. 2
( 10)


run issue are typically referred to as off-the-run issues. These issues are
not as liquid as an on-the-run issue for a particular maturity. This differ-
ence in liquidity manifests itself in wider bid-ask spreads and lower size
quotes for off-the-run issues relative to an on-the-run issue.
While the secondary market for Treasury bills is one of the most liquid
segment of the global money market, most of the trading activity occurs dur-
ing New York trading hours. In a 1997 study, Michael J. Fleming ¬nds that
while bills represent approximately 27% of trading volume of on-the-run
Treasury trading volume in New York, bills comprise only about 1% of the
trading volume in London and Tokyo. In fact, on many trading days, not a
single bill trade is brokered during overseas hours.9 One possible explana-
tion for this result is put forward in a study by Michael J. Fleming and Jose
A. Lopez. They suggest that a disproportionate share of speculative trading
in Treasury securities occurs overseas. Accordingly, longer-term coupon
Treasuries (as opposed to bills) are suitable vehicles for this type of trading.10

Treasury Dealers and Interdealer Brokers
Any ¬rm can deal in government securities, but when the Federal Reserve
engages in trades of Treasuries in order to implement monetary policy, the
New York Fed™s Open Market Desk will deal directly only with dealers
that it designates as primary or recognized dealers. The primary dealer
system was established in 1960 and is designed to ensure that ¬rms
requesting status as primary dealers have adequate capital relative to
positions assumed in Treasury securities and that their trading volume in
Treasury securities is at a reasonable level. The Federal Reserve requires
primary dealers to participate in both open market operations and Trea-
sury auctions. In addition, primary dealers provide market information
and analysis which may be useful to the Open Market Desk in the imple-
mentation of monetary policy. Exhibit 3.5 lists the primary dealers as of
October 31, 2001. Primary dealers include diversi¬ed and specialized
¬rms, money center banks, and foreign-owned ¬nancial entities.

Michael J. Fleming, “The Round-the-Clock Market for U.S. Treasury Securities,”
Economic Policy Review, Federal Reserve Bank of New York, July 1997, pp. 9-32.
Fleming, “The Round-the-Clock Market for U.S. Treasuries.”
Michael J. Fleming and Jose A. Lopez, “Heat Waves, Meteor Showers and Trad-
ing: An Analysis of Volatility Spillovers in the U.S. Treasury Market,” July 1999,
working paper.

EXHIBIT 3.5List of the Primary Government Securities Dealers Reporting to the
Market Reports Division of the Federal Reserve Bank of New York

ABN AMRO Incorporated Fuji Securities Inc.
Banc of America Securities LLC Goldman, Sachs & Co.
Banc One Capital Markets, Inc. Greenwich Capital Markets, Inc.
Barclays Capital Inc. HSBC Securities (USA) Inc.
Bear, Stearns & Co., Inc. J.P. Morgan Securities, Inc.
BMO Nesbitt Burns Corp. Lehman Brothers Inc.
BNP Paribas Securities Corp. Merrill Lynch Government Securities
CIBC World Markets Inc. Inc.
Credit Suisse First Boston Corporation Morgan Stanley & Co,. Incorporated
Daiwa Securities America Inc. Nomura Securities International, Inc.
Deutsche Banc Alex Brown Inc. Salomon Smith Barney Inc.
Dresdner Kleinwort Wasterstein Secu- UBS Warburg LLC
rities Zions First National Bank

Source: Federal Reserve Bank of New York (as of October 31, 2001)

Primary dealers trade with the investing public and with other dealer
¬rms. When they trade with each other, it is through intermediaries
known as interdealer brokers. Dealers leave ¬rm bids and offers with
interdealer brokers who display the highest bid and the lowest offer in a
computer network tied to each trading desk and displayed on a monitor.
The dealer responding to a bid or offer by “hitting” or “taking” pays a
commission to the interdealer broker. The size and prices of these transac-
tions are visible to all dealers at once. The fees charged are negotiable and
vary depending on transaction volume.
Six interdealer brokers handle the bulk of daily trading volume. They
include Cantor, Fitzgerald Securities, Inc.; Garban Ltd.; Liberty Broker-
age Inc.; RMJ Securities Corp.; Hilliard Farber & Co. Inc.; and Tullett &
Tokyo Securities Inc. These six ¬rms serve the primary government deal-
ers and approximately a dozen other large government dealers aspiring to
be primary dealers.
Dealers use interdealer brokers because of the speed and ef¬ciency
with which trades can be accomplished. With the exception of Cantor,
Fitzgerald Securities Inc., interdealer brokers do not trade for their own
account, and they keep the names of the dealers involved in trades con¬-
dential. The quotes provided on the government dealer screens represent
prices in the “inside” or “interdealer” market. Historically, primary deal-
ers have discouraged attempts to allow the general public to have access
to them. However, as a result of government pressure, GovPX is a joint
venture of ¬ve of the six interdealer brokers and the primary dealers in
which information on best bids and offers, size, and trade price are dis-
U.S. Treasury Bills

tributed via Bloomberg, Reuters and Knight-Ridder. In addition, some
dealers have developed an electronic trading system that allows trading
between them and investors via Bloomberg. One example is Deutsche
Morgan Grenfell™s AutoBond System.

While U.S. Treasury bills are very important instruments in the money mar-
ket, there is some evidence which suggests that bill yields no longer serve as
benchmark instruments from which other money market instruments are
priced. First, the correlation between the 3-month bill rate and the Federal
Funds rate has diminished considerably in recent years.11 To illustrate this,
we examine weekly observations of the Federal Funds rate and the 3-month
bill rate for the period of January 1, 1987 to December 31, 1999.12 During
the ¬rst nine years of this period, the correlation coef¬cient between the
Federal Funds and 3-month bills was 0.99. However, during the period
1996-1999, the correlation drops to 0.64. Second, a study by Gregory R.
Duffee suggests that the U.S. Treasury bill market is becoming increasingly
segmented and there is a measurable increase in the idiosyncratic variability
of the bill yield since the mid-1980s.13 One possible explanation is that
when foreign central banks intervene in currency markets to manage the
exchange rate between the dollar and other currencies, they normally buy/
sell U.S. Treasury bills.14 As a result, the yield on bills may not track the
yields on other money market instruments as closely as in the past.

Treasury Bill Yields versus LIBOR
LIBOR is the interest rate which major international banks offer each other
on Eurodollar certi¬cates of deposit (CD) with given maturities. The matu-
rities range from overnight to ¬ve years. So, references to “3-month
LIBOR” indicate the interest rate that major international banks are offer-
ing to pay to other such banks on a CD that matures in three months.
Eurodollar CDs pay simple interest at maturity on an ACT/360 basis.
LIBOR serves as a pricing reference for a number of widely traded ¬nancial
products and derivatives (e.g., ¬‚oaters, swaps, structured notes, etc.).

The Federal Funds rate is a bank™s cost of borrowing immediately available funds
from another institution primarily overnight.
Source: Federal Reserve Statistical Release H.15
Gregory R. Duffee, “Idiosyncratic Variation of Treasury Bill Yields,” Journal of
Finance (June 1996), pp. 527“551.
See, Timothy Q. Cook, “Treasury Bills,” in Instruments of the Money Market,
Seventh Edition, (Richmond: Federal Reserve Bank of Richmond), pp. 75“88.

Because of LIBOR™s importance in the global money markets, it is
instructive to examine the relationship between Treasury bill yields and
LIBOR. We expect LIBOR rates to be higher than the yields on bills of
the same maturity because investors in Eurodollars CDs are exposed to
default risk. Panel a of Exhibit 3.6 presents a Bloomberg graph of the
yield curves for U.S. Treasury bills and LIBOR (out to a maturity of 1
year) on March 13, 2002. The Treasury bill yield curve is the lower
curve and is represented by a solid black line. Panel b of the exhibit pre-
sents the data used in constructing the two yield curves. The fourth col-
umn indicates the spread between LIBOR and the Treasury bill yield for
a given maturity.
In order to understand the relationship between LIBOR and Treasury
bill yields over time, we examine the period January 1, 1987 to December
31, 1999. We focus on the spread (in basis points) between 3-month
LIBOR and 3-month Treasury yields each week (Friday) during this time
period. Exhibit 3.7 is a time series plot of weekly spreads. Two striking
features can be observed. First, there are a handful of prominent spikes in
the data that re¬‚ect ¬nancial/global crises. Second, spreads trend down-
ward over the time period. We will consider each feature in turn.

EXHIBIT 3.6 Bloomberg Screen of LIBOR and Treasury Bills Yields
a. LIBOR and Treasury Bill Curves
U.S. Treasury Bills

EXHIBIT 3.6 (Continued)
b. Spread between LIBOR and Treasury Bill Yields

Source: Bloomberg Financial Markets

EXHIBIT 3.7 Spread Between LIBOR and Treasury Bills

Sample period: January 1, 1987-December 31, 1999

U.S. Treasury securities and the U.S. dollar are considered “safe
havens” in times of crisis, regardless of their underlying causes. During
times of turmoil, the resulting “¬‚ight to quality” widens the spread
between LIBOR rates and T-bill rates. For instance, the ¬rst spike in the
data occurs in October 1987. At the end of October 1987, the spread
between 3-month LIBOR and 3-month bills was 252 basis points. Five
weeks earlier, the spread was 106 basis points. The catalyst, of course, for
this huge increase in the spread was the collapse of the world™s equity
markets. On October 19, 1987, the Dow Jones Industrial Average fell
22.6% while markets tumbled around the world. The total world wide
decline in stock values exceeded $1 trillion.15
The next spike occurs in the fall of 1990. The precipitant was the
invasion of Kuwait by military forces from Iraq on August 2, 1990. Dur-
ing the next several weeks, the combination of rising oil prices and slow-
ing U.S. economy caused a severe drop in U.S. stocks. By the middle of
October, U.S. stocks had fallen by 18%. Once again, investors around the
world ¬‚ed to the safety of U.S. Treasuries and the spread widened to 159
basis points at the end of December 1990 (just prior the January 15, 1991
United Nations imposed deadline for Iraq to withdraw from Kuwait).
Another spike in the spread is in the fall of 1998. On August 17,
Russia devalued its currency, the rouble, and halted payments on its debt
obligations. As a result, bond prices fell across-the-board in markets
around the world. In the ensuing weeks, reports surfaced that a very
large hedge fund, Long-Term Capital Management, had sustained multi-
billion dollar losses. On September 23, the hedge fund received an infu-
sion of $3.65 billion in capital from a consortium of investment banks.
The rescue was brokered by the Federal Reserve. During this time, inves-
tors ¬‚ed emerging markets™ equity and debt, liquidity in corporate bonds
dried up, and money poured into Treasuries. The spread between 3-
month LIBOR and 3-month bills was 132 basis points on October 20,
1998. The spread returned to more normal levels as the Federal Reserve
cut the Federal Funds rate three times in the following two months to
avert a credit crunch.
The ¬nal spike in the data occurs in the fall (October/November) of
1999. Although the macroeconomic climate was relatively settled during
this time, uncertainty due to the Y2K calendar conversion engendered
some portfolio rebalancing and a ¬‚ight to quality. Once these concerns
abated, spreads quickly returned to more normal levels.
Another pattern evident in these data is the downward trend in the
spread between 3-month LIBOR and 3-month Treasury bills. To see this,
we computed summary statistics for each calendar year: mean, standard

Jeremy J. Siegel, Stocks for the Long Run (New York, NY: McGraw-Hill, 1998).
U.S. Treasury Bills

deviation, minimum and maximum. These results are presented in Exhibit
3.8. Two trends are evident: (1) the mean spreads fell over the 1987“1999
period and (2) except for the uptick in volatility in 1998“1999, volatility
trends downward as well.16 The explanation is simple. Over this period,
LIBOR became the benchmark global short-term interest rate. The major-
ity of funding for ¬nancial institutions is LIBOR-based. As this trend con-
tinues, spreads should continue to remain at these lower levels.

Panel a of Exhibit 3.9 presents two Treasury bill yield curves from
Bloomberg™s C5 screen from the Governments page captured on March
13, 2002. The top graph is constructed using yields from bills maturing
from 3 to 6 months. Correspondingly, the bottom graph is constructed
using the yields of bills maturing from zero to 6 months. Each bill issue
presented in the two graphs is identi¬ed with a -0- (on-the-run bill), X
(off-the-run bill), or a W (when-issued bill). Panel b of Exhibit 3.9 presents
the data Bloomberg used to construct these two bill yield curves.

EXHIBIT 3.8 The Spread Between 3-Month LIBOR and 3-Month Treasury Bills
Summary Statistics for 1987-1999 (in basis points)

Year Mean Standard Deviation Minimum Maximum

1987 122.42 47.56 56.00 252.00
1988 118.91 16.68 98.00 183.00
1989 104.44 22.99 56.00 144.00
1990 65.77 23.76 38.00 159.00
1991 46.02 20.58 15.00 129.00
1992 25.52 12.75 11.00 66.00
1993 16.23 5.55 8.00 29.00
1994 34.81 15.23 11.00 78.00
1995 41.50 8.40 28.00 65.00
1996 36.40 8.15 22.00 70.00
1997 53.64 12.94 33.00 77.00
1998 64.00 19.08 40.00 132.00
1999 64.72 24.60 31.00 133.00

A reasonable explanation for these trends is that the level of interest rates fell dur-
ing this period. However, the same pattern emerges when yield ratios (i.e., 3-month
LIBOR/3-month Treasury-bill) are examined.

EXHIBIT 3.9 Bloomberg Treasury Bill Screens
a. Treasury Bill Curve Screen

b. Treasury Bill Screen

Source: Bloomberg Financial Markets
U.S. Treasury Bills

EXHIBIT 3.10 Summary Statistics for Differences in Holding-Period Returns
(Ride minus Buy-and-Hold) in Basis Points from January 1987 through April 1997

Strategy Mean Median Min Max % Positive
Panel A: Three-Month Holding Period

Ride Using 6-Month 10.6 9.0 67.2 82.36
Ride Using 9-Month 16.0 14.2 106.4 73.60
Ride Using 12-Month 17.9 17.3 139.7 65.56
Panel B: Six-Month Holding Period

Ride Using 9-Month 16.1 15.8 78.8 80.04
Ride Using 12-Month 25.2 27.9 144.1 71.23

Both of these yield curves are positively sloped. With a positively
sloped Treasury bill curve, an investor receives an additional yield for
extending the bill™s maturity. This additional yield is compensation for
the additional risk of the longer security and re¬‚ects the market™s implicit
forecast of a rise in interest rates. Investors who seek to pro¬t from the
tendency for yields to fall relative to this forecast as bills move towards
maturity are pursuing a strategy known as “riding the yield curve.”
To illustrate this strategy, suppose an investor has a 3-month hold-
ing period. Consider two potential vehicles to satisfy this maturity pref-
erence. First, buy a 3-month bill and hold it to maturity. Second, buy a
6-month bill, and sell it after three months. If the yield curve is upward-
sloping and does not change over the next three months, the 6-month
bill will earn a higher return because of the increase in price due to the
decrease in yield relative to the forecast at which it was priced. As a
result, investors will collect an additional return.
For example, suppose a 91-day bill and a 182-day bill are yielding
5% and 5.25% on a bank discount basis, respectively (5.06% and
5.25% as money market yields). Buying and maturing the 91-day bill
will generate a 91-day return of 1.28%. Buying the 182-day bill and
selling after 91 days will generate 1.43% return over the same 91-day
period if the yield curve remains unchanged.
Robin Grieves, Steven V. Mann, Alan J. Marcus, and Pradipkumar
Ramanlal examine the effectiveness of riding the yield curve using Trea-
sury bills for the period January 2, 1987, through April 20, 1997.17
They ¬nd that riding the yield curve on average enhances return over a
given holding period versus a buy-and-hold strategy. Exhibit 3.10 pre-
See Robin Grieves, Steven V. Mann, Alan J. Marcus, and Pradipkumar Ramanlal,
“Riding the Bill Curve,” The Journal of Portfolio Management (Spring 1999), pp.

sents summary statistics for the differences in holding period returns.
These return differences are reported in basis points. Panel A presents
the mean, median, minimum, maximum, and the percentages of return
differences that are positive (i.e., meaning the riding strategy outper-
forms the buy and hold) for the 3-month holding period. Panel B pre-
sents the same information for the 6-month holding period.
For a 3-month holding period, the results in Exhibit 3.10 indicate
that riding the yield curve using 6-month bills provides an additional 10
basis points in returns on average and outperforms a buy-and-hold strat-
egy over 82% of the time. Rides using longer bills increase the additional
return, with a corresponding decrease in the percentage of rides that beat
the buy-and-hold. For the 6-month holding period, the results suggest a
similar story. A 6-month ride using the 9-month bill adds approximately
16 basis points on average, is effective 80% of the time, and has the high-
est (i.e., the most desirable) minimum return of all ¬ve riding strategies
examined. A ride using the 12-month bill adds about 25 basis points on
average and outperforms the buy-and-hold strategy 71% of the time.
Of course, the higher returns generated by the riding strategies come
at the expense of higher variability and the possibility of negative returns.
However, Grieves, Mann, Marcus, and Ramanlal provide evidence which
suggests that only the most risk-averse investors would reject the riding
strategy categorically. Further, investors who ride the yield curve during a
Federal Reserve tightening cycle will meet with disappointing results
because an unexpected rise in short rates can potentially eliminate any
term premium present in longer-maturity bills. For example, beginning
February 4, 1994 and ending on February 1, 1995, the Federal Reserve
Open Market Committee increased the Federal Funds target rate seven
times from 3% to 6%. Grieves, Mann, Marcus, and Ramanlal examine
the performance of the riding strategy during this period and ¬nd that the
overall performance of riding the yield curve deteriorates considerably.

There is a substantial body of empirical evidence that suggests that cer-
tain Treasury bills have special value in addition to the value attributable
to their cash ¬‚ows.18 This additional value is present in bills whose matu-
rity dates immediately precede calendar dates when corporate treasurers

See, for example, Kenneth D. Garbade, Fixed Income Analytics (Cambridge, MA:
MIT Press, 1996) and Joseph P. Ogden, “The End of the Month as a Preferred Hab-
itat: A Test of Operational Efficiency in the Money Market,” Journal of Financial
and Quantitative Analysis (September 1987), pp. 329-343.
U.S. Treasury Bills

require cash to make payments. Two prominent examples are quarter-end
bills and tax bills. Quarter-end bills mature immediately prior to the end
of the quarter. Similarly, tax bills mature immediately prior to important
federal corporate income tax dates (March 15, April 15, June 15, Septem-
ber 15, and December 15). Both quarter-end and tax bills usually trade at
a higher price and correspondingly offer a lower yield relative to the Trea-
sury bill curve. As an example, on July 22, 1999, three Treasury bills
maturing on September 23, September 30, and October 7 (all in 1999)
were yielding 4.48%, 4.43%, and 4.51%, respectively.19 Thus, in an oth-
erwise upwarding-sloping curve, the September 30 bill looks expensive
relative to the two surrounding bills.
The reason for this additional or special value is straightforward.
Corporate treasurers may desire to invest excess cash on hand in securi-
ties that mature at the end of the quarter and whose cash ¬‚ows at matu-
rity can be used to liquidate short-term liabilities (e.g., accounts payable)
before reporting their quarterly balance sheets. A bill that matures the
week after the quarter™s end would require the treasurer to sell the secu-
rity prior to maturity; a bill that matures the week before would require
the treasurer to reinvest the maturity payment for an additional week.
Accordingly, the bills that mature one week before or after the end of the
quarter would not necessarily be viewed as close substitutes for the quar-
ter-end bill. As such, the quarter-end bill possesses a “convenience” value.
The reasoning for tax bills is analogous. Kenneth Garbade presents evi-
dence that quarter-end and tax bills trade at lower yields and higher
prices relative to nearby bills suggesting the convenience value is priced.20
While possessing no special payment dates, deliverable bills appear
also to have special value. Deliverable bills are those that are deliverable
against the Treasury bill futures contract on the IMM. The underlying
instrument of the Treasury bill futures contract is a 3-month (13-week)
Treasury bill with a face value of $1 million. The short or seller of this
contract agrees to deliver to the buyer at the settlement date a Treasury
bill with 13 weeks remaining to maturity and a face value of $1 million.
The Treasury bill delivered can be newly issued or seasoned (e.g., a 26-
week bill that has 13-weeks remaining to maturity on the contract™s set-
tlement date). Deliverable bills are usually expensive to the Treasury bill
curve prior to the settlement of the futures contract against which it is

See, Paul Bennett, Kenneth Garbade, and John Kambhu, “Enhancing the Liquidity
of U.S. Treasury Securities in an Era of Surpluses,” FRBNY Economic Policy Re-
view, forthcoming.
See Garbade, Fixed Income Analytics. Garbade finds that “month-end” bills trade
cheap to the bill curve but the effect is much smaller.

Agency Instruments

.S. government agency securities can be classi¬ed by the type of
U issuer”those issued by federal agencies and those issued by govern-
ment sponsored enterprises. Moreover, U.S. government agencies that
provide credit for the housing market issue two types of securities: deben-
tures and mortgage-backed/asset-backed securities. Our focus in this
chapter is on debentures. We discuss short-term mortgage-backed securi-
ties and asset-backed securities in Chapters 9 and 10, respectively.
Federal agencies are fully owned by the U.S. government and have been
authorized to issue securities directly in the marketplace. They include the
Export-Import Bank of the United States, the Tennessee Valley Authority
(TVA), the Commodity Credit Corporation, the Farmers Housing Adminis-
tration, the General Services Administration, the Government National
Mortgage Association, the Maritime Administration, the Private Export
Funding Corporation, the Rural Electri¬cation Administration, the Rural
Telephone Bank, the Small Business Administration, and the Washington
Metropolitan Area Transit Authority. The only federal agency that is an
active issuer of short-term debt obligations is the TVA. With the exception
of securities of the Tennessee Valley Authority and the Private Export
Funding Corporation, the securities are backed by the full faith and credit
of the United States government. Interest income on securities issued by
federally related institutions is exempt from state and local income taxes.
Government sponsored enterprises (GSEs) are privately owned,
publicly chartered entities. They were created by Congress to reduce the
cost of capital for certain borrowing sectors of the economy deemed to
be important enough to warrant assistance. The entities in these privi-
leged sectors include farmers, homeowners, and students. GSEs issue
securities directly in the marketplace. Today there are six GSEs that cur-
rently issue debentures: Federal National Mortgage Association, Federal
Home Loan Mortgage Corporation, Federal Agricultural Mortgage

Corporation, Federal Farm Credit System, Federal Home Loan Bank
System, and Student Loan Marketing Association. The interest earned
on obligations of the Federal Home Loan Bank System, the Federal
Farm Credit System, and the Student Loan Marketing Association are
exempt from state and local income taxes.
Although there are differences between federal agency and GSEs, it
is common to refer to the securities issued by these entities as U.S.
agency securities or, simply, agency securities. In this chapter we will dis-
cuss the short-term debt obligations issued by the six GSEs and the TVA.
Exhibit 4.1 presents a graph of the short-term debt obligations of six of
the entities discussed in this chapter for the time period 1990“2000.
(The Federal Agricultural Mortgage Corporation is not included.)
Note that all of the securities issued by these entities expose an
investor to credit risk. Consequently, agency securities offer a higher
yield than comparable maturity Treasury securities. Nevertheless,
agency securities are considered to be safer than all other ¬xed-income
investments except U.S. Treasuries because of the strong fundamentals
of their underlying businesses and because of the agencies™ government
af¬liation. Several of the agencies have authority to borrow directly
from the U.S. Treasury. Additionally, there is a perception among inves-
tors that the government implicitly backs the agency issues and would
be reluctant to let an agency default on its obligations. Agency issuers
are also attractive to some investors because their interest income is
exempt from state and local taxation for many of the issuers (it is not
exempt for Fannie Mae, Freddie Mac or Farmer Mac issues.)

EXHIBIT 4.1 Short-Term Agency Debt Issuance*

* The Bond Market Association is the source of the data for constructing the exhibit.
Agency Instruments

The Federal National Mortgage Association (“Fannie Mae”) is a GSE
chartered by the Congress of the United States in 1938 to develop a sec-
ondary market for residential mortgages. Fannie Mae buys home loans
from banks and other mortgage lenders in the primary market and
either holds the mortgages until they mature or issues securities backed
by pools of these mortgages. In addition to promoting a liquid second-
ary market for mortgages, Fannie Mae is charged with providing access
to mortgage ¬nance for low-income families and underserved segments
of the economy. Fannie Mae™s housing mission is overseen by the U.S.
Department of Housing and Urban Development (HUD), and its safety
and soundness is overseen by the Of¬ce of Federal Housing Enterprise
Oversight (OFHEO). Although it is controversial, Fannie Mae main-
tains a direct line of credit with the U.S. Treasury.

Discount Notes
Fannie Mae issues short-term debt for following three reasons: (1) to fund
purchases of mortgages; (2) to raise working capital; and (3) for asset-lia-
bility management purposes. Fannie Mae issued $782.95 billion in dis-
count notes in 2000 and $512.53 billion in the ¬rst half of 2001.
Discount notes are unsecured general obligations issued at a discount
from their face value and mature at their face value. They are issued in
book-entry form through the Federal Reserve banks. Discount notes have
original maturities that range from overnight to 360 days with the excep-
tion of 3-, 6-month, and 1-year maturities. These maturities are available
through Fannie Mae™s Benchmark Bills® program discussed shortly.
Discount notes are offered every business day via daily posting by
Fannie Mae™s selling group of discount note dealers. Exhibit 4.2 lists the
Fannie Mae discount note dealers as of October 2000. These dealer
¬rms make a market in these discount notes and the secondary market is
well-developed. Investors may choose among cash-, regular-, or skip-
day settlements.

Benchmark Bills
Fannie Mae introduced the Benchmark Bills® program in early November
1999 as an important component of its discount note program. Bench-
mark Bills, like discount notes, are unsecured general obligations issued
in book-entry form as discount instruments and are payable at par on
their maturity date. However, unlike discount notes, Benchmark Bills are
issued at regularly scheduled weekly auctions where the size of the issu-
ance is announced in advance. When the program was launched, Bench-

mark Bills were issued in two maturities”3-month and 6-month. In
October 2000, Fannie Mae introduced a one year (360 days) that are auc-
tioned every two weeks.1
Fannie Mae announces the size of each weekly auction on Tuesday
sometime during mid-morning Eastern time. The amount of securities
offered for sale at each auction for 3-month Benchmark Bills is $4 to $8
billion, for 6-month maturities $1.5 to $4 billion and for one-year matu-
rities a minimum of $1 billion. Fannie Mae issued $334 billion of Bench-
mark Bills in 2000 and $237.86 billion in ¬rst six months of 2001.
Exhibit 4.3 presents a Bloomberg news report from September 18,
2001 of a Fannie Mae auction announcement of 3- and 6-month Bench-
mark Bills. The auction itself is conducted on Wednesdays. Fannie Mae
accepts bids from a subset of eight of the dealers from its Selling Group
of Discount Note Dealers.2 These eight dealers (called ACCESS dealers)
can submit bids on their own account or on behalf of their customers.
The bids may be either competitive or non-competitive. The minimum
bid size is $50,000 with additional increments of $1,000. Moreover,
bidding dealers are subject to a 35% takedown rule. A takedown rule
limits the amount a single buyer can bid on or hold to 35% of the total
auction amount.

EXHIBIT 4.2 Fannie Mae Discount Note Dealers

Banc of America Securities, LLC Morgan Stanley & Co. Inc.
Banc One Capital Markets, Inc. Myerberg & Company, L.P.
Berean Capital, Inc. Ormes Capital Markets, Inc.
Blaylock & Partners, L.P. Pryor, McClendon, Counts & Co., Inc.
Credit Suisse First Boston Corp. Redwood Securities Group, Inc.
Deutsche Bank Securities Inc. Robert Van Securities
Fuji Securities Inc. Salomon Smith Barney Inc.
Gardner Rich & Company Siebert, Branford, Shank & Co., LLC
Goldman, Sachs & Co. SBK-Brooks Investment Corp.
HSBC Securities (USA) Inc. UBS Warburg LLC
Jackson Securities, Inc. Utendahl Capital Partners, L.P.
J.P. Morgan Securities Inc. Walton Johnson & Company
Lehman Brothers Inc. The Williams Capital Group, L.P.
Merrill Lynch Government Securities,

Source: Fannie Mae
One-year Benchmark Bills mature 360 days from issuance or the first available
business day if a weekend day or a holiday occurs 360 days from issuance.
Non-ACCESS dealers may bid in auctions only on behalf of their customers.
Agency Instruments

EXHIBIT 4.3 Bloomberg Announcement for a Fannie Mae Benchmark Bill Auction

Source: Bloomberg Financial Markets

Bids are submitted in the form of yields on a bank discount basis
out to three decimal points and are accepted between 8:30 a.m. and
9:30 a.m Eastern time. The submitted bids are ranked from lowest to
highest. As noted previously, this is equivalent to arranging the bids
from highest price to the lowest price. Starting from the lowest yield
bid, all competitive bids are accepted until the amount to be distributed
to the competitive bidders is completely allocated.3 The highest accepted
bid is called the stop out discount rate and all accepted bids are ¬lled at
this price (i.e., a single price auction). Exhibit 4.4 presents a Bloomberg
news report of the results of a September 19, 2001 auction of 3-month
and 6-month Benchmark Bills. Non-competitive bids are also executed
at the stop out discount rate and are allocated on the basis of when the
bids were received (i.e., ¬rst-come, ¬rst-serve).
Although the Benchmark Bills program is a subset of their well-
established discount notes program, Fannie Mae has taken steps such
that the two programs do not interfere with one another. Speci¬cally,

The total amount of each auction that can be distributed through non-competitive
bids is limited to 20%.

Fannie Mae does not issue discount notes in any given week with a
maturity date within one week on either side of a Benchmark Bill™s
maturity date. For example, in a particular week, Fannie Mae will not
issue a discount note with a maturity between two months, three weeks
to three months, one week. The maturity lockout is in effect for 6-
month and 1-year Benchmark Bills as well. However, the two programs
are also complementary in that a 3-month Benchmark Bill with two
months until maturity may be “reopened” as a 2-month discount note
with the same maturity date and CUSIP as the bill.
Exhibit 4.5 presents a Bloomberg DES (security description) screen
for a 1-year Benchmark Bill issued on August 28, 2001 and matures on
August 23, 2001. As can be seen from the “ISSUE SIZE” box in the cen-
ter of the screen, $2 billion of these securities were issued. Further, the
minimum face value is $1,000. The day count convention”like virtually
every security discussed in this book”is Actual/360.

EXHIBIT 4.4 Bloomberg Announcement of
Fannie Mae Benchmark Bill Auction Results

Source: Bloomberg Financial Markets
Agency Instruments

EXHIBIT 4.5 Bloomberg security Description Screen of a
Fannie Mae Benchmark Bill

Source: Bloomberg Financial Markets

Benchmark Bills trade at a spread over comparable maturity U.S.
Treasury Bills due to the modicum of credit risk that investors to which
Fannie Mae debt investors are exposed. Exhibit 4.6 presents some sum-
mary statistics of daily 3-month, 6-month, and 1-year Benchmark Bill
yield spreads versus comparable maturity U.S. Treasury Bills for the
period August 1, 2000 through July 20, 2001. We present the mean, stan-
dard deviation, minimum and maximum. Panels a, b and c of Exhibit 4.7
presents a time series plot of 3-month, 6-month, and 1-year yield spreads,
respectively for the same time period. Note that the yield spreads spike
the last week of December 2000. This phenomenon is due to unwilling-
ness of money managers to hold spread product around the calendar turn.
Instead, for annual reporting purposes, they increase their holdings of
U.S. Treasury bills. Moreover, U.S. Treasury bills that mature at the end
of a quarter or at the end of the year trade at a higher price and corre-
spondingly offer a lower yield relative to the Treasury bill curve.4
See, Robin Grieves, Steven V. Mann, Alan J. Marcus, and Pradipkumar Ramanlal,
“Riding the Bill Curve,” The Journal of Portfolio Management (Spring 1999), pp.

EXHIBIT 4.6 Summary Statistics of the Yield Between Benchmark Bills versus
U.S. Treasury Bill Yields

3-Month 6-Month 1-Year
Statistic Yield Spread Yield Spread Yield Spread

Mean 31.307 26.984 37.528
Standard Deviation 13.627 9.626 10.381
Minimum 2.036 6.731 16.552
Maximum 98.504 58.709 77.686

EXHIBIT 4.7 Time Series of Benchmark Bill Spreads

a. 3-Month Benchmark Bill Spread

b. 6-Month Benchmark Bill Spread
Agency Instruments

EXHIBIT 4.7 (Continued):
c. 1-Year Benchmark Bill Spread

The Federal Home Loan Mortgage Corporation (“Freddie Mac”) is a
GSE chartered by the Congress of the United States in 1970 to improve
the liquidity of the secondary mortgage market. Freddie Mac purchases
mortgage loans from individual lenders and either sells securities backed
by the mortgages to investors or holds the mortgages until maturity. Like
Fannie Mae, Freddie Mac is similarly charged with providing access to
mortgage ¬nance for low-income families and underserved populations.
Also like Fannie Mae, Freddie Mac is regulated by HUD for its housing
mission and by OFHEO for safety/soundness issues. Freddie Mac main-
tains a direct line of credit with the U.S. Treasury.

Discount Notes
In 2000, Freddie Mac issued $2.076 trillion in discount notes. While at
issuance these notes can range in maturity from overnight to 365 days,
half of these notes have maturities of three days or less. The most popular
maturities are one month and three months. Freddie Mac discount notes
are offered for sale continuously with rates posted 24 hours a day (busi-
ness days) through a group of investment banks that belong to the Fred-
die Mac dealer group. These notes are issued in book entry form through
the Federal Reserve Bank of New York and a minimum face value of
$1,000 with increments of $1,000 thereafter. The pricing conventions are
the same as U.S. Treasury bills.

Reference Bills
Freddie Mac™s Reference Bills® program was announced November 17,
1999. The program is similar in structure to Fannie Mae™s Benchmark
Bills. One important difference between the two is that Reference Bills®
are offered in more maturities namely, one month (28 days), two
months (56 days), three months (91 days), six months (182 days), and
one year (364 days).
Like U.S. Treasury bills and Benchmark Bills, Reference Bills are sold
weekly using a Dutch auction. 1-month and 2-month Reference Bills are
auctioned each week on Monday, while 3-month maturities are auctioned
weekly on Tuesday. The 6-month and 1-year Reference Bills are auctioned
every four weeks on Tuesday on an alternating schedule such that every
two weeks either a 6-month or a 1-year maturity will be auctioned. In
order to give their investors ¬‚exibility, Freddie Mac offers multiple settle-
ment dates. For Reference bills auctioned on Mondays, investors may
choose between cash and regular settlement dates. For those auctioned on
Tuesdays, investors may choose between cash, regular, and skip-day settle-
ment dates. Auctions of Reference Bills are announced on Thursday for the
following week and have a minimum size of $1 billion.
Exhibit 4.8 presents a Bloomberg DES (Security Description) of a 3-
month Reference Bill that was auctioned on September 11, 2001 and
matures on September 25, 2001. Exhibit 4.9 presents YA (Discount/
Yield Analysis). Note the yield on a bank discount basis for this Refer-
ence Bill is 2.28154. Given the yield on a bank discount basis, the price
is found the same way as the price of a Treasury bill in Chapter 3 by
¬rst solving for the dollar discount (D) as follows:

D = Yd — F — (t /360)

Yd = discount yield
F = face value
t = number of days until maturity
The price is then

price = F ’ D

With a settlement day of September 20, 2001, the Reference Bill has
63 days remaining until maturity. Assuming a face value of $100 and a
yield on bank discount basis of 2.28154%, D is equal to

D = 0.0228154 — $100 — (84/360) = $0.532359
Agency Instruments

EXHIBIT 4.8 Bloomberg Security Description Screen of a
Freddie Mac Reference Bill

Source: Bloomberg Financial Markets


price = $100 ’ $0.532359 = $99.467641

This calculation agrees with the price displayed in the box on the upper
left-hand side of the screen in Exhibit 4.9.
Also in the Exhibit 4.9 are various yield calculations located in a
box on the left-hand side of the screen. The CD equivalent yield (also
called money market equivalent yield) makes the quoted yield on a bank
discount basis more comparable on other money market instruments
that pay interest on a 360-day basis. Recall, the formula for the CD
equivalent yield is

360Y d
CD equivalent yield = -----------------------------
360 “ t ( Y d )

The notation is the same as above.

EXHIBIT 4.9 Bloomberg Yield Analysis Screen for a Freddie Mac Reference Bill

Source: Bloomberg Financial Markets

To illustrate the calculation of the CD equivalent yield, once again we
use the information from Exhibit 4.9. The yield on a bank discount basis
is 2.28154%. The CD equivalent yield is computed as follows:

360 ( 0.0228154 )
CD equivalent yield = ------------------------------------------------------- = 0.02294 = 2.294%
360 “ 84 ( 0.0228154 )

This calculation agrees with the yield presented in the screen.
Just above the CD yield is simple interest. Simple interest is the ratio
of the cash ¬‚ow to be received from holding the security until maturity
(i.e., the discount) to the security™s price annualized on the basis of a 360-
day year. Recall from Chapter 2, the simple interest formula is simply

Simple Interest ( ACT „ 360 ) = ----------- — ( 360 „ t )

To illustrate the calculation, let™s us continue to use the Reference Bill
in Exhibit 4.9. The simple interest (ACT/360) is computed as follows:
Agency Instruments

Simple Interest ( ACT „ 360 ) = --------------------------- — ( 360 „ 84 ) = 2.294%

This calculation agrees with the one presented in the screen.
Another frequently used is called the bond-equivalent yield. As dis-
cussed in Chapter 3, this yield measure makes a yield quoted on a bank
discount basis more comparable to yields on coupon Treasuries that use
an actual/actual day count convention. Recall, the calculation of a bond
equivalent yield depends on whether the discount instrument has 182
days or less to maturity or more than 182 days. If the maturity is 182
days or less, the calculation of the bond-equivalent yield is very straight-
forward (see Chapter 3). Let™s tackle the more involved case and consider
a Reference Bill that has a maturity longer than 182 days.
As discussed in Chapter 3, when a discount instrument like a Reference
Bill has a current maturity of more than 182 days, converting a yield on a
bank discount basis into a bond-equivalent yield is more involved. Speci¬-
cally, the calculation must re¬‚ect the fact that a Reference Bill does deliver
cash ¬‚ows prior to maturity while a coupon bond delivers coupon pay-
ments semiannually and the semiannual coupon payment can be reinvested.
As an example, let™s use a 1-year Reference Bill. Exhibit 4.10 presents
a Bloomberg YA screen for this Reference Bill issued on September 12,
2001. The price of this bill is 97.5271 (per $100 of face value). This bill
matures on September 12, 2002 so as of September 20, 2001 (settlement
date) there are 357 days to maturity. Since the year 2002 is a non-leap
year, T = 365. Substituting this information in the expression above gives
the bond-equivalent yield for this 1-year Reference Bill:

“ 2 — 357 + 2 « 357 2 “ « 2 — 357 “ 1 — « 1 “ --------------------  ¹ ‚‚ 100 -
- -------------------
----------------------  365  365  97.5271
BEY = ------------------------------------------------------------------------------------------------------------------------------------------------
2 — 357 “ 1
= 0.02577 = 2.577%

The Federal Home Loan Bank System (“FHLBank System”) is a GSE cre-
ated by the U.S. Congress in 1932 whose mission is to support residential
mortgage lending and related community investment through its member
¬nancial institutions. The System provides member institutions with access
to low-cost funding, technical assistance, and special affordable housing

programs. As of mid-year 2001, member institutions numbered 7,822,
including 5,702 commercial banks, 1,536 thrifts, 530 credit unions, and
54 insurance companies, with collective assets just short of $4.5 trillion.
The System consists of 12 federally chartered, member-owned Federal
Home Loan Banks. Each regional Federal Home Loan Bank is an individ-
ual corporate entity that does not receive any taxpayer assistance. How-
ever, the FHLBank System maintains a direct line of credit with the U.S.
Treasury. The Federal Housing Finance Board regulates the FHLBank Sys-
tem regarding its mission as well as safety/soundness issues.

Discount Notes
The FHLBank System issued $861 billion in discount notes in 2000 and
$494 billion in the ¬rst six months of 2001. Like the other discount notes
discussed earlier, these securities are unsecured general obligations sold at
a discount from par and mature at their face value. Minimum face values
are $100,000 with additional increments of $1,000. The maturities range
from overnight to 360 days. FHLBank System discount notes are gener-
ally offered for sale on a continuous basis generally by one or more of the
following ways: (1) auction; (2) sale to dealers as principal; and (3) allo-
cation to selected dealers as agent in accordance with FHLBank System
procedures for reoffering the notes to investors.

EXHIBIT 4.10 Bloomberg Yield Analysis Screen for a Freddie Mac Reference Bill

Source: Bloomberg Financial Markets
Agency Instruments

EXHIBIT 4.11 Bloomberg Announcement of the
Federal Home Loan Banks™ Discount Note Offerings

Source: Bloomberg Financial Markets

Exhibit 4.11 presents information provided by the FHLBank System
and conveyed to investors on Bloomberg about their discount note pro-
gram. This screen includes the maturity, rate, and target amount to be

The Federal Farm Credit System (FFCS) established by Congress in 1916
is the oldest GSE. Its mission is to provide a steady source of low-cost
credit to the U.S. agricultural sector. The FFCS lends money to farmers
through a network of borrower-owned ¬nancial institutions and related
service organizations. Six Farm Credit Banks and one Agricultural Credit
Bank make direct long-term real estate loans to farmers through 32 Fed-
eral Land Bank Associations. The banks also provide loan funds to vari-
ous credit associations, which in turn make short-, intermediate-, and
long-term loans to farmers. The FFCS is regulated by the Farm Credit
Administration. Unlike the agencies discussed to this point, the FFCS does
not maintain a direct line of credit with the U.S. Treasury.

EXHIBIT 4.12 Bloomberg Security Description Screen of a Federal Farm Credit
System Security

Source: Bloomberg Financial Markets

Discount Notes
Under the Farm Credit Act, the FFCS issues debt through the Federal
Farm Credit Banks Funding Corporation that serves as the FFCS™s ¬scal
agent. The Funding Corporation currently issues Systemwide Bonds, Dis-
count Notes, Master Notes, and Global Debt Securities. The discount
notes are unsecured, joint obligations of the FFCS. As of January 31,
2001, the FFCS had $19.7 billion in discount notes outstanding. By
statue, the FFCS is currently authorized to have up to $25 billion in
aggregate par amount of discount notes outstanding at any one time.
Maturities range from overnight to 365 days with the majority having
maturities of less than 90 days. Minimum face values are $5,000 and then
in $1,000 increments. All discount notes have cash settlement.

Interest at Maturity Securities
The FFCS also issues short-term securities with maturities less than one
year that are issued at par and pay interest at maturity. Exhibit 4.12 pre-
sents a Bloomberg DES (Security Description) screen for an interest at
maturity security that looks much like the CDs discussed in Chapter 6.
Agency Instruments

This security was issued by the FFCS on August 1, 2001 and matured on
November 1, 2001. Note that unlike most of securities discussed in this
book, the day count convention is 30/360.
On the issuance date August 1, 2001, the yield on this security was
3.52% as can be seen from the upper left-hand side of the screen.
Accordingly, the interest at maturity is determined by multiplying the
face value, the yield at issuance, and the fraction of a year using a 30/
360 day count convention. With the 30/360 day count, all months are
assumed to have 30 days and all years are assumed to have 360 days.
There are 90 days between August 1, 2001 and November 1, 2001 using
a 30/360 day count convention.5
The interest at maturity is computed as follows assuming a $1 million
face value:

$1,000,000 — 0.0352 — (90/360) = $8,800

Exhibit 4.13 presents a Bloomberg Yield Analysis (YA) screen for this
security. Suppose a $1,000,000 face value is purchased with a settlement
day of September 21, 2001 for the full price (i.e., ¬‚at price plus accrued
interest) of $1,006,150.03 as can be seen from the “PAYMENT
INVOICE” box on the right-hand side of the screen. We know the investor
receives $1,008,800 at maturity, so the if buyer holds the security until
maturity, she will receive the difference of $2,649.97. This calculation
agrees with the “GROSS PROFIT” on the right-hand side of the screen.
A yield calculation which may require some explanation is labelled
“DISCOUNT EQUIVALENT” in Exhibit 4.13. This security is similar to a
discount security in that the security does not pay a cash ¬‚ow until matu-
rity. The discount equivalent yield puts discount notes which are quoted
on a bank discount basis and interest at maturity securities on the same
basis. Namely, suppose the face value of the security is $1,008,800 and the
security full price™s is $1,006,150.03. What is the yield on the bank dis-
count basis? To see this, recall the formula for the dollar discount (D):

D = Yd — F — (t/360)

Yd = discount yield
F = face value
t = number of days until maturity
The number of days between two dates using a 30/360 day count convention will
usually differ from the actual number of days between the two dates. In this case,
there 92 actual days between the two dates.

EXHIBIT 4.13 Bloomberg Yield Analysis Screen of a
Federal Farm Credit System Security

Source: Bloomberg Financial Markets

In this case, the face value is $1,008,800, the dollar discount is
$2,649.97, and the actual number of days until maturity is 41 since dis-
count securities use an Actual/360 day count convention. Inserting these
numbers into the formula gives us:

$2,649.97 = Yd — $1,008,800 — (41/360)

Solving for Yd gives us:

Yd = 0.02306504 = 2.306504%

The calculation agrees with the yield calculation displayed in the “YIELD
CALCULATIONS” box on the left-hand side of the screen in Exhibit 4.13.

The Federal Agricultural Mortgage Corporation (“Farmer Mac”) is a GSE
created by Congress in 1988 whose mission is to attract capital for the
Agency Instruments

¬nancing of agricultural real estate and to promote a liquid secondary mar-
ket for agricultural loans. This is accomplished by buying quali¬ed loans
from lenders (e.g., mortgage companies, savings institutions, credit unions,
commercial banks, etc.) and combining the loans into pools against which
Farmer Mac issues securities backed by these loans. Accordingly, Farmer
Mac performs a role for the agricultural mortgage market that mirrors
what Fannie Mae and Freddie Mac do for the residential mortgage market.
Farmer Mac maintains a direct line of credit with the U.S. Treasury.
On December 31, 2000, Farmer Mac had 2.201 billion dollars of
debt that was due within one year. The majority of this short-term debt is
discount notes. Discount notes are unsecured general obligation securities
that are issued in book-entry form through the Federal Reserve Banks.
Farmer Mac uses discount notes to meet short-term funding needs. The
maturities range from overnight to 365 days and are offered on a contin-
uous basis. Farmer Mac discount notes are available with cash-, regular-,
and skip-day settlement dates.
Exhibit 4.14 presents a Bloomberg DES (Security Description) for a
Farmer Mac discount note that was issued on October 24, 2000 and
matured on October 24, 2001. The maturity for Farmer Mac discount
notes will always fall on a business day. As can be seen in the “ISSUE
SIZE” box in bottom center of the screen, the minimum face value is
$1,000 with additional increments of $1,000 thereafter.

EXHIBIT 4.14 Bloomberg Security Description Screen of a Farmer Mac Discount Note

Source: Bloomberg Financial Markets

EXHIBIT 4.15 Bloomberg Yield Analysis Screen of a Farmer Mac Discount Note

Source: Bloomberg Financial Markets

Exhibit 4.15 is a Bloomberg YA (Yield Analysis) screen for the same
Farmer Mac discount note. From this screen, we see that the discount
yield is 2.28516% that corresponds to a price of 99.784179 (per $100 of
face value) with settlement on September 20, 2001. From the “CASH-
FLOW ANALYSIS” box on the right-hand side of the screen, it can be
seen that an investor can purchase $1 million face value package of notes
that mature on October 24, 2001 for $997,841.79. The interest income
of $2,158.21 is fully taxable at the federal, state, and local levels.

The Student Loan Marketing Association (“Sallie Mae”) is a GSE estab-
lished by Congress in 1972 to increase the availability of student loans.
Sallie Mae purchases from lenders guaranteed student loans originated
under the Federal Family Education Loan Program (FFELP) and corre-
spondingly makes loans to lenders secured by student loans. Of the
approximately $25 billion loaned to students annually, about 70% are
provided by private lenders under the FFELP.
Agency Instruments

EXHIBIT 4.16 Bloomberg Security Description Screen of a
Sallie Mae Callable Security

Source: Bloomberg Financial Markets

Sallie Mae is a subsidiary of USA Education, Inc. (formerly SLM
Holdings). In September 1996, legislation was passed such that Sallie
Mae™s GSE status will be phased out by September 30, 2008 and it will
be fully privatized. Unitl its GSE status terminates, Sallie Mae maintains
a direct line of credit with the U.S. Treasury. Moreover, Sallie Mae is
under the regulatory aegis of the U.S. Treasury speci¬cally, the Of¬ce of
Sallie Mae Oversight.
Sallie Mae generally funds its student loan portfolio by issuing ¬‚oat-
ing-rate debt either tied to the 91-day U.S. Treasury bill rate or to a
lesser extent 3-month LIBOR. These ¬‚oating-rate securities will be dis-
cussed in Chapter 7. In addition, Sallie Mae has an active discount note
program with $6.274 billion in discount notes outstanding as of Decem-
ber 31, 2000. Finally, Sallie Mae issues short-term interest at maturity
securities that are also callable. Exhibit 4.16 presents a Bloomberg DES
screen for Sallie Mae interest at maturity security that was issued on
August 2, 2001 that matures on July 23, 2002. The security is callable
at par on October 23, 2001, approximately three months after issuance.

The Tennessee Valley Authority (TVA) is a wholly-owned corporate
agency and instrumentality of the U.S. government. The TVA was estab-
lished in 1933 as part of President Franklin Roosevelt™s New Deal Pro-
gram to promote development of the Tennessee River and adjacent
areas. Speci¬cally, TVA manages the river system for ¬‚ood control, nav-
igation, power generation, and other purposes. TVA is the largest pro-
ducer of electricity in the U.S. Like the other agencies discussed in this
chapter, TVA has the authority to borrow from the U.S. Treasury. In
particular, TVA may borrow from the U.S. Treasury up to $150 million
for a period of one year or less. However, unlike the other agencies dis-
cussed previously, TVA™s borrowing authority is part of the federal gov-
ernment™s budget.
TVA™s discount note program is structured similarly to those
described above. There are a few differences nonetheless. First, the face
value of TVA™s discount notes is $100,000 and additional increments of
$1,000 thereafter. Second, interest on these securities is exempt from state
and local taxes except estate, inheritance, and gift taxes. Third, regula-
tions stipulate that TVA™s outstanding short-term debt shall not exceed
$5.5 billion at any one time.

Corporate Obligations:
Commercial Paper and
Medium-Term Notes

corporation that needs long-term funds can raise those funds in
A either the bond or equity markets. Alternatively, if a corporation
needs short-term funds, it may attempt to acquire funds via bank bor-
rowing. One close substitute to bank borrowing for larger corporations
with strong credit ratings is commercial paper. Commercial paper is a
short-term promissory note issued in the open market as an obligation
of the issuing entity. Commercial paper is sold at a discount and pays
face value at maturity. The discount represents interest to the investor in
the period to maturity. Although some issues are in registered form,
commercial paper is typically issued in bearer form.
The commercial paper market was developed in the United States in
the latter days of the nineteenth century and was once the province of
larger corporations with superior credit ratings.However, in recent years,
many lower-credit-rated corporations have issued commercial paper by
obtaining credit enhancements or other collateral to allow them to enter
the market as issuers. Issuers of commercial paper are not limited to U.S.
corporations; foreign corporations and sovereign issuers also issue com-
mercial paper. Commercial paper was ¬rst issued in the United Kingdom
in 1986 and was subsequently issued in other European countries.
Although the original purpose of commercial paper was to provide
short-term funds for seasonal and working capital needs, it has been
issued for other purposes, most prominently for “bridge ¬nancing.” For
example, suppose that a corporation desires long-term funds to build a
plant or acquire equipment. Rather than raising long-term funds immedi-

ately, the issuer may choose to postpone the offering until more favorable
capital market conditions prevail. The funds raised by issuing commercial
paper are employed until longer-term securities are issued. Commercial
paper is also used as bridge ¬nancing to ¬nance corporate takeovers.

The maturity of commercial paper is typically less than 270 days; a typi-
cal issue matures in less than 45 days. Naturally, there are reasons for
this. First, the Securities and Exchange Act of 1933 requires that securi-
ties be registered with the Securities and Exchange Commission (SEC).
Special provisions in the 1933 act exempt commercial paper from these
registration requirements so long as the maturity does not exceed 270
days. To avoid the costs associated with registering issues with the SEC,
issuers rarely issue commercial paper with a maturity exceeding 270 days.
In Europe, commercial paper maturities range between 2-365 days. To
pay off holders of maturing paper, issuers generally “rollover” outstand-
ing issues; that is, they issue new paper to pay off maturing paper.
Another consideration in determining the maturity is whether the
paper would be eligible collateral by a bank if it wanted to borrow from
the Federal Reserve Bank™s discount window. In order to be eligible, the
paper™s maturity may not exceed 90 days. Because eligible paper trades at
a lower cost than paper that is ineligible, issuers prefer to sell paper
whose maturity does not exceed 90 days.
The combination of its short maturity and low credit risk make com-
mercial paper an ideal investment vehicle for short-term funds. Most
investors in commercial paper are institutional investors. Money market
mutual funds are the largest single investor of commercial paper. Pension
funds, commercial bank trust departments, state and local governments,
and non¬nancial corporations seeking short-term investments comprise
most of the balance.
The market for commercial paper is a wholesale market and transac-
tions are typically sizeable. The minimum round-lot transaction is
$100,000. Some issuers will sell commercial paper in denominations of
Commercial paper is the largest segment of money market exceeding
even U.S. Treasury bills with just over $1.5 billion in commercial paper
outstanding at the end of April 2001. Exhibit 5.1 presents a monthly time
series of the amount of commercial paper outstanding for the period Jan-
uary 1991 through April 2001. The source of these data is the Federal
Reserve. The Federal Reserve Bank of New York collects the data on the
Medium-Term Notes

amount of commercial paper outstanding from 16 commercial paper
dealers and 43 ¬rms that sell commercial paper directly to investors on
forms FR 2957a and b. The Federal Reserve Bank of New York also col-
lects, seasonally adjusts, and releases month-end data on outstanding
commercial paper from the same respondents.

Direct Paper versus Dealer Paper
Commercial paper is classi¬ed as either direct paper or dealer paper.
Direct paper is sold by an issuing ¬rm directly to investors without using
a securities dealer as an intermediary. The vast majority of the issuers of
direct paper are ¬nancial ¬rms. Because ¬nancial ¬rms require a continu-
ous source of funds in order to provide loans to customers, they ¬nd it
cost effective to have a sales force to sell their commercial paper directly
to investors. Direct issuers post rates at which they are willing to sell com-
mercial paper with ¬nancial information vendors such as Bloomberg,
Reuters, and Telerate.
Although commercial paper is a short-term security, it is issued
within a longer term program, usually for three to ¬ve years for Euro-
pean ¬rms: U.S. commercial paper programs are often open-ended. For
example, a company might establish a 5-year commercial paper pro-
gram with a limit of $100 million. Once the program is established the
company can issue commercial paper up to this amount. The program is
continuous and new paper can be issued at any time, daily if required.

EXHIBIT 5.1 Commercial Paper Outstanding

Source: Federal Reserve

In the case of dealer placed commercial paper, the issuer uses the ser-
vices of a securities ¬rm to sell its paper. Commercial paper sold in this
manner is referred to as dealer paper. Competitive pressures have forced
dramatic reductions in the underwriting fees charged by dealer ¬rms.
Historically, the dealer market has been dominated by large invest-
ment banking ¬rms because the Glass-Steagall Act prohibited commercial
banks from underwriting commercial paper. In June 1987, however, the
Federal Reserve granted subsidiaries of bank holding companies the
power to underwrite commercial paper. Commercial banks began imme-
diately making inroads into the dealer market that was once the exclusive
province of investment banking ¬rms. This process was further acceler-
ated when the Gramm-Leach-Bliley Act was signed into law in November
1999. The reforms enacted in the Gramm-Leach-Bliley Act repealed the
Glass-Steagall Act that mandated arti¬cial barriers between commercial
banks, investment banks, and insurance companies. Now each is free to
expand into the others™ businesses.

The Secondary Market
Although commercial paper, as noted, is the largest sector of the money
market, there is relatively little trading in the secondary market. The rea-
son being is that most investors in commercial paper follow a “buy and
hold” strategy. This is to be expected because investors purchase com-
mercial paper that matches their speci¬c maturity requirements. Any sec-
ondary market trading is usually concentrated among institutional
investors in a few large, highly rated issues. If investors wish to sell their
commercial paper, they can usually sell it back to the original seller
either dealer or issuer.

All investors in commercial paper are exposed to credit risk. Credit risk is
the possibility the investor will not receive the timely payment of interest
and principal at maturity. While some institutional investors do their own
credit analysis, most investors assess a commercial paper™s credit risk
using ratings by a nationally recognized statistical rating organizations
(NRSROs). The SEC currently designates only Fitch, Moody™s, and Stan-
dard & Poor™s as NRSROs for rating U.S. corporate debt obligations.
Exhibit 5.2 presents the commercial paper ratings from the NRSROs.
The risk that the investor faces is that the borrower will be unable to
issue new paper at maturity. This risk is referred to as rollover risk. As a
safeguard against rollover risk, commercial paper issuers secure backup
Medium-Term Notes

lines of credit sometimes called “liquidity enhancement.” Most commer-
cial issuers maintain 100% backing because the NRSROs that rate com-
mercial paper usually require a bank line of credit as a precondition for a
rating. However, some large issues carry less than 100% backing. Backup
lines of credit typically contain a “material adverse change” provision
that allows the bank to cancel the credit line if the ¬nancial condition of
the issuing ¬rm deteriorates substantially.1
Historically, defaults on commercial paper have been relatively rare.
As of mid-2001, the last default of any consequence occurred on January
31, 1997 when Mercury Finance Co.”a sizeable player in the automobile
lending business”defaulted on $17 million in commercial paper. The


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