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Report to Congressional Committees: 

May 2004: 

DEBT CEILING: 

Analysis of Actions Taken during the 2003 Debt Issuance Suspension 
Period: 

GAO-04-526: 

GAO Highlights: 

Highlights of GAO-04-526, a report to congressional committees

Why GAO Did This Study: 

GAO is required to review the steps taken by the Department of the 
Treasury (Treasury) to avoid exceeding the debt ceiling during the 2003 
debt issuance suspension period. The committee also directed GAO to 
determine whether all major accounts that were used for debt ceiling 
relief have been properly credited or reimbursed. Accordingly, GAO 
determined whether Treasury followed its normal investment and 
redemption policies and procedures for the major federal government 
accounts with investment authority, analyzed the financial aspects of 
actions Treasury took during this period, and analyzed the impact of 
policies and procedures Treasury used to manage the debt during the 
period.

What GAO Found: 

On February 20, 2003, Treasury determined that a debt issuance 
suspension period was in effect. A debt issuance suspension period is 
any period for which the Secretary of the Treasury has determined that 
obligations of the United States may not be issued without exceeding 
the debt ceiling. During this period, which lasted until May 27, 2003, 
the Secretary took actions related to the Government Securities 
Investment Fund of the Federal Employees Retirement System (the G-
Fund), the Civil Service Retirement and Disability Fund (the Civil 
Service fund), and the Exchange Stabilization Fund (ESF) to avoid 
exceeding the debt ceiling. Also, during fiscal year 2003, the 
Secretary initiated several actions involving the Civil Service Fund, 
FFB, and the Treasury general fund that related to Treasurys efforts 
to manage the amount of debt subject to the debt ceiling. The Secretary 
took other actions to avoid exceeding the debt ceiling, such as 
suspending the sales of State and Local Government Series Treasury 
obligations and recalling non-interest-bearing deposits held by 
commercial banks as compensation for banking services provided to 
Treasury.

The actions taken, which were consistent with legal authorities 
provided to the Secretary and related to the G-Fund, the Civil Service 
fund, and ESF, initially resulted in interest losses to the G-Fund and 
ESF and principal and interest losses to the Civil Service fund. When 
the debt ceiling was increased to $7.4 trillion on May 27, 2003, the 
Secretary fully invested the G-Funds investments and on May 28, 2003, 
fully restored the interest losses, as required by law. On June 30, 
2003, the Secretary fully compensated the Civil Service fund for 
principal and interest losses, as required by law. The losses related 
to ESF could not be restored without special legislation. As a result, 
related ESF losses of $3.6 million were not restored. 

The actions initiated by Treasury in fiscal year 2003 that involved the 
early redemption of FFB debt obligations held by the Civil Service fund 
and exchanges of obligations among the Civil Service fund, FFB, and the
Treasury general fund resulted in all three parties realizing gains or 
incurring losses. In some cases, GAO has been able to quantify the 
gains or losses that occurred as a result of these transactions. For 
example, according to FFB estimates, the Civil Service fund lost more 
than $1 billion in interest because of FFBs redemption of FFB 
obligations held by the Civil Service fund before their maturity date 
and unforeseen interest rate changes. In other cases, however, 
information needed to understand the potential consequences of these 
actions will not be available for a number of years. The Secretary 
currently lacks the statutory authority to restore such losses and has 
not developed documented policies and procedures that can be used to 
minimize such losses in future actions that may be taken by Treasury 
that involve FFB and an account with investment authority such as the 
Civil Service fund.

GAO recommends that the Secretary of the Treasury (1) seek statutory 
authority to restore Civil Service fund losses associated with the 
October 2002 early redemption of Federal Financing Bank (FFB) 
obligations and (2) direct the Under Secretary for Domestic Finance to 
document necessary policies and procedures for exchange transactions 
between FFB and a federal government account with investment authority 
and seek any statutory authority necessary to implement the policies 
and procedures. Treasury agreed with our recommendations and has 
already taken certain steps to document the policies and procedures. 

www.gao.gov/cgi-bin/getrpt?GAO-04-526
 
To view the full product, including the scope and methodology, click on 
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[End of section]

Contents: 

Letter: 

Background: 

Results in Brief: 

Objectives, Scope, and Methodology: 

Chronology of Events: 

Normal Investment and Redemption Policies Used on Major Federal 
Government Accounts with Investment Authority: 

Actions Related to the G-Fund: 

Actions Related to ESF: 

Actions Related to the Civil Service Fund: 

Effects of Exchange of Debt Obligations between the Civil Service Fund, 
FFB, and Treasury: 

Documented Policies and Procedures Needed for Civil Service and FFB 
Exchange Transactions: 

Conclusions: 

Recommendations for Executive Action: 

Agency Comments and Our Evaluation: 

Appendixes: 

Appendix I: Gains and Losses on Federal Accounts with Investment 
Authority: 

Gains and Losses Associated with Normal Investment and Redemption 
Activity: 

Gains and Losses Associated with Unusual Events: 

Appendix II: Limitations of the Present Value Analysis Approach to 
Determining Economic Gains and Losses: 

Appendix III: Gains and Losses Associated with Transactions between the 
Civil Service Fund, FFB, and the Treasury General Fund: 

Civil Service Fund Interest Losses Associated with the October 18, 
2002, FFB Early Redemption: 

Civil Service Fund Gains and Losses Associated with the 2003 Exchange 
Transaction: 

FFB and Treasury General Fund Gains and Losses Associated with the 2003 
Exchange Transaction: 

Appendix IV: Transactions between FFB and the Civil Service Fund: 

1985 Debt Ceiling Crisis: 

1995/1996 Debt Ceiling Crisis: 

2003 Debt Issuance Suspension Period: 

Appendix V: Comments from the Department of the Treasury: 

Related GAO Products: 

Tables: 

Table 1: Chronology of Events: 

Table 2: Balance of Obligations Held by the Selected 25 Major Federal 
Government Accounts with Investment Authority as of January 31, 2003: 

Table 3: Gains, Losses, and Changes in Portfolio Balances Related to 
Exchanges between the Civil Service Fund and FFB: 

Table 4: Example of the Impact on a $1 Million 6 Percent Obligation 
Using Different Present Value Discount Factors and Maturity Dates: 

Table 5: Example of Effects of Changing Interest Rates on Present Value 
Analyses: 

Table 6: Maturity Dates and Interest Rates Associated with FFB 9(a) Debt 
Obligations Redeemed before Maturity on October 18, 2002: 

Table 7: Comparison of Expected Interest Earnings on October 18, 2002, 
Redemption Using Different Rates: 

Table 8: How the March 5, 2003, Transactions between the Civil Service 
Fund, FFB, and the Treasury General Fund Generated a Gain for FFB: 

Table 9: Example of How Differing Interest Rates Affect Gains and Losses 
Recognized by FFB and the Treasury General Fund on the Exchange of Par 
Value Specials for FFB Obligations: 

Figures: 

Figure 1: Debt Subject to the Debt Ceiling, 1984-2003: 

Figure 2: Debt Exchange Process Used for Fiscal Year 2003 Debt Ceiling 
Relief: 

Letter May 20, 2004: 

The Honorable Richard Shelby 
Chairman 
The Honorable Patty Murray 
Ranking Minority Member 
Subcommittee on Transportation/Treasury and General Government 
Committee on Appropriations 
United States Senate: 

The Honorable Ernest J. Istook, Jr. 
Chairman 
The Honorable John W. Olver 
Ranking Minority Member 
Subcommittee on Transportation and Treasury, and Independent Agencies 
Committee on Appropriations 
House of Representatives: 

Historically, the Congress and the President have enacted laws to 
establish a limit on the amount of public debt that can be outstanding 
(debt ceiling).[Footnote 1] On various occasions over the years, normal 
government financing has been disrupted because the Department of the 
Treasury (Treasury) had borrowed up to, or near, the debt ceiling and 
legislation to increase the debt ceiling had not been enacted. On 
February 20, 2003, Treasury determined that a debt issuance suspension 
period was in effect. A debt issuance suspension period is any period 
for which the Secretary of the Treasury has determined that obligations 
of the United States may not be issued without exceeding the debt 
ceiling.[Footnote 2] This debt issuance suspension period lasted until 
May 27, 2003, when the Congress and the President raised the debt 
ceiling to the current $7.4 trillion. During the 2003 debt issuance 
suspension period, Treasury took several actions to raise funds to meet 
federal obligations without exceeding the debt ceiling.

We are required to review the steps taken by Treasury to avoid 
exceeding the debt ceiling and to determine whether all major accounts 
that were used for debt ceiling relief have been properly credited or 
reimbursed.[Footnote 3] Accordingly, we (1) developed a chronology of 
significant events, (2) determined whether Treasury followed its normal 
investment and redemption policies and procedures for the major federal 
government accounts with investment authority,[Footnote 4] (3) analyzed 
the financial aspects of actions Treasury took during the debt issuance 
suspension period and assessed the legal basis of these actions, and 
(4) analyzed the impact of the policies and procedures Treasury used to 
manage the debt during the debt issuance suspension period. This report 
presents the results of our review of the actions taken and the 
policies and procedures Treasury implemented during the 2003 debt 
issuance suspension period.

Background: 

The federal government began with a debt of about $75 million in 1790. 
In February 1941, the Congress and the President enacted a law that set 
an overall limit of $65 billion on Treasury debt obligations that could 
be outstanding at any one time.[Footnote 5] The law was amended to 
raise the debt ceiling several times between February 1941 and June 
1946. The ceiling established in June 1946, $275 billion, remained in 
effect until August 1954. At that time, the first temporary debt 
ceiling was enacted, which added $6 billion to the $275 billion 
permanent ceiling.

The Congress and the President have enacted numerous temporary and 
permanent increases in the debt ceiling. As shown in figure 1, the 
amount of outstanding debt subject to the debt ceiling[Footnote 6] has 
increased from $1.6 trillion on September 30, 1984, to $6.7 trillion on 
September 30, 2003.

Figure 1: Debt Subject to the Debt Ceiling, 1984-2003: 

[See PDF for image]

Note: At no point did the amount of outstanding debt exceed the debt 
ceiling at the end of the above-noted fiscal years. However, at the end 
of fiscal years 1984, 1985, and 1986, the difference between the amount 
of debt subject to the debt ceiling and the debt ceiling was about $25 
million-the smallest amount for the period shown in the figure. The 3 
years with the next-smallest differences were 1995 (about $15 billion), 
1990 (about $34 billion), and 1989 (about $40 billion).

[End of figure]

The total amount of debt subject to the debt ceiling as of January 31, 
2003, the month before Treasury entered into the 2003 debt issuance 
suspension period, was about $6.4 trillion. About 44 percent, or $2.8 
trillion, was held by federal government accounts with investment 
authority, such as the Social Security trust funds,[Footnote 7] the 
Civil Service Retirement and Disability Trust Fund (Civil Service 
fund), the Exchange Stabilization Fund (ESF), and the Government 
Securities Investment Fund of the Federal Employees' Retirement System 
(G-Fund). The remaining $3.6 trillion represents marketable and 
nonmarketable obligations held by the public.

The Secretary of the Treasury has several responsibilities related to 
the federal government's financial management operations, including 
paying the government's obligations and investing receipts of federal 
government accounts with investment authority not needed for current 
benefits and expenses. To meet these responsibilities, the Secretary of 
the Treasury is authorized by law to issue the necessary 
obligations[Footnote 8] to federal government accounts with investment 
authority for investment purposes and to borrow the necessary funds 
from the public to pay government obligations.

Under normal circumstances, the debt ceiling is not an impediment to 
carrying out these responsibilities. Treasury is notified by the 
appropriate agency (such as the Office of Personnel Management for the 
Civil Service fund) of the amount that should be invested (or 
reinvested), and Treasury makes the investment. In some cases, the 
agency may also specify the obligation that Treasury should purchase. 
The Treasury obligations issued to federal government accounts with 
investment authority count against the debt ceiling. If these accounts' 
receipts are not invested, the amount of debt subject to the debt 
ceiling does not increase.

We have previously reported on aspects of Treasury's actions during the 
2002 debt issuance suspension period and the 1995/1996 and other debt 
ceiling crises[Footnote 9] (see Related GAO Products).

Statutory Authorities Specifically Enacted to Help Treasury Avoid 
Exceeding the Debt Ceiling: 

When Treasury is unable to borrow because the debt ceiling has been 
reached, the Secretary of the Treasury is unable to fully discharge his 
financial management responsibilities using normal methods. In 1985, 
the federal government experienced a debt ceiling crisis from September 
3 through December 11. During that period, Treasury took several 
actions that were similar to those discussed later in this report. For 
example, Treasury redeemed Treasury obligations held by the Civil 
Service fund earlier than normal in order to borrow sufficient cash 
from the public to meet the fund's benefit payments and did not invest 
some of the fund's receipts. In 1986 and 1987, after Treasury's 
experiences during prior debt ceiling crises, the Congress enacted 
several authorities authorizing the Secretary of the Treasury to use 
the Civil Service fund and the G-Fund[Footnote 10] to help Treasury 
manage its financial operations during a debt ceiling crisis. Those 
authorities, which Treasury used during the 2003 debt issuance 
suspension period, addressed (1) redemption of Civil Service fund 
obligations, (2) suspension of Civil Service fund investments, and (3) 
suspension of G-Fund investments.

1. Redemption of obligations held by the Civil Service fund. Subsection 
8348(k) of title 5, United States Code, authorizes the Secretary of the 
Treasury to redeem obligations or other invested assets of the Civil 
Service fund before maturity to prevent the amount of public debt from 
exceeding the debt ceiling.[Footnote 11] The Secretary of the Treasury 
must determine that a debt issuance suspension period exists in order 
to redeem Civil Service fund obligations early. The statute authorizing 
the debt issuance suspension period and its legislative history are 
silent as to how the Secretary of the Treasury should determine the 
length of a debt issuance suspension period.

2. Suspension of Civil Service fund investments. Subsection 8348(j) of 
title 5, United States Code, authorizes the Secretary of the Treasury 
to suspend additional investment of amounts in the Civil Service fund 
if the investment cannot be made without causing the amount of public 

debt to exceed the debt ceiling.[Footnote 12] Subsection (j) also 
authorizes the Secretary of the Treasury to make the Civil Service fund 
whole after the debt issuance suspension period has ended.

3. Suspension of G-Fund investments. Subsection 8438(g) of title 5, 
United States Code, authorizes the Secretary of the Treasury to suspend 
the issuance of additional amounts of obligations of the United States 
to the G-Fund if issuance cannot occur without causing the amount of 
public debt to exceed the debt ceiling. Subsection (g) also authorizes 
the Secretary of the Treasury to make the G-Fund whole after the debt 
issuance suspension period has ended.

Other Authorities Relied on by Treasury to Avoid Exceeding the Debt 
Ceiling: 

During the 2003 debt issuance suspension period, Treasury relied upon 
authorities in addition to those mentioned above to help manage the 
amount of debt subject to the debt ceiling. Treasury has also relied on 
these other authorities during prior periods when it needed to take 
special actions to avoid exceeding the debt ceiling.

Suspension of ESF Investments: 

Section 5302 of title 31, United States Code, authorizes the Secretary 
of the Treasury to determine when and if excess funds for ESF will be 
invested. During previous debt ceiling difficulties, Treasury used this 
authority to suspend reinvestment of maturing ESF investments to ensure 
that the debt ceiling was not exceeded.

FFB 9(a) Obligations Exchanged with the Civil Service Fund: 

In addition to obligations issued under subsection 8348(d) of title 5, 
United States Code, other obligations are lawful investments by the 
Civil Service fund. For example, subsection 8348(e) of title 5, United 
States Code, authorizes the Secretary of the Treasury to invest surplus 
Civil Service funds in other interest-bearing obligations of the United 
States or obligations guaranteed as to both principal and interest by 
the United States, if the Secretary of the Treasury determines that the 
purchases are in the public interest. Further, obligations issued by 
other agencies, such as the Tennessee Valley Authority,[Footnote 13] 
the United States Postal Service,[Footnote 14] and the Federal 
Financing Bank (FFB),[Footnote 15] are lawful investments for all 
fiduciary, trust, and public funds whose investments are under the 
control of the United States, and such obligations are suitable 
investments for the Civil Service Fund.[Footnote 16] Treasury relied on 
such authorities during the 1985 and 1995/1996 debt ceiling crises to 
exchange obligations issued (commonly referred to as FFB 9(a) 
obligations) or held by FFB[Footnote 17] that were not subject to the 
debt ceiling for Treasury obligations held by the Civil Service fund 
that were subject to the debt ceiling.

Other Special Authorities: 

In addition to the authorities previously discussed, Treasury has on 
occasion received special authorities that pertained to specific 
situations.[Footnote 18] These special authorities are discussed in our 
report on the 1995/1996 debt ceiling crisis.[Footnote 19]

Impact of Gains and Losses on Accounts with Investment Authority: 

Gains and losses associated with federal government accounts with 
investment authority and Treasury's general fund can occur for a 
variety of reasons.[Footnote 20] For example, (1) the type of 
obligation held may be more susceptible to changes in interest rates 
and (2) the procedures used to make adjustments can have significant 
consequences for an account's earnings. Whether these gains and losses 
affect an account's recipients depends on whether the fund balance is 
used to determine recipients' benefits. One example where the fund 
balance has a direct impact on participants is the G-Fund. 
Specifically, G-Fund earnings are directly related to the amount that 
G-Fund participants will receive when they redeem their investments. On 
the other hand, the fund balance in the Civil Service fund does not 
affect the ultimate payments that retirees and their surviving 
dependents will receive because the payments will be made from the 
Treasury general fund even if the Civil Service fund's assets are fully 
liquidated. Appendix I provides additional information on how gains and 
losses may occur in accounts with investment authority.

Results in Brief: 

In February 2003, Treasury entered into a debt issuance suspension 
period because certain receipts of federal government accounts with 
investment authority could not be invested without exceeding the $6.4 
trillion debt ceiling in effect at the time. This debt issuance 
suspension period began on February 20, 2003, and lasted until May 27, 
2003. It involved Treasury's departure from normal investment and 
redemption procedures for the G-Fund, ESF, and the Civil Service fund, 
including exchanging FFB debt obligations for Treasury obligations held 
by the Civil Service fund. Treasury also took other actions to avoid 
exceeding the debt ceiling, such as suspending sales of State and Local 
Government Series (SLGS) Treasury obligations[Footnote 21] and 
recalling non-interest-bearing deposits held by commercial banks as 
compensation for banking services provided to Treasury.

We found that during the 2003 debt issuance suspension period, Treasury 
used its normal investment and redemption policies and procedures to 
handle receipts and maturing investments and to redeem Treasury 
obligations for all but 1 of the 25 major federal government accounts 
with investment authority that we reviewed. These 25 accounts 
constituted about 77 percent, or about $2.1 trillion, of the $2.8 
trillion in Treasury obligations held by federal government accounts 
with investment authority on January 31, 2003. The departure from 
normal investment policy and procedures involving one Highway Trust 
Fund transaction occurred when Treasury erroneously redeemed certain 
Highway Trust Fund obligations and held the redeemed funds until they 
were needed to pay fund expenses rather than reinvesting them when the 
error was detected. We determined that the Highway Trust Fund did not 
incur any losses due to this error and that the debt ceiling would not 
have been exceeded even if (1) the error had never been made or (2) 
Treasury had reinvested the funds when the error was detected.

Consistent with available legal authorities, Treasury departed from its 
normal investment and redemption procedures for 3 other major federal 
government accounts with investment authority--the G-Fund, ESF, and the 
Civil Service fund--that accounted for about $640 billion of Treasury 
obligations outstanding on January 31, 2003. During the 2003 debt 
issuance suspension period, Treasury took the following actions related 
to the 3 accounts: 

* Treasury did not reinvest some of the maturing obligations held by 
the G-Fund, causing a loss to the G-Fund of about $362.5 million in 
interest. On May 27, 2003, when the debt ceiling was raised, the 
Secretary of the Treasury fully invested the G-Fund's available funds 
and on May 28, 2003, fully restored the lost interest on the G-Fund's 
uninvested funds in accordance with subsection 8438(g) of title 5, 
United States Code. Consequently, the G-Fund was fully compensated for 
its interest losses.

* Treasury did not reinvest some of the maturing obligations held by 
ESF. As a result, ESF incurred interest losses of about $3.6 million. 
Treasury does not have statutory authority to restore these interest 
losses.

* Treasury redeemed about $32.4 billion of Treasury obligations held by 
the Civil Service fund before they were needed to pay Civil Service 
fund benefits and expenses and suspended investment of about $2.5 
billion in certain Civil Service fund receipts. On May 27, 2003, when 
the debt ceiling was raised, Treasury invested about $30.8 billion of 
uninvested receipts of the Civil Service fund. These receipts were 
associated with (1) collections made by the Civil Service fund that had 
not been invested and (2) funds associated with the early redemptions 
that had not been used for Civil Service fund benefit payments and 
expenses. As a result of these transactions, the Civil Service fund 
lost about $100.8 million. On June 30, 2003, Treasury fully restored 
this loss on the Civil Service fund's uninvested funds in accordance 
with subsection 8348(j) of title 5, United States Code.

In addition to the actions described above, Treasury initiated the 
following actions involving the Civil Service fund, FFB, and the 
Treasury general fund during fiscal year 2003: 

* On October 18, 2002, FFB exercised its right to redeem about $15 
billion of FFB 9(a) obligations held by the Civil Service fund prior to 
their maturity.

* On March 5, 2003, FFB issued an FFB 9(a) obligation of about $15 
billion to the Civil Service fund in exchange for about $15 billion in 
Treasury obligations held by the Civil Service fund. FFB used these 
Treasury obligations to purchase FFB 9(b) debt obligations held by 
Treasury. Consequently, Treasury canceled the FFB 9(b) debt obligations 
that FFB had purchased as well as the Treasury obligations originally 
issued to the Civil Service fund. These transactions made about $15 
billion of additional borrowing authority available under the debt 
ceiling because FFB 9(a) obligations are not subject to the debt 
ceiling.

* On June 30, 2003, FFB redeemed the FFB 9(a) obligation issued to the 
Civil Service fund and borrowed the necessary funds from Treasury using 
FFB 9(b) obligations. FFB redemption proceeds were reinvested in the 
Civil Service fund in accordance with Treasury's normal investment 
policies and procedures.

Gains or losses on the exchange of obligations between the Civil 
Service fund and FFB can result when (1) the exchange occurs or (2) the 
underlying assumptions used to determine the exchange price are not 
realized. Although we found that the exchange transactions that we 
reviewed were fair to both parties on the date of the exchange, 
quantifying the long-term effects of these transactions on the parties 
involved is difficult and complex because the exchanges were structured 
to last many years. In some cases, we were able to quantify the gains 
or losses that have occurred or can be expected to occur that relate to 
the fiscal year 2003 exchange transactions. In other cases, however, 
the information needed to understand the potential consequences of 
these actions will not be available for a number of years. Regardless 
of whether they sustain any additional gains or losses over the long 
term, the Civil Service fund, FFB, and the Treasury general fund 
incurred increased risks of gains and losses that they would not have 
incurred if these transactions had not occurred.

More important, risks, such as unforeseen interest rate changes, 
related to the transactions between FFB and the Civil Service fund are 
not typically incurred by these organizations during their normal 
operations. History has shown, however, that the risks may be 
substantial. For example, according to FFB estimates, the Civil Service 
fund lost interest of over $1 billion on a $15 billion transaction in 
October 2002 when FFB decided to redeem early its 9(a) obligations that 
were issued to the Civil Service fund.[Footnote 22] These obligations 
related to Treasury's efforts to manage the debt during the 1985 debt 
ceiling crisis, and the losses occurred because of (1) the unexpected 
early redemption by FFB and (2) unforeseen interest rate changes. 
Although the Secretary of the Treasury has statutory authority to 
restore losses resulting from not investing Civil Service fund receipts 
or from early redemption of Treasury obligations held by the Civil 
Service fund during a debt issuance suspension period, the Secretary of 
the Treasury does not have statutory authority to restore the types of 
losses that can result from exchange transactions between FFB and a 
federal government account with investment authority. Accordingly, 
Treasury needs statutory authority to restore the losses associated 
with the October 2002 early redemption of FFB 9(a) obligations.

As we noted in our report on the fiscal year 2002 debt issuance 
suspension periods,[Footnote 23] documented policies and procedures 
would allow Treasury to better determine the potential impacts 
associated with the policies and procedures it implements to manage the 
amount of debt subject to the debt ceiling. Although Treasury adopted 
our recommendation and developed policies and procedures for managing 
investment and redemption activities of the Civil Service fund and the 
G-Fund during a debt issuance suspension period, such policies and 
procedures do not address how exchange transactions between the Civil 
Service fund and FFB should be handled. It is the process of 
documenting the policies and procedures that (1) allows Treasury 
management to ascertain the effects of these policies and procedures 
and whether those effects introduce any additional risks to the parties 
involved, (2) allows Treasury to understand whether it may need 
additional statutory authority to ensure that all funds are adequately 
protected, and (3) reduces the chance for confusion and risk of errors 
should Treasury need to use the policies and procedures in the future.

We are recommending that the Secretary of the Treasury (1) seek the 
statutory authority to restore the losses associated with FFB's early 
redemption of FFB 9(a) obligations, with restoration computed in a 
manner that maintains equity between the Civil Service fund and 
Treasury, and (2) direct the Under Secretary for Domestic Finance to 
document the necessary policies and procedures that should be used for 
exchange transactions between FFB and a federal government account with 
investment authority during a debt issuance suspension period and seek 
any statutory authority necessary to implement the policies and 
procedures.

Treasury agreed with our recommendations and stated that (1) it will 
seek statutory authority to restore losses incurred by federal 
government accounts with investment authority and by FFB as a result of 
actions taken for the purpose of fiscal management during a "debt limit 
impasse" and (2) it will document appropriate policies and procedures 
that should be used for exchange transactions between FFB and a federal 
government account with investment authority to ensure the long-term 
fairness to all parties. Treasury also noted that it has already taken 
certain steps in documenting the policies and procedures that should be 
used in future exchange transactions.

Objectives, Scope, and Methodology: 

Our objectives were to: 

* develop a chronology of significant events related to the 2003 debt 
issuance suspension period,

* evaluate the actions taken during the 2003 debt issuance suspension 
period in relation to the normal policies and procedures Treasury uses 
for investments and redemptions for major federal government accounts 
with investment authority,

* analyze the financial aspects of Treasury's actions taken during the 
2003 debt issuance suspension period and assess the legal basis of 
these actions, and: 

* analyze the impact of the policies and procedures Treasury used to 
manage the debt during the 2003 debt issuance suspension period.

To develop a chronology of the significant events related to the 2003 
debt issuance suspension period, we obtained and reviewed applicable 
documents. We also discussed Treasury's actions during the debt 
issuance suspension period with senior Treasury officials.

To evaluate the actions taken during the 2003 debt issuance suspension 
period in relation to the normal policies and procedures Treasury uses 
for certain federal government accounts with investment authority, we 
obtained an overview of the policies and procedures used and reviewed 
selected investment and redemption activity to determine whether those 
transactions were processed in accordance with Treasury's normal 
policies and procedures. Over 200 different federal government accounts 
with investment authority hold Treasury obligations, and Treasury 
officials stated that normal investment and redemption policies and 
procedures were used for all but 3 of these accounts.

From the federal government accounts with investment authority for 
which Treasury used its normal investment and redemption policies and 
procedures, we selected for review accounts with (1) investments in 
Treasury obligations that exceeded $10 billion on January 31, 2003 (17 
accounts), or (2) recurring investment or redemption transactions of $1 
billion or more from February through May 2003 (8 accounts). For 18 of 
these 25 accounts, we reviewed selected investment and redemption 
transactions from February through May 2003. For the remaining 7 
accounts, which are managed by the Bureau of the Public Debt, we 
reviewed all investment and redemption transactions from February 
through May 2003 except those related to 1 account. For this account, 
we reviewed all investment and redemption transactions that exceeded 
$250 million.[Footnote 24]

The 25 selected federal government accounts with investment authority 
accounted for about 77 percent, or about $2.1 trillion, of the $2.8 
trillion in Treasury obligations held by federal government accounts 
with investment authority on January 31, 2003.[Footnote 25] For all 25 
selected accounts in our review, we confirmed with personnel from the 
respective agencies the total amount of investment and redemption 
activity reported by Treasury from February 1, 2003, through May 31, 
2003.[Footnote 26] In any case where normal investment and redemption 
policies and procedures were not followed, we obtained documentation 
and other information to help us understand the basis for and impact of 
the alternative policies and procedures that were used.

To analyze the financial aspects of Treasury's actions that departed 
from normal investment and redemption policies and procedures, we (1) 
reviewed the methodologies Treasury developed to minimize the impact of 
such departures on the G-Fund, ESF, and the Civil Service fund; (2) 
quantified the impact of the departures; (3) assessed whether any 
principal and interest losses were fully restored; and (4) assessed 
whether any losses were incurred that could not be restored under 
Treasury's current statutory authority.

To assess the legal basis for Treasury's departures from its normal 
policies and procedures, we identified the applicable legal authorities 
and determined how Treasury applied them during the 2003 debt issuance 
suspension period. Our evaluation included authorities related to 
issuing and redeeming Treasury obligations during a debt issuance 
suspension period and restoring losses after such a period has ended.

To analyze the impact of the policies and procedures used by Treasury 
to manage the debt during a debt issuance suspension period, we 
reviewed the actions taken and the Treasury policies and procedures 
used during the 2003 debt issuance suspension period. To determine the 
stated policies and procedures used that related to the Civil Service 
fund and FFB exchange transactions, we discussed with Treasury 
officials the actions taken during this period and examined the support 
for these actions. We also compiled and analyzed source documents 
relating to previous debt issuance suspension periods, including 
executive branch legal opinions, memorandums, and correspondence.

We performed our work from February 2003 through March 2004, in 
accordance with U.S. generally accepted government auditing standards. 
We requested comments on a draft of this report from the Secretary of 
the Treasury or his designee. The written response from Treasury's 
Under Secretary for Domestic Finance is reprinted in appendix V.

Chronology of Events: 

In June 2002, the debt ceiling was raised to $6.4 trillion. In December 
2002, Treasury concluded that this amount might be reached in the 
latter half of February 2003. Table 1 shows the significant actions the 
Congress and the executive branch took from June 28, 2002, through June 
30, 2003, that relate to the debt ceiling.

Table 1: Chronology of Events: 

Date: June 28, 2002; 
Action: The Congress and the President enacted Pub. L. No. 107-199, 
which raised the debt ceiling to $6.4 trillion.

Date: October 18, 2002; 
Action: FFB repaid about $15 billion of 9(a) obligations it had issued 
to the Civil Service fund as a result of the 1985 debt ceiling crisis.

Date: December 24, 2002; 
Action: Treasury notified the Congress that debt subject to the limit 
might reach the debt ceiling in the latter half of February 2003.

Date: February 19, 2003; 
Action: The Secretary of the Treasury announced his intent to suspend 
G-Fund investments beginning on February 20, 2003. Treasury suspended 
the sales of SLGS Treasury obligations. On May 23, 2003, Treasury 
announced that the sale of SLGS Treasury obligations would resume on 
May 27, 2003.

Date: March 5, 2003; 
Action: FFB exchanged a $15 billion 9(a) obligation for U.S. Treasury 
obligations held by the Civil Service fund.

Date: March 25 and 28, 2003; 
Action: Treasury called back about $8 billion of Treasury deposits held 
by commercial banks as compensating balances. According to Treasury 
officials, these funds were returned to the banks on April 28, 2003.

Date: March 31, 2003; 
Action: The Secretary of the Treasury began suspending ESF investments.

Date: April 1 and 3, 2003; 
Action: Treasury called back about $23.1 billion of Treasury deposits 
held by commercial banks as compensating balances. According to 
Treasury officials, these funds were returned to the banks on April 22, 
2003.

Date: April 4, 2003; 
Action: The Secretary of the Treasury declared a debt issuance 
suspension period beginning no later than April 11, 2003, and lasting 
until July 11, 2003, which allowed Treasury to redeem Treasury 
obligations held by the Civil Service fund earlier than normal and to 
suspend investments of Civil Service fund receipts.

Date: May 1, 2, and 6, 2003; 
Action: Treasury called back about $43.4 billion of Treasury deposits 
held by commercial banks as compensating balances. According to 
Treasury officials, these funds were returned to the banks on June 16, 
2003.

Date: May 15, 2003; 
Action: Treasury postponed announcement of its weekly 13-week and 26-
week bill auctions to avoid exceeding the debt ceiling.

Date: May 19, 2003; 
Action: The Secretary of the Treasury extended the previously declared 
debt issuance suspension period until December 19, 2003, which allowed 
Treasury to redeem additional Treasury obligations held by the Civil 
Service fund earlier than normal and to continue to suspend investments 
of Civil Service fund receipts.

Date: May 22, 2003; 
Action: Treasury postponed announcement of its weekly 13-week and 26-
week bill auctions and its monthly 2-year note to avoid exceeding the 
debt ceiling.

Date: May 27-28, 2003; 
Action: On May 27, 2003, the Congress and the President enacted Pub. L. 
No.108-24, which raised the debt ceiling to $7.4 trillion and ended the 
debt issuance suspension period. Treasury invested all uninvested funds 
of the G-Fund, ESF, and the Civil Service fund on May 27, 2003, and on 
May 28, 2003, restored the losses incurred by the G-Fund.

Date: June 30, 2003; 
Action: Treasury fully restored the principal and interest losses 
incurred by the Civil Service fund that related to (1) the failure to 
promptly invest Civil Service fund receipts and (2) redeeming 
obligations before they were needed to pay fund benefits and expenses. 
FFB also redeemed the $15 billion 9(a) obligation it issued to the 
Civil Service fund on March 5, 2003. 

Sources: Treasury and GAO.

[End of table]

Normal Investment and Redemption Policies Used on Major Federal 
Government Accounts with Investment Authority: 

Federal government accounts with investment authority that are 
authorized to invest their receipts, such as the Civil Service 
fund,[Footnote 27] the G-Fund,[Footnote 28] the Social Security 
funds,[Footnote 29] and the Federal Employee Health Benefits 
Fund,[Footnote 30] are generally authorized or required to invest them 
in nonmarketable Treasury obligations. Under normal conditions, 
Treasury is notified by the appropriate agency of the amount that 
should be invested or reinvested on its behalf, and Treasury then makes 
the investment. In some cases, the actual obligation that Treasury 
should purchase is also specified. When a federal government account 
with investment authority needs to pay benefits and expenses, Treasury 
is normally notified of the amount and the date that the disbursement 
is to be made. Depending on the account, Treasury may also be notified 
to redeem specific obligations. Based on this information, Treasury 
redeems an account's obligations.

Our analysis of the 25 major federal government accounts with 
investment authority for which Treasury stated it had followed its 
normal investment and redemption policies and procedures during the 
2003 debt issuance suspension period showed that for all but 1 account-
-the Highway Trust Fund--Treasury used its normal investment and 
redemption policies and procedures to handle receipts and maturing 
investments and to redeem Treasury obligations. Table 2 lists the 
federal government accounts with investment authority included in our 
analysis.

Table 2: Balance of Obligations Held by the Selected 25 Major Federal 
Government Accounts with Investment Authority as of January 31, 2003: 

Dollars in billions.

Federal Old Age and Survivors Insurance Trust Fund[A]; 
Obligations held as of January 31, 2003: $1,231.

Federal Hospital Insurance Trust Fund; 
Obligations held as of January 31, 2003: 238.

Department of Defense Military Retirement Fund; 
Obligations held as of January 31, 2003: 178.

Federal Disability Insurance Trust Fund[A]; 
Obligations held as of January 31, 2003: 162.

Unemployment Trust Fund; 
Obligations held as of January 31, 2003: 57.

Federal Supplemental Medical Insurance Trust Fund; 
Obligations held as of January 31, 2003: 34.

Bank Insurance Fund; 
Obligations held as of January 31, 2003: 31.

Employee Life Insurance Fund; 
Obligations held as of January 31, 2003: 26.

Nuclear Waste Disposal Fund; 
Obligations held as of January 31, 2003: 24.

Federal Housing Administration---Liquidating Account; 
Obligations held as of January 31, 2003: 23.

Highway Trust Fund; 
Obligations held as of January 31, 2003: 19.

Department of Defense Medicare Retirement Fund; 
Obligations held as of January 31, 2003: 16.

Airport and Airway Trust Fund; 
Obligations held as of January 31, 2003: 13.

Pension Benefit Guaranty Corporation; 
Obligations held as of January 31, 2003: 13.

Foreign Service Retirement and Disability Fund; 
Obligations held as of January 31, 2003: 12.

National Service Life Insurance Fund; 
Obligations held as of January 31, 2003: 11.

Savings Association Insurance Fund; 
Obligations held as of January 31, 2003: 11.

Railroad Retirement Account; 
Obligations held as of January 31, 2003: 9.

Employees' Health Benefits Fund; 
Obligations held as of January 31, 2003: 8.

Guarantees of Mortgage-Backed Securities, Government National Mortgage 
Association; 
Obligations held as of January 31, 2003: 7.

National Credit Union Share Insurance Fund; 
Obligations held as of January 31, 2003: 5.

Federal Savings and Loan Insurance Fund; 
Obligations held as of January 31, 2003: 3.

Railroad Retirement Social Security Equivalent Benefit Account; 
Obligations held as of January 31, 2003: 2.

Abandoned Mines Reclamation Fund; 
Obligations held as of January 31, 2003: 2.

Postal Service Fund; 
Obligations held as of January 31, 2003: 1.

Total; 
Obligations held as of January 31, 2003: $2,136. 

Source: Treasury.

[A] These are Social Security trust funds.

[End of table]

On February 27, 2003, Treasury redeemed about $343 million of Highway 
Trust Fund obligations in error. In March 2003, during its normal 
reconciliation processes, Treasury identified this error. Although 
normally such errors are corrected by investing the funds redeemed in 
error on the date the error is detected, Treasury did not do so. 
Rather, it decided to hold the excess funds in an uninvested funds 
account until they were needed to pay Highway Trust Fund expenses. The 
funds were used to pay the fund's expenses through March 24, 2003. 
According to Treasury officials, the primary reasons for not making the 
necessary reinvestment transaction on the date the error was detected 
and validated were that (1) the Highway Trust Fund does not earn 
interest on its investments[Footnote 31] and (2) the time necessary to 
identify the error and fully understand its impact meant that very 
little time actually elapsed when the funds could have been invested. 
Therefore, the Highway Trust Fund was not harmed by Treasury's decision 
to not invest the funds. However, Treasury officials subsequently 
agreed that the over-redemption should have been reinvested on the day 
the error was detected and adequate information was available to 
understand the amount that should have been invested, regardless of 
whether the Highway Trust Fund earns interest on its 
investments.[Footnote 32] Holding the excess funds in an uninvested 
funds account reduced the amount of debt subject to the debt ceiling by 
no more than $343 million for 26 days during the 2003 debt issuance 
suspension period.

To determine whether Treasury would have exceeded the debt ceiling if 
it had not committed this error or had reinvested the over-redeemed 
amount of funds when the error was discovered, we reviewed the invested 
balances in the G-Fund during this period. As noted elsewhere in this 
report, Treasury used the G-Fund during the 2003 debt issuance 
suspension period to ensure that the investment activities associated 
with federal government accounts with investment authority, such as the 
Highway Trust Fund, do not cause Treasury to exceed the debt ceiling. 
Based on our review, we found that the debt ceiling would not have been 
exceeded even if Treasury had not made the original error or had 
invested these funds when the error was detected, since other policies 
and procedures would have ensured a corresponding reduction in the 
amount of funds invested on behalf of the G-Fund. For example, on 
February 27, 2003, the computation Treasury used to determine the 
amount that should be invested in the G-Fund showed that Treasury could 
invest about $22.9 billion of G-Fund receipts. If the Highway Trust 
Fund error had not been made, this computation would have shown that 
Treasury could have invested about $22.6 billion in the G-Fund, or 
about $0.3 billion less than what was actually invested. Therefore, the 
amount of debt subject to the debt ceiling would have remained 
unchanged from its reported $6.4 trillion level.

Actions Related to the G-Fund: 

Subsection 8438(g)(1) of title 5, United States Code, authorizes the 
Secretary of the Treasury to suspend the issuance of additional amounts 
of obligations of the United States to the G-Fund if the issuance 
cannot be made without causing the amount of public debt to exceed the 
debt ceiling. Each day from February 20, 2003, to May 27, 2003, 
Treasury determined the amount of funds that the G-Fund would be 
allowed to invest in Treasury obligations and, when necessary, 
suspended some investments and reinvestments of the G-Fund receipts and 
maturing obligations that would have caused the debt ceiling to be 
exceeded.

On February 20, 2003, when the Secretary of the Treasury determined 
that a debt issuance suspension period had begun, the G-Fund held about 
$48.3 billion of Treasury obligations that would mature that day. To 
ensure that it did not exceed the debt ceiling, Treasury did not 
reinvest about $8.5 billion of these obligations on that date.

The amount of the G-Fund's receipts that Treasury invested changed 
daily, depending on the amount of the federal government's outstanding 
debt. Although Treasury can accurately predict the outcome of some 
events that affect the outstanding debt, it cannot precisely determine 
the outcome of others until they occur. For example, the amount of 
obligations that Treasury will issue to the public from an auction can 
be determined some days in advance because Treasury can control the 
amount that will be issued. On the other hand, the amount of savings 
bonds that will be issued and redeemed and the amount of obligations 
that will be issued to, or redeemed by, various federal government 
accounts with investment authority are difficult to precisely predict. 
Because of these difficulties, Treasury needed a way to ensure that the 
normal investment and redemption activities associated with Treasury 
obligations did not cause the debt ceiling to be exceeded and also to 
maintain normal investment and redemption policies for the majority of 
these accounts. To do these things, each day during the debt issuance 
suspension period, Treasury: 

* calculated the amount of debt subject to the debt ceiling, excluding 
the receipts that the G-Fund would normally invest;

* determined the amount of G-Fund receipts that could safely be 
invested without exceeding the debt ceiling and invested this amount in 
Treasury obligations; and: 

* suspended investment, when necessary, of the G-Fund's remaining 
receipts.

For example, on February 27, 2003, the amount of debt subject to the 
debt ceiling, excluding the G-Fund's requested investment of about $49 
billion, was about $6,377 billion or about $23 billion below the debt 
ceiling. Accordingly, Treasury invested about $23 billion in the G-
Fund. The remaining $26 billion was uninvested. In accordance with law, 
interest on the uninvested funds was paid once the debt issuance 
suspension period ended.

During the 2003 debt issuance suspension period, the G-Fund lost about 
$362.5 million in interest because its excess funds were not fully 
invested. Subsection 8438(g)(3) of title 5, United States Code, 
requires the Secretary of the Treasury to make the G-Fund whole by 
restoring any losses once the debt issuance suspension period has 
ended. On May 27, 2003, when the debt ceiling was raised, Treasury 
fully invested the G-Fund's receipts and on May 28, 2003, fully 
restored the lost interest on the G-Fund's uninvested funds. 
Consequently, the G-Fund was fully compensated for its interest losses 
during the 2003 debt issuance suspension period. We verified that after 
this interest payment, the G-Fund's obligation holdings were, in 
effect, the same as they would have been had the debt issuance 
suspension period not occurred.

Actions Related to ESF: 

On several occasions from March 31, 2003, through May 23, 2003, 
Treasury did not reinvest some of the maturing obligations held by ESF. 
Because ESF's obligations are considered part of the federal 
government's outstanding debt subject to the debt ceiling, that debt is 
reduced when the Secretary of the Treasury does not reinvest ESF's 
maturing obligations. Since ESF was not fully invested, it incurred 
interest losses of $3.6 million during the 2003 debt issuance 
suspension period. The Secretary of the Treasury is not authorized by 
law to restore these losses.

The purpose of ESF is to help provide a stable system of monetary 
exchange rates. The law establishing ESF authorizes the Secretary of 
the Treasury to invest ESF's balances not needed for program purposes 
in obligations of the federal government. This law also gives the 
Secretary of the Treasury the sole discretion for determining when, and 
if, the excess funds will be invested. During previous debt ceiling 
crises, Treasury exercised the option of not reinvesting ESF's maturing 
Treasury obligations, which helped the federal government to stay 
within the debt ceiling and enabled Treasury to subsequently raise 
additional cash.

Actions Related to the Civil Service Fund: 

During the 2003 debt issuance suspension period, the Secretary of the 
Treasury redeemed certain Treasury obligations held by the Civil 
Service fund earlier than normal and suspended the investment of 
certain Civil Service fund receipts. In addition, as discussed later, 
the Civil Service fund exchanged Treasury obligations it held for a $15 
billion FFB 9(a) obligation.

Obligations Held by the Civil Service Fund Redeemed Earlier Than 
Normal: 

Subsection 8348(k)(1) of title 5, United States Code, authorizes the 
Secretary of the Treasury to redeem obligations or other invested 
assets of the Civil Service fund before maturity to prevent the amount 
of public debt from exceeding the debt ceiling. The statute does not 
require that early redemptions be made only for the purpose of making 
Civil Service fund payments. Further, the statute permits early 
redemptions even if the Civil Service fund has adequate cash balances 
to cover such payments.

Before redeeming Civil Service fund obligations earlier than normal, 
the Secretary of the Treasury must determine that a debt issuance 
suspension period exists. The statute authorizing the debt issuance 
suspension period and its legislative history are silent as to how to 
determine the length of a debt issuance suspension period. On April 4, 
2003, the Secretary of the Treasury declared that a debt issuance 
suspension period, as it relates to the Civil Service fund, would begin 
no later than April 11, 2003, and would last until July 11, 2003. On 
May 19, 2003, the Secretary of the Treasury extended this period until 
December 19, 2003.

On April 8, 2003, and May 20, 2003, Treasury redeemed about $12.2 
billion and $20.2 billion, respectively, of the Civil Service fund's 
Treasury obligations using its authority under subsection 8348(k)(1) of 
title 5, United States Code. The $32.4 billion redemption amount was 
determined based on (1) the length of the initial debt issuance 
suspension period (April 8 through July 11, 2003) and the related 
extension (through December 19, 2003) and (2) the estimated monthly 
Civil Service fund benefit payments that would occur during that 
time.[Footnote 33] These were appropriate factors to use in determining 
the amount of Treasury obligations to redeem early.

Treasury redeemed about $12.2 billion early to cover the obligations 
associated with the May, June, and July 2003 estimated benefit payments 
on April 8, 2003. As such, when May's benefit payments were due, 
Treasury redeemed only the $60 million difference between the amount 
that had been redeemed early for the month of May and the actual amount 
of benefit payments to be made.

Investment of Civil Service Fund Receipts Suspended: 

Subsection 8348(j)(1) of title 5, United States Code, authorizes the 
Secretary of the Treasury to suspend additional investment of amounts 
in the Civil Service fund if the investment cannot be made without 
causing the amount of public debt to exceed the debt ceiling. From 
April 8, 2003, through May 26, 2003, the Civil Service fund had about 
$2.5 billion in receipts that were not invested. On May 27, 2003, after 
the debt ceiling was raised, these receipts were invested.

Civil Service Fund Losses Associated with Early Redemptions and 
Suspended Investments Restored: 

When the Secretary of the Treasury redeems obligations earlier than 
normal or refrains from promptly investing Civil Service fund receipts 
because of debt ceiling limitations, the Secretary is required by 
subsection 8348(j)(3) of title 5, United States Code, to immediately 
restore, to the maximum extent practicable, the Civil Service fund's 
obligation holdings to the proper balances when a debt issuance 
suspension period ends and to restore lost interest on the next normal 
interest payment date. Consequently, Treasury took the following 
actions once the debt issuance suspension period had ended: 

* Treasury invested about $30.8 billion of uninvested receipts on May 
27, 2003. These receipts were associated with (1) collections made by 
the Civil Service fund that had not been invested and (2) funds 
associated with the early redemptions that had not been used for 
benefit payments and expenses.

* Treasury paid the Civil Service fund on June 30, 2003, about $100.8 
million as compensation for principal and interest losses incurred 
because of the actions it had taken. This was the first semiannual 
interest payment date since the debt issuance suspension period ended. 
June 30, 2003, was the proper restoration date according to the statute 
authorizing the restoration.

We verified that after these transactions the Civil Service fund's 
obligation holdings were, in effect, the same as they would have been 
had the debt issuance suspension period not occurred.

Effects of Exchange of Debt Obligations between the Civil Service Fund, 
FFB, and Treasury: 

During fiscal year 2003, Treasury initiated the following actions 
involving the Civil Service fund, FFB, and the Treasury general fund 
related to its efforts to (1) address FFB cash flow issues resulting 
from previously issued FFB 9(a) obligations to the Civil Service fund 
and (2) manage the amount of debt subject to the debt ceiling: 

* On October 18, 2002, FFB redeemed prior to maturity $15 billion in 
FFB 9(a) obligations held by the Civil Service fund. The $15 billion in 
FFB 9(a) obligations do not count against the debt ceiling.[Footnote 
34] These FFB 9(a) obligations were the result of a series of 
transactions stemming from a Treasury-directed exchange of Treasury 
obligations held by the Civil Service fund for FFB 9(a) obligations to 
assist Treasury in managing the debt during the 1985 debt ceiling 
crisis. This early redemption resulted in a loss of over $1 billion on 
October 18, 2002, to the Civil Service fund because of lost interest.
[Footnote 35]

* On March 5, 2003, FFB issued an FFB 9(a) obligation of about $15 
billion to the Civil Service fund in exchange for about $15 billion in 
Treasury obligations that had been held by the Civil Service fund. FFB 
used the Treasury obligations to purchase FFB 9(b) obligations held by 
the Secretary of the Treasury.[Footnote 36] As a result, the FFB 9(b) 
debt obligations were canceled and the Treasury obligations that were 
no longer outstanding were canceled.[Footnote 37] Consequently, 
Treasury was provided about $15 billion in additional borrowing 
authority under the debt ceiling.

* On June 30, 2003, FFB redeemed early the 9(a) obligation it had 
issued to the Civil Service fund on March 5. Treasury reinvested the 
FFB redemption proceeds in accordance with its normal investment 
policies and procedures.

Our review found that on March 5, 2003, and June 30, 2003, the Civil 
Service fund received fair value based on a present value 
analysis[Footnote 38] for the obligations it surrendered. However, 
whether the Civil Service fund will have any long-term gains or losses 
associated with these transactions will not be known for some time.

Gains or losses on the exchange of obligations between the Civil 
Service fund and FFB can result when (1) the exchange occurs or (2) the 
underlying assumptions used to determine the exchange price are not 
realized. We have found that the initial transactions between FFB and 
the Civil Service fund relating to a given period in which Treasury was 
experiencing debt ceiling difficulties[Footnote 39] were fair to both 
parties on the date of the exchange. However, quantifying the long-term 
effects of these transactions on the parties involved is difficult and 
complex because the exchanges were structured to last many years. The 
longer the period in the analysis used to evaluate the fairness of a 
given transaction, such as a present value analysis, the greater the 
probability that the underlying assumptions used to determine the 
original exchange price will not accurately reflect the future years' 
events. This risk is also incurred when the obligations relating to an 
exchange remain outstanding for a long time. When the assumptions used 
to determine the initial exchange prices are not realized (e.g., the 
obligation is redeemed sooner than expected), gains and losses can 
result from interest rate changes and reinvestment of the repayment in 
obligations that do not have comparable maturities. For further 
discussion on the limitations of using a present value methodology to 
determine gains and losses, see appendix II.

In some cases, we have been able to quantify the gains or losses that 
have occurred or can be expected to occur that relate to the fiscal 
year 2003 transactions. However, in other cases, the information needed 
to understand the potential consequences of the actions taken on March 
5 and June 30, 2003, will not be available for a number of years, and 
we are unable to determine the potential impacts at this time. Table 3 
summarizes the gains and losses associated with the fiscal year 2003 
transactions between the Civil Service fund, FFB, and the Treasury 
general fund that we have been able to quantify and those that cannot 
be determined at this time.

Table 3: Gains, Losses, and Changes in Portfolio Balances Related to 
Exchanges between the Civil Service Fund and FFB: 

Result of FFB's October 18, 2002, early redemption of FFB 9(a) 
obligations held by the Civil Service fund: Gains/losses on transaction 
date (Oct. 18, 2002); 
Effect on Civil Service fund: Result of FFB's October 18, 2002, early 
redemption of FFB 9(a) obligations held by the Civil Service fund: The 
Civil Service fund lost interest with a present value of over $1 
billion on the date of the exchange because FFB redeemed funds early 
and they were invested in Treasury obligations at a significantly lower 
interest rate than the rates on the FFB 9(a) debt obligations; 
Effect on FFB: Result of FFB's October 18, 2002, early redemption of 
FFB 9(a) obligations held by the Civil Service fund: Gain unknown; 
Effect on Treasury general fund: Result of FFB's October 18, 2002, 
early redemption of FFB 9(a) obligations held by the Civil Service 
fund: Not applicable.

Result of FFB's October 18, 2002, early redemption of FFB 9(a) 
obligations held by the Civil Service fund: Additional gains/losses 
through June 30, 2005; 
Effect on Civil Service fund: Result of FFB's October 18, 2002, early 
redemption of FFB 9(a) obligations held by the Civil Service fund: The 
Civil Service fund will lose about $33.4 million in nominal interest 
because Treasury invested FFB's repayment to the Civil Service fund on 
October 18, 2002, in accordance with its normal investment policies and 
procedures rather than using the present value assumptions used to 
calculate the over $1 billion of interest; 
Effect on FFB: Result of FFB's October 18, 2002, early redemption of 
FFB 9(a) obligations held by the Civil Service fund: Not applicable; 
Effect on Treasury general fund: Result of FFB's October 18, 2002, 
early redemption of FFB 9(a) obligations held by the Civil Service 
fund: Not applicable.

Net result of the March 5, 2003, exchange of Treasury obligations held 
by the Civil Service fund for FFB 9(a) obligation and FFB's June 30, 
2003, early redemption of the obligation: Net gains/losses on 
transaction dates (Mar. 5, 2003, and June 30, 2003) and changes in 
portfolio balances; 
Effect on Civil Service fund: The Civil Service fund's portfolio 
balance increased by $1.153 billion. This increase occurred because the 
present value of the FFB 9(a) obligation redeemed on June 30, 2003, was 
greater than the face amount of the Treasury obligations exchanged on 
March 5, 2003. The majority of this increase was necessitated by 
Treasury having to invest the June 30, 2003, redemption in obligations 
with a lower interest rate than the Treasury obligations used in the 
exchange on March 5, 2003. Further, as discussed in app. III, falling 
interest rates made the FFB 9(a) obligation more valuable on June 30, 
2003, than if the Civil Service fund had maintained the Treasury 
obligations exchanged on March 5, 2003, in its portfolio. This increase 
was about $139.5 million and resulted in a gain to the Civil Service 
fund. This gain was included in the $1.153 billion increase in Treasury 
obligations; 
Effect on FFB: 
* FFB incurred a $633 million net loss caused by the difference between 
(1) the additional $1.153 billion payment from FFB to the Civil Service 
fund to ensure that the Civil Service fund's future interest earnings 
would be comparable to its expected interest earnings if the June 30, 
2003, FFB repayment was invested in obligations with maturities that 
were consistent with the present value assumptions and (2) the $520 
million gain on FFB's sale of the Civil Service fund obligations to 
Treasury; 
* FFB's loan balance to Treasury increased by about $1.1 billion 
because of additional short-term borrowing from Treasury, which was 
repaid on April 1, 2004; 
Effect on Treasury general fund: The Treasury general fund incurred a 
$520 million loss on the purchase from FFB of the Civil Service fund 
Treasury obligations because Treasury purchased them at more than their 
par value.

Net result of the March 5, 2003, exchange of Treasury obligations held 
by the Civil Service fund for FFB 9(a) obligation and FFB's June 30, 
2003, early redemption of the obligation: Gains and losses after June 
30, 2003, and changes in portfolio balances; 
Effect on Civil Service fund: Unknown; 
Effect on FFB: FFB has an expected gain of $1.153 billion. This 
expected gain results from the fact that FFB's interest costs 
associated with its June 30, 2003, borrowings from Treasury that were 
used to redeem the FFB 9(a) obligation issued to the Civil Service fund 
are significantly lower than its expected interest income from its loan 
portfolio; 
Effect on Treasury general fund: None. 

Sources: Treasury and GAO.

[End of table]

As discussed in the preceding narrative and shown in table 3, it is 
difficult to quantify all the losses and gains associated with the 
transactions between FFB and the Civil Service fund. A more detailed 
explanation of these gains and losses, as well as the reasons why not 
all of the effects of these transactions can be quantified at this 
time, is provided in appendix III. Regardless of whether they sustain 
any additional gains or losses over the long term, the Civil Service 
fund, FFB, and the Treasury general fund incurred increased risks of 
gains and losses that they would not have incurred if these 
transactions had not occurred. More important, the risks related to the 
transactions between FFB and the Civil Service fund are not typically 
incurred by these organizations during their normal operations.

It is important to remember that the risks associated with these 
exchange transactions are not undertaken for programmatic reasons. 
Rather, they are made at the direction of the Secretary of the Treasury 
to help manage the federal government's operations when debt ceiling 
difficulties occur. FFB and Treasury have flexibilities that allow them 
to structure transactions that reduce or even eliminate the losses that 
FFB can incur. However, similar flexibilities are not available to the 
Civil Service fund. Furthermore, although the Secretary of the Treasury 
has statutory authority to restore losses resulting from not investing 
Civil Service fund receipts or from early redemption of Treasury 
obligations held by the Civil Service fund during a debt issuance 
suspension period, the Secretary does not have the statutory authority 
to restore the types of losses, discussed above, that result from 
exchange transactions. Appendix IV discusses transactions between the 
Civil Service fund and FFB that related to previous debt management 
difficulties.

Documented Policies and Procedures Needed for Civil Service and FFB 
Exchange Transactions: 

As we noted in our December 2002 report, documented policies and 
procedures would allow Treasury to better determine the potential 
impacts associated with the policies and procedures it implements to 
manage the amount of debt subject to the debt ceiling. Although 
Treasury adopted our recommendation and developed policies and 
procedures for managing investment and redemption activities of the 
Civil Service fund and the G-Fund during a debt issuance suspension 
period, such policies and procedures do not address how exchange 
transactions between the Civil Service fund and FFB should be handled. 
While we recognize that Treasury needs a great deal of flexibility to 
structure transactions that fit specific events, we believe that 
guidelines related to exchange transactions between the Civil Service 
fund and FFB can be developed that minimize the risk to both parties.

It is the process of documenting the policies and procedures that 
allows Treasury management to ascertain the effects of these policies 
and procedures and whether those effects introduce any additional risks 
to the parties involved. In addition, documenting the policies and 
procedures allows Treasury to understand whether it may need additional 
statutory authority to ensure that all funds are adequately protected. 
Furthermore, if effectively implemented, documentation of the policies 
and procedures reduces the chance for confusion and risk of errors 
should Treasury need to use the policies and procedures in the future. 
These points were discussed in our December 2002 report to 
Treasury.[Footnote 40] During our review of the actions taken during 
the 2003 debt issuance suspension period that were affected by those 
policies and procedures, we found that none of the problems or 
potential problems that we discovered in the 2002 debt issuance 
suspension period had occurred.

Conclusions: 

The Secretary of the Treasury can take many actions to manage federal 
government operations during a debt issuance suspension period. In some 
cases, these actions pose no long-term financial risk to affected 
parties because of the statutory authorities currently available to the 
Secretary of the Treasury. As noted earlier, Treasury used these 
authorities to restore, in total, $463 million in losses incurred by 
the G-Fund and Civil Service fund. However, other actions expose the 
affected parties to financial risks that are not normally incurred as 
part of their programmatic operations. Whether the risks associated 
with specific actions result in actual losses or gains may not be known 
until many years after the action has been taken. History has shown, 
however, that the risks may be substantial. For example, according to 
FFB estimates, on October 18, 2002, the Civil Service fund lost 
interest of over $1 billion on a $15 billion transaction entered into 
in 1985 because of the unexpected early redemption of 9(a) obligations 
issued by FFB and unforeseen interest rate changes. Treasury lacks the 
statutory authority to restore such losses and has not developed the 
documented policies and procedures that can be used to minimize such 
losses in future exchanges between FFB and federal government accounts 
with investment authority, such as the Civil Service fund.

Recommendations for Executive Action: 

We recommend that the Secretary of the Treasury perform the following 
two actions: 

* Seek the statutory authority to restore the losses associated with 
the October 2002 early redemption of FFB 9(a) obligations. The amount 
of the restoration should be computed in a manner that maintains equity 
between the Civil Service fund and Treasury.

* Direct the Under Secretary for Domestic Finance to document the 
necessary policies and procedures that should be used for exchange 
transactions between FFB and a federal government account with 
investment authority during a debt issuance suspension period and seek 
any statutory authority necessary to implement the policies and 
procedures.

Agency Comments and Our Evaluation: 

In written comments on a draft of this report, Treasury agreed with our 
recommendations and stated that (1) it will seek statutory authority to 
restore losses incurred by federal government accounts with investment 
authority and by FFB as a result of actions taken for the purpose of 
fiscal management during a "debt limit impasse" and (2) it will 
document appropriate policies and procedures that should be used for 
exchange transactions between FFB and a federal government account with 
investment authority to ensure long-term fairness to all parties. 
Treasury has stated that the authority it will seek includes the 
restoration of the losses associated with the October 2002 early 
redemption of FFB 9(a) obligations as we recommended. Until Treasury 
develops its specific legislative proposal and the policies and 
procedures it will use relating to transactions between FFB and federal 
government accounts with investment authority, we cannot determine the 
scope of the statutory authority it may seek. Treasury also noted that 
it has already taken certain steps in documenting the policies and 
procedures that should be used in future exchange transactions.

Treasury stated that it plans to use FFB's independent auditor to 
"ensure that the terms and structure [of exchange transactions] clearly 
achieve the intended accounting result and long-term financial fairness 
to all parties, prior to transaction approval and execution." Treasury 
and its independent auditor will need to ensure that this arrangement 
does not result in a problem with auditor independence under U.S. 
generally accepted government auditing standards.[Footnote 41] The 
independence standard requires that auditors should avoid situations 
that could lead reasonable third parties with knowledge of the relevant 
facts and circumstances to conclude that the auditor is not able to 
maintain independence in conducting its financial statement audit. For 
example, audit organizations should not perform management functions or 
make management decisions for entities that they also audit.

Specific technical comments provided orally by Treasury were 
incorporated in this report as appropriate.

We are sending copies of this report to the Chairmen and Ranking 
Minority Members of the Senate Committee on Appropriations; the Senate 
Committee on Governmental Affairs; the Senate Committee on the Budget; 
the Senate Committee on Finance; the Subcommittee on Financial 
Management, the Budget, and International Security, Senate Committee on 
Governmental Affairs; the House Committee on Appropriations; the House 
Committee on Government Reform; the House Committee on the Budget; the 
House Committee on Ways and Means; the Subcommittee on Government 
Efficiency and Financial Management, House Committee on Government 
Reform; and the Subcommittee on Civil Service and Agency Organization, 
House Committee on Government Reform. We are also sending copies of 
this report to the Secretary of the Treasury, the Under Secretary for 
Domestic Finance of the Department of the Treasury, the Inspector 
General of the Department of the Treasury, the Director of the Office 
of Management and Budget, and other agency officials. In addition, the 
report will be available at no charge on the GAO Web site at http://
www.gao.gov.

If you need further assistance or if you or your staff have any 
questions concerning this report, please contact Chris Martin, Senior 
Level Technologist, at (202) 512-9481 or Louise DiBenedetto, Assistant 
Director, at (202) 512-6921. Other key contributors to this report were 
Wendy M. Albert, Arkelga L. Braxton, and Richard T. Cambosos.

Signed by: 

Gary T. Engel: 
Director Financial Management and Assurance: 

Signed by: 

Keith A. Rhodes: 
Chief Technologist, Applied Research and Methods: 

[End of section]

Appendixes: 

Appendix I: Gains and Losses on Federal Accounts with Investment 
Authority: 

Gains and losses can be broken down into two main categories: (1) gains 
and losses associated with normal investment and redemption activity 
and (2) gains and losses associated with unusual events, such as a debt 
issuance suspension period. Treasury's long-standing position is that 
gains and losses associated with normal investment and redemption 
activity are borne by the applicable federal government account and 
that no special action should be taken to adjust an account's 
investment portfolio for these gains and losses. On the other hand, 
when the loss is incurred because of unusual events and account 
participants have a vested interest in the fund, Treasury has, in many 
cases, received the necessary authority to restore such losses.

Gains and Losses Associated with Normal Investment and Redemption 
Activity: 

Federal government accounts with investment authority generally invest 
in interest-bearing nonmarketable Treasury obligations. The investment 
and redemption activities related to these obligations can cause gains 
and losses from, for example, changing interest rates and certain 
errors that are found and corrected. Treasury has a long-standing 
position that gains and losses associated with normal investment and 
redemption activities are a cost of doing business. Therefore, Treasury 
makes no attempt to adjust an account's investment portfolio for such 
activities.

Gains and Losses Associated with Security Valuation: 

As noted earlier, one of Treasury's basic management policies for 
federal government accounts with the authority to invest is to maintain 
equity between these accounts and the general fund--the fund used to 
pay most government obligations. To do so, Treasury issues two basic 
types of nonmarketable obligations--market-based and par value 
specials. Most market-based obligations are mirror images of existing 
Treasury obligations that are traded on the open market and are 
purchased or sold at open market prices.[Footnote 42] Par value 
specials, on the other hand, are issued and redeemed at par.

The interest rates for par value specials are specified in the enabling 
statute or by administrative action. For example, for the G-Fund, Civil 
Service fund, and Social Security funds, the par value rate is based on 
the average rate for comparable marketable obligations, as defined by 
Treasury, with 4 or more years to maturity. This rate is established 
monthly, and all investments for a given month must bear the same rate. 
When a federal government account with investment authority needs to 
redeem obligations to pay benefits and expenses, Treasury redeems these 
obligations and pays the fund the par value plus any accrued interest. 
Although only certain accounts are allowed to invest in par value 
specials, the majority of the $2.8 trillion of account investments on 
January 31, 2003, were invested in par value specials. Equity between 
accounts investing in par value specials and the Treasury general fund 
is not maintained because (1) the interest rate is determined only 
monthly and (2) the term of the investment is not relevant, as shown in 
the following examples: 

* The interest rate used to invest an account's receipts is determined 
only monthly. If market interest rates fall during the month, the 
Treasury general fund pays the account more interest than market 
conditions dictate; if market interest rates rise during the month, the 
investment account receives less interest than market conditions 
dictate.

* Many federal government accounts with investment authority holding 
par value specials hold these obligations for a number of years. 
Accordingly, the interest rates can vary significantly. For example, 
the Civil Service fund has obligations that carry interest rates 
ranging from 3.5 percent to 8.75 percent in its portfolio that matures 
on June 30, 2005. Even the rates for the portfolio that matures on June 
30, 2014, range from 3.5 percent to 6.5 percent. However, when the 
obligations are needed to pay benefits, they are redeemed at par 
regardless of current market rates. In times of high interest rates, 
redeeming a low-interest-rate obligation at par benefits the account 
redeeming the par value special. On the other hand, during periods of 
low interest rates, redeeming obligations at par benefits Treasury's 
general fund.

* The interest rate paid on Treasury obligations with 4 or more years 
to maturity is based on a statutory formula developed in the 1920s to 
ensure equal semiannual interest payments for obligations held for 
exactly 1 year. However, as we noted in our 1987 report on the Civil 
Service fund, when investments are held for less than a year, 
Treasury's method does not ensure that the account is neither 
overcompensated nor undercompensated. In the major accounts with 
investment authority, such as the Civil Service and Social Security 
funds, a large number of investments in par value specials are 
subsequently redeemed, sometimes just days later, for benefit payments 
and expenses, rather than held to their maturity. Activity associated 
with current-year investments that were subsequently redeemed in the 
current investment year for program benefits and expenses can be 
significant.[Footnote 43] Such activity totaled well over $100 billion 
dollars between January 31, 2003, and June 30, 2003, for the Civil 
Service and Social Security funds. In addition, as noted elsewhere, the 
G-Fund, whose investments receive the par value rate, redeems and 
reinvests its entire portfolio each business day.[Footnote 44]

Gains and Losses Associated with Adjustments: 

Treasury makes many adjustments to the accounting records to reflect 
accounting events. Reasons for adjustments may include (1) information 
received late from an account caused by agreed-upon processing delays 
such as those associated with the Social Security funds and (2) certain 
errors made by either Treasury or the account. We found in a 1987 
review that the procedures for making adjustments to accounts holding 
par value specials, which are still being used, do not ensure that the 
results of adjustments are equitable.[Footnote 45] For example, during 
our 1987 review we noted that one error that Treasury made and 
corrected cost the Civil Service fund almost $400,000 in lost interest 
earnings. Specifically, according to Treasury records, the Office of 
Personnel Management (OPM) instructed Treasury to redeem about $400 
million of obligations on behalf of the Civil Service fund on July 5, 
1984. However, Treasury did not make this redemption until OPM notified 
Treasury of the error in August. Treasury then redeemed the lowest-
interest-bearing obligations available at that time, which had rates of 
8.75 and 9.75 percent. The interest earnings for this redemption were 
computed through July 5 (the original requested redemption date). Had 
the redemption taken place on July 5, the obligations bearing interest 
rates of 7.5 and 7.625 percent would have been used because the 
portfolio held lower-rate obligations at that time. As a result, the 
Civil Service fund lost about $400,000 of interest earnings. Treasury 
agreed with our methodology for computing the effects of this error and 
with the amount of the loss.

Gains and Losses Associated with Unusual Events: 

Treasury and the Congress have a long-standing position of obtaining 
the necessary authority to restore interest that was not credited to an 
account with investment authority because of unusual events. GAO, the 
Congress, Treasury, and agencies associated with the accounts commonly 
refer to this forgone interest as a loss to the fund. Several examples 
follow.

* In OPM's comments on our report on the actions taken during the 1985 
debt ceiling crisis, it stated that the Civil Service fund "should be 
'made whole' when available funds are not properly invested. This is 
especially important for situations [such as] . . . when the [Civil 
Service fund] lost interest as the result of debt ceiling 
limitations.": 

* Section 6002 of the Omnibus Budget Reconciliation Act of 
1986[Footnote 46] added subsections (j), (k), and (l) to section 8348 
of title 5, United States Code, (1) to authorize the Secretary to 
suspend investment of amounts in the Civil Service fund in government 
obligations and to redeem prior to maturity government obligations held 
by the Civil Service fund when necessary to avoid exceeding the debt 
ceiling and (2) to authorize the Secretary to make the fund whole after 
the debt issuance suspension period. The joint explanatory statement of 
the committee of conference accompanying the Omnibus Budget 
Reconciliation Act of 1986 states that the amendment requires the 
Secretary "to make the Fund whole for any earnings lost as a result of 
the suspension or disinvestment by a combination of special cash 
payment actions."[Footnote 47]

* Treasury's July 30, 2003, letter to the Congress concerning the 2003 
debt issuance suspension period stated that Treasury has paid interest 
"totaling $100,822,854.44, representing the amount that would have been 
earned, but for the debt issuance suspension period." Treasury also 
noted that this "represents the interest lost" by the Civil Service 
fund.

It is also a long-standing practice for the Congress and the President 
to provide the necessary authority to restore losses caused by unusual 
events. For example, during the 1985 debt ceiling crisis, Treasury was 
granted the authority to restore the majority of interest losses 
associated with its actions to avoid exceeding the debt ceiling. 
Furthermore, as recommended in our report on the 1985 debt ceiling 
crisis, Treasury received the authority in 1986 and 1987 to fully 
restore the losses associated with certain actions it takes in regard 
to the Civil Service fund and G-Fund during debt ceiling difficulties.

[End of section]

Appendix II: Limitations of the Present Value Analysis Approach to 
Determining Economic Gains and Losses: 

A present value analysis is used to provide a basis for understanding 
the value of an obligation using current market conditions when that 
obligation is being purchased, sold, or exchanged before maturity. The 
present value[Footnote 48] of an obligation depends on (1) the coupon 
rate, (2) the length of time the obligation is outstanding, and (3) the 
current market rate (commonly referred to as the discount factor). 
Table 4 shows a simple example of the present values of three $1 
million obligations bearing a coupon rate of 6 percent with three 
different maturities and using three different discount factors.

Table 4: Example of the Impact on a $1 Million 6 Percent Obligation 
Using Different Present Value Discount Factors and Maturity Dates: 

Years to maturity: 5; 
Discount factor for a 6 percent coupon rate obligation: 5 percent: 
$1,043,295; 
Discount factor for a 6 percent coupon rate obligation: 6 percent: 
$1,000,000; 
Discount factor for a 6 percent coupon rate obligation: 7 percent: 
$958,998.

Years to maturity: 10; 
Discount factor for a 6 percent coupon rate obligation: 5 percent: 
1,077,217; 
Discount factor for a 6 percent coupon rate obligation: 6 percent: 
1,000,000; 
Discount factor for a 6 percent coupon rate obligation: 7 percent: 
929,764.

Years to maturity: 25; 
Discount factor for a 6 percent coupon rate obligation: 5 percent: 
1,140,939; 
Discount factor for a 6 percent coupon rate obligation: 6 percent: 
1,000,000; 
Discount factor for a 6 percent coupon rate obligation: 7 percent: 
883,864. 

Source: GAO analysis.

Note: In this example, interest is paid annually, the principal balance 
is held until maturity, and the present values are computed on an 
interest payment date.

[End of table]

As shown in table 4, when the discount factor differs from the coupon 
rate, the present value of an obligation will differ from the face 
value--the longer the time interval, the greater the increase or 
decrease in value.

As noted in our discussion on the effects of exchanges of obligations 
between the Civil Service fund, the Federal Financing Bank (FFB), and 
the Department of the Treasury (Treasury), Treasury used a present 
value analysis to help ensure that the exchange of Treasury obligations 
held by the Civil Service Retirement and Disability Fund (Civil Service 
fund) for obligations issued by FFB was fair to both parties. The 
present value approach was also used to determine the amount of losses 
incurred by the Civil Service fund when FFB repaid its obligations 
before they were scheduled to mature. A key assumption in making a 
present value calculation is that the underlying assumptions on 
interest rates and cash flows will not change. For example, if a 
present value calculation shows that an obligation's cash flows are 
worth $1 billion today assuming that the $1 billion can be invested in 
a 4 percent obligation that matures on June 30, Year 2, then it is 
critical that the investment be made in an obligation that bears an 
interest rate of 4 percent and that the obligation matures on June 30, 
Year 2. Otherwise, a gain or loss can occur if interest rates change, 
as shown in table 5.

Table 5: Example of Effects of Changing Interest Rates on Present Value 
Analyses: 

Event: January 5, Year 1; 
Present value assumption: $1 billion will be invested in an obligation 
maturing on June 30, Year 2, at 4 percent; 
Actual: $1 billion is invested in an obligation maturing on June 30, 
Year 1, at 4 percent; 
Effect on federal government account with investment authority: There 
is no adverse effect on the account.

Event: June 30, Year 1, scenario I; 
Present value assumption: Not applicable; 
Actual: $1 billion obligation at 4 percent purchased on January 5, Year 
1, matures and is reinvested in an obligation maturing on June 30, Year 
2, at 3.5 percent; 
Effect on federal government account with investment authority: The 
account will lose about $5 million because of lower interest rate.

Event: June 30, Year 1, scenario II; 
Present value assumption: Not applicable; 
Actual: $1 billion obligation at 4 percent purchased on January 5, Year 
1, matures and is reinvested in an obligation maturing on June 30, Year 
2, at 4.5 percent; 
Effect on federal government account with investment authority: The 
account will gain about $5 million because of higher interest rate. 

Source: GAO.

[End of table]

Although the initial exchange was fair, as shown in table 5, since the 
actual terms of the obligations issued were not the same as those used 
in the present value assumption, the account is subject to risks 
associated with interest rate changes.

Another limitation associated with a present value analysis is that it 
does not consider reinvestment risk.[Footnote 49] For example, in the 
case of the March 5, 2003, exchange between FFB and the Civil Service 
fund, the Treasury obligations exchanged matured from June 30, 2004, 
through June 30, 2011. However, the FFB 9(a) obligation received had a 
different cash flow. Therefore, if the principal and interest payments 
associated with the FFB 9(a) obligation could not be invested at the 
same discount factor used in the present value analysis, then a gain or 
loss would result. If the cash flows can be invested at a higher 
interest rate, then a gain will occur. Conversely, if the cash flows 
are reinvested at a lower rate, then a loss will occur.

[End of section]

Appendix III: Gains and Losses Associated with Transactions between the 
Civil Service Fund, FFB, and the Treasury General Fund: 

Civil Service Fund Interest Losses Associated with the October 18, 
2002, FFB Early Redemption: 

During the 1985 debt ceiling crisis, Treasury for the first time 
invested excess receipts of the Civil Service fund in FFB 9(a) 
obligations.[Footnote 50] Because FFB 9(a) obligations are not subject 
to the debt ceiling, this action allowed Treasury to borrow more cash 
from the public. At the time of the purchase, these FFB 9(a) 
obligations carried the same terms and conditions as the Treasury 
obligations held by the Civil Service fund.[Footnote 51] As such, as 
long as FFB did not redeem the debt obligations prior to maturity or 
the obligations were not otherwise redeemed before needed to pay Civil 
Service fund expenses in accordance with its normal redemption policies 
and procedures, the exchange transaction would result in no adverse 
consequences for the Civil Service fund. However, on October 18, 2002, 
FFB exercised its right to redeem its obligations before maturity, 
which resulted in over $1 billion in interest losses to the Civil 
Service fund.[Footnote 52]

According to FFB calculations, the present value interest loss to the 
Civil Service fund was over $1 billion when FFB redeemed its 
obligations.[Footnote 53] FFB appropriately calculated this loss using 
a present value methodology that assumed that the Civil Service fund 
could invest the $15 billion proceeds from the early redemption of the 
FFB 9(a) obligations at 3.875 percent--the October 2002 investment rate 
for Civil Service fund investments--and the funds could be invested 
with the same maturities as the redeemed FFB 9(a) obligations. Table 6 
shows a comparison of the maturity dates and interest rates associated 
with the FFB 9(a) obligations that were redeemed early.

Table 6: Maturity Dates and Interest Rates Associated with FFB 9(a) 
Debt Obligations Redeemed before Maturity on October 18, 2002: 

Dollars in billions.

June 30, 2003; 
Principal amount: 5; 
Interest rate on FFB 9(a) debt obligations: 9.25%; 
October 2002 investment rate: 3.875%.

June 30, 2004; 
Principal amount: 5; 
Interest rate on FFB 9(a) debt obligations: 8.75%; 
October 2002 investment rate: 3.875%.

June 30, 2005; 
Principal amount: 5; 
Interest rate on FFB 9(a) debt obligations: 8.75%; 
October 2002 investment rate: 3.875%.

Source: Treasury.

[End of table]

FFB's present value analysis assumed that the redemption proceeds would 
be invested at 3.875 percent using the same maturity dates that were 
applicable to the original FFB 9(a) obligations. The redemption 
proceeds were actually invested in a 3.875 percent obligation that 
matured on June 30, 2003, since Treasury's normal policies and 
procedures require that current-year receipts be invested in 
obligations that mature on June 30 of the current investment year.

On June 30, 2003, $10 billion of the October 18, 2002, investment was, 
in effect, reinvested in obligations bearing an interest rate of 3.5 
percent--the rate applicable to Civil Service fund investments for June 
2003. Accordingly, Treasury invested $10 billion with $5 billion 
maturing on June 30, 2004, and $5 billion on June 30, 2005, at an 
interest rate of 3.5 percent. The remaining $5 billion that was 
received on October 18, 2002, was used to pay current-year fund 
benefits and expenses and therefore was not available for reinvestment 
on June 30, 2003. Although FFB redemption proceeds were invested with 
the same maturity dates as the original FFB 9(a) obligations, they will 
be invested for a time at 3.5 percent rather than the 3.875 percent 
assumed in the present value analysis. Therefore, in addition to the 
over $1 billion interest loss incurred on October 18, 2002, discussed 
above, the Civil Service fund will incur about $33.4 million of 
additional interest losses (commonly referred to as a nominal interest 
loss) in these future years because of the lower-than-assumed interest 
rate on the reinvested amounts.

Table 7 compares the expected interest earnings associated with the 
October 18, 2002, FFB 9(a) redemption prior to maturity using the 
present value assumptions and the expected interest earnings that would 
be received if the obligations were held to maturity.

Table 7: Comparison of Expected Interest Earnings on October 18, 2002, 
Redemption Using Different Rates: 

Period: October 18, 2002, through June 30, 2003; 
Principal balance outstanding: $15 billion; 
Nominal interest if invested at assumed 3.875 percent: $406 million; 
Nominal interest at actual investment rate of 3.5 percent: Not 
applicable since funds were invested at 3.875%; 
Nominal interest gain or loss: $22.9 million gain[A].

Period: June 30, 2003, through June 30, 2004; 
Principal balance outstanding: $10 billion; 
Nominal interest if invested at assumed 3.875 percent: $387.5 million; 
Nominal interest at actual investment rate of 3.5 percent: $350 
million; 
Nominal interest gain or loss: $37.5 million loss.

Period: June 30, 2004, through June 30, 2005; 
Principal balance outstanding: $5 billion; 
Nominal interest if invested at assumed 3.875 percent: $193.75 
million; 
Nominal interest at actual investment rate of 3.5 percent: $175 
million; 
Nominal interest gain or loss: $18.8 million loss.

Period: Total net nominal interest loss; 
Nominal interest gain or loss: $33.4 million loss. 

Source: GAO.

[A] Since Treasury invested the $15 billion in 3.875 percent 
obligations, these obligations became available for redemption to pay 
the Civil Service fund's benefits and expenses using Treasury's normal 
investment and redemption policies and procedures. However, if Treasury 
had invested the FFB repayment in accordance with the present value 
analysis, $10 billion of the FFB repayment would not have been 
available for use by the Civil Service fund during the investment year 
ending on June 30, 2003. Accordingly, Treasury would have redeemed 
higher-interest-rate obligations in order to pay the Civil Service 
fund's benefit payments and expenses during this period. Although an 
exact estimate of this interest rate differential is difficult to 
quantify, the amount of benefit to the Civil Service fund by not 
redeeming these higher-rate obligations could be as much as $22.9 
million.

[End of table]

In our report on the 1985 debt ceiling crisis,[Footnote 54] we noted 
that Treasury officials stated that a basic trust fund management 
policy is to ensure equity between the various trust funds and the 
Treasury general fund--the fund used to pay most government 
obligations--and that none of the funds unduly benefit from Treasury's 
management. Although the losses discussed in this section resulted from 
a transaction between FFB and the Civil Service fund, the transaction 
between these two funds was not initially undertaken for programmatic 
reasons; rather, it was undertaken by the Secretary of the Treasury to 
help manage debt during the 1985 debt ceiling crisis, and the early 
redemption in 2002 was undertaken to help manage FFB's cash flow 
problems.

Civil Service Fund Gains and Losses Associated with the 2003 Exchange 
Transaction: 

On March 5, 2003, Treasury exchanged certain Treasury obligations held 
by the Civil Service fund for an FFB 9(a) obligation of about $15 
billion issued by FFB to the Civil Service fund. The purpose of this 
transaction, similar to the purpose of the transaction that occurred 
during the 1985 debt ceiling crisis discussed above, was to make about 
$15 billion of additional borrowing authority available under the debt 
ceiling. Figure 2 shows the process for debt ceiling relief during 
fiscal year 2003.

Figure 2: Debt Exchange Process Used for Fiscal Year 2003 Debt Ceiling 
Relief: 

[See PDF for image]

[End of figure]

However, unlike the terms and conditions of the 1985 exchange 
transaction, the terms and conditions of the FFB 9(a) obligation issued 
to the Civil Service fund during the 2003 debt issuance suspension 
period were different from those of the Treasury obligations 
surrendered. Specifically, the terms of the FFB 9(a) obligation held by 
the Civil Service fund stated that if FFB redeemed its obligation 
before maturity, the redemption price would be based on current market 
rates rather than par value, which was the basis used in the 1985 
exchange. Therefore, to ensure that the value of the exchange was fair 
to both parties on the date of the exchange, Treasury used a present 
value analysis to compare the value of future cash flows expected from 
the Treasury obligations being exchanged by the Civil Service fund with 
the value of future cash flows expected from the FFB 9(a) obligation. 
On June 30, 2003, FFB redeemed its March 5, 2003, 9(a) obligation 
before the December 2035 maturity date. As discussed below, these 
transactions introduced risks to the Civil Service fund that it would 
not have incurred had this exchange not taken place.

The transactions between the Civil Service fund and FFB fairly 
compensated the Civil Service fund, based on a present value analysis, 
on the date of the exchanges. The net result of the March 5, 2003, and 
June 30, 2003, transactions between the Civil Service fund and FFB was 
that the Civil Service fund had about $1.153 billion more in Treasury 
obligations than it did before the March 5, 2003, transaction. This 
increase in Treasury obligations held by the Civil Service fund 
occurred because the prevailing market interest rates at the time of 
the exchanges were lower than the rates of the Treasury obligations 
exchanged with FFB. However, the Civil Service fund had a gain of only 
about $139.5 million[Footnote 55] because it had to invest the proceeds 
from the obligation FFB redeemed on June 30, 2003, at a lower interest 
rate. In other words, the Civil Service fund had more principal to 
invest but was unable to invest that principal at a rate as high as the 
rate of the Treasury obligations it had surrendered. Therefore, the 
Civil Service fund needed more principal to generate approximately the 
same returns as the obligations it had originally surrendered during 
the transaction on March 5, 2003. The long-term economic effect of the 
June 30, 2003, transaction on the Civil Service fund depends on the 
terms of the obligations in which the proceeds are invested.

In this case, one way to have helped ensure that the Civil Service fund 
would not have cash flow gains or losses associated with investment of 
the proceeds from the FFB redemption would have been to invest the 
proceeds using a methodology that ensured that the fund had cash flows 
similar to those from the original Treasury obligations used for the 
exchange on March 5, 2003. This methodology is commonly referred to as 
a "cash flow" approach. However, the cash flow approach can also result 
in gains and losses, since it does not consider the reinvestment risks
[Footnote 56] that may be present. Appendix II discusses how the cash 
flow methodology ensures that a cash flow gain or loss does not occur 
and how reinvestment risks are not considered in this methodology.

Treasury's approach for investing the June 30, 2003, FFB redemption 
proceeds was to apply its normal investment policies and procedures. In 
this case, Treasury, in effect, (1) replaced the dollar value of the 
obligations used for the March 5, 2003, exchange with 3.5 percent 
Treasury obligations and (2) divided the remaining proceeds equally 
over a 15-year period. While this approach differs from the cash flow 
approach and may result in future gains and losses, the key point is 
that Treasury has not yet developed documented policies and procedures 
for managing such transactions. The process of documenting the policies 
and procedures that should be used for such transactions allows 
Treasury's management to understand the impacts of various alternatives 
and whether they introduce any additional risks to the parties 
involved. It also helps Treasury evaluate whether it may need 
additional statutory authority to ensure that all accounts are 
adequately protected. Further, if effectively implemented, 
documentation of policies and procedures reduces the chance for 
confusion and risk of errors should Treasury need to use the policies 
and procedures in the future.

FFB and Treasury General Fund Gains and Losses Associated with the 2003 
Exchange Transaction: 

FFB and the Treasury general fund had gains and losses associated with 
the March 5, 2003, and the June 30, 2003, transactions. As shown in 
table 3, the net result for FFB of these two transactions was a $633 
million loss on June 30, 2003. FFB expects to earn about $1.153 billion 
in future years to offset this loss. The Treasury general fund also 
lost $520 million, which is not expected to be recovered. Several key 
decisions and actions related to the March 5, 2003, and June 30, 2003, 
transactions are discussed below.

Treasury Accepted Par Value Specials at Their Present Value: 

On March 5, 2003, Treasury purchased from FFB the Treasury obligations 
(par value specials) that FFB had acquired from the Civil Service fund. 
Treasury agreed to pay FFB about $520 million more than the par value 
of these obligations. As payment for this purchase, Treasury sold back 
to FFB 9(b) obligations issued by FFB that Treasury held. In effect, 
Treasury canceled about $15.7 billion of the FFB 9(b) obligations it 
held with about $15.2 billion of Treasury par value specials that FFB 
had received from the Civil Service fund. Therefore, FFB had a gain and 
the Treasury general fund had a corresponding loss on the exchange. 
Table 8 shows how this transaction generated a gain for FFB.

Table 8: How the March 5, 2003, Transactions between the Civil Service 
Fund, FFB, and the Treasury General Fund Generated a Gain for FFB: 

Description: Value of the canceled FFB 9(b) obligations held by 
Treasury (face value of about $15.473 billion and accrued interest of 
about $230 million); 
Amount: $15.703 billion.

Description: Redemption value of Treasury obligations received from the 
Civil Service fund in exchange for FFB 9(a) obligation (about $15.045 
billion of principal and about $138 million of accrued interest); 
Amount: $15.183 billion.

Description: Debt canceled in excess of redemption value of Treasury 
obligations exchanged (gain to FFB and loss to Treasury general fund); 
Amount: $520 million.

Source: Treasury.

[End of table]

The March 5, 2003, exchange was in contrast to FFB's October 18, 2002, 
early redemption of its 9(a) obligations held by the Civil Service 
fund. On October 18, 2002, Treasury decided that the FFB 9(a) 
obligations being redeemed prior to maturity that were related to 
Treasury's effort to manage the 1985 debt ceiling would be redeemed at 
par value and that the Civil Service fund would incur the loss. 
Treasury's redemption of par value specials in excess of their par 
value is also in contrast to its normal policies and procedures, which 
allow agencies holding the par value specials only to redeem them from 
Treasury at face value to pay for the fund's benefits and expenses. If 
Treasury had accepted the par value specials at par rather than at 
current market rates, then the total losses to FFB would have been 
about $1.153 billion rather than the $633 million total net loss 
resulting: 

from the March 5, 2003, and June 30, 2003, transactions.[Footnote 57] 
The $1.153 billion is also the amount of the gain FFB expects to make 
in future periods.

The key difference between the March 5, 2003, exchange and the normal 
exchanges between Treasury and federal government accounts with 
investment authority related to their investments in par value specials 
is that for the March 5, 2003, exchange between Treasury and FFB, a 
present value analysis was used to calculate the amount of debt that 
should be removed from Treasury's books--the same analysis that 
Treasury used to ensure that the exchange between FFB and the Civil 
Service fund was fair. Whether FFB or the Treasury general fund incurs 
a gain or loss when par value specials are used to cancel FFB 9(b) 
obligations depends greatly on the value of the Treasury obligations 
held by the Civil Service fund that are selected for the exchange. For 
example, if the interest rates on the Treasury obligations held by the 
Civil Service fund had been 3.875 percent rather than 5.25 percent, 
Treasury would have exchanged par value specials with a value of about 
$16.2 billion held by the Civil Service fund with FFB, and FFB would 
have provided these to Treasury to cancel the $15.7 billion of FFB 9(b) 
obligations. In this case, Treasury would have recognized a gain rather 
than the loss that was recorded because 5.25 percent par value specials 
were used in the exchange. Table 9 provides a simplified example of how 
this works.

Table 9: Example of How Differing Interest Rates Affect Gains and 
Losses Recognized by FFB and the Treasury General Fund on the Exchange 
of Par Value Specials for FFB Obligations: 

Interest rate associated with Civil Service fund's par value specials: 
3.875 percent; 
Principal and accrued interest of Civil Service fund obligations: 
required for exchange: $16.2 billion; 
Book value of Treasury loans to FFB: $15.7 billion; 
Gain or loss to FFB: $500 million loss; 
Gain or loss to Treasury: $500 million gain.

Interest rate associated with Civil Service fund's par value specials: 
5.25 percent; 
Principal and accrued interest of Civil Service fund obligations: 
required for exchange: $15.2 billion; 
Book value of Treasury loans to FFB: $15.7 billion; 
Gain or loss to FFB: $500 million gain; 
Gain or loss to Treasury: $500 million loss. 

Source: GAO.

[End of table]

FFB Issued Additional 9(b) Obligations on June 30, 2003, to Redeem FFB 
9(a) Obligation: 

As discussed earlier, when FFB decided on June 30, 2003, to redeem 
prior to maturity the 9(a) obligation it had issued to the Civil 
Service fund, another present value analysis was performed. As a result 
of this analysis, FFB had to borrow about $16.6 billion from Treasury 
using 9(b) obligations to redeem the $15 billion FFB 9(a) obligation it 
had issued to the Civil Service fund. FFB needed these additional funds 
because the FFB 9(a) obligation was based on an interest rate yield of 
5.25 percent and the interest rate used in the present value analysis 
was 3.5 percent (the June 2003 Civil Service fund investment rate). 
According to FFB officials, the following approach was used to 
structure this $16.6 billion loan from Treasury: 

* FFB borrowed $15.4 billion using principal repayments that mirrored 
principal payments used in the original FFB 9(a) obligation to the 
Civil Service fund, which, in turn, mirrored the underlying FFB loans 
made to its borrowers. For example, if FFB held a loan that called for 
a $10 million principal payment on December 31, 2005, then FFB would 
have borrowed $10 million from Treasury with a December 31, 2005, 
repayment date. In effect, after these transactions, FFB's loan 
repayments for its 9(b) obligations to Treasury mirrored the underlying 
loan principal repayments that FFB expected to receive from its loan 
portfolio.

* FFB borrowed about $1.1 billion using a short-term obligation.

The $1.1 billion corresponds to FFB's net loss of $633 million and the 
Treasury general fund's loss of $520 million, which were realized on 
the March 5, 2003, and June 30, 2003, transactions. According to FFB's 
2003 financial statements, FFB expects to recover its loss in future 
years.[Footnote 58]

FFB repaid the short-term $1.1 billion 9(b) obligation on April 1, 
2004, since FFB had adequate cash flows from its loans to make these 
payments. According to FFB officials, these increased cash flows 
resulted from (1) the reduced interest costs associated with the 
October 18, 2002, early redemption of FFB 9(a) obligations issued to 
the Civil Service fund noted earlier in this report and (2) the reduced 
interest costs associated with the June 30, 2003, FFB 9(b) obligations 
that were used to redeem the FFB 9(a) obligation issued to the Civil 
Service fund on March 5, 2003. Therefore, once the short-term 9(b) 
obligation is redeemed, the future principal payments associated with 
FFB's loan portfolio will, for all practical purposes, mirror the 
principal payments that will be made to Treasury. However, the interest 
earnings on FFB's loan portfolio will be far greater than the interest 
payments that will be due to Treasury on FFB 9(b) obligations issued to 
Treasury. This interest rate differential will then translate into 
increased earnings for FFB that can be expected to offset the losses 
associated with the 2003 exchange transactions with the Civil Service 
fund.

[End of section]

Appendix IV: Transactions between FFB and the Civil Service Fund: 

During the 1985 debt ceiling crisis, Treasury for the first time 
invested excess Civil Service fund receipts of the Civil Service fund 
in FFB 9(a) obligations. Treasury has also exchanged Treasury 
obligations held by the Civil Service fund for obligations held or 
issued by FFB when Treasury experienced debt ceiling difficulties 
during the 1995/1996 debt ceiling crisis and the 2003 debt issuance 
suspension period. These exchanges and their effects on the Civil 
Service fund are discussed below.

1985 Debt Ceiling Crisis: 

During the 1985 debt ceiling crisis, Treasury for the first time 
exchanged about $15 billion of Treasury obligations held by the Civil 
Service fund for obligations issued by FFB. The purpose of this 
transaction was to make $15 billion of additional borrowing authority 
available under the statutory debt ceiling. At the time the transaction 
was made, these FFB obligations were mirror images of the Treasury par 
value specials held by the Civil Service fund. As long as the FFB 
obligations were held to maturity or redeemed in accordance with the 
normal redemption policies of the Civil Service fund, this transaction 
would result in no adverse financial consequences for the Civil Service 
fund. As noted earlier in this report, it was not until October 2002 
that the Civil Service fund portfolio was affected by this transaction.

1995/1996 Debt Ceiling Crisis: 

During the 1995/1996 debt ceiling crisis, Treasury exchanged about $8.6 
billion of Treasury obligations held by the Civil Service fund for 
federal agency obligations held by FFB. The purpose of this transaction 
was to make an additional $8.6 billion of borrowing authority available 
under the statutory debt ceiling. Since the federal agency obligations 
held by FFB differed from the terms and conditions of the obligations 
held by the Civil Service fund, the task of determining a fair exchange 
price was more complicated than in 1985. Because the effects of these 
differences in terms and conditions can be significant, a generally 
accepted methodology was used that considered such factors as (1) the 
current market rates for outstanding Treasury obligations at the time 
of the exchange, (2) the probability of changing interest rates, (3) 
the probability of the federal agency paying off the debt early, and 
(4) the premium the market would provide to an obligation that could be 
redeemed at par regardless of market interest rates. Treasury then 
obtained the opinion of an independent third party to determine whether 
its valuations were accurate.

In 1997, portions of the obligations received in this transaction were 
repaid early. Since the original analysis included a factor for the 
risk associated with the federal agency redeeming its obligations 
early, the Civil Service fund did not suffer any adverse consequences.

2003 Debt Issuance Suspension Period: 

During the 2003 debt issuance suspension period, Treasury once again 
exchanged Treasury obligations held by the Civil Service fund for a $15 
billion FFB 9(a) obligation. However, unlike the 1985 exchange, the 
terms and conditions associated with the FFB 9(a) obligation was not 
identical to the terms and conditions of the Treasury obligations held 
by the Civil Service fund. Therefore, to ensure that the transaction 
was fair to both parties, Treasury performed a present value analysis 
of the cash flows associated with the FFB obligation and the cash flows 
associated with the Treasury obligations held by the Civil Service 
fund. Furthermore, it was agreed that if FFB redeemed this obligation 
before maturity, the price paid would be based on current market rates. 
An agreement between FFB, Treasury, and Treasury on behalf of the Civil 
Service fund allowed the Secretary of the Treasury on behalf of the 
Civil Service fund to redeem the FFB 9(a) obligation at par. As noted 
earlier, in June 2003 FFB redeemed this obligation and the Civil 
Service fund had a $139.5 million gain.

[End of section]

Appendix V: Comments from the Department of the Treasury: 

DEPARTMENT OF THE TREASURY 
WASHINGTON, D.C.

April 30, 2004:

UNDER SECRETARY:

Mr. Gary T. Engel 
Director:

Financial Management and Assurance 
General Accounting Office 
Washington, D.C. 20548:

Dear Mr. Engel,

Thank you for the opportunity to comment on the draft report entitled 
Debt Ceiling: Analysis of Actions Taken During The 2003 Debt Issuance 
Suspension Period (GAO-04-526). We appreciate the high level of 
professionalism exhibited by GAO staff in conducting this exhaustive 
analysis of a very complex matter.

As your draft report indicates, when Treasury borrowing in 2003 reached 
the federal debt ceiling and legislation to increase the debt ceiling 
had not been enacted, the Secretary of the Treasury took a series of 
actions involving the Civil Service Retirement and Disability Fund 
("Civil Service fund"), the Government Securities Investment Fund ("G 
Fund") of the Federal Employees' Retirement System, the Exchange 
Stabilization Fund, and the Federal Financing Bank ("FFB"). We are 
pleased that you concluded that all of Treasury's actions were 
"consistent with legal authorities provided to the Secretary," and that 
the investment losses of the Civil Service fund and the G Fund 
resulting from the Secretary's determination that a "debt issuance 
suspension period" existed were fully restored as required by law.

Responses to Recommendations:

Following are our responses to the recommendations for executive action 
made in the draft report.

"GAO recommends that the Secretary of the Treasury...

"(1) seek the statutory authority, to restore the losses associated 
with the October 2002 early redemption of Federal Financing Bank (FFB) 
obligations, computed in a manner to maintain equity between the Civil 
Service fund and Treasury,":

Treasury will seek statutory authority to restore losses incurred by 
federal government accounts with investment authority and by FFB as a 
result of actions taken for the purpose of fiscal management during a 
debt limit impasse. We look forward to working with Congress to enact 
legislation providing the Secretary with such authority.

As you know, it was a difficult decision for Treasury to execute the 
2002 early redemption of FFB obligations held by the Civil Service 
fund. In 2002, FFB was facing imminent cash flow stress attributable to 
the long-term consequences of the exchange transactions that Treasury, 
FFB, and the Civil Service fund entered into during a debt limit 
impasse in 1985. As a result of the structure of those transactions, 18 
years later, FFB had a limited set of choices: (a) do nothing, and risk 
a liquidity crisis for FFB; or (b) exercise the par call option which 
was included as a term of the original transactions.

Exercising the call option presented, in our view, fully calculable 
costs (i.e., reinvestment risk) to the Civil Service fund compared to 
the alternative. As a result, the Treasury executed a course of action 
that was considered the least harmful of a short list of less than 
palatable options.

"GAO recommends that the Secretary of the Treasury...

(2) direct the Under Secretary of Domestic Finance to document the 
necessary policies and procedures that should be used for exchange 
transactions between FFB and a federal government account with 
investment authority and seek any statutory authority necessary to 
implement the policies and procedures. ":

Treasury agrees that it will document appropriate policies and 
procedures to be used for exchange transactions between FFB and a 
federal government account with investment authority to ensure the 
long-term fairness to all parties to such complex market based 
transactions. However, we are gratified that you recognized in your 
report that "Treasury needs a great deal of flexibility to structure 
transactions that ft specific events." On its own initiative, Treasury 
has already taken notable steps in the direction of documenting 
policies and procedures for exchange transactions. For example, during 
the debt issuance suspension period of 2003, the Treasury Under 
Secretary for Domestic Finance, who is, ex officio, also the President 
of FEB, approved core guidelines for future exchange transactions.

As you noted in your analysis, the 2003 exchange transaction was 
executed within the time frame of the 2003 debt issuance suspension 
period and reversed shortly thereafter. We appreciate GAO's 
acknowledging, "The transactions between the Civil Service fund and FFB 
fairly compensated the Civil Service fund, based on a present value 
analysis, on the date of the exchanges. " As noted in your analysis, 
the Civil Service fund received a substantial increase in the amount of 
Treasury securities that the fund holds as investments, and FFB's 
financing base was restructured, allowing it to recover losses over 
time.

FFB has taken additional steps to ensure the long-term fairness to all 
parties of exchange transactions. Not the least of these is the 
requirement that all exchange transactions be reviewed by FFB's 
independent auditor to ensure the terms and structure clearly achieve 
the intended accounting result and long-term financial fairness to all 
parties, prior to transaction approval and execution. The Inspector 
General for Treasury, who oversees 
the audits of FFB, has been asked to include such reviews in the scope 
of its audit contracts.

Conclusion:

Congress granted the Secretary of the Treasury statutory authority to 
manage the government's financial operations in order to avoid 
exceeding the debt ceiling during a debt issuance suspension period. 
During the most recent episode, lasting from February 20 through May 
27, 2003, Treasury took - as in previous administrations - a number of 
actions to stay under the debt ceiling. All of the actions taken then, 
as in previous occurrences, were authorized by law. However, not all of 
the authorized actions that the Secretary takes to protect the full 
faith and credit of the United States are without cost. As long as 
there continues to be the possibility for a debt limit impasse in the 
future, Treasury will need to retain maximum flexibility in order to 
safeguard the credit standing of the U.S. in the world markets and 
execute its duty to the nation.

Sincerely,

Signed by: 

Brian C. Roseboro:

Under Secretary for Domestic Finance:

Related GAO Products: 

[End of section]

We have previously reported on aspects of Treasury's actions during the 
2002 debt issuance suspension period and earlier debt ceiling crises in 
the following reports: 

Debt Ceiling: Analysis of Actions During the 2002 Debt Issuance 
Suspension Periods. 
[Hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO-03-134]
Washington, D.C.: December 13, 2002.

Debt Ceiling: Analysis of Actions during the 1995/1996 Crisis. 
[Hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO/AIMD-96-130]
Washington, D.C.: August 30, 1996.

Information on Debt Ceiling Limitations and Increases. 
[Hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO/AIMD-96-49R]
Washington, D.C.: February 23, 1996.

Debt Ceiling Limitations and Treasury Actions. 
[Hyperlink, http:// www.gao.gov/cgi-bin/getrpt?GAO/AIMD-96-38R]
Washington, D.C.: January 26, 1996.

Social Security Trust Funds. 
[Hyperlink, http://www.gao.gov/cgi-bin/ getrpt?GAO/AIMD-96-30R]
Washington, D.C.: December 12, 1995.

Debt Ceiling Options. 
[Hyperlink, http://www.gao.gov/cgi-bin/ getrpt?GAO/AIMD-96-20R]
Washington, D.C.: December 7, 1995.

Civil Service Fund: Improved Controls Needed Over Investments. 
[Hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO/AFMD-87-17]
Washington, D.C.: May 7, 1987.

Treasury's Management of Social Security Trust Funds during the Debt 
Ceiling Crises. 
[Hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO/HRD-86-45]
Washington, D.C.: December 5, 1985. 

A New Approach to the Public Debt Legislation Should Be Considered. 
FGMSD-79-58. Washington, D.C.: September 7, 1979.

(198243): 

FOOTNOTES

[1] The public debt limit is established by 31 U.S.C.  3101 (2000) as 
amended by Pub. L. No. 107-199,  1, 116 Stat. 734 (2002) and Pub. L. 
No. 108-24, 117 Stat. 710 (2003).

[2] 5 U.S.C.  8348(j)(5)(B), 8438(g)(6)(B) (2000).

[3] See the Report of the Conference Committee, H.R. Rep. No. 108-401, 
at 915 (2003), that accompanied the Consolidated Appropriations Act, 
2004, Pub. L. No. 108-199, January 23, 2004, which incorporated the 
request for our review appearing in H.R. Rep. No. 108-243, at 145 
(2003).

[4] Most of these accounts are commonly referred to as trust funds.

[5] The public debt limit established by 31 U.S.C.  3101 applies to 
the total of the face amount of obligations issued under chapter 31 of 
title 31, United States Code, and the face amount of obligations whose 
principal and interest are guaranteed by the U.S. government that are 
outstanding at any one time.

[6] Not all of the obligations issued by federal government agencies 
are subject to the debt ceiling because either they are not issued 
under chapter 31 of title 31, United States Code, or their principal 
and interest are not guaranteed by the U.S. government. See, for 
example, obligations that may be issued by the Tennessee Valley 
Authority (TVA) under authority of section 15d(a) of the TVA Act of 
1933, 16 U.S.C. 831n-4(a) (2000), and obligations that may be issued by 
the United States Postal Service (USPS) under the authority of 39 
U.S.C. 2005(a) (2000). See Transaction between the Federal Financing 
Bank and the Department of the Treasury, 20 Op. Off. Legal Counsel 64 
at 75 (1996).

[7] The Social Security trust funds consist of the Federal Old-Age and 
Survivors Insurance Trust Fund and the Federal Disability Insurance 
Trust Fund.

[8] The majority of obligations held by federal government accounts 
with investment authority are Government Account Series (GAS) 
securities (commonly referred to as Treasury securities). GAS 
securities consist of par value securities and market-based securities, 
with terms ranging from on demand to 30 years. Par value securities are 
issued and redeemed at par (100 percent of the face value), regardless 
of current market conditions. Market-based securities, however, can be 
issued at a premium or discount and are redeemed at par value on the 
maturity date or at market value if redeemed before the maturity date.

[9] For example, see U.S. General Accounting Office, Debt Ceiling: 
Analysis of Actions During the 2002 Debt Issuance Suspension Periods, 
GAO-03-134 (Washington, D.C.: Dec. 13, 2002); Debt Ceiling: Analysis of 
Actions during the 1995/1996 Crisis, GAO/AIMD-96-130 (Washington, D.C.: 
Aug. 30, 1996); Civil Service Fund: Improved Controls Needed Over 
Investments, GAO/AFMD-87-17 (Washington, D.C.: May 7, 1987); and 
Treasury's Management of Social Security Trust Funds During the Debt 
Ceiling Crises, GAO/HRD-86-45 (Washington, D.C.: Dec. 5, 1985).

[10] The G-Fund consists of nonmarketable Treasury obligations held in 
trust by the federal government as custodian on behalf of individual 
federal employee participants.

[11] The amount of outstanding obligations that can be redeemed using 
this authority is limited to the "amount of funds not exceeding the 
amount equal to the total amount of the payments authorized to be made 
from the fund" during the debt issuance suspension period. 5 U.S.C.  
8348(k)(2) (2000).

[12] The authority to suspend investments is an exception to the 
requirement in 5 U.S.C.  8348(c) (2000) that the Secretary immediately 
invest the portion of the fund that is not immediately required for 
payments in interest-bearing obligations of the United States.

[13] Section 15d(d) of the TVA Act of 1933, 16 U.S.C.  831n-4(d) 
(2000).

[14] 39 U.S.C.  2005(d)(3) (2000).

[15] Section 9(d) of the Federal Financing Bank Act of 1973, 12 U.S.C. 
 2288(d) (2000).The act's purposes include assuring coordination of 
federal and federally assisted borrowing programs with the overall 
economic, fiscal, and debt management policies of the government and 
reducing the cost of federal and federally assisted borrowing from the 
public. 12 U.S.C.  2281.

[16] See Transaction between the Federal Financing Bank and the 
Department of the Treasury, 20 Op. Off. Legal Counsel 64 at 67-70 
(1996), concluding that USPS and TVA obligations are suitable 
investments of the Civil Service fund.

[17] Such obligations include TVA and USPS obligations.

[18] See, for example, Pub. L. No. 104-103, 110 Stat. 55 (1996) 
(authorizing the Secretary of the Treasury to issue obligations equal 
to the amount of March 1996 Social Security payments and exempting the 
obligations from counting against the ceiling) and Pub. L. No. 104-115, 
110 Stat. 825 (1996) (exempting certain trust fund obligations issued 
during a limited period and in a limited amount from being subject to 
the debt ceiling).

[19] GAO/AIMD-96-130.

[20] Treasury and the Congress have a long-standing position of 
obtaining the necessary authority to restore interest that was not 
credited to an account with investment authority because of unusual 
events. GAO, the Congress, Treasury, and the agency commonly refer to 
this forgone interest as a "loss" to the fund.

[21] The SLGS obligations program was established in 1972, following 
federal legislation enacted in 1969 restricting state and local 
governments from earning arbitrage profits by investing bond proceeds 
in higher-yielding investments.

[22] In its analysis relating to the early redemption of FFB 9(a) 
obligations, FFB noted that the beneficiaries of the Civil Service fund 
are subject to a defined benefit plan and that under current law, their 
benefits will be honored and paid regardless of the return on the Civil 
Service fund's investments. See "Federal Financing Bank Borrowings from 
the Civil Service Retirement and Disability Fund," Memorandum for Peter 
Fisher, President, FFB, from Paula Farrell, Secretary, FFB (Aug. 16, 
2002). 

[23] GAO-03-134.

[24] Because of the large amount of documentation related to the 
transactions, we reviewed only those transactions that exceeded $250 
million, which we determined would be more susceptible to manipulation 
affecting the debt ceiling than transactions below that amount.

[25] The 3 funds for which Treasury did not follow its normal 
investment and redemption policies and procedures were also reviewed 
and had obligation balances totaling $640 billion on January 31, 2003. 
Therefore, the 28 funds reviewed totaled about $2.776 trillion, or 
about 99 percent of the $2.815 trillion obligations held by the funds 
on January 31, 2003.

[26] We used the full-month periods of February 1, 2003, through May 
31, 2003, which include the activity during the 2003 debt issuance 
suspension period (February 20, 2003, to May 27, 2003), because 
accounting records and reports are generally maintained on a monthly 
basis. 

[27] 5 U.S.C.  8348(d) (2000).

[28] 5 U.S.C.  8438(e) (2000).

[29] Section 201(d) of the Social Security Act, 42 U.S.C.  401(d) 
(2000).

[30] 5 U.S.C.  8909(c) (2000).

[31] Subsection 9503(f)(2) of title 26, United States Code, provides 
that after September 30, 1998, Highway Trust Fund assets would be 
invested in non-interest-bearing U.S. obligations. Thus, the Highway 
Trust Fund does not earn interest on its investments. As such, failure 
to invest excess fund receipts did not have an economic effect on the 
fund.

[32] Treasury policies and procedures call for the correcting entry to 
reflect the actual date that the transaction should have been recorded. 
For example, in this case, if the Treasury policies and procedures had 
been followed, the over-redemption detected and validated in March 2003 
would have been invested on the appropriate date.

[33] According to Treasury officials, they use the amount of expected 
benefit payments that will be issued on the first business day of a 
month in this calculation. For any other benefit payments and expenses 
incurred by the Civil Service fund during the month, obligations are 
redeemed on that payment date.

[34] Comptroller General Opinion to the Honorable John LaFalce, 
Chairman, Subcommittee on Economic Stabilization, House Committee on 
Banking, Finance and Urban Affairs, B-138524 (Oct. 30, 1985), and The 
Federal Financing Bank and Debt Ceiling: Hearing before the 
Subcommittee on Economic Stabilization of the House Committee on 
Banking, Finance and Urban Affairs, 99th Cong. 28-34 (1986) (Statement 
of Harry Havens, Assistant Comptroller General, U.S. General Accounting 
Office).

[35] In its analysis relating to the early redemption of FFB 9(a) 
obligations, FFB noted that the beneficiaries of the Civil Service fund 
are subject to a defined benefit plan and that under current law, their 
benefits will be honored and paid regardless of the return on the Civil 
Service fund's investments. See "Federal Financing Bank Borrowings from 
the Civil Service Retirement and Disability Fund," Memorandum for Peter 
Fisher, President, FFB, from Paula Farrell, Secretary, FFB (Aug. 16, 
2002). 

[36] Section 9(b) of the Federal Financing Bank Act of 1973, 12 U.S.C. 
 2288(b) (2000), authorizes FFB to issue obligations to the Secretary 
of the Treasury, and the Secretary is authorized at his discretion to 
purchase such obligations.

[37] For a detailed discussion of the legal support for these 
transactions, see Memorandum for Secretary Snow from David D. 
Aufhauser, "Authority of the Secretary of the Treasury and the Federal 
Financing Bank to Enter into a Series of Transactions That Are Intended 
to Reduce the Amount of Outstanding Debt That Is Subject to the Debit 
Limit Statute" (Mar. 4, 2003).

[38] Present value is the discounted value of a payment or stream of 
payments to be received in the future, taking into consideration a 
specific interest or discount rate. Present value represents a series 
of future cash flows expressed in today's dollars.

[39] The Civil Service fund and FFB have exchanged obligations on 
several occasions, including during the 2003 debt issuance suspension 
period.

[40] GAO-03-134.

[41] U.S. General Accounting Office, Government Auditing Standards: 
2003 Revision, GAO-03-673G (Washington, D.C.: June 2003).

[42] For example, if the price of a 2-year note maturing on July 1, 
2005, is 101, the account would either pay or receive a $1 premium for 
each $100 of face value, depending on whether the account was 
purchasing or selling the security. On the other hand, if the price is 
99, the account would either pay or receive a $1 discount from the $100 
face value. The purpose of premiums and discounts is to adjust the 
market price of securities with various terms and conditions (e.g., 
interest rates, maturity dates, and interest payment dates) to ensure 
that comparable securities will provide similar yields or returns to an 
investor.

[43] For example, on June 3, 2003, Treasury, using its normal 
investment and redemption policies and procedures, redeemed about $6 
billion that had been invested on June 2, 2003, for a Social Security 
account.

[44] The difference between the market-based rate for obligations that 
mature the next business day and the G-Fund's par value rate can be 
significant. For example, on March 31, 2004, the market-based rate for 
investments that matured the next business day was 1 percent, while the 
rate used for G-Fund investments was 4 percent.

[45] GAO/AFMD-87-17.

[46] Pub. L. No. 99-509, 100 Stat. 1874, 1931 (1986).

[47] H.R. Conf. Rep. No. 99-1012, at 256 (1986).

[48] Present value is the discounted value of a payment or stream of 
payments to be received in the future, taking into consideration a 
specific interest or discount rate. Present value represents a series 
of future cash flows expressed in today's dollars.

[49] Reinvestment risk is the risk that proceeds received in the future 
will have to be reinvested at a lower potential interest rate in the 
case of a government account with the authority to invest or that the 
proceeds will be reinvested at a higher rate in the case of the 
Treasury general fund.

[50] The cash that Treasury lends to FFB under a 9(b) obligation is 
derived from Treasury borrowing under chapter 31 of title 31, United 
States Code. Thus, the agency obligation financed by FFB is counted 
against the public debt ceiling in this manner.

[51] U.S. General Accounting Office, Civil Service Fund: Improved 
Controls Needed over Investments, GAO/AFMD-87-17 (Washington, D.C.: May 
7, 1987).

[52] According to FFB, this early redemption was necessary because its 
maturing loans would not provide sufficient funds to enable FFB to 
repay the entire principal amounts due to the Civil Service fund when 
these obligations matured. FFB also noted that its loan portfolio had 
been shrinking, making it more difficult for FFB to pay interest on its 
9(a) obligations to the Civil Service fund. See "Federal Financing Bank 
Borrowings from the Civil Service Retirement and Disability Fund," 
Memorandum for Peter Fisher, President, FFB, from Paula Farrell, 
Secretary, FFB (Aug. 16, 2002).

[53] According to an FFB official, FFB did not calculate the comparable 
benefit to it by making this repayment.

[54] GAO/AFMD-87-17.

[55] This gain was computed by taking the present value on June 30, 
2003, of the Treasury obligations that were exchanged with FFB on March 
5, 2003, and comparing this hypothetical value to the present value of 
the FFB 9(a) obligation that was redeemed on June 30, 2003. A gain 
occurred because the interest rate had changed since the March 5, 2003, 
exchange. Specifically, as noted earlier, the March 5, 2003, interest 
rate used to determine the exchange value was 3.875 percent, but on 
June 30, 2003, the interest was 3.5 percent. Since the FFB obligation 
had a longer term than the Treasury obligations, the reduction in 
interest rates had a greater effect on the FFB 9(a) obligation, that 
is, the FFB 9(a) obligation became more valuable. See app. II for a 
discussion on how changing interest rates and terms affect a present 
value analysis.

[56] Reinvestment risk is the risk that proceeds received in the future 
will have to be reinvested at a lower potential interest rate in the 
case of a government account with the authority to invest or that the 
proceeds will be reinvested at a higher rate in the case of the 
Treasury general fund.

[57] The amount of the June 30, 2003, short-term loan from Treasury 
used to finance this loss that is discussed in the next section was 
about $1.1 billion.

[58] U.S. Department of the Treasury, Office of Inspector General, 
Audit of the Federal Financing Bank's Fiscal Years 2003 and 2002 
Financial Statements, OIG-04-013 (Washington, D.C.: Dec. 9, 2003).

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