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
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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 [email protected] . 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. ***