There’s a very thin line between fear and greed.
As March 2020 unfolded, the financial markets began to unravel. Investors of all stripes simply wanted to get rid of risk, so everything was for sale at the same time. Money market funds, mortgage backed securities, corporate bonds, junk bonds and all related markets were quickly collapsing: all sellers and no buyers!
In early March, the Federal Reserve Bank (the “Fed”) stepped into the breach to stabilize financial markets and support the flow of credit to consumers, businesses, banks, and state & local governments. The actions taken by the Fed have been decisive, timely and massive. Thus far, they have managed to stabilize financial markets. The actions they have taken are summarized below.
Interest Rates are the Primary Weapon
On March 6, the Fed cut the Federal Funds Rate by 0.75%. Shortly thereafter, the Fed cut rates a further 0.75%, bringing the Federal Funds Rate to a range of 0.00% to 0.25%. The Federal Funds rate is the key short-term interest rate in the US banking system and drives the cost of all types of debt. This action reduced the cost of mortgages, auto loans, home equity loans and business loans. These interest cost savings leave more cash in borrowers pockets to mitigate the impact of the recession.
Keeping the Financial Markets Open
When investors only want to hoard cash or gold, financial markets cease to operate. In these circumstances, the Fed can become the buyer of last resort. If done properly, these Fed investments lead to a renewed confidence in the markets with more normal two-way markets developing.
In the COVID-19 crisis, the Fed acted quickly and in impressive size. Some of the key actions taken are discussed below.
First, the Fed resumed quantitative easing. In early March, they announced that they would buy $500 billion of Treasury securities and $200 billion of agency mortgage backed securities in the secondary markets. On March 23, they announced that these two programs would be unlimited.
Other actions included backstopping money market funds, adding massive liquidity to the securities repo market, direct lending to banks and relaxing bank capital requirements. These two latter actions help banks maintain reasonable levels of new lending.
The Fed instituted several programs to support business. One was the Primary Corporate Credit Facility to provide direct lending to major employers. These Fed loans would have no interest due for six months, provided the borrower paid no dividends and made no stock buy backs. They also activated the Secondary Market Corporate Credit Facility to buy bonds and ETF’s in the secondary markets. To prop up the short-term corporate debt market, the Commercial Paper Funding Facility was also opened.
Recognizing a gap in the government’s stimulus programs, on April 9 the Fed announced the Main Street Lending Program to provide loans to companies too big for the Paycheck Protection Program and too small for the Primary Corporate Credit Facility. This program can provide up to $600 billion of loans to companies with up to 15,000 employees or $5 billion in revenue.
Auto loans, student loans and credit card debt are all types of consumer loans that are funded by lenders in the securitization markets. Instead of holding these loans on their books, banks package these types of loans into large diversified pools and sell them off to the bond market.
With the unemployment rate headed to 20%, it was clear there would be a high level of consumer defaults on the interest and principal payments on these loans, so the securitization market began to shut down.
To address this problem, the Fed reopened the Term Asset-Backed Securities Facility to lend to holders of asset-backed securities collateralized by student loans, auto loans and credit cards.
Helping State Governments and Municipalities
State and local revenues, both taxes and fees, are under real pressure owing to the COVID-19 shutdown. With normal revenues sharply down, the need for new debt becomes paramount.
The Fed addressed this issue with a $500 billion facility to lend directly to states, counties and municipalities.
How Much Money Are We Talking About
If you’ve been reading earlier articles in The Informed Vermonter, you will know that the federal government’s economic stimulus measures exceed $2 trillion. Well, the measures outlined above are even bigger. Here is an attempt to add it all up.
Federal Reserve Bank COVID-19 Response
|Federal Reserve Program||Amount ($ billions)|
|US Treasury Purchases||500 plus as needed|
|Agency Mortgage Backed Security Purchases||200 plus as needed|
|Primary Corporate Credit Facility & Secondary Market Corporate Credit Facility||750|
|Main Street Lending Program||600|
|Term Asset-Backed Securities Loan Facility||100|
|State & Local Lending Facility||500|
|Repo Market Operations||1,000|
|Primary Dealer Credit Facility||As Needed|
|Money Market Mutual Fund Liquidity Facility||As Needed|
|Total||3,650 plus As Needed amounts|
$3.6 trillion! The amounts are huge, but the risks are not. The massive Repo Market Operations, Primary Dealer and Money Market Mutual Fund Facilities are mostly providing overnight loans and never longer than 90 days. These loans are also collateralized with investment grade securities. The Treasury securities purchased by the Fed have no default risk as the government can print the money to repay them.
The other programs mostly involve investment grade corporate and consumer debt securities (a small bit of the Secondary Market Corporate Credit Facility may have found its way into the junk bond market) where the risks are manageable but not zero. In these programs, money appropriated under the CARES Act has been provided by the Treasury Department to the Fed to cover anticipated losses. These reserves for possible losses are small in comparison to the size of the programs and may not be fully needed at the end of the day. Indeed, there is a sporting chance the Fed will make money on all this.
Many of the programs discussed above were developed to address the 2008-2009 financial crisis. As a result, the Fed was able to move very rapidly in the COVID-19 crisis…much more so than in 2008. Consequently, despite an unemployment rate heading to depression era levels, US financial markets have remained relatively stable and credit has continued to flow to both consumers and businesses.
Unlike the federal government, which has been on a borrowing binge since the current President took office, the Fed was reasonably well positioned for the COVID-19 crisis. They had been raising interest rates from late 2015, leaving them room to cut rates at the beginning of the COVID crisis. Also, the Fed greatly reduced its balance sheet by selling the securities it purchased during and after the 2008-2009 recession. This allowed the Fed to move aggressively and with confidence to support credit markets now.
As a result of these Fed actions, US corporations have been able to raise hundreds of billions of cash in the bond markets to cushion the blow from the COVID-19 recession. Indeed, record new issue levels have been recorded. Corporations such as Boeing, Ford Motor, Southwest Air and Carnival Cruise Lines, all severely and adversely affected by the COVID-19 pandemic, have been able to raise substantial amounts of private capital to help weather the storm.
Also, 401k and IRA account balances are all better off thanks to the Fed.