Dealing with the Deficit
John Richards
Head of US Strategy
RBS
The deficit: Is there a problem? We can finance the government deficit now
because private borrowing has fallen sharply due to deleveraging and the
recession. Plus, monetary policy is exceptionally accommodative.
2
Net Supply of High Quality Assets: Trending lower even before
QE2 removes $600bln in Treasuries through June 2011
(bln)
2009
2010
2011
Treasury
1284
1600
1200
Agency
-17
-202
-120
Agency MBS
445
-65
100
IG Corporate
239
286
159
1951
1619
1254
Total
3
Gross General Government Debt for 2010 (% of GDP)
So, what’s the problem? 2011 projections of deficit to GDP and public debt to GDP
levels put the US dangerously near some “bad” company. And it potentially gets worse
over time. Historically, the US has been in the middle of the pack.
160%
Lebanon
Japan
Japan's Govt.
Debt is 225%
140%
120%
100%
Italy
Ireland
Greece
80%
UK
France
EurozoneAustria
Portugal
India
Egypt
60%
Spain
US 2011
Latvia
Lithuania
40%
20%
0%
-13%
Belgium
US 2021
Iceland
-11%
Red = Eurozone
Teal = G10
Orange = Asia
Blue = CEEMEA
Pink = LatAm
-9%
Hungary
Germany
Israel
Canada
Netherlands
Malta
Philippines
Malaysia Brazil
Argentina
Turkey Taiwan
Cyprus
Sweden
Switzerland
Slovenia
Finland Colombia
Czech
Croatia
Slovakia
Korea
New Zealand
Denmark Thailand
Peru
Mexico
Romania
South Africa
China
Ukraine
Ecuador
Australia
Indonesia
Venezuela Luxembourg
Estonia
Russia
Chile
Kazakhstan
Poland
-7%
-5%
-3%
-1%
1%
3%
General Government Balance for 2010 (% of GDP)
4
Norway
Singapore
Saudi Arabia
5%
7%
Deficits: Why do we care?
• Intergenerational wealth transfers: passing the future tax liability to our kids
• International wealth transfers: Foreigners and their children will have a future claim on us and our
children
• Resource allocation: public vs private; efficient vs inefficient; high growth vs low growth; debt service
costs become an increasing share of GDP
• Geopolitical: Foreign governments, especially central banks, not individuals, generally hold US debt,
giving foreign governments potentially undesirable political leverage over us
• USD reserve currency status: Global trends may be moving away from the dollar
• Inflation/monetization/currency debasement: Historically, this “slippery slope” has been a huge
problem for many of the countries that have tried it, sometimes leading to hyper inflation and economic
collapse
• Higher interest rates: Interest rates are the main transmission channel through which the economy is
affected. Crowding out; Credit rating; What happens when the Fed stops buying?
• Loss of flexibility: Could we deal with another crisis with our finances so badly strained?
• Financial strains: The rollover problem
• The debt-death spiral: Forced fiscal austerity lowers GDP, which increases deficits, which forces
further austerity. Greece and Ireland face this problem now.
5
The evolution of UST ownership: note increasing foreign holdings
Holdings of Treasuries by Agent as % Treasury Debt Outstanding
60%
50%
40%
30%
20%
10%
Households
Foreigners
Banks
6
Pensions + Insurers
Mutual Funds
2009
2007
2005
2003
2001
1999
1997
1995
1993
1991
1989
1987
1985
1983
1981
1979
1977
1975
1973
1971
1969
1967
1965
1963
1961
1959
1957
1955
0%
Foreign ownership is highly concentrated.
Foreign Holdings by Selected Groups in % Total Foreign Holdings
40%
35%
30%
25%
20%
15%
10%
5%
China & HK
Taiwan
Oil Exporters
2009
2008
2007
2006
2005
2004
2003
2002
2001
2000
1999
1998
1997
1996
1995
1994
1993
1992
1991
1990
0%
Japan
China and other Non-Japan Asia hold nearly 20% of total Treasury debt outstanding, or 37% of debt
held by foreigners. These ratios are up from 2% and 11%, respectively, in early 1994.
7
The deficit
A tail of three projections
8
1. CBO’s “current law” projection – things are ok, sort of…
• Under current law, deficits drop sharply at a percent of GDP, returning to the comfort zone of 3.1%
by 2014.
• But, debt held by the public continues to rise modestly, going from 70% in 2011 to 77% in 2021.
• This leaves the economy exposed to roll over, crowding out problems, and many of the other
problems discussed above.
4000
Baseline Issuance
Baseline Deficit
Baseline Rollover
3000
2500
2000
1500
1000
500
2021
2020
2019
2018
2017
2016
2015
2014
2013
2012
0
2011
UST Issuance, $Billions
3500
Source: CBO, RBS
9
Current law: reflects some potentially unrealistic assumptions
• Medicare payments for physicians services don’t increase
• Payroll tax cuts expire in 2011
• Alternate min tax is not indexed to inflation
• Bush era tax cuts expire for everyone in 2012
• Discretionary spending increases at the rate of inflation, instead of much faster as has been
the case in recent years
10
2. Projection: Assumes most of the programs, the most important being the
Bush-era tax cuts, are continued. The deficit averages 6.1% of GDP and debt held
by the public reaches 97% of GDP by 2021. Clearly, we have a deficit problem or rather
a whole set of potential problems.
20000
15000
10000
5000
11
Source: CBO, RBS
2021
2020
2019
2018
2017
2016
2015
2014
2013
2012
0
2011
Total Debt Held By Public, $Billions
25000
A scale up of current issuance under assuming tax cuts, etc made
permanent.
600
500
$Billions
400
2011 Issuance
300
2016 Issuance
2021 Issuance
200
100
0
2y
3y
5y
7y
10y
30y
Source: CBO, RBS
12
3. Sensitivity analysis: 1% lower growth along with the continuation of the
current tax cuts and other programs would increase the deficit by more than USD
1 trillion by 2021 and cumulatively by more than USD 3 trillion. (The deficit is
sensitive to also very interest rates and inflation assumptions.)
25000
1% Lower Growth
20000
1% Higher Growth
15000
10000
5000
2021
2020
2019
2018
2017
2016
2015
2014
2013
2012
0
2011
Total Debt Held By Public, $Billions
RBS Projected
Source: CBO, RBS
13
What to do about the deficit?
• Avoid another recession; don’t create excessive fiscal drag by moving too quickly
• Grow
• Manage inflationary expectations aggressively
• On the expenditure side – address rising medical costs and social security
• Cut discretionary spending
• Bring the troops home as soon as possible
• On the revenue side, think long and hard before making tax cuts permanent
• Be sensitive to foreign holders
• Lengthen the maturity of the debt
• Explore new avenues of finance
14
New Avenues of Finance
15
Market and regulatory changes are favorable to UST ownership
• GSE debt issuance is expected to decline.
• The roll off of bank debt issued under the Temporary Liquidity
Guarantee Program (TLGP).
• Muni credit is coming into question, increasing demand for safe haven
assets, like Treasuries.
• Money Markets face a shortage of short-term paper because of the
contraction of the Commercial Paper (CP) market, boosting demand for
short-term Treasury paper.
• Legislative and regulatory developments have the potential to lead to
greater demand for long dated securities and liquid, high quality products.
• Who to target? Banks, pension funds and insurance companies, retail
investors, state and local investment authorities.
16
Ultra-Long Bonds
• Demand. There is significant demand for high-quality, long-duration bonds from
entities with long-duration liabilities such as insurance companies and pension
funds.
• Strips. The arithmetic of the maturity-duration relationship (duration rises much
more slowly than maturity for ordinary coupon bonds) suggests that if ultra-long
bonds are issued, they be made strippable (the duration of strips rises linearly with
maturity).
• Pricing. Dealers can determine where they see demand for the P-strip and then
work backward to determine where to bid whole ultra-long coupon bond auctions.
• Distribution. P-strip demand will give dealers a solid basis for bidding ultra- long
coupon auctions. Syndication methods have been successful in other countries and
could further support the distribution process but normal reverse Dutch auction
process may also be sufficient.
• Costs. Ultra-long bond yields are unlikely to be significantly higher than those in the
30yr sector, keeping issuing costs down. Spreads in the U.S. swap market and in
overseas ultra-long bond markets are very tight to 30yr rates.
17
Ultra-Long Analytics: Duration tapers off rapidly with
maturity. This effect is greater at higher coupons.
Duration vs. Maturity at Various Coupons
3535
%3%5%30
4%
30 6%5%
3%
6%
4%
5%
6%
2020
Duration
Duration
2525
1515
1010
55
00
10
30
20
20
30
10 █ 4%50
30
40
40█205% 60
█30
3%
█50
6%
40
70
6040
Maturity,Maturity,
Yrs
Yrs
50
60
70
Yrs
60 100
80
7050Maturity,
90
80
9070
Maturity,
Yrs
18
80
10080
90
100
90
100
Make Ultra-Longs Strippable: STRIPS duration, however, is a linear
function
of maturity, making STRIPS a good tool for increasing
100
duration and3%
for liability
4%cash-matching
90
5%
STRIPS
3%
5%
STRIPS
100
100
80
8080
60
Duration vs. Maturity
4%
6%
7070
50
6060
40
Duration
Duration
Duration
9090
70
6%
5050
30
4040
20
3030
10
20
020
1010
00
10
20
30
40
10
20
30
40
10
█ 3%
█ 4%
20
█ 5%
30
█ 6%
40
█ STRIPS
50
60
Maturity,
Yrs
50
60
50Maturity, Yrs60
Maturity,
Yrs
19
70
80
90
100
70
80
90
100
70
80
90
100
Pricing Ultra-Longs: Dealers determine the demand for P-strips by
investors at various yields and then decide where to bid for the ultra-long
coupon issue, e.g. a 5% P-strip on a 50 year bond should have a coupon
of around 4.60%
P-strip and coupon yield on a 50-year maturity Treasury
5.20
5.20
5.10
50y50y
P STRIPS
P5.10
STRIPS
50y P STRIPS
50y50y
ParPar
Bullet
Bullet
5.00
5.00
50y Par Bullet
0bp
-10bp
Yield
Yield
4.90
4.90
4.80
4.80
4.70
4.70
4.60
4.60
4.50
4.50
4.40
4.40
4.45%
4.50%
-5bp
-5bp-10bp4.55%
4.55%
parpar
cpn
cpn
-5bp
4.55% par cpn
4.60%
+5bp
+5bp
+10bp
+10bp +5bp
4.55% par cpn
par coupon base scenario and changes
—♦—
50y P STRIPS —■— 50y Par Bullet
parpar
coupon
coupon
base
base
scenario
scenario
and
changes
changes
par and
coupon
base scenario and changes
20
4.65%
+10bp
Callable Bonds
• Demand-supply gap. Callable Treasuries could fill an emerging gap between
demand and supply.
• Replacing GSE supply. Treasuries are relatively close substitutes for
Agencies.
• Corporate callable issuance. There may be demand for a regularly issued
callable long maturity Treasury.
• Cost. Pricing models suggest the incremental cost to Treasury of issuing
callables is manageable, eg 18 bp for a 5yrNC1yr and 8 bp for a 2yrNC6mo.
• Risk. Demand for callables tends to fall off if investors expect rates are heading
higher. Investors generally expect (hope) to be called. Once a rate-rise cycle
gets underway or market volatility increases, Treasury may have to offer higher
yield enhancement to maintain a regular issuance program or be willing to
curtail the program.
21
Overall Net Callable Issuance Declined in 2010 by $384 bln
Net Callable Issuance
1200
1000
800
600
400
200
0
-200
-400
-600
2001
Agencies
2002
Agency MBS
2003
2004
Non-Agency MBS
2005
Total
22
2006
2007
2008
2009
2010
GSE Portfolio Changes Drive Net Issuance Overall…
400
300
300
200
200
100
0
-100
-200
-300
-400
Combined Portfolios ($bn)
400
400
400
300
300
200
200
100
100
0
0
-100
-100
-200
Total Net Issuance ($bn)
Combined Portfolios ($bn)
FNMA, FHLMC,
FHLB
Portfolio
Growth/Shrinkage
vs. Net Issuance
FNMA,
FHLMC,
FHLB
Portfolio Growth/Shrinkage
vs. Net Issuance
100
0
-10
-20
-200
-300
-300
-400
-40
-400
-500
-50
-500
-600
-500
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
1997
1998
1999
2000
2001
2002
2003
2004
2005
2006
2007
2008
2009
2010
Source: RBS,Source:
FNMA,RBS,
FHLMC,
FHLB
Annual Chg in
Combined
Portfolios
Total Net Issuance
FNMA,
FHLMC, FHLB
Annual
Chg in
Combined Portfolios
Total Net Issuance
Note: FHLB is the combination of the advance and investment portfolios. Issuance includes discount notes, bullets, callables and floaters.
23
-30
-60
Structure: Short lockouts (6mo and 1yr) dominate the
Agency market
2010 Callable Issuance Lockout by Quarter
2010 Callable Issuance Lockout by Quarter
120%
120%
100%
100%
Other
Other
1yr
1yr
80%
80%
Other
Other
Other
Other
1yr
1yr
Other
Other
1yr
1yr
1yr
1yr
6m
6m
60%
60%
6m
6m
6m
6m
6m
6m
40%
40%
3m
3m
3m
3m
3m
3m
3m
3m
20%
20%
1m
1m
1m
1m
0%
0%
Q1
Q1
1m
3m
█ 1m
6m
█ 3m
█ 6m
Q2
Q2
1yr
Other
█ 1yr █ Other
1m
1m
1m
1m
Q3
Q3
Q4
Q4
Source: RBS
24
Pricing and Cost to Treasury: Incremental cost of issuing
callables in the present Agency-range is estimated to be
8-22 bp according to fair value pricing models. Empirical
evidence from the Agency market is consistent with these
results.
Estimated Value of Embedded Call Options
10y NC 5y
5y NC 1y
3y NC 1y
3y NC 6m
2y NC 6m
bullet par cpn
3.559
2.031
1.107
1.107
0.664
forward rate
5.435
2.481
1.515
1.297
0.828
callable par cpn
3.690
2.246
1.229
1.228
0.771
pick-up, bp
13.1
21.6
12.1
12.0
10.6
vol
0.229
0.4036
0.567
0.5
0.76
25
Money Market Instruments
• Regulatory changes are creating new demand for short-term instruments such as Treasury bills
and short callables.
─ Estimates of the overall increase in demand for government debt to meet the new liquidity
requirements in order to comply with Basel III range from $400-800 bln.
─ Most of the increased demand is likely to be for short maturity, highly liquid securities,
whose risk weighting is zero.
• Money market mutual funds: regulatory changes are requiring them to shorten up on the
maturity of their assets.
• Banks et al: at the same time, new regulations require banks and others to lengthen the
maturity of their liabilities.
• The demand-supply gap will naturally widen further in a rising rate environment.
• Treasury has room to issue more bills if it desires to do so. Bills outstanding as a percent of
total U.S. Treasury debt have returned to pre-crisis levels as has the average maturity of the
debt.
• Costs. More bill issuance may conflict with objective of further lengthening the maturity of the
debt and expose Treasury to rollover risk and higher funding costs in a rising rate cycle.
26
Room to Issue More Bills: T-bills as percent of
marketable debt have fallen back to around 20% from the
almost 35% of 2008/2009
Bills as % of Marketable Debt
45
40
35
30
25
20
15
10
5
27
2012
2010
2008
2006
2004
2002
2000
1998
1996
1994
1992
1990
1988
1986
1984
1982
1980
1978
1976
1974
1972
1970
1968
1966
1964
1962
1960
1958
1956
1954
1952
1950
1948
1946
1944
1942
1940
0
Regulatory Paradox: Regulations are creating a possible
niche for increased bill and callable issuance targeting
money market mutual funds
• Money Market Mutual Funds (MMMFs)
─ SEC 2a-7 regulations requires the MMMFs to shorten the term of their assets by
bringing the weighted asset maturity to 60 days from 90 days and to maintain 30% of
their assets have to mature within 7 days.
─ This has increased the MMMFs demand for short-dated securities.
• Banks and others
─ Basel III requires banks to lengthen their liabilities.
• The gap
─ There may be room for increased bill and callable issuance to fill the emerging gap
between MMMFs and issuers that will be created by new regulations.
─ This gap will naturally widen (MMMFs will want more short paper and banks and
others will want to lengthen liabilities) if market participants expect that we are entering
a rate hike cycle.
─ Puttable securities with puts exercisable every 60 days would find interest among
MMMFs and offer a lower nominal initial interest rate for the U.S. Treasury.
28
Household Holdings of Treasury Debt has Increased
Recently
29
Bonds for Individual Investors
• Increasing household ownership of Treasuries has the potential to
broaden the investor base significantly. Each 1% increase holdings as a
percent of household assets = ~$535 bln.
• Holdings of Treasuries by households are up sharply since the financial
crisis and demographics favor further increases in the long run.
• But household holdings of savings bonds has been relatively stable for
the past few years at low levels ($190 bln).
• Households now have many, more liquid alternatives to savings bonds,
which are simpler and which do not face severe penalties for early
redemption.
• Focus on instruments that appeal to both households and institutional
investors.
30
Floating Rate Securities with Short Dated Reference
Rates
• A floating rate instrument, whose reset and reference rate are
the same, eg a 6 mo reset with the 6 mo bill rate as its reference
rate, would be a “convenience” product, allowing both individuals
and institutions to avoid the inconvenience of rolling bill positions
or incurring transaction costs in the secondary market.
• Institutional demand for such instruments could be strong based
on the likely increase in holdings of short term, high quality
assets required by Basel III.
• Demand will likely increase if rates are expected to rise.
• From Treasury’s point of view, such instruments are attractive
because they reduce rollover risks.
31
CMT-Style Floaters: The reference rate is generally on a maturity
that is much longer than the reset period, eg a 5yr reference rate
and a 6 mo reset period. Japan and France have tried these with
mixed success.
Sample term sheet:
• Maturity: 10yrs.
• Reference rate: 5yr auction rates set in the period just prior to the reset date.
• Margin: A “margin” is set at auction, which is subtracted (or added to) from the reference rates. The
margin is fixed for the life of the bond.
• The margin reflects investors’ demand for floating rate assets at a spread to their floating rate liabilities.
• Floor: Future coupon payments can not go below zero.
Demand:
• These securities may be demanded by deposit-taking entities, which have floating rate liabilities that
they fund at a spread using fixed rate assets. Such instruments give them a spread pick up and some
protection from rising rates.
• Individuals, especially those who expect rising rates or who have floating rate mortgages, may also
find these securities attractive.
32
Stripping Out the Inflation Uplift from TIPS: To create additional
overall demand for TIPS
Pros
• Separating the final cash flow into two components – an unadjusted principal
and the inflation accrual or uplift (“pure” inflation) may increase the demand for
TIPS overall.
• Demand for the pure inflation uplift could come from TIPS funds, pension funds,
insurance companies, corporations, and retail investors.
• Similar demand for pure inflation uplift has been seen in other currencies.
Cons
• Dealers may be resistant to holding the residual strips, decreasing overall
liquidity.
• Demand for the non-pure inflation component may be less robust than demand
for the inflation uplift.
• Tax issues and fungibility issues with principal strips off conventional whole
bonds.
33
What to expect
─Measures to expand retail investment in Treasury securities.
─Ultra-long bonds with maturities of 40 or 50 years. Such bonds should be
strippable.
─Callable securities, especially those with relatively short maturities and
lockouts, and possibly a regularly issued longer-maturity callable.
─Instruments targeting the money markets and households, including FRNs
where the reference rate and reset periods are short-dated and
synchronized.
─Changes in the structure of TIPS stripping program to enable investment in
the “pure” inflation component of TIPS principal repayments in order to
augment overall liquidity in the TIPS market.
─ Buybacks and similar measures to help Treasury smooth out the large
increase in rollovers coming in the coming decade.
34
Summary and conclusions
• The US indeed has a deficit problem, but it also has time to deal with it.
• The solutions are at hand: let the Bush era tax cuts lapse or find other
revenue raising solutions, get a handle on medical costs, rethink social
security to reflect current demographics, bring the troops home (as
soon as possible), keep a tighter grip on non-defense discretionary
spending, keep up pro-growth policies but be sensitive to inflationary
expectations and avoid another recession.
• New funding avenues will help, including: ultra-longs, callables, money
market FRNs, stripped TIPS, and buy-backs.
• Process needs to be de-politicized to avoid a policy blunders of
premature fiscal tightening or kicking the can down the road.
35