Debt Ceiling: Analysis of Actions Taken During the 2003 Debt Issuance Suspension Period
Published: 2004-05-20T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: GAO is required to review the steps taken by the Department of the Treasury (Treasury) to avoid exceeding the debt ceiling during the 2003 debt issuance suspension period. The committee also directed GAO to determine whether all major accounts that were used for debt ceiling relief have been properly credited or reimbursed. Accordingly, GAO determined whether Treasury followed its normal investment and redemption policies and procedures for the major federal government accounts with investment authority, analyzed the financial aspects of actions Treasury took during this period, and analyzed the impact of policies and procedures Treasury used to manage the debt during the period.
section_title: What GAO Found
paragraphs: On February 20, 2003, Treasury determined that a debt issuance suspension period was in effect. A debt issuance suspension period is any period for which the Secretary of the Treasury has determined that obligations of the United States may not be issued without exceeding the debt ceiling. During this period, which lasted until May 27, 2003, the Secretary took actions related to the Government Securities Investment Fund of the Federal Employees' Retirement System (the G-Fund), the Civil Service Retirement and Disability Fund (the Civil Service fund), and the Exchange Stabilization Fund (ESF) to avoid exceeding the debt ceiling. Also, during fiscal year 2003, the Secretary initiated several actions involving the Civil Service Fund, FFB, and the Treasury general fund that related to Treasury's efforts to manage the amount of debt subject to the debt ceiling. The Secretary took other actions to avoid exceeding the debt ceiling, such as suspending the sales of State and Local Government Series Treasury obligations and recalling noninterest- bearing deposits held by commercial banks as compensation for banking services provided to Treasury. The actions taken, which were consistent with legal authorities provided to the Secretary and related to the G-Fund, the Civil Service fund, and ESF, initially resulted in interest losses to the G-Fund and ESF and principal and interest losses to the Civil Service fund. When the debt ceiling was increased to $7.4 trillion on May 27, 2003, the Secretary fully invested the G-Fund's investments and on May 28, 2003, fully restored the interest losses, as required by law. On June 30, 2003, the Secretary fully compensated the Civil Service fund for principal and interest losses, as required by law. The losses related to ESF could not be restored without special legislation. As a result, related ESF losses of $3.6 million were not restored. The actions initiated by Treasury in fiscal year 2003 that involved the early redemption of FFB debt obligations held by the Civil Service fund and exchanges of obligations among the Civil Service fund, FFB, and the Treasury general fund resulted in all three parties realizing gains or incurring losses. In some cases, GAO has been able to quantify the gains or losses that occurred as a result of these transactions. For example, according to FFB estimates, the Civil Service fund lost more than $1 billion in interest because of FFB's redemption of FFB obligations held by the Civil Service fund before their maturity date and unforeseen interest rate changes. In other cases, however, information needed to understand the potential consequences of these actions will not be available for a number of years. The Secretary currently lacks the statutory authority to restore such losses and has not developed documented policies and procedures that can be used to minimize such losses in future actions that may be taken by Treasury that involve FFB and an account with investment authority such as the Civil Service fund.

section_title: Letter
paragraphs: Historically, the Congress and the President have enacted laws to establish  a limit on the amount of public debt that can be outstanding (debt ceiling).  On various occasions over the years, normal government financing has  been disrupted because the Department of the Treasury (Treasury) had  borrowed up to, or near, the debt ceiling and legislation to increase the debt  ceiling had not been enacted. On February 20, 2003, Treasury determined  that a debt issuance suspension period was in effect. A debt issuance  suspension period is any period for which the Secretary of the Treasury has  determined that obligations of the United States may not be issued without  exceeding the debt ceiling. This debt issuance suspension period lasted  until May 27, 2003, when the Congress and the President raised the debt  ceiling to the current $7.4 trillion. During the 2003 debt issuance  suspension period, Treasury took several actions to raise funds to meet  federal obligations without exceeding the debt ceiling.
We are required to review the steps taken by Treasury to avoid exceeding  the debt ceiling and to determine whether all major accounts that were  used for debt ceiling relief have been properly credited or reimbursed.  Accordingly, we (1) developed a chronology of significant events,   (2) determined whether Treasury followed its normal investment and  redemption policies and procedures for the major federal government  accounts with investment authority, (3) analyzed the financial aspects of  actions Treasury took during the debt issuance suspension period and  assessed the legal basis of these actions, and (4) analyzed the impact of the  policies and procedures Treasury used to manage the debt during the debt  issuance suspension period. This report presents the results of our review  of the actions taken and the policies and procedures Treasury implemented  during the 2003 debt issuance suspension period.
subsections: section_title: Background
paragraphs: The federal government began with a debt of about $75 million in 1790. In  February 1941, the Congress and the President enacted a law that set an  overall limit of $65 billion on Treasury debt obligations that could be  outstanding at any one time. The law was amended to raise the debt ceiling  several times between February 1941 and June 1946. The ceiling  established in June 1946, $275 billion, remained in effect until August 1954.  At that time, the first temporary debt ceiling was enacted, which added   $6 billion to the $275 billion permanent ceiling.
The Congress and the President have enacted numerous temporary and  permanent increases in the debt ceiling. As shown in figure 1, the amount  of outstanding debt subject to the debt ceiling has increased from   $1.6 trillion on September 30, 1984, to $6.7 trillion on September 30, 2003.
The total amount of debt subject to the debt ceiling as of January 31, 2003,  the month before Treasury entered into the 2003 debt issuance suspension  period, was about $6.4 trillion. About 44 percent, or $2.8 trillion, was held  by federal government accounts with investment authority, such as the  Social Security trust funds, the Civil Service Retirement and Disability Trust Fund (Civil Service fund), the Exchange Stabilization Fund (ESF),  and the Government Securities Investment Fund of the Federal Employees’  Retirement System (G-Fund). The remaining $3.6 trillion represents  marketable and nonmarketable obligations held by the public.
The Secretary of the Treasury has several responsibilities related to the  federal government’s financial management operations, including paying  the government’s obligations and investing receipts of federal government  accounts with investment authority not needed for current benefits and  expenses. To meet these responsibilities, the Secretary of the Treasury is  authorized by law to issue the necessary obligations to federal government  accounts with investment authority for investment purposes and to borrow  the necessary funds from the public to pay government obligations.
Under normal circumstances, the debt ceiling is not an impediment to  carrying out these responsibilities. Treasury is notified by the appropriate  agency (such as the Office of Personnel Management for the Civil Service  fund) of the amount that should be invested (or reinvested), and Treasury  makes the investment. In some cases, the agency may also specify the  obligation that Treasury should purchase. The Treasury obligations issued  to federal government accounts with investment authority count against  the debt ceiling. If these accounts’ receipts are not invested, the amount of  debt subject to the debt ceiling does not increase.
We have previously reported on aspects of Treasury’s actions during the  2002 debt issuance suspension period and the 1995/1996 and other debt  ceiling crises (see Related GAO Products).
subsections: section_title: Statutory Authorities Specifically Enacted to Help Treasury Avoid Exceeding the Debt Ceiling
paragraphs: When Treasury is unable to borrow because the debt ceiling has been  reached, the Secretary of the Treasury is unable to fully discharge his  financial management responsibilities using normal methods. In 1985, the  federal government experienced a debt ceiling crisis from September 3  through December 11. During that period, Treasury took several actions  that were similar to those discussed later in this report. For example,  Treasury redeemed Treasury obligations held by the Civil Service fund  earlier than normal in order to borrow sufficient cash from the public to  meet the fund’s benefit payments and did not invest some of the fund’s  receipts. In 1986 and 1987, after Treasury’s experiences during prior debt  ceiling crises, the Congress enacted several authorities authorizing the  Secretary of the Treasury to use the Civil Service fund and the G-Fund to  help Treasury manage its financial operations during a debt ceiling crisis.  Those authorities, which Treasury used during the 2003 debt issuance  suspension period, addressed (1) redemption of Civil Service fund  obligations, (2) suspension of Civil Service fund investments, and   (3) suspension of G-Fund investments. 1. Redemption of obligations held by the Civil Service fund. Subsection  8348(k) of title 5, United States Code, authorizes the Secretary of the  Treasury to redeem obligations or other invested assets of the Civil  Service fund before maturity to prevent the amount of public debt from  exceeding the debt ceiling. The Secretary of the Treasury must  determine that a debt issuance suspension period exists in order to  redeem Civil Service fund obligations early. The statute authorizing the  debt issuance suspension period and its legislative history are silent as  to how the Secretary of the Treasury should determine the length of a  debt issuance suspension period.  2. Suspension of Civil Service fund investments. Subsection 8348(j) of  title 5, United States Code, authorizes the Secretary of the Treasury to  suspend additional investment of amounts in the Civil Service fund if  the investment cannot be made without causing the amount of public debt to exceed the debt ceiling. Subsection (j) also authorizes the  Secretary of the Treasury to make the Civil Service fund whole after the  debt issuance suspension period has ended. 3. Suspension of G-Fund investments. Subsection 8438(g) of title 5,  United States Code, authorizes the Secretary of the Treasury to suspend  the issuance of additional amounts of obligations of the United States  to the G-Fund if issuance cannot occur without causing the amount of  public debt to exceed the debt ceiling. Subsection (g) also authorizes  the Secretary of the Treasury to make the G-Fund whole after the debt  issuance suspension period has ended.
section_title: Other Authorities Relied on by Treasury to Avoid Exceeding the Debt Ceiling
paragraphs: During the 2003 debt issuance suspension period, Treasury relied upon  authorities in addition to those mentioned above to help manage the  amount of debt subject to the debt ceiling. Treasury has also relied on these  other authorities during prior periods when it needed to take special  actions to avoid exceeding the debt ceiling.
subsections: section_title: Suspension of ESF Investments
paragraphs: Section 5302 of title 31, United States Code, authorizes the Secretary of the  Treasury to determine when and if excess funds for ESF will be invested.  During previous debt ceiling difficulties, Treasury used this authority to  suspend reinvestment of maturing ESF investments to ensure that the debt  ceiling was not exceeded.
section_title: FFB 9(a) Obligations Exchanged with the Civil Service Fund
paragraphs: In addition to obligations issued under subsection 8348(d) of title 5, United  States Code, other obligations are lawful investments by the Civil Service  fund. For example, subsection 8348(e) of title 5, United States Code,  authorizes the Secretary of the Treasury to invest surplus Civil Service  funds in other interest-bearing obligations of the United States or  obligations guaranteed as to both principal and interest by the United  States, if the Secretary of the Treasury determines that the purchases are in  the public interest. Further, obligations issued by other agencies, such as the Tennessee Valley Authority, the United States Postal Service, and the  Federal Financing Bank (FFB), are lawful investments for all fiduciary,  trust, and public funds whose investments are under the control of the  United States, and such obligations are suitable investments for the Civil  Service Fund. Treasury relied on such authorities during the 1985 and  1995/1996 debt ceiling crises to exchange obligations issued (commonly  referred to as FFB 9(a) obligations) or held by FFB that were not subject  to the debt ceiling for Treasury obligations held by the Civil Service fund  that were subject to the debt ceiling.
section_title: Other Special Authorities
paragraphs: In addition to the authorities previously discussed, Treasury has on  occasion received special authorities that pertained to specific situations.  These special authorities are discussed in our report on the 1995/1996 debt  ceiling crisis.
section_title: Impact of Gains and Losses on Accounts with Investment Authority
paragraphs: Gains and losses associated with federal government accounts with  investment authority and Treasury’s general fund can occur for a variety of reasons. For example, (1) the type of obligation held may be more  susceptible to changes in interest rates and (2) the procedures used to  make adjustments can have significant consequences for an account’s  earnings. Whether these gains and losses affect an account’s recipients  depends on whether the fund balance is used to determine recipients’  benefits. One example where the fund balance has a direct impact on  participants is the G-Fund. Specifically, G-Fund earnings are directly  related to the amount that G-Fund participants will receive when they  redeem their investments. On the other hand, the fund balance in the Civil  Service fund does not affect the ultimate payments that retirees and their  surviving dependents will receive because the payments will be made from  the Treasury general fund even if the Civil Service fund’s assets are fully  liquidated. Appendix I provides additional information on how gains and  losses may occur in accounts with investment authority.
section_title: Objectives, Scope, and Methodology
paragraphs: develop a chronology of significant events related to the 2003 debt   evaluate the actions taken during the 2003 debt issuance suspension  period in relation to the normal policies and procedures Treasury uses  for investments and redemptions for major federal government  accounts with investment authority,   analyze the financial aspects of Treasury’s actions taken during the 2003  debt issuance suspension period and assess the legal basis of these  actions, and  analyze the impact of the policies and procedures Treasury used to  manage the debt during the 2003 debt issuance suspension period.
To develop a chronology of the significant events related to the 2003 debt  issuance suspension period, we obtained and reviewed applicable  documents. We also discussed Treasury’s actions during the debt issuance  suspension period with senior Treasury officials.
To evaluate the actions taken during the 2003 debt issuance suspension  period in relation to the normal policies and procedures Treasury uses for  certain federal government accounts with investment authority, we  obtained an overview of the policies and procedures used and reviewed  selected investment and redemption activity to determine whether those  transactions were processed in accordance with Treasury’s normal policies  and procedures. Over 200 different federal government accounts with  investment authority hold Treasury obligations, and Treasury officials  stated that normal investment and redemption policies and procedures  were used for all but 3 of these accounts.
From the federal government accounts with investment authority for which  Treasury used its normal investment and redemption policies and  procedures, we selected for review accounts with (1) investments in  Treasury obligations that exceeded $10 billion on January 31, 2003 (17  accounts), or (2) recurring investment or redemption transactions of  $1 billion or more from February through May 2003 (8 accounts). For 18 of  these 25 accounts, we reviewed selected investment and redemption  transactions from February through May 2003. For the remaining 7  accounts, which are managed by the Bureau of the Public Debt, we  reviewed all investment and redemption transactions from February  through May 2003 except those related to 1 account. For this account, we  reviewed all investment and redemption transactions that exceeded   $250 million.
The 25 selected federal government accounts with investment authority  accounted for about 77 percent, or about $2.1 trillion, of the $2.8 trillion in  Treasury obligations held by federal government accounts with investment  authority on January 31, 2003. For all 25 selected accounts in our review,  we confirmed with personnel from the respective agencies the total  amount of investment and redemption activity reported by Treasury from  February 1, 2003, through May 31, 2003. In any case where normal  investment and redemption policies and procedures were not followed, we  obtained documentation and other information to help us understand the  basis for and impact of the alternative policies and procedures that were  used.
To analyze the financial aspects of Treasury’s actions that departed from  normal investment and redemption policies and procedures, we   (1) reviewed the methodologies Treasury developed to minimize the impact  of such departures on the G-Fund, ESF, and the Civil Service fund;   (2) quantified the impact of the departures; (3) assessed whether any  principal and interest losses were fully restored; and (4) assessed whether  any losses were incurred that could not be restored under Treasury’s  current statutory authority.
To assess the legal basis for Treasury’s departures from its normal policies  and procedures, we identified the applicable legal authorities and  determined how Treasury applied them during the 2003 debt issuance  suspension period. Our evaluation included authorities related to issuing  and redeeming Treasury obligations during a debt issuance suspension  period and restoring losses after such a period has ended.
To analyze the impact of the policies and procedures used by Treasury to  manage the debt during a debt issuance suspension period, we reviewed  the actions taken and the Treasury policies and procedures used during the  2003 debt issuance suspension period. To determine the stated policies and  procedures used that related to the Civil Service fund and FFB exchange  transactions, we discussed with Treasury officials the actions taken during  this period and examined the support for these actions. We also compiled  and analyzed source documents relating to previous debt issuance  suspension periods, including executive branch legal opinions,  memorandums, and correspondence.
We performed our work from February 2003 through March 2004, in  accordance with U.S. generally accepted government auditing standards.  We requested comments on a draft of this report from the Secretary of the  Treasury or his designee. The written response from Treasury’s Under  Secretary for Domestic Finance is reprinted in appendix V.
section_title: Chronology of Events
paragraphs: In June 2002, the debt ceiling was raised to $6.4 trillion. In December 2002,  Treasury concluded that this amount might be reached in the latter half of  February 2003. Table 1 shows the significant actions the Congress and the  executive branch took from June 28, 2002, through June 30, 2003, that  relate to the debt ceiling.
section_title: Normal Investment and Redemption Policies Used on Major Federal Government Accounts with Investment Authority
paragraphs: Federal government accounts with investment authority that are  authorized to invest their receipts, such as the Civil Service fund, the   G-Fund, the Social Security funds, and the Federal Employee Health  Benefits Fund, are generally authorized or required to invest them in  nonmarketable Treasury obligations. Under normal conditions, Treasury is  notified by the appropriate agency of the amount that should be invested or  reinvested on its behalf, and Treasury then makes the investment. In some  cases, the actual obligation that Treasury should purchase is also specified.  When a federal government account with investment authority needs to  pay benefits and expenses, Treasury is normally notified of the amount and  the date that the disbursement is to be made. Depending on the account,  Treasury may also be notified to redeem specific obligations. Based on this  information, Treasury redeems an account’s obligations.
Our analysis of the 25 major federal government accounts with investment  authority for which Treasury stated it had followed its normal investment  and redemption policies and procedures during the 2003 debt issuance  suspension period showed that for all but 1 account—the Highway Trust  Fund—Treasury used its normal investment and redemption policies and  procedures to handle receipts and maturing investments and to redeem  Treasury obligations. Table 2 lists the federal government accounts with  investment authority included in our analysis.
On February 27, 2003, Treasury redeemed about $343 million of Highway  Trust Fund obligations in error. In March 2003, during its normal  reconciliation processes, Treasury identified this error. Although normally  such errors are corrected by investing the funds redeemed in error on the  date the error is detected, Treasury did not do so. Rather, it decided to hold  the excess funds in an uninvested funds account until they were needed to  pay Highway Trust Fund expenses. The funds were used to pay the fund’s  expenses through March 24, 2003. According to Treasury officials, the  primary reasons for not making the necessary reinvestment transaction on  the date the error was detected and validated were that (1) the Highway  Trust Fund does not earn interest on its investments and (2) the time  necessary to identify the error and fully understand its impact meant that  very little time actually elapsed when the funds could have been invested.  Therefore, the Highway Trust Fund was not harmed by Treasury’s decision  to not invest the funds. However, Treasury officials subsequently agreed  that the over-redemption should have been reinvested on the day the error  was detected and adequate information was available to understand the  amount that should have been invested, regardless of whether the Highway  Trust Fund earns interest on its investments. Holding the excess funds in  an uninvested funds account reduced the amount of debt subject to the  debt ceiling by no more than $343 million for 26 days during the 2003 debt  issuance suspension period.
To determine whether Treasury would have exceeded the debt ceiling if it  had not committed this error or had reinvested the over-redeemed amount  of funds when the error was discovered, we reviewed the invested balances  in the G-Fund during this period. As noted elsewhere in this report,  Treasury used the G-Fund during the 2003 debt issuance suspension period  to ensure that the investment activities associated with federal government  accounts with investment authority, such as the Highway Trust Fund, do  not cause Treasury to exceed the debt ceiling. Based on our review, we  found that the debt ceiling would not have been exceeded even if Treasury  had not made the original error or had invested these funds when the error  was detected, since other policies and procedures would have ensured a  corresponding reduction in the amount of funds invested on behalf of the  G-Fund. For example, on February 27, 2003, the computation Treasury used  to determine the amount that should be invested in the G-Fund showed that  Treasury could invest about $22.9 billion of G-Fund receipts. If the Highway  Trust Fund error had not been made, this computation would have shown  that Treasury could have invested about $22.6 billion in the G-Fund, or  about $0.3 billion less than what was actually invested. Therefore, the  amount of debt subject to the debt ceiling would have remained unchanged  from its reported $6.4 trillion level.
section_title: Actions Related to the G-Fund
paragraphs: Subsection 8438(g)(1) of title 5, United States Code, authorizes the  Secretary of the Treasury to suspend the issuance of additional amounts of  obligations of the United States to the G-Fund if the issuance cannot be  made without causing the amount of public debt to exceed the debt ceiling.  Each day from February 20, 2003, to May 27, 2003, Treasury determined the  amount of funds that the G-Fund would be allowed to invest in Treasury  obligations and, when necessary, suspended some investments and  reinvestments of the G-Fund receipts and maturing obligations that would  have caused the debt ceiling to be exceeded.
On February 20, 2003, when the Secretary of the Treasury determined that a  debt issuance suspension period had begun, the G-Fund held about   $48.3 billion of Treasury obligations that would mature that day. To ensure  that it did not exceed the debt ceiling, Treasury did not reinvest about   $8.5 billion of these obligations on that date.
The amount of the G-Fund’s receipts that Treasury invested changed daily,  depending on the amount of the federal government’s outstanding debt.  Although Treasury can accurately predict the outcome of some events that  affect the outstanding debt, it cannot precisely determine the outcome of  others until they occur. For example, the amount of obligations that  Treasury will issue to the public from an auction can be determined some  days in advance because Treasury can control the amount that will be  issued. On the other hand, the amount of savings bonds that will be issued  and redeemed and the amount of obligations that will be issued to, or  redeemed by, various federal government accounts with investment  authority are difficult to precisely predict. Because of these difficulties,  Treasury needed a way to ensure that the normal investment and  redemption activities associated with Treasury obligations did not cause  the debt ceiling to be exceeded and also to maintain normal investment and  redemption policies for the majority of these accounts. To do these things,  each day during the debt issuance suspension period, Treasury   calculated the amount of debt subject to the debt ceiling, excluding the  receipts that the G-Fund would normally invest;  determined the amount of G-Fund receipts that could safely be invested  without exceeding the debt ceiling and invested this amount in Treasury  obligations; and  suspended investment, when necessary, of the G-Fund’s remaining  receipts.
For example, on February 27, 2003, the amount of debt subject to the debt  ceiling, excluding the G-Fund’s requested investment of about $49 billion,  was about $6,377 billion or about $23 billion below the debt ceiling.  Accordingly, Treasury invested about $23 billion in the G-Fund. The  remaining $26 billion was uninvested. In accordance with law, interest on  the uninvested funds was paid once the debt issuance suspension period  ended.
During the 2003 debt issuance suspension period, the G-Fund lost about  $362.5 million in interest because its excess funds were not fully invested.  Subsection 8438(g)(3) of title 5, United States Code, requires the Secretary  of the Treasury to make the G-Fund whole by restoring any losses once the  debt issuance suspension period has ended. On May 27, 2003, when the  debt ceiling was raised, Treasury fully invested the G-Fund’s receipts and  on May 28, 2003, fully restored the lost interest on the G-Fund’s uninvested  funds. Consequently, the G-Fund was fully compensated for its interest  losses during the 2003 debt issuance suspension period. We verified that  after this interest payment, the G-Fund’s obligation holdings were, in effect,  the same as they would have been had the debt issuance suspension period  not occurred.
Actions Related to ESF On several occasions from March 31, 2003, through May 23, 2003, Treasury  did not reinvest some of the maturing obligations held by ESF. Because  ESF’s obligations are considered part of the federal government’s  outstanding debt subject to the debt ceiling, that debt is reduced when the  Secretary of the Treasury does not reinvest ESF’s maturing obligations.  Since ESF was not fully invested, it incurred interest losses of $3.6 million  during the 2003 debt issuance suspension period. The Secretary of the  Treasury is not authorized by law to restore these losses.
The purpose of ESF is to help provide a stable system of monetary  exchange rates. The law establishing ESF authorizes the Secretary of the  Treasury to invest ESF’s balances not needed for program purposes in  obligations of the federal government. This law also gives the Secretary of  the Treasury the sole discretion for determining when, and if, the excess  funds will be invested. During previous debt ceiling crises, Treasury  exercised the option of not reinvesting ESF’s maturing Treasury  obligations, which helped the federal government to stay within the debt  ceiling and enabled Treasury to subsequently raise additional cash.
section_title: Actions Related to the Civil Service Fund
paragraphs: During the 2003 debt issuance suspension period, the Secretary of the  Treasury redeemed certain Treasury obligations held by the Civil Service  fund earlier than normal and suspended the investment of certain Civil  Service fund receipts. In addition, as discussed later, the Civil Service fund  exchanged Treasury obligations it held for a $15 billion FFB 9(a) obligation.
subsections: section_title: Obligations Held by the Civil Service Fund Redeemed Earlier Than Normal
paragraphs: Subsection 8348(k)(1) of title 5, United States Code, authorizes the  Secretary of the Treasury to redeem obligations or other invested assets of  the Civil Service fund before maturity to prevent the amount of public debt  from exceeding the debt ceiling. The statute does not require that early  redemptions be made only for the purpose of making Civil Service fund  payments. Further, the statute permits early redemptions even if the Civil  Service fund has adequate cash balances to cover such payments.
Before redeeming Civil Service fund obligations earlier than normal, the  Secretary of the Treasury must determine that a debt issuance suspension  period exists. The statute authorizing the debt issuance suspension period  and its legislative history are silent as to how to determine the length of a  debt issuance suspension period. On April 4, 2003, the Secretary of the  Treasury declared that a debt issuance suspension period, as it relates to  the Civil Service fund, would begin no later than April 11, 2003, and would  last until July 11, 2003. On May 19, 2003, the Secretary of the Treasury  extended this period until December 19, 2003.
On April 8, 2003, and May 20, 2003, Treasury redeemed about $12.2 billion  and $20.2 billion, respectively, of the Civil Service fund’s Treasury  obligations using its authority under subsection 8348(k)(1) of title 5, United  States Code. The $32.4 billion redemption amount was determined based  on (1) the length of the initial debt issuance suspension period (April 8  through July 11, 2003) and the related extension (through December 19,  2003) and (2) the estimated monthly Civil Service fund benefit payments  that would occur during that time. These were appropriate factors to use  in determining the amount of Treasury obligations to redeem early.
Treasury redeemed about $12.2 billion early to cover the obligations  associated with the May, June, and July 2003 estimated benefit payments  on April 8, 2003. As such, when May’s benefit payments were due, Treasury  redeemed only the $60 million difference between the amount that had  been redeemed early for the month of May and the actual amount of benefit  payments to be made.
section_title: Investment of Civil Service Fund Receipts Suspended
paragraphs: Subsection 8348(j)(1) of title 5, United States Code, authorizes the  Secretary of the Treasury to suspend additional investment of amounts in  the Civil Service fund if the investment cannot be made without causing the  amount of public debt to exceed the debt ceiling. From April 8, 2003,  through May 26, 2003, the Civil Service fund had about $2.5 billion in  receipts that were not invested. On May 27, 2003, after the debt ceiling was  raised, these receipts were invested.
section_title: Civil Service Fund Losses Associated with Early Redemptions and Suspended Investments Restored
paragraphs: When the Secretary of the Treasury redeems obligations earlier than  normal or refrains from promptly investing Civil Service fund receipts  because of debt ceiling limitations, the Secretary is required by subsection  8348(j)(3) of title 5, United States Code, to immediately restore, to the  maximum extent practicable, the Civil Service fund’s obligation holdings to  the proper balances when a debt issuance suspension period ends and to  restore lost interest on the next normal interest payment date.  Consequently, Treasury took the following actions once the debt issuance  suspension period had ended:  Treasury invested about $30.8 billion of uninvested receipts on May 27,  2003. These receipts were associated with (1) collections made by the  Civil Service fund that had not been invested and (2) funds associated  with the early redemptions that had not been used for benefit payments  and expenses.
Treasury paid the Civil Service fund on June 30, 2003, about   $100.8 million as compensation for principal and interest losses incurred  because of the actions it had taken. This was the first semiannual  interest payment date since the debt issuance suspension period ended.  June 30, 2003, was the proper restoration date according to the statute  authorizing the restoration.
We verified that after these transactions the Civil Service fund’s obligation  holdings were, in effect, the same as they would have been had the debt  issuance suspension period not occurred.
section_title: Effects of Exchange of Debt Obligations between the Civil Service Fund, FFB, and Treasury
paragraphs: During fiscal year 2003, Treasury initiated the following actions involving  the Civil Service fund, FFB, and the Treasury general fund related to its  efforts to (1) address FFB cash flow issues resulting from previously issued  FFB 9(a) obligations to the Civil Service fund and (2) manage the amount  of debt subject to the debt ceiling:  On October 18, 2002, FFB redeemed prior to maturity $15 billion in FFB  9(a) obligations held by the Civil Service fund. The $15 billion in FFB  9(a) obligations do not count against the debt ceiling. These FFB 9(a)  obligations were the result of a series of transactions stemming from a  Treasury-directed exchange of Treasury obligations held by the Civil  Service fund for FFB 9(a) obligations to assist Treasury in managing the  debt during the 1985 debt ceiling crisis. This early redemption resulted in a loss of over $1 billion on October 18, 2002, to the Civil Service fund  because of lost interest.
On March 5, 2003, FFB issued an FFB 9(a) obligation of about $15 billion  to the Civil Service fund in exchange for about $15 billion in Treasury  obligations that had been held by the Civil Service fund. FFB used the  Treasury obligations to purchase FFB 9(b) obligations held by the  Secretary of the Treasury. As a result, the FFB 9(b) debt obligations  were canceled and the Treasury obligations that were no longer  outstanding were canceled. Consequently, Treasury was provided  about $15 billion in additional borrowing authority under the debt  ceiling.
On June 30, 2003, FFB redeemed early the 9(a) obligation it had issued  to the Civil Service fund on March 5. Treasury reinvested the FFB  redemption proceeds in accordance with its normal investment policies  and procedures.
Our review found that on March 5, 2003, and June 30, 2003, the Civil Service  fund received fair value based on a present value analysis for the  obligations it surrendered. However, whether the Civil Service fund will  have any long-term gains or losses associated with these transactions will  not be known for some time.
Gains or losses on the exchange of obligations between the Civil Service  fund and FFB can result when (1) the exchange occurs or (2) the  underlying assumptions used to determine the exchange price are not  realized. We have found that the initial transactions between FFB and the  Civil Service fund relating to a given period in which Treasury was  experiencing debt ceiling difficulties were fair to both parties on the date  of the exchange. However, quantifying the long-term effects of these  transactions on the parties involved is difficult and complex because the  exchanges were structured to last many years. The longer the period in the  analysis used to evaluate the fairness of a given transaction, such as a  present value analysis, the greater the probability that the underlying  assumptions used to determine the original exchange price will not  accurately reflect the future years’ events. This risk is also incurred when  the obligations relating to an exchange remain outstanding for a long time.  When the assumptions used to determine the initial exchange prices are  not realized (e.g., the obligation is redeemed sooner than expected), gains  and losses can result from interest rate changes and reinvestment of the  repayment in obligations that do not have comparable maturities. For  further discussion on the limitations of using a present value methodology  to determine gains and losses, see appendix II.
In some cases, we have been able to quantify the gains or losses that have  occurred or can be expected to occur that relate to the fiscal year 2003  transactions. However, in other cases, the information needed to  understand the potential consequences of the actions taken on March 5 and  June 30, 2003, will not be available for a number of years, and we are  unable to determine the potential impacts at this time. Table 3 summarizes  the gains and losses associated with the fiscal year 2003 transactions  between the Civil Service fund, FFB, and the Treasury general fund that we  have been able to quantify and those that cannot be determined at this  time.
As discussed in the preceding narrative and shown in table 3, it is difficult  to quantify all the losses and gains associated with the transactions  between FFB and the Civil Service fund. A more detailed explanation of  these gains and losses, as well as the reasons why not all of the effects of  these transactions can be quantified at this time, is provided in appendix  III. Regardless of whether they sustain any additional gains or losses over  the long term, the Civil Service fund, FFB, and the Treasury general fund  incurred increased risks of gains and losses that they would not have  incurred if these transactions had not occurred. More important, the risks  related to the transactions between FFB and the Civil Service fund are not  typically incurred by these organizations during their normal operations.
It is important to remember that the risks associated with these exchange  transactions are not undertaken for programmatic reasons. Rather, they are  made at the direction of the Secretary of the Treasury to help manage the  federal government’s operations when debt ceiling difficulties occur. FFB  and Treasury have flexibilities that allow them to structure transactions  that reduce or even eliminate the losses that FFB can incur. However,  similar flexibilities are not available to the Civil Service fund. Furthermore,  although the Secretary of the Treasury has statutory authority to restore  losses resulting from not investing Civil Service fund receipts or from early  redemption of Treasury obligations held by the Civil Service fund during a  debt issuance suspension period, the Secretary does not have the statutory  authority to restore the types of losses, discussed above, that result from  exchange transactions. Appendix IV discusses transactions between the  Civil Service fund and FFB that related to previous debt management  difficulties.
section_title: Documented Policies and Procedures Needed for Civil Service and FFB Exchange Transactions
paragraphs: As we noted in our December 2002 report, documented policies and  procedures would allow Treasury to better determine the potential impacts  associated with the policies and procedures it implements to manage the  amount of debt subject to the debt ceiling. Although Treasury adopted our  recommendation and developed policies and procedures for managing  investment and redemption activities of the Civil Service fund and the G- Fund during a debt issuance suspension period, such policies and  procedures do not address how exchange transactions between the Civil  Service fund and FFB should be handled. While we recognize that Treasury  needs a great deal of flexibility to structure transactions that fit specific  events, we believe that guidelines related to exchange transactions  between the Civil Service fund and FFB can be developed that minimize the  risk to both parties.
It is the process of documenting the policies and procedures that allows  Treasury management to ascertain the effects of these policies and  procedures and whether those effects introduce any additional risks to the  parties involved. In addition, documenting the policies and procedures  allows Treasury to understand whether it may need additional statutory  authority to ensure that all funds are adequately protected. Furthermore, if  effectively implemented, documentation of the policies and procedures  reduces the chance for confusion and risk of errors should Treasury need  to use the policies and procedures in the future. These points were  discussed in our December 2002 report to Treasury. During our review of  the actions taken during the 2003 debt issuance suspension period that  were affected by those policies and procedures, we found that none of the  problems or potential problems that we discovered in the 2002 debt  issuance suspension period had occurred.
section_title: Conclusions
paragraphs: The Secretary of the Treasury can take many actions to manage federal  government operations during a debt issuance suspension period. In some  cases, these actions pose no long-term financial risk to affected parties  because of the statutory authorities currently available to the Secretary of  the Treasury. As noted earlier, Treasury used these authorities to restore, in  total, $463 million in losses incurred by the G-Fund and Civil Service fund.  However, other actions expose the affected parties to financial risks that  are not normally incurred as part of their programmatic operations.
Whether the risks associated with specific actions result in actual losses or  gains may not be known until many years after the action has been taken.  History has shown, however, that the risks may be substantial. For  example, according to FFB estimates, on October 18, 2002, the Civil Service  fund lost interest of over $1 billion on a $15 billion transaction entered into  in 1985 because of the unexpected early redemption of 9(a) obligations  issued by FFB and unforeseen interest rate changes. Treasury lacks the  statutory authority to restore such losses and has not developed the  documented policies and procedures that can be used to minimize such  losses in future exchanges between FFB and federal government accounts  with investment authority, such as the Civil Service fund.
section_title: Recommendations for Executive Action
paragraphs: We recommend that the Secretary of the Treasury perform the following  two actions:  Seek the statutory authority to restore the losses associated with the  October 2002 early redemption of FFB 9(a) obligations. The amount of  the restoration should be computed in a manner that maintains equity  between the Civil Service fund and Treasury.
Direct the Under Secretary for Domestic Finance to document the  necessary policies and procedures that should be used for exchange  transactions between FFB and a federal government account with  investment authority during a debt issuance suspension period and seek  any statutory authority necessary to implement the policies and  procedures.
section_title: Agency Comments and Our Evaluation
paragraphs: In written comments on a draft of this report, Treasury agreed with our  recommendations and stated that (1) it will seek statutory authority to  restore losses incurred by federal government accounts with investment  authority and by FFB as a result of actions taken for the purpose of fiscal  management during a “debt limit impasse” and (2) it will document  appropriate policies and procedures that should be used for exchange  transactions between FFB and a federal government account with  investment authority to ensure long-term fairness to all parties. Treasury  has stated that the authority it will seek includes the restoration of the  losses associated with the October 2002 early redemption of FFB 9(a)  obligations as we recommended. Until Treasury develops its specific  legislative proposal and the policies and procedures it will use relating to  transactions between FFB and federal government accounts with  investment authority, we cannot determine the scope of the statutory  authority it may seek. Treasury also noted that it has already taken certain  steps in documenting the policies and procedures that should be used in  future exchange transactions.
Treasury stated that it plans to use FFB’s independent auditor to “ensure  that the terms and structure  clearly achieve the  intended accounting result and long-term financial fairness to all parties,  prior to transaction approval and execution.” Treasury and its independent  auditor will need to ensure that this arrangement does not result in a  problem with auditor independence under U.S. generally accepted  government auditing standards. The independence standard requires that  auditors should avoid situations that could lead reasonable third parties  with knowledge of the relevant facts and circumstances to conclude that  the auditor is not able to maintain independence in conducting its financial  statement audit. For example, audit organizations should not perform  management functions or make management decisions for entities that  they also audit.
Specific technical comments provided orally by Treasury were  incorporated in this report as appropriate.
We are sending copies of this report to the Chairmen and Ranking Minority  Members of the Senate Committee on Appropriations; the Senate  Committee on Governmental Affairs; the Senate Committee on the Budget;  the Senate Committee on Finance; the Subcommittee on Financial  Management, the Budget, and International Security, Senate Committee on  Governmental Affairs; the House Committee on Appropriations; the House  Committee on Government Reform; the House Committee on the Budget;  the House Committee on Ways and Means; the Subcommittee on  Government Efficiency and Financial Management, House Committee on  Government Reform; and the Subcommittee on Civil Service and Agency  Organization, House Committee on Government Reform. We are also  sending copies of this report to the Secretary of the Treasury, the Under  Secretary for Domestic Finance of the Department of the Treasury, the  Inspector General of the Department of the Treasury, the Director of the  Office of Management and Budget, and other agency officials. In addition,  the report will be available at no charge on the GAO Web site at  http://www.gao.gov.
If you need further assistance or if you or your staff have any questions  concerning this report, please contact Chris Martin, Senior Level  Technologist, at (202) 512-9481 or Louise DiBenedetto, Assistant Director,  at (202) 512-6921. Other key contributors to this report were Wendy M.  Albert, Arkelga L. Braxton, and Richard T. Cambosos.
section_title: Gains and Losses on Federal Accounts with Investment Authority
paragraphs: Gains and losses can be broken down into two main categories: (1) gains  and losses associated with normal investment and redemption activity and  (2) gains and losses associated with unusual events, such as a debt  issuance suspension period. Treasury’s long-standing position is that gains  and losses associated with normal investment and redemption activity are  borne by the applicable federal government account and that no special  action should be taken to adjust an account’s investment portfolio for these  gains and losses. On the other hand, when the loss is incurred because of  unusual events and account participants have a vested interest in the fund,  Treasury has, in many cases, received the necessary authority to restore  such losses.
subsections: section_title: Gains and Losses Associated with Normal Investment and Redemption Activity
paragraphs: Federal government accounts with investment authority generally invest in  interest-bearing nonmarketable Treasury obligations. The investment and  redemption activities related to these obligations can cause gains and  losses from, for example, changing interest rates and certain errors that are  found and corrected. Treasury has a long-standing position that gains and  losses associated with normal investment and redemption activities are a  cost of doing business. Therefore, Treasury makes no attempt to adjust an  account’s investment portfolio for such activities.
subsections: section_title: Gains and Losses Associated with Security Valuation
paragraphs: As noted earlier, one of Treasury’s basic management policies for federal  government accounts with the authority to invest is to maintain equity  between these accounts and the general fund—the fund used to pay most  government obligations. To do so, Treasury issues two basic types of  nonmarketable obligations—market-based and par value specials. Most  market-based obligations are mirror images of existing Treasury  obligations that are traded on the open market and are purchased or sold at  open market prices. Par value specials, on the other hand, are issued and  redeemed at par.
The interest rates for par value specials are specified in the enabling statute  or by administrative action. For example, for the G-Fund, Civil Service  fund, and Social Security funds, the par value rate is based on the average  rate for comparable marketable obligations, as defined by Treasury, with 4  or more years to maturity. This rate is established monthly, and all  investments for a given month must bear the same rate. When a federal  government account with investment authority needs to redeem  obligations to pay benefits and expenses, Treasury redeems these  obligations and pays the fund the par value plus any accrued interest.  Although only certain accounts are allowed to invest in par value specials,  the majority of the $2.8 trillion of account investments on January 31, 2003,  were invested in par value specials. Equity between accounts investing in  par value specials and the Treasury general fund is not maintained because  (1) the interest rate is determined only monthly and (2) the term of the  investment is not relevant, as shown in the following examples:  The interest rate used to invest an account’s receipts is determined only  monthly. If market interest rates fall during the month, the Treasury  general fund pays the account more interest than market conditions  dictate; if market interest rates rise during the month, the investment  account receives less interest than market conditions dictate.
Many federal government accounts with investment authority holding  par value specials hold these obligations for a number of years.  Accordingly, the interest rates can vary significantly. For example, the  Civil Service fund has obligations that carry interest rates ranging from  3.5 percent to 8.75 percent in its portfolio that matures on June 30, 2005.  Even the rates for the portfolio that matures on June 30, 2014, range  from 3.5 percent to 6.5 percent. However, when the obligations are  needed to pay benefits, they are redeemed at par regardless of current  market rates. In times of high interest rates, redeeming a low-interest- rate obligation at par benefits the account redeeming the par value  special. On the other hand, during periods of low interest rates,  redeeming obligations at par benefits Treasury’s general fund.
The interest rate paid on Treasury obligations with 4 or more years to  maturity is based on a statutory formula developed in the 1920s to  ensure equal semiannual interest payments for obligations held for  exactly 1 year. However, as we noted in our 1987 report on the Civil  Service fund, when investments are held for less than a year, Treasury’s  method does not ensure that the account is neither overcompensated  nor undercompensated. In the major accounts with investment  authority, such as the Civil Service and Social Security funds, a large  number of investments in par value specials are subsequently redeemed,  sometimes just days later, for benefit payments and expenses, rather  than held to their maturity. Activity associated with current-year  investments that were subsequently redeemed in the current investment  year for program benefits and expenses can be significant. Such activity  totaled well over $100 billion dollars between January 31, 2003, and   June 30, 2003, for the Civil Service and Social Security funds. In  addition, as noted elsewhere, the G-Fund, whose investments receive  the par value rate, redeems and reinvests its entire portfolio each  business day.
section_title: Gains and Losses Associated with Adjustments
paragraphs: Treasury makes many adjustments to the accounting records to reflect  accounting events. Reasons for adjustments may include (1) information  received late from an account caused by agreed-upon processing delays  such as those associated with the Social Security funds and (2) certain  errors made by either Treasury or the account. We found in a 1987 review  that the procedures for making adjustments to accounts holding par value  specials, which are still being used, do not ensure that the results of  adjustments are equitable. For example, during our 1987 review we noted  that one error that Treasury made and corrected cost the Civil Service fund  almost $400,000 in lost interest earnings. Specifically, according to Treasury  records, the Office of Personnel Management (OPM) instructed Treasury to  redeem about $400 million of obligations on behalf of the Civil Service fund  on July 5, 1984. However, Treasury did not make this redemption until OPM  notified Treasury of the error in August. Treasury then redeemed the  lowest-interest-bearing obligations available at that time, which had rates  of 8.75 and 9.75 percent. The interest earnings for this redemption were  computed through July 5 (the original requested redemption date). Had the  redemption taken place on July 5, the obligations bearing interest rates of  7.5 and 7.625 percent would have been used because the portfolio held  lower-rate obligations at that time. As a result, the Civil Service fund lost  about $400,000 of interest earnings. Treasury agreed with our methodology  for computing the effects of this error and with the amount of the loss.
section_title: Gains and Losses Associated with Unusual Events
paragraphs: Treasury and the Congress have a long-standing position of obtaining the  necessary authority to restore interest that was not credited to an account  with investment authority because of unusual events. GAO, the Congress,  Treasury, and agencies associated with the accounts commonly refer to this  forgone interest as a loss to the fund. Several examples follow.
In OPM’s comments on our report on the actions taken during the 1985  debt ceiling crisis, it stated that the Civil Service fund “should be ‘made  whole’ when available funds are not properly invested. This is especially  important for situations  . . . when the  lost  interest as the result of debt ceiling limitations.”
Section 6002 of the Omnibus Budget Reconciliation Act of 1986 added  subsections (j), (k), and (l) to section 8348 of title 5, United States Code,  (1) to authorize the Secretary to suspend investment of amounts in the  Civil Service fund in government obligations and to redeem prior to  maturity government obligations held by the Civil Service fund when  necessary to avoid exceeding the debt ceiling and (2) to authorize the  Secretary to make the fund whole after the debt issuance suspension  period. The joint explanatory statement of the committee of conference  accompanying the Omnibus Budget Reconciliation Act of 1986 states  that the amendment requires the Secretary “to make the Fund whole for  any earnings lost as a result of the suspension or disinvestment by a  combination of special cash payment actions.”
Treasury’s July 30, 2003, letter to the Congress concerning the 2003 debt  issuance suspension period stated that Treasury has paid interest  “totaling $100,822,854.44, representing the amount that would have been  earned, but for the debt issuance suspension period.” Treasury also  noted that this “represents the interest lost” by the Civil Service fund.
It is also a long-standing practice for the Congress and the President to  provide the necessary authority to restore losses caused by unusual events.  For example, during the 1985 debt ceiling crisis, Treasury was granted the  authority to restore the majority of interest losses associated with its  actions to avoid exceeding the debt ceiling. Furthermore, as recommended  in our report on the 1985 debt ceiling crisis, Treasury received the authority  in 1986 and 1987 to fully restore the losses associated with certain actions it  takes in regard to the Civil Service fund and G-Fund during debt ceiling  difficulties.
section_title: Limitations of the Present Value Analysis Approach to Determining Economic Gains and Losses
paragraphs: A present value analysis is used to provide a basis for understanding the  value of an obligation using current market conditions when that obligation  is being purchased, sold, or exchanged before maturity. The present value  of an obligation depends on (1) the coupon rate, (2) the length of time the  obligation is outstanding, and (3) the current market rate (commonly  referred to as the discount factor). Table 4 shows a simple example of the  present values of three $1 million obligations bearing a coupon rate of 6  percent with three different maturities and using three different discount  factors.
As shown in table 4, when the discount factor differs from the coupon rate,  the present value of an obligation will differ from the face value—the  longer the time interval, the greater the increase or decrease in value.
As noted in our discussion on the effects of exchanges of obligations  between the Civil Service fund, the Federal Financing Bank (FFB), and the  Department of the Treasury (Treasury), Treasury used a present value  analysis to help ensure that the exchange of Treasury obligations held by  the Civil Service Retirement and Disability Fund (Civil Service fund) for  obligations issued by FFB was fair to both parties. The present value  approach was also used to determine the amount of losses incurred by the  Civil Service fund when FFB repaid its obligations before they were  scheduled to mature. A key assumption in making a present value  calculation is that the underlying assumptions on interest rates and cash  flows will not change. For example, if a present value calculation shows  that an obligation’s cash flows are worth $1 billion today assuming that the  $1 billion can be invested in a 4 percent obligation that matures on June 30,  Year 2, then it is critical that the investment be made in an obligation that  bears an interest rate of 4 percent and that the obligation matures on   June 30, Year 2. Otherwise, a gain or loss can occur if interest rates change,  as shown in table 5.
Although the initial exchange was fair, as shown in table 5, since the actual  terms of the obligations issued were not the same as those used in the  present value assumption, the account is subject to risks associated with  interest rate changes.
Another limitation associated with a present value analysis is that it does  not consider reinvestment risk. For example, in the case of the March 5,  2003, exchange between FFB and the Civil Service fund, the Treasury  obligations exchanged matured from June 30, 2004, through June 30, 2011.  However, the FFB 9(a) obligation received had a different cash flow.  Therefore, if the principal and interest payments associated with the FFB  9(a) obligation could not be invested at the same discount factor used in  the present value analysis, then a gain or loss would result. If the cash flows  can be invested at a higher interest rate, then a gain will occur. Conversely,  if the cash flows are reinvested at a lower rate, then a loss will occur.
section_title: Gains and Losses Associated with Transactions between the Civil Service Fund, FFB, and the Treasury General Fund
subsections: section_title: Civil Service Fund Interest Losses Associated with the October 18, 2002, FFB Early Redemption
paragraphs: During the 1985 debt ceiling crisis, Treasury for the first time invested  excess receipts of the Civil Service fund in FFB 9(a) obligations. Because  FFB 9(a) obligations are not subject to the debt ceiling, this action allowed  Treasury to borrow more cash from the public. At the time of the purchase,  these FFB 9(a) obligations carried the same terms and conditions as the  Treasury obligations held by the Civil Service fund. As such, as long as  FFB did not redeem the debt obligations prior to maturity or the  obligations were not otherwise redeemed before needed to pay Civil  Service fund expenses in accordance with its normal redemption policies  and procedures, the exchange transaction would result in no adverse  consequences for the Civil Service fund. However, on October 18, 2002,  FFB exercised its right to redeem its obligations before maturity, which  resulted in over $1 billion in interest losses to the Civil Service fund.
According to FFB calculations, the present value interest loss to the Civil  Service fund was over $1 billion when FFB redeemed its obligations. FFB  appropriately calculated this loss using a present value methodology that  assumed that the Civil Service fund could invest the $15 billion proceeds  from the early redemption of the FFB 9(a) obligations at 3.875 percent— the October 2002 investment rate for Civil Service fund investments—and  the funds could be invested with the same maturities as the redeemed FFB  9(a) obligations. Table 6 shows a comparison of the maturity dates and  interest rates associated with the FFB 9(a) obligations that were redeemed  early.
FFB’s present value analysis assumed that the redemption proceeds would  be invested at 3.875 percent using the same maturity dates that were  applicable to the original FFB 9(a) obligations. The redemption proceeds  were actually invested in a 3.875 percent obligation that matured on   June 30, 2003, since Treasury’s normal policies and procedures require that  current-year receipts be invested in obligations that mature on June 30 of  the current investment year.
On June 30, 2003, $10 billion of the October 18, 2002, investment was, in  effect, reinvested in obligations bearing an interest rate of 3.5 percent—the  rate applicable to Civil Service fund investments for June 2003.  Accordingly, Treasury invested $10 billion with $5 billion maturing on   June 30, 2004, and $5 billion on June 30, 2005, at an interest rate of 3.5  percent. The remaining $5 billion that was received on October 18, 2002,  was used to pay current-year fund benefits and expenses and therefore was  not available for reinvestment on June 30, 2003. Although FFB redemption  proceeds were invested with the same maturity dates as the original FFB  9(a) obligations, they will be invested for a time at 3.5 percent rather than  the 3.875 percent assumed in the present value analysis. Therefore, in  addition to the over $1 billion interest loss incurred on October 18, 2002,  discussed above, the Civil Service fund will incur about $33.4 million of  additional interest losses (commonly referred to as a nominal interest loss)  in these future years because of the lower-than-assumed interest rate on  the reinvested amounts.
Table 7 compares the expected interest earnings associated with the  October 18, 2002, FFB 9(a) redemption prior to maturity using the present  value assumptions and the expected interest earnings that would be  received if the obligations were held to maturity.
In our report on the 1985 debt ceiling crisis, we noted that Treasury  officials stated that a basic trust fund management policy is to ensure  equity between the various trust funds and the Treasury general fund—the  fund used to pay most government obligations—and that none of the funds  unduly benefit from Treasury’s management. Although the losses discussed  in this section resulted from a transaction between FFB and the Civil  Service fund, the transaction between these two funds was not initially  undertaken for programmatic reasons; rather, it was undertaken by the  Secretary of the Treasury to help manage debt during the 1985 debt ceiling  crisis, and the early redemption in 2002 was undertaken to help manage  FFB’s cash flow problems.
section_title: Civil Service Fund Gains and Losses Associated with the 2003 Exchange Transaction
paragraphs: On March 5, 2003, Treasury exchanged certain Treasury obligations held by  the Civil Service fund for an FFB 9(a) obligation of about $15 billion issued  by FFB to the Civil Service fund. The purpose of this transaction, similar to  the purpose of the transaction that occurred during the 1985 debt ceiling  crisis discussed above, was to make about $15 billion of additional  borrowing authority available under the debt ceiling. Figure 2 shows the  process for debt ceiling relief during fiscal year 2003.
However, unlike the terms and conditions of the 1985 exchange  transaction, the terms and conditions of the FFB 9(a) obligation issued to  the Civil Service fund during the 2003 debt issuance suspension period  were different from those of the Treasury obligations surrendered.  Specifically, the terms of the FFB 9(a) obligation held by the Civil Service  fund stated that if FFB redeemed its obligation before maturity, the  redemption price would be based on current market rates rather than par  value, which was the basis used in the 1985 exchange. Therefore, to ensure  that the value of the exchange was fair to both parties on the date of the  exchange, Treasury used a present value analysis to compare the value of  future cash flows expected from the Treasury obligations being exchanged  by the Civil Service fund with the value of future cash flows expected from  the FFB 9(a) obligation. On June 30, 2003, FFB redeemed its March 5, 2003,  9(a) obligation before the December 2035 maturity date. As discussed  below, these transactions introduced risks to the Civil Service fund that it  would not have incurred had this exchange not taken place.
The transactions between the Civil Service fund and FFB fairly  compensated the Civil Service fund, based on a present value analysis, on  the date of the exchanges. The net result of the March 5, 2003, and June 30,  2003, transactions between the Civil Service fund and FFB was that the  Civil Service fund had about $1.153 billion more in Treasury obligations  than it did before the March 5, 2003, transaction. This increase in Treasury  obligations held by the Civil Service fund occurred because the prevailing  market interest rates at the time of the exchanges were lower than the rates  of the Treasury obligations exchanged with FFB. However, the Civil Service  fund had a gain of only about $139.5 million because it had to invest the  proceeds from the obligation FFB redeemed on June 30, 2003, at a lower  interest rate. In other words, the Civil Service fund had more principal to  invest but was unable to invest that principal at a rate as high as the rate of  the Treasury obligations it had surrendered. Therefore, the Civil Service  fund needed more principal to generate approximately the same returns as  the obligations it had originally surrendered during the transaction on  March 5, 2003. The long-term economic effect of the June 30, 2003,  transaction on the Civil Service fund depends on the terms of the  obligations in which the proceeds are invested.
In this case, one way to have helped ensure that the Civil Service fund  would not have cash flow gains or losses associated with investment of the  proceeds from the FFB redemption would have been to invest the proceeds  using a methodology that ensured that the fund had cash flows similar to  those from the original Treasury obligations used for the exchange on  March 5, 2003. This methodology is commonly referred to as a “cash flow”  approach. However, the cash flow approach can also result in gains and losses, since it does not consider the reinvestment risks that may be  present. Appendix II discusses how the cash flow methodology ensures  that a cash flow gain or loss does not occur and how reinvestment risks are  not considered in this methodology.
Treasury’s approach for investing the June 30, 2003, FFB redemption  proceeds was to apply its normal investment policies and procedures. In  this case, Treasury, in effect, (1) replaced the dollar value of the obligations  used for the March 5, 2003, exchange with 3.5 percent Treasury obligations  and (2) divided the remaining proceeds equally over a 15-year period. While  this approach differs from the cash flow approach and may result in future  gains and losses, the key point is that Treasury has not yet developed  documented policies and procedures for managing such transactions. The  process of documenting the policies and procedures that should be used  for such transactions allows Treasury’s management to understand the  impacts of various alternatives and whether they introduce any additional  risks to the parties involved. It also helps Treasury evaluate whether it may  need additional statutory authority to ensure that all accounts are  adequately protected. Further, if effectively implemented, documentation  of policies and procedures reduces the chance for confusion and risk of  errors should Treasury need to use the policies and procedures in the  future.
section_title: FFB and Treasury General Fund Gains and Losses Associated with the 2003 Exchange Transaction
paragraphs: FFB and the Treasury general fund had gains and losses associated with the  March 5, 2003, and the June 30, 2003, transactions. As shown in table 3, the  net result for FFB of these two transactions was a $633 million loss on   June 30, 2003. FFB expects to earn about $1.153 billion in future years to  offset this loss. The Treasury general fund also lost $520 million, which is  not expected to be recovered. Several key decisions and actions related to  the March 5, 2003, and June 30, 2003, transactions are discussed below.
subsections: section_title: Treasury Accepted Par Value Specials at Their Present Value
paragraphs: On March 5, 2003, Treasury purchased from FFB the Treasury obligations  (par value specials) that FFB had acquired from the Civil Service fund.  Treasury agreed to pay FFB about $520 million more than the par value of  these obligations. As payment for this purchase, Treasury sold back to FFB  9(b) obligations issued by FFB that Treasury held. In effect, Treasury  canceled about $15.7 billion of the FFB 9(b) obligations it held with about  $15.2 billion of Treasury par value specials that FFB had received from the  Civil Service fund. Therefore, FFB had a gain and the Treasury general fund  had a corresponding loss on the exchange. Table 8 shows how this  transaction generated a gain for FFB.
The March 5, 2003, exchange was in contrast to FFB’s October 18, 2002,  early redemption of its 9(a) obligations held by the Civil Service fund. On  October 18, 2002, Treasury decided that the FFB 9(a) obligations being  redeemed prior to maturity that were related to Treasury's effort to manage  the 1985 debt ceiling would be redeemed at par value and that the Civil  Service fund would incur the loss. Treasury’s redemption of par value  specials in excess of their par value is also in contrast to its normal policies  and procedures, which allow agencies holding the par value specials only  to redeem them from Treasury at face value to pay for the fund’s benefits  and expenses. If Treasury had accepted the par value specials at par rather  than at current market rates, then the total losses to FFB would have been  about $1.153 billion rather than the $633 million total net loss resulting from the March 5, 2003, and June 30, 2003, transactions. The $1.153 billion  is also the amount of the gain FFB expects to make in future periods.
The key difference between the March 5, 2003, exchange and the normal  exchanges between Treasury and federal government accounts with  investment authority related to their investments in par value specials is  that for the March 5, 2003, exchange between Treasury and FFB, a present  value analysis was used to calculate the amount of debt that should be  removed from Treasury’s books—the same analysis that Treasury used to  ensure that the exchange between FFB and the Civil Service fund was fair.  Whether FFB or the Treasury general fund incurs a gain or loss when par  value specials are used to cancel FFB 9(b) obligations depends greatly on  the value of the Treasury obligations held by the Civil Service fund that are  selected for the exchange. For example, if the interest rates on the Treasury  obligations held by the Civil Service fund had been 3.875 percent rather  than 5.25 percent, Treasury would have exchanged par value specials with  a value of about $16.2 billion held by the Civil Service fund with FFB, and  FFB would have provided these to Treasury to cancel the $15.7 billion of  FFB 9(b) obligations. In this case, Treasury would have recognized a gain  rather than the loss that was recorded because 5.25 percent par value  specials were used in the exchange. Table 9 provides a simplified example  of how this works.
section_title: FFB Issued Additional 9(b) Obligations on June 30, 2003, to Redeem FFB 9(a) Obligation
paragraphs: As discussed earlier, when FFB decided on June 30, 2003, to redeem prior  to maturity the 9(a) obligation it had issued to the Civil Service fund,  another present value analysis was performed. As a result of this analysis,  FFB had to borrow about $16.6 billion from Treasury using 9(b) obligations  to redeem the $15 billion FFB 9(a) obligation it had issued to the Civil  Service fund. FFB needed these additional funds because the FFB 9(a)  obligation was based on an interest rate yield of 5.25 percent and the  interest rate used in the present value analysis was 3.5 percent (the June  2003 Civil Service fund investment rate). According to FFB officials, the  following approach was used to structure this $16.6 billion loan from  Treasury:  FFB borrowed $15.4 billion using principal repayments that mirrored  principal payments used in the original FFB 9(a) obligation to the Civil  Service fund, which, in turn, mirrored the underlying FFB loans made to  its borrowers. For example, if FFB held a loan that called for a   $10 million principal payment on December 31, 2005, then FFB would  have borrowed $10 million from Treasury with a December 31, 2005,  repayment date. In effect, after these transactions, FFB’s loan  repayments for its 9(b) obligations to Treasury mirrored the underlying  loan principal repayments that FFB expected to receive from its loan  portfolio.
FFB borrowed about $1.1 billion using a short-term obligation.
The $1.1 billion corresponds to FFB’s net loss of $633 million and the  Treasury general fund’s loss of $520 million, which were realized on the  March 5, 2003, and June 30, 2003, transactions. According to FFB’s 2003  financial statements, FFB expects to recover its loss in future years.
FFB repaid the short-term $1.1 billion 9(b) obligation on April 1, 2004, since  FFB had adequate cash flows from its loans to make these payments.  According to FFB officials, these increased cash flows resulted from   (1) the reduced interest costs associated with the October 18, 2002, early  redemption of FFB 9(a) obligations issued to the Civil Service fund noted  earlier in this report and (2) the reduced interest costs associated with the  June 30, 2003, FFB 9(b) obligations that were used to redeem the FFB 9(a)  obligation issued to the Civil Service fund on March 5, 2003. Therefore,  once the short-term 9(b) obligation is redeemed, the future principal  payments associated with FFB’s loan portfolio will, for all practical  purposes, mirror the principal payments that will be made to Treasury.  However, the interest earnings on FFB’s loan portfolio will be far greater  than the interest payments that will be due to Treasury on FFB 9(b)  obligations issued to Treasury. This interest rate differential will then  translate into increased earnings for FFB that can be expected to offset the  losses associated with the 2003 exchange transactions with the Civil  Service fund.
section_title: Transactions between FFB and the Civil Service Fund
paragraphs: During the 1985 debt ceiling crisis, Treasury for the first time invested  excess Civil Service fund receipts of the Civil Service fund in FFB 9(a)  obligations. Treasury has also exchanged Treasury obligations held by the  Civil Service fund for obligations held or issued by FFB when Treasury  experienced debt ceiling difficulties during the 1995/1996 debt ceiling crisis  and the 2003 debt issuance suspension period. These exchanges and their  effects on the Civil Service fund are discussed below.
subsections: section_title: 1985 Debt Ceiling Crisis
paragraphs: During the 1985 debt ceiling crisis, Treasury for the first time exchanged  about $15 billion of Treasury obligations held by the Civil Service fund for  obligations issued by FFB. The purpose of this transaction was to make   $15 billion of additional borrowing authority available under the statutory  debt ceiling. At the time the transaction was made, these FFB obligations  were mirror images of the Treasury par value specials held by the Civil  Service fund. As long as the FFB obligations were held to maturity or  redeemed in accordance with the normal redemption policies of the Civil  Service fund, this transaction would result in no adverse financial  consequences for the Civil Service fund. As noted earlier in this report, it  was not until October 2002 that the Civil Service fund portfolio was  affected by this transaction.
section_title: 1995/1996 Debt Ceiling Crisis
paragraphs: During the 1995/1996 debt ceiling crisis, Treasury exchanged about   $8.6 billion of Treasury obligations held by the Civil Service fund for federal  agency obligations held by FFB. The purpose of this transaction was to  make an additional $8.6 billion of borrowing authority available under the  statutory debt ceiling. Since the federal agency obligations held by FFB  differed from the terms and conditions of the obligations held by the Civil  Service fund, the task of determining a fair exchange price was more  complicated than in 1985. Because the effects of these differences in terms  and conditions can be significant, a generally accepted methodology was  used that considered such factors as (1) the current market rates for  outstanding Treasury obligations at the time of the exchange, (2) the  probability of changing interest rates, (3) the probability of the federal  agency paying off the debt early, and (4) the premium the market would  provide to an obligation that could be redeemed at par regardless of market  interest rates. Treasury then obtained the opinion of an independent third  party to determine whether its valuations were accurate.
In 1997, portions of the obligations received in this transaction were repaid  early. Since the original analysis included a factor for the risk associated  with the federal agency redeeming its obligations early, the Civil Service  fund did not suffer any adverse consequences.
section_title: 2003 Debt Issuance Suspension Period
paragraphs: During the 2003 debt issuance suspension period, Treasury once again  exchanged Treasury obligations held by the Civil Service fund for a   $15 billion FFB 9(a) obligation. However, unlike the 1985 exchange, the  terms and conditions associated with the FFB 9(a) obligation was not  identical to the terms and conditions of the Treasury obligations held by the  Civil Service fund. Therefore, to ensure that the transaction was fair to both  parties, Treasury performed a present value analysis of the cash flows  associated with the FFB obligation and the cash flows associated with the  Treasury obligations held by the Civil Service fund. Furthermore, it was  agreed that if FFB redeemed this obligation before maturity, the price paid  would be based on current market rates. An agreement between FFB,  Treasury, and Treasury on behalf of the Civil Service fund allowed the  Secretary of the Treasury on behalf of the Civil Service fund to redeem the  FFB 9(a) obligation at par. As noted earlier, in June 2003 FFB redeemed  this obligation and the Civil Service fund had a $139.5 million gain.
section_title: Related GAO Products
paragraphs: We have previously reported on aspects of Treasury’s actions during the  2002 debt issuance suspension period and earlier debt ceiling crises in the  following reports: Debt Ceiling: Analysis of Actions During the 2002 Debt Issuance  Suspension Periods. GAO-03-134. Washington, D.C.: December 13, 2002.
Debt Ceiling: Analysis of Actions during the 1995/1996 Crisis.  GAO/AIMD-96-130. Washington, D.C.: August 30, 1996.
Information on Debt Ceiling Limitations and Increases. GAO/AIMD-96- 49R. Washington, D.C.: February 23, 1996.
Debt Ceiling Limitations and Treasury Actions. GAO/AIMD-96-38R.  Washington, D.C.: January 26, 1996.
Social Security Trust Funds. GAO/AIMD-96-30R. Washington, D.C.:  December 12, 1995.
Debt Ceiling Options. GAO/AIMD-96-20R. Washington, D.C.: December 7,  1995.
Civil Service Fund: Improved Controls Needed Over Investments.  GAO/AFMD-87-17. Washington, D.C.: May 7, 1987.
Treasury’s Management of Social Security Trust Funds during the Debt  Ceiling Crises. GAO/HRD-86-45. Washington, D.C.: December 5, 1985.
A New Approach to the Public Debt Legislation Should Be Considered.  FGMSD-79-58. Washington, D.C.: September 7, 1979.
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