FROM THE OFFICE OF PUBLIC AFFAIRS

One idea that is important to all of us at Treasury, from Secretary O’Neill on down, is that we must continuously seek to improve the services we provide. Today I would like to talk about a couple of initiatives very high on our list of priorities.  First, I want to ensure that we have proper auction procedures, second I want to discuss direct bidding and third I will talk about TIPS.  Though this sounds like a random list, they have a common thread—to help us achieve the lowest possible borrowing cost over time.

Auction Contingencies [Chart 1]
First I will talk about auctions. I believe that by reducing uncertainty around the auction process—both for treasury and the bidder—we can meet our primary objective, to borrow at the lowest cost, over time.

Within the auction process, I would like to talk to you about contingency plans when systems go down in the minutes before an auction closes. 

First and foremost our goal is to do everything we can to get your bid into the auction before the auction close.  I can not stress that enough – if we can’t get your bid into an auction, we are unquestionably, unambiguously worse off. 

As you know, we have a rules based auction system – we have no choice, our status as issuer depends on you having complete confidence in the integrity of the auction process and integrity means absolute consistency in how we handle bids.  Through consistency, we provide greater transparency which translates into lower Treasury borrowing costs.

As we build better systems, work that obviously precedes and will follow this administration, we need to establish guidelines—not rules—for emergency bidding in the event that a system goes down up to and at an auction close.

Responding to such an event necessarily requires coordination of your efforts and ours.

It also requires judgment – no two problems are the same.  We want to increase the flexibility with which we respond, but this will require you to be more flexible too. 

Starting next week, if, and only if, you have connectivity problems in the last ten minutes before an auction close, call us and, using your judgment, consolidate your bids into a number that can be quickly entered into our auction system. 

When I say, judgment, I mean that consolidation should vary depending on the number of bids you have and the time before an auction close.  With eight minutes to close and five bids, you may have time to submit all your bids; with two minutes to close and 12 bids, you are unlikely to get them all in.  With connectivity problems two minutes before the close, you will need to, in the vocabulary of the medical community, perform triage by consolidating bids to one or two large, single yield bids.   

In any case, do not delay – you should submit any bid as soon as it is finalized. If you have customer bids ten minutes before an auction, submit them.  If you have house bids that are finalized twenty minutes before an auction, submit them.

Under no circumstances, should the ability to phone in a bid give you or your customers extra leeway in bid submission.  I am not here to tell you how to run your businesses, but it would be frustrating for Treasury and your customers to miss an auction because traders felt they were holding an option giving them the right to bid.

If you have connectivity problems, and if you consolidate bids, we will treat that consolidated bid as a house bid – you will be responsible for dispersing awards, we will effectively treat your customer awards as W.I. trades. 

This relaxation of rules on our part only comes with genuine problems – we will verify that you had connectivity problems after the auction.  

In working through this proposal, we considered formalizing the time prior to close when we would accept emergency bids, the number of emergency bids that could be submitted, and what rights and obligations you would have under emergency bidding procedures.  Frankly, I was not comfortable with the inflexibility of a formal process.  The small problems that are most likely to turn into big problems are those that would not occur to us in developing a formal process.  Consequently, I am not going to pinpoint a time or number of bids that assures you enough time to telephone in a bid.  But the NY Fed and Bureau of Public Debt are confident they can input one bid with 2 minutes to auction close.  That is not a rule, nor are we bound to that 2 minutes.  It is a guideline we are comfortable with and one that I hope, if a situation ever requires it, you will be comfortable with as well.  Above all, I hope you will view this proposal in the context in which it is offered:  as part of our goal to do everything we can to get your bid into the auction before the auction close. 

As systems evolve and improve, I encourage all of you to keep a watchful eye on your Fedline terminals during auctions.  The auction process is one of risk management, I want to make sure you give due emphasis to the operational as well as market risks.  What I am proposing today is a way for you to prepare for system failures should they occur.  I want no confusion over what you should do or whom you should call if you experience a systems failure.  We will reinforce this emergency bidding process at our dealer visits and at formal training sessions.

Direct Bidding [Chart 2]

As many of you know, Treasury is promoting both auctions and the ability to bid direct to investors.  I want to state right off the bat that we are not looking to disintermediate dealers.  Your ability to take down and place our debt is immensely valuable to us and to the market as a whole. 

However, in today’s day and age, we should be able to provide investors with the technological and operational ability to bid directly if they choose.  In today’s environment, our debt may very well be distributed in the most cost-effective way possible.  As market conditions dictate possible changes in risk management and as dealers consolidate, however, Treasury must start to think about a world in which the primary dealers in aggregate are somehow constrained from underwriting ¾ of our debt issuance.

In this past year we will have held about 185 auctions and distributed over $3 trillion in bills and notes. We all know that treasury can attractively issue debt under the current environment; we don’t know the costs to treasury in an environment where there are fewer dealers and less capital allocated towards risk trading.

TIPS
• [Chart 3] By broadening our investor base and diversifying our funding sources, we believe we can reduce our borrowing costs over time.
• Tips can diversify Treasury’s risk profile, as well.
• We believe that Tiis should be viewed as a different asset class.  The market is still quite young—essentially five years old—and it is still evolving.  In fact, a year or two ago, there were concerns that the Tips program was in jeopardy.  I am here to put those fears to rest
• [Chart 4]  Even though, I just said that Tips represent a different asset class, we issue TIPS the same way we do nominal bonds.
• At Treasury, we are committed to issuing large, liquid securities.  We announced a new Tips policy in May of this year.  In order to increase the number of auctions—without moving too fast and getting ahead of the market—we increase the number of auctions from two to three, with two reopenings.
• Reopenings can sometimes cost Treasury money because we don not capture the on-the-run premium.  However, the benefits of large and liquid issuance provide a more stable secondary market.
• [Chart 5] The one point on this slide that I want to highlight is the deflation protection.  Principal is guaranteed at maturity.
• [Chart 6]Our commitment is also evident in our issuance.  We have become the world’s largest IIS issuer with more than $140 billion outstanding.

• a much higher percentage of auction awards are allocated to investment funds, a further indication that the market has come to believe we are committed to TIPS.

• One of the reasons I am here today is try and grow the yellow slice of the pie.  Penetration of the international market is surprisingly weak given there is such diversified European linker issuance.

• [Chart 7]  Increased issuance and greater market acceptance has led to increased liquidity.  Tips may never trade with the liquidity of nominal Treasuries, but that may not be the appropriate standard – by any other measure, liquidity is good and promises to get better.

• Over the 5 years we have been issuing inflation-indexed securities, some analysts have said they are a more expensive form of borrowing than the comparable nominal securities. It’s too early to pass judgment on the cost effectiveness of these instruments.  It takes time and effort to build a critical mass of liquidity.   The right time to assess their cost-effectiveness is after they have worked their way through at least an entire interest rate cycle or two.
• [Chart 8]  The decision to invest is yours and I do not want to encourage an investment that may or may not be appropriate for you.  But I do want to point out a few things.  These securities are of particular value to investors because their prices move differently from conventional securities. Their real (inflation unadjusted) price varies inversely with real U.S. interest rates, not nominal interest rates, making them very attractive for risk diversification.  We also think that Treasury Inflation-Indexed Securities are a unique asset class – dollar-denominated, inflation- protected, backed by U.S. full faith and credit – that every diversified investor should own.  As you can see they have lower risk than the Lehman index and 10-year note, both absolute and relative.
• [Chart 9]  We believe there is and will be strong demand for inflation protected notes backed by the full faith and credit of the US Government.  We are excited about the growth prospects for Tips.  I would like to encourage everyone here to contact Treasury or myself should you have any suggestions in how to grow this asset class.

Thank you very much.  I would be happy to take any questions

Charts: Treasury Debt Management