Debt Management: Treasury Has Improved Short-Term Investment Programs, but Should Broaden Investments to Reduce Risks and Increase Return

Debt Management: Treasury Has Improved Short-Term Investment
Programs, but Should Broaden Investments to Reduce Risks and
Increase Return (20-SEP-07, GAO-07-1105).

Growing debt and net interest costs are a result of persistent
fiscal imbalances, which, if left unchecked, threaten to crowd
out spending for other national priorities. The return on every
federal dollar that the Department of the Treasury (Treasury) is
able to invest represents an opportunity to reduce interest
costs. This report (1) analyzes trends in Treasury's main
receipts, expenditures, and cash balances, (2) describes
Treasury's current investment strategy, and (3) identifies
options for Treasury to consider for improving its return on
short-term investments. GAO held interviews with Treasury
officials and others and reviewed related documents.
-------------------------Indexing Terms-------------------------
REPORTNUM: GAO-07-1105
ACCNO: A76507
TITLE: Debt Management: Treasury Has Improved Short-Term
Investment Programs, but Should Broaden Investments to Reduce
Risks and Increase Return
DATE: 09/20/2007
SUBJECT: Debt
Federal debt
Federal funds
Federal reserve banks
Fund audits
Lending institutions
Program evaluation
Risk management
Treasury accounts
US Treasury securities
Financial management
Financial institutions
Financial reporting

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GAO-07-1105

* [1]Results in Brief
* [2]Background
* [3]Treasury's Short-Term Cash Available for Investment Fluctuat

* [4]Treasury's Cash Balances Available for Short-Term Investment
* [5]Treasury's Cash Balances Available for Short-Term Investment
* [6]The TGA Protects against Overdraft and a Stable Balance Assi
* [7]TGA Balances Earn an Implicit Return

* [8]Treasury's Short-Term Investment Strategies Have Evolved ove

* [9]The TT&L Program Serves Key Functions but Has Significant Li
* [10]TIO Program Earns a Better Rate of Return Than TT&L but Expo
* [11]Treasury's Repo Pilot Has Continued to Improve Overall Retur

* [12]Options Exist to Increase Treasury's Rate of Return and Redu

* [13]Treasury Should Minimize TT&L Investments and Expand the Rep
* [14]Treasury Will Need to Consider Primary Investment Objectives

* [15]Primary Investment Objectives
* [16]Design and Operating Decisions

* [17]Conclusions
* [18]Matter for Congressional Consideration
* [19]Recommendation for Executive Action
* [20]Agency Comments and Our Evaluation
* [21]Trends in Treasury's Operating Cash Balance
* [22]Trends in Treasury's Investment Allocation
* [23]Collateral in the TT&L and TIO Programs
* [24]Collateral Allocation in Treasury's Short-Term Investment Pr
* [25]Special Direct Investments
* [26]The TGA and the Federal Reserve's Execution of Monetary Poli
* [27]Value of Spread between TIO and TT&L Rates in 2006
* [28]Estimated Return Treasury Could Earn by Reallocating Funds f
* [29]GAO Contact
* [30]Acknowledgments

* [31]Delivery-Versus-Payment (DVP) Arrangement

* [32]Dynamic Investment
* [33]Haircut
* [34]Repurchase Agreement (repo)
* [35]Special Direct Investment (SDI)
* [36]Term Investment Option (TIO)
* [37]Treasury General Account (TGA)
* [38]Treasury Tax & Loan (TT&L)
* [39]Triparty Arrangement

* [40]GAO's Mission
* [41]Obtaining Copies of GAO Reports and Testimony

* [42]Order by Mail or Phone

* [43]To Report Fraud, Waste, and Abuse in Federal Programs
* [44]Congressional Relations
* [45]Public Affairs
* [46]PDF6-Ordering Information.pdf

* [47]Order by Mail or Phone

Report to the Committee on Finance, U.S. Senate

United States Government Accountability Office

GAO

September 2007

DEBT MANAGEMENT

Treasury Has Improved Short-Term Investment Programs, but Should Broaden
Investments to Reduce Risks and Increase Return

GAO-07-1105

Contents

Letter 1

Results in Brief 3
Background 4
Treasury's Short-Term Cash Available for Investment Fluctuates According
to a Predictable Pattern 6
Treasury's Short-Term Investment Strategies Have Evolved over Time, but
Restrictions Still Subject Treasury to Several Risks and Lower Returns 12
Options Exist to Increase Treasury's Rate of Return and Reduce Risk on
Short-Term Investments 23
Conclusions 28
Matter for Congressional Consideration 28
Recommendation for Executive Action 29
Agency Comments and Our Evaluation 29
Appendix I Trends in Treasury's Operating Cash Balance and Allocation of
Short-Term Investments 31
Trends in Treasury's Operating Cash Balance 31
Trends in Treasury's Investment Allocation 32
Appendix II Acceptable Collateral in Treasury's Short-Term Investment
Programs 34
Collateral in the TT&L and TIO Programs 34
Collateral Allocation in Treasury's Short-Term Investment Programs 36
Special Direct Investments 37
Appendix III The TGA Was Treasury's Only Investment between 1974 and 1978
40
Appendix IV Timeline of Key Treasury Actions for the Treasury Tax and Loan
and Term Investment Option Programs 42
Appendix V Changes in the TGA Target Balance and the Federal Reserve's
Open Market Operations 43
The TGA and the Federal Reserve's Execution of Monetary Policy 43
Appendix VI Detailed Methodology of Calculations 46
Value of Spread between TIO and TT&L Rates in 2006 46
Estimated Return Treasury Could Earn by Reallocating Funds from TT&L to
Repos 46
Appendix VII Comments from the Department of the Treasury 49
Appendix VIII GAO Contact and Staff Acknowledgments 50
Glossary 51

Tables

Table 1: Since 2003, Treasury's Daily Operating Cash Balances Have
Increased in Dollar Volume and Become More Volatile 9
Table 2: Treasury's Short-Term Investment Programs 13
Table 3: Five Largest Participants in TT&L Program in Fiscal Year 2005 by
Total Volume 15
Table 4: Five Largest Participants in TT&L Program in Fiscal Year 2006 by
Total Volume 15
Table 5: TIO Funds Are Concentrated in Two TIO Participants 19
Table 6: Advantages of Triparty Compared with Delivery-Versus-Payment
(DVP) Trading Arrangements 28
Table 7: Since 2003, Treasury's Daily Operating Cash Balance Increased in
Both Dollar Volume and Volatility for Most Parts of Each Month 31
Table 8: Since 2003, Treasury's Daily Operating Cash Balance Increased in
Dollar Volume for Each Business Day of the Week and in Volatility for Each
Business Day of the Week 31
Table 9: Average Cash Operating Balance by Investment for Past 5 Years 32
Table 10: Share of Investment Balance (i.e., Funds Excluding TGA) by
Investment Type 33
Table 11: Share of Investment Balance by Investment Type, March-September
2006 33
Table 12: Acceptable Collateral in the TT&L and TIO Programs 35
Table 13: Examples of Collateral Not Accepted in TT&L and TIO Programs 36
Table 14: Allocation of Collateral in Treasury's Short-Term Investment
Programs 37
Table 15: Changes in the TGA Target Balance since 1988 43
Table 16: Average TIO Rate and Marginal Earnings in Fiscal Year 2006
Relative to TT&L Deposits 46
Table 17: Treasury Could Increase Its Earnings by Investing in Repos 47

Figures

Figure 1: Trends in Treasury's Operating Cash Balance, Fiscal Year 2006 7
Figure 2: Instances of High and Low Treasury Daily Operating Cash
Balances, Fiscal Years 2003-2006 9
Figure 3: The TGA Daily Balance, Fiscal Year 2006 11
Figure 4: TT&L Rate Was Fixed at Federal Funds Rate Minus 25 Basis Points
in 1978 as a Proxy for the Market Repo Rate, but Repo Rates Have since
Increased Relative to TT&L Rates 17
Figure 5: Repo Clearing and Settlement Arrangements 22
Figure 6: Allocation of Treasury's Operating Balance by Type of
Investment, Fiscal Year 2006 24
Figure 7: Trends in SDIs, 2002-2006 38
Figure 8: Treasury's Collateral Margins Table 39
Figure 9: Neutralizing the Effect of the High TGA Balance 44

Abbreviations

BIC borrower-in-custody
CM bill cash management bill
DTS Daily Treasury Statements
DVP delivery-versus-payment
FRB Federal Reserve Bank
FRS Federal Reserve System
GFOA Government Finance Officers Association
GSE government-sponsored enterprise
OFP Office of Fiscal Projections
repo repurchase agreement
SDI Special Direct Investment
SOMA System Open Market Account
TGA Treasury General Account
TIO Term Investment Option
TIP Treasury Investment Program
Treasury Department of the Treasury
TT&L Treasury Tax & Loan

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United States Government Accountability Office
Washington, DC 20548

September 20, 2007

The Honorable Max Baucus
Chairman
The Honorable Charles E. Grassley
Ranking Member
Committee on Finance
United States Senate

Growing debt and net interest costs are a result of persistent fiscal
imbalances. In July 2007, the Office of Management and Budget projected
that interest costs on debt held by the public will increase by almost 25
percent over the next 5 years to $290 billion. If left unchecked, interest
spending threatens to crowd out spending for other national priorities.
The Department of the Treasury (Treasury) is responsible for managing the
funds that flow through the federal government's accounts, which are
maintained across the 12 Federal Reserve Banks and rolled into one
account, the Treasury General Account (TGA), at the end of each day.
Treasury frequently has funds available for short-term investment because
government collections and disbursements do not always align. In fiscal
year 2006, Treasury's operating balance averaged $26.4 billion per day.
The return on every federal dollar that Treasury is able to invest
represents an opportunity for the U.S. government to reduce net interest
costs.

Although there have been dramatic changes in financial markets that have
allowed investors to increase their rate of return while reducing risk,
Treasury's investment authority has not changed over the past three
decades. Under current law Treasury is only permitted to invest in
depositary institutions and in obligations of the United States
government.1 In addition to the TGA, Treasury invests in three
collateralized instruments with depositary institutions--Treasury Tax &
Loan (TT&L) notes, Term Investment Option (TIO) offerings, and limited
repurchase agreements (repo). The introduction of TIOs in 2002 and of
repos in 2006 were part of Treasury's effort to update its cash management
practices and improve earnings and capacity without increasing
unacceptable risks.2 In 2007, the Administration asked Congress to update
Treasury's authority for selected short-term investments.3

1 31 U.S.C. S 323.

This report is part of our ongoing work on Treasury's cash and debt
management practices and was requested by the U.S. Senate Committee on
Finance. The objectives of this report are to (1) analyze trends in
Treasury's main receipts, expenditures, and cash balances, (2) describe
Treasury's current investment strategy, and (3) identify options for
Treasury to consider for improving its return on short-term cash
investments.

To describe Treasury's cash management and short-term investment practices
we analyzed trends in cash available for short-term investment with data
collected from Treasury's publicly available Daily Treasury Statements. To
evaluate Treasury's current investment strategy and identify options for
improving Treasury's return while mitigating risk, we interviewed agency
officials from Treasury, the Federal Reserve Board of Governors, Federal
Reserve Bank of New York, and Federal Reserve Bank of St. Louis, and
reviewed policies for managing short-term investments. With data provided
by Treasury, we analyzed participation in and returns of Treasury's
short-term investment programs. We also interviewed market analysts and
officials from seven financial institutions, including participants in
Treasury's short-term investment programs, to gain a market perspective.
In addition, we obtained documents from foreign and state governments to
learn about their short-term investment practices. We performed our review
from March 2006 through July 2007 in accordance with generally accepted
government auditing standards. See appendix VI for more details on how we
calculated rates and potential return for Treasury's short-term
investments.

2In our 2006 report on Treasury's use of cash management bills (CM bills),
we found that Treasury could run higher cash balances to avoid issuing
high-cost CM bills, but that the interest earned on excess cash balances
was generally insufficient to cover borrowing costs. We recommended that
Treasury explore options, such as repos, to increase earnings on excess
cash balances and thereby reduce the use of some CM bills. GAO, Debt
Management: Treasury Has Refined Its Use of Cash Management Bills but
Should Explore Options That May Reduce Costs Further, [48]GAO-06-269
(Washington, D.C.: Mar. 30, 2006).

3Budget of the United States Government, Fiscal Year 2008--Appendix.

Results in Brief

Treasury regularly has cash available for short-term investment because of
frequent and predictable swings in its operating cash balance. Both the
total amount and volatility of Treasury's operating cash balance have
increased in recent years. Before Treasury invests any portion of its
operating cash balance, Treasury generally targets a $5 billion balance in
the TGA. Treasury seeks to maintain a balance in the TGA large enough to
protect against overdraft and attempts to keep it stable to avoid
interfering with the Federal Reserve's implementation of monetary policy.
Treasury earns an implicit return on TGA balances as part of the Federal
Reserve's weekly remittance to Treasury, but the exact amount is difficult
to identify because the Federal Reserve does not assign certain portions
of its investment portfolio to Treasury's account. Although an account
balance greater than $5 billion would provide Treasury with increased
overdraft protection, it could also increase borrowing, which would be
costly whenever Treasury faces a negative funding spread.

Treasury invests any of its operating cash in excess of its TGA balance in
three short-term programs--TT&L, TIO, and a repo pilot. The TT&L program
provides Treasury with an effective system for collecting federal tax
payments while assisting the Federal Reserve in executing monetary policy,
but it subjects Treasury to concentration risk and earns a return well
below the market rate.4 By concentration risk, we mean the risk of a large
share of Treasury's deposits being concentrated in relatively few
depositary institutions. The TIO program, established in 2003, earns a
greater rate of return than the TT&L program, but it also subjects
Treasury to concentration risk.5 Both programs also present capacity
concerns. By capacity concerns, we mean that Treasury's ability to invest
all available cash may be hindered because of decreases in the number of
participants or insufficient collateral available for depositary
institutions to secure Treasury's investments on days when Treasury has
high cash balances. As a third short-term investment alternative, Treasury
began testing repos through a pilot program in 2006, consistent with GAO
recommendations.6 Repos have earned near market rates of return, but
because of the pilot's scope and the current, limited legislative
authority under which it operates, the repo participants, collateral,
trading terms, and trading arrangements are restricted.

4In this report, when we refer to the TT&L program we are referring only
to the tax collection services of depositary institutions and additional
investments that Treasury makes in accounts called TT&L Main Accounts,
which we refer to as TT&L accounts. Although sometimes considered under
the same umbrella, we do not include the TIO program in our definition of
the TT&L program.

5The TIO program was piloted in 2002 and became a permanent program in
2003.

6 [49]GAO-06-269 .

A permanent, expanded repo program could permit Treasury to earn a higher
rate of return, expand investment capacity and reduce concentration risk.
If provided the authority for a permanent, expanded repo program, Treasury
would benefit from considering industry investment practices, such as
those used by the Federal Reserve. In designing the program's operational
elements and managing risks that are associated with the selection of
program participants, collateral types, terms of trade, and trading
arrangements, Treasury will need to tailor the repo program to meet its
liquidity needs and to achieve a higher rate of return while keeping risks
at a minimum. In a permanent, expanded repo program, Treasury should
consider both allowing broker dealers as counterparties and expanding
acceptable collateral types to alleviate capacity concerns and increase
rates of return. Treasury should also consider the effect of adopting an
electronic trading platform and a triparty clearing and settlement system
on rates of return, investment flexibility, and operational efficiency.

In written comments on a draft of this report, Treasury agreed with our
findings, conclusions, and recommendations. The Fiscal Assistant
Secretary's letter is reprinted in appendix VII.

Background

In managing the funds that flow through the federal government's account,
Treasury frequently accumulates cash due to timing differences in when
borrowing occurs, taxes are received, and agency payments are made.
Treasury often receives large cash inflows in the middle of the month and
makes large, regular payments in the beginning of the month. In general,
Treasury seeks to maintain low cash balances and repay debt whenever
possible, as the interest earned on short-term investments is generally
insufficient to cover additional borrowing costs.7

As fiscal agents and depositaries for the federal government, the Federal
Reserve Banks provide services related to the federal debt, help Treasury
collect funds owed to the federal government, process electronic and check
payments for Treasury, invest excess Treasury balances and maintain
Treasury's bank account, the TGA, through which most federal receipts and
disbursements flow. TGA funds are available for immediate disbursement and
are one of Treasury's most liquid investments.

Over the past several decades, technological advances and global expansion
have led to significant changes in financial markets. Lending institutions
have developed greater capacity to increase returns and manage risks, and
increased regulatory freedom has helped to spur new markets. Greater
computer power and better telecommunications networks have reduced
barriers that once limited investment opportunities. In particular,
significant growth has occurred in the segment of the money market that
includes the use of repurchase agreements, or repos. A repo is the
transfer of cash for a specified amount of time, typically overnight, in
exchange for collateral. When the term of the repo is over, the
transaction unwinds, and the collateral and cash are returned to their
original owners, with a premium paid on the cash.

The repo market has become one of the largest segments of the U.S. money
market and is used by government and private institutional investors to
invest short-term excess cash. In the first quarter of 2007, the average
daily volume of outstanding total repos was $3.6 trillion, according to
information provided to the Federal Reserve by primary dealers that engage
in repo transactions. Over $114.3 trillion in repo trades involving U.S.
Government Securities were reported in the first quarter of 2007, with an
average daily volume of approximately $1.8 trillion.8 Repos were used by
the Federal Reserve as early as 1917 and play an important role in the
conduct of monetary policy operations since the Federal Reserve uses repos
to dampen transient fluctuations in the supply of reserves available to
the banking system. For the past 20 years, large corporations have been
shifting cash assets out of bank accounts into instruments such as repos,
which have enabled them to increase the returns on their short-term cash
assets with minimum risk to their funds.

7Paying down the federal debt would generally save the federal government
more money than the government would likely earn on short-term
investments. However, the short periods of time for which Treasury has
excess cash make paying down the federal debt not an option. In 2006, GAO
recommended that Treasury minimize its short-term borrowing. See
[50]GAO-06-269 .

8See Securities Industry and Financial Markets Association's May 2007
Research Quarterly report, available at [51]www.sifma.org .

Electronic systems have increased the speed of repo transactions and
expanded the range of investors that can participate. Innovative
arrangements for accepting collateral in the repo market, specifically
triparty arrangements, have reduced transactions costs, credit risks, and
operational risks. In a triparty repo an independent custodian bank acts
as an intermediary between the two parties in the transaction and is
responsible for clearing and settlement operations. The triparty structure
typically reduces costs, minimizes operational and credit risks, and has
the potential to increase returns. The Federal Reserve has been using
triparty arrangements for its repos since 1999.

Treasury's Short-Term Cash Available for Investment Fluctuates According to a
Predictable Pattern

Treasury's operating cash balance fluctuates according to a predictable
pattern although the swings in daily cash balances have grown larger in
recent years. Before Treasury invests any portion of its operating cash
balance, Treasury generally targets a $5 billion balance in the TGA.9
Treasury seeks to maintain a balance in the TGA large enough to protect
against overdraft and attempts to keep the balance stable to avoid
interfering with the Federal Reserve's implementation of monetary policy.
Balances held in the TGA earn an implicit rate of return.

Treasury's Cash Balances Available for Short-Term Investment Exhibit Predictable
Cyclical Patterns

Patterns in receipts and disbursements cause frequent but predictable
swings in federal cash balances, which regularly provide Treasury with
cash available for short-term investment. Treasury's daily operating cash
balance, the amount of cash remaining after receipts and disbursements are
accounted for, averaged $26.4 billion in fiscal year 2006.

The receipts Treasury uses to finance federal expenditures come primarily
from two sources: (1) tax revenues from sources such as personal and
corporate income taxes, payroll withholdings, or other fees the federal
government imposes; and (2) cash borrowed from the public through
Treasury's regular auctions of debt securities. Treasury's daily operating
cash balance is generally lower at the beginning of each month due to
mandatory expenditures and then rises in the middle of each month upon the
arrival of Treasury's scheduled receipts. (See fig. 1.)10 Treasury's cash
balances also fluctuate depending on the time of year, with mid-month
increases that are particularly large in January, March, April, June,
September, and December. Treasury receives major corporate or nonwithheld
individual estimated tax payments, or both, in these months, which
significantly increases Treasury's daily operating cash balance. Increases
are highest in April, when Treasury receives and processes the prior
year's individual income tax liability settlements and the first estimated
payments of the current tax year from individuals and calendar year
corporations.

9Between 1974 and 1978, the TGA was Treasury's only short-term investment
and absorbed all excess cash. See app. III for more details.

Figure 1: Trends in Treasury's Operating Cash Balance, Fiscal Year 2006

10In 2006, Treasury shifted its issuance date for a new 5-year note from
mid-month to the end of the month. Over time this will decrease the
mid-month spike in receipts. Tax deposit schedules, however, are set by
either statute or regulation.

Large payments for programs such as Medicare, Social Security, federal
retirement, and veterans' compensation frequently occur during the first 3
days of each month, significantly lowering Treasury's daily operating cash
balance at the beginning of each month.11 One quarter of fiscal year 2006
outlays were paid in the first 3 days of the month.12 Like the tax deposit
schedule, the majority of the payment dates for these large benefit
programs are statutory, which limits Treasury's flexibility in cash
management.13

Treasury's Cash Balances Available for Short-Term Investment Have Both Increased
and Grown More Volatile over Time

In fiscal year 2006, Treasury's average daily operating cash balance was
$26.4 billion, an $8.5 billion increase from fiscal year 2003. (See table
1.) Swings in daily cash balances have also grown over time. Days with
high cash balances--and hence significant amounts of short-term cash for
investment--have more than quadrupled since 2003. (See fig. 2.) Cash
balances tend to be highest at the end of the month before large mandatory
payments are made. Over the past 3 years, cash balances have generally
increased in both dollar volume and volatility for most parts of each
month and for each business day of the week. Appendix I provides more
details on these trends.

11Social Security benefits for those who filed before May 1, 1997, are
delivered on the 3rd of each month. Social Security benefits that were
filed for on or after May 1, 1997, are assigned 1 of 3 new payment days
based on the date of birth of the insured person, and are delivered on the
second, third, or fourth Wednesday of every month. If the scheduled
Wednesday payment day is a federal holiday, payment is made on the
preceding day that is not a federal holiday.

12In total, Treasury made about $750 billion in cash payments in the first
3 days of months in fiscal year 2006.

13Treasury must also repay regular bills that mature on Thursdays and
notes that mature in the middle and end of each month. However, Treasury
generally pays them by rolling over debt (i.e., issuing new debt to pay
maturing debt).

Table 1: Since 2003, Treasury's Daily Operating Cash Balances Have
Increased in Dollar Volume and Become More Volatile

(Dollars in billions)
Fiscal year Fiscal year Fiscal year Fiscal year
2003 2004 2005 2006
Daily average cash balance 17.9 20.5 25.9 26.4
Standard deviation 10.8 13.8 18.3 21.0
Coefficient of variationa
(percent) 60 67 71 80

Source: GAO analysis of Treasury data.

Note: Our calculations include only operating cash balances on business
days, not weekends and holidays.

aCoefficient of variation is a measure of volatility, calculated by
dividing the standard deviation by the mean. A larger percentage indicates
greater volatility.

Figure 2: Instances of High and Low Treasury Daily Operating Cash
Balances, Fiscal Years 2003-2006

The TGA Protects against Overdraft and a Stable Balance Assists with Monetary
Policy

Before investing any portion of its operating balance, Treasury generally
seeks to maintain a stable $5 billion balance in the TGA to protect
against overdraft. An overdraft of the TGA could occur if the anticipated
receipts for the day fall short of expectation or if there are
unanticipated disbursements. Treasury cannot risk an overdraft because the
Federal Reserve is not authorized to lend directly to Treasury, in part to
preserve the Federal Reserve's independence as the nation's central bank.
Before 1988, as federal payments became larger and the volatility of
Treasury's operating cash balance increased, Treasury and the Federal
Reserve increased the TGA target balance. According to Federal Reserve
officials, improvements in the forecasting of receipts and expenditures
have permitted them to not make any permanent increases to the TGA since
1988 despite continued increases in operating balance volatility. See
appendix V for more detail on Treasury's modifications to the TGA target
balance since 1988.

In the past, Treasury relied on compensating balances in depositary
institutions as a source of liquidity on rare occasions. For example, in
the week of September 11, 2001, Treasury pulled $12.6 billion from such
compensating balances to cover a financing gap caused by the cancellation
of a 4-week-bill auction. However, this source of liquidity has not been
available since 2004.14

A stable TGA balance assists the Federal Reserve in its execution of
monetary policy. If Treasury's TGA balance exceeds or falls short of its
target, the Federal Reserve must neutralize its effect on bank reserves
through open market operations. See appendix V for more details on how the
Federal Reserve injects or withdraws cash from the banking system in
response to changes in the TGA. As shown in figure 3, in 2006 the TGA
balance deviated more than 20 percent from its $5 billion target 17 times.
In 9 of the 17 times, Treasury and the Federal Reserve had agreed in
advance to target a balance other than $5 billion. Treasury and the
Federal Reserve sometimes decide to target different balances for reasons
that include increased volatility on major tax due dates and the
facilitation of short-term reserve management.

14See GAO, Debt Management: Backup Funding Options Would Enhance
Treasury's Resilience to a Financial Market Disruption, GAO-06-1007
(Washington, D.C.: Sept. 26, 2006). The Federal Reserve does not have
general authority to provide immediate, short-term funding to Treasury
except in very limited circumstances under 31 U.S.C. S 5301. GAO has
recommended that Treasury explore other sources of emergency funding in
case of a widespread financial disruption similar to the one caused by the
terrorist attack on September 11, 2001.

Figure 3: The TGA Daily Balance, Fiscal Year 2006

TGA Balances Earn an Implicit Return

Although Treasury does not earn explicit interest on the TGA, it does earn
an implicit return as part of the Federal Reserve's weekly remittance to
Treasury. However, the Federal Reserve told us that the amount cannot be
easily identified.15 The implicit return Treasury receives depends on
whether the purchases the Federal Reserve makes to offset the TGA balance
are permanent or temporary. In a stable TGA target environment, such as
exists today, the implicit return is roughly equivalent to the rate earned
by the Federal Reserve on its portfolio of Treasury securities. For
temporary increases in the TGA, the implicit return is roughly equal to
the rate the Federal Reserve earns on its overnight repos. According to
the Federal Reserve, the return cannot be isolated because it does not
assign specific portions of its investment portfolio to the TGA. The
Federal Reserve records the TGA on its balance sheet as a liability and
offsets increases in the TGA by purchasing additional assets.16

15Treasury recognizes that the government receives an implicit return on
TGA balances from the Federal Reserve and used it as an official
investment vehicle between 1974 and 1978. See app. III for more details.

While a higher TGA target balance would provide Treasury with increased
overdraft protection and earn market rates of return, it could increase
borrowing, which is costly whenever Treasury faces a negative funding
spread. A negative funding spread occurs when the interest earned on cash
balances is insufficient to cover the cost of the increased borrowing
necessary to maintain these balances. Conversely, if the Treasury were to
face a neutral or positive funding spread, increases would not be costly.
When Treasury's cash balances are particularly low, it may have to raise
funds by issuing additional debt in order to maintain a stable and
sufficient TGA balance.

Treasury's Short-Term Investment Strategies Have Evolved over Time, but
Restrictions Still Subject Treasury to Several Risks and Lower Returns

In order to maintain a stable TGA balance, Treasury must place operating
cash above its $5 billion target in depositary institutions' TT&L accounts
or into other short-term investments. The three short-term vehicles
currently used by Treasury subject Treasury to high concentration risks
and have limited capacity. TT&L provides Treasury with an effective system
for collecting taxes but subjects Treasury to concentration risk and
offers low rates of return. To improve returns, Treasury established the
TIO program in 2003, which provides near market rates of return but still
subjects Treasury to concentration risk and does not alleviate Treasury's
capacity concerns. Treasury's repo pilot, introduced in 2006, provides a
third limited investment option. Treasury earned near market rates of
return in the pilot, but because of its temporary status and limits in
Treasury's current legislative authority, the pilot's features--including
participants, collateral, trading terms, and clearing and settlement
arrangements--are restricted and prevent Treasury from accessing the
broader repo market. Table 2 shows the number of participants, investment
terms, relative performance, and concentration risk of these three
investment programs.

16Although it is certain that money held in the TGA earns a return,
Federal Reserve officials caution that calculating precisely what share of
the Federal Reserve's remittances to Treasury is associated with changes
in the TGA balance is problematic. The Federal Reserve does not assign
certain portions of its investment portfolio to the TGA. Instead, the
portfolio reflects changes in the entire reserve balance sheet, of which
the TGA is just a part. Changes in Treasury's cash held in the TGA may
directly affect this balance sheet, but the total amount of money returned
to Treasury can only be linked to changes in the Federal Reserve's overall
portfolio, most of which are not related to the TGA.

Table 2: Treasury's Short-Term Investment Programs

Basis
points
above Concentration by
Number of TT&L volume of top two
Investment depositary rate of participants
program institutions Term Rate 4.90a (percent)
TT&L Callable Fed funds
(established on demandd rate less
in 1978)b 25 basis
953c points 0 53
TIO 1-32 days Auction
(established (legal determines + 18
in 2003) maximum of uniform basis
60e 90 days) rate points 50
Repo pilot Overnight Auction + 21
(established determines basis
in 2006) 2 rates points 100

Source: GAO analysis of Treasury data.

aEstimates use average rates for the period March 27, 2006, to March 26,
2007, the first 12 months of Treasury's repo pilot.

bTT&L accounts were originally established in 1917, but the current
program did not take shape until 1978.

cIncludes retainers and investors accounts only. There were also 8,089
collectors that served as conduits for tax collection, but did not hold
Treasury cash for investment. Retainer, investor and collector accounts
are described below.

dMajority of funds called on same-day basis or with 1-day advance notice.
Smaller banks, banks with less than $100 million in tax payments or less
than $100 million in deposit liabilities are generally provided between 3
and 12 days advance notice.

eNumber of TIO participants current as of February 2007.

The TT&L Program Serves Key Functions but Has Significant Limitations

The TT&L program provides Treasury with an effective system for collecting
federal tax payments and helps Treasury meet its target balance in the
TGA, but it subjects Treasury to concentration risk and earns a return
well below market rate. In addition, the TT&L poses capacity concerns. In
2006, Treasury invested about 30 percent of its operating cash in TT&L
deposits, with a daily average of $7.6 billion.

TT&L Benefits: The TT&L program represents a collaboration between
Treasury and over 9,000 commercial depositary institutions that collect
tax payments, about 1,000 of which also hold funds and pay interest to
Treasury. (See table 2.) There are three categories of participation:
collectors, retainers, and investors. The majority of TT&L participants
are collectors--they receive tax payments from customers and transfer the
payments to Treasury's account at the Federal Reserve. Retainers perform
the same tax collection functions but may also retain specified amounts of
the cash in an interest-bearing account until the money is called by
Treasury. Investors not only collect and retain cash, but also may accept
funds from Treasury though different investment options. In one of these
options, the depositary institution agrees to accept automatic direct
deposits from Treasury made hourly throughout the day in the event that
Treasury cash receipts are greater than anticipated. These automatic
deposits--known as dynamic investments--are an important part of the TT&L
program because they are currently Treasury's only option for placing
late-day cash and helping Treasury to meet its target TGA balance.17

TT&L Participant Concentration: TT&L deposits are highly concentrated
among a few large depositary institutions. For the past couple of years,
Treasury has invested almost half of TT&L deposits with one depositary
institution. Reasons for this concentration include consolidation in the
banking industry over the last two decades and the lack of investment
caps. In 2006, the five largest TT&L participants accounted for 66 percent
of the total funds invested in TT&L accounts, up from 62 percent in 2005.
(See tables 3 and 4.) This creates not only concentration risk but also
capacity concerns. If one or two of the largest depositary institutions
were to lower their TT&L balance limits or withdraw from the program
entirely, Treasury's investment capacity would fall far below that needed
to accept the total amount of funds that Treasury needs to invest during
peak tax collection dates. In addition, the number of depositary
institutions participating in the TT&L program and thus willing to accept
Treasury cash has decreased over the past few years. According to
Treasury, at times it has been unable to place all of the cash it wished
to invest in part because of a reduction in the number of TT&L
participants.

17For purposes of this report, TT&L capacity includes only the collateral
pledged to TT&L accounts. During periods of significant tax receipts,
Treasury also invests cash in Special Direct Investments that are secured
with collateral held by depositary institutions in an off-premises
collateral arrangement. For more information on Special Direct
Investments, see app. II.

Table 3: Five Largest Participants in TT&L Program in Fiscal Year 2005 by
Total Volume

Bank Percent of total for all banks
Bank A 46
Bank B 7
Bank C 4
Bank D 3
Bank E 3
Subtotal of top five banks 62
Remaining banks (981) 38
Total ($1.1 trillion) 100

Source: GAO analysis of Treasury data.

Note: Banks A through E in this table are not necessarily the same
depositary institutions as in tables 4 and 5.

Table 4: Five Largest Participants in TT&L Program in Fiscal Year 2006 by
Total Volume

Bank Percent of total for all banks
Bank A 43
Bank B 9
Bank C 8
Bank D 4
Bank E 3
Subtotal of top five banks 66
Remaining banks (920) 34
Total ($965 billion) 100

Source: GAO analysis of Treasury data.

Note: Banks A through E in this table are not necessarily the same
depositary institutions as in tables 3 and 5.

TT&L Rates of Return: The interest rate earned on deposits in retainer and
investor accounts is fixed at the federal funds rate minus 25 basis
points.18 TT&L deposits are an inexpensive source of funding relative to
market alternatives for depositary institutions, but Treasury can withdraw
certain funds on short notice and funds are subject to strict collateral
requirements. See appendix II for a discussion of TT&L collateral
requirements.

18One basis point is equivalent to 0.01 percent (1/100th of a percent) or
0.0001.

When Treasury set the TT&L rate in 1978, it was a close approximation of
the overnight repo rate, which Treasury considered an economically similar
transaction. Treasury elected to use a proxy rate at the time because
information on the daily overnight repo rate was not widely available. The
repo market has grown considerably, and information about repo rates is
now readily available.19 Since 1978 the spread between the federal funds
rate and the repo rate has narrowed significantly from about 25 basis
points to about 9 basis points in recent years.20 As a result, the spread
between the TT&L rate and the overnight repo rate has grown larger,
leaving Treasury earning a fixed rate on TT&L accounts that is well below
market rates. (See fig. 4.) In July 1999 Treasury proposed changing the
interest rate on TT&L deposits to align it with the overnight repo rate
since Treasury viewed TT&L deposits as overnight investments, similar to
repo transactions. However, financial institutions opposed the rate
change; in 2002 Treasury modified the proposal and began exploring the
short-term investment alternatives discussed later in this report,
specifically TIOs and repos.

19The Federal Reserve began publishing data on repo transactions conducted
with primary dealers in October 1980.

20Specifically, the spread was about 9 basis points between January 3,
2005, and May 19, 2006, with a standard deviation of 7 basis points.
Source: Marcia Stigum and Anthony Crescenzi, Stigum's Money Market, 4th
ed. (New York: McGraw-Hill, 2007).

Figure 4: TT&L Rate Was Fixed at Federal Funds Rate Minus 25 Basis Points
in 1978 as a Proxy for the Market Repo Rate, but Repo Rates Have since
Increased Relative to TT&L Rates

TIO Program Earns a Better Rate of Return Than TT&L but Exposes Treasury to
Similar Risks

Treasury's TIO program, fully established in 2003, earns Treasury a higher
rate of return than the TT&L program but shares the TT&L program's
concentration risk and Treasury's capacity concerns in part because the
same depositary institutions participate in both programs.21 TIO
investments differ from TT&L deposits in two critical dimensions: (1) they
are auctioned rather than placed at a fixed rate and (2) they are placed
for a fixed number of days rather than being callable at will. Through the
TIO program, Treasury auctions off portions of its excess cash at a
competitive rate for a fixed number of days. The TIO program's auction
format allows Treasury to receive a competitive, market-based interest
rate for its surplus cash. Meanwhile, the participating depositary
institutions benefit from knowing in advance the exact amount and timing
of the investment.

While depositary institutions have no control over when
funds are deposited or withdrawn from the TT&L accounts, they know exactly
how long TIO funds will be deposited, and through competitive bidding have
more direct influence over the amount of funds that they receive. By 2006,
approximately 60 percent of Treasury's short-term investments were shifted
into TIOs. In fiscal year 2006 Treasury invested $500 billion through TIO
auctions. As of February 2007, 60 TT&L depositaries participated in the
TIO program, up from 43 in 2004. The textbox provides additional details
on how Treasury conducts TIO auctions.

21The TIO program was piloted in 2002 and became a permanent program in
2003.

TIO Rates: TIOs earn a higher rate of return than TT&L deposits. In fiscal
year 2006, TIO auction rates were on average 17 basis points higher than
TT&L rates over the same terms, increasing Treasury's gross return by
approximately $20 million.22 The TIO rates were also about 3 basis points
below Treasury's benchmark for a market rate, which is based on repo rates
of similar terms and collateral. There are variations among TIO auctions
regarding the length of the term and the amount of cash offered that
affect rates. According to a Federal Reserve study, TIO rates are most
competitive for TIO term lengths of 5 days or greater, and the larger the
auction size, the lower the TIO rate.

TIO Participant Concentration: Although the TIO program has increased
Treasury's rate of return, it has not lessened its concentration risk, in
part because TIO investors must be TT&L depositaries and they can receive
up to 50 percent of funds offered by Treasury per auction. TIO investment
concentration has increased in recent years. In fiscal year 2006, 50
percent of TIO funds were awarded to two depositary institutions, up from
about 40 percent in fiscal year 2004. (See table 5.)

22See app. VI for more details.

Table 5: TIO Funds Are Concentrated in Two TIO Participants

Share of total TIO auction
amounts awarded by top 10
participants
Fiscal
year Fiscal
Fiscal year 2004 2005 year 2006
Bank Percentage Bank Percentage Bank Percentage
Bank A 19 Bank A 35 Bank A 27
Bank B 18 Bank B 19 Bank B 23
Bank C 11 Bank C 8 Bank C 7
Bank D 7 Bank D 5 Bank D 4
Bank E 6 Bank E 4 Bank E 3
Bank F 6 Bank F 3 Bank F 3
Bank G 5 Bank G 2 Bank G 3
Bank H 5 Bank H 2 Bank H 2
Bank I 4 Bank I 2 Bank I 2
Bank J 3 Bank J 2 Bank J 2
All 14 All 16 All
other other other
banks banks banks
(26) (37) (43) 23
Total Total Total
($237 ($564 ($495
billion) 100 billion) 100 billion) 100

Source: GAO analysis of Treasury data.

Note: Banks A through J are not necessarily the same depositary
institution in each year nor are they necessarily the same depositary
institutions as in tables 3 and 4.

TIO Collateral and Capacity: TIO collateral restrictions are similar to
those in the TT&L program, and because depositary institutions participate
in both programs, participants' total capacity is divided between the two
programs. Depositary institutions transfer collateral between the TIO and
TT&L programs in order to participate in upcoming TIO auctions, which
depletes the amount of collateral and capacity in TT&L accounts. According
to Treasury, TT&L account capacity declined between 2001 and 2006, but
capacity has shifted from TT&L accounts to the TIO program such that total
investment capacity remained in line with the average capacity from 2001
to 2006. This shift of capacity from TT&L accounts to the TIO program
presents challenges to using all of the capacity when there is a sudden
and significant increase in Treasury's cash balance (e.g., if the balance
spikes up for only 1 or 2 days). There have been a few instances in the
last few years in which Treasury has raised or considered raising the
target Federal Reserve balance because TT&L accounts were close to
capacity. Appendix II provides additional information on the types of
collateral pledged in TIO auctions and how they are valued.

Treasury's Repo Pilot Has Continued to Improve Overall Returns, but Is Currently
Limited in Scope

Like the TIO program, the repo pilot provides Treasury with higher rates
of return than TT&L deposits, but current legal restrictions and the
pilot's limited scope prevent Treasury from accessing a broader repo
market. At $4 billion per day, Treasury's repo pilot is small relative to
the $1.8 trillion per day repo market.

In March 2006 as part of its initiative to modernize its cash management
program, Treasury began operating a 1-year pilot program to invest excess
cash into repos, consistent with GAO recommendations.23 The objectives of
the pilot were to (1) assess the effect of this type of investment
operation on both Treasury and Federal Reserve operations, internal
systems, and processes, and (2) explore the benefits of using repos to
expand Treasury's investment capacity and increase the return on invested
funds. Initially there was only one participant; a second participant was
added in August 2006. In the first 12 months of the repo pilot program,
Treasury conducted 235 repo transactions, and invested $645 billion
altogether. Treasury's repo investments in the second half of fiscal year
2006 made up 11 percent of its total short-term investment balance. In
that first year of the repo pilot, rates were on average 21 basis points
higher than TT&L rates and earned close to Federal Reserve repo rates. In
its evaluation of the pilot, Treasury found that it can effectively
conduct repo transactions with a limited number of counterparties without
adverse effect on its or the Federal Reserve's operations, internal
systems, and processes.

Repo Participants: Under current law, Treasury is limited to investing its
excess cash in depositaries maintaining TT&L accounts and in obligations
of the United States. As a result, it cannot invest with securities
dealers who play a prominent role in the repo market. The Federal Reserve
conducts all of its repos with 21 securities dealers, who are selected
based on their ability to make good markets, participate meaningfully in
Treasury auctions, and provide market intelligence that is useful to the
Federal Reserve in the formulation and implementation of monetary
policy.24 In 2006, the Federal Reserve had an average daily balance of
$25.3 billion in repos with selected securities dealers.

23 [52]GAO-06-269 .

24For a listing of primary dealers, see
http://www.newyorkfed.org/markets/pridealers_current.html (downloaded on
July 9, 2007).

Repo Term and Frequency: The repo pilot program offers only repos that
have a term of 1 business day. Although this term comprises the largest
share of the repo market, some participants invest in repos with longer
terms. In addition, the repo pilot program conducts only a single daily
auction at 9 a.m. Other repo participants conduct transactions throughout
the day in the broader repo market, allowing them to place cash late in
the day.

Repo Bids: Bidding for Treasury's repo pilot program is conducted by
telephone, which is consistent with market convention for repos with a
limited number of participants. Industry experts view telephone trading as
an efficient way to conduct trades for offerings with a few
counterparties. A greater number of counterparties may require an
electronic trading system in order to prevent delays between the time rate
quotes are made and accepted. Electronic trading systems also reduce
trading costs and the risk of clearing errors. In 2006 the Federal Reserve
upgraded to a new electronic trading system, FedTrade, to manage its repo
trades with primary dealers. Treasury officials told us that they were
exploring the capabilities of an electronic system similar to that used by
the Federal Reserve and its application to an expanded repo program.

Repo Collateral: Because of its current investment authority, Treasury
only accepts Treasury securities as collateral in its repo pilot program.
Participants in the larger repo market, including the Federal Reserve,
accept a wider range of collateral types including mortgage-backed
securities and U.S. government agency securities.25 Although repos backed
by Treasury securities constitute the largest share of the repo market,
there are some important limitations to demand for such repos. Most
importantly for Treasury, the demand for repos backed by Treasury
securities is lowest during times when Treasury has the most cash to
invest. This happens in April and May, when, in response to high tax
receipts, Treasury reduces the number of Treasury bills available in the
market. Additionally, the rates received on repos backed by
mortgage-backed securities and U.S. agency securities are typically higher
than the rates for Treasury securities.

25U.S. agency securities refer to securities issued or guaranteed by U.S.
government corporations like the Government National Mortgage Association
(Ginnie Mae) or by U.S. government-sponsored enterprises (GSE) like the
Student Loan Marketing Association (Sallie Mae), Federal National Mortgage
Association (Fannie Mae), and Federal Home Loan Mortgage Corporation
(Freddie Mac). While some agency securities are backed by the full faith
and credit of the United States government, GSEs are not.

Repo Clearing and Settlement: Clearing is the process of calculating the
obligations of the counterparties to make deliveries of securities or
payments of cash. Settlement is the transfer of cash and securities
between the party and counterparty. For repo transactions, clearing and
settlement are typically done through either a delivery-versus-payment
(DVP) or triparty arrangement. In a DVP arrangement, as is used in the
repo pilot program, the party and counterparty complete the clearing and
settlement processes. In a triparty agreement, an independent custodial
bank manages the clearing and settlement process.

As illustrated in figure 5 below, in a DVP transaction, cash is
transferred to the party, and the securities are delivered to the
counterparty or its fiscal agent. The delivery of securities is done over
a secure transfer system operated by the Federal Reserve Banks, which
allows the transfer of certain types of securities such as U.S. Treasury
and U.S. government agency securities. In triparty repos, both
counterparties maintain accounts at a third-party custodian bank that
facilitates the transfer of cash and securities between accounts. A
broader range of securities can be used as collateral because the
securities are already in accounts at the independent custodial bank.

Figure 5: Repo Clearing and Settlement Arrangements

Options Exist to Increase Treasury's Rate of Return and Reduce Risk on
Short-Term Investments

Treasury Should Minimize TT&L Investments and Expand the Repo Program to
Increase Returns and Reduce the Risks of Concentration and Constrained Capacity

Treasury could increase its return on investment by continuing to reduce
funds in TT&L accounts and reallocate those funds to a mix of TIOs and
repos. In 2006, Treasury invested an average of $7.64 billion per day in
the TT&L program. Treasury generally maintains at least $2 billion in the
TT&L program as a means of maintaining active participation in the
program. Retaining some TT&L banks to take direct investments as part of a
broadened array of investment options would likely be advantageous for
Treasury, by helping to provide Treasury with a more diversified set of
investment options and by presumably increasing overall investment
capacity. As illustrated in figure 6, during certain times of the year,
Treasury has large balances in TT&L accounts earning a below-market rate
that could instead be invested in an expanded repo program. If Treasury
had invested TT&L funds in excess of the $2 billion floor in repo
investments and earned the Federal Reserve's overnight repo rate, we
estimate that Treasury could have earned an additional $12.6 million in
2006.26 Investing in repos could also reduce the high levels of
concentration and alleviate the limited capacity in the TT&L and TIO
programs by accessing the almost $2 trillion broker-dealer repo market.

26For additional details on the estimate of Treasury's additional
earnings, see app. VI.

Figure 6: Allocation of Treasury's Operating Balance by Type of
Investment, Fiscal Year 2006

Treasury Will Need to Consider Primary Investment Objectives If Given Authority
to Design a Permanent, Expanded Repo Program

In designing the operational elements of a permanent, expanded repo
program, Treasury would need to consider industry investment practices in
designing the program's operational elements and managing risks that are
associated with the selection of participants, collateral types, terms of
trade, and trading arrangements. Since the repo pilot was conducted under
current limited authority, Treasury did not have the opportunity to
consider design decisions, such as we discuss in this section.

Primary Investment Objectives

In establishing a permanent, expanded repo program, Treasury would benefit
from the insights gained in its repo pilot program and from examining
recommended investment practices and federal regulations of other repo
operations. Three sources of recommended short-term investment practices
are the Government Finance Officers Association (GFOA), an organization
that advises state and local governments' finance officials, the Federal
Reserve Policy on Payments System Risk, and the federal repo regulations
issued by the Federal Deposit Insurance Corporation.27 Guidance for
recommended short-term investment practices cite three primary objectives,
in order of priority: (1) risk management, (2) liquidity, and (3) yield.

Risk Management: According to the GFOA, the preservation and safety of
principal is the foremost objective of short-term investments, which is
accomplished by minimizing certain risks that are present in repo
investments:

(a) Credit Risk: The risk that a repo party will not fulfill its
obligations to Treasury.
(b) Concentration of Credit Risk: The risk of loss attributable to
the magnitude of Treasury's investment in a single party.
(c) Custodial Risk: The risk that, in the event of a failure of a
repo, Treasury will not be able to recover the full value of
collateral securities that are in possession of outside parties.
(d) Interest Rate Risk: The risk that changes in interest rates
will adversely affect the fair value of Treasury's investment.

In a permanent repo program, Treasury will need to establish criteria to
select counterparties to minimize exposure to credit risk, consider its
overall exposure to each party and any of its related parent companies,
and to monitor its exposure to interest rate risk. In determining with
whom Treasury would be willing to conduct repos, Treasury would need to
monitor the possibility of losses due to the high concentration of
investments with a few participants. Specifically, Treasury would need to
consider its overall exposure to each counterparty and any of its related
parent companies and subsidiaries in its investments. To reduce interest
rate risk, Treasury already requires TT&L participants to provide a
greater amount of collateral than the amount of cash received.28 In a
permanent repo program, Treasury will also need to monitor its exposure to
market/interest rate risk that would arise from accepting a wider variety
of collateral and investing at times for terms longer than overnight.

27For copies of these see the GFOA's Web site, [53]www.gfoa.org , the
Federal Reserve's Web site at
[54]http://www.federalreserve.gov/paymentsystems/psr/default.htm , and the
Federal Deposit Insurance Corporation Policy Statement on Repurchase
Agreements of Depositary Institutions with Securities Dealers and Others,
Federal Register, vol. 63, no. 34 (Feb. 20, 1998).

28This requirement is called a "haircut." A haircut is the percentage that
is subtracted from the market value of the collateral. The size of the
haircut reflects the perceived risk associated with the pledged assets.

Liquidity: Recommended investment practices related to liquidity are
designed to ensure availability of funds when needed. The GFOA identifies
two elements: (1) setting the term of some repo investments to mature when
cash needs are highest and (2) having some repo investments that allow the
investor to obtain cash on short notice without penalty. For Treasury,
cash needs are greatest on or near the beginning of each month. The
ability to obtain cash on short notice might be accomplished by engaging
in overnight repos that can be rolled over every day. Treasury's optimal
mix of overnight and longer-term repos would depend on the patterns of
Treasury receipts and cash available for short-term investments and on the
timing and size of expected cash needs.

Yield: An expanded repo program has the potential to improve Treasury's
return on investments relative to TT&L rates while maintaining current
minimal risk investment policies. Treasury has already incorporated a
recommended practice in its repo pilot program related to assessing the
yield performance of a repo investment program. Specifically, Treasury
compared the return on its repo pilot investments to an appropriate market
benchmark.

Design and Operating Decisions

In designing a permanent, expanded repo program, Treasury should consider
the investment principles cited above in its selection of participants,
collateral types, trading processes, and clearing and settlement
arrangements.

Repo Participants: Expanding the repo program to include securities
dealers, with whom Treasury does not currently invest, would increase
Treasury's investment capacity and could reduce the concentration risk
found in the TT&L and TIO programs. In its evaluation of the repo pilot
program, Treasury raised the possibility of expanding the range of parties
to include the 21 securities dealers selected by the Federal Reserve to
conduct its monetary policy operations. Whether Treasury uses the same
criteria used by the Federal Reserve or develops its own criteria to
select an acceptable set of counterparties, expanding to securities
dealers would give Treasury greater access to the repo market and expand
its investment capacity.

Repo Collateral: Expanding the type of collateral acceptable in a
permanent repo program could also increase Treasury's return and
investment capacity. Treasury would benefit from adopting the practice of
other participants in the repo market, including the Federal Reserve,
which accepts a wider range of collateral types, such as mortgage-backed
securities and U.S. government agency securities. For example, the Federal
Reserve selects from participant's propositions across three different
types of collateral. The rates it accepts depend on the attractiveness of
participant bids relative to current rates in the financing market for
each particular class of collateral.

Repo Trading: Treasury should consider adopting an electronic trading
system if it expands beyond a small number of participants to ensure
transparency and fairness. Trading in Treasury's repo pilot program is
conducted by telephone, which is consistent with market convention for
repos with a limited number of participants. However, a greater number of
counterparties may require an electronic trading system in order to
prevent time delays, lower the risk of operational errors, and reduce
trading costs. According to Treasury, it is exploring the capabilities of
an electronic system similar to that used by the Federal Reserve that
would allow it to conduct repo operations with a large number of parties
in a transparent and fair manner. The exact costs of such a system are
currently unknown.

Clearing and Settlement: Treasury should consider the advantages and
disadvantages of adopting a triparty clearing and settlement arrangement
for an expanded repo program. A triparty arrangement would reduce clearing
and settlement costs, facilitate the expansion of collateral, and increase
investment flexibility. According to an industry expert, the primary
benefit of triparty arrangements is that the securities are held by a
commercial clearing bank, which reduces risk and administrative work for
both repo counterparties. For Treasury, triparty arrangements would reduce
the expenses of monitoring, clearing, and settlement. Triparty
arrangements would also facilitate the use of a broader range of
securities for collateral because custodian banks can hold classes of
securities that cannot be transferred over Fedwire. In addition, triparty
arrangements would expand Treasury's processing capacity, and allow
Treasury to make additional repo investments later in the day to
accommodate unanticipated excess cash.

Although there are certain disadvantages to triparty arrangements, there
may be options that Treasury could explore to reduce them. Unsecured
intraday exposure may exist because there is a time lag between when cash
from a repo transaction is transferred from the counterparty's account and
when the counterparty receives the collateral associated with the
transaction. In addition, with a triparty arrangement, Treasury would not
take possession of the pledged securities as its fiscal agent, the Federal
Reserve, does in a DVP arrangement. According to Treasury, there may be a
number of ways to mitigate these risks. See table 6 for a summary of
triparty advantages and disadvantages.

Table 6: Advantages of Triparty Compared with Delivery-Versus-Payment
(DVP) Trading Arrangements

Advantages Disadvantages
Accommodates a wider variety of Unsecured intraday exposure may exist
collateral, potentially leading because the cash is transferred from the
to higher returns. counterparty's account earlier in the day
and collateral is transferred later in the
day.
Expands processing capacity of The counterparty does not take possession
Treasury. of the pledged securities.
Allows for increased investment The counterparty is unable to call back
flexibility and for Treasury to funds intraday.
make repo investments later in
the day.
Reduces the expense of
participants doing their own
monitoring, clearing, and
settlement facilities.

Source: GAO analysis.

Conclusions

In the face of persistent federal deficits accompanied by growing net
interest costs, and given the opportunities created by significant
innovations in financial markets, further progress in Treasury's
short-term investment practices is possible. Treasury is to be commended
for its efforts to modernize cash management that have resulted in higher
returns on short-term investments while maintaining current minimal risk
investment policies, but it is possible to do more. Our analysis shows
that a permanent, expanded repo program could increase earnings while
maintaining current minimal risk investment policies.

Matter for Congressional Consideration

Congress should consider providing the Secretary of the Treasury with
broader authority in the design of an expanded program of repurchase
agreements. Congress could note that it expects that in the selection of
participants, decisions about acceptable collateral, and choice of other
design features the Secretary will follow a process designed to mitigate
various types of risks including concentration risk, credit risk, and
market/interest rate risk. The decision not to legislate in detail how
Treasury invests cash does not remove Congress's oversight authority or
responsibility. To assist Congress with oversight, the legislation could
require the Secretary to report annually on the Treasury investment
program.

Recommendation for Executive Action

We recommend that the Secretary of the Treasury explore the reallocation
of its short-term investments as discussed in this report and, if provided
the authority to do so, implement a permanent, expanded repo program that
would help Treasury meet its short-term investment objectives while
maintaining current minimal risk investment policies. If provided the
authority for a permanent, expanded repo program, Treasury should consider
allowing broker dealers as counterparties and expanding acceptable
collateral types to alleviate capacity concerns and increase rates of
return. The effects on rates of return and operational efficiencies of an
electronic trading platform and a triparty clearing and settlement system
should also be considered. When making decisions about short-term
investment programs, Treasury should follow a systematic process to
identify and mitigate various types of risks including concentration risk,
credit risk, and market/interest rate risk. Treasury should consider the
costs and benefits of each alternative and determine whether the benefits
to the federal government outweigh any costs. Treasury should also
consider how its investment programs might be combined to produce outcomes
that are more beneficial, and should consider the effect of its
investments on similar Federal Reserve open market operations.

Agency Comments and Our Evaluation

We requested comments on a draft of this report from the Secretary of the
Treasury. Treasury agreed with our findings, conclusions, and
recommendations. The Fiscal Assistant Secretary's letter is reprinted in
appendix VII. Treasury also provided technical comments, which we have
incorporated as appropriate. We also received technical comments from the
Federal Reserve, which we have incorporated as appropriate.

As agreed with your offices, unless you publicly announce the contents of
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GAO's Web site at [55]http://www.gao.gov .

If you or your staff have any questions about this report, please contact
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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 VIII.

Susan J. Irving
Director for Federal Budget Analysis
Strategic Issues

Appendix I: Trends in Treasury's Operating Cash Balance and Allocation
of Short-Term Investments

Trends in Treasury's Operating Cash Balance

We used publicly available Daily Treasury Statements to analyze the
Department of the Treasury's (Treasury) availability of cash during times
of the month and days of the week during fiscal years 2003-2006. Our
analysis shows that cash balances tend to be highest at the end of the
month before large mandatory payments are made. Over the past 3 years,
cash balances have increased in both dollar volume and volatility for most
parts of each month and for each business day of the week. (See tables 7
and 8.)

Table 7: Since 2003, Treasury's Daily Operating Cash Balance Increased in
Both Dollar Volume and Volatility for Most Parts of Each Month

Fiscal year Fiscal year
Fiscal year 2003 Fiscal year 2004 2005 2006
Average Average Average Average
daily daily daily daily
balance Coefficient balance Coefficient balance Coefficient balance Coefficient
Days (dollars of (dollars of (dollars of (dollars of
of in variationa in variationa in variationa in variationa
month billions) (percent) billions) (percent) billions) (percent) billions) (percent)
1-7 13.6 60 12.7 60 19.5 90 21.5 109
8-14 10.8 37 9.5 53 13.9 75 18.0 100
15-21 21.5 55 26.3 47 32.0 50 29.7 57
22-end
of
month 23.6 47 29.9 47 35.0 53 33.7 63

Source: GAO analysis of Treasury data.

aVolatility is measured by coefficients of variation (standard deviation
divided by the mean). A larger percentage indicates greater volatility.

Table 8: Since 2003, Treasury's Daily Operating Cash Balance Increased in
Dollar Volume for Each Business Day of the Week and in Volatility for Each
Business Day of the Week

Fiscal year Fiscal year
Fiscal year 2003 Fiscal year 2004 2005 2006
Average Average Average Average
daily daily daily daily
balance Coefficient balance Coefficient balance Coefficient balance Coefficient
(dollars of (dollars of (dollars of (dollars of
Days of in variationa in variationa in variationa in variationa
week billions) (percent) billions) (percent) billions) (percent) billions) (percent)
Monday 20.1 52 22.0 59 27.6 69 28.0 73
Tuesday 18.1 64 20.0 75 26.9 69 26.6 87
Wednesday 18.0 68 21.0 73 27.0 76 26.0 86
Thursday 18.5 53 21.1 62 25.3 65 26.4 72
Friday 15.0 63 18.5 67 23.2 74 24.9 82

Source: GAO analysis of Treasury data.

aVolatility is measured by coefficients of variation (standard deviation
divided by the mean). A larger percentage indicates greater volatility.

Trends in Treasury's Investment Allocation

Treasury's trend over the past 5 years has been to move cash available for
investment out of the Treasury Tax & Loan (TT&L) Main Account and into
Term Investment Option (TIO) offerings and recently into repurchase
agreements (repo). Treasury piloted the TIO program in 2002, and the
program became a permanent program in October 2003. The addition of the
repo pilot program in March 2006 provided Treasury with an additional
option for investment. (See table 9.)

Table 9: Average Cash Operating Balance by Investment for Past 5 Years

Dollars in billions
Treasury Total
Fiscal Total operating cash General TT&L Main investment
year balance Account Accounts TIO Repo balance
2002 27.2 5.6 20.9 0.8 0.0 21.7
2003 17.9 5.9 10.1 1.9 0.0 12.0
2004 20.5 5.3 9.0 6.2 0.0 15.2
2005 25.9 5.1 7.9 13.0 0.0 20.9
2006 26.4 5.0 7.6 12.4 1.3 21.4

Source: GAO analysis of Treasury data.

With the development of the TIO program and the repo pilot, Treasury's
investments in TT&L accounts have declined as it began placing more and
more of its operating balance in these programs, particularly TIO since
the repo pilot did not begin until March 2006. Specifically, the share of
Treasury's three investments (not including the balance in the Treasury
General Account [TGA]) in TT&L accounts declined from 96 percent in fiscal
year 2002 to only 36 percent in 2006. In contrast, the share of Treasury's
investments in the TIO program grew to over 60 percent by 2005 and
remained the largest program by share of volume in 2006 at almost 60
percent. (See table 10.)

Table 10: Share of Investment Balance (i.e., Funds Excluding TGA) by
Investment Type

Percent
Fiscal year TT&L Main Accounts TIO Repo Total investment balance
2002 96 4 0 100
2003 84 16 0 100
2004 59 41 0 100
2005 38 62 0 100
2006 36 58 6 100

Source: GAO analysis of Treasury data.

In the repo pilot's first 6 months, Treasury allocated about 11 percent of
its total investments to the repo pilot on average. (See table 11.) It
appears that Treasury primarily allocated funds away from TT&L and into
the repo pilot rather than from TIO. TIOs as a percentage of total
investments were down only slightly from 62 percent for 2005 to 60 percent
for the first 6 months of the repo pilot, while TT&L deposits decreased
from 38 percent to 30 percent over the same periods.

Table 11: Share of Investment Balance by Investment Type, March-September
2006

Percent
TT&L Main Total investment
Period Accounts TIO Repo balance
March-September 2006 (first 6 months
of repo pilot) 30 60 11 100

Source: GAO analysis of Treasury data.

Note: Figures do not sum to 100 because of rounding.

Appendix II: Acceptable Collateral in Treasury's Short-Term Investment
Programs

This appendix provides additional information on acceptable collateral for
the Department of the Treasury's (Treasury) short-term investment
programs. The first section discusses acceptable collateral in the
Treasury Tax and Loan (TT&L) and Term Investment Option (TIO) programs.
The second section discusses collateral distribution among Treasury's
short-term investment programs. In the third section, we describe
Treasury's Special Direct Investment (SDI) program, which provides
additional capacity for Treasury in times when its operating cash balance
is very high. Finally, in the fourth section we provide a table of
"haircuts" that Treasury places on collateral depositary institutions
pledged in exchange for Treasury funds. A haircut is the percentage that
is subtracted from the market value of the collateral. The size of the
haircut reflects the perceived risk associated with the pledged assets.
See figure 8.

Collateral in the TT&L and TIO Programs

Traditionally, Treasury has accepted a wide range of collateral in the
TT&L program to ensure sufficient capacity and mitigate risk. To reduce
risk, Treasury requires that a greater amount of collateral be pledged
than the amount of cash received. Known as a "haircut," the excess amount
pledged may increase depending on the maturity, quality, scarcity, and
price volatility of the underlying collateral. In the late 1990s, faced
with budget surpluses and a lack of sufficient capacity in the TT&L
program, Treasury expanded the range of TT&L collateral to include
asset-backed securities and also agreed to accept commercial loans in less
restrictive arrangements in its SDI program. Depositary institutions pay a
uniform interest rate on all deposits regardless of collateral type for
both regular TT&L investments and SDI investments.

Treasury restricts assets pledged in the TT&L and TIO programs to nine
collateral categories. (See table 12.) While any of the nine categories of
collateral may be pledged to secure TT&L funds, collateral pledged in the
TIO program is restricted to collateral types specified in the TIO auction
announcement. Certain assets are not acceptable in any of Treasury's
short-term investment programs, such as mutual funds and obligations of
foreign countries. (See table 13.) As discussed earlier in this report,
collateral acceptable in the repo pilot program is restricted to Treasury
securities.

Table 12: Acceptable Collateral in the TT&L and TIO Programs

Category 1 Obligations issued and fully insured or guaranteed by the U.S.
government or a U.S. government agency
Category 2 Obligations of government-sponsored enterprises and
corporations of the United States that under specific statute
may be accepted as security for public funds
Category 3 Obligations issued or fully guaranteed by international
development banks
Category 4 Insured student loans or notes representing educational loans
insured or guaranteed under a program authorized under Title IV
of the Higher Education Act of 1965, as amended, or Title VII
of the Public Health Service Act, as amended
Category 5 General obligations issued by the states of the United States
and by Puerto Rico
Category 6 Obligations of counties, cities, or other U.S. government
authorities or instrumentalities that are not in default on
payments on principal or interest and that may be purchased by
banks as investment securities under the limitations
established by appropriate federal bank regulatory agencies
Category 7 Obligations of domestic corporations that may be purchased by
banks as investment securities under the limitations
established by appropriate federal bank regulatory agencies
Category 8 Qualifying commercial paper, commercial and agricultural loan,
and banker's acceptances approved by the Federal Reserve System
at the direction of the Treasury
Category 9 Qualifying and publicly issued asset-backed securities that are
Aaa/AAA rated by at least one nationally recognized statistical
rating agency and approved by the Federal Reserve System at the
direction of the Treasury

Source: Treasury.

Note: Data are from
[56]http://www.treasurydirect.gov/instit/statreg/collateral/collateral_acctaxandloan.pdf
, downloaded on July 18, 2007.

Table 13: Examples of Collateral Not Accepted in TT&L and TIO Programs

Common and preferred stock
Consumer paper or consumer notes
Foreign currency-denominated securities
Mutual funds
Construction loans
Obligations issued by the pledging bank or affiliates of the pledging bank
Obligations of foreign countries
Collateralized bond obligations, collateralized loan obligations, and
collateralized mortgage-backed securities except as otherwise noted
Real estate mortgage notes (one-to-four family mortgages are acceptable
only if held in a borrower-in-custody arrangement to secure SDIs)

Source: Treasury.

Note: Data are from
[57]http://www.treasurydirect.gov/instit/statreg/collateral/collateral_acctaxandloan.pdf
, downloaded on July 18, 2007.

Collateral Allocation in Treasury's Short-Term Investment Programs

Table 14 shows Federal Reserve data on the relative use of different
collateral types pledged for the TT&L and TIO programs. The repo pilot
only accepts Treasury securities. According to the Federal Reserve,
mortgage-backed securities make up 60 percent of the collateral depositary
institutions pledged for TT&L funds. In the TIO program, commercial loans
make up half of the collateral depositary institutions pledged to secure
Treasury funds.1 (See table 14.) Forty percent or less of the collateral
pledged in the TT&L and TIO programs is made up of acceptable collateral
types other than mortgage-backed securities and commercial loans.

1Commercial loans must be held under an Off-Premise Collateral arrangement
in order to be pledged as collateral in the TIO program. This arrangement
is available to TT&L depositaries qualifying for the Federal Reserve's
Borrower-in-Custody (BIC) program. To qualify for the BIC program, an
institution must be in sound financial condition, in the judgment of its
primary regulator and the Federal Reserve. A commercial loan eligible to
be placed under the BIC collateral program must meet a minimal/normal risk
rating requirement.

Table 14: Allocation of Collateral in Treasury's Short-Term Investment
Programs

Percent
Type of collateral Regular TT&La TIOa Repo pilotb
Commercial loans 3 50 Not accepted
Treasury, agency, and corporate 10 25 Only Treasury
securities securities accepted
Mortgage-backed securities 60 10 Not accepted
Other 27 15 Not accepted

Source: GAO analysis of Treasury documents and Warren B. Hrung, "An
Examination of Treasury Term Investment Interest Rates," Federal Reserve
Bank of New York, Economic Policy Review, vol. 13, no. 1 (March 2007).

aThe TT&L and TIO distributions apply to January 2005.

bThe Treasury repo pilot, which began in 2006, is restricted to accepting
only Treasury securities as collateral in transactions.

Special Direct Investments

To address capacity limits in its operating cash balance, Treasury added
the SDI program in 1982. This provides Treasury additional TT&L capacity
when operating cash balances are unusually high. While collateral used to
secure Treasury's cash in regular TT&L accounts must be held by a Federal
Reserve Bank (FRB) or a Treasury-authorized FRB-designated custodian, in
an SDI, the depositary institution may use collateral retained on its
premises in what is called an off-premises collateral arrangement.
Acceptable collateral in the SDI program includes student loans,
commercial loans, and one-to-four family mortgages, the last of which is
only accepted in the SDI program. SDI balances earn the same rate of
return as TT&L balances and may be withdrawn at any time by Treasury.

Since 2002, the number and dollar amount of SDIs have decreased, in part
because of the establishment of the TIO program in 2003. (See fig. 7.)

Figure 7: Trends in SDIs, 2002-2006

Figure 8: Treasury's Collateral Margins Table

Appendix III: The TGA Was Treasury's Only Investment between 1974 and 1978

Although the Department of the Treasury (Treasury) receives an implicit
return on Treasury General Account (TGA) balances from the Federal
Reserve, the TGA is not considered an official short-term investment
vehicle. However, between 1974 and 1978 a number of circumstances forced
Treasury to hold the bulk of its total operating cash balance in the TGA.

Prior to 1977, Treasury Tax & Loan (TT&L) depositaries were not authorized
to pay interest on Treasury's deposits. At the time, Treasury placed cash
in these depositaries, which provided a number of services, such as
handling subscriptions to U.S. securities, issuing savings bonds, and
processing Treasury checks. However, a number of developments between 1964
and 1974 brought an end to this practice. Tax receipts grew significantly,
increasing the size of TT&L accounts. Interest rates had risen
considerably, providing significantly greater earnings potential on TT&L
balances. There was a decline in the number of Treasury-related services
that banks performed. In addition, there was no correlation between the
level of service a bank provided and amount of funds it received. As a
result, it was possible for banks that provided only a few services to
receive large TT&L deposits for which they paid no interest while other
banks that provided numerous Treasury-related services received too little
interest on TT&L deposits to offset their costs.

In 1974 Treasury concluded that the benefits depositary institutions
received from holding TT&L funds substantially outweighed the aggregate
value of the services that these institutions provided. In order to recoup
some of its lost earnings, Treasury pursued what it described as a
"stop-gap" policy. Treasury moved all of the funds it reasonably could
from its non-interest-bearing TT&L accounts to its Federal Reserve
account, the TGA. In turn, the Federal Reserve acted to offset the drain
on reserves caused by increasing the size of its securities portfolio.
This then led to larger weekly remittances to Treasury. In 1976 Treasury
estimated that it received $365 million in indirect earnings from the
Federal Reserve in this way.

This shift of placing almost all excess cash in the TGA created problems
for the conduct of monetary policy by increasing the volatility of the
TGA. The average weekly swings in the TGA balance more than doubled from
$533 million to $1,388 million between 1974 and 1975. As a result, the
Federal Reserve had to make frequent large purchases of securities in
order to reinvest the funds that the TGA was absorbing from the banking
system. On some occasions the Federal Reserve was unable to offset the
large swings in the TGA balance through temporary open market operations,
and it had to request that Treasury redeposit funds in the TT&L accounts
to avoid having to make outright purchases of securities in the secondary
market. In 1977 legislation was enacted authorizing Treasury to earn
interest on its short-term investments. Treasury began investing a greater
share of its operating cash balance in interest-bearing accounts at
commercial banks in 1978, leaving a smaller stable amount invested in the
TGA.

Appendix IV: Timeline of Key Treasury Actions for the
Treasury Tax and Loan and Term Investment Option Programs

aGray boxes indicate events that do not happen on a daily basis.

Appendix V: Changes in the TGA Target Balance
and the Federal Reserve's Open Market Operations

While the Department of the Treasury (Treasury) has not made permanent
changes to the Treasury General Account (TGA) balance since 1988, Treasury
continues to adjust the TGA balance and modify its target balance to
accommodate major corporate and tax due dates. (See table 15.)

Table 15: Changes in the TGA Target Balance since 1988

Date Change in target balance
October 11, 1988 Increased from $3 billion to $5 billion
April 1992 December and March increased from $5 billion to $7
billion on the day after the corporate tax due date

January, April, June, September increased from $5 billion
to $7 billion from the day after the major individual or
corporate tax due date until generally the end of the
month
April 1995 Accelerated the date of increase to the major corporate
or individual tax due date from the day after
September 2004 Stopped increasing the balance from $5 billion to $7
billion on, and following, major corporate and individual
tax due dates
September 2006 Began increasing the balance back to $7 billion on major
corporate tax due dates

Source: Treasury.

The TGA and the Federal Reserve's Execution of Monetary Policy

Treasury also seeks to keep the target balance stable to assist the
Federal Reserve in executing monetary policy. If Treasury's TGA balance
exceeds or falls short of its target, the Federal Reserve must neutralize
the change in overall reserves through market interventions. If Treasury
has greater amounts of short-term cash than can be invested through other
investment programs, the cash would have to be deposited into the TGA. If
the TGA exceeded its $5 billion target, the Federal Reserve would have to
inject large amounts of reserves into the market. On the other hand,
insufficient funds in the Treasury's total operating cash balance could
cause the TGA to fall below its target, and the Federal Reserve would have
to take reserves out of the system. (See fig. 9.)

Figure 9: Neutralizing the Effect of the High TGA Balance

All depositary institutions in the United States are required to maintain
a certain percentage of their customers' checking account balances as
reserves. A depositary institution with a temporary shortfall in reserves
can borrow funds from an institution with a surplus of reserves on a
short-term basis. The interest rate that banks charge one another for this
short-term lending is known as the federal funds rate. By adding or
draining the level of reserves in the banking system, the Federal Reserve
is able to influence the supply of reserves and thus the federal funds
rate, which in turn has a significant effect on a wide range of short-term
interest rates and, ultimately, the economy as whole.

The two most common operations the Federal Reserve uses to intervene in
the market are outright securities purchases and repurchase agreements
(repo). To address a permanent increase in the demand for reserve
balances, the Federal Reserve purchases securities outright in the
secondary market. When the Federal Reserve purchases securities, it
credits the account of the security dealer's depositary institution,
thereby increasing the aggregate level of reserves in the banking system.
Securities purchased in these operations are kept in the System Open
Market Account, or SOMA, portfolio. Currently, the SOMA portfolio contains
only U.S. Treasury debt.

To make more frequent seasonal or daily adjustments to aggregate reserve
levels, the Federal Reserve uses repos. To temporarily add (drain) reserve
balances to (from) the banking system, the Federal Reserve makes a
collateralized loan (borrows against collateral) for a period typically
ranging from 1 to 14 days. For repo transactions, the Federal Reserve
primarily accepts Treasury securities for collateral, but also accepts a
small amount of federal agency securities.

Appendix VI: Detailed Methodology of Calculations

Value of Spread between TIO and TT&L Rates in 2006

In fiscal year 2006, the Department of the Treasury (Treasury) invested a
daily average of $12.4 billion in Term Investment Option (TIO) offerings,
or almost 60 percent of its short-term investment balance. The rates
earned through TIO investments were on average 17 basis points higher than
the rates earned on Treasury Tax and Loan (TT&L) deposits over the same
periods. We calculate that the value of this spread over the course of
2006 was about $20 million.

To determine the value of this spread between TT&L and TIO rates, we
compiled publicly available data on TIO auction award amounts, TIO auction
rates, and average TT&L rates earned over the period of each TIO auction.
Treasury conducted 103 TIO auctions in fiscal year 2006. To calculate the
value of the spread between the TIO rate and average TT&L rate per
auction, we first calculated the spread between the two rates for each
auction. We then calculated the value of that spread in dollars by
adjusting the rate for length of term, and multiplying it by the auction
award amount.1 We then added up the spread value in dollars for each of
the 103 auctions to obtain a total. (See table 16 below.)

Table 16: Average TIO Rate and Marginal Earnings in Fiscal Year 2006
Relative to TT&L Deposits

Average TT&L Average
Average TIO rate per TIO-TT&L Dollar value of
Total rate (in auction (in spread (in spread for all fiscal
number of percentage percentage percentage year 2006 auctions(in
Period auctions points) points) points) millions)
Fiscal
year
2006 103 4.61 4.48 0.17 $19.9

Source: GAO analysis of Treasury data.

Estimated Return Treasury Could Earn by Reallocating Funds from TT&L to Repos

We estimate that if Treasury had earned an overnight repo rate on most of
the funds that it invested in TT&L deposits in fiscal year 2006 instead of
the TT&L rate, Treasury could have potentially earned an additional $12.6
million. Treasury generally maintains at least $2 billion in the TT&L
program as a means of maintaining active participation in the program. We
calculated that Treasury's balance in TT&L accounts exceeded this minimum
balance threshold in fiscal year 2006 on 276 calendar days by an average
of $7 billion. Altogether, the amount of available operating cash in
excess of this threshold totaled $1.9 trillion in fiscal year 2006, about
three times the amount necessary to meet the minimum balance.

1Repo rates are straight add-on interest rates calculated on a
360-day-year basis. To adjust for term, the rate is multiplied by the
number of days the repo is outstanding and then divided by 360.

When it set the current TT&L rate to 25 basis points below the federal
funds rate in 1978, Treasury considered overnight repos to be an
acceptable market-based comparison to TT&L deposits. The Federal Reserve
conducts overnight repos with its primary broker-dealers. We estimate that
if Treasury had invested this $1.9 trillion in a higher yielding
investment earning the same rate as Federal Reserve repos, Treasury could
have earned an additional $12.6 million in fiscal year 2006, or 5.4
percent of its return on available TT&L deposits. (See table 17.)

Table 17: Treasury Could Increase Its Earnings by Investing in Repos

Return on
TT&L Additional
balances return on Percent
in excess TT&L increase
Return on of $2 balances in of return
Daily TT&L TT&L billion excess of on TT&L
balance in balances at $2 billion balances
Total daily excess of in excess Federal at Federal in excess
TT&L $2 of $2 Reserve Reserve of $2
balance billiona billion repo rate repo rate billion
Fiscal
year 2006 $2,597.36 $1,943.82 $234.52 $247.11 $12.59
total billion billion million million million 5.4%
Fiscal
year 2006 $7.12 $7.04 $0.85 $0.90 $0.05
average billion billion million million million
Fiscal
year 2006
days 365 276 276 276 276

Source: GAO analysis of Treasury data.

aIncludes only the amount above $2 billion for days when the TT&L Main
Account balance is greater than $2 billion. For example, if the total TT&L
balance was $6.5 billion, then $4.5 billion would be included.

To calculate this potential increase in gross return on Treasury's
short-term investments, we compiled publicly available data on short-term
investments in fiscal year 2006 from Daily Treasury Statements (DTS) and
the Federal Reserve. We calculated the daily balance invested in TT&L
accounts, including Special Direct Investments (SDI), from DTS data as
well as the effective TT&L rate. We also calculated the effective rate
earned by the Federal Reserve on overnight repos for each available
calendar day in 2006.2 On days where rate data were not available because
an overnight repo was not in effect, we assumed a rate by averaging the
first available rates before and after the missing rate.3 There were 276
calendar days in fiscal year 2006 where the daily TT&L Main Account
balance exceeded $2 billion. For each day, we determined (1) what Treasury
actually earned from the residual balance over $2 billion by multiplying
the balance amount by the effective TT&L rate for that day, and (2) what
Treasury could have earned from the residual balance by multiplying the
balance amount by the actual or estimated Federal Reserve overnight repo
rate. We then calculated the total dollar spread between these two returns
for all 276 days.

2To calculate the effective rate, we created a weighted average for all
overnight repos conducted by the Federal Reserve that day.

3This occurred on 102 of the 365 calendar days in fiscal year 2006.

Appendix VII: Comments from the Department of the Treasury

Appendix VIII: GAO Contact and Staff Acknowledgments

GAO Contact

Susan J. Irving, (202) 512-9142 or [email protected]

Acknowledgments

In addition to the contact named above, Jose Oyola (Assistant Director),
Jessica Berkholtz, Amy Bowser, Tara Carter (Analyst-in-Charge), Richard
Krashevski, Thomas McCabe, Matthew Mohning, Nicolus Paskiewicz, and Albert
Sim made contributions to the report. Melissa Wolf, James McDermott, Dawn
Simpson, and Dean Carpenter also provided key assistance.

Glossary

Delivery-Versus-Payment (DVP) Arrangement

The repo trading arrangement in which the party and counterparty complete
the clearing and settlement processes.

Dynamic Investment

Automatic deposits that occur when depositary institutions agree to accept
direct deposits from the Department of the Treasury (Treasury) when
Treasury cash receipts are greater than anticipated. Dynamic investments
are made hourly throughout the day and are Treasury's only option for
placing late-day cash.

Haircut

The percentage that is subtracted from the market value of the collateral.
The size of the haircut reflects the perceived risk associated with the
pledged assets.

Repurchase Agreement (repo)

The transfer of cash for a specified amount of time, typically overnight,
in exchange for collateral. When the term of the repo is over, the
transaction unwinds, and the collateral and cash are returned to their
original owners, with a premium paid on the cash.

Special Direct Investment (SDI)

An investment vehicle that provides Treasury additional Treasury Tax and
Loan (TT&L) capacity when operating cash balances are unusually high. In
an SDI, the depositary institution may use collateral retained on its
premises in what is called an off-premises collateral arrangement.
Acceptable collateral in the SDI program includes student loans,
commercial loans, and one-to-four family mortgages, the last of which is
only accepted in the SDI program. SDI balances earn the same rate of
return as TT&L balances and may be withdrawn at any time by Treasury.

Term Investment Option (TIO)

Deposits in depositary institutions that allow Treasury to auction off
portions of its excess cash at a competitive rate for a fixed number of
days.

Treasury General Account (TGA)

Treasury's bank account, through which most federal receipts and
disbursements flow. It is maintained across the 12 Federal Reserve Banks
and rolled into one account at the end of each business day.

Treasury Tax & Loan (TT&L)

A collaboration between Treasury and over 9,000 commercial depositary
institutions that collect tax payments. About 1,000 of these depositary
institutions also hold funds and pay interest to Treasury.

Triparty Arrangement

The repo trading arrangement in which an independent custodian bank acts
as an intermediary between the two parties in the transaction and is
responsible for clearing and settlement operations.

(450486)

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Highlights of [65]GAO-07-1105 , a report to the Committee on Finance, U.S.
Senate

September 2007

DEBT MANAGEMENT

Treasury Has Improved Short-Term Investment Programs, but Should Broaden
Investments to Reduce Risks and Increase Return

This report (1) analyzes trends in Treasury's main receipts, expenditures,
and cash balances, (2) describes Treasury's current investment strategy,
and

(3) identifies options for Treasury to consider for improving its return
on short-term investments. GAO held interviews with Treasury officials and
others and reviewed related documents.

[66]What GAO Recommends

GAO suggests that Congress consider providing the Secretary of the
Treasury with broader authority in the design of an expanded repo program.
GAO also recommends that Treasury explore the reallocation of its
short-term investments and, if provided the authority to do so, implement
a permanent, expanded repo program that would help Treasury meet its
short-term investment objectives while maintaining current minimal risk
investment policies. Treasury agreed with our findings, conclusions, and
recommendations and said it is committed to exploring ways to improve its
short term-investment programs.

In managing the funds that flow through the federal government's account,
Treasury frequently accumulates cash because of timing differences between
when borrowing occurs, taxes are received, and agency payments are made.
Treasury often receives large cash inflows in the middle of the month and
makes large, regular payments in the beginning of the month.

Treasury uses three short-term vehicles--Treasury Tax & Loan (TT&L) notes,
Term Investment Option (TIO) offerings, and limited repurchase agreements
(repo)--to invest operating cash. Before Treasury invests any portion of
its operating cash balance, Treasury generally targets a $5 billion
balance in its Treasury General Account (TGA) which is maintained across
the 12 Federal Reserve Banks. The TT&L program provides Treasury with an
effective system for collecting federal tax payments while assisting the
Federal Reserve in executing monetary policy, but it subjects Treasury to
concentration risk and earns a return well below the market rate. The TIO
program earns a greater rate of return but it also subjects Treasury to
concentration risk. Both programs also present capacity concerns. Treasury
began testing repos through a pilot program in 2006. Repos have earned
near market rates of return, but because of the pilot's scope and the
current, limited legislative authority under which it operates, the repo
participants, collateral, trading terms, and trading arrangements are
restricted.

Allocation of Treasury's Operating Balance by Investment Type, Fiscal Year
2006

A permanent, expanded repo program could permit Treasury to earn a higher
rate of return, expand investment capacity, and reduce concentration risk.
If given authority to design such a program, Treasury would need to tailor
it to meet liquidity needs and to achieve a higher rate of return while
minimizing risks that are associated with the selection of program
participants, collateral types, terms of trade, and trading arrangements.

References

Visible links
48. fhttp://www.gao.gov/cgi-bin/getrpt?GAO-06-269
49. fhttp://www.gao.gov/cgi-bin/getrpt?GAO-06-269
50. fhttp://www.gao.gov/cgi-bin/getrpt?GAO-06-269
51. fhttp://www.sifma.org/
52. fhttp://www.gao.gov/cgi-bin/getrpt?GAO-06-269
53. fhttp://www.gfoa.org/
54. fhttp://www.federalreserve.gov/paymentsystems/psr/default.htm
55. fhttp://www.gao.gov/
56. fhttp://www.treasurydirect.gov/instit/statreg/collateral/collateral_acctaxandloan.pdf
57. fhttp://www.treasurydirect.gov/instit/statreg/collateral/collateral_acctaxandloan.pdf
58. fhttp://www.gao.gov/
59. fhttp://www.gao.gov/
60. fhttp://www.gao.gov/fraudnet/fraudnet.htm
61. mailto:[email protected]
62. mailto:[email protected]
63. mailto:[email protected]
64. fhttp://www.gao.gov/cgi-bin/getrpt?GAO-07-1105
65. fhttp://www.gao.gov/cgi-bin/getrpt?GAO-07-1105
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