Debt Management
Backup Funding Options Would Enhance Treasury's Resilience to a Financial Market Disruption
Gao ID: GAO-06-1007 September 26, 2006
The September 11, 2001, attacks significantly affected the financial markets that the U.S. Treasury (Treasury) relies on. To understand how Treasury could obtain funds during a future potential wide-scale financial market disruption GAO examined (1) steps Treasury and others took during the September 11 attacks and after to assure required debt obligations and payments were made on time and ensure liquidity in the markets, (2) major actions Treasury and others have taken since the attacks to increase the resiliency of the auction process, and (3) the opinions of relevant parties on the main design features of any backup funding options. We conducted interviews with Treasury officials and others and reviewed appropriate documents.
In response to the effects of the September 11 attacks on the financial markets, Treasury canceled a scheduled 4-week bill auction after communicating with the Federal Reserve Bank of New York (FRBNY). Treasury then used compensating balances from banks across the country to help meet its obligations on time. Compensating balances were replaced by direct payments in 2004. Also, in response to the attacks' financial effects, the Federal Reserve lent billions of dollars to both domestic and foreign financial institutions through a combination of methods to help markets recover. Federal Reserve actions and market behavior in the aftermath of the September 11 attacks are informative when considering potential alternative funding sources for Treasury during a future wide-scale financial market disruption. Treasury, the Federal Reserve, and primary dealers have added contingency sites and systems intended to increase the resilience of the auction process. Regardless of resiliency efforts, the nature and impact of a potential future wide-scale disruption are unknown. In addition, Treasury has at least one less source of cash since the compensating balances Treasury relied upon during the September 11 attacks are no longer used. Finally, Treasury's cash management policy of minimal cash balances to lower borrowing costs further limits Treasury's access to cash during a wide-scale disruption. All these factors make it prudent for Treasury to explore other funding alternatives to use during a wide-scale disruption. Relevant parties with whom we spoke, including primary dealers, agreed. They also generally agreed on a list of main design features including source of funds, situations for use, approvals, and costs, among others, that should be considered when weighing alternative funding options. Discussions with Treasury, the Federal Reserve, and other relevant parties have led GAO to conclude that a two-tiered approach is promising. The first tier consists of two funding options involving a range of appropriate financial institutions, namely a credit line and a private placement of a flexible security known as a cash management (CM) bill. The second tier involves a direct draw from the Federal Reserve that would provide Treasury a last resort source of funds when other options are not viable. A credit line with several financial institutions would involve a prior transparent commitment or understanding by certain financial institutions to provide funds to Treasury. A private placement of a CM bill would involve a prior arrangement to issue a CM bill after communicating with certain senior executives at financial institutions who would have the ability and authority to meet Treasury's immediate funding needs. Finally, a direct draw from the Federal Reserve would require a change in the law to allow the Federal Reserve to directly lend to Treasury. Appropriate limitations, adequate flexibility, and accountability would have to be included in the design.
Recommendations
Our recommendations from this work are listed below with a Contact for more information. Status will change from "In process" to "Open," "Closed - implemented," or "Closed - not implemented" based on our follow up work.
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GAO-06-1007, Debt Management: Backup Funding Options Would Enhance Treasury's Resilience to a Financial Market Disruption
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entitled 'Debt Management: Backup Funding Options Would Enhance
Treasury's Resilience to a Financial Market Disruption' which was
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Report to the Chairman, Committee on Ways and Means, House of
Representatives:
United States Government Accountability Office:
GAO:
September 2006:
Debt Management:
Backup Funding Options Would Enhance Treasury's Resilience to a
Financial Market Disruption:
Debt Management:
GAO-06-1007:
GAO Highlights:
Highlights of GAO-06-1007, a report to the Chairman, Committee on Ways
and Means, House of Representatives
Why GAO Did This Study:
The September 11, 2001, attacks significantly affected the financial
markets that the U.S. Treasury (Treasury) relies on. To understand how
Treasury could obtain funds during a future potential wide-scale
financial market disruption GAO examined (1) steps Treasury and others
took during the September 11 attacks and after to assure required debt
obligations and payments were made on time and ensure liquidity in the
markets, (2) major actions Treasury and others have taken since the
attacks to increase the resiliency of the auction process, and (3) the
opinions of relevant parties on the main design features of any backup
funding options. We conducted interviews with Treasury officials and
others and reviewed appropriate documents.
What GAO Found:
In response to the effects of the September 11 attacks on the financial
markets, Treasury canceled a scheduled 4-week bill auction after
communicating with the Federal Reserve Bank of New York (FRBNY).
Treasury then used compensating balances from banks across the country
to help meet its obligations on time. Compensating balances were
replaced by direct payments in 2004. Also, in response to the attacks‘
financial effects, the Federal Reserve lent billions of dollars to both
domestic and foreign financial institutions through a combination of
methods to help markets recover. Federal Reserve actions and market
behavior in the aftermath of the September 11 attacks are informative
when considering potential alternative funding sources for Treasury
during a future wide-scale financial market disruption.
Treasury, the Federal Reserve, and primary dealers have added
contingency sites and systems intended to increase the resilience of
the auction process. Regardless of resiliency efforts, the nature and
impact of a potential future wide-scale disruption are unknown. In
addition, Treasury has at least one less source of cash since the
compensating balances Treasury relied upon during the September 11
attacks are no longer used. Finally, Treasury‘s cash management policy
of minimal cash balances to lower borrowing costs further limits
Treasury‘s access to cash during a wide-scale disruption. All these
factors make it prudent for Treasury to explore other funding
alternatives to use during a wide-scale disruption. Relevant parties
with whom we spoke, including primary dealers, agreed. They also
generally agreed on a list of main design features including source of
funds, situations for use, approvals, and costs, among others, that
should be considered when weighing alternative funding options.
Discussions with Treasury, the Federal Reserve, and other relevant
parties have led GAO to conclude that a two-tiered approach is
promising. The first tier consists of two funding options involving a
range of appropriate financial institutions, namely a credit line and a
private placement of a flexible security known as a cash management
(CM) bill. The second tier involves a direct draw from the Federal
Reserve that would provide Treasury a last resort source of funds when
other options are not viable. A credit line with several financial
institutions would involve a prior transparent commitment or
understanding by certain financial institutions to provide funds to
Treasury. A private placement of a CM bill would involve a prior
arrangement to issue a CM bill after communicating with certain senior
executives at financial institutions who would have the ability and
authority to meet Treasury‘s immediate funding needs. Finally, a direct
draw from the Federal Reserve would require a change in the law to
allow the Federal Reserve to directly lend to Treasury. Appropriate
limitations, adequate flexibility, and accountability would have to be
included in the design.
What GAO Recommends:
We recommend that the Secretary of the Treasury examine the
requirements for establishing a line of credit and a private placement
of a CM bill and select the most appropriate option(s) as a first tier.
As a second tier, Congress should consider allowing the Federal Reserve
to lend directly to the Treasury during a wide-scale disruption using a
carefully crafted last resort funding option. Both Treasury and the
Federal Reserve agreed that Treasury should examine the first-tier
options. Neither took a position on the second tier, but both
emphasized the importance of maintaining the independence of the
central bank.
[Hyperlink, http://www.gao.gov/cgi-bin/getrpt?GAO-06-1007].
To view the full product, including the scope and methodology, click on
the link above. For more information, contact Susan J. Irving at (202)
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[End of Section]
Contents:
Letter:
Results in Brief:
Background:
Objectives, Scope, and Methodology:
Treasury Canceled an Auction and Used Certain Cash Balances to Help
Meet Its Obligations during the Week of September 11, 2001:
Compensating Balances Are No Longer Used:
The Federal Reserve Used a Number of Methods to Provide Liquidity to
Domestic and Foreign Financial Institutions:
Since the Attacks, Treasury and the Federal Reserve Have Added Staffed
Locations and Data System Capability Intended to Increase Auction
Resilience:
Primary Dealers Have Taken Actions Intended to Increase Their
Resilience and Treasury Has Suggested Additional Improvements:
Despite Actions Intended to Increase Auction Resilience, Exploring
Funding Alternatives Outside of the Auction Process Is Appropriate:
Relevant Parties Validated Design Features and a Potential Tiered
Approach to Treasury Funding Options Has Emerged from Discussions:
Conclusion:
Recommendations for Executive Action:
Matters for Congressional Consideration:
Agency Comments:
Appendix I: Cost and Complexity Rule Out Other Options That Were
Discussed:
Appendix II: Background on Previous Treasury Draw Authorities:
Appendix III: Comments from the Department of the Treasury:
Appendix IV: Comments from the Board of Governors of the Federal
Reserve System:
Appendix V: GAO Contact and Staff Acknowledgments:
Tables:
Table 1: Matrix Treasury Presented to Dealers on Potential Responses to
Contingencies:
Table 2: Design Features of 1979 Cash and Securities Draw Authorities:
Figures:
Figure 1: Treasury Acted to Ensure Funding after the September 11
Attacks:
Figure 2: Four Major Processes Must Be Performed for Treasury to
Receive Its Cash After Announcement:
Figure 3: Current Operations of the Auction and Issuance of Marketable
Treasury Securities:
Figure 4: Concentrated Use of Cash Draw Authority 1942-1981 (Days
Federal Reserve Held Special Short-Term Treasury Certificates):
Figure 5: Borrowing Concentrated Around Tax Payment Months 1942-1981
(Days Federal Reserve Held Special Short-Term Treasury Certificates):
Figure 6: Cash and Securities Draw Authority Transactions:
United States Government Accountability Office:
Washington, DC 20548:
September 26, 2006:
The Honorable William M. Thomas:
Chairman:
Committee on Ways and Means:
House of Representatives:
Dear Mr. Chairman:
The massive destruction caused by the September 11, 2001, attacks on
the World Trade Center and the resulting loss of life, facilities,
telecommunications, and power significantly affected U.S. financial
markets, including the markets for U.S. Treasury (Treasury) securities.
The attacks exposed the vulnerability to a serious wide-scale
disruption[Footnote 1] of the markets that Treasury relies on as a
regular source for financing government operations and large, regularly
occurring payments such as Social Security benefits. In response to the
attacks, Treasury canceled a scheduled auction of 4-week bills on
September 11 and used compensating balances--noninterest-bearing cash
balances used to compensate banks for various services--to help meet
its obligations on time.
However, compensating balances are no longer used. In addition,
Treasury's cash management policy is to maintain minimal cash balances
in order to lower borrowing costs. We reported earlier this year that
the combination of a minimal cash balance policy and the unavailability
of previous methods for accessing cash warrant closer attention to
Treasury's ability to raise cash--and ultimately meet federal payment
obligations--should normal auctions be unavailable in the event of
another wide-scale disruption to financial markets.[Footnote 2]
In your continuing interest in how Treasury borrows the money required
to finance the federal government and in recognition of the risks of a
wide-scale financial market disruption, you asked us how Treasury might
obtain funds should normal financial market operations be significantly
degraded or closed due to a catastrophic emergency. Specifically, we
examined (1) steps Treasury and the Federal Reserve took during the
week of the September 11, 2001, attacks and during the weeks following
the attacks to assure required debt obligations and payments were made
on time and ensure liquidity in the financial markets, (2) major
actions Treasury, the Federal Reserve, and primary dealers have taken
since the September 11 attacks to increase the resiliency of Treasury's
auction process and participation, and (3) the opinions of relevant
parties[Footnote 3] on the main design features of any cash draw
authority and how the features would affect accountability and
congressional oversight, enhance Treasury's operations, affect Federal
Reserve operations, and influence the views of capital market
participants.
Results in Brief:
Treasury canceled a 4-week bill auction and used certain cash balances
to help meet its obligations during the week of the September 11, 2001,
attacks. Also in response to the attacks' financial effects, the
Federal Reserve provided large amounts of liquidity[Footnote 4] to
financial institutions. Since the attacks, Treasury and the Federal
Reserve have added staffed locations and data systems capability for
critical auction functions. Primary dealers--who are awarded a large
proportion of Treasury securities at auction--have also taken actions
intended to increase their resiliency. Regardless of actions taken to
increase resiliency, exploring other funding options is appropriate and
a promising two-tiered approach that would provide Treasury additional
access to cash during a wide-scale disruption has emerged.
To make up for the cash shortfall associated with the cancellation of
the 4-week bill auction in 2001, Treasury used compensating balances,
which were subsequently eliminated in 2004,[Footnote 5] to help meet
its obligations on time. It resumed auctions within a week and replaced
compensating balances within 10 business days of the attacks.
In the days following the attacks, the Federal Reserve expanded
liquidity, providing billions of dollars to domestic and foreign
financial institutions through open market operations, securities
lending transactions, discount window lending, and other
actions.[Footnote 6] As Treasury considers an alternative source of
cash during a possible future wide-scale disruption, it should be
cognizant that the Federal Reserve was, is, and potentially will be a
significant source of liquidity for many financial institutions in a
crisis.
Since the September 11 attacks, Treasury and the Federal Reserve,
acting as Treasury's fiscal agent, have staffed additional operational
locations[Footnote 7] and added data systems capability intended to
increase auction resilience. Treasury and the Federal Reserve have
added locations in different geographic regions from their primary
locations for all four critical auction functions. Treasury
periodically tests sites during live auctions, conducts mock auctions,
and stipulates that if it cannot conduct any disrupted auction within
an hour of the originally scheduled time it will communicate
information to market participants as it becomes available.
Primary dealers have also taken actions to increase resiliency. All
primary dealers have contingency sites and most have systems that link
directly to Treasury's auction systems at their contingency sites.
Because of the nature of financial markets, almost all primary dealer
contingency locations are well within the same geographic regions as
their primary sites and most dealers plan on staff relocating to their
contingency sites.
Regardless of the progress of resiliency efforts, the nature and impact
of a potential future wide-scale disruption remain unknown. In
addition, since compensating balances were eliminated in 2004, Treasury
has at least one less source of funds on which to rely. Finally,
Treasury's cash management policy of minimal cash balances to lower
borrowing costs further limits Treasury's access to cash during a wide-
scale disruption. The combination of these factors makes it prudent for
Treasury to explore other funding alternatives to use during a wide-
scale disruption. Relevant parties with whom we spoke, including
primary dealers, agreed.
These parties also generally agreed that the main design features that
should be considered when weighing alternative funding options include
situations for use, type of collateral, transaction type, approvals,
costs, amount limit, time limit, inclusion under the debt ceiling,
disclosure, and length of authority (if required). However, the
specifics would depend on the proposed options.
Discussions with Treasury and Federal Reserve officials and other
relevant parties have led us to conclude that a two-tiered approach
could enhance Treasury's ability to obtain funds during a wide-scale
disruption. The first tier consists of two funding options involving a
range of appropriate financial institutions, namely a credit line and a
private placement of a cash management (CM) bill. The second tier
involves a direct draw from the Federal Reserve that would provide
Treasury a last resort source of funds when other options are not
viable.
We recommend that the Secretary of the Treasury determine the main
design features and examine any implementation requirements for
establishing a line of credit and a private placement of a CM bill with
a range of appropriate private sector financial institutions for use
during a wide-scale disruption, and select the most appropriate
option(s). In addition, Congress should consider establishing an
explicit, carefully crafted, last resort draw authority to permit the
Federal Reserve to lend directly to the Treasury. This authority should
be limited to situations in which all other funding options are not
viable during a wide-scale disruption.
In written comments on a draft of this report, both Treasury and the
Federal Reserve agreed that Treasury should examine the first-tier
funding options described in this report. Although neither took a
position on our suggestion that Congress should consider permitting the
Federal Reserve to lend directly to the Treasury, both emphasized the
importance of maintaining the independence of the central bank. For
example, Treasury stated that it, "is generally opposed to arrangements
in which governments, at their discretion, can borrow directly from
their central bank as such arrangements compromise the independence of
the central bank." As our report notes, we also recognize the
importance of maintaining the independence of the central bank and
suggest an approach that we believe provides both flexibility and
reduces the vulnerability to abuse. Both Treasury and Federal Reserve
Board staff also provided technical comments which we incorporated as
appropriate. Their letters are reprinted in appendix III and appendix
IV respectively.
Background:
The September 2001 terrorist attacks and the subsequent collapse of the
twin World Trade Center towers damaged more than 400 structures across
a 16-acre area, and claimed almost 2,800 lives. Financial services
industry employees accounted for about 74 percent of the victims. Dust
and debris blanketed the area, creating difficult and hazardous
conditions that complicated recovery efforts. Many financial
organizations lost telecommunications service when the 7 World Trade
Center building collapsed and debris struck a major Verizon central
switching office that served approximately 34,000 businesses and
residences.[Footnote 8] Over 13,000 customers also lost power. To
accommodate the rescue and recovery efforts and maintain order,
pedestrian and vehicle access to the area encompassing the financial
district was restricted through September 13, 2001.[Footnote 9]
The attacks severely disrupted the secondary markets for government
securities and money market instruments primarily because of the impact
on the brokers that facilitate trading among dealers (broker-dealers)
and on one of the clearing banks for those trades. Two banks--the Bank
of New York (BONY) and JPMorganChase--provided clearing and settlement
services (and still do) for many major broker-dealers in the government
securities market. Clearing banks transferred funds and securities for
their customers that purchased or sold government securities based on
instructions received by the Government Securities Clearing Corporation
(GSCC).[Footnote 10] As a result of the attacks, BONY had difficulty
reestablishing its connections with GSCC and its own account at the
Federal Reserve, and its customers had difficulties connecting with
BONY. These problems contributed to the disruption of the secondary
government securities market. BONY had to evacuate four facilities,
including its primary telecommunications data center and over 8,300
staff, because they were located near the World Trade Center. By
September 14 BONY reestablished connectivity with GSCC and began
receiving and transmitting instructions for securities
transfers.[Footnote 11]
Both the Federal Reserve's Fedwire Securities Service, which provides
safekeeping, transfer, and settlement services for securities issued by
Treasury and other federal agencies, and its Fedwire Funds Service,
which provides payments services associated with securities sales and
other large-value transactions, continued processing transactions
without interruption. Although the Federal Reserve Bank of New York
(FRBNY), which manages the Fedwire services, sustained damage to some
communication lines, the Fedwire services were not interrupted because
the facilities that process transactions were not located in lower
Manhattan. Over 30 banks initially lost connectivity to Fedwire
services, but most were able to reestablish connections through backup
systems, and most payment system operations continued with minimal
disruption.
The Federal Reserve, Treasury, and primary dealers all play important
roles in Treasury auctions. The Federal Reserve and its associated
Federal Reserve banks function as the United States government's fiscal
agent and perform a variety of services for the Treasury including
handling Treasury auctions, accepting bids, communicating bids to
Treasury, issuing Treasury securities to winning bidders, and
collecting payment for securities.
Treasury borrows the money needed to operate the federal government and
manages the government's outstanding debt subject to a statutory
limit.[Footnote 12] Treasury's primary debt management goal is to
finance the government's borrowing needs at the lowest cost over time.
To meet this objective, Treasury issues debt through auctions in a
"regular and predictable" pattern across a wide range of securities.
Treasury publishes a schedule with tentative announcement,[Footnote 13]
auction, and settlement (issue) dates up to 6 months in advance of
regular security auctions. Depending on the type of security, Treasury
typically auctions and then issues a security within a week or less.
Treasury generally issues short-term regular bills with 4-, 13-, and 26-
week maturities every Thursday and issues 2-and 5-year notes at the end
of each month. Three-and 10-year notes are issued in the middle of each
quarter. Treasury reopens 10-year notes--or increases the amount
outstanding for these notes--1 month after their initial issuance. In
addition, Treasury issues Treasury Inflation-Protected Securities
(TIPS) in 5-, 10-, and 20-year maturities in certain months according
to the TIPS' maturity. [Footnote 14] Finally, Treasury issues 30-year
bonds in February and August and reopens these issues in May and
November, respectively.
Treasury supplements its regular and predictable schedule with flexible
securities called cash management (CM) bills. Unlike for other
securities, Treasury does not publish information on CM bills on its
auction schedule. Instead, Treasury generally announces CM bill
auctions anywhere from 1 to 4 days ahead of the auction. The term to
maturity--the length of time the bill is outstanding--varies according
to Treasury's cash needs. CM bills allow Treasury to finance very short-
term cash needs--for as little as 1 day--while providing short notice
to market participants.[Footnote 15]
As of the end of fiscal year 2005, about 46 percent of marketable
Treasury securities held by the public will mature during the next 24
months. As these securities mature and are replaced by new debt, the
cost to finance the federal government's debt will vary with changing
interest rates.
The bidders in Treasury auctions include depository institutions,
individuals, dealers and brokers, pension and retirement funds,
insurance companies, investment funds, foreign and international
entities, the Federal Reserve, and others. In recent years the
percentage of U.S. Treasury securities held internationally has
increased. Although the categories of bidders are diverse, primary
dealers, other commercial bank dealer departments, and other nonbank
dealers and brokers received almost 60 percent of auction awards of
marketable securities between August 2001 and May 2006. Federal Reserve
banks received almost 21 percent during that same time period for their
own accounts. Primary dealers are banks and securities brokers that
trade in U.S. government securities with the Federal Reserve. Primary
dealers have functioned for over 40 years as the distribution and
support system for Treasury debt and play a "vital" role[Footnote 16]
in the price discovery process.[Footnote 17] The FRBNY designates
primary dealers based on certain capital requirements, and requires
primary dealers to participate meaningfully in both Federal Reserve
open market operations and Treasury auctions to maintain their
designation. However, the Federal Reserve does not have regulatory
authority over dealers acting in the primary dealer role.
In the past, outside of the auction process, Treasury had access to a
cash draw authority intended for emergencies. Intermittently between
1942 and 1981, Treasury was able to directly sell (and purchase)
certain short-term obligations to (and from) the Federal Reserve in
exchange for cash. Treasury used the cash draw authority infrequently
and mostly in times of war or armed conflict. Congress last granted the
authority in 1979 and limited the amount Treasury could draw to $5
billion. Congress allowed this authority to expire in 1981 (see app. II
for more background information). Although the existence of a previous
draw authority is relevant, we are not suggesting restoration of this
authority in its previous form due to certain limitations.
Objectives, Scope, and Methodology:
To understand the steps that Treasury and the Federal Reserve took
during the week of the September 11 attacks and during the following
weeks to assure required debt obligations and payments were made on
time and ensure liquidity in the financial market, we conducted
interviews with knowledgeable Treasury and Federal Reserve officials
and staff. We also reviewed prior audit reports and other documentation
from GAO, the Federal Reserve, and Treasury. We analyzed and examined
these sources to develop a time line with key actions and to determine
actions and financial market behavior that are informative when
considering alternative funding sources for Treasury.
To understand major actions Treasury, the Federal Reserve, and primary
dealers have taken since the September 11 attacks to increase the
resiliency of Treasury's auction process and participation, we
interviewed Treasury and Federal Reserve officials and staff involved
in conducting primary dealer visits, the auction process, and systems.
We reviewed Treasury contingency and continuity of operations (COOP)
plans and other documents that described contingency sites, staff
training topics, contingency exercise results, and other Treasury
summaries. We also interviewed executives and staff involved and
familiar with resiliency efforts at 14 primary dealers and executives
involved with emergency planning at The Bond Market Association, the
industry association representing participants in the government
securities and other debt markets. In addition, some of our work was
based on internal knowledge derived from Treasury audits we have
conducted in the past.
To describe the opinions of relevant parties on the main design
features of any cash draw authority and how the features affect
accountability and congressional oversight, enhance Treasury's
operations, affect Federal Reserve operations, and influence the views
of capital market participants, we interviewed Treasury officials
involved with debt management, policy, operations, fiscal management,
auctions, and legal matters. Further, we interviewed Federal Reserve
officials involved with monetary affairs, open market and discount
window operations, and Treasury auction staff and researchers. In
addition, we communicated with foreign debt management officials, and
conducted interviews with executives and staff involved with Treasury
auctions at 14 primary dealers and senior executives at two major
commercial banks. We also spoke with other capital market participants,
and had discussions with senior congressional staff concerned with
oversight. We analyzed relevant Treasury, Federal Reserve, and capital
market documentation to obtain government and capital market
perspectives. We validated, with relevant parties, main design features
for consideration when structuring an alternative cash draw arrangement
and looked for emerging funding options based on discussion with
relevant parties.
We conducted our review in Washington, D.C., and New York, N.Y., from
March 2006 through September 2006 in accordance with generally accepted
government auditing standards.
Treasury Canceled an Auction and Used Certain Cash Balances to Help
Meet Its Obligations during the Week of September 11, 2001:
Treasury took a number of steps in reaction to the September 11 attacks
to ensure it met its obligations during a time of disrupted financial
markets, as summarized in figure 1. It canceled an auction scheduled
for September 11, withdrew compensating balances held in depository
institutions across the country, communicated with the FRBNY about the
status of markets, and resumed its normal auction schedule within 1
week of the attacks.
Figure 1: Treasury Acted to Ensure Funding after the September 11
Attacks:
[See PDF for image]
Source: GAO (data); PhotoDisc (upper left photo), and FEMA/Andrea
Booher (lower right photos).
[End of figure]
Treasury Canceled a 4-week Bill Auction in Response to the Attacks'
Effects:
Treasury decided to postpone and then cancel a planned auction of $10
billion worth of 4-week bills because of financial market degradation
due to the September 11 attacks. In addition, various infrastructure
concerns at the FRBNY made it unclear whether it could have conducted
an auction.[Footnote 18] Following its normal borrowing schedule, on
September 10 Treasury announced its intention to auction $10 billion
worth of 4-week bills on September 11 to help pay off $11 billion worth
of 4-week bills that were about to mature on September 13.
According to a senior Treasury debt management official, after the
September 11 attacks, Treasury initially wanted to postpone but not
cancel the auction. Treasury officials consulted with the FRBNY about
market conditions and learned that some primary dealers had evacuated
their office buildings that morning.
As the magnitude of the attacks became clearer Treasury decided to
cancel the auction. A markets officer in charge of Treasury auction
staff located at the FRBNY told us that it was unclear if they could
have executed the auction because of evacuations, structural integrity,
and other concerns at the time. Treasury issued a press release on
September 12 confirming the cancellation of the 4-week bill auction and
that Treasury had no plans for rescheduling the auction. Treasury
officials determined that canceling the auction would not damage
Treasury's reputation for "regular and predictable" auctions, given the
nature of the attacks.
Treasury Relied on Compensating Balances to Help Meet Its Debt
Obligations:
Treasury decided on September 11 to initiate procedures to withdraw
almost $13 billion of compensating balances--noninterest-bearing cash
balances that Treasury used to compensate banks for various services--
to make up for the cash shortfall associated with the cancellation of
the $10 billion 4-week bill.[Footnote 19] Treasury officials told us
that they wanted to pull back as much cash as possible and as quickly
as possible without harming the financial position of the banks.
Treasury's ending operating cash balance on September 11 was just a
little over $11 billion, which would have been insufficient to pay off
maturing 4-week bills on September 13, meet Treasury's other
obligations, and maintain the $5 billion target in its Federal Reserve
account.
Treasury contacted banks across the country holding compensating
balances on September 11 and asked them to confer with other bank
executives and consider whether withdrawing a total of $12.6 billion on
September 13 would cause any harm to the banks' operations. The banks
responded that the withdrawals would not, and according to senior
Treasury officials, also offered to help Treasury in any way during the
crisis. Treasury transmitted formal letters on September 12 specifying
amounts to be withdrawn on September 13. On that date Treasury received
the $12.6 billion from compensating balances and returned posted
collateral to applicable banks. Treasury did not pay any penalties
because compensating balances could be withdrawn by Treasury at any
time, and no telecommunications problems were encountered in completing
the transfers.
Treasury Met Its Debt Obligations on Time, Resumed Auctions within a
Week, and Replaced Compensating Balances within 10 Business Days of the
Attacks:
Treasury paid almost $43 billion in maturing bills (including about $11
billion of maturing 4-week bills) and received about $35 billion from
issuing bills on September 13. Additionally, on September 13 Treasury
announced its intention to auction 13-and 26-week bills and executed
the auction on September 17, 2001, awarding almost $35 billion,
resuming its normal auction schedule. In deciding to resume auctions,
Treasury held conversations with market participants and the FRBNY who
conveyed that the market was ready to bid on auctions. The September 17
auction proceeded normally according to one senior debt management
official and bid-to-cover ratios[Footnote 20]--a commonly cited measure
of auction performance and market demand for securities--were similar
to the 13-and 26-week bill auctions held just before September 11.
Finally, Treasury replaced $11.2 billion of compensating balances on
September 21 and another $2 billion on September 24.[Footnote 21] Banks
were required to pledge certain types of collateral to secure
compensating balances and one bank could not pledge enough collateral
until September 24.
Compensating Balances Are No Longer Used:
Treasury replaced compensating balances with direct payments to banks
for certain services in 2004.[Footnote 22] This effectively eliminated
the alternative source of funds Treasury had drawn on during the
September 11 attacks. Compensating balances were--as the name implies-
-noninterest-bearing balances deposited in banks to compensate them for
collecting tax and nontax receipts. Banks could make loans or buy
investments with the compensating balances, which were fully
collateralized.
The amount of any compensating balance was determined by Treasury based
on specified interest rates.[Footnote 23] Current Treasury officials
told us that they did not view compensating balances as a substitute
cash backup source except in extraordinary circumstances. Further, a
combination of circumstances starting in 2002 made compensating
balances "inefficient and disruptive" for Treasury.[Footnote 24]
Declining interest rates required increases in balances while the need
to stay under the debt-limit[Footnote 25] required decreases in
balances, which later had to be reversed and increased to unusually
high levels. For example, September end-of-month compensating balances
increased from about $6 billion, to $13 billion, and then to $27
billion in fiscal years 2000, 2001, and 2002, respectively. Treasury
began to phase out compensating balances in 2003 and drew down the
compensating balances to zero in 2004.
The Federal Reserve Used a Number of Methods to Provide Liquidity to
Domestic and Foreign Financial Institutions:
Consistent with its goal of maintaining the stability of the financial
system and containing systemic risks, the Federal Reserve took action
in response to the attacks' financial effects. The Federal Reserve
communicated that it was available as a source of liquidity and
provided billions of dollars through various means to banks and
financial market participants experiencing liquidity problems as a
result of the September 11 attacks.
The Federal Reserve announced its willingness to provide liquidity on
September 11 several times via systems and official statements. For
example, soon after the attacks the Federal Reserve broadcast that it
was fully operational on the Fedwire system--the Federal Reserve's
large-value electronic payment system. In a second broadcast message it
announced that it was available to meet liquidity needs. Around noon,
the Federal Reserve Board of Governors issued a press release stating
that "The Federal Reserve System is open and operating. The discount
window is available to meet liquidity needs." These statements along
with others by a Federal Reserve governor and a Federal Reserve bank
president on that day[Footnote 26] were intended to reassure financial
markets that the Federal Reserve System was functioning normally and to
encourage banks to view the discount window as a source of liquidity.
According to a then Director of Research at the Federal Reserve Bank of
Richmond who has since become that bank's President, the statements
also signaled to banks a "distinct" shift in how the Federal Reserve
would view discount window borrowing.[Footnote 27]
The Federal Reserve provided liquidity through discount window and open
market operations. We previously reported that banking regulatory staff
told us that the attacks largely resulted in a funding liquidity
problem rather than a solvency crisis for banks.[Footnote 28] Thus, the
challenge the Federal Reserve faced was ensuring that banks had
adequate funds to meet their financial obligations. Settlement problems
also prevented broker-dealers and others from using the repo
markets[Footnote 29] to fund their daily operations. In 4 days after
the attacks, the Federal Reserve provided billions of dollars to banks
through various means to overcome the problems resulting from unsettled
government securities trades and financial market dislocations. For
example, the Federal Reserve provided $37 billion in overnight credit
through its discount window on September 11, $46 billion on September
12, and $8 billion on September 13. In contrast, no overnight discount
window credit was provided on September 10 and September 14. It also
conducted securities purchase transactions and other open market
operations to provide needed funds to illiquid institutions. For
example, the Federal Reserve held a zero end-of-day balance in
overnight repos on September 10 and September 11, but end-of-day
balances increased to $38 billion on September 12 and peaked at $81
billion on September 14 during the 4 days following the attacks. In
addition, the Federal Reserve waived daylight overdraft fees for all
account holders and eliminated the penalty on overnight overdrafts for
depository institutions from September 11 through September 21. Had
these actions not been taken, some firms unable to receive payments may
not have had sufficient liquidity to meet their other financial
obligations, which could have produced other defaults and magnified the
effects of September 11 into a systemic solvency crisis.
The Federal Reserve provided additional liquidity by continuing its
normal check crediting schedule despite delays in transportation. The
grounding of air transportation complicated and delayed some check
clearing, since both the Federal Reserve and private providers relied
on overnight air delivery to transport checks between banks in which
they are deposited and banks on which they are drawn. The Federal
Reserve continued to credit the value of deposits to banks even when it
could not present checks and debit the accounts of paying banks. The
Federal Reserve decided to not offset this float through open market
operations to continue providing liquidity. Crediting banks for
deposited checks before receiving the corresponding credit from banks
on which the checks were drawn causes float. This additional liquidity-
-normally less than $1 billion outstanding at any one time--peaked at
over $47 billion on September 13, 2001.
To provide dollars needed by foreign institutions, the Federal Reserve
also arranged new or expanded swap lines with the Bank of Canada, the
European Central Bank, and the Bank of England. The swap lines involved
exchanging dollars for the foreign currencies of these
jurisdictions,[Footnote 30] with agreements to re-exchange amounts
later. These temporary arrangements provided funds to settle dollar-
denominated obligations of foreign banks whose operations were affected
by the attacks.
According to a Federal Reserve official, the large injections of
liquidity were also necessary in part to offset large reserve drains
from other autonomous factors--factors that affect the supply of
balances but are generally outside the control of the Federal Reserve.
For example, as previously noted, the level of check float peaked at
$47 billion on September 13 and a foreign currency swap added $20
billion of balances on that same day, but another autonomous factor
reduced balances by over $30 billion on that day, which was between $15
billion and $20 billion more than prior levels.
To further increase liquidity, the Federal Open Market Committee
(FOMC)[Footnote 31] announced on September 17 that it would lower its
federal funds target rate by 50 basis points[Footnote 32] to 3 percent
and the Federal Reserve Board of Governors approved a 50 basis point
reduction in the discount rate to 2-1/2 percent.[Footnote 33] In its
announcement the Federal Reserve stated that it would "continue to
supply unusually large volumes of liquidity to the financial markets,
as needed, until normal market functioning is restored." The FOMC
acknowledged that the actual federal funds rate might fall below its
target in this situation. According to a then Director of Research at
the Federal Reserve Bank of Richmond, who has since become that bank's
President, market participants expected a decline in the federal funds
rate driven perhaps by the large amount of liquidity injected by the
Federal Reserve, creating excess reserve balances.[Footnote 34]
Market participants typically use government securities as collateral
for financing or to meet settlement obligations. When some broker and
bank facilities were destroyed or lost connectivity, the results of
trading information, such as amounts of securities or funds to transfer
and the ability to transfer funds, were lost or degraded for days. If
trade information is not correct and funds and securities are not
properly transferred, the trade will be considered a "fail." To help
alleviate failed trades resulting from the attacks, the Federal Reserve
and Treasury loaned and auctioned securities respectively. From
September 11 through September 13, the Federal Reserve loaned $22
billion of securities from its portfolio to broker-dealers that needed
securities to complete settlements of failed trades. The Federal
Reserve also reduced restrictions on its securities lending, leading to
a sharp increase in borrowing at the end of September 2001.[Footnote
35]
Treasury also conducted an unplanned, special issuance of 10-year notes
in order to prevent a possible financial crisis.[Footnote 36] According
to current and former Treasury officials involved with this decision,
on September 17 it became evident that the stopped and incomplete
trading on September 11 resulted in increasing fails in the secondary
market. Treasury officials described how a rapid rise in fails at the
end of September and beginning of October was based on demand for the 5-
and 10-year notes. After conferring with capital market participants
who recommended a reopening, or increasing the amount outstanding, of
the 5-or 10-year notes, Treasury officials decided to reopen the 10-
year note. They reasoned that since the note was already scheduled to
reopen in November, investors---who were anticipating the November
reopening---would be better prepared for the issuance than for a 5-year
note. Treasury officials concluded that the additional supply of the 10-
year note produced a positive "psychological" effect on markets by
providing increased confidence about the certainty of supply helping to
decrease fails in the 5-and 10-year notes trades.
Some Federal Reserve Actions and Financial Market Behavior Are
Informative When Considering Alternative Funding Sources for Treasury:
Immediately after the September 11 attacks, many financial
institutions, including some foreign central banks, looked to the
Federal Reserve to provide liquidity through various methods. As
Treasury considers potential financial institutions for funding sources
during a wide-scale disruption, it will need to remain cognizant of the
fact that the Federal Reserve was, is, and potentially will be, the
provider of liquidity for many financial institutions in a crisis.
Further, the amount and terms of the liquidity provided by the Federal
Reserve to financial institutions will likely affect the
characteristics of any funding alternatives available to Treasury. As
discussed previously, the Federal Reserve eased restrictions and
lowered interest rate targets to provide expanded liquidity to
financial institutions. Finally, the market fails and other collateral
issues in the secondary market may affect the type of security Treasury
will want to issue in a crisis. Treasury officials recognize that
during a crisis, investors tend to exhibit a "flight-to-quality"
behavior, moving their capital away from riskier investments to safer
investment vehicles, such as U.S. Treasury securities. These
considerations are discussed later in this report.
Since the Attacks, Treasury and the Federal Reserve Have Added Staffed
Locations and Data System Capability Intended to Increase Auction
Resilience:
After an auction is announced, the critical functions that must occur
without interruption for Treasury to raise the required funds from the
issuance of Treasury securities are (1) auction, (2) prepare issue
file, (3) issue securities, and (4) cash transfer (see fig. 2). If any
of these functions are disrupted, Treasury would not be able to obtain
the cash needed from an auction. During the September 11 attacks,
Treasury and the Federal Reserve, acting as Treasury's fiscal agent,
had two operational locations to conduct auctions, one operational
location to prepare files with important issuance information, one
operational location to issue securities, and one operational location
with a secondary location--which could be activated if necessary--to
transfer cash. Since then, Treasury and the Federal Reserve have added
locations for all of Treasury's critical auction process functions.
Treasury depends on certain systems to auction and issue its
securities. The critical systems that must be operational for an
auction to occur and for Treasury to receive the funds from that
auction are (1) the auction system which receives and processes bids
for securities, (2) the funds and securities transfer system, (3) the
book-entry accounting system, and (4) the cash reporting system. In
addition, since the September 11 attacks the Federal Reserve has
strengthened its out-of-region data system capability. Figure 2
describes each of these processes and associated systems.
Figure 2: Four Major Processes Must Be Performed for Treasury to
Receive Its Cash After Announcement:
[See PDF for image]
Source: GAO.
[End of figure]
Treasury and the Federal Reserve Have Added Sites for All Four Critical
Functions Since the September 11 Attacks:
Treasury and the Federal Reserve have added sites that are
geographically separated from each other for all four of Treasury's
critical auction functions, as seen in figure 3. Contingency sites are
located in different geographic regions and do not require staff to
relocate from the primary site, while backup facilities are generally
located in the same region as the sites they are intended to backup.
For example, staff would relocate from a primary site, like site A in
figure 3, to the cold backup facility listed under site A in a
contingency.
Figure 3: Current Operations of the Auction and Issuance of Marketable
Treasury Securities:
[See PDF for image]
Source: GAO.
Notes: Gray sites have been added since the September 11 attacks.
A hot site is generally staffed and has systems operating during the
routine performance of the function. Hot sites simultaneously perform
the function.
A warm site is generally staffed and has systems operating on a
periodic basis (i.e., bi-weekly) or is aware and ready to take over
when necessary during the operations of the function.
A cold site is generally not staffed to perform its associated function
on a routine or nonroutine basis until the organization deems it
necessary due to some contingency.
[End of figure]
Auctions can now be performed at three operational locations with one
backup facility. All three locations are fully operational for every
auction.
Issuance files can now be prepared at one operational location with a
backup facility and one semi-operational location. Site D is
geographically separated from site A, periodically performs the
functions for specific auctions, and can be immediately activated to
perform the tasks of this function. Further, site A has trained staff
at its backup facility that can perform the tasks of this function
after being notified of a contingency situation or event.
Securities can now be issued at one operational location with a backup
facility and one semi-operational location. Site E periodically
performs the function of issuing securities for specific auctions
approximately once every 2 weeks. This site is also geographically
located in another region.
The cash transfer function has added two cold contingency locations
since September 11, 2001. Site B is the primary location and sites G
and H are the secondary locations, which are geographically separated
from site B and can be activated in the case of a contingency event.
Site C is now a third contingency location that was a secondary
location at the time of the September 11 attacks.
Treasury Alternates Sites to Process Auctions and Conducts Mock Auction
Tests:
Treasury periodically switches auction processing between sites during
live auctions to test their readiness and conducts mock auctions. For
example, in one exercise, Treasury directed one site to take over the
auction processing from another site during a live auction. Treasury
reported the test a success since staff demonstrated their ability to
"seamlessly" take over and perform auction closing procedures, release
auction results, and complete other normal post-auction activities. In
another exercise, Treasury conducted a manual mock auction to expose
staff to an atypical situation and reported achieving its objective of
calculating auction results within 2 hours.[Footnote 37]
Treasury Has Adopted a Flexible Contingency Policy for Auction
Disruptions:
In April 2003, Treasury began discussing options for postponing a
scheduled auction "when the market is operating in a contingency or
extraordinary environment" with dealers. In July of that year, Treasury
presented dealers with a matrix of contingencies and Treasury
responses, shown in table 1.
Table 1: Matrix Treasury Presented to Dealers on Potential Responses to
Contingencies:
Contingency: Treasury/Fed operational/technical problems;
Treasury response: Delay auction.[A] Notify market of specific length
of delay (e.g., 1 hour).
Contingency: Treasury/Fed systems failure;
Treasury response: Reschedule auction; Notify market of rescheduling
with specific date and time if possible. If not immediately possible,
provide follow-up with specific date and time as soon as feasible.
Contingency: Bidder connectivity disrupted (some participants affected,
auction still covered);
Treasury response: Response will depend on strength of auction
coverage. If delay is necessary, then notify market of specific length
of delay (e.g., 1 hour).
Contingency: Bidder connectivity disrupted (many participants affected,
auction not covered);
Treasury response: Delay auction.[A] Notify Market Of Specific Length
Of Delay (E.G., 1 Hour).
Contingency: Independent of connectivity auction not covered;
Treasury response: Delay auction.[A] Notify Market Of Specific Length
Of Delay (E.G., 1 Hour).
Source: U.S. Treasury.
[A] If an auction is delayed for any reason, Treasury will notify the
market of the delay and the new closing time. In all cases, a delay
will cause Treasury to reject all competitive bids already tendered and
participants will need to resubmit competitive bids when the auction
resumes.
[End of table]
Treasury gathered feedback from participants and concluded a more
flexible contingency approach would be appropriate. Treasury told us
that some dealers suggested that writing rules for various
contingencies may be too burdensome and that it may be to Treasury's
advantage to remain discreet on how certain auction fails will be
handled. For example, in the case where one or two dealers have missed
the auction, and if the auction was covered sufficiently, then Treasury
may want to complete the auction without the missing parties. Treasury
told us that it needs a flexible approach because there are an
"infinite number of possible situations" to which it might have to
respond, so the best it can do is provide general guidelines about how
it will respond. According to Treasury, the matrix of Treasury
responses to a number of possible contingencies was generally
considered comprehensive and reasonable by the dealers they
interviewed.
The Bond Market Association (TBMA)[Footnote 38] commended Treasury for
developing the matrix of possible circumstances, but encouraged
Treasury to expand its list of contingencies to include actions
Treasury would take in the face of extraordinary circumstances such as
natural disasters, terrorist attacks, suspension of trading, or a
disruption to the clearance and settlement system. TBMA proposed that
Treasury delay and reschedule an auction in these circumstances, while
notifying the market with a specific date and time if possible or
provide this information as soon as feasible. The association predicted
that market participants would likely support the decision to delay the
auction, assuming the securities were still auctioned and settled by
the originally announced issuance date. TBMA stated that it was unclear
what the impact of these circumstances would be on future auctions.
This discussion process resulted in the following Treasury statement in
February 2004: "Treasury will conduct any announced auction that is
disrupted within an hour of the originally scheduled time and in the
event that circumstances and conditions are such that a one hour
postponement cannot be met, Treasury will communicate information to
market participants as it becomes available."
Primary Dealers Have Taken Actions Intended to Increase Their
Resilience and Treasury Has Suggested Additional Improvements:
All primary dealers have contingency sites. According to Treasury, most
primary dealers have systems that link directly to Treasury's auction
systems at their contingency sites and have conducted connectivity
tests to ensure they could participate in an auction from their
contingency sites if required. Because of the nature of the financial
markets, almost all primary dealer contingency locations are within the
same geographic region as their primary sites. Treasury periodically
visits dealers, and has suggested improvements in systems and testing
for many dealers. According to 14 dealers with whom we spoke, dealer
personnel are cross-trained to bid on and complete auctions for all
types of Treasury securities.
A Treasury official with whom we spoke noted that the nature of
financial markets encourages the close proximity of staff. A professor
of economics has stated, "high density levels are particularly
conducive to chance meetings, regular exchanges of new ideas, and the
general flow of information" [Footnote 39] that aid in the rapid access
to information that is crucial to financial markets. This likely helps
to explain why almost all primary dealers' primary sites are within the
same geographic region. All 23 primary dealers also have at least one
contingency site for their operations, generally in the same geographic
region as their primary sites, since most primary dealers plan on
relocating their staff from their primary sites to their contingency
sites during a wide-scale disruption. Treasury expects this migration
might take several hours. Treasury also expects it might have to
postpone an auction for a day, depending on the severity of the
disruption, so dealers have enough time to report to their contingency
sites.
According to Treasury officials, 17 primary dealers[Footnote 40] have
added systems at their contingency sites that directly link with
Treasury auction systems and have successfully tested the connectivity
of these systems. Treasury encouraged dealers to add these systems and
offered cost information on these systems so dealers could more easily
consider the systems implementation. All of the dealers have the
ability to submit auction bids via the Internet or phone at their
contingency sites.
Eight dealers[Footnote 41] have told Treasury that they have
participated in live auctions from their contingency sites, but
Treasury told us that its auction systems do not automatically track
whether or not dealers are participating in auctions from contingency
sites. Treasury has encouraged dealers to conduct live auction tests
from their contingency sites and plans to continue to work with primary
dealers to increase their resiliency by developing test plans for
primary dealers to participate in mock auctions. One dealer expressed
reservations about participating in an auction from a contingency site
because it would not want to take bids from traders over the phone,
while another dealer stated that it planned to conduct a mock auction
before participating in a live auction from the contingency site.
Primary dealers we spoke with said they have cross-trained their staff
to participate in auctions of different Treasury securities and told us
that they have sufficient staff trained to participate and provide
backup support. These same dealers estimated about 15 to 20 people per
dealer are involved in the Treasury auction process, including support
personnel. While some dealers indicated that their overseas staff are
able to participate in auctions, other dealers expressed reservations
about the readiness of their overseas staff to bid on auctions. In
addition, while some dealers report having backup personnel for traders
and multiple sites, one reports that backup personnel are in the same
location as traders, and most plan on relocating their staff from
primary locations to their contingency sites during a wide-scale
disruption.
Despite Actions Intended to Increase Auction Resilience, Exploring
Funding Alternatives Outside of the Auction Process Is Appropriate:
Regardless of the progress of resiliency efforts, the nature, duration,
and effects of any potential future wide-scale disruption are unknown.
In addition, since compensating balances are no longer used, Treasury
has at least one less source of funds to rely upon. Current Treasury
officials stated they had not viewed compensating balances as a cash
source except in extraordinary circumstances such as the September 11
attacks, and a former Treasury official acknowledged that compensating
balances provided extra flexibility for Treasury. Finally, Treasury's
cash management policy of maintaining minimal cash balances to lower
borrowing costs further limits Treasury's access to cash during a wide-
scale disruption. The combination of these factors makes it prudent for
Treasury to explore alternative backup funding options to use during a
wide-scale disruption. The relevant parties with whom we spoke,
including primary dealers, agreed.
Relevant Parties Validated Design Features and a Potential Tiered
Approach to Treasury Funding Options Has Emerged from Discussions:
These parties also generally agreed that the main design features to be
considered when weighing alternatives for backup funding options are
the situations for use, source of funds, type of collateral,
transaction type, approvals, determination of cost, amount limit, time
limit, inclusion under debt ceiling, disclosure, and length of
authority (if required). However, the specifics would depend on
proposed options. For example, some parties thought that borrowing from
the Federal Reserve should require higher level approval than borrowing
from financial institutions.
Discussions with Treasury and Federal Reserve officials and other
relevant parties have led us to conclude that a two-tiered approach
could enhance Treasury's ability to obtain funds during a wide-scale
disruption. We discussed design features and broad options with
relevant parties and progressively adjusted options based on comments
and our own analysis. The two-tiered approach is suggested as a
strategy to be used only when auctions are not viable based on some
sort of wide-scale disruption to the financial markets that Treasury
relies upon, and not as a substitute or complement to Treasury's normal
auction process when market prices become expensive, or cash balances
are lower than expected. The first tier consists of two funding options
involving a range of appropriate financial institutions, namely (1) a
credit line and (2) a private placement of a CM bill. The second tier
involves a direct draw from the Federal Reserve that would provide
Treasury a last resort source of funds when other options are not
viable. Under this system, Treasury would first seek to use the credit
line and/or the private placement of a CM bill. Then, if and only if
those options are not available or insufficient, would it turn to the
Federal Reserve.
Any system for obtaining cash from financial institutions--whether
through a line of credit or private placement of a CM bill--may, in a
crisis, ultimately depend on the Federal Reserve to provide liquidity
to those institutions.[Footnote 42] One party suggested the viability
of a credit line or a private placement of a CM bill would likely be
enhanced if these options involved depository institutions that could
borrow from the discount window. Most market participants with whom we
spoke preferred a direct draw authority for the Treasury. Although that
might be the most direct route, we recognize the importance of
maintaining the independence of the central bank. For example, some
economists believe that if a central bank regularly lends money to the
government (Treasury), it would lead to an expansion of the monetary
base and inflation and the expectation that the central bank would lend
to the government whenever the government wants.
The Committee on Banking and Currency also recognized the importance of
central bank independence in the establishment of the Federal Reserve
in 1913. In its report the committee stated, "It can not be too
emphatically stated that the committee regards the Federal reserve
board as a distinctly nonpartisan organization whose functions are to
be wholly divorced from politics. In order, however, to guard
absolutely against any suspicion of political bias or one-sidedness, it
has been deemed expedient to provide in the law against a preponderance
of members of one party."[Footnote 43]
A tiered approach would recognize independence concerns, offering both
flexibility and protection against the potential for abuse because of
its two-stage structure. The availability of the first tier would
provide Treasury an extra option(s) outside of its normal auction
process to obtain funds making it less likely that Treasury would have
to go to the second tier, the Federal Reserve, as a last resort funding
option.
Some relevant parties with whom we spoke noted that consideration of
how any funding option would interact with the debt ceiling is
important to consider given the number of times in recent years
Treasury has operated in an environment under debt ceiling constraints,
including debt issuance suspension periods (DISP).[Footnote 44] A wide-
scale disruption such as occurred on September 11 could also result in
a delay in congressional action to raise the debt limit. This in turn
could worsen any problems in the government's ability to finance
operations. Given this, some relevant parties suggested that if a wide-
scale disruption occurred when Treasury was at or near the debt limit,
use of any alternative funding option during such a disruption should
be excluded from the debt ceiling. Others argued that any funding
options should be included in the debt ceiling to prevent having the
options become a tool to evade the debt ceiling.
Primary dealers we spoke with stated that if Treasury did postpone an
auction and use any of these funding options, they preferred that
Treasury resume auctions as soon as possible. They also expressed a
strong desire to maintain the originally scheduled settlement date,
even if an auction had to be performed on the settlement date.
In addition, the impact on the Federal Reserve of replacing an auction
with one of these options would have to be considered since the Federal
Reserve places bids to replace its existing securities inventories at
many Treasury auctions. Other options we discussed but were less viable
are summarized in appendix I.
Obtain a Line of Credit with Financial Institutions:
A credit line would provide Treasury a prior transparent commitment or
understanding with several financial institutions to provide funds to
Treasury during a wide-scale disruption. The financial institutions
would have to have the willingness and capability to lend money to
Treasury in the appropriate amount and time required by Treasury.
Treasury could select the financial institutions through a bidding
process or other procedure on a periodic basis that could help
determine and perhaps lower any required fees or costs that this
arrangement would entail. Canada and France have similar borrowing
arrangements with financial institutions. For example, Canada has a $6
billion (U.S.) standby line of credit with a syndicate of international
banks. Also, according to a French debt management official, France has
credit lines with some primary dealers on which it could draw during a
wide-scale disruption.
Some primary dealers suggested that Treasury seek such a line of credit
with a broad range of financial institutions that could include not
only commercial banks but also institutional mutual funds and others
who could meet Treasury requirements. Another party suggested that
institutional mutual funds may not be practical because these funds
typically obtain cash by selling short-term assets, which might not be
possible in a crisis.
Some parties, including commercial bankers with whom we spoke, stated
providing liquidity to Treasury based on a formal line of credit might
require regular maintenance fees to offset costs associated with the
treatment of regulatory capital for the line of credit under U.S. and
international capital standards. However, since funds would be lent to
the U.S. Treasury, it is unclear if this arrangement would be subject
to the same requirements as guaranteeing credit to other
borrowers.[Footnote 45]
Some commercial banks raised the possibility of a prearranged
understanding with Treasury instead of a formal commitment. Since an
understanding is not a formal commitment, it would not impose costs on
banks, and so might not require any maintenance fees. These commercial
bankers told us that they would very likely lend funds to Treasury
because it is in their financial interest to ensure that Treasury can
make its payments, but that such an understanding would be subject to
fulfilling their own liquidity needs in a time of crisis. As discussed
previously, and given the actions taken during the September 11
attacks, it seems likely that the Federal Reserve would be available to
provide commensurate liquidity to depository institutions. Federal
Reserve officials we spoke with said that an obligation from Treasury
would likely be accepted as sufficient collateral by a depository
institution at the discount window. Although an understanding could
avoid fees, it does not offer the certainty of a committed line of
credit for Treasury's use.
Private Placement of a Cash Management Bill:
A private placement of a CM bill would involve a prior arrangement to
issue a CM bill after communicating with certain senior executives at
financial institutions who would have the ability and authority to
purchase a CM bill that meets Treasury's immediate funding needs. The
specific terms of the CM bill, such as amount, yield, settlement date,
and maturity, would be determined at the time of CM bill placement.
Similar to the credit line option, some market participants suggested
that Treasury seek a broad range of financial institutions that could
include not only commercial banks but also institutional mutual funds
that could meet Treasury requirements. The Federal Reserve would again
likely provide liquidity to depository institutions. Since this option
involves delivering a security, clearing and settlement systems would
have to be functioning adequately to complete transactions.
Some parties told us that the market would react positively to
accepting a tradable security like a CM bill because it fits well with
their normal operations and implied that Treasury may benefit from
flight-to-quality behavior in a crisis. Some parties also commented
that this option was appropriately aligned with Treasury's current
operations, since Treasury is used to issuing CM bills and has
auctioned and issued CM bills in 1 day under normal conditions.
Among a number of policy and operational issues that must be considered
before Treasury could place a cash management bill, Treasury would have
to decide how to set an appropriate price when it executes this
arrangement. During a wide-scale disruption to financial markets, price-
discovery--the process that determines an appropriate clearing price at
auction--would likely prove challenging to financial institutions
because of degradation in the financial market.
Explicitly Authorize a Treasury Draw Authority with the Federal
Reserve:
In the event that the first tier options involving financial
institutions proved insufficient, turning to the Federal Reserve as a
last resort funding source would require a change in law to allow the
Federal Reserve to directly lend to Treasury. Appropriate limitations,
adequate flexibility, and accountability would have to be included in
the design.
As we previously discussed, primary dealers and commercial bankers
generally agreed that this was the most resilient and direct way for
Treasury to ensure it met its obligations. Some Treasury and Federal
Reserve officials we spoke with also confirmed that this method would
likely be technically and operationally easy to implement. In addition,
despite central bank independence concerns discussed previously,
primary dealers and commercial bankers we spoke with stated that they
did not think this arrangement would damage Treasury's or the Federal
Reserve's reputation if it is used in a limited way during a wide-scale
disruption.
Although direct lending by a central bank is not without precedent, it
is viewed as a last resort. For example, although the Canadian federal
government has legal authority to borrow directly from the Bank of
Canada--its central bank--this legal authority was last used in the
early 1960s and is not expected to be used in the future.
Some parties, including Federal Reserve officials, expressed concerns
about any direct lending arrangement and the potential for abuse of
such authority in the future. They thought a high hurdle would be
appropriate for using this authority. For example, one Federal Reserve
official emphasized that this option should only be considered during a
situation where it was "physically impossible" for Treasury to conduct
auctions and after judgment is reached at suitably high levels in the
executive branch and at the Federal Reserve that other options would
not work. Another Federal Reserve official stated that it is important
to clarify that this option should only be used in a national
emergency. Another party concerned with Treasury oversight commented to
us that legislation should be written "very tightly" to limit this
authority to when it is absolutely required. Some Federal Reserve
officials suggested that the approval for a direct draw should be at a
very high level--perhaps the President of the United States, Secretary
of the Treasury, and the Chairman of the Federal Reserve, and wanted to
maintain some veto power on the draw to preserve the Federal Reserve's
independence.
Federal Reserve officials concerned with central bank independence and
the risks of direct lending stated that any draw from the Federal
Reserve should be at a market price, perhaps even higher to discourage
use, even though they acknowledged that proceeds from a higher price
would eventually be delivered back to Treasury. Some officials
suggested that the Federal Reserve should be able to review the draw
arrangement daily to ensure it did not last longer than necessary.
There was broad agreement among Federal Reserve officials with whom we
spoke that the draw should be reversed as soon as Treasury could hold
an auction again and that any arrangement should be fully transparent
and disclosed by Treasury and the Federal Reserve.
Other parties emphasized the need to maintain some flexibility for
Treasury while protecting central bank independence. An approach that
appears promising would be to require joint approval from the Chairman
of the Federal Reserve and the Secretary of the Treasury. Since a
Federal Reserve Chairman is unlikely to agree to a direct draw unless
convinced that other options are not viable, this would provide
sufficient protection against abuse of this authority. Since the
authority is predicated on a wide-scale emergency and disruption,
adding presidential approval might unnecessarily delay necessary
actions without adding any additional protection beyond that provided
by requiring agreement of the Chairman of the Federal Reserve. Both the
duration of the draw and the amount might be established at the time
the Secretary and Chairman agree to the direct draw.
If the authority is to be provided, a decision on how to facilitate
congressional oversight would be necessary. One party concerned with
congressional oversight referred to a "delicate balance" between
Treasury's need to obtain funding during a wide-scale disruption and
Congress's need to conduct oversight of debt management. One
possibility would be to require notification of the majority and
minority leadership in both houses of Congress at the time of a draw
and report after the use of this authority in addition to regular
reporting requirements. Finally, legislation developing an authority
for a direct draw might require periodic review and renewal by
Congress.
Conclusion:
The combination of minimal cash balances and the elimination of
compensating balances have effectively increased Treasury reliance on
the auction process as a funding source. Treasury, the Federal Reserve,
and primary dealers have taken actions intended to increase the
resilience of the auction process. Regardless of resiliency efforts,
the duration and the effects of a potential future wide-scale
disruption are unknown. All these factors make it prudent to explore
other funding options for Treasury to use during a wide-scale
disruption.
Although Treasury, the Federal Reserve, primary dealers, and other
financial institutions might be able to develop some funding mechanism
at the time of a wide-scale disruption, prearranged funding
alternatives offer the advantage of explicit legal approaches with
adequate built-in oversight and disclosure requirements. One approach
discussed earlier requires changes in law. Without having prearranged
access to additional funding sources and methods outside of the normal
auction process, Treasury is missing an opportunity to strengthen its
ability to obtain funds--and ultimately meet payment obligations--
during a wide-scale disruption to the financial markets it relies upon.
A tiered system that involves a range of private sector financial
institutions as a first tier and the Federal Reserve as a second tier
would expand Treasury's access to cash and would enhance its ability to
obtain necessary funds during a major, wide-scale disruption while
limiting the potential for abuse.
Recommendations for Executive Action:
We recommend that the Secretary of the Treasury examine in detail the
implementation requirements for establishing a line of credit and a
private placement of a CM bill with a range of appropriate private
sector financial institutions, select the most appropriate option(s),
and take steps to put required frameworks into place for use during a
wide-scale disruption. Implementation details to be considered for both
options include determining the design features discussed earlier,
including situations or criteria for use, how to determine the
appropriate financial institutions to rely upon, and the amount needed.
For the private placement of a CM bill, the cost or price determination
method would have to be analyzed since price discovery may not be
possible in a significantly degraded financial market. For a credit
line, ways to reduce the cost of an understanding or a guarantee of
credit would have to be explored, such as a prearranged proposal
process that determines the fees (if any) and terms of the transaction.
As Treasury explores these options, it should consider how other
countries have implemented alternative funding options to obtain any
useful insights on its design, recognizing that the U.S. Treasury
market has a unique role as the largest and most active debt market in
the world.
Matters for Congressional Consideration:
Congress should consider providing the Federal Reserve the explicit
authority to lend directly to Treasury as a last resort when other
options are not viable during a wide-scale disruption. Developing a
direct draw authority would require careful consideration and
determination of design features and any other requirements to support
Treasury's need for an effective funding source, the Federal Reserve's
independence, and congressional oversight and accountability concerns.
An approach that appears promising would be to require that both the
Secretary of the Treasury and Chairman of the Federal Reserve approve
any draw and agree on specific amounts and duration at the time of any
draw. This might balance independence and accountability concerns with
the need for sufficiently prompt action and flexibility.
Agency Comments:
We requested comments on a draft of this report from the Secretary of
the Treasury and the Chairman of the Board of Governors of the Federal
Reserve System. The agencies' letters are reprinted in appendix III and
appendix IV, respectively. Both Treasury and the Federal Reserve noted
that they had taken steps to increase their resiliency in recent years
but agreed that Treasury should examine the first-tier funding options
described in this report. Although neither took a position on our
suggestion that Congress should consider permitting the Federal Reserve
to lend directly to the Treasury, both emphasized the importance of
maintaining the independence of the central bank. For example, Treasury
stated that it, "is generally opposed to arrangements in which
governments, at their discretion, can borrow directly from their
central bank as such arrangements compromise the independence of the
central bank." Treasury and the Federal Reserve suggested that any
legislation that would provide the Federal Reserve the authority to
lend directly to the Treasury should be very carefully and tightly
drawn to preserve the independence of the central bank. As our report
notes, we also recognize the importance of maintaining the independence
of the central bank and suggest an explicit, carefully crafted, last
resort authority and approach that we believe provides both flexibility
and reduces the vulnerability to abuse. Indeed, part of the rationale
for a two-tiered approach is to reduce the chances that the Treasury
would ever need to turn to the Federal Reserve. Both Treasury and
Federal Reserve Board staff also provided technical comments, which we
incorporated as appropriate.
We are sending copies of this report to the Ranking Minority Member of
the House Committee on Ways and Means, the Chairs and Ranking Minority
Members of the House Committee on Financial Services, the Senate
Committee on Finance, the Senate Committee on Banking, Housing and
Urban Affairs, the Secretary of the Treasury, the Chairman of the Board
of Governors of the Federal Reserve System, and other interested
parties. We will also make copies available to others upon request. In
addition, the report will be available at no charge on GAO's Web site
at [Hyperlink, http://www.gao.gov].
If you or your staff have any questions about this report please
contact Susan J. Irving at (202) 512-9142 or irvings@gao.gov. Contact
points for our Offices of Congressional Relations and Public Affairs
may be found on the last page of this report. GAO staff making key
contributions to this report are listed in appendix V.
Sincerely yours,
Signed by:
Susan J. Irving:
Director, Federal Budget Analysis:
[End of section]
Appendix I: Cost and Complexity Rule Out Other Options That Were
Discussed:
Holding Additional Cash Balances Would Not Be Cost Efficient:
Although holding excess cash balances would supply the Department of
the Treasury with an extra source of funds to draw from in an
emergency, it is generally more cost-efficient to repay debt than run
higher cash balances because the interest earned on excess cash
balances is generally insufficient to cover borrowing costs. As we
previously reported, because of this negative funding spread, Treasury
has placed increased emphasis on minimizing cash balances to reduce
overall borrowing cost.[Footnote 46] Treasury's current cash balance
target is $5 billion, which represents the amount to be held at the
Federal Reserve. Treasury invests excess cash above the $5 billion
target in Treasury Tax and Loan (TT&L) accounts,[Footnote 47] the Term
Investment Option (TIO) program, and Repurchase Agreement (Repo) pilot
program. TT&L accounts are held at financial institutions and earn
interest rates equal to the federal funds rate less 25 basis points, a
rate set in 1978 originally intended to reflect the rate paid on
overnight repurchase (repo) agreements--a short-term collateralized
loan used by dealers in government securities.[Footnote 48] The rate
earned on TT&L accounts is generally less than the average rate
Treasury pays on CM and other regular short-term bills. The TIO program
was introduced in 2002 to add investment capacity to the TT&L program
and to increase the rate that Treasury earns on invested funds. The
Repo program is a pilot program that allows Treasury to place a portion
of its excess operating funds with TT&L depositories through a repo
transaction for a set period of time at an agreed upon rate of
interest. Treasury told us that it now places over 70 percent of its
cash balances through the TIO and Repo program. Treasury officials with
whom we spoke acknowledged that holding additional cash balances would
not be a viable option because of the negative funding spread.
Foreign Central Banks Add Complexity to Obtaining Funds:
Treasury and Federal Reserve officials we spoke with agreed that
borrowing from foreign central banks may require some sort of currency
conversion, unless the banks had adequate funds in dollars. The
currency conversion would presumably have to occur on a very short-term
and possibly same day basis. If the foreign central banks did not have
adequate dollar-based liquidity, they may have to rely on the Federal
Reserve to provide them with liquidity. As discussed previously, the
Federal Reserve conducted currency swaps with some foreign central
banks to help them fulfill their dollar-denominated obligations.
Treasury officials we spoke with acknowledged that although this type
of arrangement is possible, it is less promising because of the
transactions and currency conversions that would likely be required. In
addition, Treasury told us that although most large foreign banks
operating in the U.S. have access to the discount window, Treasury
would not advocate relying upon these banks for emergency funding.
[End of section]
Appendix II: Background on Previous Treasury Draw Authorities:
In the past, Treasury had access to both a cash and securities draw
authority. Intermittently between 1942 and 1981, Treasury was able to
directly sell (and purchase) certain short-term obligations to (and
from) the Federal Reserve in exchange for cash. Congress first granted
this cash draw authority temporarily in 1942,[Footnote 49] allowed it
to lapse several times, and extended it 22 times until 1979, when it
modified some of the terms and added controls.[Footnote 50] In 1979,
Congress also authorized a securities draw authority, which permitted
Treasury to borrow securities from the Federal Reserve, sell them, and
then repurchase the securities in the open market and return the
securities to the Federal Reserve within a specified period.[Footnote
51] The securities draw authority was never used.
After Congress authorized Treasury to earn interest on its Treasury Tax
& Loan (TT&L) account balances in 1977,[Footnote 52], [Footnote 53]
Congress allowed both draw authorities to expire in 1981. In a 1979
proceeding, one Member of Congress said that after World War II, the
cash draw authority allowed Treasury to carry lower cash
balances.[Footnote 54] According to another Member, since TT&L accounts
earned interest, there was no reason for Treasury not to "keep plenty
of cash on hand" thereby reducing the need for a draw
authority,[Footnote 55] although the interest that Treasury earned on
these accounts was .25 percentage points below the federal funds
rate.[Footnote 56] Current Treasury officials to whom we spoke said
that they did not know if the passage of legislation allowing Treasury
to earn interest on its TT&L accounts led Congress to allow both draw
authorities to expire. Table 2 summarizes the key design features of
Treasury's draw authorities in 1979. A somewhat fuller discussion of
each feature follows.
Table 2: Design Features of 1979 Cash and Securities Draw Authorities:
Design features: Situations specified for use;
Cash draw authority: Emergencies, markets closed;
Securities draw authority: More routine for cash management purposes.
Design features: Source of funds;
Cash draw authority: Federal Reserve Bank System;
Securities draw authority: Financial market (through sale of borrowed
securities from Federal Reserve).
Design features: Type of collateral;
Cash draw authority: None;
Securities draw authority: None.
Design features: Transaction type;
Cash draw authority: Direct sale of special short-term certificates to
Federal Reserve;
Securities draw authority: Borrow security from Federal Reserve and
sell to financial market, repurchase security and return to Federal
Reserve.
Design features: Approvals;
Cash draw authority: Five Governors of Federal Reserve System Board;
Securities draw authority: Federal Open Market Committee.
Design features: Cost determination;
Cash draw authority: Interest rate of .25 percent below discount rate
of Federal Reserve Bank of New York;
Securities draw authority: Market value of securities when Treasury
repurchases.
Design features: Amount limit;
Cash draw authority: $5 billion;
Securities draw authority: No limit.
Design features: Time limit;
Cash draw authority: No later than 30 days;
Securities draw authority: Repurchase of securities no later than 6
months.
Design features: Inclusion in debt ceiling;
Cash draw authority: Included in debt subject to limit;
Securities draw authority: Included in debt subject to limit.
Design features: Disclosure;
Cash draw authority: Annual Federal Reserve report to Congress;
Securities draw authority: None specified.
Design features: Length of authority;
Cash draw authority: 2 years;
Securities draw authority: 2 years.
Source: GAO.
[End of table]
Situations When Treasury Used Previous Draw Authorities:
The Treasury Draw Policy, as amended in 1979 (hereafter, amended
Treasury Draw Policy) stated that Treasury could use the cash draw
authority in only "unusual and exigent circumstances."[Footnote 57] In
1979, both Federal Reserve and Treasury officials supported the
extension of the cash draw authority for emergencies. A Treasury
Assistant Secretary said that Treasury might not have sufficient time
to raise funds through the securities draw authority and that the cash
draw authority provided Treasury with immediate funds to meet
unforeseen developments, especially if these developments transpired
late in the trading day.[Footnote 58] A Federal Reserve Board Governor
testified that the cash draw authority functioned well in the past and
that Treasury needed this authority to obtain immediate funds when
securities markets might be in "general disarray" based on a national
emergency.[Footnote 59] Members of Congress said a number of times that
they intended Treasury to use the cash draw authority only in certain
situations, such as when military attacks disrupt or close
markets.[Footnote 60] One Member cited examples beyond wartime when the
use of the cash draw authority might be appropriate, such as grave
health and well-being emergencies or nuclear accidents.[Footnote 61]
Treasury used previous cash draw authorities infrequently. Between 1942
and 1981, the Federal Reserve held special short-term certificates
purchased directly from the Treasury on 228 days. In the years Treasury
used this authority, it borrowed on average about 11 days per year. Use
of this authority was concentrated mostly in times of war or armed
conflict, as seen in figure 4. The most Treasury borrowed on a single
day throughout the period was $2.6 billion in 1979.
Figure 4: Concentrated Use of Cash Draw Authority 1942-1981 (Days
Federal Reserve Held Special Short-Term Treasury Certificates):
[See PDF for image]
Source: GAO analysis of Federal Reserve annual reports.
[End of figure]
In the years Treasury used the cash draw authority, it most often used
it surrounding tax payment dates in March, June, and September and to a
lesser extent in January, April, October, and December, as seen in
figure 5.[Footnote 62] In other months, Treasury used this authority
for less than 10 days total per month. According to a 1979 testimony by
a Federal Reserve Governor, Treasury had used the authority in earlier
years to offset cash drains just before funds became available from
quarterly income tax payments. He went on to explain that Treasury used
the cash draw authority less in recent years since it relied more often
on cash management bills to "cover low points in its cash balance"
prior to tax payment dates.[Footnote 63] In that same proceeding, an
Assistant Secretary of the Treasury credited the access to short-term
funds, specifically weekly bills and cash management bills, with
reduced use of the cash draw authority after 1975.[Footnote 64]
Figure 5: Borrowing Concentrated Around Tax Payment Months 1942-1981
(Days Federal Reserve Held Special Short-Term Treasury Certificates):
[See PDF for image]
Source: GAO analysis of Federal Reserve annual reports.
[End of figure]
After 1979, the cash draw authority was only to be used in emergencies,
while the securities draw authority could be used "in more routine
circumstances."[Footnote 65] However, we did not find any evidence that
Treasury used the securities draw authority between 1979 and its
expiration in 1981. One Member of Congress described how the securities
draw authority could be used when Treasury did not have the time to
"prepare and market" a new security issue quickly enough to meet short-
term cash needs. He reasoned that since Treasury would borrow "seasoned
securities" from the Federal Reserve --existing securities in the
Federal Reserve's portfolio--that Treasury would be able to sell them
quickly enough to meet cash needs.[Footnote 66] A committee report also
stated that the requirement for Treasury to repurchase securities in
the open market would subject Treasury to market discipline.[Footnote
67]
Source of Funding:
The source of funds for the cash draw authority was the Federal
Reserve, while the source of funds for the securities draw authority
was the financial market. As shown in figure 6, when using the cash
draw authority, Treasury sold special short-term certificates directly
to the Federal Reserve in exchange for cash from the Federal Reserve.
The amended Treasury Draw Policy also specified that Treasury could
borrow obligations (securities) from the Federal Reserve and sell them
in the open market (in exchange for cash) to meet short-term cash
needs, as shown in figure 6.[Footnote 68]
Collateral Used:
The cash draw authority did not require any specific collateral beyond
the special short-term Treasury certificates that the Federal Reserve
purchased from Treasury. The securities draw authority also did not
require any collateral.
Type of Financial Transaction:
The cash draw authority and securities draw authority represented
different transactions. As shown in figure 6, the cash draw authority
directly involved only the Federal Reserve and Treasury, while the
securities draw authority involved the Federal Reserve, Treasury, and
the financial market.
Figure 6: Cash and Securities Draw Authority Transactions:
[See PDF for image]
Source: GAO analysis, PhotoDisc (images).
[End of figure]
In 1979, members of Congress and Treasury officials discussed how these
transactions might affect monetary policy. For example, a number of
members saw the cash draw authority as a way to monetize the debt and
in effect print new money, thereby complicating monetary
policy.[Footnote 69] In a letter to Congress, Treasury wrote that the
cash draw authority did not create problems for monetary policy since
the Federal Reserve could offset Treasury borrowings through its open
market operations, thus having the same net effect as if Treasury
borrowed from the market instead of the Federal Reserve.[Footnote 70]
Approvals on Use of Draw Authority:
According to the amended Treasury Draw Policy, at least five members of
the Board of Governors of the Federal Reserve System had to approve
purchases and sales of bonds, notes, or other obligations to the United
States (Treasury) by the Federal Reserve.[Footnote 71] The act also
specified that the securities draw authority was subject to the
approval, rules, and regulations of the Federal Open Market
Committee.[Footnote 72]
The Cost of the Draw Authorities:
The cost that Treasury paid to use the draw authorities was implied in
the interest rate that the Federal Reserve charged or the market value
of the securities that Treasury repurchased. The interest rate Treasury
paid to use the cash draw authority changed between 1942 and 1981. The
Federal Reserve reported that Treasury paid a fixed .25 percent
interest rate on the amount borrowed when it used this authority
through December 3, 1957; after December 3, 1957, and through the
expiration of this authority it paid a rate set at .25 percent below
the prevailing discount rate of the Federal Reserve Bank of New
York.[Footnote 73] Although a memorandum of understanding between the
Federal Reserve and Treasury was not readily available and may not have
existed, according to one Member of Congress the interest rate for the
cash draw authority was "arbitrarily" set by negotiations between
Treasury and the Federal Reserve.[Footnote 74]
In contrast, legislative history shows some members intended to subject
Treasury to "market discipline" when it used the securities draw
authority. During discussions in 1979, to describe market discipline,
one member offered a scenario in which Treasury would repurchase
securities at a slightly higher price than it paid for them--since the
securities would be closer to maturity--and that this price
differential reflected a fair market interest rate on Treasury's
borrowing.[Footnote 75] A Federal Reserve Governor noted that Treasury
could pay a substantial premium for selling securities it borrowed from
the Federal Reserve late in the day because the action would probably
take market participants by surprise. He went on to say that if markets
were unsettled Treasury may not be able to sell all of the securities
it needed.[Footnote 76]
Amount and Time Limits for Use of Draw Authorities:
Congress limited the amount and time that Treasury could use the cash
draw authority. The amended Treasury Draw Policy stated that the
aggregate amount of obligations acquired (at any one time by the 12
Federal Reserve banks) directly from the United States (Treasury) could
not exceed $5 billion.[Footnote 77] In addition, the act specified that
Treasury could use the cash draw authority for renewable periods not to
exceed 30 days.
Congress limited the amount of time that Treasury could use the
securities draw authority but did not limit the amount of securities
Treasury could borrow. The amended Treasury Draw Policy required
Treasury to repurchase obligations (securities) no later than 6 months
after the date of sale and return these securities to the Federal
Reserve.[Footnote 78]
The Inclusion of Draw Authorities in the Debt Ceiling:
The use of the cash and securities draw authorities was not expressly
excluded from the debt subject to limit.
Disclosure of the Use of the Draw Authorities:
Congress specified reporting requirements for the cash draw authority
but not for the securities draw authority. The amended Treasury Draw
Policy required the Board of Governors of the Federal Reserve System to
include detailed information about use of the cash draw authority in
its annual report to Congress.[Footnote 79] In addition, a Treasury
Assistant Secretary testified in 1979 that any previous use of the cash
draw authority was reported in the daily Treasury statement of cash and
debt operations and in the weekly Federal Reserve statement.[Footnote
80]
Expiration of Draw Authorities:
The amended Treasury Draw Policy established the cash and securities
draw authority for 2 years.[Footnote 81] In 1979, members of Congress
deliberated over how long to extend the authorities, some advocating 1
year, while others advocated 2 or 5 years. Those who advocated shorter
periods wanted to give Congress a chance to evaluate the authorities'
use and make modifications, if necessary, prior to a 5-year
period.[Footnote 82] After the expiration of the authorities, the
Federal Reserve was and still is limited to purchasing and selling
obligations of the United States only in the open market.
[End of section]
Appendix III: Comments from the Department of the Treasury:
Assistant Secretary:
Department Of The Treasury Washington:
September 7, 2006:
Ms. Susan J. Irving:
Director, Federal Budget Analysis:
GAO:
441 G Street, NW Room 2908:
Washington, DC 20548:
Dear Ms. Irving:
This responds to your letter of August 8, 2006 to Secretary Paulson
requesting our comments on the draft report entitled Debt Management:
Backup Funding Options Would Enhance Treasury's Resilience to a
Financial Market Disruption (GAO-06-1007). The report makes two
recommendations for improving on the government's ability to raise cash
in emergency situations when the financial markets are not functioning.
These recommendations are: (1) Treasury should examine the
implementation requirements for establishing a back-up line of credit
or the direct placement of cash management bills with a broad range of
appropriate financial institutions to be activated in situations where
the financial markets are unable to meet our cash needs; and (2) that
Congress should examine whether the Federal Reserve should lend
directly to the Treasury, as a last resort, during a wide-scale
disruption to the financial markets.
Since September 11, 2001, Treasury has been working with the Federal
Reserve to implement more robust processes to ensure that the
Department can effectively carry out its cash and debt management
responsibilities even in the most adverse and challenging conditions.
As your recommendations on the line of credit and direct placement of
securities would provide other alternatives for meeting our funding
needs in emergencies, we agree that Treasury should examine these
options and the related implementation requirements and issues.
The draft report also recommends that Congress consider allowing the
Federal Reserve to lend directly to the Treasury, as a last resort,
during a wide-scale disruption to the financial markets. Treasury is
generally opposed to arrangements in which governments, at their
discretion, can borrow directly from their central bank as such
arrangements compromise the independence of the central bank. Any
proposal to grant authority to the Federal Reserve to lend directly to
Treasury should carefully study the terms and conditions that would be
necessary to ensure the independence of the Federal Reserve in its
lending decisions and the conduct of monetary policy.
We appreciate the opportunity to review an advance copy of the report
and provide our comments on the recommendations. We look forward to
working with you in improving our debt management program.
Sincerely,
Signed by:
Emil W. Henry, Jr.
[End of section]
Appendix IV: Comments from the Board of Governors of the Federal
Reserve System:
Board Of Governors Of The Federal Reserve System:
Washington, D. C. 20551:
Division Of Monetary Affairs:
September 6, 2006:
Ms. Susan J. Irving:
Director, Federal Budget Analysis Strategic Issues:
U.S. Government Accountability Office:
441 G. Street N.W.
Washington, D.C. 20548:
Dear Ms. Irving:
We appreciate the opportunity to comment on the GAO's draft report
entitled "Backup Funding Options Would Enhance Treasury's Resilience to
a Financial Market Disruption."
As you are aware, the Treasury and the Federal Reserve, as well as
financial institutions and other major market participants, have made
substantial strides in recent years in enhancing their capabilities for
operating in contingency situations. Nonetheless, circumstances can be
envisioned in which it may be exceedingly difficult for Treasury to
raise cash in the markets. While such a situation may be improbable,
the consequences should it occur could be quite serious. Accordingly,
we agree that it is appropriate to consider the pros and cons of
various arrangements that would provide additional assurance that the
Treasury could meet the nation's financial obligations even in
circumstances of severe disruption to financial markets.
The GAO's report recommends a two-tiered approach to providing such
assurance. As the first tier, the Treasury would establish private
credit lines and make arrangements for private placements of cash
management bills. The Federal Reserve has not studied such measures and
has not formulated a view on their feasibility or desirability but
concurs that further study by the Treasury of such arrangements could
be worthwhile. However, the Treasury and taxpayers have benefited over
the years from reliance on funding through a transparent auction
process in the open market, suggesting that a pre-announced means of
setting a market-related price for any borrowings under the proposed
private credit arrangements would be a key issue.
The GAO recommends that the Congress consider legislation that would
establish a second tier of emergency cash facilities by authorizing the
Federal Reserve to lend directly to the Treasury during a wide-scale
disruption. Especially should the first-tier arrangements be
established, the likelihood that the Treasury would need to borrow from
the Federal Reserve seems remote. In addition, as the report
recognizes, contemplating the possibility of direct lending to the
Treasury raises very serious issues regarding the independence of the
central bank. It also poses other significant policy issues, such as
treatment of any such lending under the debt ceiling. The importance of
these issues implies that Congress would need to give very careful
consideration to the disadvantages of creating such lending authority.
Eliminating the potential for abuse of a direct lending authority would
seem to necessitate a number of rigorous requirements, such as
certifications by the Secretary of the Treasury, and perhaps the
President, as well as by the Federal Reserve Board or Chairman that
funding in the markets was not possible and that the reason market
funding was not available was related to disruption of market
infrastructure. It would also be essential that such a facility could
not be used as a means of evading debt ceiling constraints or otherwise
become involved in what are intrinsically political decisions. I should
emphasize that the Board has not taken a position as to whether
creation of such a direct lending authority would be appropriate and
has not considered in any detail suitable specifications for such a
facility.
Federal Reserve staff have separately provided a number of specific
comments and suggestions on the draft. We understand that GAO will take
these into account in preparing the final report.
Please do not hesitate to contact me if we can be of further
assistance.
Sincerely,
Signed by:
Vincent R. Reinhart Director:
[End of section]
Appendix V: GAO Contact and Staff Acknowledgments:
GAO Contact:
Susan J. Irving, (202) 512-9142:
Acknowledgments:
In addition to the contact named above, Jose Oyola (Assistant
Director), Julie Atkins, Richard Cambosos, Dean Carpenter, Abe Dymond,
Cody Goebel, Thomas McCabe, James McDermott, Naved Qureshi, Keith
Slade, and Dawn Simpson made significant contributions to this report.
FOOTNOTES
[1] We broadly refer to a wide-scale disruption as an event that causes
a severe disruption or destruction of critical infrastructure
components across a geographic area or that results in a wide-scale
evacuation or inaccessibility of certain areas.
[2] GAO, Debt Management: Treasury Has Refined Its Use of Cash
Management Bills but Should Explore Options That May Reduce Cost
Further, GAO-06-269 (Washington, D.C.: Mar. 30, 2006).
[3] Relevant parties include Treasury and Federal Reserve officials and
staff, and capital market participants such as traders, senior
executives of financial institutions, and trade association executives.
We also had discussions with congressional staff regarding oversight.
[4] The term liquidity is used broadly here to encompass cash and
credit in hand and promises of credit to meet needs for cash.
[5] Although Treasury's authority to use compensating balances has not
been eliminated, it no longer uses compensating balances to pay for
financial agent services. It now directly pays for services, which it
says improves cash management.
[6] The discount window is the lending mechanism used by Federal
Reserve banks to lend funds to depository institutions on a short-term
basis to cover temporary liquidity needs or reserve deficiencies.
[7] An operational location is a site that is staffed and has systems
operating during the routine performance of the function.
[8] When this Verizon facility was damaged, about 182,000 voice
circuits, more than 1.6 million data circuits, and more than 11,000
lines serving Internet service providers were lost.
[9] GAO, Potential Terrorist Attacks: Additional Actions Needed to
Better Prepare Critical Financial Market Participants, GAO-03-414
(Washington, D.C.: Feb. 12, 2003).
[10] Broker-dealers submitted trade information to GSCC, which compared
and netted this information and sent settlement information to clearing
banks, such as BONY and JPMorganChase. In 2003, GSCC merged into the
Fixed Income Clearing Corporation, which now handles the clearing and
settlement of U.S. government securities for its member firms.
[11] GAO-03-414.
[12] Treasury's authorities are codified in chapter 31 of title 31 of
the United States Code.
[13] The tentative auction schedule provides the date but not the
actual amount of an auction, which Treasury provides in an announcement
generally a few days prior to auction.
[14] GAO-06-269.
[15] For more information on CM bills see GAO-06-269.
[16] See Remarks of the Under Secretary Brian C. Roseboro before The
Bond Market Association's Annual Meeting, April 22, 2004, js-1454.
[17] Price discovery is the process that primary dealers undertake that
determines an appropriate clearing price at auction.
[18] According to Treasury, the Bureau of Public Debt--a bureau of the
Treasury---could have conducted the auction since its systems were
available and operational.
[19] The total impact on Treasury's cash balance resulting from the
cancellation of the auction was a shortfall of $11.5 billion, including
$1.5 billion of Federal Reserve holdings scheduled to be rolled into
the 4-week bill. So, other things being equal, Treasury would have had
to pull $11.5 billion in compensating balances to make up for the
cancellation of the 4-week bill.
[20] The bid-to-cover ratio is the ratio of the amount of bids received
in a Treasury security auction compared with the amount of awarded
bids. The 13-week bill auction on September 10, 2001, resulted in a bid-
to-cover ratio of 2.06, and the September 17, 2001, auction resulted in
a ratio of 2.31. The 26-week bill auction on September 10, 2001,
resulted in a bid-to-cover ratio of 2.29, and the September 17, 2001,
auction resulted in a ratio of 2.19.
[21] Treasury replaced $12.6 billion in compensating balances and
deposited an additional $0.6 billion in compensating balances based on
certain requirements that determined the amount.
[22] Section 218 of the Transportation, Treasury, and Independent
Agencies Appropriations Act, 2004, Pub. L. No. 108-199, Div. F, 118
Stat. 279, 321 (Jan. 23, 2004), established a permanent, indefinite,
appropriation for Treasury to reimburse financial institutions for
depository and financial services previously reimbursed by means of
compensating balances.
[23] The banks' compensation for performing these services was based on
the imputed earnings from the compensating balances calculated at the
91-day Treasury bill rate. Treasury determined the amount to deposit by
comparing the value of services provided with the imputed earnings on
the compensating balances.
[24] U.S. Office of Management and Budget, Budget of the U.S.
Government, Analytical Perspectives, Fiscal Year 2006 (Washington,
D.C.: 2005), p. 249.
[25] The debt limit is a legal ceiling on the amount of gross federal
debt (excluding some minor adjustments), which must be raised
periodically by Congress to accommodate additional federal borrowing.
[26] See statements by Federal Reserve Governor Edward Gramlich and
Federal Reserve Bank of New York President William McDonough in Jeffrey
M. Lacker, "Payment System Disruptions and the Federal Reserve
Following September 11, 2001," Journal of Monetary Economics, vol. 51,
issue 5 (July 2004), 935-965.
[27] See Jeffrey M. Lacker, "Payment System Disruptions and the Federal
Reserve Following September 11, 2001," Journal of Monetary Economics,
vol. 51, issue 5 (July 2004), 935-965.
[28] GAO, Potential Terrorist Attacks: Additional Actions Needed to
Better Prepare Critical Financial Market Participants, GAO-03-414
(Washington, D.C.: Feb. 12, 2003).
[29] Repo or a repurchase agreement is a form of short-term
collateralized borrowing used by dealers in government securities. See
GAO-06-269 for more information on repurchase agreements.
[30] Although swap lines permitted up to a total of $90 billion to be
exchanged, the maximum foreign currency swap during this period was
about $20 billion on September 13, 2001.
[31] As part of the Federal Reserve, the Federal Open Market Committee
oversees open market operations, which are used to implement monetary
policy on a day-to-day basis.
[32] One basis point is equal to 1/100th of a percent. Thus, 50 basis
points are .50 percentage points.
[33] The Federal Reserve Board of Governors exercises general
supervision over the operations of the Federal Reserve banks. The
Federal Reserve banks establish the discount rates subject to review
and determination of the Federal Reserve Board of Governors.
[34] See Jeffrey M. Lacker, "Payment System Disruptions and the Federal
Reserve Following September 11, 2001," Journal of Monetary Economics,
vol. 51, issue 5 (July 2004), 935-965.
[35] The Federal Reserve loans out securities from its System Open
Market Account (SOMA) subject to certain limits. The Federal Reserve
suspended per dealer limits on SOMA holdings on September 11 and
further loosened terms on September 13.
[36] GAO-03-414.
[37] Calculating results within 2 hours assumes all bids have been
received and processed.
[38] TBMA is an industry association representing participants in the
government securities and other debt markets.
[39] Edward L. Glaeser, "Urban Colossus: Why is New York America's
Largest City?" FRBNY Economic Policy Review (December 2005), p. 22.
[40] As of August 2006, 3 additional primary dealers have installed
systems that directly link with Treasury auction systems and are in the
process of conducting user tests.
[41] As of August 2006.
[42] The Federal Reserve's regular lending authority generally extends
only to depository institutions.
[43] H.R. Rep. No. 63-69, at 43 (1913).
[44] When debt is nearing the statutory limit, Treasury has to take a
number of extraordinary steps to meet the government's obligation to
pay its bills while keeping under the debt ceiling. DISPs have been
declared for certain periods in fiscal years 2002, 2003, 2005, and
2006. For more information on DISPs see GAO-06-269 and GAO-04-526.
[45] Some commercial bankers we spoke with said that certain
international banking capital accords would require them to incur costs
if a credit line is guaranteed. Another party thought that banks would
not necessarily incur costs because guaranteeing credit to the U.S.
Treasury may be viewed differently under those accords. U.S. banking
regulators are currently determining the application of a new approach
to calculate regulatory credit risk capital requirements based on a new
international capital accord.
[46] GAO, Debt Management: Treasury Has Refined Its Use of Cash
Management Bills but Should Explore Options That May Reduce Cost
Further, GAO-06-269 (Washington, D.C.: Mar. 30, 2006).
[47] The TT&L program helps stabilize the supply of reserves in the
banking system. If Treasury held all its cash in its Federal Reserve
account, increases in its cash position would drain reserves from the
banking system, and decreases would add reserves. Thus, the Federal
Reserve would have to conduct frequent and perhaps large open market
operations to mitigate undesired fluctuations in bank reserves and the
federal funds rate. The TT&L program also helps Treasury manage federal
tax receipts and earn interest on public funds.
[48] GAO-06-269.
[49] The cash draw authority lapsed in certain months in 1973, 1974,
1976, and 1977. See H.R. Rep. No. 96-111, 7 (1979).
[50] Treasury Draw Policy, as amended, Pub. L. No. 96-18, sec. 1 (c),
93 Stat. 35 (Jun. 8, 1979).
[51] Pub. L. No. 96-18, sec. 2.
[52] Treasury Tax and Loan Accounts are funds held in accounts at
financial institutions in the name of the U.S. Treasury. Their purpose
is to dampen fluctuations in bank reserves, process federal tax
payments, and provide an interest-earning location for cash.
[53] Public Moneys Investment Act, Pub. L. No. 95-147, 91 Stat. 1227
(Oct. 28, 1977).
[54] 125 Cong. Rec. 10081 (1979) (Statement of Congressman Hansen).
[55] 125 Cong. Rec. 10080 (1979) (Statement of Congressman Wylie).
[56] The federal funds rate is the interest rate at which financial
institutions exchange balances in their accounts at the Federal Reserve
with each other on an overnight and unsecured basis.
[57] Pub. L. No. 96-18.
[58] Federal Reserve-Treasury Draw Authority: Hearing on H.R. 2281 and
H.R. 421 before the Subcommittee on Domestic Monetary Policy of the
House Committee on Banking, Finance and Urban Affairs, 96th Cong. 18-20
(1979) (letter from the Honorable Roger Altman, Assistant Secretary of
the Treasury, to the Honorable Parren J. Mitchell, Chairman of the
Subcommittee on Domestic Monetary Policy, House Committee on Banking,
Finance and Urban Affairs, March 16, 1979).
[59] Federal Reserve-Treasury Draw Authority: Hearing on H.R. 2281 and
H.R. 421 before the Subcommittee on Domestic Monetary Policy of the
House Committee on Banking, Finance and Urban Affairs, 96th Cong. 7-8
(1979) (statement of the Honorable J. Charles Partee, member, Board of
Governors of the Federal Reserve System).
[60] 125 Cong. Rec. 10081 (1979) (Statement of Congressman Hansen) and
125 Cong. Rec. 10083 (1979) (Statement of Congressman Mitchell).
[61] 125 Cong. Rec. 10083 (1979) (Statement of Congressman Mitchell).
[62] Both corporate and individual estimated tax payment dates occur in
April, June, and September. In addition, corporate tax payment dates
occur in March, October, and December. An individual estimated tax
payment date also occurs in January.
[63] Federal Reserve-Treasury Draw Authority: Hearing on H.R. 2281 and
H.R. 421 before the Subcommittee on Domestic Monetary Policy of the
House Committee on Banking, Finance and Urban Affairs, 96th Cong. 7-8
(1979) (statement of the Honorable J. Charles Partee, member, Board of
Governors of the Federal Reserve System).
[64] Federal Reserve-Treasury Draw Authority: Hearing on H.R. 2281 and
H.R. 421 before the Subcommittee on Domestic Monetary Policy of the
House Committee on Banking, Finance and Urban Affairs, 96th Cong. 9-10
(1979) (Statement of Paul H. Taylor, Fiscal Assistant Secretary of the
Treasury).
[65] H.R. Rep. No. 96-111, at 2 (1979).
[66] 125 Cong. Rec. 12514 (1979) (Statement of Congressman Mitchell).
[67] H.R. Rep. No. 96-111, at 2 (1979).
[68] Pub. L. No. 96-18.
[69] 125 Cong. Rec. 10080, (1979) (Statement of Congressman Wylie) and
125 Cong. Rec. 10081, (1979) (Statement of Congressman Hansen).
[70] Federal Reserve-Treasury Draw Authority: Hearing on H.R. 2281 and
H.R. 421 before the Subcommittee on Domestic Monetary Policy of the
House Committee on Banking, Finance and Urban Affairs, 96th Cong. 18-20
(1979) (letter from the Honorable Roger Altman, Assistant Secretary of
the Treasury, to the Honorable Parren J. Mitchell, Chairman of the
Subcommittee on Domestic Monetary Policy, House Committee on Banking,
Finance and Urban Affairs, Mar. 16, 1979).
[71] Pub. L. No. 96-18.
[72] The Federal Open Market Committee is part of the Federal Reserve
and oversees open market operations to promote monetary policy.
[73] The discount rate is the rate that commercial banks pay to borrow
funds from the Federal Reserve. The Federal Reserve Board of Governors
sets this rate.
[74] 125 Cong. Rec. 12515 (1979) (Statement of Congressman Stanton).
[75] 125 Cong. Rec. 10081 (1979) (Statement of Congressman Hansen).
[76] Federal Reserve-Treasury Draw Authority: Hearing on H.R. 2281 and
H.R. 421 before the Subcommittee on Domestic Monetary Policy of the
House Committee on Banking, Finance and Urban Affairs, 96th Cong. 7-8
(1979) (statement of the Honorable J. Charles Partee, member, Board of
Governors of the Federal Reserve System).
[77] Pub. L. No. 96-18.
[78] Pub. L. No. 96-18.
[79] Pub. L. No. 96-18.
[80] Federal Reserve-Treasury Draw Authority: Hearing on H.R. 2281 and
H.R. 421 before the Subcommittee on Domestic Monetary Policy of the
House Committee on Banking, Finance and Urban Affairs, 96th Cong. 9-10
(1979) (Statement of Paul H. Taylor, Fiscal Assistant Secretary of the
Treasury).
[81] Pub. L. No. 96-18.
[82] 125 Cong. Rec. 10082 (1979) (Statement of Congressman Rousselot).
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