Coda: Another Observation About Federal Agency Debt

The last issue of Beyond the News described the changes in  debt issuance by federal agencies since the Great Recession, noting three key points: (1)  shrinkage in the amounts issued by Fannie Mae and Freddie Mac, (2) a sharp reduction in the volume of short-term discount notes issued, and (3) the shift toward callable notes which expose investors to interest rate risk.  A subscriber noted that another change has been the increased use of floating rate notes.

So, we took a look. The following chart tells the story:

Variable rate notes have grown from about 2.5% of outstanding long-term debt for Fannie Mae and 5.8% for Freddie Mac in 2007 to more than 20% of long term debt for Freddie Mac and 27% for Fannie Mae, at the end of last year.

Nothing wrong with variable rate debt for an LGIP or money fund investor. In fact, the growth of this segment has provided them with a much-needed option to buy something other than a Treasury bill for government-oriented funds.

But variable rate debt is of little use for those who want to match cash flow requirements because their total future value is uncertain.

So this is another change that makes Federal agency debt less friendly to state and local government investors.

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Predicting Default

The game is on to predict the debt ceiling curve kink (AKA “if there is a default on Treasury debt when will it occur?”). It is known to be played by portfolio managers and traders who focus on the short-term markets for Treasuries and who are concerned that if the Treasury runs out of money, if even for a few days, it might be unable to repay maturing Treasury bills.

While few doubt that Treasury ultimately would make good on its obligations, a failure to pay could put the maturing security into default. LGIPs and money funds that are managed to a stable net asset value would be immediately affected if they held these bills.

So, the game is to guess (“predict” is too definite a term) which Treasury bills might be affected, and to avoid holding them. When buyers identify these bills they cheapen in the secondary market, thus leading to an anomaly in the normally smooth yield curve for Bills.

Here’s a picture of the Treasury bill curve as compiled by Bloomberg earlier this week, in a post about the kink in the Treasury curve:

The blue dots represent Treasury bill yields for maturities shown on the horizonal axis. Normally they would form a line with a consistent slope or a curve that varies a bit for each maturity. But in this case, the bills maturing in July and August have cheapened, resulting in higher yields, presumably because some large investors are avoiding them.

While a potential problem is still months off—most observers think the point will be in late June or July—the game has begun.

Think it can’t happen?  Well maybe the debt ceiling problem will be resolved by including an increase in the massive budget/tax bills that are now in Congress, but some doubt that the issue will be settled so easily.

The last time this game was widely played was in 2023.  It kicked off when Treasury hit the debt ceiling in mid-January.  Once it did, the Treasury secretary invoked extraordinary measures to ration cash, which started the year 2023 at about $600 billion.

The following chart shows balances in the Treasury account during the last round.

By the end of May the balance had shrunk to under $50 billion—barely three days (!) of Federal outlays—when Congress suspended the ceiling and Treasury was able to resume issuance of bills.

Want to play? Well it doesn’t take any particular skills or access to fancy financial models because the variables are largely “known unknowns” to use a term made famous by Donald Rumsfeld.  All you have to do is to “guess” the daily receipts and outlays for the Federal government between now and mid-July.  Keep in mind that spending will total about $3 trillion over the next five months.  So, if we get down to the wire, we’re talking about precision of about one percent of cash flows to predict the day Treasury may actually run out of money.

As perceptions/forecasts change, the kink in the curve will move up or back in time by a week or two. As it moves, if you are a fund or pool manager you’ll go to great lengths to avoid the bills that might default.  Or you may try to sit out the game entirely by avoiding July and August bills.

If you have spare cash, are confident that the Treasury will ultimately pay its debt, and are not worried about justifying the holdings to concerned constituents the kink (i.e. “cheap”  bills) might present an investment opportunity, though most buyers on this basis are likely to be hedge funds or proprietary trading shops. 

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Expanded FDIC Insurance? Still Possible

_{By Boscophotos - Own work, CC BY-SA 3.0, https://commons.wikimedia.org/w/index.php?curid=44173320}

We’ve posted a couple of times on the idea of expanding deposit insurance for public agencies.  The point has been to identify a need and highlight the potential benefits for state and local governments and for smaller banks that rely on public unit deposits for core funding.

There’s not much new to report, except that the Trump administration has floated the idea of eliminating the Federal Deposit Insurance Corporation and folding the insurance function into the Treasury Department.  This is not imminent, and it would require Congressional action so consideration would be protracted. But if changing the operation of FDIC or eliminating it as a separate agency gains traction it will be timely for public units to be heard on this matter.

The major Washington-focused groups like the Government Finance Officers Association, National Association of State Treasurers and organizations representing cities, counties, etc. have a few other things to focus on these days including Trump’s shuttering or scaling back of Federal agencies, suspension or impoundment of funds and the possibility that changes to the tax code could erode or end tax exemption for municipal bonds.

But we’re still keeping an eye out for an opportunity to improve deposit insurance for public units.  Governing has just published a post written by Girard Miller titled “Can as Revamped FDIC Better Protect the Public Purse?” that seeks to encourage finance folks to engage on this issue. It’s worth reading.

As noted, there are as few other things going on in Washington these days, but at some point revising the bank regulatory framework and the future of the FDIC will be on the front burner.