FROM THE OFFICE OF PUBLIC AFFAIRS

I am pleased to be with you to talk about some of the debt management challenges Treasury faces as we continue to pay down publicly held debt. The Treasury Borrowing Advisory Committee of the Bond Market Association has provided valuable assistance in this process. While the history of this Committee goes back to the Truman Administration, debt paydown presents a far different challenge than anything the Committee has addressed in the past. Their insights will continue to be very valuable to us as we go forward. I particularly want to thank Ken deRegt for his leadership of this group. I also want to thank Micah Green for inviting me here today.

By the end of this fiscal year, we will have achieved three straight years of unified budget surpluses -- a feat unimaginable just a few years ago. The unified surpluses for the three years are estimated to total just over $400 billion. These surpluses cap the longest series of improvements in budget results in the history of the United States.

This progress has had a significant effect on Treasury financing. As we announced at the May Quarterly Refunding, we expect to have paid down an estimated $355 billion in just under three years.

As a result, Treasury debt is becoming ever smaller relative to the size of the economy and the capital markets. Since 1994, the ratio of Treasury debt held by the public has fallen from 50 percent of GDP to an estimated 35 percent at the end of June. We expect this to continue to decline, falling to less than 20 percent by 2005. In the U.S. capital markets, Treasury's share of debt outstanding has fallen from more than 33 percent six years ago to 23 percent today. The drop is even more dramatic in terms of gross new issuance. Treasurys share of new issuance has dropped nearly in half over that period.

Reducing Treasury debt held by the public brings many benefits to the economy and all Americans. It also brings new challenges for Treasury debt managers. While the challenges are new, our primary goals remain the same: (1) to provide effective cash management; (2) to achieve the lowest cost financing for the taxpayers; and (3) to promote efficient capital markets.

In pursuing these goals, we have consistently followed five interrelated principles:

• First, the maintenance of the "risk-free" status of Treasury securities to assure ready market access and lowest cost financing.
• Second, the maintenance of consistency and predictability in our financing program to reduce uncertainty in the market and help to minimize our overall cost of borrowing.
• Third, the promotion of Treasury market liquidity, within the constraints of our borrowing needs, both to promote efficient capital markets and to lower Treasury borrowing costs.
• Fourth, financing across the yield curve to enable us to appeal to a broad range of investors and to mitigate refunding risks.
• Finally, unitary financing through which we aggregate the financing needs of all programs of the Federal Government and borrow as one nation, ensuring that all programs benefit from Treasury's low borrowing rate.

Thus far, Treasury has managed the decline in publicly held debt primarily by paying off debt as it has matured (refunding the maturing debt with smaller amounts of new debt). In any year, there is a significant amount of previously issued Treasury bill and coupon debt maturing. The amount of this maturing debt in any year is still far greater than the surplus. The surplus is currently equal to approximately half of the amount of maturing coupon debt. Thus, we increasingly have been able to reduce issuance of new debt, reducing both the size and the frequency of offerings. Taken together, we have decreased the size of bill issuance by 28 percent and of coupon debt by over 50 percent since 1996.

Until earlier this year, we had maintained the frequency of bill auctions, while reducing auction sizes. The average size of bill auctions has fallen from close to $20 billion in 1996 to just under $16 billion this year. This February, we announced the first reduction in the frequency of bill auctions as we moved from monthly to quarterly one-year bill auctions. Because bills mature quickly, changes in issuance affect the stock of outstanding bills very rapidly. Overall, the privately held bill market has shrunk from $586 billion at the end of 1996 to $437 billion at the end of June, a reduction of 25 percent.

As has been customary, we will continue to use bill issuance as a mechanism to respond to seasonal fluctuations in cash positions and needs. We also continue to look at eliminating the one year bill. As we discussed in May, there are a limited number of statutory provisions that reference the one-year bill for the purpose of setting interest rates. We are pleased with the progress to date of our discussions with Congress to designate appropriate alternative reference rates for student loans rates and other statutorily set rates that currently reference the one-year bill.

There have been significant changes in coupon issuance, as well. Auctions for regular coupon offerings have been reduced by more than one-third, from 39 to 25 a year. Moreover, six of those 25 remaining auctions are now regularly scheduled reopenings for 5- and 10-year notes and 30-year bonds. Thus, we have effectively reduced coupon issuance to nineteen specific issues, cutting the number of issues effectively in half. If at some point in the future we adopt the recommendation of the Borrowing Advisory Committee to move from monthly to quarterly auctions of two-year notes, we could further reduce coupon issuance to eleven specific issues.

The actions taken to date have allowed Treasury to significantly reduce overall coupon issuance, while maintaining large, liquid issues. Based on current auction sizes, the volume of Treasury's coupon issuance has dropped from $582 billion in FY 1996 to approximately $250 billion, well over 50 percent. With the policy of reopenings, however, the reduction in the average issue size has declined only 16 percent, from $14.8 billion in 1996 to $12.4 billion currently.

While the reductions in coupon issuance have been significant, they have had a much less significant effect in percentage terms on the size of the outstanding stock of coupon debt. The coupon market by definition is longer maturity debt. As a result, the size of the privately held outstanding privately held coupon debt has decreased from $2.45 trillion to $2.11 trillion from the end of FY 1996 to the end of June, a reduction of only fourteen percent. Outstanding privately held debt with a maturity of five years or more, however, has increased during this period from $740 billion to $828 billion, an increase of eleven percent.

Over our nation's financial history, we also have paid down debt by buying debt back before it matures. From time to time, during periods of sustained budget surpluses, Treasury has entered the market to repurchase its debt. Debt repurchases were first proposed by Secretary of the Treasury Alexander Hamilton in a plan he submitted to Congress in 1795 to extinguish the debt within thirty years. Albert Gallatin, the fourth Secretary of the Treasury, later conducted the first debt repurchases during the period from 1807 to 1812. The last time Treasury paid down debt in this manner was seventy years ago under Secretary Andrew Mellon. In this new period of sustained surpluses, it is important to renew this tradition.

Buybacks have the potential to bring more balance to the paydown of the debt. Prior to the buyback program, all of the paydown was on the short end of the maturity spectrum. Even this fiscal year, of the $216 billion that we estimated in May would be paid down, almost 90 percent will go to paying down debt as it matures. Only approximately 11 percent of total paydown for the fiscal year will be used to pay down debt prior to maturity.

We have been very pleased with the results of the initial buybacks. We have completed half of the $30 billion of buyback operations that we plan to conduct this year. In May, we announced a regular schedule for the buyback program. We anticipate that in the future we will announce the aggregate size of the operations on a quarterly basis at the Quarterly Refunding Announcement. We continue to analyze the buyback results to determine how we can best use this debt management tool.

Debt held by the public is expected to shrink further. The Administration's Mid-Session Review of the budget forecasts that publicly held debt will be reduced by $1.2 trillion over the next five years and by $2.9 trillion over ten years. Continued fiscal discipline will present additional challenges in debt management.

First, the effect of eight years of fiscal discipline is already showing up in Treasury's maturing debt. There will be a great deal less maturing debt to be redeemed in the very near future. At its peak in FY 1998, we had $510 billion in maturing coupon debt. By 2002, maturing coupon debt will fall below $400 billion. Depending on issuance patterns, maturing coupon debt is likely to have declined by 2004 to below $300 billion. At some point, it is likely that maturing coupon debt will decline to an amount that is less than the unified surplus.

Second, the challenge of how to continue to issue sufficient longer-term debt while best reducing outstanding debt, recognizing the maturity structure of the currently outstanding debt. Paying down debt only by redeeming maturing debt, by its nature, is asymmetrical, with the paydown in the shorter end of the maturity spectrum. As of June, however, over $460 billion of privately held Treasury debt had a remaining maturity of more than ten years. Based on current issuance and buyback schedules, this outstanding longer-term debt will decline by only three percent on a net basis this calendar year. In contrast, debt with a remaining maturity of less than 10 years will decline three times faster, by approximately 9 percent.

Treasury securities currently play an important role in the global capital markets. They are actively used for hedging purposes. They provide a pricing benchmark across the yield curve. The Federal Reserve uses transactions in Treasury securities to affect the supply of reserves in the banking system.

The Federal Reserve currently holds a little over $500 billion of Treasury securities in the System Open Market Account, or "SOMA". The Federal Reserve System last week announced changes in how it will manage the SOMA portfolio, setting limits as to the percentages of each outstanding issue that it will hold, with percentages declining by maturity. The effect of this change will be that the Federal Reserve will no longer consistently roll over 100 % of their maturing securities into new issues.

While many things may change over the next 24 months, based on the Federal Reserve's current holdings and Treasury's current auction sizes, the new procedure could lead to net redemptions approaching $30 billion in coupon securities. In addition, this year there have been net bill redemptions by the Federal Reserve, primarily due to the reduction in Treasury's 52-week bill issuance. These net redemptions were just over $7 billion in the last quarter and are likely to be somewhat higher this quarter. The Federal Reserve would meet its additional portfolio needs primarily with purchases in the secondary market, subject to the same limits by maturity as for purchases at auction.

The Federal Reserve consulted closely with Treasury concerning these changes. We believe that they will allow the Federal Reserve to adjust the quantity and composition of the SOMA portfolio in a manner consistent with the Federal Reserve's portfolio needs and consistent with Treasury's broad debt management objectives. These changes also may allow Treasury greater scope in the future to maintain the size of coupon issuance.

With the significant reduction in the supply of Treasury securities that has taken place over the last five years, other market participants have already begun to adjust, as well. In the corporate bond markets, high-grade corporate issuers are positioning themselves as pricing benchmarks by consolidating their issuance into fewer, larger issues. At the shorter end of the yield curve, prime commercial paper, and other instruments have begun taking on a benchmark role. Eurodollar futures already are actively used for this purpose. Interest rate swaps and other debt instruments may become more relevant pricing benchmarks as the transition continues.

Derivatives and other debt instruments may also be seen as suitable hedging vehicles. While they have different risk characteristics than Treasury securities, some may have a higher correlation to the securities being hedged than Treasury securities currently have. Some of these characteristics may make derivatives and other debt instruments attractive as potential supplemental or alternative hedging vehicles.

In all likelihood, financial markets will adjust to the shrinking stock of Treasury securities in variety of ways. Market participants will determine which instruments or combinations of instruments best meet their needs. As we continue on the path of debt reduction, the market alone will determine what instruments will be most widely used in the future. In the meantime, the market for U.S. Treasury securities remains the deepest, most liquid securities market in the world.

In conclusion, reducing Treasury debt held by the public brings many benefits to the economy and all Americans. While the debt pay down presents new challenges, the goals and principles Treasury follows remain the same. Consistent with these goals and principles, Treasury has made significant changes in its debt management program, including reducing issuance size and frequency, instituting permanent reopenings, and re-instituting debt buybacks after seventy years. These changes have set the stage for other changes that may be necessary in the future and for a smooth transition by the Treasury markets and market participants.

Thank you.