This year the combined efforts of the Treasury and Fed arguably resulted in the market averting depression-like conditions. Hats off to both Treasury Secretary Steven Mnuchin and Fed Chairman Jerome Powell for creating a once-in-a-lifetime pact out of necessity that crossed many red lines to intervene directly in markets and indirectly in the economy. That cooperation seems to be coming apart as the Treasury requested that the Fed return unused funds that it had given the Fed for its emergency lending facilties, and the Fed Chair confirmed that the Fed would work out arrangements to return the unused funds. Why is this important?
A short summary of how the mechanics of the Fed’s stimulus works might help the reader understand why any breakdown in this shotgun wedding before year-end could break the market’s confidence – and complacence.
Though wonks might nitpick on my description, here is how the Fed-Treasury compact operates when it comes to making COVID-19 related loans, which are massive in size. Treasury and Fed got together and set up a number of special purpose vehicles (SPV) with an alphabet soup of acronyms like the MSLNF, CPFF, PDCF, MMLF, PMCCF, SMCCF, TALF, PPPLF and a few others (see full list here). They all work essentially the same: the Fed loans money to the SPV, and the US Treasury, i.e. the taxpayer, puts in the equity to back the loans, the unused portion of which is the money that the Treasury wants back at the end of the year. The SPV then goes out and makes loans. If there are any losses, as always the equity holder, i.e. the US taxpayer, swallows those losses first. So, as always, the equity is the shock-absorber or the foundation on which the leverage stands.
Where does the Treasury get the money to put into the SPV? Basically it borrows the money by issuing Treasury bills and bonds, which directly affects the Federal deficit. The curious reader will now ask: who does the Treasury borrow money from? The short answer is whoever is willing to lend. This involves foreigners, US pensions, and even mom and pop savers. Increasingly, however, the biggest buyer of the debt is the US Central Bank, yes, the Fed itself. The Fed now owns more Treasuries than any other single owner in the world (source: Federal Reserve).
So if the reader is still following me let us summarize where we are so far. The Treasury borrows money from the Fed; the Fed basically “prints” this money. Then the Treasury takes this money to the SPV and creates an equity stake. Against this borrowed money the Fed lends more money – to be precise it can lend out around ten times the equity. Sound like leverage? That’s because it is! So for each $500 billion of equity that the Treasury provides, the Fed can in principle lend out $5 Trillion (!) of loans. So if the Treasury pulls back most of the capital, no new loans can be made, but the loans already made are backed by roughly 10% of the loan value in Treasury’s equity.
To repeat: the SPV is supposed to lend money (or invest in bonds, which is the same thing). If it is able to do so, then the interest income from the loans or bonds can be paid back to the Fed and the Treasury and thus the taxpayer. The Treasury can use this interest income for anything that it has authorization from Congress to do, and the Fed for its part, takes the interest income, and yes, you get it, gives it back to the Treasury, after keeping a small amount to pay for the cost of running itself. But earning interest is not the main reason for this approach. The bazooka, i.e. trillions of levered buying ability, exists to create a backstop; as the Fed started to buy corporate bonds and ETFs, credit spreads tightened and equity markets made new records. Credibility of the Fed is based on the Treasury’s equity. Sounds like something, actually a lot of something, for nothing. Which it is, as long as the house of cards does not collapse for whatever reason.
Now, suppose the Fed is not able to lend the money because everyone who is eligible has already borrowed as much as they can. In 2020, ”zombie” companies have gorged themselves on record amounts of debt that the Fed and buyers from around the world have bought. With no business, and no income, they can still walk into the Fed and ask for more loans. Reminds me of the housing market bubble of 2007-2008 when folks with no income, no balance sheet, and no job could get “no-doc”, “NINJA” ( “no income, job or asset verification”) loans for buying second and third flippers.
So where we are is that the Fed wants to make loans, but no one who needs them is stepping forward. The loans and the “bazooka” of almost $5 trillion of loans has few buyers since everyone is done borrowing – they already have too much savings, and most people are not able to take vacations or even buy hot tubs or RVs due to supply chain problems.
This is where the friction between the Treasury and Fed is today. If the Fed does not make loans, the Treasury’s equity is tied up and earning little income and not impacting the economy which depends on more consumption driven by the borrowing.
The Fed is between a rock and a hard place. If it does not follow its lending discipline (whatever little is left of it), then it lends to speculators and zombies, which results in an asset-price bubble and subsequent collapse. However, if it returns the Treasury’s equity, it has no backing on which to potentially make loans in the future if they are needed. As they say, no equity, no credit, and a levered Fed with no equity will be in very tough place politically. And what about the current portfolio of junk bonds etc. they have already bought? If the zombies go back into their grave (i.e. refuse to pay), then the Fed won’t be able to prop up the market unless a new emergency authorization for levered asset purchases is created by the next government.
Now that the reader is caught up in the state of the dispute, what can investors do?
My (maybe wishful) view is that rationality should eventually prevail. The thought of an orphaned Fed with a massively levered balance sheet won’t be considered very seriously, if at all. But anything can happen these days. If the SPVs are forced to return capital to the Treasury, a credit market unwind could cascade into an equity market selloff because the Fed has little excess equity cover to buy any more credit which is indirectly purchasing equity in disguise. So for the time being, my bet is that the Fed will ease loan terms, and in exchange for an implicit extension of the programs, make more loans more aggressively as we enter the year end. Or a new, social program friendly government could actually follow up some time next year with an even larger program to stimulate credit. Which is to say that we could be setting up for another upside melt-up in the equity markets.
Whatever the short-run outcome investors should be wary that houses of cards are inherently unstable, and if the rational course is not the one that is taken, they should be prepared to run for the exits or hedge while there is still time to do so. Given the size of the breakup, a big move in the markets is in the process of building either way.