This is part 5 of my ongoing coverage of the Federal Reserve’s Coronavirus actions. You can read Part 1 here, Part 2 here, Part 3 here and Part 4 here. Thursday’s post was very unfortunately timed as its main theme was the lack of big actions for almost two weeks and then the Federal Reserve announced a big suite of policy actions a mere hour later. The bright side is it makes writing this post relatively straightforward- we’re breaking down the many different things that were announced on Thursday. That being said, this is probably the most wide-ranging and complicated Federal Reserve announcement yet. What exactly is this “2.3 Trillion dollars” in lending devoted to?
Municipal Liquidity Facility
Despite coming later in the announcement, I’m going to start with what I’ve been harping on for a while- Local and State debt purchases. Before getting into the details, I want to take a step back and comment on how huge this moment is. A decade ago, purchases of state and local municipal debt would have been unimaginable. There were not even leftists proposing state and municipal bond purchases at that time. It will forever change monetary policy that an option on the table is loosening financial constraints of state and local governments. One way to think about this is to look at Europe. Europe has no federal budget of macroeconomic significance and certainly doesn’t have a federal debt for the European Central Bank to buy and sell. Instead it picks and chooses the Eurozone member government debts it purchases- or doesn’t purchase. This is a political issue of profound significance. U.S. monetary policy may become politicized in this way, especially as we likely stay near zero interest rates for an extended period of time. We will likely be debating these points for many years to come.
The first significant thing to know about the Municipal Liquidity Facility (MLF) is that it is set up through a special purpose vehicle using section 13.3 emergency authority. This is significant because it means the Federal Reserve is trying to avoid the precedent of using section 14.2(b) powers where it has authority to purchase state and local debt of maturities 6 months or less. The program is authorized to buy debt that matures 2 years from the date of issuance or less, which is substantially shorter than congresswoman Maxine Waters’s proposal of 5 years or less. Since this facility is using special emergency powers and the Federal Reserve has politically committed to the idea that it “can’t take losses”, this program requires an “equity injection” from the Treasury and will be getting it to the tune of 35 billion dollars. The program is capped per issuer in that it can only purchase notes equal to 20% of the issuer’s 2017 revenue.
The strangest and worst thing about the Municipal Liquidity Facility is the arbitrary population cut offs on eligibility for the program. While all states are allowed participation in the program, cities must have at least 1 million residents to get support while counties must have at least 2 million residents. The logic of these cutoffs is that states can use their better financial situation to support smaller municipalities. This is bad reasoning and ignores the political divides between small local governments and their state governments. As Brookings Institution fellow Aaron Klein pointed out on twitter, this arbitrarily benefits cities in the southwest and the west coast which annexed adjacent territory. To the extent that population limits make sense (I’m skeptical of that), it certainly doesn’t make sense to exclude cities with large Metropolitan Statistical Areas. Also, as he says, this excludes the 35 most African American cities. That is unacceptable
Using city population (not metro) helps western cities that annexed land. 4 of the 10 cities the @federalreserve chose for special credit access are in Texas, 3 in California + Phoenix. Only 2 in eastern time zone (50% of US population).
— Aaron Klein (@Aarondklein) April 10, 2020
The facility is capped at 500 billion dollars which, while large, does not seem anywhere near large enough given the need. An associated Federal Reserve Bank of New York blog post argues that this cap is well above municipal and state issuance of short maturity liabilities. This defense is not very convincing for a number of reasons. First, the latest crisis radically raises financing needs because of collapses in incomes and sales which in turn collapse tax revenues. Second states not only need to be able to cover current shortfalls but they also need to be able to refinance longer maturity debt which they may have trouble refinancing under current conditions. This program has been launched under the assumption that sub-federal governments are facing short term “cash flow” issues because of delays in the payment of income taxes.
The problem is this crisis is not merely about those delays, it is about actual losses in income for these governments. They need to quickly begin issuing small denomination, tax receivable IOUs so they can become less worried with the fiscal effects of the collapse. The Federal Reserve can facilitate their issuance and circulation by purchasing large quantities of these small denomination “Tax Anticipation Notes”.
Overall, this program is a good start but it doesn’t recognize the long term support the Federal Reserve will need to provide sub-federal governments, including territories like Puerto rico and smaller cities. This is a historic moment and it will hopefully be the first of many to come.
Paycheck Protection Program Lending Facility
This facility is far more conventional than the Municipal Liquidity Facility. It, like Term Asset-Backed Securities Loan Facility, is meant to provide liquidity to certain asset classes by making those assets acceptable collateral for loans. In fact, at first glance, what is strange is that this is a distinct facility rather than simply an extension of TALF. After all, certain loans guaranteed by the small business association are already acceptable as collateral for TALF. One reason that could motivate this decision is to highlight and make clear to everyone that these loans were getting liquidity backing. The details make it clear that there is a specific reason- the all important matter of recourse. These loans are no-recourse which means the borrower can default and all the lender will have is the collateral for the loan. In essence, a no-recourse loan is a purchase which gives the seller the opportunity to hold the underlying collateral in case holding it is profitable to them.
This facility on one level makes sense- the Federal Reserve should do all it can to support congress’s program to help small businesses. On another level, it drives me absolutely crazy. If we were simply going to have banks originate loans and then have the Federal Reserve purchase them, why did we bother with congressional appropriations in the first place? This could have simply been a part of the Federal Reserve’s Main Street Lending Program. The political football that is the losses the Federal Reserve would have taken from forgiving loans could have been fixed by alternative accounting gimmicks. Instead of equity stakes into Federal Reserve SPVs, congress could have simply said that all losses should be booked in a separate emergency facility account that doesn’t count when calculating the Federal Reserve’s net-worth. Simply having the Fed manage and implement this program would have been far simpler than trying to roll out this program and have the Fed come in to fix technical issues in the background. This is a clear case where congress didn’t adequately think through program design and their initial design has been rendered incoherent by subsequent events.
Main Street Lending Program
The Main Street Lending Program is probably the most “out there” program announced. Municipal bond purchases are a big deal, but they also date back to a provision in the Federal Reserve Act from 1934. These programs are not completely unprecedented- during the great depression there was a section 13(b) in the Federal Reserve Act which provided similar powers- but those powers were removed in 1958 and are mostly forgotten. There is nothing the Fed wants to do less than lend to individual small businesses. There is no type of loan that needs proper underwriting more than a loan to a small business and the fed is currently nowhere near set up to do underwriting on individual loans. Their solution to this is have banks make loans and then the Federal Reserve will purchase 95% of those loans originated. The theory being that having to hold 5% of the loans on their books will incentivize prudent underwriting. This seems… optimistic and will likely slow down the lending process considerably.
The program is actually divided up into two facilities, similar to the corporate debt facilities. There is a facility for purchasing existing loans of the accepted maturity and structure called the “Main Street Expanded Loan Facility”. There is also a new loan facility straightforwardly called the “Main Street New Loan Facility”. The loans must have a 4 year maturity from the date the loan was made. The big benefit of these loans is that they defer principal and interest for one year. This is an extraordinary feature for the Federal Reserve to include as it represents losses today that may, or may not be made with future payments. That said, just because its extraordinary the Fed included it doesn’t mean it’s very beneficial to borrowers. As always, a business will take this kind of loan over going out of business but greater quantities of debt still put them on more and more of a backfoot.
– principal and interest payments deferred for one year.
The terms of accessing the facility naturally center around what to do with the proceeds of the loan. You aren’t allowed to repay other debts with it and should only make scheduled principal payments. You also aren’t allowed to seek reductions in your lines of credit. In contrast to PPP loans, these loans only require borrowers to make “reasonable efforts” to keep employees on payroll. Finally, for the duration of the loan, borrowers must restrict executive compensation, dividends and stock buybacks. The terms of these loans are about what we’d expect. The coming months will tell us how they are enforced. Finally, the facilities will be purchasing up to 600 billion dollars in loans. It doesn’t seem like this will be enough, though between this and PPP we’re getting to very high dollar amounts directed to small businesses
The first three programs we assessed are brand new. The next two under discussion are already announced programs that we are already very familiar with. TALF has been expanded to include Commercial Mortgage Backed Securities rated AAA by rating agencies and a number of newly issued Collateralized Loan Obligations. Recall that these loans are non-recourse, so they function as effectively purchases of these assets. The overall size of the program hasn’t been expanded, which suggests there hasn’t been much interest in it so far. Overall though, these changes are relatively small.
More interesting are the changes to the corporate debt facilities. As I expected, the facility has been changed to “grandfather” in corporations who had their ratings downgraded recently. Strangely, they picked March 22nd as the cutoff date when its possible that a company would have already been downgraded because of coronavirus predictions by then. The overall size of the Primary Market Corporate Credit Facility and the Secondary Market Corporate Credit Facility has also been expanded to 750 billion dollars altogether. The differential caps have been eliminated so that now any entity that meets the minimum rating standard will get the same benefit. The secondary market facility is now capped at 10% the eligible corporation’s highest outstanding total of securities at any point in the past year. The primary market facility is capped at 130% of the eligible corporation’s highest outstanding loans plus securities outstanding over the past year. Additionally, they’ve introduced an overall program cap. Both facilities combined will not devote more than 1.5% of their total size to any one eligible issuer. That is currently 11.25 billion dollars. The overall amount of shares of an exchange traded fund that the program will hold is also capped at 20% of their outstanding shares.
It is becoming a running theme in my coverage here that the Fed’s announcements are both a great leap forward for them but, at the same time, far too little. The latest announcements are no different. I’m also concerned that the accounting gimmick the Federal Reserve and the Treasury have chosen to politically defend the Federal Reserve from attack is inhibiting the functioning of their programs. A different accounting gimmick- such as creating a special account for emergency facilities where losses are booked but don’t affect the Federal Reserve’s balance sheet and calculation of net-worth- wouldn’t have relied on congress appropriating specific sums of money to be invested in Federal Reserve programs. That political effort could instead be devoted elsewhere. Meanwhile, the Federal Reserve could declare open-ended purchases that would be far more effective. Currently they are running into the “Quantitative Easing” problem where it takes many, many purchases to get a small movement in interest rates. Their municipal purchases program especially suffers from. It will be interesting to see how they deal with this problem as time goes on.