Debt Management: Backup Funding Options Would Enhance Treasury's Resilience to a Financial Market Disruption
Published: 2006-09-26T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: The September 11, 2001, attacks significantly affected the financial markets that the U.S. Treasury (Treasury) relies on. To understand how Treasury could obtain funds during a future potential wide-scale financial market disruption GAO examined (1) steps Treasury and others took during the September 11 attacks and after to assure required debt obligations and payments were made on time and ensure liquidity in the markets, (2) major actions Treasury and others have taken since the attacks to increase the resiliency of the auction process, and (3) the opinions of relevant parties on the main design features of any backup funding options. We conducted interviews with Treasury officials and others and reviewed appropriate documents.
section_title: What GAO Found
paragraphs: In response to the effects of the September 11 attacks on the financial markets, Treasury canceled a scheduled 4-week bill auction after communicating with the Federal Reserve Bank of New York (FRBNY). Treasury then used compensating balances from banks across the country to help meet its obligations on time. Compensating balances were replaced by direct payments in 2004. Also, in response to the attacks' financial effects, the Federal Reserve lent billions of dollars to both domestic and foreign financial institutions through a combination of methods to help markets recover. Federal Reserve actions and market behavior in the aftermath of the September 11 attacks are informative when considering potential alternative funding sources for Treasury during a future wide-scale financial market disruption. Treasury, the Federal Reserve, and primary dealers have added contingency sites and systems intended to increase the resilience of the auction process. Regardless of resiliency efforts, the nature and impact of a potential future wide-scale disruption are unknown. In addition, Treasury has at least one less source of cash since the compensating balances Treasury relied upon during the September 11 attacks are no longer used. Finally, Treasury's cash management policy of minimal cash balances to lower borrowing costs further limits Treasury's access to cash during a wide-scale disruption. All these factors make it prudent for Treasury to explore other funding alternatives to use during a wide-scale disruption. Relevant parties with whom we spoke, including primary dealers, agreed. They also generally agreed on a list of main design features including source of funds, situations for use, approvals, and costs, among others, that should be considered when weighing alternative funding options. Discussions with Treasury, the Federal Reserve, and other relevant parties have led GAO to conclude that a two-tiered approach is promising. The first tier consists of two funding options involving a range of appropriate financial institutions, namely a credit line and a private placement of a flexible security known as a cash management (CM) bill. The second tier involves a direct draw from the Federal Reserve that would provide Treasury a last resort source of funds when other options are not viable. A credit line with several financial institutions would involve a prior transparent commitment or understanding by certain financial institutions to provide funds to Treasury. A private placement of a CM bill would involve a prior arrangement to issue a CM bill after communicating with certain senior executives at financial institutions who would have the ability and authority to meet Treasury's immediate funding needs. Finally, a direct draw from the Federal Reserve would require a change in the law to allow the Federal Reserve to directly lend to Treasury. Appropriate limitations, adequate flexibility, and accountability would have to be included in the design.

section_title: Letter
paragraphs: The massive destruction caused by the September 11, 2001, attacks on the  World Trade Center and the resulting loss of life, facilities,  telecommunications, and power significantly affected U.S. financial  markets, including the markets for U.S. Treasury (Treasury) securities.  The attacks exposed the vulnerability to a serious wide-scale disruption of  the markets that Treasury relies on as a regular source for financing  government operations and large, regularly occurring payments such as  Social Security benefits. In response to the attacks, Treasury canceled a  scheduled auction of 4-week bills on September 11 and used compensating  balances—noninterest-bearing cash balances used to compensate banks  for various services—to help meet its obligations on time.
However, compensating balances are no longer used. In addition,  Treasury’s cash management policy is to maintain minimal cash balances  in order to lower borrowing costs. We reported earlier this year that the  combination of a minimal cash balance policy and the unavailability of  previous methods for accessing cash warrant closer attention to  Treasury’s ability to raise cash—and ultimately meet federal payment  obligations—should normal auctions be unavailable in the event of  another wide-scale disruption to financial markets.
In your continuing interest in how Treasury borrows the money required  to finance the federal government and in recognition of the risks of a wide- scale financial market disruption, you asked us how Treasury might obtain  funds should normal financial market operations be significantly degraded  or closed due to a catastrophic emergency. Specifically, we examined   (1) steps Treasury and the Federal Reserve took during the week of the  September 11, 2001, attacks and during the weeks following the attacks to  assure required debt obligations and payments were made on time and  ensure liquidity in the financial markets, (2) major actions Treasury, the  Federal Reserve, and primary dealers have taken since the September 11  attacks to increase the resiliency of Treasury’s auction process and  participation, and (3) the opinions of relevant parties on the main design  features of any cash draw authority and how the features would affect  accountability and congressional oversight, enhance Treasury’s  operations, affect Federal Reserve operations, and influence the views of  capital market participants.
subsections: section_title: Background
paragraphs: The September 2001 terrorist attacks and the subsequent collapse of the  twin World Trade Center towers damaged more than 400 structures across  a 16-acre area, and claimed almost 2,800 lives. Financial services industry  employees accounted for about 74 percent of the victims. Dust and debris  blanketed the area, creating difficult and hazardous conditions that  complicated recovery efforts. Many financial organizations lost  telecommunications service when the 7 World Trade Center building  collapsed and debris struck a major Verizon central switching office that  served approximately 34,000 businesses and residences. Over 13,000  customers also lost power. To accommodate the rescue and recovery  efforts and maintain order, pedestrian and vehicle access to the area  encompassing the financial district was restricted through September 13,  2001.
The attacks severely disrupted the secondary markets for government  securities and money market instruments primarily because of the impact  on the brokers that facilitate trading among dealers (broker-dealers) and  on one of the clearing banks for those trades. Two banks—the Bank of  New York (BONY) and JPMorganChase—provided clearing and settlement  services (and still do) for many major broker-dealers in the government  securities market. Clearing banks transferred funds and securities for their  customers that purchased or sold government securities based on  instructions received by the Government Securities Clearing Corporation  (GSCC). As a result of the attacks, BONY had difficulty reestablishing its  connections with GSCC and its own account at the Federal Reserve, and  its customers had difficulties connecting with BONY. These problems  contributed to the disruption of the secondary government securities  market. BONY had to evacuate four facilities, including its primary  telecommunications data center and over 8,300 staff, because they were  located near the World Trade Center. By September 14 BONY  reestablished connectivity with GSCC and began receiving and  transmitting instructions for securities transfers.
Both the Federal Reserve’s Fedwire Securities Service, which provides  safekeeping, transfer, and settlement services for securities issued by  Treasury and other federal agencies, and its Fedwire Funds Service, which  provides payments services associated with securities sales and other  large-value transactions, continued processing transactions without  interruption. Although the Federal Reserve Bank of New York (FRBNY),  which manages the Fedwire services, sustained damage to some  communication lines, the Fedwire services were not interrupted because  the facilities that process transactions were not located in lower  Manhattan. Over 30 banks initially lost connectivity to Fedwire services,  but most were able to reestablish connections through backup systems,  and most payment system operations continued with minimal disruption.
The Federal Reserve, Treasury, and primary dealers all play important  roles in Treasury auctions. The Federal Reserve and its associated Federal  Reserve banks function as the United States government’s fiscal agent and  perform a variety of services for the Treasury including handling Treasury  auctions, accepting bids, communicating bids to Treasury, issuing  Treasury securities to winning bidders, and collecting payment for  securities.
Treasury borrows the money needed to operate the federal government  and manages the government’s outstanding debt subject to a statutory  limit. Treasury’s primary debt management goal is to finance the  government’s borrowing needs at the lowest cost over time. To meet this  objective, Treasury issues debt through auctions in a “regular and  predictable” pattern across a wide range of securities. Treasury publishes  a schedule with tentative announcement, auction, and settlement (issue)  dates up to 6 months in advance of regular security auctions. Depending  on the type of security, Treasury typically auctions and then issues a  security within a week or less. Treasury generally issues short-term  regular bills with 4-, 13-, and 26-week maturities every Thursday and issues  2- and 5-year notes at the end of each month. Three- and 10- year notes are  issued in the middle of each quarter. Treasury reopens 10-year notes—or  increases the amount outstanding for these notes—1 month after their  initial issuance. In addition, Treasury issues Treasury Inflation-Protected  Securities (TIPS) in 5-, 10-, and 20-year maturities in certain months  according to the TIPS’ maturity.  Finally, Treasury issues 30-year bonds in  February and August and reopens these issues in May and November,  respectively.
Treasury supplements its regular and predictable schedule with flexible  securities called cash management (CM) bills. Unlike for other securities,  Treasury does not publish information on CM bills on its auction schedule.  Instead, Treasury generally announces CM bill auctions anywhere from 1  to 4 days ahead of the auction. The term to maturity—the length of time  the bill is outstanding—varies according to Treasury’s cash needs. CM bills  allow Treasury to finance very short-term cash needs—for as little as   1 day—while providing short notice to market participants.
As of the end of fiscal year 2005, about 46 percent of marketable Treasury  securities held by the public will mature during the next 24 months. As  these securities mature and are replaced by new debt, the cost to finance  the federal government’s debt will vary with changing interest rates.
The bidders in Treasury auctions include depository institutions,  individuals, dealers and brokers, pension and retirement funds, insurance  companies, investment funds, foreign and international entities, the  Federal Reserve, and others. In recent years the percentage of U.S.  Treasury securities held internationally has increased. Although the  categories of bidders are diverse, primary dealers, other commercial bank  dealer departments, and other nonbank dealers and brokers received  almost 60 percent of auction awards of marketable securities between  August 2001 and May 2006. Federal Reserve banks received almost   21 percent during that same time period for their own accounts. Primary  dealers are banks and securities brokers that trade in U.S. government  securities with the Federal Reserve. Primary dealers have functioned for  over 40 years as the distribution and support system for Treasury debt and  play a “vital” role in the price discovery process. The FRBNY designates  primary dealers based on certain capital requirements, and requires  primary dealers to participate meaningfully in both Federal Reserve open  market operations and Treasury auctions to maintain their designation.  However, the Federal Reserve does not have regulatory authority over  dealers acting in the primary dealer role.
In the past, outside of the auction process, Treasury had access to a cash  draw authority intended for emergencies. Intermittently between 1942 and  1981, Treasury was able to directly sell (and purchase) certain short-term  obligations to (and from) the Federal Reserve in exchange for cash.  Treasury used the cash draw authority infrequently and mostly in times of  war or armed conflict. Congress last granted the authority in 1979 and  limited the amount Treasury could draw to $5 billion. Congress allowed  this authority to expire in 1981 (see app. II for more background  information). Although the existence of a previous draw authority is  relevant, we are not suggesting restoration of this authority in its previous  form due to certain limitations.
section_title: Objectives, Scope, and Methodology
paragraphs: To understand the steps that Treasury and the Federal Reserve took  during the week of the September 11 attacks and during the following  weeks to assure required debt obligations and payments were made on  time and ensure liquidity in the financial market, we conducted interviews  with knowledgeable Treasury and Federal Reserve officials and staff. We  also reviewed prior audit reports and other documentation from GAO, the  Federal Reserve, and Treasury. We analyzed and examined these sources  to develop a time line with key actions and to determine actions and  financial market behavior that are informative when considering  alternative funding sources for Treasury.
To understand major actions Treasury, the Federal Reserve, and primary  dealers have taken since the September 11 attacks to increase the  resiliency of Treasury’s auction process and participation, we interviewed  Treasury and Federal Reserve officials and staff involved in conducting  primary dealer visits, the auction process, and systems. We reviewed  Treasury contingency and continuity of operations (COOP) plans and  other documents that described contingency sites, staff training topics,  contingency exercise results, and other Treasury summaries. We also  interviewed executives and staff involved and familiar with resiliency  efforts at 14 primary dealers and executives involved with emergency  planning at The Bond Market Association, the industry association  representing participants in the government securities and other debt  markets. In addition, some of our work was based on internal knowledge  derived from Treasury audits we have conducted in the past.
To describe the opinions of relevant parties on the main design features of  any cash draw authority and how the features affect accountability and  congressional oversight, enhance Treasury’s operations, affect Federal  Reserve operations, and influence the views of capital market participants,  we interviewed Treasury officials involved with debt management, policy,  operations, fiscal management, auctions, and legal matters. Further, we  interviewed Federal Reserve officials involved with monetary affairs, open  market and discount window operations, and Treasury auction staff and  researchers. In addition, we communicated with foreign debt management  officials, and conducted interviews with executives and staff involved with  Treasury auctions at 14 primary dealers and senior executives at two  major commercial banks. We also spoke with other capital market  participants, and had discussions with senior congressional staff  concerned with oversight. We analyzed relevant Treasury, Federal  Reserve, and capital market documentation to obtain government and  capital market perspectives. We validated, with relevant parties, main  design features for consideration when structuring an alternative cash  draw arrangement and looked for emerging funding options based on  discussion with relevant parties.
We conducted our review in Washington, D.C., and New York, N.Y., from  March 2006 through September 2006 in accordance with generally  accepted government auditing standards.
section_title: Treasury Canceled an Auction and Used Certain Cash Balances to Help Meet Its Obligations during the Week of September 11, 2001
paragraphs: Treasury took a number of steps in reaction to the September 11 attacks to  ensure it met its obligations during a time of disrupted financial markets,  as summarized in figure 1. It canceled an auction scheduled for September  11, withdrew compensating balances held in depository institutions across  the country, communicated with the FRBNY about the status of markets,  and resumed its normal auction schedule within 1 week of the attacks.
subsections: section_title: Treasury Canceled a 4-week Bill Auction in Response to the Attacks’ Effects
paragraphs: Treasury decided to postpone and then cancel a planned auction of   $10 billion worth of 4-week bills because of financial market degradation  due to the September 11 attacks. In addition, various infrastructure  concerns at the FRBNY made it unclear whether it could have conducted  an auction. Following its normal borrowing schedule, on September 10  Treasury announced its intention to auction $10 billion worth of 4-week  bills on September 11 to help pay off $11 billion worth of 4-week bills that  were about to mature on September 13.
According to a senior Treasury debt management official, after the  September 11 attacks, Treasury initially wanted to postpone but not cancel  the auction. Treasury officials consulted with the FRBNY about market  conditions and learned that some primary dealers had evacuated their  office buildings that morning.
As the magnitude of the attacks became clearer Treasury decided to  cancel the auction. A markets officer in charge of Treasury auction staff  located at the FRBNY told us that it was unclear if they could have  executed the auction because of evacuations, structural integrity, and  other concerns at the time. Treasury issued a press release on September  12 confirming the cancellation of the 4-week bill auction and that Treasury  had no plans for rescheduling the auction. Treasury officials determined  that canceling the auction would not damage Treasury’s reputation for  “regular and predictable” auctions, given the nature of the attacks.
section_title: Treasury Relied on Compensating Balances to Help Meet Its Debt Obligations
paragraphs: Treasury decided on September 11 to initiate procedures to withdraw  almost $13 billion of compensating balances—noninterest-bearing cash  balances that Treasury used to compensate banks for various services—to  make up for the cash shortfall associated with the cancellation of the   $10 billion 4-week bill. Treasury officials told us that they wanted to pull  back as much cash as possible and as quickly as possible without harming  the financial position of the banks. Treasury’s ending operating cash  balance on September 11 was just a little over $11 billion, which would  have been insufficient to pay off maturing 4-week bills on September 13,  meet Treasury’s other obligations, and maintain the $5 billion target in its  Federal Reserve account.
Treasury contacted banks across the country holding compensating  balances on September 11 and asked them to confer with other bank  executives and consider whether withdrawing a total of $12.6 billion on  September 13 would cause any harm to the banks’ operations. The banks  responded that the withdrawals would not, and according to senior  Treasury officials, also offered to help Treasury in any way during the  crisis. Treasury transmitted formal letters on September 12 specifying  amounts to be withdrawn on September 13. On that date Treasury  received the $12.6 billion from compensating balances and returned  posted collateral to applicable banks. Treasury did not pay any penalties  because compensating balances could be withdrawn by Treasury at any  time, and no telecommunications problems were encountered in  completing the transfers.
section_title: Treasury Met Its Debt Obligations on Time, Resumed Auctions within a Week, and Replaced Compensating Balances within 10 Business Days of the Attacks
paragraphs: Treasury paid almost $43 billion in maturing bills (including about   $11 billion of maturing 4-week bills) and received about $35 billion from  issuing bills on September 13. Additionally, on September 13 Treasury  announced its intention to auction 13- and 26- week bills and executed the  auction on September 17, 2001, awarding almost $35 billion, resuming its  normal auction schedule. In deciding to resume auctions, Treasury held  conversations with market participants and the FRBNY who conveyed that  the market was ready to bid on auctions. The September 17 auction  proceeded normally according to one senior debt management official and  bid-to-cover ratios—a commonly cited measure of auction performance  and market demand for securities—were similar to the 13- and 26-week  bill auctions held just before September 11.
Finally, Treasury replaced $11.2 billion of compensating balances on  September 21 and another $2 billion on September 24. Banks were  required to pledge certain types of collateral to secure compensating  balances and one bank could not pledge enough collateral until September  24.
section_title: Compensating Balances Are No Longer Used
paragraphs: Treasury replaced compensating balances with direct payments to banks  for certain services in 2004. This effectively eliminated the alternative  source of funds Treasury had drawn on during the September 11 attacks.  Compensating balances were—as the name implies—noninterest-bearing  balances deposited in banks to compensate them for collecting tax and  nontax receipts. Banks could make loans or buy investments with the  compensating balances, which were fully collateralized.
The amount of any compensating balance was determined by Treasury  based on specified interest rates. Current Treasury officials told us that  they did not view compensating balances as a substitute cash backup  source except in extraordinary circumstances. Further, a combination of  circumstances starting in 2002 made compensating balances “inefficient  and disruptive” for Treasury. Declining interest rates required increases  in balances while the need to stay under the debt-limit required decreases  in balances, which later had to be reversed and increased to unusually  high levels. For example, September end-of-month compensating balances  increased from about $6 billion, to $13 billion, and then to $27 billion in  fiscal years 2000, 2001, and 2002, respectively. Treasury began to phase out  compensating balances in 2003 and drew down the compensating balances  to zero in 2004.
section_title: The Federal Reserve Used a Number of Methods to Provide Liquidity to Domestic and Foreign Financial Institutions
paragraphs: Consistent with its goal of maintaining the stability of the financial system  and containing systemic risks, the Federal Reserve took action in response  to the attacks’ financial effects. The Federal Reserve communicated that it  was available as a source of liquidity and provided billions of dollars  through various means to banks and financial market participants  experiencing liquidity problems as a result of the September 11 attacks.
The Federal Reserve announced its willingness to provide liquidity on  September 11 several times via systems and official statements. For  example, soon after the attacks the Federal Reserve broadcast that it was  fully operational on the Fedwire system—the Federal Reserve’s large- value electronic payment system. In a second broadcast message it  announced that it was available to meet liquidity needs. Around noon, the  Federal Reserve Board of Governors issued a press release stating that  “The Federal Reserve System is open and operating. The discount window  is available to meet liquidity needs.” These statements along with others by  a Federal Reserve governor and a Federal Reserve bank president on that  day were intended to reassure financial markets that the Federal Reserve  System was functioning normally and to encourage banks to view the  discount window as a source of liquidity. According to a then Director of  Research at the Federal Reserve Bank of Richmond who has since become  that bank’s President, the statements also signaled to banks a “distinct”  shift in how the Federal Reserve would view discount window  borrowing.
The Federal Reserve provided liquidity through discount window and open  market operations. We previously reported that banking regulatory staff  told us that the attacks largely resulted in a funding liquidity problem  rather than a solvency crisis for banks. Thus, the challenge the Federal  Reserve faced was ensuring that banks had adequate funds to meet their  financial obligations. Settlement problems also prevented broker-dealers  and others from using the repo markets to fund their daily operations. In  4 days after the attacks, the Federal Reserve provided billions of dollars to  banks through various means to overcome the problems resulting from  unsettled government securities trades and financial market dislocations.  For example, the Federal Reserve provided $37 billion in overnight credit  through its discount window on September 11, $46 billion on September  12, and $8 billion on September 13. In contrast, no overnight discount  window credit was provided on September 10 and September 14. It also  conducted securities purchase transactions and other open market  operations to provide needed funds to illiquid institutions. For example,  the Federal Reserve held a zero end-of-day balance in overnight repos on  September 10 and September 11, but end-of-day balances increased to $38  billion on September 12 and peaked at $81 billion on September 14 during  the 4 days following the attacks. In addition, the Federal Reserve waived  daylight overdraft fees for all account holders and eliminated the penalty  on overnight overdrafts for depository institutions from September 11  through September 21. Had these actions not been taken, some firms  unable to receive payments may not have had sufficient liquidity to meet  their other financial obligations, which could have produced other defaults  and magnified the effects of September 11 into a systemic solvency crisis.
The Federal Reserve provided additional liquidity by continuing its normal  check crediting schedule despite delays in transportation. The grounding  of air transportation complicated and delayed some check clearing, since  both the Federal Reserve and private providers relied on overnight air  delivery to transport checks between banks in which they are deposited  and banks on which they are drawn. The Federal Reserve continued to  credit the value of deposits to banks even when it could not present  checks and debit the accounts of paying banks. The Federal Reserve  decided to not offset this float through open market operations to  continue providing liquidity. Crediting banks for deposited checks before  receiving the corresponding credit from banks on which the checks were  drawn causes float. This additional liquidity—normally less than $1 billion  outstanding at any one time—peaked at over $47 billion on September 13,  2001.
To provide dollars needed by foreign institutions, the Federal Reserve also  arranged new or expanded swap lines with the Bank of Canada, the  European Central Bank, and the Bank of England. The swap lines involved  exchanging dollars for the foreign currencies of these jurisdictions, with  agreements to re-exchange amounts later. These temporary arrangements  provided funds to settle dollar-denominated obligations of foreign banks  whose operations were affected by the attacks.
According to a Federal Reserve official, the large injections of liquidity  were also necessary in part to offset large reserve drains from other  autonomous factors—factors that affect the supply of balances but are  generally outside the control of the Federal Reserve. For example, as  previously noted, the level of check float peaked at $47 billion on  September 13 and a foreign currency swap added $20 billion of balances  on that same day, but another autonomous factor reduced balances by  over $30 billion on that day, which was between $15 billion and $20 billion  more than prior levels.
To further increase liquidity, the Federal Open Market Committee  (FOMC) announced on September 17 that it would lower its federal funds  target rate by 50 basis points to 3 percent and the Federal Reserve Board  of Governors approved a 50 basis point reduction in the discount rate to   2-1/2 percent. In its announcement the Federal Reserve stated that it  would “continue to supply unusually large volumes of liquidity to the  financial markets, as needed, until normal market functioning is restored.”  The FOMC acknowledged that the actual federal funds rate might fall  below its target in this situation. According to a then Director of Research  at the Federal Reserve Bank of Richmond, who has since become that  bank’s President, market participants expected a decline in the federal  funds rate driven perhaps by the large amount of liquidity injected by the  Federal Reserve, creating excess reserve balances.
Market participants typically use government securities as collateral for  financing or to meet settlement obligations. When some broker and bank  facilities were destroyed or lost connectivity, the results of trading  information, such as amounts of securities or funds to transfer and the  ability to transfer funds, were lost or degraded for days. If trade  information is not correct and funds and securities are not properly  transferred, the trade will be considered a “fail.” To help alleviate failed  trades resulting from the attacks, the Federal Reserve and Treasury loaned  and auctioned securities respectively. From September 11 through  September 13, the Federal Reserve loaned $22 billion of securities from its  portfolio to broker-dealers that needed securities to complete settlements  of failed trades. The Federal Reserve also reduced restrictions on its  securities lending, leading to a sharp increase in borrowing at the end of  September 2001.
Treasury also conducted an unplanned, special issuance of 10-year notes  in order to prevent a possible financial crisis. According to current and  former Treasury officials involved with this decision, on September 17 it  became evident that the stopped and incomplete trading on September 11  resulted in increasing fails in the secondary market. Treasury officials  described how a rapid rise in fails at the end of September and beginning  of October was based on demand for the 5- and 10-year notes. After  conferring with capital market participants who recommended a  reopening, or increasing the amount outstanding, of the 5- or 10-year  notes, Treasury officials decided to reopen the 10-year note. They  reasoned that since the note was already scheduled to reopen in  November, investors—-who were anticipating the November reopening—- would be better prepared for the issuance than for a 5-year note. Treasury  officials concluded that the additional supply of the 10-year note produced  a positive “psychological” effect on markets by providing increased  confidence about the certainty of supply helping to decrease fails in the 5-  and 10-year notes trades.
subsections: section_title: Some Federal Reserve Actions and Financial Market Behavior Are Informative When Considering Alternative Funding Sources for Treasury
paragraphs: Immediately after the September 11 attacks, many financial institutions,  including some foreign central banks, looked to the Federal Reserve to  provide liquidity through various methods. As Treasury considers potential  financial institutions for funding sources during a wide-scale disruption, it  will need to remain cognizant of the fact that the Federal Reserve was, is,  and potentially will be, the provider of liquidity for many financial  institutions in a crisis. Further, the amount and terms of the liquidity  provided by the Federal Reserve to financial institutions will likely affect  the characteristics of any funding alternatives available to Treasury. As  discussed previously, the Federal Reserve eased restrictions and lowered  interest rate targets to provide expanded liquidity to financial institutions.  Finally, the market fails and other collateral issues in the secondary  market may affect the type of security Treasury will want to issue in a  crisis. Treasury officials recognize that during a crisis, investors tend to  exhibit a “flight-to-quality” behavior, moving their capital away from  riskier investments to safer investment vehicles, such as U.S. Treasury  securities. These considerations are discussed later in this report.
section_title: Since the Attacks, Treasury and the Federal Reserve Have Added Staffed Locations and Data System Capability Intended to Increase Auction Resilience
paragraphs: After an auction is announced, the critical functions that must occur  without interruption for Treasury to raise the required funds from the  issuance of Treasury securities are (1) auction, (2) prepare issue file,   (3) issue securities, and (4) cash transfer (see fig. 2). If any of these  functions are disrupted, Treasury would not be able to obtain the cash  needed from an auction. During the September 11 attacks, Treasury and  the Federal Reserve, acting as Treasury’s fiscal agent, had two operational  locations to conduct auctions, one operational location to prepare files  with important issuance information, one operational location to issue  securities, and one operational location with a secondary location—which  could be activated if necessary—to transfer cash. Since then, Treasury and  the Federal Reserve have added locations for all of Treasury’s critical  auction process functions.
Treasury depends on certain systems to auction and issue its securities.  The critical systems that must be operational for an auction to occur and  for Treasury to receive the funds from that auction are (1) the auction  system which receives and processes bids for securities, (2) the funds and  securities transfer system, (3) the book-entry accounting system, and   (4) the cash reporting system. In addition, since the September 11 attacks  the Federal Reserve has strengthened its out-of-region data system  capability. Figure 2 describes each of these processes and associated  systems.
subsections: section_title: Treasury and the Federal Reserve Have Added Sites for All Four Critical Functions Since the September 11 Attacks
paragraphs: Treasury and the Federal Reserve have added sites that are geographically  separated from each other for all four of Treasury’s critical auction  functions, as seen in figure 3. Contingency sites are located in different  geographic regions and do not require staff to relocate from the primary  site, while backup facilities are generally located in the same region as the  sites they are intended to backup. For example, staff would relocate from  a primary site, like site A in figure 3, to the cold backup facility listed  under site A in a contingency.
Auctions can now be performed at three operational locations with one  backup facility. All three locations are fully operational for every auction.
Issuance files can now be prepared at one operational location with a  backup facility and one semi-operational location. Site D is geographically  separated from site A, periodically performs the functions for specific  auctions, and can be immediately activated to perform the tasks of this  function. Further, site A has trained staff at its backup facility that can  perform the tasks of this function after being notified of a contingency  situation or event.
Securities can now be issued at one operational location with a backup  facility and one semi-operational location. Site E periodically performs the  function of issuing securities for specific auctions approximately once  every 2 weeks. This site is also geographically located in another region.
The cash transfer function has added two cold contingency locations since  September 11, 2001. Site B is the primary location and sites G and H are  the secondary locations, which are geographically separated from site B  and can be activated in the case of a contingency event. Site C is now a  third contingency location that was a secondary location at the time of the  September 11 attacks.
section_title: Treasury Alternates Sites to Process Auctions and Conducts Mock Auction Tests
paragraphs: Treasury periodically switches auction processing between sites during  live auctions to test their readiness and conducts mock auctions. For  example, in one exercise, Treasury directed one site to take over the  auction processing from another site during a live auction. Treasury  reported the test a success since staff demonstrated their ability to  “seamlessly” take over and perform auction closing procedures, release  auction results, and complete other normal post-auction activities. In  another exercise, Treasury conducted a manual mock auction to expose  staff to an atypical situation and reported achieving its objective of  calculating auction results within 2 hours.
section_title: Treasury Has Adopted a Flexible Contingency Policy for Auction Disruptions
paragraphs: In April 2003, Treasury began discussing options for postponing a  scheduled auction “when the market is operating in a contingency or  extraordinary environment” with dealers. In July of that year, Treasury  presented dealers with a matrix of contingencies and Treasury responses,  shown in table 1.
Treasury gathered feedback from participants and concluded a more  flexible contingency approach would be appropriate. Treasury told us that  some dealers suggested that writing rules for various contingencies may  be too burdensome and that it may be to Treasury’s advantage to remain  discreet on how certain auction fails will be handled. For example, in the  case where one or two dealers have missed the auction, and if the auction  was covered sufficiently, then Treasury may want to complete the auction  without the missing parties. Treasury told us that it needs a flexible  approach because there are an “infinite number of possible situations” to  which it might have to respond, so the best it can do is provide general  guidelines about how it will respond. According to Treasury, the matrix of  Treasury responses to a number of possible contingencies was generally  considered comprehensive and reasonable by the dealers they  interviewed.
The Bond Market Association (TBMA) commended Treasury for  developing the matrix of possible circumstances, but encouraged Treasury  to expand its list of contingencies to include actions Treasury would take  in the face of extraordinary circumstances such as natural disasters,  terrorist attacks, suspension of trading, or a disruption to the clearance  and settlement system. TBMA proposed that Treasury delay and  reschedule an auction in these circumstances, while notifying the market  with a specific date and time if possible or provide this information as  soon as feasible. The association predicted that market participants would  likely support the decision to delay the auction, assuming the securities  were still auctioned and settled by the originally announced issuance date.  TBMA stated that it was unclear what the impact of these circumstances  would be on future auctions.
This discussion process resulted in the following Treasury statement in  February 2004: “Treasury will conduct any announced auction that is  disrupted within an hour of the originally scheduled time and in the event  that circumstances and conditions are such that a one hour postponement  cannot be met, Treasury will communicate information to market  participants as it becomes available.”
section_title: Primary Dealers Have Taken Actions Intended to Increase Their Resilience and Treasury Has Suggested Additional Improvements
paragraphs: All primary dealers have contingency sites. According to Treasury, most  primary dealers have systems that link directly to Treasury’s auction  systems at their contingency sites and have conducted connectivity tests  to ensure they could participate in an auction from their contingency sites  if required. Because of the nature of the financial markets, almost all  primary dealer contingency locations are within the same geographic  region as their primary sites. Treasury periodically visits dealers, and has  suggested improvements in systems and testing for many dealers.  According to 14 dealers with whom we spoke, dealer personnel are cross- trained to bid on and complete auctions for all types of Treasury  securities.
A Treasury official with whom we spoke noted that the nature of financial  markets encourages the close proximity of staff. A professor of economics  has stated, “high density levels are particularly conducive to chance  meetings, regular exchanges of new ideas, and the general flow of  information”  that aid in the rapid access to information that is crucial to  financial markets. This likely helps to explain why almost all primary  dealers’ primary sites are within the same geographic region. All 23  primary dealers also have at least one contingency site for their  operations, generally in the same geographic region as their primary sites,  since most primary dealers plan on relocating their staff from their  primary sites to their contingency sites during a wide-scale disruption.  Treasury expects this migration might take several hours. Treasury also  expects it might have to postpone an auction for a day, depending on the  severity of the disruption, so dealers have enough time to report to their  contingency sites.
According to Treasury officials, 17 primary dealers have added systems at  their contingency sites that directly link with Treasury auction systems  and have successfully tested the connectivity of these systems. Treasury  encouraged dealers to add these systems and offered cost information on  these systems so dealers could more easily consider the systems  implementation. All of the dealers have the ability to submit auction bids  via the Internet or phone at their contingency sites.
Eight dealers have told Treasury that they have participated in live  auctions from their contingency sites, but Treasury told us that its auction  systems do not automatically track whether or not dealers are  participating in auctions from contingency sites. Treasury has encouraged  dealers to conduct live auction tests from their contingency sites and plans  to continue to work with primary dealers to increase their resiliency by  developing test plans for primary dealers to participate in mock auctions.  One dealer expressed reservations about participating in an auction from a  contingency site because it would not want to take bids from traders over  the phone, while another dealer stated that it planned to conduct a mock  auction before participating in a live auction from the contingency site.
Primary dealers we spoke with said they have cross-trained their staff to  participate in auctions of different Treasury securities and told us that  they have sufficient staff trained to participate and provide backup  support. These same dealers estimated about 15 to 20 people per dealer  are involved in the Treasury auction process, including support personnel.  While some dealers indicated that their overseas staff are able to  participate in auctions, other dealers expressed reservations about the  readiness of their overseas staff to bid on auctions. In addition, while some  dealers report having backup personnel for traders and multiple sites, one  reports that backup personnel are in the same location as traders, and  most plan on relocating their staff from primary locations to their  contingency sites during a wide-scale disruption.
section_title: Despite Actions Intended to Increase Auction Resilience, Exploring Funding Alternatives Outside of the Auction Process Is Appropriate
paragraphs: Regardless of the progress of resiliency efforts, the nature, duration, and  effects of any potential future wide-scale disruption are unknown. In  addition, since compensating balances are no longer used, Treasury has at  least one less source of funds to rely upon. Current Treasury officials  stated they had not viewed compensating balances as a cash source  except in extraordinary circumstances such as the September 11 attacks,  and a former Treasury official acknowledged that compensating balances  provided extra flexibility for Treasury. Finally, Treasury’s cash  management policy of maintaining minimal cash balances to lower  borrowing costs further limits Treasury’s access to cash during a wide- scale disruption. The combination of these factors makes it prudent for  Treasury to explore alternative backup funding options to use during a  wide-scale disruption. The relevant parties with whom we spoke, including  primary dealers, agreed.
section_title: Relevant Parties Validated Design Features and a Potential Tiered Approach to Treasury Funding Options Has Emerged from Discussions
paragraphs: These parties also generally agreed that the main design features to be  considered when weighing alternatives for backup funding options are the  situations for use, source of funds, type of collateral, transaction type,  approvals, determination of cost, amount limit, time limit, inclusion under  debt ceiling, disclosure, and length of authority (if required). However, the  specifics would depend on proposed options. For example, some parties  thought that borrowing from the Federal Reserve should require higher  level approval than borrowing from financial institutions.
Discussions with Treasury and Federal Reserve officials and other  relevant parties have led us to conclude that a two-tiered approach could  enhance Treasury’s ability to obtain funds during a wide-scale disruption.  We discussed design features and broad options with relevant parties and  progressively adjusted options based on comments and our own analysis.  The two-tiered approach is suggested as a strategy to be used only when  auctions are not viable based on some sort of wide-scale disruption to the  financial markets that Treasury relies upon, and not as a substitute or  complement to Treasury’s normal auction process when market prices  become expensive, or cash balances are lower than expected. The first tier  consists of two funding options involving a range of appropriate financial  institutions, namely (1) a credit line and (2) a private placement of a CM  bill. The second tier involves a direct draw from the Federal Reserve that  would provide Treasury a last resort source of funds when other options  are not viable. Under this system, Treasury would first seek to use the  credit line and/or the private placement of a CM bill. Then, if and only if  those options are not available or insufficient, would it turn to the Federal  Reserve.
Any system for obtaining cash from financial institutions—whether  through a line of credit or private placement of a CM bill—may, in a crisis,  ultimately depend on the Federal Reserve to provide liquidity to those  institutions. One party suggested the viability of a credit line or a private  placement of a CM bill would likely be enhanced if these options involved  depository institutions that could borrow from the discount window. Most  market participants with whom we spoke preferred a direct draw  authority for the Treasury. Although that might be the most direct route,  we recognize the importance of maintaining the independence of the  central bank. For example, some economists believe that if a central bank  regularly lends money to the government (Treasury), it would lead to an  expansion of the monetary base and inflation and the expectation that the  central bank would lend to the government whenever the government  wants.
The Committee on Banking and Currency also recognized the importance  of central bank independence in the establishment of the Federal Reserve  in 1913. In its report the committee stated, “It can not be too emphatically  stated that the committee regards the Federal reserve board as a distinctly  nonpartisan organization whose functions are to be wholly divorced from  politics. In order, however, to guard absolutely against any suspicion of  political bias or one-sidedness, it has been deemed expedient to provide in  the law against a preponderance of members of one party.”
A tiered approach would recognize independence concerns, offering both  flexibility and protection against the potential for abuse because of its  two-stage structure. The availability of the first tier would provide  Treasury an extra option(s) outside of its normal auction process to obtain  funds making it less likely that Treasury would have to go to the second  tier, the Federal Reserve, as a last resort funding option.
Some relevant parties with whom we spoke noted that consideration of  how any funding option would interact with the debt ceiling is important  to consider given the number of times in recent years Treasury has  operated in an environment under debt ceiling constraints, including debt  issuance suspension periods (DISP). A wide-scale disruption such as  occurred on September 11 could also result in a delay in congressional  action to raise the debt limit. This in turn could worsen any problems in  the government’s ability to finance operations. Given this, some relevant  parties suggested that if a wide-scale disruption occurred when Treasury  was at or near the debt limit, use of any alternative funding option during  such a disruption should be excluded from the debt ceiling. Others argued  that any funding options should be included in the debt ceiling to prevent  having the options become a tool to evade the debt ceiling.
Primary dealers we spoke with stated that if Treasury did postpone an  auction and use any of these funding options, they preferred that Treasury  resume auctions as soon as possible. They also expressed a strong desire  to maintain the originally scheduled settlement date, even if an auction  had to be performed on the settlement date.
In addition, the impact on the Federal Reserve of replacing an auction with  one of these options would have to be considered since the Federal  Reserve places bids to replace its existing securities inventories at many  Treasury auctions. Other options we discussed but were less viable are  summarized in appendix I.
subsections: section_title: Obtain a Line of Credit with Financial Institutions
paragraphs: A credit line would provide Treasury a prior transparent commitment or  understanding with several financial institutions to provide funds to  Treasury during a wide-scale disruption. The financial institutions would  have to have the willingness and capability to lend money to Treasury in  the appropriate amount and time required by Treasury. Treasury could  select the financial institutions through a bidding process or other  procedure on a periodic basis that could help determine and perhaps  lower any required fees or costs that this arrangement would entail.  Canada and France have similar borrowing arrangements with financial  institutions. For example, Canada has a $6 billion (U.S.) standby line of  credit with a syndicate of international banks. Also, according to a French  debt management official, France has credit lines with some primary  dealers on which it could draw during a wide-scale disruption.
Some primary dealers suggested that Treasury seek such a line of credit  with a broad range of financial institutions that could include not only  commercial banks but also institutional mutual funds and others who  could meet Treasury requirements. Another party suggested that  institutional mutual funds may not be practical because these funds  typically obtain cash by selling short-term assets, which might not be  possible in a crisis.
Some parties, including commercial bankers with whom we spoke, stated  providing liquidity to Treasury based on a formal line of credit might  require regular maintenance fees to offset costs associated with the  treatment of regulatory capital for the line of credit under U.S. and  international capital standards. However, since funds would be lent to the  U.S. Treasury, it is unclear if this arrangement would be subject to the  same requirements as guaranteeing credit to other borrowers.
Some commercial banks raised the possibility of a prearranged  understanding with Treasury instead of a formal commitment. Since an  understanding is not a formal commitment, it would not impose costs on  banks, and so might not require any maintenance fees. These commercial  bankers told us that they would very likely lend funds to Treasury because  it is in their financial interest to ensure that Treasury can make its  payments, but that such an understanding would be subject to fulfilling  their own liquidity needs in a time of crisis. As discussed previously, and  given the actions taken during the September 11 attacks, it seems likely  that the Federal Reserve would be available to provide commensurate  liquidity to depository institutions. Federal Reserve officials we spoke  with said that an obligation from Treasury would likely be accepted as  sufficient collateral by a depository institution at the discount window.  Although an understanding could avoid fees, it does not offer the certainty  of a committed line of credit for Treasury’s use.
section_title: Private Placement of a Cash Management Bill
paragraphs: A private placement of a CM bill would involve a prior arrangement to  issue a CM bill after communicating with certain senior executives at  financial institutions who would have the ability and authority to purchase  a CM bill that meets Treasury’s immediate funding needs. The specific  terms of the CM bill, such as amount, yield, settlement date, and maturity,  would be determined at the time of CM bill placement. Similar to the  credit line option, some market participants suggested that Treasury seek  a broad range of financial institutions that could include not only  commercial banks but also institutional mutual funds that could meet  Treasury requirements. The Federal Reserve would again likely provide  liquidity to depository institutions. Since this option involves delivering a  security, clearing and settlement systems would have to be functioning  adequately to complete transactions.
Some parties told us that the market would react positively to accepting a  tradable security like a CM bill because it fits well with their normal  operations and implied that Treasury may benefit from flight-to-quality  behavior in a crisis. Some parties also commented that this option was  appropriately aligned with Treasury’s current operations, since Treasury is  used to issuing CM bills and has auctioned and issued CM bills in 1 day  under normal conditions.
Among a number of policy and operational issues that must be considered  before Treasury could place a cash management bill, Treasury would have  to decide how to set an appropriate price when it executes this  arrangement. During a wide-scale disruption to financial markets, price- discovery—the process that determines an appropriate clearing price at  auction—would likely prove challenging to financial institutions because  of degradation in the financial market.
section_title: Explicitly Authorize a Treasury Draw Authority with the Federal Reserve
paragraphs: In the event that the first tier options involving financial institutions  proved insufficient, turning to the Federal Reserve as a last resort funding  source would require a change in law to allow the Federal Reserve to  directly lend to Treasury. Appropriate limitations, adequate flexibility, and  accountability would have to be included in the design.
As we previously discussed, primary dealers and commercial bankers  generally agreed that this was the most resilient and direct way for  Treasury to ensure it met its obligations. Some Treasury and Federal  Reserve officials we spoke with also confirmed that this method would  likely be technically and operationally easy to implement. In addition,  despite central bank independence concerns discussed previously,  primary dealers and commercial bankers we spoke with stated that they  did not think this arrangement would damage Treasury’s or the Federal  Reserve’s reputation if it is used in a limited way during a wide-scale  disruption.
Although direct lending by a central bank is not without precedent, it is  viewed as a last resort. For example, although the Canadian federal  government has legal authority to borrow directly from the Bank of  Canada—its central bank—this legal authority was last used in the early  1960s and is not expected to be used in the future.
Some parties, including Federal Reserve officials, expressed concerns  about any direct lending arrangement and the potential for abuse of such  authority in the future. They thought a high hurdle would be appropriate  for using this authority. For example, one Federal Reserve official  emphasized that this option should only be considered during a situation  where it was “physically impossible” for Treasury to conduct auctions and  after judgment is reached at suitably high levels in the executive branch  and at the Federal Reserve that other options would not work. Another  Federal Reserve official stated that it is important to clarify that this  option should only be used in a national emergency. Another party  concerned with Treasury oversight commented to us that legislation  should be written “very tightly” to limit this authority to when it is  absolutely required. Some Federal Reserve officials suggested that the  approval for a direct draw should be at a very high level—perhaps the  President of the United States, Secretary of the Treasury, and the  Chairman of the Federal Reserve, and wanted to maintain some veto  power on the draw to preserve the Federal Reserve’s independence.
Federal Reserve officials concerned with central bank independence and  the risks of direct lending stated that any draw from the Federal Reserve  should be at a market price, perhaps even higher to discourage use, even  though they acknowledged that proceeds from a higher price would  eventually be delivered back to Treasury. Some officials suggested that the  Federal Reserve should be able to review the draw arrangement daily to  ensure it did not last longer than necessary. There was broad agreement  among Federal Reserve officials with whom we spoke that the draw  should be reversed as soon as Treasury could hold an auction again and  that any arrangement should be fully transparent and disclosed by  Treasury and the Federal Reserve.
Other parties emphasized the need to maintain some flexibility for  Treasury while protecting central bank independence. An approach that  appears promising would be to require joint approval from the Chairman  of the Federal Reserve and the Secretary of the Treasury. Since a Federal  Reserve Chairman is unlikely to agree to a direct draw unless convinced  that other options are not viable, this would provide sufficient protection  against abuse of this authority. Since the authority is predicated on a wide- scale emergency and disruption, adding presidential approval might  unnecessarily delay necessary actions without adding any additional  protection beyond that provided by requiring agreement of the Chairman  of the Federal Reserve. Both the duration of the draw and the amount  might be established at the time the Secretary and Chairman agree to the  direct draw.
If the authority is to be provided, a decision on how to facilitate  congressional oversight would be necessary. One party concerned with  congressional oversight referred to a “delicate balance” between  Treasury’s need to obtain funding during a wide-scale disruption and  Congress’s need to conduct oversight of debt management. One possibility  would be to require notification of the majority and minority leadership in  both houses of Congress at the time of a draw and report after the use of  this authority in addition to regular reporting requirements. Finally,  legislation developing an authority for a direct draw might require periodic  review and renewal by Congress.
section_title: Conclusion
paragraphs: The combination of minimal cash balances and the elimination of  compensating balances have effectively increased Treasury reliance on the  auction process as a funding source. Treasury, the Federal Reserve, and  primary dealers have taken actions intended to increase the resilience of  the auction process. Regardless of resiliency efforts, the duration and the  effects of a potential future wide-scale disruption are unknown. All these  factors make it prudent to explore other funding options for Treasury to  use during a wide-scale disruption.
Although Treasury, the Federal Reserve, primary dealers, and other  financial institutions might be able to develop some funding mechanism at  the time of a wide-scale disruption, prearranged funding alternatives offer  the advantage of explicit legal approaches with adequate built-in oversight  and disclosure requirements. One approach discussed earlier requires  changes in law. Without having prearranged access to additional funding  sources and methods outside of the normal auction process, Treasury is  missing an opportunity to strengthen its ability to obtain funds—and  ultimately meet payment obligations—during a wide-scale disruption to  the financial markets it relies upon. A tiered system that involves a range  of private sector financial institutions as a first tier and the Federal  Reserve as a second tier would expand Treasury’s access to cash and  would enhance its ability to obtain necessary funds during a major, wide- scale disruption while limiting the potential for abuse.
section_title: Recommendations for Executive Action
paragraphs: We recommend that the Secretary of the Treasury examine in detail the  implementation requirements for establishing a line of credit and a private  placement of a CM bill with a range of appropriate private sector financial  institutions, select the most appropriate option(s), and take steps to put  required frameworks into place for use during a wide-scale disruption.  Implementation details to be considered for both options include  determining the design features discussed earlier, including situations or  criteria for use, how to determine the appropriate financial institutions to  rely upon, and the amount needed. For the private placement of a CM bill,  the cost or price determination method would have to be analyzed since  price discovery may not be possible in a significantly degraded financial  market. For a credit line, ways to reduce the cost of an understanding or a  guarantee of credit would have to be explored, such as a prearranged  proposal process that determines the fees (if any) and terms of the  transaction. As Treasury explores these options, it should consider how  other countries have implemented alternative funding options to obtain  any useful insights on its design, recognizing that the U.S. Treasury market  has a unique role as the largest and most active debt market in the world.
section_title: Matters for Congressional Consideration
paragraphs: Congress should consider providing the Federal Reserve the explicit  authority to lend directly to Treasury as a last resort when other options  are not viable during a wide-scale disruption. Developing a direct draw  authority would require careful consideration and determination of design  features and any other requirements to support Treasury’s need for an  effective funding source, the Federal Reserve’s independence, and  congressional oversight and accountability concerns. An approach that  appears promising would be to require that both the Secretary of the  Treasury and Chairman of the Federal Reserve approve any draw and  agree on specific amounts and duration at the time of any draw. This might  balance independence and accountability concerns with the need for  sufficiently prompt action and flexibility.
section_title: Agency Comments
paragraphs: We requested comments on a draft of this report from the Secretary of the  Treasury and the Chairman of the Board of Governors of the Federal  Reserve System. The agencies’ letters are reprinted in appendix III and  appendix IV, respectively. Both Treasury and the Federal Reserve noted  that they had taken steps to increase their resiliency in recent years but  agreed that Treasury should examine the first-tier funding options  described in this report. Although neither took a position on our  suggestion that Congress should consider permitting the Federal Reserve  to lend directly to the Treasury, both emphasized the importance of  maintaining the independence of the central bank. For example, Treasury  stated that it, “is generally opposed to arrangements in which  governments, at their discretion, can borrow directly from their central  bank as such arrangements compromise the independence of the central  bank.” Treasury and the Federal Reserve suggested that any legislation  that would provide the Federal Reserve the authority to lend directly to  the Treasury should be very carefully and tightly drawn to preserve the  independence of the central bank. As our report notes, we also recognize  the importance of maintaining the independence of the central bank and  suggest an explicit, carefully crafted, last resort authority and approach  that we believe provides both flexibility and reduces the vulnerability to  abuse. Indeed, part of the rationale for a two-tiered approach is to reduce  the chances that the Treasury would ever need to turn to the Federal  Reserve. Both Treasury and Federal Reserve Board staff also provided  technical comments, which we incorporated as appropriate.
We are sending copies of this report to the Ranking Minority Member of  the House Committee on Ways and Means, the Chairs and Ranking  Minority Members of the House Committee on Financial Services, the  Senate Committee on Finance, the Senate Committee on Banking, Housing  and Urban Affairs, the Secretary of the Treasury, the Chairman of the  Board of Governors of the Federal Reserve System, and other interested  parties. We will also make copies available to others upon request. In  addition, the report will be available at no charge on GAO’s Web site at  http://www.gao.gov.
If you or your staff have any questions about this report please contact  Susan J. Irving at (202) 512-9142 or irvings@gao.gov. Contact points for  our Offices of Congressional Relations and Public Affairs may be found on  the last page of this report. GAO staff making key contributions to this  report are listed in appendix V.
section_title: Appendix I: Cost and Complexity Rule Out Other Options That Were Discussed
subsections: section_title: Holding Additional Cash Balances Would Not Be Cost Efficient
paragraphs: Although holding excess cash balances would supply the Department of  the Treasury with an extra source of funds to draw from in an emergency,  it is generally more cost-efficient to repay debt than run higher cash  balances because the interest earned on excess cash balances is generally  insufficient to cover borrowing costs. As we previously reported, because  of this negative funding spread, Treasury has placed increased emphasis  on minimizing cash balances to reduce overall borrowing cost. Treasury’s  current cash balance target is $5 billion, which represents the amount to  be held at the Federal Reserve. Treasury invests excess cash above the $5  billion target in Treasury Tax and Loan (TT&L) accounts, the Term  Investment Option (TIO) program, and Repurchase Agreement (Repo)  pilot program. TT&L accounts are held at financial institutions and earn  interest rates equal to the federal funds rate less 25 basis points, a rate set  in 1978 originally intended to reflect the rate paid on overnight repurchase  (repo) agreements—a short-term collateralized loan used by dealers in  government securities. The rate earned on TT&L accounts is generally  less than the average rate Treasury pays on CM and other regular short- term bills. The TIO program was introduced in 2002 to add investment  capacity to the TT&L program and to increase the rate that Treasury earns  on invested funds. The Repo program is a pilot program that allows  Treasury to place a portion of its excess operating funds with TT&L  depositories through a repo transaction for a set period of time at an  agreed upon rate of interest. Treasury told us that it now places over 70  percent of its cash balances through the TIO and Repo program. Treasury  officials with whom we spoke acknowledged that holding additional cash  balances would not be a viable option because of the negative funding  spread.
section_title: Foreign Central Banks Add Complexity to Obtaining Funds
paragraphs: Treasury and Federal Reserve officials we spoke with agreed that  borrowing from foreign central banks may require some sort of currency  conversion, unless the banks had adequate funds in dollars. The currency  conversion would presumably have to occur on a very short-term and  possibly same day basis. If the foreign central banks did not have adequate  dollar-based liquidity, they may have to rely on the Federal Reserve to  provide them with liquidity. As discussed previously, the Federal Reserve  conducted currency swaps with some foreign central banks to help them  fulfill their dollar-denominated obligations. Treasury officials we spoke  with acknowledged that although this type of arrangement is possible, it is  less promising because of the transactions and currency conversions that  would likely be required. In addition, Treasury told us that although most  large foreign banks operating in the U.S. have access to the discount  window, Treasury would not advocate relying upon these banks for  emergency funding.
section_title: Appendix II: Background on Previous Treasury Draw Authorities
paragraphs: In the past, Treasury had access to both a cash and securities draw  authority. Intermittently between 1942 and 1981, Treasury was able to  directly sell (and purchase) certain short-term obligations to (and from)  the Federal Reserve in exchange for cash. Congress first granted this cash  draw authority temporarily in 1942, allowed it to lapse several times, and  extended it 22 times until 1979, when it modified some of the terms and  added controls. In 1979, Congress also authorized a securities draw  authority, which permitted Treasury to borrow securities from the Federal  Reserve, sell them, and then repurchase the securities in the open market  and return the securities to the Federal Reserve within a specified period.  The securities draw authority was never used.
After Congress authorized Treasury to earn interest on its Treasury Tax &  Loan (TT&L) account balances in 1977,,  Congress allowed both draw  authorities to expire in 1981. In a 1979 proceeding, one Member of  Congress said that after World War II, the cash draw authority allowed  Treasury to carry lower cash balances. According to another Member,  since TT&L accounts earned interest, there was no reason for Treasury not  to “keep plenty of cash on hand” thereby reducing the need for a draw  authority, although the interest that Treasury earned on these accounts  was .25 percentage points below the federal funds rate. Current Treasury  officials to whom we spoke said that they did not know if the passage of  legislation allowing Treasury to earn interest on its TT&L accounts led  Congress to allow both draw authorities to expire. Table 2 summarizes the  key design features of Treasury’s draw authorities in 1979. A somewhat  fuller discussion of each feature follows.
subsections: section_title: Situations When Treasury Used Previous Draw Authorities
paragraphs: The Treasury Draw Policy, as amended in 1979 (hereafter, amended  Treasury Draw Policy) stated that Treasury could use the cash draw  authority in only “unusual and exigent circumstances.” In 1979, both  Federal Reserve and Treasury officials supported the extension of the cash  draw authority for emergencies. A Treasury Assistant Secretary said that  Treasury might not have sufficient time to raise funds through the  securities draw authority and that the cash draw authority provided  Treasury with immediate funds to meet unforeseen developments,  especially if these developments transpired late in the trading day. A  Federal Reserve Board Governor testified that the cash draw authority  functioned well in the past and that Treasury needed this authority to  obtain immediate funds when securities markets might be in “general  disarray” based on a national emergency. Members of Congress said a  number of times that they intended Treasury to use the cash draw  authority only in certain situations, such as when military attacks disrupt  or close markets. One Member cited examples beyond wartime when the  use of the cash draw authority might be appropriate, such as grave health  and well-being emergencies or nuclear accidents.
Treasury used previous cash draw authorities infrequently. Between 1942  and 1981, the Federal Reserve held special short-term certificates  purchased directly from the Treasury on 228 days. In the years Treasury  used this authority, it borrowed on average about 11 days per year. Use of  this authority was concentrated mostly in times of war or armed conflict,  as seen in figure 4. The most Treasury borrowed on a single day  throughout the period was $2.6 billion in 1979.
In the years Treasury used the cash draw authority, it most often used it  surrounding tax payment dates in March, June, and September and to a  lesser extent in January, April, October, and December, as seen in figure  5. In other months, Treasury used this authority for less than 10 days total  per month. According to a 1979 testimony by a Federal Reserve Governor,  Treasury had used the authority in earlier years to offset cash drains just  before funds became available from quarterly income tax payments. He  went on to explain that Treasury used the cash draw authority less in  recent years since it relied more often on cash management bills to “cover  low points in its cash balance” prior to tax payment dates. In that same  proceeding, an Assistant Secretary of the Treasury credited the access to  short-term funds, specifically weekly bills and cash management bills, with  reduced use of the cash draw authority after 1975.
After 1979, the cash draw authority was only to be used in emergencies,  while the securities draw authority could be used “in more routine  circumstances.” However, we did not find any evidence that Treasury  used the securities draw authority between 1979 and its expiration in 1981.  One Member of Congress described how the securities draw authority  could be used when Treasury did not have the time to “prepare and  market” a new security issue quickly enough to meet short-term cash  needs. He reasoned that since Treasury would borrow “seasoned  securities” from the Federal Reserve —existing securities in the Federal  Reserve’s portfolio—that Treasury would be able to sell them quickly  enough to meet cash needs. A committee report also stated that the  requirement for Treasury to repurchase securities in the open market  would subject Treasury to market discipline.
section_title: Source of Funding
paragraphs: The source of funds for the cash draw authority was the Federal Reserve,  while the source of funds for the securities draw authority was the  financial market. As shown in figure 6, when using the cash draw  authority, Treasury sold special short-term certificates directly to the  Federal Reserve in exchange for cash from the Federal Reserve. The  amended Treasury Draw Policy also specified that Treasury could borrow  obligations (securities) from the Federal Reserve and sell them in the open  market (in exchange for cash) to meet short-term cash needs, as shown in  figure 6.
section_title: Collateral Used
paragraphs: The cash draw authority did not require any specific collateral beyond the  special short-term Treasury certificates that the Federal Reserve  purchased from Treasury. The securities draw authority also did not  require any collateral.
section_title: Type of Financial Transaction
paragraphs: The cash draw authority and securities draw authority represented  different transactions. As shown in figure 6, the cash draw authority  directly involved only the Federal Reserve and Treasury, while the  securities draw authority involved the Federal Reserve, Treasury, and the  financial market.
In 1979, members of Congress and Treasury officials discussed how these  transactions might affect monetary policy. For example, a number of  members saw the cash draw authority as a way to monetize the debt and  in effect print new money, thereby complicating monetary policy. In a  letter to Congress, Treasury wrote that the cash draw authority did not  create problems for monetary policy since the Federal Reserve could  offset Treasury borrowings through its open market operations, thus  having the same net effect as if Treasury borrowed from the market  instead of the Federal Reserve.
section_title: Approvals on Use of Draw Authority
paragraphs: According to the amended Treasury Draw Policy, at least five members of  the Board of Governors of the Federal Reserve System had to approve  purchases and sales of bonds, notes, or other obligations to the United  States (Treasury) by the Federal Reserve. The act also specified that the  securities draw authority was subject to the approval, rules, and  regulations of the Federal Open Market Committee.
section_title: The Cost of the Draw Authorities
paragraphs: The cost that Treasury paid to use the draw authorities was implied in the  interest rate that the Federal Reserve charged or the market value of the  securities that Treasury repurchased. The interest rate Treasury paid to  use the cash draw authority changed between 1942 and 1981. The Federal  Reserve reported that Treasury paid a fixed .25 percent interest rate on the  amount borrowed when it used this authority through December 3, 1957;  after December 3, 1957, and through the expiration of this authority it paid  a rate set at .25 percent below the prevailing discount rate of the Federal  Reserve Bank of New York. Although a memorandum of understanding  between the Federal Reserve and Treasury was not readily available and  may not have existed, according to one Member of Congress the interest  rate for the cash draw authority was “arbitrarily” set by negotiations  between Treasury and the Federal Reserve.
In contrast, legislative history shows some members intended to subject  Treasury to “market discipline” when it used the securities draw authority.
During discussions in 1979, to describe market discipline, one member  offered a scenario in which Treasury would repurchase securities at a  slightly higher price than it paid for them—since the securities would be  closer to maturity—and that this price differential reflected a fair market  interest rate on Treasury’s borrowing. A Federal Reserve Governor noted  that Treasury could pay a substantial premium for selling securities it  borrowed from the Federal Reserve late in the day because the action  would probably take market participants by surprise. He went on to say  that if markets were unsettled Treasury may not be able to sell all of the  securities it needed.
section_title: Amount and Time Limits for Use of Draw Authorities
paragraphs: Congress limited the amount and time that Treasury could use the cash  draw authority. The amended Treasury Draw Policy stated that the  aggregate amount of obligations acquired (at any one time by the 12  Federal Reserve banks) directly from the United States (Treasury) could  not exceed $5 billion. In addition, the act specified that Treasury could  use the cash draw authority for renewable periods not to exceed 30 days.
Congress limited the amount of time that Treasury could use the securities  draw authority but did not limit the amount of securities Treasury could  borrow. The amended Treasury Draw Policy required Treasury to  repurchase obligations (securities) no later than 6 months after the date of  sale and return these securities to the Federal Reserve.
section_title: The Inclusion of Draw Authorities in the Debt Ceiling
paragraphs: The use of the cash and securities draw authorities was not expressly  excluded from the debt subject to limit.
section_title: Disclosure of the Use of the Draw Authorities
paragraphs: Congress specified reporting requirements for the cash draw authority but  not for the securities draw authority. The amended Treasury Draw Policy  required the Board of Governors of the Federal Reserve System to include  detailed information about use of the cash draw authority in its annual  report to Congress. In addition, a Treasury Assistant Secretary testified in  1979 that any previous use of the cash draw authority was reported in the  daily Treasury statement of cash and debt operations and in the weekly  Federal Reserve statement.
section_title: Expiration of Draw Authorities
paragraphs: The amended Treasury Draw Policy established the cash and securities  draw authority for 2 years. In 1979, members of Congress deliberated  over how long to extend the authorities, some advocating 1 year, while  others advocated 2 or 5 years. Those who advocated shorter periods  wanted to give Congress a chance to evaluate the authorities’ use and  make modifications, if necessary, prior to a 5-year period. After the  expiration of the authorities, the Federal Reserve was and still is limited to  purchasing and selling obligations of the United States only in the open  market.
section_title: Appendix III: Comments from the Department of the Treasury
section_title: Appendix IV: Comments from the Board of Governors of the Federal Reserve System
section_title: Appendix V: GAO Contact and Staff Acknowledgments
subsections: section_title: Acknowledgments
paragraphs: In addition to the contact named above, Jose Oyola (Assistant Director),  Julie Atkins, Richard Cambosos, Dean Carpenter, Abe Dymond, Cody  Goebel, Thomas McCabe, James McDermott, Naved Qureshi, Keith Slade,  and Dawn Simpson made significant contributions to this report.