Market functionality needs to be restored no matter how anyone feels about the methods it may take to get there. If the current market conditions persist, the consequences may be severe.
How did we get here?
Increasing volatility and falling asset prices have resulted in a significant deleveraging of the non-banking system (which includes Hedge Funds, Mutual Funds, Exchange Traded Funds, Money Markets Funds, Private Equity and Offshore pools of liquidity). This process of de-risking has put pressure on the banking system (and the broker-dealer community) that does not have the regulatory capacity to handle this volume of selling. Thus far, the Federal Reserve’s (Fed) tools have been focused on addressing the banking system, however the real stresses live in the non-banking system and therefore require a solution that operates outside traditional bank channels. Time is of the essence as the Fed is quickly exhausting its tools and the market so far has been unimpressed by rate cuts, Quantitative Easing (QE) and the first use of 13(3) clause since the 2008 crisis to open a Commercial Paper Funding Facility. While the Fed will continue to keep the banks liquid, well-funded and solvent, they do not currently have the scope to address the trouble growing outside the banks. This has become the responsibility of the Treasury and Congress, which can ONLY be aided by the Federal Reserve.
Realistically, there are no easy solutions for what is happening right now and the low hanging fruit at the Fed has already been picked. We are approaching the point where creative solutions to tackle the risk head-on are required. All roads forward require Congressional approval and they would need to be directed on two fronts: 1) providing the Treasury with capital to purchase assets (similar to TARP in 2008) and 2) extending the authority of the Federal Reserve to provide liquidity for a broader swath of assets.
How would it happen?
While there are certain legal aspects which are beyond the scope of this analysis, broadly speaking, only Congress has the authority to approve legislation that funds/authorizes the Treasury to implement an Asset Relief Program. Additionally, only Congress has the authority to amend the Federal Reserve Act (FRA). It would be most appropriate for the Treasury Secretary to request an amendment to the FRA (the Fed should distance itself from this type of request to maintain political independence). Since the Treasury runs the Financial Stability Oversight Committee (FSOC) and the Treasury’s initiative would rely on the Fed for funding and liquidity, ultimately the Treasury Secretary, with the tacit support of the Fed, should ask Congress for help.
The Treasury Secretary should request USD100 billion from Congress to be applied to an Asset Relief Program.
He should also request, from Congress, a temporary amendment to the 13(3) “exigent clause” within the FRA which would allow the Fed to lend money against all dollar denominated investment grade assets provided all losses were indemnified by the Treasury.
Following congressional approval, the Fed would trigger clause 13(3) and instruct the NY Fed to establish a credit facility to a special purpose vehicle (SPV) similar to the Commercial Paper Funding Facility (CPFF). The NY Fed would provide 90-day recourse loans to the SPV secured by all the assets within the SPV.
The US Treasury would provide USD 100 billion in capital to the SPV and guarantee all loans (and interest owed) that are made to the SPV.
Asset classes eligible for purchase by the SPV would be all outstanding US dollar denominated investment grade issuers (eligibility based on rating agency requirements) with maturities less than 3 years. This would minimize the longer-term credit risk of the SPV to the Treasury and Fed. The lending capacity of the credit facility would be calibrated to the collateral haircuts at the Discount Window, providing the SPV with maximum flexibility and leverage in excess of the Treasury’s capital commitment.
The credit facility with the SPV would remain in place until at least January 1, 2024 or the Treasury withdrew its capital.
The SPV would outsource the management of the vehicle to sub-advisors (similar to what was done with the Private-Public Investment Program “PPIP” during the ’08 crisis) who would replicate a Bloomberg 1 – 3 Year index.
The SPV would buy assets as necessary through the end of 2020 and then, market permitting, allow the holdings to run-off or be reinvested.
The success of the program would result in the stabilization of the corporate bond market. As this occurs, the Treasury should transition out of the market and allow the private sector to re-enter. The Term Asset-Backed Securities Loan Fund (TALF) initiated in 2008, should serve as the guide to encourage private sector to purchase new corporate debt. A TALF-like program would continue to provide funding support as the transition from public to private capital evolves. Treasury will reduce the tax payers’ commitment to the market and ensure ongoing functionality.
Why this would work
This program would allow for funding and liquidity to be targeted at the non-banking system and prevent an amplification of the economic impact.
Removing a large amount of front-end investment grade collateral from the universe will free up liquidity across both the banking and non-banking system and create a pathway towards normalcy for the market.
Further, the program would reduce roll-over and funding risk in the corporate sector helping minimize the potential labor market impact during a period of depressed revenues for Corporate America
The program would adhere to all of the other conditions of the 13(3) exigent clause but broaden the eligible collateral while applying risk parameters similar to the Discount Window.
The program we are describing would effectively be a combination of several elements from the Commercial Paper Funding Facility, the Term Auction Facility, the Public-Private Investment Program and the Term Asset-Backed Securities Loan Facility that were implemented in 2008. It would allow for the public sector to support market functionality and eventually transition the risk back to the private sector. While this strategy is targeted at corporate credit, other vehicles could be constructed to target other sectors and asset classes.
The impact of the COVID-19 virus is unprecedented and the knock-on impacts to the economy and the financial system are still not fully understood. There will be a time and a place to reflect on how markets got here and the role the banking and non-banking entities play in the broader financial system as well as the role of government and the Fed as a backstop. But for now, the focus needs to be on restoring market functionality as quickly and efficiently as possible so policy makers to can focus on initiatives to address the economic fallout in a broad and far reaching way. .
While the Fed has made some herculean attempts to restore investor confidence and market functionality, the burden has shifted to the Treasury Secretary. In his roles as the Chair of the FSOC and the intermediary between monetary and fiscal policy, coordination is now needed. All roads lead to Congressional approval and the Treasury Secretary is the person to compel legislation to enable a solution outside the normal intermediary channels. The window for success is narrowing and unconventional tools, programs and partnerships will undoubtable need to be deployed to restore confidence. The blueprints are in place, with some creative alterations, for the Treasury in coordination with the Fed and Congress to target corporate bonds while remaining within the existing framework of the Federal Reserve. All options must be considered.