The full text on this page is automatically extracted from the file linked above and may contain errors and inconsistencies.
JOINT TREASURY-^FEOERALMSERVE
STUDY OP THE U.S. GOVERNMENT
SECIJRITIES
MARKE?
STAFF STUDIES-PART
3
J-6.6
7
-r
JOINT TREASURY-FEDERAL RESERVE
GOVERNMENT
MARKET
SECURITIES
STUDY OF THE
Staff
U.S.
Studies— Part 3
December 1973
NOTE TO READERS
The papers
in this pamphlet were prepared as
background material for a joint TreasuryFederal Reserve study of the U.S. Government
securities market initiated in early 1966 to
evaluate how that market was functioning in
light of the institutional and public policy
changes that had taken place in the first half
of the 1960's. The final Report of the Joint
Treasury-Federal Reserve Study of the
Government
U.S.
Securities
Market was
published in April 1969.
For the most part the individual papers do
not include data or
comments concerning the
period after mid-1967.
^
Library of Congress Catalog Card
this pamphlet may be obtained from Pubh'cations Services, Division of Administrative Services,
Board of Governors of the Federal Reserve System.
Copies of
D.C. 20551. The price is $1.00 per
copy; in quantities of 10 or more sent to one ad-
Washington,
Number 76-606840
85 cents each. Remittances
payable to the order of the Board
the Federal Reserve System in a
at par in U.S. currency. (Stamps
dress,
accepted.)
should be
made
of Governors of
form collectible
and coupons not
CONTENTS
NEW TECHNIQUES
IN DEBT MANAGEMENT
FROM THE LATE
THROUGH 1966
1
1950's
Lawrence Banyas
DEALER PROFITS AND
11
CAPITAL AVAILABILITY IN THE
GOVERNMENT SECURITIES INDUSTRY,
1955-65
U.S.
William G. Colby,
Jr.
AUTOMATING OPERATIONS
IN THE
117
GOVERNMENT SECURITIES MARKET
Felix T. Davis
and Matthew
J.
Hoey
Lawrence Banyas
Deputy Assistant to the Secretary
U.S. Treasury Department
NEW TECHNIQUES
IN
DEBT MANAGEMENT
CONTENTS
I.
II.
INTRODUCTION
HISTORICAL
Innovations
in
5
SUMMARY
Treasury
5
5
Bills
Issuance of Coupon Securities
Cash Refunding
Advance Refunding
Bond Auctions
at a
Discount
Participation Certificates
Innov.'^ons
III.
in
Nonmarketabie Issues
MARKET IMPACT AND ANALYSIS OF MAJOR NEW TECHNIQUES
22
Innovations
Participation Certificates
22
27
30
47
APPENDIX
53
Treasury
Cash Refunding
Advance Refunding
IV.
7
8
10
14
15
18
in
Bills
NEW TECHNIQUES
I.
IN
DEBT MANAGEMENT
INTRODUCTION
As
in
new techniques and innomanagement were demeet specific needs. Some of these
other
veloped to
needs were already well established by the late
1950's while others evolved
related
later,
but
all
management
The
objectives.
basic functions of
Of equal imdebt management in
refinance maturing obligations.
portance
is
the role of
—
major national policy goals promotion and maintenance of sound noninflationachieving
ary growth in the U.S.
economy and progress
of subsidiary objectives
may
also
To
and maintain a well-balanced
achieve
debt structure;
To
provide debt instruments that are de-
signed to meet market and nonmarket require-
ments;
To minimize the interference of
management actions with
Treasury debt management are to borrow for
expenditures not covered by revenues and to
number
be cited:
are
fundamental and continuing debt
to
A
fields,
vations in Treasury debt
ury's debt
tion of Federal Reserve
To
the execu-
monetary policy; and
minimum
hold interest costs to a
a framework consistent with
A
the Treas-
later addition to these
all
within
other goals.
aims has been the
coordination of the financings of Federal agen-
toward balancing our country's international
cies
accounts.
context of broad economic policy objectives.
II.
IN
TREASURY BILLS
Toward the fall of 1958 the Treasury became increasingly concerned over the lack of
receptivity in the market, even to short-term
offerings.
Faced with the huge increase
deficit in
fiscal
that
much
of
bills.
At
money market
area of
that time, only 91 -day bills
were being issued except for the seasonal taxanticipation
fered each
bills.
week
amount oftotal volume
In expanding the
to increase the
of the 91 -day bills outstanding, the Treasury
would have run the
the
Treasury within the
6-month bill in December
bill was not intended as
13-week bill. While the
shorter bills were reduced,
risk of not
having the of-
by subscriptions. Inby lengthening the maturity of the bills,
the same amount offered each week would be
fering adequately covered
stead,
able to support a proportional increase in the
The 26-week
1958.
a substitute for the
weekly offerings of
they were continued
most liquid
for those investors preferring the
Treasury borrowing instrument.
Developing a
out of necessity, would have
to be financed in the
Treasury
in the
1959, the Treasury felt
year
it,
those of
SUMMARY
HISTORICAL
INNOVATIONS
with
cycle
full
of
6-month
bills
while cutting back on 3-month offerings was a
slow process in a period of pressing
relatively
and
immediate
1-year
in
bill
Thus,
needs.
cycle involving
the
quarterly
amounts of $2
billion
each issuance was introduced in the spring
of
1959 to
as
little
offered
fill
that gap. In order to interfere
as possible with certificates generally
in
the
quarterly
refinancings
at
the
midpoints of February, May, August, and No-
vember,
mature
the
at
1-year
midmonth
bills
were
designed
in January,
to
April, July,
and October.
During the period through 1959, the currencies of most industrialized countries of the free
world had become convertible or fixed in terms
volume outstanding. For example, $1 billion of
13-week bills offered each week would keep
$13 billion outstanding and $1 billion of 26week bills could maintain $26 billion outstanding, and so forth. Conversely, it would need
only $1/2 billion of 26-week bills to maintain
$13 biUion outstanding. Accordingly, these
lost
considerations led to the introduction of the
excess of outgo over income resulted mainly
of gold
and/or
dollars.
Due
to increases in the
U.S. balance of payments deficit the Treasury
gold steadily and increasingly.
The
rising
from U.S. military commitments, foreign aid,
tourism, export of capital, and more particularly, from the lure of higher interest rates
abroad following currency convertibility. To
discourage the
flight of
short-term funds seek-
ing higher rates overseas after the onset of the
1960-61 recession, bill rates were prevented
from declining to the low levels that had been
reached during earlier postwar recessions.
In 1961 the procedure familiarly called "op-
was undertaken jointly by the
Federal Reserve System and the Treasury. The
System's role was to divert part of its open
market operations for monetary expansion into
the coupon issue area, including maturities
over 1 year. By so doing, the System would be
eration twist"
helping to hold long-term interest rates
down
economy, while refraining
from putting downward pressure on short-term
rates. Debt management's part in the process
was to increase the supply of bills: first, in the
conventional way by increasing offerings of
regular bills; and second, by offering bill strips
from time to time. These strips consisted of a
to spur the domestic
simultaneous addition to a number of consecutive weekly maturities of existing bills. The announcements stipulated that tenders had to include, in one bid, equal amounts of each
maturity offered in the strip. The comphcated
nature of the bidding for the strips tended to
discourage
ders.
As
rapidly
but the most sophisticated bid-
all
a result,
than
rates probably rose more
would have through the
bill
they
more gradual system
cycle of regular
of increments to a whole
amount
crease in the
In the meantime the quarterly 1-year bill
had not been enthusiastically received by the
market, and its performance during the next
several years was relatively spotty. To diminish
the impact of such bills on the market, the
Treasury reached the decision in 1963 to reduce substantially the amounts in each offering,
but to increase the frequency of the offerings.
1-year
of 1-year bills outstand-
ing on the completion of the cycle.
The initiation of the month-end annual bill
had an important effect on Treasury debt management choices and decisions in the shortterm coupon issue area. These bills virtually
replaced the 1-year certificate, which had been
the basic "anchor" issue in the quarterly refi-
nancings.
except for one offering of
August 1966 the Treasury has
Instead,
in
certificates
15 to 21 months'
issued short-term notes of
In
maturity.
addition,
the
pricing
of
these
short-term notes has been strongly influenced
by the
results of the 1-year bill auctions
imme-
diately preceding a financing.
In early September 1966, following announcements that Federal borrowing from the
public, including agency borrowing, would be
cut back and that sales of participation certificates (PC's) would be postponed until the
credit markets improved, the Treasury embarked upon a new month-end cycle of 9-
month
to raise part of
bills
its
current cash
At the same time the 1-year segment of
the monthly cycle was reduced slightly. Including the strip of three 9-month bills offered in
November 1966, only two monthly issues remained by the end of the year, to complete the
9-month cycle.
Chart 1 shows the composition of outstanding bills by original term to maturity. In early
needs.
December 1958,
the
6-month
bill,
just before
the inception of
regularly issued
totaled $23.4 billion.
bill offerings.
Accordingly, the quarterly cycle of
version permitted an appreciable over-all in-
By
the
end
3-month bills
of 1966 the
regular weekly and monthly bills outstanding
amounted
$34.4
to
bfllion.
billion or
$57.8
billion
—an
Of the $57.8 bUlion
29 per cent were
increase
total,
of
$16.9
originafly issued as
45 per cent were
and the combined 9-month and
1-year bills were $14.8 billion or 26 per cent.
By and large the 21/2 -fold expansion of reg-
3-month
6-month
bills,
$26.0
billion or
bills,
ularly issued bflls
occurred without straining
the absorptive capacity of the market,
and the
was converted into a monthly cycle beginning in August 1963. Although the amounts
offered were cut back by about 60 per cent,
added choices of maturities played a
significant
role in the orderly distribution of the
expanded
the greater frequency of offerings in the con-
volume.
bills
NEW TECHNIQUES
DEBT MANAGEMENT
IN
GROWTH OF REGULARLY ISSUED TREASURY
BILLS,
I
November 1958
^
December
1966
31,
I
BY ORIGINAL TERM TO MATURITY
*
Includfs SI. 2 billion strip of 4-. 5-. and 6-monlh bills issued m Novcr
dated Dec. 31. 1966, delivered Jan. 3, 1967.
in 1958 a figure for No
t Includes $0.4 billion
—
Note. Data are for end of year except that
shown. Based on data from U.S. Treasury Dept.
ISSUANCE OF COUPON SECURITIES
AT A DISCOUNT
actively
explored the
question of issuing coupon securities at a discount. At that time the General Counsel of the
Treasury held that public debt legislation enacted soon after U.S. entry into World
had overridden an
War
II
1958
the Attorney General rendered an opinion in
concurrence with the Treasury General Coun-
which stated that
it
was
over the years. In practice, however,
to
One advantage
sues below par
to the investor of offering is-
that the discount can usually
if
Accordingly, the Treasury began
coupon issues at a discount late in
1958. Although reasonably certain that it had
legal sanction for such issuances, stemming
from the wartime legislation, the Treasury did
the issue
gain (or loss)
This
if
is
of
investors
and
is
tage
taxable
the issue
sold before matu-
is
no advantage
nontaxable
to
not a very important advan-
to
holders
ordinarily,
to offer
cause
it
was
that
felt
below-par
would not be favorably received by
The
pon
offerings
the market.
principal advantage of discounting cou-
issues
is
that
it
"fine tune" the yields
them more
enables the Treasury to
on
attractive.
its
offerings to
Equally
close
make
pricing
held
be treated as the cost basis for determining a
obligations.
not exercise the option until 1958, mainly be-
is
Moreover, the discount price can
to maturity.
the issuance of U.S.
flexibility in
is
be treated as a capital gain
rity.
ury greater
had
pay above par for a closely priced offering
a somewhat cautious market environment.
clearly the intent
of Congress to give the Secretary of the Treas-
it
been found that investors were generally loath
in
earlier provision against of-
fering a security at less than par. Also in
sel
higher coupon rate at a premium.
next
the
This had been done on a number of occasions
1958 the Treasury
In
could, of course, be accomplished by providing
are
there
definite
limits
amount of discount
would be permitted
Section
Code
the
original
capital
because
allowable
issue,
gain
which
treatment.
1232 of the 1954 Internal Revenue
spells out this limitation, as follows:
"If the original
'4 of
at
to
1
%
issue discount
is
less
than
of the redemption price at maturity,
multiplied by the
number
of complete years to
maturity, then the issue discount shall be con-
sidered to be zero."
However,
if
the discount at original issue
is
V4 per cent or
each
full
year
more
to
of the maturity value for
treated as ordinary income.
discount
the
maturity,
For example,
2-year note held to maturity
if
a
issued at a
is
would be
of 99.50, the 0.50 discount
price
is
because the market had softened. The 0.30
discount in this case, however, was original-
and therefore the additional
issue-discount,
issue
of 3y8"s could not be regarded as truly identical
the February issue in the market.
to
In
treated as ordinary income for tax purposes,
order to differentiate between the two, the ad-
99.51, the 0.49 discount
but at a price
of, say,
discount
issue
(that
—up
to
of the discount based
on
be
original-issue-discount treatment for tax pur-
is,
the
how
amount
original-
99.50 example
long the issue has been held
—would
considered ordinary income. Suppose that in
the
first
example above, where a 2-year note
was issued
at 99.50, the original investor sells
the note for 99.75 at the
end
of
year.
1
The
pro rata part of the discount for the time he
has held the note
is
0.25, or one-half of the
issue discount. Since his gain
is
ordinary income.
it
would
still
If
is
0.25,
the gain were
all
of
less, all
be ordinary income, but
if it
poses,
at
was found desirable
it
many
a discount on
to issue securities
Since the
occasions.
was introduced in 1958, discount issuances through 1966 totaled about $97 billion
of coupon obligations for cash or in exchange
practice
for maturing securities.
of
CASH REFUNDING
were
second buyer then holds the note
and redeems it at 100 (face
value), the pro rata share of the discount for
the second year would also be 0.25, and the
second investor's gain would also be all ordito
to be stamped,
it
more, the excess over 0.25 would be a capital
gain. If the
ditional issue
the remaining term to maturity the
above), any gain on subsequent sale
the pro rata
had
and during
market had
to provide separate quotations for each part.
However, the right to issue certificates,
notes, and bonds at a discount has served the
Treasury well. Within the limitation precluding
would be treated as capital gain.
According to the tax code, under
In
the
fall
of
1958 and throughout 1959 the
Treasury also experienced a substantial
rise in
the proportion of maturing issues that
pubHc
maturity
holders turned in for cash, instead of accepting
attractively
course,
is
exchange
priced
terest-rate environment, in
nary income.
The problems stemming from an
issue-discount obligation
relate
to
of holdings
this
and
at
munerative
varying pur-
could create numerous prob-
lems.
In this connection, an anomalous situation
developed with an issue of Treasury notes in
1964.
In the regular quarterly
refunding in
February of that year, the anchor issue ofEered
by the Treasury was an 18-month, 3% per
cent note at a discount price of
the discount
was
less
99%.
the
that
offered
issues
re-
may
it
market.
was faced with
In either case, the Treasury
an increasing volume of
when,
in
addition
to
attrition
massive
quirements, large amounts of
needed.
To meet
ury announced in
succeeding
have
the
this
preemptive
Instead,
a time
new funds were
development, the Treas-
March 1960
maturities
at
refunding re-
that holders of
would not necessarily
right
the Treasury
to
at
an
exchange
its
discretion
Since
was not
considered original-issue-discount for tax pur-
During the following April, the Treasury reopened the 3% per cent note to raise
needed cash, but this time the price was 99.70
poses.
or
subsequently be obtained at lower cost in the
offer.
than Va per cent of the
par redemption price at maturity,
more
original-
trading in
ration of the discount must be continued. For
chase prices,
of
which investors be-
lieve that alternative instruments are
the secondary market, in which case the pro-
odd periods
This,
offers.
a natural consequence of a rising in-
would pay
tained
amount
One
off
maturing issues with funds ob-
by offering an approximately similar
of
new
securities for cash subscription.
of the problems that arose
of the cash refunding technique
from the use
was
related to
the rollover of maturing issues held by official
NEW TECHNIQUES
DEBT MANAGEMENT
IN
when
coupon
Beginning with the November 1963 cash re-
Reserve and the
funding, the Treasury announced that subscrib-
accounts. In a rights refunding,
issue matures,
Government
roll
the Federal
Accounts
Investment
over their holdings into the
a
generally
new
securities
offered, while other investors subscribe for as
many
new
new cash
of the
case of
In
while the Gov-
all
allotted a
$100
generally
full,
except
allotment
to small subscribers
those
allotment
full
the
that
their holdings of eligible securities
million or less. All other investors are subject
tions) allotted in
to
certify
prior to the announcement.
predetermined amount in
amounts
to
financings the Federal Re-
ernment Accounts have usually been
percentage
entitled
issues as they wish. In the
serve does not participate at
to
would be reamounts of their
subscriptions do not exceed the amounts of
ers
quired
for
minor
from buying up the eligible issues after the announcement to acquire a larger amount of an
attractively priced offering, possibly for speculative purposes.
As
in offerings for
in cash refundings
instances
involve
that
fundings the Treasury had to find a
cash
way
re-
to ac-
cord the same treatment to the holdings of the
is
intended to prevent any of the listed holders
(small subscrip-
full.
immediately
The stipuladon
subscriptions,
new
such as
cash, other factors
maximum
allowable
cash deposits, allotment ratios,
and minimum allotments have been varied to
suit particular conditions.
The cash
Federal Reserve and Treasury Accounts as in
num-
refinancing procedure has a
rights refundings; otherwise their subscriptions
ber of advantages over rights refundings. In a
would be subject to percentage allotment as
would those of all other subscribers. In that
cash operation the Treasury determines
and Treasury (for
Government Investment Accounts) would
much
more
of one or
issues
event, the Federal Reserve
Thus, the technique offers
the
ditional cash can be raised
it
wants to
flexibility in that
than the total amount maturing, or
or else these olBcial investors would acquire
is
either
more or
less of the
new
maturing
securities than
issues. In either
desired, the exact extent of
termined.
tion,
By
the
it
if
attrition
can be prede-
same token, unwanted
which may occur
in
ad-
by offering more
have to guess the correct percentage allotment,
their holdings of the
how
offer.
attri-
a rights refunding,
case, but mainly with respect to the Federal
can be avoided. In addition, with more
would be an unwanted effect on the money market of unpredictable extent: toward ease if more were acquired than held, or toward restraint if less
were acquired.
The problem was resolved by allowing all
control over subscriptions and allotments, ex-
Reserve's
allotment,
there
cessive speculative activity can be
flexible
more
easily
held within bounds.
However, there are two principal advantages
of rights over cash refundings. First, an investor
knows exactly how much of
a
new
issue
investors to turn in their maturing securities to
he will be allotted in a rights operation. This
pay for the new
one category all
preferred by the relatively smaller, less sophis-
issues,
and by including
official-type
holders or
in
ac-
counts whose subscriptions would be allotted
These accounts,
in full.
as
listed in
the
first
ticated investor
who would have
is
to guess the
allotment ratio in a cash refunding and pad his
subscription accordingly. If the guesses
on
al-
cash refinancing announcement of the August
lotment ratios
1960
have to accept more of the new securities
than they had wanted. Hence, smaller banks
and other institutional investors are ordinarily
litical
and their poand the instrumentalities
pension and retirement and
maturities, include: States
subdivisions
thereof,
public
funds. Government Investment
Accounts, the Federal Reserve Banks, interna-
other
public
tional organizations in
more
are
too
small,
investors
may
inclined to participate in rights refund-
ings than in cash operations.
which the United States
The second
basic advantage of using rights
market rather than the Treasury de-
holds membership, foreign central banks, and
is
foreign states.
termines the amount taken of each issue
that the
when
two or more options are provided. When the
sets the amounts of each issue of-
some tend-
amounts of debt extension, with a minimum
prevailing longer-term rates, was
advance refunding. In an advance refunding
option for
the Treasury offers holders of existing issues,
Treasury
fered in a cash refunding, there
ency to Hmit the
fear that
it
will not
be adequately covered. For
that reason longer options
may be
or
small,
trarily
is
size of the longer
may be made
arbi-
eliminated entirely.
Thus, rights refundings tend to maximize debt
The Treasury made
use of the
extensive
cash refunding technique from
its
inception in
August 1960 through November 1966. During
that period there were 26 quarterly refinanc-
Of
which are not due to mature for some time,
the opportunity to exchange their holdings for
longer issues.
these, 10
were cash operations.
for
many
when
when
the rapid
of debt extension to bring about a better balin the
maturity structure of the market-
able debt would have to be explored. Strenuous
had been made to
the period between Sep-
fairly successful efforts
lengthen the debt in
tember 1957 and January 1959, but the inexorable passage of time
temporary.
In
rendered the success
the
ensuing
period
of
rapid upturn in market rates of interest, the
normal
methods
extension
debt
of
cash offerings or refundings
strongly
felt to
at
through
maturity were
be inadequate and costly
deed, they were possible at
if,
in-
all.
In the normal
term issues shortened, they gravitated into the
hands of intermediate- and short-term holders,
mainly commercial banks and corporations.
when
the issues matured, holders of
short-term issues were not inclined to accept
long-term bonds
—
time —
refundings
that
in
The
otherwise be
legislation
provided
Accordingly,
issues
most
cases
for exchange to the
eligible
offered.
issues
in
could carry over the cost basis of
Generally,
Federal
new
and State
supervisory authorities followed the Treasury's
lead
in
allowing such
accounting treatment,
and under the provision many
vestors,
including
could take
institutional in-
not subject
those
tax,
to
advantage of the exchange offer
without having to show a substantial book loss
on the old
issues being replaced. In essence,
the nontaxable exchange provision postponed
the recognition of any gain (or loss) until the
new
were subsequently sold or
securities
re-
deemed.
The new
legislation
impediment
removed another
advance refunding
provided that the issue price
operations.
It
of the
security
old
also
successful
to
would become the issue
which precluded treating the
having been offered at an original-
price of the new,
course of events, as longer-
Finally,
in-
so stipulated by the Secretary of
Treasury.
their
quite
was
for nontaxable exchanges in advance refund-
investors
economic expansion that had started in the spring of 1958
was in full swing, the Treasury became increasingly convinced that alternative methods
In early 1959,
who would
investors
unwilling to exchange.
ings,
ADVANCE REFUNDING
and
of 1959, legislation
ease and simplify advance refunding operations
the
ance
summer
In the
troduced to modify the tax code sufficiently to
extension.
ings.
impact on
exchange; thus in rights
the usual type of operation up to
a reverse transfer of maturing issues
new
issue as
issue discount for tax purposes. In
without
profit
the
on the
new
provision
sale of the
new
any
many
cases,
subsequent
securities
would
have been converted from a capital gain into
ordinary income.
After the groundwork had been completed,
the Treasury tried a pilot advance refunding in
necessary. Ex-
June 1960. The operation was considered a
success, and it led to the full-scale advance re-
cept in a period of falling interest rates, there
funding of October 1960. In September 1960
chance for substantial amounts of
the Treasury issued a white paper. Debt Management and Advance Rejnnding, in which
basic concepts were discussed. The paper indi-
to long-term investors
was
little
became
long-term offerings to be taken. The method
decided
upon
as
promising truly
significant
NEW TECHNIQUES
IN
DEBT MANAGEMENT
cated that "senior" advance refundings, such
as the
October 1960 operation, should involve
outstanding issues maturing between 5 and 12
years whose holders
would be offered long-
term bonds with terms of 15 years or more.
"Junior" advance refundings, such as the June
1960 operation, would involve outstanding is1
and 5 years whose
.holders would be offered medium-term issues
sues maturing between
in the 5- to 10-year maturity range.
Thus, the
sues were included with junior advance refund-
Third, outstanding issues maturing in 5
ings.
years or less were
made
advance
refundings
eligible for
And
into long-term issues.
exchange
fourth, the scope of
was greatly enlarged
in
terms of the number of eligible issues in one
operation and the amounts of these issues in
public hands.
Advance refunding into long-term
was effectively prohibited when market
issues
yields
longer outstanding issues in a senior refunding
rose above the 4V<i per cent interest limitation
would be replaced by the new
on bonds
issues offered in
a junior refunding, leaving the
1-
to
5-year
area open to regular refundings of maturing
sues and cash offerings.
It
was
felt
is-
that in this
leapfrog process the ownership pattern of the
outstanding issues would remain relatively undisturbed, market churning
would be reduced,
and the upward pressure on longer-term interest rates would be much smaller than with
similar-term
conventional
refundings
at
ma-
in
the
fall
of
1965.
In 1966 the
technique was combined with regular refund-
and limited to the advance refunding of
maturing within, 6 months into notes
coming due within 5 years.
ings
issues
Even a brief history of advance refunding
would be incomplete without including a description
debt
of
its
evolution
restructuring
changes
tool
into
a formidable
through
conceptual
and the development of subsidiary
techniques.
turity.
In addition,
since
advance refundings are
not subject to any predetermined schedule, the
Treasury can choose the most opportune time
for such operations in relation to the
market
environment and to other debt management
objectives.
Moreover, unlike refunding
no expectation
at
ma-
no problem because there
turity, attrition is
that nearly
all
is
of the publicly
held portion of an eligible issue will be ex-
changed and no cash payoff of the remainder
involved. Thus, the Treasury runs little risk,
and any appreciable amount extended not only
is
improves the debt structure but also reduces
the refunding burden
when
the issue finally
matures.
While the precepts regarding the leapfrog
principle generally continued to be
observed,
the role of advance refunding
At
and ofby and large, to those
that could be accommodated on a straight
par-for-par basis. It was held by some that any
adjustment payments to, or by, the subscriber
would complicate the operation beyond the
chance of success. However, such adjustment
(or "boot") payments were successfully introduced in the third advance refunding. Thereafter, boot payments made possible a much
wider choice of eligible and offered issues and,
in fact, led to advance refundings in which as
many as nine eligible issues were exchangeable
for any of three offered issues.
By the time of the March 1962 advance refunding, congressional questions and criticisms
first
the choice of outstanding
fered issues
was
against the
new technique
limited,
led to hearings be-
Committee on March
14 and 16. Criticism centered particularly on
the senior refundings in which World War II
tap 2'/2's had been replaced by the Treasury
was gradually
expanded beginning in 1962. First, junior- and
senior-type offerings were included within one
operation. Second, the mechanics of advance
refunding were applied to outstanding issues
fore the Senate Finance
maturing within
parent increase in cost to the maturity date of
1
year, with the objective of
reducing large concentrations of early maturities to facilitate
finally
regular refinancing
came due, and
later
when they
such short-term
is-
with long-term 3Vi
The
ap-
was considered too great to be
by the subsequent likely saving in interOn the other hand, there seemed little or
the old issues
offset
est.
per cent bonds.
12
debt maturing within
year.
As
no opposition to junior refundings since the elwere due to be refunded relatively
soon anyway. Thus, no truly senior advance
in short-term
igible issues
shown
refunding has been attempted since 1962.
from 1958 through 1965 to an increase of $21
billion. The volume of coupon issues declined
from $43 billion to $33V2 billion in that time,
in
Another development resulted from the advance refunding of issues maturing within 1
some
year. In
cases
making the offered
bills.
Chart
2, this
1
procedure was effective
holding the under- 1-year marketable debt
bills grew by about $30 bilhon.
However, the sharp curtailment of advance refunding following the January 1965 operation
was chiefly responsible for the rapid build-up
while regular
issues
produced substantial "rights" values for the eligible issues. Holders unwilhng to
exchange "rights" were thus encouraged to sell
in the market and to invest the proceeds temattractive
porarily in
in
of within- 1 -year debt during 1966.
addition to
In
This had the effect of depress-
making room
for
bills,
ad-
actively
vance refunding greatly reduced amounts of
seeking to increase such yields for balance of
short-term issues in public hands by breaking
such experi-
up large concentrations of early maturities.
This is clearly illustrated by Chart 3. From the
second half of 1961 through 1966 advance
refundings reduced maturing issues held by the
public by between $1 billion and $9 bilhon, or
an average of $5Vi billion for each semiannual
ing
yields
bill
when
the Treasury
payments reasons. After the
ence the sale of additional
announcement
the
was
bill
effectively
first
bills at
was
the time or
of the intention to sell bills
used to prevent any substantial
rate declines.
The
and
had other important
By removing large blocks of early maroom was made for expanding the volregular bills without an undue increase
pre-refunding of near maturities
By 1963,
following the inception of
junior advance refundings
period.
aspects.
pre-refunding, whereby issues maturing within
turities,
ume
2
of
1
year were
ing,
made
eligible for
the regular refunding
COMPOSITION OF THE UNDER 1-YEAR MARKETABLE DEBT, 1958-66
COUPON ISSUES
DECEMBER
Includes $2,7 billion of spt-cial bills nKiliinn;; M.iv
$(1,4 billion
of 4-month bills dated be
t Includes
Note. Based on data from U.S. Treasury Dept.
31
-
*
—
31,
1966,
delivered
Jan.
3,
1967.
advance refund-
burden was sharply
NEW TECHNIQUES
IN
DEBT MANAGEMENT
PUBLICLY HELD TREASURY-ISSUE MATURITIES
Effect of Advance Refundings in Reducing Actual Maturities
Semiannually, July 1960 December 1966
By
—
—had
doing a good job of
advance refunding
in
held amounts to be rolled over each half year
debt extension
in effect already provided
had declined to between $5 billion and $7
billion. These smaller maturities greatly facilitated the quarterly refunding operations and
additional longer options.
reduced.
the second half of 1964, publicly
The
part played by advance refunding in re-
structuring the over- 1 -year marketable debt
is
Moreover, the actual amounts by which early
amply demonstrated in Chart 4. By the end of
1959 the most vulnerable segment of intermediate- and long-term debt, the 1- to 5-year maturities, had increased to $611^ billion. This
were reduced understate consider-
portion of the debt poses the constant threat of
ably the true contribution of advance refunding
dropping into the under- 1 -year category. When
the Treasury is foreclosed by the 4V4 per cent
indeed, in
easily
some
successful
have been
maturities
risky,
cases,
made
when otherwise
if
they
might
not impossible altogether.
to easier regular refunding.
ductions,
cash refundings
Without such
re-
most of the much larger original
would have been rolled
limitation
on bonds from extending beyond 5
maturities, of necessity,
years, this sensitive area of the maturity struc-
over into short-term issues requiring refunding
ture
again after a year or two.
to 5-year debt
In some cases so much of an eligible issue
was extended through advance refunding that
from $40 billion 5 years earlier. The $9 billion
growth in 1960 occurred partly as a result of
the pilot advance refunding in June that year,
while the big senior refunding in October had
the publicly held portion appeared too small
for
more than one option in the regular reat maturity. It was felt in such cases
funding
that
if
the resulting longer issue were too tiny,
market characteristics would be impaired.
While this, of course, was true, it is clear that
its
no
is
likely to
effect in that
Thereafter,
grow.
By December
had grown
to nearly
1960, 1-
$71 billion
maturity area.
however,
advance
refunding
played a very significant role in increasing the
volume of
issues
with
loneer
maturities.
As
14
4
STRUCTURE OF THE OVER 1-YEAR MARKETABLE DEBT, 1959-66
1-TO 5-YEAR MATURITIES
ISSUED
5-
TO 20-YEAR MATURITIES
IN
ADVANCE REFUNDINGSISSUED
IN
REGULAR FINANCING: —
20 YEARS AND OVER
late as
December 1966, advance refunding had
accounted for 72 per cent of the $17 bilhon
in
20-year-or-longer bonds outstanding, and for
53 per cent of the diminished 5- to 20-year
maturities. Even in the 1- to 5-year area 39
per cent of the outstanding issues had origi-
nated in advance refundings.
In summary, the importance of advance re-
funding
in
improving the structure of the mar-
debt
ketable
can
scarcely
be
exaggerated.
From June 1960 through January 1965
$68
billion
nearly
of securities were extended into
longer-term issues in 11 operations
—an
aver-
age of $6.2 bilhon per operation, of which
$5.7 billion was publicly held.
The scope
of
advance refundings gradually increased during
the period.
billion
By combining
and $22
issues in the July
ations,
the
extension of
curities.
as
much
as
$26'/i
billion of publicly held eligible
1964 and January 1965 operbrought about the
Treasury
more than $18 bilhon
of those se-
Yet, despite these massive doses of
debt extension and the upward pressure of the
continuing economic
expansion beginning
in
1961, the impact on long-term interest rates
NEW TECHNIQUES
IN
DEBT MANAGEMENT
well as other dealers, brokers,
and banks
the group.
The
tion of these
will-
members
ing to be affiliated with the major
sitive
economic and
to
news of
political
basic idea behind the organiza-
marketing groups was to
Second, obtaining advance commitments from
large
kinds,
spread the risk of handling a large issue and to
prospective investors was likely to be
ensure as wide a distribution as possible of the
particularly in a cautious
bonds
Third,
to the investing public.
—
The first auction for bonds amounting
$250 milhon was held in January 1963.
—
invitation to bid
its
all
both domestic and foreign. Thus, the
underwriters could not stand much exposure.
of
the Treasury
that the issue could carry either a
Government bond market
the
broad, and one long-term Treasury issue
In
much
like another, that
market
new
maturity area of the
so
is
to
announced
4 or
difficult,
market environment.
is
so
stability in the
issue could not
be
per
successfully maintained by the winning syndi-
it would mature in
30 years, but would become callable after 25
years. The winning bid at a'price of 99.85111
per $100 for the bonds as 4's of 1988-93
cate. Attempts by the syndicate to stabiUze the
market would be very difficult, especially if the
other market professionals were to sell the
provided an interest cost to the Treasury of
Federal Reserve in maintaining an "even keel"
4.008 per cent, and the bonds were reoffered
during the auction and early reoffering period
The un-
could not be expected to continue indefinitely.
4'/8
cent coupon rate, and that
at par.
The
reoffering
was a
success.
issue
derwriters were able to dispose of the securities,
terminate price restrictions, and dissolve
the selling group in 2 days.
And
short.
As a
the
fourth,
result of the
problems involved, syndi-
cate underwriting of long-term bonds has not
been used since April 1963. At the time, mar-
The Treasury held the second auction
April 1963 for $300 million of bonds. The
in
in-
bidding for an entire issue of long-
term bonds were too great even
1988-94. The winning bid was 100.55119 on
a 414 per cent coupon at an interest cost of
offered were limited to
4.093 per cent, and the bonds were reoffered
PARTICIPATION CERTIFICATES
100.75 to yield 4.082 per cent. However,
this issue
first
proved more
difficult to sell
auction offering and remained
syndicate restrictions for
some
time.
than the
bound by
It
so hap-
pened that the chances for the second offering
to achieve a quick sellout were substantially
dampened by the announcement of an impending large telephone company issue on the day
of the Treasury auction.
The
interest
cost to
the
Treasury on the
auction bonds was probably less than if they
had been sold in regular financings. The yield
spread on each of the auction issues was 8
basis points above prevailing Treasury market
rates as compared with an average spread of
about 12 basis points for regular Treasury of-
The new
$300
The sale of participation
management tool orginated
method of selling longterm bonds created a number of problems.
First, the underwriting risk was great because
the Government bond market is extremely senauction
as
issues
in
amounts
debt
a
1953 mainly as
program
part of a generalized
the
if
million or less.
to
hold
down
the Federal debt subject to statutory limit, but
the budgetary effect
first
PC's
—
the
was
also recognized.
Commodity
The
Credit Corporation
—
(CCC) certificates of interest were (and still
were through 1966) short-term instruments of
participation
in
a
pool of crop loans. They
have been taken mostly by commercial banks,
to redemption on demand,
and have been guaranteed by the CCC.
For a number of years the CCC certificates
of interest were the only PC's offered by the
have been subject
Federal Government, except for a small Reconstruction Finance Corporation
ferings.
com-
ket circles held strongly that the risks of
petitive
vitation to bid called for either 4's or 4'/8's of
at
of the
attitude
in
(RFC)
1954, which was liquidated 2 years
Ordinarily, PC's of the
CCC
result
issue
later.
when crop
loans are taken over by banks or other financial
institutions, instead of
being presented for pay-
ment by
Government. In that way the
the
CCC
PC's reduce expenditures for loans and
at the
same time do not add
to the debt.
PC
In fuller explanation, the proceeds of
have a twofold fiscal effect: When deposited in the general fund balance, the proceeds
sales
new
diminish the Treasury's refunding or
rowing needs. Thus, the public debt
is
PC's against a pool of selected foreign
to issue
loans in
its
originally
portfolio.
10-year
These
certificates
obligations
(later
were
7-year)
bor-
with semiannual level amortizations of princi-
reduced
pal to coincide roughly with the amortization
much
or prevented from increasing as
Even before the Federal Credit Programs
Committee report, the Export-Import Bank of
Washington (Eximbank) in 1962 had begun
as
it
The
schedules of the loans in the pool.
certifi-
would have without the PC's. The explanation
of the effect on budget expenditures is more
complicated. The money for most Federal
credit programs is drawn from revolving funds
set
up under congressional authorizations.
Drawings by the agencies represent borrowings
from the Treasury; as these agencies make
loans to the pubhc, the funds used become
cates were offered only to commercial banks,
budget expenditures. The process
made
subject to redemption in part or in full
at the
option of the holder or of the
when
is
reversed
loans are repaid by the public, or are
sold to private investors, or
As
sued.
when PC's
are
is-
the repayments or the proceeds of
mainly those with a substantial interest
eign loans.
By
in for-
the terms of the offerings, the
Eximbank PC's had
limited
negotiability,
in
banks originally subscribing could sell
only subparticipations to correspondent banks
that the
or other affiliated institutions.
this
To make up
for
lack of liquidity, the participations were
beginning 2Vi
years
from
Eximbank
As a
date.
issue
source of funds, additional issues of PC's were
Eximbank from time
outright sales or of PC's were deposited in the
sold by the
became negative
budget expenditures, and at the same time
agency indebtedness to the Treasury was re-
out appreciably changing the basic terms of
should also be stressed, however,
grams Committee recommendation on an en-
some replenishment
larged role for private credit, active considera-
duced.
It
PC
that
they
balance,
Treasury's
sales represented
of loanable funds for the credit programs.
To stem
to tune with-
the instrument.
pursuance of the Federal Credit Pro-
In
tion
began
to
be given to expanding the scope
the rising tide of private loans and
of participation offerings. After intensive study,
mortgages held by the Government, outright
sales of financial assets had been actively pur-
legislation was introduced and enacted in September 1964 empowering the Federal National
sued under some programs.
were
clearly
However, these
not large enough to affect the
growth of Federally financed
To study this and other
related problems, the President appointed a
Committee on Federal Credit Programs, with
over-all
rapid,
credit to the public.
Secretary of the Treasury
the
The Committee submitted
ary 1963, and
among
tions the
report
financing
should
credit
be
it
as
many recommendaurged that
substituted
was
Chairman.
report in Febru-
feasible to
for
do
private
Federal-agency-held
seemed
to
Committee's
(FNMA)
to
act
as
gages as the backing for a
fering.
new type
of
PC
of-
In effect, marketing of these PC's rep-
resented the sale of the interest and principal
payments on the mortgages. Accordingly, the
PC's were arranged to mature serially to correspond with the payments inflow. In the mortgage field, PC's have distinct advantages over
outright sales of mortgages: They remove the
risk of default; they eliminate servicing costs;
In
and they attract investors otherwise not interested in mortgages directly.
The mortgages involved in the first PC offerings were from FNMA's Management and
Liquidation and Special Assistance portfolios
and from the portfoho of the Veterans Admin-
and mortgages
promise the speediest approach for
implementing the
tion.
loans
Association
public
so.
regard the sale of participations in pools
this
of
whenever
its
strongly
its
Mortgage
trustee for pooling Federal-agency-held mort-
recommenda-
NEW TECHNIQUES
istration
fering in
IN
DEBT MANAGEMENT-
17
(VA). FNMA sold the initial PC ofNovember 1964, as a $300 million,
expanded
for an
PC program
went forward,
culminating in the Participation Sales Act of
10-year serial issue with $30 million maturing
1966, passed in May. Under the statute the
each year.
potential coverage of credit
The marketing arrangement
as originally set
up remained essentially unchanged through
1966. Under this arrangement PC offerings
were awarded by FNMA to one very large
underwriting
fered
which
syndicate,
them
the
to
turn
in
public
investing
scribed interest rates and prices.
price for each of the maturities
reof-
at
pre-
The rate and
making up the
were determined by negotiation between
the syndicate and FNMA, with Treasury con-
issue
was a
currence. Also included
scale of under-
writing charges or commissions for each of the
serial maturities
paid by
FNMA.
FNMA
PC's posed a number
For example, some of the
serial maturities were unpopular and hard to
sell; the amount of each serial maturity was
small, making dealer operations in the secondary market difficult and risky; although negotiof market problems.
PC's were
the
able,
more time
ter
requiring
and handling; and the
though backed by a let-
for transfer
FNMA,
guarantee by
ing
registered,
all
Treasury
if
willingness
to
lend
funds
to
be
After the
first
few
offerings, the receptivity
FNMA
PC's declined in the
rapidly rising interest-rate environment follow-
ing the enlargement of the
Asia. During the
for
Eximbank
for
bank
war
in Southeast
same period the environment
weakened as demand
offerings
credit increased sharply. Despite at-
make
the Eximbank-type PC's more
by reducing the time to earliest redemption by holders and by making them
eligible for discounting by the Federal Reserve,
the Eximbank found it increasingly difficult to
attractive
PC's
In
addition,
ap-
the
PC
the
offerings with
management operations and
debt
its
authorizes
legislation
to
ap-
prove the direct sales of certain financial as-
The programs and agencies
sets.
Act
listed in the
are:
Home AdminisDepartment of Agriculture, relating to
farm operations, farm ownership, housing, and
soil and water;
Loans for academic facilities by the Office
of Education, Department of Health, Education, and Welfare;
Loans and mortgages held by the Department of Housing and Urban Development exrelated
to
secondary market
cept
those
Direct loans of the Farmers
operations of
FNMA;
Loans and mortgages held by the VA;
Loans held by the Eximbank;
Loans held by the Small Business Administration.
According
at
reasonable rates of interest.
increase
further
the
role
of
private
sales
to the
House Banking and Cur-
at
$33.3
direct Federal loans
billion,
assuming
all
PC
sales
contem-
document
had been completed. Of this amount, however,
only some $10 billion to $11 bilhon of financial assets were in programs listed in the act.
During the second quarter of 1966, yields
on Federal agency issues and PC's rose
sharply relative to Treasury market rates as
private and public credit demands soared. Federal agencies were faced with greatly increased
demands from those unable to borrow from
banks and other sources. In consequence, the
agencies
FNMA,
in
all
plated in the January 1966 budget
funds primarily as a result of the war, plans
and
the level of
bill,
outstanding on June 30, 1966, was estimated
view of the greater need for
credit,
provide for congressional
rency Committee report on the participation
of the market to
To
To
Act requires congressional
Treasury to coordinate the
fully bind-
ing legally.
tempts to
the
insufficiency of the pools to service the PC's.
to
necessary, for servicing the PC's,
was not considered by some
enlarged.
proval, through appropriations, to cover any
from the Secretary of the Treasury regard-
FNMA,
sell
tially
control,
tration,
Aside from rates and prices, the terms and
conditions of the
programs subject
was substan-
to inclusion in participation pools
—
particularly
and the
the
farm
home
credit
loan
banks,
agencies
—
in-
18
creased their market borrowing. Together with
PC program
expanded
by the
budget for fiscal year 1967, these demands
created a very depressed and unhealthy atmosphere in the credit markets. By late August the
markets had become so severely tightened that
interest rates rose to the highest levels in 40
the
called for
years or more.
In
this
situation
the
administration
acted
vigorously to dispel apprehension and to ease
pressures on the
money and
capital markets.
San Francisco; wire transfer facilities among
major money market centers; and an
opinion by the Attorney General that PC's are
full faith and credit instruments of the United
these
States.
from 1962
1966 totaled about $5% billion. Of
this amount about $4 billion remained outstanding on December 31, 1966, after redemptions, amortizations, and maturities. The shift
of these amounts from Federal to private
Sales of participation certificates
through
In addition to other measures, the President,
credit
on September 9, 1966, requested the curtailment of agency borrowing. The next day the
Secretary of the Treasury announced that
scheduled sales of PC's would be postponed
until the credit markets improved, and any
new money to meet Federal agency needs in
excess of maturities would be provided by the
Government Investment Accounts.
As a result of official measures to relieve
pressures, interest rates dropped quickly and
the tightness in the money and capital markets
gradually eased. Toward the end of the year,
the environment was considered appropriate
for FNMA to announce the first offering of
PC's following the early September postpone-
tion.
ment. Additional legislation providing congres-
meet insufficiencies of
from the loan pools to service PC interest payments was enacted in September.
In the meantime, while market receptivity to
the growing volume of PC's was reaching a
low ebb during the summer of 1966, meetings
were held among market participants, representatives of the Treasury, the Bureau of the
Budget, FNMA, and other interested agencies
to discuss measures for improving the market
sional authorization to
some degree
required
By and
to believe that
of experimenta-
however, there
large,
is
reason
through adequate coordination
with Treasury debt
management and Federal
agency borrowing operations, PC's could have
continued to play a useful and beneficial
fiscal
role.
INNOVATIONS
NONMARKETABLE
IN
ISSUES
The history of debt management innovations
would be incomplete without mentioning developments
area of nonmarketable
Although such issues do
not have a direct impact on the market, they
have important effects in changing the supply
of marketable issues and in carrying out broad
debt management and national economic pol-
Treasury
in
the
securities.
interest
characteristics
gestions
of
of
the
PC's.
market
Most
of
the
professionals
sug-
were
FNMA PC's announced in
December. These included: the concentration
of one offering into as few as two or three sepadopted for the
arate maturities, instead of small annual serial
maturities; optional bearer or registered forms
icy objectives.
Savings bonds. By the spring of 1959, the
bond program was faltering and in evident trouble. Sales of Series E and H bonds
had declined from $5.3 billion in fiscal year
savings
1956
to $4.5 billion in 1959; in the latter year
—
—reached more
the net cash drain
over sales
than $0.6
billion.
Twice before, in 1952 and again in 1957,
the Treasury had raised savings bond rates by
small fractions of 1 per cent: first, from 2.9 to
3 per cent to maturity in May 1952 and then
3Vi per cent in February 1957. As
from
3 to
rate
competition for
3'/4
savings
sharpened,
the
per cent became clearly inadequate. Ac-
of the certificates; denominational exchanges
cordingly,
the
coupon issues to be provided by the Federal
Reserve Banks of New York, Chicago, and
permitting
the
of
the excess of redemptions
Treasury requested legislation
rate
to
bonds to be increased to
maturity
3%
on savings
per cent begin-
NEW TECHNIQUES
June
ning in
DEBT MANAGEMENT
IN
The enacted
1959.
maximum
raised the
legislation
allowable savings
bond
4V4 per cent, provided the President
rate to
found that the increase would be
crease of $7Vi billion in the 7Vi years from
mid-1959
E
tional interest.
Additionally,
the
Treasury asked for and
December 1966, or an average
billion
per year.
Coincidentally, the average rate of growth in
the na-
in
to
growth rate of $1
H
and
bonds outstanding during the 20
years ending 1966, although anything but con-
was also $1 billion a year, or a total of
$20 billion. This is $20 billion the
was granted statutory permission to raise future earning rates on all outstanding E and H
bonds. Under this innovation yields for the
remaining period to the next maturity were
stant,
increased generally by Vz
other publicly held Federal debt during that
same increase
bonds
of
as provided
to maturity.
per cent, the
1
The higher
and H
on out-
E
on new
rates
about
Treasury did not have to raise
making possible an $8V2
period instead of an $1
market,
in the
billion decrease in all
billion increase.
1 '/i
Retirement Bonds. In January 1963 the
to
Treasury introduced United States Retirement
switch out of old bonds into
Plan Bonds to provide an alternative invest-
greatly reduced incentives to
new ones and
move out of sav-
ment medium under the Self-Employed Individuals Tax Retirement Act of 1962 (26
U.S.C. 401-05). As a parallel to retirement
and pension plans covering employees only,
the Act affords self-employed persons the opportunity to set up retirement plans subject to
approval by the Internal Revenue Service.
Under an approved plan, any qualified selfemployed person (for himself and his em-
standing
bonds
ehminated
any incentive
bonds altogether. In asking the Congress
for permission to raise earning rates on outstanding bonds, the Treasury also felt that it
ings
has something of a trusteeship function on behalf of millions
of individual
savers
who do
not follow interest-rate trends closely, and that
on the grounds of equity, these holders were
entitled to the increased earning rates.
The new
rates
worked
quite well in bringing
and between
June 1959 and June 1965 the volume of outstanding E and H bonds increased by more
than $6 billion. During this period, the relative
stability of long-term interest rates was a
strong factor in sustaining the performance of
a
turnaround
in
the
program,
the program.
In the
ings
fall
of 1965 as competition for sav-
intensified,
E
H
and
bond
sales
were
ployees)
is
entitled to deduct
$2,500, whichever
is
10 per cent or
from the net income
less,
of each person for retirement purposes.
retirement funds,
become
including earnings
taxable to the retiree as the
The
thereon,
money
is
disbursed upon retirement, or beginning at age
59 1/2, or earlier
disability,
Most
or at death.
approved self-employed retirement plans are
administered by bank and insurance company
trustees
or as custodial accounts, with fairly
again flagging and redemptions rising. In con-
wide latitude for the investment of the funds.
sequence, the Treasury asked the President to
These
raise the rate to maturity
on new bonds from
may be
various
types
of
public
and
private securities including equities. There are,
expenses for man-
3.75 to 4.15 per cent, and increased the earn-
of
ing rates on outstanding bonds to next matu-
aging or maintaining custody of the retirement
rity
by 0.4 per
sification
1966, the
of
cent. Despite the
the
competition
extreme intenfor
savings
in
E and H bond program performed
course,
administrative
fund investments.
United States Retirement Bonds were designed as an investment
medium wherein no
remarkably well after the announcement of the
administrative cost would be involved. Other
improvement
advantages of these bonds are: (1) safety regarding risk of default; (2) a guaranteed level
in savings
bond
rates in
Febru-
ary 1966. In the ensuing 10 months to the end
of the year, the amount of E and H savings
bonds outstanding grew by nearly $1.0 billion
to
$50.2
billion.
This represented a total
in-
rate
of return
until
they are redeemed;
ready availability throughout the country
banks and other financial
institutions,
(3)
at
or di-
20
from Federal Reserve Banks, or
the U.S.
States in exchange for dollars. Instead of using
Treasury; and (4) the fact that income from
those dollars to buy a large block of market-
rectly
these retirement plan
bonds
is
not subject to
The rate of earning on United States Retirement Bonds has generally been the same as
that on new Series E and H savings bonds.
Retirement bonds were not actively promoted
by the U.S. Treasury, but they do represent a
investment
significant
outlet
to
many
self-
employed persons. The fact is, however, that
by the end of calendar year 1966, only $18
million were outstanding.
Foreign-series securities. Nonmarketable
securities issued to foreign central banks and
governments, payable in dollars, were introduced in August 1961 under the authority of
the Second Liberty Bond Act. These issues include certificates, generally 3 months to maturity; 1- to 5-year notes; and bonds, which in
practice have had maturities between 1 and 7
years. Most foreign-series securities have been
general,
the
foreign-series
were made redeemable
in
whole or
certificates
in part at
the option of the holder on 2 days' notice,
longer issues were
into
3-month
usually
made
and
convertible
certificates. In special cases cer-
been redeemable at the option of the United States while
others, by prior agreement, have been made
subject to redemption before maturity. In all
cases payments on early redemption are at par.
tain over- 1 -year maturities have
The
principal purposes of the foreign-series
securities
The German marks
received in exchange by
would thus increase foreign
exchange reserves for payments purposes or
the United States
for protecting the position of the dollar.
The nonmarketable foreign bonds issued in
1964 to Canada in connection with the Columbia River project and treaty provide an example of the use of longer-term foreign-series
securities for bilateral financial
The agreement
have been: to insulate certain large
from having a major impact on
the U.S. Government securities markets; to
provide issues that are not subject to market
risk; to furnish longer-term investment media
transactions
arrangements.
called for project funds to be
raised in the United States and accordingly
$254 million was turned over to the Canadian
Government, which then transferred $204 million in Canadian dollars to the British Columbia Government to pay for construction costs.
Of the $254 million U.S. dollars, $50 million
was used to pay off U.S. commercial bank
loans
issued for special purposes.
In
German central bank might innonmarketable foreign-series, 3-month
certificates at the going rate on 3-month bills.
able issues, the
vest in
estate taxes.
to
Columbia.
British
The remaining
$204 million of such dollars was invested by
the Canadian Government in nonmarketable,
U.S.
foreign-series
bonds,
nonconvertible
to
prevent the transaction from having an imme-
payments impact. The bonds
mature serially in equal
amounts over a 7-year period, and as the
bonds are paid off, the U.S. dollars received
are added to Canadian foreign exchange rediate balance of
were
arranged
to
serves.
The outstanding amount
sues
grew
November
clined
to
to a
of foreign-series is-
peak of nearly $1.2
1965.
billion in
After that these issues de-
about $600 million by the end of
1966. Of this amount, nearly $330 million was
in over-1-year convertible issues,
which do not
for facilitating certain types of bilateral finan-
enter into U.S. international payments deficits
arrangements; to finance currency swap
on the "liquidity balance" basis.
Foreign-currency-series securities. In Oc-
cial
agreements; and to induce long-term capital
nonmar-
which improve the U.S. balance of
payments position.
Although not all of these purposes are com-
to official foreign entities.
mon
to all transactions, they are interrelated.
nonmarketable foreign issues payable in U.S.
For example, in a swap transaction. West German marks may be obtained by the United
dollars, the authority to provide these securi-
inflows,
tober 1961 the Treasury began to
sell
ketable securities payable in foreign currencies
ties
As
in the case of the
stems from the Second Liberty
Bond
Act.
NEW TECHNIQUES
DEBT MANAGEMENT
IN
The use of such issues
War I when Treasury
denominated
ness
in
originated during
World
certificates of indebted-
currency were
Spanish
given in payment for war materiel purchased
in that country.
Originally,
could
be
either
certificates
with maturities of
limited in any
1
way
year or
of
indebtedness
less,
or bonds not
as to the term to maturity.
Issuing foreign-currency bonds gave the Treas-
convertibility.
This greatly increased the potential for largescale flows of funds
from the United States to
foreign markets seeking higher rates of return.
In
foreign-currency-series securities
had moved to currency
tries
turn,
movements could
such
change-rate
difficulties
ex-
create
and produce an adverse
impact on the balance of payments.
As
the United States continued to sustain
balance of payments
deficits,
exchange
foreign
official
of comparable maturity, the statutory 4'/i per
produced a
flow of dollars into the hands of central banks
in countries with favorable payments balances.
Most of these dollars were invested at interest
in short-term marketable Treasury issues to
satisfy liquidity needs. Although these investments represented a reduction in potential
cent interest limit effectively foreclosed the
drain of U.S. gold, they did not fully meet
ury
of
full
leeway to provide maturities upwards
year as long as the interest rates paid re-
1
mained 414 per cent or
less.
Since the rates on
foreign-currency issues have generally been de-
termined by market yields on Treasury issues
is-
suance of bonds when market rates rose above
efforts to stabilize
other needs.
Although
that level. Accordingly, the Treasury requested
legislation,
which was passed
in
November
1966, to permit also the issuance of foreigncurrency-series notes having original maturities
of
1
to 5 years.
were redeemable, usually
holder. Others were
turity
at the option of the
made payable
before
ma-
according to prior agreement or were
callable
by the U.S. Treasury. In all cases of
payments are at par.
early redemption,
The
reduced
basic purposes of the
new
foreign-cur-
use has
their
since
the
currency-series
been substantially
mid-1960's,
securities
the
foreign-
do furnish another
investment alternative, thus helping to reduce
demand
the
Through 1966 most foreign-currency certificates had an original maturity of 3 months,
usually subject to redemption on 2 days' notice.
The longer issues generally had original maturities of 15 to 24 months and most were
made convertible into 3-month certificates, or
rates
for U.S. gold; they also directly
provide the United States with foreign currency
needed
to protect the dollar against speculation
and to meet day-to-day requirements arising
from trade, tourism, foreign aid, military commitments
and so
abroad,
forth.
Ordinarily
But in
payments
deficits, the purchase of foreign exchange with
dollars would only increase the amount of dolforeign currency
is
bought with
dollars.
a situation of sustained balance of
lars in foreign
hands.
The technique
of bor-
rowing foreign currency was used to avoid the
build-up of foreign dollar holdings.
rency issues were to provide a supply of for-
In addition to providing foreign exchange,
eign exchange for conducting operations to de-
foreign-currency
beyond
1
fend the U.S. dollar, to help cushion demands
year count as long-term investments. These
is-
on the U.S. gold stock by adding a new investment medium for foreign central banks and
governments, and to assist in meeting U.S. balance of payments deficits. In addition, the foreign-currency securities have proved to be a
useful device for temporarily augmenting international liquidity.
The more immediate developments
leading
to the introduction of foreign-currency issues
started in 1959, after a
number
of
major coun-
sues
bring
U.S.
issues
maturing
international
accounts
into
closer balance
on the generally accepted "liquidity balance of payments" basis, because
they are nonconvertible bonds or notes, which
cannot be optionally exchanged for certificates
or redeemed before 1 year.
Aside from being hquid earning assets to
central banks and governments, issues payable
in
foreign currencies are riskless in that they
protect the lender against exchange risk.
22
Through 1966 foreign-currency
denominated
Austrian
in
francs,
German marks,
francs.
The volume
ItaHan
were
issues
Belgian
schillings,
and Swiss
lire,
of foreign-currency series
outstanding rose to a peak of $1.3 billion in
III.
TREASURY BILLS
Treasury
larly offered
sonal
IN
of the calendar year 1966, regu-
end
the
tax- anticipation
nearly 2i/i
(excluding the sea-
had
series)
was by
risen
to
amount outstanding at
December 1958 from $23V'2
$57%
to
billion
bills
times the
the beginning of
rise
—
billion.
far the largest
This $34i/4
growth
in
billion
any cate-
gory of the public debt over the period, and it
represented more than 70 per cent of the increase in the total public debt.
The
increase in
volume of Treasury bills in the 8 years
after 1958 took place during two expansions
of the economy and one recession. By and
large it occurred without undue strains on
the money market except in early 1960 and
the
in
holder.
MARKET IMPACT AND ANALYSIS OF MAJOR NEW TECHNIQUES
INNOVATIONS
By
September 1965, but by the end of 1966 the
amount had declined to $860 million. Of this
total about $750 million was subject to redemption or conversion at the option of the
September 1966
To
rate cycle.
cussful expansion
careful use
at the crests of the interest-
a considerable degree the suc-
of the
program was
result
the
new techniques and
of
inno-
The 6-month
bill.
The 6-month
bill
did not
market acceptance immediately.
new bills were offered in
amounts of $400 million each week while offerings of 3 -month bills were reduced from
$1,800 million to $1,600 million. By June
full
the
Originally
1959,
when
6-month
3-month
and the economic recession was well under
way. (See Appendix Table 1 for 3- and 6month bill auction rates.)
The low point in Treasury short-term borrowing rates was reached in April 1961, at avauction
erage
the Treasury
bills
bill
to
$500
offerings
$1.0 billion and $1.2
upped
its
million
had declined
billion,
offerings of
while
to
the
between
average discount
on new 3- and 6-month bills had moved
up sharply and the spread between them had
climbed from an average of about 25 basis
points in the first few auctions to a high of 81
basis points. In consequence, the $500 million,
6-month bill cycle was not completed until the
rates
1 Background
tables and other material
found in the Appendix.
will
be
of
rates
2.18
per cent for 3
months and 2.30 per cent for 6 months. By
contrast, in the 1957-58 recession the low
point for 3-month bills was 0.64 per cent. In
the next economic expansion, starting in the
spring of 1961, short-term rates did not really
begin to
rise until after
the
first
offering of a
had been made in June of that
year and after the supply of 6-month bills had
been increased to $600 million per week.
By the late spring of 1961, the 6-month
strip of bills
Treasury
bill
was achieving
The coverage
ance.
subscriptions
vations.
achieve
second half of calendar year 1960. By that
time the peak of interest rates had been passed
to
ratio
—
full
that
allotments
market acceptis,
—was
the ratio of
averaging
220 per cent versus 185 per cent for the
3 -month bill. This occurred despite the increase in the weekly offerings of 6-month bills
to $500 million, while the 3-month offerings
had been gradually reduced from $1.8 billion
nearly
before
the
introduction of the longer
about $1.1 billion
in
bill
to
1961. During the period
from the cyclical high in rates in January 1960
to mid- 1961, the spread in average discount
rates between the two maturities had declined
to about 15 basis points, indicating a growing
awareness of the greater gain potential in the
longer bills. (See Appendix Table 3.)
Also during this period, bidding in the
6-month auctions became increasingly sophisticated. From 1959 to mid- 1961, the range in
an auction from the average of all successful
bid prices to the stop-out, the lowest accepted
NEW TECHNIQUES
bid,
narrowed
DEBT MANAGEMENT
IN
Expressed in terms
from the average bid rate
the stop-out rate declined from 4 basis
significantly.
the year, monthly average spreads did not rise
of yields, the range
above 20 basis points, and they were generally
to
considerably
points to
1
less.
Subscription coverage on the
longer of the two maturities had slipped a
basis point.
While the decline in average rate spreads
between the 3- and 6-month bills may well be
attributed to expectations of greater gains on
the longer bills in a falling-interest-rate envi-
ronment, the increased concentration of bids
demonstrates more clearly market acceptance
6-month bill.
By the end of 1963, following the Federal
Reserve discount rate increase from 3 to 3Vi
per cent, rates in the weekly auctions had also
of the
risen to 3V^ per cent or more.
The
increase in
but
tle,
was
it
still
lit-
close to 190 per cent during
1964
compared with
The bids on
6-month bills continued to be closely bunched
around the average rate, and the yield range
the fourth quarter of
175 per cent for 3-month
as
bills.
between the auction average and the stop-out
was usually less than 1 basis point. By this
time, also, dealer net positions in over-92-day
were running two to three times as large
bills
as in shorter
bills. It is quite likely that with an
upward-sloping yield curve continuing in the
rates reflected the enlarged
volume of weekly
amount of 3-month bills issued
each week had grown to $1.3 billion, and of
6-month bills to $0.8 billion. As a result of a
short-term area the market
offerings as the
a greater propensity for gain in the longer
$1.0 billion bill-strip-offering in October 1963,
the usual measures of market receptivity did
which added $100 million to 10 weekly maturities in the 26-week cycle, the total volume
of weekly bills outstanding had increased to
appreciably. During this period
on 3- and 6-month bills gradually rose,
and they were about 4V& and 414 per cent by
early December before the discount rate was
increased to 4V2 per cent.
Following the increase in the discount rate,
$38.5
billion, of
which
bills originally
accounted
maturity
to
for
$21.8
6 months
billion
or
about 57 per cent.
Despite the growth in the volume
of the
and the increases in short-term
interest rates that had taken place between
mid-1961 and December 1963, monthlylonger
bills
felt
there
was
still
bills.
Despite the escalation of the war in Viet-
nam
in July
1965, the situation with respect to
change
not
rates
bill
rates again rose rapidly
during the
the
first
and
after a
pause
jumped to
In the mean-
half of 1966, they
40
highest levels in
years.
time, dealer net positions in bills dwindled in
average rate spreads in the weekly auctions
response to expectations of higher rates in the
between the two maturities declined from about
25 basis points in December 1958 to 14 basis
short-term area, and by June 1966 they were
points in
December 1963. At times
the spreads
reached a low of 3 basis points,
and they
averaged 15 basis points during the period. In
corroboration
the
6-month
vironment,
of
the
market's
the
receptivity
of
a rising-interest-rate en-
in
bill
high
concentration
of
bids
the lowest points since such statistics be-
at
came
available in
3-month
the period of extreme tightness that developed
around the auction averages continued without
in the credit
significant change.
ing vigorous
During 1964, offerings of 6-month bills
were gradually increased to $1.0 billion per
week by the fall, while the 3 -month bill was
reduced from $1.3 biUion to $1.2 bilHon dur-
allay apprehensions
ing most of the period. Rates in the auctions
had moved close
to
count rate increase
4 per cent after the
in
dis-
November, but during
1960. Weekly offerings of
had again increased to $1.3 billion, but the spread between the two maturities
gradually widened and reached a high of 50
basis points in early September 1966, during
bills
markets.
Two weeks
and
average
follow-
relieve the pressure of
Federal agency borrowings and
the
later,
action by the administration to
PC
offerings,
reached
peaks of 5.59 per cent on the 3-month and
6.04 per cent on the 6-month bill.
The jump
the
levels
in
in
rates
bill
realization that part of the
auctions
was touched off by
burden of Govern-
ment financing and foregone PC sales would
have to be borne by the bill market. Market
hesitance in the auctions was demonstrated by
the widened range from the average rate to the
stop-out, which in the case of 6-month bills
fluctuated sharply from 1 to more than 6 basis
points in the third quarter. Oddly enough,
however, during
this
period the ratio of sub-
than the rates on comparable coupon issues.
And
that did not include the value of the tax-
and-loan-account credit created, which would
have added an estimated 31 basis points to the
It should be recalled, however, that
spread.
1959 was a year of rapidly
rising interest rates,
an environment not very conducive
new
cessful introduction of a
on annual
to the suc-
instrument. (For
Appendix Table
on both the 3- and
remained remarkably constant,
hovering around 170 per cent for the former
details
and around 200 per cent for the
cut back to $1.5 billion. Despite the reduction
allotments
scriptions
to
6-month
bills
In the
fall
latter.
of 1966, as tightness in the credit
began
to decline, and with that the spreads between
average rates on 3- and 6-month bills in the
weekly auctions dropped to less than 10 basis
markets was gradually eased,
bill
rates
by the year-end. In further evidence of
return to more normal conditions, the
points
the
On
in
the
bills see
4.)
rollover of the 1-year bill cycle
first
January 1960 the amount of the issue was
January 15, 1960,
in offerings, the cost of the
1-year
(average discount rate) was 5.07
bill
per cent. This was equivalent to a coupon yield
was the highest rate
by the Treasury for any issue
of 5.36 per cent and
of
interest paid
in
1958—61
the
The
interest-rate cycle.
next
1-year
auction
bill
range of bids from the average to the stop-out
1960, with $2.0 billion offered
was reduced to less than a basis point in November and December. At the same time,
dealer positions in bills maturing beyond 92
which
coupon-equivalent
of
yield
—
—
April
in
resulted in a
4.84
per
cent,
days rose sharply, indicating again the greater
But the
spread of 1.03 per cent above the comparable
1 -year-coupon-issue rate was the largest in the
gain potential on longer
quarterly cycle,
bills.
was 23
basis
points
lower.
the value of tax-and-loan-ac-
if
In summary, the market adjusted extremely
count credit
in the fixst four auctions in
6-month
Treasury bills. In the process, the amount of
weekly bills outstanding grew from $23 Vi billion in December 1958 at the start of the
6-month bill cycle to nearly $43 billion at the
end of 1966. Of that total, $26 billion, or 60
per cent, originated in 6-month bills. During
the same period the weekly offerings increased
disregarded.
The
well
to
the
increased
volume
of
The 1-year
bill.
A
was originated
bills that
quarterly cycle of 1-year
in
the
is
is
easily seen in the
range of bids from
average to the stop-out, a high for the
cycle of 13 basis points in terms of
1-year
bill
yield.
Thereafter,
the
amounts
in
the
next
three offerings were cut back to $1.5 bilHon;
after that they
were restored to $2.0 bilUon
through July 1962. During
this
period the cov-
erage ratio picked up from an average of 148
only from $1.8 bilUon to $2.3 billion.
bills
tion
1959
apathetic bidding in this auc-
1959. Issues of such
year averaged $2.0 billion per quarter
first two auctions of 1960 to
209 per cent in the next three, but ranged
from 173 to 208 per cent when offerings were
per cent in the
and about 330 days to maturity. Each offering
was adequately covered by the subscriptions,
with an average coverage ratio of 176 per cent.
This is not surprising because payment through
tax-and-loan-account credit was permitted. The
new bill cycle was expensive by comparison
with coupon-issue yields in the market. The
4.20 per cent average bank discount rate in the
increased to $2.0 biUion. Following the cut-
auctions adjusted to a coupon-equivalent yield
$2.0
basis of 4.41 per cent
was 38
basis points
more
backs to $1.5 bilHon, the concentration of bids
around the average returned to more normal
ranges.
For the
remaining
year
of
the
quarterly
amount offered in
four quarters was raised to $2.5
cycle through July 1963, the
three of the
billion
cycle
whereas in the other quarter
billion.
it
stayed at
Thus, by the time the monthly
was introduced, the
total
amount
of
NEW TECHNIQUES
IN
DEBT MANAGEMENT
had
outstanding
annual
bUls
billion.
During
risen
to
$9.5
period the coverage ratio
this
did not change significantly on the average, but
other
measures
market
improving
indicated
acceptance.
For the quarterly cycle
nonbank
as a whole,
dealer awards ranged from 19 to 35 per cent
of total public allotments
—excluding
the offer-
ings paid through tax-and-loan-account credit,
which were awarded almost
mercial banks.
The average
entirely to
com-
of 25 per cent for
nonbank dealer awards to total allotments for
the quarterly bills compares with 21 per cent
on 3- and 6-month bills during the same period.
This indicates a greater participation of
bill
auction.
During the period from July 1960
to July
sophisticated bidders in the 1-year
a high of 44 basis points in August and re-
mained
high for the next three issues,
fairly
following the introduction of the 9-month
prove.
1963 the range of bids in the quarterly auctions from the midpoint to the stop-out declined to about Vi of 1 basis point. However,
bill
the spreads of coupon-equivalent rates above
any standard of measurement. Because
coupon-issue yields fluctuated sharply, ranging
auction instrument,
from 4 basis points less than 1 -year-couponissue yields to 52 basis points more. The higher
come
spreads
coincided
generally
raise short-term rates to
with
efforts
to
be more competitive
began
in
per month
cycle,
which
market reception than the quarterly cycle. The
subscription coverage averaged about 225 per
fall
1964. While this
the smaller
of 1963 through the end of
is
amounts
not significant in view of
offered, other
measures of
market acceptance clearly showed the preference for the monthly cycle. Spreads above
coupon-issue rates narrowed significantly, averaging about 12 basis points through the middle
of
as a
1966 as compared with more than twice
that average spread for
all
of the issues in the
nonbank
monthly
performed quite well
going
structure
of
developed
in the
summer
of 1966, the spread
above comparable coupon-issue yields rose to
to be-
tight
money
in the
been
has
rates
shaken.
9-month
bill,
The
bill.
which began
brief history of the
in
September 1966,
provides only a short-run opportunity for anal-
Coverage ratios on the four $500 million
monthly offerings in 1966 averaged 217 per
cent. However, only 83 per cent, or $1.7 bilysis.
$2.0 billion
lion of the
public holders.
Of
total,
was
allotted to
the $1.7 billion in public al-
lotments, 41 per cent was awarded to
dealers.
year
bill
nonbank
comparison, the simultaneous
In
1-
auctions produced an average cover-
age ratio of 210 per cent for the four $900
million
offerings.
those
In
cent, or $2.8 billion,
was
(See Appendix Table 5.)
25 per cent for the quarterly offerings.
Under the extreme monetary tightness that
tends
a
interest
of which the dealers were
Moreover,
it
in
market environment or when confidence
dealer
cycle.
market by
it is an
the
however,
awards as a percentage of total public allotments in the monthly cycle through mid- 1966
increased to an average of 43 per cent from
quarterly
cycle, the 1-year
in
expensive
relatively
The 9-month
billion
August 1963, met with a much better
cent from the
summary,
In
with rates abroad.
The $1.0
bill.
However, the range of bids from the average
to the stop-out rose to 10 basis points in June
1966, but the range in other monthly auctions
did not exceed 4 basis points. In December
the spread above coupon-issue yields declined
to normal levels once again as market expectations improved in an environment clearly reflecting moves toward further monetary ease.
In the second half of 1966, public allotments
dropped to 75 per cent of total offerings; during this period, the percentage of nonbank
dealer awards to public allotments fell to 23
per cent in the August auction, but picked up
again when the credit markets began to im-
auctions
79 per
allotted to the public,
awarded 44 per
In the four 9-month auctions of
cent.
1966 the
range of successful bids from the average to
the
3
somewhat greater than for
The average range was nearly
stop-out was
the annual
basis
1-year
bills.
points
bills,
as
against 2
but the difference
basis
may
points for
easily
be
at-
)
26
tributed to the newness of the
9-month
instru-
ment
tax-and-loan-account
through
credit,
the market, the four 9-month bills averaged
which was estimated to be worth 50 basis
points. Taking that into account, the spread
above the average of going rates on compara-
5.72 per cent (coupon-equivalent) for a spread
ble
ment.
In comparison with coupon-issue yields in
26 basis points above comparable coupon
issues, while the annual bills auctioned at the
same time averaged 5.74 per cent, about 27
basis points
above
1
-year-coupon-issue yields.
Thus, the early performance of the 9-month
bill was about on a par with the annual bill by
of these standards of comparison,
any
which
implies that the relative sizes of the amounts
offered
— $500
9-month
—
bill
million
per
month
of
the
versus $900 million of the 1-year
represented
a
good balance between the
two.
Bill strips.
offerings
From June
1961,
when
were made, through 1966,
the
first
six strips
of bills totaling $6.8 billion were issued.
That
amount included a $1.2 billion strip of three
month-end maturing bills issued in November
1966 as part of the 9-month cycle. (For details on strips of bills see Appendix Table 6.
The first bill strip covered 18 maturities of
$100 million each, with terms ranging from 8
to 25 weeks. The strip was sold at an average
bank discount
P-
3
j
i
rate of 2.31 per cent with pay-
bill
maturities
In June
of
1961,
was 35
when
basis points.
the
first
strip of bills
was offered, short-term rates were dechning
and the strip had no significant effect in turning rates upward. However, each subsequent
strip of weekly bills had a substantial impact
on the market. For example, in November
1961 the 3-month bill rate rose 14 basis points
between the announcement date for the strip of
bills and the day of the auction, and it rose
another 17 basis points between the auction
the payment date.
The degree of market impact
assess in each case because some
and
is
difficult to
of the effects
were anticipated by the
an aftermath of pre- or junior ad-
of the strip offering
market
as
vance refundings, which tended to put downward pressure on bill rates as rights were liquidated by holders not interested in the advance
refunding
All
offer.
of the
subscriptions
strips
were well covered, with
190 to 259 per
ranging from
cent of allotments. Official accounts did not
take part in the strip offerings;
INCREASES IN REGULAR BILLS OUTSTANDING,
November 1958 December 1966
all
of the offer-
NEW TECHNIQUES
IN
DEBT MANAGEMENT
about 6 per cent. In the next 4 years,
were publicly allotted. Awards to nonbank dealers averaged 55 per cent of total allotments for the four strips for which payment
through tax and loan accounts was not
permitted. In the last two of these, nonbank
dealers accounted for 67 per cent of total al-
billion, or
lotments, indicating that sophisticated bidders
for details see
ings
were getting an increasing share of awards of
Summary
prior
innovations
of
regularly
of
issued
in
The
bills.
outstanding
bills
6-month
advent of the
the
to
grew by $12.5
regular bills outstanding
biflion.
in
bill
But of
amount pub-
that
holders acquired only $2.7 billion or 22
lic
per cent while the
accounts absorbed
official
(See Chart 5;
$9.8 billion, or 78 per cent.
Appendix Table
During the
big
the
rise
when
1959,
largely
—
—November
a substantial part of
occurred in
holdings
public
in
7.)
4-year period
first
1958-December 1962
bill strips.
amount
December 1966,
to
the brunt of deficit financing
borne by the
bill
market
in
was
a tight
December 1958 increased by 2Vi times by the
end of 1966. By and large, this substantial
increase was smoothly absorbed by the market.
monetary environment. But a greater part took
place in 1961 and 1962, when official action
was directed toward increasing the amount of
For the most part, the increase occurred during an 8-year period of widely fluctuating
liquidity in the
From
short-term rates.
the start of the eco-
nomic expansion, beginning in 1961, through
1966 average discount rates in the 3- and
6-month bill auctions ranged from 2.2 and 2.3
per cent, respectively, at the 1961 low points to
5.6 and 6.0 per cent at the peak in September
1966, and the range on annual bills was almost
3%
About one-half
as great.
percentage-point
in
rise
of the S'/i
bill
rates
to
took
place in the 9 months after the increase in the
Reserve discount rate
Federal
Even
1965.
strain
little
so,
in
December
market operated with
the period of sharp market
the bill
until
tension in the late
summer
of 1966. After ad-
ministration action to dispel fears and to relieve
and
some
PC
of the pressure of agency borrowing
sales, the
normal flow of
bifls into
and
economy
the expansion then
in the early years of
under way.
During the second 4 years, through Decem1966, the Federal Reserve System again
began to increase its bill holdings as the need
ber
"operation
for
this period,
twist"
waned.
Also
during
business corporations increasingly
found other short-term investments such as
commercial bank CD's more profitable than
—
Treasury bills, and later in the period ^from
mid-1965 through most of 1966 the banks
found it desirable to reduce their bill holdings
to meet the insatiable private demand for bank
credit. From 1964 on, the Federal Reserve increasingly acquired bills in open market operations to replace gold losses and rebuild the reserves needed for the continuation of economic
—
expansion.
However, even during the period
of rapid
out of the market was quickly restored. This
increase
occurred despite some apparent increase in the
counts, commercial banks and dealers contin-
impending burden on the bill market resulting
from the reduced pressures of Government
financing elsewhere on the credit markets.
bills.
An
crease
important
in
aspect
regularly
of
issued
the
bills
IVi-iold in-
should
be
pointed out. In the 4 years or so from the end
of
in
the
holdings
bill
of
official
ac-
major "underwriters" for new
Reserve found
it expedient to buy more bills than coupon issues in its open market operations did not
detract from the bill market's ability to undertake the distribution of the added supply.
ued
to act as the
The
fact that the Federal
November 1958 through December 1962,
by
amount public investors
absorbed $20.5 billion or 94 per cent, while
holdings of the Federal Reserve and Government Investment Accounts increased by $1.3
regularly issued bills outstanding increased
$21.8
billion.
Of
CASH REFUNDING
that
When
the
Treasury began
in
1960
to
refi-
nance through cash subscriptions instead of
rights
exchanges in
its
quarterly refinancings,
28
the change in technique gave rise to a
of questions.
After some 6Vi
quarterly cash refundings in
worth of new
lion
swers to a
ably clear.
securities
number
and 10
which STlVi bilwere issued, anyears
number of the questions are reasonSome of the questions are:
cash refinancing a complete substitute
Is
for rights refundings?
Which does a
better job of restructur-
ing the debt?
Which
more
is
expensive
for
the
Treasury?
How
do they compare with regard to
and activity of the dealer
the participation
market?
The following information provides some
the
bilhon
$71^/6
issued
in
quarterly
cash refinancings through 1966, $35Vi billion
was awarded
of the
to public subscribers (other than
Government Investment Accounts). During the same period $141
of
new
securities
rights refundings.-
Of
were issued
in
16
these, public holders re-
ceived $75 billion for an average exchange of
$4.7
billion. In the
cash refinancings the aver-
age amount allotted to public subscribers was
$3.5
billion,
indicating
the
that
Treasury
tended to use the exchange approach for the
some $7% billion were allotted in
The average length of these
longer issues in rights refundings was slightly
less than 60 months, or nearly 5 years, and in
terms of debt extension was equal to $42%
billion times 5 years or $212 bilhon bondyears. The average length in cash operations
was 70 months, but the effective debt extension was only $45 billion bond-years. Moreover, of these longer issues the pubhc allotment in
rights
was $35Vi
biUion
in
cash subscriptions.
comparison with
of
the
10 cash operations only a
billion in cash
opera-
effective in extending the length of those hold-
roUed over at
ings that are not automatically
maturity.
One
attribute of cash financings that has
counterpart in rights refundings
ury's control over the
amounts
is
$3.1 bilhon of
new money was
offered, includ-
new
About
raised in seven
of the 10 cash refundings, while in the
eration, instead of raising
no
the Treas-
ing additional cash or planned attrition.
first
cash, there
op-
was
about $660 million of planned payoff. In the
other two cases, offerings just about replaced
amounts without
attrition or ad-
ditional cash.
The
shorter-term anchor issue was offered. In three
two options were offered; and in one
operation there were three options. The Treas-
$6%
Thus, rights refundings were far more
the maturing
six
other than
ings, while
larger operations.
In
of offerings to debt extension.
billion in securities
anchor options were issued in rights refund-
the Federal Reserve and
billion
two types
About $42%
tions.
relevant comparisons:
Of
understates the difference in the contribution
variation in the allotment ratios illus-
one of the chief disadvantages of cash
trates
others,
ury provided more options to extend maturities
Of the 16 exchange
two were limited to one option. In each of these cases pubhc holdings of
the maturing issues were about $2Vi billion,
which was considered too small to warrant
more than a single option. Of the 14 remaining rights operations, 10 provided two options
and four had three options.
The average length of the issues offered in
rights exchanges was 28 months as against 22
months in the cash operations. But this greatly
in the rights refundings.
operations, only
refinancings.
ments to
The
ratio
For
details see
Appendix Table
8.
pubhc
allot-
15
individual issues offered in the cash refundings
ranged from 12 to 100 per cent. The 100 per
—
$365 million
bonds in August 1962, of
which $315 million was subscribed for and alcent allotment was on a small
—
issue of long-term
lotted to the public. In
November 1965,
a very
cautious market environment produced an al-
lotment ratio of 48 per cent on a single-option
18-month
received
total
note. In this case
much more than
in
many
subscribers
they wanted of the
$3.2 billion awarded to the public, which
weak secondary market
Even without those two
contributed to a very
-
of total
total public subscriptions for the
the
new
issue.
—
1
NEW TECHNIQUES
IN
DEBT MANAGEMENT
cases, however, the variation in allotment ratios to public investors
from 12
was
still
—with
about 35 per cent
to
an aver-
age ratio of 21 per cent.
The
cost
terms
in
of
on
cash offerings than on rights refundings. These
spreads are the differences between the offering rates and market yields on comparable
outstanding
needed
was
than existing
slightly
Such
maturities.
less
spreads
are
new issues more attractive
issues. The average spread was
make
to
lowing a financing. Expressing the exposure in
each financing as a percentage of allotments,
Treasury
the
to
"underwriting spreads"
These data indicate the dealers' degree of exposure to market risk in or immediately fol-
quite large
the
22 per cent of
1
basis points in the rights ex-
V4
changes. This was not due to the greater proportion
longer-term issues
of
There
refundings.
rights
offered
the
in
been no
has
dis-
cernible pattern in the spreads with respect to
However, on both kinds of
maturity.
the
offerings
spreads declined substantially from early
1963
to late 1966.
The
per cent, with an 11 Vi per cent average. Here
the difference in the
and
market
in
activity of the dealer
cash as compared with rights re-
fundings showed no clear-cut differences, ac-
cording to
statistics
on dealer
activity
by the Federal Reserve Bank of
These
statistics,
which begin
in
compiled
New
York.
1961, included
nine of the 10 cash refinancings and 13 of 16
through 1966. In these financ-
rights operations
two averages
is
negligible,
indicating that the dealers were about equally
willing to take risks in either type of financing.
A
ume
third index of dealer activity
immediately
or
is
the vol-
of trading in when-issued securities during
available
through
after
nearly
for
seventh
the
a
Data are
financing.
refundings
the
of
all
day following the
nouncement of terms. Although trading
an-
in cash
operations did not start until after the sub-
books closed, while trading
scription
began
refundings
participation
total issues to the
an average of 1 1 per cent, and on the rights
approach the range was from about 7 to 20Vi
about lOV^ basis points in the cash operations
as against
was 5
pubUc for
the range in the case of cash refundings
to
nouncements,
immediately
difference
this
in rights
an-
the
after
procedure
in
is
not considered significant due to the high concentration
Trading
of
in
trading
rights,
the
in
mainly
dealers prior to exchange,
first
few days.
by
was excluded since
accumulations
can be considered equivalent to dealer
that
awards
cash refinancings.
in
The volume
of
trading in each financing has been related to
amount
ings dealer activity varied widely within each
the
to
the
type of offering, but the averages were not far
public, to allow for differences in the size
and
(See Appendix Tables 9 and 10.)
For example, awards to reporting dealers
through cash subscriptions ran from about 6V2
to more than 20 per cent of total allotments to
apart.
the public for an average of roughly 12'/i per
cent.
Issues
dealers
to
rights
in
refundings
ranged from approximately 9 to 26'/2 per cent
and averaged 14'/i per
The small difference between the two av-
total
in the
number
in
one type of opera-
Another
comparison
net
long
refi-
which data were available,
trading ranged from 21 to 32 V2 per cent, for
an average of 26 per
31
cent.
cent. In rights operations
—from
was somewhat broader
per cent
—
for an average of
13'/i
19Vi per
However, the difference between the two
averages
is
not large.
One
possible explanation
stems from the circumstance that unsophisti-
tion as in the other.
maximum
two types of
trading volume in cash
six of the eight for
to
much
of refundings in the
The average
cent.
about as
issued
nancings ran from liVi to 43 per cent, but in
the range
ticipate
securities
operations.
of issues to the public
erages reflects the dealers' willingness to par-
of
of
position
activity
of
when-issued securities in a cash
the
is
dealers
in
cated
ample
investors
—
—
the
smaller
banks,
for
ordinarily prefer rights refundings
exto
refinancing
cash refinancings. Guessing the probable per-
plus
centage allotment in a cash operation requires
when-issued securities in a rights operation.
a high degree of market sophistication. Even
and
the
maximum
position
in
rights
30
expert appraisal
guess
more or
much
possibly
new
of the
less
than they wish to hold,
curities
may
often wrong. Rather than
and receive possibly much
is
incorrectly
many
se-
investors
amount
prefer to acquire the exact desired
secondary market.
in the
the fact that the
average of the marketable
coupon debt outstanding
each midyear durwas about $154 bilof which about $117 bilUon was publicly
at
ing the 6'/4-year period
held. Thus, the
advance refundings during the
period represented offers to
marketable
the
roll
debt
over some
the
in
1%
public's
hands, with the turn-ins amounting to about
cent.
multiplicity
of
offerings
and maturities of the
rates
with
eligible
verita-
respect
to
and offered
more than 65 outstanding issues
and about 25 newly offered issues were involved, with several of these eligible and ofissues. In all,
fered issues used again in succeeding operations.
The
maturities of
new
issues offered in
exchange ran from a little less than 4 years to
more than 38 years, while those of outstanding
eligible issues ranged from less than a month
more than 10%
to
holdings
public
years.
of
The percentages
eligible
issues
All
groups
necessary
is
for
of
these
the
advance refundings occurred
peak-to-peak
interest-rate
August 1966. The offering
advance
refunding
in
the
released
prior to the full-scale advance refunding operation of
pre-,
October 1960. The three categories are
junior,
and senior advance refundings,
based on the terms to maturity of the
eligible
issues involved. Pre-refunding refers to the ex-
change of
with remaining terms
eligible issues
than
to maturity of less
1
year; junior advance
refunding refers to those maturing between
1
and 5 years; and senior advance refunding to
those 5 years or longer. These are arbitrary
distinctions, particularly when it is found that
seven of the 18 junior refunding issues had
remaining terms of
IVz years, while the
to
1
32 pre-refunding issues had remaining terms
of a month to 9% months.
ranging from
For the purposes of this paper, the measure
yields
performance
of
been
based
cycle,
on the
advance
in
refundings
has
on the percentage of
primarily
publicly held issues exchanged. In this regard,
performance
number
of
is
complicated by the fact that a
the
pre-refunding and junior re-
funding issues were
made
more than
eligible in
one advance refunding. Moreover, some
ble
issues
standing
—
eligi-
were reopened that is, the outamounts were added to between
—
advance refundings.
Over
all,
about 34 per cent of the issues
publicly held that were
in
made
eligible for ad-
1960-66 were exchanged,
the eligible issues are all regarded as not
if
having been previously included in an earlier
advance refunding.
If
such double counting
is
eliminated, the average proportion exchanged
cent.*
For purposes of
Appendix Table
provides detailed informa1
on each advance refunding and the totals for
1960-66.
coupon
analytical
two of which were described
paper on
white
would be about 46 per
2
tion
issues
refundings have been grouped into three categories,
vance refunding
spanning a period from early January 1960 to
late
eligible
Performance factors. With such wide variand terms, some degree of segregation of these operations into more compa-
of
exchanged
covered a range of 8.6 to 72.2 per cent.
within
while
%
These advance refundings included a
ble
ranged from IVa to 5 per cent.
rable
Between June 1960 and August
1966 the Treasury conducted 13 advance refunding operations. In magnitude a total of
about $286 billion in outstanding issues was
made eligible for exchange offers, and of these
about $204 biUion was in public hands.
Slightly over $69 billion, or more than onethird of public holdings, was exchanged.^ The
scope of these operations can be judged from
60 per
1966,
rates
purposes. Thus, for most analyses the advance
Scope.
times
on
gust
ations in rates
ADVANCE REFUNDING
lion,
new issues ran from a low of 3.63 per cent in
March 1961 to a high of 5.24 per cent in Au-
1
-
Based on figures
in
Appendix Table
11.
NEW TECHNIQUES
DEBT MANAGEMENT
however, and with the extensive
ownership as maturities shorten, in
simplicity,
changes
IN
in
the analyses that follow, allowance
is
made
for
This
strongly
implies
that
the
shorter
the
length of the eligible issue, the larger the per-
centage that will be exchanged.
As
a
broad
double counting only within category groups.
generalization that
For example, an
However, other factors also had a bearing
on performance in advance refundings. One
such factor was the coupon rate of the eligible
issue. In making this comparison, the total
amount exchanged of all issues of a certain
coupon rate was divided by the amounts of
eligible issue in a junior re-
funding category (1- to 5-year maturity) that
was involved twice in an advance refunding
without having been added to in the meantime
is treated as one eligible issue merely having
been offered additional options; or for some
purposes
second
the
involvement
is
disre-
ings,
became
of each
gory
(
within- 1 -year maturity)
is
regarded as
one not subject to a previous advance refunding.
Account
case
eligible
issues
involved
made
As shown
of
additions
to
senior
of
IVi's) was
taken
between advance refundings. In
refundings none of the
eligible issues
the
also
is
in
Chart
World War
more than once.
(the
eligible
6,
II
producing a weighted-average percentage
initial
coupon
size
exchanged.
First,
use of each individual issue
only the
was consid-
when an issue was made eligimore than once it was closer to maturity,
hence more apt to have a higher turn-in rate
based on the amount remaining in public
ered. Generally,
ble
Moreover,
hands.
investors
pre-refundings with
the case.
those issues in public hands before the refund-
garded. However, a junior refunding issue that
eligible again in the pre-rcfunding cate-
is
in
pre-refundings
assumed that when the
many
issues reached
maturity, the refunding offer might include a
nearly 45 per cent of eligible public holdings
short-term option only, or that the operation
exchanged were the most successful category if
account is taken of the same issue having been
involved in more than one advance refunding.
might be a cash refinancing with no right to
Junior refundings were the next most successful
pon
size
top
tier of
category with 37Vi
per cent exchanged, and
senior refundings are last with 32 Vi per cent.
exchange.
Chart 7 shows the relationship between cou-
and the percentage exchanged. The
bars gives only a hint of any signifi-
cant relationship
if all
EXCHANGES OF PUBLICLY HELD ISSUES
REFUNDINGS, 1960-66
AMOUNTS INVOLVED
_
of the ehgible issues in-
IN
ADVANCE
PERCENTAGE EXCHANGED
AMOUNT
SfEXCHANGED
OVCR
5 VRS.
-TERM TOMATURH or EllGieLC ISSUES-
SIZE OF ELIGIBLE-ISSUE COUPON RATES IN ADVANCE
REFUNDINGS RELATED TO PERCENTAGE OF PUBLIC HOLDINGS
EXCHANGED: First Offerings Only
from U.S. Tre
volved in the advance refundings are lumped
no tendency because only one coupon
But when they are distributed according to the type of operation in which they
made
together.
—
pre-, junior, or senior refund-
fairly
apparent that a rough inverse
were involved
ings
—
it is
On
size
was
eligible.
the basis of prehminary studies, the cor-
relations in the pre-
and junior refundings are
not precise enough for truly predictive pur-
correlation exists between the size of the ehgible-issue
coupon
rate
and the percentage ex-
changed. The tendency
is
more evident
in the
case of pre-refundings than in junior advance
refundings,'' while the senior refundings
show
• The one issue clearly out of line in the junior refunding was the V/a per cent note of Feb. 15,
1965, with 67 per cent exchanged in the January
1965 advance refunding. It was barely over 1 year to
maturity at the time and was held largely by banks
and corporations willing to turn in their holdings for
the rights value involved. In addition, dealers were
more satisfied to position the notes until maturity
since that eligible issue carried the second highest
coupon rate in the refunding, thus reducing their
carrying cost. The issue bearing the highest coupon
rate, 4 per cent, was not so readily available, and
relatively fewer rights were turned in to the market.
NEW TECHNIQUES
IN
DEBT MANAGEMENT
poses. Such studies of the resuhs in advance
servations to permit any meaningful conclu-
refundings through July 1964 indicate a coeffi-
sions.
(r) of .565
cient of correlation squared
the case of pre-refundings
and only about .243
the case of junior operations.
in
possible that as the
in
number
is
It
quite
of advance refund-
tors
It
is
—such
issue, its length,
ble
also
coupon size of the offered
and the shortness of the eligi-
remaining term
issue's
significant.
And
ings of all types grows and additional refinements are used, the statistics will yield more
policy
favorable results.
time of a refunding
In those cases where
made
same
the
issue
no pattern emerges with respect to size of
coupon, mainly because there are too few ob-
ing,
and
of
to
the
interest-rate
maturity
course,
general
are
only
monetary
environment
become
—
with
at
the
overriding.
Another apparently important factor
As shown in Chart
length of extension.
is
the
8,
the
greater the extension, the smaller the percent-
age that
is
likely to
be taken
in pre-
and junior
PERCENTAGE OF ELIGIBLE ISSUES EXCHANGED RELATED TO
THE LENGTH OF EXTENSION IN ADVANCE REFUNDINGS
8
First Offerings
p
2
observations,
limited
was
advance refund-
eligible again in a later
however, that other fac-
evident,
as the
3
H
5
6
Only
—
34
refundings. In senior operations no truly significant pattern
formance
emerges except that the per-
the
in
better than in
first
the
senior
refunding
was
second, and better in the
(The terms to maturity of the eligible issues in each of the last
two senior refundings were longer than those
in the preceding one. Moreover, each succeeding refunding occurred later, and the ofi:ered
issues were the same in each case. Therefore,
second than
the
first
in the
third.
senior refunding provided the longest
extensions of the three, the second produced
the next longest extensions, and the last pro-
duced the shortest extensions. The lengths of
the extensions are shown in Appendix Table
11.) Here again the correlation between years
of extension and percentages exchanged even
in the pre- and junior operations is imprecise
and cannot be used with any appreciable deanother
factor
that
should
logically
attempt to find useful relationships for
multiple
number
sufficient
may be
of
degrees
freedom.
fundings grows, the data will provide
It
more
precisely useful statistical conclusions.
Investor participation. The following anal-
advance refundings through
two in 1966 were combinations
of regular refundings at maturity and precover
yses
The
1965.
the
last
refundings, thus precluding the investor classifi-
cation of the offered issues originating from
the regular as against the pre-refunding issues.
This
leaves over
still
exchanges for
$62Vi
billion of public
analysis.''
The ownership
pattern in those exchanges
between the three
senior refundings and the pre- and junior re-
The
senior operations included as el-
IVi's of September 1967-72,
pay-
of
that as experience with advance re-
from
(boot)
a
amount of
cant results primarily because the
fundings.
course, has to take adjustment
in
signifi-
data then available was too small to provide a
have had a substantial bearing on the percentage exchanged is the increase in coupon rate
the eligible to the offered issue. This, of
1964
study yielded no
correlation
closely follows the division
gree of confidence for predictive purposes.
Still
An
the advance refundings through July
igible issues the
World War
ing terms of over 5 years.
included
II 21/2
The
all
's
and the
with remain-
pre- and junior
ments into account. As with the other factors
mentioned, a very rough relationship appears
to exist, but again it is imprecise and does not
refundings
stand the test of correlation significance.
panies and mutual savings banks together ac-
Prehminary studies
failed
to
up any
turn
conclusive evidence that the attractiveness of
the offerings in terms of the yield spread
on
the offered issues above the prevaihng market
pattern of rates
had any appreciable
effect
on
When measured
against another variable
the size of the offered-issue
coupon
However,
this is
—
not too surprising. With an
upward-sloping yield curve, although gradually
diminishing in slope, the longer options carried
the higher coupons during most of the active
advance refunding period of June 1960 to January 1965, and apparently the length of the extension
was
As
a stronger factor than the
in
Table
1,
insurance com-
quired 50 per cent of the $7.6 billion in
3'/2
new
per cent bonds in the senior refundings.
In the
first
two senior operations these investor
accounted for more than 58 per cent of
the BVi's taken; but in the third, they could
classes
more
fully
because their hold-
ings of the 2Vi's ehgible in that refunding
had
been largely depleted by conversion into nonmarketable
2%
per cent bonds in 1951 and
1952.
Pension funds of State and local governments exchanged over $800 million of the
wartime IVi's, picking up the next largest part
of the offered long-term 3'/2's. Other State and
local funds
coupon
''
size of offered issues.
indicated
the per-
centage taken showed an inverse relationship.
other eUgible issues.
(See Appendix Table 13.)
not participate
the proportion exchanged.
all
accounted for nearly $650 million,
Exchanges
in the
1960-65 advance refundings, by
Appendix Table 12.
investor classes, are covered in
NEW TECHNIQUES
IN
DEBT MANAGEMENT
TABLE 1: PUBLIC PARTICIPATION
OF INVESTOR
Investor class
35
IN
ADVANCE REFUNDINGS,
1960-65,
BY CLASS
36
TABLE
2:
PUBLIC
IN
MATURITY DISTRIBUTION OF ISSUES ACQUIRED BY THE
1960-65, BY CLASS OF INVESTOR
ADVANCE REFUNDINGS,
In billions of dollars
NEW TECHNIQUES
DEBT MANAGEMENT
IN
5-year maturities declined by nearly $13
lion over the period. This
37
bil-
the maturity area
is
which a large part of commercial bank ac-
into
quisitions
advance
the
in
would
refundings
have shortened with the passage of time. Since
they acquired almost $30 billion of issues in
the 4- to 10-year maturity area,
it
follows that
the banks, like the dealers, were generally act-
ing in an underwriting capacity in these operations. In addition, the
ing
these
securities
mechanism for distributwas through the dealer
market. Thus, in large measure, the success of
the advance refunding technique was due to
the underwriting and distributing functions of
these two groups.
Market impact.
In
its
white paper called
Debt Management and Advance Refunding the
long-term investors would be given
thought,
the opportunity to extend their intermediate-
term
holdings
before
those
largely gravitated into the
had
securities
hands of short-term
inducement to extend
would be provided by higher coupon rates of
interest, based on the higher investment yields
resulting from an upward-sloping, market-pattern-of-rates curve. Moreover, in such an exinvestors. In general, the
change the injection of new long-term funds
would be substantially smaller than in a regular maturity refunding, hence the upward pressure on long-term rates would be minimized.
These tenets remained generally in effect
through the March 1962 combination juniorsenior refunding. Thereafter, however, senior
advance refunding was discontinued. First, be-
Treasury maintained that the impact of ad-
cause of congressional criticism, and second,
vance
because after
refunding
on
long-term
interest
would be much smaller than that
rates
of ordinary
all
the holders of the wartime
2l4's had been given an opportunity to ex-
cash financing or of maturity refunding, given
change, few alternative low coupon issues re-
equal volumes of long-term debt extension in
mained
The
either case.
discussion in the white paper
of exchanging intermediate-term
bonds
on the one hand, and finding new long-term
funds or issuing long-term bonds for cash or in
refundings at maturity, on the other.
It was thought, in the latter case, that new
cash borrowing would absorb long-term funds
otherwise available for private or State and
local needs and that the added supply of long
Treasury bonds would exert upward pressure
on interest rates generally. It was also felt that
this would occur in regular refundings at maissues for long-terra (senior refundings)
By
turity.
the time issues that
long-term
reached
maturity,
were
they
originally
would be
held mostly by short-term investors or as liquid-
by other
and neither of
these investor groups would want long-term
bonds in exchange. In that case, new longterm investment funds would be required for
the purchase of the "rights" or the "whenity reserves
issued"
new
maturity,
investors,
a
re-
the
publicly
fall
of 1960 to
1962, $8.0 billion of existing
spring of
held issues had been extended into
new long-term bonds maturing beyond
15
volume of debt
extension, yields on mortgages and on longterm corporate and municipal bonds continued
years. Despite this substantial
to decline.
During the
period
that
through
followed
January 1965, the Treasury revised
its
position
on the circumstances under which long-term
bonds might be issued in advance refundings.
In most of the combination junior and pre-
March 1962, the existing issues
made eligible for exchange into
refundings after
involved were
long-term bonds. Consequently, a substantial
expansion
in the role of the dealer
market was
required in the transfer of rights, in helping to
underwrite the refundings, and in distributing
the
new
issues to firm holders.
tively little net
Although
new money was needed,
rela-
the re-
securities in "rights" refundings at
vised procedure induced a considerable degree
new
and a substantial amount
overhang of the new securities in the after
market. Nevertheless, it was felt that these pre-
thus
paralleling
the
effect
of
long-term issues sold for cash.
In
for senior advance
In the meantime, from the
centered primarily on the contrast between the
relative ease
as candidates
fundings.
senior
advance
refunding,
of market churning
of
it
was
38
[yields on public
9
and private long-term
issues, 1960-66
—
Note. Montlily averages of daily ligurLs, except for FHA mortgages, which are secondary
market yields as ot the hrst of the month, as reported by the Federal Housing AdministraBonds New Aa corporate; Treasury estimates of reoffcring rates; new municipals:
Bond Buyer's index of 20 issues
—
tion.
and junior refundings would act
as catalysts to
reduce market hesitance and to increase activinterest in the long-term securities in
and
ity
general. Thus,
it
was expected
upward
that the
either leveled off or declined in five of the eight
refundings
in
which
bonds
long-term
issued. Also, in five of the eight cases,
were
by the
time the subscription books had been closed,
impact on long-term rates would continue to
long-term rates were approximately back to or
be small.
were under
Expectations based on the newer concepts
During the March
1962 to January 1965 period, yields on longterm Treasury issues rose 13 basis points from
4.01 to 4.14 per cent, but rates on private and
were
fairly
municipal
shown
Aa
in
well
realized.
long-term
Chart
9.
obligations
declined,
The monthly average
corporate reoffering rates declined
of
as
new
basis
1
point; mortgage rates in the secondary market
new
declined 25 basis points; and yields on
municipal bonds
Appendix Table
fell
about 9 basis points. (See
14.)
During
this
period an
additional $6.3 billion of publicly held Treas-
ury issues were extended beyond 15 years.
While the more prolonged
effect of
is
not
readily discernible in a period of slowly rising
bond
yields, the
immediate rate impact of such
operations was clearly minimal. This
trated in Chart 10. After the initial
lowing
the
announcement,
is
illus-
jump
long-term
fol-
yields
to
be
flat
announcement,
or to dechne
thereafter.
In the three refundings wherein long-term
rates
were
slightly higher 15
market days
the announcement, the rates were
up
after
less
than
from the level before the announcement. In most cases, yields remained
level for some time thereafter. Obviously, mar5 basis points
ket trend comparisons cannot be carried
further
in
this
connection,
as
other
would increasingly influence the
much
factors
interest-rate
environment soon after a refunding.
One
that
advance
refundings on long-term Treasury yields
their levels at the
and they continued
shown in Chart 10 is
remained remarkably stable
interesting point
market
yields
most part from one refunding operation
Except for the October 1960 and
the March 1963 operations, yields on longterm U.S. Treasury issues were within an 11for the
to another.
basis-point
range
immediately following
the
announcements.
The experience with long-term bonds
issued
NEW TECHNIQUES
IN
DEBT MANAGEMENT
39
advance refundings through 1965 amply
in the
demonstrates that debt extension can be ac-
complished
with
long-term rates.
relatively little impact on
Between October 1960 and
January 1965 about $14.3
billion in publicly
held eligible issues were extended into maturities
ranging from nearly 17 to more than 38
economic
expansion. In fact, average market rates on
mortgages and yields on corporate and municipal bonds were generally lower at the end of
years, during a period of substantial
this
period than at the beginning, while Treas-
ury long-term rates were
less
than one-quarter
of a percentage point higher. Only after the
enlargement of the war in Vietnam in July
1965, followed by the increase in the Federal
Reserve discount rate
est rates
The
begin to
in
December, did
inter-
economy was not
in
accelerated rise in interest rates pro-
fully reflected in the in-
long-term Treasury yields because
the 414 per cent interest ceiling brought to an
abrupt halt the chance of any increase in the
supply of long-term bonds. The upward pressure
fully
on Treasury
in
the
yields
was
re-
on a 4-year, 9-month note
combined maturity and
pre-refunding operation of August 1966. During the extreme credit squeeze that followed
the refunding announcement in late July, the
market yield on the new SVa's rose to a high
of 5% per cent on August 29.
Dealer participation and activity. Availin
the
able statistics on dealer activities compiled
Bank
of
New York
by
give
the clear impression (Table 3) that dealer participation in the first five
BOOKS CLOSING DATE*
JAN. 22, 1964
V_
or inlerest-adjustment, date.
**In the refundings ot September 1961, March 1962, and March 1963, books were
about one week earlier.
Note. Based on data from U.S. Treasury Dept.
—
In
a 5V4 per cent rate
was required
ANNOUNCEMENT DATE
* Issue,
area.
sponse to the sharp increase in market yields,
advance refundings
LONG-TERM TREASURY YIELDS DURING RELEVANT ADVANCE REFUNDINGS
I
more
reflected
intermediate-term
the Federal Reserve
rise sharply.
duced by the war and by the overheating of
10
the
crease
40
TABLE 3: ALLOTMENTS, MAXIMUM NET POSITION,
AND TRADING VOLUME OF REPORTING
DEALERS IN ADVANCE REFUNDINGS, 1960-65
Percentages of total publi
NEW TECHNIQUES
DEBT MANAGEMENT
On
advance refundings.
the
in
IN
the
average,
they acquired 21 per cent of total issues to the
gree of debt extension in another way. But
is
difficult to
escape the conclusion that the
it
is-
public in the advance operations through Janu-
suance of long-term bonds in cash financings
compared with 14V2 per cent in
the quarterly rights refundings from August
or through regular refundings at maturity, in
ary 1965, as
1961 through
One index
May
1966.
same volume as through advance refundwould either have been impossible under
the
ings,
per cent interest ceiling, or without
maxiwhen-
the ceiling
would have been considerably more
issued securities, which measures the degree of
expensive.
The experience with
mum
of dealer activity
net long position in
their exposure to
market
risk.
As
of total public allotments, this
same
in
is
rights
their
plus
a percentage
was about the
both types of operations. In the quar-
terly rights refundings
tioned, dealers'
during the period men-
maximum
net positions per re-
the
4'/i
regular financ-
comparison with advance refundings
ings in
in
the 1960's clearly points to that conclusion.
As indicated in Table 5, the total amount of
bonds of over-1 0-year maturities issued in the
3-year period from April 1960 through April
cash financings or regular maturity re-
funding averaged 11.3 per cent of total public
1963
allotments, as against 10.7 per cent in the ad-
fundings was $1.9 billion. During this period
vance refundings. But excluding the
the Treasury
first
five
advance refundings, their maximum net positions in the other six averaged 13.4 per cent.
Another measure of dealer activity is the
volume of trading in when-issued securities
during or immediately after a financing.
Com-
parable data indicate that dealers traded the
new
issues
more
actively in the
advance
re-
funding operations than in the regular quarrefundings.
terly
Available figures on trading
through the seventh day following the announcements of terms show that the accumulated volume of trading in the advance refundings was 24.8 per cent of total issues to the
public as compared with 19.4 per cent in the
quarterly rights operations. Excluding the
five
rises
by
first
advance refundings, the trading volume
to 27.8 per cent of the new issues taken
all
public holders.-'
Cost of advance refunding.
It is
virtually
impossible to quantify the "true" net extra cost
from advance refunding.
or saving
resulting
Once such
a refunding has been
consummated
no one can know, or even guess with confidence, what would have happened without it
or by attempting to accomplish the same de-
in
the last strenuous attempts
issue long-term
then abandoned as an impractical means of
producing
scale.
debt
on
extension
substantial
a
In these financings the Treasury issued
long-term bonds on five separate occasions in
amounts averaging about $380 million per of(For details see Appendix Table 17.)
During a closely similar period the Treasury
conducted five advance refundings in which
bonds longer than 10 years were offered. The
total amount extended was $13.6 billion, and
fering.
about
averaged
$2.7
billion
per
operation.
bonds
was nearly 2% years longer, and their interest
yield was about 3 basis points (0.03 per cent)
less, than on the bonds issued for cash or in
regular refundings. Thus, although the two
methods achieved roughly comparable degrees
The average term
of
to maturity of these
debt extension
costs,
closely
at
similar
interest
average amount extended per ad-
the
vance refunding was more than seven times as
great.
In
(For
the
Treasury
For a discussion of the longer-run effect of
advance refunding on dealer trading volume in the
intermediate- and long-term areas of the market, see
Louise Ahearn and Janice Peskin, Market Pcrfonii-
made
bonds without resorting to
advance refunding. It was also the period during which the bond auction was introduced and
to
details see
remaining
found
over- 10-year
it
debt
Appendix Table 17.)
advance refundings the
possible
by
to
another
increase
$4.2
the
billion
^
ance as Reflected
this series, pp.
in
Aggregative Indicators, Part 2 of
Ill and 112.
without
offering
an
than 4.25 per cent. In
investment
yield
higher
about
$17%
billion
all,
of long-term debt was advance refunded between October 1960 and January 1965 before
,
TABLE
5:
ISSUES OF OVER-10-YEAR TREASURY BONDS, 1960-65
Average
Amount
of dollars)
n
offering
yield
offering
yield
(in per cent)
issued
(in millions
spread '
per cent)
(in
cash financings and regular refundings al
maturity, Apr. 1960-Apr. 1963
In advance refundings:
Oct. 1960-Sept. 1963 .
Jan. 1964-Jan. 1965 =.
1
2
sues of comparable maturity.
cash financings or regular refundings at maturity
Spreads above market yields o
No bonds longer than 10 year;
i
this period.
the rise in interest rates during the last
mer
sum-
of the period effectively foreclosed the of-
claims from time to time that Treasury
the
little impact on economic
management could not comforta-
debt operations have
fering of issues longer than 5 years because of
cycles, debt
the 4V^ per cent interest limitation on bonds.
bly ignore even the marginal procyclical effect
In terms of spreads above existing market
yields on comparable maturities, long-term
of a large-scale absorption of long-term funds
bonds issued for cash and in regular refundings appeared to be about as attractive as
those in advance refundings. The average of
offering yield spreads was 12 basis points in
the cash and maturity refundings and 11 basis
points in the first five advance refunciings.
In view of these statistics, it seems probable
that regular operations on the scale of advance
refundings could not have succeeded. Long-
ings during a recession.
two of the regular refundings during the 1960-63 period were for
compare favorably. For
cash subscription. In both of these cases the
through cash subscription or in regular refund-
allotment ratio was 100 per cent, indicating a
considerable degree of unwillingness on the
ings
term bonds offered
in
part of investors to subscribe for long-term
It seems reasonable to infer that massive
amounts of debt cannot be extended at long
term through regular means, except possibly
during a fairly protracted recession. Despite
ISSUED
6:
n cash financings and regular refundings
maturity. May 1960-Nov. 1966
'
Gov-
ernments, would also be a strong procyclical
influence.
As was
true of long-term issues, the relative
costs of advance refunding offerings in the in-
termediate maturity area and of similar maturissued
ities
issues
regular
in
maturing
in 3
appear to
comparison new
financings
this
through 10 years offered
were matched against similar issues of-
fered in advance refundings.
As shown
in
Table
6,
from
May 1960
through November 1966, about $45 billion of
3- to 10-year securities were issued at an average offering rate of 4.15 per cent with an average term of 5.6 years in regular financings. In
comparison, issues of a similar term offered in
TREASURY SECURITIES MATURING BETWEEN
3
AND
Amount
Average
issued
of dollars)
offering
yield
(in per cent)
44.9
4.15
56.5
4.11
;
In advance refundings, June 1960-Aug. 1966.
interest rates,
including long-term rates other than on
YEARS
10
IN 1960-66
(in billions
Moreover, as indicated
any upward pressure on
earlier,
is-
sues.
TABLE
cash financings or regular maturity refund-
in
Spreads above market yields on outstanding issues of comparable maturity.
Average
offering
yield
spread ^
per cent)
(in
NEW TECHNIQUES
IN
DEBT MANAGEMENT
advance refundings, totaled $56.5
43
billion,
at
refunding
is
not mandatory as
an average investment yield of 4.11 per cent
of a
maturing
(For
may
logically
with an average maturity of 6.4 years.
details see
Appendix Table
funding
comparable maturity was slightly more in the
advance refundings than in cash financings and
regular refundings. In practice, however, such
spreads have not been an important factor in
turity
exchange percentage
in
ad-
value
the
of
new cash do
not reflect the
tax-and-loan-account credit in-
volved.
It
case
be
regular financings
the
noted,
tended was for the
not
however, that
should
of
all
full
the
in
the
debt ex-
term of 5.6 years while
of the 6.4 years in advance refunding
represents debt extension. In advance refund-
reduced by the
ing the debt extension
is
maining terms of the
eligible
issues.
re-
In the
in the first place
structure
of
to
is
improve the ma-
marketable
the
same point
at
debt,
it
maturity
would have been extended to
the eligible issues
the
effect
be measured on the basis of
seems appropriate to assume that
of time as in the actual ad-
vance refundings.
More
vance refundings. Moreover, the yield spreads
in financings for
the refunding
the reason for offering an advance re-
since
fered yields above market rates on issues of
determining the
is
Thus, the budget
an issue reaches maturity. But
waiting until
18.)
In this case, the average spread of the of-
issue.
the
explicitly,
additional
cost
(per
$100) is the difference between the interest
rate on the outstanding eligible issue and the
rate on the new issue offered in exchange, acting over the remaining term of the old issue.
The saving (per $100)
is the difference between the interest rate on the new issue offered
in the exchange and the rate that would be required to reopen the same new issue when the
remainder of the old issue reaches maturity.
This difference
applied to the period from
is
case of junior advance refunding into interme-
the maturity of the old issue to the maturity of
diate issues this can reduce the debt extension
the new.
The following
considerably. But even with full allowance for
analysis includes only those
on 3- to 10-year issues in the advance refundings was 5.3 years.
Thus the bond-years of extension (amounts
eligible
times years) in the regular financings totaled
to guess the interest
$250
the remainder of the eligible issues maturing in
the average extension
this,
billion years;
and
in the
advance refund-
issues
of
exchanges but also precludes any need
all
the future.
into the intermediate area at an interest rate
on the
It
that
was comparable
to
and
in fact slighdy less
It
is
abundantly clear that by advance
This
is
true
maturing through 1966.
whether or not the 414 per cent
interest
taken into account.
cost
is
the cost
the budget- or dollar-
concept as shown in the report of the
Senate
Finance
Committee hearings on ad-
vance refunding, March
approach
it
is
implicitly
1962.'"
re-
eligible issues
than that in issuance for cash or in maturity
One approach toward determining
rates required to refund
funding the Treasury saved very substantially
refunding.
of advance refunding
matured before December
1966. This not only covers about 80 per cent
$299 billion years.
would seem, therefore, that advance refunding was also successful in extending debt
ings,
that
ceiling
on
over-5-year
offerings
is
Under assumption "A" in Table 7, if the
Treasury had waited and could have refunded
the maturing issues into the
in the
advance refundings
new
issues offered
at rates
above 414
In this
per cent, the over-all net saving would have
assumed that advance
more than $700 million. This is the
amount saved by having refunded
earlier.
Through 1963 the Treasury would
have incurred a net loss. But as rates rose dur-
14,
totaled
theoretical
1° U.S.,
Congress, Senate, Committee on Finance.
Hearings of Mar. 14 and 16, 1962, Advance Refundin!' and Debt Management,
87th Cong., 2d Sess.,
1962, pp. 14 and 15.
ing the course of the interest-rate cycle, the net
TABLE 7: ESTIMATED INTEREST COST OR SAVINGS IN ADVANCE
REFUNDING OF ELIGIBLE ISSUES THAT MATURED BEFORE
DECEMBER
31, 1966
In millions of dollars
nterest cost
between the
eligible
and
the otTered
Assumption A on interest saving: Saving based on difference between rate on the new
security ottered
olTered in the advance refunding and the mark
market rate required to reopen the
offered issue when the eligible issue reached maturity.^
Eligible
issues
maturing
in—
NEW TECHNIQUES
IN
DEBT MANAGEMENT
to the dates of the advance
added
refundings,
the
would be discounted more than the
savings
costs because the savings are further in
the future. Nevertheless, the discounted values
produce a net over-all savings of more
the advance refundings would have been far
more expensive and would have had a much
greater repercussion in the capital market,
indeed
it
would have been possible
at
all.
if
It
than $200 million on the amounts exchanged
also appears certain that, through 1966, advance refunding produced interest savings for
which would have matured by the end of
1966. Thus, even under the more realistic assumption regarding the 4V^ per cent interest
the Treasury, even if the early benefits of an
improved debt structure are ignored. Moreover, any reasonable assumption on the inter-
still
Treasury undoubtedly saved on
ceiling, the
terest cost as a result of
in-
having previously ex-
tended debt through advance refunding.
From
this,
may be
it
Treasury over the long run
only
is
interest rates
if
But that
trend.
is
inferred
is
bound
that the figures in assumption
the
that
upward
The fact
"B" tend
to
understate the benefits of advance refunding.
Not only were the amounts extended placed
well beyond the need to refund them at the
historically high rate levels that followed, but
was
also there
the probability that
much
of the
$59 billion maturing through 1966 or later
would have been refunded and most likely rerefunded one or more times. This most certainly would have added to the upward pressure on the rates for refunding the issues that
did actually mature.
From
a budget-cost point of view, approxi-
came to maturity and was refunded in the regway during the SVi years from mid- 1961
through 1966. About $99 bilUon of that
amount was publicly held, of which over $50
ular
was
in eligible
advance refunding issues
maturing through 1966. It seems reasonable to
suppose that the net effect of reducing the
publicly
held
short-dated
having reduced publicly
coupon debt
—wherein
fre-
at escalating rates of interest
would have been required
— would have added
considerably to the interest saved directly as a
result of
advance refunding.
Tax consequences
of advance refundThere have been two types of tax treatment of exchanges in advance refunding: nontaxable exchanges with the tax effect on gains
ing.
or losses generally postponed; and taxable ex-
changes with an immediate tax
effect
on gains
or losses.
Beginning with the July 1964 advance refunding, taxable exchange treatment has been
accorded to the pre-refunding
maturing
in 6
months or
the passage of the
until
less.
eligible
From
issues
that time
Tax Reform Act
of
1969, the Treasury decided that issues as close
mately $185 billion of marketable coupon debt
billion
held
quent refinancing
to benefit
are in an ever
a superficial view.
est saving involved in
refunding
load
one-third should have produced
by more than
some lowering
to maturity as 6 months should be regarded as
maturing issues for tax purposes. Under such
tax treatment any gain or loss
was recognized
immediately for tax purposes and was reportable for the year in which the exchange took
place.
Advance refunding exchanges
ble
if
are nontaxa-
so designated by the Secretary of the
Treasury under the authority of Section 1037
of the Internal
Revenue Code
as
amended
in
of interest rates required for the regular re-
September 1959. As defined in the code, any
gain or loss in such an exchange is not recog-
fundings.
nized for tax purposes at the time of the ex-
If
assumed
that lessening of the rate required
have averaged as
massive debt extension through cash financing
is postponed until the new
by the taxpayer are sold, redeemed, or otherwise disposed of, whichever
comes first. As originally prescribed, the designation of an exchange as nontaxable was not
permissive; it had to be treated as such by all
or refunding at maturity on a scale matching
taxpayers.
is
to
points, the budget savings
turities
little
based on
as 5 basis
total
ma-
would have been over $90 million a
year.
In
summary,
it
seems almost certain that
change but instead
securities received
46
In a nontaxable exchange, any subsequent
gain
or
upon the
loss
new
other disposal of the
gain
redemption,
sale,
issues
a capital
is
a taxpayer unless the securities
to
stock in trade, as in the case of dealers.
capital gain
short or long term
is
are
The
determines whether the
period that
holding
or
measured
is
from the purchase date of the eligible issue
turned in by the taxpayer to the disposal date
new
of the
issue offered in the exchange. If the
period of holding
any gain (or
is
loss)
is
also to
mutual
whether acquired
issues,
in
advance
refundings or otherwise, were considered to be
ordinary losses for tax purposes, while gains in
excess of losses were capital gains. (Gains on
less
is
is
than the
determined
sum
cost basis of the old issue. If the
of the
boot plus the new-issue value exceeds the oldis recognized immedino case can the amount recognized be greater than the amount of the boot
received by the taxpayer. (For examples of the
But
the excess
in
tax treatment of boot see p. 74.)
The
losses in excess of gains in a given year
on coupon
pro-
this
by comparing the sum of the boot received by
the investor and the fair market value of the
new issue at the time of exchange with the
ately.
—and
to deter-
the total value received by
cost basis of his old issue. This
issue basis,
To commercial banks
if
the investor in the exchange
a long-term capital gain
savings banks and savings and loan associa-
—
cedure holds only
greater than 6 months,
(or loss).
tions
from the cost basis of the old issue
mine the basis of the new issue. But
in
advance
One
generali-
tax consequences of boot
refunding can be quite complex.
that may be made, however, is that
boot paid to a taxpayer by the Treasury improves his yield after tax as compared with
zation
by
providing the same investment yield on the of-
banks and savings and loan associations are
treated as ordinary income in symmetry with
losses or ordinary losses.) Thus, until the pas-
fered issue before tax, but without boot. Boot
securities
acquired
sage of the
cial
July
after
Tax Reform Act
banks tended
to
of 1969,
advantage
of
in
order to take
unsymmetrical tax
the
treatment of gains and losses on coupon se-
This practice was confined mostly to
curities.
their holdings of
paid by a taxpayer to the Treasury has the opposite effect.
As
commer-
segregate gains in one
year and losses in another
greater
1969,
11,
Governments (and municipal
a fairly simple illustration, let us
that a 5-year,
rently priced in the
price, yield
market
at
96.20 (decimal
about 3.84 per cent)
ble for exchange into
bond without
assume
3 per cent existing issue cur-
boot.
is
made
eligi-
a 25-year, 4 per cent
Based on the price
eligible issue, the offering
of the
investment yield be-
on the 25-year 4's would be 4.25 per
Given these assumptions, the "minimum
bonds). Advance refunding allowed considerable latitude in this regard during the term to
fore tax
maturity of the offered issues.
reinvestment rate" before tax for the 20-year
The September 1959 Act covering nonrecognition of gains or losses in advance refundings also
amended
the code with respect to the
cost basis of the eligible and offered issues. In
par-for-par
a
without
exchange,
adjustment
cent.
extension would be 4.41 per cent. This
tures, in
offer.
to
added
the
Treasury,
the
boot
is
invariably
it
ma-
had
he
accepted
the
exchange
^-
Table 8 shows the
ing investment yield
if
when
order to equal the return on the 4 per
bond,
cent
becomes the cost basis of the new
issue received by the investor. However, when
an adjustment payment is made by the investor
the
rate at
proceeds of his 3 per cent issue
(boot) payments, the cost basis of the eligible
(old) issue
is
which an investor who elects
not to exchange would have to reinvest the
minimum
boot
is
effect of tax on the offerand the reinvestment rate
used to equate the terms of the ex-
to the cost basis of the old issue to de-
termine the basis of the
When
new
issue.
1-
boot
investor, the
is
paid by the Treasury to the
payment
is
ordinarily subtracted
For a
fuller
Feb. 20,
explanation
of
the
reinvestment
offer of
from the advance refunding
1963, which is shown on p. 75.
rate see excerpt
NEW TECHNIQUES
IN
DEBT MANAGEMENT
TABLE
YIELD
47
8: TAX EFFECT OF BOOT PAYMENTS ON INVESTMENT
AND REINVESTMENT RATE
Assumptions: The tax rate is 48 per cent {the corporate marginal rate) on the coupon income and 25
per cent on long-term capital gain. The taxpayer is a nonbank corporation. The cost basis of the 5year. 3 percent issue outstanding is 98 per $!00; and its current market price is 96.20. The exchange
is nontaxable.
Coupon
rale
(per cenl)
the problem helped to trigger a major study of
budget concepts and practice, while the politi-
problems and implications sharply divided
cal
the Congress on the subject.
At
the time of the controversy proponents
principal
and
income of an
interest
ir-
revocably pledged pool of loans, the practice
They claimed
represents the sale of assets.
credit
programs
more
are
PC
under the
that
procedures
the
of
costs
Federal Government
the
to
also
truly reflected than
if
the
Moreover, they said that PC's provide a
costs.
means
attracting
for
was
less
even
into
the
by the pool of loans
at less cost than afi'orded
They pointed out
funds
private
credit areas represented
by other alternatives.
that the cost of selling PC's
than the cost of selling assets directly,
which the Federal Govservicing responsibility and
in those cases in
ernment
retains full
provides a
full
to act as trustee for pooling
market yields on Treasury and Federal
agency
major impact of issuing
1966 after the escalation of the
Vietnam in mid- 1965, and after the insecurities, the
PC's came
war
in
in
crease in the discount rate in
December
of that
year. Increased sales of
PC's had been forecast
budget for
year 1966, with a sub-
in the
fiscal
year 1967.
stantially larger increase in fiscal
During the December 1964-June 1966 pe-
programs
were financed through Treasury advances to
agencies at rates below Treasury borrowing
FNMA
offerings started during a period of slowly ris-
ing
of the sale of PC's believed that, as shares in
the
powering
Federal-agency-held mortgages. Although these
PC's
riod,
by
held
the
public
more than
doubled, from $2.0 billion to nearly $4.4
bil-
same period, public borrowing by
Federal credit agencies also expanded sharply.
In fact, during the I'/i years from December
1964 through June 1966, Federal agency debt
held by the public increased from $12.1 biUion
In the
lion.
$17.6
to
billion, at
roughly
3'/^
times the an-
nual rate of increase in the preceding 4 years.
To
a considerable extent, the expansion of
agency borrowing resulted from a
growing demand for credit generally. CommerFederal
guarantee.
Those on the other side felt strongly that a
PC is a somewhat thinly disguised device for
banks and other lending
cial
institutions, fac-
new
ing heavy borrowing requirements in a tighten-
funds into fully guaranteed PC's free of servic-
ing money and credit market environment,
began to ration credit and choose among borrowers. Unsatisfied borrowers, including farm-
selling another debt instrument. Attracting
ing costs merely proves that the attraction
indeed a Government security. Moreover,
is
all
of the improvements in their terms and conditions since early
ity
1967
to
enhance marketabil-
made the PC's resemble direct debt obligamore and more and to resemble sales of
tions
assets less
As
and
a matter of fact, that aspect of PC's did
not become a significant problem until after
FNMA-type
vember 1964. Before
had been sold by the
eral
and small businessmen, turned to the Fedagencies to meet credit needs ordinarily
supplied by the private institutions. In addition, the tightening situation
offerings in
such
that
CCC
for
No-
The
savings and loan associations experienced
particularly
instruments
ketable instruments.
many
tions increased their
years
home
eral
bank PC's, which date back to May 1962,
had also been distributed without fanfare,
FNMA
it
should be noted they were sold to
a rather select group
of
Other PC's had been sold
liquidating the
in
commercial banks.
in
heavy withdrawals of funds, for
reinvestment at higher rates of return in mar-
without repercussions, while the early Exim-
although
produced a sharp
reduction in the supply of mortgage money.
less.
the advent of the
ers
the process
of
RFC.
The FNMA offerings of PC's, which began
November 1964, followed legislation em-
an attempt
to
a result, the associa-
borrowing from the Fedbanks. At the same time
loan
increased
As
its
purchases of mortgages in
support the secondary market.
Faced with expanded
credit
demands, these
Federal agencies sharply increased their market borrowing. Also during this period the increased
demand
for
bank
credit for business
loans and other private needs, plus the bur-
geoning
corporate
and municipal
long-term
NEW TECHNIQUES
IN
DEBT MANAGEMENT
PUBLIC HOLDINGS OF MARKETABLE TREASURY
FEDERAL AGENCY OBLIGATIONS
11 AND
50
TABLE
9:
1962-66
'
EXPORT-IMPORT BANK PC OFFERINGS, RATES, AND SPREADS,
NEW TECHNIQUES
DEBT MANAGEMENT
IN
was 10 years on the
duced
first
was
PC's, but this
re-
to 7 years thereafter.
About $2.1
in
Eximbank PC's
billion of these
were issued but by December 1966 about $1.0
had been
billion
mostly through the
retired,
over, in the belief of
The Exim-
exercise of the redemption option.
bank-type PC's were relatively expensive
struments as indicated in Table
in-
bond counseling,
some lawyers specializing
was a definite need
there
from the Attorney General that
if required, would be guaranteed to meet interest and principal payments.
As indicated in Table 10, the interests costs
on the first three PC's averaged between 7 and
for an opinion
Treasury funds,
9 basis points above
spread
comparable agency issue
and between 14 and
per cent above
Treasury yields. These spreads seemed to be
above market rates on Federal agency issues
quite reasonable in view of the newness of the
and even above the commercial bank rate. In
later offerings, the spreads above agency issue
ings in the
first
somewhat
much more
expensive in the rapidly rising in-
As
9.
Eximbank
a new, untried instrument the
PC's started with a
fairly
high
yield
rates declined, partly as a result of a
improved customer reception, but mainly due
mounting upward rate pressures in the
agency market. Comparisons with the prime
rate do not indicate a close relationship,
mainly because the prime rate was held at artificial levels, with compensating balances providing the
finer
tuning needed for rate
offered instruments.
terest-rate
to
flexibihty.
Attempts
to
raise
target
amounts through
Eximbank offerings in 1966 proved unsuccessful. As a result, beginning in 1967 the terms
and conditions of Eximbank PC's were
changed
to
conform with
the newest
FNMA-
type PC's.
three offerings of
Eximbank PC's
FNMA
PC's were
the
first
fairly well
received at rates generally in line with yields
existing
agency
issues.
This occurred de-
spite the underwriters' dislike of
such as small
10- to
It
However, the two offer1966 were relatively
half of
environment
at the time.
should be mentioned that the comparison
PC
costs with yields on outstanding agency
depended on the validity of dealers' quotations in the agency market. If it can be
argued that dealers' quotations were not much
further ou of line with '"true" market values
at any one time than at another, the changes
of
issues
in the
tive
spreads are a reasonable index of rela-
additional costs needed to ensure market
acceptance.
In
1965-66
the
above
spreads
Treasury rates on the parts of
PC
offerings
maturing after 5 years reiected the lack of any
possible increase in the supply of over-5-year
In contrast to the
on
%
yields
serial maturities
some
features
extending over a
15-year period and the availability of
the obligations only in registered form.
TABLE
10:
More-
Treasury issues
in the
immediate future.
The first FNMA PC's following the postponement of scheduled offerings by the SecreSeptember 1966 carand conditions strongly
recommended by market professionals during
the summer. In the improved market environment at the end of the year, the average intertary of the Treasury in
ried
revised
terms
FNMA PC OFFERINGS, RATES AND SPREADS
1964-66
'
Average
Average
Federal
lerni
{in years}
(in per
agency
market
yields
Nov. 1964.
July 1965..
Dec. 1965
I
reasury
market
yields
4.37
4.54
4.76
Apr. 1966..
June 1966..
Jan. 1967
•
"
'.
Including the January 1967 offering announced on Dec. 19. 1966.
Public portion of offering; in addition, S500 rrtillion was taken by Government Investment Accounts.
est-cost spread
above Federal agency rates on
new PC's was
In summary, the
FNMA-type
PC's, particu-
models following the September 1966
postponement, appeared to have earned a place
conformance with the
pre- 1966 levels. However, the average spreads
above Treasury yields remained large, reflect-
larly the
ing the continuing substantial yield differentials
extent,
the nature of PC's as viewed
between Treasury and agency
market
at the
the
in
issues.
in the roster of regular
agency
time was resolved.
issues.
To
that
by the
NEW TECHNIQUES
IV.
IN
DEBT MANAGEMENT
APPENDIX
TABLES
1.
Monthly average
rates
on 91- and 182-day Treasury
bills in
the weekly auctions
November 1958-December 1966
2.
3.
4.
5.
91-day Treasury
55
—
—
1958-66
182-day Treasury bills
quarterly averages of auction results, 1958-66
Auction results on 1-year Treasury bills, quarterly or monthly, 1959-66
Auction results on 9-month Treasury bills, monthly, 1966
bills
quarterly averages of auction results,
6.
Trcasury-bill-strip auction results
7.
Regularly issued
8.
Treasury coupon securities issued
bills
56
57
58
59
59
59
outstanding, selected dates
in rights
and
in
cash quarterly refinancings,
August 1960-December 1966
9.
60
Dealer activity in quarterly rights refundings, 1961-66
61
cash refinancings, 1961-66
61
10.
Dealer activity
11.
Advance
12.
13.
Exchanges
Exchanges
1960-65
14.
Yields on long-term Treasury, municipal, and private securities, 1960-66
15.
Dealer activity
16.
18.
New issues ofTered, terms to maturity, and allotments to
and dealers
69
Treasury bonds with over 10 years to maturity issued in cash financings and regular
refundings at maturity and in advance refundings. 1960-65
70
Treasury securities maturing in 3 through 10 years issued in cash financings and regular
19.
Estimated cost or savings
Advance
in quarterly
refundings,
in
1960-66
advance refundings by investor
in senior
in
and
in pre-
classes,
62
66
1960-65
and junior advance refundings by investor
classes.
advance refundings, 1960-65
66
67
68
refundings, 1960-65:
total public
17.
refundings at maturity and in advance refundings, 1960-66
in
advance refundings
—
Eligible issues
71
maturing before
December
20.
21.
31, 1966
Types of exchange and adjustment (boot) payments in advance refundings, 1960-66
Market yields on Federal agency and Treasury issues at constant maturities, and
reoffering rates
on new corporate bonds
—
Selected dates,
1963-66
72
73
74
EXAMPLES OF TAX TREATMENT OF ADJUSTMENT (BOOT) PAYMENTS
74
EXCERPT FROM ADVANCE REFUNDING OFFER OF
75
FEB. 20, 1963
NEW TECHNIQUES
APPENDIX TABLE
IN
DEBT MANAGEMENT
1
MONTHLY AVERAGE RATES ON 91- AND 182-DAY TREASURY BILLS
WEEKLY AUCTIONS, NOVEMBER 1958-DECEMBER 1966
'
Nov.
Dec.
Jan..
2.914
Feb.
Mar.
2.420
2.327
2.288
2.359
Apr.
May
June
July.
Aug.
Sept.
Oct..
Nov.
Dec.
4.436
3.954
3.439
3.244
3.392
4.840
2.641
4.321
3.693
3.548
3.684
2.909
.396
.826
.735
.694
.719
2.838
2.789
2.804
Sept..
.945
.837
.792
Oct..
.751
3.085
3.005
2.947
2.859
July.
Aug..
'Bank discount nu
3-week average.
•
IN
THE
APPENDIX TABLE
2
91-DAY TREASURY BILLS— QUARTERLY AVERAGES OF AUCTION RESULTS, 1958-66
NEW TECHNIQUES
APPENDIX TABLE
IN
DEBT MANAGEMENT
3
182-DAY TREASURY BILLS— QUARTERLY
AVERAGES OF AUCTION RESULTS, 1958-66
nl r;ues
Acccpled
Received
Nonkink
deale
Received Accepted
Ri
und spreads
APPENDIX TABLE 4
AUCTION RESULTS ON 1-YEAR TREASURY BILLS, QUARTERLY OR MONTHLY, 1959-66
NEW TECHNIQUES
IN
DEBT MANAGEMENT
APPENDIX TABLE 5
AUCTION RESULTS ON 9-MONTH TREASURY BILLS, MONTHLY, 1966
APPENDIX TABLE 8
TREASURY COUPON SECURITIES ISSUED IN RIGHTS AND IN CASH
QUARTERLY REFINANCINGS, AUGUST 1960-DECEMBER 1966
NEW TECHNIQUES
APPENDIX TABLE
DEALER ACTIVITY
DEBT MANAGEMENT
IN
9
IN
QUARTERLY RIGHTS REFUNDINGS, 1961-66
Cumulative volume of trading
Dealers
as per cent
of public
To
the
public,
Amount
(in
issues to
millions
of dollars)
(in
public
6,387
8,593
6,683
2/15/62...
5/15/62..
11/15/62.
Amount
Per cent of
millions
of dollars)
tolal
7.2
8.9
9.7
2/15/63...
5/15/63...
8/15/63...
15.4
12.8
10.3
21 .4
13.6
17.9
5/15/66
Total, or average ....
Excluding 8/1/61
E.xcluding 2/15/62
•
13,590
Excluding combination maturity and pre-refundings in Februai
and August 1966.
^
'
- Includes position in outstanding reopened issues except in
1961 refunding.
APPENDIX TABLE
DEALER ACTIVITY
10
IN
Augu
^
Dealers reporting to the Federal Re
n.a.
Not
available.
QUARTERLY CASH REFINANCINGS, 1961-66
Dealers a
per cent
of public
8/15/62..
5,107
11/15/63.
3,972
1,516
11.2
928
22.0
936
867
Total, or average ....
Excluding 2/15/61
284
397
16.1
571
12.5
454
14.3
735
20.9
738
20.9
3,504
12.3
32,118
.
28,398
Dealers reporting to the Federal Reserve Bank of New York.
" In tolal new issues {where more
than one). Includes positions in outstanding issues
'Trading through seventh day after announcement. Includes trading in outstandir
reopened.
'
I
n.a.
Not
available.
23
While books were open.
Through seventh day afte
Bank of
New
York.
O
62
C c u
£
300QOQQQOO
1111111177
SOOO^ON —
•lOf^CN
£s
6?
— Mrno, — O—
^
£?
B?
5?
(3
00 u.
<UJ
HOC
XlU
UJ<
Q.>
Q.Q
<<
f
a
6*
:.^
6?
s;
6*
£*
6^
:sj
:s?
:>?
s?
NEW TECHNIQUES
i
I
I
I
I
I
I
I
IN
DEBT MANAGEMENT
M
1
"'9??^???
£?£?
656§
6§&?
t"^^
^
£^
fe§
£?
171 1171
-7
?T-?=!
^
6*
6*^
St
S*
^
6*
;^
SS
g;
I
I
I
I
I
I
7
I
I
I
I
I
I
I
I
I
II
171
I
7?7?=r7?=r t1'7T=7"i"ri'777?T=i-'
sss?
sSsS
?
?
sss?
sS6n
sSb?
ssss
sSfeS
fiSS?
SS6^
NEW TECHNIQUES
II
??-
IN
Mill
DEBT MANAGEMENT
II
r??f??-
2I
II
II
,
APPENDIX TABLE
EXCHANGES
IN
12
ADVANCE REFUNDINGS BY INVESTOR CLASSES,
1960-65
Dealer:
and
broker-
Pension
1,090
328
1,337
1962— Mar,
Sept
1963— Mar,
Sepl.
1964— Jan.
July
1965— Jan
,
.
1,877
4,731
4,403
3,365
1,442
5,501
5,650
348
1,194
1,567
1,539
658
1,086
1,426
Other
300
254
508
156
NEW TECHNIQUES
IN
DEBT MANAGEMENT
67
3 2 S
§
a?
?:r;i§
iijU
-IZ
mo
So
^u:S<S^ ^<;;iOZQ
4li.S<S-?
^<J:oza
..
APPENDIX TABLE
DEALER ACTIVITY
15
To
the
IN
ADVANCE REFUNDINGS,
Amounts
P"''"'^-
6/23/60.
4,077
10/3/60.
3,396
3/30/61
.';,443
9/29/61
2,827
3/9/62.
4,178
9/20/62.
3/15/63.
9/18/63.
1/29/64.
7/24/64.
Total, or av
Excluding:
3/9/62.
(in
deiile
mil-
lions of
dollars)
Per cent
of issues
to public
—
NEW TECHNIQUES
IN
DEBT MANAGEMENT
APPENDIX TABLE 16
ADVANCE REFUNDINGS, 1960-65: NEW ISSUES OFFERED,
TERMS TO MATURITY, AND ALLOTMENTS TO TOTAL PUBLIC AND DEALERS
Advance
refunding of
69
APPENDIX TABLE 17
TREASURY BONDS WITH OVER 10 YEARS TO MATURITY ISSUED
FINANCINGS AND REGULAR REFUNDINGS AT MATURITY
AND IN ADVANCE REFUNDINGS, 1960-65
above outstanding-
of dollars)
Cash
11/15/61
3H%
Bd.
8/15/62
41^%
Bd.
8/15/87-92
30-0
1/17/63
4%
Bd.
2/15/88-93
30-1
4/18/63
4H%
Bd.
5/15/89-94
Total, or average
5/15/75-85
11/15/74
issue yields
financings and regular rcfundings
Bd.
25-1'
13^
31-1
24-4
{in
per cent)
issued
414%
CASH
Spread
Amount
{in millions
4/5/60
IN
New
cash
.
.
NEW TECHNIQUES
APPENDIX TABLE
IN
DEBT MANAGEMENT
18
TREASURY SECURITIES MATURING IN 3 THROUGH 10 YEARS ISSUED
FINANCINGS AND REGULAR REFUNDINGS AT MATURITY AND IN
ADVANCE REFUNDINGS, 1960-66
Amount
Offering
issued
yield (in
(in millions
per cenl)
of dollars)
Cash
4HTo
VA^r
5/15/60.
8/15/60.
11/15/60.
Nt.
Bd.
3^'"; Bd.
5/15/65
5/15/68
5/15/66
3M%Nl.
VA%Bd.
8/15/64
5/15/68
5/15/66
3Ji%Bd.
11/15/61.
A%
A%
1/24/62.
2/15/62.
4/18/62.
5/15/62.
5/15/62.
8/15/62.
11/15/62.
Bd.
10/1/69
Nl.
^7,. Bd.
3$/8% Nl.
Bd.
8/1 5/66
VA%
4%
4%
1
,
1
.213
8/15/68
2/15/66
2/15/69
2/15/72
4K''; Bd.
5/15/74
Rights
Cash
rl'dg.
4.625
3.875
Rights
3.75
Rights
Rights
Rights
3.75
3.98
3.81
3.68
Rights
Rights
11/15/71
Bd.
Bd.
Cash
3.94
4.00
4.00
rl
Rights
10-0
9 A)
5%Nl.
2/15/66.
8/15/66.
11/15/66.
5K%Nt.
5=8%
Total, or average.
6/23/60.
3/30/61
.
.
May
Nt.
11/15/70
5/15/71
11/15/71
2,839
2,578
1,734
Rights
Rights
Cash
rfdg.
5.00
5.25
5.375
1960-Nov. 1966
.
.
3/9/62.
9/20/62...
.
Nl.
8/15/71
8/15/67
Bd.
8/15/72
4rr Bd.
3Ji
%
4%
2/15/67
11/15/71
11/15/68
9/15/73
3/15/63...
9/18/63...
1/29/64...
7/24/64.
,
4%
4%
Vs'y,
1/19/65...
Bd.
Bd.
Bd.
8/15/70
10/1/69
11/15/73
2/15/70
2/15/74
4.104
.
3.809
4.06
3.645
3.965
4.02
4.147
4,287
1,515
1,591
9-11
3,894
6-63i
2,223
3,726
4,357
5-2K
9-3J-i
and
and
and
Jr
Jr
Jr
4.155
4.07
4.229
4.175
4.238
4.976
2/15/66...
8/15/66...
Total, or average.
9-5'
4-11
9-11
1960-.\ug. 1966
CASH
Spread (in
per cenO
above oulstandingissue yields
financings and regular refundings
2.113
070
IN
O
E
a;
~
o
.....
NEW TECHNIQUES
IN
DEBT MANAGEMENT
73
APPENDIX TABLE 20
TYPES OF EXCHANGE AND ADJUSTMENT (BOOT) PAYMENTS
Types
IN
ADVANCE REFUNDINGS,
1960-66
exchange: Nontaxable, recognition of gains or losses postponed;
Taxable, immediate recognition
of
Excliangcs by
Total exchanges
Boot
Boot
Boot
Boot
Boot
paid to
investor
paid by
investor
paid by
investor
paid to
investor
paid by
investor
tlie
public
Amounts exchanged
1960— June..
Oct..
3,979
.
1961— Mar..
4,864
1,519
Sept..
1962— Mar..
7,519
Sept.
1963— Mar..
7,3.^1
6,548
Sept.
1964— Jan.
.
1
.
July.
.
1965— Jan...
,999
9. 284
9 258
9,765
9,063
,
1966— Feb...
Aug.
Total
.
.
.
.
(Net
vestor)
1960—June..
Oct...
1961— Mar..
33.1
Sept.
1962— Mar..
50.9
34. S
Sept.
1963— Mar..
Sept.
.
38.6
.
,
1964— Jan...
July..
2.5
1965— Jan...
9.7
1966— Feb...
Aug.
Total
1
.
I,3U7
2,908
.
.
Boot paid
,
74
APPENDIX TABLE
21
MARKET YIELDS ON FEDERAL AGENCY AND TREASURY ISSUES AT CONSTANT
MATURITIES, AND REOFFERING RATES ON NEW CORPORATE BONDS
—
SELECTED DATES, 1963-66
In per cent per
annum
NEW TECHNIQUES
IN
DEBT MANAGEMENT
EXCERPT FROM ADVANCE REFUNDING OFFER OF
12.
Explanation of
minimum reinvestment
A holder of the oulslanding eligible securities Iwd llie option of
accepting the Treasury's exchange offer or of holding thent to
maturity. Consetiuently, he can compare the interest plus (or
minus) any payment, other than the adjustment of accrued
interest, he will receive resulting from exchanging now with the
total of the interest on the eligible issues and what he inight
obtain by reinvesting the proceeds of the eligible securities at
maturity.
The income before tax for making the extension now through
exchange will be the coupon rates plus (or minus) any payment
on the new issues. If a holder of the eligible securities does noi
make the exchange he would receive the coupon rates on the
eligible issues to their maturity and would have to reinvest at
that time at a rate eiiual to that indiciited in paragraph 13 below
lor the remaining terms of the issues now offered, in order to
efunding
Paragraph 12 of Treasury
nnounced Feb. 20, 1963.
1
Investment rates on the
the eligible securities
Eligible securities
>
FEB.
20,
rate for the extension of maturity in
1963
advance refunding
equal the return (including any payjitent) he would receive by
accepting the exchange offer. For example, if the 3'; bonds of
2/15/64 arc exchanged for 3-ls'^ bonds of 11/15/71 the investor receives 2-Vs'"c: interest for the entire eight years and
eight months plus $.70 (per $100 face value) immediately. If
the exchange is not made, a i'i rale will be received until February 15. 1964, requiring reinvestment of the proceeds of the
3's of 1964 at that time at a rale of at least 4.11 '";, for the remaining seven years and nine months, all at compound interest,
to average out to a 3-J^';f, rate for eight years and eight months
plus the S.70 immediate payment. This minimum reinvestment
rale of the extension period is shown in the table under paragraph 13. The minimum reinvestment rates for the other issues
included in the exchange are tilso shown in the table under
p.iragraph 13.
oft'e
new notes and bonds
offered in
exchange
to
holders of
William G. Colby,
Jr.
Economist
Federal Reserve Bank of
New York
DEALER PROFITS AND CAPITAL AVAILABILITY
CONTENTS
I.
II.
III.
INTRODUCTION
81
SUMMARY
82
Profits
Capital
82
83
DEALER PROFIT PERFORMANCE
84
The Income Equation
85
87
93
96
97
99
Trading Profits
Net Carry
Trends in Trading Profits plus Carry, by Type and Size of Dealer
Operating Expenses
Regression Results
IV.
DEALER CAPITAL: CAPACITY
IN
THE INDUSTRY
Invested Capital
Margins Required
Capital
V.
VI.
Adequacy
102
103
106
109
RATE OF RETURN ON CAPITAL
110
APPENDIX
112
Summary
112
113
115
of Dealer Income and Expenses, 1964 and 1965
Regression Equations
Measurement of Dealer Capital
DEALER PROFITS AND CAPITAL AVAILABILITY
INTRODUCTION
I.
5 years 1961-65, average annual
from dealer operations in U.S. Government securities fell substantially below the
For
the
profits
5-year period.^
level attained in the previous
This decline culminated in a net loss of more
when only
20
tude and direction of certain measurable aspects of dealer profits and related variables.
The
limitations of the data are
avoid excessive
detail,
numerous; to
only the more impor-
tant qualifications are described.
the entrance of additional dealers over the past
Data on dealer income have been gathered
from three sources. Differing in their construction and coverage, these disparate series present the most serious constraint to meaningful
interperiod income analysis. One source is the
study of the Government securities market
made by Meltzer and von der Linde, which
few years as well as from recent innovations
records various annual income and expense
than $14 million in 1965,
dealers reported a profit
3 of
from these operations.
This deterioration has caused some concern
about the maintenance of a strong dealer industry and has brought into question the effects
of increased competition
official policies
The
resulting
from
in
and operations.
task of this study
is
twofold:
(1)
to
and evaluate the factors bearing on
dealer profitability, such as changing economic
circumstances, industry structure, and operating techniques utilized by the Federal Reserve
specify
and the Treasury; and (2) to ascertain the
under current market conditions, with a view to judging whether
sufficiency of dealer capital
the industry will have sufficient capital so that
it
can continue to "make markets" and to ab-
sorb large
The
official
operations.
discussion in this paper
based largely
to
the less complicated nature of their activities
and the existence of more reliable profit data
for them; any known or suspected variations in
bank dealer operations or behavior are noted.
Both the description and the evaluation of
dealer profit performance are severely constrained by the fragmentation and inadequacies
of the data and by the absence of clear and
consistent definitions underlying the data
meant
Many
to give
com-
of the dealer data presented are
some
indication of the magni-
In this paper, virtually all references to dealer
operations in U.S. Government securities include
operations in Federal agency securities and, commencing in 1961, certificates of deposit. Where data
include operations in bankers' acceptances and municipal and corporate securities, which are undertaken by many dealer firms, specific note is made.
'
dealers" (bank and
nonbank)
for the 11 years
1948-58.- This series covers earnings and expenses on
all
types of securities operations for
nonbank dealers but covers only
Government securities operations of
banks. Details on reporting procedures and
methods of allocating income and expenses are
absent. The series includes the 5 bank dealers
and the 12 nonbank dealers trading with the
Federal Reserve Open Market Account in
1958; however, that was not the exact group
the diversified
the U.S.
'
is
on the operations of nonbank dealers owing
pilation.
fig-
including net profits, for "all reporting
ures,
of "authorized" dealers in each of the
as
noted
is
A
study
market
-
U.S.
by
years,
is an unpubGovernment securities
George Benston, conducted
second source of
lished
1 1
in the discussion of dealer capital.
of
Dr.
Congress,
profits data
the
Joint
Economic Committee,
/(
of the Dealer Market for Federal Govenuncnt
report written by Allan H. Meltzer and
Gert von der Linde. Joint Committee Print (Washington, D.C.: Government Printing Office, 1960).
Sillily
Securities;
17 dealers were: Bankers Trust Company,
York; Chemical Bank New York Trust Company, Continental Illinois National Bank and Trust
Company of Chicago; The First National Bank of
Chicago; Morgan Guaranty Trust Company of New
York; Bartow Leeds & Co.; Briggs, Schaedle & Co.,
Inc.; C. F. Childs & Co., Inc.; C. J. Devine & Co.;
Discount Corporation of New York; The First Boston
Corporation; Aubrey G. Lanston & Co., Inc.; New
York Hanseatic Corporation; Wm. E. Pollock & Co.,
Inc.: Chas. E. Quincey & Co.; D. W. Rich & Company, Inc.; and Salomon Bros. & Hutzler.
'The
New
:
under the auspices of the Banking and Cur-
bined profit concept, and the absence of trad-
rency Committee of the House of Representa-
ing profit (or carry) data for bills as contrasted
In this study, data for the
tives.
Government
securities
operations of individual firms were
collected
on a monthly
from 1958
coupon
with
securities,
may
seriously bias the
statistical analysis.
to
Finally, partially disaggregated data for indi-
1963; here, too, procedural and allocative de-
vidual dealers are available for operations in
was the only one
U.S. Government securities from the reporting
program initiated for nonbank dealers in 1964
and for bank dealers in 1965 by the Market
basis
are missing. This series
tails
with sufficient observations to permit
statistical
which was undertaken despite known
analysis,
shortcomings in the data. Because of the ina-
most dealers to separate trading proffrom interest income on Treasury bills, and
bility of
its
the differences
number
of
among
dealers in classifying a
income and expense components,
the series used for measuring profits
ing profits plus carry." ("Carry"
is
"trad-
is
defined as
the diflierence between interest earned on securities held in position
and the
interest cost of
Federal Reserve Bank
York. Although these figures cannot
Statistics Division of the
New
of
be directly related to the earlier
are a
more
reliable
series,
actual profit performance.
A
short analysis of
aggregate income statements for these 2 years
is
presented in the Appendix. Again, the inabil-
ity
trading profits
to segregate
bills
from
on Treasury
interest accruals, plus diverse alloca-
financing them. This difference, or "net carry,"
tive practices, precludes exact inter-firm
may be
parisons of trading or carry.
positive or negative.
Use of
)
this
com-
they
and detailed statement of
com-
SUMMARY
II.
PROFITS
rupted interval of economic expansion, which
The sharply deteriorating trend in earnings
of U.S. Government securities dealers from
was accompanied by generally rising and, perhaps more importantly, nonvolatile interest
rates.
1961
through
1966,
late
after
several
ex-
tremely successful years, has been offered as
evidence that public and private innovations in
financial
markets have been detrimental to the
profitability of the industry.
This deterioration
some concern about the future effectiveness of the industry in accommodating public
led to
(official)
and private
activity in
the market.
This study examined the effects of such innovations, as well as the impact of the
and
ade,
institutional
economic
2. The sharp reduction in dealer profits for
1961-65 inclusive can be attributed in great
measure to the negative effects of cyclically declining securities prices on dealer positions as
monetary conditions tightened. Treasury bill
yields rose in each year of this period, and
long-term bond yields moved higher in every
year but 1962. (In that year, there was some
improvement in dealer earnings.) Furthermore,
with trading activity in long-term securities ob-
environment of the past dec-
on aggregate
profits
of
dealers,
and
served to
ness,
1.
A
longer view of dealer profit perform-
ance, from the late
1940's, reveals
move
inversely with monetary tight-
it
reached the following conclusions
a strong
cyclical pattern of earnings. This suggests that
recent low levels were not abnormally
below those of other periods at the same stage
the
a
coupon
declining
issues
volume
after
of
portunities for profits
on turnover.
the differential between longinterest rates
the
transactions
Finally, as
and short-term
narrowed with higher
rate levels,
tendency for profitable carry was mini-
in the business cycle.
mized and eventually eliminated. At
the early 1960's
ing, sufficient data are not available for a
The principal feature of
was the extended and uninter-
in
1963 led to reduced op-
this writ-
com-
—
DEALER PROFITS AND CAPITAL AVAILABILITY
plete analysis, although early reports indicate
1966, with the abrupt drop in security
that
yields late in the year,
was a very profitable
period for dealers;
fact lends support to
this
hypothesis that cyclical monetary condi-
the
have dominated the
tions
profit
performance of
when
Still,
a major rate reversal oc-
accurately.
5.
Developments
private
the
in
sector
tended to affect dealer profits adversely. The
greater mobility
and
sensitivity
of investible
funds, inherent in the growth of Federal funds
dealers.
long-term
assessing
In
3.
1950's.
curred in late 1966, dealers reacted swiftly and
of
profitability
activity
and
in the
expanded use of
certificates
dealers, the effects of innovations in financial
of deposit (CD's), contributed to a flattening
markets by public and private sectors become
increasingly important. Both sectors may have
of yield curves
contributed
most
the
to
change
notable
namely, the nature of the business cycle
The
structure
for
competed
itself.
and
to a relatively higher rate
financing
for
directly
Both uses
positions.
funds
that
otherwise
might have been available more cheaply to
well-defined and relatively short cycle of
finance dealer positions. Furthermore, the in-
been supplanted by a new pat-
creased competition of these instruments for
the 1950's has
tern, as yet
perhaps not entirely visible or iden-
short-term funds undoubtedly aggravated the
will represent
pressure on dealers to reduce quoted spreads
tifiable. If this
pattern persists,
it
a changed environment for dealer operations
Government
for short-maturity U.S.
and one to which dealers must attempt to adjust. Such a pattern may mean, for example,
that a longer period of meager returns will be
parent increase in competition
followed by a relatively short but highly profita-
ers
ble interval, with
becoming imperative
it
for
securities.
During the early 1960's, there was an aparising
from the entry
of three
among dealers
new bank deal-
and the "net" entry of one sizable nonbank
numbers may have
dealer. This expansion in
dealers to be able to identify promptly the turn-
contributed
ing point.
spreads and reduced the existing dealers' shares
One
ment
aspect of the changed cyclical environ-
was apparently harmful
that
to
broader grounds, was the
—
from
intracyclical
price
fluctuations
(through appropriate, well-timed position adjustments)
4.
It
is
may
decline.
difficult
to
measure the extent
to
which public innovation, in the broad sense of
new and evolving fiscal and monetary action
and debt management, guided the prolonged
expansion
—and
in
doing
so,
how
it
affected
and their perception of
Whether these essentially exogen-
capital
deterioration
would
Available
evidence suggests that dealers were less successful in adjusting positions in anticipation of
price changes in the
1960's than in the late
in
Insufficient
profits.
capital
to
in
is,
A
circumstance of
presumably detrimental
efficient and effective market performance
accommodating public and private opera-
insufficient
capital
is
This study found that the amount of
capital
unclear.
accommodate
to
act as a constraint
ciated with large positions.
tions.
about rate movements and thus hindered
available
on the desired expansion of positions and on the concomitant
willingness of dealers to assume the risks asso-
risks.
ous decisions reduced or increased uncertain-
would be
future market operations, in light of the past
expectations
is
of transactions.
CAPITAL
market
or helped dealer profits
on
This study also investigated whether adequate
dealer
ties
volume
of the rising
pressure
increased
stability of interest
Not only do bid-asked spreads tend to
narrow with diminished volatility of rates
making transactions less profitable but also
rates.
gains
the
dealer
though unquestionably valuable on
earnings,
to
possessed
capital
by nonbank dealers
sufficiently liquid
to satisfy
(that
margin
requirements) plus the amount of funds potentially
available to
bank dealers
is
far in excess
of any possible needs in the foreseeable future.
Estimated
minimum
capital
requirements
(for positioning daily-average gross long posi-
tions of $4.6 billion in
Of
million.
1965) were about $42
nonbank dealer
this total,
positions
"required" $29 million. These dealers reported
aggregate invested capital of $261 million in
1965 and had allocated $86 million of the
support their positions.
total to
reasonable
It is
nonbank dealers'
capital that could conceivably be employed as
margins is, at the least, considerably more than
$100 million.
Bank dealers, who accounted for approxiassume that the amount
to
of
minimum mar-
mately one-third of estimated
gin
requirements, in fact are not subject to
such capital
with
financed
are
In fact, three new banks and
two nonbank firms entered the industry. The
departures by two nonbank dealers were for
reasons unrelated to market performance. The
willingness of both old and new dealers to
commit their available capital to expand positions,
dealers.
however,
profitable
is
not a
realistic
amount
of
for the industry as a
constraint
on the ex-
trend in earnings in the early
1960's certainly had no perceptible effect on
investment except to the extent that
capital
III.
If
expected profits in U.S. Gov-
securities operations are
exceeded by
potential gains in other activities, or
if
they are
not sufficient to compensate for the risks of
making markets, dealers are unlikely
to
com-
mit capital to positioning Government securi-
pansion of positions.
The adverse
shifted readily to ac-
used to expand positions under unfavorable
capital potentially available for margining se-
whole
the
own
circumstances.
enormous and
to
employment.
ernment
is
unrelated
that provide greater opportunities for
and by
curities
largely
and mobile and may be
tivities
through borrowing in the Federal funds market
issuing CD's. In short, the
is
amount available. For both nonbank dealers
and bank dealers, such funds tend to be liquid
readily
their
may be augmented
funds. These funds
slowed the growth in capital of ex-
profits
Even if alternative uses did not exist, "dormant" capital may be less costly than capital
requirements since the bulk of
positions
their
low
isting
ties.
Nevertheless, there
is
no doubt that ample
capital will be forthcoming
justify
its
expected profits
if
utilization.
DEALER PROFIT PERFORMANCE
income on
This section describes the elements of deal-
eral dealers reported their
income and expenses and then explores
the impact of postulated relationships between
selected exogenous variables and observed
trading profits while others included
ers'
performance. The testing of these rela-
profit
tionships
and regression
both visual
utihzes
analyses.
The behavior
and
of net income and of
components
derlying
The
also in
Table
cessive
series
trading
expenses
operating
briefly.
—
—may
data, presented
1,
in
nonbank
be
un-
carry,
reviewed
Chart
1
and
are linked for the three suc-
despite
several
The Meltzer-von der Linde data
viously noted,
its
profits,
all
terest earned. In
any event,
to obtain valid estimates of
cause
of
the
by individual
to
dealers, particularly with regard
operating expenses, necessitated interpola-
tion of data for subgroups of dealers in order to
income and expense levels.
bank dealer data were
not collected at all. The industry figures shown
in Table 1 include estimates for income and
cover, as pre-
In 1964, as noted earlier,
two
series
was impossible
annual net carry
the
arrive at aggregate
operations of participating
with
with in-
entire 1948-65 interval beproblem of separating trading
profits from interest earned on bills.
For both the Meltzer—von der Linde and
Benston series, gaps in the figures submitted
throughout
discrepancies.
dealers whereas the other
it
bills
it
only the Government securities opera-
expenses of bank dealers; these estimates are
Net carry, in the Benston figures, had to
be combined with trading profits because sev-
based on nonbank dealer figures and on data
obtained informally from several dealer banks.
reflect
tions.
DEALER PROFITS AND CAPITAL AVAILABILITY
1
INCOME AND EXPENSES OF
I
I
U.S.
GOVERNMENT SECURITIES DEALERS, 1948-65
MELTZER-VON DER LINDE DATA
19571
I
I
Despite these shortcomings, certain conclu-
may be drawn from
sions
the
linked series.
First, it is evident that trading profits have
been the primary determinant of net income
and that their extreme volatility has led to
wide fluctuations in the level of net income.'
Trading
appear to move
in turn,
profits,
versely with the business cycle. Years in
in-
which
trading profits were high were generally associ-
and
with
rates,
and years of low returns with expansion
and
declining
from 1956
And
to 1965.
it
would seem
one
to
view average earnings
as
abnormally swollen as to characterize those
in
the
1961—65 period
in the earlier 5 years
as unusually poor.
THE INCOME EQUATION
Broadly
speaking,
net
the
income,
before
accruing to dealers from Government
interest
Furthermore, in years when
were low the industry as a
if
as valid
operations
securities
and
represents
sum
the
of
minus
operating
expenses.'' In order to identify the
exogenous
trading
profits
carry
rising rates.
trading
profits
whole often sustained net losses, as in 1950,
1955, 1965, and perhaps in 1948 and 1956 if
profits
for
Government
securities
operations
alone are considered.
Second, profits in the peak years
1958, and
1960
—appear
as a
— 1957,
hump
in
the
earnings picture rather than as the culmination
and subsequently reversed
misleading to compare
and contrast profits in only the two halves of
of
1
;
uses the 5-year periods,
taxes,
ated
recessions
the 10 years
!9591
a
trend.
well-defined
Thus
it
may be
• Data
on the relative contributions of capital
gains or losses and spreads ("turnaround" prices) to
these swings in trading profits are not available.
However, the behavior of these two components
be examined later.
will
variables that influence dealer earnings
and
to
diagnose their effect on earnings over the past
decade, the elements of income and expense
can be viewed as the products of independent,
or possibly interdependent, components.
Trading
profits, the
primary element of net
income, are the sum of differences between the
purchase and sale price of each security sold.
The purchase-sale
split
conceptually
price
into
differential
two
facets:
can
(1)
be
the
spread, which represents the bid-offer quotations at
which a dealer would simultaneously
Hereinafter, the terms "dealer" and "dealer function" refer only to the Government securities opera"'
tions of participating firms.
86
TABLE
1:
INCOME AND EXPENSES OF
SECURITIES DEALERS, 1948-65
U.S.
GOVERNMENT
DEALER PROFITS AND CAPITAL AVAILABILITY
= number of bonds sold
= p.t - p., -I
= price at end of period
Si,
i^Pit
Pi,
bond
coupon on
=
= number
Ci,
Pit-i
period
/
in period
ined
/,
in dollars
per
=
F=
V =
net of gross long and
borrowed
on
rate
funds borrowed during period
constant
ex-
1960's the
number
bill
of dealers
as short-term investment instruments
was
U.S.
supply
Government
elasticities in
securities,
the market for
thereby narrowing
spreads.
of
risks
making
markets.
Quoted
1950 are presented in Table 2. It is
bill spreads narrowed throughout
the late 1950's and continued to decline in the
early 1960's while spreads on coupon securities exhibited mixed behavior. It should be
since
noted that the spreads recorded here are an-
nounced quotations,
which
may
vary
to
a
greater or lesser degree from the actual or inside spreads at
which trades are effected. The
between announced
possibility of a discrepancy
inside spreads increases as spreads widen,
do
in the case of longer-term issues.
and carry
rates were prephenomena, the
long-term profitability of Government securities dealers would depend in great measure on
the behavior of spreads. Although much de-
price changes
to be primarily cyclical
tailed empirical analysis
is
dealers for
of these
evident that
sumed
CD's
mand and
variable
representing
spreads for several maturity categories of secu-
If
among
developments should have increased the de-
/
fixed expenses
diary broker service and a reward for assum-
and
both to the
vastly expanded. Theoretically, both of these
/
Spread. The bid-asked spread encompasses
as they
refers
increased and the use of Federal funds and
funds
both compensation for performing the interme-
rities
case,
spreads in the
1,
TRADING PROFITS
the
this
of alternative instruments and
—
components can now be investigated separately in measuring the impact
of changing exogenous variables.
ing
Competition, in
is examon operating expenses.
of variable costs
to the degree of competition
/th issue, in dollars
penses
Each
section
business. Coincident with the narrowing of
interest
total
the
of bonds held at the end of
during period
Bit
in
substitutability
short positions in the /th issue
=
b,
The behavior
costs.
/
remains to be done,
it
possible to suggest several factors that influ-
ence the width of security spreads.
Intuitively
component
one
would
expect
the
service
of spread to vary inversely with the
degree of competition and the level of variable
2: SPREAD BETWEEN DEALERS' QUOTED
AND ASKED PRICES ON U.S. GOVERNMENT
TABLE
BID
SECURITIES, 1950-65
2
CHANGES
IN
TREASURY
BILL RATES, 1948-66
I
'58
—Changes
Federal Reserve
derived
I
I
rages
f
I
I
of
daily
volume
undertaken
for each category; this exercise
is
spread quotations
is
making
and
markets
influencing the width of
the
associated with
risk
maintaining
positions
under conditions of potential price decline and
capital loss. Although risk cannot be measured
it
should be reflected
in the volatility
of the short-run rate or in price changes over
time.
Chart 2 shows the pattern of rate
3-month bills.
dropped considerably
ity for
with the late
1950's.
It
in
is
volatil-
clear that volatility
1961-65 compared
The primary
reduced price fluctuation should be
effect
to
of
lower
the risks inherent in positioning securities and
therefore
I
as
I
to
spread. This
contract the risk
would depress
daily-average rates on 3-month
component
profitability,
of
even
from 1948 to 1950 when the Federal Reserve
was pegging interest rates. Indeed, bill spreads
were widest in the years immediately following
removal of the pegs. (Reduced volatility in the
1960"s is also evident in Appendix Tables 6
and 7 of the Ahearn-Peskin study; these tables
record the frequency of large and small daily
price changes.)
In examining the financial environment of
the 1960's, Ettin concludes that
stability
to
in
the
dealers, the reason for
early
1960's
movements by
tion
with "operation twist."
It
is
As
.
.
more
the Treasury and Federal
contributed
'
".
ag-
response to short-run rate
to
a
greater
stability
Reof
evidence, he notes the increased
Reserve
in the 1960's
—which had
the effect of
was the
greater control of interest rates exerted by the
Open Market Committee
flexible
use of repurchase agreements by the Federal
might be zero.
many
and
gressive
yields."
According
in
declined
when the program was iniand that they remained relatively stable
through most of 1965. The only period of commensurate stability shown on the chart was
the actual net price change for periods of either
stability or instability
bills
tiated,
serve
Federal
the
in
Chart 2 that month-to-month fluctuations
though the expected value of price changes or
rate
|
published
sharply in 1961,
in the next section.
The second element
directly,
I
figures
Biilleiin.
evaluated only in the context of the trend in
sales
'64
'62
'60
I
Note.
in conjunc-
evident in
Edward C.
vii-onment
of
Government
p. 22.
Ettin,
the
"Financial and Economic Enin Relation to the U.S.
1960's
Securities Market," Part 2 of this series,
DEALER PROFITS AND CAPITAL AVAILABILITY
eliminating
sharp
short-term
pressures
89
stem-
—
ming from outright purchases and sales and
the greater care taken by the Treasury in the
pattern and timing of its actions.
At the same time, Ettin attributes a good
portion of the stability
short-term rates dur-
in
ing the period to events and innovations in the
private sector.
Most important was
and balanced growth
in
the steady
output with relatively
constant prices and costs, which led to expec-
would be stable. In
expanded use of Federal
the risks associated with short-term rate
move-
ments. The circumstance of balanced growth
and of expectations that
rates
would be steady
could well have dominated rate changes in the
1960's. Needless to say, this situation
be permanent.
If
not,
the
may
reduction in
which implies lower spreads and
profits,
not
risk,
would
be only transitory.
Transactions." Linked to spread in the inis the volume of sales. Ceteris
come equation
tations that interest rates
paribus, profits should be positively related to
addition, substantially
sales
funds and of CD's as short-term instruments
raised the elasticities of supply
Treasury
securities,
tending
and demand for
smooth out
to
short-run imbalances between the two.
Whether behavior
tributed
more
in the public sector
to
be
seen.
—assuming
short-term stability to be a continuing goal of
—and
policy
the
increase
in
mobility
the
of
funds and the substitutability of instruments in
the
private sector should permanently lower
3
however,
the
of
interplay
spreads and of sales in various ma-
turity categories complicates the
measurement
of each component. Spreads were observed to
bills
but widened for some
longer-term coupon issues; on the other hand,
sales
climbed steeply for
bills
but behaved er-
The
increased sensitivity of the Treasury and the
Federal Reserve to rate volatility
in
have declined for
con-
to rate stability than behavior in
the private sector remains
volume;
changes
^ The data on dealer transactions and positions are
those utilized in other papers prepared for this study,
and they are subject to the same qualifications. Of
particular importance are the revisions of reporting
procedures and coverage in 1960, which essentially
preclude detailed interperiod ( 1950's versus 1960's)
comparisons of transactions and position effects on
profits.
SPREAD PROFITS ON
GOVERNMENT
U.S.
SECURITIES, 1955-65
I
MATURITY CATEGORY (YEARS)
TREASURY
BILLS
1959
i5i:.;
.
1965
1
I
Note.
—Spread
pi
Dealer
bid
iked qu
actions (Table 3), inflated to a gr
iroduct
were computed
annual basis.
lies
>
and
.'I
kule-half
iht-
of
dilkiLtiee between
d.ulN-average trans-
go
TABLE
DEALERS' DAILY-AVERAGE GROSS TRANSACTIONS
GOVERNMENT SECURITIES BY MATURITY CATEGORY,
3:
IN U.S.
1955-65
In millions of dollars
Year
DEALER PROFITS AND CAPITAL AVAILABILITY
From 1963
1963.
1965, total sales of cou-
to
pon issues fell 20 per cent.
The decline in spread profits after 1962
clearly depressed dealer income in 1964 and
1965. At the same time, one can hardly con-
growth
contingent not only on
is
but also on debt
lion
the
rise
management
Treasury
in
1955-65 period
bills
fiscal
policy.
policy
$1
bil-
outstanding during
$20 million
led to a
in daily-average transactions in bills,
coupon
A
rise
whereas a
clude from the foregoing analysis that gross
$1 billion rise in
spread profits contributed significantly to the
an expansion of only $3 million to $4 million
reduced
level of net
income
the preceding 5
to
tive
1961-65 relaNot only did
in
years.
spread profits reach a peak
in
1962, but also
1961-65
the average level of spread profits for
was $4
million, or nearly 5 per cent,
above the
earlier 5-year period.
Furthermore,
spread
profits
on
Federal
agency securities were undoubtedly higher
in
owing to expanded sales.
Dealer sales of agency securities generally paralleled the trend in issues outstanding, which
grew from $2.9 billion in 1955 to $7.9 billion
the
in
later
period
1960 and $13.8
billion
in
1965.
Dealer
doubled in the
Although narrower
spreads did offset much of the 150 per cent
expansion in bill volume from 1955 to 1965,
spread profits on bills were a minor component of the total. Had spreads been the same
in 1965 as in 1960 (the peak year for net income), spread profits on bills would have been
of
agency
securities
1960-65
period
alone.
sales
increased by only $7 million, a small incre-
ment
in total
spread
profits.
Future growth in spread
profits will
depend,
on the trends in spreads and in sales
of U.S. Government securities. Increased competition from other money market instruments
and from additional dealers is likely to remain.
On the other hand, rate volatility, which has
been somewhat greater since late 1965, is difof course,
ficult
to
predict.
The
stability
so evident in
in trading in
coupon
securities stimulated
issues.
Nevertheless, before concluding that growth
volume of short-term issues outstanding
more than a similar growth
in coupon issues, differences in the profitability
of sales in various maturity classes must be
in the
will benefit dealers
considered, along with the effect of debt increases in each class on spreads themselves. In
1962, for example, a sharp increase in outstanding 5- to 10-year issues
in
enhanced spread
profits.
ever, this expansion
is
initially resulted
Subsequently, how-
believed to have led to
narrower spreads due to the greater availability
or liquidity of these securities.
Sales volume, particularly in longer-term securities,
also varies inversely with the degree
monetary tightness. In the early 1960's,
coupon sales turned down in all maturity categories except issues with maturities of over 20
of
^''
years;
from
1963 to
when
1965,
interest
coupon issues
declined almost 20 per cent. In late 1966 and
early 1967, when interest rates turned down,
sales of such issues expanded appreciably
rates
were
total sales of
rising,
above the average
level of the
preceding 2V^
years.
Price (rate) changes; positions. The sec-
ond and by
far
trading profits
is
more
component
volatile
the gain
of
or loss associated
with price changes of securities held in position.
These changes are a function of ecoactivity and monetary policy and are
was based on a peculiar combination of public and private factors,
any or all of which may change considerably.
Sales volume is a function primarily of the
level and maturity composition of outstanding
nomic
marketable debt.^' Since the turnover of secu-
dealer positions, and the success of dealers in
rates in the early 1960's
rities
(dealers sales/debt outstanding)
dimin-
ishes as the time to maturity lengthens, sales
See Ahearn-Peskin, Part 2 of
this series.
accepted as part of the dealers' environment.
Trading
profits
vary
directly
changes and depend on the
such
changes,
the
anticipating price
The
size
size
with
price
and rapidity of
and composition of
movements.
close relationship between rate changes
1^ Sales of Federal agency securities rose in every
year from 1960 to 1965.
92
TRADING PROFITS PLUS NET CARRY,
y,
I
T-
AND CHANGE
BILL RATE, 1948-65
TREASURY
IN
CHANGE
IN BILL
RAT
llnverted scale)
Note —For
bill
rate
drsc
average
is
lining
Decemlie
midyear for compa
and dealer revenues is apparent in Chart 4,
which presents annual changes in the 3-month
(plotted inversely) and the annual
bill rate
level
trading profits plus carry.
of
when movements
—
the
in
bill
rate
In years
reversed
by a moveminus or vice versa the
level of gross profits changed in accordance
with the rate movements as plotted. For all
other years (except 1958), when the bill rate
continued to change in the same direction as
in the prior year (as for example in 1954), the
"wrong" movement in gross profits can be attributed largely to a rebound effect, since capital gains and losses were not cumulative from
direction
as indicated in the chart
ment from
—
plus to
The
tions.
tal
and extent of price movements and
ing positions appropriately.
the market,
als in
and flow of
rates in
some years modified
In
relationship.
profits
undoubtedly derived
long-term
the observed rate/
1962 the
profits
in
rise in gross
in part
from
falling
long-term rates over the year.
The
tions
size
and the composition of dealer posi-
determine the impact of a given price
change on trading
ticularly in
profits.
Large positions, par-
long-term coupon securities, will
naturally affect profits
more than small
posi-
in fact the
mechanism
may be
ex-
prices.
The year 1958
how
dealers
offers
a clear example of
were able to
profit
by making
timely adjustments in their positions during a
sharp intraycar change in securities prices. In
that year trading profits soared despite a sharp
rise in
bond
positions
movements
in adjust-
the profession-
pected to do better than break even in the ebb
change was usually diminished. Of course, the
of
and
As
for effecting price changes, dealers
in
and direction
on positions depends on the
success of dealers in anticipating the direction
year to year and the magnitude of the rate
size
net contribution to profits of capi-
gains or losses
bill
rates.
and a very small net decline
Table 4 presents average daily
rates
for all dealers in each quarter of
1958 along with changes in bill and long-term
bond rates; it also shows trading profits plus
nonbank dealers. In the first half
nonbank dealers had trading profits plus carry of $36.1 milhon, compared with
$6.4 million in the second half. With estimated
operating expenses of about $17 million for
carry for
all
of the year,
the year as a whole,
it
is
apparent that non-
bank dealers as a group suffered net losses in
the third and fourth quarters. Yet, they were
DEALER PROFITS AND CAPITAL AVAILABILITY
able to post the second highest annual net in-
come in the entire 1948-65 period.
The emergence of an apparently new pattern of economic expansion
one that is much
—
longer than the pattern of the 1950's and that
is
followed by short, sharp retrenchments in in-
terest rates
dealers.
—has
altered the flow of profits to
The implied
indeterminate.
Less
would tend
facie,
effect
on earnings
frequent
to indicate a
cycles,
drop
is
still
prima
in long-
same time magnify the importance of catching the peaks and
troughs in rate movements. Greater control of
economic growth should also imply decreased
amplitude in rate movements; this in turn, determ profitability and
spite
at the
the abihty of dealers to adjust relative
positions correctly at alternate
business cycle, would
opportunities.^''
factors
and
is
stages
of the
mean diminished
earning
Potentially
the extent to
contract
positions,
these
offsetting
which dealers expand
particularly
in
the
longer-maturity categories, and the timing of
these changes.
TABLE
4:
NET POSITIONS
GOVERNMENT
AND TRADING
IN U.S.
SECURITIES, RATE CHANGES,
PROFITS PLUS NET CARRY, QUARTERLY 1958
94
YIELDS ON
U.S.
GOVERNMENT SECURITIES COMPARED WITH
DEALER BORROWING COSTS, 1960-65
REPURCHASE AGREEMENTS
H^HL'^^^
Note.
— Borrowing
were selected from special reports
rates
submitted by several nonbank dealers and are believed to be
representative of all borrowing costs of nonbank dealers. Rates
on repurchase agreements represent the cost of short-term
borrowing from sources other than New York City banks.
"All borrowing" is the over-all cost of financing reported by
should
these
be
with rates on
bank dealers have
associated
closely
Indeed,
substitutes.
one dealer; over-all financing costs of other dealers may vary
slightly, depending on the particular mix of borrowing from
New York City banks and other sources. Treasury bill rates
are monthly averages of daily rates on the outstanding bill
closest
to a 3-month maturity; rate on U.S. Government
long-term bonds, from Federal Reserve Bulletin.
and longer-term bond
suitable
typically applied the Federal funds or the 3-
ability
month
in
computing the cost of
bill rate in
inter-
rates should provide
proxy for tracing relative carry
a
profit-
over time. Such differences are plotted
Chart
6.
In general, the carry differential
ent types of dealer financing, as reported by
and
widened
during
recessions
(1958,
1960-61) when interest rate levels were low,
and narrowed as rates rose." (During boom
periods the 3- to 5-year rate had a tendency to
rise above the long-term rate, making interme-
3-
diate-term issues relatively less costly to posi-
funds used.
nal
part,
Nonbank
have also financed securities
costs approximate to these
as
shown
in
Chart
month bill rate and
Government bonds.
at interest
money market
5. Interest
selected dealers, are
their
for
dealers,
rates,
costs for differ-
shown along with the
the rate on long-term U.S.
net
In the absence of actual data on net carry,
the difference between the
tion.)
3-month
bill
rate
Thus,
carry
" Most
flected
it
is
evident that the behavior of
over the past decade has usually
of the fluctuation in the differentials re-
changes
in rates
on 3-month
bills.
DEALER PROFITS AND CAPITAL AVAILABILITY
compounded
profits.-"
declined,
In
it is
the impact of changing prices
1961,
when
prices
of
on
securities
estimated that a large part of net
—
economic expansion the
tened. On the assumption
occurred in
yield curve
period,
this
had
flat-
that a similar pattern
is
it
impossible
to
income perhaps $3 million out of total net
income of $6 million represented profits on
carry. In most other boom years, however,
such as 1956, 1957, and 1965, it is likely that
help or hinder earnings depends on whether
aggravated already di-
financing costs are higher or lower than se-
negative carry profits
—
minished levels of trading profits and net
in-
in supplies of bills versus longer-term issues.
Whether
position
curity yields.
potential for profitable carry declined
from 1961 to 1965 as the Treasury
and the Federal Reserve worked jointly to in-
steadily
crease the relative supply of
to induce higher yields,
bills, in
and
to
an attempt
decrease the
relative supply of longer-term securities, with
an attendant lowering of
should be noted that
in
yields.
However,
it
previous periods of
-"In 1961, when the difference between short- and
long-term rates was quite large, net profits from
carry were estimated to have been about $3 million.
This estimate was based on average annual interest
rates and on net dealer positions for several maturity
categories of securities, with the assumption that
carrying costs were equal to the 6-month bill rate.
to
turities
and
size
composition
Although there may have been
some tendency
come.
The
assess accurately the relative impact of changes
for positions
vary
yield differential,
with
the
in
sign
different
of
the
macost-
Ahearn-Peskin found neither
strong nor consistent relationships of the type
to
be expected.
tory
It
is
probable that the inven-
and expectations about prices
outweighed considerations with regard
motive
largely
to carry.
The
fact that significant relationships
were found between short positions and carry
suggests that dealers may have preferred to use
short sales to
meet customer needs rather than
to hold securities with negative carry.-'
-^ This
observed relationship may be spurious,
however, since short sales may be more directly related to the behavior of interest rates.
ESTIMATES OF CARRY PROFITS ON SELECTED MATURITIES OF
U.S. GOVERNMENT BONDS, 1955-65
Note.— Rates on U.S. Government ^rcuntius
Federal Reserve BiiUeim. The J-monih bill rale
financing dealers' positions.
pru.\y tor the rate charged for
'
Dealer profits (or losses) from carry also depend on the type and source of borrowed
funds. Referring again to Chart 5, the cost of
repurchase agreements, such as those made
with corporations, was noticeably lower than
bank
the rate paid for
loans,
Among bank
loans.
charged by "out-of-town" banks
rates
during most of the late 1950's were Vt. point
New York City banks.
or more below those of
These
differentials,
narrowed sub-
however,
stantially during the early 1960's;
much
of the
shrinkage has been attributed to the broader
use of competing instruments, notably Federal
funds and CD's. Greater mobility of bank reserves has meant that rates on out-of-town
bank funds have become more sensitive to,
and thus have moved closer to, rates prevailing
at New York banks. Likewise, the development of CD's, which can be tailored to meet
needs and which have rates
above those on short-term bills, has vireliminated the advantageous position
nonbank dealers, and five small nonbank dealers are shown in Table 5.
From 1958 to 1963, the operations of the
large nonbank dealers were generally the most
profitable of the three groups, and this group
five large
had the greatest consistency in performance.
Not until 1965 did a large dealer incur a loss
in its Government securities operations. Small
nonbank dealers, nevertheless, were not far behind in 1960-61, and in 1962, 1964, and
1965
not more so, but that at the same time
firms,
if
small
dealers
have been more vulnerable to
changing conditions. One important source of
enhanced profitability has presumably
the
been
agency
had been held by dealer repurchase agreements as an outlet for short-term funds.
From an
dealers.
been as profitable per unit of sales as large
slightly
that
nonbank
examination of individual dealer performance,
1960 small dealers have
it appears that since
specific corporate
tually
earnings per unit exceeded
gross
their
those of the larger
increasing
the
activity
in
proportion
total
of
Federal
of
transactions
the
smaller firms.
Per-unit
gross
earnings
of
bank
behind those of nonbank
lagged
every year.
This
result,
dealers
dealers
in
and differences be-
TRENDS
IN TRADING PROFITS PLUS
CARRY, BY TYPE AND SIZE
tween the large and small nonbank dealers,
does not necessarily imply varying levels of ef-
OF DEALER
ficiency
order to evaluate differences in performance among dealers, figures for trading profits
In
plus carry were deflated
by gross annual
sales
for three dealer groups in each of the years
1958-65. The
results
for
five
bank
dealers.
:
.
,
Range: Higli
nonbank dealers:
Weighted average
Unweighted average
Range High
ive large
:
Low
'ive
small nonbank dealers:
Weighted average
Unweighted average
Range: High.
Low
1
Interest expense based
i
;
on Federal funds.
expertise.
Bank
their
rather,
dealers,
activity
in
the
bill
market, where profits per unit of sales are lowest.
However, because
correspondingly
tions,
TABLE 5: TRADING PROFITS PLUS CARRY PER MILLION
DOLLARS OF SALES, 1958-65, BY DEALER GROUPS
Five bank dealers
Weighted average.
Unweigiited average.
or
concentrated
have
it
is
bill
less capital
impossible
to
positions
require
than coupon posi-
determine
which
DEALER PROFITS AND CAPITAL AVAILABILITY
TABLE 6: RATIOS OF SELECTED INCOME AND
EXPENSE ITEMS TO GROSS SALES, BY
DEALER GROUPS, 1964-65
In dollars per million dollars of gross
s;ilcs
97
may be
misleading. In
in transactions
bills
—
entirely
tlie
first
place, growth
term operating expenses
has been mainly in Treasury
so
since
1960
—where
gate
sales.
—
Of
derive
increases in salary expenses pre-
course,
it
is
related
petitively sustainable;
TABLE
U.S.
7:
if
from certain operating economies
in-
bank
activities.
fivg
large
-' Data for individual dealers are not shown. In
1964 and 1965, 7 and 9 of 12 nonbank dealers, respectively, had operating expenses between $73 and
$105 per million dollars of sales.
com-
OPERATING EXPENSES PER MILLION DOLLARS OF SALES,
1948-65
for
nonbank dealers averaged $90 and $95 in
1964 and 1965, respectively, whereas corre-
not, the trend in long-
GOVERNMENT SECURITIES DEALERS,
nonbank dealers
Unit operating expenses of the
a matter of conjecture
levels are
of
herent in sharing overhead expenses with other
sumably derived from profit-oriented bonuses.
Were this the case, the relatively low level of
costs per unit of sales in the 1960's may have
been achieved largely at the expense of bowhether these salary and wage
been
of unit expenses reported
expenses are closely related to net income. In
nuses.
aggre-
years.-"'
indicates that per-unit operating
most years when profits rose
1949, 1953,
1957, 1958, and 1960
operating expenses
(per unit) advanced also, paced primarily by
The
the
—has
The lower (weighted) average level
by bank dealers for
their Government securities operations in 1965
($77 versus $96 for nonbank dealers) may
Second, a comparison of figures in Table 7
salaries.
in
sales
1964 and 1965 showed virtually no year-to-year
change (Table 6). Moreover, the expense
variations among dealers were small in both
portion of over-all spread profits per unit of
—
—both
of
unit
The expense data
spread profits are lowest. In this sense, per-
1
per
understated.
gross
unit fixed expenses have increased as a pro-
and Table
and
'
:
DEALER PROFITS AND CAPITAL AVAILABILITY
spending costs for the
were $166 and
five
99
small nonbank deal-
The
$165.-''
forth earlier in that:
large differ-
rather
ences in both years between the two groups of
profits
ers
nonbank
bank
may
dealers
economies of
be explained in part by
diversification,
suggested for
as
on balance the large dealers were considerably more diversified. Such a
finding would have important implications for
dealer profitability over the long term, as would
dealers, since
economies of scale with
volume of transactions.
Rank correlation analysis was employed
signs of
definite
re-
to
terms of both
and changes (from 1964 to 1965) in
transactions and unit operating expenses, but
no significant relationships were found. This
result casts considerable doubt on the meanlevels
may have
these differences
from the
sales
large part of
in effect
stemmed
"denominator," wherein varying
mixes produced dissimilar unit expenses.
The two
in
sales
A
dealers with the highest unit expenses
1965, for example, also had the highest ra-
tios of
agency transactions to
and both were small
total transactions
dealers.
REGRESSION RESULTS
deals with gross
it
before
taxes,
(2)
from trading and carry are lumped together as the dependent variable, and (3)
gross earnings are deflated by sales.-"
A
gross earnings concept was substituted for
income because of the unreliability and incompleteness of monthly data on operating expenses. In view of the problems that dealers
net
encountered in preparing the annual reports
Statistics Division for
1964 and 1965, it is doubtful that the dealers
were able to allocate to their Government seoperations
curities
fittle
more than
clearing
charges on a monthly basis. In addition, two
nonbank dealers submitted no expense data
at
all.
The dependent
ingfulness of the described cost differences be-
tween large and small dealers.
(1)
earnings
net
submitted to the Market
spect to the
test for the latter relationship, in
than
ported
trading
some dealers
—
variable
carry,
since
—reported
noted earlier
as
income) from
gregate
both re-
includes
and net
profits
bills
whereas others included
it
as
ag-
trading profits
with interest earned.
Total trading profits plus carry was deflated by
monthly
nonbank
sales of all
dealers to elimi-
nate the effects of market growth and bring out
more
ment
securities operations.
able
(A'li)
specifically
is
the
profitability
of
Govern-
The dependent
vari-
expressed as dollars of trading
Multiple regression analysis was employed to
profits plus carry per million dollars of sales.
estimate the relative importance of the con-
The
tributing
tion.
It
components
in the net
income equa-
should be noted that the observed reare
lationships
although
positions
with
—
it
is
in
terms
certain
of
realized
variables
—
Xi
particularly
the dealers' adjustments to ex-
and the resultant discrepancy between expected and realized profits that should
be of major concern.
Equations were estimated by using the
monthly data on dealer earnings furnished for
the Benston study. These data encompass the
6 years 1958-63 and thus were conveniently
divisible into two subintervals, which more or
less coincided with the two broad periods
under investigation. The general model tested
here differs basically from the equation set
Unweighted averages were used
to lessen the bias of
extreme values.
in this
instance
variables
were
tested
as
Spread
1.
profits,
— Quoted
bid-asked spread on 3-month
bills
Transactions
2.
pectations
-''
independent
follows
X-,
— Sales,
all securities,
nonbank dealers
— transactions, dealers
dealers
Xi — Coupon transactions,
X3
Bill
all
all
Rates and rate changes
3.
A's
— Change
end-of-month. 3-month
in
bill
rate
Xr,
— Change
in
long-term
bond
rate
(Federal Reserve series)
X:
— Change
in
preceding
Xs
-
— 3-month
bill
rate,
last
3
days of
month
bill
rate
Only nonbank dealer data were used since bank
dealers submitted no figures on interest expense.
100
— positions, dealers
dealers
Xio — Coupon positions,
dealers
Xn— Total positions,
X^
Bill
the preceding
cluded.
Others
1960 data
variable for
re-
— Dummy
all,
same
of the
independent variables. Differences in specificaentailed
mainly alternative
transactions,
and rate differential or level variaowing to substantial multicollinearity
positions,
variables. Five representative equations
are presented
Appendix Table
in
earlier subperiod, observations
3.
In
the
were used only
through April 1960 because of the discontinuity
data created by reporting revisions
in the
in the following
month.
Rate changes. Interest-rate-change
—
varia-
proxy for realized changes in the
proved to have the greatest
value of positions
impact on monthly trading profits plus carry.
Two such variables were employed in every
bles
the
—
equation
change
—
in
month-end
month-end
to
the 3-month Treasury bill rate (Z,,)
the
and the change
in the
monthly-average level of
long-term U.S. Government bond rates
(A",;),
using the Federal Reserve series on Govern-
ment bond
highly
These two series were not
and each contributed
yields.
intercorrelated
substantially to the total explained variation.
Experimentation
variables
with
indicated
various
that
this
rate-change
particular
pair
yielded the best results.
A
the 1958-April
1960 period and for the
full
6
ently larger than the bill coefficient (Zn), often
— 1958-63,
same dependent variable and many
bles,
therefore in-
proved to be highly significant for
1958-April
months when
for
1960, and 1961-63. The equations used the
among
rate over the last 3 days of
17 equations were estimated for each
of three time periods
tion
It
bill
month {X-) was
Several tentative observations may be drawn
from the examination of the rate-change coefficients. The bond coefficient {X,0 was consist-
variable
there were advance refundings
In
month-end would
The change
years 1958-63.
vision
X\-i
3-month
in the
all
Xn — Dummy
at
lead to unrealized gains or losses.
all
all
5.
changes that occur
rate
Positions
4.
third rate-change variable
was used con-
currently, but for a slightly different purpose.
Dealers, in calculating monthly income figures
for the Benston series,
may
not have included
the unrealized appreciation or depreciation on
month-end positions. Such gains or losses
would usually be realized in the succeeding
month. On the assumption that dealers turn
over their positions every few days, only those
by a factor of two or more. Changes in bond
were undoubtedly more representative of
broad changes in security yields than were variations in the bill rate, and given changes in
long-term yields have a greater effect on prices.
Second, the rate-change coefficients were al-
rates
ways larger
in the early 1960"s than in the late
1950's. This suggests that dealers carried larger
positions
relative
to
transactions in the later
period.
Spread.'^
The spread on Treasury
bills
{Xi) was positively related to gross earnings
in all periods tested, although the coefficients
were significant only for regressions covering
the full 6 years
and were much smaller than
the rate-change coefficients. Despite the impor-
tance over the long run of spread profits to
dealer income, there are several reasons
why
two results might be expected. First, the
spread on bills may not have been a valid
proxy for all spreads; for example, whereas
bill spreads narrowed throughout much of the
these
-^
The
variable serving as a measure of spread
bid-asked differential on the new 3-month
bill, as reported by the Securities Department of the
Federal Reserve Bank of New York in its "Composite Closing Quotations" for the Thursday following
was
the
each new auction. Spreads on bills were typically
smaller during the week of auction than in succeeding weeks. The new 91-day bill, for example, might
have had a 3-basis-point spread on Thursday while
the 84-day bill (issued the previous week) had a
quoted 6-point spread, reflecting in part the greater
dispersion and scarcity of the latter issue. The Thursday quoted spread on the new 3-month bill was
considered
more
more
sensitive to
representative
of
actual
changing competitive and
spreads,
risk
con-
and less a function of scarcity than bills that
had been fully digested in the market. The monthly
spread figure is an arithmetic average of Thursday
ditions,
figures.
DEALER PROFITS AND CAPITAL AVAILABILITY
1955-65
issues
Because
selecting a meaningful
the
of
coupon
difficulty
in
for the
—
—
underestimation of spread influence relative to
spread
in interest rates.-''
between
itself.'' Our hypothesis was that tradvolume is inversely related to spread, since
higher volume enhances liquidity in the market
and therefore reduces the risk element in the
variable
spread.
The
riods,
initial
the
runs,
significantly
(X..)
is
more
sions, the bill rate
(X^) was substituted for the
rate differential, representing not only carry but
general monetary conditions as well. Occasionally the results
were
significant,
and they had
the expected sign; however, the variable contributed very
little
to the explanatory
power
of
the set of independent variables.
Transactions. To estimate the effect of
trading volume on profitability, trading profits
plus
carry per
unit
of sales
were regressed
pe-
so for the 6-year and the
bill
likely
stemmed from
The dependent
types.
rate, the rate-spread variable was found
be highly correlated with the 3-month bill
rate itself. Hence, in the final set of regres-
transactions
in all three
The
coefficients for total
transactions
difficult to assess the validity of the
bond
to
and
coupon
for
be positive
3-year intervals.
composition
Federal
the
yields of long-term
to
(X,) were
found to be negative and significant in the
same periods. With these mixed results, it is
sales
It
pilot regression
coefficient
(X,) was found
Reserve series
bonds and the 3-month
bill rate was tested as a proxy for net carry.
The variable coefficients were never significant
and occasionally had the wrong sign. Furthermore, because of the relative stability of the
on
With gross
ing
monthly data as opposed to,
annual data
has undoubtedly led to an
Carry rates. In
dealers.'"'
ables might be expected to reflect changes in
The second reason may be the lack of
month-to-month variation of bill spreads,
particularly in the 1961-63 period. (Quoted
coupon spreads varied even less.) As a result,
much of the importance of spread contributions to income may have shown up in the
constant terms, which were typically similar in
magnitude to the rate-change coefficients. In
changes
nonbank
of
bid-asked spreads not picked up by the spread
were not segregated, a variable
coupon spread was not introduced.
say,
sales
earnings already deflated by sales, these vari-
and for coupon
bills
issues
addition, use of
total
proxy and of the fact
trading profits for
that
some
on
spreads
period,
widened.
101
that
the
hypothesis.
observed
effect
the nature of the data involved.
variable incorporates profits on,
and transactions in, both bills and coupon securities. Because transactions are considerably
more profitable for coupon issues than for bills,
the
dependent variable should vary with the
of total sales between the two
The differential effect of composition
changes on the numerator and denominator of
the dependent variable, therefore, may well
have produced the particular regression
at hand.
A dummy
months
variable
(A',,,)
results
was introduced for
which advance refundings occurred in the 1958-63 period. The coefficient
was consistently positive and significant for rethe 8
in
gressions covering the 6-year period but neither consistently positive nor significant for the
1961-63 interval in which six refundings were
conducted. Inasmuch as activity in coupon is-
against three variables for transactions
(pur-
sues
increased
chases plus sales):
deal-
when
there were refundings, higher profits per
ers,
bill
transactions of
coupon transactions
of
all
all
dealers,
and
substantially
unit of total sales might be expected
basis of the foregoing argument.
On
a monthly basis, interest rates fluctuated
more widely than did quoted spreads. Were annual
data used, the relative magnitude of spread changes
would increase while the gains and losses associated
with monthly rate changes would cancel out to some
degree. The annual "net" of monthly changes in
trading profits plus carry would therefore be more
-'-'
sensitive to variations in spread.
months
during
the coefficients for the
The
on the
fact that
1961-63 period were
"' It
was necessary to use total sales for the latter
group because no breakdowns between bills and coupon issues were readily available for either transactions or sales.
•" Shortcomings
in the spread variable
cussed under "Spread" beginning on p. 100.
are
dis-
were positive
not significantly different from zero suggests,
ever, both coefficients
assuming that the number of refunding obser-
1950's (1958-April 1960) and negative in the
vations
coupon
was not inadequate, that spreads on
issues were lower during refunding
(1961-63).
1960's
early
spreads between
(New York
months.
in the late
Examination of
at banks
dealer loan rates
and out-of-town) suggests
City
were
inserted alternately with the bill rate (X^) as
proxies for net carry profits, on the assumption
that the average excess of these over the 3-
that all capital gain or loss effects associated
at that time. In light of these results, there is
with position levels had been removed by the
strong likelihood that coefficients in the two
Positions.
Dealer-position
variables
month
riod,
variables.''The results were
mixed and generally insignificant. The bill coefficient (X.,) was negative and the coupon
coefficient (Xio) was positive for the 6-year
rate-change
bill
rate
was greater
in the earlier pe-
implying a higher negative carry on
subintervals
may have
and
a
been influenced
in fact
by factors other than relative
capital gains
bills
rates,
such as
losses associated with posi-
tion levels.^'
period, as might be expected, with a positively
At the same
sloping yield curve. ^^
time,
how-
ss Although the 3-month bill rate was
used as a
proxy for financing costs in the discussion of net
carry, financing costs have typically exceeded that
rate. See footnote 20.
'* Revisions
in data coverage and reporting procedures may also have aff'ected the results.
s'
Position data were for all dealers since nonbank
were not readily available for
1958-60.
33 This note appears in opposite column.
dealer figures alone
IV.
DEALER CAPITAL: CAPACITY
IN
THE INDUSTRY
study refers
The only
to shareholder or partnership equity in a firm
bank dealer
The term
—
that
is,
"capital"
used
net worth.
in
this
Net worth
ployed as a base for calculating
is
also
assumed
is
measure
to function as a
and constraint on, a
em-
often
profitability. It
firm's ability to
of,
borrow.
historical data available for
non-
capital are those for aggregate net
worth; therefore, in the subsequent analysis of
trends in invested capital over the past two
it
has been necessary to use this
broad concept. At the same time, alternative
decades,
diffi-
concepts of capital more appropriate to the
render net worth a poor measure for
assessing either profitability or the potential for
measurement of borrowing capacity and profitability have been developed to give some per-
borrowing by Government
spective to the analysis.
Unfortunately, conceptual and statistical
culties
nonbank
In the case of
in segregating capital
as
Government
securities dealers.
used for their operations
securities dealers arise
both be-
cause of the intermingling of activities in an
operational
sense
and because
capital
often
flows from one activity to another depending
on the
relative
profitability
of
each
at
any
point in time. There could be similar complications for
dealers
bank
regard
dealers, but as
capital
as
A
dealers, difficulties
neither
a rule such
a
relevant
constraint on the expansion of positions nor a
discussion of measures of capital for non-
bank dealers and
of
the
arguments against
applying such measures to bank dealers
is
pre-
sented in the Appendix. In brief, two concepts
are developed for
capital available,
of
nonbank
is
nonbank dealers
dealers:
The
used to estimate the
to
expand
the second, capital in use,
is
first,
ability
their positions;
used to derive a
meaningful rate of return on equity. Capital
available
is
essentially the
maximum amount
of net worth available to cover margin require-
The portion of net worth representing
book value of furniture or stock exchange
suitable standard for assessing the profitability
ments.
of the dealer function.
the
—
DEALER PROFITS AND CAPITAL AVAILABILITY
memberships, for example,
in use
ital
eligible.
Cap-
simply that portion of net worth
is
meet margin requirements
actually used to
effect, the
not
is
103
—
in
excess of the purchase price of posi-
Government and agency securiand CD's over the amount of funds bor-
tions in U.S.
ties
rowed.
rity of collateral;
rities
risk
The primary
defect in using total net worth
to detect secular shifts
of
the
no way
among competing func-
is
that there
Insofar
firm.
is
of
shifts
as
that
type represent permanent or semi-permanent
commitments
that could inhibit flexibility, the
trends in capacity growth will be misstated.
On
margins on longer-term secu-
are higher because of the greater price
incurred by the lender. In sum, the ex-
pandability of dealer positions depends on the
amount
size
to gauge industry size
tions
quirements vary according to type and matu-
of capital available for margins;
of required margins;
with the
latter,
and types
—
and
in
on the
conjunction
on the maturity composition
of securities held by dealers.
change. Changes in the level
nonbank dealer firms over the
past two decades have resulted from varying
profit performance,
the entry and exit of
firms, and decisions about the retention or dis-
Sources
of capital
of
of
the other hand, the available net worth data
bursement of earnings.
may be
a reasonably accurate measure of capi-
clude the addition or withdrawal of capital by
For ex-
individual officers or partners, the issuance of
to
long-term debt, and unrealized appreciation or
available in certain circumstances.
tal
ample,
for
nonbank dealers
active
prior
1960, the dealer function constituted an important
—
if
not the most important
—
part of
Thus observed trends in
amount of
U.S. Government securities
the firm's activities.
net worth should validly reflect the
capital available to
dealers for their operations.
Marginal factors
in-
shows the year-end level
nonbank dealers for
1948-65, based on two overlapping series.
The first series, 1948-58, was compiled by
Meltzer and von der Linde largely on the basis
of annual financial statements; it includes what
depreciation. Table 8
of aggregate net worth of
appears to be net worth plus recognizable re-
INVESTED CAPITAL
The expansion
is
of
a function of the
through borrowing
amount
of capital available
and of the nature of the
assets that
as financing collateral. Dealers in
may
serve
Government
an extreme in the utilizaborrowed funds or leverage, for they
securities represent
tion of
The second
1955-65, was comfrom both financial statements and supplementary data available on a
confidential basis to the Credit Department of
the Federal Reserve Bank of New York. Much
of the discrepancy between the two series in
the 1955-58 period stems from the inclusion
serves.
assets
series,
piled by the author
typically maintain a capital/asset ratio of less
than 5 per cent. Their ability to operate with
this
exaggerated leverage
on the
is
based, of course,
and risk characteristics of their
namely U.S. Government seExpansion is limited, however, since
liquidity
TABLE 8: TOTAL NET WORTH OF NONBANK
DEALERS IN U.S. GOVERNMENT SECURITIES,
1948-65
collateral assets,
curities.
nonbank dealers are required to provide some
margin to the lender as protection against potential price declines on securities used as
collateral.^^
These
^^
capital
—
or
margin
—
re-
Collateral securities are necessary for long posiFor short positions the margin provides protection against price increases in the
loaned securities. Bank dealers also have expansion
constraints, but these constraints are not of the same
tions or short positions.
nature. See Appendix.
Year
—
more permanent-type reserves in the second series. Some of the variation may also result from diiferences in treatment of unreaHzed
One bank dealer that began trading with the
System Open Market Account in 1954 ceased
gains or losses.
small nonbank dealer in mid- 1955, the industry
of
The
figures
worth
on net
generated
by
Meltzer and von der Linde cover the 12 non-
bank
dealers "designated for handling transac-
tions in U.S. securities (with the
Market Account)"
in
System Open
1958. In the 1948-52
period, however, only 5 of these dealers were
more than 12
actually so designated, whereas
were trading with the Federal Reserve at one
time or another in 1953-58; thus, net worth
for the group, as
we have
defined
it,
was over-
stated in the Meltzer-von der Linde series for
1948-52 and perhaps slightly understated for
1953-58. The discrepancy would probably be
on the order of 10 per cent or less, however.
For the two periods examined more thoroughly, 1955-60 and 1960-65, the net worth
figures (from the Federal Reserve Bank of
New York) are those for all authorized nonbank dealers.
period
the
For
1948-55.
Change,
1948-52,-"' there were 10 recognized dealers
5 nonbank firms and 5 dealer departments of
commercial banks. The five nonbank dealers
had an estimated net worth of $45 million at
the end of 1952, and in each of these firms a
considerable portion of activity was devoted to
operations in Government securities. Based on
their participations in sales and on their positions at that time, the five bank dealers probably "contributed" an additional $10 million
to
$15 million
of capital."
In 1953 capital and other requirements for
trading with the System
Open Market Account
were eased, and nine additional nonbank dealers received such authorization. These firms
added an estimated $10 million of capital.
Although three of them, each with net worth of
less
than $500,000, ceased operations within 3
years, the other six
'•"
The end of
remained
the calendar year
in the
is
industry.
used as the
1955. With the addition of a
the end of
at year-end consisted of 5 bank and 12 nonbank dealers with aggregate capital of perhaps
$85 million to $90 million, including an estimated $15 million to $18 million for bank
dealers.
Change, 1955-60. From 1955 to 1960, the
membership of authorized firms remained unchanged. Total net worth of nonbank dealers
rose from $72 million to almost $96 million, a
gain of 33 per cent. During the period about
$1.3 million of new capital was invested in
dealer firms and perhaps $6 million or $7 million
als
was withdrawn; the bulk
of the withdraw-
occurred because of the death or retirement
of participating partners
and
officers.
With a
decline of about $2 million in long-term debt
—from $3.3
million to $1.4 million
—
ap-
it is
parent that between $25 million and $30 million of earnings
Dividend
differed
or
were retained in the industry.
disbursement
among nonbank
policies
clearly
dealers. First
Boston
Corporation earned $20 milfion in 1955-60
and paid out 88 per cent of
dividends.
Similarly,
paid out 80 per cent of
profits.
this
Discount
its
amount
in
Corporation
$6.4 million of net
Largely as a result of
this policy, the
net worth of these two firms grew only 7
and
8 per cent, respectively. Other firms, however,
expanded
their net
worth considerably,
six
by
50 per cent or more. It is perhaps significant
that First Boston and Discount are the only
publicly
owned
firms.
Only four firms had long-term debt outstanding during the period, and all of them
were medium-sized or small. At three of these
firms, such debt declined between 1955 and
1960, leaving a total of only $1.4 million for
the industry in the latter year.
Change,
1960-65.
Between
1960
and
1965, the dealer industry experienced several
ref-
erence for inckision or exckision of authorized firms.
''
This and subsequent estimates of capital of
bank dealers are in effect capital available approximately the amount that would have been necessary
to conduct the operation on an independent basis.
—
at
membership changes. Three bank and two
nonbank dealers joined the industry, one nonbank dealer merged with a large brokerage
firm, and two nonbank dealers withdrew. Both
—
DEALER PROFITS AND CAPITAL AVAILABILITY
105
withdrawals from the industry were for reasons
unrelated to firm performance in the Govern-
ment securities market. By 1965, the number
of bank dealers had risen from 5 to 8, and
there were still 12 nonbank dealers.
Total net worth of all recognized nonbank
dealers jumped from $96 million in 1960 to
$261 million in 1965. Of the net increase of
$165 million, $148 million represented the
entry of two dealers plus the merging broker-
age firm, $25 million came from the increase
worth of these three firms over the 5
in net
and $12 million represented
years,
cumulation
the
at
nine
capital ac-
previously
existing
was a drop
$20 million in net worth because of the two
departures and the withdrawal of some capital
from the merged dealer.
For the nine previously active dealers alone,
net worth advanced $11.9 million to $83.6
million from 1960 to 1965, an increase of
16.6 per cent. This growth compares with a
rise of $17.5 million
32 per cent during the
earlier period. Three of the nine firms experienced a decline in net worth from 1960 to
1965, however, and $10.4 million of the $11.9
million increase was concentrated at two
firms. Partially offsetting this rise
of
mary
dealers from 1955 to 1960; between
1961 and 1965, three additional banks became
primary dealers and were authorized to trade
with the System
Open Market Account. When
gross transactions are used as a measure of
they show that the five older bank dealers
grew approximately 23 per cent from 1955 to
1960 and 34 per cent from 1960 to 1965.
Since most of this growth in transactions was
in the bill sector where margin requirements
size,
are
minimal,
the
of
rate
could easily have been
less
capital
expansion
than the growth in
bank dealer capital availat $15 million to
1955, may not have exceeded
1960 and, for the same prefive bank dealers, $25 million
transactions; thus,
able,
which was estimated
$18 million
$20 million
in
in
viously existing
the period; at the very least, earnings perform-
$27 mOlion in 1965. ,ln 1965, the three new
bank dealers accounted for 27 per cent of total
transactions by bank dealers, a figure that
would imply an additional $8 million of employed capital. Such a figure added to the estimate for the five dealers indicates that bank
dealers had a capital investment of $33 million
to $35 million, a figure that is close to the $35
million estimated by the banks themselves in
1965 as necessary for their operations.
In summary, the total net worth of the active
nonbank dealers plus the assumed capital investment of the bank dealers rose from a range
of $85 million to $90 million in 1955 to about
$115 million in 1960. Based on figures of capital available for the entering nonbank dealers,
the 1965 figure for capital funds employed in
Government securities operations by bank and
nonbank dealers was about $140 milUon. This
represents an approximate increase of 60 per
cent over the decade. For perspective, over the
same interval net positions and gross transactions for all dealers
after some adjustment
for reporting revisions
are estimated to have
expanded on the order of 67 per cent and 100
per cent, respectively. The two increases
stemmed largely from changes in Treasury
ance provided
bills.
—
—
dealers.
Capital could presumably have grown faster
had dealers retained a greater share of income
earned. At the same time, fragmentary evi-
dence suggests that
in the
1960's the propor-
tion of the total earnings of
nonbank dealers
accruing from operations in Government securities
years.
was substantially smaller than in earlier
For 1964 and 1965 combined, for ex-
ample, the Government securities operations of
these
dealers
resulted
in
a net loss of $6.8
million whereas aggregate
income before taxes
from all sources amounted to $128 million
($100 million of which was earned by one
large brokerage house).
capital
available
expand the
ties
could
little
It is
thus possible that
have declined during
incentive
capital used in
for
dealers
Government
to
securi-
operations.
As
previously noted, five banks were pri-
to
—
—
Capital growth in the industry in
came about almost
1955-60
entirely through the reten-
tion of earnings. After that, the
major share
106
perhaps two-thirds
—
of
new
capital
devolved
from new entrants, as growth in the older firms
slowed because of declining earnings. Whereas
net worth appears to have risen in line with
expanding market activity, as measured by
positions
and transactions,
tain that capital
is
it
not so cer-
expanded at a
during 1960-65.
available has
comparable pace, particularly
on position
levels.
tions held at
However, the
any particular time
level of posiis
of expected profits as determined
a function
by transac-
tion volume, spreads, expected price changes,
and other
factors. Unless expected returns are
may not be induced to expand positions to what might be
considered, on other criteria, the most efficient
high and/or risks low, dealers
level. In this investigation
we
are limited to an
estimate of the degree to which positions could
MARGINS REQUIRED
be expanded, given favorable conditions, be-
The adequacy
of
dealer
capital
depends on
the relationship between available capital
and
The latter is a function of the
and composition of dealer positions as
fore
encountering
straint.
required capital.
is
size
of criteria
well as the margins required per dollar of securities held.
How
large can positions
grow be-
fore margin requirements exhaust the available
assuming a desire on the part of dealexpand inventories to that point?
The assumption of dealers' desire to expand
positions is crucial. As evidenced by the
strong, positive relationship between the size of
an individual dealer's capital and his position,
capital available operates as a broad constraint
valid
the
absolute
capital
con-
As noted in the Appendix, this exercise
for nonbank dealers, but a different set
must be developed for judging the
expandability of positions of bank dealers.
Margin
rates.
The most
striking
feature
about quoted margin rates for Government sedealers
the diversity of quotations
capital,
curities
ers to
for each of the various maturity categories, to-
TABLE
9:
is
gether with the apparent flexibility in applying
such
quotations.
Schedules
of
approximate
and by
and by two clearing banks in 1966,
are presented in Table 9. The rates are ap-
rates,
as
reported
in
earlier
studies
dealers
MARGINS REQUIRED ON COLLATERAL LOANS AND REPURCHASE AGREEMENTS
In basis points unless otherwise noted
DEALER PROFITS AND CAPITAL AVAILABILITY
als
many
margins are
set
value of the
bills,
in
ments. Tlie consensus of persons interviewed
was tiiat margin requirements had, if anytliing,
narrowed over the past decade. Several noted
requirements were,
current
that
below the
years
In
narrow or
be
of
to
number
a
less strictly
stable
of
should be
it
some tendency
relatively
practice,
in
set
connection
this
is
periods
margins
"officiar"
ago.
noted that there
to
for margins
enforced during
rates,
as
in
the
early 1960's.
The maturity
ernment
the
in
(U.S. Govwas the overriding factor
of the collateral
securities)
determination
of
margins
required,
and despite variations among lenders, advertised margins seemed to be granted to all Government securities dealers without discrimination.
At the same time, discussions with
dealers and clearing banks indicated that preferential treatment
in the form of waiving
minimum requirements was extended by
some lenders on the basis of business received
or of the size of the borrower in terms of capital. Size was a factor in that lenders were typically more careful in checking, on a day-to-
—
—
adequacy of margins provided
by small dealers. Large dealers might be undermargined one day, and simply be asked to
day
basis, the
provide more coverage the next. Nevertheless,
it
by taking the current market
instances individu-
were quite vague about minimum require-
proximate because
is
doubtful that large dealers were able to
operate
on
continuously
margins
narrower
than small dealers over any extended period of
time.
In order to estimate
minimum
requirements for past position
total
levels,
it
capital
is
nec-
essary to assign margin rates to each maturity
category or type of position activity. Margin
in
terms of their bid price,
and rounding down to the nearest convenient
number.'-' The margin on CD's is computed
similarly,
although the requirement
with the source of the
CD,
that
is,
may
bank. For coupon securities maturing in
or
accrued interest
less,
margin, since
it is
vary
the issuing
1
year
effect serves as
in
a
rarely counted as part of the
collateral value. In order to reflect the
conven-
and CD's and the
addition of accrued interest on within- 1 -year
coupon securities, Va of 1 per cent was applied to bills and CD's and V2 of 1 per cent to
the coupon securities.
For coupon securities maturing after 1 year,
financing is again handled on a flat basis, that
is, excluding accrued interest. For issues maturing in 1 to 5 years, margins ranged from V2
point to 2 points, with the more frequent quoience factor in financing
tation nearer to
1
point.
accrued
for
sion
bills
To make some
interest,
Wi
selected for our computations.
turing
from 2
in
lower
5
to
10
years,
provi-
per cent was
For
issues
quotations
ma-
ranged
to 5 points
but were generally on the
Again,
allowing for convenience
side.
per cent was applied to
For issues with maturities of
over 10 years, margin rates quoted were from
3 to 5 points. In this case, 4 per cent was used
for 10- to 20-year issues and 5 per cent for issues maturing after 20 years.
Federal agency securities, having become
much more actively traded and widely held,
appear to have experienced declining margin
and accrued
this
interest, 3
category.
requirements
over
the
past
decade.
In
the
Meltzer-von der Linde study, 5 per cent was
used to compute dollar margin requirements
were reported on the basis of par value. Because bill
positions were reported at par value, however, aggregate margin requirements for bills may be slightly
totals
rates for
rities
Treasury
maturing
zero to as
in
much
bills,
1
as
CD's, and other secu-
year or
1
less
point.'''
ranged from
Typically,
bill
overstated. In congressional hearings in 1958, a survey
indicated that initial margins for loans at commercial
Zero margin generally means that the loan is
covered by an equivalent dollar amount of collateral
securities valued at the hid price. Although a computational distinction between points ($10,000 per million par value) and per cent of market value exists,
the overriding convenience factor has rendered the
•'^
distinction
virtually
irrelevant;
in
this
study,
there
need be no computational distinction because position
banks against collateral (U.S. Government securities)
maturing in 1 year or less were as follows: of $1.95
billion of financing, 47 per cent was financed initially
at zero margin, 23 per cent at W point or less, 14
per cent at 1 point. 10 per cent at 2 points, and 6
per cent at 3 points or more.
••''For example, a 180-day bill bid at 98.321 might
be valued at 98.250 for collateral purposes.
—
108
applied uniformly to
all
types and maturities.
As
of 1967, several sources said agency securi-
ties
were accorded the same margins as com-
parable maturities for U.S. Government securities. For agency securities maturing in 1 year
per cent margin was used; for
those maturing after 1 year, a 3 per cent mar-
or
less,
a
positions; the second, used as a comparative
check,
was applied.
Margin rates for borrowed
summary
A
on the maturity of the
margins are
rity sectors
collateral,
lower
slightly
in the
depend
movements
positions
loans
covering
borrowed,
securities
because
move
prices of these securities
direction as those that are put
involved in
up
the
same
in the
as collateral.
borrowed
margins required on
then, are a
securities,
largely
because of the inconvenience entailed in calcu-
direct
Aggregate
the gross long positions,
of dealer capital needed to support the
amount
observed
level
—and
composition
—
posi-
of
without regard for the relative size of
tions,
period, in the
borrowed
either
against
securities."
approximation of the minimum
first
the total collection of securities submitted as
against
esti-
of capital used
to the fullest extent pos-
collateral
as
the
collateral
borrow
or
(The dollar value of a loan, of course, does
change with security prices.) Margins
range from virtually zero on bills to 3 points
for securities maturing in over 10 years. However, as a rule of thumb, 2 points is applied to
not
concerning
This entails using the entire gross long
although the
is
second method.
assumption
minimum amount
that dealers
sible.
longer-matu-
than they are for direct loans. Less
risk of adverse price
method
results of the first
figures for the
necessary
mates of the
is
securities
The
are presented in detail in Table 10, as are the
1
gin
based on the gross short plus net
is
long positions.
short
method,
from more
more than $40
on
Based
position.
this
capital requirements rose
dealers'
than $23 million in 1960 to
by 74 per
million in 1965, or
When
cent.
net
long positions were at their peak during this
week ended August 21, 1964,
requirements were $57 million.
The second approximation
needed takes the
of
dealers'
minimum
cap-
short positions
margin allowances for individual issues.
A total of two points was therefore applied
when estimating total margins on dealers' short
ital
positions.
can be used to repay outstanding loans and,
concomitantly, the released collateral can be
lating
Minimum
capital requirements. Applying
the margin rates selected in the foregoing discussion,
minimum
capital
requirements were
estimated for dealers' average positions from
1960 to 1965, and for the week of highest
daily-average positions, that
is,
August 17-21,
1964.'" Position data are given for all dealers,
even though bank dealers financed the bulk of
their positions themselves and hence were not
subject to margin requirements; the importance
of
this
procedure
will
be noted
later.
Two
methods of calculation were employed. The
is based on dealers' gross long
primary one
into account.
When
dealers
to sell short, the proceeds
shifted
noted
to
borrow
when long-term
collateral
borrowed securities
Moreover, bills sold short are
often financed by "due bills," which are unsecured borrowings requiring no margins. Potentially offsetting these margin advantages, howplied to
to direct loans.
ever,
is
the
fact
that
institutions
bills
lend
required with direct loans.
By
applying the straight 2-point margin
and the previously selected margins
sues are typically taken into position several days (or
more) prior to actual issue and payment. This
practice occurs largely in bills, however, where the
impact on capital is relatively small.
that
margins on Treasury
when used as collateral than are normally
securities require larger
ment basis, the position data lead to some overstatement of capital requirements because new security is-
to
is
when apthan when applied
being used, margin rates are lower
frequently used as a rule of
prior
As
cover the borrowed securities.
earlier,
1960 were available
only on a net basis, precluding meaningful analysis
or interperiod comparisons. Reported on a commit-
'"Data for years
securities
of the short sales
of securities
—
thumb by
lenders
to dealers' gross short positions
to net long
Minimization of capital used does not necesimply the least-cost combination of capital and
borrowing.
'1
sarily
...
..
DEALER PROFITS AND CAPITAL AVAILABILITY
109
TABLE 10: WIlNriVIUIVI AGGREGATE CAPITAL REQUIREMENTS FOR
FINANCING DEALER POSITIONS, SELECTED PERIODS,
BY MATURITY CATEGORY
5.09
Coupon
1
7.02
6.31
year
1-5 years.
.
.
5-10 years.
10-20 years..
After 20 years
.
Agency
6.50
7.17
securilu
Within
1.48
1.31
8.20
7.15
1.24
3.14
7.52
8.39
5.29
8.30
26.52
31.59
35.12
40.63
29.24
33.48
36.88
44.99
10.04
3.14
1.15
7.72
2.66
6.24
4.73
1.29
1.16
1.45
1.94
1.19
1.04
1.72
:
Within 1 year
After 1 year.
lificates of deposit.
Total
tross short plus net lonj
Gross short position
Net long position.
.
.
25.11
Total.
24.69
58.94
Includes long-term repurchase agreements.
Includes long-term repurchase agreements.
margin of 2 points was applied to the entire short
position; then selected margins were applied to net long positions in eitch category.
1
A
-
Note.
— Figures based on daily-average positions.
positions in each maturity category, aggregate
another way. The results, shown in Table 10,
near-term requirements of public and private
market participants. The foregoing analysis of
invested capital and of minimum requirements
were consistently above the totals computed
from gross long positions but not by very large
available
minimum
capital requirements
were estimated
amounts; the differences ranged from 5 to 11
per cent. The higher margins imposed on short
positions in bills weighed
more
heavily than
reduced margins on long-term collateral securities,
is
is
an important deter-
minant of capital requirements. '-
this
pected
'-
rate
availability
for
and
to
under cur-
judge
its
accommodating
to
exthe
similar types of
errors, not only with regard to the validity of
margin
rates applied hut also in terms of the practical prob-
lems of daily financing activities. In the latter sense,
both methods probably underestimate needed capital
by implicitly assuming a degree of fle.xibility and efficiency in the distribution of collateral
rates
However,
may
offset
among
lend-
under current clearing arthe generous estimates of
ers not practically feasible
rangements.
some
for
amounts of
capital
positioning
were
securities.
at
a faster
1960's than did the proxies
for capital available, the absolute
gap between
the two widened.
Far from seeing a withdrawal of invested
most firms grew in size
and six firms entered the
Furthermore, since bank dealers
capital in dealer firms,
from 1960
own
study was to ascer-
Both techniques are subject
margin
during the
industry.
tain the sufficiency of dealer capital
rent market conditions
1965
to 1965,
finance the bulk of their positions with their
CAPITAL ADEQUACY
primary task of
in
While capital requirements grew
but the variation between the two methods
not sufficient to indicate that the relative size
of the short positions
A
indicates that adequate
of this bias.
funds, the potential capacity of the indus-
grew substantially with the addition of
three new bank dealers. Indeed, of the $18
million increase in required capital from 1960
to 1965, bank dealers accounted for $9 million. In 1965, the actual amount of capital required
that is, the requirements of nonbank
dealers
was just under $29 million. This can
be compared roughly with total nonbank
dealer capital of $261 million and capital of
$86 million allocated to operations in Government securities. With the> mobility of funds
try
—
—
among
firms' various functions,
there
is
little
doubt that there
is
sufficient capital
meet any foreseeable needs
to
in the
securities, dealers
near fu-
their positions to
ture.
The
mentioned
crucial factor, as
may be unwilling to expand
accommodate official or private operations and may divert resources to
other, more profitable uses.
available
earlier, in
Nothing
determining whether public and private operations will be
accommodated
efficiently
is
the
expected profitability of such accommodation.
When
profit
expectations
sources can be shifted to
are
favorable,
Government
re-
securi-
operations by dealers, even to the point
ties
where bank dealers may raise additional funds
CD and Federal funds markets. Alterna-
in the
tively, when prices are expected
when bid-asked spreads narrow
where they do not cover the
V.
to decline or
to
the point
risks of holding
early
in
the
analysis
of
profits
in
the
however, indicated that dealer
1960's,
—
—
income and return on capital would remain permanently at low levels. Therefore it is
net
likely that dealers will continue to
respond to
profit opportunities as they arise. Nevertheless,
efforts to
prevent deterioration in market per-
formance, however defined, can succeed only
if
there
profits.
is
reasonable assurance of adequate
Capital will be
more than
sufficient
if
this occurs.
RATE OF RETURN ON CAPITAL
When
combined operations
Computing a meaningful rate of return for
employed by dealers in their U.S. Government securities operations is severely ham-
before taxes.
capital
each nonbank dealer were examined, however,
pered by the problems inherent in specifying
per cent (1964) and 27 per cent (1965). In
and measuring the appropriate capital base
and in making the proper allocations of income and expenses to this and closely related
rates of return
functions. Furthermore,
the
it is
almost impossible
may accrue to the dimake markets in U.S.
to assess the returns that
versified
dealers
Government
that
securities. Nevertheless, the rates
by Meltzer-von der Linde
for 1948-58 are presented in Table 11. These
data refer to income from all operations of
nonbank dealers.
The Benston study did not provide suffi-
the rates of return
the
of
on net worth averaged 26
both years, as might be expected, the highest
were achieved primarily by the
larger, diversified firms. In
1965,
when 10
of
nonbank dealers reported losses in
Government securities operations, 5 had overall profits and 4 of these were the large diver12
sified dealers.
of return reported
ciently
detailed figures
to
permit meaningful
on capital for 1959-63.
nonbank dealers only
whereas income data were for all dealers.
Clearly, the return was very high in 1960 and
quite low in 1963.
calculations of return
Capital data werel for
For 1964 and 1965, nonbank dealers
mated
that they
and $85.5
their
million, respectively, of capital to
Government
on these
esti-
had allocated $82.2 million
securities operations.
figures, the rates of return
per cent in 1964 and
-
Based
were 3.7
12.3 per cent in 1965
TABLE 11: RATIO OF AGGREGATE NET INCOME
TO NET WORTH, NONBANK DEALERS, 1948-58
Year
—
DEALER PROFITS AND CAPITAL AVAILABILITY
Some comparison
lar
fields
such
of rates of return in simi-
as
among
investment firms has been
brokerage
or
predictable clue about potential capital
Any
undertaken.
The second, and perhaps more important,
comparison of this nature, however, suffers
from difficulties that are more extensive than
simply allocating capital and income. Foremost
constraint on interindustry comparisons
are the problems of average versus marginal
various types of enterprise.
measurement, and the specification of a risk
differential. Currently available data on income
ble to
and
capital allow
computation only of average
rates of return for
The crux
ever,
is
extended periods of time.
of efficient capital allocation,
the marginal rate of return, that
howis,
the
move-
ments.
problem of assigning a
risk
component
is
the
to rates
of return in order to reflect the riskiness of
ers
assume
that
It
may be
Government
reasona-
securities deal-
should receive greater risk-compensation per
unit of invested capital
—
given the risks associ-
ated with highly leveraged positions and volatile
prices
minimal
—
than,
capital
say,
risk
brokerage firms with
how much
exposure;
income per marginal change in capiIn a diversified dealer firm, where consid-
greater this compensation should be, however,
erable portions of capital are mobile, average
very wide cyclical swings in earnings and the
change
tal.
in
rates of return to various functions
may
differ
although marginal rates are equal. Similarly,
is
a matter of conjecture.
difficulties in
Federal
Indeed, given the
quantifying nonmarket factors
Reserve
support
of
rates
—
just
after
average rates
World War
marginal
may differ among firms and yet
rates may be equal. Thus, differences
to generate a reliable long-run rate of return
observed average rates of return provide no
for the U.S.
in
II,
for
example
Government
it
is
impossible
securities industry.
APPENDIX
VI.
SUMMARY OF DEALER INCOME
AND EXPENSES,
A
statement
of
1964
AND
aggregate
1965
income
on
the
Government securities operations of the
12 nonbank dealers in 1964 and 1965 and the
8 bank dealers in 1965 is presented in Appendix Table 1. In 1965 nonbank dealers incurred
U.S.
an aggegate loss of $9.9 million, before allowance for income taxes, from these operations;
only 2 of the 12 dealers realized a
profit.
In
had shown a profit in 1964
and their combined pre-tax net income had
totaled $3.1 million. Bank dealers had similar
contrast, 9 firms
1965; as a group they lost $4.5
Only one bank reported a net gain.
The primary cause of net losses in 1965 was
the extremely low level of trading profits, particularly on coupon securities. Spread profits
for coupon issues, based on annual sales and
difficulties in
million.
APPENDIX TABLE 1
DEALER INCOME AND EXPENSES ON
GOVERNMENT SECURITIES OPERATIONS,
AND NONBANK DEALER NET INCOME
FROM ALL OTHER ACTIVITIES,
1964
AND
1965
In ihousands of dollars
Govcrnmenl
ope rations
DEALER PROFITS AND CAPITAL AVAILABILITY
REGRESSION EQUATIONS
APPENDIX TABLE 2
LIST OF INDEPENDENT VARIABLES FOR MULTIPLE REGRESSIONS
Symbol
Variable
Unit
Quoted bid-asked spread on the new 3-month Treasury
monthly averages of Thursday observations
Total sales, nonbank dealers, monthly averages of daily figures
Xz
Bill transactions, all dealers,
Xi
Coupon
transactions,
X,
Change
in
X,
Monthly change
Reserve
dealers,
in
series),
Change
3-month
X,
Bill positions, all dealers,
x,„
Coupon
X,i
Total positions,
X,o
Dummy
Dummy
Includes Federal agency
;
riiies
3-month
bill rate,
bill rate, last 3
dealers,
-|-I
days of preceding month
Percentage points
Percentage points
Percentage points
figures
Millions of dollars
figures
monthly averages of daily
figures
figures
'
months, January 1958-April 1960
for refunding
Millions of dollars
daily figures
monthly averages of daily
variable, 4-1 for all
and CD's.
'
Percentage points
monthly averages of daily
positions, all dealers,
variable,
figures
rate
monthly averages of daily
all
Millions of dollars
long-term U.S. Government bond rate (Federal
monthly averages of
X^
in
bill
Basis points
Millions of dollars
figures
monthly averages of daily
end-of-month, 3-month
X,
^13
'
all
monthly averages of daily
bill.
'
months
in
1960-63
'
Millions of dollars
Millions of dollars
0|-
|-|-
,^l
I
III
111
II
III
III
III
III
II
III
I
I
II
I
I
I
Qj'
S 3
ffiO
<I1J
HOC
XUJ
<
^
<S
I
^
s;
I
< s
2
I
<
I
I
I
I
"
I
III
III
DEALER PROFITS AND CAPITAL AVAILABILITY
115
MEASUREMENT OF DEALER CAPITAL
may be
Dealers. The broadest measure of
the accapital is net worth
Nonbank
—
nonbank dealer
counting residual of assets over
liabilities.
It
has the advantage of being easily calculated
and
it
does provide an indication of the
protection afforded creditors.
Moreover,
risk
it
is
of
1958-63 period.
A narrower measure of capital, and one
which more closely reflects a dealer's ability
to expand positions, is capital available. Capital available represents the amount of capital
that management is able or willing to commit
to the financing of Government securities. If
not formally allocated by management, it is essentially net worth minus all assets not servicecapital for the
able
loan
as
finance
positions.
for example,
would be
collateral
to
stock
and fixtures, good faith deposits,
exchange memberships, and the mini-
mum
capital
furniture
ships
requirements for such member-
and for other firm
Finally, there
is
For example, a lucrative cormay pre-empt capital normally committed to financing a Treasury reparticular time.
funding operation.
In selecting a meaningful base to
biases exist
tial
a third potential measure,
over the value of loans against
which such securities have been pledged.
There is considerable evidence that all three
concepts were used in the most recent figures
on allocated capital collected by the Market
Statistics Division of the Federal Reserve Bank
York. However, some dealers, lacking
guidelines,
presented
figures
unre-
lated to any of these concepts.
Capital available
priate
measure
less there
is
is
some
—
additional
—because
it
is
for position expandability, un-
a policy limit set by
to
Government
culation,
it
management
may
securities financing.
should not be
be devoted
As
difficult for
corporated
to
expandability,
in reserve for financ-
would not be
securities,
in-
in the base. In this case, profitability
would be overstated. Alternatively, a capital
figure for firms that deal in both U.S. Government and other securities would certainly
include funds that are normally used for operations in other securities; this
would lead
to
an
for
profitability.
for cal-
At nondiversified
would result in
course, both concepts
firms,
the
of
same
Dealers in other than U.S. Government se-
may
not necessarily squeeze borrow-
ings to the limit
—
that
is,
always borrow with
minimal margins, siphoning
off or
adding capi-
as the level of positions requires. In ques-
tal
how much
tioning whether or
minimum
of the
required
is
capital in excess
included in ob-
served capital in use by diversified dealers, a
feasible
normative
assumption
is
suggested:
namely, that dealers faced with alternative apginal
of limited capital
benefits
of
allocating
Under such
equate the marfunds
to
each
would be
committed to maintaining Government securities positions when it is profitable to do so.
When competing needs for capital are slack,
activity."
a plan capital
manage-
ment to provide a realistic estimate of the
amount of capital that is potentially available.
A serious drawback to the use of such a figure
as a guidehne
being held
Government
ing
plications
undoubtedly the appro-
on the amount of capital that
both the capital-available
employed in other activities that
amount of capital available
capital not
is,
curities
New
in
and the capital-in-use concepts. For example,
in assessing the capital-in-use concept, any
ket value of securities positions, including ac-
allocative
measure
one should remember that poten-
profitability,
capital figure.
of
relative
funds at any
porate underwriting
which is the amount of funds
actually committed as margins for financing
positions. In practice, it is the excess of marinterest,
and of the
particular situation
a
not be stable but
overstated base and to an understated figure
activities.
capital in use,
crued
may
a function of the perceived profitability
profitability of alternative uses of
the only available statistical measure of dealer
Specifically excluded,
available
that capital
however,
is
Dynamically, capital flows are created hy .shifts
marginal revenue functions of various activities arising from changing market conditions, expectations, and opportunities for capital use in each ac'
'
in
the
tivity.
presumably borrowings would be minimized,
but
this
would be a function
financing
of
charges.
Bank Dealers. A
for
bank dealers
measure criterion
capital
virtually meaningless, be-
is
to estimate profitabihty for this
It is difficult
group
of
dealers
may borrow more
eral funds
sitions,
In
dealers.
the
market purely
first
bank
place,
heavily in the Fed-
to support dealer
po-
on the theory that the larger borrow-
cause capital does not function as a constraint
ings
on position expansion, nor is it used for calculating profitability. In sum, the concepts of
capital available and capital in use have no
useful interpretation in the bank dealer situa-
positions.
are
offset
To
this
by
these
of
the
liquidity
extent,
no bank
capital
this case
is
committed; the margin in
is
simply
constrained
good name of the bank. Secondly, there is
problem of defining an appropriate opportunity cost for the amount of funds in use
be
it deposits
(and capital) or borrowings that
would have been allocated to other bank
activities.^' This is perhaps one reason why
limits set
bankers,
tion.
The expansion
of positions in
Government
banks is
by formal or informal position
by management, usually for several
securities in the dealer operations of
maturity categories. Under certain conditions,
these
maximum
discretion
of
levels
may
be exceeded
management;
pansion of dealer positions
by factors not
role.
directly
at the
alternatively,
may be
ex-
restrained
related to the
dealer
In particular, several bank dealers pro-
vide considerable assistance to their banks in
adjusting
the
banks'
reserves,
often
through
short sales or the placing of repurchase agree-
ments.
Even though
theoretically divorced
investment portfolio,
physically
the
dealer operation
is
from management of the
it is
often integrated both
and operationally with the money
centers. In short, no matter what
management
the formal maximums may
may be determined in large
quidity needs, which may run
ties
be,
expandability
part by bank
biUty of the latter
is
adequate.
the
—
—
who
only recently have experimented
with functional cost analysis, have not devel-
oped standards for judging dealer profitability.
To quote one banker, "... a black figure is
good; the bigger, the better."
Finally,
banks
differ
in
their
use
of
the
dealer operation for servicing customers and,
as previously noted, in their assistance in adjusting reserve positions.
Because many dealers
are operationally integrated with other
management
money
functions, the difficulties of allo-
cating expenses properly,
combined with the
from
tangible costs and the intangible returns
servicing customers
and
assisting reserve
ad-
justment, render any statement of profitability
tenuous at best.
li-
counter to securi-
market considerations even when
the
profita-
'
Differences
in
securities operations
between U.S. Government
and other uses of funds would
comparing re-
rislv
also have to be taken into account in
turns
on funds
in use.
Felix T. Davis
and Matthew
J.
Hoey
Government Bond and Safekeeping Department
Federal Reserve Bank of New York
AUTOMATING OPERATIONS
IN
GOVERNMENT SECURITIES
CONTENTS
I.
II.
INTRODUCTION
121
SECURITIES CLEARING ARRANGEMENT
122
Clearing Telegraphic Transfers of Government Securities
Development of a Full-Scale Government Securities Clearing
122
Arrangement
Other Transactions Processable Through Clearings
123
126
III.
BOOK-ENTRY PROCEDURE
127
IV.
EFFECTING CLEARING SETTLEMENTS THROUGH BOOK-ENTRY
128
CLEARING AND BOOK-ENTRY APPLIED TO AGENCY SECURITIES
129
CONCLUSION
130
V.
VI.
AUTOMATING OPERATIONS
I.
GOVERNMENT SECURITIES
IN
INTRODUCTION
The market
ernment
in
of
securities
known today
as
—
U.S.
the
Gov-
so important both
This
paper describes
that
clearing
ment, which includes 8 of the
1 1
arrange-
New York
of trading that
member banks whose operations in the
Government bond market, either directly or as
clearing agent for nonbank dealers, are suffi-
issuance of Liberty
ciently
and
to fiscal policy
economy
—had
to the well-being of our
beginnings in the expansion
its
was accomplished through the
Loan Bonds during World
War L With the exception of the Federal Re-
City
broad to warrant
the clearing concept
serve System's telegraphic facilities for trans-
tance,
ferring securities, introduced in 1921, the dec-
local transfers of
ades since World
in
War
I
have seen few changes
cumbersome
the
and
time-consuming
observed in issuing, receiving, and
practices
securities.
The purmade by the primary dealers
Government securities frequently num-
Government
delivering
chases and sales
in U.S.
ber in the thousands on a single day, and so
is
it
apparent that an enormous amount of un-
pleting
individual
securities;
an experimental clear-
was created
ble to transfers of securities
that
between two
York City member banks and banks
Federal Reserve
districts
originally designed.
A
which
it
tion of the various types of transfers of
ernment
clearing
through
was
brief illustrated descrip-
Gov-
securities eligible for inclusion in the
arrangement
appears
in
Charts
1
3.
ticipants that maintain securities accounts with
was made toward
reducing the need for individual deliveries of
ing arrangement
City, in addition
interdistrict transfers for
New
delivery of the securities concerned.
Government
to the
was applica-
is
In mid- 1965 a beginning
the participants
now encompasses
securities among
Government
in New York
At the same time that the securities clearing
was being developed in New
York, plans were also being formulated within
the Federal Reserve System for the establishment of a book-entry procedure in connection
with the issuance and custody of U.S. Government securities held by the Reserve Banks for
member banks and certain other market par-
expended in comtransactions by physical
necessary time and effort
their participation in
such an arrangement. Of even greater impor-
in
other
through the Federal
arrangement
the Reserve Banks.
book-entry
Among
other things, the
procedure will contribute to the
facilities.
further development of the securities clearing
and bookNote.
entry procedures have been improved and expanded
since this paper was prepared in June 1969. In addi-
the daily net clearing balances by the delivery
Reserve System's telegraphic transfer
—
Many
aspects of
the
clearing
tion, the clearing participants currently include all
member banks
Association.
of
the
New York
Clearing
12
House
arrangement by eliminating the need to
of definitive securities. This prospect
settle
and other
important implications of the book-entry concept are discussed in this paper.
SECURITIES CLEARING ARRANGEMENT
II.
CLEARING TELEGRAPHIC TRANSFERS
OF GOVERNMENT SECURITIES
From
Bank
time
of
to
New
time,
Yorlc
tlie
Federal
Reserve
has considered various
proposals to reduce the substantial volume of
Government securities that are delivered daily
to
as fiscal agent of the
and from the Bank,
United States, in connection with interdistrict
telegraphic transfers of such securities among
Federal Reserve cities. Early in 1965 the Bank
formulated a proposal designed to achieve this
objective.
contemplated a
between the Reserve
Bank and seven of the major New York City
member banks ' that would provide for the esIn
essence,
clearing
the
proposal
arrangement
tablishment of securities clearing accounts at
the Reserve
Bank
in the
name
of each partici-
pating bank; in lieu of the physical deliveries
of securities by or to the New York City mem-
ber banks in connection with each individual
telegraphic transfer, appropriate entries would
be made
in the clearing
closed-circuit teletype
accounts by means of
notification to or
from
bank concerned. Settlement of the securities
owing at the close of business each day, based
on the net balances in the securities clearing
accounts of each participant, would be made
by deliveries of securities at the Reserve Bank,
the
amounts indicated by such balances, at
or after the close of business. It was estimated
that, over all, this clearing process would result
in reducing by about 80 per cent the burden
in the
of physically handling the securities associated
with these transactions.
experience, Bankers Trust
test
Manufacturers Hanover Trust
Company and
Company were
invited to join the operation in mid- 1966, fol-
lowed successively by First National City
Bank, Chemical Bank New York Trust Company, Chase Manhattan Bank, and the Bank
of
New
York.
With these additional banks the clearing
arrangement had grown to include as active
~
participants 8 of the 1 1 New York City banks
bond
Government
whose operations in the
market, either directly or as clearing agent for
nonbank dealers, were on a scale broad enough
to
participation in a local clearing ar-
make
rangement
attractive
During the
and
efficient.
stages of the clearing ar-
initial
rangement, questions necessarily arose about
the limitations on participation that should be
established.
For example, although
contemplated
inally
would extend only
banks
City
— and
to the principal dealers in
ties
—
number
a
It
it
was
orig-
arrangement
member
through them
Government
securi-
of exploratory inquiries
received regarding direct
ticipation.
the
to the seven largest
New York
in
that
were
nonbank dealer par-
did not appear necessary or ap-
propriate for the
Bank
to enter into direct ar-
rangements with nonbank dealers so long as
their clearing needs were adequately served by
the
member banks in the clearing group. Simithe Bank believed that dealer banks lo-
larly,
cated in other districts could and should par-
Following discussion of this proposal with
the Treasury Department, the Bank received
Treasury approval early in 1965 to conduct a
pilot-test operation of
ment with Morgan Guaranty Trust Company.
The pilot test was begun in July of that year
and in August was extended to include Irving
Trust Company. On the basis of the successful
ticipate
in
the
clearing
the facilities offered
banks
in
New York
arrangement through
by participating member
City.
such a clearing arrange-
1 Bankers
Company, Chase
Trust
Bank, Chemical Bank New York Trust
First National City Bank. Irving Trust
Manufacturers Hanover Trust Company,
gan Guaranty Trust Company.
Manhattan
Company,
Company,
and Mor-
-
Frankhn National Bank became the ninth active
in June 1969. Marine Midland Grace
participant
Trust Company and United States Trust Company
have joined in signing the clearing agreement but
have no immediate plans for active participation.
AUTOMATING OPERATIONS
1
IN
GOVERNMENT SECURITIES
2
LOCAL NEW YORK CITY TRANSFER
I
PHYSICAL DELIVERY -1
AUTOMATING OPERATIONS
3
IN
GOVERNMENT SECURITIES
MULTIPLE TRANSFER, Involving
PHYSICAL DELIVERY
-
Tim
All
Participating Banks
data processing equipment can be
electronic
put into operation by the Bank. Such equip-
ment
have
will
transfer
the
same time
it
will
of
capability
instructions
purposes
—
at
be capable of capturing
the
all
and accountincluding the development of
net securities balances of the various partici-
—and
—
—
pants
for the entry of debits
payments
representing
transferred
to
member banks
equipment
the
reserve
and
the
credits
securities
accounts
concerned. Until
installed,
is
for
As another means
switching
automatically;
pertinent information for clearing
ing
denominated certificates until the net
ment of balances each day.
of
the
this electronic
messages must be
re-
mum
of encouraging the maxi-
use of the clearing arrangement, banks
and other
Treasury
delivery
new
institutions subscribing to
Government
of
settle-
offerings
bill
of
securities
those
—
—such
as the
are permitted to take
securities,
whole or in
in
part, as a credit to their clearing
the issue in question.
Inasmuch
ble portion of such
newly issued
destined for transfer
issues
weekly
by wire
account for
as a considera-
to
securities
is
other local
or to other Federal Reserve
clearing banks,
layed and settlement positions developed by
Banks and branches, on the
manual methods. Accordingly, the volume of
intracity transactions must be kept within manageable limits by establishing relatively high
(in
1969,
dollar amounts per transaction
$250,000) as the minimum eligible for han-
of the clearing arrangement can
the transactions involving the principal dealers
dling through the clearing arrangement.
in
issue date, this use
eliminate a
great deal of unnecessary physical handling for
all
concerned.
Looking forward
Government
to the time
securities
will
when most
of
be accommo-
dated by the clearing arrangement, the scope
OTHER TRANSACTIONS PROCESSABLE
THROUGH CLEARINGS
of the clearings could be broadened to include
securities
States
amount of daily traffic
between the Reserve Bank and the New York
City banks and dealers in connection with the
There
is
or
Government
securities.
making physical
issued
by agencies of the United
a possibility that
principle
of
is
discussed later.
clearing
and
valuables on a net balance basis
nor
is
the use of telegraphically
settling
is
for
not new,
communicated
of
information to effect the transfer of securities
The rapid completion
between a seller and a purchaser. However,
the combination of these two established con-
denominational
exchanges,
of such exchanges can often be a critical factor
in
The
a substantial
"splitting,"
—
deliveries
on
a timely basis.
cepts in the current clearing arrangement, sup-
In order to expedite these denominational ex-
ported by the high-speed switching and data
changes, the clearing arrangement was broad-
processing capabilities offered by today's elec-
ened, effective in January 1969, to allow the
tronic computers, can assist in coping with the
participants to request the "change" they re-
quired
over
the
clearing
teletype
facihties,
thereby deferring the inclusion of the larger-
rapidly growing physical burden that
is
already
taxing the resources of large-volume handlers
of
Government
securities.
AUTOMATING OPERATIONS
IN
GOVERNMENT SECURITIES
BOOK-ENTRY PROCEDURE
I.
In June
1963 the Board of Governors of the
Federal
Reserve
System
suggested
the
that
Conference of Presidents of the Federal Re-
Banks consider adopting a book-entry
serve
arrangement for Government securities held
in
While not expressed
Conference
in the
Presidents,
of
approval of the
adoption
of
the
book-entry procedure for safekeeping accounts
effectively
brought to an end the longstanding
policy of the Reserve
Banks against the ac-
custody by Federal Reserve Banks for their
ceptance of safekeeping deposits from banks
member banks
located in the central financial districts of their
means
a
as
of
freeing
vault
—
space, reducing the burden of cutting coupons
respective
and
because of the limited vault
collecting interest,
and minimizing the
risk
of misplacing securities of high value. Follow-
ing a study of this
proposal by the Reserve
Banks, discussions were held with
officials
of
Department and performance
tests were conducted at selected Reserve Banks.
Meanwhile, counsel for the Reserve Banks
Treasury
the
in
association with counsel for the Treasury
cities
and because there is a considerable
amount of movement between member bank
holdings and securities held by city banks as
custodians for their correspondent banks, trust
and others, including pledged ac-
accounts,
proved by the Conference of Presidents, the
of the Internal
placement
tive securities for
counts
discontinue issuing definiin the
and instead may
affected
custody acrely
on
ties.
Originally, the book-entry procedure ap-
plied only to
member banks
its,
Government
as
( 1 )
securities
free safekeeping depos-
(2) collateral to Reserve
and (3)
collateral
to
held for
Bank advances,
Treasury tax and loan
accounts and other public deposits. Pursuant
to
regulations
specific
governing book-entry
accounts formulated by the Treasury Depart-
ment, the program was put into
effect at the
various Federal Reserve offices on January
1968, and
ties
at
all
such
holdings of
Government
1,
securi-
offices for the three types of ac-
counts were converted to a book-entry basis
by the end of
that year. In addition, a
number
of custody accounts maintained
Reserve Bank of
Department
New
by the Federal
York for the Treasury
and for various
organizations were converted.
international
member banks made little response to
offer of this new service. In addition,
the
banks have been reluctant to put any of these
under the book-entry system because
securities
Revenue Service (IRS)
rulings
regarding the identification of such book-entry
securities for tax purposes.
As
a
computer-based system of book-entry securi-
member
confined to the investment holdings of
counts,
may
facilities available
banks,
The proposal was approved in principle by the Conference of Presidents in December 1965.
By means of the book-entry procedure apReserve Banks
primarily
initiated
However, because the
first promulgated was
the Reserve Banks.
at
book-entry procedure as
continued to review the legal implications of
the proposed book-entry procedure.
a policy
a major step toward
overcoming some of
the obstacles impeding the full-scale use of the
procedure,
book-entry
ment
is
revising
the
Treasury Depart-
and broadening
its
applicable
regulations to permit the conversion of certain
accounts
third-party
to
a
book-entry
This revision, though applicable
basis.
at the outset
pledged accounts of the types currently in
to
effect
at
the
Federal
Reserve
Banks
and
branches, nevertheless opens the door to the
inclusion of additional categories of accounts
maintained by
member banks
subject to the
orders of others, such as correspondent banks,
trust
accounts, and
ernment
being
nonbank dealers
in
Gov-
securities. Coincidentally, attempts are
made
to bring about a modification of
IRS regulation on book-entry securities,
which if successful should simplify the carrying
the
out of transactions in these accounts.
Although large-scale adoption of the book-
—
—
entry procedure by banks in the central finan-
discussions
would present no difficulties in
terms of maintenance by the Reserve Bank of
banks with a view to converting their holdings
to a book-entry system also. The inclusion of
cial
districts
the required book-entry records,
could gen-
it
amount of daily traffic befrom depositors for physical
be held with foreign central
will
Open Market Account and
the
Reserve Bank's foreign accounts
cause of requests
entry
delivery
of securities
to
their
or to others for their account.
representatives
As
discussed in
the following section, however, the effects of
this
New
York,
will
be reduced
to the extent that the securities can be trans-
ferred
among
participating banks through the
existing securities clearing arrangement,
which
requires only teletype notification rather than
physical delivery.
Plans have been
ties in
the System
book-entry
IV.
movement
counts and
made to convert the securiOpen Market Account to a
procedure.
At some future date
sion
would greatly
facilitate
member
banks.
may be
book-entry arrangements
of
the
from the purtransactions between these ac-
further in the future
Still
book-
in the
of securities resulting
chase and sale
increased activity, at least at the Federal
Reserve Bank of
procedure
New York
the
erate a substantial
the exten-
one or
at
more Reserve Banks to accommodate virtually
all owners of Government securities
including nonbanking institutions and individuals
through member banks. Once the principle of
relatively unlimited computer storage capacity
is accepted, there would be no insurmountable
—
barriers to the furnishing of book-entry cus-
tody service to
all
types of holders.
EFFECTING CLEARING SETTLEMENTS THROUGH BOOK-ENTRY
As already
discussed,
book-entry proce-
the
As
to the intracity transfers.
a consequence, the
dure that was adopted by the Federal Reserve
local transfer activity will be increasingly ex-
Banks in January 1968 was restricted to Government securities owned by member banks
and deposited with their Reserve Banks to be
or
held either in free safekeeping, or as collateral
tions.
Reserve Bank advances. Treasury tax and
loan accounts, or public deposits. Within a
balances at the end of each day will involve a
to
short time,
however, the book-entry concept
could be extended to apply to
all
Government
panded
pledged
to include transfers involving
accounts,
third-party
collateral
to
dealer
loans and loans to others, and similar transac-
Thus
the net settlements of the clearing
broad cross section of the kinds of accounts
maintained by any one participating bank.
Under
the
book-entry procedure these
di-
by member banks for their own
or for other accounts, thereby encompassing a
verse
number
fore not possible to settle the clearing account
securities held
of additional categories of holdings
including pledge arrangements
—not
provided
for under the present system.
The development
ties
of the
Government securiaccompa-
clearing arrangement has been
types
among
of
accounts
not
those that are eligible, and
it
included
is
balances through book-entry accounts.
ever,
once steps are taken
unrestricted
Government
to
the
For example, while interdistrict transfers of securities between Federal
Reserve Banks and branches are restricted to
bona fide sale transactions or to the borrowing
or the return of securities by a primary securities dealer, no such fimitation has been applied
mated Government
there-
How-
permit relatively
securities custody serv-
member banks on a book-entry
way will be clear to permit a fully
ices to
nied by a gradual broadening of the types of
transactions covered.
are
basis,
auto-
securities clearing arrange-
ment. In lieu of physical settlements the Reserve
Bank would merely
credit or debit the
respective book-entry accounts of the clearing
banks with the par amounts of the Government
securities issues owing to or owing from each
AUTOMATING OPERATIONS
bank
IN
GOVERNMENT SECURITIES
To
as a result of the netting process.
per-
of a
large
volume
mit accurate accounting to their depositors, the
amounting
member banks would be expected
lions of dollars,
maintain
to
adequate internal records indicating the exact
each of their dealer or custody ac-
interest of
counts in the net clearing settlements and
the
account
book-entry
resulting
in
balances.
Normally, the clearing settlements would
in
Government
of
securities,
the aggregate to hundreds of mil-
from the banks where the
se-
are lodged to the banks that are ex-
curities
tending the loans.
counting,
The
examining,
labor involved in the
and movement of
this
normally defer the
collateral causes delays that
in-
delivery of the pledged securities to the lending
volve only one debit or credit entry for each
until late in the afternoon. Under a
combined book-entry and clearing procedure,
these transfers could be effected simply by
making entries in the affected accounts at the
Reserve Bank and confirming them by appro-
affected securities issue in a bank's book-entry
account, but in certain cases a limited
of subaccounts
number
would be maintained for
indi-
vidual banks corresponding to the general categories
of account
forth)
on the books of the bank.
(investment,
trust,
and so
banks
teletype
priate
The proceeds
notification.
of
the use of book-entry procedures relates to the
would be debited to the reserve account of the lending bank and credited to the
borrowing dealer, through the reserve account
of its clearing bank, at the same time that the
movement
securities are transferred in the
One
the loan
area of expansion of the clearing ar-
rangement that should be greatly assisted by
of securities as collateral for over-
night loans
made by banks
Government
in
securities.
when
well after midday,
lied
up
curities
the dealers have tal-
their total receipts
and assessed
loans
these
nonbank dealers
Normally negotiated
call
to
and
their
for
the
deliveries of se-
cash requirements,
physical
movement
counts. All entries
the following day
book-entry ac-
would then be reversed on
when
the loan
is
liquidated.
Such an arrangement, in addition to saving
time, would also eliminate the risks inherent in
amounts of
the exposure of large dollar
ties in
securi-
the streets.
CLEARING AND BOOK-ENTRY APPLIED TO AGENCY SECURITIES
V.
There
has
been
a
rapid
growth during
re-
cent years in the volume of securities offered
purchasers located
try are
in
other parts of the coun-
obligated to lodge their holdings with
New York
by the various agencies of the U.S. Govern-
correspondents
ment. The attractive rates on agency securities,
substantial costs incident to shipment to their
which are virtually indistinguishable from Government securities from the standpoint of
safety, have generated considerable interest on
the part of all investor classes and have re-
own
sulted in a steadily rising trading pace for such
securities in the
major
financial markets.
With few exceptions,
through
the
Federal
and paid for
Reserve Bank of
York. Since most of these issues are not
facilities of the
number
of instances, however, arrange-
ments have been made whereby
New York
City subscribers to certain bearer issues of the
National
Federal
Mortgage
Association
and
Export-Import Bank of the United States
may transfer their allotments, through Federal
Reserve System telegraphic
facilities, to either
New
the
eligi-
serve Bank, which will complete delivery
Chicago or the San Francisco Federal Re-
from
a supply of unissued stock maintained for that
Federal Reserve System,'
purpose. In addition, telegraphic transfers re-
Telegraphic transfer between Reserve Banks and
branches is possible only where stocks of unissned
securities are maintained at such banks in connection
with the original issue and related fiscal services.
'
city.
In a
through the leased
ble for telegraphic transfer
wire
City or to incur
the
securities of agencies
of the United States are issued
in
sulting
from subsequent transactions
securities
may be
effected
among
in
these
these three
Reserve Banks by means of the same
facilities.
The
further development and expansion of
the securities clearing arrangement discussed in
paper must be extended,
this
clude
obligations
of
the
of
United
comcommunity. To
the extent that these non-Government securiStates
plete
ties
if
the
service
arrangement
to the
may become
to furnish
is
financial
eligible for telegraphic trans-
through Federal Reserve facilities, they
must be among the issues represented in the
clearings. In any event the anticipated expansion of the clearing arrangement may necessifer
mechanism
tate the use of this
local delivery of
not these issues
transfer
noted
eral
agency
become
securities
later to securities
owned by
owned by
and customers of these banks,
no doubt ultimately lead to the inclusion
of securities of Government agencies as well.
The resulting expansion of the clearing arrangement and the book-entry procedure to
the depositors
will
roughly twice the number of individual issues
view of the immense recordkeeping capability
As
cities.
New York
in providing
—whether
securities
in
Govwould
for
—
such an ar-
of the sophisticated data processing
now
available. Since the
equipment
Reserve Banks have
long been accepting the deposit for custody of
types of securities
all
rities
—from
—
including agency secu-
member
their
banks, no question
of policy should arise in this connection.
CONCLUSION
The years that have elapsed since the start of
World War I have seen remarkable changes
affecting almost every aspect of the
The myriad
benefits
of
a
economy.
computer-oriented
society appear on
all sides, and sophisticated
and time-saving devices have become
labor-
commonplace
and
streets of
in practically all areas of finan-
industrial
activity.
Nevertheless,
Manhattan and other
throughout the country are
the
financial censtill
filled
with
hundreds of messengers making thousands of
trips
Government
eligible for telegraphic
be absorbed by the participants
ters
custody
involved in each category at the present time
ernment or non-Government
cial
to
member banks and
book-entry
of
Reserve Banks, applicable
should present no administrative problem in
an intracity clearing service
VI.
initially
at the
whether or
securities,
any costs incurred by the Fed-
Reserve Bank of
arrangements
to simplify the
among Federal Reserve
earlier,
The establishment
time, to in-
in
agencies
rangement rather than by the Treasury Department.
each day
—
delivering
individual
lots
of
back and forth among the banks and
dealers that comprise the Government bond
securities
market
—
exactly
they did when the
Loan Bonds was made
as
offering of Liberty
first
five
decades ago. The failure to complete any one
delivery by the appointed time can cause the
cancellation of security transactions involving
millions of dollars, can result in unanticipated
and unnecessary
interest costs,
and can create
operational problems that
of participants
in
may
affect a
number
these transactions.
change these cumbersome
methods and to allow the traders in
Government securities to function free of the
limitations imposed by antiquated physical deIt
essential to
is
delivery
livery
can
methods. Since transactions
now be
means
finally
of teletype,
consummated
in securities
seconds by
and painfully slow individual
deliveries can be replaced
in
by end-of-day
settle-
ment on a book-entry basis, the means are
at hand for radically improving the market
mechanism. The savings in time and labor resulting from the elimination of most physical
securities-handling tasks will also result in more
economical operations on the part of all Government bond dealers, their clearing banks,
the Treasury Department, and the Federal
Reserve Bank of New York.
The combination
niques,
clearing
of teletype delivery tech-
procedures,
and book-entry
AUTOMATING OPERATIONS
arrangements
IN
GOVERNMENT SECURITIES
—conducted with
computer-switching and
—can broaden scope
the aid of rela-
data-
tively unlimited
the
storage capability
Government
trading
never before thought
completion
of
activities
possible.
transactions,
to
a
of
degree
Instantaneous
with
immediate
payment in Federal funds, will become commonplace and markets throughout the country
will
be as accessible as those across the
street.
proportion to the increase
in
the
number
of
banks and other participants covered by the
new arrangements.
In a period
when extreme
time pressures, heavy workloads, and shortages
of skilled
they
will
operations,
manpower
continue
are crucial factors
to
problems that
ers,
and others
store physical securities will diminish in direct
ties
operations.
—
in
all
— and
securities
new techniques offer the
many of the growing
are now faced by banks, dealinvolved in Government securi-
these
promise of solutions to
Further, the need to issue, receive, deliver, or
be
12G7
@FedFRASER