oversight

Government Agency Transactions with the Federal Financing Bank Should Be Included on the Budget

Published by the Government Accountability Office on 1977-08-03.

Below is a raw (and likely hideous) rendition of the original report. (PDF)

                         DOCUVFNT RESUME

03102 -   .A21732841

Government Agency Transactions with the Federal Financing Bank
Should Be Included on the Budget. PAD-77-70; B-174958. Augu-t 3,
1977. 41 pp. + 2 appendices (15 pp.).

Report to the Congress; by Flmer B. Staats, Comptroller General.
Contact: Program Analysis Div.
Budget Function: General Government (800); Interest: Other
    Interest (902).
Organization Concerned - Department of the Treasury; Federal
    Financing Bank; Office of anagement and Budget.
congressional Relevance: House Committee on Banking, Finance ani
    Trban Affairs: Congress,
Authority: Federal Financing Bank Act 12 U.S.C. 2281). P.L.
    93-135, title II.
          Excluding the Federal Financing Bank from Federal
budget totals and other questionable budget practices combine to
produce an inadequate and incomplete picture of Federal credit
assistance. Findings/Conclusions: In its 4 years of operation,
the Federal Financing Bank hes helped agencies to borrow money
at a cost savings. Although it was oricinally thought that the
Bank would finance its activity by issuing its own securities in
the private money and capital markets, nearly all of the Bank's
borrowing has been from the Department of the Treasury. Thisat
borrowing arrangement saves money for agency borrowers and
present has small effect upon debt management and monetary
policy. Problems created by the off-budget status of the Bank
combine with other deviations of current budget practices to
provide an understatement of federal outlays. Purchase of
Government-guaranteed borrowings is one of the most troublesome
aspects of the Bank's off-budget status.      Recommendations:
Congres'; should: require  that  the  Bank's receipts and
disbursemets   be included  in  the  Federal budget totals; require
that the receipts and disbursements of all off-budget Federal
agencies that borrow from the Bank be included in the budget
totals: require that sales of Certificates of Beneficial
ownership be treated as borrowing it.agency budgets rather than
as asset sales; and monitor the 3ank's growth ti determine when,
if ever, the indirect costs of the current borrowing arrangement
with the Treasury outweigh the benefits of savings achievablR oa
agency borrowing that this practice provides. (Authsr/SC)
REPORT TO TiHE CONGRESS

BY THE' COMPTROLLER ,GENERAL
OF THE UNITED STATES




Government Agency Transactions
With The Federal Financing Bank
Should Be Included On The Budget
In its 4 years of opera-ion, the Federal Fi-
nancing Bank has helped Federal agencies bor-
,ow money, at a cost savings. However, the
transactions of ;he Federal Financing Bank
affect the Gov:rnment's budget and policy.
Excluding he Federal Financing Bank from
Federal budget totals and oher questio)able
budget practices combine to produce an
inadequate and incomplete picture of Federa,
credit assistance. The current borrowing ar-
rangement w;th the reasury saves monev for
agency borrowers and at oresent has small
effects upon debt management and monetary
policy.




PAD-77-70                                       AUGUST 3, 1977
                   COMPTROLLER GENERAL
                                        OF THE UNITED STATAs
                              WASINGTON, D.C. 20g48




 B-174958




 To the President of the Senate
                                and the
 Speaker of the House of Representatives

      This report is an analysis of
 with the off-budget status of        the problems associated
                                the Federal Financing Bank
 and its borrowing relationship
                                 with the Treasury. Neither
 the Bank's status nor its borrowing
 to the fundamental intermediation     arrangement is crucial
 tended to play. They result,       role  the Bank was in-
 inefficiencies.                however,  in real costs and

     The report addresses two issues:
     --   What is the best means of reflecting
                                               the
          credit assistance activity of
          Government in the budget while the Federal
                                          preserving
          the benefits from the intermediation
          the Federal Financing Bank was        role
                                          intended to
          play?
     --   Does the borrowing arrangement
          Federal Financina              between the
                            Bank and the Treasury
          have any significant ill effects
                                           on the
          conduct o Treasury debt management
                                              and
          monetary policy?
     We made our review pursuant to
                                    the Budget and Accounting
Act, 1921 (31 U.S.C. 53), and
of 1950 (31 U.S.C. 67).       the Accounting and Auditing Act

     We are sending copies of this
Office of Management and Budget,   report to the Director,
Treasury.                        and the Secreta   of the




                                   Comptroller General
                                   of the United States
 COMPTROLLER GENERAL'S                 GOVERNMENT AGFNCY TRANSACTIONS
 REORT TO THE CONGRESS                 WITH THE FEDERAL FINANCING BANK
                                       SHOULD BE INCLUDED ON THE BUDGET
              D I G E S T

              The Federal Financing Bank was established on
              December 29, 1973. It was created to function
              as a financial go-between, purchasing the dif-
              ferent kinds of debt and guaranteed obligations
              of Federal agencies and pri:,ate borrowers and
              substituting its own borrowin.g for that of the
              agencies. Its accomplishments have been note-
              worthy. Throucih coordination of the timing as-
              pects of agency borrowing and its standardiza-
              tion, agency borrowing costs have been reduced.

              Two aspects of the Bank's activities are not
              strictly related to its essential role as a
              financial conduit. First, when the Fedfral
              Financing Bank was established, its receipts
              and disbursements were excluded from the budget
              totals. Second, it was originally thought that
              the Bank would finance its activity y issuing
              its own securities in the private money and
              capital markets.  Instead, nearly all of the
              Bank's borrowing has been from the Department
              of the Treasury.

             This report considers how these factors
             cause substantive changes in the meaning of
             Federal outlays and deficits, the design of
             Federal assistance programs, and the alloca-
             tion of Federal resources.  It also considers
             changes that have occurred in the level, com-
             position, and maturity structure of the Federal
             debt, which may in turn affect the conduct of
             Treasury debt management and monetary policy.

             These changes are not related to the basic
             role that the Bank was intended to play. They
             relate to the way the Bank's transactions
             intermingle with questionable budget practices
             to produce an inadequate and incomplete pic-
             ture of Federal credit assistance activity.
             They could also potentially relate to the cur-
             rent borrowing arrangement with the Treasury.

             The problems created by the off-budcet status
             of the Bank combine with other deviations of
IauSurs.    upon removal, the report                        PAD-77-70
covwr*td   should   noted heron.i
current budget practices from those recommended
by the President's Commission on Budget Concepts.
Most notable among these are the budget treat-
ment of Certificates of Beneficial Ownership,
Bank purchases of agency assets, and Bank pur-
chases of Government-guaranteed bcrrowings of
private entities. The combined effect of these
factors provides an understatement of ederal
outlays estimated to accumulate to nearly $30
billicn by the end of fiscal year 19?8.

Federal Finaincing Bank purchases of the
Government-quaranteed borrowings of private
entities is ne of the most troublesome con-
sequences of the Bank's off-budget status.
This practice has a potential for failures to
design into loan guarantee programs the essen-
tial element of risk sharing and the poten-
tial for oversubsidization when guarantee
pLZgrams are appropriate and use of credit
assistance devices when such devices may be
inappropriate.
Including the Bank's receipts and disbursements
in the budget totals would eliminate mst of
the understated outlays that currently result
from the way credit assistance that goes
through the Bank is reflected in the budget.
But, it would not greatly increase the ration-
ality of decisions made regarding allocations
of resources among Federal assistance programs.
Concerns about on-budget status for the Bank
are valid largely because of the budget treat-
ment given certain credit assistance trans-
actions. If budget conventions were changed to
reflect the true nature of these transactions,
much of the agency borrowing currently going
through an on-budget Bank would continue at a
cost savings. Bank origination of the
Government-backed borrowings of private entities
is a questionable practice, and an on-budget
Federal Financing Bank might eliminate this
practice. The benefit;3 of reduced interest
costs to assisted private borrowers are ques-
tionable, and the cost savings from this
practice may also be illusory.




                     ii
            When the Bank finances its purchases of agency
            debt through the Treasury, the liquidity mix of
            public holdings of the Federal debt is changed.
            The Treasury finances its lending to the Bank
            by issuing its own securities. Treasury secu-
            rities are shorter term than the displaced
            agency securities the Bank purchases and, in
            all likelihood, the securities that the Bank
            would sell in the private money and capital
            markets if it could not rely on the Treasury.

            Because of this, the maturity structure of the
            Federal debt is shortened. We estimate that by
            the end of fiscal year 1978, the average matur-
            ity of the Federal debt will ' ve been reduced
            by about 3 percent as a rsult f the Bank's
            operations and its borrowing arrangement with
            the Treasury. We also estimate that the pub-
            lic's short-term Federal dent holdings will
            have increased by about $12.1 billion and that
            long-term Feaeral debt holdings will have been
            reduced by nearly the same amount as a result
            of the Bank's activities and its borrowing ar-
            rangement with the Treasury.

            Theoretically, this compositional shift in the
            maturity structure of the Federal debt should
            affect the Treasury debt management through its
            effect on the term structure of interest rates.
            It may also affect monetary policy by providing
            commercial banks with a greater stock of read-
            ily marketable assets that may be easily liq-
            uidated co finaince loan expansion at the same
            time that the Federal Reserve Board is trying
            to curb loan expansion.
            The empirical evidence generally supports the
            theory. But, the Bank's operations are small
            in relation to the operations of the Treasury
            and the commercial banking system. Thus, the
            compositional shift out of agency securities
            into Treasury securities induced by the Bank
            is estimated to have small effects on the
            maturity structure of the Federal debt, the
            term structure of interest rates, or monetary
            policy through fiscal year 1978. The Bank's
            lending activity would have to grow quite large
            before such effects could be considered serious.


Tear Shet
                                iii
AGENCY COMMENTS

Formal agency comments on this report were not
requested. The draft report, however, was
reviewed by staff of the Office of Management
and Budget and the Department of the Treasury
on an informal basis. These comments were
considered in preparing the final report.
Treasury officials maintain that the overall
maturity of the Bank's portfolio is about 4
years. The calculations in chapter 4 include
the Bank's transactions in agency debt and
Certificates of Beneficial Ownership in the
fourth quarter of 1976 and the first quarter
of 1977. Therefore, they do not include all
of the Bank's transactions since its inception.

RECOMMENDATIONS

In view of te current and potential consequences
resulting fr.m the off-budget status of the
Federal Financing Bank, deviations of current
from recommended budget treatment of some Fed-
eral credit assistance activity, and the curLent
borrowing arrangement between the Bank and the
Treasury, GAO recommends that the Congress:

-- Require that the Bank's receipts and disburse-
   ments be included in the Federal budget
   totals.
-- Require that the receipts and disbursements
   of all off-budget Federal agencies that bor-
   row froma the Bank be included in the budget
   totals.
-- Require that sales of Certificates of Bene-
   ficial Ownership be treated as borrowing in
   agency budgets rather than as asset sales.

-- Monitor the Bank's growth to determine when,
   i. ever, the indirect costs of the current
   borrowing arrangement with the Treasury out-
   weigh the benefits of savings achievable on
   agency borrowing that this practice provides.




                     iv
                      C o n t e   t s

                                                       Page
DIGEST

CHAPTER

    I      INTRODUCTION                                   1
               Perspective of the report                  2
    2      FFB'S ROLE, FUNCTIONS AND IMPLICATIONS        5
               FFB as an intermediary                    5
               Effect of FFB transactions on
                 Federal outlays                         7
               Budget outlays and the nature of
                 Federal assistance                      7
               Federal debt flows                       10
     3     IMPLICATIONS OF FFB'S OFF-BUDGET STATUS      12
               Recommendations of the President's
                 Commission on Budget Concepts          13
               Potential for poor design of Feeral
                 assistance programs                    16
               Effect on outlay totals of an
                 on-budget FFB                          19
               Should the FFB be placed on the
                 budget?                                20
               Recommendations to the Congress          24

4          IMPLICATIONS OF FFB OPERATIONS ON THE
             CONDUCT OF DEBT MANAGEMENT AND MONETARY
             POLICY                                     26
               Debt nianagment policy                   26
               Monetary policy                          35
               Summary                                  39
               Agency comments                          40
               Recommendation to the Congress           41
APPENDIX

     I     Estimated effect of FFB-induced changes
             in the maturity composition of the
             Federal debt on interest rates             42
    II     Estimated commercial bank portfolio
             recompositions during periods of
             restrictive monetary policy                45
                  ABBREVIATIONS
CBO   Certificate of Beneficial Ownership
FFB   Federal Financing Bank
GAO   General Accounting Office
                         CHAPTER 1

                        INTRODUCTION


     One of the more significant innovation; in Federal
finance in recent years was establishing the Federal
Financing Bank (FFB) on December 29, 1973. According to
testimony given for PFB's establishment, it was needed
because: 1/
    "Many existing 4.deral agencies are now
    required to finance their programs directly
    in the securities markets * * *. These
    agencies must develop their own financing
    staffs, and their abilities to cope with
    their principal rogram functions are
    lessened by the eed also to deal with the
    complex debt mar erent operations essential
    to minimizing their borrowing costs and
    avoiding cash flow problems which could
    disrupt their basic lending programs.

    qInterest costs of the various Federal agency
    financing methods rnrmally exceed Treasury
    borrowing costs by substantial amounts, despite
    the fact that these issues are backed by the
    Federal Government. Borrowing costs are
    increased because of the sheer proliferation
    of competing issues crowding each other in the
    financing calendar, the cumbersome nature of
    many of the securities, and the limited markets
    in which they are sold * * *.

    "Under the proposed legislation these essentially
    debt management problems could be shifted fI
    the program agencies to the Federal Financing
    Bank. Many of the obligations which are now
    placed directly in the private market under
    numerous Federal programs would instead be
    financed by the Bank. The Bank in turn would
    issue its own securities. The Bank would have
    the necessary experti., flexibility, volume,



1/ U.S. Congress, House Committee on Ways and Means, Federal
   Financing Bank Act Hearings, Mar. 1, 1973, 93rd Cong.,
   Ist sess., p. 2.



                             1
          and marketing power to minimize financing
          costs and to assure an effective flow of
          credit for programs established by the
          Congress."
     FFB has reduced the cost of borrowing by the executive
branch agencies. FFB'i establishment coordinated at least
some agency borrowing. Standardizing the financial instru-
ments used to finance Federal credit programs has occurred
since all of FFB's current borrowing is from the Treasury.

     We believe that creating a central facility for coor-
dinating the debt management aspects of Federal credit pro-
grams is a good idea. The benefits of coordinating, stand-
ardizing, and hence reducing costs that accrue to such an
institution within the Federal Government are substantial.
In 1975 the cost savings resulting from FFB and its borrowing
arrangement with the Treasury was estimated to be $70 million.
These savings are partly due to FFB's borrowing from the
Treasury instead of the public.
PERSPECTIVE OF THE REPORT
      Indirect costs resulting from FFB are not fully recog-
nized. This report analyzes these indirect costs. Some    of
the costs are potential; isae currently exist. They may be
grouped into two main categories. First, FFB affects the
meaning of Federal budget outlays and deficits. Related
to this are considerations regarding the potentials
alterations in credit program design and questionablefor
choices of Federal policy tools to achieve particular
program objectives. Second, a potential exists for FFB
to adversely affect the conduct of debt management and
monetary policy.   In this latter context, debt mangement
policy does not refer to the coordination aspects of agency
financing in which FFB's function provides definite bene-
fits. Instead, we are referring to the Treasury debt
management policy. Neither the off-budget status of FFB nor
its borrowing arrangement with th- Treasury is essential to
its basic intermediation role.

    In he next chapter we discuss certain aspects of the
Federal Financing Bank Act, explain the basic role that FB
plays as a financial intermediary, and describe the types of
transactions that FFB engages in. This is provided as a back-
ground for the analysis in the remainder of the report.




                             2
      In chapter 3 the ways in which the off-budget status of
FFB affects the meaning of budget outlays and deficits are
discussed. FFB was established as an off-budget ent:ity, but
we believe that its operations are an integral part of the
Federal Government operations and should be assessed t-o-
gether with other Federal operations within the context of
the Federal budget. FFB's off-budget status removes a large
segment of direct lending activity from the Federal budget
totals.

     Related to this are concerns about FFB's

     -- purchase of Government-backed loans that would
        have otherwise been financed in private markets;

     -- budget treatment of Certificates of Beneficial
        Ownership (CBOS), 1/ most notably those of-the
        Farmers Home Adminstration, and FFB's purchase
        of these securities; and

     -- purchase of agency assets that would have other-
        wise been sold in private capital markets.
Under current budget conventions, each of these transac-
tions is treated in a way which disguises the true nature
of the transaction and leads to an understatement of the
total financing activity of the Federal Government. All of
these practices offer the potential for favoring credit as-
sistance devices rather than alternative Federal assistance
devices, which may be more efficient in assuring the achieve-
ment of program goals. This problem is most important in
cases in which FFB purchases the Government-backed borrowing
of private entities. 2/

l/Certificates of Beneficial Ownership represent "ownership"
  of interests in a pool of loans made and still held by a
  selling agency. These securities are sold by the agency
  and guaranteed by the Government. When they are sold, by
  statute they are treated in the budget as a sale of a loan
  asset, although the loans in which CBOs nominally evidence
  interest are still held by the administering agency. There
  are no real benefits to purchasers from the transactions in
  the underlying loans. GAO believes that sales of these
  securities do not differ i a meaningful way from borrowing
  and should be so reflected in the budget.

2/An excellent source for the budget implications of FFB is
  Robert W. Kilpatrick and Thomas J. Cuny, The Federal
  Financing Bank and the Budget, Executive Office of the
  President, Office of Management and Budget, Technical
  Paper Series BRD/FAB 76-1, Jan. 26, 1976.

                              3
     Concerns are also expressed about FFB financing of
other off-budget activities.

     In chapter 4 FFB's implications for the conduct of debt
management and monetary policy are analyzed. It was origi-
nally thought that FFB would generally finance its lend-
ing by borrowing in the private money and capital markets.
The possibility of borrowing from the Treasury was not ruled
out, however. Currently, all FFB borrowing is from the
Treasury. Treasury funds its lending to FFB by issuing its
own securities, Treasury securities are more marketable than
the agency securities that would have been issued in the
absence of FFB. They are also Etore marketable than FFB bor-
rowings would have been if FFB could not have relied on the
Treasury for financing. Much of the savings attributable to
use of FFB is the result of tne greater marketability of
Treasury securities. However, these conditions have led to
a shortened maturity structure of the Federal debt and have
increased the liquidity and marketability of the public's asset
holdings.

     As a result of the current borrowing arrangement with
the Treasury, the efficiency with which debt management and
monetary policy are conducted may be affected. The way in
which this happens is complex, but the existence of this
relationship between alterations in the maturity structure
of public asset holdings and conduct of stabilization policy
is reasonably well established. Despite this relationship,
the present size of FFB is insufficient to raise concerns
about detrimental effects. And, FFB would have to grow much
larger before these effects would be cause for substantial
concern.




                             4
                          CHAPTER 2
            FFB's ROLE, FUNCTIONS, AND IMPLICATIONS
     The Federal Financing Bank functions as a financial
intermediary or go-between. It either lends funds to or
purchases the loans of Federal agencies responsible for ad-
ministering Federal credit programs and to those directly
benefiting from Federal credit assistance. It obtains these
funds by issuing its own securities.  Its borrowings are
held almost entirely by the Treasury. In this chapter we
describe the types of transactions FFB engages in and the
effects of these transactions on the nature of Federal
assistance.  We also summarize the effects of these trans-
actions o the meaning of budget outlays and deficits and
on the composition of the Federal debt.
FFB AS AN INTERME"IARY

     FFB was created on December 29, 1973, by the Federal
Financing Bank Act (12 U.S.C. 2281).  Its purpose is spelled
out in section 2 of the act.

     "The Congress finds that demands for funds
     through Federal and federally assisted borrowing
     programs are increasing faster than the total
     supply of credit and that such borrowings are
     not adequately coordinated with overall Federal
     fiscal and debt management policies. The purpose
     of this Act is to assure coordination of these
     programs with the overall economic and fiscal
     policies of the Government, to reduce the costs
     of Federal and federally assisted borrowings
     from the public, and to assure that such
     borrowings are financed in a manner least
     disruptive of private financial markets and
     institutions."
     Section 9 of the act authorizes FFB to issue in the
private markets and have outstanding up to $15 billion of its
own securities. FFB is also authorized to borrow from the
Secretary of the Treasury without limit, subject to the Treas-
ury's approval. Section 6 declares that FFB may purchase "any
obligation which is issued, sold, or guaranteed by a Federal
agency."
     It is clear from the testimony given prior to approval
uf the act that FFB was not intended to be a program agency.
Neither FFB nor the Secretary of the Treasury is authorized
to make such judgments regarding the purposes of Federal


                             5
agency programs. Discretion is authorized only with regard to
the debt management aspects of an agency borrowing operation.
Accordingly, section 7(b) prohibits the Secretary of the Treas-
ury from withholding approval of an agency borrowing operation
for a period longer than 60 days unless there is a detailed
explanation of the Secretary's reasons for doing so. In no
case may approval be withheld for more than 120 days.

     These above sections of the act imply that FFB is no more
than a financial conduit. Prior to FFB, agencies sought the
Treasury's approval of the terms and timing of most offerings,
though these relationships were not formalized in all cases.
In this sense, the relationship of the agencies to the Treas-
ury is unchanged by the creation of FFB.

     Through creation of a centralized Federal intermediary,
it was felt that FFB would be a more attractive source of
financing for agency borrowers than the private capital market
because FFB could borrow more cheaply. There is little doubt
that this is true. Lack of standardization, which translates
into poor or nonexistent secondary markets, and the accompany-
ing limited market interest in these securities caused inter-
est rates to be higher than those that could be achieved
through larger and more standardized FFB or Treasury offerings.

     The potential benefits of FFB are related closely to
those that flow from any intermediation process. That is,
interest rates are reduced because of an ability to offer a
more attractive source of loanable funds financed through the
issuance of claims that are more attractive to lenders than
face-to-face transactions. In spite of this, there are impor-
tant differences between FFB and private sector intermediaries.
For all practical purposes, FFB is a "blind" intermediary. Be-
cause of the constraints outlined in its act, FFB is a captive
lender with decisions regarding important considerations, such
as use of proceeds, outside of its control. The responsibility
for those decisions remains with the borrowing or guaranteeing
agency. Regardless of whether the original intent of the act
was that FFB would be a private market borrower, the fact is
that virtually all FFB borrowing has been from the Treasury.

      FFB is one step removed from the discipline of the
market.   Interest rates set on its borrowing are those which
'the Treasury faces and adjusts to in view of its borrowing
costs. The interest rates set on the loans FFB makes to the
agencies or private credit market borrowers are set at a one-
eighth of one percentage point markup from the Treasury




                             6
borrowing rates. In our report 1/ we found that FFB hac ac-
cumulated a surplus of $126 million. We recommended that FFB
discontinue the practice of adding a fraction of a percent to
the rates it charges on its loans in view of the lack of evi-
dence supporting the existence of risks faced y FFB or the
Treasury under the current arrangement that the markup is
supposed to cover.

     FFB is nothing more than a financial conduit. Neverthe-
less, FFB's existence has affected financial flows between the
private and public sectors, and the alterations in these flows
have repercussions which go beyond being strictly financial.

EFFECT OF FFB TRANSACTIONS
N   FDERAL OUTLAYS

     FFB engages in four types of transactions.   It purchases:
     1.   On- and off-budget agency debt securitis that would
          otherwise have been sold to the private apital mar-
          kets.
     2.   Agency Certificates of Beneficial Ownership that are
          guaranteed by the issuing agency and would otherwise
          have been sold in private capital markets.

     3.   Agency assets guaranteed by the agency that would
          otherwise have been sold to private capital markets.

     4.   Federally guaranteed borrowings of nongovernmental
          entities that would otherwise have been sold in the
          private capital markets.

     Important differences exist between these transactions.
These differences currently affect Federal budget outlays
and the level and composition of Federal indebtedness. They
also potentially affect choices made between types of Federal
assistance devices.

BUDGET OUTLAYS AND TE
NATURE OF FEDERAL ASSISTANCE

     Except for Federally guaranteed loans to private bor-
rowers, the paper which Federal agencies sell to FFB is used



1/"Audit of the Financial Statements of the Federal Financing
  Bank--Fiscal Years 1975 and 1976."



                               7
mainly to finance direct lending programs. 1/ Mone   is
borrowed by agencies and then it is loaned out. T'ere are
two basic ways to do this. Government agencies can borrow
funds throuah issuance of their own debt obligations and
loan t'ie roceeds from this borrowing, taking back pRder
showing the obligation of the borrower t pay back principal
and interest. Or, they can make loans and then sell that
paper in private capital markets.

     In the first case, t;.e Government retains ownership of
the loans agencies have made. In the second case, ownership
of the loan is transferred to the private sector; and the
paper showing the loan, which is sold by the agency, is
Government-backed for principal and interest. 2/

     In the case of agency obligations and CBOs, the first
method of financing is used. When agency assets are sold,
the second method of financing is used. 3/

     Two aspects of these three types of transactions
need to be emphasized. First, the paper sold in all three
of these transactions is used to finance direct loans.
Regardless of whether the paper is sold to the private capital
markets or FFB, the programs remain irect loan programs.
Second, budget treatment of these transactions difflers.
Borrowing   (debt transactions) is not reflected in     he budget
to      . On ytheleni ir         expenditure          activity
~nanced    y the borrowing counts as outlays.

     In agency lending financed by the sale of agency obliga-
tions, the lending is reflected in the budget regardless
of whether the source of loanable funds is the private
capital markets or FFB (provided that the agency is on the
budget) because sale of agency obligations is a debt trans-
action.


l/Two exceptions to this are borrowing by the Tennessee
  Valley Authority and the United States Postal Service.
  They borrow to finance direct expenditures.

2/In some cases, agencies may sell loans without such a
  guarantee. Since unguaranteed loans are relatively rare
  and since FFB could not purchase them, they are ignored
  for purposes of this report.

3/We consider CBO sales as agency borrowing. This is in con-
  flict with current budget treatment, but iE supported by
  the recommendations of the President's Commission on
  Budget Concepts.

                               8
     In the case of an asset sale, though the Federal
Government loars the funds, the administering agency offsets
this loun outlay by selling the loan k9r-the private capital
markets or FFB. When the agency sells the loan to the
private capital markets, it no longer holds the loan and,
therefore, its original loan outlay is canceled by the
proceeds from its sale. There was an outlay when the loan
was made, and there is a negative outlay when the loan is
sold. This same treatment applies when an agency sells a
loan to FFB. That is, the net outlay effect in the agency's
account is still zero. But the Federal Government still
retains possession of the loan; and, logically, the loan
should show up as an outlay in the budget as an asset purchase.
There are two loan outlays--that made when the agency loans
the funds and that made when FFB purchases the loan from the
agency. There is one receipt--the proceeds to the agency when
it sells the paper to FFB. But FFB's outlay does not show up
on the budget totals because its outlays do not show up on
the budget.

     Under existing budget conventions and existing statutes,
CBO sales are treated exactly the same as asset sales even
though the loans which CBOs finance are still held by the
agency. 1/ Regardless of whether these securities are sold
into private capital markets or to FFB, thi outlay effect in
the agency account is the same. CBOs are :nt reflected in the
budget as borrowing. If CBOs were reflected in the budget as
borrowing, as we believe they should, the loan outlays of the
agency financed by CBO sales would be reflected in the budget
regardless of whether the private sector or FFB purchased



1/With regard to he Farmers Home Administration, Public
  Law 93-135, title II provides "That the SecLetary [of
  Agriculture] may, on an insured basis or otherwise, sell
  any notes in the fund or sell certificates of beneficial
  ownership therein to the Secretary of the Treasury, to the
  private market, or to such other sources as the Secretary
  may determine. Any sale by the Secretary of notes or of
  beneficial ownership therein shall be treated as a salt
  of assets for the purpose of the Budget and Accountir
  Act, 1921, notwithstanding the fact that the Secretary,
  under an agreement with the purchaser or purchasers, holds
  the debt instruments evidencing the loans and holds or
  reinvests payments thereon for the purchaser or purchasers
  of the notes or of the certificates of beneficial ownership
  therein * * *




                              9
 them. In terms of current budget treatment, when FFB pur-
 chases CBOs, the Federal Government retains the asset or loan.
 The agency's sale of this paper is reflected as a negative
 outlay, and the corresponding FFB outlay does not show up on
 the budget.

      When FFB purchases the guaranteed obligations of private
 borrowers, guaranteed loans are converted into direct loans.
 When this occurs, Federal outlays that are not reflected in
 the budget increase.  The outlay effects of this transaction
 do not appear in the administering agency's budget, regardless
 of whether the source of funds for the Government-backed ob-
 ligations is the private securities market or FFB. This
 practice results in the most troublesome consequences for
 budgetary control of resource transfers within the Federal
 Government and between the public and private sectors.

      FFB's off-budget status leads to direct loans occurring
 outside of the budget in the guise of guaranteed loans. Con-
 sequently, it offers the potential for a failure to design
 into appropriate loan guarantee programs the essential in-
 gredients of risk sharing. In addition, the potential exists
 to favor credit assistance programs when they may not be ap-
 propriate. The potential for this to occur exists in all
 FFB transactions that occur off the budget under current
 budget conventions. It is most likely to be realized, how-
 ever, for FFB purchases of Government-guaranteed borrowing
 of private borrowers.

     The aspects of FFB's off-budget status are discussed
in the next chapter.
FEDERAL DEBT FLOWS

     FFB's transactions affect both the level and composi-
tion of Federal indebtedness. These effects are reviewed
briefly for each of the four types of transactions we have
described. In each of these transactions, it is important
to keep in mind that the ultimate source of funds is always
private money and capital markets.

      1. FFB purchase of an agency obligation. Currently,
,all FFB borrowing is from the Treasury. Treasury finances
 its loans to FFB by selling its own securities.
 of this, when agencies sell their obligations to Because
                                                  FFB,
 agency debt held by the public is reduced (over what it
would have been) and holdings of the Treasury debt are in-
 creased. The level of Federal indebtedness is unchanged,
but its composition does chanige.  Agency debt is swapped
 for Treasury debt.


                             10
      2. FFB purchase of Certificates of Beneficial Owner-
ship. Because CBOs are not presently considered agency
FFB s purchase of this paper raises the level of Federal debt,
indebtedness. We believe that CBOs should be considered
agency borrowing since the original loan remains in
hands of the agency. If one adopts this view, the the
                                                    level
of Federal indebtedness is unchanged, but its composition
changed. Agency debt is swapped for Treasury debt.         is

     3. FFB purchase of an agency asset.   When th'.s trans-
action occurs, the FeeralGovernment retains possession
of the loan.  The transaction is financed through an in-
crease in the Treasury debt, which increases the level
Federal indebtedness over what it would have been       of
                                                  had the
loan been sold in the private capital markets.

      4. FFB purchase of the guaranteed loans of private
borrowers   The effect of this transaction on the Treasury
debt and on the level of Federal indebtedness is identical
with the third transaction. The level of Federal
ness increases, all of which is in the form of the indebted-
debt.                                               Treasury

     We believe, in a substantive sense, the first
of transactions change the composition of Federal two types
ness, but not its level. Agency debt is swapped    indebted-
                                                 for Treasury
debt. In the last two types of transactions, Federal
ness increases. All of the increase is in the form      indebted-
debt. This also involves a compositional change in   of  Treasury
indebtedness because the Federal debt has a heavier Federal
                                                     concentra-
tion of Treasury debt.
     Changes in the composition and level of Federal debt
affect the liquidity mix of the public's asset holdings.
These changes in liquidity mix have implications
                                                 for the
efficiency with which debt management and monetary
are conducted. We address this issue in chapter    policy
                                                 4.




                             11
                             CHAPTER 3
           IMPLICATIONS OF     FB'S OFF-BUDGET STATUS
     Section ll(c) of the Federal Financing Bank Act places
the receipts and disbursem.ents of the Federal Financing Bank
outside of the totals of the U.S. budget. To some extent
FFB's off-budget status reflects the Department of the
Treasury view that FFB is merely a passthrough mechanism for
financing agencies using FFB. 1/ In this regard, Paul A.
Volker, then Undersecretary of the Treasury for Monetary
Affairs, said:
     "The Federal Financing Bank is       a device
     to remove programs from the Fedeadl budget; nor
     is it a device to bring programs back into the
     budget. The Bank would in no way affect the
     existing budget treatment of Federal credit
     programs. If a program is now financed outside
     of the budget, that treatment would continue.
     If a program is now financed in the budget, that
     treatment would continue. The bank is intended
     to improve the financing of all Federal borrowing
     activities regardless of theii budget treatment." 2/

     This statement does not address the appropriateness of
the "existing budget treatment." Under the FFB arrangement,
the way in which budget totals reflect credi t assistance ac-
tivity does not change. Regardless of FFB, guaranteed loans
appear outside the budget; CBO sales are still used to offset
agency lending, asset sales are similarly treated, direct
loans by on-budget agencies show up in the budget, and loans
by off-budget agencies do not.

     Concern about on-budget status for FFB rests on a pre-
servation of budget neutrality. Related to this is the
contentior that because of outlay effects which would result
with an on-budget FFB, agencies whose credit assistance ac-
tivity is currently not reflected in the budget may have to
return to the private capital markets for borrowing needs to



1/The Federal Financing Bank--Its Role and Functions, Congres-
  sional Research Service, Library of Congress, June 1975,
  p. CRS-6.

2/Hearings before the Committee on Banking, nhusing and Urban
  Affairs, U.S. Senate, May 15, 17, and 18, 1972, p. 7.


                               12
avoid the outlay effects. This in turn would eliminate much
of the cost savings resulting from FFB.

     But, the question remalnls whether ezxisting budget treat-
ment best reflects Federal activities and, in addition,
whether FFB's inclusion on the budget or changes in current
budget practices would provide a different and more accurate
depiction of Federal credit assistance activities.

RECOMMENDATIONS OF THE PRESIDENT'S
COMMISSION ON BUDGET CONCEPTS

     In its report, the Preident's Commission on Budget Con-
cepts noted that

     "To work well, the governmental budget process
     should encompass the full scope of programs and
     transactions that are within the Federal sector
     and not subject to the economic disciplines
     of the marketplace." 1/

According to this principle, if the marketplace does not impose
the discipline fcr allocating resources, the budget process
must. The Commission's 1967 report represents the last major
review of budget presentation for the Federal Government.

     The current budget treatment of FFB's transactions
directly, or indirectly in combination with other budget
practices, deviates from the Commission's recommendations.
     FFB is off the budget. By the Commission's criteria
for budget inclusion, FFB should be included in the budget
totals. The primary criterion for exclusion was that the
activity in question be fully owned and controlled by private
parties. FFB is unquestionably owned and controlled by the
Federal Government.
     FFB makes direct loans to on- and off-budget agencies
and to economic units outside the Federal establishment.
The President's Commission on Budget Concepts ecomm.ended
that direct lending activity be included in the Budget totals.
The Commission recognized that although loans were probably
different from direct expenditures in their economic impact,



1/Reprt of the President's Commission on Budget Concepts,
  U.S. Government PrintingOffice, Washington, D.C., Oct.
  1967, p. 24.



                              13
they still represent a transfer of resources within the
Federal domain and between the public and private sectors. 1/

     When FFB purchases on-budget agency debt obligations,
the budget totals are not affected because the agency loans
to the private sector from borrowed funds are reflected in
the budget. When FFB purchases off-budget agency debt obliqa-
tions used to finance lending or direct expenditure activity,
the transaction is not reflected in the budget totals because
the activities of other off-budget agencies are excluded from
outlays. When FFB loans funds to economic units outside of
the Federal estab.ishment or purchases assets that would have
otherwise been purchased by the private sector, budaet out-
lays are understated by the amount of FFB outlays.  It is not
relevant to argue that had the private sector, instead of
FFB, been on the other side of either of these transactions,
the budget totals would be unaffected. What is important is
that the private sector is not the source of funds; the Fed-
eral sector is.   nd, the outlays associated with those kinds
of transactions do not appear in the budget totals.

     FFB purchases CBOs from Government agencies. 2/ The most
notable of these types of transactions are those which occur
between FFB and the Farmers Home Administration. The discus-
sion of budget treatment of CBOs is for the most part refer-
enced to these securities. 3/

     At the time of the Commission's report, sales of these
types of instruments were treated as asset sales.  Proceeds
were used to reduce the loan outlays of the agencies sellinq
this type of paper.  The Commission was critical of this
practice and recommended that:



i/Report of the President's Commission on Budget ConceptsL
  U.S. Government Printing Office, Washington, D.C., Oct.
  1967, pp. 48 and 49.

2/CBOs are sold to FFB by Farmers Home Administration, which
  is on the budget, and by the Rural Electrification and
  Telephone Revolving Fund of the Rural Electrification Ad-
  ministration, which is off the budget.

3/This is done to avoid greatly complicating the discussion.




                             14
     "Participation certificates should be treated as a means
     of financing, not s an offset to expenditures which
     operates to reduce a budget deficit." 1/

     The reason for the recommended treatment was that sale
of these instruments does not involve the transfer of a
Government-held asset to the private sector.  Instead, the
transaction involves sale of paper which is nominally tied
to an underlying pool of direct loans made, serviced, and
still held by the agency. No meaningful difference exists
between the sale of a CBO and the sale of an agency obliga-
tion. These certificates are borrowings and should be
treated as such in the budget. 2/

     The complexities introduced by FFB purchase of these
securities are as follows.  If these certificates were given
the recommended budget treatment, FFB purchases would have
no effect on outlay totals. The transaction would be
identical to FFB's purchase of on-budget agency debt with
the outlay reflected in the budget through the lending activity
of the agency (provided the agency is on the budget).  Since
current budget practice does not treat the obligations in
the recommended way, FFB's purchase is an PB outlay, the pro-
ceeds are used to reduce on-budget agency loan expenditures,
and the budget totals are reduced by the amount of the FFB
purchase.



1/Report of the President's Commission on Bud et Concepts,
  U.S. Government Printing Office, Washington, D.C., Oct.
  1967, p. 48.
2/Treasury Secretary Fowler and Budget Director Schultze dis-
  agreed with this recommendation. They felt that the sale
  of any credit agency obligation should be treated as an
  offset to loan expenditures. Their rationale was that as
  long as these obligations do not call upon the revenues or
  general borrowing of the Treasury, the net lending fig-ire
  should reflect sale of these obligations as well as repay-
  ments. Regardless of which position one favors, FFB pur-
  chases of these instruments are a drain on Federal revenues
  or borrowing and these outlays are not reflected in the
  budget.




                             15
POTENTIAL FOR POOR DESIGN OF
FEDERAL ASSISTANCE PROGRAMS
     The Federal Financing Bank Act permits FFB to act as
lender when agencies guarantee the debt of private sector
borrowers. FFB purchases only fully guaranteed obligations;
most of these are securities market instruments. This practice
converts guaranteed loans into direct loans, which are not
reflected in the Federal budget totals at the present time.

     Loan guarantee programs are growing. Part of their pop-
ularity stems from the belief that they are costless. Because
of this and because of FFB's off-budget status, there is a
potential for the unwarranted growth of loan guarantees with
an FFB connection. But the growth in loan guarantees would,
to a large extent, be in name only. More important is the
potential for poorly designed assistance programs because
there is a potential for increasing use of full guarantees
to achieve program goals where partial guarantees or more
direct forms of Federal'assistance are more appropriate.
P:inciples of risk sharing
     As a general financial principle, 100-percent loan
guarantees are something to be avoided--not encouraged. Loan
guarantee programs t the maximum extent feasible should
incorporate into their 6esign risk sharing by both borrowers
and private lending institutions. If borrowers and lenders
are not exposed to commercial risk, the normal incentives
for successful completion and management of the project on
which funds are loaned are absent. Also, the probability that
the loan guarantee program will achieve its intended objective
is diminished.

     Some fully guaranteed loan programs may require equity
participation; others may not. If equity participatu...  is re-
quired, the incentive on the part of the borrower to complete
and successfully manage the assisted project varies in direct
relation to the borrower's rate of equity participation.   If
no equity participation is required, not only are the desir-
able borrower incentives absent, but the risk to the project
is higher because of its highly leveraged position and vulner-
ability to failure from variable revenue flows.
     Regardless of the amount of equity participation required,
fully guaranteed loans eliminate the normal incentives of pri-
vate lenders to carefully evaluate the applicant's prospects
and provide the neceszary followup on the loan. In the absence




                               16
of normal lender incentives, the probability of the approved
borrower's success and repayment of principal is reduced.
ImpVjcit subsidy
     Presumably, an advantage of FFB purchase of guaranteed
loans is reduced interest costs to assisted borrowers. This
is questionable. First, if a subsidy was not intended when
the loan guarantee program was designed, reduced costs to as-
sisted borrowers are not desirable. Second, the increased
subsidy is only desirable when it increases the likelihood
of successful achievement of goals. An increased likelihood
of reduced debt service costs increasing success rates is
doubtful in view of the absence of normal commercial incen-
tives on fully guaranteed loans. Third, although interest
costs to borrowers may be lower, costs to agencies may be
higher. For, when FFB purchases fully guaranteed loans, agen-
cies assume the full banking function with its attendant
costs, particularly in the case of new loan guarantee pro-
grams.
Potential results
     At the present time most FFB purchases of guaranteed
loans are fully guaranteed instruments of private borrowers.
For fully guaranteed loans the Government assumes all of the
risk, and a close relationship between the borrower and the
Government is desirable. A potential problem may arise if
new loan guarantee programs are designed to conform with
the types of programs in which there is current FFB involve-
ment, rather than being designed to most efficiently accom-
plish program goals.

     The design of loan guarantee programs and the merits
of loan guarantees, direct loans, and other direct forms
of Federal assistance have long been discussed. / Loan


1/The major Government studies of Federal credit assistance
  that have addressed this issue are: Commission on Organ-
  ization of the Executive Branch of the Government, "Task
  Force Report on Lending Agencies," (Washington, D.C.: Gov-
  ernment Printing Office); Commission on Organization of the
  Executive Branch of the Government, "Federal Business En-
  terprises," (H. Doc. 152, 81st Cong.); The Report of the
  Commission on Money and Credit, (Englewood Cliffs, I.J.:
  Prentice Hall, Inc., 1961); Report of the Committee n Fed-
  eral Credit Programs, which was published in 19636
  A Study of Federal Credit Programs, Subcommittee on )omes-
  tic Finance, Committee on Banking and Currency, Vol. 1
  (Washington, D.C.: Government Printing Office, 1964); and
  The Report of the President's Commission on Budget Concepts
   Washington, D.C.: Government Printing Office, 1967).

                              17
guarantees can be effective policy instruments in some
cases and ineffective in oher cases. Partial guarantees
are generally to be preferred to full guarantees since com-
mercial incentives are lacking for full guarantee programs.
In general, fully guarante:d loans should be justifiable on
about the same basis as direct loans. Specifically, the
reduced debt service costs from a partial guarantee are not
sufficient to induce poteintial borrowers to undertake so-
cially or economically worthwhile projects. Only a full
guarantee with lower debt service costs or a direct loan
with an even lower debt service cost will be sufficient to
achieve program goals.
     On the other hand, use of credit assistance in .he form
of either direct or guaranteed loans may be entirely inappro-
priate in cases where reduced debt service burdens chieved
by the program are likely to be minor, because the r;sk to
the project is not the major impediment to its undertaking,
or when debt service burdens pose so large an impediment
that neither partial nor fully guaranteed loans or direct
loans are likely to achieve program goals.
     As a general principle, we believe fully guaranteed
loans should be avoided. If they can be justified, then
direct loans are probably a better assistance device from
the Federal perspective, because the Federal oversight role
should be greater.

     Because of FFB's off-budget status and the current
budget treatment of loan guarantees, however, a potential
exists for:

     -- The use of full guarantees purchased by FFB, when
        the commercial risk sharing is a more appropriate
        and less costly means of ac'.ieving program goals.
     -- Use of full guarantees, when the justifiable assis-
        tance device is direct loans, that instead of being
        included in the budget totals can he excluded from
        the budget totals and the budget pocess.

     -- A choice of credit assistance over direct expendi-
        ture forms of credit assistance, when the latter
        seems more likely to achieve program goals.

     Putting FFB on the budget might eliminate these poten-
tial problems, but it would not solve any of the longstanding
problems associated with the favored budget status of loan
guarantees. Whether FFB is on or off the budget, loan guaran-
tee programs might still be used where inappropriate, but at


                              18
 least there would not be as large a potential for
                                                   use of full
 guarantees or direct loans where they are not appropriate.

 EFFECT ON OUTLAY TOTALS
 OF AN ON-BUDET FFB

      If FFB's transactions were included in the budget
 outlays would be affected in the following ways.       totals,

      1. FFB purchase of on-budget agency debt. Outlay
would be unchange because when te proceeds from            totals
purchase are loaned out or otherwise spent by the   an FFB  debt
would be included in the budget totals. Other       agency,  they
                                                transactions
in this process would cancel each other, as they
                                                  do now.
      2. FFB purhase of off-budge t agency debt. Under cur-
rent budget rules relating to off-budget agencles,
actions (borrowing) between these agencies and       debt trans-
                                                the  Treasury,
and presumably between these agencies and an on-budget
are not treated as outlays. Only transactions             FFB,
are reflected as outlays. Thus, even if FFB werewith  the  public
budget, the outlays of most off-budget agencies     placed  on the
their activity through FFB would remain outside  which  finance
If FFB is placed on the budget, then off-budget the budget.
rowing from FFB should also be brought onto the agencies bor-
                                                 budget.
      3. FFB purchase of an agency asset. When there
physical transferof an on-budget or off-budget        is a
                                                 agency asset
to FFB, the loan outlays of the agency would be
                                                 reduced.
FFB's purchase of the asset would be fully reflected
totals as an FFB direct loan expenditure under        in outlay
                                                current budget
rules.

     4. FFB purchase of CBOs. If current budget
these transactions continues, FFB purchase of this treatment of
be reflected on the budget as FFB loan outlay.      paper would
curities were treated as agency ouligations (as  If these se-
                                                 we believe
they should be), they would be included in the
agency selling the paper when the proceeds were outlays of the
                                                 loaned out.
Either way, outlays would be increased by the amount
lending.                                              of agency

     5. FFB purchase of uaranteed loans.    I FFB continued
to purchase guaranteed loans that would have otherwise
originated in private capital markets, the bdget       been
would fully reflect this direct loan expenditure  totals
account.                                         in the FFB

     Although FFB's transfer onto the budget would
all of the deviations of current from recommended not correct
                                                   budget
practice, the effect on budget outlays would be
keeping with recommendations from the Commission nearly  in
                                                  on Budget
                              19
Concepts. Although the current budget treatment of CBOs is
incorrect in our view, the true nature of the transactions
would be reflected in the outlay totals as FFB direct loans.
But, they would not be reflected in the agency totals. Sales
of assets to FFB would also be reflected as FFB direct loans,
as would its purchases of loan guarantees if this practice
continued. To the extent that agencies financing their lend-
ing and direct expenditure activity through FFB debt trans-
actions remain off the budget, outlays would remain under-
stated by the amount of that activity.

     FFB has grown considerably since it began operations in
1974. Its loan holdings totaled $25 billion as of October 1,
1976. Of this total, approximately $15 billion was not in-
cluded in the budget attributable to FFB. By 1978 it is
estimated that FFB will hold $48 billion in securities, of
which about $30 billion will represent a cumulative under-
statement of the budget totals attributable to FFB.

     FFB purchases of off-budget agency debt are estimated
to be a smaller proportion of its holdings in fiscal year
1977 and fiscal year 1978 than in prior years. This is be-
cause of the inclusion of the Export-Import Bank on the budget
beginning in fiscal year 1977.  Holdings of CBOs (primarily
those of the Farmers Home Administration) occupy the most
important portfolio position in future years. True agency
asset holdings, as distinct from CBOs, are estimated to com-
prise only a small portion of FFB's portfolio in fiscal year
1978. FFB holdings of private guaranteed borrowings are
expected to increase slightly in future years averaging about
16 percent of all FFB holdings in fiscal years 1977 and 1978.
(See table 1.)
     The anticipated growth in FFB's CBO purchases is cause
for concern. By fiscal year 1978 it is estimated that FFB
will hold $20.5 billion in Farmers Home Administration certi-
ficates. These holdings are expected to account for almost
43 percent of all FFB holdings. As a result, since FFB's
creation a total of about $20 billion in direct lending act-
ivity by the Farmers Home Administration of the Department of
Agriculture will have gone through FFB and, since FFB is
off the budget, been excluded from the budget totals
SHOULD FFB BE PLACED ON THE BUDGET?

     Would an on-budget FFB be the best means of correcting
the way in which the Federal credit assistance which goes




                             20
                            Table 1

           Relative Share of Outstanding Loans Held by
                  FFB by Type of Transaction
                      FY    Transition    Est. FY    Est. FY
Transaction          1976     quarter       1977       1978
                     -------------- (Percent)----------------
FFB purchase
  of on-budget
  agency debt        9.73     10.57         27.57        28.25
FFB purchase of
  off-budget
  agency debt       34.88     31.34          9.93         9.73
Purchase of
  agency assets      1.26      5.26          3.75         1.14
Purchases of
  CBOs              40.00     38.65         42.81        44.55
FFB purchases of
  loan guarantees   14.08     14.19         15.94        16.33
Source:   Special Analysis of the Budget of the U.S. Govern-
          ment, FY 1978, table E-2b.
through FFB would be reflected in the budget? Putting
FFB on the budget would include in the activities of the
Federal establishment most of the outlays of agencies which
currently relate to FFB outside the budget. This would make
the Federal budget surplus or deficit more meaningful,
because it would make more accurate the spending and bor-
rowing implied by those deficits. This in turn would make
more meaningful conclusions about the aggregate economic im-
pact of the Federal Government on the nation.
     But, it would not include all of them; and, more impor-
tant, under existing budget conventions, all on-budget agency
lending and guaranteeing activity that is not now reflected
in the budget would appear in the account of an on-budget FFB.
This activity would be included in the general Government
function rather than in the functions in which the agency
lending programs are included. This might be avoided by (1)
splitting the FFB account among the Federal functions so
that the outlays are included in the same function as the
agency's lending program or (2) devising a budget technique
that would result in reporting the outlays in the accounts
of he administering agency and offsetting these against the
FFB account.




                              21
     If the activities of lending agencies are not properly
reflected in individual program or functional accounts, it
is difficult to see how the budget process can properly al-
locate Federal resources among Federal credit pr3grams,
between credit programs and direct expenditure programs, and,
ultimately between the public and private sectors of the
economy.

     The way FFB affects the meaning of Federal outlays and
deficits is not solely a function of its off-budget status.
The problem with the way Federal credit assistance going
through FFB is reflected in the budget results from the
combined effects of FFB's off-budget status and other devia-
tions of actual from recommended budget treatment of these
activities.

     For example, FFB purchases of on-budget agency obliga-
tions are properly reflected in the budget now because of the
way that borrowing is reflected in the budget and because
these agencies are on the budget. If off-budget agencies
which currently engage in debt transactions (borrow) with FFB
were placed on the budget, their lending and direct expendi-
ture activity would be reflected on the budget in their re-
spective accounts, regardless of the budget status of FFB.

     If CBOs were given the recommended budget treatment--
namely, if sales of these securities were treated as borrowing
rather than asset sales which reduce loan outlays--then FFB
purchase of these issues would be reflecl-d in the accounts
of the borrowir  agencies, regardless of the budget status
of FFB.

     The combined effects of eliminating the off-budcet status
of agencies that borrow from FFB to finance lending and
of proper budget treatment of CBOs would bring a considerable
amount of lending and direct expenditures, currently oc-
curring outside of the budget, onto the budget.

     Asset sales to FFB are currently properly treated in the
selling agency's account. When these securities are sold to
FFB, a problem arises because the Federal Government retains
possession of the loans and overall outlays are understated
by the amount of FFB purchases. If FFB remains off the bud-
get, this problem will ontinue to exist unless the Federal
Government's continued ownership of the paper is reflected as
an outlay in the account of the agency selling the paper. It
might be argued that since the Federal Government still re-
tains possession of the asset, the best place to reflect this
is in the agency account. This treatment would increase the
agency's outlays and would technically be at variance with
recommended budget practices.


                             22
     FiB purchase of guaranteed loans is a questionable
practice, because its off-budget status may lead to an
inappropriate increase in direct loan programs disguised as
loan guara-tee programs. Putting FFB on the budget might
eliminate he current and potential problems associated
with this practice.

     The concern that if FFB is included on the budget, many
of the transactions that currently go through FFB would no
longer occur appears legitimate in view of the currer' bud-
get treatment of Federal creditprograms. Agencies may have
to return to the private capital markets to finance loan pro-
grams in order to avoid the outlay impacts that would result
from dealing with FFB. This in turn would eradicate the cost
savings that have been achieved through FFB's creation.

     Because of outlay effects, guaranteed loans to private
borrowers might no longer L. purchased by an on-budget FFB.
However, this is desirable. It is not an undesirable result
in view of the potential problem which FFB's current status
poses for design of Federal assistance programs and because
the cost savings achievable under the present arrangement for
loan guarantees may be illusory.

     CBOs might also be sold in private capital markets rather
than to an on-budget FFB. But the only reason this would
occur is because the present treatment of these transactions
disguises their true nature. If such sales were treated as
borrowing, they could continue to be sold to an on-budget
FFB at a cost savings.

     Asset sales by agencies are a more difficult problem.
Since current budget treatment of these transactions in the
agency's account is correct, the outlay effects of sales of
these securities to an on-budget FFB might cause them to be
sold in the private capital markets, sacrificing the cost
savings achievable through FFB. This problem could be
overcome by scoring the outlays in the agency's account.
Technically, this would be incorrect. In this case, one
needs to decide whether the benefits from cost savings on
asset sales to an off-budget FFB exceed the costs of failing
to fully reflect the scope of Federal lending activity in
the budget. In view of the other problems that FFB's off-
budget status creates, we believe that the benefits from
cost savings on asset sales are not worth the continued
off-budget status of FFB.

     Budget neutrality has to do with preserving the budget
treatment of agency transactions with FFB in the agency's



                             23
account. This in turn involves assuring continued funding
of programs. But there are two ways to view budget rnutrality
as it relates to the budget status of FFB. It can either be
viewed in terms of current budget treatment, or it can be
viewed i terms of proper budget treatment of agency trans-
actions      FFB. Under existing budget conventions, the
only way . preserve budget neutrality and achieve the bene-
fits that flow from FFB appears to be with an off-budget FFB.
But, aside from FFB's off-budget status, if other budget con-
ventions which we have raised concerns about were changed
to more accurately reflect the true nature of credit assist-
ance activity, certain activities would continue to be
financed through FFB.
      If off-budget agencies financing activity through FFB
were placed on the budget, depending on the nature of their
transactions with an on-budget FFB, some would continue
(CBO sales and agency borrowing) with proper budget treat-
ment. CBO sales by on-budget agencies would continue to
flow through FFB because having changed the way that these
securities are reflected in the budget, FFB's budget status
would be irrelevant to the agency selling CBOs. To this
extent, with proper budget treatment, an on-budget FFB should
be neutral in its effects under a proper regime of budget con-
ventions. On the other hand, neutrality could not be pre-
served in view of the outlay impacts for FFB loans to private
guaranteed borrowers and probably could not be preserved for
loan sales to FFB. In the former case, this is desirable.
In the latter case, a cost savings may have to be sacri-
ficed.

RECOMMENDATIONS Tr      ONGRESS
     The combined effe.   of FFB's off-budget status and
other deviations of actual from recommended budget treatment
of credit assistance activities with an FFB connection re-
sult in
     -- an inaccurate depiction of some Federal credit
        assistance;

     -- the potential for poor design of credit
        assistance devices and poor choices between
        those and other Federal assistance devices; and
     -- a dilution of the accuracy of Federal outlays
        and deficits.

     Placing FFB on the budget would, by itself, improve
upon the last of these problems; but it would not solve the
former two.


                              24
     In order for Federal credit assistance activity cur-
rently going through FB to be more adequately reflected on
the budget, we recommend that the Congress require that
    -- FFB's receipts and disbursements be included in
       the Federal budget totals;

    -- the receipts and disbursements of off-budget
       agencies that borrow from FB be included in
       the budget; and
    -- CBOs be treated as agency obligations and,
       therefore, be treated in the Federal budqet
       as borrowing.




                             25
                         CHAPTER 4
        IMPLICATIONS OF FFB OPERATIONS ON THE CONDUCT

           OF DEBT MANAGEMENT AND MONETARY POLICY
    Changes in the mix of public holdings of the Treasury and
agency debt result from FFB operations. These changes affect
the liquidity of public asset holdings. Treasury securities
are more liquid than agency securities. Through induced
changes in the liquidity mix of the public's asset holdings,
FFB may potentially affect monetary and debt management
policy.

    The effect of changes in the maturity composition and
liquidity of the public's holdings of Government securities
on the term structure of interest rates, on the maturity
structure of the Federal debt, and on the ease with which the
Federal Reserve Board is able to control credit availability
cannot be precisely quantified. But arguments with specific
examples and evidence may be cited to show that these effects
exist. The importance of FFB-induced shift3 in liquidity
depends on the size of the shift as well as on the strength of
relationships between public holdings of liquid assets, the
maturity structure of interest rates, and the ability of the
Federal Reserve Board to control credit availability.

DEBT MANAGEMENT POLICY
    Economic stabilization is not an explicit goal of debt
management policy. Deficits, the amount of borrowing nec-
essary to finance deficits, and the effect of borrowing on
the level of the public debt are more appropriately cate-
gorized as results of fiscal policy. Debt management
policy is oriented more toward manipulation of the existing
stock of public debt toward shorter or longer maturities
in order to reduce the costs of borrowing. But, in doing
this, debt management policy affects te liquidity mx of
the public's asset holdings and therefore could have an in-
direct effect upon economic stabilization.

    All loans currently made by FFB are financed by bor-
rowing from the Treasury. The Treasury in turn borrows
from the public by issuing its own securities. Thus, th
annual incrase in Treasury debt resulting from FFB opera-
tions is about equal to FFB's annual net lending activity.
The accounting for outlays from FFB net lending are smaller
than its total net lending outlays because certain of its
loan outlays appear as outlays in the accounts of borrowing


                              26
agencies that are included in the agency budget totals. To
attribute these outlays to FFB would be double counting.
Relationships between Federal outlays, FFB net lending out-
lays, the Treasury and agency borrowing, and other means of
financing deficits are shown in table 1.

Changes in Federal debt aggregates

     The increase in the Treasury debt induced by FFB since
1974 accumulated to $25.9 billion by October 1, 1976, and is
estimated to be $48 billion at the end of fiscal year 1978.
(See line 17.) Gross Federal debt includes both agency debt
and Treasury debt. Because the operations of the FFB displace
a lrge amount of agency with Treasury debt, the increase in
gross Federal debt is less than the increase in the Treasury
debt. This increase due to FFB was $15 billion on October
1, 1976, and is estimated to be $29.8 billion by the end of
fiscal year 1978.

     But, the FFB-induced increase in the gross Federal debt
is a poor measure of FFB's effect on Federal indebtedness.
This is because CBOs are not currently treated as borrowing,
and therefore are not considered agency debt. In our opinion,
there is no difference in substance between CBOs and agency
debt. If CBOs are treated this way, there is no effect on
the level of Federal indebtedness when they are sold to FFB.
Agency debt is swapped for the Teasury debt. Because CBOs
are not considered agency debt and therefore part of the
gross Federal debt, the increase in gross Federal debt due
to FFB does not reflect the reduction in agency debt result-
ing from FFB purchase of CBOs. Thus, the increase in gross
Federal debt due to FFB overstates the effect of FFB trans-
actions with agencies and private guaranteed borrowers on
the level of Federal indebtedness.

     After adjusting for CEOs, the increase in Federal
borrowing due to FFB operations accumulated to $5.5 billion
on October 1, 1976. It is expected to total 8.8 billion by
the end of fiscal year 1978. This increase is the estimated
amount of increased Federal borrowing that will be required
to finance FFB purchases of true agency assets and origina-
tion of guaranteed loans that would have otherwise originated
in the private sector. This figure represents the increase
in Federal liabilities attributable to the existence of FFB.
It measures the extent to which contingent liabilities have
been converted into direct liabilities. Without FFB, this
increase in Federal indebtedness would probably not have
occurred. Table 2 preseits the adjusted figures in lines 22
through 24. CBO sales are shown in line 20.



                            27
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                                                                                                                                               28
     FFB-induced increases in the Treasury debt are large
relative to total increases in the Treasury debt after fiscal
year 1974, particularly during the transition quarter. Sim-
ilar ratios for gross Federal debt are lower because of the
agency debt offset, and the ratios for FFB-induced increases
in Federal borrowing are quite small except in the transi-
tion quarter. These ratios are presented in lin:es 25, 26,
and 27 of table 3.

     The FFB-induced cumulative increase in Federal borrowing
is about 2.9 percent of the increase in total Federal bor-
rowing on October 1, 1976, and is estimated to decline to
2.6 percent by the end of fiscal year 1978. Of a total of
$337.5 billion increased Federal borrowing estimated to occur
between fiscal years 1974 and 1978, only $8.8 billion is
directly attributable to FFB.

Changes in the maturity composition
of the Federal debt

     Compositional changes between agency and the Treasury
debt securities induced by FFB affect the maturity composi-
tion of the Federal debt and the liquidity of public asset
holdings. In general, agency debt is not as liquid as the
Treasury debt of comparable maturity.  If it were, there would
be a question about the effectiveness of FFB in achieving a
cost savings on agency borrowing. The main reason for the
lower liquidity of agency securities is the lack of a well
organized secondary market in these securities. This in
turn is attributable to a lack of familiarity with agency
securities. Treasury securities, on the other hand, are
traded in the deepest and most resilient secondary market in
the world, particularly in the shorter and intermediate
maturities.

     Aside fom this obvious difference in liquidity between
agency and Treasury securities, the maturity structure also
differs. Agency securities have a longer maturity structure
than Treasury securities and are less liquid for this reason.
We estimated this difference in order to measure changes that
have occurred in the average maturity of the Federal debt and
in the public's liquid asset holdings. The latter measure
may be expected to affect the term structure of interest
rates.

     In order to measure changes in maturity composition of
the Federal debt resulting from FFB-induced displacement
effects, we compared the maturity structure of new money
Treasury financings with the maturity structure of FFB
purchases of agency obligations and CBOs. We assumed that


                            29
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the maturity structure of displaced agency borrowings would
have been approximately the same as that which exists on FFE
purchases.
     The average term to maturity differs substantially be--
tween the Treasury debt and FFB financings. The Treasury's
new money financings had an average maturity of 3.57 years;
FFB financing had maturities averaging 9.7 years. The
largest difference occurs in the long and short ends of the
market.  (See table 4.) The difference between long-term
debt relative shares is due partly to the fact that long-
term Treasury borrowing is currently constrained by xistinj
law.
     For purposes of measuring the effect that FFB has had on
the average maturity of the Federal debt, it was necessary
to net the average maturity figure of FFB financings -f COs.
For, in the absence of PFB, these securities would
be part of the Federal debt. The average maturity o FFB
purchases of agency debt was 9.04 years. '(See footnote,
table 4.) The average maturity of the increased Treasury
debt is estimated to be around 3.6 years.

     Gross Federal debt is estimated to be $785 billion by the
end of fiscal year 1978. With no FFB, this figure would be
about $30 billion less. We were unable to obtain a figure on
the average maturity of the Federal debt; but regardless of
what the true figure is, 1/ we estimate that the FFB-induced
compositional shifts between the Treasury and agency securities




1/The average maturity of marketable interest-bearing public
  debt held by private investors was 2.75 years as of March
  1977.  This debt comprises about 45 percent of total Federal
  debt at the end f 1977, and its average maturity estab-
  lishes a lower bound on what the average maturity of the
  Federal debt is likely to be. An upper bound was estab-
  lished by assuming that all other securities comprising
  the Federal debt have an average maturity of 20 years. If
  this is the case, the average maturity of the Federal
  debt would be around 12 years.




                            31
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will have reduced the average maturity of
between 3.5 and 3.8 percent by the end of the Federal debt by
                                          fiscal year 1978. 1/
Whatever the aerage maturity of the Federal
be between 3.5 and 3.8 percent lower than    debt is, it wilT
                                          it would have been
without FFB.
Effect of FFB-induced changes in
maturity composition of borrowing on
the term structure of interest rates

      Debt securities sold by the Treasury
 Government agencies, including the Federal are purchased by
 as well as by the public. Purchases of theReserve Board,
by budget agencies have been substantial      Treasury debt
                                           in certain years. On
the other hand, budget agency investment
not been substantial. Our interest in this in agency debt has
                                              section is in
measuring compositional shifts in securities
lic, not by Government agencies. For, the      held by the pub-
                                             liquidity
the public's holdings of Government securities         mix of
term structure of interest rates. We, therefore, affects  the
                                                    net out
increases in the Treasury debt of those securities
the Government and assume that all reductions        held by
def:t between 1974 and 1978 would have een      in agency
                                             held in private
portfolios.

     FFB-induced increases in the
non-Federal Reserve public and by Treasury  debt held by the
                                  the Federal Reserve are
shown in lines 31 and 32 of table 3. These
                                             figures are ob-
tained by multiplying the FFB-induced increase
debt by the ratios of public and Federal        in Treasury
                                         Reserve purchases
of the Treasury debt to total the Treasury
FFB-induced reductions in agency debt and debt flotations.
                                           CBOs are shown in
lines 18 and 20 of table 2.

     This data is summarized in the following
                                              table.


1/This is the range of percentage changes
  of years to maturity implied by increasesin average number
  of $48 billion, with an average maturity in Federal debt
                                            of 37    years,
  and decreases in Federal debt of $18.2 billion,
  average maturity of 9.04 years (when the          with an
  of outstanding Federal debt is allowed    average  maturity
                                          to range between
  3 and 12 years).  Percentage changes are insensitive to
  the assumptions made regarding average.




                             33
                                                Table 5
                           FFB-Induced ncreases in Treasury Debt and
                          Reductions in Agency Debt Held by the Public

                                                                  Transition        E          Est.
                              FY 1974    PY 1975     FY 1976        quarter    FY       177   FY 1978
                                                            (--------------------------(millions)----------------
 Treasury debt held
   by the public
       Non-Federal
         Reserve public       -$120     $10,238       $7,644
       Federal Reserve                                              $3,486     $ 9,845        $7,368
                                195         936        14815            484        867           761
           Total Treasury
            debt                  75        11,174        8,659      3,970      10,712         8,129
Less agency debt held
  by the public
      Agency securities         500          6,518     2,980
      COOs                                                             853       3,415         3,969
                                             5,000    _3,966         1l037       6,282         5,099
          Total agency
            debt                500         11,518     6,946         1,890       9,696         9,068
Total                         -$425     $     -344    $1,713        $2,080     $ 1,015        $ -939




     The net figures shown at the bottom of the table
sent the increase or decrease in Federal borrowing from epre-
                                                         the
public. Because in certain years Treasury securities sales
to budget agencies have been large, these net figures
smaller than the increase in Federal borrowing of $8.8 are
                                                        bil-
lion discussed earlier. The increase in Federal borrowing
fr3m the public between 1974 and 1978 is estimated to total
only $3.1 billion.
     To measure the compositional shift between short- and
long-term securities held by the public, which is induced
by FFB, the percentage of distribution of maturity struc-
tures for the Treasury and FFB financing was multiplied
by increases in the Treasury debt and reductions in agency
debt due to FFB. (See table 4 and 5.)

     The results indicate that FFB operations have led to
average yearly increases in debt aturing within 1 year of
aoout $2.1 billion and nearly equal reductions in long-
term debt. Cumulative increases in short-term debt are
estimated to be $12.1 billion by the end of fiscal year 1978
at the same time that long-term debt will have been reduced


                                                34
by around $11.3 billion.   These estimates are presented in
table 6.
     These increases in the supply of short-term securities
should raise short-term rates above what they would have
been in FFB's absence. Similarly, the reduced supply of
long-term securities should be expected to relieve pressures
in that end of the market and reduce long-term rates.

     We analyzed the interest rate effects of FFB-induced
changes in the maturity composition of public holdings of the
Federal debt. Although FFB operations result in a slight
shortening of the maturity of the Federal debt, the compo-
sitional shifts from long- to short-term securities are not
large enough to have much effect on interest rates. The
largest FFB-induced shift into short-term securities is
estimated to be $3.1 billion in fiscal year 1977. According
to our analysis (app. I), in order for FFB-induced increases
in short-term debt to raise short-term rates by 1 full per-
centage point, annual compositional shifts into short-term
debt would have to be about $85 billion per year.

     There should be little cause for concern about FFB's
effects on the average maturity of the Federal debt or in-
terest rates. FFB's operations are presently too small to
produce any significant effects.

MONETARY POLICY

     Economic stabilization is the overriding goal of monetary
policy. Theoretically, the Federal Reserve Board can control
credit availability in the economy through alterations in the
reserve positions of commercial banks. The degreee of control
which the Federal Reserve Board is actually able to exert is
partly determined by the liquid asset holdings of the com-
mercial banking system and the public. Since these holdings
are influenced by FFB, some relation exists between FFB and
the workings of monetary policy.

     FFB's current operations may affect the ability of the
Federal Reserve Board to control credit availability over
the course of the business cycle. As indicated, the current
FFB borrowing arrangement with the Treasury increases the
liquidity of the public's asset holdings. We have estimated
that since FFR began operations in fiscal year 1974, short-




                            35
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                                                                                        36
term public debt holdings of private investors and the Federal
Reserve Board have increased by $12.1 billion over what they
would have been in FFB's absence. 1/

     According to John Culbertson,

     "There is * * * a social cost of additional public
     holdings of liquid assets which   * * undercuts
     the complex logic of the financial system, and
     makes the economy more unstable and less control-
     lable." 2/
     The stock of liquid asset holdings affects monetary
policy as follows. Suppose the rate of economic activity
is high and inflationary pressures are building. The
Federal Reserve Board might be expected to take steps to
:urb the rate of spending in order to reduce inflationary
pressures by attempting to reduce credit availability. This
could be done by trying to reduce excess reserve positions
of commercial barks through open market sales, making boL-
rowing at the discount window or through interbank trans-
actions less attractive, or increasing commercial bank reserve
requirements. The extent to which any of these policies
will be effective depends in part on the amount of noncash
liquid assets held by commercial banks. If liquid asset
holdings are substantial, commercial banks may sell off
such securities to meet increased required reserve positions,
avoid the discount window, replenish excess reserves, or
maintain lending activity.

     Interest rates usually rise when the economy is expand-
ing. Consequently, there would be an incentive for those
holding idle money balances to purchase the liquidated assets



I/It is not entirely clear that this is the best measure of
  increased liquidity as it affects monetary policy. If
  public and agency short-term debt were equally liquid,
  this increase wouild almost perfectly reflect the increase
  in liquidity due to FFB. But, agency securities are
  probably not as liquid as Treasury securities. A more
  appropriate measure of increased liquidity might lie
  between the net increase figure of $12.1 billion and the
  gross increase in short-term Treasury debt held by the
  public of $19.6 billion, which is attributable to FFB.

2/John M. Culbertson, "Discussion" in Issues in Federal
  Debt Management, proceedings of a conterence neld in
  June 1973, Federal Reserve Bank of Boston, p. 33.


                            3,
o£ the commercial banking system. Also commercial banks
would have an incentive to lend out the proceeds from sale
of liquid assets rather than accumulate them as excess re-
serves. The opportunity cost of holding idle money balances
increases for both commercial banks and the nonbank public
when interest rates are rising.

     This mechanism means that the greater the amount of
liquid assets held by the public, the greater the potential
for liquidating large volumes and expanding credit just
when the Federal Reserve Board may be trying to restrict
credit.
     FFB's borrowing arrangement is linked with the conduct
of monetary policy because the Treasury finances deficits
and refinances borrowing with securities that are shorter
term, more easily marketable, and therefore more liquid than
the agency debt that FFB displaces. The stock of liquid
assets, in theory, should affect the ability of the Federal
Reserve Board to control the availability o credit. This
in turn depends partly on the way in which commercial banks
may finance loan expansion during periods of credit restric-
tion by liquidating Treasury securities.

     We verified the existence of the theoretical relation-
ships described above. Our analysis i contained in appendix
II, and the results are summarized below.

      According to our findings, loan expansion by commerical
b1 nks was significantly higher during periods of restrictive
monetary policy than during periods of relative credit ease.
This result can be attributed to the large loan expansion
which occurred during the 1972 and 1974 period of credit re-
striction. In all other periods, loan expansion was unaf-
fected by restrictive monetary policy. This seeming inef-
fectiveness of monetary policy in reducing loan expansion is
partly explained by a consistent pattern of commercial bank
Treasury security liquidations during restrictive credit
periods. Between 1959 and 1976, the average quarterly liqui-
dation f Treasury securities by commercial banks attributable
to restrictive monetary policy was $2.49 billion.

  . The seeming ineffectiveness of the Federal Reserve
Board is somewhat misleading. Loan demand is generally higher
when the rate of economic activity is high. Our estimates in-
dicate that with the exception of the 1972 to 1974 period,
loan expansion during tight money periods did not differ
significantly from that during easy money periods. This in-
dicates that monetary policy had some effect on curbing loan
demand because if nothing had been done, loan expansion might

                            38
have been greater. But, since something was doner loan ex-
pansion would have been lower if commercial banks could not
liquidate Treasury securities.
     In spite of the evidence supporting the theoretical
relationships described above, the increased liquidity due
to FFB has a near-term potential for only marginal effects
on the ability of the Federal Reserve Board to control
credit availability.
     Assuming that commercial banks hold a reasonably stable
proportion of the stock of outstanding Treasury securities,
according to available data, commercial banks might be expected
to buy about 25 percent of the increase in privately held
Treasury securities attributable to FFB. If the net in-
crease in short-term Treasury securities attributable to
FFB were $12.1 billion, 1/ by 1978 commercial banks could
be expected to purchase 3 billion of this increase. If
we use the gross increase in short-term Treasury securities
figure of $19.6 billion, the commercial banking system would
be expected to purchase about $4.9 billion of the increase.
Commercial bank liquidations of Treasury securities averaged
4 percent of their holdings during restrictive credit periods
between 1959 and 1976. If we apply this percentage to our
casual estimate of FFB-induced increases in Treasury securi-
ties held by commercial banks, we get a potential quarterly
liquidation figure of $120 million by 1978 that is due to FFEB.
This figure is about 4.8 percent of the historical average
quarterly rate of liquidation by commercial banks during re-
strictive credit periods. The same figure for gross increases
in short-term Treasury scurities is about 7.9 percent.

     These figures are rough, but they indicate that FF is
unlikely to affect greatly the conduct of monetary policy.
FFB's activities are not large enough, compared to those of
the Treasury and the commercial banking system, to more than
barely affect the monetary policy. No cause for concern
exists therefore over the compositional shifts between Trea-
sury and agency securities estimated to occur through fiscal
year 1978.

SUMMARY

     Through its borrowing arrangement with the Treasury, FFB
is able to alter the maturity structure of the Federal debt
toward greater liquidity.  It is estimated that the net in-
crease in liquid Treasury security holdings of the public


l/The estimate discussed on p. 34.


                             39
attributable to FFB will be $12.1 billion by the end of
fiscal year 1978.  Theoretically, this increase affects debt
management by shortening the average maturity of the Federal
debt and through its effect on the term structure of interest
rates.  It affects monetary policy by providing commercial
banks with a greater stock of assets that may be liquidated
to finance loan expansion when the Federal Reserve Board is
trying to curb loan expansion.
     The evidence supports the theory. But, because FFB's
operations are small in relation to the operations of the
Treasury and the commercial banking system, the FFB-induced
compositional shift out of agency securities into Treasury
securities is estimated to have small effects on the maturity
structure of the Federal debt, the term structure of interest
rates, or monetary policy. FFB's lending activity would have
to grow considerably before such effects could be serious.
     The effects estimated in this chapter do not result
solely from FFB's existence. Rather, the effects result from
the combination of FB's existence (in terms of its lending)
and its borrowing arrangement with the Treasury. The increase
in the Federal debt resulting from FFB's activity would be
the same if FFB sold its own securities. But, unless it
financed its operations with the same short maturity struc-
ture of borrowing as the Treasury, the estimated effects of
FFB operations on the maturity of the Federal debt, on the
term structure of interest rates, and on monetary policy would
be lower than we have estimated.  It is unlikely that the
maturity structure of FFB's financing would be as short as
the Treasury's. Currently, FFB borrows from the Treasury
with maturities to match the maturities f its loans. The
average maturity of FFB's lending is estimated to be about
9 years. To the maximum extent possible, if FFB issued its
own securities, it would be desirable o match the m curity
structure of its borrowing with that cf its lending.

AGENCY COMMENTS

     Formal agency comments on this report were not re-
quested. The draft report, however, was reviewed by staff
of the Office of Management and Budget and the Department of
the Treasury on an informal basis. These comments were con-
sidered in preparing the final report.
     Treasury officials maintain that the overall maturity of
FFB's portfolio is about 4 years. The calculations in chap-
ter 4 include FFB's transactions in agency debt and Certifi-
cates of Beneficial Ownership in the fourth quarter of 1976



                             40
and the first quarter of 1977. Therefore, they
                                                do not
include all of FFB's transactions since its inception.

RECOMMENDATION TO THE CONGRESS

     The potential effects described will not occur
they are only possible in the long run.              soon for
                                         Currently, it does
not seem necessary to change FFB's borrowing
the Treasury. It results in cost savings to arrangement with
                                             agency
and has no significant ill effects on debt managementborrowers
tary policy.                                           or mone-

     Nevertheless, it is important that the Congress
of the longrun potential that this arrangement        be aware
                                                has
desirable effects on the conduct of debt management for  un-
tary policy. We therefore recommend that the         and  mone-
                                               Congress moni-
tor FFB's growth with a view toward determining
ever, the indirect costs of the current Treasury when, if
                                                  borrowing
arrangement outweigh the benefits that the practice
                                                     provides
in savings achievable on aency borrowing.




                            41
APPENDIX I                                         APPFNDIX I

    ESTIMATED EFFECT OF FFB-INDUCED CHANGES £N THE MATURITY

       COMPOSITION OF THE FEDERAL DEBT ON INTEREST RATES
     FFB-induced increases in the supply of short-term
securities should raise short-term rates above what they would
have been in FFB's absence. Similarly, the reduced supply of
long-term securities should relieve pressures in that end of
the market and reduce long-term rates.

     The empirical evidence for the effects of compositional
shifts in Government securities on relative interest rates is
sketchy. Evidence produced to date indicates that composi-
tional shifts between short- and long-term securities affect
levels of short- and long-term rates, but only minimally.

     We applied the results from two studies of this effect
to our data on net increases or decreases in short- and long-
term securities induced by FFB. 1/ Our results, presented in
table I-1 are based on calculations done by Nordhaus and
Wallich. 2/
     Based on the estimates developed by Okun and Scott, it
appears that FFB-induced changes in the maturity structure
of Government debt have not much affected the term structure
of interest rates. When we take a simple average of the Okun
and Scott estimates, FFB-induced increases in short-term debt
may raise short-term interest rates between 1 and 4 basis
points (that is, by 1 to 4 percent of 1 percentage point).
FFB-induced reductions in long-term debt are estimated to
raise, not lower, long-term rates by no more than about 1.2
basis points during any year between 1974 and 1978.



l/Arthur M. Okun, "Monetary Policy, Debt Management and
  Interest Rates: A Quantitative Proposal," pp. 142-188 in
  Financial Markets and Economic Activity, edited by Donald
  Hester and James Tobin, New Haven, Yale University Press.
  1967; and Robert Haney Scott, "Liquidity and the Term
  Structure of Interest Rates," Quarterly Journal of
  Economics, 79 (Feb. 1965). pp. 135-145.

2/William D. Nordhaus and Henry C. Wallich, "Alternatives for
  Debt Management," pp. 9-26, in Issues in Federal Debt Man-
  agement, proceedings of a conference held in June 1973,
  Federal Reserve Bank of Boston.




                            42
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                                                                                                                          43
APPENDIX I                                        APPENDIX I

     This latter result is somewhat perplexing. It is attrib-
utable to the dominance of Scott's estimate of positive in-
terest rate effects of shifts out of long-term bonds. But,
that estimate may result from the fact that the Treasury tends
to float long-term bonds when interest rates are relatively low.
Thus, one would tend to observe increases in long-term Treasury
debt coincidentally with lower long-term rates. This identifi-
cation problem has not been adequately overcome in any of the
work done to date.
     Another possible explanation for the inverse relation
between compositional changes at the long end of the Govern-
ment secu-ities market and long-term rates is that shifts out
of long-term securities and into short-term securities raise
short-term rates. These rates may dominate the yield structure.
When the relative share of short-term securities is increased,
short-term rates rise. This increase, in turn, may be trans-
mitted along the entire yield structure, raising the level of
rates across all maturities.

     Despite the shortcomings of the estimates, compositional
changes between short- and long-term securities due to FFB
do not seem large enough to have strong effects. The largest
shift into short-term securities is estimated to be $3.1 bil-
lion in fiscal year 1977. If we believe the estimates for
this sort of shift on short-term rates, then in order for
FFB-induced increases in short-term debt to increase short-
term rates by 1 full percentage point, the shift to short-
term debt would have to be around $85 billion per year. 1/
Even if the estimates understate the true effect, FFB opera-
tions do not at present seem large enough to produce a com-
positional shift from long- to short-term securities capable
of having much more than barely perceptible interest rate
effects.


1/Based on the average level of Federal debt outstanding of
  $635 billion between fiscal years 1974 and 1978.




                             44
 APPENDIX II
                                                      APPENDIX II

         ESTIMATED COMMERCIAL BANK PORTFOLIO RECOMPOSITIONS
         DURING PERIODS OF RESTRICTIVE MONETARY POLICY

      According to John Culbertson,  "There is * * * a social
 cost of additional public holdings of  liquid assets which pre-
 cisely parallels the social cost of redundant
                                                cash balances
 dnd zero incentive to economize cash. It undercuts
 plex logic of the financial system and makes         the com-
                                               the economy more
 unstable and less controllable." 1/

       Short-run variations in the rate of spending
 strained by the availability of finance.              are con-
                                           1/ Theory suggests
 that the greater the amount of liquid assets
 public, the greater the ability of the public held by the
 times to liquidate those assets out of their at opportune
 exchange for cash balances. These cash balancesportfolios in
 be used for extending credit into other areas       may in turn
                                                 or
 ing consumption expenditures. One of the crucial for financ-
 of the theory is that those purchasing the            ingredients
                                             assets do so with
 idle money balances. 2/ This means that the
amount of liquid assets held by the public,    greater the
                                              the greater the
potential for converting money balances that
not have been loaned out or spent into active would otherwise
                                                 money
capable of financing increased rates of expenditure. balances
      Activation of idle money balances is most likely
when interest rates are rising above their                 to occur
                                            contemporary aver-
age and when expected rates of inflation are
                                               high. At these
times, the opportunity cost of holding idle
becomes high. It is also at these times that  money   balances
                                                the
Reserve Board might be trying to restrain credit Federal
                                                    availability.
      The way in which the stock of liquid asset
                                                   holdings af-
fects monetary policy would be as follows.
rate of economic activity is high and that    Suppose   that the
                                            inflationary
sures are building. The Federal Reserve Board                pres-
                                                  might be


1/John M. Culbertson, "Discussion" in Issues
                                             in Federal Debt
  Management, proceedings of a conferece
                                      h    eld in June 1§7
  Federal Reserve Bank of Boston, p. 33.
2/Warren L. Smith, "Monetary Policy and the
                                            Structure of Mar-
  kets," in Readings in Money, National Income
  tion Policy, ed., Warren L. Smith and Ronald and Stabiliza-
                                               TeTgen, Richard
  D. Irwin,Inc. (Homewood, Ill., 1965), pp.
                                             356-372.




                              45
APPENDIX II                                      APPENDIX II
expected to take steps to curb the rate of spending in order
to reduce inflationary pressures through attempts to reduce
credit availability. This could be done by attempting to re-
duce excess reserve positions of commercial banks through
open market sales, making borrowing at the discount window
less attractive, or increasing commercial bank reserve re-
quirements.

     The extent to which any of these policies will be ef-
fective depends in part on the amount of noncash liquid
assets held by commercial banks. If liquid asset holdings
are substantial, they may be sold off to meet increased re-
quired reserve positions, avoid the discount window, replen-
ish excess reserves, or maintain lending activity. Interest
rates usually rise during periods when the rate of economic
activity is high. Because of this, there would be an in-
centive on the part of those holding idle money balances to
purchase the liquidated assets of the commercial banking
system. An incentive would also exist on the part of com-
mercial banks to loan out proceeds from the sale of liquid
assets rather than accumulate them as excess reserves. The
opportunity cost of holding idle money balances increases
for both commercial banks and the nonbank public when inter-
est rates are rising.
     This means that the greater the amount of liquid
assets held by the public, the greater the potential for
their liquidation in large volumes and expansion of credit
when the Federal Reserve Board may be seeking to reduce the
rate of spending through reductions in credit availability.
Liquid asset holdings are one reason for the slack that may
potentially exist between achievement of desired policy goals
and what actually happens.

     In addition to the instability that theoretically can
result from portfolio adjustments of the commercial banking
system, liquid asset sales may also be expected by the non-
bank public when expected rates of inflation are high. The
proceeds from such sales may be used to finance consumption
expenditures or may be loaned out. This in turn would ag-
gravate inflationary trends.
EMPIRICAL EVIDENCE SUPPORTING SHIFTS
IN PORTFOLIOS OF COMMERCIAI BANKS
DURING PERIODS OF CREDIT RESTRAINT

     In order to test for the phenomenon we have been describ-
ing, we compared changes in loans and U.S. Government securi-
ties held by commercial banks during periods of monetary re-
striction and ease over the period beginning in the second
quarter of 1959 and ending in the fourth quarter of 1976.


                            46
APPENDIX II                                            APPENDIX II

     In 1958 Warren L. Smith presented evidence supporting the
notion of compositional shifts out of U.S. Government Securi-
ties in order to finance loan expansion based on experience
from the 1954 to 1957 period of credit restraint 1/ In order
to test for        her level of generality for SmithTs conclu-
sions, we examii,.' the portfolio swaps between loans and
Treasury securities by commercial banks during periods of
credit restraint and credit ease. These periods; are:

       Credit restraint                 Credit ease
      1959-II   to   1960-I         1960-II   to   1965-III
      1965-IV   to   1966-IV        1967-I    to   1968-III
      1968-IV   to   1970-I         1970-II   to   1972-III
      1l72-IV   to   1974-IV        1975-I    to   1976-IV
     Our definition of credit restraint periods is somewhat
subjective. They were defined by examining movements in four
key credit aggregates around a simple linear trend from 1959
to 1976. These credit aggregates were the Federal funds rate,
the level of the 3-month Treasury hill rate, and the percen-
tage changes in the money stock (M1) and the monetary base.
Whenever a sustained movement of the interest rate variables
from below the trend line to above the trend line began, that
quarter was picked as a candidate for the beginning of a
credit restraint period. The reverse was true for the mone-
tary aggregates. That is, we looked for sustained movements
from above the trend line to below the trend line. When the
interest rate and monetary variables began retracing their
movements (usually the quarter following the peak or trough),
the period of credit restraint was defined to end.
     The definition of credit restraint periods given above is
subjective because all four credit aggregates did not move in
unison with each other. Periods of credit restraint were
therefore defined to include quarters n which the strongest
collective influence of all variables seemed to exist. But,
different people might have differing opinions on when this
occurred.

     Adopting the approach used by Smith, the aggregates and
quarterly averages of the principal factors affecting the
money supply are presented in tables II-1 and II-2 during



l/"Warren L. Smith, Monetary Policy and the Structure of
  Markets," in Readings in Money, National Income and Stabli-
  zation Policy, ed. Warren L. Smith and Ronald Teigen,
  Richard D. Irwin, Inc. (Homewood, Ill., 1965), pp. 356-372.


                               47
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                                                                                                                               49
APPENDIX II                                       APPENDIX II

credit ease and restraint.   The most important information is
contained in table II-2.

     The quarterly growth of the money supply during each of
the periods of credit restraint was considerably lower than
during periods of credit ease, with the exception of the
period after 1972. Furthermore, except for the 1972 to 1974
period, loan expansion at first glance appears to have been
moderately checked during periods of monetary restraint, but
not to the extent that one might expect based on the growth
in the money stock. For example, during the 1965 to 1966
period of credit restraint, the growth in the money stock was
about one-half its rate of growth in the ensuing period of
credit ease. Yet, loan expansion was only slightly lower dur-
ing the period of credit restraint than in the 1967 to 1968
period.

     There are two things to notice about loan expansion be-
tween 1959 and 1976. First, with the exception of the period
after 1972, loan expansion is trended upward. This raises a
question about whether monetary policy had any effect at all
on checking loan expansion by commercial banks because, in our
sample, restraint periods precede periods of relative credit
ease. Second, during periods of credit restraint, loan expan-
sion appears to be financed mainly through the sale of U.S. Gov-
ernment securities and time deposit inflows in view of the
decline in increases in the money stock. Time deposit in-
flows are lower during periods of credit restraint, but a
presumed commercial bank desire to economize on money balances
coupled with relatively low reserve requirements on time de-
posits mean that a given inflow of time deposits can support
a substantial amount of lending during these periods.

     From 1959 to 1972, it appears that a policy of credit
restraint had little effect on the rate of growth of commer-
cial bank lending activity, particularly when the trended na-
ture of this variable is recognized. Furthermore, it appears
that Treasury liquidations partially explain this result.
Treasury securities were always sold off during periods of
credit restriction and almost always accumulated during peri-
ods of credit ease.
      This does not mean that monetary policy had no effect on
'curbing loan demand, however. Loan demand is generally higher
when the rate of economic activity is high. The data indi-
cates that except for the 1972 to 1974 period, loan expansion
during tight money periods did not differ substantially from
that during easy money periods. This indicates that monetary
policy had some effect on curbing loan demand because if
nothing had been done, loan expansion might have been greater.


                             50
 APPENDIX II
                                                     APPENDIX II

 But, in view of the fact that something was
                                             done, loan expan-
 sion would have been lower if commercial banks
 liquidate Treasury securities.                 could not

       The 1972 to 1976 priod is different from earlier
                                                           years.
 This period's results dominate the results for
 period. The averages for the entire period       the  entir~
 loan expansion was greater during restrictiveindicate that
                                                than during
 ease periods. In addition, the growth in the
 not effectively checked. This is misleading.   money   supply was
 interpretation that the Federal Reserve Board   We   prefer  the
                                                was able to ef-
 fectively control money growth when it wished
 this had little if any effect on loan expansionto do so, but
 banks. This interpretation is to some extent      by commercial
                                                explained by
 liquidation of Treasury securities.

     We verified this general impression using
gression techniques. In this analysis, changes multiple re-
bank holdings of loans and Treasury securities in commercial
                                               were correlated
with variables that theoretically should explain
                                                  such changes.
Potentially, multiple regression analysis enables
trol the full range of influences thought to       one to con-
dent variable and to solate and measure the  affect  the depen-
                                             effect
key influences on the dependent variable. However,   of certain
                                                     this poten-
tial is rarely fully realized.

     The hypothesis tested was as follows. Loan
commercial banks is not significantly affected    expansion by
                                                by restrictive
monetary policy because loans re financed during
periods with the proceeds from iquidation of        tight money
securities.                                    U.S.  Treasury

     The model which we entertained relates changes
ings of loans and Treasury securities to            in hold-

     -- two key credit aggregates designed to measure
        rate of high-powered money expansion and the the
        relative cost of borrowed reserves;

     -- time deposit inflows, which are also a means
        ing loan expansion;                          of financ-

     --the rate of inflation; and

     -- a crude proxy for restrictive or easy monetary
                                                       policy.
Definitions of the variable- used and expectations
                                                    regarding
the singular influence of explanatory variables
                                                 follow.




                             51
APPENDIX II                                      APPENDIX II


Dependent variables
     1. Quarterly change in loans held by commercial banks
(DALB)--The quarterly increase or decrease in commercial
bank loan holdings between 1959 and 1976.

     2. Quarterly change in U.S. Treasury securities held
by commercial banks (DBFB)--The quarterly increase or
decrease in commercial bank holdings of U.S. Government
securities between 959 and 1976.

     3. Quarterly change in combined commercial bank
holdings_of loans and U.S. Government securities (DA)--The
quarterly increase or decrease in commercial bank holdings
of loans and U.S. Government securities from 1959 to 1976.
Independent variables

     1. Level of loan holdings of commercial banks (ALB)---
The quarterly level of loan holdings of commercial banks
from 1959 to 1976. Preliminary data analysis indicated that
both levels of and first differences in this variable were
trended upward. In order to account for the trend in DALB,
its level was included as an explanatory variable. We could
have used percentage changes in loan holdings as a dependent
variable nd possibly eliminated the need for ALB, but we
felt that this would make interpretation of results more dif-
ficult.

     2. Level of U.S. Government security holding s of
commercial banks (BFB)--The quarteryievel of U.S. Govern-
ment security holdings of commercial banks from 1959 to 1976.
This variable was included in equations designed to estimate
DBFB for the same reasons that levels of loan holdings were
included in equations designed to estimate DALB.
     3. Level of combined holdings of loans and U.S.
Government securities by commercial banks (A---Te  quarterly
level of combined oan and Government security holdings of
commercial banks from 1959 to 1976. This variable was in-
cluded in equations designed to estimate DA for the same
reasons that ALB and BFB were used to estimate their re-
spective first differences.

     4. Quarterly rate of growth of the monetary base--
annualized basis (PMB)--The quarterly percentage change in the
monetary base annualized from 1959 to 1976. The monetary base
consists of member bank reserves at Federal Reserve banks,
vault cash, and currency in circulation. It is partly through



                             52
APPENDIX II                                      APPENDIX II

growth in the monetary base that loan expansion and acquisi-
tion of securities may occur. We expect that the greater the
rate of growth in the monetary base, the greater the quarterly
increase in both loans and U.S. Treasury securities holdings
by commercial banks. The monetary base was one of the vari-
ables whose movements were examined to define credit ease and
restraint. In spite of this, we feel that this variable must
be included along with our proxy for monetary policy because
it is expected to explain movements in loans and U.S. Govern-
ment securities that are less discrete and occur in addition
to those explained by a posture of credit restraint or ee.

     5. Quarterly rate of growth of time deposits--
annualized basis (PTD)--The quarterly percentage ncrease or
aecrease in time deposit inflows to commercial banks annual-
ized between 1959 and 1976. In chapter 4, we saw that inflows
of time deposits provide an alternative to demand deposits
for financing loan expansion. We expect that the greater the
rate of growth of time deposits, the greater the expansion
of both loans and U.S. Government securities holdings.

     6. Quarterly rate of growth of the consumer price
index--annualized basis (PCPI)--The quarterly percentage in-
crease or decrease in the Consumer Price Index annualized
from 1959 to 1976. We used this variable as a proxy for in-
flationary expectations, but have no apriori.basis for expect-
ing it to positively or negatively affect changes in loan and
Treasury security holdings.

     7. Interest rate spread between the 3-month Treasury
bill rate and the Federal funds rate--(RT-FF)--Te i  ference
between the quarterly level of interest rates on 3-month Treas-
ury bills and the Federal funds rate. The Federal funds rate
is established by the Federal Reserve Board as a range within
which interbank loans may be made. The higher the Federal
funds rate is relative to the Treasury bill rate, the lower
the incentive to borrow to finance loan expansion, and the
greater the incentive to liquidate Treasury securities. We
have no basis for expecting loan expansion to be affected di-
rectly by the spread, but we do expect that the higher the
Federal funds rate relative to the Treasury bill rate, the
greater will be the liquidation of Treasury securities to
finance a given amount of loan expansion. Thus, we expect a
direct relationship between changes in Treasury security hold-
ings and RT-FF.

     8. Monetary policy (MD)--A dummy variable equal to
one during periods o credit restraint (defined in ch. 4)
and zero, otherwise. We expect loan expansion to be



                            53
APPENDIX II                                      APPENDIX II


insignificantly affected by the monetary policy variable.
This means that regardless of the posture of monetary policy,
roan expansion by commercial banks is relatively unaffected.
We expect a F;gnificantly negative relationship between hold-
ingc of Treai ry securities and restrictive monetary policy.
     T>e for     -- +ement of our null hypotheses is as follows.
          Ho       D. T./     MD = 0
          Ho.:    ~DB- 4/     MD < 0

     The source of :1l data used in this analysis is the Data
Resources, Incorpurated, Central Data Base.
     There were numerous ways of measuring the variables de-
scribed above. In addition, there were other proxies for
potential loanable funds, relative costs of obtaining those
funds, and reserve position influences. We decided on the
actual variables, used as described above, and the way they
were measured after examining correlation matrices of various
configurations of independent variables. The configurations
that produced intolerable intercorrelations between the mone-
tary policy dummy and other independent variables were re-
jected. The independent variable set described above produces
no intercorrelations between monetary policy and other indepen-
dent variables exceeding .51 during the 1959 to 1976 period.
RESULTS

     Changes in loan and U.S. Government securities holdings
by commercial banks were regressed on the above described
independent variables for the entire 1959 to 1976 period and
for two subperiods. The partitioning of the sample was done
to test for the stability of relationships in view of our
observation that the 1972 to 1974 tight credit period seemed
to dominate the average tendency for expansion of loans dur-
ing restrictive credit periods. The results are presented in
table II-3.
     The signs on the coefficients conform fairly well with
our expectations, but in many cases the coefficients are not
significantly different from zero at the 95 percent level.
The coefficient on the monetary policy dummy variable in
equation 1 indicates that over the entire 1959 to 1976 period,
loan expansion averaged $4.7 billion higher during restrictive
credit periods than it was during nonrestrictive periods. The
coefficient is statistically significant at the 95 percent
level. This seems to result from the large loan expansion that
occurred during the 1972 through 1974 period. Comparing the


                             54
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                                                                                                                                                         55~~~~~~
APPENDIX II                                      APPENDIX II

monetary policy coefficients for the 1959 to 167 and 1968 to
1976 subperiods in equations 4 and 7, note that no signifi-
cant difference existed between loan expansions during tight
and easy credit periods during the earlier period. But dur-
ing the later period, loan expansion was significantly greater
during tight than during easy credit periods.

     Changes in Treasury securities holdings were signifi-
cantly negative during tight credit periods for the entire
1959 to 1976 period and for the two subperiods. Thus, we
accept Ho2. We have reservations about rejecting Hol because
of the domin:nce of the aberration that occurred between 1972
and 1974. We find it somewhat difficult to accept the gen-
erality that loan expansion is higher during tight money peri-
ods. At any rate, based on these results, no evidence indi-
cates that loan expansion by commercial banks is curbed by
restrictive monetary policy.

     These results, coupled with our casual observations con-
tained above, lead us to conclude that between 1959 and 1976
monetary policy was not particularly effective in curbing loan
expansion by commercial banks. This result is at least partly
explained by the consistent pattern of commercial bank Treas-
ury securities liquidations, the proceeds of which were loaned
out during these restrictive periods.




                            56