Window-dressing the Treasury's debt auction: John Kemp

Thu Feb 5, 2009 6:10am EST

-- John Kemp is a Reuters columnist. The views expressed are his own --

By John Kemp

LONDON (Reuters) - Following yesterday's quarterly refunding announcement by the U.S. Treasury, investment banks will be working the telephones hard to find clients to buy the record $67 billion worth of new Treasury securities scheduled to be auctioned, starting next week.

Just over half the total amount ($36.3 billion) is needed to repay existing notes and bonds that are set to mature; the remainder ($30.7 billion) is new borrowing needed to cover the cost of bank rescues, fiscal stimulus and the deficit in the regular budget.

The refunding portion should be relatively simple, since the money that needs to be raised is matched by the amount of funds investors will be receiving back from the government as old debts mature and are repaid. Refunding involves persuading investors to re-invest maturing funds into new securities. Only the price/yield is an issue, albeit a thorny one.

New borrowing will be more challenging because it involves attracting additional funds into the Treasury market. The risk/return characteristics of Treasury debt are not particularly attractive at present. The interest rate cycle is close to the trough, yields are at multi-decade lows, and risks to investors from both the rate cycle and inflation are probably concentrated on the upside.

The Fed has talked about buying longer-dated Treasury securities in an attempt to create a "buyer of last resort" to guarantee investors a floor under the market.

But buying an instrument that has limited upside capital potential, and where mitigation of downside capital risk depends on the Fed's uncertain willingness and ability to buy unlimited quantities if the price falls too far, is probably not attractive for most investors.

Some commentators have suggested that the normal role of benchmark U.S. Treasury bonds providing "riskless returns" has been inverted and they now provide returnless risks.

So the investment banks may find it hard to find customers for the new issues.

But it is unthinkable the auctions could "fail" either by drawing insufficient bids, or drawing bids but only at very high yields.

Financial theater requires the auction is fully subscribed, and over-subscribed, at prices and yields close to those prevailing in the market (currently about 3.65% for 30-year paper and 2.95% for ten-year notes).


In line with convention, the primary bond market dealers will guarantee to take up the entire issue. Any bonds and notes that cannot be sold immediately to customers will be taken into their own books. In turn, the Fed will make sufficient funds available to the dealers to cover the cost of carrying the extra debt on their books until it can be sold on.

In effect, the Fed will guarantee to buy up the unsold proportion of the debt issues, but indirectly via the primary dealers, preserving the important illusion the central bank is not monetizing the government's borrowing.

The deal (banks guarantee to buy the whole issue, and the Fed guarantees to lend them the money) is attractive for the banks because the Fed will be lending short-term funds at an interest rate close to zero while the banks will be buying assets yielding 2.5-3.0%.

The risk is the bond prices will fall between the time the banks buy them at auction and the time they are eventually sold to investors. But the Fed can mitigate this by promising or threatening to enter the market and buy bonds if their prices fall too far.

Moreover, the banks are not in a position to refuse. The losses which they might incur from a fall in bond prices in the short term (perhaps $3-5 billion) are dwarfed by the amount of support they are receiving from the U.S. Treasury in other ways via the Troubled Assets Relief Program (TARP) and other government rescue packages. Helping the Treasury by taking up the balance of the debt issue is a small price to pay.

If the primary dealers struggle to find sufficient customers for the new debt instruments, it will show up in three places over the next fortnight:

(1) An increase in the volume of repo lending by the Federal Reserve Bank of New York (FRBNY) to relieve "tightness" in the money market, as reported daily on the FRBNY's website (here).

(2) A reduction in the volume of "excess reserves" held by the commercial banks with the Federal Reserve, as reported weekly by the Board of Governors in its H.4.1 release "Factors Affecting Reserve Balance of Depository Institutions and Condition Statement of Federal Reserve Banks" (here).

(3) An increase in the volume of government securities held by the commercial banks on their balance sheets, as reported by the Board of Governors in its weekly H.8 release "Assets and Liabilities of Commercial Banks in the United States" (here).

It is quite likely the New York Fed will pre-build liquidity in the money market in advance of next week's auctions, to ensure the primary dealers have sufficient cash on hand to absorb the issue.


Moreover, the Fed's willingness to start open market operations in longer-dated Treasury securities, and the increasing volume of these securities in existence, should make them more liquid and give the banks more comfort to start holding them.

The Fed may be able to persuade the banks to start holding some of their "reserves" in the form of seven, ten and thirty-year Treasury debt, rather than demand deposits at the central bank.

Commercial banks are currently holding $736 billion in reserves with the Federal Reserve. These are the funds that the Fed credited to the commercial banks after it bought short-term Treasury bills and other assets from the commercial banks last year to supply them with temporary liquidity.

Only a relatively small proportion would need to be shifted across into government debt to ensure the auctions were covered.

The Fed would still be monetizing the government debt issue, but in a far less obtrusive way. The Fed would be buying private debts from the banking system, in order to free the banking system up to buy public debts from the Treasury.

Excess bank balances have been falling in recent weeks, and are currently at the lowest level for two months. Meanwhile the proportion of government and federal agency securities in bank assets has been rising from 11.71% a year ago to 12.01% at the outset of the crisis in September, 12.62% at the start of December, and now 13.16% at the end of January.

Bank holdings of safe Treasury and agency paper as a proportion of total assets have started to rise, breaking a five-year downswing (here).

In effect, the Fed's open market operations, and the Treasury's borrowing program, are resulting in a massive asset swap.

The proportion of private debt on banks' balance sheets is being reduced, while the proportion of safer government debt is rising, helping reduce the overall riskiness of their portfolios. Meanwhile the proportion of private debt on the Fed's balance sheet is rising, ensuring the Fed, and ultimately the Treasury, is shouldering a larger chunk of the default and liquidity risk associated with these assets.

Next week's debt auctions will not fail, but the interactions between the Treasury, the Fed and the commercial banks will result in a further quiet transformation of bank portfolios and transfer of risk.

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