Presentation to the Treasury Borrowing Advisory Committee

U.S. Department of the Treasury Office of Debt Management January 30, 2007

Fiscal Perspectives

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Recent US economic performance has been strong

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Corporate and individual tax receipts remain strong
Corporation Taxes
$ Billions 100 Record $88.3 billion 90 Major Corporate Tax Dates 80 Fiscal 2006 Y-O-Y growth = 24.8% 70 70 80 90 $ Billions 100

60

60

50

50

40

40

30

30

20

20

Individual Taxes
10 10 $ Billions 250 0 Oct-03 Oct-04 Oct-05 Jan-03 Jan-04 Jan-05 Jan-06 Oct-06 Apr-03 Apr-04 Apr-05 Apr-06 Jul-03 Jul-04 Jul-05 Jul-06 0 Major Individual Tax Dates Fiscal 2006 Y-O-Y growth = 11.4% $ Billions 250

200

200

150

150

100

100

50

50

0 Oct-03 Oct-04 Oct-05 Jan-03 Jan-04 Jan-05 Jan-06 Oct-06 Apr-03 Apr-04 Apr-05 Jul-03 Apr-06 Jul-04 Jul-05 Jul-06

0

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Corporate profits and equity markets continue to rise
Source: Haver Analytics

After-tax Corporate Profits
$ Trillions 1.6 $ Trillions 1.6

1.4

1.4

1.2

1.2

1.0

1.0

0.8

0.8

0.6

0.6

0.4

0.4

0.2

0.2

S&P 500 Index
1450 13.6% rise in 2006 1350 1350 1450

0.0 Q1-03 Q1-04 Q1-05 Q1-06

0.0

1250

1250

1150

1150

1050

1050

950

950

850

850

750 Source: Haver Analytics 650 May-05 May-06 Nov-04 Nov-05 Jul-03 Jul-04 Dec-06 Oct-03 Feb-05 Feb-06 Aug-05 Sep-06 Apr-03 Jan-03 Jan-04 Apr-04

750

650

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Nonfarm payrolls continue to post gains while the unemployment rate remains low
Change in Nonfarm Payrolls (SA, Thousands) and the Civilian Unemployment Rate
400 7.0%

300

6.0%

200

5.0%

100

4.0%

0

3.0%

-100

2.0%

-200 M-O-M Change in Nonfarm Payrolls -300 Jul-03 Jul-04 Jul-05 Jan-03 Jan-04 Jan-05 Jan-06 Jul-06 Civilian Unemployment Rate

1.0%

0.0%

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Treasury continues to monitor other trends

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Housing market trends appear uneven, and energy prices, while moderating, remain volatile
Median Sales Price of Existing Single-Family Homes and Year-Over-Year Change
20% Y-O-Y Change 15% Median Sales Price 225 $ Thousands 275

10%

175

5%

125

0%

75

-5%

25

Source: Haver Analytics -10% Jan-03 Jan-04 Jan-05 Jan-06 -25 $/barrel 90

West Texas Intermediate Crude Oil
$/barrel 90

80

80

70

70

60

60

50

50

40

40

30

30

20

20

10 Source: Haver Analytics 0 May-05 Nov-04 Nov-05 Dec-06 Jan-03 Oct-03 Jul-03 Feb-05 Jan-04 Aug-04 Aug-05 Jun-06 Sep-06 Apr-03 Apr-04 Mar-06

10

0

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And while deficits have been declining, government expenditures continue to outpace receipts
Federal Deficit/Surplus as a Percentage of GDP
Percent 3.0 Percent 3.0

2.0

2.0

1.0

1.0

0.0

0.0

-1.0

-1.0

-2.0

-2.0

-3.0

-3.0

Federal Receipts and Outlays as a Percentage of GDP
-4.0 95 96 97 98 99 00 01 02 03 04 05 06 Fiscal Year 21.0 -4.0 Percent 22.0 Receipts Outlays 21.0 Percent 22.0

20.0

20.0

19.0

19.0

18.0

18.0

17.0

17.0

16.0

16.0

15.0

15.0

14.0 95 96 97 98 99 00 01 02 03 04 05 06 Fiscal Year

14.0

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Given recent trends, we would like the Committee’s views on the following: What is the Committee's view on the fiscal outlook in 2007 and beyond? Is Treasury’s issuance calendar adequately placed to address its future funding needs?

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Competitiveness of the US Treasury Market

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The US Treasury market is the most liquid government debt market in the world

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Among major sovereign debt markets, average daily trading volume is highest in the US Treasury market
Average Daily Debt Trading Volume
blns $ 600 500 400 300 200 100 0 2000 2001 2002 2003 2004 2005 2006 US Japan UK

So urce: FR2004 P rimary Dealer, Japanese Securities A sso ciatio n, UK DM O

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Treasury market liquidity remains healthy
Primary auction demand is deep and continues to evolve Average daily trading volume in the on-the-run US Treasuries continues to grow Bid-ask spreads remain narrow Average trade sizes in the secondary market are growing Growth of the US inflation-linked market has surpassed that of all other major inflation-linked debt issuers

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Features of the US Treasury market: Transparency Regular and predictable issuance Minimal regulatory burden

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Secretary Paulson’s Principles on Competitiveness in US Capital Markets

Treasury remains committed to strengthening not only the Treasury market but also US capital markets as a whole.
Global view Evolving and responsive regulatory structure Rules based on sound principles Risk-based approach to regulation Enforcement to deter bad behavior, not hinder innovation or responsible risk taking
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We welcome the Committee’s views on the following: How does the competitiveness of the US Treasury market compare to that of foreign bond markets? Are there steps that we should undertake to ensure that the Treasury market remains the preeminent debt market?

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Treasury Borrowing Advisory Committee Presentation to the Treasury January 30, 2007

A Review of Short-Term Debt Issuance as it Relates to Short-Term Borrowing Needs

PAGE 1

Outlays and Receipts Rising

3 2.5

Outlays and Receipts, Fiscal Year Totals

Receipts

Outlays

2

$Trillions

1.5 1 0.5 0

`

1985

1986

1987

1988

1989

1990

1991

1992

1993

1994

1995

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

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Source: US Department of Treasury

2006

The question before this committee, and the investment community at large, is whether the steps taken by the Treasury and others have been sufficient to withstand a future wide scale disruption, or whether additional measures should be considered and implemented at this time. This report will touch upon the following:
Current borrowing need volatility
The factors that will contribute to further volatility in borrowing needs The effectiveness of short-term debt securities in the current environment Treasury’s effectiveness of managing high cash balances (TT&L--Treasury Tax and Loan and the TIO--Term Investment Option, a pilot program offered to TT&L participants) If the market were to face a large scale disruption at a time when Treasury cash balances were low, is the Treasury well placed to handle such a contingency event? Is Wall Street Prepared? Review the suggestions presented to Congress by the GAO; both positive and negative Additional tools or issues the Treasury should consider at this time

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Volatility of Borrowing Needs in Dollar Terms
300 200 100
billions
billions

Outlays Q/Q $b (+/- 1 SD)

300 200 100 0 -100

Receipts Q/Q $B (+/- 1SD)

0 -100
Source: US Department of Treasury

-200 -300 80 85 90 95 00 05

-200 -300 80 85 90 95 00 05

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Source: US Department of Treasury

Borrowing Have Been Trending Lower, Despite Volatility in Outlays & Receipts

Fiscal Year
2003 2004 2005 2006 OMB CBO Primary Dealers
$Billions

Budget
-$375 -$411 -$321 -$248 -$339 -$172 -$275

Budget % GDP
3.4% 3.5% 2.5% 1.9%

2007 Estimates Budget

Budget % GDP
-2.4% -1.3% -2.0%

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Source: US Department of Treasury

Contributing Factors to Forecast Errors: Reviewing the Obvious

Cyclical Influences Price of Oil Supplemental Appropriations Aging Population Tax Provisions

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Contributing Factors: Supplemental Appropriations

Supplemental Appropriations: 2000-2006
Year $Millions Informal Title

2000 2001 2002 2003

2004

2005

2006

Military Construction Defense $27,479 Emergency Supplemental and Resc. Recovery Response to Terrorist Acts $45,317 Defense Emergency Supplemental and Resc. $81,107 Emergency Wartime Supplemental Appropriations Emergency Supplemental Appropriations for Disaster Relief Act Legislative Branch $117,703 Supp for Defense/Iraq/Afghanistan Defense 2005 2004 Emergency Disaster Relief Supp. $160,410 Emergency Supplemental for Hurrican Disasters Assistance Act, 2005 Emerg. Supp. Approp. Act for Defense, Global War on Terror and Tsunami Relief, 2005 Emerg. Supp. Approp. Act to Meet Immediate Needs Arising from Consequences of Hurrican Katrina, 2005 Second Emergency Supp. Appropriations Act for Katrina, 2005 $94,430 Defense Approp. Actm, includes Katrina, Avian Flu, and a-t-b SBA disaster loans program account Act for Defense, the Global War on Terror, and Hurrican Recovery

$16,952

Source: CBO

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Source: Congressional Budget Office (CBO)

Contributing Factors: Aging Population
Medicare Spending as a % of GDP
Forecast

14 13 12 11 10 9 8 7 6 5 4 3 2 1 0
1970 1990

% of GDP

1998

2002

2006

2010

2014

2030

2050

2070

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Source: The Board of Trustees, Federal Hospital Insurance and Federal Supplementary Medical Insurance Trust Funds

Contributing Factors: Tax Provisions

Long term borrowing needs rose substantially in the wake of the first round of Bush Tax cuts earlier this decade. OMB estimates borrowing needs will decline sharply once those tax provisions expire in 2010. Legislated tax changes since February decrease receipts 2006-2009, then increase receipts in both 2010 and 2011.

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A Review of the Effectiveness of Short-Term Debt Instruments

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Effectiveness of Short-Term Debt Instruments

Over the past several years the Treasury implemented the following innovations in short term financing:
July 2001: Introduced 4-week bill program, reducing reliance on cash management (CM) bills 2001: 52 week bill issuance suspended October 2003: Launched the Term Investment Option Program (TIO) 2004: Eliminated compensating balances In line with Treasury’s mandate to maintain low cash balances they now operate with a direct pay for services model March 2006: Launched repurchase agreement pilot program

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Effectiveness of Short-Term Debt Instruments: 4-Week Bills

$450 $400 $350 $300 $Billions $250 $200 $150 $100 $50 $0 $275

Amount of CM Bill Issuance (Fiscal Years) $346 $268

$235 $227 $164 $176 $124 $175

$247

$252

1996 1997 1998 1999 2000 2001 2002 2003 2004 2005 2006

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Source: US Department of Treasury

Effectiveness of Short-Term Debt Instruments: CM Bills

140000 120000 100000
$Millions

Cash Balance

CM Bill Issued

80000 60000 40000 20000 0
10/03 12/03 2/04 4/04 7/04 9/04 11/04 2/05 4/05 6/05 8/05 11/05 1/06 3/06 6/06 8/06 10/06 1/07

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Source: US Department of Treasury

Short-term debt instruments: Flexibility in Issuance
45 40 35 Number of Days 30 25 20 15 10 5 0 25 28 33 29 20 10 12 8 11 11

Weighted Average Term to Maturity of CM Bills (Fiscal
33

1996

1997

1998

1999

2000

2001

2002

2003

2004

2005

2006

$1,200 $1,000 $ illio s B n $800 $600 $400 $200 $0 2001 2002 $92 $863

4-week Bill Issuance

$880

$908 $742 $791

2003

Fiscal Year

2004

2005

2006

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Source: US Department of Treasury

The Opposite End of the Spectrum: Managing High Cash Balances

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Managing High Cash Balances: TT&L Accounts

Treasury Tax and Loan (TT&L) Accounts
The TT&L accounts earn Fed Funds less 25 basis points, a rate set by the Treasury in 1978, not in line with current market rates. The interest earned on TT&L accounts creates a negative funding spread for the Treasury. It is insufficient to cover the cost of funding short-term debt instruments. In the late 1990s as financing rates became more transparent, the Treasury proposed to bring the interest rate in line with current market rates, which would have increased the return on Treasury balances by more than 20 basis points. TT&L participants met the Treasury’s suggestion with significant resistance citing that the wider spread was appropriate compensation for the transaction. In response to the resistance from TT&L participants, and in an effort to reduce the negative funding spread, the Treasury introduced the Term Investment Option pilot program in 2002.
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Managing High Cash Balances: TIO Accounts

Term Investment Option (TIO)
The TIO pilot program proved successful and transitioned into a permanent program in October 2003. Over the first forty-two auctions, the difference between auction rates and what he Treasury would have earned had it left the balances in Main TT&L Accounts (FF less 25bp) was uniformly positive and averaged 17.3 basis points.1 The Treasury has continued to successfully pursue new and innovative ways to increase the interest earned on high cash balances: most recently launching a pilot repo program. 70% of high cash balances that flow through TT&L accounts are now redirected into the TIO and Repo programs.

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Federal Reserve, Recent Innovations in Cash Management, Volume 10, Number 11

Managing High Cash Balances: Pilot Repurchase Agreement Program

Repurchase Agreement Pilot Program (Repo)
Repurchase Agreement Pilot Program started in March 2006. It operates on a DVP basis only with TT&L depositories. The pilot program currently earns a better funding rate than both the TT&L and TIO accounts.1 Since the Treasury launched the pilot Repurchase Agreement Program, over $206 billion TT&L funds have been invested.2

1 2

GAO-06-0269 216th Annual Government Financial Management Conference, Department of the Treasury
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Low Treasury Cash Balances and Wide Scale Market Disruptions The Implications

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Backup Funding Options: Industry Capacity and Resilience
The Treasury, Federal Reserve, large member banks, clearing banks, key clearing entities and primary broker-dealers have upgraded capacity to address business continuity issues not considered prior to 9/11, moving from cold backup to hot backup and fully staffed, geographically diversified operating centers.
Post 9/11 the Treasury and the Federal Reserve staffed additional operational locations and added data systems capability to increase auction resilience. In addition, they have added locations in different geographic regions for all four critical auction functions. BoNY operates Broker Dealer Services Division, including day-to-day securities clearing services, in three geographically dispersed locations: NYC, NJ and FL. Each center has capacity to process 100% of daily activity. Pre 9/11, Chase operated clearing services out of NYC with a data-only back-up facility in NJ. Now, in addition to NYC, Chase has fully staffed facility in Dallas, Texas, which handles approximately 50% of its daily volume and has capacity to process 100%. In addition, Chase has upgraded its NJ site and established a Maryland backup site. Pre 9/11, the FICC operated a single facility from 55 Water Street. They have diversified geographically though the addition of a full-service location in Tampa, Florida, capable of processing 100% of activity. In addition, several members of the executive management team operate from offices in Garden City, NY. While no one can fully anticipate unforeseen events, the industry has significantly reduced the probability of the “auction/securities grid” failing through their investment in multiple levels of backup, with specific focus on critical business lines and functions.

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GAO’s Recommendations to Congress, September 2006
Recommendation: examine the requirements for Treasury to establish a line of credit.
Financial institutions, specifically large commercial banks, would have to be willing and capable of lending money to Treasury in the appropriate amount and time required by Treasury. Under Basel II, banks would incur 100% capital charges for unsecured loans. Negotiations would have to consider how a collective capital charge in a high stress environment would impact the banking system and define the circumstances under which Base II could be waived. Because the nature and impact of potential future wide-scale disruptions are unknown, uncertainty exists regarding the ability of participating institutions to meet their obligations.

Recommendation: examine the ability of the Treasury to issue a cash management bill for private placement.
Institutions have ability and authority to purchase a CM bill that meets Treasury’s funding needs. Federal Reserve plays large role, by providing liquidity to depository institutions. Clearing and settlement systems must function to complete transactions.
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GAO’s Recommendations to Congress, September 2006

Recommendation: 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.
Severs the long standing independence of the Federal Reserve. What defines a “wide-scale” disruption? War? National disaster? The most carefully crafted bills are subject to revision. In the event the Federal Reserve lost independence, the cost of future funding would likely increase to compensate for political uncertainty. The amount of risk premium the market could demand is as ambiguous as predicting the future disruption. Congress has provided the Federal Reserve with considerable scope for independently exercising its best judgment as to what monetary policy should be. At the end of the day, it is public confidence that is a central bank's most precious commodity in a democracy.1

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1

McDonough: The Importance of Central Bank Independence in Achieving Price Stability, July 2, 2002

Tri-party Repurchase Agreements: A Consideration for Contingency Planning

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Tri-Party Repurchase Agreements: A Contingency Planning Consideration

Execution
Treasury raises cash by issuing securities, e.g. T-Bills, appropriately staggering maturities. Treasury invests in open tri-party repurchase agreements at prevailing market rates with banks and primary dealers. In the event of a significant market disruption, the Treasury, at its option, may elect to close open tri-party trades and receive proceeds. Banks may return funds directly, primary dealers may make funds available at the clearing banks, BoNY and Chase. In the event market participants require additional liquidity, the Federal Reserve, at its option, may perform open market operations and discount window transactions to maintain market stability.

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Tri-Party Repurchase Agreements: A Contingency Planning Consideration

Treasury issues additional securities for emergencies (say, $25b in 4-week bills.)

Treasury executes $25b of tri-party repo with counterparties on open

Market Event

Treasury closes $25b of tri-party repos

Street and Banks need additional liquidity in response to market conditions.

FRBNY adds liquidity through open market operations and the discount window.

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Tri-Party Repurchase Agreements: A Contingency Planning Consideration

Advantages
Disintermediation of Fed and Treasury. Maintains credibility of Federal Reserve. If in the event the “auction/security grid” failed, the Treasury would still have cash on hand to fund liabilities. Flexibility to scale up auction size over time as social security outlays expand. Reduces interest expense by eliminating the negative funding spread.

Funding Costs
Financially, the proposed structure may prove attractive based on T-Bill versus overnight tri-party financing rates. Using current market rates, a 4 week bill with a bond equivalent yield of 4.98% compares favorably to the equivalent GC repo yielding 5.18%. In this example Treasury would earn 18 basis points in positive carry.

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Tri-Party Repurchase Agreements: A Contingency Planning Consideration

Considerations
Transaction cost may outweigh potential spread advantage. Volatility of daily financing rates may be of concern. Repurchase agreements may not be adequate to cover emergency funding needs. Explore private placement CM bills as a second tier alternative or supplement to tri-party participation.

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