(Bloomberg Opinion) -- Federal Reserve Chair Jerome Powell and Treasury Secretary Steven Mnuchin could be heroes for state and local governments. If they wanted to be, that is.
More than three months after the central bank unveiled its Municipal Liquidity Facility, Illinois remains the only borrower to tap the Fed for funding. As Claudia Sahm, director of macroeconomic policy at the Washington Center for Equitable Growth, noted on Twitter last week in exasperation, that means the Fed is using just $1.2 billion of its $500 billion in potential firepower — which rounds down to 0%.
I share her frustration. The reason the facility is gathering dust, as I wrote last month, is because the Fed’s interest rates are far too punishing for the overwhelming majority of state and municipal governments. Considering that Powell and Mnuchin effectively skirted the law so the Secondary Market Corporate Credit Facility could buy a broad swath of company bonds at near-record prices, it’s puzzling why they’re being so stingy with lending to localities, where budget constraints are already causing layoffs and reduced public services, to say nothing of the challenges in safely opening public schools for the fall.
One scantly reported element of the House of Representatives’ Health and Economic Recovery Omnibus Emergency Solutions (HEROES) Act: Congressional Democrats sought to force the hands of Powell and Mnuchin. The legislation would, among other things, keep the MLF operational until the end of 2021, allow it to buy maturities as long as 10 years, include lending to U.S. territories, and, most remarkably, “ensure that any purchases made are at an interest rate equal to the discount window primary credit interest rate,” which is 0.25%.
Imagine that — 0.25% — seemingly regardless of credit rating! Even with the 10-basis-point origination fee that’s part of the facility’s term sheet, that rate would still amount to the going yield on top-rated municipal bonds maturing in three years. Just about every eligible state, territory, locality and government agency would line up to borrow at that kind of rate. Those in the most trouble, like Illinois and the Metropolitan Transportation Authority, would quite possibly max out their credit lines.
It’s clear that neither the Fed nor the Treasury want this kind of scenario. They’d much prefer the half-trillion-dollar facility grease the wheels of the $3.9 trillion municipal-bond market and be used as a last resort for the weakest issuers. New York Fed economists concluded in a June 29 blog post that “market conditions for municipal securities have improved significantly” thanks to the central bank’s various backstops.
Still, considering the majority of the U.S. House wanted to significantly loosen the terms for states and cities to borrow, Powell and Mnuchin should at least try to meet them in the middle. Mnuchin is given extraordinary latitude through the Coronavirus Aid, Relief, and Economic Security Act to work with the Fed to set up new lending programs. There’s little in terms of constraints:
A loan, loan guarantee, or other investment by the Secretary shall be made under this section in such form and on such terms and conditions and contain such covenants, representations, warranties, and requirements (including requirements for audits) as the Secretary determines appropriate. Any loans made by the Secretary under this section shall be at a rate determined by the Secretary based on the risk and the current average yield on outstanding marketable obligations of the United States of comparable maturity.
I’d concede that equating the interest rate on any 10-year muni bond to the fed funds rate is probably too aggressive and would distort the existing market. But, for example, there’s nothing stopping Mnuchin from offering states and localities the same borrowing cost as the federal government, plus the fee. Tacking on 10 basis points to benchmark Treasuries ends up generating a rough approximation of the triple-A muni yield curve:
With that, the most creditworthy states and cities wouldn’t have much incentive to go to the Fed, while lower-rated municipalities would get a lifeline. The yield spread between triple-B and triple-A munis remains almost three times what it was in February and wider than at any point from mid-2014 through 2019. It’s roughly the same story for single-A versus top-rated bonds.
I could make any number of crude models for MLF pricing that would make more sense than the current iteration. The exact yield levels aren’t what’s important. What matters is that states and cities are on the front lines of the battle with Covid-19 and are in dire need of assistance. Even as the U.S. labor market starts to rebound from the worst of the pandemic, governments have shed workers to balance their budgets. The number of employees on state payrolls has tumbled for four months to the lowest level since 2001, while localities cut 1.26 million people in April and May alone.
In this context, the seeming unwillingness to open up the MLF to more borrowers makes a mockery of Powell’s insistence that its emergency facilities were all established with the American workforce in mind. He has said people might be “able to keep their jobs because companies can finance themselves.” But what about their state and city governments? The Fed says the MLF was meant “to help state and local governments better manage cash flow pressures in order to continue to serve households and businesses in their communities.” It has failed in that mission.
Mark Grant at B Riley FBR Inc., who mentioned the HEROES Act language in a note, summarized the predicament faced by his hometown of Fort Lauderdale, Florida: “Issue new bonds, very problematical at present, raise taxes, almost impossible now, cut expenditures, all politicians hate this, or try to improve the return on their investment portfolios. The response to my last suggestion was a deafening silence.”
Grant suggests the Fed would balk at Congress setting the terms for which munis it can buy and at what interest rate. “While the Fed was created by Congress in 1913 and it does have the authority to provide guidance to the Fed, this may be seen as crossing the line,” he wrote. Sahm, on the other hand, says the Fed needs such an explicit go-ahead to dive into uncharted waters. Congress “missed their chance to avoid a penalty rate,” she said in a phone interview. “If you want the Fed to do this, you have to tell them to do it.”
It doesn’t have to come to that. Members of both political parties have praised Powell for his steady hand through the coronavirus crisis. With Democrats advocating for massive grants to state and local governments while prominent Republicans promote the appeal of Chapter 9 bankruptcy, municipalities need a way to quickly break through partisan infighting before Covid-19 further damages their economies and steers them toward punishing austerity measures.
The Fed’s facility is that path forward. But not in its current form.
(Corrects the discount window primary credit interest rate in the fourth paragraph.)
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Brian Chappatta is a Bloomberg Opinion columnist covering debt markets. He previously covered bonds for Bloomberg News. He is also a CFA charterholder.
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