To Reduce Our Federal Debt Risk, Let's Issue Equity

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The problem with the federal debt is not only its size but when it needs to be refinanced. A shade less than 70% of the $16 trillion of outstanding federal debt matures in 5 years or less. A 2% rise in rates would, very quickly, almost double Treasury's interest costs.

Why doesn't Treasury extend the maturity of this debt to protect us? Interest rates on longer term debt are greater than on short term debt. Every 1% increase in rates today will cost the taxpayer $10 billion annually per $1 trillion; Treasury officials are playing the current low short term rates for every penny. So far they have been correct.

However, let's ask: "Couldn't financial engineers design a better instrument than debt?" Debt saddles the issuer with fixed costs, offering no relief if the future does not live up to expectations; and debt exposes the investor to the ravages of unanticipated inflation.

Let Treasury offer a more equity-like instrument, one that paid the investor a constant percent of nominal Gross Domestic Product ("GDP"), and nothing more, for, say, 30 years. Then the investor would have protection from inflation, Treasury would get some relief when the economy was in recession and, since it self-liquidates, there would be no need to refinance the issue; hence we would no longer burden our progeny with our profligate ways.

Indeed, we can sum up the benefits of GDP Certificates ("Certificates") as follows:
• Investors purchase a no-load, no-fee, marketable term annuity with inflation protection, growth, no counter-party risk and a low correlation with stocks and bonds during periods of inflation - a new asset class.
• Treasury raises capital, buys a financial hedge and sells inflation insurance with a self-amortizing instrument.

Treasury does offer TIPS, Treasury Inflation Protected Securities: but GDP is driven not only by inflation, but by increases in productivity and the workforce. This is truly a "Buy America" security producing an annual return that should be 1 to 2% greater than the Consumer Price Index. Self-liquidating Certificates are also high cash-flow vehicles, whereas TIPS pay only income and must be refinanced at maturity.

Other points of interest:
• Because there in no explicit interest rate in the contract, Certificates seem to conform to Sharia law making them attractive for Sovereign Wealth Funds.
• GDP is subject to revisions. A small portion of each year's payment would need to be escrowed for several years. Claims on this escrow pool would be tradable.

Given reasonable assumptions as to current interest rates, growth rates and inflation expectations; a payment of, say, 0.2% of GDP for 30 years (slightly more than $30 billion currently, but rising over the years) would raise about $1 trillion. One calculates $1 trillion as the percent of GDP offered multiplied by the present value of GDP over the term of the issue. The actual pricing of that stream of payments must be adjusted downward from the $1 trillion figure to reflect the value of Treasury's financial hedge and then upward to reflect the value of the investors' inflation protection.

This concept has been examined by former Treasury officials and notables in academe and finance, all of whom helped shape the argument. They also note that Treasury is not innovative and will not be the first to issue Certificates. It is ironic that America, the bastion of innovation and free markets, has a Treasury that chooses to lead from behind; especially so since the problems associated with innovation can be readily solved.

Not all innovations are successful. An innovative Treasury must have a way to 'bury the dead'. The procedure should be standard and well understood by the market. One suggestion is that once Treasury determines an issue no longer meets its needs, holders of that security will have a limited amount of time to convert to the nearest straight Treasury on either side of the issue's maturity or duration. The price of the issue being 'sold' would be its average over, say, the 20 trading days preceding Treasury's determination: the price of the straight Treasuries being 'purchased' would be the closing price on the market after Treasury receives the order from the investor, much like the purchase of a mutual fund. Investors choosing not to convert would hold the security to maturity, subject to limited liquidity should they ever want out.

Whether or not Treasury decides to offer Certificates, the potential damage to the budget from a rise in rates is sufficiently dire that Treasury should take steps to make itself a far more innovative organization.

 

Evan Schulman is President and Founder of Tykhe LLC, which received a patent for Sales Certificates, a financial instrument which allows entities to raise capital by securing revenues.  His career is documented in the books "Super Traders"(Alan Rubenfield, Irwin Books, 1992) and "How I Became a Quant" (Richard Lindsey & Barry Schachter, John Wiley & Sons, 2007).   

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