Former Treasury Official's Testimony at Finance Committee Hearing on Debt Reduction

GARY GENSLER

[1] Chairman Grassley, Ranking Member Baucus, members of the committee, thank you for the opportunity to appear here today to discuss Treasury debt held by the public. Though questions related to the nation's debt are often technical and arcane, the relationship of this issue to larger budget debates requires that it now be subject to a more public airing. In particular, you have asked how much of the $3.4 trillion in publicly held debt is available to be paid off through 2011. (Table I summarizes the currently outstanding publicly held debt.)

[2] I recently had the honor to serve as Treasury Undersecretary for Domestic Finance. Amongst my duties as Undersecretary was the oversight of debt management during the time when Treasury made a smooth transition from financing a deficit to paying down over $400 billion in publicly held debt. Prior to this time, I was a partner of the international investment-banking firm Goldman, Sachs, and worked on Wall Street for 18 years.

[3] Though some debt may be difficult to retire, I believe that less than $500 billion is truly unavailable to pay down through 2011. I believe that over $2.9 trillion of the currently outstanding $3.4 trillion in publicly held debt could be paid off without any significant cost or "premium."

[4] More specifically, Treasury can pay off this debt without any significant cost or premium, by: (1) allowing the vast majority of this debt to mature as it comes due; (2) repurchasing the majority of Treasury's current long term marketable debt smoothly over time at market prices; and (3) making other changes as part of sound debt management, such as discontinuing issuance of the 30-year bond and certain other issues of securities. My analysis assumes that the $185 billion Savings Bond program would continue.

[5] Separate and apart from the question of how much debt is available to be paid, some have raised a question about the economic and financial consequences of reducing the supply of Treasury securities. In other words. even if most of the debt was available to be paid down, would it harm the economy to remove Treasury securities from the marketplace?

[6] The U.S. capital markets already have been adjusting to a declining role of Treasury securities and a transition period is well underway. Treasury securities, which once represented close to one-half of the U.S. bond market, now represent less than one- quarter. There are many other instruments currently competing for new roles in this changing environment. I believe that the U.S. capital markets, the most innovative and creative in the world, will surely adapt over time.

[7] Responding to this concern in recent Congressional testimony, Chairman Greenspan said that Treasury securities are readily substitutable with other types of securities and that while ". . . it would be slightly less efficient than the riskless securities, the great advantage of reducing the debt effectively to zero, in my judgment, would overcome that."

REPAYING DEBT BY ALLOWING IT TO MATURE

[8] In the past, when the government had deficits, it went to the public -- individuals, financial institutions, and local or foreign governments -- and borrowed the money. Interest is currently being paid for these loans. Our recent commitment to fiscal discipline has allowed us to begin repaying that debt, thereby reducing interest costs for the taxpayers.

[9] Over $400 billion in debt already has been paid off, primarily by simply using budget surpluses to pay off bonds as they mature -- as opposed to rolling them over, and borrowing the same sum again. This method continues to be the most direct way to retire debt.

[10] Nearly $2.5 trillion in marketable debt will mature or is callable by 2011. In addition, there is $150 billion in non- marketable debt held by state and local governments, 90% of which matures within five years. All of this combined $2.6 trillion in debt, representing 76% of the publicly held debt, can be repaid as it comes due with no premium or additional cost.

CHANGING TREASURY ISSUANCE

[11] One of Treasury's traditional tools to manage the debt is to change the menu of new issues offered to the public. Treasury can initiate issuance of new securities when needed or discontinue issuance of specific securities during times of surpluses. For instance, Treasury initiated issuance of State & Local Government Securities in 1972, callable 30-year bonds in 1977 and non-callable 30-year bonds in 1985. In contrast, Treasury also has discontinued at least six different securities over the last 16 years: 20-year bonds and callable bonds in 1985; 4-year notes in 1991; 7-year notes in 1993: 3-year notes in 1998: and 52-week bills earlier this year.

[12] Given projected surpluses and debt paydown, Treasury can use this traditional tool and stop issuing new long-term debt.

[13] For example, the Treasury Borrowing Advisory Committee, a group of top outside financial experts, informally voted at their last meeting to recommend elimination of the 30-year bond. The Borrowing Advisory Committee meets quarterly to advise the Secretary of the Treasury, bringing together over 20 leaders of the bond market from commercial banks, investment banks and large investors. The history of the Committee dates back to at least the Truman Administration. Many other participants in the market also expect the Treasury to discontinue 30-year bonds later this year. In addition, the Treasury Borrowing Advisory Committee supported the elimination of the 30-year Treasury Inflation Protected Securities.

[14] To ensure that all new offerings mature before 2011, Treasury also could consider eliminating issuance of new 10-year notes. While this action is not currently anticipated broadly in the markets, discussion of it has begun to appear in Wall Street research reports. In addition, both the Congressional Budget Office and the General Accounting Office have recently included discontinuance of 10-year notes within their analyses of future debt management actions.

DISCONTINUING STATE AND LOCAL GOVERNMENT SECURITIES

[15] Treasury also has the authority to discontinue issuance of various series of non-marketable debt. In particular, they can stop issuing State and Local Government securities (SLGSs). Treasury initiated a review of this option last summer.

[16] State and local governments currently invest $150 billion in Treasury securities with the proceeds of advanced refunding of their liabilities. Treasury has no statutory obligation to issue such securities. Just as other investors are, municipalities could adjust to a world of declining Treasury securities by investing in alternative debt instruments. They would still need to abide by anti- arbitrage rules related to the tax code and would likely change indenture agreements in their future offerings. This generally could be done, however, as most of this debt matures within 5 years, leaving a number of years prior to 2011 to make adjustments.

[17] The General Accounting Office highlighted this possibility last month in their report to Congress, entitled "Debt Management Actions and Future Challenges." They said, "the Treasury ultimately may be forced to reassess its issuance of non-marketable securities, such as the state and local government series." In addition, some private sector forecasters assume that the program will be eliminated.

THE OTHER $800 BILLION IN DEBT

[18] With at least $2.6 trillion in debt maturing by 2011, what about the other approximately $800 billion in debt? This includes approximately $280 billion in other non-marketable debt (excluding the SLGSs) and approximately $520 billion in marketable debt maturing after 2011.

NON-MARKETABLE DEBT

[19] Some of this remaining debt is non-marketable debt such as savings bonds, long maturity zero-coupon bonds, and Treasury securities held by the Thrift Savings Plan. In combination, these total approximately $280 billion or 8% of the publicly held debt.

[20] There are currently $185 billion in savings bonds outstanding. This program, while not growing for many years, still has broad public acceptance and is thought by many to be an important vehicle to promote private savings among small savers. While this debt is likely to decline modestly over time, it may be truly unavailable to be redeemed.

[21] There also are $55 billion (face amount) in long maturity zero-coupon bonds. These were issued to foreign governments to back the Brady program ($25 billion) and to the REFCorp and FICO to back the resolution of the thrift crisis ($30 billion.) While these bonds are non-marketable and generally mature after 2011, foreign holders have been asking Treasure to redeem some of them. In particular, foreign governments have been refunding their Brady bonds and the underlying Treasury zero-coupon bonds have been redeemed. In total, over the last three years, $11 billion in zeros held by foreign governments have been redeemed. In addition, working with Congress, Treasury in the future could consider purchasing REFCorp and FICO bonds in the market and thereby effectively redeeming the underlying zeros. Therefore, the amount of non-marketable zeros will likely decline over the next ten years.

[22] The Thrift Savings Plan holds $33 billion in Treasury debt to back Federal Government employees' selections of investing in the bond market. While the TSP invests directly in private sector bonds and equity securities, the arrangement with Treasury regarding Treasury bond investments was set up during the mid 1980's in a period of significant and growing fiscal deficits. All of these securities actually mature daily and are then rolled over into new securities. If desired, Congress, the Treasury and the TSP could consider alternatives for this program.

[23] In summary, this $280 billion in various non-marketable securities are amongst the hardest Treasury securities to redeem. It is likely, however, that they will decline over the next ten years to less than $250 billion due to modest declines in savings bonds, foreign redemption of zeros, and possible changes related to other non-marketable debt.

LONG-MATURITY MARKETABLE DEBT AND DEBT BUYBACKS

[24] There are currently about $520 billion in bonds (including inflation-indexed bonds) maturing after 2011 that trade freely in the market. The Federal Reserve holds about $60 billion, leaving only approximately $460 billion in private hands.

[25] One of our founding fathers, Alexander Hamilton, first recommended one of the most basic and sound options at Treasury's disposal: debt buybacks. This is simply the government buying bonds in the secondary market prior to their maturity.

[26] Hamilton, the first Secretary of the Treasury, submitted a plan to Congress in 1795 to extinguish the debt within thirty years. Albert Gallatin, appointed Secretary of the Treasury by Thomas Jefferson, conducted the first debt repurchases during the period from 1807 to 1812. Used subsequently throughout our nation's history during times of sustained surpluses buybacks were once again employed last year.

[27] Treasury successfully repurchased $30 billion par amount of long-maturity debt last year. To date, Treasury has successfully and efficiently conducted 2-4 buyback operations repurchasing $36.2 billion par amount of debt. The Treasury has received on average 4.1 offers for every bond repurchased. Because the average maturity of the redeemed issues has been long, 18.3 years on average, these buybacks have kept the average length of the marketable debt from extending by 3 months.

[28] Debt buybacks have now become a regular and predictable part of the Treasury's debt management program. There is a regular schedule of two operations per month with a practice of announcing a target buyback amount each quarter.

[29] The financial markets anticipate that Treasury will repurchase between $35 billion and $45 billion in debt this year and continue this program well into the future. Many investment banks project significant continuing buybacks. For instance, Merrill Lynch recently projected approximately $245 billion in buybacks over the next 5 years. Last year, Goldman, Sachs projected the program growing to W-50 billion this year and to higher levels going forward. Wrightson Associates forecasts that Treasury will continue buybacks at the current pace into the future. The General Accounting Office in their report to Congress last month also assumed that buybacks would continue into the future.

[30] Over time Treasury can continue to smoothly repurchase substantial amounts of long-term debt at market-level prices. Moreover, foreign holders of long-term debt should not present an obstacle to this goal. Edwin Truman, a former senior official for international matters at the Federal Reserve and subsequently at the Treasury presented testimony in this regard last week stating; "Foreign holders do not present unique obstacles to programs directed at paying down Treasury's publicly held debt prior to maturity on reasonable terms." With your permission, I would like to ask that such testimony also be included in the record of this hearing.

[31] As mentioned earlier, the Federal Reserve holds about $60 billion of debt that matures after 2011 as part of its roughly $500 billion Treasury portfolio. The Federal Reserve System is undergoing an examination of how it would conduct monetary policy without this debt. Chairman Greenspan has that it would be "a little more difficult to do it that way, but the advantages of reducing the debt are such that that should be our first priority." In other words, the Federal Reserve holdings should not be an obstacle to paving down the debt.

[32] In addition to buybacks, Treasury also could reinstitute debt exchanges, last used in 1972. Through this mechanism, Treasury could offer investors new short-maturity debt in exchange for their current longer-maturity debt. The Borrowing Advisory Committee has recommended use of these exchanges. In addition, debt exchanges are common practice for private sector and sovereign government issuers. For instance, the United Kingdom, Spain, and the Netherlands regularly use them as part of their debt management.

THE QUESTION OF POSSIBLE PREMIUMS

[33] Some have suggested, however, that any efforts to buy back debt would involve expensive premiums. The Administration has suggested that it might cost between $50 and $150 billion in premiums to buy back long maturity debt. Experience and judgment suggest otherwise.

[34] It might be best to start by defining two different types of premiums. The first is paid when the coupon interest rate on a bond is, higher than the current prevailing interest rates. This so- called "market premium" equals the present value of the excess of the coupon rate over the current market interest rate. As this simply represents a timing shift of paying up front for avoiding above- market interest rates in the future, this "market premium" has no long-term cost to the government.

[35] The second question is whether Treasury might be required to pay more than the regular market premium to repurchase bonds in the market. It is this second question that has been discussed in policy circles during the last few weeks.

[36] Wall Street firms and Treasury have reviewed two factors in their analyses to date that are pertinent to the overall questions related to possible premiums.

[37] First, where has Treasury purchased bonds in relation to the market price? Investment firms have measured "concessions," which can be defined as the difference between the yield paid on repurchased bonds and the yield in the market place at the exact time of a particular buyback operation. Merrill Lynch and Goldman, Sachs both have consistently found that concessions have been negligible. The General Accounting Office concurred with these results when they reported to Congress last month, that "while there was variation across the 20 buyback operations, generally the average concession was small or negative."

[38] Over the first 24 buyback operations, Treasury has paid a concession versus the market of only a fraction of one basis point (1/100th of one percent). For non-callable debt, there appears to be a concession to the market on average of only 1/10th to 2/10ths of a basis point. This equates to only $80,000 to $165,000 per billion dollars of buybacks or approximately $8 to $17 million per $100 billion in buybacks. To reach the Administration's estimates for premiums of between $50 and $150 billion, these concessions would have to expand over 1,000 fold.

[39] Second, where has Treasury purchased bonds in relation to their ability to issue new long maturity securities? Treasury tracks the average yields of buybacks and compares it to new issue yields (interpolated yields on comparable maturity securities are based upon new issue 10-year notes and 30-year bonds). Consistently, Treasury has been able to purchase securities over 20 to 25 basis points cheaper than the interpolated new issue yield. This reflects how much Treasury gains by capturing the liquidity premium market participants are willing to pay for newly issued securities.

[40] Using a slightly different approach, Goldman, Sachs has found similar results. They have reported that the Treasury has saved taxpayers $1.25 billion through the first $36 billion in buybacks. This equates to roughly 25 basis points of savings or over three dollars in savings per every $100 of buybacks.

[41] To reach the Administration's estimates of premiums, these savings would not only have to turn into losses, but they would have to be of dramatic proportions. Losses on average would have to mount to between $11 and $33 dollars for every $100 in buybacks -- the equivalent of approximately 70 to 250 basis points in yield loss.

[42] To summarize, to date buybacks have lead to significant savings for taxpayers with only negligible concessions to the market. Furthermore, debt buybacks are a crucial tool for the nation to affect a smooth glide path to debt reduction.

THE QUESTION OF SCARCITY

[43] Some have suggested, however, that when long-maturity bonds become scarcer, they will become more expensive, even possibly making them impossible to repurchase. While at first glance, this view seems to be consistent with traditional economic relationships of supply and demand; there is an important additional factor that affects the securities market -- the importance of liquidity.

[44] As supply declines, so too does the attractiveness of individual securities. The more of a security that exists, the more readily that security is tradable and generally the more liquid it is. The less of a security that exists, the less readily that security is tradable and generally the less liquid it is.

[45] Investors generally value liquidity and are willing to pay more for large liquid issues. One of Treasury's five core principles of debt management, in fact, is to promote liquidity, so as to lower Treasury borrowing costs.

[46] It is not entirely clear, then, what will happen to yields as the long-maturity Treasury market declines in size. There actually is relevant evidence from the market, however, that could suggest a decline in price and an increased will ingness to sell to the Treasury.

[47] First, it is interesting to look at securities that the market views as having the identical credit risk as Treasury securities, but with less tradable supply. There are a number of examples. In particular, REFCorp and FICO bonds were issued backed by the U.S. Government. (The principal is backed by zero coupon Treasury securities and the Treasury provides for any shortfall in interest.) REFCorp bonds, with only $22 billion outstanding, trade about 30 basis points cheaper than comparable Treasury securities. The smaller $8 billion pool of FICO bonds trade even cheaper, at about 50 basis points over Treasury yields. On the other hand, the larger, approximately $65 billion, callable Treasury market trades about 15 basis points over comparable non-callable securities on an option- adjusted basis.

[48] Second, the recent buybacks provide some evidence. Since buybacks began on callable bonds, decreasing their supply, callable Treasury securities have cheapened by approximately 5 basis points. In addition, the most significantly repurchased non-callable bonds have not gotten more expensive. In fact, since the first buyback operation, the 3 most repurchased bonds have actually cheapened modestly, by 0.3 to 0.5 basis points, versus comparable maturity and coupon Treasuries.

[49] Lastly, experience in other countries is interesting. A number of countries, including the United Kingdom, Spain, the Netherlands and New Zealand have recently conducted debt exchanges. This is a mechanism whereby newly issued debt is exchanged for currently outstanding debt. Evidence from these countries shows that debt has not gotten richer as it has gotten scarcer. To the contrary, bonds have increasingly cheapened as the amounts outstanding shrank.

[50] To summarize, there is ample evidence that, as bonds become scarcer, they lose liquidity and generally become cheaper. While there may come a time eventually when it becomes difficult to repurchase long-maturity Treasury debt, this has not been the case to date and is not likely for some time to come. As buybacks continue and supply shrinks, those investors who value liquidity will be more willing to sell long-maturity Treasury bonds.

SUMMARY OF AVAILABLE DEBT TO BE REPAID

[51] By discontinuing new issuance of long-maturity debt, using debt buybacks, and possibly reinitiating debt exchanges, Treasury could smoothly retire one-half, and possibly up to two-thirds, of its current long-term marketable debt in private hands over the next ten years. By continuing to work closely with the Federal Reserve regarding their holdings, this would leave less than $230 billion in marketable debt outstanding.

[52] If Treasury were to continue issuing 10-year notes for the next several years, they could later conduct buybacks of the majority of these securities as well. Moreover, Treasury will continue to have seasonal cash management needs and will periodically wish to address those needs by issuing and redeeming short-term cash management bills.

[53] In sum, the amount of truly unavailable debt should be thought of as less than $500 billion -- the less than $230 billion in long-maturity marketable debt, plus the less than $250 billion in non-marketable debt previously discussed.

[54] There is $3.4 trillion in publicly held debt currently outstanding. Approximately $200 billion of this will be paid off during the remainder of this year. This will leave $3.2 trillion in publicly held debt at the end of this year.

[55] With less than $500 billion in debt truly unavailable to be redeemed, there remains $2.7 trillion in debt available to be paid off between 2002 and 2011.

COMPARISON TO OTHER ESTIMATES

[56] Some have asked why this estimate differs from the one included in the last Clinton Office of Management and Budget report. That estimate was done for a different purpose. It was included in "baseline" estimates -- numerical pictures of the budget that assume existing policies, including debt-management policies, continue unchanged. Given that approach, OMB did not feel it necessary to consult with Treasury in preparing those estimates.

[57] The Congressional Budget Office recently estimated that $818 billion in debt might be unavailable to be redeemed over the next ten years. The principal differences from my estimate relate to assumptions about debt management. CBO's report is also a "baseline" estimate. In it, they did not discontinue the SLGSs program and they assumed that current Treasury policy had only a modest continuance of debt buybacks. Therefore, CBO was not suggesting or necessarily aware of possible changes in future Treasury debt management practices.

[58] The new Administration suggests that $1.2 trillion of debt would be unavailable to be repaid. This was based upon a model that continued issuance of all long-term debt at current levels for at least 5 years; continued issuance of inflation indexed securities at current levels for at least 5 years; continued issuance of SLGSs; and discontinued the buyback program. One curious implication of the model, as reported in analyst reports, was the near-term elimination of the Treasury bill market, and the discontinuance of 2-year and 5- year notes while maintaining issuance of long maturity debt.

[59] As the analysis in my testimony indicates and judgment and experience I support, Treasury has ample alternatives available to manage the debt to a much lower amount than indicated by the OMB model.

CONCLUSION

[60] With sound debt management Treasury can readily pay down the vast majority of the publicly held debt. Of the $3.4 trillion currently outstanding publicly held debt, over $2.9 million is available to be repaid through 2011. This would leave less than $500 billion in debt truly unavailable to be repaid in that timeframe.

[61] Thank you. I would be happy to answer your questions.

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