LIST OF COMMENTERS responding to the PROPOSED TREASURY INFLATION-INDEXED SECURITIES RULE September 27, 1996 (61 FR 50924) COMMENTERS APEX Investment Associates, Inc. L. Napoleon Cooper Louis Crandall, Wrightson Associates Robert L. Elgin HSBC Securities, Inc. PSA The Bond Market Trade Association Reed Smith Shaw & McClay * * * * * * * * * * COMMENT LETTERS BEGIN HERE. * * * * * * * * * * * APEX Investment Associates, Inc. 4001 West Devon Avenue Chicago, Illinois 60646-4523 September 26, 1996 Ms. Darcy Bradbury Deputy Assistant Secretary for Finance U.S. Department of the Treasury 1500 Pennsylvania Avenue, N.W. Washington, D.C. 20220 Dear Ms. Bradbury: Congratulations - Your "Inflation-Indexed Notes" will be a great success. In fairness to investors, the capital appreciation should be treated as capital gain. If this is not feasible, then the tax on the capital portion should be paid at time of redemption, or sale by the investor. Sincerely, Alexander A. Lothan President APEX Investment Associates, Inc. 4001 West Devon Avenue Chicago, Illinois 60646-4523 CC: Mr. Robert Rubin P.S. In future years, these notes will be considered one of Mr. Rubin's greatest contributions to this administration. * * * * * * * * * * L. Napoleon Cooper 2400 16th Street, N.W., Suite 545 Washington, D.C. 20009 October 23, 1996 Copy for Government Securities Regulations Staff The Honorable Robert E. Rubin, Secretary U.S. Department of the Treasury -- Room 3330 Washington, D.C. 20220 Re: A Formal Petition Calling For the Secretary of the Treasury to Authorize for 1997, Under 31 CFR Part 340 (7-1-95 Edition), An Initial Trial $20-Billion-Par-Amount Issuance of An Additional Inflation-Indexed Federal Security that will Facilitate Seed Capital Formation In the Non-Profit Sector--A Unique New Series of Federal Debt that - Among Its Distinctions Would Mandate A Minimum 50 Basis Points Reduction In Taxpayer Financed Interest Expenses (Versus A Like Amount and Maturity of Conventional Treasury Bonds). And, Subject to A Successful Trial, A Reduction that If Extended Across Our Total National Debt, Would Equal An Annual $25 Billion Federal Budget Cost Savings for Taxpayers Dear Secretary Rubin: Owing entirely to the structure adopted by the Department for its January 15, 1997 issuance of new inflation-protection notes under 31 CFR Part 356 (versus 31 CFR Part 340--the basis of this Petition incorporating our comments concerning that proposed amendment to Part 356); the insurmountable obstacle that that strippable, structure represents for us; and the business, trust indenture and fiduciary responsibilities unique to our not-for- profit entity's existing debt (which must be collateralized by 30 year maturity Treasury obligations), Project 76--An American Affair, Inc., will not be participating with that auction of 10 year I-P Notes, nor with any of the Department's subsequent auctions of other maturities based upon that same I-P security structure. Project 76 may, however, be expected - given no other alternative - to invest in conventional non-indexed 30 year maturity Treasury securities in order to meet its collateral obligation to its creditors. That is, they would comply with its debt's strict indenture requirements. But the structurally suitable conventional Treasury bond's lack of inflation protection will prohibit Project 76's officers and directors from allowing it to offer Treasury the minimum 50 basis points interest expense reduction for U.S. taxpayers that Project 76's purchases of I-P securities would otherwise generate (the fiduciary obstacle). Finally, in this connection, should our request be denied that the issuance of Part 340 inflation-indexed securities be authorized, absent the domestic and virtually unlimited potential taxable investor demand for Part 356 inflation-indexed Treasury securities represented by Project 76's requirement and that of other taxable American investors (a result of the structure already decided upon by the Department for January 15, 1997, Part 356 securities), our Nation's federal budget will be exposed unnecessarily to the risk of potentially massive outflows of U.S. taxpayer funds to foreign governments and other tax-exempt purchasers of U.S. inflation-protection securities without Americans ever receiving the promised and\or justifying benefit of reduced borrowing costs (an important area of likely focus for any post auction Congressional hearings). Accordingly, this Petition is submitted to the Secretary of the Treasury. The 31 CFR Ch.II Part 340 (7-1-95 Edition) (Regulations Governing the Sale of Treasury Bonds Through Competitive Bidding) Authority: Sec. 8, 50 Stat. 48 1, as amended; R.S. 3706; secs. 1, 4, 18, 5, 40 Stat. 288, as amended, 290, as amended, 1309, as amended, 290, as amended; secs. 19, 20, 48 Stat. 343, as amended; 31 U.S.C. 738a, 739, 752, 752a, 753, 754, 754a, 754b. Source: 27 FR 12481, Dec. 18, 1962. Section 340.0 Authority for sale of Treasury bonds through competitive bidding. "(a) The Secretary of the Treasury may, from time to time, by public notice, offer Treasury bonds for sale and invite bids therefor. The bonds so offered and the bids made will be subject to the terms and conditions and the rules and regulations ... set forth [in the CFR], except as they may be modified in the public notice or notices; issued by the Secretary in connection with particular offerings. The bonds will be subject also to the general rules and regulations of the Treasury Department, now or hereafter prescribed, governing United States securities. They will be issued pursuant to the authority of the Second Liberty Bond Act, as amended. (b) The terms public notice, notices, or announcement as used in [Part 340 of the CFR] mean the Public Notice of Invitation to Bid on Treasury bonds and any supplementary or amendatory notices or announcements with respect thereto, including, but not limited to any statement released to the press by the Secretary of the Treasury and notices sent to those who have filed notices of intent to bid or who have filed bids." Section 340.1 Public notice-description of bonds-terms of offer. "When bonds are offered for sale through competitive bidding, bids therefor will be invited through the form of a public notice or notices issued by the Secretary of the Treasury. The notice or notices will either fix the coupon rate of interest to be borne by the bonds or prescribe the conditions under which bidders may specify the late and will set forth the terms and conditions of the bonds, including maturities ... [and] the terms and conditions of the offer, including the amount of the issue for which bids are invited.... This Petition as submitted to the Secretary requests that the Secretary utilize the authority granted him under Chapter 31 of Title 31, United States Code, to authorize an initial minimum $20 billion U.S. trial issuance by the Department for the year 1997 (for the Charitable Bond(Tm) program and for other purposes, including sale to the general public), of additional inflation- protection bonds inclusive of both the structure and maturity specified by the Respondent in his July 31, 1996, letter attached (including related attachments and exhibits), as submitted to the Secretary and to the Government Securities Regulation Staff of the Bureau of the Public Debt, in connection with Treasury's Assistant Secretary for Financial Markets' 31 CFR Part 356, Advanced Notice of Proposed Rulemaking and Request for Comment, concerning Treasury's intention to issue Inflation-Protected federal securities. Further, the Petition requests that the Secretary's initial authorization provide therein, subject only to a successful trial offering of such securities on the terms and conditions approved by the Secretary (including the mandated 50 basis points cost savings for U.S. taxpayers), for a regular schedule for the offering of such securities at whatever level the Secretary may then deem appropriate and in the public interest. And, it incorporates herewith the Respondent's comments concerning the Department's proposed January 15, 1997 issuance of Inflation- Protection Notes under 31 CFR Part 356. Our 31 CFR Part 340 Inflation-Protection Treasury Bond (For an outline of key departures from Treasury's 31 CFR Part 356 version to be auctioned on January 15, 1997, see enclosures.) Finally, we continue to advocate a Department examination of the relevant legal, regulatory and tax issues, as well as a cost- benefit-analysis of the cost to/savings for taxpayers; other public-interest benefits (including Project 76's ability to help facilitate up-to $300 billion in new capital formation over the next decade for pump priming private-non-profit-sector investment in improving: . public education, including public libraries, recreational facilities and the depressed neighborhoods around them, . public broadcasting, including real-time-broadband-satellite telecommunications infrastructure, . and public housing and nutrition assistance); as well as in determining the true potential for measurably expanding the domestic taxable-investor-market for U.S. Treasury securities; as well as in assessing what would be a prudent level of on-going Department oversight of Project 76 and related Charitable Bond(Tm) program activities. Such an examination is in the public interest and should be conducted by the appropriate divisions of the U.S. Department of the Treasury. And, the conclusions you will be able to reach will thereafter, more than justify an accommodation by your office of this Petition calling for an authorization of a trial issuance for the year 1997 of our required inflation-indexed security structure. (To examine a would-be 5.5 percent example of how our requested 30-year maturity inflation-indexed security structure would actually appear in a 6 percent 30-year maturity conventional Treasury bond environment, see the "List of Exhibits" to the attached copy of the July 31, 1996, letter addressed to the Honorable Robert E. Rubin (at Exhibit 1)). Again, we welcome an early meeting with the appropriate authorities of the Department to not only arrive at a thorough understanding of all matters relating to this Petition, but to agree on the array of information, talent and expertise both sides will need to bring to bear to manage successfully the historic challenge before us. May we hear from you or your designate at your earliest convenience? Thank you for your consideration. Sincerely, Enclosures: Comments Concerning Proposed CFR Part 340 Security's Key Departures from Part 356 Version Being Auctioned January 15, 1997 Copy of July 31, 1996, Letter to the Secretary of the Treasury, Including Its List of Exhibits and 11 Exhibits NOTE: ENCLOSURES/EXHIBITS ARE NOT DUPLICATED HEREIN -- THEY WERE PART OF COMMENTER'S SUBMISSION OF JULY 31, 1996, AND CAN BE OBTAINED FROM THE ANPR DOCUMENTATION FILE. ______ PART TWO OF TWO Again, owing entirely to the structure adopted by the Department for its January 15, 1997 issuance of new inflation-protection notes under 31 CFR Part 356 (versus 31 CFR Part 340-the basis of the attached letter\Petition incorporating our comments concerning that proposed amendment to Part 356); the insurmountable obstacle that strippable structure represents for us; and the business, trust indenture and fiduciary responsibilities unique to our not-for-profit entity's existing debt (which must be collateralized by 30 year maturity Treasury obligations), Project 76--An American Affair, Inc., will not be participating with that auction of 10 year I-P Notes, nor with - an of the Department's subsequent auctions of other maturities based upon that same I-P security structure. NOTE: The following comments distinguish the key aspects of the trial issuance of inflation-indexed obligations we have petitioned the Secretary to authorize for issuance and sale during calendar 1997 (under 31 CFR Part 340), from those the Department has announced an intention to auction (under 31 CFR Part 356), effective January 15, 1997. Also, we will have no further comment with respect to whether or not a market currently exists for Treasury's Canadian model 31 CFR Part 356 inflation-protection notes, including, as to whether or not Treasury will be able to achieve through its 31 CFR Part 356 initiative either of its stated objectives: 1) a "50 basis points" or greater reduction in borrowing costs for U.S. taxpayers or 2) a significant expansion of the domestic market for Treasury securities. We, however, do believe that on the merits we can demonstrate that a trial issuance of securities such as we have requested under 31 CFR 340 is in the public, as well as national interest. COMMENT CONTEXT - Again, the following comments are made on behalf of two separate and distinct, yet unopposed interests and, as such, reflect the views and concerns of both entities. Specifically, I am commenting: . first, as an officer of Project 76 - An American Affair, Inc., an exempt entity that has an existing primarily "buy-and-hold" requirement, in connection with collateralizing restructured versions of its own debt, to purchase inflation indexed federal securities such as we have petitioned the Secretary to authorize under Chapter 31 Title 31 of the United States Code (31 CFR 340) (purchases over the next 10 to 15 year period of portfolios of such obligations on virtually any scale the Treasury is interested in issuing them); and, . second, I am commenting as the principal of the for-profit entity that has an existing plan for packaging the restructured and partially collateralized securities of that not-for-profit entity, into two unit-investment-trust-intermediary-product formats, for ultimate distribution to individual and corporate investors, and in a unique tax-advantaged, as well as non-tax- advantaged form (the income from which, "would not receive [or require] special tax treatment requiring a change in current Federal income tax laws"). TOPICS SELECTED FOR COMMENT SCHEDULE - Our proposed trial issuance of inflation-indexed securities under the 31 CFR Part 340 can rely equally well on a quarterly auction as the Department has decided upon for its Canadian model being auctioned under modifications to the 31 CFR at Part 356 on January 15, 1997. A more regular auction may be justified for 1998 and beyond depending upon the results of the requested 1997, $20 billion, initial trial offering (which we hope will commence in the second quarter of 1997, at some point after the regular April offering of conventional 30-year maturity Treasury bonds but before the anticipated April 15 offering of 31 CFR Part 356 Canadian-Model Inflation-protection bonds). STRUCTURE AND INDEX - Our proposed trial issuance of inflation- indexed securities under the CFR Part 340 would be based on a modified, current pay structure where all the inflation compensation and real interest is paid out and\or accrues semiannually. Modified that is, in that our 30 year maturity effectively floating rate security would pay only accrual interest through year 10 and distribute cash interest coupons during years 11 through maturity. For an actual example of this structure, see "List of Exhibits" (at Exhibit 1) to the attached copy of our July 31, 1996, letter to the Secretary. The index to be used to measure inflation for our proposed structure also will be the nonseasonally adjusted Consumer Price Index for all Urban Consumers or the CPI-U. MATURITY - A 30-year bond with coupons (40, beginning in year 11) and a 30 year "zero-coupon" bond. INDEXING METHODOLOGY - For our proposed structure, the inflation component of the coupon's "constant yield" will be adjusted for inflation every six months. The "constant yield" will include both "real" return and inflation compensation components, and be based on the investor's "bid" and initial "cost basis." The initial "real" yield component of the "constant yield" determination will be made by the Secretary based on the then current yield payable on 30 year maturity conventional Treasury bonds (minus no less than 50 basis points). The Secretary's yield announcement will reflect that 50 basis points discount from like maturity conventional Treasury bond yields. The investor's ultimate "constant yield" could reflect more of a discount, depending on actual winning-competitive-bid auction results). The inflation component of the "constant yield" will be adjusted every six months and the initial "real" return component of the "constant yield" will remain constant through maturity. BIDDING RESTRICTIONS - There will be no percentage-of-the-total- offering limitation placed on awards to bidders, so long as the yield bid does not exceed the total yield announced by the Secretary (including the mandated 50 basis points cost savings for U.S. taxpayers). MINIMUM GUARANTEE - NONE. INDEX RATIO - Reference CPI applicable to the original issue date. REFERENCE CPI - Same as inflation-protection Treasury securities to be issued under 31 CFR Part 356. PAYMENT DATES - Adjusted inflation plus real return components will be paid and/or accrue semiannually. STRIPS - N/A That is, due to the unique structure of the coupon components of our proposed 31 CFR Part 340 30 year maturity inflation-indexed obligation, separating or stripping interest from principal cash-flow streams would not be possible or useful to investors. And, subject to the discretion of the Secretary, an ability to separate and trade individual coupon components (including real interest, the inflation compensation and the principal or proportion of the "cost-basis") would be useful (see BOOK-ENTRY SYSTEMS below). TAXATION - The current federal income tax treatment for "original issue discount" securities will apply to the inflation-indexed securities that are the subject of our petition calling for their trial issuance under the 31 CFR Part 340. Otherwise, income from the bonds would not receive special tax treatment requiring a change in current federal income tax laws. AUCTION TECHNIQUE - Multiple-price auction. That is, an auction in which each successful bidder pays the price equivalent to the "constant yield" or rate that it bid (based on that bidders "cost basis" therein). MINIMUMS AND MULTIPLES TO BID, HOLD AND TRANSFER - The minimum to bid, hold and transfer is an original "cost basis" of $1,000. Larger amounts will be multiples of $1,000. BOOK-ENTRY SYSTEMS - 31 CFR Part 340 inflation-indexed securities will be held and transferred in either of two book-entry systems: "TRADES" and "TREASURY DIRECT." The securities will be maintained and transferred at their original "cost basis," not at their value based on inflation-adjusted "constant yield." Individual coupon components, (made up of the real return and inflation-compensation interest components plus the appropriate O.I.D tax regulation determined proportion of the security's "cost-basis") may be maintained and transferred subject to a determination by the Secretary. * * * * * * * * * * * Louis Crandall Wrightson Associates 99 Wall St, 17th Floor New York, NY 10005 October 21, 1996 Topic: Proposed changes in uniform offering circular regarding inflation-protection bonds The Treasury has emphasized its intention to enhance the liquidity of its new index-linked (I/L) bonds by reopening them as often as possible. The fact that stripped coupons from different I/L bonds are not interchangeable makes it extremely important to consolidate I/L debt into as few separate issues as possible. Unfortunately, the Treasury is not always able to reopen bonds as frequently as it would like. The OID tax-code restrictions on deep discounts often prevent reopenings of conventional bonds that would otherwise be desirable. The same may be true for I/L bonds. This will be more problematic for I/L bonds because the importance of consolidating issues is much greater than it is for conventional bonds. The Treasury could address this problem in one of two ways. First, it could relax the OID restrictions for I/L bonds. As a general matter, the Treasury has insisted that the I/L bond program should stand on its own without special concessions from the tax code. Relaxing the OID rules seems a very minor concession, however. An alternative solution would be to make a minor adjustment to the auction procedure. The Treasury currently plans to use the standard single-price auction format, in which the coupon on a newly issued note is rounded down to the next eighth of a percent. This results in an initial price that is always at or below par. If the Treasury rounded the coupon up instead of down, the initial price would always be at or above par. In other words, the new I/L bond would start life that much farther above the OID floor, increasing the odds that it will be a candidate for a reopening in the future. This would make little difference for a 30-year I/L bond, but it would give the Treasury valuable leeway with a 10-year note. The traditional objection to rounding the coupon up rather than down is that investors may end up having to pay more than they anticipate for a security priced above par. Since the Treasury expects to do as many I/L reopenings as possible, it is already prepared to sell these securities at a premium. There is a precedent for rounding coupons up rather than down. I believe that REFCORP coupons in the late 1980s and early 1990s were rounded to the closest eighth of a percent, which led to a mixture of issue prices above and below par. Louis Crandall Wrightson Associates 99 Wall St, 17th Floor New York, NY 10005 * * * * * * * * * * * Bob Elgin 7261 Kingsbury Blvd. St. Louis, MO 63130-4141 October 25, 1996 Mr. Kenneth Papaj Government Securities Regulations Staff Bureau of Public Debt 999 E Street N.W., Room 515 Washington, DC 20239-0001 Dear Sir: Congratulations on your imminent introduction of inflation-protection securities. Having followed the decade-long failure of HUD to institute Price Level Adjusted Mortgages, I realize that your progress has been a real challenge. These comments are too late to be part of your general solicitation of May 20, 1996. These comments are too radical to be germane to your specific proposals of September 27, 1996. These comments are most relevant to your future solicitation about Savings Bonds to be issued in 1998, but can benefit from at least a year's lead time, so I am requesting that they be processed within the current comment period. I have read through the comments that you received last summer and found them most edifying in their breadth and knowledge. However, the majority of them were from "middlemen", who want to reprocess these issues for sale to the general public. There is an inherent conflict of interest here. If you want to minimize the cost to the taxpayer and maximize the benefits to the ultimate purchaser, then you must minimize the profits to the middlemen. If practicable, you want to do away with the middleman altogether. Merrill Lynch, Vanguard, even TIAA, et al are not going to give you the best advice on how to do this! To my great surprise, I did find one commentator who beat me to the punch in his very timely comment last May 17. (Comment Letter 16 in your internet file.) Mr. Roland G. Caldwell of Caldwell Trust Company, Venice, Florida simply suggests: "Next, if you really want to save dollars and give investors protection, simply issue debt without maturities. All debt of the greatest nation on earth should be repayable upon demand; the interest rate paid daily would be set by the marketplace. If you need more money, raise it. If you want to pay some debt off, lower it. As you above all should know, markets are very efficient and can set the rate for you." Perhaps his presentation was too succinct to make any impression, for I see minimal progress towards your oft stated goals of simplicity, ease of understanding, liquidity, reduced risk, and reduced cost to the treasury. At this point, your greatest risk is that this new issue will become a footnote in the history of finance (as the Gilts are in the UK), when it could have been the opening shot in a revolutionary improvement in economic efficiency. Hoping the you will take a second look, I am fleshing out his comment with a concrete proposal in the format of your September 25, 1996 presentation to the press. Thank you for your interest. Sincerely, Robert L. Elgin Proposed Description of new UNITED STATES SAVINGS BILLS SCHEDULE - The first auction will be on Monday January 5, 1998. The Bills will be auctioned and issued weekly thereafter, i.e. January 12, January 20, January 26, February 2, February 9, February 17,... STRUCTURE - The Savings Bills' structure will be based on Dollar Bills, with one modification: their value will be determined by integration of the weekly auction bid rate. MATURITY - None. A Bill may be redeemed at any auction date after it has been issued. INDEXING METHODOLOGY - The principal of the Savings Bill will be indexed to the "Savings Index." To calculate the dollar value for a particular auction date, the par value at issuance is multiplied by the value of the "Savings Index" on that auction date. MINIMUM GUARANTEE - None. The value of Savings Bills will increase every week. INDEX RATIO - None. The "Savings Index" is used directly without reference to the issue date of a particular Bill. REFERENCE "SAVINGS INDEX" - The reference "Savings Index" for Monday, the fifth day of January, 1998 will have a value of 1.000000. Its value will be incremented each day to effectuate the yield bid accepted at the most recent Savings Bill auction. The Treasury will include these index values in the press release announcing each auction result and publish them with its other interest data. PAYMENT DATES - None. No cash transactions occur until the customer elects to redeem a Bill. STRIPS - None. Savings Bills will be the ultimate stable store of value. No one strips a gold bar. TAXATION - None. AUCTION TECHNIQUE - The Treasury will offer Savings Bills through a uniform price auction. Bidders will bid a nominal yield and the Savings Index will increment to deliver this nominal yield until the next weekly auction. Amounts bid will be in terms of the par value back on the Index starting date of January 5, 1998. Settlement amounts are determined by formulas below. MINIMUMS AND MULTIPLES TO BID, HOLD, AND TRANSFER - The minimum to actively bid to buy, hold, or transfer is a par value of $1,000 or multiples thereof. However, smaller denominations down to $50 par are allowed for noncompetitive purchases and redemptions. BOOK-ENTRY SYSTEMS - Treasury Savings Bills may be held and transferred in either of two book-entry systems: the commercial book-entry system (TRADES) and TREASURY DIRECT. The securities will be maintained and transferred at their par value, before application of the Savings Index. IN ADDITION, Savings Bills will be issued in the form of Bearer Bonds in various denominations down to a par value of $50. FORMULAS Definitions P = par or face value of the Savings Bill PA = purchase amount paid for the Bill SA = settlement amount received on redemption i = nominal yield in decimals at the most recent auction date SI = Savings Index Formulas: SI(January 5, 1998) = 1.000000 SI(date) = SI(date - 1) x (1 + i(date-1)/365) PA = P x SI(purchase date) SA = P x SI(settlement date) Discussion of the Proposed Description This proposal is certainly much simpler - the formulas even transmit perfectly on the internet. It provides the ultimate in liquidity. It assures current market earnings at no risk to principal (aside from Federal default). It can save the Treasury tens of billions of dollars each year. This proposal would also triple M2 leading to hyperinflation, require an absolute dictator to reform the tax system, and cause massive layoffs in the financial sector leading to a Depression. O well, nobody's perfect! Seriously, there are many problems to be worked out, but they are not as intractable as they may appear at first glance. I visit each of the sections for comments below. SCHEDULE - The auctions were set weekly, because that is the highest frequency presently used for any denomination of federal securities. Ultimately, as suggested by Mr. Caldwell, the rates should adjust daily, or even continuously on an electronic world exchange. Thus, although the settlement price is technically guaranteed only on auction days, this would eventually give the true price at all times. STRUCTURE - What is a structure based on Dollar Bills? By this I mean that a Savings Bill will just exist like a Dollar Bill - it will never expire, it will never result in coupon payments, no taxes will be due while it is held or when it is redeemed, it will just be a store of value. This value is determined by the formulas given above. MATURITY - The Savings Bills must have no maturity so that they are all indistinguishable except by their size (par value). This means the Treasury don't really need to buy any back. So long as the Treasury is doing any net financing, the purchasers won't know or care whether they are receiving a brand new Bill or one just redeemed by a previous owner. Thus the value of an old Bill will be identical to that of a new Bill. So, "no maturity" guarantees "arbitrary maturity" at the election of the holder. INDEXING METHODOLOGY - The par value must refer to the very first issue date (assumed to be 01/05/98) rather than to the issue date of a particular Bill both for simplicity and to maintain indistinguishability (see MATURITY). MINIMUM GUARANTEE - Unlike inflation, interest rates cannot go below zero in general practice. Why would anyone want to buy a Savings Bill that had a negative interest rate this week, when they can just hold cash until next week when they can use it to buy a larger Bill? Thus, the Savings Index, by its method of construction, will never fall. So the purchaser is automatically assured of getting back not only his initial principal, but any increment that he/she has earned in previous weeks. INDEX RATIO - Again, for all Savings Bills to be indistinguishable, the value must be calculable directly from its par value and the current level of the Savings Index, without reference to its own issue date. Thus an "index ratio", giving the increase in value since the issue date is not needed for buying, selling, or taxes. REFERENCE "SAVINGS INDEX" - This is the heart of the entire proposal. The "Savings Index" overcomes all the common drawbacks associated with indexing a financial instrument to inflation. It has no lags; it is not dependent on government definitions and revisions; it is easily compared to yields on other instruments. But, does the Savings Index measure inflation? Yes and no. Over the long term, nobody can measure inflation! How many hundred percent has our income increased over that of a cave man? It is only when we compare similar lifestyles that we can get approximate agreement on a measure of inflation. No one will ever have a scientific "proof" that the current CPI exaggerates inflation by 0.5% or 1.5% because it is precisely the invention of new products that create new "needs" that cause the most uncertainty in the current index. The Savings Index certainly will not always track closely to the CPI. It was already mentioned that it cannot go negative. On the other hand, especially for the last 10 years, most of the first world nations have real returns after taxes on government debt that were a percent or two above zero. The high liquidity of Savings Bonds will cause them to have lower returns than other federal debt and they are tax-free. So, it is plausible to expect them to yield within a percent or so of the CPI, at least under common economic conditions. The flip side of the relationship between the Savings Index and inflation is the conventional wisdom that investments in government securities in a taxed account do not keep up with inflation in the long run. If that remains true, it will mean that the Savings Index will provide a slight underestimate of inflation. However, it will still be a much safer investment than assets with fixed nominal returns. Since the Savings Index will be created by the Treasury auctions, it will need to be responsible for keeping both historical and current values accessible to the general public. PAYMENT DATES - No further comment. STRIPS - Of course, someone will want to apply STRIPS to Savings Bills. Although there are no coupons, there is nominal appreciation. The main point is that Savings Bills maintain constant value better than almost any other asset, so that for ordinary investors they are the last item in their portfolio that needs hedging against. TAXATION - Taxation is the second most important point of the entire proposal. It is not necessary that Savings Bills be uniquely tax-exempt, only that the Savings Index is not significantly impacted by tax effects. The simplest political expedient would be to institute 28% withholding on Savings Bills along with capital gains classification so that the great majority of taxable investors would never see the withheld funds. The Savings Index would give the value after withholding. More complicated calculations than are shown here would apply after final redemption for those in a different bracket. (Even your current proposal for Inflation-Protection Savings Bonds includes deferral of tax impacts until redemption.) However, this still violates the principal that old and new Savings Bills should be indistinguishable and would encourage anyone in a lower bracket to constantly churn his/her holdings to get the tax refunds. A better solution would be to get this particular type of issue declared tax-free. It is not a question of being fair or unfair to other investors. As several other commentators have noted, the tax status of federal debt has little impact on other taxpayers because the interest rate accepted by the market takes the tax impacts into account and nearly compensates. The best long-term solution is to declare that ALL investment earnings up to the earnings received with Savings Bills are tax-free. This provides a particularly elegant way to index capital gains and thus could be at the heart of a thoroughgoing tax reform program. Notice that the Savings Index is available on a daily and timely basis, so it is a simple matter to divide all financial transactions by the value of the savings index on the same day in order to put everything on a "real" basis and then calculate taxes based on the "real" investment income. [The Savings Index could be defined constant before 1998, or synthesized, by the Treasury, from other interest rate records should the reformers wish to make the benefits retroactive.] One could even extend the treatment to wages and other income so that taxes would also be paid in "real" terms, thus automatically charging or crediting interest at the Savings Index rate on early or late tax payments. The possibilities here are intriguing - but I am digressing. AUCTION TECHNIQUE - It might not be entirely clear just what the bidders are bidding on in a Savings Bill auction. What they are really saying is that this is the annual yield required to make them part with their money for ONE week. If they actually redeem at the next auction, their settlement amount will have increased by the amount of change in the Savings Index, which was based on their previous bid, so that they will receive the earnings that they desired. The great majority of purchasers will keep most of their investment from week to week and their earning may increase or decrease from their original bid. By definition, most of these changes will be satisfactory to most investors, even if not anticipated, because any attempt by most of them to leave will cause the next bid to rise by enough to dissuade most of them. In effect, although the rates may fluctuate widely at times, the Treasury will appear to read their mind even when they are not bidding. If the bidding ever becomes continuous, then investors will be indicating the rates necessary to part with their funds for just the next few minutes. MINIMUMS AND MULTIPLES TO BID, HOLD, AND TRANSFER - I see no reason to change the size limits for active participants, but there needs to be some provision to handle the small denominations that have always been important for many Savings Bond investors. BOOK-ENTRY SYSTEMS - What are "Bearer Bonds"? By this I just mean that purchasers can have actual certificates that can be passed freely from person to person without re-registering. (Perhaps with optional registering if theft is expected to be a problem.) These should be not that different from Federal Reserve Notes (ordinary currency), so that they can be hidden in the mattress, put in a safe deposit box, or whatever, just like money. Such flexibility would greatly increase the incentive for the poor to save, since they could thus earn about the same return on their investment as a millionaire using a money market account. It would also facilitate demand from oversees investors, drug runners, etc. Oops! Yes, I suppose international crime would be interested. But not to worry. As long as Savings Bills were not available in much larger denominations than Federal Reserve Notes, money laundering would not be facilitated by much. Money market rates are peanuts in that world. FORMULAS - Perhaps the SI formula needs to be explained in English as well. The formula in terms of (date) and (date-1) is meant to be applied recursively, that is, repeatedly, in order to calculated the value of the Savings Index for any future date. The interest rate to be used will be repeated seven days in a row until the next auction. If auctions are held daily, then the interest rate would also be changed daily. For a continuous auction, the Savings Index formula would be an integration. Final Discussion Some other topics that didn't come up in the above sections: Won't indexing income amount to a massive tax cut and increase the deficit? We need to consider the whole package. Many of the benefits of indexing have already been enacted into the tax law as special favors - capital gains top rate, housing rollover, mortgage interest deduction, etc. These would need to be repealed or modified to avoid double counting many benefits. Also, the lower interest payments on the federal deficit would be an important counterbalance. Presumable the existing rate structure will also be flattened more so there won't be any "other things held equal" comparison. How will Savings Bills impact inflation? Liquidity seemed to be a common goal among the commentator and the Treasury. This was not true when Savings Bonds (War Bonds) were invented. Then they were designed specifically to soak up cash and transform it into a long-term investment with early withdrawal penalties. If the Treasury really wanted liquidity, it could just issued currency equal to the entire national debt and its interest costs would disappear, but we would have wild inflation. Savings Bills would be almost as liquid, but there would be much more incentive to hold them as they earn interest. So their velocity would be much lower and more could safely be issued. A lot more could be issued if the reserve ratio were changed at the same time. Remember that the reserve ratio was invented because there was not enough gold to go around, so we had to have money in some multiple of the precious metal base. If Savings Bills are as good a store of value as gold, then we have potentially a much bigger monetary base, so we don't need to multiply the money supply so much through the reserve ratio. It appears that there is plenty of room to issue enough Savings Bills to save substantially on interest payments without necessarily increasing inflation. Is there more to this comparison of Savings Bills and gold? Yes, indeed. Gold was once the medium of international exchange. The gold standard allowed trade between developed nations to proceed without any uncertainty in exchange rates, because both currencies were nominally convertible into gold and therefore really convertible at a fixed rate into each other. Savings Bills could reinstitute a gold-like standard. Assume the British issue their own Savings Bills as a substantial fraction of their national debt. Then let us say that the two nations agree that a par $1,600 American Savings Bill will be freely exchangeable for a par 1,000 pounds U.K. Savings Bill. This will set the exchange rate between dollar and pounds, but will not hold it fixed. Instead, the exchange rate will drift at exactly the annual rate of the difference between the interest rates on the two types of Savings Bills. What is the advantage of that? A tremendous reduction in the daily fluctuations in the exchange rates. Currently a half percent change in one day is not uncommon. For that to happen with the Savings Bills locked together, the interest rates would need to differ by 183%! So the exchange rates would drift almost imperceptible in any one day, but could easily shift by several percent over the course of a year. This could be the key to the "firm, but flexible" exchange rates that the Europeans have been trying to institute in recent years. In conclusion, Savings Bills could be a key ingredient in a major reformation of the international economic system. Eliminating the need for any cash payout of interest on the National Debt is just the beginning. Or they could become a footnote. The choice is up to you. Background Dr. Robert L. Elgin received a Ph.D. in Physics from Caltech in 1973. A considerable number of physicists have gone into finance in the last 20 years as funds for basic physics research have dwindled. They usually bring with them a high level of competence in mathematics and a distinctive method of problem solving. They tend to look for a few simple principles that can explain a mass of data. They take special pains to make accurate measurements and worry about the stability of their measuring sticks. It is only natural for them to take exception to calculations based on an instrument as unstable as the dollar and to look for a more invariant statistic. Sometimes they even bring in strange concepts from their major such as indistinguishability. I hope you have enjoyed following my own explorations and perhaps found some suggestions of interest to you among the many oversimplifications. Copyright 1996 Robert L. Elgin PS to the email version. I am mailing a hardcopy today, but since your are planning to put comments back on the internet, I am sending you this copy as well, already in internet format. * * * * * * * * * * HSBC Securities, Inc,, 140 Broadway New York, NY 10005 October 25, 1996 Mr. Kenneth J. Papaj, Director Government Securities Regulations Staff Bureau of the Public Debt 999 E Street, NW Washington, DC 20239 Re: Proposed Rule: Inflation-protection Securities Dear Mr. Papaj: HSBC Securities Inc. appreciates the opportunity to comment on the Proposed Rule issued by the Department of the Treasury regarding inflation-protection securities. Clearly, the Treasury has gone to great lengths to work with financial market participants in the design and implementation of these securities, reading our comments and, wherever possible, making decisions so that the needs of the market place are met. As a result, we have great confidence that a vibrant market in inflation-protection securities will develop in very short order. As far as the securities themselves are concerned, there is little or nothing we would care to ask be changed. However, there is one issue that we think should be considered further: Inflation-protection Strips. The proposed design of inflation-protection strips is a balance of two fundamental goals that were discussed repeatedly throughout the development process: ù Keep the structure as simple as possible. ù The best way to achieve simplicity is to keep the structure as near to that of the conventional securities market as possible. In the strips market, then, as in the broad market, the goal was simplicity first, familiarity second. But the reason people advocated these two points in their comment letters was to encourage the rapid development of a liquid market. A healthy, liquid market, after all, will develop fastest if the greatest pool of investors understand the structure rapidly and are willing to invest quickly. In the case of the strips market, there were two regular features of conventional strips that are incompatible with each other in real return strips: 1) Strips are sold in $1000 increments, and 2) Strips are fungible. Apparently, a decision was made to sacrifice fungibility in order to maintain the simplicity of regular strips denomination. Unfortunately, this decision may very well mean that the liquid market that simplicity is intended to foster will never develop. Virtually every strips trader recalls when the first stripped securities were not fungible. Failed trades when a particular maturity was on special or pieces of a security tied up in defeasance deals that simply could not be undone were frequent. The result was a small, illiquid market. Treasury has proposed getting around this problem by reopening issues that are in short supply. Unfortunately, that's unlikely to solve all the problems. There is another way. HSBC Securities strongly recommends that the Treasury consider the attached description of an inflation- protection strip that would be entirely fungible with other inflation-protection strips. It is somewhat more complicated in nominal terms than the model proposed by the Treasury, most notably in that the stripped pieces might not always have values equal to $1000. Instead, the securities are divided into pieces of equal real value. This is a workable system that would result in a fungible market. Without fungibility, traders fear that these new securities will be strippable in name only. If you are interested in pursuing this issue in more detail, I would be happy to send Robin Grieves and Christopher Low to Washington for further discussion. Please call me on my direct line (212) 825-9477. Sincerely, Robert D. Sbarra Executive Managing Director Chief Operating Officer - Fixed Income HSBC Securities, Inc,, 140 Broadway New York, NY 10005 ----- STRIPS for inflation-protection bonds and notes Creating STRIPS from the proposed inflation protected bonds presents no insurmountable obstacles provided the rule that coupon STRIPS be created in $1000 increments is relaxed. It is simply a matter of defining the cash payment for STRIPS on different dates and recognizing that the par value of STRIPS created from a bond will not necessarily match the par value of the coupons within a bond. Stripping would be simplified if the cash payments for all STRIPS are defined with the same index date. For now suppose that only 30-year bonds are issued. For the first bond, we will see 60 coupon STRIPS and one principal STRIPS. If the coupon rate is 3%, the payments to the coupons will be .015 x 1,000,000 x (Index end/Index begin). If the beginning index date for the STRIPS is set equal to the beginning index of the first inflation protected bond, then the nominal amount of each of the STRIPS will be $15,000. But different beginning index dates for the STRIPS are possible. For example, STRIPS payments could be PAR x (Index end/100). In that case, each coupon STRIPS from the first bond would have a par value of $15,000 x (100/Index begin). Further, one would use an annuity of less than $15,000 per period to reconstitute the bond. Now, let a second bond on the same payment cycle be issued two years later. Suppose the coupon rate on the second bond is also 3.0%. Then the payments will be for .015 x 1000 x (Index end/Index begin+2). In this case, even though the coupon stream within the bond appears to be the same at $15,000 every six months, the par amount of the STRIPS from the bond would be smaller (assuming the beginning index is higher). The par amount of the STRIPS from the second bond will be $15,000 x (100/Index begin+2). To reconstitute the first bond with STRIPS from the second, a greater par value of the second bond must be stripped. Nevertheless, the calculations are simple and straightforward. The only fly in the ointment is the $1000 par rule for coupon STRIPS. It would be easy enough to impose on the first bond, but would interfere with stripping the appropriate amount of other issues. A more specific example follows: A Simple Example of Fungible STRIPS from Inflation Protection Bonds Example Suppose the 3s of 1/15/27 begin with an initial pricing CPI of 158.0 and that the CPI for determining the coupon payment one year later is 162.7. Then, the second coupon payment will be $15,000 * (162.7/158.0) = $15,446.20 per million. If the pricing CPI two years later is 167.6, the coupon payment will be $15,000 * (167.6/158.0) = $15,911.39 per million. Now suppose that the 4s of 1/15/28 are issued on the first anniversary of the 3s of 1/15/27. Its pricing CPI will be 162.7 at the outset and its second coupon payment will be $20,000 * (167.6/162.7) = $20,602.34 per million. Let's make a stripping rule such that all STRIPS pay as if their initial CPI equals 100. This rule will not change any cashflows from any bond. It only acts as a translator to put all STRIPS on an equal footing. All that happens is the par amounts of the STRIPS differ from the par amount of the coupon payments within the bonds. When we strip the 3s of 1/15/27, instead of getting $15,000 par of each coupon of the STRIPS per million of the bond, we will get $15,000 * (100/158.0) = $9493.67. But, what payment will we receive from the stripped coupon of 1/15/98? We will get $9493.67 * (162.7/100) = $15,446.20 --just as we ought. And on 1/15/99 we will receive $9493.67 * (167.6/100) = $15,911.39 -- again, just right. When the 4s of 1/15/28 get stripped, the coupons will all be for $20,000 * (100/162.7) = $12,292.56. We can either hold the 1/15/99 coupon STRIPS until it pays the $20,602.34 per million or we can use $9493.67 of it to reconstitute the 3s of 1/15/27. The STRIPS can be fungible easily. Robin Grieves HSBC Securities 212-825-3571 * * * * * * * * * * PSA The Bond Market Trade Association 40 Broad Street New York, NY 10004-2373 November 6, 1996 Mr. Kenneth Papaj, Director Government Securities Regulations Staff Bureau of the Public Debt Department of the Treasury 999 E Street, N.W., Room 515 Washington, D.C. 20239-0001 Re: Proposed Rule: Inflation Protection Securities Dear Mr. Papaj: PSA The Bond Market Trade Association ("PSA")1 appreciates the opportunity to comment on the proposed amendment to the Uniform Offering Circular for the Sale and Issue of Marketable Book-Entry Treasury Bills, Notes and Bonds (the "Proposal") issued by the Department of the Treasury (the "Treasury") to accommodate the public offering of inflation protection securities. In PSA's view, Treasury has been very responsive to many of the concerns and issues raised by PSA in its comment letter2 on the Advance Notice of Proposed Rulemaking ("ANPR") 3 regarding the design details and structure for the new securities. In particular, PSA is supportive of Treasury's decision to model the new securities on Canada's Real Return Bonds and the choice of the CPI-U as the inflation index. PSA also appreciates Treasury's efforts to conform the new securities, operationally and with respect to the auction technique, to the extent possible, to other fixed principal Treasury securities. Finally, subject to certain caveats discussed below, PSA is supportive of Treasury's decision to make the new securities available for stripping. Notwithstanding the foregoing, PSA believes that there are a number of market practice, regulatory, operational and technical issues which must be resolved in order to foster a smooth and orderly auction and efficient secondary market for the new securities in January. In this regard, foremost among concerns raised by PSA members is the issue of timing. The inflation protection securities are scheduled to be issued in mid-January 1997. Yet there are many unanswered questions regarding certain material aspects of the new securities, such as industry conventions regarding the manner in which the securities will be priced and quoted, the valuation of stripped interest components, the manner in which the securities will be treated under numerous regulatory regimes, and significant operational concerns related to all of these issues. While PSA is continues to work closely with member firms to resolve some of the market-related issues, it is unclear whether all of the foregoing issues will be resolved in the coming weeks. In addition, the resolution of some issues is beyond the purview or control of market participants, such as the regulatory treatment for the new securities. Finally, even assuming the foregoing trading, market practice and regulatory issues can be resolved in the coming weeks, firms will have to make significant changes to their internal trading, trade processing, settlement, risk management, accounting, regulatory and tax reporting systems, among others, leaving market participants little time to build, test and implement such internal systems changes before trading in the new securities commences in January. Additionally, while PSA members are supportive of Treasury's decision to make the new securities available for the STRIPS4 program, market participants are extremely concerned about the lack of fungibility of stripped interest components. Treasury recognized this concern in the Proposal and indicated that it may reopen issues to alleviate lack of liquidity in the strips market. However, PSA members are concerned that reopenings may not be an effective solution to the lack of fungibility since Treasury would only be able to reopen issues on a limited basis. Market participants have also indicated a concern with the lack of any industry convention, such as a factor or formula, for purposes of valuing stripped interest components for trading, trade settlement, accounting and tax reporting purposes. Finally, member firms have recommended that Treasury include in the final rules additional hypotheticals and examples for calculating accrued interest and inflation-adjusted principal for the new securities and strips under different scenarios. Such examples and hypotheticals would be extremely helpful for market participants and would provide a valuable benchmark for firms as they implement changes to their internal auction, trading, trade processing, settlement, risk management, accounting, regulatory and tax reporting systems, among others, to accommodate the new securities. In the first part of this comment letter, PSA will address in greater detail the industry's central concerns which have been highlighted above. In the second part of this letter, PSA will offer certain additional technical comments and recommendations. I. PSA's Central Concerns Regarding the Proposal A. Timing The first issuance of 10-year inflation protection notes is scheduled for mid-January 1997. Yet, as noted above, there are still many unanswered questions regarding certain market practice, regulatory, technical and operational aspects of the new securities that are still in the process of being resolved by market participants and regulators. With respect to the market practice issues, at Treasury's suggestion, PSA has formed an Inflation Bond Trading Practices Task Force and other working groups and subcommittees, comprised of representatives of trading, operations, research and compliance professionals at PSA member firms, to address many of the trading and market practice issues. While these industry task forces and working groups will address, on an accelerated basis, how the new securities and stripped components will be quoted and priced, such issues may not be completely resolved until, at the earliest, mid-November. Moreover, many of the market practice issues that will be addressed by the PSA task forces and industry working groups will have significant impact on, and may in fact dictate, the changes that will be required to be made to internal trading, clearance and settlement systems at broker-dealers and other market participants. Unfortunately, with the January issuance several weeks away, dealers and other market participants will have little time following resolution of these significant market practice issues to design specifications for, implement and test the necessary systems changes. 5 As Treasury may recall, PSA members previously indicated that they would need approximately six months from publication of the final rules to prepare for trading, clearance and settlement of the new securities. Additionally, as discussed in more detail below, many questions have been asked regarding the manner in which the new securities will be required to be treated under numerous regulatory regimes, including federal securities, banking, tax and accounting regulations. For example, it is unclear whether the securities will be required to be reported and carried at the original face amount or at an inflation-adjusted principal amount under various regulatory regimes, such as for regulatory capital and margin purposes and for broker-dealer reporting purposes. Resolution of these issues, which is not within the control of market participants, will significantly impact numerous internal systems changes at broker-dealers and other regulated market participants. Moreover, it is presently unclear whether securities, banking and accounting regulatory agencies, among others, have begun to consider how the inflation protection securities will be treated under their respective regulations and whether such issues will be resolved before January. As an adjunct to the issue of timing, many firms have indicated a reluctance to begin implementing the numerous systems and corresponding procedural and recordkeeping changes until (i) the market practice issues are resolved and (ii) Treasury and the Internal Revenue Service ("IRS") have published final rules for the new securities (which are expected to be published in early December). Thus, while many firms are closely analyzing the Proposal and determining which systems will be impacted, many are hesitant to begin significant and costly systems changes until they are assured that both market practice issues and regulations governing the new securities have been finalized.6 This is not to suggest that market participants will wait until the last moment to begin making the necessary systems changes for the new securities; however, the implementation processes will not be completed by many firms until they are assured that no further changes will be made to the Proposal. Finally, of related concern with respect to the timing of the first issuance, is the fact that the Proposal will be finalized in December, a time of year when senior management at many market participants and institutional investors will be required to focus their time and resources on internal year-end accounting, profit and loss and budget analyses. As a practical matter, it will be extremely difficult for such entities to focus on marketing and investing in a new product at the end of the calendar year. Additionally, as Treasury is aware, the Boskin Commission is expected to publish its report in December on the methodology used by the Bureau of Labor Statistics to calculated the CPI index. While PSA agrees with Treasury's choice of the CPI-U index for the inflation protection securities, market participants have indicated that they would prefer to have additional time to analyze such report before the first issuance of the new securities in January. B. Strips Market participants appear eager to create as liquid a market as possible for the new securities. In this regard, PSA is supportive of Treasury's decision to make the securities available for stripping. However, for reasons discussed below, PSA believes that under the proposed security structure, and under existing stripping requirements, the availability of stripped interest components for inflation protection securities would not likely enhance the liquidity of the new securities. First, of primary concern to market participants is the lack of fungibility of stripped interest components. Second, and of related concern, is the need for a market convention regarding the appropriate factor or formula to be used for valuing and pricing strip interest components. 1. Fungibility As noted above, market participants have expressed significant concern with the lack of fungibility of stripped interest components. Treasury recognized this concern in the Proposal and highlighted its ability to increase the amount outstanding of the stripped interest components through reopenings of the underlying securities. PSA member firms, however, have indicated that reopenings alone would not resolve the lack of fungibility since Treasury would only be able to reopen issues on a limited basis. As an alternative to the use of reopenings, one PSA member firm has recommended to Treasury (in a separate comment letter),7 a procedure that it believes would foster the creation of fungible stripped interest components. While the specific details of the recommendation will not be outlined herein, in general terms it would enable the strips to have equal real values, thus fostering fungibility, while not always having nominal values that equal multiples of $1,000. In addition, under the recommendation, Treasury would be required to relax the existing requirement that the par amount of the security (without the inflation adjustment), must be in an amount that, based on its interest rate, will produce a semiannual interest payment in a multiple of $1,000. Whether or not this particular recommendation is accepted by Treasury, market participants believe that in order for the strips program to be successful from a market perspective, Treasury or market participants must devise a viable method to create fungible strips. 2. Valuation Market participants have also expressed concern about the lack of guidance from Treasury and the present lack of market consensus regarding the appropriate method for valuing stripped interest components. Some PSA members have suggested that Treasury provide a factor or formula or other guidance to be used uniformly by market participants to value the strips. As the issuer of the securities, Treasury is in the best position to provide such information and could provide added consistency and regularity to the market by doing so. In the event that Treasury is unwilling to provide such guidance, it will nevertheless be important for all market participants to apply the same valuation formula consistently. A particular need exists for consistency with respect to trading, trade settlement, regulatory, tax and accounting treatment, among others. In this regard, PSA's newly formed Inflation Bond Trading Practices Task Force will consider whether PSA, as an industry trade association, would be a proper source for promulgation of such a factor or formula. However, as Treasury is aware, even if PSA were to recommend a specific valuation methodology, it would only be able to do so on a completely voluntary basis and could not compel market participants to follow PSA's recommended guidelines. In fact, whenever PSA makes recommendations to the market, especially regarding market practice issues, it cautions its members to make an individual determination as to whether such recommendations are appropriate for the particular firm based on their own facts and circumstances. Nevertheless, if market participants must rely on PSA or private financial service companies to provide such valuation guidance, discrepancies and confusion could result if valuation formulas used by market participants vary from one another. To the extent that a standard valuation formula or other guidance could be provided by Treasury, PSA believes it would minimize significant uncertainty regarding the strips market and would, in the long run, benefit the market for inflation protection securities. As noted above, market participants believe that a successful strips program is essential to liquidity. As a practical matter, while PSA (and others) would willingly step into the fold to provide market participants with guidance for valuing the strips, it is much more likely that market participants would consistently rely on a formula provided by Treasury than on formulas provided by PSA or private pricing services. Finally, as PSA expressed in the first comment letter, anything that Treasury can do to minimize uncertainty and confusion regarding the terms of the new securities will benefit the market and enhance liquidity. II. Additional Comments on Specific Aspects of the Proposal A. Publication of Reference CPI Numbers and Index Ratios 1. Publication of Reference CPI Numbers Treasury requested comment on whether a monthly publication of the reference CPIs numbers would be useful to market participants. PSA strongly recommends that Treasury provide a monthly publication of the reference CPI numbers for, at a minimum, the preceding three months. PSA also recommends that Treasury maintain a permanent, publicly available record of all reference CPI numbers used by Treasury in calculating principal and interest payments. This is particularly important in light of Treasury's proposed course of action in the event a previously reported CPI number is revised or rebased to a different year by the Department of Labor. For example, Treasury has proposed that if a previously reported CPI number is revised, Treasury will continue to use the previously reported CPI number in calculating the inflation-adjusted principal and interest payments. Similarly, Treasury has proposed that if the CPI number is rebased to a different year, Treasury will continue to use the CPI number based on the base reference period in effect when the security was first issued as long as the CPI continues to be published. In each case, market participants will need to have ready access, throughout the life of all outstanding inflation protection securities, to the CPI numbers in effect before any revisions or rebasing takes place. This is particularly true for any securities issued in a month for which the reference CPI number is revised or rebased. PSA believes that it would be inappropriate for Treasury to expect market participants to rely on CPI numbers published solely by the Department of Labor, especially when such numbers, after revisions or rebasing, will be different from those used by Treasury in calculating inflation-adjusted principal and interest on outstanding inflation protection securities. As a matter of clarity and consistency, there is a strong preference among market participants to refer to one source for reference CPI numbers, rather than continually reviewing and comparing CPI numbers announced separately by Treasury and the Department of Labor. It would be easier and more practical for market participants to refer to one primary source for all reference CPI numbers. A single reference source for all CPI numbers will also foster the clearance and trade settlement process in that it will enable market participants to avoid discrepancies in settlement amounts potentially arising from nonconforming reference CPI numbers and index ratios. In light of the foregoing, PSA recommends that Treasury maintain a master list of all reference CPI numbers used by Treasury for calculating inflation-adjusted principal and interest on outstanding inflation protection securities and that such a list be published and made available electronically through the internet, TAAPS (Treasury Automated Auction Processing System) and other automated electronic delivery systems on a monthly basis. Finally, as a practical matter and in light of Treasury's proposed procedures in the event a CPI number is revised or rebased, PSA recommends that Treasury clarify in the final rules that in the event of any inconsistencies or discrepancies between reference CPI numbers published by Treasury and those published by the Department of Labor, those published by Treasury will take precedence. 2. Publication of Index Ratios Treasury explained in the Proposal that it does not intend to publish index ratios because market participants should be able to make the calculations themselves based on publicly available CPI numbers. While this is certainly true, market participants have indicated a strong preference for Treasury to publish daily index ratios on a month to month basis. Even though PSA believes that many institutional market participants and large broker-dealers will likely perform their own calculations, such market participants will benefit from the ability to check their calculations and systems against the Treasury numbers to ensure that they conform. In this regard, a list of index ratios published by Treasury will provide a valuable benchmark for even the most sophisticated market participants to ensure that their own calculations and databases are in accordance with the numbers being used by Treasury. Additionally, smaller market participants and retail investors who do not have ready access to the necessary systems to perform the daily index ratio calculations would likely also benefit by Treasury's publication of such numbers. As with publication of the reference CPI numbers, publication by Treasury of the index ratios on a month-to-month basis will provide consistency to the comparison and settlement process for the new securities. Finally, reliance upon index ratios provided by Treasury will provide consistency among market participants regarding compliance with regulatory, tax and accounting issues. B. Minimum Guarantee Proposed Section 356.30(b) provides that if at maturity the inflation-adjusted principal is less than the original par amount of the security, an additional amount will be paid at maturity so that the additional amount plus the inflation-adjusted principal equals the original par amount. As a technical drafting matter, PSA suggests that Treasury make clear in Section 356.30(b) its obligation to pay the greater of the inflation-adjusted principal amount or original par. Some market participants found the current proposed language somewhat unclear in that it focuses solely on what happens in the event the inflation-adjusted principal is less than par, while in most cases it is expected that at maturity the inflation-adjusted principal will be more than the original par, which is the amount that will be paid by Treasury. C. Hypotheticals Market participants have strongly recommended that additional hypotheticals be provided by Treasury in the Appendices to the Uniform Offering Circular. Additional hypotheticals would be extremely useful for market participants as they develop, implement and test systems changes to accommodate the new securities. For example, market participants have suggested that Treasury provide sample calculations of adjusted principal and accrued interest for a 10-year inflation protection note during the course of several specific days, including the day before the interest payment date, the interest payment date, and the day following the interest payment date. In addition, PSA members have suggested that Treasury provide sample calculations for redemption amounts at maturity in the event the inflation-adjusted principal is less than the original par amount in order to illustrate the minimum guarantee. Sample calculations of accrued interest and interest payments during periods of deflation would also be helpful. Finally, sample calculations of adjusted principal and accrued interest on when-issued trades for newly issued and reopened securities would be useful. The foregoing additional sample calculations would provide a valuable benchmark for broker-dealers and other market participants, such as the clearing banks and clearing corporations in developing, implementing and testing systems changes. D. Securities Clearance, Auction Takedown and Trade Comparison As PSA discussed in its prior comment letter on the ANPR, member firms have indicated a strong preference for the new securities to be eligible for processing and netting by registered clearing corporations, such as the Government Securities Clearing Corporation and Delta Clearing Corp. This would enable clearing corporation participants to take advantage of available auction takedown, trade comparison and netting services. PSA understands that such clearing corporations are in the process of updating their systems in order to accommodate the new securities. However, as with many of the other operational issues that must be resolved before the January 1997 issuance, PSA believes that the clearing corporations and other similar organizations will be coordinating their systems changes with market participants to reflect, if possible, market consensus regarding trading and valuation conventions. As explained above, PSA is in the process of actively meeting with dealers, the clearing corporations and the clearing banks to reach consensus and establish guidelines regarding some of these trading and related market issues. E. Regulatory Reporting Issues Many questions have been raised by PSA member firms regarding the manner in which the inflation protection securities will be required to be treated for regulatory reporting purposes. As Treasury is aware, the key issue is whether the securities should be reported at the original face amount or the inflation-adjusted principal amount. For example, firms have inquired whether for purposes of large position reporting, the reportable position should reflect original par amount or the inflation-adjusted par amount. This example is particularly relevant since market participants are in the process of making systems changes to prepare for large position reporting and recordkeeping which will go into effect in March 1997. Similarly, firms have inquired whether for valuation reporting purposes, such as for purposes of determining regulatory capital and margin amounts, the securities should be valued at the original face amount or an inflation-adjusted principal amount. Additional regulatory issues involve the primary dealer position reports submitted to the FRBNY, compliance with regulatory capital requirements, and disclosure obligations, such as customer confirmations.8 While representatives of Treasury and the FRBNY have informally addressed some of these regulatory issues, PSA believes that market participants would benefit significantly if formal guidance could be provided by Treasury and other regulators with respect to the manner in which such securities are required to be valued, recorded and reported under different regulatory regimes. In this regard, PSA urges Treasury to provide guidance both to market participants and to other regulators regarding the manner in which the inflation protection securities are carried and reported for regulatory purposes, including, without limitation, under securities, tax and accounting regulations. PSA will be pleased to assist Treasury in any way possible in providing industry guidance and input on any of these regulatory issues. Finally, as has been noted throughout this comment letter, the manner in which the inflation protection securities will be required to be valued, recorded and reported under different regulatory regimes will have significant impact on systems changes at PSA member firms. As Treasury is aware, many of these reporting systems are currently automated. To the extent that all regulators can agree on a consistent approach and reporting treatment for the inflation protection securities, it would simplify the required systems changes and reduce market confusion regarding compliance. PSA appreciates the opportunity to comment on the Proposal and looks forward to continuing the exchange of ideas between Treasury and market participants as the issue date for inflation protection securities approaches. Any questions regarding this letter may be directed to the undersigned, or Stephanie S. Wolf, Vice President and Assistant General Counsel of PSA at (212) 440-9431. Sincerely yours, Edwin F. Payne, Chairman PSA Government and Federal Agency Division 40 Broad Street New York, NY 10004-2373 cc: Stephanie S. Wolf, PSA 1 PSA The Bond Market Trade Association represents securities firms and banks that underwrite, trade and sell debt securities, both domestically and internationally. Its members include all of the primary dealers recognized by the Federal Reserve Bank of New York, as well as other government securities dealers. 2 Letter to Kenneth Papaj, Director, Government Securities Regulation Staff, Bureau of the Public Debt, dated July 12, 1996, from Edwin F. Payne, Chairman, PSA Government and Federal Agency Division. 3 61 FR 25164 (May 20, 1996). 4 Separate Trading of Registered Interest and Principal Securities ("STRIPS"). 5 In addition to internal auction, trading, trade processing, settlement, risk management, accounting, and tax reporting systems, numerous internal regulatory reporting systems will be affected by the introduction of inflation protection securities. Such systems include internal valuation systems for purposes of calculating margin and regulatory capital amounts, systems that generate customer confirmations, systems designed to capture information for the primary dealer reports submitted to the Federal Reserve Bank of New York ("FRBNY"), and systems that capture information for broker-dealer regulatory reports, such as FOCUS reports. 6 Unfortunately, many market participants point to the fact that shortly after publication of the Proposal in September 1996, Treasury published certain technical and typographical corrections to the proposed formulas on October 2, 1996 (61 FR 194 (October 4, 1996)), as an indication that their concern is justified. 7 Letter dated October 25, 1996, to Kenneth J. Papaj, Director, Government Securities Regulations Staff, Bureau of the Public Debt, from Robert D. Sbarra, Chief Operating Officer, Fixed Income, HSBC Securities, Inc. 8 For example, firms have questioned how they will comply with the obligation to disclose yield to maturity on customer confirmations which is required under SEC Rule 10b-10. * * * * * * * * * * Reed Smith Shaw & McClay 1301 K Street, N.W. Suite 1100, East Tower Washington, D.C. 20006-3317 September 27, 1996 Darcy E. Bradbury, Assistant Secretary--Financial Markets U S Treasury Department 1500 Pennsylvania Avenue, NW Room 2334 Washington DC 20220 Dear Assistant Secretary Bradbury: IRS Notice 96-51 (9/25/96) discloses a serious gap in the Treasury Department's plan to broadly market inflation-indexed securities. An inflation-indexed Debt Instrument is an obligation that clearly delineates that portion of a payment representing the payment of interest and that portion of a payment to the holder of the obligation that represents an amount identical to the amount loaned in real rather than nominal dollars. Where such a repayment scheme is separately and clearly delineated, the rationale for treating transfers of such nominal amounts as taxable income is an issue that should be addressed as part of the plan to offer such securities. I am not aware of any existing statutory authority that would permit the IRS, on its own, to conclude that the transfer of nominal amounts as inflation adjustments to holders of new inflation-indexed Treasury securities are not subject to Federal income tax. On the other hand, it seems to me that before such an investment is offered for sale to the general public, as a suitable investment for other than tax exempt entities, including qualified plans, etc., the Treasury has an obligation to put forward a legislative proposal for Congressional consideration that would provide an exclusion under the tax law for the inflation compensating payments made in connection with these obligations. As it now stands, investors are to be offered a below market rate of return in exchange for inflation protection that, by the way, will be reduced by the imposition of income tax on the nominal amount of each semi-annual inflation adjustment to principal. That, it seems to me, represents less than full inflation protection for a taxable, individual investor. That type of investor, if there is to be no change in the proposed tax treatment for inflation-adjustment payments, should be fully informed of the potential "tax detriment" accompanying these newly proposed Treasury securities. Thank you for taking the time to review these comments. Sincerely yours, William Morris Reed Smith Shaw & McClay 1301 K Street, N.W. Suite 1100, East Tower Washington, D.C. 20006-3317