This column contains corrections.
The ongoing, severe shock to the economy caused by the coronavirus pandemic has led the Federal Reserve to take a series of extraordinary actions. In addition to making massive purchases of Treasury and agency mortgage-backed securities, the Fed has implemented a significantly expanded version of its Great Recession playbook to shore up the economy. It has to date established 11 special lending facilities capable of buying more than $2.3 trillion in assets. Lending on this scale will dwarf what was done in the Great Recession.
Moreover, some of these facilities will take the Fed into new territory. It will now buy newly issued corporate bonds from individual firms, as well as buy participations in newly issued loans and expansions of existing credit lines. In the process, it will directly set interest rates for bonds and in the case of loan and credit line participations, determine the permissible range of interest rates and set parameters around loan uses. These innovations will give the Fed increased direct say into aspects of financial market operation.
Of course, standing ready to purchase large amounts of financial assets helps to preserve the liquidity and stability of the financial system. When there is a buyer of last resort, there is a greater ability to buy and sell financial assets without causing big changes in prices—that is, markets for those assets stay more liquid. This liquidity reduces the likelihood of asset fire sales, which can drastically reduce the value of assets and make the financial intermediaries holding them insolvent. Hence, the financial system is more stable, and disruptions to the flow of credit are reduced.
However, there is more than one way for the Fed to support financial stability and liquidity. From the point of view of taxpayers who will be exposed to substantial risk by this rescue program, there are significant flaws in its structure, operation, and oversight. If the Fed is to deliver essential support to the economy in a manner that is fair and equitable to all taxpayers, and does not compromise Fed independence, these shortcomings must be addressed. Four sets of changes must be made if the Fed is to achieve this goal:
- Credit to private parties must be conditioned on worker and taxpayer protections.
- Potential conflicts of interest must be addressed.
- Facility operations must be fully and contemporaneously transparent.
- Accountability for the structure, operation, and outcomes of the rescue must be stronger and contemporaneous.
Given the expanded scale and scope of this lending program, it is crucial to get the design right.
Signs of financial market stress
Since the beginning of the global coronavirus crisis, there has been a growing, collective recognition that the pandemic-induced shutdown would sharply reduce economic activity and income and make it difficult for some firms and sectors to repay their debts. The result has been a flight to safety, as many investors opted to sell equities and other risky financial assets and hold cash and government securities.
Stock market price declines came first, beginning in mid-February, followed by big price changes in other financial instruments. The price of corporate bonds provides a clear example. Beginning in late February, interest rates on corporate bonds began to spike upward. By late March, the rates were at their highest since the Great Recession, increasing the cost of finance for businesses and households at exactly the wrong time.
The upward movement eased after March 23—the date the Fed announced the establishment of facilities to purchase new and existing corporate bonds. There were similar movements in interest rates for other forms of business borrowing such as commercial paper.
These financial market disruptions originated in the nonfinancial economy, as the pandemic shut down economic activity. The prices of corporate bonds are declining, and interest rates on those bonds rising, because many corporations are experiencing dramatic falls in revenue, raising the risk of default. This scenario differs from the Great Recession, which was caused by the collapse of the house-price asset bubble and the resulting insolvency of major financial institutions.
However, there is no guarantee that financial institutions will avoid increased stress as this crisis develops. The deeper and longer the contraction, the greater the number of businesses and households that will have difficulty paying their debts, and the greater the losses that financial institutions may experience. The relatively high levels of U.S. corporate and household debt suggest that the volume of defaults could be quite large.
The changes introduced by the Dodd-Frank Act have so far helped keep financial institutions stable. Banks, for example, have been required to finance their activity with substantially more loss-absorbing equity than before the financial crisis, despite steps taken by the Trump administration to weaken these requirements. This has meant that banks are able to take higher losses without experiencing runs by their depositors and creditors.
However, bank equity can be eroded by ongoing borrower defaults and asset price declines. Recent bank earnings reports, for example, illustrate this dynamic. If the crisis deepens, important financial institutions may experience sharper losses and declines in equity, which could force the Fed to take additional actions to support them.
The structure of Fed rescue actions
To deal with financial market stress and limit negative effects for the overall economy, the Fed has so far set up 11 special lending facilities, with the combined capacity to spend a total of more than $2.3 trillion. This is more than 10 percent of 2019 U.S. gross domestic product.
This enormous undertaking is predicated on Section 13(3) of the Federal Reserve Act, which grants the board of governors of the Federal Reserve the power in “unusual and exigent circumstances” to make loans to “any individual, partnership or corporation” through a program or facility with broad-based eligibility. The program or facility must be designed to ensure that it is “for the purpose of providing liquidity to the financial system, and not to aid a failing financial company, and that the security for emergency loans is sufficient to protect taxpayers from losses and that any such program is terminated in a timely and orderly fashion.” Furthermore, facility procedures must “prohibit borrowing from programs and facilities by borrowers that are insolvent.” The treasury secretary must approve all lending programs. But beyond these conditions, the Fed has discretion about how much to lend and to whom.
As in the Great Recession, the Fed is exercising its lending authority via special purpose vehicles (SPVs). The principal funding of each SPV is from the Fed, and each SPV is used to buy specified assets that are held as collateral. But following protocol established during that crisis, the Treasury provides a fraction of the funding for each SPV, and those funds are in an “equity” position. This means that the Treasury—that is, taxpayers—will bear any losses of the SPV, up to the value of its investment. It is unclear how losses that exceed the Treasury’s contribution would be allocated.
The Treasury uses congressionally authorized funds for these contributions to Fed SPVs. To date, these funds have come from the Treasury’s Exchange Stabilization Fund (ESF) and a $454 billion allocation to support essential business in the CARES Act. The ESF, although initially established during the fixed exchange rate era, was later redefined in an expansive manner that allows the Treasury to purchase a wide variety of financial instruments. CARES Act funds have some conditions attached, depending on how they are deployed, but the Treasury has wide latitude to determine where contributions are made and on what conditions. While it has used a substantial portion of that allocation, the remainder could be used to further expand the capacity of Fed lending facilities.
So far, the Treasury has not used its control of ESF and CARES Act funds to insist that those who use the Fed rescue facilities take actions to protect workers and taxpayers, except when the CARES Act explicitly requires it.
The structures of the 11 lending facilities established thus far, as well as the source of Treasury contributions to each, are summarized in Table 1.
Public policy issues raised by the Fed’s rescue efforts
While Fed action has helped to preserve financial market stability and the operation of the nonfinancial economy, the structure and operation of this vast lending program raises several issues of public policy, outlined below, that must be addressed.
More than $1 trillion in lending will directly benefit large firms, which are required to do nothing in return
Six of the 11 lending facilities will buy financial assets that are, in general, issued or held by large, sophisticated firms. These firms are not required to do anything to compensate taxpayers for credit that, without Fed support, would be unavailable on equivalent terms.
- Two facilities—the Primary Market Corporate Credit Facility (PMCCF) and Secondary Market Corporate Credit Facility (SMCCF)—will use $750 billion to buy existing or newly issued corporate bonds from firms that were rated as investment grade on March 22, as well as below investment grade, or “junk” bonds, from firms that have lost investment grade rating since that date. The facilities will also purchase interests in syndicated loans from eligible issuers. That is to say, a huge amount of money will be used to support the ability of a relatively small number of very large firms to borrow. In 2019, Standard & Poor’s rated only about 7,000 corporate bond issuers as investment grade, although there are about 6 million firms in the United States.
It should be noted that since it was first announced, the structure of the PMCCF has been altered in a manner that sidesteps restrictions on corporations that sell their bonds to the facility. In its March 23 incarnation, the PMCCF had equity finance from the ESF and planned to provide loans. By April 9 it was larger, and the Treasury had substituted CARES Act money to fund its equity position. But the April 9 program no longer offers loans. Because of this change, the Treasury was able to contribute CARES Act funds without requiring users of the facility to cease dividends and buybacks, and to limit executive compensation.
- The Term Asset-Backed Securities Loan Facility (TALF) will lend $100 billion secured by highly rated asset-backed securities, which are bonds created by banks and other financial market institutions and backed by pools of smaller individual loans such as auto loans, student loans, and credit card receivables, issued on or after March 23.**
- The Commercial Paper Funding Facility (CPFF) will buy $100 billion of commercial paper, which are unsecured short-term promissory notes usually issued by large corporations that are often sold in denominations of $1 million.
- The Money Market Mutual Fund Liquidity Facility (MMLF) will lend $100 billion secured by collateral purchased by banks from prime, single-state, and tax-exempt money market funds, such as commercial paper, asset-backed commercial paper, and short-term municipal debt.***
- The Primary Dealer Credit Facility (PDCF) will provide loans of up to 90 days to primary dealers, collateralized by margin-adjusted investment grade debt securities and some equity securities. Loans will be made through the Federal Reserve Bank of New York. No limit is set.
Of course, these asset purchases and loans will have a wide range of desirable effects. Access to credit helps firms operate and helps households finance consumption. Financial firms and investors are protected from losses on the assets they hold, and financial markets are stabilized.
However, according to current descriptions of these facilities, the issuers of corporate bonds, syndicated loans, and commercial and asset-backed commercial paper, as well as the operators of money market funds, will get significant direct benefits without being asked to compensate taxpayers who will bear the risk of extending extraordinary support.
Conflicts of interest are built into the operation of several facilities
The Fed has indicated that bond buying by the PMCCF and SMCCF will be executed by BlackRock, a financial firm with about $7 trillion under management. Among other things, BlackRock operates retail mutual and exchange-traded fund bond funds, and it actively manages portfolios for individual and institutional clients. Hence, BlackRock will be pricing and purchasing assets on behalf of the Fed, when those actions will affect the company’s own financial interests and those of its business clients. This fact is implicitly recognized in a recent BlackRock announcement that it will waive management fees on exchange-traded funds that it buys on behalf of the Federal Reserve. Moreover, BlackRock will have advance information about purchases and prices that could be used to advantage its portfolio management business.
The Fed has also indicated that collateral for PDCF loans will be valued by the Bank of New York Mellon. Since this bank may well have ongoing business relationships with primary dealers providing the collateral, as well as with firms whose assets they are valuing, there are also potential conflicts of interest in the operation of this facility.
Taxpayer protection for loans to Main Street business is inadequate
The Main Street Lending Program (MSLP) consists of three facilities that will collectively have funding to buy $600 billion in bank loans extended to firms with up to 15,000 employees or up to $5 billion in annual revenue:
- The Main Street New Loan Facility (MSNLF) will purchase loans of $500,000 to $25 million. Conditions on the loans include the requirement that they are made to borrowers who were in sound financial condition at the end of 2019 and have a ratio of current debt to adjusted 2019 earnings of no more than 4-to-1. The lending bank will retain 5 percent of the loans on its books.
- The Main Street Priority Loan Facility (MSPLF) will purchase loans of the same size as those purchased by the MSNLF, but borrowers can have a ratio of debt to adjusted 2019 earnings of no more than 6-to-1. The lending bank will retain 15 percent of the loans on its books.
- The Main Street Expanded Loan Facility (MSELF) will purchase four-year term loans of $10 million up to $200 million, which will be used to increase the size of existing term loans or revolving credit facilities currently extended to borrowers with a ratio of debt to adjusted 2019 earnings of no more than 6-to-1. The lending bank will retain 5 percent of the loans on its books.
For all loans sold to the MSLP, borrowers cannot pay interest or principal on outstanding debt until the Main Street loan is repaid. But there are important exceptions to this limitation: Borrowers are allowed to pay debt or interest that is mandatory and due and are allowed to make regularly scheduled repayments of credit lines.
The rules for participation in this program make it likely that some very risky loans will be shifted onto the government balance sheet.
First, the risk retention requirements of the program provide limited protection for taxpayers. Under Main Street rules, banks must retain a 5 percent interest in any MSNLF or MSELF loan and 15 percent interest in any MSPLF loan. Hence, when a borrower defaults on a loan, the lending bank takes part of the associated loss. But the bank’s potential loss will be reduced by origination and loan servicing fees, in addition to any interest it might earn, and it need not consider the majority of the loss that will be borne by the public via the lending facilities. As a consequence, these retention requirements may fail to deter some very high-risk lending.
Moreover, the ability of borrowers to repay existing loans to the lending bank appears to enable banks with outstanding loans to failing borrowers to shift loss to the MSLP. A bank facing default on an existing loan or credit line can reduce its loss by making a new loan at a repayment deadline—with the understanding that the existing loan will be paid off—and selling off the new loan to the Main Street facilities. The bank’s loss on the new loan will be only a fraction of the loss on the old loan, and the borrower will delay default to the future.
These weaknesses may be consequential. Consider the example of shale oil and gas. Exploration and production of shale oil and gas is a capital-intensive enterprise that is viable only when oil and gas prices are high, debt finance is easily available, and interest rates on that debt are sufficiently low. The current collapse in oil prices means that many of these companies, especially those with large debt overhangs, are in dire financial straits. Under these rules, their existing bank lenders may be able to extend more credit to these firms at greatly reduced risk to themselves, and they may be able to shift losses for loans already on their books onto the federal government.
It is worth remarking that recent changes to the structure of the MSLP make it more likely that it will support shale oil lending. On April 9, the MSNLF required that new loans could not be used to repay or refinance existing loans or lines of credit extended by the lending bank. On April 30, repayment was permitted. By creating the MSPLF on April 30, the debt-to-earnings ratio for new loans was raised from 4-to-1 to 6-to-1. On April 30, the loan limit for the MSELF was raised to $200 million, up from the $150 million limit on April 9. These changes were advocated by shale of companies and their allies.
Moreover, it should be recognized that the ability of banks to shift losses to the Main Street facilities has the potential to circumvent the intent of Federal Reserve Act Section 13(3)(B)(ii), which expressly prohibits Fed lending to insolvent firms. The Main Street facilities will buy loans made by banks, and so long as the banks themselves are solvent, these Federal Reserve Act limitations will be formally met. In practice, however, loans may be bought from banks who are acting to reduce losses from borrowers who are about to default. Therefore, there could be substantial Fed lending to firms that are in reality insolvent or very close to being insolvent, but at one step removed.
Transparency in facility operation may be limited
Under Section 13(3), the Fed is required to report regularly on the operation of emergency lending facilities, beginning seven days after they are authorized. The reports include the terms and conditions of lending, along with the identity of individual recipients. At the request of the chair of the Fed’s board of governors, the required reports may be kept confidential and delivered only to the chair and ranking member of the Senate Banking, Housing, and Urban Affairs Committee and the House Financial Services Committee. This provision was designed to prevent runs on financial institutions that turn to the Fed for help. While the Fed will publicly disclose some data on all facilities using CARES Act funds, it has not pledged to release detailed credit agreements or deal documents related to these facilities. Moreover, it has not announced plans to disclose support extended via facilities such as the CPFF, TALF, and MMLF.
Accountability is lacking
Although the CARES Act intended to provide strong oversight for the rescue funds it provides, those provisions of the law are likely to be ineffective. The Trump administration has sabotaged the Pandemic Response Accountability Committee (PRAC), established by the act, by removing Glenn Fine, the Defense Department’s acting inspector general, from his position. Although Fine had been appointed executive director of the PRAC, he can no longer serve in that positions because he is no longer an inspector general.
In addition, the administration announced in its signing statement accompanying the CARES Act that it would not allow the special inspector general for pandemic recovery, also established by the act, to report administration refusals to provide information to Congress, as required by the law. This announcement was followed by the nomination of a White House counsel to be special inspector general.
Finally, the Congressional Oversight Commission, also established by the CARES Act, lacks subpoena power, which is essential to examine the construction and operation of this very complex set of facilities.
Making the Fed rescue more effective
Although significant public policy issues exist related to the operation of the Fed rescue activities, there are ways to effectively address these concerns.
All emergency lending to private parties must be conditional on worker and taxpayer protections
Much of Fed lending to private parties will go to large firms, which are not required to take any steps to protect their workers or taxpayers in return for public support. Instead of giving these companies a free pass, requirements such as those in Section 4003(c)(3)(D)(i) of the CARES Act should be extended to all private parties that use Fed facilities to obtain credit, regardless of the funding source for Treasury equity investments. These CARES Act provisions prevent dividend payments and stock buybacks; cover workforce retention, maintenance of wages, and a moratorium on outsourcing or offshoring jobs; and honor existing collective bargaining agreements and neutrality in any union organizing effort. Protections such as these should be provided to the American households who are standing behind this enormous rescue effort.
Taxpayers, who bear the risk of loss by supporting the Fed facilities, should also share in the gains that rescued firms will experience once the economy recovers. For publicly traded firms, this should be done by requiring the firms to provide equity options equal in value to a fixed proportion, say 10 percent, of the aid that they receive. If any private firms receive aid, equivalent financial instruments should be required. Government ownership positions should have priority if a firm enters bankruptcy.
There is ample precedent for lenders requiring participation in the upside of recovery. The government required equity warrants as part of the General Motors Co. and Chrysler rescues during the Great Recession. And when Warren Buffett came to the aid of Goldman Sachs during that crisis, he required stock options along with repayment of the loan that he made.
The MSLP must protect the interest of taxpayers more effectively
The conditions and metrics established for the MSLP may allow banks to make highly risky loans and to shift much of the loss for those loans, and loans they have already on their books, onto the public. While this might work to the benefit of some banks and some of their borrowers, it is not in the public interest.
The Fed can avoid these outcomes. A prohibition on using MSLP loans to repay existing loans made by the lending bank will foreclose banks’ ability to shift losses to the public. Higher bank participation requirements will reduce the incentive of banks to make very-high-risk loans.
Conflicts of interest in the operation of lending facilities must be addressed
The Fed plan to use private sector financial actors, including banks and asset managers, to operate lending facilities creates potential conflicts of interest. It is not clear how the potential for cronyism, self-dealing, and insider trading will be eliminated. The Fed must publicly address these potential conflicts and explain how they will be prevented.
Transparency must be full and contemporaneous
While the Fed has the option of keeping details about the operation of its lending facilities confidential, it should be judicious about decisions to do so. Instead of keeping important details secret, the Fed’s default option should be contemporaneous public disclosure of all credit agreements and deal documents for loans made by the rescue facilities.
There is precedent for this level of disclosure: The Treasury made deal documents related to the rescue of the auto industry during the Great Recession publicly available on a website. Rescue details should be withheld only if financial stability is at stake, and then only until stability threats have passed.
In addition, any information that members of the Congressional Oversight Commission deem relevant for their work should be promptly provided.
If these kinds of disclosures are not made, it may be impossible to identify the ultimate beneficiaries of Fed lending. Obscurity of this kind makes it easier for cronyism to operate.
Accountability must be effective and contemporaneous
There needs to be thorough public examination of crucial operational rules as they are being put in place, as well as a contemporaneous, public accounting of who benefits and who does not as a result of those rules for all Fed facilities.
Accountability is especially relevant when there is direct lending to individual corporations. The public needs detailed knowledge of facts, such as the standards used to determine PMCCF bond purchases and interest rates; what purchases are made and at what rates; and what purchases were declined. They also need to have sufficient information to be assured that pressure is not exerted directly or indirectly on facility managers to favor particular corporations. Similar considerations apply to MSLP loans. There needs to be transparency around which firms receive these loans, the risk characteristics of these borrowers, the terms on which each loan is made, and whether the loans are used to refinance existing loans from the same lender. There needs to be sufficient information to determine whether lenders using the program collectively favor particular borrowers and disadvantage or decline to fund other borrowers.
Accountability is also highly relevant to the operation of the Municipal Liquidity Facility, which will the buy debt of states and municipalities. It will be important to know which debt has been purchased, how the interest rates on that debt are set, and if any states or localities were denied purchase or disadvantaged by interest rate determinations.
Without this kind of scrutiny of all lending facilities, the door to cronyism is open, and Fed independence could be compromised.
Moreover, Congress should give the Congressional Oversight Commission subpoena power and expand its authority to oversee all Fed facilities funded with ESF as well as CARES Act funds. The commission should not wait until after money has gone out the door to fully and publicly examine the structure, operation, and effects of the lending facilities.
Should the operation of the commission be frustrated, which is an unfortunate possibility, the House Financial Services Committee and Senate Banking, Housing, and Urban Affairs Committee, both of which do have subpoena power, should step into the shoes of the commission.
The Fed rescue of financial firms during the Great Recession was often criticized for being what was characterized as a cost-free bailout for the very entities that caused that crisis. Present circumstances are obviously very different. The current crisis is directly tied to the economic effects of the coronavirus pandemic, and Fed actions are helping to sustain the economy. Providing financial market stability and liquidity can limit what Ben Bernanke termed “financial acceleration” of contractions in aggregate demand, output, and employment.
However, the current Fed rescue effort, which is far larger in scale and scope, needs significant amendment. By adopting the suggested changes detailed herein, the rescue effort will be seen now, and in the future, as more effective and equitable. The public will be better off, and the Fed’s crucial role in navigating this economic crisis will be more easily understood and less subject to popular backlash.
Marc Jarsulic is senior fellow and chief economist at the Center for American Progress. Gregg Gelzinis is senior policy analyst for Economic Policy at the Center.
** Correction, May 15, 2020: The text has been changed to make clear that the facility is making loans secured by asset-backed securities, not purchasing the securities.
*** Correction, May 15, 2020: The text has been changed to make clear that the facility is making loans secured by assets purchased from funds, not purchasing the assets.
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