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Treasury-Federal Reserve Study o f the
U.S. Government S e c u r i t i e s Market


S t a f f Study prepared by
He limit Wendel
Economist, Board of Governors
Kay 22, 1967



Research Library

The Position of Nonbank Dealers When Treasury Securities
Permitted in Tax^ and Loan Accounts*
(by Helmut Wendel)

Summary and Conclusion
Treasury permission to accept payment for debt issues by
credit to tax and loan accounts gives commercial banks an incentive
to underwrite such issues, even if an underwriting loss is involved.
When the tax-and-loan-account priviledge is granted, bank competition
frequently makes underwriting activity unprofitable for the nonbank
The Treasury has provided tax-and-loan eligibility only
in the case of cash financings in which Treasury cash balances are
augmented for some time to come.

Such financings impose abrupt net

additional credit demands on the economy, which can be accommodated
with least disturbance to financial markets, if there is a concomitant
expansion of bank credit.

When the banks are given the underwriting

incentive through tax-and*loan eligibility, the desired bank credit
expansion tends to be generated in a smooth manner and, in addition,
the Treasury tends to economize on interest costs.
When the Treasury needs to borrow additional funds, it
frequently finds it convenient to sell a large issue of new securities
that will satisfy its financing requirements for a time span of several


For a related presentation and for some further detail, see, Irving
Auerbach, "United States Treasury Cash Balances and the Control of
Member Bank Reserves," in Fiscal and Debt Management Policies (prepared
for the Commission on Money and Credit, 1963) pp. 352-8.



Cash financing of this sort, which tends to involve one or

several billion dollars of new money, results in a temporary swelling
of Treasury cash balances and imposes a sudden large additional
credit demand on financial markets.

The commercial banking system

acting in cooperation with the Federal Reserve is geared to handle
such large sudden shifts in credit demands in a smooth manner, and
a temporary increase in commercial bank credit for such financing
purposes does not prejudice an ultimate financing of Treasury deficits
either directly out of business saving, or indirectly out of household saving.

Hence, when the Treasury taps a large amount of new

money a concomitant expansion of bank credit is desirable and
In this general setting, the Treasury has adopted the
practice to accept payment in commercial bank tax-and-loan accounts
for large security issues that will increase its cash balance for
more than a few days.

Banks who underwrite for such security issues

(for their own account or for customers') thus pay for them merely
by crediting their tax-and-loan accounts and they can count on
keeping the new tax-and-loan account for a number of days.

As a

result, the immediate excess-reserve drain for the underwriting banks
is smaller than in a normal security purchase where it is unlikely
that the seller of the security will use his proceeds to build up a
deposit balance at the purchasing bank.

In the case of a tax-and-

loan account issue, the immediate excess-reserve drain consists of
the required reserves that have to be maintained for the tax-and-loan

-3account, and the remainder of the drain is postponed until the Treasury
calls the tax-and-loan account to be transferred to its Federal Reserve

Since this practice makes tax-and-loan account issues unusually

attractive to commercial banks, the banks are willing to underwrite them
at interest rates below the going market yield.

The Treasury thus finds

that tax-and-loan account financing (1) economizes on interest costs, (2)
automatically insulates the size of the Treasury's balance of the Federal
Reserve banks from the financing operation, and (3) insures bank participation in the underwriting for bulky security issues, for which some
form of bank credit expansion is required in any case.
Treasury Bill Auctions
In Treasury bill auctions that involve the replacement of
a maturing bill by a new issue of equal or somewhat larger size, the
Treasury requires either direct payment to its account at Federal Reserve
Banks or an exchange of maturing bills for the new issues.

There is

no particular advantage to investors in using the exchange option, and
generally they find it more convenient to settle their accounts for

However, when a bill auction involves tapping the market for

net new funds in excess of, say, one billion dollars and when the


sury has not scheduled an offsetting large payment on the same day, the
Treasury will invariably permit payment for the new bill? by credits to
taxrand-loan accounts.

Banks can retain both their own and their,cus-

tomers allotments in tax-and-loan accounts, and they will, of course,
do so,


-4In the bill auctions that require direct payments to the
Federal Reserve, nonbank dealers usually perform an important underwriting function.

From January 1961 to Novermber 1966, for instance,

there were 49 bill auctions for one-year bills alone with full payment required to the Federal Reserve accounts.

They represented either

rollovers or new cash financings, and they involved $60.7 billion of

Out of this total, nonbank dealers obtained allotment in the

amount of $20.1 billion, representing an average of 33 per cent (see

Obviously, the nonbank dealers invested much time, skill, and

capital into the task of submitting profitable bids at bill auctions,
and having acquired special skills in placing bids for bills they may
understandably be disappointed when the Treasury, for reasons described
above, permits payment in tax-and-loan accounts on some other bill
financings which to the market appear quite similar in character.
Since issues with tax-and-loan account eligibility involve special
advantages to the banks that carry tax-and-loan accounts, these banks
will submit bids below the market yield on comparable issues.


is described in more detail in the Appendix the banks are willing
to take a capital loss in placing underwriting bids for such issues,
and because of this bank competition the nonbank dealers are completely excluded from participating in the underwriting on a profitable basis until banks start distributing their allotments.

Some one-year bills were issued during this period in new cash
financings with fifty per cent of the payment permitted in taxand-loan accounts. These are excluded from the figures cited here.

The present paper is particularly addressed to the
question whether permission to make payment in tax-and-loan accounts
imparts an unintended or unfair handicap on the profit-making
opportunities of nonbank dealers.

For the case of auction issues

this question is evaluated as follows;


The specialization of dealers in underwriting regular
Treasury bill issues, and in taking speculative positions
in Government securities generally, implies that any
institutional obstacle which limits a dealer's ability
to underwrite a certain Treasury offering will restrict
his opportunities of making profits in the very area
where his skill is most developed.

Thus, an arbitrary

recourse by the Treasury to the tax-and-loan account
provision could be criticized as discriminatory against
nonbank dealers.

However, the Treasury's permission for payment in taxand-loan accounts has not been granted arbitrarily in
the past.

It has been granted only when a large cash

offering was not matched by large outpayments, and when
the cash offering thus imposed an abrupt net new demand
for credit on the economy. In such cases the impact of the
cash offering--without bank underwriting--would impose a
temporary stringency on capital markets or would require
large offsetting operations by the Federal Reserve. It is
desirable, therefore, to soften the impact of such new
financings by matching the temporary increase in Treasury


-6balances with a temporary increase in commercial bank

This can be accomplished most smoothly, if the

banks themselves are given an incentive to underwrite the
new issue.

Any realistic alternative financing technique

would still require an expansion of bank credit but,
perhaps, in the form of loans to dealers who could then
function as underwriters.

In view of the fact that the

dealer loan market is more personal and less broad than
the Government securities market, such an alternative
would be less reliable as an operating device than present techniques.

Moreover, the present techniques broaden

• the underwriting support for the Treasury issues by bringing in the banks and at the same time minimize the interest
costs to the Treasury because of the tax-and-loan incentive.

In summary, then,it appears that when banks underwrite
large new money financings by the Treasury, they simultaneously perform the functions of underwriting and of
providing additional net new credit.

Since the nonbank

dealers can only perform the first of these two functions,
the conclusion emerges that they are not arbitrarily excluded from providing services which they could adequately

It may also be noted that banks which have dealer departments usually make only one tender in the tax-and-loan
eligible bill auctions both for their dealer and investment
account, and then normally allocate, at most, a small

portion of their allotment to their dealer department.—
Hence, on the face of it, the competitive position of
the nonbank dealers vis a vis the bank dealers seems not
to be affected by the tax-and-loan account eligibility
of certain financings.
Flotations of Coupon Issues
Much of the analysis that was developed above applies also
when the Treasury issues a coupon security at a fixed rate of interest,
in order to raise new cash.

New-cash financings at a fixed rate of

interest practically always involve a large operation in which the
Treasury raises more than one billion dollars at one time.

Hence dur-

ing the six years covered by this analysis, tax-and-loan account eligibility was provided in all new-cash financings in which coupon securities
were sold without the auction mechanism.

From 1961 through 1966, there

were six such financings in which a total $9.0 billion of funds were
raised from the public.

While in the case of the Treasury bill auctions

with tax-and-loan account eligibility, successful bids by banks
accounted for virtually 100 per cent of the total issue, bank
allotments to these six coupon issues represented 76 per cent of
the total sold to the public.

Nonbank dealer allotments of these

issues accounted for 5 per cent, and the remainder was sold directly
to various other types of investors.

As might be expected, bank

Based on unpublished data provided by the Federal Reserve Bank of
New York.


allotments were especially large for coupon issues with short
maturities, since for such securities the benefit of temporary
tax-and-loan deposits makes up a larger portion of the total
returns on the investment than in the case of longer-term securities.
The relative allotments to banks and tononbank dealers in
these new cash financings can be compared to their allotment rates
in cash exchange offerings, where the new issues replaced maturing
ones and where payment in Federal funds (or in maturing securities)
was required.

Among coupon issues such cash exchanges involved

$32.1 billion of securities betwen 1961 and 1966 after subscriptions
by U. S. Government investment accounts and Federal Reserve Banks
are excluded.

Bank allotments accounted for 51 per cent of

this total, and nonbank dealer subscriptions for 10 per cent*


data indicate that dealer underwriting was relatively low in the
new money offerings which carried tax-and-loan eligibility.


attractiveness of the tax-and-loan offerings to nonbank dealers
can be evaluated by comparing issue prices with the ask prices
that were established in trading on a when-issued basis#


the three short-term cash financings with tax-and-loan eligibility*
one finds that the ask prices in the first three days of when-issued
trading averaged out to be the same as the issue price.

In the

case of the three longer-term financings with tax-and-loan eligibility,
the comparable ask prices were 5/32 higher on average*

These results

can again be compared with the experience of the cash-exchange

Here the when-issued ask price for new short-term

-9issues (under two years in maturity) tended to be 4/32 above the
issue price, while the ask price for longer-term issues average
5/32 higher than the issue price.
The conclusion seems warranted that the Treasury does
take the tax-and-loan privilege into account by shading the price
upward in the case of short-term new-cash issues with tax-and-loan

In the sample investigated here the nonbank dealers

were well advised to leave this underwriting to the banks as, in
fact, they tended to do#
In the pricing of longer-term new-cash issues, the
Treasury appears to be sensitive to the possible absorption difficulties of a n€iW cash issue, and hence3 it seems to allow for
some underwriting profit in addition to the tax-and-loan incentive.
The allotment data show that nonbank dealers underwrite 6.8 per
cent of such issues and this suggests that underwriting participation
by nonbank dealers in. these flotations is inhibited only to a
moderate extent.

The Volute of Tax-and-Lean Eligibility to Commercial Banks.
Assume that the Treasury issues a security which is expected

to trade at price M in the market: judging by the prevailing level of
market yields and the shape of the yield curve.

Potential underwriters

then would expect to find buyers for this security at price M plus
(or minus) a premium (or a discount) depending on special expectations
that these underwriters hold about the near-term movement of market

Disregarding these special expectational factors, nonbank


-10dealers would be willing to underwrite the security issue as long
as they can obtain it at a price slightly below M or lower.
If the security is issued with payment permitted by
credits to tax-and-loan accounts, its expected price in market trading is not likely to be affected and can still be represented by
price H.

Banks, however, will be willing to underwrite such a

security issue at a price greater than M.

The bank will estimate

the average number of days that the tax-and-loan account which it
creates in payment for an allotment of the new security, will
remain deposited with the bank.

During that number of days the

bank has the security on hand either for sale or as an interestearning investment, but its opportunity cost consists only of the
required reserves that have to be maintained to carry the tax-andloan account.

Hence, there exists a cost disparity between bank

and nonbank investors:

during the interval of a number of days,

the bank's cost consists of the required reserve fraction, while
the cost to nonbank investors consists of the full amount of their
Suppose that bank reserve requirements are 15 per cent
and that the average life of the tax-and-loan account will be 10

A bank that has been allotted 100 units

of the new security

at price P can plan to sell its allotment on a when-issued basis
at price M.

It thus can count on obtaining $10011 in Federal funds

on the day of issue.

Out of these proceeds it needs to deposit

$15P with the Federal Pveserve for reserve requirements and it needs

-11to pay an additional $85P 10 days later—on average—when the taxand-loan account is called,

During 10 days, the bank has at its

disposition $100M— $15P which it can use for an interest-earning
investment of its chosing.

The value of this earning power can be

measured by the going rate on Federal funds.

Suppose the cost of

$100M-$15P for 10 days, at the going Federal funds rate, is V.
At the end of 10 days, then, the bank can expect to have obtained
extra earnings valued at V*

Hence the bank would break even as

an underwriter if its eventual payment of $100P should equal the
funds that it has obtained, namely, $100M 4- V,
Thus the break-even underwriting price for the bank can
be computed by solving for P in this equation:

100P - 100M -I- V


M -!- V/100

If the going rate on Federal funds is R, V can be
calculated as follows in this example:

V = [10(R)/360]IIOO(M) - 15 (P)]
Substituting equation (2) into equation (1):


P - M + [10(R)/360][M - .15(P)]
By algebraic manipulation, equation (3) can be transformed


P = M 360 -j- ICR

10R (.15)

As represented in equation (4), P represents the issue
price at which an underwriting bank would expect to break even.


-12Whenever the actual issue price is below P, but greater than M,
banks can achieve underwriting profits, but nonbank dealers would
tend to suffer losses as underwriters.

Allotted To
Nonbank Commercial
issued to
Financings Dublic 5/ Dealers
(In billions of dollars)


Selected Bill Auctions
1. All bills with tax-and
loan eligibility 2/
2. One-year bills without
tax-and-loan eligibility



Selected Coupon Issues
1. All issues with tax-and
loan eligibility



















maturing within 2 years 3/
maturing after 2 years 4/








Cash exchanges—(not taxand loan eligible)







maturing within 2 years
maturing after 2 years










Excess of Market
Ask - Price Over
Issue Price 1/



Less than $50 million dollars.
Average ask prices at close of first three days of when-issued trading compared to issue prices.
In six auctions, included here, only 50 per cent of payment was eligible for tax-and-loan accounts.
Includes a 1-year, 7-month note issued October 11, 1961, (with 75 per cent of payment eligible for tax-and
loan accounts), a 1-year, 4-month note issued April 8, 1964, and 9-month certificate issued January 19, 1966.
Includes a 7-year, 8-1/2 - month bond issue January 24, 1962, a 6-year, 4-month bond issued April 18, 1962,
and a 7-year, 2-month bond issued June 20, 1963.
The data on bill auctions include allotments to Federal Reserve Banks and Government investment accounts;
the data on coupon issues exclude such allotments.