Introduction Treasury Securities Mortgage-Backed Securities Treasury issues marketable debt securities in the form of bills, notes, and bonds; these are used to refinance debt, to help raise new funds needed to finance deficits, and to manage the government's cash flow. Treasury also provides a mechanism for the issuance of zero-coupon instruments, which represent the principal and interest coupon payments from selected Treasury notes and bonds of 10 or more years to maturity. The resulting securities, known as STRIPS (Separate Trading of Registered Interest and Principal of Securities), may be separately owned and are traded at a deep discount from face value because they pay zero interest until maturity.4 Treasury auctions its securities to the public using the Federal Reserve Banks as its fiscal agent. All marketable Treasury securities, including STRIPS, are issued in book-entry form with ownership recorded in an account established by a Federal Reserve Bank or at Treasury, and investors receive only a receipt as evidence of purchase. Treasury securities comprise about 59 percent of the nearly $3.3 trillion marketable U.S. Government securities outstanding as of December 31, 1989. Mortgage-backed government securities represent an interest in a group 3Treasury bills are short-term obligations that mature in a year or less. T-Bills do not pay interest during their term; the interest earned is the difference between the price paid by the investor and the par value paid by the government at maturity. Treasury notes and bonds are both debt securities that pay interest every 6 months and the par value at maturity. Notes have initial maturities of more than 1 year up to 10 years, and bonds have longer maturities, usually 30 years. Treasury also issues nonmarketable securities to government trust funds and other accounts, such as the Social Security trust fund and the Federal Deposit Insurance Corporation (FDIC). 4Before Treasury made STRIPS available, certain government securities dealers began issuing zero Introduction Agency Securities payment of scheduled interest and the ultimate repayment of principal. FNMA issues similar securities but guarantees timely repayment of principal as well. There is greater uncertainty regarding the duration of a mortgage-backed security than with a Treasury bond because any unscheduled prepayments of principal on the underlying mortgages are passed through to the holders of the security, thereby creating prepayment risk. Mortgage-backed securities are sold directly by issuers to securities dealers. Mortgage-backed securities account for about 28 percent of the government securities outstanding as of December 31, 1989.5 Although some agency securities are direct debt obligations of certain federal agencies, most are obligations of government-sponsored enterprises (GSE). GSES sell debt obligations in the financial markets and channel the proceeds to agricultural, student loan, small business, and mortgage lending institutions either through direct loans or through the purchase of loans originated by these institutions. Although all agency securities are exempt from SEC registration, the nature of the government's backing varies. A few are backed by the full faith and credit of the United States, others are supported by the issuing agency's right to borrow from the Treasury, but some lack any formal governmental backing. The major categories of agency securities actively traded in the government market are those issued by FNMA, FHLMC, Federal Home Loan Banks, the Student Loan Marketing Association, and the Farm Credit System. These agencies typically issue the securities through groups of dealers, known as selling groups, who locate purchasers. Agency securities account for about 13 percent of the government securities outstanding as of December 31, 1989. 5The previous discussion described the common mortgage-backed pass-through security. Because of the uncertainty of the principal payments, other mortgage-backed securities have been developed, such as collateralized mortgage obligations (CMOS), which are designed to give the investor greater certainty about the timing of the repayment of principal. Under a CMO, the investor buys the right to receive the interest or principal payments during various periods of time. Also, there are interest only and principal only mortgage-backed securities which allow investors to deal separately with the expected return from the interest and principal portions of a pool of mortgages. These types of securities can be considered government securities if they are issued by FHLMC or FNMA, but many are issued by private institutions as SEC-registered securities. Introduction Repurchase Agreements A principal focus of the act was regulation of repurchase agreements Repurchase agreements are important in that they serve as a principal means by which dealers obtain money to finance their securities inventories; the Federal Reserve implements monetary policy; and public bodies, financial institutions, and other corporate investors invest cash balances. Dealers use repos aggressively, because they can obtain funds inexpensively and offer government securities to investors as security for the transaction. Dealers also initiate what are termed reverse repo transactions, in which the dealer is the initial purchaser of securities, to obtain securities that are needed either to meet delivery requirements or to engage in other repo transactions. For many dealers, repo and reverse repo transactions have become a major line of business. Primary dealer activity in this market averaged over $776 billion per day in 1989, which is more than double the 1985 level and about 6 times greater than the average daily volume of regular trading in Treasury securities reported by these dealers. While repurchase agreements are important, they also involve potential Introduction Derivative Products Treasury securities are also the basis for derivative products that are an The Secondary Market Except for futures and some options contracts that are bought and sold Secondary market trading performs two important functions. First, it "Mortgage-backed securities are the exception. Unless otherwise specified by the parties to a trade, mortgage-backed securities settle by class once each month on designated settlement dates. 7Certain changes in government policy, events, or new information of any type lead to expectations of changes in interest rates. Actions by dealers and other secondary market participants transmit these expectations into changes in interest rates on Treasury securities. Then, through arbitrage between the market in Treasury securities and the debt and equity markets, other interest rates are affected. Introduction Importance of the Secondary The safety, efficiency, and liquidity of secondary market trading systems have a direct impact on the rate of interest that must be paid on newly issued government debt. Easier resale opportunities lower investment risk, which in turn lowers the rate of interest that must be paid to sell the public debt. This fact is important considering the large amounts of money-$1.2 trillion in 1989-that Treasury must raise each year to finance current budget deficits and to refinance existing debt. The liquidity of the secondary market also contributes to the Federal Reserve System's ability to conduct monetary policy. A central feature of monetary policy is the frequent purchase or sale of securities in the secondary market by the Federal Reserve Bank of New York (FRBNY).8 In 1989, open market operation transactions averaged about $6 billion per business day. The more liquid the secondary market is, the easier and cheaper it is for the FRBNY to conduct these transactions. Primary Dealers Dealers are firms that buy and sell securities for their own accounts to FRBNY can designate as many primary dealers as it believes to be appropriate. The number of primary dealers has grown over the years, although there has been a slight drop during the past year. There were 8FRBNY buys securities in the market when the Federal Reserve System wants to inject money into the banking system, and it sells securities when it wants to reduce the banking system's money supply. These transactions, conducted by the open market desk of the Federal Reserve Bank of New York for the System Open Market Account, are nearly all in the form of repurchase agreements and matched transactions. When the Federal Reserve makes a repurchase agreement with a government securities dealer, the Federal Reserve buys a security for immediate delivery with an agreement to sell the security back at the same price by a specific date (usually within 15 days) and receives interest from the dealer at a specified rate. This arrangement allows the Federal Reserve to temporarily inject cash into the economy to meet a temporary need and to withdraw these reserves as soon as that need has passed. Matched transactions are the reverse of repurchase agreements and are used to temporarily withdraw cash from the economy. |