As Prepared for Delivery
I want to thank the Futures Industry Association for organizing this conference.
We believe that it is very important to maintain an open and transparent relationship with financial markets, and venues like this present excellent opportunities for that sort of communication.
My background is in the investment management industry and for over 25 years I attended meetings and programs like this as an investor, not an issuer. As someone who used to trade in the futures markets, I have a great deal of appreciation for the importance of these markets to the functioning of the financial system.
I have now served at the Treasury for seven months as Assistant Secretary for Financial Markets. In that role, I oversee the Office of Federal Finance, which is responsible for U.S. Treasury debt management. I also oversee the Office of Capital Markets, which is focused on financial market policy, and right now on implementing Dodd-Frank legislation and the reform of the U.S. housing finance system.
I believe that this is an important time to be engaged in the U.S. government and particularly at the Treasury as we work to right the economy, financial markets and fiscal outcomes.
Today, I have been asked to say a few words on the state of the U.S. economy, the progress on restoring order to financial markets, and the plan for managing our national debt.
After my remarks, I believe there will be time for a discussion on questions of direct interest to the futures industry.
The U.S. Economy and Fiscal Position
America continues to recover from the worst recession since the Great Depression, beginning in December 2007 and lasting for 18 months.
Since 2008, we have taken unprecedented steps to regain financial market stability and restore growth. While necessary, these steps have had significant implications for debt management and financial market regulatory reform. In the longer term, the legacy of the financial crisis and ensuing recession will require significant fiscal discipline to restore budget balance.
After a year of positive growth in GDP, we are seeing improvements in revenues at the federal level. Corporate tax revenues are running over 40 percent above last year's levels and personal income taxes are 5 percent ahead.
Still, due to the deep economic recession, there has been a large imbalance between revenues and expenditures, which caused the fiscal deficit to reach nearly 10 percent of GDP in FY 2009. We expect this year's deficit to be a similar or slightly lower percentage of GDP.
However, the Administration's decision to freeze non-security discretionary spending, together with economic recovery, will reduce deficits over the next few years. The official forecast from the Office of Management and Budget shows the deficit falling to 4 percent of GDP by FY 2015.
We have also benefited from a steady stream of repayments of investments made under the Troubled Asset Relief Program (TARP). TARP has proven remarkably successful in achieving its goal of stabilizing the financial sector and laying the foundation for our nation's economic recovery – at a fraction of the cost that was originally anticipated. While originally authorized to provide up to $700 billion in assistance, we spent far less than that amount. New estimates indicate that the program may end up costing $50 billion or less – approximately 7 percent of the original appropriation. To date, TARP has recovered $225 billion in revenue from these investments and repayments are expected to continue as time goes on.
At the end of this year, the National Commission on Fiscal Responsibility and Reform, a bipartisan commission established by President Obama, will offer ideas to further reduce our deficit. Once the fiscal commission finishes its work and as our economy strengthens, the President and the Administration are committed to making the tough choices necessary to reduce our deficits.
While we have seen important signs of improvement, some recent data on the economy have been more mixed. The business sector has been a source of strength. Businesses have started to increase investment in equipment and software, which leads directly to GDP growth. However, data on the labor market has been less encouraging. While private sector employment has expanded in each of the last eight months, 15 million Americans remain out of work and future improvements in unemployment are likely to be slow. Accordingly, private forecasters have lowered their average growth forecasts to 2 percent for the second half of 2010 and 3 percent for 2011.
In addition, many consumers' balance sheets are still impaired for a number of reasons related to stress in the housing and financial markets. As consumers work to repair their balance sheets by deleveraging and saving – which is a good exercise for the long term - household consumption will contribute less to growth in the short term.
An important contributor of the downturn, the housing market, remains weak and the shadow inventory of foreclosed-upon and vacant housing will likely weigh on residential investment for some time. Nevertheless, low interest rates are helping homeowners to refinance and the trajectory of delinquencies and foreclosures is starting to improve. Home prices have started to stabilize in most markets, albeit at lower levels relative to their peak in early 2007. We are also seeing some signs of stabilization in the commercial real estate market and the re-emergence of financial transactions to reduce inventory. A key to further improvement in both of these areas, of course, must be gains in employment.
The downside risks to the economy have led some to forecast a "double dip" recession. That is not our forecast and seems unlikely. We are in an important transition period as government support for the economy subsides and private demand takes over. The economic data show that this transition is happening – private demand, including business investment and even consumer spending, has increased recently and will likely continue to increase in the second half of 2010. During this transition, periods of weaker economic data are not surprising, especially given the depth of the economic downturn we experienced.
While we have come quite a distance from the winter of 2009, when the economy was losing more than 700,000 jobs a month, more remains to be done for the millions of Americans who remain out of work. That is why the President recently announced a new plan for rebuilding and modernizing America's roads, rails and runways. This will help the economy in the short term, while setting a foundation for continued growth and prosperity over the longer term. In addition, the President has proposed allowing businesses to write off investments made in 2011, which will further encourage businesses to get off the sidelines and put their profits to work creating jobs.
Despite recent volatility, one reason for the reemergence of confidence in the economy is the recovery of the financial markets since the first quarter of 2009. The stock market, measured by the S&P 500, is up nearly 70 percent since the March 2009 low. Credit sectors have also performed well as corporate debt, municipal bonds, and asset backed securities have all recovered significant ground.
Together with the recovery of the banking sector, improvements in these credit markets will make financing more widely available for all types of borrowers, which will in turn facilitate economic recovery. Let me be clear that not all parts of the financial markets are back to where they were pre-crisis – nor should all be – but we have largely restored stability to these markets.
We are also confident that futures markets, and in particular the market for Treasury futures, will remain highly liquid as the country moves forward toward economic recovery. As you all know, we are already seeing volumes in Treasury futures rebound. CBOT-traded Treasury futures of virtually every maturity were up significantly during the first nine months of 2010 as compared to the same period a year earlier.
What is not back to normal is investor confidence and that will take both time and significant action to restore. After a tumultuous decade marked by high levels of volatility and negative returns in many sectors, investors are understandably cautious. Retreating to the sidelines has been a frequent response from market participants over the past two years. Very low returns on cash investments and money market funds make this a painful choice, even in a low inflation environment.
The financial regulatory reform legislation signed into law at the end of July is the beginning of a process to build stronger financial infrastructure, stronger financial institutions with more capital and greater liquidity, to enhance transparency and reporting of trading activity, and to make sure that there is a level playing field for all market participants.
The financial crisis laid bare some of the regulatory gaps that existed as well as the lack of tools to combat areas of systemic risk. The "to do list" from the legislation is quite long with many studies, definitions, and rulemakings that must be conducted across regulatory agencies and the Administration. Nevertheless, this is where the real work begins to protect the American financial system from another meltdown.
An important component of the bill is the creation of the Financial Stability Oversight Council. This group is made up of ten voting members, including the principal regulatory bodies that govern our banking and securities industries. Additionally, there are five non-voting members of the Council. The committee will be chaired by the Secretary of the Treasury. The FSOC, as it is called, will be responsible for monitoring financial market conditions and managing systemic risk through the designation of certain firms for heightened supervision.
The bill also establishes an Office of Financial Research within the Treasury Department – to support the Council through the standardization, collection and analysis of data concerning risks to financial stability.
Further, the legislation compels regulators to impose stronger prudential standards, and establishes a comprehensive regulatory framework for the derivatives markets.
I know that the derivatives title of the Dodd-Frank legislation is of particular interest to the people in this room. While much work remains to be done by the regulatory community before we have final rules, I believe that the legislation will help to make these markets safer and more transparent.
Changes to the laws governing financial markets naturally raise uncertainties and concerns about the future viability of various segments of and participants in the markets. This has been the case historically, but the futures exchanges not only survived, they prospered.
Because the provisions of the Dodd-Frank Act will affect the way that business in these markets is conducted for years to come, Treasury will work with the CFTC and SEC, as well as through the new Financial Stability Oversight Council to ensure that markets thrive and systemic risk is mitigated.
I know that you are going to have the opportunity later in the day to explore some of these issues in greater depth with representatives from the CFTC and the SEC.
Beyond derivatives markets, the bill improves investor protection, provides for greater alignment of incentives in the securitization markets, and creates a single agency dedicated to consumer financial protection. Together, these measures will make our system safer and more resilient.
Looking forward, we have begun the process of evaluating options to reform our system of housing finance. The Administration plans to deliver a proposal on the future of housing finance in January. The plan will provide for the future of Fannie Mae and Freddie Mac, currently in conservatorship since September 2008.
Any efforts to reform the system must take into account questions of transition. We are very mindful of the need to maintain stability in housing finance and markets as we begin this effort.
These reforms at home will be complemented by efforts abroad. It is crucial to coordinate with governments from around the world to improve global financial stability and the safety and security of financial markets and institutions.
The work of the Basel Committee over the last year, culminating in the agreement announced in September, will significantly tighten the system of global capital requirements in a number of important ways. Critically, the amount of capital that banks will be required to hold relative to risks they take will increase substantially. In contrast to the current rules, which allow a wide range of forms of capital, the new requirements are set in terms of high quality common equity that will truly absorb losses when firms get into trouble.
We cannot know with certainty how the economy and the financial system will evolve, but these heightened capital requirements, along with other important reforms, should substantially reduce the likelihood that we will soon repeat the sort of severe financial crisis that we have just lived through.
U.S. Treasury Debt Management
Despite elevated issuance through the past few years, we have been able to finance our needs at record low cost and with strong interest from investors, both domestic and international.
Let me begin with the supply side. Since the end of 2008, outstanding debt held by the public has grown from $5.2 trillion to $8.5 trillion. The balance of our non-public debt is largely held in the trust funds set up for Social Security and Medicare. To meet the extraordinary financing needs of the government through this period we built a large framework of regular auctions, increasing not just the size of auctions, but the frequency and maturity of bond auctions. For example, we moved from quarterly to monthly auctions of 10- and 30- year bonds. We also re-introduced the 3- and 7- year maturities.
At the end of 2008, Treasury was forced to raise a significant amount of cash in a very short period of time, largely due to financial stability related capital injections. These needs were met through a significant increase in the issuance of Treasury bills. As the markets calmed and liquidity needs subsided, we have been able to moderate bill issuance and finance more of our needs from Treasury notes and bonds, from maturities of 2-years out to 30-years. Today, T-bills represent about 20 percent of our outstanding issuance, down from nearly 35 percent at the end of 2008.
Despite this decrease in bill issuance, this proportion is still relatively high compared to other sovereign issuers who simply do not provide the same amount of liquidity at the front-end of the yield curve. We feel that this liquidity is important for the global economy to function well.
One consequence of providing this liquidity is a lower average maturity of our debt than many other countries. Still, this figure has increased dramatically over the past 18 months from 48 months at the end of 2008, to approximately 59 months today, a significant change given the amount of debt outstanding.
At this point, we feel that the composition of the Treasury portfolio balances our financing needs with demand that we are seeing from the marketplace. This reduces reinvestment risk, contributes to a lower cost of borrowing for the American taxpayer, and maintains the liquidity and safety of Treasury securities.
We have been conscious to maintain this balance while bringing down auction sizes. Beginning in May, we announced that we would begin decreasing note and bond issuance to reflect improving fiscal outcomes and a lower borrowing need than was initially envisioned. We began a program of gradually decreasing auction sizes at a steady pace. Since May, we have cut approximately $300 billion on an annualized basis. More recently we have stated that we expect the level of borrowing to stabilize in the near- to intermediate-term. The ultimate level of borrowing over this time horizon will depend on the pace and extent of the economic recovery, but our current forecast is for net new borrowing to step down significantly in 2012.
One area where we have increased supply is in the issuance of Treasury Inflation Protected Securities (TIPS). Feedback from the market indicated strong interest in more frequent and larger issuance of these securities, which are issued with a low real interest rate coupon and are subject to price adjustments tied to the Consumer Price Index. These bonds have been popular both as a hedge against future inflation as well as a good portfolio diversifier. Our overall issuance of TIPS has grown from $58 billion in 2009 to over $80 billion this year, and should reach over $100 billion next year.
While overall issuance has surged, interest rates have come down from pre-crisis levels, and as a result interest expense is at less than 1.5 percent of GDP, the lowest level in more than 40 years. As the Fed keeps short term rates anchored close to zero, Treasury rates have also remained low. If rates begin to rise because of a growing economy, we would expect a beneficial impact to revenues, which would offset our need to borrow.
The important point is that this record level of issuance has been accomplished at very low interest rates that will be in place over the life of these bonds. The low cost of borrowing has been driven by a number of economic factors, but largely by very strong demand.
At the beginning of the past decade, the amount of bids in Treasury auctions averaged close to two times the amount offered for sale. Over the past two years, bids have risen to cover Treasury auctions on average by three times.
Periodic flights to quality as markets react to unsettling news, the need for greater liquidity and margins of safety have all played a role in very strong demand for Treasury auctions. There has also been a reduction of supply from other parts of the bond market, such as asset backed security issuance and corporate debt. Five years ago, Treasury debt represented 25 percent of the market as measured by the Barclay's Aggregate Index. Today it represents 33 percent.
It is interesting to look at trends in ownership of Treasury securities. Although the data is imperfect and subject to annual revision, it appears that domestic ownership has risen over the past two years. The Federal Reserve data on ownership also shows increasing holdings by domestic banks, households and other private investors.
All of this supports a higher savings dynamic at work in the U.S., along with a desire by financial institutions to carry more and higher quality capital reserves.
Foreign ownership has also grown in dollar terms if not in market share. We welcome a broad investor base for U.S. Treasury debt and note the growing participation of emerging markets as investors with excess reserves put them work, in a safe and prudent manner.
Finally, I should acknowledge that the Federal Reserve remains a very large investor in our market. The Fed recently announced that it will reinvest principal repayments from their large mortgage backed securities portfolio into Treasury securities. However, I would like to underscore that their decision to purchase Treasuries in the secondary market does not, and will not, impact our debt management strategy. As debt managers, we are focused on the issuance of securities to the private market at the lowest cost over time. Fed monetary policy decisions are independent of that calculus.
The unusual measures that have been taken by the Fed and the Treasury over the past few years are indicative of the depth and severity of the recession that we have recently endured. The consequences of this recession are still being felt across America and within our government.
Still, we are moving in the right direction. The economy continues to heal and financial markets are in a considerably stronger position then they were just a short time ago. The recent passage of financial regulatory reform legislation in the United States is a major step in the right direction, but more work remains to be done both domestically and internationally. Finally, we are beginning to see the effects of economic recovery in reduced borrowing needs.
Together, all of these developments will make the global financial system healthier and safer for individuals, businesses, investors and consumers. The founder of the company that I worked for used to say that change was the only certainty. I believe that the work underway to strengthen financial markets and restore investor confidence represents very positive change.
Thank you again for your time today.