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

Letter

Background

The federal government began with a debt of about $75 million in 1790. In February 1941, the Congress and the President enacted a law that set an overall limit of $65 billion on Treasury debt obligations that could be outstanding at any one time. 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).

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

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

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

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

Suspension of ESF Investments

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

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

In addition to obligations issued under subsection 8348(d) of title 5, United States Code, other obligations are lawful investments by the Civil Service fund. For example, subsection 8348(e) of title 5, United States Code, authorizes the Secretary of the Treasury to invest surplus Civil Service funds in other interest-bearing obligations of the United States or obligations guaranteed as to both principal and interest by the United States, if the Secretary of the Treasury determines that the purchases are in the public interest. Further, obligations issued by other agencies, such as the Tennessee Valley Authority, 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.

Other Special Authorities

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.

Impact of Gains and Losses on Accounts with Investment Authority

Gains and losses associated with federal government accounts with investment authority and Treasury’s general fund can occur for a variety of reasons. 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.

Objectives, Scope, and Methodology

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.

Chronology of Events

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

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

Federal government accounts with investment authority that are authorized to invest their receipts, such as the Civil Service fund, 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.

Actions Related to the G-Fund

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

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

The amount of the G-Fund’s receipts that Treasury invested changed daily, depending on the amount of the federal government’s outstanding debt. Although Treasury can accurately predict the outcome of some events that affect the outstanding debt, it cannot precisely determine the outcome of others until they occur. For example, the amount of obligations that Treasury will issue to the public from an auction can be determined some days in advance because Treasury can control the amount that will be issued. On the other hand, the amount of savings bonds that will be issued and redeemed and the amount of obligations that will be issued to, or redeemed by, various federal government accounts with investment authority are difficult to precisely predict. Because of these difficulties, Treasury needed a way to ensure that the normal investment and redemption activities associated with Treasury obligations did not cause the debt ceiling to be exceeded and also to maintain normal investment and redemption policies for the majority of these accounts. To do these things, each day during the debt issuance suspension period, Treasury calculated the amount of debt subject to the debt ceiling, excluding the receipts that the G-Fund would normally invest; determined the amount of G-Fund receipts that could safely be invested without exceeding the debt ceiling and invested this amount in Treasury obligations; and suspended investment, when necessary, of the G-Fund’s remaining receipts.

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

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

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

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

Actions Related to the Civil Service Fund

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

Obligations Held by the Civil Service Fund Redeemed Earlier Than Normal

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

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

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

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

Investment of Civil Service Fund Receipts Suspended

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

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

When the Secretary of the Treasury redeems obligations earlier than normal or refrains from promptly investing Civil Service fund receipts because of debt ceiling limitations, the Secretary is required by subsection 8348(j)(3) of title 5, United States Code, to immediately restore, to the maximum extent practicable, the Civil Service fund’s obligation holdings to the proper balances when a debt issuance suspension period ends and to restore lost interest on the next normal interest payment date. Consequently, Treasury took the following actions once the debt issuance suspension period had ended: Treasury invested about $30.8 billion of uninvested receipts on May 27, 2003. These receipts were associated with (1) collections made by the Civil Service fund that had not been invested and (2) funds associated with the early redemptions that had not been used for benefit payments and expenses.

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

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

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

During fiscal year 2003, Treasury initiated the following actions involving the Civil Service fund, FFB, and the Treasury general fund related to its efforts to (1) address FFB cash flow issues resulting from previously issued FFB 9(a) obligations to the Civil Service fund and (2) manage the amount of debt subject to the debt ceiling: On October 18, 2002, FFB redeemed prior to maturity $15 billion in FFB 9(a) obligations held by the Civil Service fund. The $15 billion in FFB 9(a) obligations do not count against the debt ceiling. 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.

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

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

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

Conclusions

The Secretary of the Treasury can take many actions to manage federal government operations during a debt issuance suspension period. In some cases, these actions pose no long-term financial risk to affected parties because of the statutory authorities currently available to the Secretary of the Treasury. As noted earlier, Treasury used these authorities to restore, in total, $463 million in losses incurred by the G-Fund and Civil Service fund. However, other actions expose the affected parties to financial risks that are not normally incurred as part of their programmatic operations.

Whether the risks associated with specific actions result in actual losses or gains may not be known until many years after the action has been taken. History has shown, however, that the risks may be substantial. For example, according to FFB estimates, on October 18, 2002, the Civil Service fund lost interest of over $1 billion on a $15 billion transaction entered into in 1985 because of the unexpected early redemption of 9(a) obligations issued by FFB and unforeseen interest rate changes. Treasury lacks the statutory authority to restore such losses and has not developed the documented policies and procedures that can be used to minimize such losses in future exchanges between FFB and federal government accounts with investment authority, such as the Civil Service fund.

Recommendations for Executive Action

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

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

Agency Comments and Our Evaluation

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

Treasury stated that it plans to use FFB’s independent auditor to “ensure that the terms and structure 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.

Gains and Losses on Federal Accounts with Investment Authority

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

Gains and Losses Associated with Normal Investment and Redemption Activity

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

Gains and Losses Associated with Security Valuation

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

Gains and Losses Associated with Adjustments

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

Gains and Losses Associated with Unusual Events

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

In OPM’s comments on our report on the actions taken during the 1985 debt ceiling crisis, it stated that the Civil Service fund “should be ‘made whole’ when available funds are not properly invested. This is especially important for situations . . . 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.

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

A present value analysis is used to provide a basis for understanding the value of an obligation using current market conditions when that obligation is being purchased, sold, or exchanged before maturity. The present value 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.

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

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

During the 1985 debt ceiling crisis, Treasury for the first time invested excess receipts of the Civil Service fund in FFB 9(a) obligations. 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.

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

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

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.

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

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

Treasury Accepted Par Value Specials at Their Present Value

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

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.

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

As discussed earlier, when FFB decided on June 30, 2003, to redeem prior to maturity the 9(a) obligation it had issued to the Civil Service fund, another present value analysis was performed. As a result of this analysis, FFB had to borrow about $16.6 billion from Treasury using 9(b) obligations to redeem the $15 billion FFB 9(a) obligation it had issued to the Civil Service fund. FFB needed these additional funds because the FFB 9(a) obligation was based on an interest rate yield of 5.25 percent and the interest rate used in the present value analysis was 3.5 percent (the June 2003 Civil Service fund investment rate). According to FFB officials, the following approach was used to structure this $16.6 billion loan from Treasury: FFB borrowed $15.4 billion using principal repayments that mirrored principal payments used in the original FFB 9(a) obligation to the Civil Service fund, which, in turn, mirrored the underlying FFB loans made to its borrowers. For example, if FFB held a loan that called for a $10 million principal payment on December 31, 2005, then FFB would have borrowed $10 million from Treasury with a December 31, 2005, repayment date. In effect, after these transactions, FFB’s loan repayments for its 9(b) obligations to Treasury mirrored the underlying loan principal repayments that FFB expected to receive from its loan portfolio.

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

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

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.

Transactions between FFB and the Civil Service Fund

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

1985 Debt Ceiling Crisis

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

1995/1996 Debt Ceiling Crisis

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

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

2003 Debt Issuance Suspension Period

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

Related GAO Products

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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