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.