Saturday, May 4, 2013

Floating-rate Treasury debt

Last week the Treasury announced that is it going ahead with floating-rate debt, and gave some details how it will work. The Wall Street Journal coverage is here and the Treasury announcement is here. I wrote about the issue at some length last fall, here (And freely admit some of today's essay repeats points made there.)

Right now, the Treasury rolls over a lot of debt. For example, about one and a half trillion dollars is in the form of Treasury bills, which mature in less than a year. So, every year, the Treasury sells one and a half trillion dollars of new bills, which it uses to pay off one and a half trillion dollars of old bills.

With floating-rate debt, all the buying and selling is avoided. Instead, the Treasury periodically sets a new rate, so that the floating rate security has value one dollar (just as the maturing bill would have). It's the same thing, except the bill sits in the investor's pocket.

When interest rates go up, fixed-coupon long term debt falls in price. Floating-rate debt does not -- the interest payment goes up, so that the value of the debt is stable. Thus, even though its maturity may be long -- the Treasury mentioned two years -- the value of the debt is as safe as that of very short-term debt.

Homeowners are familiar with the system. An adjustable rate mortgage works the same way. You could take out a one-year balloon mortgage and refinance every year. But the adjustable rate is a lot simpler .

Now, I'm usually a Modigliani-Miller fan, and from the point of view of frictionless finance, it doesn't make any difference whether the Treasury has floating rate debt or rolls over debt. So why do I like this so much?

As a minor benefit, floating rate debt is just a little bit safer. It is possible that markets refuse to roll over debt, leaving the Treasury technically insolvent, unable to pay the principal on its existing debt. This is basically what happened in Greece. With floating rate debt, the Treasury would still face a crisis, unable to borrow new money, and forced next month to pay huge interest on the floating rate debt. But at least the crisis would be averted a bit and not result in immediate default. This is a very unlikely circumstance, you say, and I agree, but we all thought the last financial crisis was unlikely too until it happened.

A deeper benefit, I think, is that floating-rate Treasury debt opens the way to a run-free financial system.  I want huge capital requirements on banks for all assets except floating-rate or short term Treasury debt. And I don't like runs in money market funds.

The usual answer is, "that's nice, but people need lots of safe securities. We need banks and money market funds holding risky securities to intermediate to provide the vast amount of safe securities people want. You have to put up with runs, TBTF guarantees, massive regulation and so on."

Well, suppose the Treasury were to fund itself entirely by floating rate debt. We could have $11 trillion of floating-rate debt, generating $11 trillion of perfectly safe money-market fund assets. We can be awash in fixed-value assets, and could happily ban the rest, largely eliminating run-prone assets from the financial system.

(What about the interest rate risk, you ask? Didn't I just advocate the opposite, that Treasury needs to issue longer-term debt? Yes, but the Treasury can swap out the interest rate risk with fixed-for-floating swaps. Who will buy those swaps? The same people who are buying long-term Treasuries now. Of course, I also suspect that in addition to the Fed's $3 trillion of interest-paying reserves, which are also floating-rate US government debt, the demand will not be more than a few trillion.)

My  complaint though (you knew I'd complain, no?) is that Treasury did not go far enough. The proposal says that the Treasury will pay a rate determined by an index,
We have decided to use the weekly High Rate of 13-week Treasury bill auctions, which was described in the ANPR, as the index for Treasury FRNs.
This means that the price of the floating-rate notes will deviate somewhat from par ($100.)

I would much rather that the Treasury pegged the value to exactly $100 at all times, buying and selling at that price between auctions, and using direct auctions to reset the rate every month or so.

Why? The alleged "safe asset" demand is for assets with absolutely fixed value. This is why money market funds and their customers are howling about proposals to let values float. With these floating-rate bonds as assets, we will still need money market funds or narrow banks to intermediate, and provide assets with truly fixed values, wiping out a few tens of precious basis points for the end customer in the process (and tempting that customer to "reach for yield" and get us back in to trouble again).

If the Treasury issued fixed-value floating-rate debt, in small denominations, electronically transferable, we might not need such funds at all. Or, they would have to compete on providing better IT services for retail customers (likely!) rather than managing the small price fluctuations of floating-rate Treasury assets. The Treasury says it wants to broaden the investor base. Well, the "Treasury money market fund" open to retail investors like you and me is the broadest base it can imagine!

The Treasury may be deliberately avoiding this outcome, to keep money market funds in business (i.e. to provide them with a little artificial profit), as the Fed kept the Federal funds rate 10 bp or so above zero to keep such funds in business. But if funds need an artificially hobbled government security to stay in business, we should let them vanish.

I think the Treasury should also make them perpetual. The proposal says the floaters will have a two-year maturity, forcing owners to cash in principal and buy new again, and Treasury to refinance. Why? Why not make this just like a money market account -- floating rate perpetuities? Big enough surpluses so that the Treasury has to buy back perpetuities are a long way away!

In sum, A- Treasury!  But, instead of indexing, fix the price at $100 at all times, using an auction to reset rates; make them available in small denominations to regular investors with easy electronic transfers; and lengthen the maturity. A lot.

Then we can start clamping down on all the stuff that blew up in 2008.


  1. "I think the Treasury should also make them perpetual."

    The fed has already done that by turning Treasury securities into zero coupon perpetuals. Now that they have done that, why fuss any more.

  2. "I would much rather that the Treasury pegged the value to exactly $100 at all times, buying and selling at that price between auctions, and using direct auctions to reset the rate every month or so."

    Why do you need an auction to set the rate? The peg automatically determines the rate. (If the rate is too low/high, the treasury would be forced to buy/sell).

    1. Treasury needs to set the amount that they're paying periodically ... you could back it out from the trading price, but the formal rate-setting mechanism would still be an auction. Plus, that adds a bit of integrity to the process.

  3. Would like to see your take on the UST issuing 100 year debt, 50 year debt, 30 year debt; increasing the duration of the portfolio today at lower rates than historical rates.

  4. Better, if we are going to all floating rate securities then just have Congress budget how much interest it wants to pay on its securities.

    Take total interest expenditures authorized by Congress divided by total debt outstanding and that is the interest paid. Why bother with all the rigamarole of auctions?

  5. Here is the problem in a nutshell:

    Congress sets the amount of debt to be borrowed (non-market process)
    Congress sets the amount of tax revenue to be collected for a given amount of economic activity (non-market process)
    Federal reserve and others set interest rate (market process)

    Something has to give. Either interest expense must be a non-market process set by Congress, debt auctions must be allowed to fail via market process, tax revenue must be set by a market process, or another arrangement must be reached.

    Standard and Poors understood this when they downgraded U. S. government debt.

    "Right now, the Treasury rolls over a lot of debt. For example, about one and a half trillion dollars is in the form of Treasury bills, which mature in less than a year. So, every year, the Treasury sells one and a half trillion dollars of new bills, which it uses to pay off one and a half trillion dollars of old bills."

    Treasury rolls over the principle on the debt. The interest payments are made from tax revenue.

  6. Setting the value at exactly $100.00 and standing ready to buy for cash at any time at that price makes the instrument callable for all practical intents and purposes and that brings back the problems of roll over risk and runs.

    1. so you are saying that if there were a run on government debt, they would just dump all the debt back on the government for cash?

      would the government be obligated to buy it back though?

    2. I was responding to Professor Cochrane's suggestion that "the Treasury pegged the value to exactly $100 at all times, buying and selling at that price between auctions".

      An "obligation" to buy back is built in to Cochrane's suggestion.

    3. Absalon,

      I think John addressed that by saying that the floating rate securities should be perpetual (similar to British Consuls). In that case, there is no rollover risk.

  7. One question. Suppose the government has $15 trillion in short-term (say one-day) debt. Every day debt holders receive cash from the government and place bids for the next day. If it is known that the government is auctioning off $15T in new debt (to cash holders), then what incentive is there to bid a low rate / high price? In this situation the Treasury will have to limit the amount of debt. Perhaps it could say: we will auction off $10T to the highest bidders, and the remaining $5T will receive interest on reserves of 50% of the auction rate.

  8. Pr. Cochrane,

    Your cheering of floating rate treasuries isn't quite consistent with prior posts where you criticized QE (correctly in my view) for shortening the interest rate risk profile of the consolidated US Govt balance sheet.

    Furthermore, you say:

    "I would much rather that the Treasury pegged the value to exactly $100 at all times, buying and selling at that price between auctions, and using direct auctions to reset the rate every month or so."

    What you're describing here is auction rate securities (ARS). These put an immense amount of pressure on the borrower if it ever faces a credit/liquidity crisis. The only common form of funding that's more toxic than ARSs is rolling short term debt.

    1. Excellent comment.
      First, if after converting all debt under a year to fixed-value floating-rate, there is still demand for more, the Treasury can issue it, and then swap the interestr rate risk.
      Second, what I'm describing is closer to a money market fund. ARS don't promise fixed value between auctions. But the roll over risk is no different than the current risk, with short-term bonds that really are rolled.
      Third, you forget that he who prints money need never default!

    2. Thanks!

      On second:

      When someone shows up and asks the Treasury to bid their paper back at par, the Treasury has to deliver funds that it does not have. Presumably it won't issue 30 year fixed rate every time someone comes to get a bid on a floating rate note so the only place to get the funds from is the Fed. This means that inter-auctions, it's the Fed that effectively commits to lock the market at par on these notes.

      On first, there are several issues with these Swaps:
      - They would have to trade in and out of them every time someone bought and sold the notes at par or accept some deviation from the strategy you describe where a fixed amount is left unhedged and the rest is hedged.
      - There is currently no market for Swaps with that floating rate index. Not that one couldn't be created..

      On third, yes I think we share that view. Inflate or default..

      None my objections are show-stoppers, but I think there is a solution to what you're trying to achieve that is simpler from a financial engineering standpoint. If I understand correctly, you're ultimately trying to create a safe money-like asset that doesn't require bank alchemy (turning risky assets into risk-free asset). I'm fully onboard with that, here's the alternative I have in mind:

      Overnight repo with generous haircuts on Govt bond collateral (or potentially other collateral)

      For instance, the haircut formula could be something like 5% + 1% per year to maturity. For the borrower to take a loss, on a repo of a 10-year asset, yields would have to widen by more than 150bps in a single day *and* their counterparty would have to go bad.

      If the Fed were to use such instrument in its assets, even if the government credit deteriorated, it would be insulated as it would ask for more an more collateral everyday. If things got really bad it could ask for a different type of collateral with wider haircuts.

      Banks could be subject to the same rules, or simple go with full reserve banking which is functionally identical.

      I don't think we should design a system that assumes government debt is risk-free. Doing so would remove the option to default and only leave the option to inflate.

      In my little dream world, the Fed couldn't care less about the situation of government credit and the banking system would continue to operate smoothly through a government default.


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