Could the Treasury selectively default on the Fed’s debt?

Published in The Hill with Paul H. Kupiec.

A reporter from this publication recently asked how a debt ceiling standoff might impact the banking system. One obvious answer is that if the Treasury ran out of cash and defaulted on the payments owed on its debt securities, the banking system would suffer since it collectively owns, per our calculations, about $1.3 trillion in Treasury securities that have always been treated as “risk-free.”

U.S. Treasury securities do not have cross-default clauses, so the Treasury could choose to default on only a specific set of selected securities sparing banks and others. This gives rise to a provocative question:

Could the U.S. Treasury save cash by selectively defaulting just on securities owned by the Federal Reserve System? How would this impact the Fed? How much cash would be freed up to pay other Treasury bills?

The Federal Reserve owns about $5.3 trillion in U.S. Treasury securities. The Fed’s 2022 audited financial statements show that $721 billion of these securities mature between April 1 and Dec. 31 and that the Fed received almost $116 billion in interest payments from the Treasury last year, or about $9.6 billion a month. Between now and Dec. 31, the Fed is scheduled to receive about $800 billion in interest and maturing principal payments from the Treasury, cash Treasury could use to pay its other bills if it stopped paying the Fed.

How would the Fed cope with a selective Treasury default? The same way it is managing what we’ve calculated is an ongoing $8.6 billion in operating losses per month — by borrowing the additional money it needs to operate and thus creating more debt for the consolidated government and ultimately a taxpayer liability.

If the Treasury suspended all payments due on its securities held by the Federal Reserve System, presumably by agreement with the Federal Reserve, the Fed would be short the cash it previously received. It would increase its borrowing to fund its operations, but the impact on the Fed’s reported operating loss would depend on the details of the suspension agreement and the accounting treatment adopted by the Fed.

Once Congress lifts the debt ceiling, we presume that the Treasury would pay the Fed its balances in arrears. Would the Treasury also pay accrued interest on the suspended amounts it owes the Fed? If so, at what rate?

The suspension of interest payments would clearly reduce the Fed’s cash interest received but it would not immediately increase the reported Federal Reserve operating losses. The Fed would likely account for suspended interest payments as non-cash interest income earned and create a new asset category, “interest income receivable from Treasury,” on its balance sheet.

The non-payment of interest would increase, dollar-for-dollar, the amount the Fed needs to borrow to pay its bills. Going forward, the Fed would have to continue borrowing to fund suspended Treasury balances. If these balances accrued interest at the Fed’s borrowing cost, there would be no future impact on the Fed’s reported operating income. If the Treasury agreed to a lower interest accrual rate or no interest accrual, the Fed’s reported operating losses would increase.

If the suspended maturing principal payments are merely delayed until Congress increases the debt ceiling, the Fed would likely record these as deferred balances due from the U.S. Treasury and would not create a reserve for a credit loss. The suspension would disrupt the Fed’s quantitative tightening plans as its Treasury security balances would not run off as planned.

With the suspension of interest payments on the Fed’s portfolio of U.S. Treasury securities, the Fed would increase its borrowing to cover not only its ongoing operating losses, now about $8.6 billion per month, but also the additional cash shortfall created by the suspension, about $9.6 billion a month, for a total new borrowing of $18.2 billion a month.

The Fed would fund its cash shortfall by (1) printing paper Federal Reserve Notes or (2) borrowing reserves from banks and other financial institutions through its reverse repurchase program. Because the Fed’s ability to fund its losses by printing paper currency is limited by the public’s demand for Federal Reserve Notes, the Fed will have to borrow most of the funds paying an interest rate of 4.90 percent on borrowed reserve balances and 4.80 percent on the balances borrowed using reverse repurchase agreements.

Loans to the Federal Reserve System, whether from reserve balances or repurchase agreements, are backed by Treasury securities owned by the Fed, or by the full faith credit of the U.S. federal government, since the Fed is the fiscal agent of the U.S. Treasury. However, unlike securities issued by the Treasury, when the Federal Reserve borrows, its loans are not counted in the federal government debt that is limited by the statutory debt ceiling. Indeed, Federal Reserve system cash operating losses are not counted as expenditures in federal budget calculations. Because of these budgetary loopholes, Fed operating losses are excluded from any federal budget deficit cap and its borrowings circumvent the statutory federal debt ceiling.

Could the U.S. Treasury take the extraordinary step of selectively halting interest and principal payments on the Treasury securities owned by the Federal Reserve System? We do not recommend such an action but see nothing in law or current Federal Reserve accounting and operating practices that would preclude it should the Treasury need to take emergency measures to avoid a wider federal government default.

If extraordinary measures are needed, a better alternative is free up funds by updating the Congressionally legislated price of the Treasury’s 8,000 tons of gold to ensure prompt payments on all the Treasury’s debt and maintain the credit performance of the United States government.