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Advisory Committee on Banking Policy

January 7, 2003

MEMORANDUM TO: FDIC Advisory Committee On Banking Policy
FROM:: Steven O. App
Deputy to the Chairman & Chief Financial Officer
SUBJECT: Selling the BIF and SAIF's AFS Securities and Broadening Investment Authority for the BIF and SAIF

At the November 13, 2002 meeting of the FDIC's Advisory Committee on Banking Policy (the Committee), I discussed with you the substantial unrealized gains on the Bank Insurance Fund's (BIF) and Savings Association Insurance Fund's (SAIF) available-for-sale (AFS) Treasury securities.1 As you will recall, these unrealized gains were a key reason the BIF's reserve ratio was able to stay at or above its designated reserve ratio of 1.25% of estimated insured deposits. Chairman Powell noted that were the FDIC a private entity, it could look at options for protecting these unrealized gains. However, certain options available to a private entity, such as futures contracts or other means of hedging, are not available to the FDIC under our statutory authority. Because of this, Chairman Powell requested I review whether selling some or all of the AFS securities might insulate the BIF's reserve ratio from the negative consequences of a rise in interest rates. He also asked me to report to the Committee the results of our review.

In addition, at the November meeting, Committee members discussed whether the FDIC should seek more flexibility in managing its investments as part of the deposit insurance reform legislation.

The Investment Advisory Group (IAG)2 met on November 21, 2002, and discussed these issues at length. It is the collective judgment of the IAG members that:

  1. The FDIC not sell the BIF and SAIF AFS securities at this time.


  2. The risks of pursuing, obtaining, and exercising broadened investment authority at this time outweigh the potential benefits.


On December 11, 2002, I briefed Chairman Powell about our conclusions. Below is a summary of that briefing.

Selling the BIF's and SAIF's AFS Securities

The IAG recommended that the FDIC not sell the AFS securities at this time, based on the following three main factors:

  • On a total return basis, there is no clear advantage to selling the AFS securities compared to holding the AFS securities. Staff analyzed several different interest rate scenarios over a seven-year holding period. Under the scenarios deemed most likely to occur, holding the AFS securities is the best longer term outcome in three out of four instances. In those instances, the relatively high interest revenue earned on the AFS securities, as well as the inflation adjustments earned on AFS Treasury inflation-indexed securities (TIIS), more than compensates for the decline in the current unrealized gains over time compared to investing in very short term maturity securities, waiting for expected increases in yields, and then reinvesting over the same time horizon.


  • Policy issues may preclude selling such securities absent a current need for liquidity. The U.S. Treasury prohibits federal investors from engaging in investment practices that result in windfall gains and losses, including large-scale restructuring of investment portfolios to take advantage of short-term yield fluctuations.


  • The BIF and SAIF are already well protected against a rise in interest rates. As a consequence of following the FDIC Corporate Investment Policy and building sufficient liquidity based on historical and/or projected bank/thrift failure rates, there are three factors that serve to hedge the FDIC against the adverse consequences of rising interest rates:


- The large amount of overnight investments, about $6.1 billion
- The large amount of maturing securities, about $5.5 billion through the end of    2003
- The large holdings of Treasury-inflation indexed securities, about $7.5 billion.

This total, $19.1 billion, is approximately 45% of the $42.5 billion book value of the BIF's and SAIF's combined investments in U.S. Treasury securities as of November 20, 2002. Therefore, should interest rates rise, while it will adversely affect the FDIC's AFS security holdings, the FDIC is well positioned to take advantage of that rise in yields.

Broadening Investment Authority for the BIF and SAIF

Regarding this matter, the IAG concluded that actively seeking broadened authority at this time is not advisable, citing three main factors:

  • Potential for market signaling


  • Public perception


  • Market illiquidity of non-U.S. Treasury securities in a time of increased financial market turmoil

Background

The FDIC is significantly constrained by statute as to what it can do in managing the investment portfolios of the BIF and SAIF insurance funds. Essentially, the FDIC is allowed to purchase only U.S. Treasury securities and must do so through the non-marketable Government Account Series (GAS) Program administered by the U.S. Treasury's Bureau of Public Debt. The issue of requesting expanded investment authority was studied in late 2000 under then FDIC Chairman Tanoue. Staff's and the IAG's recommendation at that time was not to pursue such authority as the potential risks, on balance, were believed to outweigh the potential benefits.

Subsequently, the FDIC commissioned a March 20, 2001, independent report titled Reform of Deposit Insurance.3 The report's authors, Alan S. Blinder and Robert F. Wescott, were asked to address whether the FDIC should pursue a more flexible investment policy. The authors stated in their report that "the advantages of moving to a more flexible investment policy are well known from modern portfolio theory: a more diversified portfolio can deliver both lower risk and a higher return than a portfolio that is not diversified." However, the authors concluded that "[o]ur instincts are that the FDIC is such an important symbol of consumer protection that it should continue to invest in the safest, most liquid assets available-that is, U.S. Treasuries through the Bureau of Public Debt."

Benefits

Clearly, the main benefit in obtaining expanded investment authority is the potential to significantly enhance the investment returns of the funds. In the past, staff estimated that by investing in a conservative mix of alternate fixed income investments, the FDIC could enhance the yields achieved on its deposit insurance investment portfolios by approximately 50 to 70 basis points. This equates to about $155 to $215 million and $55 to $75 million additional investment income per year for BIF and SAIF respectively, based upon October 31, 2002, investment balances.

Other benefits accruing to the BIF and SAIF from expanded investment authority include:

  • Greater agency independence and flexibility.


  • Ability to conduct reverse repurchase agreement transactions4 (assumes related changes to the FDIC's statutory borrowing authority were also legislated).


Risks

The three main risks of obtaining and exercising expanded investment authority for the BIF and SAIF are: (1) potential for market signaling, (2) public perception, and (3) potential market illiquidity in a time of increased financial market turmoil.

  • With respect to market signaling, if the BIF and SAIF owned significant blocks of securities in the private markets and began to liquidate them in advance of a probable failing bank funding need, market participants might interpret our actions as liquidity driven and begin to hazard guesses as to which institutions would be most likely to fail. This has the potential to cause or facilitate deposit runs on troubled banks-even ones that are not actually the target of the FDIC's closure activity.


  • With respect to public perception, it is likely that at least upon occasion, the FDIC's actions as a fixed income investor would be questioned, especially to the extent BIF or SAIF incurred credit-related losses or even if it realized significant gains. In essence, were the FDIC to achieve market or trading gains on corporate issued debt, the market could ascribe such gains to insider knowledge obtained by the FDIC through its role as a bank regulator.


  • With respect to potential market illiquidity in a time of increased financial market turmoil, there is a distinct possibility that the FDIC could need access to most, if not all, of the funds on deposit in the BIF and SAIF at the very time the market for fixed income securities other than U.S. Treasuries is thin-that is, essentially illiquid.


Further, Congress has demonstrated little interest in recent years in lifting the restrictions on FDIC investment authority. Moreover, the U.S. Treasury has staunchly opposed such requests from other agencies. To give you a sense of its opposition, attached is a letter (see Attachment A) to Senator Fred Thompson signed by then Treasury Undersecretary John D. Hawke (now Comptroller of the Currency and current FDIC board member) dated November 3, 1997, delineating Treasury's opposition to the U.S. Postal Service's effort to move its funds outside the Treasury.

In general, the U.S. Treasury views the combined FDIC holdings of Government Account Series securities simply as part of their overall Federal Government cash management responsibilities. Attachment B demonstrates this, showing the FDIC funds, BIF and SAIF together, as the eighth largest of 164 such funds, totaling over $2.7 trillion. Were the FDIC to request broadened investment authority, we believe it may be met with indifference by Congress and would be opposed by the U.S. Treasury. Nonetheless, we will continue to dialogue with both market participants and Treasury officials regarding future possibilities and options in the dynamic investment marketplace.

I will be updating you on these matters and related issues at the next Committee meeting.

Attachments

1. Under generally accepted accounting principles, securities designated AFS are subject to a mark-to-market process, and unrealized gains or losses flow through to comprehensive income, and are reflected in the respective Fund's balance. As of November 20, 2002, the BIF's portfolio of AFS securities had unrealized gains totaling $694.6 million; $449.7 million (or 65%) of the $694.6 million in unrealized gains were in Treasury inflation-indexed securities (TIIS), and $244.9 million (or 35%) of the unrealized gains were in conventional and callable Treasury notes and bonds. For SAIF, the unrealized gains were $241.9 million; $155.0 million (or 64%) of the $241.9 million in unrealized gains were in TIIS, and $86.9 million (or 36%) of the unrealized gains were in conventional and callable Treasury notes and bonds.

2. The Investment Advisory Group advises the CFO on the FDIC's investment strategy. Chaired by the CFO, it includes four other FDIC senior executives.

3. Blinder, Alan S. and Wescott, Robert F. Reform of Deposit Insurance: A Report to FDIC, March 20, 2001. http://www.fdic.gov/deposit/insurance/initiative/reform.html

4. One such use of a reverse repurchase program would be to obtain inexpensive financing to fund failing bank resolutions. Under such a program, the FDIC would pledge its marketable securities to obtain inexpensive short-term financing, use the funds to pay off insured depositors, and then pay down the financing as the failed bank's assets were liquidated.

Last Updated 03/21/2003 communications@fdic.gov

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