Office of Debt Management

Fiscal Year 2011 Q4 Report
Table of Contents

I. Fiscal

A. Quarterly Tax Receipts p. 4

B. Outlays p. 5

C. Treasury Net Nonmarketable Borrowing p. 7

D. Cumulative Budget Deficits by Fiscal Year p. 8

E. Deficit and Borrowing Estimates p. 9

F. American Jobs Act p. 10

G. Budget Surplus/Deficit with OMB Forecast p. 11

II. Portfolio Metrics

A. Net Marketable Issuance On "Auto Pilot " Versus Deficit Projections p. 13

B. Weighted Average Maturity of Marketable Debt p. 14

C. Recent and Future Portfolio Composition p. 15

D. Recent and Future Maturity Profile p. 16

III. Demand

A. Bid-to-Cover Ratios p. 19

B. Investor Class Auction Awards p. 23

C. Foreign Awards at Auction p. 30

D. Primary Dealer Awards at Auction p. 34

2
Section I:

Fiscal

3
4

-100%

-50%

0%

50%

100%

150%

Sep-01

Jan-02

May-02

Sep-02

Jan-03

May-03

Sep-03

Jan-04

May-04

Sep-04

Jan-05

May-05

Sep-05

Jan-06

May-06

Sep-06

Jan-07

May-07

Sep-07

Jan-08

May-08

Sep-08

Jan-09

May-09

Sep-09

Jan-10

May-10

Sep-10

Jan-11

May-11

Sep-11

Year o

ver Year %

C

han

ge

Quarterly Tax Receipts

Corporate Taxes Non-Withheld Taxes (incl SECA) Withheld Taxes (incl FICA)
-

100

200

300

400

500

600

700

800

900

1,000

Health an

d

H

u

man

Services

S

ocial Security

A

d

ministratio

n

Defense-Military

Treasury

A

griculture

Lab

or

Veterans Affairs

Transp

ortatio

n

Office of Perso

n

nel

Management

E

d

ucatio

n

$ b

n

Ten Largest Outlays for FY 2011

5
6

Medicare

63%

Medicaid

31%

Other

6%

Health and Human Services

($891 bn)

Outlay Breakdown FY 2011

Old age

and

survivors

insurance

76%

Disability

insurance

17%

Other

7%

Social Security

Administration ($784 bn)

Outlay Breakdown FY 2011

Military

Personnel

24%

Research,

Devel.

11%

Other

3%

Defense-Military ($687 bn)

Outlay Breakdown FY 2011

Procurement

19%

Operations and

Maintenance

43%

Interest on

marketable

public debt

44%

Other

Interest

41%

Earned

income tax

credit

4%

Other

11%

Treasury ($537 bn)

Outlay Breakdown FY 2011
7

-30

-20

-10

0

10

20

30

Q1-02Q

2-02

Q3-02Q

4-02

Q1-03Q

2-03

Q3-03Q

4-03

Q1-04Q

2-04

Q3-04Q

4-04

Q1-05Q

2-05

Q3-05Q

4-05

Q1-06Q

2-06

Q3-06Q

4-06

Q1-07Q

2-07

Q3-07Q

4-07

Q1-08Q

2-08

Q3-08Q

4-08

Q1-09Q

2-09

Q3-09Q

4-09

Q1-10Q

2-10

Q3-10Q

4-10

Q1-11Q

2-11

Q3-11Q

4-11

$ b

n

Fiscal Quarter

Treasury Net Nonmarketable Borrowing

Foreign Series State and Local Govt. Series (SLGS) Savings Bonds
8

0

200

400

600

800

1,000

1,200

1,400

1,600

Octo

ber

N

o

vem

ber

Decem

ber

Jan

uary

February

March

A

pril

May

Ju

ne

July

A

u

g

ust

Septem

ber

$ b

n

Cumulative Budget Deficits by Fiscal Year

FY2009 FY2010 FY2011
9

FY 2012-2014 Deficit and Borrowing Estimates

In Billions

$

Primary

Dealers* CBO** OMB***

FY 2012 Deficit Estimate 1,132 973 1,334

FY 2013 Deficit Estimate 951 623 833

FY 2014 Deficit Estimate 812 380 476

FY 2012 Deficit Range 1,000-1,411

FY 2013 Deficit Range 750-1,200

FY 2014 Deficit Range 650-1,100

FY 2012 Marketable Borrowing Range 950-2,450

FY 2013 Marketable Borrowing Range 800-2,250

Estimates as of: Oct-11 Aug-11 Oct-11

*Based on primary dealer feedback on October 24, 2011. Deficit estimates are averages.

**Current law, prior to any Joint Committee actions or sequester.

***Deficit projections with American Jobs Act and President’s deficit reduction proposals.
3. Elements of the American Jobs Act

(CBO)

10

Tax Cuts ($ bn)

Payroll tax cut for employees $179

Payroll tax cut for employers $69

Expensing $6

Delay 3% withholding $0.5

Long-term unemployed $11

Subtotal, tax cuts $265.5

Spending ($ bn)

Teachers & first responders $35

School modernization $30

Immediate transportation $50

Infrastructure bank $10

Project Rebuild $15

Wireless -$11

Unemployment extension $49

Unemployment reforms $5

Subtotal, spending $183

TOTAL $448.5 billion

Elements of the American Jobs Act (OMB)
11 Projection

-12%

-10%

-8%

-6%

-4%

-2%

0%

2%

4%

-2,500

-2,000

-1,500

-1,000

-500

0

500

199519961997199819992000200120022003200420052006200720082009201020112012201320142015201620172018201920202021

Fiscal Year

Budget Surplus/Deficit with OMB Forecast

OMB Surplus/Deficit in $ bn-(L) OMB Projections with American Jobs Act-(L)

OMB Current Policy Surplus/Deficit as a % of GDP-(R)
Section II:

Portfolio Metrics

12
Portfolio & SOMA holdings as of 9/30/2011. Assumes current issuance size, SOMA reinvestment and no attempt to match future financing 13

needs.

-500

0

500

1,000

1,500

2,000

200720082009201020112012201320142015201620172018201920202021

$ b

n

Fiscal Year

Bills 2/3/5 7/10/30 TIPS OMB Deficit Projections with American Jobs Act

Projected Net Marketable Borrowing Assuming Note and Bond

Issuance Remains Constant
14

45

50

55

60

65

70

75

80

Sep-07Sep-08Sep-09Sep-10Sep-11Sep-12Sep-13Sep-14Sep-15Sep-16Sep-17Sep-18Sep-19Sep-20Sep-21

Weig

hted

A

verage Maturity (M

o

nths)

Weighted Average Maturity of Marketable Debt

Absent Policy Changes

Historical Adjust All Nominal Coupons

Portfolio & SOMA holdings as of 9/30/2011. To match OMB’s projected financing needs for the next 10 years, all nominal coupon securities

(2-, 3-, 5-, 7-, 10-, and 30-year) were adjusted by the same percentage. This scenario does NOT represent any particular course of action that

Treasury is expected to follow. Instead, it is intended to demonstrate the basic trajectory of average maturity absent changes to the mix of

securities issued by Treasury.
15

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

2006200720082009201020112012201320142015201620172018201920202021

%

of P

ortfolio

Recent and Future Portfolio Composition as Issued, %

Bills Nominal Coupons TIPS

Portfolio & SOMA holdings as of 9/30/2011. To match OMB’s projected financing needs for the next 10 years, all nominal coupon securities

(2-, 3-, 5-, 7-, 10-, and 30-year) were adjusted by the same percentage. This scenario does NOT represent any particular course of action that

Treasury is expected to follow. Instead, it is intended to demonstrate the basic trajectory of average maturity absent changes to the mix of

securities issued by Treasury.
16

-

2,000

4,000

6,000

8,000

10,000

12,000

14,000

16,000

18,000

200720082009201020112012201320142015201620172018201920202021

$ b

n

Fiscal Year

Recent and Future Maturity Profile, $ bn

< 1yr [1, 2) [2, 3) [3, 5) [5, 7) [7, 10) >= 10yr

Portfolio & SOMA holdings as of 9/30/2011. To match OMB’s projected financing needs for the next 10 years, all nominal coupon securities

(2-, 3-, 5-, 7-, 10-, and 30-year) were adjusted by the same percentage. This scenario does NOT represent any particular course of action that

Treasury is expected to follow. Instead, it is intended to demonstrate the basic trajectory of average maturity absent changes to the mix of

securities issued by Treasury.
17

0%

10%

20%

30%

40%

50%

60%

70%

80%

90%

100%

200720082009201020112012201320142015201620172018201920202021

Fiscal Year

Recent and Future Maturity Profile, %

< 1yr [1, 2) [2, 3) [3, 5) [5, 7) [7, 10) >= 10yr

Portfolio & SOMA holdings as of 9/30/2011. To match OMB’s projected financing needs for the next 10 years, all nominal coupon securities

(2-, 3-, 5-, 7-, 10-, and 30-year) were adjusted by the same percentage. This scenario does NOT represent any particular course of action that

Treasury is expected to follow. Instead, it is intended to demonstrate the basic trajectory of average maturity absent changes to the mix of

securities issued by Treasury.
Section III:

Demand

18
1.5

2

2.5

3

3.5

4

4.5

5

Sep-01Sep-02Sep-03Sep-04Sep-05Sep-06Sep-07Sep-08Sep-09Sep-10Sep-11

Bid-to-C

o

ver Ratio

Bill Bid-to-Cover Ratios

4-Week (13-week moving average) 13-Week (13-week moving average)

26-Week (13-week moving average) 52-Week (6-month moving average)

19
2

2.2

2.4

2.6

2.8

3

3.2

3.4

3.6

Mar-09

Ju

n-09

Sep-09

Dec-09

Mar-10

Ju

n-10

Sep-10

Dec-10

Mar-11

Ju

n-11

Sep-11

Bid-to-C

o

ver Ratio

Short Nominal Coupon Bid-to-Cover Ratios

(6-Month Moving Average)

2-Year 3-Year 5-Year

20
2.4

2.5

2.6

2.7

2.8

2.9

3

3.1

3.2

3.3

Sep-09

Dec-09

Mar-10

Ju

n-10

Sep-10

Dec-10

Mar-11

Ju

n-11

Sep-11

Bid-to-C

o

ver Ratio

Long Nominal Coupon Bid-to-Cover Ratios

(6-Month Moving Average)

7-Year 10-Year 30-Year

21
1

1.5

2

2.5

3

3.5

Sep-01Sep-02Sep-03Sep-04Sep-05Sep-06Sep-07Sep-08Sep-09Sep-10Sep-11

Bid-to-C

o

ver Ratio

TIPS Bid-to-Cover Ratios

5-Year 10-Year (6-month moving average) 20-Year 30-Year

22
23

Depository

Institutions

0.4% Individuals

2.0%

Primary Dealers

57.2%

Other Dealers &

Brokers

11.0%

Pension &

Insurance

0.4%

Investment Funds

16.0%

Foreign &

International

12.1%

Other

0.9%

Investor Class Auction Awards: Bills

FY2011

Excludes SOMA add-ons.
24

-20%

-15%

-10%

-5%

0%

5%

10%

Primary

Dealers

Other Dealers

&

Bro

kers

In

vestment

F

u

n

ds

F

oreig

n

&

Internatio

nal

C

han

ge fro

m

F

Y11

Change in Bill Auction Awards by Investor Class

FY11 less FY10 FY11 less FY09 FY11 less FY08 FY11 less FY07 FY11 less FY06

Excludes SOMA add-ons.
25 Excludes SOMA add-ons.

Short = 2/3/5yr, Long = 7/10/30yr

Depository

Institutions

0.5%

Individuals

0.3%

Primary

Dealers

51.2%

Other Dealers

& Brokers

11.6%

Pension &

Insurance

0.1%

Investment

Funds

13.7%

Foreign &

International

22.4%

Other

0.1%

Investor Class Auction Awards:

Short Nominal Coupons, FY2011

Depository

Institutions

0.4%

Individuals

0.1%

Primary

Dealers

45.1%

Other

Dealers &

Brokers

7.3% Pension &

Insurance

0.1%

Investment

Funds

21.1%

Foreign &

International

25.8%

Other

0.1%

Investor Class Auction Awards:

Long Nominal Coupons, FY2011
26 Excludes SOMA add-ons.

Short = 2/3/5yr

-20%

-15%

-10%

-5%

0%

5%

10%

15%

Primary

Dealers

Other Dealers

&

Bro

kers

In

vestment

F

u

n

ds

F

oreig

n

&

Internatio

nal

C

han

ge fro

m

F

Y11

Change in Short Nominal Coupon Auction Awards

by Investor Class

FY11 less FY10 FY11 less FY09 FY11 less FY08 FY11 less FY07 FY11 less FY06
27 Excludes SOMA add-ons.

Long = 7/10/30yr

-30%

-25%

-20%

-15%

-10%

-5%

0%

5%

10%

15%

Primary

Dealers

Other Dealers

&

Bro

kers

In

vestment

F

u

n

ds

F

oreig

n

&

Internatio

nal

C

han

ge fro

m

F

Y11

Change in Long Nominal Coupon Auction Awards

by Investor Class

FY11 less FY10 FY11 less FY09 FY11 less FY08 FY11 less FY07 FY11 less FY06
28

Depository

Institutions

0.1%

Individuals

0.6%

Primary Dealers

49.4%

Other

Dealers

&

Brokers

3.4%

Pension &

Insurance

0.6%

Investment Funds

34.9%

Foreign &

International

10.9%

Other

0.2%

Investor Class Auction Awards: TIPS

FY2011

Excludes SOMA add-ons.
29 Excludes SOMA add-ons.

-15%

-10%

-5%

0%

5%

10%

Primary

Dealers

Other Dealers

&

Bro

kers

In

vestment

F

u

n

ds

F

oreig

n

&

Internatio

nal

C

han

ge fro

m

F

Y11

Change in TIPS Auction Awards by Investor Class

FY11 less FY10 FY11 less FY09 FY11 less FY08 FY11 less FY07 FY11 less FY06
30 Total Foreign includes both private and public.

0

20

40

60

80

100

120

140

160

180

200

Ju

n-09

Sep-09

Dec-09

Mar-10

Ju

n-10

Sep-10

Dec-10

Mar-11

Ju

n-11

Sep-11

M

o

nthly

Private A

ward ($b

n)

Total Foreign Awards of Treasuries at Auction, $ bn

Bills 2/3/5 7/10/30 TIPS
31

0%

5%

10%

15%

20%

25%

Ju

n-09

Sep-09

Dec-09

Mar-10

Ju

n-10

Sep-10

Dec-10

Mar-11

Ju

n-11

Sep-11

%

A

warded to

F

oreig

n In

vestors

Foreign Awards of Bills at Auction, %

Excludes SOMA add-ons.
32

0%

5%

10%

15%

20%

25%

30%

35%

40%

45%

50%

Ju

n-09

Sep-09

Dec-09

Mar-10

Ju

n-10

Sep-10

Dec-10

Mar-11

Ju

n-11

Sep-11

%

A

warded to

F

oreig

n In

vestors

Foreign Awards of Nominal Coupons at Auction, %

2/3/5 7/10/30

Excludes SOMA add-ons.
33 Excludes SOMA add-ons.

0%

5%

10%

15%

20%

25%

Ju

n-09

Sep-09

Dec-09

Mar-10

Ju

n-10

Sep-10

Dec-10

Mar-11

Ju

n-11

Sep-11

%

A

warded to

F

oreig

n In

vestors

Foreign Awards of TIPS at Auction, %

5-Year 10-Year 20-Year 30-Year
40%

45%

50%

55%

60%

65%

Ju

n-09

Sep-09

Dec-09

Mar-10

Ju

n-10

Sep-10

Dec-10

Mar-11

Ju

n-11

Sep-11

%

of T

otal C

o

m

petitive A

m

o

u

nt A

warded

Primary Dealer Awards at Auction, %

4/13/26-Week (13-week moving average) 52-Week (6-month moving average)

2/3/5 (6-month moving average) 7/10/30 (6-month moving average)

TIPS (6-month moving average)

34
1

TBAC Committee Charge

The Impact of a Prolonged Period of Low-Interest

Rates on Financial Markets

November 2011
2

Borrowers

Question:

Review where we are in the credit cycle. Is consumer and business credit expanding? If so, which sectors

(mortgages, C&I loans, etc)? How is this recovery different from past recoveries given the level of rates and

the availability of credit?

Conclusion:

This recovery tracks below past recoveries. C&I loan growth is picking up but is still soft compared to

previous recoveries. Meanwhile, lending to households is weak, especially for real estate. On the supply

side, credit standards are gradually loosening, in line with prior episodes.

Discussion:

• Total loan growth is picking up, as banks are making more commercial and industrial loans.

• However, consumer and real estate loan growth remains weak, reflecting household deleveraging efforts and a

stagnant-to-falling housing market.

• Compared with previous recoveries, bank credit is relatively soft across all major sectors. Part of this may be attributed

to high corporate cash balances, which decreases demand for bank credit.

• Lending standards are gradually loosening and are generally in line with previous recoveries.

• The shadow banking sector, which was so important for fueling credit earlier in the century, is continuing to contract.
3

Borrowers

C&I loans growing ...

Source: Federal Reserve
4

Borrowers

... but well below most previous recoveries.

Source: Federal Reserve
5

Borrowers

Real estate loan growth well below previous recoveries.

Source: Federal Reserve
6

Borrowers

U.S. Corporate Liquid Assets

0

200

400

600

800

1,000

1,200

1,400

1,600

1,800

2,000

2,200

1Q90 3Q91 1Q93 3Q94 1Q96 3Q97 1Q99 3Q00 1Q02 3Q03 1Q05 3Q06 1Q08 3Q09 1Q11

Source: FRB Flow of Funds

15%

20%

25%

30%

35%

40%

45%

50%

55%

60%

Total liquid assets Liquid assets/Short-term liabilities

High levels of corporate cash may be lowering demand for bank loans.
7

Borrowers

All forms of bank credit trailing past recoveries

Source: Federal Reserve
8

Borrowers

Lending standards gradually loosening, in line with previous recoveries

Source: Fed Senior Loan Office Survey
9

Borrowers

The “shadow banking sector” has shrunk as well

• The unprecedented growth of the shadow banking sector 2000-2008 has contracted meaningfully

Source: Federal Reserve Flow of Funds report, Bureau of Economic Analysis
10

Long-Duration Fixed Income Managers

Question:

Are there signs that institutional investors are reaching for yield by taking on more duration and/or

credit risk?

Conclusion:

Index tracking managers have some leeway to extend duration vs. taking on credit risk. International

diversification may be an attractive option. Long liability managers are taking more duration risk and

increasing credit exposure.

Discussion:

• For managers that tend to track an index, there is greater ability to go long or short duration versus that index

as opposed to increasing credit risk. Managers that have credit exposure tend to move up in quality in times of

market stress, so much will depend on the liquidity situation at the time. There may be a desire to diversify not

via duration or credit, but by investing in higher yielding foreign bonds.

• After Operation Twist, money managers extended to 30yr maturities, as evidenced by the 10s-30s Treasury

curve flattening from 136bps to 96bps in two weeks.

• Asset manager exposure in 2011 has overall shifted to an increased exposure to credit (following page).

Long liability managers (pension and insurance):

• Pension and Insurance accounts are taking on more duration risk and also have been increasing their credit

exposure. Additionally, where risk is appropriate, they are extending into longer duration credit instruments.
11

Long-Duration Fixed Income Managers

2011 duration extension has been in Investment Grade credit, recently rebalanced some to

US Treasuries

Source: Bloomberg
12

Money Market Funds

Question:

What do low rates mean for the profitability and viability of money funds? Will there be more consolidation in this

industry?

Conclusion:

Money market funds will face increasing challenges as margins remain small, if positive at all. Consolidation has been

slow, more consolidation is expected.

Discussion:

• The money market fund (MMF) business model has been under pressure. MMFs barely return over their fee structure. Prime

funds are still profitable, Treasury-only not and are often subsidized by other arms of the institution. A flat yield curve exacerbates

narrow margins.

• Consolidation has been limited thus far, but more consolidation is expected. Historically, MMF business has been highly

profitable, so firms are reluctant to exit. Smaller firms have a harder time subsidizing the business. Larger MMF’s have difficultly

leaving the parent because the business will no longer have the support of the parent. Also, 2a7 Fund Assets Under

Management (AUM) is $1.7tn. AUM is estimated to grow to $1.8tn by 2014. 20 Fund complexes account for ~80% of the 2a7

AUM. AUM is already highly concentrated.

• Margins are small, if positive at all. Since 2008, the trend has been to de-risk the portfolio, assisted by regulation. For example,

SEC rule 2a7 caused MMF’s to shorten WAM’s and WALA’s. This has also narrowed margins. However, the benefit is that only

a major systemic event would cause a fund to “break the buck,” to the tune of spreads moving ~4-5 times 2008 moves.

• Due to low rates, some MMFs see redemptions as investors take out low-yielding funds and deposit them in bank accounts to at

least gain FDIC insurance.

• If the Fed was to lower the Interest on Overnight Excess Reserve (IOER) rate, it would further pressure MMFs. Typically, money

funds have an operation cost of around 15 to 20 basis points. Lower front end rates would exacerbate their stress and could lead

to a loss of AUM.

• Note a cut in the IOER could lead to a higher effective fed funds rate. Since the FDIC charge was introduced, domestic

banks have reduced their participation in the fed funds market. If the IOER were cut, foreign banks would also find it less

attractive to participate in the Fed Funds market (i.e. since the return from borrowing funds cheaply overnight and putting them to

the Fed would be reduced). Thus, the only participants left in the funds market might be those considered less creditworthy -

those who pay a higher rate to borrow.
13

0

500

1,000

1,500

2,000

2,500

3,000

3,500

4,000

4,500

Jan-00

Jul-00

Jan-01

Jul-01

Jan-02

Jul-02

Jan-03

Jul-03

Jan-04

Jul-04

Jan-05

Jul-05

Jan-06

Jul-06

Jan-07

Jul-07

Jan-08

Jul-08

Jan-09

Jul-09

Jan-10

Jul-10

Jan-11

Jul-11

M

MF A

U

M ($bn)

Total MMF AUM

Money Market Funds

Source: ICI

Total MMF assets have stabilized, expected to remain stable and grow slightly.
14

Money Market Funds

De-risking has been substantial since the crisis.

Treasury Securities as % of MMF Assets (Taxable) Commercial Paper as % of MMF Assets (Taxable)
15

Money Market Funds

Reinvested Dividends: one measure of profitability

Money Market Mutual Funds: Reinvested Dividends
16

Money Market Funds

Question:

Will this have an impact on short-term credit availability for corporations (e.g. CP issuance, etc)?

Conclusion:

No.

Discussion:

• While margins are under pressure, AUM will be stable to growing. Thus, MMFs will continue to seek yield

and thus provide ample short-term credit availability to corporations. This also provides desired

diversification. With assets stable, MMFs will seek yield in a low rate environment.

• There is currently a supply/demand imbalance as corporations are cash rich, lowering supply and

demand for yield is large. This is unlikely to change.

• Recent risk aversion is likely to reverse somewhat over a medium term horizon as MMFs are forced to

add yield.
17

Foreign Investors

Question:

What impact will low rates have on foreign investors, particularly foreign reserve managers? Are these

investors extending duration? Are they moving away from Treasuries? If they are moving away from

Treasuries, where are the flows going – other sovereigns, real assets, equities?

Conclusion:

Diversification has been ongoing, but limited by lack of deep and liquid foreign bond markets. Recent central

bank activity has been primarily currency-related. Demand for Treasuries has remained firm.

Discussion:

• TIC data shows continued net buying of US debt, especially US Treasuries. Post 2008, foreign investors have shied

away from corporate debt.

• Custody holdings have been falling recently, but this appears currency related as monetary authorities actively

influence their exchange rates. Managed currencies that are artificially weakened (due to intervention or pegs) leads to

dollar accumulation and US Treasury purchases.

• Diversification into foreign bond markets has been happening (Canada, Australia in particular), but liquidity and depth

is an issue. The total size of Canadian government bond market is ~$610bn and Australia ~$225bn. US Total

Marketable Debt as of August 31st is $9.5tn. There has been some evidence foreign investors were selling into the

post-Operation Twist decline in US rates.

• Developed market rates are low globally, if rates rise outside the US, but US rates stay low, it could fuel further

diversification as we saw in Japan.
18

Foreign Investors

TIC data shows healthy US Treasury inflows, and foreign investors credit averse post

2008. A potential risk is a shift back.
19

Foreign Investors

World USD reserves continue to climb.
20

Foreign Investors

Reserve accumulation tied to currency policy.

0

500

1000

1500

2000

2500

3000

3500

Jan-96 Jan-97 Jan-98 Jan-99 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10 Jan-11

6

6.5

7

7.5

8

8.5

China FX Reserves ($bn, lhs) USD/CNY (inverted, rhs)

Source: Bloomberg
21

Foreign Investors

Source: Bloomberg

Asian Dollar Index (ADXY) versus US marketable securities held in custody for foreign

official and international accounts.
22

Foreign Investors

Foreign investors are still buying Treasuries, though less than 2009-2010.
23

Foreign Investors

Foreign Investors own almost half of US Treasury debt outstanding.
24

Foreign Investors

Foreign participation in 10- and 30-year auctions has been consistent.
25

Foreign Investors

Despite recent fall, Fed custody holdings have been trending higher.

Source: Federal Reserve
26

Banks

Question:

Discuss the impact on net interest margin and overall bank profitability. Does a low-rate environment

impact small banks differently than large banks? Domestic banks vs. foreign banks?

Conclusion:

Net interest margins (NIMs) will be under pressure. Larger banks’ greater diversification will lower their

sensitivity to NIM in comparison to smaller banks. Domestic vs. foreign is a function of the shape of

individual foreign yield curves.

Discussion:

• Liabilities on bank balance sheets tend to be shorter in duration than assets, thus when the yield curve flattens or

inverts, net interest margins could decline as the cost of funds rises more rapidly than the income from earning

assets.

• To the extent funding rates fall at the same rate as lending rates, NIM is maintained. However, lending is not

growing and bank portfolios are shifting from higher margin lending to lower margin lending and investment grade

securities. This is pressuring NIM. Will regulations force margins even tighter?

• During the crisis, as rates fell quickly, legacy loans caused NIM to improve (chart next page). That cycle is over as

loan volumes are off and investment rates lower.

• Additionally, for some banks, the interest earned on loans may be tied to U.S.-denominated interest rates such as

the federal funds rate while the interest paid on debt may be based on international rates such as LIBOR. If those

spreads fail to compress, this could lower the net interest margin and net interest income.

• Moody’s (8/11): “Fed’s decision to announce expectation of 0-0.25% Fed Funds Target rate through mid 2013 is

credit negative for banks as it erodes NIMs at a time when non-core portfolios are being rundown, non-interest

income is eroded by regulation, and negligible loan growth is expected on weak economy.”

• Top 8 US banks saw NIM in 3Q11 fall to an average of 3.39%, from 3.48% in 2Q11, and 3.57% in 3Q10.
27

Banks

Source: Bloomberg

Treasury 2y-10y Curve

140

160

180

200

220

240

260

280

300

Sep-10 Oct-10 Nov-10 Dec-10 Jan-11 Feb-11 Mar-11 Apr-11 May-11 Jun-11 Jul-11 Aug-11 Sep-11 Oct-11

B

P

August 9th FOMC Operation Twist

Yield curve has flattened this year in response to Fed policy

Treasury 2y-10y Curve
28

Banks

Source: FDIC

Net Interest Margins – all insured institutions.

• Due to lag of legacy loans rolling off, NIM is still currently higher than late 2006

0.00

2.00

4.00

6.00

8.00

10.00

12.00

Feb-90Feb-91Feb-92Feb-93Feb-94Feb-95Feb-96Feb-97Feb-98Feb-99Feb-00Feb-01Feb-02Feb-03Feb-04Feb-05Feb-06Feb-07Feb-08Feb-09Feb-10Feb-11

Yield on Assets (%)

3.00

3.20

3.40

3.60

3.80

4.00

4.20

4.40

NIM (%)

Yield on Earning Assets of All Insured Institutions Cost of Funding Earning Assets for all Insured Institutions NIM All Insured Inst
29

Banks

Discussion – Large versus small.

• FDIC (2005): “Larger and more diversified institutions and credit card specialists appear to be less vulnerable to

interest-rate and term-structure shocks, but still sensitive to credit shocks. Both of these relationships may reflect the

greater use of off balance-sheet instruments that help these institutions hedge their interest-rate risk. In comparison,

agricultural banks, mortgage specialists, commercial loan specialists with real assets less than $300 million, and small

non-specializing banks with real assets less than $300 million are sensitive to all three types of shocks examined in

this paper—credit, interest-rate, and term structure shocks.”

• Larger banks would have greater diversification which reduces their sensitivity to NIM. With other core business

revenues down, however, sensitivity to prolonged low rates is higher. Fees on other businesses (credit cards) have

given support.

• Smaller banks generally more dependant on NIM. The chart the next page shows smaller banks have been able to

preserve NIM, likely due to legacy loans. Without diverse revenue streams, small banks will likely be impacted to a

greater degree in the future if rates remain low.

• Dominion Bond Rating Service (3/07): DBRS found an inverse relationship between banks’ AUMs and NIM. The

relationship is driven more by higher loan yields and asset mix of smaller banks rather than funding costs and funding

mix. Smaller banks have smaller loans that have higher yields due to greater risk of losses and similar labor-intensive

booking process. Smaller banks had more core deposits and less reliance on wholesale funding so overall cost of

funding was lower than for larger banks. Large banks benefited more from Fed cutting rates rapidly from 2001-2004

due to their higher reliance on wholesale funding.
30

Banks

Source: FDIC

2.90%

3.10%

3.30%

3.50%

3.70%

3.90%

4.10%

4.30%

3/1/20023/1/20033/1/20043/1/20053/1/20063/1/20073/1/20083/1/20093/1/20103/1/2011

Assets > $10 Billion Assets $1 Billion - $10 Billion All Insured Institutions

Assets $100 Million - $1 Billion Assets < $100 Million

Quarterly Net Interest Margin (NIM)

Net Interest Margins – all insured institutions by size
31

Banks

Source: FDIC

Net Interest Margins – approximate three year lag (32 months)

3.00

3.20

3.40

3.60

3.80

4.00

4.20

4.40

Jan-90Jan-91Jan-92Jan-93Jan-94Jan-95Jan-96Jan-97Jan-98Jan-99Jan-00Jan-01Jan-02Jan-03Jan-04Jan-05Jan-06Jan-07Jan-08Jan-09Jan-10Jan-11

NIM (%)

-1.00

0.00

1.00

2.00

3.00

4.00

5.00

6.00

7.00

8.00

9.00

Fed Funds Target (%) and 2s10s Curve (100bp)

NIM All Insured Inst Fed Funds Target UST 2s10s Curve

~32 months

~32 months
32

Securities Dealers/Repo Trading

Question:

Will low rates impact the liquidity of Treasury securities, particularly if carry becomes compressed?

How will this impact repo markets?

Conclusion:

Ample Treasury supply should serve to keep the Treasury market deep and liquid. Regulatory

requirements raises bank demand for Treasuries, which will keep supply to repo market high.

Discussion:

• At current auction sizes, liquidity should not be a problem even as investors adopt carry and rolldown

strategies. Even as these trades become popular, the overall size of Treasury supply should serve to keep the

Treasury market deep and liquid. If auction sizes are heavily cut within a low rate environment then liquidity

may drop, but considering the cyclicality of issuance this is unlikely.

• Bid-ask spreads in highly liquid products remain relatively tight. However, in times of stress, liquidity premiums

for less liquid products may rise. E.g. in Japan, liquidity premiums rose sharply for inflation-linked and floatingrate Japanese debt.

• Banks are major lenders of US Treasuries, MBS, and Corporates. Banks currently hold ~$1.8tn in US

Treasuries and MBS. Basel III and other regulatory requirements will necessitate additional ownership of

between $400 and $800bn of high quality zero-weight securities. This will keep lending markets liquid. If banks

hold fewer Treasuries, high cash levels will drive repo rates lower.

• Collateral requirements to support centrally cleared transaction and OTC transactions by 2015, when combined

with Liquidity Coverage Ratio requirements, will be between $1.6tn and $5.5tn (median estimate $3.5tn).

Current estimates of OTC margin requirements (2010) is $1.5tn. This collateral will consist mainly of

government debt.
33

Insurance Companies

Question:

How will low rates impact the profitability of insurers? What challenges do low rates pose in terms of assetliability management, risk-based capital, investor policy redemptions, and product demand?

Conclusion:

Inability to match long liabilities with fixed income stream will shift allocations into higher yielding assets.

Discussion:

• Insurance companies seek returns against long duration liabilities such as universal life and fixed annuities.

• Near term (6 months), insurance companies generally do not plan on changing the duration of their bond portfolio

• In a lengthy period of low for longer, insurance companies would increase their exposure to IG credit, HY credit, real

estate, alternative investments, structured products, hard assets, and derivatives. Generally, this will be at the

expense of US Treasuries.

• Approximately half expect modest pressure on their credit ratings, and most see some change necessary to their

overall business strategy and product line emphasis.
34

Insurance Companies

Discussion continued – Moody’s report (August 19th 2011)

• “While US life insurers are not expected to incur significant near-term losses from the current low interest rate

environment, low rates over a long period (5+ years) would subject them to substantial losses that could result in

downgrades, some multi-notch.

• An extended period of low interest rates would lead not only to significantly lower investment income, but also to

higher statutory reserve requirements and meaningful DAC (Deferred Acquisition Cost) writedowns (on GAAP

financials), weakening companies’ profitability, capital adequacy and financial flexibility.

• Most affected would be issuers that have sizable exposure to fixed-rate immediate and deferred annuities, universal

life and interest sensitive insurance policies with high minimum crediting rates, variable annuities with lifetime

guaranteed income benefits, long-term care and long-term disability.

• Least affected would be issuers of primarily participating whole life, term life, group life, pensions, and non-guaranteed

variable life and annuities. Generally, these products have interest crediting rates that are minimal or not guaranteed.

• Few insurers have bought protection against lower interest rates, either because of the high cost of doing so or

because they deem the risk to be remote. Exceptions are the minority of companies that have bought interest rate

floors, insurers with interest rate hedging programs for variable annuity lifetime income guarantees, and companies

that have locked in interest rates on the investment of future premiums for products such as no-lapse universal life and

long-term care.

• Our review of the 2008–10 regulatory cash flow testing filings for a representative group of US life insurers showed

that when interest rates declined, insurers saw a material worsening of reserve margins, with several companies

needing to post additional statutory reserves. As expected, results showed that insurers performed much worse under

declining rate scenarios than under increasing scenarios.”
35

Pensions

Question:

How will low rates impact pensions’ asset/liability framework?

Conclusion:

Pension funds have become increasingly underfunded. They are highly sensitive to the level of corporate

bond yields. If low rates cause investors to reach for yield and buy corporates (lowering their yield), it will

hurt pension funds.

Discussion:

• Goldman Sachs estimates that as of August 2011, Aggregate Pension Funded Status was 75% (S&P 500 Companies,

US Plans)1

1: Source: Goldman Sachs Research, Capital IQ, Company reports. US plans sponsored by S&P 500 companies. 2011E as of mid August.
36

Funded Status Sensitivity

Pension Funded Status Sensitivity1
37

Mortgage Lenders/REITS/Servicers

Question:

How will low rates impact mortgage originators’ balance sheets, profitability, and capital? Will a flatter

curve alter borrowers’ preferences for mortgage products?

Conclusion:

Lower rates and a flatter curve will spark origination, but a sustained low rate environment could lead to

refi burnout. There is great legislative uncertainty. A flatter curve should incentivize borrowers to extend.

Discussion:

• Lower yields will spark origination as borrowers lock in lower rates, either for purchase or refi. A flat curve also

encourages borrowers to lock in these rates for longer, so we see ARM to fixed refis.

• In a sustained low rate environment, to protect profitability originators may not reduce the primary and secondary

spread they earn on originations in order to maintain profitability. This may reduce or impair the benefit to the

consumer from low rates.

• Initially in a low rate environment as refis increase, originators may face capacity constraints (this constraint may

further motivate keeping spreads wide – lower volumes require wider spreads). If rates remain low for a sustained

period of time, we could start to see a burnout effect in refinancing, which would slow down the volumes for

originators and also hamper profitability.

• Due to still high levels of uncertainty in the market regarding HARP, originators are likely to be cautious until there

is evidence that the changes result in sustained borrower demand.
38

Mortgage Lenders/REITS/Servicers

Question:

How will REITs respond if rates fall and the curve flattens?

Conclusion:

A low, flat yield curve will lower carry and trigger pre-payments, hurting REIT profitability. Capital raising will

also be challenged. REIT activity will likely slow overall in a prolonged low rate environment.

Discussion:

• As of June 2011, REITs held $185 Billion in Agency MBS. For perspective, REITs held only $65B in Agency MBS in

June 2010. REITs market share of Agency MBS is up to 3.0%, from 1.0% last year. The biggest holders of MBS

remain commercial banks (20%), the US government (Fed and Treasury, 15%), foreign investors (13%), and the

GSEs (11%).

• REITs aggressively raised capital in 2011. YTD capital raises by publically traded mortgage REITs are $9.732 Billion,

this is $4.11B more than in full year 2010 (the next highest year)

• Assuming a 6:1 leverage ratio—which we figure is relatively conservative for REITs—this $9.7B translates to almost

$60B in buying power. This was a positive for the MBS basis in early 2011, as REITs were active purchasers of

Agency ARMs and Pass-throughs. It is believed most of this has been invested.

Public Residential Mortgage REIT Issuance of Equity

-

2,000

4,000

6,000

8,000

10,000

12,000

2003 2004 2005 2006 2007 2008 2009 2010 2011

$ millions

Completed through 9/30/11
39

Mortgage Lenders/REITS/Servicers

Discussion continued

• REITs generally fund at the short end (usually through short term repo) and buy out the curve. Consequently a

steep curve is beneficial because REITs can finance at low rates and earn good carry. The Fed’s pledge to keep

short rates under 0.25% until mid-2013 is a strong positive for REIT financing, assuming there is bank balance

sheet available. However, if bank balance sheet were to dry up, REITs would be pressured to sell. REIT funding is

mostly short term facilities (as opposed to lines of credit) so funding is typically not available in crisis. Since most

REITs are 6-8 times levered, if the repo facilities were to be pulled, capital raises would be difficult and asset sales

may occur.

• Furthermore, the chance of a bull flattening or any rally in the back end is a negative for REIT, as it hurts the carry

trade and lower rates will likely trigger prepayments in Agency MBS.

• An increase in prepayments will likely occur as a result of lower rates. Additionally, there remains much uncertainty

as to the scope and magnitude of government changes on refinancing. However, any market or legislative force

that increases prepays would eventually put cash back to the REITs, which would likely reinvest in Agency Passthroughs and ARMs (in turn pressuring rates lower).

• A drop in rates will likely curb REIT capital raises, as REITs may find levels unattractive. In addition, any curve

flattening will hamper ARM creation - a favored investment vehicle for REITs is whole pools of Agency ARMs. If the

drop is significant enough to put banks in balance-sheet-reduction mode, then REITs will no longer have accessible

financing and may be pressured to sell assets.

• For the majority of mortgage REITs, the latest price/book ratios are at or below 1 (table above). As a result, capital

raises look to be difficult in Q4 2011. Furthermore, REIT dividends per share were either flat or below Q1 levels. In

general, these numbers indicate a slowdown in REIT activity.
40

Mortgage Lenders/REITS/Servicers

Question:

How will low rates impact mortgage servicers’ balance sheets, profitability, and capital? Will a flatter

curve alter borrowers’ preferences for mortgage products?

Conclusion:

Servicers will see their Mortgage Servicing Rights (MSRs) impacted during a period of

refinancing/prepays. As with originators, there is great legislative uncertainty.

Discussion:

• For larger banks, often the lending bank and the servicing bank are the same. The activity of the originator will

likely dictate the activity of the servicer.

• With any decline in rates, servicers are likely to be the most impacted as the MSR they hold is highly leveraged

to prepayments. Currently, there is $10.385tn of mortgage debt outstanding.

• Servicers receive mortgage servicing rights as compensation for servicing the loan. MSRs are similar to a

stream of IO. When a loan prepays in full, that stream of income is cut off. So when prepayments increase, the

value of MSRs diminishes. This valuation can maybe be offset if the servicer becomes the servicer on the new

loan (assuming refi).

• If there is a refi burnout effect with rates low for a long time, servicer profitability is maintained.

• Note the FHFA is exploring changes to servicer compensation, likely reducing the maximum amount a servicer

is required to hold. So overall, we expect servicers to gradually lighten up on MSRs ahead of these changes.
41

Treasury Financing

Question:

What, if anything, should Treasury do in response to an extended low rate environment?

Conclusion:

Treasury should continue to investigate new product alternatives in order to diversify its investor base.

Discussion:

• If the Treasury desires more current income, it can borrow short to reduce funding costs.

• If the Treasury is concerned about rollover risk, it can continue to extend the average maturity of the debt. The

Treasury will then accept increased incremental funding costs to ensure the long run stability of financing. This can

also be achieved, in part, through the issuance of floating-rate notes in lieu of T-bills.

• If investors over time seek out higher yielding assets, it may put pressure on the US Treasury as it seeks to finance

the deficit. Introducing alternative products should ease this potential pressure, such as floating rate notes and 50yr

strippable bonds.