Under the Coronavirus Aid, Relief, and Economic Security (CARES) Act, Congress appropriated $454 billion to the Treasury’s Exchange Stabilization Fund (ESF) to backstop emergency lending facilities known as “special purpose vehicles” (SPVs).[1] With the Treasury backstop, the Fed has the potential to lend a maximum of $4.5 trillion to fund the SPVs, which hold the assets off the Fed’s balance sheet—including emergency lending to corporations, small and medium-sized businesses, municipalities, and states (see Torres). In April, the Fed announced plans to lend nine SPVs up to $2.3 trillion to boost the economy (see Timiraos and Fed’s Press Release). However, the Fed has only provided about 6 percent of that amount (see Cox). All of the SPVs have now been activated (see Condon).
Although the Fed’s new lending powers were intended to counter the U.S. economic collapse following the government-ordered lockdown to combat the pandemic, they risk giving the Fed a permanent footprint in private credit markets. In this article, I focus on the consequences of the Fed’s entry into the corporate credit market, with the establishment of the Primary and Secondary Market Corporate Credit Facilities (CCFs).[2]
The Primary Market CCF, which opened on June 29, is designed to buy newly issued bonds, while the Secondary Market CCF began buying ETFs specializing in corporate debt on May 12 and began purchasing individual corporate bonds (including both investment-grade and high-yield bonds) after June 15. The later are “fallen angels”—that is, bonds of firms that were investment grade prior to March 23, but are now rated as junk bonds. The Primary Market CCF is backed by $50 billion from the Treasury’s ESF, while the Secondary Market CCF is backed by $25 billion. As of June 24, the Secondary Market CCF’s asset purchases only amounted to $8.7 billion (see Condon). The following section examines the objectives and operation of the Secondary Market CCF; the Primary Market CCP has yet to buy any bonds.[3]
Objectives and Operation of the Secondary Market Corporate Credit Facility (SMCCF)
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 via the CARES Act and Section 13(3) of the Federal Reserve Act. The “Investment Management Agreement” for the SMCCF set out the objectives for the facility while the “Credit Agreement” established the procedures for operating the program.
Objectives of the SMCCF
According to the Investment Management Agreement, the objectives of the SMCCF, including its relation to the Primary Market CCF, are as follows:
The [Corporate Credit] Facility is designed to achieve three objectives: (1) to provide broad support for secondary credit markets to facilitate orderly and timely risk transfer; (2) to support primary issuance for solvent borrowers at borrowing rates that are well aligned with the secondary market reflecting more normalized levels; and (3) to reduce the incidence and severity of market dysfunction, fire sales, and indiscriminate liquidation [p. 41, emphasis added].
Investment and Credit Agreements
The procedures for establishing the SMCCF, as described in the investment and credit agreements, are the following:
- The Secretary of the Treasury first approves the SPV.
- The Fed’s Board of Governors (not the Federal Open Market Committee) then establishes the Secondary Market CCF.
- The New York Fed sets up a limited liability company in Delaware—the “Corporate Credit Facilities LLC.”
- The LLC’s obligations to the New York Fed (“as lender”) are spelled out in the Credit Agreement: Loans are to be “secured by all the assets” of the LLC; 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”; and the New York Fed imposes investment guidelines to ensure the objectives of the SPV are implemented by the investment manager.
- The CCFs are to be terminated by September 30, 2020, unless otherwise instructed by the Board of Governors and the Treasury.
This is a detailed process with numerous legal documents and compliance requirements intended to prevent BlackRock from unfairly benefiting from its management role. The following paragraph from the Investment Management Agreement, Section 8.4, “Effective Internal Controls,” is illustrative of the complex relationship between the New York Fed and BlackRock:
The Manager shall provide to the FRBNY the System and Organization Control 1 (“SOC 1”)-Type II reports of the Manager and its Affiliates with respect to their respective operations and controls relevant to the performance of services under this Agreement, which reports have been prepared by an accredited independent auditor in accordance with the American Institute of Certified Public Accountants’ Statement on Standards for Attestation Engagements (SSAE No. 18) and International Standards of Attestation Engagements No. 3402, or successor standard report (“SOC 1 Reports”). The Manager shall provide SOC 1 Reports to the FRBNY at least annually. If the Manager’s SOC 1 Report covers a period other than a calendar year, the Manager shall also provide the FRBNY a letter signed by a responsible officer of the Manager attesting for the period of time from the end of the period covered by the SOC 1 Report through the calendar year in which that end date occurs (the “bridge period”) that (i) there have been no material changes to the tested controls during the bridge period; (ii) the control objectives remain in place; and (iii) the description of the services and related internal controls in the SOC 1 Report continues to be substantially accurate [p. 10, sec. 8.4.2].
In addition to strict compliance requirements, the Investment Management Agreement establishes a “Fee Schedule and Payment Procedure” (Exhibit D) that prohibits BlackRock (or any future manager) from receiving management fees when buying for its accounts under the program.[4] Nevertheless, BlackRock has already benefited by the strong uptick in the corporate ETF and bond markets stemming from the announcement effects of the CCF program. When the Fed first announced the SPV for corporate credit, the bond market saw a surge in demand for corporate debt: bond prices rose while yields fell. In response, the search for yield led to greater demand for junk bonds as well as stocks, pushing those asset prices up. Companies that were already highly levered became more so (see Wirz).
How the SMCCF Decides How Many Bonds or ETFs to Buy Each Day
The New York Fed provides a detailed description of how the SMCCF decides how many bonds or ETFs to buy on a daily basis. The language is precise and presented in the New York Fed’s “Frequently Asked Questions” (FAQs) bulletin:
The pace of purchases is based on a percentage of average daily volumes in the respective markets. The percentage to be purchased each day is based upon an array of measures of corporate bond market functioning, the rate of change of such measures, and other indicators. Measures of corporate bond market functioning include, but are not limited to, transaction cost estimates, bid-ask spreads, credit curve shape, spread levels and volatility, trading volumes, and dealer inventories. With respect to ETF purchases, ETF-specific measures such as premium or discount to net asset value (“NAV”) and creation/redemption volumes are considered. With respect to bond purchases, the results of SMCCF and PMCCF operations, demand in the PMCCF, PMCCF share of new issuance, and pricing and amounts of new issuance are considered.
If the measures used to size daily purchases indicate sustained improvement in market functioning, to levels at or near those prevailing prior to the COVID-19 dislocation, SMCCF purchases are expected to slow notably and, in some cases, could pause entirely. If those measures subsequently indicate deterioration in market functioning, however, SMCCF purchases would be expected to increase.
It is important to note the emphasis on “market functioning.” One of the Fed’s main arguments for intervening in the corporate credit market is the presumption that markets malfunction in the face of great uncertainty, like that caused by the pandemic. Yet it is normal for credit spreads and volatility to increase in the face of rising uncertainty (see Hetzel, p. 3).[5] Market participants have an incentive to collect information quickly and to factor it into their investment decisions. When faced with a pandemic and government lockdown of the economy, investors will reassess credit risks, which will show up in widening yield spreads. When central banks pursue policies that underprice risk, they distort relative yields, weaken the corrective forces of free markets, and misallocate scarce capital. Credit allocation is politicized and the “moral hazard” of mispricing risk is revealed—that is, when risk is underpriced by central banks, the demand for risky assets, such as “fallen angels,” increases. Highly indebted corporations take on more debt and risk insolvency.
Fed’s Justification for Entering the Corporate Credit Market
When the Fed announced its decision to create the Corporate Credit Facilities LLC on March 23, it justified that historic decision by arguing that central bank action was necessary to revive sagging corporate credit markets in the wake of the COVID-19 pandemic and the government’s lockdown of the economy. Private lenders faced great uncertainty in early March and were dumping their bond holdings, including investment-grade corporate bonds and ETFs. [see Wirz] As Fed Chairman Jerome Powell noted, “Investors fled from any kind of risk and … market[s] stopped functioning.”
This “market failure” narrative was also aired by Fed Vice Chairman Randal Quarles in a recent speech at the Exchequer Club in Washington:
The first phase of the impact of the COVID event on the financial system was the market turmoil we experienced in March. This was the result of severe uncertainty triggering major re-pricing and volatility in global financial markets, disrupting the flow of credit to the economy. We saw many examples of a “dash for cash,” with firms drawing down their lines of credit with banks, and the indiscriminate sale of assets by investors in order to obtain liquidity.
Likewise, Daleep Singh, executive vice president and head of the Markets Group at the New York Fed, argued that the role of the Fed during a crisis is “to make sure the financial system is functioning”—and to ensure that credit is provided to “particular parts of the economy that aren’t really getting a near-term benefit from Treasury market stabilizing” (in Hetzel, p. 14, emphasis added).
When Chairman Powell and his Board of Governors announced the new program aimed at restarting corporate debt markets via direct and indirect purchases of bonds and syndicated loans, their hope was to stabilize debt markets, aid large corporations, and stimulate employment and output. In particular, they wanted to create a strong demand for corporate bonds—even before any loans were made to the Corporate Credit Facilities (see Smialek).[6] With that aim in mind, Quarles remarked:
The authorities worked together to address the problem through a combination of monetary, fiscal, and regulatory measures. These interventions [which included the SPVs set up by the Fed and Treasury] led to rapid improvements in financial markets. Credit spreads have narrowed for both investment-grade and high-yield bonds, markets are functioning in an orderly manner, and credit provision to the economy has held up.
Powell would agree. On May 29, at an online forum at Princeton, he stated: “Even before we actually began lending, [markets] start[ed] to work again. There’s a confidence factor.” Private investors rushed back into the market, and even highly indebted firms like Boeing and Ford were able to secure funds (Boeing borrowed $22 billion in April and Ford $8 billion). Yields on investment-grade bonds fell and investors increased their demand for higher-yielding junk bonds (see Wirz).[7]
The Fed has been careful not to target individual firms in its corporate lending: It has bought ETFs tracking a broad portfolio of bonds and created its own index to guide its purchases of bonds on the secondary market.[8] Nevertheless, its intrusion in the corporate credit market affects the allocation of credit and supports bond prices and lowers yields below the true credit and default risks. More importantly, by promising to use its firepower to support both large investment-grade corporate debt and distressed firms, the Fed has created the expectation that it can price risk better than private markets and is needed to ensure that the corporate credit market functions smoothly. Yet, as Robert Hetzel, who spent more than 40 years as an economist at the Richmond Fed, notes: there was no market failure—spreads reflected investors’ expectations regarding the pandemic and how fast businesses would recover. In times of uncertainty, credit and default risks increase and should be reflected in yields (see Hetzel, p. 12).
Hetzel (p. 19) argues that the Fed’s justification for intervening in corporate credit markets rests on a false presumption—namely, that “financial markets ceased to function in mid-March, but were revived by the announcement of 13 (3) programs.” His narrative is that “markets continued to function” and that “the Fed played a key role in that continued functioning. However, its role was the traditional one of supplying ample reserves, not allocating credit.” That is why he calls the Fed’s intervention in credit markets “strikingly revolutionary” (p. 14).
Reasons for Keeping the Fed Out of the Corporate Credit Market
The close link between the Treasury and Wall Street—and the authority the Treasury secretary has in implementing the corporate credit program—endanger Fed independence. For that reason alone, having the Fed intervene in the corporate credit market is a bad idea. Other reasons for keeping the Fed out of the corporate credit market are:
- The Fed is ill-equipped to engage in corporate lending. The New York Fed has long engaged in open market operations, but now must oversee a complex SPV to buy corporate bonds, ETFs, and syndicated loans. Doing so requires more resources and staff time—at a high opportunity cost. Hiring BlackRock as a manager and coordinating with the Treasury adds more layers of bureaucracy. It also opens the Fed to politicization as monetary and fiscal policy merge. Consequently, the market allocation system for corporate credit is tainted.
- The Fed should be a “Monetary Authority” not a “National Investment Authority.” The Fed has tried to avoid picking winners and losers in making decisions about how to allocate credit. However, when it extends credit to “fallen angels,” buys ETFs that hold bonds of Apple and other profitable companies, and selects weights for its Broad Market Index, it is difficult to be fully neutral. The Fed’s discretionary powers are increased and its monetary authority diminished by a loss of independence.[9] The Fed should focus on its monetary responsibility to provide temporary liquidity to banks that are solvent and let Congress engage in spending decisions to support the private sector, which was shut down by the government to fight the pandemic.
- Private competitive markets, not the Fed or Treasury, should be setting the terms and price of corporate credit to avoid politicization of investment decisions and misallocation of credit. When the Fed effectively subsidizes highly levered companies, by allowing them “to borrow at interest rates that are not reflective of their true risks” (Kocherlakota), it is a movement toward market socialism and a danger to market liberalism.
- When companies can borrow at rates that don’t fully reflect the risks involved, the moral hazard problem can become serious—leading to even more risky investments and “zombie” corporations kept alive by “cheap” credit. This process saps funds from more profitable enterprises, slows economic growth, and reduces economic freedom.
- Capital markets by their very nature discriminate to steer capital and credit to its most productive uses. Although BlackRock is prohibited from discriminating “against any sector of the economy or region of the country,” that constraint could destroy, rather than create, societal wealth.
- The Fed’s role should be to provide a stable currency and keep nominal GDP on a stable path, not to engage in credit and fiscal policy, or to peg rates at near zero to support asset prices and create a pseudo-wealth effect. Placing a wall between fiscal and monetary policy is essential for the Fed’s independence and credibility.[10]
Congress could have placed the Treasury in charge of the SPVs for emergency lending and left the Fed free to focus on monetary policy and not intervene in credit markets or conduct fiscal policy. Although the Fed has moved slowly in using its firepower to purchase corporate debt—as well as in establishing its Main Street Lending Program and Municipal Liquidity Facility—there will be increasing political pressure to expand its footprint in those credit markets. Indeed, once started on the path of employing the central bank to extend credit to businesses, states, and municipalities, it will be difficult to reverse course. Market participants now expect the Fed to support an array of asset prices and any deviation from that policy is bound to have dire consequences. Normalization will therefore be more difficult. Hetzel is correct in arguing that, “If the Fed is going to forswear intervention in credit markets …, it will have to abandon its historic aversion to commitment and rules.” (p. 23).
The Fed’s Credibility and Independence Depend on Adopting a Monetary Rule that Limits the Scope of Monetary Policy
Since the global financial crisis and the pandemic, the Fed’s emergency lending powers have grown by leaps and bounds. Its balance sheet has gone from about $900 billion before the financial crisis to more than $7 trillion today. Its emergency lending authority has expanded dramatically as well, with a score of new SPVs and the power to leverage the Treasury’s $454 billion appropriation from Congress to as much as $4.5 trillion.
Now is the time for the Fed and Congress to think about the future of monetary policy and the steps needed to normalize Fed policy so that, when the pandemic ends, plans will be in place to ensure monetary stability and robust private credit markets.
First and foremost, Congress and the Fed need to consider moving toward a rules-based monetary system, such as one that ensures a steady growth path for nominal GDP. Forward guidance based on a sound monetary rule would be superior to “dot plots” and date-driven policy.
Congress and the Fed must recognize the limits of monetary policy. The Fed can determine the path of nominal income, but it can’t permanently increase wealth or real economic growth. Monetary policy should be divorced from credit policy and fiscal policy, which means depoliticizing the Fed. Private markets, not the Fed, should allocate credit. Lending directly to the Treasury—which is what happens when the Fed lends to an SPV—is “a dangerous and inappropriate action for any central bank,” according to Bill Nelson, chief economist at the Bank Policy Institute.[11]
In 2001, J. Alfred Broaddus and Marvin Goodfriend, officials at the Federal Reserve Bank of Richmond, wrote:
We assert two closely related principles. First, the Fed’s asset acquisitions should respect the integrity of the fiscal policymaking process by minimizing the Fed’s involvement in allocating credit across sectors of the economy. Second, assets should be chosen to minimize the risk that political entanglements might undermine the Fed’s independence and the effectiveness of monetary policy.
That is still wise advice in thinking about the use of Section 13(3) lending.
The Fed also needs to rethink the floor operating system, get rid of interest on excess reserves, and return to a corridor system—so that the stance of monetary policy is once again linked to the size of the Fed’s balance sheet (see Selgin, Plosser, Hetzel). Interest rates must be able to move freely and respond to market forces, not be rigged by government actions, either by the Fed or Treasury.[12]
This does not mean the Fed should do nothing, only that it should limit its actions to what is consistent with sound monetary policy and not try to engineer private credit markets or push up asset prices.
Conclusion
The Fed’s intervention in the corporate credit market is a risky venture. With the pandemic, the Fed has drifted into the fiscal space and is engaging in credit policy rather than pure monetary policy. Allocating credit to corporations—as well as to small and medium-sized businesses and municipalities—has taken the Fed far afield from its traditional role as lender of last resort to illiquid banks. Exiting from the current emergency programs may not be easy from a political standpoint. The longer they last, the more the Fed will be entangled with the Treasury and lose much of its independence.
Independence will be more secure—and monetary policy more predictable—the more limited the Fed’s powers are and the more guidance that is provided by a rules-based regime than by pure discretion in a fiat money world.
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[1] The ESF was created to provide an “orderly” system of exchange rates, not to take equity positions in SPVs (see Congressional Research Service).
[2] This article is based on my remarks at the Western Economic Association International’s virtual conference, June 29, 2020, and builds on earlier work (see Dorn and Dorn).
[3] For a detailed description of the Primary and Secondary Market Corporate Credit Facilities, see “FAQs: Primary Market Corporate Credit Facility and Secondary Market Corporate Credit Facility.” Unlike the Secondary Market facility, the Primary Market CCF requires that firms opt into the program. But few firms are expected to do so because the requirements are steep: corporations wanting the facility to purchase newly issued debt must be unable to secure “adequate credit” elsewhere; their debt must be investment grade or have a relatively high junk bond rating if downgraded after March 22, and the firm must be solvent (see Smialek).
[4] “The Manager [BlackRock] shall not charge the Company [SMCCF] for, and the Company will have no obligation to pay, fees to the Manager relating to the Company’s holdings of ETFs” (Investment Management Agreement, p. 54, Exhibit D). See also “Terms of Assignment for BlackRock.”
[5] References to Hetzel in this article come from the draft of his paper dated June 25, 2020, which was circulated for a panel at the Western Economic Association International’s virtual conference on June 29. The paper, “Covid-19 and the Fed’s Credit Policy,” is forthcoming as a Mercatus Center Working Paper.
[6] “The Secondary Market Corporate Credit Facility (SMCCF) was established to support credit to large employers by providing liquidity for outstanding corporate bonds.”
[7] It is difficult to determine the exact impact of the Fed’s announcement of the Primary and Secondary Market Corporate Credit Facilities, because the Fed also announced large-scale purchases of Treasuries. For other compounding factors, see Hetzel: “There is … no way to isolate the announcement effect of the Fed’s credit programs from the Fed’s monetary policy actions and from the fiscal policies in the CARES Act” (p. 12).
[8] The New York Fed reported on June 15 that its rate of purchases of outstanding corporate bonds, using its Broad Market Index, will depend on selected indicators of market functioning. In particular, the Secondary Market CCF would increase purchases “if those measures … indicate a deterioration in market functioning” (see Timiraos). The index is made up of nearly 800 eligible firms, with the highest weights given to Toyota Motor Credit, Volkswagen Group America, Daimler Finance, AT&T, and Apple (see Smialek, Cox, and Chappatta).
[9] 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).
[10] Broaddus and Goodfriend point out that the Federal Reserve’s exemption from the appropriations process means it “should avoid, to the fullest extent possible, taking actions that can properly be regarded as within the province of fiscal policy and the fiscal authorities.” They favor a Treasuries-only policy because it “leaves all the fiscal decisions to Congress and the Treasury and hence does not infringe on their fiscal policy prerogatives.” In contrast, “when the Fed extends credit to private or other public entities, … it is allocating credit to particular borrowers, and therefore taking a fiscal action and invading the territory of the fiscal authorities.” The authors recognize that, “in principle, the Fed could consider purchasing and maintaining a ‘neutral’ portfolio of non-Treasury financial assets mirroring the aggregate outstanding stock of financial assets in some way.” However, they believe that “defining and maintaining such neutrality in practice … would be exceedingly difficult if not impossible, especially in the short run.”
[11] When the assets and liabilities of the Fed are consolidated with those of the CCF LLC, “the loan from the FRBNY to CCF LLC is eliminated” (see “Factors Affecting Federal Reserve Balances of Depository Institutions”).
[12] Moving to yield curve control would be a move in the wrong direction (see Dorn). Pegging the price of government debt is not a panacea for real economic growth; it only allows for the growth of government and the demise of freedom.
