The Fed’s Unprecedented Crisis Response
During a press conference on Wednesday, National Economic Council director Larry Kudlow announced that the Senate’s coronavirus economic-relief package would total $6 trillion, but the bill itself appropriates only $2 trillion — not quite as much as Kudlow said. That gap arises from the fact that nearly a quarter of the Senate bill — $454 billion — will go toward guaranteeing loans extended by the Federal Reserve. Because the Fed can lend roughly ten times what it holds in collateral for non-government debt, $454 billion from the Treasury could back as much as $4.5 trillion in credit.
Section 13(3) of the Federal Reserve Act gives the Fed the power to act as “lender of last resort” (LOLR) to financial institutions, individuals, or corporations in “unusual and exigent circumstances,” so long as borrowers post collateral. Typically, the Fed channels LOLR credit through the “discount window” for Fed member banks. Though LOLR power extends beyond banks, from the 1930s to 2008 the Fed refrained from lending to non-depository institutions. During the Great Financial Crisis, however, the Fed extended its LOLR power into the “shadow banking” system, a somewhat misleading moniker for the commercial-paper and money markets in which banks and corporations access short-term credit.
In 2008 a run on short-term debt securities caused a liquidity shortage. As markets sold off during the mortgage crisis, investors fled from even the safest markets. That triggered a “fire sale,” whereby falling asset prices depressed collateral values and fueled demand for cash, which further pushed down asset prices. Otherwise solvent businesses found themselves unable to fund daily operations. In order to smooth the markets, the Fed invoked 13(3) authorities to intervene in commercial-paper and money markets, as well as to guarantee certain asset-backed securities and provide cash to primary credit dealers.
The COVID-19 pandemic has caused a similar fire sale, but on a broader scale. Over the past month, plummeting revenue has led to a shortage of cash across the economy. Unable to pay their creditors without selling assets, some struggling businesses must liquidate a portion of their holdings to avoid defaulting. But during a crisis, nobody wants to buy assets. Fearing a protracted economic shutdown, panicked investors flee into cash and risk-free Treasury securities, and businesses become cash-starved.
This time around, the Fed acted early to provide liquidity to funding markets, first with a massive intervention in the repurchase-agreement market, and later with similar measures in commercial-paper and money markets. Now, with the passage of the Senate bill, the Fed will wade into medium-term debt markets for the first time through three new lending facilities.
Primary Market Corporate Credit Facility (PMCCF)
Through the PMCCF, the Fed will provide credit to investment-grade corporations by issuing loans and purchasing newly issued bonds with up to four-year maturities. These loans will, in the Fed’s words, “allow companies access to credit so that they are better able to maintain business operations and capacity during the period of dislocations related to the pandemic.” Interest rates will be set slightly higher than the market rate prior to the coronavirus outbreak, but borrowers can defer payments for six months or longer at the Fed’s discretion.
The Fed will hold these loans in a special-purpose vehicle (SPV), capitalized with $10 billion from the Treasury. This structure allows the Treasury to own the debt while the Fed funds and administers lending facilities. Since the Federal Reserve Act bars the Fed from incurring losses on investments, the Treasury’s equity stake in the SPV allows the Fed to buy securities it would otherwise be unable to.
Corporations that defer payments on PMCCF debt will be barred from buying back stock or paying dividends until they begin to pay interest. The legislation also includes the possibility of loan forgiveness for corporations that retain 90 percent of their employees.
Secondary Market Corporate Credit Facility (SMCCF)
Similar to the primary facility, the SMCCF enables the Fed to purchase bonds already trading on the secondary market. The Treasury will back those purchases with $10 billion, but in this case, maturities can reach up to five years. These purchases will not only stabilize markets but also ease monetary policy by lowering the spread between Treasury yields and corporate bond yields, effectively making credit cheaper and thereby spurring aggregate demand. The SMCCF caps purchases at 10 percent of a company’s bonds outstanding in the previous year, significantly lower than the cap of 110 to 140 percent on PMCCF purchases. The higher cap for the primary market means that direct loans will be less focused on broad market stability than on propping up low-risk, high-quality companies that are incurring losses because of the coronavirus shutdown.
Main Street Business Lending Program (MSBLP)
In another unprecedented departure from traditional policy, the Fed announced plans for a midsized-business lending program. Small- and medium-sized enterprises (SMEs) access credit through the banking system, not the capital markets. As a result, the Fed’s market interventions do not directly alleviate credit stress for SMEs. Liquidity provisions in securities and interbank-lending markets make more capital available for SMEs, but that credit may not reach the downstream businesses in a timely manner. While the spending package passed by the Senate on Wednesday expands Small Business Administration loans for companies with fewer than 500 employees, the Fed’s MSBLP will lend to businesses with 500 to 10,000 employees. As of now, the Fed has not outlined its plans for SME lending; because the program will cover a much larger number of companies without agency-rated debt, the MSBLP will be comparatively more difficult to manage.
Consequences
The Fed’s interventions seem to have already had an impact. The premium on investment-grade and municipal bonds — called “bond spreads” — fell substantially this week, after hitting its highest level since 2009. Less upward pressure on yields means borrowers can fund operations at a lower cost, which will help them weather the storm of the coronavirus shutdown.
But what amounts to a partial nationalization of systemically important financial markets also raises concerns. The lender-of-last-resort function is historically unpopular because the public sees “liquidity provision” as a byword for bailouts. The extension of credit to smaller firms, coupled with fiscal efforts to alleviate consumer hardship, should somewhat temper those concerns. But not everybody gets access: Riskier corporations, many of which have incurred losses through no fault of their own, do not qualify for these loan programs. The Fed can’t rescue everyone, which leaves it open to accusations that it picks winners and losers.
In the aftermath of this crisis, central bankers will have to reflect on how to enact sustainable monetary policy in a zero-interest-rate environment. While the Fed has taken a “whatever it takes” approach, throwing liquidity at every problem it encounters, a long-term crisis playbook may require structural reform of the financial system and monetary regime.
