Alphabet soup

It's that time of the economic cycle. Financial writers are flocking to the phrase alphabet soup again. This was a phrase we all adopted in 2008 to describe the hodge podge of credit facilities created by the Federal Reserve to deal with the credit crisis. Twelve years later, alphabet soup applies just as well to the Fed's response to the coronavirus crisis.

As in 2008 the Fed is currently trying to get funding into as many nooks & crannies of the credit system as it can. The easiest way to do this would be for the central bank to create a slew of new deposits and either lend them directly to corporations (and other counterparties like municipalities) or buy up already-issued corporate bonds and other debt instruments.

But things aren't that easy. The Fed's money is taking a somewhat tortuous route into credit markets.

Like 2008, the Fed has reacted to the crisis by incorporating a bunch of special purpose vehicles, or SPVs. An SPV is a subsidiary or corporation that is legally distinct from the Fed, but controlled by it. The Fed has then been lending fresh money to the SPV. And then the SPV on-lends this money to corporations, or buys up their bonds and other debt instruments.

To illustrate, take the Fed's newly unveiled Primary Market Corporate Credit Facility (PMCCF). The Fed is using this facility to lend to an SPV, this SPV in turn purchasing bonds directly from corporate issuers, like Walmart. The hope is that by providing Walmart with direct access to Fed credit, the retailer will be better able to maintain business operations during the pandemic.

Why doesn't the Fed just directly purchase Walmart bonds?

About all the Federal Reserve can legally buy are Treasury bills and other safe government securities. The Federal Reserve Act prohibits the central bank from purchasing Walmart bonds or any other type of corporate debt.

But a Fed-created SPV isn't really subject to the same set of rules as the Fed, right? If it is legally remote enough from the Fed, an SPV can "lawfully" buy all the Walmart bonds that the Fed can't, no? That's basically the strategy that the Fed took in 2008, and it is taking it again.

But that SPV still needs to be funded. Luckily for the Fed, Section 13(3) of the Federal Reserve Act allows it to exercise broad lending powers in an emergency. So the Fed invokes 13(3), lends funds to the SPV, and then has the SPV buy Walmart debt. Voila, the Fed has purchased Walmart bonds without actually buying Walmart bonds. All the legal i's have been dotted, the t's crossed.

The SPV structure isn't just a legal hack. It also allows the Fed to protect itself.

Each of the five or six SPVs that have been created over the last two weeks is backed up by the U.S. government. This means that if the SPV's loans or bond portfolio falls in value, the central bank needn't worry. The Federal government will promise to make it whole.

Take the aforementioned Primary Market Corporate Credit Facility, or PMCCF. The Treasury has currently invested $10 billion in the SPV to which the PMCCF will lend. So if the Fed buys $10 billion in Walmart bonds via the SPV, and Walmart goes bankrupt and its bonds become worthless, the Fed still gets $10 billion back. It's the Treasury that loses its investment, not the Fed. The SPV structure is a tidy way to formalize the Treasury's support.

To get more context about this protection, let's compare the PMCCF to another facility created by the Fed, the Primary Dealer Credit Facility, or PDCF. The goal of the PDCF is to get funds to primary dealers, large financial institutions that make markets in all sorts of assets including the all-important US government securities market.

To create the PDCF, the Fed has also invoked Section 13(3) of the Federal Reserve Act. The Fed's interactions with primary dealers are limited by law to buying and selling government-issued assets. The central bank can't lend to dealers, certainly not on the basis of exotic sorts of collateral. But the emergency powers embedded in Section 13(3) allow the Fed it to open a broad lending channel to primary dealers.

Unlike the rest of the alphabet soup of facilities that invoke Section 13(3), the Primary Dealer Credit Facility is not set up as an SPV, nor does it enjoy $10 billion in protection from the U.S. Treasury. I have it on good authority that the Fed doesn't believe that a firewall is necessary. A strict process is already in place to vet primary dealers. Furthermore, the Fed has an ongoing relationship with dealers because they mediate all central bank purchases and sales of government securities.

But the Fed knows very little about the counterparties that it will lend to under the other facilities it has created, like the PMCCF. To make up for this extra risk, it wants to get some protection from the Treasury should those counterparties fail.

And in a nutshell, that's why the Fed has taken such a circuitous route to get funds into the credit system.

The bigger picture is that you've got a very old set of laws embodied in the Federal Reserve Act. Many of these rules were designed back in 1913 when America was still mostly a farming economy. Debts were almost always short-term back then, usually in the form of a bill of exchange, a debt instrument that doesn't really exist anymore. Heck, a whole section of the Act is about discounting "agricultural paper". That section probably hasn't been invoked in fifty years.

Meanwhile, a massively complex financial system has evolved over the last century. All sorts of new exotic credit instruments have emerged, say like asset-backed commercial paper. Farming, once a dominant sector, now accounts for a tiny part of the US economy. In a modern crisis like the one we are in, Federal officials believe that they need to be able to deal in these new types of securities. And reach new industries. Because the Act is mostly designed for a previous era, Fed lawyers have had to drill a strange new path to the credit markets via Section 13(3), SPVs, and Treasury support.   

I'm going to leave off now. Readers will obviously have a lot of unanswered questions.  

• Should the Fed be lending such a massive amount of money to such a wide variety of borrowers? (I don't have a good answer).
• Why is the Money Market Mutual Fund Liquidity Facility called the MMLF and not the MMMFLF? (Nathan Tankus deals with this and much more in his two part overview of what the Fed has done up till now).
• Aren't the Treasury backstops a waste of ammo? (George Selgin has a good explanation about why they exist, and I am inclined to agree with him. They're not a gimmick.)
• Aren't the SMCCF and PMCCF unprecedented? (Yes, they are. These facilities fund SPVs that either lend directly to corporations or buy corporate bonds in secondary markets. The Fed never went this far in 2008). Are they a good idea? (In a recent blog post, Stephen Cecchetti  & Kermit Schoenholtz argue that they aren't.)
• Shouldn't the Fed limit its support to buying bonds in the secondary market rather than lending directly to corporations? (Narayana Kocherlakota says no. He is opposed to the PMCCF, but likes the SMCCF. George Selgin and I don't see much difference between the SMCCF and PMCCF.)