The Fed’s Corporate Lending Facilities: A Case of Pseudo Markets
When the Federal Reserve announced on March 23 that it would purchase eligible corporate debt, syndicated loans, and exchange-traded funds (ETFs) via a special purpose vehicle (SPV), backstopped by the Treasury, moribund markets jumped. Highly leveraged companies like Carnival, Ford, and Boeing, which were unable to obtain funds in the bond market, suddenly found themselves able to borrow at rates that discounted the true credit risks. BlackRock, which will be managing the SPV, recorded a record inflow of nearly $4 billion to its iShares iBoxx High Yield Corporate Bond ETF in April, and also attracted investors to its iShares U.S. Investment-Grade Corporate Bond ETF.
Real versus Pseudo Credit Markets
Although the Fed's intent is to provide temporary liquidity to large U.S. firms, the promise of supporting corporate bond prices and making loans to highly leveraged companies undermines corrective market forces: real markets are supplanted by pseudo markets in which the central bank will be subsidizing distressed companies and politicizing the allocation of capital. Initially private investors may purchase more corporate debt, but if corporations use that credit to pay off existing debt, and do not invest in productive capital, losses may continue. Private investors then will have an incentive to offload their holdings to the SPV, effectively socializing those losses. Moreover, the Fed's financing of those purchases will further expand its balance sheet and make it difficult to exit the corporate debt market without creating additional financial turmoil. Perhaps that is why the Fed has been slow to roll out the SPV.
Those who value private, free markets recognize that the Fed's promise to revitalize corporate debt markets is, in reality, a step toward market socialism. In a dynamic market economy, private investors have many options and will take prudent risks based on expected future profits. If investors decide to buy bonds rather than stocks, they will do so only if the interest rate offered exceeds the opportunity cost of tying up their capital in one use relative to their next best alternative. With millions of investors and constantly changing circumstances, market interest rates will adjust to new information: some investors will gain, others will lose. That is the logic of the market.
Freely competitive markets ensure that relative prices reflect opportunity costs and that capital is allocated according to consumer preferences. Whenever governments or central banks interfere with that free-market process, the allocation of capital will diverge from that preferred by consumers—and there will be a loss of economic and individual freedom.
Section 13(3) on Steroids
The COVID-19 pandemic and the government-mandated lockdowns sharply reduced output and employment while increasing the demand for money. The Fed quickly reacted by reducing its policy rate to near zero, using forward guidance, and reigniting its large-scale asset purchase program (also known as quantitative easing or QE). In addition, the Fed, in conjunction with the Treasury, used its emergency lending authority under Section 13(3) of the Federal Reserve Act to set up a number of off-balance sheet SPVs.[1]
Although the Federal Reserve Act prohibits the Fed from buying corporate bonds, the Fed circumvented that restriction by having the Treasury authorize a SPV with two corporate credit facilities (CCFs): a Primary Market CCF to directly purchase newly issued investment-grade bonds of large corporations with maturities up to four years, as well as the bonds of "fallen angels" (i.e., corporations whose debt was downgraded to junk after March 22); and a Secondary Market CCF authorized to buy existing, investment-grade corporate bonds with maturities up to five years, as well as some debt from "fallen angels" and ETFs that specialize in corporate debt (see New York Fed, Condon, Marte, and Egan).
The Primary Market facility, expected to open later this month, will be backstopped by the Treasury's $50 billion equity investment, which the Fed can leverage up to $500 billion. The bonds will be held by the SPV (off the Fed's balance sheet), but the Fed's loans to the facility will show up on its balance sheet. The Secondary Market facility, which began purchasing ETFs on May 12, is backstopped by the Treasury's $25 billion equity investment. Thus, the Treasury's overall investment in the CCFs amounts to $75 billion. Those funds were appropriated by Congress as part of the $2.3 trillion CARES (Coronavirus Aid, Relief, and Economic Security) Act (see Condon).
Instead of Congress directly providing credit to the corporate sector via fiscal policy, the decision was made to let the Fed do the heavy lifting and extend its lending authority via a loose interpretation of Section 13 (3). It is instructional to understand how the Fed sets up the CCFs by examining the "Investment Management Agreement" for the Secondary Market CCF, dated May 11, 2020.[2]
That Agreement states, that, after receiving approval by the Secretary of the Treasury, the Federal Reserve's Board of Governors established the Secondary Market CCF, and the New York Fed then set up a limited liability company in Delaware called "Corporate Credit Facilities LLC." The company's obligations to the New York Fed ("as lender") are specified in a Credit Agreement. Loans are to be "secured by all of the assets of the Company." Finally, the asset manager, BlackRock Financial Markets Advisory, "shall not exercise such authority with any purpose or design of favoring or discriminating against any sector of the economy or region of the country."
The Fed initially will use BlackRock Financial Markets Advisory as the sole investment manager for the CCFs, and the New York Fed will impose investment guidelines to ensure that the objectives of the SPV are implemented. The CCFs are supposed to end operations by September 30, 2020, unless otherwise instructed by the Board of Governors and the Treasury. However, "the New York Fed will continue to fund the CCFs after such date until the CCF's holdings either mature or are sold" (New York Fed).
Subsidizing Corporate Credit Does Not Eliminate Risk
Setting up the SPV with Treasury backing takes some risk off the table for the Fed, but if the failure rate is higher than expected, the Treasury will have to acquire more funds from Congress to indemnify the Fed. The great uncertainty surrounding the pandemic and lockdown makes it very difficult to predict which firms will survive and which will fail, thus making the Fed's job of deciding how to allocate its credit a guessing game. There is no reason experts at the Fed will have better information than the market. BlackRock can supply its expertise, but there is no guarantee of success—especially in light of the nondiscrimination requirement. Indeed, the whole purpose of private, free markets is to discriminate in order to get an efficient allocation of scarce capital. When that mechanism is thwarted by central bank intervention, debt markets become politicized—and both the credibility and independence of the monetary authority becomes compromised. Taxpayers are also put at risk when emergency lending fails (see Long).
Narayana Kocherlakota, former president of the Federal Reserve Bank of Minneapolis, and now at the University of Rochester, has recognized the danger of allowing companies "to borrow at interest rates that are not reflective of their true risks." Recessions naturally cause private investors to demand a risk premium because of the increased probability of defaults on corporate debt. That risk does not disappear when the Fed and Treasury step in to create a SPV to subsidize it. It is merely shifted elsewhere—most likely to future taxpayers.
Conclusion
The Fed is ill-equipped to engage in corporate lending. Congress made the Federal Reserve a "monetary authority"—but now wants it to be a "national investment authority" as well.[3] In the process, the Fed's credibility and independence will be tested. The line between monetary and fiscal policy is quickly vanishing as the Fed gains more and more power, in the hope that it will save the real economy. However, restoring economic growth requires revitalizing real markets, not creating pseudo markets.
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[1] Section 13(3) of the Federal Reserve Act arose out of the Banking Act of 1932, otherwise known as the first Glass-Steagall Act, and became law on July 21, 1932, when Senator Glass added it as an amendment to the Emergency Relief and Construction Act. It is interesting to note that Glass, the founder of the Federal Reserve System, and Fed Board member Charles Hamlin were concerned that the Reconstruction Finance Corporation (RFC) might crowd out lending by the Fed, and convinced President Hoover to veto a bill designed to increase the RFC's lending authority.
Initially Section 13(3) was very restrictive and the Fed only approved a few Section 13(3) loans during the Great Depression. In 1991, Congress eliminated the constraint that the Fed could only discount "the same type of paper that was otherwise eligible for discount at a Federal Reserve Bank." The Fed used the expanded powers under Section 13(3) to help bail out Bear Stearns and AIG, and to set up the Term Securities Lending Facility, Term Asset-Backed Securities Loan Facility, and Commercial Paper Funding Facility during the 2007–2009 financial crisis. The Dodd-Frank Act amended Section 13(3) by requiring that Fed loans only go to a "program or facility with broad-based eligibility" and by prohibiting the Fed to "aid a failing financial company" or "borrowers that are insolvent." Also, all facilities established under Section 13(3) now require prior approval by the Secretary of the Treasury. This summary draws from Arthur S. Long, a partner at Gibson, Dunn & Crutcher.
[2] The Primary Market CCF Investment Management Agreement has not yet been published.
[3] Lev Menand distinguishes between a monetary authority and an investment authority: "Whereas a monetary authority strives to manage the money supply in a neutral way that encourages sustainable economic growth and price stability, an investment authority is necessarily non-neutral. Its investments affect relative prices and make some projects more attractive and cheaper to finance and other projects more expensive and difficult to finance" (p. 25). Hockett and Omarova make the case for a national investment authority.
