Rationalization and Obligation, Part III: Premium Bonds, and Asset Sales

By Joe Firestone

In Part I of this six-part series I presented the President’s explanation of why he can’t use alternative options for coping with the default threat arising out of refusal to raise the debt ceiling, a summary of the kinds of difficulties characterizing it, and discussed two of seven options, selective default, and the exploding option, the President has to deal with it, apart from the way he seems to have chosen. In Part II I discussed the next three options, platinum coins, 14th amendment, and consols, and commented on the legal issues related to them. Here, in Part III, I’ll cover two options which have started getting attention most recently.

Premium Bonds

6. Premium Bonds (See wigwam’s discussion):

“. . . are those whose interest rates are sufficiently high relative to their principal that they are expected to sell at a premium (i.e., negative discount), bringing their full issue price (principal plus premium) to the Treasury while adding only their principal to the national debt.”

Matt Levine explains the idea in more detail here, and here. But what it amounts to is that the debt subject to the limit is the total face value of all the unredeemed fixed maturity date debt instruments of the United States. So, if the Treasury auctions off a bond and sells it for more than its face value, then it gets enough money to not only roll over debt equal to the face value, but also to pay down additional debt, or deficit spend, as well. But, how can it sell a debt instrument by more than its face value? The answer is to offer interest rates higher than the rates offered for conventional bonds.

How high the rates would need to be, and the duration of the premium bonds offered, would need to be determined by how much in additional funds would be needed to stay under the debt ceiling and spend all appropriations. Levine suggests a “. . . 10-year at a 1.836% yield and the 30 at 3.026%” for example. So, interest rates for the premium bonds would not have to be sky high. Nevertheless, there is a problem with the idea of premium bonds:

”Of course then you’d have to pay the interest! This would be a fairly short-term solution; after a year of doing this you’d be incurring an extra $250+ billion in interest payments that you’d have to fund by issuing ever-higher-coupon Treasuries, leading I suppose to a death spiral. If I were doing this on a tabula rasa I’d probably bump the interest rate a bit at the cost of deferring payments for a year or two, making this a breathing-room rather than permanent solution, but obviously the further you get from regular-Treasury-bond structure the weirder this looks.”

And there is another problem too. The Federal Reserve controls interest rates in the United States by targeting its Federal Funds Rate, which is currently very near zero. This rate in turn influences Treasury offering which are only a bit higher for short-term debt instruments, and progressively higher for longer-term instruments. These rates, in turn, percolate throughout the economy and keep interest burdens where the Fed thinks they should be in the current fragile economy. However, if the Treasury begins to offer securities at much higher interest rates, than this will affect other investments throughout the economy that will have to offer rates higher than Treasury premium rates throughout the economy. In short, premium bonds will undermine Fed monetary policy even as they stave off default.

Kevin Drum also offers some negatives to the premium bonds idea after remarking favorably on it. He hints at legal difficulties and wonders about what a judge would say about it. But he has no real legal objection to this. He also remarks on the confidence issue. I’ll take that up below.

sales of material and cultural assets to the Fed,

7. The last option, sales of material and cultural assets to the Fed, just arose out of a multi-party e-mail exchange about debt ceiling issues. Warren Mosler pointed out:

the coin is about the fed buying an asset from the govt.
they could buy other gov assets as well? national parks? military equipment? spr? etc. etc. any asset sale to the Fed by the gov. works same? legal restrictions?

And L. Randall Wray expanded on the idea and shortly thereafter blogged this piece offering the following proposal, a bit tongue in cheek.

. . . We’ve got museums and national parks shut down. Why not sell them to the Fed? We can find a few trillion dollars of Federal Government assets to sell–and the Treasury can pay down enough debt to postpone hitting the debt limit for years. Heck, if we run out of Parks and Recreation facilities to sell, why not have the Fed start buying up National Defense? How much are our Nukes worth? That should provide enough spending room to keep the Deficit Hawk Republicans and Democrats happy for a decade or two.

This proposal shares with Jack Balkin’s “exploding option” proposal the idea that the Treasury Department can sell assets to the Federal Reserve to raise revenue. I’ve been able to find no prohibition in law that would make this illegal. And, as long as a fair price reflecting likely market value is paid by the Fed, I don’t think such transactions would raise legal problems.

This option is a temporary one. But it might buy enough time for Congress to become Democratic again, whereupon the Democrats could repeal the debt limit legislation, ending debt ceiling crises.

There is a problem with this option relating to who within the Fed system buys Treasury’s assets. The Federal Reserve Board of Governors is a self-funding Federal Agency; but it is nevertheless Federal, so the sale of Government property to it still leaves the assets in the hands of Government. But what happens if the assets are sold to one or more of the regional Fed Banks. These are agents of the Federal Government, but they privately owned. The transfer of Federal assets would surely raise the issue of turnover of federal property to the private sector. Also, if the regional Fed Banks ever sold any of those assets to private organizations that are not agents of the Government, for example, the big banks whose representatives sit on the regional Fed Bank Boards, we would see immediate charges of corruption and private sector looting of Government property. The next post, Part IV, will cover differences among options in their likelihood of having severe legal problems, or seriously undermining loss of public confidence in debt instruments.

38 Responses to Rationalization and Obligation, Part III: Premium Bonds, and Asset Sales

  1. As far as I can tell (admittedly a cursory read), current Treasury regs require that both coupon and principal are set at auction. If accurate, the premium bond idea won’t work under current law; which is a bit ironic, given that Levine’s Twitter handle says he “looks stuff up.” ;) http://www.newyorkfed.org/research/current_issues/ci11-2/ci11-2.html

  2. I am not sure that I understand the issue of undermining Fed policy. This seems to confuse coupon versus yield on treasury securities. While the premium coupon would increase the amount received to some amount above par and reduce the face value that would need to be issued to achieve a funding target, the yield is determined by the market. Ignoring factors related to market acceptance of these bonds, the yield should be similar to “normal” treasuries as the premium price should produce a yield that is comparable to current market levels. The aggregate dollars invested by UST buyers could be virtually the same. For instance, $100 of par price USTs requires the same allocation of cash from bond buyers as $90 of bonds priced at 111.11. The duration profile of premium bonds differs from par bonds so this is an oversimplification particularly because it is likely that these bonds would not find liquidity to be comparable to normal UST. Still, none of this precludes the Fed for buying these bonds and maintaining an interest rate target which is a function of UST yields and not nominal coupons.

    • Maybe that’s right. I think Levine is suggesting that the market would demand a much higher interest rate on the premium bonds to offset the cost above face value. Please see the two Levine links.

      • Levine assumes that the market yield would be not far from the market yield for existing securities.

        Premium Notes are not a permanent fix to the debt ceiling, since they function to allow an increase in borrowing because you are rolling over discount and par bonds and as those phase out and its Premium Notes maturing, you don’t get any additional leverage. That is another reason to issue 10yr 100% Notes rather than shorter term notes, even though if there may be a mismatch between demand for different yields of bonds and cost of debt service would be lower with a mix of conventional 90 day T-bills, 2, 5, 7 and 10 year notes.

        And, yes, its just a loophole, since the Treasury has not previously sold bonds on a premium basis, so the debt ceiling count simply does not explicitly count them at issue price, which leaves them counted at face value under the catch-all section (b) of the relevant section.

  3. Selling assets like national parks, creating platinum coins, etc should only be considered when US has decided to give up on capitalism providing a growing economy that benefits a majority of its citizens. If we have to step this low to solve this budget crisis, how can we argue against giant financial institutions gambling on exotic derivatives and all major commodities.

    Republicans already want to privatize Postal System so we can pay outrageous amounts to mail a letter. Yes, some people in this country have to use US Postal system and cannot pay their bills by direct banking, credit cards, etc. Not all of America has access to internet with smartphones and computers. The US Postal Office was never intended to be profitable operations nor was Social Security created as a retirement investment. Some government functions are created to provide certain services to many of its less fortunate citizens. Contrary to most Republicans belief that kind of help has made US one of strongest economies in world.

    Yes, you have proposed rational ideas for solving financial mess of US as if it was a corporation going belly up. But having US currency (considered to be strongest in global economy) stepping down to financial gimmicks in order to pacify some idiotic Republicans would lead to a loss as the major financial power in present global market. Even trying to pay our national debt or funding government departments with gimmicks would lead to demand of higher interest for US treasury bills. Our global partners would see that US government is fragmented by radicals and that this shutdown/default scare would only be the first of many to come.

    No, Pres. Obama and Senate Democrats have to stand down the Republicans this time. Even if Republicans continue to bring us to default. We can repair the default. Sure it will cost billions but the greater danger is let this faction of Republicans create “shutdowns and default” as a standard tool for getting what they want in federal budgets. Sure States go through this shutdown process and survive. But doing this on federal level amounts to throwing global economy into a tailspin.

    Bully are never satisfied. They will do it again. Americans need to open their eyes and vote them out of office. And if Americans don’t vote them out, then President must stand them down again.

    Senate Democrats should pass one year extension of debt limit without Republicans and sent it to the House. Then Pres. Obama should press the House to vote on 2-month CR and clean 1-year debt extension bills.

    • “Selling assets like national parks, creating platinum coins, etc should only be considered when US has decided to give up on capitalism providing a growing economy that benefits a majority of its citizens.”

      Hasn’t the US given up on that? All the debate we have now is about debt and deficits, not economic growth full employment.

  4. What about “the Fed” having authority to buy assets? Do the laws that created the Fed and govern their operations permit buying anything they want, or do they limit them to managing monetary policy?

    OTOH, the government routinely sells physical assets to the private sector: used furniture, obsolete warships, maybe land and a building once in a while, when they have built a new one. It’s only the scale and the purpose that would differ.

    • “What about “the Fed” having authority to buy assets? Do the laws that created the Fed and govern their operations permit buying anything they want, or do they limit them to managing monetary policy?”

      The Fed doesn’t seem to be limited to monetary policy right now. Was the astronomical credit facilities granted the banking sector monetary or fiscal policy. How about enormous QE. In any event, if the Fed allows the Treasury to go into default, this is likely to have a great impact on its low rate monetary policy. So, is the Fed justified in staving off that impact by buying trillions worth of Government assets to help prevent Treasury from defaulting? Why not?

      • I think lending to banks is part of their statutory function as the Central Bank. And QE is definitely intended, although wrong-headed, to be monetary policy. Buying the Hoover Dam seems a bit different.

        Defaulting on Treasury bonds seems unlikely, even if the ceiling is not raised. Interest on the debt is a small fraction of government income, and probably the last bill they ought not to pay, unless it’s like closing the WWII memorial, or closing the commissary at Pensacola just as the hurricane is approaching, something just to stick a finger in someone’s eye. In this case, one’s own eye. Still, if they decide to pay staff salaries and not interest on the debt, the Fed can easily continue to buy as much of it as necessary to maintain current rates. There is no limit to how much the Fed can buy, and no significant “impact” from them buying it. If the last 5 years have proven anything, that would be it.

        I’m worried about the Fed operating a dam. They may sense a lack of liquidity, and open the floodgates at exactly the wrong time ;)

        • Joe Firestone

          If the Administration is telling the truth, and if it avails itself of none of the options, and if the Republicans and Dems can’t make a deal on the debt ceiling then there will be default within 30 days of October 17. Lew says he doesn’t have enough control of payment machinery to prioritize. So he can’t put bondholders first. Of course, he may not be telling the truth. But I suspect the likelihood is greater that the Administration isn’t telling the truth about the options it will be use.

          • “Lew says he doesn’t have enough control of payment machinery to prioritize”

            Nonsense. They have certainly prioritized selective functions and their related payments during this shutdown. And then made changes to them according to the volume of the uproar. I wonder how he manages that, without control of the machinery?

            If they operate like any other large IT shop, they run hundreds of jobs each night, and each one has a specific function. One job pays the Army, another one pays Boeing, etc. The jobs run in a specific order according to a schedule, managed by a software product called – what do you know – the job scheduler. All you have to do is not run the low priority ones, and mark them “complete” in the scheduler, so that subsequent (dependent) ones can still run.

            • In order to default on interest payments, he has to not run the job that pays the interest. How does he do that without control of the machinery? He is still paying his own salary, remember, and Congress. That’s prioritizing. He’s just got his priorities wrong.

              • Here’s Brad Plumer’s take on whether the Administration can prioritize: http://wapo.st/1epSNj6

                • Yes, the significant line being

                  “the Treasury Department has kept many of key details hidden. “And yes, obviously Jack Lew has to be evasive about the possibility. … To acknowledge that payment prioritisation is possible would enable the Republicans to force the president to use it. ”

                  Politics prevents telling the truth.

                  And again, the language is backward. They talk about dire consequences if the debt ceiling “is breached”, but the real problem is if it is not breached, if the budget is suddenly balanced cold turkey.

                  Maybe another semantic problem involves “debt subject to the limit”. Apparently the author envisions the government continuing to run up debts in the form of accounts payable, while ceasing to issue bonds. As long as we do that, the harm to the macro economy will be far less than if we don’t, as long as the issue is resolved within a month or so.

        • Joe Firestone

          The Fed doesn’t have to operate the dam. It can just own it and contract the same Federal employees to run it as the rest of the Government use.

          On this:

          “I think lending to banks is part of their statutory function as the Central Bank.”

          Lending is; but QE isn’t lending. It’s buying assets; not just bonds, but also other assets, including toxic ones to safeguard the banking system.

  5. I thought that the Treasury received the face value of all the bonds, bills and notes from the primary dealers i.e. the auctions are a secondary market operation.

    Am I wrong?

    • That’s true, for current bonds. But for the premium bonds the issue price can be different from face value.

      • Really? I thought the auction was how the Treasury sold them to primary dealers, with the face amount and coupon set and announced beforehand, the price and yield (which could, of course, change the next day in the secondary market) determined by the auction.

      • Huh? I thought that some kinds of treasuries have no interest-bearing coupons and generate all of their interest by selling at a discount.

      • Yes and no. From various points at Treasurydirect.gov:

        The price and interest rate of a bond are determined at auction. The price may be greater than, less than, or equal to the bond’s par amount (or face value). (See prices and interest rates in recent auctions.)

        Treasury bills, or T-bills, are typically issued at a discount from the par amount (also called face value). For example, if you buy a $1,000 bill at a price per $100 of $99.986111, then you would pay $999.86 ($1,000 x .99986111 = $999.86111).* When the bill matures, you would be paid its face value, $1,000. Your interest is the face value minus the purchase price.

        Treasury notes, or T-notes, are issued in terms of 2, 3, 5, 7, and 10 years, and pay interest every six months until they mature.

        The price of a note may be greater than, less than, or equal to the face value of the note. For a full discussion of the price of a note, see Treasury Notes: Rates and Terms.

        When a note matures, you are paid its face value.

        You can bid for a note in either of two ways:

        With a noncompetitive bid, you agree to accept the yield determined at auction. With this bid, you are guaranteed to receive the note you want, and in the full amount you want.
        With a competitive bid, you specify the yield you are willing to accept. Your bid may be: 1) accepted in the full amount you want if your bid is less than the yield determined at auction, 2) accepted in less than the full amount you want if your bid is equal to the high yield, or 3) rejected if the yield you specify is higher than the yield set at auction.

        Key Facts

        The yield on a note is determined at auction.

        As you can see, the idea of a “premium” note or bond (not bill) is accounted for. If treasury sets the coupon rate (set at announcement) a little higher than the going rate (at the time of the auction) for the same maturity on the open market, they will get a price at auction that is higher than the face amount.

        Also, not only primary dealers can buy these at auction. Individuals or companies can submit bids in increments of $100. It seems the Federal Reserve is the only entity prohibited from buying them at auction.

        • Joe Firestone

          Do you think there’s anything in this that conflicts with Levine’s analysis:

          4. Treasury issuance mechanics. Here we are on shakier ground, but not as bad as it looks. First, the bad: Treasury’s rules exclude above-par auctions of bonds with interest rates above 0.125%:

          (b) Determining the interest rate for new note and bond issues. We set the interest rate at a 1⁄8 of one percent increment. If a Treasury note or bond auction results in a yield lower than 0.125 percent, the interest rate will be set at 1⁄8 of one percent, and successful bidders’ award prices will be calculated accordingly (see appendix B to this part for formulas).

          (1) Single-price auctions. The interest rate we establish produces the price closest to, but not above, par when evaluated at the yield of awards to successful competitive bidders.

          (2) Multiple-price auctions. The interest rate we establish produces the price closest to, but not above, par when evaluated at the weighted-average yield of awards to successful competitive bidders.
          So Treasury’s rules mostly prohibit premium bonds. This, however, does not seem to actually be a problem, since these rules are just Treasury’s rules and it can change them. (By, for instance, executive order.) Here is the adopting release for that 1/8th point rule; note that (1) it cites no statutory requirement and (2) it notes that “Because this rule relates to public contracts and procedures for United States securities, the notice, public comment, and delayed effective date provisions of the Administrative Procedure Act are inapplicable.” That means: Treasury can just change this rule whenever it wants. Now would be a good time.

          Also – as noted in that release – the rule does not apply to reopenings, and in fact Treasury has done above-par reopenings in the past; here’s one at 104.5+. A reopening – just selling more of an already-existing series of high-coupon Treasuries – would be the simplest way to do this scheme, since it would require no rule changes or departures from ordinary practice. And there are some high-dollar Treasuries to reopen.5

          On the other hand, “high-dollar” means like 150s, not 270s: there are no really high-dollar Treasuries to reopen and solve the whole problem. And if you wanted to do weird tweaks like making them puttable (see point #2 above) or deferring interest (see fn. 2) then you’d probably want a new issue, which would require changing some (purely Treasury-written and instantly-changeable) rules. In any case, the fact that above-par reopenings are kosher would seem to undercut the idea that there’s any sort of statutory ban on above-par Treasury issuance.”

          If not, then where’s the issue, John?

          • The original statement was

            “I thought that the Treasury received the face value of all the bonds, bills and notes from the primary dealers i.e. the auctions are a secondary market operation.”

            The way I read the Treasury web site, the auctions are the primary market operation, not secondary, and Treasury may receive more, less, or equal to the face value depending on how the auction goes.

            The Treasury rules cited seem to prohibit them from receiving more than the face amount, if I’m reading it right, at least with regard to the average of competitive bids. Some, including the non-competitive bidders might pay more than par? It seems to me to conflict with the web site which allows for receiving more.

            • But Levine points out that Treasury rules are not determined by legislation, and can be changed by Treasury at their convenience. That’s one of Levine’s main points about wht premium bonds are feasible.

  6. Levine suggests a “. . . 10-year at a 1.836% yield and the 30 at 3.026%” for example. So, interest rates for the premium bonds would not have to be sky high. Nevertheless, there is a problem with the idea of premium bonds:

    ”Of course then you’d have to pay the interest! This would be a fairly short-term solution; after a year of doing this you’d be incurring an extra $250+ billion in interest payments that you’d have to fund by issuing ever-higher-coupon Treasuries, leading I suppose to a death spiral.

    I disagree with both Levine’s numbers and this part of his analysis.

    Per Levine’s Bloomberg article:

    I do have one quibble with Matt’s Bloomberg article:

    The U.S. government takes in $277 billion in tax revenues each month, and spends $452 billion each month, for a monthly deficit of around $175 billion.**

    ** Source is Bloomberg’s useful CLIF [go].

    The most recent (mid-May) CBO deficit projection for 2013 that I’ve seen is $642 billion, which amounts to $53.5 billion per month, which is way smaller than $175 billion.

    Regarding that “death spiral,” one has to understand that the for economic purposes the interest rate on premium bonds is their interest as a percentage of issue price (and not as a percentage of par value) and that should be very close to prevailing interest rates.

    Also, although the debt subject to the limit will stop growing under this scheme, the effective debt (based on issue price) would continue to grow at the normal rate. We would, therefore, be in no more of a “death spiral” than we are right now. (I’m deliberately ignoring what FixTheDebt.org says about that.)

    • Joe Firestone

      “The most recent (mid-May) CBO deficit projection for 2013 that I’ve seen is $642 billion, which amounts to $53.5 billion per month, which is way smaller than $175 billion.”

      Yes, but debt instruments fall due all the time and these could require much more repayment than the $53.5 billion per month.

      • Sure, but once you repay them you’ve got that much more room under the ceiling. Rolling them over doesn’t change the total debt.

    • Good comment. The “deficit” figures of Levine do seem way, way off. His figures project out to a deficit of $2.1 T per year. As yous ay CBO projects $642 B this year and it’s expected to decline to maybe $450 B this year. I suspect Levine is using the term “deficit” in a non-conventional way.

  7. @joe Firestone on …selling assets like national parks
    Hasn’t the US given up on that? All the debate we have now is about debt and deficits, not economic growth full employment.

    MY RESPONSE is definitely NO!
    This citizen believes that President Obama needs to stand up to these Republican fanatics . Our country will support a strong leader. They will rally to fight against this bulling by Republicans. Maybe this fight is necessary to see if Americans will finally start to get involved in its government.

    Maybe they can understand that Republicans favorite messages are just:
    “Scare!
    Scare!
    Remove Government!
    not
    “Leading America to be a better country with justice and health for all its citizens not just its wealthy”

    • I was being sarcastic. That said, I think the President and most politicians have given up. That’s the trouble. They’ve been largely corrupted by campaign contributions.

  8. Pingback: Rationalization and Obligation, Part V: Differences Are Everything | New Economic Perspectives

  9. If Obama were really unsure about the legality of the measures like PCS to fund the government, he could have used a trial ballon like a $1 billion coin, have someone challenge it and see how the courts rule. This could have been done long before now to test the legality of the approach. That he didn’t bother to do so can only mean he either doesn’t want the risk of an adverse court finding before he is actually ready to use it or he simply doesn’t want any unconvetional approaches to solving the problem, no matter what the consequences.

    • I think you are right, GRP. If Obama really wanted to test the legality of PCS he could have done so in 2011 or again in Dec. 2o12, starting with something as small as $1000 and increasing every few weeks up to $1 b or even $100 b. That he chose not to probably reflects his and his advisers basically conservative bent. He just doesn’t like to do anything unconventional; it might rile the tea party Republicans whom he perennially hopes to co-opt. If he does pull out all the stops, I will be floored.

  10. Pingback: Rationalization and Obligation, Part VI: What He Ought to Do, What He Probably Will Do | New Economic Perspectives

  11. I also have a quibble with another part of Matt Levine’s analysis in his dealbreaker.com article:

    Of course then you’d have to pay the interest! This would be a fairly short-term solution; after a year of doing this you’d be incurring an extra $250+ billion in interest payments that you’d have to fund by issuing ever-higher-coupon Treasuries, leading I suppose to a death spiral.

    Obviously, the “debt subject to limit” would stop growing, but the amount of money borrowed (par+premium) continues to grow at the normal rate. And the interest on it would be at only slightly-higher-than-normal rates to make up for the smaller par value. So, I don’t see any new “death spiral” here, over and above the status quo.

  12. charles fasola

    I have a “quibble” with the fact that all of this deals only with the symptoms caused by the ever on-going crisis which is the result of FIRE sector dominance of our governmental and economic systems. It is very seldom that remedies for the actual causes are discussed. MMT is determined to work within the current bank money system and actually supports that system.

    • Joe Firestone

      Naaah! MMT writers don’t favor the present system, but suggest ways to modify it so that very important value gaps can be closed.