the clearance and
    settlement system. TBMA proposed that Treasury delay and reschedule an
    auction in these circumstances, while notifying the market with a specific
    date and time if possible or provide this information as soon as feasible.
    The association predicted that market participants would likely support
    the decision to delay the auction, assuming the securities were still
    auctioned and settled by the originally announced issuance date. TBMA
    stated that it was unclear what the impact of these circumstances would be
    on future auctions.

    This discussion process resulted in the following Treasury statement in
    February 2004: "Treasury will conduct any announced auction that is
    disrupted within an hour of the originally scheduled time and in the event
    that circumstances and conditions are such that a one hour postponement
    cannot be met, Treasury will communicate information to market
    participants as it becomes available."

      Primary Dealers Have Taken Actions Intended to Increase Their Resilience and
                     Treasury Has Suggested Additional Improvements

    All primary dealers have contingency sites. According to Treasury, most
    primary dealers have systems that link directly to Treasury's auction
    systems at their contingency sites and have conducted connectivity tests
    to ensure they could participate in an auction from their contingency
    sites if required. Because of the nature of the financial markets, almost
    all primary dealer contingency locations are within the same geographic
    region as their primary sites. Treasury periodically visits dealers, and
    has suggested improvements in systems and testing for many dealers.
    According to 14 dealers with whom we spoke, dealer personnel are
    cross-trained to bid on and complete auctions for all types of Treasury
    securities.

    A Treasury official with whom we spoke noted that the nature of financial
    markets encourages the close proximity of staff. A professor of economics
    has stated, "high density levels are particularly conducive to chance
    meetings, regular exchanges of new ideas, and the general flow of
    information" 39 that aid in the rapid access to information that is
    crucial to financial markets. This likely helps to explain why almost all
    primary dealers' primary sites are within the same geographic region. All
    23 primary dealers also have at least one contingency site for their
    operations, generally in the same geographic region as their primary
    sites, since most primary dealers plan on relocating their staff from
    their primary sites to their contingency sites during a wide-scale
    disruption. Treasury expects this migration might take several hours.
    Treasury also expects it might have to postpone an auction for a day,
    depending on the severity of the disruption, so dealers have enough time
    to report to their contingency sites.

    38 TBMA is an industry association representing participants in the
    government securities and other debt markets.

    According to Treasury officials, 17 primary dealers40 have added systems
    at their contingency sites that directly link with Treasury auction
    systems and have successfully tested the connectivity of these systems.
    Treasury encouraged dealers to add these systems and offered cost
    information on these systems so dealers could more easily consider the
    systems implementation. All of the dealers have the ability to submit
    auction bids via the Internet or phone at their contingency sites.

    Eight dealers41 have told Treasury that they have participated in live
    auctions from their contingency sites, but Treasury told us that its
    auction systems do not automatically track whether or not dealers are
    participating in auctions from contingency sites. Treasury has encouraged
    dealers to conduct live auction tests from their contingency sites and
    plans to continue to work with primary dealers to increase their
    resiliency by developing test plans for primary dealers to participate in
    mock auctions. One dealer expressed reservations about participating in an
    auction from a contingency site because it would not want to take bids
    from traders over the phone, while another dealer stated that it planned
    to conduct a mock auction before participating in a live auction from the
    contingency site.

    Primary dealers we spoke with said they have cross-trained their staff to
    participate in auctions of different Treasury securities and told us that
    they have sufficient staff trained to participate and provide backup
    support. These same dealers estimated about 15 to 20 people per dealer are
    involved in the Treasury auction process, including support personnel.
    While some dealers indicated that their overseas staff are able to
    participate in auctions, other dealers expressed reservations about the
    readiness of their overseas staff to bid on auctions. In addition, while
    some dealers report having backup personnel for traders and multiple
    sites, one reports that backup personnel are in the same location as
    traders, and most plan on relocating their staff from primary locations to
    their contingency sites during a wide-scale disruption.

    39 Edward L. Glaeser, "Urban Colossus: Why is New York America's Largest
    City?" FRBNY Economic Policy Review (December 2005), p. 22.

    40 As of August 2006, 3 additional primary dealers have installed systems
    that directly link with Treasury auction systems and are in the process of
    conducting user tests.

    41As of August 2006.

    Despite Actions Intended to Increase Auction Resilience, Exploring Funding
               Alternatives Outside of the Auction Process Is Appropriate

    Regardless of the progress of resiliency efforts, the nature, duration,
    and effects of any potential future wide-scale disruption are unknown. In
    addition, since compensating balances are no longer used, Treasury has at
    least one less source of funds to rely upon. Current Treasury officials
    stated they had not viewed compensating balances as a cash source except
    in extraordinary circumstances such as the September 11 attacks, and a
    former Treasury official acknowledged that compensating balances provided
    extra flexibility for Treasury. Finally, Treasury's cash management policy
    of maintaining minimal cash balances to lower borrowing costs further
    limits Treasury's access to cash during a wide-scale disruption. The
    combination of these factors makes it prudent for Treasury to explore
    alternative backup funding options to use during a wide-scale disruption.
    The relevant parties with whom we spoke, including primary dealers,
    agreed.

     Relevant Parties Validated Design Features and a Potential Tiered Approach to
                 Treasury Funding Options Has Emerged from Discussions

    These parties also generally agreed that the main design features to be
    considered when weighing alternatives for backup funding options are the
    situations for use, source of funds, type of collateral, transaction type,
    approvals, determination of cost, amount limit, time limit, inclusion
    under debt ceiling, disclosure, and length of authority (if required).
    However, the specifics would depend on proposed options. For example, some
    parties thought that borrowing from the Federal Reserve should require
    higher level approval than borrowing from financial institutions.

    Discussions with Treasury and Federal Reserve officials and other relevant
    parties have led us to conclude that a two-tiered approach could enhance
    Treasury's ability to obtain funds during a wide-scale disruption. We
    discussed design features and broad options with relevant parties and
    progressively adjusted options based on comments and our own analysis. The
    two-tiered approach is suggested as a strategy to be used only when
    auctions are not viable based on some sort of wide-scale disruption to the
    financial markets that Treasury relies upon, and not as a substitute or
    complement to Treasury's normal auction process when market prices become
    expensive, or cash balances are lower than expected. The first tier
    consists of two funding options involving a range of appropriate financial
    institutions, namely (1) a credit line and (2) a private placement of a CM
    bill. The second tier involves a direct draw from the Federal Reserve that
    would provide Treasury a last resort source of funds when other options
    are not viable. Under this system, Treasury would first seek to use the
    credit line and/or the private placement of a CM bill. Then, if and only
    if those options are not available or insufficient, would it turn to the
    Federal Reserve.

    Any system for obtaining cash from financial institutions-whether through
    a line of credit or private placement of a CM bill-may, in a crisis,
    ultimately depend on the Federal Reserve to provide liquidity to those
    institutions.42 One party suggested the viability of a credit line or a
    private placement of a CM bill would likely be enhanced if these options
    involved depository institutions that could borrow from the discount
    window. Most market participants with whom we spoke preferred a direct
    draw authority for the Treasury. Although that might be the most direct
    route, we recognize the importance of maintaining the independence of the
    central bank. For example, some economists believe that if a central bank
    regularly lends money to the government (Treasury), it would lead to an
    expansion of the monetary base and inflation and the expectation that the
    central bank would lend to the government whenever the government wants.

    The Committee on Banking and Currency also recognized the importance of
    central bank independence in the establishment of the Federal Reserve in
    1913. In its report the committee stated, "It can not be too emphatically
    stated that the committee regards the Federal reserve board as a
    distinctly nonpartisan organization whose functions are to be wholly
    divorced from politics. In order, however, to guard absolutely against any
    suspicion of political bias or one-sidedness, it has been deemed expedient
    to provide in the law against a preponderance of members of one party."43

    42 The Federal Reserve's regular lending authority generally extends only
    to depository institutions.

    43 H.R. Rep. No. 63-69, at 43 (1913).

    A tiered approach would recognize independence concerns, offering both
    flexibility and protection against the potential for abuse because of its
    two-stage structure. The availability of the first tier would provide
    Treasury an extra option(s) outside of its normal auction process to
    obtain funds making it less likely that Treasury would have to go to the
    second tier, the Federal Reserve, as a last resort funding option.

    Some relevant parties with whom we spoke noted that consideration of how
    any funding option would interact with the debt ceiling is important to
    consider given the number of times in recent years Treasury has operated
    in an environment under debt ceiling constraints, including debt issuance
    suspension periods (DISP).44 A wide-scale disruption such as occurred on
    September 11 could also result in a delay in congressional action to raise
    the debt limit. This in turn could worsen any problems in the government's
    ability to finance operations. Given this, some relevant parties suggested
    that if a wide-scale disruption occurred when Treasury was at or near the
    debt limit, use of any alternative funding option during such a disruption
    should be excluded from the debt ceiling. Others argued that any funding
    options should be included in the debt ceiling to prevent having the
    options become a tool to evade the debt ceiling.

    Primary dealers we spoke with stated that if Treasury did postpone an
    auction and use any of these funding options, they preferred that Treasury
    resume auctions as soon as possible. They also expressed a strong desire
    to maintain the originally scheduled settlement date, even if an auction
    had to be performed on the settlement date.

    In addition, the impact on the Federal Reserve of replacing an auction
    with one of these options would have to be considered since the Federal
    Reserve places bids to replace its existing securities inventories at many
    Treasury auctions. Other options we discussed but were less viable are
    summarized in appendix I.

    Obtain a Line of Credit with Financial Institutions

    A credit line would provide Treasury a prior transparent commitment or
    understanding with several financial institutions to provide funds to
    Treasury during a wide-scale disruption. The financial institutions would
    have to have the willingness and capability to lend money to Treasury in
    the appropriate amount and time required by Treasury. Treasury could
    select the financial institutions through a bidding process or other
    procedure on a periodic basis that could help determine and perhaps lower
    any required fees or costs that this arrangement would entail. Canada and
    France have similar borrowing arrangements with financial institutions.
    For example, Canada has a $6 billion (U.S.) standby line of credit with a
    syndicate of international banks. Also, according to a French debt
    management official, France has credit lines with some primary dealers on
    which it could draw during a wide-scale disruption.

    44 When debt is nearing the statutory limit, Treasury has to take a number
    of extraordinary steps to meet the government's obligation to pay its
    bills while keeping under the debt ceiling. DISPs have been declared for
    certain periods in fiscal years 2002, 2003, 2005, and 2006. For more
    information on DISPs see GAO-06-269 and GAO-04-526 .

    Some primary dealers suggested that Treasury seek such a line of credit
    with a broad range of financial institutions that could include not only
    commercial banks but also institutional mutual funds and others who could
    meet Treasury requirements. Another party suggested that institutional
    mutual funds may not be practical because these funds typically obtain
    cash by selling short-term assets, which might not be possible in a
    crisis.

    Some parties, including commercial bankers with whom we spoke, stated
    providing liquidity to Treasury based on a formal line of credit might
    require regular maintenance fees to offset costs associated with the
    treatment of regulatory capital for the line of credit under U.S. and
    international capital standards. However, since funds would be lent to the
    U.S. Treasury, it is unclear if this arrangement would be subject to the
    same requirements as guaranteeing credit to other borrowers.45

    Some commercial banks raised the possibility of a prearranged
    understanding with Treasury instead of a formal commitment. Since an
    understanding is not a formal commitment, it would not impose costs on
    banks, and so might not require any maintenance fees. These commercial
    bankers told us that they would very likely lend funds to Treasury because
    it is in their financial interest to ensure that Treasury can make its
    payments, but that such an understanding would be subject to fulfilling
    their own liquidity needs in a time of crisis. As discussed previously,
    and given the actions taken during the September 11 attacks, it seems
    likely that the Federal Reserve would be available to provide commensurate
    liquidity to depository institutions. Federal Reserve officials we spoke
    with said that an obligation from Treasury would likely be accepted as
    sufficient collateral by a depository institution at the discount window.
    Although an understanding could avoid fees, it does not offer the
    certainty of a committed line of credit for Treasury's use.

    45 Some commercial bankers we spoke with said that certain international
    banking capital accords would require them to incur costs if a credit line
    is guaranteed. Another party thought that banks would not necessarily
    incur costs because guaranteeing credit to the U.S. Treasury may be viewed
    differently under those accords. U.S. banking regulators are currently
    determining the application of a new approach to calculate regulatory
    credit risk capital requirements based on a new international capital
    accord.

    Private Placement of a Cash Management Bill

    A private placement of a CM bill would involve a prior arrangement to
    issue a CM bill after communicating with certain senior executives at
    financial institutions who would have the ability and authority to
    purchase a CM bill that meets Treasury's immediate funding needs. The
    specific terms of the CM bill, such as amount, yield, settlement date, and
    maturity, would be determined at the time of CM bill placement. Similar to
    the credit line option, some market participants suggested that Treasury
    seek a broad range of financial institutions that could include not only
    commercial banks but also institutional mutual funds that could meet
    Treasury requirements. The Federal Reserve would again likely provide
    liquidity to depository institutions. Since this option involves
    delivering a security, clearing and settlement systems would have to be
    functioning adequately to complete transactions.

    Some parties told us that the market would react positively to accepting a
    tradable security like a CM bill because it fits well with their normal
    operations and implied that Treasury may benefit from flight-to-quality
    behavior in a crisis. Some parties also commented that this option was
    appropriately aligned with Treasury's current operations, since Treasury
    is used to issuing CM bills and has auctioned and issued CM bills in 1 day
    under normal conditions.

    Among a number of policy and operational issues that must be considered
    before Treasury could place a cash management bill, Treasury would have to
    decide how to set an appropriate price when it executes this arrangement.
    During a wide-scale disruption to financial markets, price-discovery-the
    process that determines an appropriate clearing price at auction-would
    likely prove challenging to financial institutions because of degradation
    in the financial market.

    Explicitly Authorize a Treasury Draw Authority with the Federal Reserve

    In the event that the first tier options involving financial institutions
    proved insufficient, turning to the Federal Reserve as a last resort
    funding source would require a change in law to allow the Federal Reserve
    to directly lend to Treasury. Appropriate limitations, adequate
    flexibility, and accountability would have to be included in the design.

    As we previously discussed, primary dealers and commercial bankers
    generally agreed that this was the most resilient and direct way for
    Treasury to ensure it met its obligations. Some Treasury and Federal
    Reserve officials we spoke with also confirmed that this method would
    likely be technically and operationally easy to implement. In addition,
    despite central bank independence concerns discussed previously, primary
    dealers and commercial bankers we spoke with stated that they did not
    think this arrangement would damage Treasury's or the Federal Reserve's
    reputation if it is used in a limited way during a wide-scale disruption.

    Although direct lending by a central bank is not without precedent, it is
    viewed as a last resort. For example, although the Canadian federal
    government has legal authority to borrow directly from the Bank of
    Canada-its central bank-this legal authority was last used in the early
    1960s and is not expected to be used in the future.

    Some parties, including Federal Reserve officials, expressed concerns
    about any direct lending arrangement and the potential for abuse of such
    authority in the future. They thought a high hurdle would be appropriate
    for using this authority. For example, one Federal Reserve official
    emphasized that this option should only be considered during a situation
    where it was "physically impossible" for Treasury to conduct auctions and
    after judgment is reached at suitably high levels in the executive branch
    and at the Federal Reserve that other options would not work. Another
    Federal Reserve official stated that it is important to clarify that this
    option should only be used in a national emergency. Another party
    concerned with Treasury oversight commented to us that legislation should
    be written "very tightly" to limit this authority to when it is absolutely
    required. Some Federal Reserve officials suggested that the approval for a
    direct draw should be at a very high level-perhaps the President of the
    United States, Secretary of the Treasury, and the Chairman of the Federal
    Reserve, and wanted to maintain some veto power on the draw to preserve
    the Federal Reserve's independence.

    Federal Reserve officials concerned with central bank independence and the
    risks of direct lending stated that any draw from the Federal Reserve
    should be at a market price, perhaps even higher to discourage use, even
    though they acknowledged that proceeds from a higher price would
    eventually be delivered back to Treasury. Some officials suggested that
    the Federal Reserve should be able to review the draw arrangement daily to
    ensure it did not last longer than necessary. There was broad agreement
    among Federal Reserve officials with whom we spoke that the draw should be
    reversed as soon as Treasury could hold an auction again and that any
    arrangement should be fully transparent and disclosed by Treasury and the
    Federal Reserve.

    Other parties emphasized the need to maintain some flexibility for
    Treasury while protecting central bank independence. An approach that
    appears promising would be to require joint approval from the Chairman of
    the Federal Reserve and the Secretary of the Treasury. Since a Federal
    Reserve Chairman is unlikely to agree to a direct draw unless convinced
    that other options are not viable, this would provide sufficient
    protection against abuse of this authority. Since the authority is
    predicated on a wide-scale emergency and disruption, adding presidential
    approval might unnecessarily delay necessary actions without adding any
    additional protection beyond that provided by requiring agreement of the
    Chairman of the Federal Reserve. Both the duration of the draw and the
    amount might be established at the time the Secretary and Chairman agree
    to the direct draw.

    If the authority is to be provided, a decision on how to facilitate
    congressional oversight would be necessary. One party concerned with
    congressional oversight referred to a "delicate balance" between
    Treasury's need to obtain funding during a wide-scale disruption and
    Congress's need to conduct oversight of debt management. One possibility
    would be to require notification of the majority and minority leadership
    in both houses of Congress at the time of a draw and report after the use
    of this authority in addition to regular reporting requirements. Finally,
    legislation developing an authority for a direct draw might require
    periodic review and renewal by Congress.

                                       Conclusion

    The combination of minimal cash balances and the elimination of
    compensating balances have effectively increased Treasury reliance on the
    auction process as a funding source. Treasury, the Federal Reserve, and
    primary dealers have taken actions intended to increase the resilience of
    the auction process. Regardless of resiliency efforts, the duration and
    the effects of a potential future wide-scale disruption are unknown. All
    these factors make it prudent to explore other funding options for
    Treasury to use during a wide-scale disruption.

    Although Treasury, the Federal Reserve, primary dealers, and other
    financial institutions might be able to develop some funding mechanism at
    the time of a wide-scale disruption, prearranged funding alternatives
    offer the advantage of explicit legal approaches with adequate built-in
    oversight and disclosure requirements. One approach discussed earlier
    requires changes in law. Without having prearranged access to additional
    funding sources and methods outside of the normal auction process,
    Treasury is missing an opportunity to strengthen its ability to obtain
    funds-and ultimately meet payment obligations-during a wide-scale
    disruption to the financial markets it relies upon. A tiered system that
    involves a range of private sector financial institutions as a first tier
    and the Federal Reserve as a second tier would expand Treasury's access to
    cash and would enhance its ability to obtain necessary funds during a
    major, wide-scale disruption while limiting the potential for abuse.

                          Recommendations for Executive Action

    We recommend that the Secretary of the Treasury examine in detail the
    implementation requirements for establishing a line of credit and a
    private placement of a CM bill with a range of appropriate private sector
    financial institutions, select the most appropriate option(s), and take
    steps to put required frameworks into place for use during a wide-scale
    disruption. Implementation details to be considered for both options
    include determining the design features discussed earlier, including
    situations or criteria for use, how to determine the appropriate financial
    institutions to rely upon, and the amount needed. For the private
    placement of a CM bill, the cost or price determination method would have
    to be analyzed since price discovery may not be possible in a
    significantly degraded financial market. For a credit line, ways to reduce
    the cost of an understanding or a guarantee of credit would have to be
    explored, such as a prearranged proposal process that determines the fees
    (if any) and terms of the transaction. As Treasury explores these options,
    it should consider how other countries have implemented alternative
    funding options to obtain any useful insights on its design, recognizing
    that the U.S. Treasury market has a unique role as the largest and most
    active debt market in the world.

                        Matters for Congressional Consideration

    Congress should consider providing the Federal Reserve the explicit
    authority to lend directly to Treasury as a last resort when other options
    are not viable during a wide-scale disruption. Developing a direct draw
    authority would require careful consideration and determination of design
    features and any other requirements to support Treasury's need for an
    effective funding source, the Federal Reserve's independence, and
    congressional oversight and accountability concerns. An approach that
    appears promising would be to require that both the Secretary of the
    Treasury and Chairman of the Federal Reserve approve any draw and agree on
    specific amounts and duration at the time of any draw. This might balance
    independence and accountability concerns with the need for sufficiently
    prompt action and flexibility.

                                    Agency Comments

    We requested comments on a draft of this report from the Secretary of the
    Treasury and the Chairman of the Board of Governors of the Federal Reserve
    System. The agencies' letters are reprinted in appendix III and appendix
    IV, respectively. Both Treasury and the Federal Reserve noted that they
    had taken steps to increase their resiliency in recent years but agreed
    that Treasury should examine the first-tier funding options described in
    this report. Although neither took a position on our suggestion that
    Congress should consider permitting the Federal Reserve to lend directly
    to the Treasury, both emphasized the importance of maintaining the
    independence of the central bank. For example, Treasury stated that it,
    "is generally opposed to arrangements in which governments, at their
    discretion, can borrow directly from their central bank as such
    arrangements compromise the independence of the central bank." Treasury
    and the Federal Reserve suggested that any legislation that would provide
    the Federal Reserve the authority to lend directly to the Treasury should
    be very carefully and tightly drawn to preserve the independence of the
    central bank. As our report notes, we also recognize the importance of
    maintaining the independence of the central bank and suggest an explicit,
    carefully crafted, last resort authority and approach that we believe
    provides both flexibility and reduces the vulnerability to abuse. Indeed,
    part of the rationale for a two-tiered approach is to reduce the chances
    that the Treasury would ever need to turn to the Federal Reserve. Both
    Treasury and Federal Reserve Board staff also provided technical comments,
    which we incorporated as appropriate.

    We are sending copies of this report to the Ranking Minority Member of the
    House Committee on Ways and Means, the Chairs and Ranking Minority Members
    of the House Committee on Financial Services, the Senate Committee on
    Finance, the Senate Committee on Banking, Housing and Urban Affairs, the
    Secretary of the Treasury, the Chairman of the Board of Governors of the
    Federal Reserve System, and other interested parties. We will also make
    copies available to others upon request. In addition, the report will be
    available at no charge on GAO's Web site at http://www.gao.gov .

    If you or your staff have any questions about this report please contact
    Susan J. Irving at (202) 512-9142 or irvings@gao.gov . Contact points for
    our Offices of Congressional Relations and Public Affairs may be found on
    the last page of this report. GAO staff making key contributions to this
    report are listed in appendix V.

    Sincerely yours,

    Susan J. Irving Director, Federal Budget Analysis

    Appendix I: Cost and Complexity Rule Out Other Options That
    Were Discussed

    Holding Additional Cash Balances Would Not Be Cost Efficient

    Although holding excess cash balances would supply the Department of the
    Treasury with an extra source of funds to draw from in an emergency, it is
    generally more cost-efficient to repay debt than run higher cash balances
    because the interest earned on excess cash balances is generally
    insufficient to cover borrowing costs. As we previously reported, because
    of this negative funding spread, Treasury has placed increased emphasis on
    minimizing cash balances to reduce overall borrowing cost.1 Treasury's
    current cash balance target is $5 billion, which represents the amount to
    be held at the Federal Reserve. Treasury invests excess cash above the $5
    billion target in Treasury Tax and Loan (TT&L) accounts,2 the Term
    Investment Option (TIO) program, and Repurchase Agreement (Repo) pilot
    program. TT&L accounts are held at financial institutions and earn
    interest rates equal to the federal funds rate less 25 basis points, a
    rate set in 1978 originally intended to reflect the rate paid on overnight
    repurchase (repo) agreements-a short-term collateralized loan used by
    dealers in government securities.3 The rate earned on TT&L accounts is
    generally less than the average rate Treasury pays on CM and other regular
    short-term bills. The TIO program was introduced in 2002 to add investment
    capacity to the TT&L program and to increase the rate that Treasury earns
    on invested funds. The Repo program is a pilot program that allows
    Treasury to place a portion of its excess operating funds with TT&L
    depositories through a repo transaction for a set period of time at an
    agreed upon rate of interest. Treasury told us that it now places over 70
    percent of its cash balances through the TIO and Repo program. Treasury
    officials with whom we spoke acknowledged that holding additional cash
    balances would not be a viable option because of the negative funding
    spread.

    1 GAO, Debt Management: Treasury Has Refined Its Use of Cash Management
    Bills but Should Explore Options That May Reduce Cost Further, GAO-06-269
    (Washington, D.C.: Mar. 30, 2006).

    2 The TT&L program helps stabilize the supply of reserves in the banking
    system. If Treasury held all its cash in its Federal Reserve account,
    increases in its cash position would drain reserves from the banking
    system, and decreases would add reserves. Thus, the Federal Reserve would
    have to conduct frequent and perhaps large open market operations to
    mitigate undesired fluctuations in bank reserves and the federal funds
    rate. The TT&L program also helps Treasury manage federal tax receipts and
    earn interest on public funds.

    3 GAO-06-269 .

    Foreign Central Banks Add Complexity to Obtaining Funds

    Treasury and Federal Reserve officials we spoke with agreed that borrowing
    from foreign central banks may require some sort of currency conversion,
    unless the banks had adequate funds in dollars. The currency conversion
    would presumably have to occur on a very short-term and possibly same day
    basis. If the foreign central banks did not have adequate dollar-based
    liquidity, they may have to rely on the Federal Reserve to provide them
    with liquidity. As discussed previously, the Federal Reserve conducted
    currency swaps with some foreign central banks to help them fulfill their
    dollar-denominated obligations. Treasury officials we spoke with
    acknowledged that although this type of arrangement is possible, it is
    less promising because of the transactions and currency conversions that
    would likely be required. In addition, Treasury told us that although most
    large foreign banks operating in the U.S. have access to the discount
    window, Treasury would not advocate relying upon these banks for emergency
    funding.

    Appendix II: Background on Previous Treasury Draw Authorities

    In the past, Treasury had access to both a cash and securities draw
    authority. Intermittently between 1942 and 1981, Treasury was able to
    directly sell (and purchase) certain short-term obligations to (and from)
    the Federal Reserve in exchange for cash. Congress first granted this cash
    draw authority temporarily in 1942,1 allowed it to lapse several times,
    and extended it 22 times until 1979, when it modified some of the terms
    and added controls.2 In 1979, Congress also authorized a securities draw
    authority, which permitted Treasury to borrow securities from the Federal
    Reserve, sell them, and then repurchase the securities in the open market
    and return the securities to the Federal Reserve within a specified
    period.3 The securities draw authority was never used.

    After Congress authorized Treasury to earn interest on its Treasury Tax &
    Loan (TT&L) account balances in 1977,4, 5 Congress allowed both draw
    authorities to expire in 1981. In a 1979 proceeding, one Member of
    Congress said that after World War II, the cash draw authority allowed
    Treasury to carry lower cash balances.6 According to another Member, since
    TT&L accounts earned interest, there was no reason for Treasury not to
    "keep plenty of cash on hand" thereby reducing the need for a draw
    authority,7 although the interest that Treasury earned on these accounts
    was .25 percentage points below the federal funds rate.8 Current Treasury
    officials to whom we spoke said that they did not know if the passage of
    legislation allowing Treasury to earn interest on its TT&L accounts led
    Congress to allow both draw authorities to expire. Table 2 summarizes the
    key design features of Treasury's draw authorities in 1979. A somewhat
    fuller discussion of each feature follows.

    1The cash draw authority lapsed in certain months in 1973, 1974, 1976, and
    1977. See H.R. Rep. No. 96-111, 7 (1979).

    2Treasury Draw Policy, as amended, Pub. L. No. 96-18, sec. 1 (c), 93 Stat.
    35 (Jun. 8, 1979).

    3Pub. L. No. 96-18, sec. 2.

    4Treasury Tax and Loan Accounts are funds held in accounts at financial
    institutions in the name of the U.S. Treasury. Their purpose is to dampen
    fluctuations in bank reserves, process federal tax payments, and provide
    an interest-earning location for cash.

    5Public Moneys Investment Act, Pub. L. No. 95-147, 91 Stat. 1227 (Oct. 28,
    1977).

    6125 Cong. Rec. 10081 (1979) (Statement of Congressman Hansen).

    7125 Cong. Rec. 10080 (1979) (Statement of Congressman Wylie).

    8The federal funds rate is the interest rate at which financial
    institutions exchange balances in their accounts at the Federal Reserve
    with each other on an overnight and unsecured basis.

    Table 2: Design Features of 1979 Cash and Securities Draw Authorities

    Design features      Cash draw authority       Securities draw authority
    Situations specified Emergencies, markets      More routine for cash
    for use              closed                    management purposes
    Source of funds      Federal Reserve Bank      Financial market (through
                            System                    sale of borrowed securities
                                                      from Federal Reserve)
    Type of collateral   None                      None
    Transaction type     Direct sale of special    Borrow security from
                            short-term certificates   Federal Reserve and sell to
                            to Federal Reserve        financial market,
                                                      repurchase security and
                                                      return to Federal Reserve
    Approvals            Five Governors of Federal Federal Open Market
                            Reserve System Board      Committee
    Cost determination   Interest rate of .25      Market value of securities
                            percent below discount    when Treasury repurchases
                            rate of Federal Reserve
                            Bank of New York
    Amount limit         $5 billion                No limit
    Time limit           No later than 30 days     Repurchase of securities no
                                                      later than 6 months
    Inclusion in debt    Included in debt subject  Included in debt subject to
    ceiling              to limit                  limit
    Disclosure           Annual Federal Reserve    None specified
                            report to Congress
    Length of authority  2 years                   2 years

    Source: GAO.

    Situations When Treasury Used Previous Draw Authorities

    The Treasury Draw Policy, as amended in 1979 (hereafter, amended Treasury
    Draw Policy) stated that Treasury could use the cash draw authority in
    only "unusual and exigent circumstances."9 In 1979, both Federal Reserve
    and Treasury officials supported the extension of the cash draw authority
    for emergencies. A Treasury Assistant Secretary said that Treasury might
    not have sufficient time to raise funds through the securities draw
    authority and that the cash draw authority provided Treasury with
    immediate funds to meet unforeseen developments, especially if these
    developments transpired late in the trading day.10 A Federal Reserve Board
    Governor testified that the cash draw authority functioned well in the
    past and that Treasury needed this authority to obtain immediate funds
    when securities markets might be in "general disarray" based on a national
    emergency.11 Members of Congress said a number of times that they intended
    Treasury to use the cash draw authority only in certain situations, such
    as when military attacks disrupt or close markets.12 One Member cited
    examples beyond wartime when the use of the cash draw authority might be
    appropriate, such as grave health and well-being emergencies or nuclear
    accidents.13

    9Pub. L. No. 96-18.

    Treasury used previous cash draw authorities infrequently. Between 1942
    and 1981, the Federal Reserve held special short-term certificates
    purchased directly from the Treasury on 228 days. In the years Treasury
    used this authority, it borrowed on average about 11 days per year. Use of
    this authority was concentrated mostly in times of war or armed conflict,
    as seen in figure 4. The most Treasury borrowed on a single day throughout
    the period was $2.6 billion in 1979.

    10Federal Reserve-Treasury Draw Authority: Hearing on H.R. 2281 and H.R.
    421 before the Subcommittee on Domestic Monetary Policy of the House
    Committee on Banking, Finance and Urban Affairs, 96th Cong. 18-20 (1979)
    (letter from the Honorable Roger Altman, Assistant Secretary of the
    Treasury, to the Honorable Parren J. Mitchell, Chairman of the
    Subcommittee on Domestic Monetary Policy, House Committee on Banking,
    Finance and Urban Affairs, March 16, 1979).

    11Federal Reserve-Treasury Draw Authority: Hearing on H.R. 2281 and H.R.
    421 before the Subcommittee on Domestic Monetary Policy of the House
    Committee on Banking, Finance and Urban Affairs, 96th Cong. 7-8 (1979)
    (statement of the Honorable J. Charles Partee, member, Board of Governors
    of the Federal Reserve System).

    12125 Cong. Rec. 10081 (1979) (Statement of Congressman Hansen) and 125
    Cong. Rec. 10083 (1979) (Statement of Congressman Mitchell).

    13125 Cong. Rec. 10083 (1979) (Statement of Congressman Mitchell).

    Figure 4: Concentrated Use of Cash Draw Authority 1942-1981 (Days Federal
    Reserve Held Special Short-Term Treasury Certificates)

    In the years Treasury used the cash draw authority, it most often used it
    surrounding tax payment dates in March, June, and September and to a
    lesser extent in January, April, October, and December, as seen in figure
    5.14 In other months, Treasury used this authority for less than 10 days
    total per month. According to a 1979 testimony by a Federal Reserve
    Governor, Treasury had used the authority in earlier years to offset cash
    drains just before funds became available from quarterly income tax
    payments. He went on to explain that Treasury used the cash draw authority
    less in recent years since it relied more often on cash management bills
    to "cover low points in its cash balance" prior to tax payment dates.15 In
    that same proceeding, an Assistant Secretary of the Treasury credited the
    access to short-term funds, specifically weekly bills and cash management
    bills, with reduced use of the cash draw authority after 1975.16

    14Both corporate and individual estimated tax payment dates occur in
    April, June, and September. In addition, corporate tax payment dates occur
    in March, October, and December. An individual estimated tax payment date
    also occurs in January.

    15Federal Reserve-Treasury Draw Authority: Hearing on H.R. 2281 and H.R.
    421 before the Subcommittee on Domestic Monetary Policy of the House
    Committee on Banking, Finance and Urban Affairs, 96th Cong. 7-8 (1979)
    (statement of the Honorable J. Charles Partee, member, Board of Governors
    of the Federal Reserve System).

    Figure 5: Borrowing Concentrated Around Tax Payment Months 1942-1981 (Days
    Federal Reserve Held Special Short-Term Treasury Certificates)

    After 1979, the cash draw authority was only to be used in emergencies,
    while the securities draw authority could be used "in more routine
    circumstances."17 However, we did not find any evidence that Treasury used
    the securities draw authority between 1979 and its expiration in 1981. One
    Member of Congress described how the securities draw authority could be
    used when Treasury did not have the time to "prepare and market" a new
    security issue quickly enough to meet short-term cash needs. He reasoned
    that since Treasury would borrow "seasoned securities" from the Federal
    Reserve -existing securities in the Federal Reserve's portfolio-that
    Treasury would be able to sell them quickly enough to meet cash needs.18 A
    committee report also stated that the requirement for Treasury to
    repurchase securities in the open market would subject Treasury to market
    discipline.19

    16Federal Reserve-Treasury Draw Authority: Hearing on H.R. 2281 and H.R.
    421 before the Subcommittee on Domestic Monetary Policy of the House
    Committee on Banking, Finance and Urban Affairs, 96th Cong. 9-10 (1979)
    (Statement of Paul H. Taylor, Fiscal Assistant Secretary of the Treasury).

    17H.R. Rep. No. 96-111, at 2 (1979).

    Source of Funding

    The source of funds for the cash draw authority was the Federal Reserve,
    while the source of funds for the securities draw authority was the
    financial market. As shown in figure 6, when using the cash draw
    authority, Treasury sold special short-term certificates directly to the
    Federal Reserve in exchange for cash from the Federal Reserve. The amended
    Treasury Draw Policy also specified that Treasury could borrow obligations
    (securities) from the Federal Reserve and sell them in the open market (in
    exchange for cash) to meet short-term cash needs, as shown in figure 6.20

    Collateral Used

    The cash draw authority did not require any specific collateral beyond the
    special short-term Treasury certificates that the Federal Reserve
    purchased from Treasury. The securities draw authority also did not
    require any collateral.

    Type of Financial Transaction

    The cash draw authority and securities draw authority represented
    different transactions. As shown in figure 6, the cash draw authority
    directly involved only the Federal Reserve and Treasury, while the
    securities draw authority involved the Federal Reserve, Treasury, and the
    financial market.

    18125 Cong. Rec. 12514 (1979) (Statement of Congressman Mitchell).

    19H.R. Rep. No. 96-111, at 2 (1979).

    20Pub. L. No. 96-18.

    Figure 6: Cash and Securities Draw Authority Transactions

    In 1979, members of Congress and Treasury officials discussed how these
    transactions might affect monetary policy. For example, a number of
    members saw the cash draw authority as a way to monetize the debt and in
    effect print new money, thereby complicating monetary policy.21 In a
    letter to Congress, Treasury wrote that the cash draw authority did not
    create problems for monetary policy since the Federal Reserve could offset
    Treasury borrowings through its open market operations, thus having the
    same net effect as if Treasury borrowed from the market instead of the
    Federal Reserve.22

    21125 Cong. Rec. 10080, (1979) (Statement of Congressman Wylie) and 125
    Cong. Rec. 10081, (1979) (Statement of Congressman Hansen).

    Approvals on Use of Draw Authority

    According to the amended Treasury Draw Policy, at least five members of
    the Board of Governors of the Federal Reserve System had to approve
    purchases and sales of bonds, notes, or other obligations to the United
    States (Treasury) by the Federal Reserve.23 The act also specified that
    the securities draw authority was subject to the approval, rules, and
    regulations of the Federal Open Market Committee.24

    The Cost of the Draw Authorities

    The cost that Treasury paid to use the draw authorities was implied in the
    interest rate that the Federal Reserve charged or the market value of the
    securities that Treasury repurchased. The interest rate Treasury paid to
    use the cash draw authority changed between 1942 and 1981. The Federal
    Reserve reported that Treasury paid a fixed .25 percent interest rate on
    the amount borrowed when it used this authority through December 3, 1957;
    after December 3, 1957, and through the expiration of this authority it
    paid a rate set at .25 percent below the prevailing discount rate of the
    Federal Reserve Bank of New York.25 Although a memorandum of understanding
    between the Federal Reserve and Treasury was not readily available and may
    not have existed, according to one Member of Congress the interest rate
    for the cash draw authority was "arbitrarily" set by negotiations between
    Treasury and the Federal Reserve.26

    In contrast, legislative history shows some members intended to subject
    Treasury to "market discipline" when it used the securities draw
    authority. During discussions in 1979, to describe market discipline, one
    member offered a scenario in which Treasury would repurchase securities at
    a slightly higher price than it paid for them-since the securities would
    be closer to maturity-and that this price differential reflected a fair
    market interest rate on Treasury's borrowing.27 A Federal Reserve Governor
    noted that Treasury could pay a substantial premium for selling securities
    it borrowed from the Federal Reserve late in the day because the action
    would probably take market participants by surprise. He went on to say
    that if markets were unsettled Treasury may not be able to sell all of the
    securities it needed.28

    22Federal Reserve-Treasury Draw Authority: Hearing on H.R. 2281 and H.R.
    421 before the Subcommittee on Domestic Monetary Policy of the House
    Committee on Banking, Finance and Urban Affairs, 96th Cong. 18-20 (1979)
    (letter from the Honorable Roger Altman, Assistant Secretary of the
    Treasury, to the Honorable Parren J. Mitchell, Chairman of the
    Subcommittee on Domestic Monetary Policy, House Committee on Banking,
    Finance and Urban Affairs, Mar. 16, 1979).

    23Pub. L. No. 96-18.

    24The Federal Open Market Committee is part of the Federal Reserve and
    oversees open market operations to promote monetary policy.

    25The discount rate is the rate that commercial banks pay to borrow funds
    from the Federal Reserve. The Federal Reserve Board of Governors sets this
    rate.

    26125 Cong. Rec. 12515 (1979) (Statement of Congressman Stanton).

    Amount and Time Limits for Use of Draw Authorities

    Congress limited the amount and time that Treasury could use the cash draw
    authority. The amended Treasury Draw Policy stated that the aggregate
    amount of obligations acquired (at any one time by the 12 Federal Reserve
    banks) directly from the United States (Treasury) could not exceed $5
    billion.29 In addition, the act specified that Treasury could use the cash
    draw authority for renewable periods not to exceed 30 days.

    Congress limited the amount of time that Treasury could use the securities
    draw authority but did not limit the amount of securities Treasury could
    borrow. The amended Treasury Draw Policy required Treasury to repurchase
    obligations (securities) no later than 6 months after the date of sale and
    return these securities to the Federal Reserve.30

    The Inclusion of Draw Authorities in the Debt Ceiling

    The use of the cash and securities draw authorities was not expressly
    excluded from the debt subject to limit.

    27125 Cong. Rec. 10081 (1979) (Statement of Congressman Hansen).

    28Federal Reserve-Treasury Draw Authority: Hearing on H.R. 2281 and H.R.
    421 before the Subcommittee on Domestic Monetary Policy of the House
    Committee on Banking, Finance and Urban Affairs, 96th Cong. 7-8 (1979)
    (statement of the Honorable J. Charles Partee, member, Board of Governors
    of the Federal Reserve System).

    29Pub. L. No. 96-18.

    30Pub. L. No. 96-18.

    Disclosure of the Use of the Draw Authorities

    Congress specified reporting requirements for the cash draw authority but
    not for the securities draw authority. The amended Treasury Draw Policy
    required the Board of Governors of the Federal Reserve System to include
    detailed information about use of the cash draw authority in its annual
    report to Congress.31 In addition, a Treasury Assistant Secretary
    testified in 1979 that any previous use of the cash draw authority was
    reported in the daily Treasury statement of cash and debt operations and
    in the weekly Federal Reserve statement.32

    Expiration of Draw Authorities

    The amended Treasury Draw Policy established the cash and securities draw
    authority for 2 years.33 In 1979, members of Congress deliberated over how
    long to extend the authorities, some advocating 1 year, while others
    advocated 2 or 5 years. Those who advocated shorter periods wanted to give
    Congress a chance to evaluate the authorities' use and make modifications,
    if necessary, prior to a 5-year period.34 After the expiration of the
    authorities, the Federal Reserve was and still is limited to purchasing
    and selling obligations of the United States only in the open market.

    31Pub. L. No. 96-18.

    32Federal Reserve-Treasury Draw Authority: Hearing on H.R. 2281 and H.R.
    421 before the Subcommittee on Domestic Monetary Policy of the House
    Committee on Banking, Finance and Urban Affairs, 96th Cong. 9-10 (1979)
    (Statement of Paul H. Taylor, Fiscal Assistant Secretary of the Treasury).

    33Pub. L. No. 96-18.

    34125 Cong. Rec. 10082 (1979) (Statement of Congressman Rousselot).

    Appendix III: Comments from the Department of the Treasury

    Appendix IV: Comments from the Board of Governors of the Federal Reserve
    System

    Appendix V: GAO Contact and Staff Acknowledgments

                                      GAO Contact

    Susan J. Irving, (202) 512-9142

                                    Acknowledgments

    In addition to the contact named above, Jose Oyola (Assistant Director),
    Julie Atkins, Richard Cambosos, Dean Carpenter, Abe Dymond, Cody Goebel,
    Thomas McCabe, James McDermott, Naved Qureshi, Keith Slade, and Dawn
    Simpson made significant contributions to this report.

    (450480)

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    Highlights of GAO-06-1007 , a report to the Chairman, Committee on Ways
    and Means, House of Representatives

    September 2006

    DEBT MANAGEMENT

    Backup Funding Options Would Enhance Treasury's Resilience to a Financial
    Market Disruption

    The September 11, 2001, attacks significantly affected the financial
    markets that the U.S. Treasury (Treasury) relies on. To understand how
    Treasury could obtain funds during a future potential wide-scale financial
    market disruption GAO examined (1) steps Treasury and others took during
    the September 11 attacks and after to assure required debt obligations and
    payments were made on time and ensure liquidity in the markets, (2) major
    actions Treasury and others have taken since the attacks to increase the
    resiliency of the auction process, and (3) the opinions of relevant
    parties on the main design features of any backup funding options. We
    conducted interviews with Treasury officials and others and reviewed
    appropriate documents.

    What GAO Recommends

    We recommend that the Secretary of the Treasury examine the requirements
    for establishing a line of credit and a private placement of a CM bill and
    select the most appropriate option(s) as a first tier. As a second tier,
    Congress should consider allowing the Federal Reserve to lend directly to
    the Treasury during a wide-scale disruption using a carefully crafted last
    resort funding option. Both Treasury and the Federal Reserve agreed that
    Treasury should examine the first-tier options. Neither took a position on
    the second tier, but both emphasized the importance of maintaining the
    independence of the central bank.

    In response to the effects of the September 11 attacks on the financial
    markets, Treasury canceled a scheduled 4-week bill auction after
    communicating with the Federal Reserve Bank of New York (FRBNY). Treasury
    then used compensating balances from banks across the country to help meet
    its obligations on time. Compensating balances were replaced by direct
    payments in 2004. Also, in response to the attacks' financial effects, the
    Federal Reserve lent billions of dollars to both domestic and foreign
    financial institutions through a combination of methods to help markets
    recover. Federal Reserve actions and market behavior in the aftermath of
    the September 11 attacks are informative when considering potential
    alternative funding sources for Treasury during a future wide-scale
    financial market disruption.

    Treasury, the Federal Reserve, and primary dealers have added contingency
    sites and systems intended to increase the resilience of the auction
    process. Regardless of resiliency efforts, the nature and impact of a
    potential future wide-scale disruption are unknown. In addition, Treasury
    has at least one less source of cash since the compensating balances
    Treasury relied upon during the September 11 attacks are no longer used.
    Finally, Treasury's cash management policy of minimal cash balances to
    lower borrowing costs further limits Treasury's access to cash during a
    wide-scale disruption. All these factors make it prudent for Treasury to
    explore other funding alternatives to use during a wide-scale disruption.
    Relevant parties with whom we spoke, including primary dealers, agreed.
    They also generally agreed on a list of main design features including
    source of funds, situations for use, approvals, and costs, among others,
    that should be considered when weighing alternative funding options.

    Discussions with Treasury, the Federal Reserve, and other relevant parties
    have led GAO to conclude that a two-tiered approach is promising. The
    first tier consists of two funding options involving a range of
    appropriate financial institutions, namely a credit line and a private
    placement of a flexible security known as a cash management (CM) bill. The
    second tier involves a direct draw from the Federal Reserve that would
    provide Treasury a last resort source of funds when other options are not
    viable. A credit line with several financial institutions would involve a
    prior transparent commitment or understanding by certain financial
    institutions to provide funds to Treasury. A private placement of a CM
    bill would involve a prior arrangement to issue a CM bill after
    communicating with certain senior executives at financial institutions who
    would have the ability and authority to meet Treasury's immediate funding
    needs. Finally, a direct draw from the Federal Reserve would require a
    change in the law to allow the Federal Reserve to directly lend to
    Treasury. Appropriate limitations, adequate flexibility, and
    accountability would have to be included in the design.
    *** End of document. ***