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September 24, 2007
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Treasury Assistant Secretary Ryan
Remarks at Real Return USA:
The Euromoney Inflation Linked Products Conference

New York City- Good morning. It is a pleasure to be here in New York City, and I appreciate you inviting me to join you.

As Assistant Secretary for Financial Markets at the Department of the Treasury, I have a number of responsibilities ranging from supporting Secretary Paulson in his capacity as Chairman of the President's Working Group on Financial Markets, to working on efforts that serve to enhance the competitiveness of our capital markets, to overseeing the U.S. Treasury debt issuance and management. Our first Secretary of the Treasury, Alexander Hamilton, appreciated the value of effective debt management. Hamilton understood that though the United States was a young nation, it had to repay in full the debt incurred from the Revolutionary War having once remarked that "The debt of the United States ... was the price of liberty."

Our nation's debt has grown since the first days of our republic and today, we have nearly $9 trillion in debt outstanding, issue over $4 trillion in marketable debt annually, monitor over $500 billion in daily secondary market turnover, maintain and invest an average daily cash balance of over $20 billion, and hold auctions nearly every single business day of the year.

Included within those figures are Treasury Inflation Protected Securities, or TIPS. They too possess impressive underlying numbers: over $450 billion outstanding, nearly $70 billion in new issuance per year, and over $8 billion in average turnover daily. These statistics make our Treasury market the largest and most efficient government debt market in the world.

We are in an enviable position, but we cannot take our leadership for granted. Every day, the U.S. Treasury, like other issuers, must compete for capital in the global marketplace. With our well defined mission, prudent operating principles and robust, yet flexible issuance and management strategy, we remain committed to ensuring that the U.S. Treasury market remains the preeminent sovereign debt market in the world.

Let me take a few moments to give you some background on our debt management efforts, then discuss TIPS, and finally address a strategic issue that looms on the horizon.

As the largest issuer in the world of sovereign debt, our objective is clear and unambiguous. We seek to achieve the lowest cost of borrowing over time.

Achieving the lowest cost of borrowing necessitates the management of two other variables: constraints and risks. If issuers and investors have learned anything over the past few months it is that one must address risk in its many dimensions. From Treasury's perspective, our constraints and risks are numerous, and, once again, very large.

One constraint we face is: uncertainty. Uncertainty emanates from a number of sources. These include: significant forecast errors, unexpected legislation, issues related to the debt limit, and fluctuations in the issuance of non-marketable debt all impact our marketable borrowing.

Let me give you a specific example. The best and brightest on Wall Street, the Office of Management and Budget (OMB), and the Congressional Budget Office (CBO), each publish forecasts of the annual deficit. Despite their best efforts over the past decade, forecast errors have on average varied by $120 billion one year ahead of the upcoming fiscal year end.

Realizing the nature and presence of uncertainty requires Treasury to be as flexible as possible in our issuance decisions. However, here too we face a competing constraint, namely: size. Simply put, Treasury is too large to behave opportunistically.

Given our size, our debt issuance effectively sets the yield curve. We are unable to quickly alter issuance to take advantage of rate changes. Hence, we do not attempt to time the market or issue opportunistically.

Not surprisingly, our short term cash needs are also dynamic and effective liquidity management is critical. Our cash balances are extremely volatile and can range from $5 billion to $125 billion on a given day. While some expenditures such as Social Security and Medicare are fairly predictable, others are much more difficult to forecast both in terms of timing or scale. Similarly, tax revenues can shift dramatically in size and direction with little warning. Other non-marketable activities such as an abrupt increase in State and Local Government Securities (SLGS) may also force Treasury to reconsider our financing needs.

Like any liquidity manager, we need an array of tools and capabilities in order to most effectively manage cash balances. Some we have, others we seek. Enhancing our cash management capabilities is one of the major priorities of the Cash and Debt Management modernization initiative announced by Secretary Paulson in July.

Given our objective, and in recognition of our constraints and risks, our debt management team has developed and operates with the following core principles:

These operating principles guide Treasury in our debt management, and result in what we believe is the lowest cost of borrowing over time. By reducing uncertainty regarding supply through regular and predictable issuance, investors are free to focus more closely on the demand side, thus mitigating their – and our – risk. Moreover, by being transparent, we believe we exact a liquidity premium – a direct result of certainty of supply - which lowers the cost of borrowing for Treasury over the long run.

Because our operating principles and practices are well established, buyers of Treasury securities come to us in greater numbers, bid with more confidence, and in larger amounts.  Our predictability, coupled with our unitary financing approach to debt issuance and support of practices that enhance market integrity and openness, all serve to increase the depth and liquidity of the Treasury marketplace, and lower our borrowing costs.

The development of our marketplace has been strongly supported by efforts undertaken by market participants. Recently, the introduction of the principles-based framework outlined by the Treasury Market Practices Group (TMPG), a private sector initiative, is encouraging.  Their principles and guidelines provide a framework for market participants to evaluate and enhance their current activities in the secondary markets and to fulfill their responsibilities as stakeholders in the Treasury market.  The guidelines are practical, and possess the flexibility to deal with the global and dynamic environment in which stakeholders operate.

In fulfilling our mission, the Debt Management Office--like any prudent asset manager--must successfully identify, assess and manage risk exposures. There are many risk measures to consider and no single metric is ideal. Risk management must be approached from multiple perspectives.

Quantitative measures of risk are simply a starting point and raise some interesting questions. Should we as an issuer, look at a cost at risk model (CaR)? If so, what time period should we utilize? How should we weight certain risks versus others? Does an efficient frontier really apply for an issuer, and if so, how should we react? Do duration and convexity really apply to an issuer given our seemingly infinite asset base (i.e. tax revenues)? Can risk measures readily be applied that are consistent with our policy of regular and predictable issuance yet accommodate the huge potential variances in future fiscal environments?

A multidimensional framework helps fulfill our objective. We answer these questions by addressing the challenge from several perspectives as we assess risks, cost, and time.

Some risks increase over time, such as the probability of default on subprime mortgages the longer credit remained cheap and lending standards lax. Alternatively, some risks decrease over time such as the probability of an investor buying subprime asset backed commercial paper just because it was rated AAA.

We can approach costs in a similar perspective. Some costs, such as the price of an option as it approaches expiration, decrease over time. Other costs increase over time, and as a father of four, I can attest that one is tuition.

Applying this framework over time provides us with constructive and complementary perspectives. By identifying risks – including rollover risk, liquidity risk, duration risk, and inflation risk, we more effectively identify and mitigate potential costs. Including portfolio composition, diversification of funding sources, and demand dynamics as potential metrics also enhances Treasury's ability to measure, and ideally reduce overall costs. Such measures provide us with some perspective, but we also appreciate the limitations of such quantifiable models, and are cognizant of the underlying assumptions. We therefore supplement such perspectives with sound judgment that is informed by experience, and reviewed via routine consultation with the marketplace. Here we are fortunate to have access to the Treasury Borrowing Advisory Committee (TBAC), the primary dealer community, and other participants in our global marketplace.

Let me take a moment to focus on the topic du jour – inflation indexed securities. Treasury Inflation-Protected Securities (TIPS) have become a core portion of our overall debt portfolio. Having started the program 10 years ago, we have seen liquidity slowly build, and greater interest develop amongst various investor groups.

Just as the Federal Reserve must constantly be on guard for inflation, so must investors. Inflation remains a constant foe. TIPS offer investors an instrument to protect against inflation risk by offering real --- rather than nominal returns. From a capital preservation perspective, managing risk from a real return basis is essential.

As would be expected, TIPS are negatively correlated to equities over shorter to medium term horizons. Moreover, TIPS' low correlations with other asset classes including corporate bonds may serve to reduce a portfolio's volatility and potentially improve overall returns.

From a debt issuer's perspective, TIPS offer potential benefits, including a broader investor base and a more diversified portfolio of liabilities. Over the past decade, Treasury has grown the inflation indexed portion of our portfolio nearly five times faster than that of nominal debt. Today, it represents almost 10% of our marketable debt portfolio.

As mentioned earlier, portfolio composition and diversification are among the many factors considered when measuring lowest cost versus risk. Given the improvement of our fiscal deficit from over $400 billion in 2003 to well less than one half of that amount in fiscal year 2007, Treasury has needed to make numerous adjustments to our portfolio, while all the while remaining true to our core operating principles.

Reducing issuance remains more challenging than increasing issuance given liquidity threshold constraints and the potential uncertainty surrounding deficit forecasts. However, as our net marketable borrowing needs decline, we generally follow the following guidelines:

Consistent with these guidelines, we have made decisions to pare issuance over the past year. This included reducing the sizes of bills outstanding, lowering coupon issuance sizes, lowering the issuance size of TIPS, and most recently, discontinuing the issuance of the 3-year note. In keeping with one of our well established principles, we attempt to make such decisions in as transparent a fashion as possible such that the market impact is minimal.

While our TIPS issuance sizes have been reduced in response to smaller borrowing needs, we remain very committed to TIPS. Treasury – as well as investors and broker-dealers – have made significant investments in this market, and inflation indexed securities will remain a core component of our overall portfolio. Moreover, recent comments by the TBAC suggesting adjustments to the TIPS program are simply one of a broad set of alternative ideas.

Evaluating the proper number, type and mix of securities in our portfolio is an ongoing effort. We will continue to evaluate our financing needs in light of economic conditions and fiscal forecasts. We will make necessary adjustments as needed bearing in mind our overarching debt management principles.

I have spoken this morning about risks and fiscal challenges. But no review would be complete without addressing the most significant fiscal challenge taxpayers and future generations of Americans face: the escalating costs of entitlements.

No better example exists of a risk and cost that grows over time than the risk and cost of inaction. No panacea exists, but procrastination is not the answer to the untenable fiscal situation that we as a nation face over the long term.

I'd like to offer an alternative perspective to those made by other policy makers in addressing entitlement reform.

The perspective I offer is that of the issuer who finances the programs. Our Debt Management Office recently asked the TBAC to provide an analysis of the costs of inaction. The results were sobering. Using estimates and scenarios provided by the Congressional Budget Office, the TBAC report to Secretary Paulson concluded that, "In spite of the relatively conservative assumptions used, the results of the analysis were disturbing to all members of the Committee and highlighted quite strongly that without significant reform to entitlement programs, the strains on Treasury to finance the projected deficits over the next 40 years are dramatic and would undoubtedly result in a significant increase in `real' borrowing costs by the U.S. Government."

In relation to the size of the economy, it is estimated that current gross coupon issuance will need to be between four and fifteen times larger by 2050. The sharp elevation in the financing needs starts to become apparent as early as 2020.

More concerning, the TBAC estimated that, under the most optimistic scenario, Treasury auction sizes in the two-year note could approach $380 billion per month by 2050, while issuance of 10-year notes could approach $1.9 trillion per quarter. Just as a reference, today we auction $18 billion in 2-year notes each month and we issue $21 billion in 10-year notes each quarter. Interest costs would rise to over 4% of GDP by 2050 from just under 1.5% currently. The repercussions of inaction are simply too big to ignore.

I am optimistic that we can address both our short term and longer term fiscal challenges with the same framework with which we approach debt management – define the objective, identify and quantify the risks, evaluate the costs, and take action. This approach is applicable not just in the realm of finance, but also to public policy. I look forward to working with my colleagues in Washington, D.C., as well as continuing to work with market participants to address these critical issues.

Thank you.

For more information on the Office of Debt Management, see http://www.treas.gov/offices/domestic-finance/debt-management/index.shtml

To review the Treasury Borrowing Advisory Committee Presentation to the US Treasury July 31, 2007 "The Costs of Inaction Regarding Entitlement Reform: Potential Implications for Treasury Debt Issuance, Interest Costs, and Overall Market Dynamics", see http://www.treas.gov/offices/domestic-finance/debt-management/quarterly-refunding/08-01-2007/discussion-charts.pdf