PART ONE—Primary Issuance

Before I worked on Wall Street, I’d never really thought about government bonds. 

I mean sure, my dad had given me Series E savings bonds and told me to put them in a safety deposit box and never lose them, that they’d be valuable one day. And I’d seen those “Buy War Bonds!” posters in World War One movies and TV shows. 

But I hadn’t considered that borrowing money and issuing bonds was a whole industry that supported the economy of our entire country! They didn’t teach that in social work school!

Well, it’s true, and in 1987, I was about to enter this tiny corner of the financial world whose smooth operation was pivotal to the functioning of almost every aspect of our American lives. Who knew?

Here’s a fact. The US Government borrows a lot of money! It’s not like the Secretary of the Treasury just walks down the street and asks the local loanshark for a few bucks to cover him til payday. There’s a whole complicated operation involved and lots of players.

First there’s the Treasury Department. 

You remember them—that’s who you pay your federal taxes to every year. They’re responsible for printing all our paper and coin currency (the US mint); collecting taxes and tariffs and other monies due to the government (money coming in=income); paying all the government’s bills (money going out=expenses); managing the country’s finances (shouldn’t we have more income than expenses?!); and managing the public debt (borrowing money to fund the gap between income and expenses.) 

Of course they do other things too, like regulate the banks and set fiscal policy and prosecute people for tax fraud.

But let’s focus on the debt part for now. 

Imagine that your salary is not big enough to pay your bills. And your bills keep growing. What to do? You could find a way to reduce your bills. You could get a better paying job. Or you could run up your credit card to plug the difference. 

For the government, getting a better paying job means increasing income—raising taxes and fees. Reducing expenses means cutting programs like Social Security and Medicare or fewer dollars for the military and infrastructure and other critical services (National Parks! Interstates! Foreign aid!) All controversial topics. 

No one wants to pay more, no one wants to receive less. 

What’s a poor Treasury Secretary to do? Issue bonds!

As of this writing, the total amount of US bonds outstanding is…$24 TRILLION!

How does the Treasury go about issuing those bonds? They utilize the country’s central bank, otherwise known as the Federal Reserve Banking System. It has a seven person board of governors that sits in Washington DC and makes policy, and a group of twelve regional banks responsible for implementing that policy. The board of governors are the ones with the power to set interest rates—which you might have noticed they’ve been raising regularly these days, in the name of taming inflation.

New York (of course!) is Queen of those twelve banks. The NY Fed takes on the responsibility for managing the nation’s payment systems, overseeing the country’s banks, issuing all of the US debt, and storing 25% of the USA’s gold reserves. All right there at 33 Liberty Street in downtown Manhattan.

Back in the day, when the country was first issuing debt to fund World War One, the target buyer was individuals. It was your patriotic duty to buy bonds. You lent the government money and they’d pay you back—with interest! Guaranteed! 

How could they guarantee it? Well, the Treasury has the ability to print money (remember the mint?) and collect taxes (rates are set by Congress) so the government always has a source of funds. But the usual way they obtain funds to repay the bonds is…by issuing new bonds!

Back then, people lined up outside the NY Fed at 33 Liberty Street waiting to get to the window inside to pay their money and buy their bonds. They got a paper certificate that had coupons attached and every month, they would clip a coupon, come back to that window at the NY Fed and redeem it for a month’s worth of interest. 

Not exactly scalable when you need to borrow millions and billions and trillions of dollars!

The Fed needed intermediaries. This is where broker dealers come into the picture. A select group of broker dealers (there are only twenty-five) are designated as Primary Dealers and they have the exclusive and mandatory responsibilities of bidding on any new issue government bonds when the Treasury holds an auction and managing the resale of those bonds to individuals and institutions.

But those broker dealers are not banks so they cannot have accounts with the Federal Reserve Bank. Only banks who are members of the Federal Reserve system are allowed to have accounts at the Fed and can buy and sell government bonds through their accounts. Since the Primary Dealers are not banks (although some have sister companies that are banks), they need to have a relationship with a Federal Reserve member bank in order to buy and sell the government bonds they bid on at auction. Which brings us to our fourth set of players, the government securities clearance banks. At one point there were several Fed member banks who were willing to do this for the primary dealers (including JPMorgan where I worked) but these days there is one main government securities clearance bank who clears (i.e., lets them use their account at the Fed) for the primary dealers who don’t use their own affiliated Fed member bank: The Bank of New York.

So, four major players involved with the issuance of new US government debt—the US Treasury, the Federal Reserve Bank, the Primary Dealers and the clearance bank, the Bank of New York.

And, of course, Congress, who sets the debt limit. The debt limit is the total amount of money that the United States government is authorized to borrow to meet its existing legal obligations, including Social Security and Medicare benefits, military salaries, interest on the national debt (said interest is rising rapidly with the ongoing rate increases currently being implemented by the Federal Reserve Bank,) tax refunds, and other payments. Since 1960, Congress has adjusted the debt limit 78 times in order to allow the government to continue to meet its legal obligations by issuing debt.

What happens to all those bonds once they are issued?

To Be Continued…..PART TWO—Secondary Trading