.jpg)
I'd like to borrow a hundred million overnight.
By Melvin J. Howard
The U.S. Continental Congress
began issuing debt securities in 1776, and the United States has had debt
securities outstanding in global financial markets ever since. After the
Continental Congress failed to service U.S. Revolutionary War debts fully and
promptly, the first Secretary of the Treasury Alexander Hamilton restored U.S.
credibility in global financial markets by establishing sound principles and
goals for debt management that transformed U.S. debt from a highly speculative
and illiquid security into the safest and most liquid investment in the world.
For a brief time in 1836, the U.S. Department of the Treasury actually had
funds available to pay off the entire net debt. However, some creditors were
unwilling to redeem their Treasuries prior to maturity. Other Treasuries may
have been lost or destroyed. Therefore, the U.S. government was never “out of
debt” in 1836. The economic depression that began in 1837 sent the federal
budget back into deficit, causing net debt to rise once again.
As federal net debt is
retired, the supply of Treasuries will become scarce this will have serious
consequences in financial markets. The Treasury market will become less liquid
and less integrated. As a result, most of the characteristics that made
Treasuries so well suited for so many financial purposes will deteriorate. For
example, the cost of dealing in Treasuries as measured by interdealer bid-ask
spread will rise. Idiosyncratic differences will emerge between the yields on
Treasuries with similar maturity. Moreover, the Treasury yields and the yields
on other taxable debt securities are diverging from their historic
relationships, while Treasury yields and the yields on tax-exempt state and local debt securities
are converging. Could the Federal debt reduction cause the liquidity of the Treasury
market to deteriorate?
Repurchase
agreements (repos) are, in effect, short-term loans secured by safe liquid
collateral. In a repo transaction, a borrower simultaneously agrees to sell a
particular debt security to a lender and to buy the same security back from the
lender at a specified price on a future date, often the next day. A borrower
“repos out” the security, temporarily exchanging it for money from the lender.
The repo rate is based upon the difference between the current price and the
agreed-upon price in the repo. Because repos are fully collateralized, repo rates are
lower than rates for unsecured federal funds lending among banks. A reserve
repo is the other side of a repo transaction. A lender “reverses in” a
security, agreeing to sell it back to the borrower on a future date at an
agreed upon price. Most repos involving Treasuries occur at the general
Treasury collateral repo rate. Because banking organizations can use either the
federal funds or repo markets for overnight financing, the general Treasury
collateral repo rate tracks closely, but just below the federal fund rate.
However, if the demand for a particular Treasury is very high or the supply of
such security is limited, the repo rate for such
security can fall below the general Treasury collateral repo rate. Such
security is said to be “on special.” In other words, the lender is so desirous
of reversing in a particular Treasury that the lender is willing to let the borrower,
who owns such security, benefit from a “special” interest rate below the
general Treasury collateral repo rate. The repo market is huge and largely dependent on Treasuries
as the underlying debt security.
The average daily volume of total
outstanding repurchase (repo) and reverse repo agreement contracts totaled $7.06
trillion in the first quarter of 2008, a 21.5 percent increased over
the $5.81 trillion during the same period in 2007.
Daily
repos outstanding averaged $4.3 trillion in Q1, up 20.4%, and reverse repos
averaged $2.76 trillion, up 23.2% from a year ago. Treasury notes
accounted for the majority of repo trades (66.4%), followed by Federal
agencies (11.2%), Treasury bonds (7.7%), Treasury bills (6.9%), and Other
(7.9%), which includes discount agencies, TIPS, and more.
But all is not rosy according to Bloomberg Business Treasuries and other
fixed-income securities shrunk to $4.6 trillion daily outstanding last month,
down 35 percent from a peak of $7.02 trillion in the first quarter of 2008,
based on Federal Reserve data compiled from its 21 primary dealers. From fewer repos to
lower inventories of bonds, financial institutions are responding to more
stringent capital standards imposed by regulators around the world. Already,
the group of dealers and investors that advise the U.S. Treasury say that they
see declines in liquidity in times of market stress, including wider gaps
between bid and offer prices and the speed of completing trades. The potential
consequences are higher borrowing costs for governments, companies and
consumers.
