Treasury Securities and the U.S. Sovereign Credit Default Swap Market

D. Andrew Austin
Analyst in Economic Policy

Rena S. Miller
Analyst in Financial Economics

Paying the public debt is a central constitutional responsibility of Congress (Article I, Section 8). U.S. Treasury securities, which represent nearly all federal debt, have long been considered riskfree assets. The size of federal deficits and the projected imbalance between federal revenues and outlays, however, have raised concerns among some, including the rating agency Standard & Poor’s (S&P), which downgraded the U.S. sovereign credit rating from AAA to AA+ on August 5, 2011. S&P also cited “political brinksmanship” in debt ceiling negotiations as a factor, which raised the issue of a hypothetical federal default. Prices for Treasuries suggest that financial markets continue to consider federal debt instruments a safe haven despite the S&P downgrade. Continued concerns about rising federal debt and the ability of policymakers to reach solutions to fiscal challenges could raise borrowing costs and negatively affect capital markets.

A credit default swap (CDS) contract is a way to hedge or speculate on credit risk, including sovereign credit risk. A CDS protection buyer, in exchange for an annual fee set by the market and paid quarterly, can trade an asset issued by a “reference entity” (or a cash equivalent) for its face value if a “credit event” occurs. A CDS buyer need not own or borrow an asset issued by the reference entity, thus may hold a “naked CDS.” A committee of the derivatives trade organization, the International Swaps and Derivatives Association (ISDA), determines whether a credit event has occurred, according to their interpretation of applicable guidelines. In general, failure to make a timely payment usually constitutes a credit event, as does a repudiation of debts, and in some cases, debt restructuring. 

Some view CDS price trends for U.S. debt as an indicator of the market’s perception of the federal government’s creditworthiness. The cost of buying CDS protection on federal debt for a one-year duration has roughly doubled since the start of 2011. In mid-August 2011, U.S. CDSs traded at about 55 basis points (bps; one-hundredths of 1%), after having risen to about 63 bps after the S&P downgrade. U.S. CDS trading volume rose and prices hit a record high of about 82 bps in the week before President Obama signed the Budget Control Act of 2011 (S. 365; P.L. 112- 25) on August 2, 2011. The act included provisions to raise the debt limit and reduce deficits.

U.S. CDSs have traded in the same price range as Germany, which is far below sovereign CDS prices for Greece, Portugal, and Ireland. For example, in mid-August 2011, Greek CDSs traded around 1700 bps, Portuguese CDSs around 800 bps, and Irish CDSs around 700 bps. While the federal government faces fiscal challenges, especially in the long term, markets seem to regard fiscal stresses confronting some European governments as far more severe and immediate.

The U.S. CDS market is small and thinly traded, which may limit its reliability as a measure of the federal government’s fiscal condition. CDSs may more usefully indicate sovereign default risks for countries with more immediate fiscal challenges, such as Greece and Portugal, where sovereign default risks may be more salient due to higher levels of fiscal stress, or for larger European economies, such as Italy and Spain, which have recently come under increased fiscal stress. Four Eurozone countries imposed certain restrictions on types of sovereign CDS trading in August 2011. This report explains how the sovereign CDS market works and how such CDS price trends may illuminate fiscal stresses facing sovereign governments. Although CDS prices may be imperfect measures of the federal government’s fiscal condition, some investors may try to glean information from those price trends, which could potentially affect U.S. debt markets in the future. European calls for reform in sovereign CDS trading may also be of interest to U.S. lawmakers.


Date of Report: August 15, 2011
Number of Pages: 29
Order Number: R41932
Price: $29.95

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Department of Housing and Urban Development (HUD): FY2012 Appropriations

Maggie McCarty, Coordinator
Specialist in Housing Policy

Libby Perl
Specialist in Housing Policy

Eugene Boyd
Analyst in Federalism and Economic Development Policy

Katie Jones
Analyst in Housing Policy

Bruce E. Foote
Analyst in Housing Policy

The President’s FY2012 budget was released on February 14, 2011. It included a request for nearly $47.8 billion in gross new appropriations for HUD in FY2012. After accounting for rescissions of prior-year unobligated balances and offsets available from the Federal Housing Administration (FHA) mortgage insurance programs, the President’s request for net new budget authority for HUD in FY2012 totals just over $41.7 billion.

The President’s budget requests funding for several new initiatives that were included in prior years’ budget requests. These include $200 million for the Transforming Rental Assistance initiative to convert some units of public housing and Section 8 project-based rental assistance to a new form of rental assistance, and funding for a Choice Neighborhoods program to replace the HOPE VI public housing program. The President’s budget lists homelessness assistance as a top priority and includes increased funding for homeless assistance grants, in addition to funding for new housing plus services demonstrations.

The President’s budget, which was released prior to enactment of a final FY2011 appropriations law, also includes some funding decreases relative to FY2010. These include a 17% reduction in funding for the public housing operating fund (compared to FY2010) and funding reductions for the two largest block grant programs in HUD’s budget, the Community Development Block Grant program (a 7.5% reduction compared to FY2010) and the HOME Investment Partnerships block grant (a 10% reduction compared to FY2010). Funding for the Section 811 Housing for Persons with Disabilities and Section 202 Housing for the Elderly accounts would also be reduced relative to FY2010 under the President’s budget request. However, in the case of all of these programs except the operating fund, the President’s requested amount is higher than what was provided in the FY2011 appropriations law.

The largest accounts in HUD’s budget, the Section 8 Tenant-Based Rental Assistance account and the Section 8 Project-Based Rental Assistance account, would receive the largest funding increases under the President’s budget request, relative to both FY2010 and FY2011.

In total, the President’s funding request for HUD would result in a nearly $2.5 billion increase in gross new appropriations in FY2012 relative to FY2011. However, because the President’s budget estimates a substantial increase (nearly $2 billion) in the amount of offsetting receipts available from the Federal Housing Administration (FHA) in FY2012 relative to FY2011, the net budget authority requested in the President’s budget would represent an increase of only about $600 million in FY2012 relative to FY2011.

While not directly affecting HUD funding, the provisions in the Budget Control Act of 2011 (P.L. 112-25) relating to statutory discretionary budget caps and their enforcement through sequestration could have implications for the amount of funding available for HUD in FY2012 (see the Appendix for more information).


Date of Report: August 23, 2011
Number of Pages: 28
Order Number: R41700
Price: $29.95

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The Alternative Minimum Tax for Individuals

Steven Maguire
Specialist in Public Finance

Over time, the individual income tax has been used as a vehicle to promote various social and economic goals. This has been accomplished by according preferential tax treatment to certain items of income and expense. The net result, however, has been that by taking advantage of the preferences and incentives in the tax code, some individuals can substantially reduce their income taxes.

Congress, in 1969, enacted the predecessor to the current individual alternative minimum tax (AMT) to make sure that everyone paid at least a minimum of taxes and still preserve the economic and social incentives in the tax code. The AMT is calculated in the following manner. First, an individual adds back various tax preference items to his taxable income under his regular income tax. This amount then becomes the AMT tax base. Next, the basic exemption is calculated and subtracted from the AMT tax base. A two-tiered tax rate structure of 26% and 28% is then assessed against the remaining AMT tax base to determine liability. The taxpayer then pays whichever is greater, the regular income tax or the AMT. Finally, the AMT tax credit is calculated as an item to be carried forward to offset regular income tax liabilities in future years.

Since its inception, the value and effectiveness of the minimum tax has often been the subject of congressional debate. Recently, the combined effects of inflation and the pending expiration of the 2001 and 2003 regular income tax cuts, have increased congressional concern about the alternative minimum tax.

The 2001 and 2003 tax cuts (P.L. 107-16 and P.L. 108-27) provided for temporary increases in the basic exemption for the AMT as a means of mitigating the interaction between the reductions in the regular income tax and the AMT. The Working Families Tax Relief Act of 2004 (P.L. 108- 311) extended those increases in the AMT exemption through 2005. Tax Increase Prevention and Reconciliation Act of 2005 (P.L. 109-222) patched the AMT for 2006 and allowed nonrefundable personal tax credits to offset AMT liability in full. The Tax Increase Prevention Act of 2007 (P.L. 110-166), enacted on December 26, 2007, increased the exemption and allowed all personal and business credits against the AMT. The Tax Extenders and Alternative Minimum Tax Relief Act, which was included in the Emergency Economic Stabilization Act of 2008 (P.L. 110-343) and enacted on October 3, 2008, extended the AMT patch for the 2008 tax year.

In the 111th Congress, P.L. 111-5, The American Recovery and Reinvestment Act of 2009, included a one-year patch for the 2009 tax year, increasing the exemption amounts to $46,700 for individuals and $70,950 for joint filers. A permanent fix to the AMT would be expensive. Indexing the AMT for inflation at the 2009 levels through 2020 would cost an estimated $1.2 trillion. The revenue loss estimate assumes that the 2001 and 2003 tax cuts are extended for all taxpayers. On December 17, 2010, the AMT was patched for the 2010 and 2011 tax years by P.L. 111-312. The cost of the two-year patch was estimated to cost $136.7 billion over the 2011 to 2020 budget window. The AMT is not patched for the 2012 tax year. This means that, when coupled with the extension of the 2001 and 2003 tax cuts, roughly 34 million taxpayers will be affected by the AMT in 2012. Pairing AMT repeal with extension of the 2001 and 2003 tax cuts would generate a revenue loss of $2.7 trillion over the 2011-2022 budget window.


Date of Report: August 23, 2011
Number of Pages: 12
Order Number: RL30149
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Fannie Mae’s and Freddie Mac’s Financial Problems

N. Eric Weiss
Specialist in Financial Economics

The continuing conservatorship of Fannie Mae and Freddie Mac at a time of uncertainty in the housing, mortgage, and financial markets has raised doubts about the future of these enterprises, which are chartered by Congress as government-sponsored enterprises (GSEs) and whose debts are widely believed to be implicitly guaranteed by the federal government.

In 2008, the Federal Housing Finance Agency (FHFA) replaced the Office of Federal Housing Enterprise Oversight (OFHEO) as the GSEs’ safety and soundness regulator and took them into conservatorship. OFHEO had repeatedly assured investors that Fannie and Freddie had adequate capital, but as highly leveraged financial intermediaries, Fannie Mae and Freddie Mac had limited capital to cushion themselves against losses.

The Treasury agreed to buy mortgage-backed securities (MBSs) from the GSEs and to raise funds for them. Initially, each GSE gave Treasury $1 billion in senior preferred stock and warrants to acquire, at nominal cost, 80% of each GSE. When Treasury responds to the GSEs’ request for additional funds for the second quarter of 2011, it will hold nearly $169 billion of preferred stock in the two GSEs. Treasury has agreed to invest whatever is required to maintain GSE solvency through calendar year 2012. Now the formerly implicit guarantee is nearly explicit.

In addition to Treasury’s purchases of senior preferred stock, the Federal Reserve (Fed) has purchased GSE bonds and MBSs. According to FHFA, the Fed and Treasury together have purchased $1,356.7 billion in MBSs; these purchase programs terminated at the end of the first quarter of 2010.

Under terms of the federal government’s purchase of their preferred stock, the enterprises are required to pay the government dividends of nearly $17 billion annually (10% of the support). Housing, mortgage, and even general financial markets remain in an unprecedented situation.

Estimates of the total cost to the federal government use different baselines and vary widely. The FHFA estimates that Treasury is likely to purchase $221 billion-$363 billion of senior preferred stock by the end of 2013. The Congressional Budget Office estimates the budget cost for 2011- 2020 to be $53 billion. Standard & Poor’s has estimated the cost at $280 billion plus $405 billion to create a replacement system.

Once Treasury’s support for Fannie Mae and Freddie Mac ends, sometime after 2012, the GSEs will be challenged to pay the 10% annual cash dividend contained in their contracts. The enterprises could instead pay a 12% annual senior preferred stock dividend indefinitely.

In August 2011, Standard & Poor’s downgraded the debt of the federal government, Fannie Mae, and Freddie Mac. To date, there is no evidence that this has increased mortgage interest rates, but the impact may take longer to occur or to be detected.

The 112th Congress is likely to consider the future of the GSEs and ways to reduce the cost to the federal government.


Date of Report: August 17, 2011
Number of Pages: 26
Order Number: RL34661
Price: $29.95

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The Economic Implications of the Long-Term Federal Budget Outlook

Marc Labonte
Specialist in Macroeconomic Policy

Following the financial crisis, the budget deficit reached 10% of gross domestic product (GDP) in 2009 and 9% of GDP in 2010, a level that cannot be sustained in the long run. Concerns about long-term fiscal sustainability depend on the projected future path of the budget, absent future policy changes. While entitlement spending made little contribution to current budget deficits, the retirement of the baby boomers, rising life expectancy, and the rising cost of medical care result in projections of large and growing budget deficits over the next several decades. Social Security outlays are projected to rise from 4.8% of GDP today to 6.1% of GDP in 2035, and federal health outlays (mainly on Medicare and Medicaid) are projected to rise from 5.6% today to as much as 10.3% of GDP in 2035. These increases in spending are not expected to subside after the baby boomers have passed away. Without any corresponding rise in revenues, this spending path would maintain unsustainably large and persistent budget deficits, which would push up interest rates and the trade deficit, crowd out private investment spending, and ultimately cause fiscal crisis.

To avoid this outcome, taxes would need to be raised or expenditures would need to be reduced. Altering taxes and benefits ahead of time would reduce the size of adjustments required in the future, if the proceeds were used to increase national saving. (Making changes ahead of time would also allow individuals time to adjust their private saving behavior.) National saving can be increased by reducing the budget deficit. But if the budget savings is subsequently offset by new spending or tax cuts, the government’s ability to finance future benefits will not have improved. Individual accounts financed by increasing the budget deficit would not increase national saving or reduce the government’s fiscal imbalance, and could exacerbate that imbalance over the 75- year projection.

Relatively small tax increases or benefit reductions could return Social Security to long-run solvency. Restraining the growth in Medicare and Medicaid spending is more uncertain and difficult, however. The projected increase in spending is driven more by medical spending outpacing general spending increases than by demographic change. But it is uncertain how to restrain cost growth because much of it is the result of technological innovation that makes new and expensive treatments available. If future medical spending grows more slowly than projected, then the long-term budget outlook improves dramatically. From a government-wide perspective, Social Security or Medicare trust fund assets cannot help finance future benefits because they are redeemed with general revenues at a time when the overall budget is in deficit.

The reason revenues are not projected to rise along with outlays is that these programs are financed on a pay-as-you-go basis: current workers finance the benefits of current retirees. In the future, there will be fewer workers per retiree. Once a pay-as-you-go system is up and running and faced with an adverse demographic shift, there is no reform that can avoid making some present or future generation receive less than past generations. Under current policy, future generations will be made worse off by higher taxes or lower benefits. Under a reform that increases national saving, some of that burden would be shifted to current generations. Overall, current budget deficits negate the system’s limited existing prefunding, exacerbating the future fiscal shortfall. While entitlement spending on the elderly is the major driver behind future deficits, it played little part in the growth of the current budget deficit to unsustainable levels. Reducing the current deficit is the most straightforward and concrete step that can be taken today to reduce the future shortfall.


Date of Report: August 16, 2011
Number of Pages: 28
Order Number: RL32747
Price: $29.95

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