Treasury Official's Remarks to Bond Market Association on Commodity Futures Modernization Act

DEPARTMENT OF THE TREASURY

[1] It is a pleasure to be here today. I particularly appreciate the efforts of the Bond Market Association to provide forums, such as this one, for discussion of the important changes in Treasury's debt management.

[2] These last few years have been a remarkable time for Treasury's debt managers. When Secretary Rubin asked me in 1997 to join Treasury, the U.S. government was still running deficits. If he had told me then that one of my jobs would be advising on the paydown of nearly $400 billion of public debt by the end of the Administration, I would have thought he was exaggerating greatly, at the very least. But, in fact, that is what has come to pass. Today, I would like to share with you some of how we approached this challenge. I will then close with some thoughts about possible future challenges.

[3] During the Clinton Administration, we have moved very quickly from a sustained period of very large budget deficits to a period of substantial budget surpluses. We have gone from the challenge of funding a deficit of $290 billion in 1992 to managing a surplus of $237 billion this past year. That is over half a trillion dollars in improvement in annual budget results. In fact, this represents the longest period of consecutive fiscal improvements in our nation's history. The results of the last five years are attached in Table 1.

[4] Treasury's publicly held debt now stands at roughly a third of the Gross Domestic Product. This is down from nearly 50 percent at the start of the administration. More relevant to the bond market, however, is that privately held marketable Treasury debt, now at approximately $2.4 trillion, has been dropping in relation to the domestic debt markets -- from 32 percent in 1993 to 18 percent today. In fact, based on current projections, President Clinton will be the first President since President Truman under whom this debt has not increased during his term of office.

RE-EXAMINING OUR DEBT MANAGEMENT PHILOSOPHY IN AN ERA OF SURPLUSES

[5] As we moved from deficits to surpluses, one of the first challenges we identified was how we should articulate Treasury's debt management goals and principles. We realized, in fact, that Treasury had not prepared a formal statement of its debt management goals in many years. In reviewing Treasury's past practices and strategies for the future, it became clear that we had a consistent set of goals and principles appropriate for periods of either deficit or surplus. The Bond Market Association actually provided the forum to articulate those goals three years ago at your Annual Meeting. They were as follows:

o providing sound cash management;

o Preserving the risk free status of Treasury debt;

[7] As we moved from the old era of deficits to the new era of surpluses, we had to augment the old tools of debt management with new tools. As the budget deficits declined in 1996 and 1997, we responded using a traditional tool of debt management, adjusting the size of issuance. In 1997, for instance, even as coupon issuance increased, net bill issuance decreased by $59 billion.

[8] As surpluses started in 1998, we used two of the other traditional tools, issuance frequency and actual elimination of an issue. This led to the elimination of the three-year note and the move from monthly to quarterly five-year notes in May 1998. Subsequent changes have now cut private coupon issuance in half. Treasury's coupon issuance has dropped from more than $560 billion in FY1997 to less than $280 billion in FY2000 (see attached Table 3).

[9] As we entered 1999, it became more likely that we were moving into a period of sustained surpluses. With this transition, we realized we needed to turn to new debt management tools, as well. Since then, we have added new debt management tools in three areas: debt buybacks, regular re-openings, and revisions to Treasury's auction rules. In addition, we worked with the Federal Reserve on new guidelines for managing their System Open Markets Account ("SOMA").

BUYBACKS

[10] In early 1998, Treasury's Borrowing Advisory Committee recommended that we consider instituting a debt buyback program to reduce debt while preserving the liquidity of our benchmark issuance. The Committee cannot take all of the credit for this idea, however, as it was first recommended by Secretary Alexander Hamilton in his report to Congress in 1795. Treasury, in fact, has used buybacks throughout our nation's history in periods of sustained budget surplus, most recently seventy years ago.

[11] We felt the initiation of a buyback program would be beneficial in a number of ways. We believed that by allowing more issuance of Treasury securities, it would best promote liquidity. Debt buybacks, by bringing more balance to our debt paydown, also would help us to manage the maturity structure of Treasury's outstanding debt.

[12] There were many critical decisions in re-instituting buybacks after such a long period. One of the greatest challenges was to make sure that buybacks were not caught up in partisanship or politics in any way. One of the hallmarks of debt management is that, as a core-function of government, it has been non-partisan. We therefore worked closely with the Office of Management and Budget and with Congress to ensure that the rules developed for the budget treatment of buybacks were neutral. This was no small achievement. More than once in the 19th Century, Treasury had tried and failed for budgetary reasons to obtain the support of Congress for a debt buyback.

[13] Today, Treasury will have completed the $30 billion of buybacks we targeted for this year. We're very pleased with the results of this initial year. Debt buybacks have now become a regular and predictable part of our debt management program. We have now instituted the practice of announcing our target buyback amount at our Quarterly Refunding press conference. At the last refunding, we announced that we would target buybacks of $3 billion each month through the first calendar quarter of 2001.

RE-OPENINGS

[14] The second new tool was the initiation of regular reopenings. As the size of coupon issuance shrank, it became important to concentrate the remaining issuance on fewer unique offerings. Treasury had used reopenings from time to time in the past for the long bond and the 10-year note, but not on a regular basis. We believed, however, that reopenings would allow Treasury to maintain large, liquid debt issues, while maintaining a quarterly issuance program for longer-maturity debt, including the five-year note. We believed, also, that reopenings should be a regular and predictable feature of the market. Interestingly, the most significant challenge to getting this done was that Treasury had to issue new rules on tax treatment for reopened securities.

AUCTION RULES

[15] The third set of new tools has been changes to Treasury's auction rules. First, we changed the rules to use single price auctions for all marketable debt issuance. This improved auction participation and reduced the cost of financing Treasury's debt.

[16] Second, we announced a series of technical, but important, changes to the rules that apply to participation by Foreign and International Monetary Authority ("FIMA") account in Treasury auctions. These changes are intended to bring FIMA accounts more fully into the competitive auction.

[17] The primary market for Treasury's debt has been segmented into competitive and non-competitive bidders. As our issuance decreases, we felt it was important to integrate these segments to the greatest extent possible. Bringing foreign central banks more fully into the competitive auction will improve the liquidity and efficiency of the Treasury market and allow the Treasury to better control the amount of funds raised at auction.

SYSTEM OPEN MARKET ACCOUNT

[18] Lastly, we also worked closely with the Federal Reserve Board and the Federal Reserve Bank of New York as they have developed new policies for the purchase of Treasury securities for the System Open Market Account. They set various limits across the yield curve for Federal Reserve holdings of Treasury securities. These limits would lead the Federal Reserve to have net redemption in the primary market and therefore to purchase more securities in the secondary markets through coupon passes. The changes are designed to assist the Federal Reserve in conducting monetary policy in an environment of declining Treasury issuance. Their policy change has given us more alternatives, however, as their net redemptions provide us with greater flexibility. Over the next two years, we estimate that they will have coupon redemptions of $15 to $20 billion each year.

LOOKING FORWARD

[19] The reorientation of Treasury's debt management has been a gradual process, much like turning a battleship, but the battleship has turned. Current forecasts, from both private sector and government sources, are for annual budget surpluses of at least a quarter of a trillion dollars for several years. Some forecasters are increasing their surplus projections. While actual budget outcomes will depend on economic developments and political decisions, it seems likely that substantial surpluses will persist for some time. The challenge of the next several years, therefore, will be to pay down more than twice what we already have paid down in the last three years.

[20] At the same time, the amount of maturing coupon securities will fall substantially. While more than $425 billion come due in 2001, the amount of maturing debt is expected to fall to approximately $300 billion in 2003 and even further in the following year. With this in mind, I would like to touch briefly now on the three challenges that I see ahead for Treasury's debt management: tactical debt management decisions, market adjustments, and Federal Reserve policy on holding Treasury securities.

TACTICAL DEBT MANAGEMENT DECISIONS

[21] No doubt there will be a number of important tactical debt management decisions with regard to size and frequency of issuance and buybacks. Treasury's Borrowing Advisory Committee already has recommended that Treasury eliminate issuance of the 52-week bill in February. We have worked with Congress to revise statutes that reference the auction yield of the 52-week bill, proposing references to the one-year constant maturity yield. We have received bipartisan support and we are optimistic that some, if not all, of these revisions will be completed before Congress finally goes home. Whatever happens in the last days of Congress, elimination of the 52- week is the next appropriate step toward concentrating liquidity into our remaining issues.

[22] As further adjustments to Treasury issuance become necessary, the Borrowing Advisory Committee has suggested the next adjustment Treasury should consider would be a reduction in the frequency of issuance of two-year notes from monthly to quarterly. The two-year note currently represents over half of Treasury's coupon issuance, so it is the most likely next place to go to cut issuance. Based on current budget projections, however, such an adjustment is not likely to be needed for the next year or possibly two.

[23] Possible elimination or reduction of the 52-week bill and two-year note are relatively near-term adjustments. It is possible that, as budget surpluses evolve over the longer term, Treasury may need to consider additional changes. The challenge of Treasury's debt management, however, is the inherent variability of forecasts. The need for flexibility in the face of this uncertainty is the primary reason Treasury has continued to issue 30-year bonds.

[24] If there continues to be a substantial paydown in the debt, no doubt Treasury will examine all options in the future, including some Treasury's non-marketable debt programs, such as the State and Local Government Series or "SLGS." While Savings Bonds also are part of non-marketable debt, the Savings Bond program has a value that goes far beyond the financing it provides to Treasury. The Savings Bond program represents an important vehicle to facilitate increased private savings, particularly among small savers. It is more important than ever to encourage saving as we near retirement of the baby boom generation.

[25] It is also likely that Treasury will need to add even further new debt management tools in the future. Treasury's Borrowing Advisory Committee already has recommended that Treasury consider making coupon and principal STRIPS fungible and conducting debt exchanges. These may be issues for Treasury's debt managers to examine in the future.

MARKET ADJUSTMENTS

[26] Continued fiscal discipline has led to significant economic benefits. Further, debt reduction will lead to macroeconomic benefits of increased national savings and greater availability of funds for private investment. The decrease in Federal debt has reduced long-term interest rates and lifted output and incomes in a virtuous circle that has created further surpluses. There are a number of microeconomic challenges to be faced by the financial markets, however, as the supply of Treasury securities declines.

[27] We believe that the markets will continue to function efficiently as other instruments increasingly serve the functions for capital markets that Treasuries currently serve. The competitiveness, creativity, and innovation of the U.S. financial system will ensure a smooth transition. The process of adaptation will take time, but the transition period is already well underway.

[28] It is likely that a variety of instruments will replace Treasury securities with respect to their various functions. Market participants will determine which instruments or combinations of instruments best meet their needs. As we continue on the path of debt reduction, the market will determine what instruments will be most widely used for what purpose in the future.

[29] As the markets turn increasingly to swaps to take on some of the functions played by Treasury securities, it is ever more important to provide legal certainty for this OTC derivatives. We have worked vigorously to pass legislation providing legal certainty for swaps under the Commodity Exchange Act. I am very pleased to announce that we reached agreement late last night with Congress on such legislation, the Commodity Futures Modernization Act of 2000. This legislation, if enacted, will provide legal certainty, promote innovation, and enhance the competitiveness of U.S. financial markets.

[30] The government will have some adjustments of its own to make with the reduction in Treasury debt. As we have seen with the 52-week bill, marketable Treasury securities are used as a reference in statutes for a variety of public and private purposes. Amongst those purposes are setting the interest rate on non-marketable Treasury securities issued to the Social Security and other Federal trust funds.

[31] In the meantime, the market for Treasury securities remains the deepest, most liquid securities market in the world. Treasury will continue to promote the liquidity of its securities in the environment of declining debt. To do this, we have sought to integrate the foreign central banks into the auctions, to concentrate on fewer, larger, unique issues, and to pursue a continuing buyback program.

IMPLICATIONS FOR THE FEDERAL RESERVE

[32] The Federal Reserve currently holds about $530 billion of Treasury securities, or more than 17 percent of the publicly held marketable debt. They currently are working on a study of the implications of shrinking Treasury debt issuance on how they implement monetary policy. Treasury has fully supported their efforts. As Treasure debt has declined, Treasury, the Federal Reserve, and the markets have benefited from the close working relationship we have developed. There are a number of possible alternatives they are examining. We believe they will find effective ways to implement monetary policy in an era of declining debt.

CONCLUSION

[33] I would like to conclude on a personal note. This has been a wonderful time to be at Treasury. The economy has been strong. Treasury has had the great leadership of Secretary Rubin and Secretary Summers and, more importantly, of President Clinton, all of whom have worked hard to grow the economy, promote fiscal discipline, and enhance the competitiveness of markets. They have done this while promoting consumer protection and working to ensure that all Americans share in the benefits of this economy. It also has been a privilege to be able to work on such interesting challenges. Beyond the challenges of paying down nearly $400 billion debt, it's been a time when we were able to achieve major legislation repealing Glass- Steagall, to modernize derivatives regulation, and to lay the foundation for electronic commerce through passage of the E-Signature Act. We also were able to enact important new consumer financial privacy legislation and underscore the promise of community development, particularly through the President's New Markets initiative. I would like to thank the Bond Market Association and particularly Treasury's Borrowing Advisory Committee for their contributions along the way. Thank you.