I wrote a piece earlier, Federal Reserve policy is getting crazier and crazier, about how the Federal Reserve has dramatically reduced capital requirements for the largest banks in the country – requirements that were put into place following the 2008 financial crisis to stabilize the financial system and prevent future crises – so that those banks could help finance the deficit. There’s essentially no other way for Treasury to keep up with the insane amount of economic value the coronavirus panic has nuked and continues to nuke with every day the economy is shut down.
I believe that Trump and state and local governments have made a catastrophic mistake in (1) pushing for this shutdown in the first place and (2) drawing it out as long as they have. I think there are far more intelligent ways to protect vulnerable populations than what is being currently done (which is basically lock everyone down and wait for vulnerable people to arrive at the hospital on death’s door). But the worst thing that is happening right now is the amount of risk the financial system is assuming to keep the country operating at anything approaching economic survival. The word “existential” has been abused in Washington DC through a billion manufactured crises over the years, but I think this is legitimately an existential crisis. And it’s totally unnecessary.
Much like the infringements on civil liberties that the shutdown has involved, the Federal Reserve is moving into areas that are, well… not even remotely legal. And they aren’t legal for very good reasons. The Fed has pretty much given up any semblance of independence from the Trump administration. And the more policymakers feed the panic machine, the more the Federal Reserve has to do ever more insane things. It’s quite the negative feedback loop.
The problem is, unless the shutdown stops, the Fed cannot stop doing these questionably legal maneuvers. Because once the music (liquidity) stops, we are in a Great Depression.
The economic debate of the day centers on whether the cure of an economic shutdown is worse than the disease of the virus. Similarly, we need to ask if the cure of the Federal Reserve getting so deeply into corporate bonds, asset-backed securities, commercial paper, and exchange-traded funds is worse than the disease seizing financial markets. It may be.
In just these past few weeks, the Fed has cut rates by 150 basis points to near zero and run through its entire 2008 crisis handbook. That wasn’t enough to calm markets, though — so the central bank also announced $1 trillion a day in repurchase agreements and unlimited quantitative easing, which includes a hard-to-understand $625 billion of bond buying a week going forward. At this rate, the Fed will own two-thirds of the Treasury market in a year.
But it’s the alphabet soup of new programs that deserve special consideration, as they could have profound long-term consequences for the functioning of the Fed and the allocation of capital in financial markets. Specifically, these are:
CPFF (Commercial Paper Funding Facility) – buying commercial paper from the issuer.
PMCCF (Primary Market Corporate Credit Facility) – buying corporate bonds from the issuer.
TALF (Term Asset-Backed Securities Loan Facility) – funding backstop for asset-backed securities.
SMCCF (Secondary Market Corporate Credit Facility) – buying corporate bonds and bond ETFs in the secondary market.
MSBLP (Main Street Business Lending Program) – Details are to come, but it will lend to eligible small and medium-size businesses, complementing efforts by the Small Business Association.
To put it bluntly, the Fed isn’t allowed to do any of this. The central bank is only allowed to purchase or lend against securities that have government guarantee. This includes Treasury securities, agency mortgage-backed securities and the debt issued by Fannie Mae and Freddie Mac. An argument can be made that can also include municipal securities, but nothing in the laundry list above.
So how can they do this? The Fed will finance a special purpose vehicle (SPV) for each acronym to conduct these operations. The Treasury, using the Exchange Stabilization Fund, will make an equity investment in each SPV and be in a “first loss” position. What does this mean? In essence, the Treasury, not the Fed, is buying all these securities and backstopping of loans; the Fed is acting as banker and providing financing. The Fed hired BlackRock Inc. to purchase these securities and handle the administration of the SPVs on behalf of the owner, the Treasury.
In other words, the federal government is nationalizing large swaths of the financial markets. The Fed is providing the money to do it. BlackRock will be doing the trades.
This scheme essentially merges the Fed and Treasury into one organization. So, meet your new Fed chairman, Donald J. Trump.
In 2008 when something similar was done, it was on a smaller scale. Since few understood it, the Bush and Obama administrations ceded total control of those acronym programs to then-Fed Chairman Ben Bernanke. He unwound them at the first available opportunity. But now, 12 years later, we have a much better understanding of how they work. And we have a president who has made it very clear how displeased he is that central bankers haven’t used their considerable power to force the Dow Jones Industrial Average at least 10,000 points higher, something he has complained about many times before the pandemic hit.
When the Fed was rightly alarmed by the current dysfunction in the fixed-income markets, they felt they needed to act. This was the correct thought. But, to get the authority to stabilize these “private” markets, central bankers needed the Treasury to agree to nationalize (own) them so they could provide the funds to do it.
In effect, the Fed is giving the Treasury access to its printing press. This means that, in the extreme, the administration would be free to use its control, not the Fed’s control, of these SPVs to instruct the Fed to print more money so it could buy securities and hand out loans in an effort to ramp financial markets higher going into the election. Why stop there? Should Trump win re-election, he could try to use these SPVs to get those 10,000 Dow Jones points he feels the Fed has denied everyone.
If these acronym programs were abused as I describe, they might indeed force markets higher than valuation warrants. But it would come with a heavy price. Investors would be deprived of the necessary market signals that freely traded capital markets offer to aid in the efficient allocation of capital. Malinvestment would be rampant. It also could force private sector players to leave as the government’s heavy hand makes operating in “controlled” markets uneconomic. This has already occurred in the U.S. federal funds market and the government bond market in Japan.
Fed Chair Jerome Powell needs to tread carefully indeed to ensure his cure isn’t worse than the disease.
I think we are a long ways away from Trump even being able to do something like what the author has described here. But much like the abuse of civil liberties, I am willing to think that if governments will engage in this sort of behavior now, they will do it in the future with much less impetus. We are already seeing how quickly financial crisis-era regulations went out the window. It seems safe to say no practical limitation in the financial realm has any teeth.
All of this seemed like a good idea last week when the administration was still in “reopen the economy by Easter” mode. But right now, the entire country is being held hostage for an epidemic that is primarily centered in New York. Now we are looking at the large-scale destruction of our economic output, again, and all of the good that the stimulus had accomplished is melting away.
Once the Federal Reserve has nationalized pretty much every aspect of the financial markets, it’s going to be hard to argue that Trump is not the United States’ first socialist president. He did not start off on that path, but he sure got there fast. What a legacy.