Monday, March 23, 2020

Fed Bombshell

The Fed just announced "extensive new measures to support the economy." What's this all about?
The PMCCF will allow companies access to credit ... This facility is open to investment grade companies and will provide bridge financing of four years. ... The Federal Reserve will finance a special purpose vehicle (SPV) to make loans from the PMCCF to companies. The Treasury, using the ESF, will make an equity investment in the SPV.
When the Fed buys a Treasury bill, it creates new money with which to buy the bill. It simply increases the amount of reserves, which banks can freely transform to cash, so you can think of it as printing up money to buy the bill. Why doesn't this cause immense inflation? Well, the Fed backs the money with the bill. The overall quantity of government debt has not changed, just the composition.

When the Fed lends money to a bank or business, it looks the same as a matter of accounting. The Fed prints up money, figuratively, and gives it to the bank or business. The loan then counts on the Fed's balance sheet just like the Treasury bill as an asset backing the money.

But there is a difference. Banks and businesses can default. That "asset" may be worthless. Printing money and giving it to business and counting the loan as an asset leads to all sorts of problems.

That's why the Fed is funneling this through the Treasury. The Fed prints up a dollar, gives it to a "special purpose vehicle" along with the Treasury, and the Treasury is supposed to take the risk of default. That is, in my view, appropriate. The Fed cannot stay independent if it lends to specific risky businesses, and takes on the risk they won't pay back.  The Treasury is politically accountable.

Overall, though, the government is printing money and handing it out to businesses. Functionally it is the same as if the Treasury borrowed money, lent it to business, and the Fed bought the Treasury bills. But it happens faster, and gets around the debt limit and lots of other interference.

This post refrains from judgement. I just thought it useful to explain what's going on.


  1. This is introducing a new kind of risk into the system. It also doesn't come with strings or directives. The Airlines can use this to continue to pay their debts, but there is no cash incoming so there's no reason to keep most of their labor force employed. So this doesn't really help the unemployed. It also doesn't help small businesses or restaurants who likely won't mean "investment grade".

    There seems to be this view that stimulus will solve the problem listed above. But blindly giving 1k to everyone doesn't solve their problems for 6 months. It doesn't even cover rent for 1 month in the bay area, nor come even close to the average property tax + mortgage bill.

    I am going to ask again...can we continue to function as an economy with stopgap solutions for 6 months(the recommended time to quell the virus) all the while trying to solve the problem with unconventional tools with tons of baked in unintended consequences?

    1. No, we are collapsing the economy without a battle plan.

      At the risk of sounding callous, by government ukase we are collapsing the economy on behalf of elderly smokers who often have co-morbidities.

      All you can do is short the market.

      But one must take grim humor where one can. It has been interesting to watch former libertarians turn into statist martinets singing "Kumbaya."

  2. John-thanks for this. So, mechanically, the Federal Reserve Board prints money (creates reserves) in order to capitalize these SPVs, but the Treasury puts in a nominal or other amount of equity to each SPV in order to be the owner/investor on paper. Correct?

  3. Following your explanation, working through T-accounts, Treasury borrows, lends to businesses, Fed buys Treasury's debt. What happens when debt balloons? Does the Fed print money to the point of currency debasement?

  4. I am not aware of how precisely this works in the US, but am acquainted with how similar operations were designed in the U.K during the last crisis. The details differ slightly but may provide a useful comparison. The ultimate outcome of the arrangement was the same; the Treasury was up on the hook for defaults and the central bank's independence was preserved.

    The BOE set up an SPV called the Asset Purchase Facility (APF) which was owned by the Bank but fully indemnified by the Treasury. The Bank then loaned reserves to the APF, who then purchased assets as directed by the MPC.

  5. Valter Buffo, Recce'd, Milano, ItalyMarch 25, 2020 at 1:05 PM

    Textbooks define t-bills as "riskless assets". Something is not going accordingly to that definition these days. To sell t-bills, these days you have to go to the Central Bank. Markets would not give you cash in exchange for t-bills. At least, not a these prices.

    As the story goes, "banks exchange t-bills for reserves". As in "t-bills are different from reserves". As in "t-bills are different from cash". As in: the U.S. Government is already broke.

    In comes the Federal Reserve. In the last 10 days, the Board made unprecedented efforts to shore up everything and everybody: broken banks, broken hedge funds, borken household, a broken Government (should we leave out criminal organizations, to protect their employees?). "We buy everything" is the new mantra. Instead of containing the epidemic, women and men at the Fed chose to finance the diffusion of the epidemic of Zombie companies. The result: a gigantic premium to all inefficient economic entities, the larger the premium the more inefficient you are.

    The ultimate goal is to froze the whole economy as it is, stop its natural evolution into something more efficient by eliminating inefficient economic subjects. To protect all existing privileges.

    Going back to t-bills: the money that the Fed is paying for to private companies for t-bills priced above free market prices is money spent to buy nothing. Money for nothing, as in a nice Dire Straits song. It is a scheme, a fraud to the public.

    For this fraud, in my opinion they should be prosecuted for a criminal offence, and eventually incarcerated, for abusing of their power an leading the economy towards chaos. They will not be, of course: and the price of their moral hazard will be paid by everybody else in the economy.

    Policy makers today completely miss the functioning of the relationship between financial markets and the real economy, as is explained for instance in Harrison Kreps 1078. Asset prices are a function of a market-wide price of risk (nothing to do with individual preferences) and future payoffs. When payoffs go to zero, asset values go along to zero, disregarding average returns, variances and covariances, and correlations. Policy makers do not get this: as showed by that guy, the one who recently defined the 400-bn intervention to shore up the broken U.S. repo market as "a little problem". Like talking to kids.

    But vindication comes: the face of Donald J. Trump during recent tv pressers, that was ... magic. We badly miss his daily Tweet about the "new stockmarkets records", that he used to close with "Enjoy!". Today, I am sending him my warm "Enjoy". With all due respect, Mr. President, wait for what comes next. And enjoy.


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