Treasury's Sale of Zero-Coupon Bonds to Mexico

Published by the Government Accountability Office on 1990-08-14.

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

                    United States General Accounting Oflice     / 42    ”u 3           ’


For Release on      Treasury's   Sale   of     Zero-Coupon    Bonds
Delivery               to Mexico
Expected at
10:00 a.m. EDT
August 14, 1990

                    Statement  of
                    Allan I. Mendelowitz
                    Director,  International         Trade,    Energy    and
                       Finance Issues
                    Before the
                    Committee on Banking,    Finance          and Urban     Affairs
                    House of Representatives


GAO/T-NSIAD-90-61                                                       GAO Form 160 (12/W
Mr. Chairman and Members of the Committee:

We are happy to be here this morning to discuss our review of
Treasury’s pricing of zero coupon bonds that were sold to Mexico
in March 1990. In addition, we are also commenting on proposals
to extend GAO’s audit authority to the Exchange Stabilization
Fund (ESF).

This Treasury sale of zero coupon bonds (commonly referred to as
“zeros”) to Mexico was part of the restructuring of Mexico’s
commercial bank debt under the “Brady Plan.” The sale was a
private placement to Mexico (i.e., the bonds were sold directly
to Mexico at a negotiated price).   A zero pays all interest and
principal together in one payment at maturity, and thus is sold
at a deep discount from its face value.   To date, Treasury has
issued zeros only five times.   In contrast, a coupon bond has
multiple semiannual interest payments in addition to the
principal payment.   The sale of coupon bonds at auction is the
usual way in which Treasury borrows medium and long-term.
Dealers who trade Treasury securities have created an
essentially equivalent instrument to a zero, called “STRIPS.”
They create STRIPS by separating a coupon bond’s interest
payments from each other and from the bond’s principal and then
selling the rights to these payments separately.
The United States encouraged the negotiations between Mexico and
its commercial bank creditors that culminated in the recent
rescheduling.    The United States also encouraged the World Bank,
the International      Monetary Fund and Japan to lend Mexico funds.
Mexico received assistance in the following ways.

          -- Most of the commercial banks exchanged their Mexican
            loans for two types of new Mexican government bonds,
            One type had a face value that was 35 percent lower
            than the principal of the loans they replaced.     The
            other type replaced the original loan’s variable
            interest rate with a lower fixed interest rate of 6.25

          -- A few commercial banks provided new loans to Mexico
            equal to 25 percent of their outstanding medium and
            long term Mexican loans.

The U.S. Treasury zeros discussed above are being used as
collateral to secure the principal of the new Mexican government
bonds.     Mexico exchanged these new bonds for about 93 percent of
the debt owed foreign commercial banks.

The restructuring agreement also called for 18 months of bond
interest to be guaranteed by funds placed in an escrow account by
Mexico.     However, Mexico was to have received the interest earned

on this account.   When the agreement-in-principle    was made on
July 23, 1989, the parties to the negotiations expected that the
principal and interest guarantees would cost Mexico $7 billion.

During the 5 weeks preceding the pricing decision, the U.S.
Department of the Treasury had an intense internal debate over
the proper pricing of the zeros that would be sold to Mexico.
Central to the debate was the disagreement over whether to base
the price of the zeros on the STRIPS rate or the Treasury coupon
bond rate.   The price of a zero is determined by its interest
rate; the lower the interest rate, the higher its price.   During
this time period the yield on STRIPS was about 25 basis points
lower than the yield on coupon bonds.

One side of the debate called for selling the bonds at a price
that was based on the yield on STRIPS, similar bonds traded on
U.S. markets, arguing, in part, that this was the closest to a
market price for the private placement.     The other side called
for selling the zeros at a lower price based on the yield on 30-
year coupon bonds, arguing, in part, that pricing in this way
represented Treasury’s cost of borrowing.    In addition, this side
argued that pricing the zeros based on the yield on STRIPS would
endanger the restructuring   agreement.   At a Treasury meeting on
January 4, 1990, proponents of coupon based pricing argued that a
price with a yield under 7.90 percent would cause the whole

transaction to fall apart.   At a lower yield, Mexico would not
have the resources to complete the restructuring.

On January 5, 1990, the Secretary decided to price the zeros
based on the 30-year coupon bond yield.        Treasury used the
interest rate prevailing in the market on January 3 to 5, 1990,
less a 0.125 percent accommodation fee, which equaled 7.925
percent.   We have no official documents from the Secretary
explaining the rationale for his decision.   On March 28, 1990 the
Treasury sold Mexico $30.2 billion in zeros (at face value, the
amount paid at maturity) for $2.990 billion.

A Treasury official told us that, even after the zeros were priced
to yield 7.925 percent, Mexico needed approximately $311 million
more than had been expected when the agreement-in-principle           was
reached in July 1989. This shortfall arose because interest rates
had declined (thus increasing the price of the zeros), and the
banks chose a different mix of options than had been expected.
Mexico covered this shortfall by contributing    slightly less than
$100 million in additional reserves and by funding the escrow
account somewhat differently    than originally called for in the

Considerable controversy has developed concerning the pricing of
these zero-coupon bonds. As you requested, we reviewed the issue
and concluded that Treasury set a price for the bonds that

involved an effective subsidy of approximately $192 million.       In
our view, the interest rate used to set the price of the zeros was
higher than that indicated by comparable market rates of interest
( i.e., those for STRIPS), which lowered the price of the private

We believe that the Secretary of the Treasury had the legal
authority to set this price for the transaction under review.
The Secretary has broad discretion to set the price and other
terms of Treasury bonds in order to fund the national debt.

While it was within the Secretary’s legal authority, we think
that the pricing decision was neither appropriate nor good public
policy.   The Secretary’s decision to price the zeros based on the
coupon bond rate resulted in an effective subsidy for Mexico of
about $192 million as compared to a price for the zeros based on
the yield on STRIPS. There may be credible arguments that can be
made to support a U.S. government financial contribution       to the
solution of the less developed countries’ debt crisis, and it is
not clear whether the Mexican restructuring would have succeeded
without some such contribution.     Nevertheless, we believe that if
Treasury wished to help Mexico, the correct way would have been
to obtain congressional approval through the authorization      and
appropriations   process, rather than with an effective subsidy
provided through the under pricing of the zeros.
In the long run, this decision could set a precedent that will
cost the United States many times more than $192 million.          The
Mexico deal was the first of many agreements anticipated under the
Brady Plan.     Foreign governments and commercial banks may well
expect the U.S. government to contribute resources so that their
own concessions can be reduced.         Again, such contributions may be
in our national interest, but they ought to be funded through
explicit congressional authorization.


The sale of zero-coupon bonds to Mexico was one element of the
restructuring   of Mexico’s international   debt under the Brady
Plan, the administration’s   approach to dealing with the less
developed country debt crisis.     Under the terms of the
restructuring   agreement between Mexico and its international     bank
creditors, much of Mexico’s outstanding commercial bank debt was
exchanged for newly issued, dollar-denominated,      Mexican
government bonds with principal secured by the zeros.

Mexico also purchased a small amount of zeros from Japan, Canada,
France, and the United Kingdom for use in a similar manner for
loans denominated in currencies other than dollar.       We have not
examined the pricing of these bonds in detail, although
representatives of one nation noted that they relied on the U.S.
decision as a basis for their pricing decision.

On March 29, 1990, Mexico paid $2.990 billion for U.S. zeros,
promising $30.2 billion at maturity on December 31, 2019, for a
yield of 7.925 percent.     Treasury priced these zeros by
subtracting its usual one-eighth percent (0.125 percent)
accommodation fee from its estimate of average closing rates on
30-year coupon bonds (8.05 percent) for January 3 to 5, 199O.l

Using the 30-year coupon bond rate to set the price of the zeros
was not appropriate.       Coupon bonds and zeros are fundamentally
different   instruments.   In the case of 30-year bonds with the same
face value, a zero has 1 payment 30 years after the bond is
issued, while a coupon bond has 61 payments--60 semiannual
interest payments and 1 principal payment.      Because of this
difference in payments, these bonds are fundamentally different
instruments and generally have different yields.    Another way to
view this difference is that a zero pays its rate of return on
principal and accumulated interest for the full term of the bond,
while a coupon bond pays its rate of return on only the principal
because the interest is paid semiannually rather than accumulated.

      lTreasury sold zero-coupon bonds four other times in addition
to this sale to Mexico -0 to the Resolution Funding Corporation
(Refcorp) in October 1989, January 1990, and April 1990, and to
Mexico in March 1988 as collateral for then new Mexican bonds in a
smaller exchange of old loans for bonds, commonly referred to as
the “Mexico-Morgan deal.” Treasury charged Refcorp an
administrative fee of 0.125 percent interest, while in the
previbus sale to Mexico Treasury charged a fee of 0.25 percent
The rate of interest on a zero when issued determines its price.
The issue price of the bond varies inversely with the rate of
interest.   If the rate of interest rises, the issue price of the
bond falls, and if the rate of interest falls, the issue price of
the bond rises,

For this zero sale to Mexico and for three of the four other zero-
coupon bond sales by Treasury, the market’s yield for long-term      ’
STRIPS was lower than for a coupon bond with the same maturity.
In the other zero sale, however, the yield on STRIPS was higher
than the corresponding coupon bond yield.       (These sales are
described in the Appendix I.)

The United States would have received about $192 million more for
this sale of zeros to Mexico if Treasury had based the zero price
on the 30-year STRIPS yield rather than the 30-year coupon bond
yield, assuming Treasury continued to charge its usual 0.125
percent accommodation fee. 2         Had Treasury used STRIPS for
pricing, it would have priced the zeros based on the market yield
of an essentially identical instrument rather than one which has
very different characteristics than the zeros. Had this been

     20ur estimate and Treasury’s method are both modestly extrapolated
to 30 years because on January 3 to 5 1990, the longest maturities
of the securities on which these estimates were based was 29.61

done, Treasury would have priced the zeros with a yield of 7.708
percent compared to the 7.925 percent rate that was used.

While the Treasury does not ordinarily issue zero-coupon bonds,
and those few that it has issued are not traded in the secondary
market, the STRIPS yield is an appropriate measure of the market’s
yield for a single future Treasury payment like the zero. 3

Dealers who trade Treasury bonds create STRIPS by separating the
principal payment of a coupon bond from the semiannual interest
payments.   Consequently, when this process is applied to 30-year
Treasury coupon bonds, it creates 30-year STRIPS that are
equivalent to a 30-year zero-coupon bonds. A 30-year STRIP
provides only one payment from Treasury to the bond holder in 30
years, and is, therefore, an appropriate vehicle for pricing 30-
year Treasury zeros.

      3 An alternative way of measuring the market yield on a Treasury
payment in thirty years is by calculating the 30-year “theoretical
spot yield,” also called the “hypothetical spot yield.” However,
measurement of this yield appears to be subject to more variation
because it is based on groups of Treasury coupon bonds and
different groups will generate different estimates. Bonds in each
group have similar characteristics such as common dates for
interest payments, but generally have different maturities. The
theoretical spot rate assumes that payments at the same date
receive the same yield regardless of which bond in the group they
origiqated from. Consequently, a 30-year theoretical spot rate
for a group of Treasury coupon bonds measures the yield on a
payment in 30 years for the bonds in that group.
Since 1985, Treasury has encouraged these STRIPS by issuing
coupon bonds in book entry form through the Federal Reserve
System in a way that helps private dealers separate interest and
principal payments.

On January 3 to 5, 1990, the yield on 30-year Strips averaged
7.708 percent compared to the then 7.925 percent yield on 300year
coupon bonds, both rates are computed after deducting the usual
one-eighth of a percent accommodation fee charged by Treasury.4

         OF T&&QXJRY , S OTHER
        OF ZEROCOUPON          BONDS

Treasury sold zeros twice before and twice after pricing the zero
we are concerned about today.     In each of these four other sales,
Treasury made use of the STRIPS yield or the spot yield to price
the initial sale or to set the conditions for calling or
redeeming the zero coupon bonds.

More importantly,   the two earlier agreements contain clauses that
lessen the burden on Treasury resources. In the deal to

      4 We estimate that the theoretical spot yield (after deducting a
0.125 percent fee) was about 7.716 percent on January 3 to 5,
1990. We obtained this estimate by averaging the 7.816 percent
estimate by a major investment bank with the 7.616 percent
estimate by a major commercial bank. If the Treasury had priced
the zeros sold to Mexico based upon this spot yield estimate and
continued to charge its usual 0.125 ercent accommodation fee, the
Unit&d States would have received P184 million more for the
zeroes than it actually received.
restructure some Mexican debt that was organized by Morgan
Guaranty Bank, Treasury avoided costs by (1) pricing for sale
based on a benchmark rate (8.66 percent) that was then less than
both the coupon rate (8.90 percent) and the STRIP rate (9.13
percent), (2) charging a larger fee (0.25 percent) at sale, and
(3) requiring additional fees due Treasury for exercising the
call and redemption options.

In the October 1989 sale to Resolution Funding Corporation
(Refcorp), Treasury based the sales price on the STRIPS rate that
was at 7.71 percent, about 25 basis points (0.25 percent) lower
than the coupon bond rate.

It is not possible to determine a strictly comparable market
price for the two zero sales to Refcorp which followed the
pricing decision we reviewed because these zeros mature in 40
years and the longest maturing STRIPS and coupon bonds were then
slightly less than 30 years. We can point out however that
these zeros sold to Refcorp had substantially lower yields at
sale than the longest STRIPS and coupon bonds.

These examples raise the fundamental issue of our review as to
why Treasury priced the March 29, 1990, zero-coupon bond sale to
Mexico in a way that was so unfavorable to the United States?


A vigorous internal debate preceded the pricing decision of
January 5, 1990, particularly     during the preceding 5 weeks.
Based on our review of what Treasury informed us were all
documents concerned with this issue, we conclude the

         -- There were two opposing groups in this debate.
             Discussion centered on choice of the benchmark on
             which to base the price and what fees, if any, to

         -- The group that argued for no or low fees, also
             argued for pricing based on the 30-year coupon rate
             rather than the 30-year STRIPS rate.    During this
             time, the coupon rate exceeded the STRIP rate by
             about 25 basis points (0.25 percent).

         -- A major consideration in the debate was the effect
             of the pricing decision on the size of the
             shortfall in Mexican resources to complete this
             deal, and whether this concern should affect the
             pricing decision.   In order to complete the
             agreement between Mexico and the banks, Mexico
     a       needed enough hard currency to put 18 months of

             interest into escrow and to purchase the zero-
             coupon bonds.

        -- Both groups were concerned about how the pricing
             decision would be viewed.’

The arguments made in favor of coupon pricing included the

        -- If Treasury used an interest rate to price the zero-
             coupon bonds that was less than 7.90 percent, Mexico’s
             shortfall would be large enough to risk the success of
             the Mexican restructuring agreement and even the Brady

        -- There was precedent established in the Mexico-Morgan
             zero-coupon bond sale of January 1988 in which the zero
             coupon bonds were priced based on the coupon rate
             combined with a fee of 0.25 of a percent interest.

        -- The coupon rate was the same rate at which Treasury
             itself borrowed through its 30-year coupon bonds.
             Therefore, the transaction would not cost the Treasury

      -- The STRIPS market was not deep when compared to the
         much larger 30-year coupon bond market.       This sale was
         large compared to the STRIPS market.       If Treasury
         borrowed on the STRIPS market, this would cause the
         STRIPS rate to rise and lessen the difference between
         it and the coupon rate.

The arguments made in favor of STRIPS pricing included:

      -- Pricing should not be influenced by Treasury concerns
         about the size of anticipated shortfall in Mexican
         resources. The shortfall developed because interest
         rates had fallen since the agreement-in-principle
         between the banks and Mexico, and the banks had chosen
         options in a different mix than had been expected.

        All the other bonds that Treasury sold in private
         placements had been based on market rates for that
         security type, except for the Mexico-Morgan deal.     In
         that case, Treasury borrowed at a rate that was even
         more favorable to the United States than the prevailing
         STRIPS rate.   In addition, a precedent had been set by
         Treasury’s most recent zero-coupon bond sale in which
         Treasury had priced the bonds at the STRIPS rate (and
         charged a 0.125 percent fee).

        -- Treasury should price its bond sales in the same way as
           financial markets.    Treasury should charge a zero-
           coupon price for a zero-coupon sale; not a coupon price
           for a zero-coupon sale. If coupon rates are used, it
           would be clear to everyone that Mexico received a

        -- Treasury should not sell bonds to Mexico on more
           favorable terms than it sells similar bonds to domestic

        -- The price should not be significantly more favorable
           than that which Mexico would pay if it purchased zero-
           coupon bonds directly from the STRIPS market.      It was
           estimated that if Mexico went into the STRIPS market to
           buy the required bonds, the price of the bonds would be
           driven up so that the interest rate on them could fall
           as much as 100 basis points (1 percent) lower than the
           STRIPS rate.

There were arguments over the fee that Treasury would include
in the pricing.   The arguments made for charging no fees or
small fees included:

       -- At Treasury’s urging, international   financial
           institutions   and other governments were making

             substantial contributions to the Mexican deal.
             Under these circumstances, it would be unseemly for
             the United States to charge large fees and make
             money at their expense.

       -- The customary 0.125 percent fees for state and local
             governments should not have any bearing on Mexico’s
             fees because it is charged as a condition for the tax
             benefits of the bonds issued by state and local

       -..   If a fee must be charged for the zero-coupon bonds,
             Treasury should charge a fee that translates to the
             same up-front amount on a zero as the 0.125 percent
             fee comprises for coupon bonds sold state and local
             governments.   Since these coupon sales are charged a
             fee that equals 1.4 percent of the principal, a fee
             equal to 1.4 percent of the principal should also be
             charged Mexico for these zeros which translates into 4
             to 5 basis points of interest not the proposed 12.5
             basis points of interest .

The arguments made for charging larger fees included:

      -- Fees should be charged similar to Treasury’s other
             private placements such as the 0.25 percent interest

          fee in the Mexico-Morgan transaction and the 0.125
          percent interest fee charged in all other private

       -- How can Treasury charge Mexico a lower fee than it had
          recently charged domestic entities?   In the then most
          recent private placement of a zero to Refcorp in
          October 1989, Treasury charged a 0.125 percent fee, as
          it did for coupon bond sales to state and local

       -- The fee should reflect the potential impact on the
          market.   If Mexico purchased STRIPS from the financial
          markets instead of zeros from Treasury, the price of
          STRIPS would be even higher (and the yield lower) than
          it was.

      EXCH&VGF;: ST-ATION              FUND

On February 6, 1990, Mr. Chairman, you and the Honorable Lee
Hamilton, Chairman of the Joint Economic Committee, requested that
we review administration   policies on the granting of bridge loan
support from the Exchange Stabilization Fund for developing
country financial restructuring packages. In particular you asked

if the administration   had recently changed the policy for Poland,
and if it had, the reasons for the change.

As we recently advised you, we are not able to answer the
questions posed in your letter.    On April 23, 1990, in response
to GAO’s notification   to Treasury about this review,   Under
Secretary Mulford stated:

         “I would like to call your attention to paragraph (a)(2)
         of 31 U.S.C. 5302, which provides that decisions of the
         Secretary as to the use of the ESF are final and may not
         be reviewed by another officer or employee of the
         Government.    Subject to that provision, Treasury would be
         prepared to consider written questions concerning these

Under these constraints, we are unable to perform an objective
review of the policies of ESF or do a financial audit of this
fund.   However, we do support the principal of giving us the
authority to do such reviews and audits.

In letters to you dated June 25 and 26, 1990, Treasury Secretary
Brady and Federal Reserve Board Chairman Alan Greenspan each
expressed strong opposition to your recent proposal to amend
section 5302 of title 31 of the U.S. Code to permit these audits.
In their letters, the Secretary and Chairman stated that the

  , ’
- 1

        proposal created risks to sensitive working relationships and
        communications with foreign governments and central banks that are
        central to the operation of ESF.

        We recognize that Secretary Brady ahd Chairman Greenspan have
        legitimate concerns regarding the need for confidentiality     in the
        operations of the fund.    We appreciate the sensitive nature of the
        operations and agree that it would be inappropriate      for the
        details of fund transactions to become public, particularly    the
        details of foreign exchange interventions.     Congress itself has
        expressed such concerns in legislative materials associated with
        the enactment and subsequent amendment of section 5302.

        Nonetheless, we also share your concern, expressed in your June
        26, 1990, statement introducing the proposal to amend section
        5302, that

               “...Congress and the U.S. taxpayer . . . have the right to
               know if foreign currency intervention    is effective and if
               the taxpayers’ money is being properly protected against
               the risks of such activities...”

        We believe that our authority to audit ESF would be consistent
        with our mission and appropriate to support legislative branch
        oversight of the fund.    Congress needs to be fully informed about
        the ndture, magnitude, and effectiveness of ESF transaction.

We believe legislation can be drafted that would enable us to
assist congressional oversight of this fund in a way that
recognizes the validity and legitimacy of the concerns of
Secretary Brady and Chairman Greenspan.            We do not believe that
the need for confidentiality     is inconsistent with our audit
authority.    We frequently audits classified defense and
intelligence programs and other executive branch programs that
require strict information     security.   We have in place strict and
rigorous policies to maintain the security and confidentiality       of
information    consistent with the requirements of originating
agencies. Classified, proprietary, or other sensitive data is
safeguarded by the procedures for gaining access, handling, and
enforcing regulations against unauthorized use or disclosure.
Access is limited on a need-to-know basis.

For example, we have access to Internal Revenue Service tax data,
including, when appropriate, files that show taxpayer names and
social security numbers, under strict controls and for specific
purposes.     Similarly, we have limited authority to audit the
operations of the Federal Reserve and other federal entities
responsible for bank regulation.         In carrying out our
responsibilities   under this authority, we have access to the
regulators’ reports on bank examinations.         Again, strict controls
govern this access.

Mr. Chairmah, this concludes my statement.   I will be happy to
respond to any questions you may have.


  APPENDIX       I                                                         APPENDIX      I

                                               UPON BONDS

Purchaserda;tcLmPrice                     xiddy
                     (years) ($Million)
Mexico    3/28/90     29.76 $2990.4        7.925 %   Par yieldb-0.125%   8.04% 7.71%
Earlier sales:
Mexico    3/30/88     20       $492.1      8.41%     Par yieldb-0.25%    8.90% 9.13%
Refcorp 10/27/89      29.97    $485.1     7.59%      STRIPS-O. 125%      7.91% 7.65%
Later sales:
Refcorp   l/29/90      39.97    $262.8 7.5 1%        Calc.c-O. 125%      8.47% 8.06%
Refcorp   4/16/90      40       $171.8 7.68%         Calc.c-O. 125%      8.57%   8.17%

aAfter a fee has been charged
bTreasury’s estimate of coupon bond yields from its par yield curve
eliminates a peak in coupon bond yields that tends to occur at a maturity of
20 years.
C”Calc.” is a complex calculation based on the yields of seven bonds: two
Treasury STRIPS, two Refcorp STRIPS, one Treasury coupon bond and two Refcorp
coupon bonds.
dYields of instruments whose maturity is closest to 30 years, except for (1)
the 3/30/88 Mexico transaction yields are for instruments with maturities
closest to 20 years, and (2) the 3/28/90 sale to Mexico the yield was
extrapolated less than a year in order to have a maturity of 30 years.