November 2, 2010
The Committee convened in closed session at the Hay Adams Hotel at 9:03 a.m. All Committee members were present. Assistant Secretary for Financial Markets Mary Miller, Deputy Assistant Secretary (DAS) for Federal Finance Matthew Rutherford and Director of the Office of Debt Management Colin Kim welcomed the Committee. Other members of Treasury staff included Fred Pietrangeli, Moji Jian, Jennifer Imler and Alfred Johnson. Federal Reserve Bank of New York members Mark Cabana and Dina Marchioni were also present.
DAS Rutherford opened the discussion with a presentation to the Committee. He noted that the budget deficit for FY10 printed at $1.294 trillion. This was an improvement from the Administration's previous estimate of approximately $1.45 trillion. Rutherford noted that the recent improvement in the fiscal situation was led by improvements in tax receipts, led by a 43 percent year-over-year increase in corporate taxes. Personal income tax receipts also continue to rise, although at a more gradual pace as the economy continues to experience below potential growth. Ongoing TARP repayments have been another source of income that has reduced Treasury's borrowing needs.
Looking ahead to FY11, DAS Rutherford noted that total receipts are projected to increase to 15.8 percent of GDP. Over the coming years, receipts as a percentage of GDP are expected to gradually increase back towards the historical average of 18 percent. This improvement is built into many forecasters' estimate of the deficit. A survey of the primary dealers found that the average deficit forecast for FY11 is $1.214 trillion, over $200 billion below OMB's forecast.
Rutherford noted that the forecast involves some level of uncertainty. The potential for individual tax rate changes in the coming months could have a significant impact on receipts. OMB forecasts assume that individuals earning over $250,000 will have their tax rates rise, while other earners will continue to pay at the current rates. Uncertainty surrounding the passage of the annual AMT extension could also impact the forecast for receipts.
The outcome of tax policy, coupled with uncertainty about the economic growth outlook, will impact Treasury's ability to continue to cut auction sizes in the coming months. Rutherford suggested that Treasury will likely maintain auction sizes at the current levels over the coming quarter to assess the fiscal outlook. However, it was noted that further reductions in offering amounts could take place in 2011.
Rutherford then discussed recent trends in auction participation. Over the past quarter, bid-to-cover ratios have remained extremely high for bill, note, bond, and Treasury Inflation Protected Securities (TIPS) auctions. A comparison to other sovereign issuers underscored that Treasury auctions remain well subscribed. He highlighted that domestic funds continue to be active participants in the auction process, and that foreign demand remains robust.
He noted that Treasury has been very pleased with the recent performance of TIPS auctions. Despite this year's 48 percent increase in gross issuance, demand for TIPS has been robust. Bid-to-cover ratios have been rising and concentration in TIPS secondary market trading has fallen. The performance of the asset class has given Treasury confidence to continue to expand the program going forward. Rutherford noted that this could be accomplished through an additional five and 30-year TIPS reopening.
Director Kim then turned to the current state of the Treasury portfolio. Overall, bills as a share of the total outstanding portfolio continued to fall since the last time the committee met. He noted that bills (including SFP) currently make up approximately 21 percent of the portfolio, compared to the pre-crisis average of approximately 24 percent. He indicated that Treasury is watching the bill market for signs of strain, but to date the market continues to function relatively well.
Kim noted that the decline in bill issuance mirrors the increase in coupons as a percentage of the portfolio. Nominal coupons currently make up 72 percent, which is above the long-term average of 69 percent. He noted that TIPS currently comprise 7 percent of the portfolio and issuance in this program will continue to steadily increase over the next year. For calendar year 2011, Treasury expects to issue over $100 billion in TIPS. It was highlighted that this would likely stabilize TIPS as a percentage of the overall portfolio.
Director Kim noted that Treasury continues to reduce some of the rollover risk embedded in the portfolio. The average maturity of the debt currently stands at 59 months, which is in line with the average observed over the last 30 years. Going forward, Kim indicated that this measure will continue to gradually extend further. He also noted that the percentage of debt maturing in one, two and three years are at historic lows.
Rutherford then briefly concluded with a discussion on the long-term fiscal challenges facing debt managers. Aside from a review of the OMB mid-session review forecasts, he indicated that the bipartisan fiscal commission is expected to present their findings in December.
The Committee then turned to the first question in the charge. Four general questions were posed by a member of the Committee to frame the discussion. First, what should Treasury do with nominal auction sizes over the coming quarter? Second, what should be the average maturity of the Treasury debt portfolio? Third, how should the Treasury think about bills in the portfolio? Fourth, what changes should Treasury make to the TIPS calendar?
Members noted that there was significant uncertainty surrounding the future of the Bush tax cuts and the economic growth outlook. Some suggested it might be prudent for Treasury to stabilize nominal coupon issuance for the next several months until clarity regarding the fiscal situation emerges.
With regard to the average length, several members of the Committee noted that if Treasury continued with its current issuance pattern, the average length would gradually increase from current levels. One member suggested that Treasury should issue significantly more 30-year bonds, despite some metrics that suggest that long-term issuance is expensive (i.e. the spread between 10- and 30-year yields). This member underscored that 30-year rates were near historic lows. Overall, the committee was comfortable with continuing to extend the average maturity of the debt.
The discussion about lengthening the average maturity of the debt led to a discussion about the size of the Treasury bill market. One member noted that bills were near historically low levels as a percent of the portfolio and that further shrinkage would be problematic for the bill market. Another member stated that negative bill rates ultimately benefit Treasury, because reduced bill issuance would most likely result in making longer-dated coupons and bank deposits more attractive to investors. Members agreed that Treasury should monitor the bill market going forward.
At this point, a member asked about the impact of the Fed's potential quantitative easing (QE2), expected to be announced at the November 2010 FOMC meeting. The question arose regarding whether the Fed and the Treasury were working at cross purposes, given that Treasury is extending the average maturity of the portfolio while the Fed is expected to purchase longer-dated securities. The member noted that from an economic perspective, the Fed's purchase of longer-dated coupons via increasing reserves was economically equivalent to Treasury reducing longer-dated coupons and issuing more bills.
It was pointed out by members of the Committee that the Fed and the Treasury are independent institutions, with two different mandates that might sometimes appear to be in conflict. Members agreed that Treasury should adhere to its mandate of assuring the lowest cost of borrowing over time, regardless of the Fed's monetary policy. A couple members noted that the Fed was essentially a "large investor" in Treasuries and that the Fed's behavior was probably transitory. As a result, Treasury should not modify its regular and predictable issuance paradigm to accommodate a single large investor.
The discussion then turned to TIPS. A member outlined a plan to expand the TIPS program to monthly issuance by adding second reopenings of 5-year TIPS and 30-year TIPS. It was noted that Treasury has been gradually increasing the program and that market participants expected further increases in the program in Calendar Year 2011. Since Treasury auctions of TIPS tend to be "liquidity events", the idea of second reopenings and having TIPS auctions every month would improve liquidity.
Several members raised the issue of the cost of the TIPS program, suggesting that the cost of the program has remained high relative to nominal issuance. Some suggested that Treasury undertake another cost study in the future. It was, however, recommended that Treasury increase the size of the program and add the additional reopenings.
The Committee next turned to the second question in the charge concerning the outlook for non-bank financial institutions in the aftermath of the 2008 financial crisis and the more diminished role played by these entities in the allocation of credit.
The presenting member began with a theoretical discussion of similarities and differences between non-bank and traditional bank financial institutions, noting that both institutions engage in maturity transformation, liquidity transformation, and credit quality transformation. However, it was noted that traditional banks engaging in these activities are subject to regulatory oversight, have deposit insurance, and have access to a lender of last resort. This is not the case for the non-bank financial institutions.
The presenter then discussed the primary changes in "shadow-bank" liabilities versus traditional bank liabilities. The main changes in shadow bank liabilities include a large decline in commercial paper, asset-backed securitizations, and repurchase transactions (repos). On the traditional banking side, the presenter noted that bank liabilities are continuing to grow, particularly small time deposits. The presenter highlighted that, although shadow banking liabilities have declined, they still exceed traditional bank liabilities.
The presenting member highlighted the sharp post-Lehman decline in money fund balances as one reason for the contraction of shadow bank credit. The member noted that prime money market funds' assets under management (AUM) fell from their August 2008 peak of $1.3 trillion to about $800 billion in Q4 2008. However, as of September 2010, total prime fund assets were only down by $252 billion from the peak. The presenter also noted the enormous shrinkage of security lenders as a large source of credit creation. The assets under management of securities lenders fell from over $3 trillion in Q4 2007 to just over $1.5 trillion in Q2 2010.
The member then went on to cite the large declines in issuance by sophisticated ABCP issuers such as SIVs and securities arbitrage vehicles and repo utilization. The member underscored that ABCP securitization grew steadily until 2007 before reversing course in 2008.
Supply and demand dynamics were discussed next. It was noted that while supply of money market instruments (excluding U.S Treasury securities of less than 1 year) has declined considerably since September 2008, demand has grown. The member noted, however, that a large portion of the decline in supply appears to have stabilized. On the demand side, the member noted that the popularity of structured products and floating rate securities has diminished since the crisis.
The member concluded by discussing the overall implication of the diminished role of the shadow bank credit allocation on the US Treasury market. The member forecast higher Treasury security holdings as the likely outcome of these changes. This is due to a combination of factors that include high investor demand for cash-like investments, lower supply of alternative products, and regulatory changes like 2a-7 liquidity requirements and the Basel 3 liquidity coverage ratio.
The Committee next turned to the question in the charge regarding the impact of the Basel 3 on financial markets and the Treasury debt market. The presenting member began by noting that Basel 3 is going to impose stricter capital, liquidity, and leverage requirements on regulated financial institutions over the next decade. The benefits of doing so will be a significant reduction in systemic risk to the global banking system.
The presenter stated that Basel 3 is still a work in progress and many details have yet to be decided. That said, Basel 3 is significantly broader in scope and a more complex regulatory undertaking relative to prior Basel accords. It is also being implemented at a faster pace than previous Basel accords and these changes are occurring at a time when global economic activity is slow. Isolating the potential macro-economic and financial market impacts of Basel 3 is made more difficult by the fact that there are a number of other regulatory reforms being considered around the globe.
The presenter then began discussing the changes in the Basel capital requirements. Capital requirements for banks are expected to rise due to the proposed increases in risk weights for certain asset classes and an overall increase in capital ratios. By some estimates, risk weighted assets are expected to increase by 60 percent. Calibration of the capital requirements going forward is critical to maintaining support for certain credit activities such as securitization and hedging. The presenter suggested that without proper capital calibration, borrowing rates will likely increase under Basel 3, and the inability for banks to hedge credit risk will ultimately reduce the bank's ability to extend credit. Capital calibration may impact such performance metrics like return on equity and the cost of equity for large banks, which in turn, may impact the supply of lendable funds and potentially move some lending activity outside of the regulated banking system into the non-bank financial system.
The presenter next focused the discussion on the Basel 3 liquidity ratios. Liquidity ratios are intended to guard against runs on banks' wholesale liabilities. This requirement is expected to be implemented by December 31, 2011. The liquidity coverage ratio is defined as the "stock of high quality assets divided by the projected net cash outflows over a 30 day horizon." High quality assets are defined as cash, sovereign, investment grade corporate and public sector debt, while cash outflows include retail deposits, unsecured wholesale funding, secured funding, conduits and contingent liabilities. As proposed in Basel 3, the liquidity requirement may prove to be problematic, particularly with regard to the treatment of deposits and unfunded liabilities. Banks would be required to carry a higher percentage of liquid assets, which would reduce lending capacity and banks' return on assets.
Overall, it was noted that these proposed changes in liquidity requirements could result in higher lending costs, reduced interbank liquidity, diminished ability of banks to hedge credit risk and a reduced ability to provide back-stop facilities for commercial paper. It could also lead to an expansion of the non-bank financial system.
The presenter then discussed the proposed leverage ratios contained in Basel 3. As currently proposed, Basel 3 creates a more conservative leverage standard than currently exists for most US banks, due to a stricter definition of Tier 1 capital in combination with a broader definition of total assets (including off balance sheet derivatives and contingent liabilities). The leverage ratios are expected to be implemented by 2015 and imply further deleveraging by US banks in order to comply with the proposed rule. This requirement would also impact the ability of banks to provide credit lines.
The presenter also noted that Basel 3 will have an impact on Treasury markets by its impact on economic growth and rules governing the ownership of securities and loans. There have been a number of studies on the potential macroeconomic impacts of Basel 3. These estimates indicated that Basel 3 will result in an increase in lending rates of between 20 to 100 basis points in the US, and real GDP growth impacts of -0.1 percent per year to -0.9 percent per year. In terms of Treasury securities, Basel 3 will probably result in banks holding more Treasury and agency securities in their portfolios and fewer loans. There are a range of estimates but one private forecast predicted that Basel 3 liquidity requirements would result in $400 billion of new Treasury security purchases by U.S. commercial banks by 2015.
The Committee finally addressed the fourth question in the charge regarding the implications of a second round of quantitative easing. The member provided a presentation that considered market expectations of QE2 and its impact over the medium- and long-term horizons.
The presenting member stated that the market expects the Federal Reserve to purchase $100 billion per month, as well as $30 billion per month in MBS reinvestments. This will total $1,560 billion in Treasury purchases over the next year. The member stated, however, that market participants believe the Fed will leave the status of QE2 open ended, with purchases ultimately dependent on economic conditions. The presenter also noted that the program should last six months to two years.
The presenting member thought that over the medium term (one to two years), QE2 would force Treasury yields lower and would likely lead the curve to flatten in the five- to ten-year sector. Meanwhile, the risk premium in 30-year bonds would likely increase given concerns about inflation and the value of the U.S. dollar.
The presenter stated that financial markets generally believe that QE2 will push swap spreads wider as the float of U.S. Treasury supply declines. It was also noted that there could be some tightness in the repo market. Credit spreads are also expected to tighten alongside other risk premiums. While mortgages will initially trade wider versus Treasuries, the presenter expected that mortgage spreads should narrow relative to both the Treasury and swap curves. The presenter further noted that rate volatility will decline as market rates approach zero, with realized volatility in the long-end remaining higher as uncertainty and re-inflation fears increase.
According to the presenting member, liquidity issues could arise as the projected scope of QE2, along with MBS reinvestments, may exceed the entire combined expected net issuance of Treasuries, Agencies, Agency MBS, and Investment Grade Corporates. The member noted that potential illiquidity in the intermediate sector of the Treasury curve could push some investors into bills, 30-year Treasuries, and/or riskier assets.
The member noted that the U.S. Treasury and Federal Reserve are two independent, separate institutions with different mandates. As a result, it was noted that Treasury should not alter its issuance strategy. However, the presenting member suggested that Treasury could address potential illiquidity issues through additional issuance in sectors impacted by QE.
The presenting member then discussed the potential impact on financial markets of the Federal Reserve's exit strategy from QE2. The member noted that there was the potential for an extreme market reaction associated with the Fed's exit from potential purchases. This risk, however, may be mitigated according to the presenter, if the Fed were to gradually and predictably sell the assets on its balance sheet.
Finally, the presenting member also stated that the Fed's monetary policy actions had global ramifications. It was noted that the recent depreciation of the U.S. dollar has forced many central banks around the globe to re-calibrate their monetary policy stances.
The meeting adjourned at 12:00 PM.
The Committee reconvened at the Department of the Treasury at 5:00 p.m. All of the Committee members were present. The Chairman presented the Committee report to Secretary Geithner.
A brief discussion followed the Chairman's presentation but did not raise significant questions regarding the report's content.
The Committee then reviewed the financing for the remainder of the October through December quarter (see attached)
The meeting adjourned at 5:15 p.m.
Deputy Assistant Secretary for Federal Finance
United States Department of the Treasury
November 2, 2010
Matthew E. Zames, Chairman
Treasury Borrowing Advisory Committee
Of The Securities Industry and Financial Markets Association
November 2, 2010
Ashok Varadhan, Vice Chairman
Treasury Borrowing Advisory Committee
Of The Securities Industry and Financial Markets Association
November 2, 2010
Treasury Borrowing Advisory Committee Quarterly Meeting
Committee Charge – November 2, 2010
Taking into consideration Treasury's short, intermediate, and long-term financing requirements, as well as uncertainties about the economy and revenue outlook for the next few quarters, what changes to Treasury's coupon auctions do you recommend at this time, if any?
Outlook for Non-Bank Financial Institutions Post 2008 Financial Crisis
Prior to the 2008 financial crisis, a number of entities including hedge funds, SIVs, conduits, money funds, monolines, investment banks, and other non-bank financial institutions played a critical role in providing credit and liquidity across the global financial system. Many of these entities now play a more diminished role in the allocation of credit. Please discuss the current state of non-bank financial institutions. What is the outlook for these nonbank financial institutions and given the outlook, what are the implications for financial markets and the Treasury market.
Potential Impacts of Basel III Regulatory Reform
The Basel III banking regulatory framework, which is expected to be implemented by the end of 2012, includes tighter definitions of Tier 1 capital, prescribed leverage and liquidity ratios, counter cyclical capital buffers, and new limits on counterparty credit risk. We would like the Committee to comment on the potential impact of Basel III on financial markets and the Treasury market.
Implications of Global Quantitative Easing (QE)
Globally, monetary authorities of many large economies are engaging in various forms of quantitative easing in an effort to improve growth, increase employment, and boost capacity utilization. Please comment on the effectiveness of these efforts. What are the potential intermediate and long-term impacts for financial markets and the Treasury market, specifically.
Financing this Quarter
We would like the Committee's advice on the following:
- The composition of Treasury notes and bonds to refund approximately $13.8 billion of privately held notes maturing on November 15, 2010.
- The composition of Treasury marketable financing for the remainder of the October 2010- December 2010 quarter, including cash management bills.
- The composition of Treasury marketable financing for the January 2011-March 2011 quarter, including cash management bills.