3/30/2020
By buying large amounts of some debt (treasuries and agency mortgages, primarily, but also targeted purchases in other segments), the Fed has agreed to become a natural source of promised or actual demand where there otherwise might not be any. This can help stem the tide of possible price declines, as well as keep interest rates and spreads within a stable range level. The Fed has operated an infrequently-discussed exchange-stabilization mechanism throughout its century-long history, which contains a variety of powers to assist liquidity of financial markets when needed. These new facilities created are an offshoot of that function. In normal times, there is a hesitancy by the Fed to become too involved in risk markets, due to the moral hazard in doing so, except for extraordinary economic times, where the benefits outweigh the risks. The ‘moral hazard’ is the perception of rewarding companies that take risk, just to be bailed out when the outcome turns negative, making the risk asymmetric. No doubt these will be debated after the fact for years, as the government interventions in 2008 continue to be by academics.
Through a slightly different mechanism, by providing a backstop for commercial paper, the Fed actions allow markets to continue to flow freely. Buying paper on the open market functions much like another ‘bridge loan’ over a period of time that is expected to be temporary. For instance, large credit-worthy companies may be in otherwise decent financial shape, but the coronavirus-related slowdown could disrupt normal borrowing for day-to-day accounts payable/receivable activities, which are financed through these very short term loans. In order to avoid a default or spike in borrowing rates, Fed actions help smooth market expectations (similar in some respects to co-signing for another’s loan, providing the lender more reassurance in ultimate repayment). This doesn’t mean a blank check necessarily, though. When conditions improve, it’s expected that the Fed will eventually back away from the magnitude of guarantees, if not all of them.
The critical goal here is to avoid a ‘run’ on credit. It’s not unlike the concept of a bank run from the early 1930’s. Prior to the days of FDIC insurance enacted by FDR during the Great Depression in 1933, banks were vulnerable to crises of confidence. If a particular bank was seen as weak, depositors (a few at first, but growing to a swarm or an entire town if rumors spread) would demand their funds back. Being levered institutions, bank assets have traditionally been tied up in longer-term loans (like residential mortgages and business loans) and could only provide immediate cash for some depositors but not all on any given day. If enough demand built up, the bank became insolvent and failed, causing everyone’s deposit balances to be wiped out. However, when the underlying depositor funds became insured by FDIC, the underlying fear and need for a bank run disappeared. The same thing can happen with certain types of fixed income, especially when the ‘run’ is through an ETF or other vehicle with a liquidity ‘mismatch’ (liquid trading vehicle, less liquid underlying components).
Another secondary objective is yield curve control, which affects the cost of funding for borrowers, whose rates are based on the treasury yield curve, such as corporates and municipals. With enhanced activity by the Fed, keeping rates low in this time of recovery is critical, and could positively affect the stability of intermediate- and long-term bond assets.
Specifically, the Fed announced a variety of policy changes, as well as enhancements of several existing and created new facilities, intended to grease the wheels of financial markets:
- After first committing to buying $500 bil. in treasuries, and $200 bil. in agency mortgage debt, the cap was removed, and buying power became open-ended/unlimited. This is designed to provide monetary stimulus (intended to lower rates across the longer-term part of the yield curve in addition to the short-term part already controlled by the fed funds rate), as well as normalized market functioning. The smoothing of market function when ‘logjams’ in certain assets occur is subtle and less-discussed, but is an important role of the Fed historically. This could be described as the Fed’s version of the ECB’s ‘whatever it takes’ announcement years ago.
- Primary Market Corporate Credit Facility (PMCCF, New). Designed to support the issuance of new bonds and loans for investment-grade companies with up to 4-year maturities (high yield excluded).
- Secondary Market Corporate Credit Facility (SMCCF, New). Provides liquidity for corporate bonds already in the market, including more significant corporate bond ETFs interestingly, and serves as a ‘workaround’ to purchasing corporate debt directly not allowed by statute, but similar to what has been happening in Europe and Japan.
- Term Asset-Backed Securities Loan Facility (TALF, Resurrected from 2008). Supports new issuance of asset backed securities, which are technically separate assets from corporate debentures. These include bonds backed by student, auto, credit card, and other SBA loans.
- Commercial Paper Funding Facility (CPFF, Existing/Expanded). Can buy commercial paper, providing a ‘release valve’ of sorts in the event of large redemptions in prime money market mutual funds and locked-up commercial paper markets. Money market funds have traditionally been uninsured (not guaranteed by the FDIC, as prospectuses have historically stated), but are treated by many Americans as stable savings vehicles nonetheless. Thus, due to their immense size, maintaining their stability is an important goal of the federal government.
- Money Market Mutual Fund Liquidity Facility (MMLF, Existing/Expanded). Similar concept as the CPFF, but focuses on purchasing short-term municipal variable-rate demand notes (VRDNs) and traded certificates of deposit. VRDNs are an important source of short-term financing for municipalities, which rely on such bridge lending to manage expenses in between lumpier income from tax receipts.
- Small business/‘Main Street’ lending program, expected, but not yet established.