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Fed’s ‘Infinite Cash’ Put to the Test in a World of Leverage

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·5 min read
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(Bloomberg Opinion) -- Neel Kashkari, president of the Federal Reserve Bank of Minneapolis, said Sunday night on CBS’s “60 Minutes” that “there is an infinite amount of cash in the Federal Reserve. We will do whatever we need to do to make sure there’s enough cash in the banking system.”

Roughly 12 hours later, the central bank backed up those words with its most aggressive action yet to combat the coronavirus-induced credit crunch. In a statement Monday morning, it announced open-ended purchases of U.S. Treasuries and agency mortgage-backed securities. The Fed will buy “in the amounts needed to support the smooth functioning of markets for Treasury securities and agency MBS.” Just a week ago, it had suggested caps of $500 billion of Treasuries and $200 billion of agency MBS. Large numbers, to be sure, but not quite a “whatever it takes” promise.

But that’s not all. The Fed unveiled details about several other programs, which will provide up to $300 billion in new financing, including a Secondary Market Corporate Credit Facility, which allows the central bank unprecedented access to the U.S. credit markets. The Treasury will make an initial $10 billion investment in this special-purpose vehicle, which can then purchase corporate bonds rated triple-B or higher with no more than five years until maturity. Notably, it can also buy U.S.-listed exchange-traded funds that “provide broad exposure to the market for U.S. investment grade corporate bonds.”

The Fed actually announced several more measures, but the moves to address the chaos in Treasuries and corporate bonds are likely the most immediately significant. That’s because a look at the debt markets since the collapse of Lehman Brothers Holdings Inc. shows that it’s governmental and nonfinancial corporate obligations that have ballooned in the past decade. So it’s no wonder that they’re responsible for straining the financial system this time around.

During the weekend, I read “Firefighting: The Financial Crisis and Its Lessons,” by Ben S. Bernanke, Timothy F. Geithner and Henry M. Paulson Jr. I was struck by these lines in the introduction:

“Financial crises recur in part because memories fade.”

“It was fueled, as crises usually are, by a credit boom, in which many families as well as financial institutions became dangerously overleveraged, financing themselves almost entirely with debt. The danger was heightened because so much risk had migrated to financial institutions that operated outside the constraints and protections of the traditional banking system.”

“The financial panic paralyzed credit and shattered confidence in the broader economy, and the resulting job losses and foreclosures in turn created more panic in the financial system.”

Note how “families” and “financial institutions” are singled out as taking on too much leverage heading into 2008. No one denies that. But as I showed in this data visualization, households and banks haven’t increased their debt as a percentage of gross domestic product in the past decade. Whether because of increased regulations or simply because they were burned last time around, they’ve been relatively prudent with taking on debt.

The same can’t be said of nonfinancial corporations. Encouraged by rock-bottom interest rates from the Fed, Corporate America ramped up its borrowing, with companies in many cases willingly allowing their credit ratings to slide and using debt proceeds to buy back stock. The market value of the Bloomberg Barclays investment-grade corporate bond index, a proxy for the size of the broad market, has grown from about $1.8 trillion in October 2008 to more than $6 trillion as of this month. The Institute of International Finance estimates that global nonfinancial corporate debt has grown by some $27 trillion since the 2008 crisis.

When writing about this in September 2018, when the Fed was still raising interest rates and trimming its balance sheet, I said that “all the talk about global central banks beginning a ‘great unwind’ of their extraordinary monetary stimulus is positively quaint,” given the buildup in debt over the decade. Monday’s extraordinary actions by the Fed, in truth, never seemed a matter of “if,” but rather “when” and “why.” The vast sums of bonds sloshing around in the financial system would be too great during times of stress not to cause precisely what Bernanke, Geithner and Paulson saw in 2008: “Paralyzed credit and shattered confidence in the broader economy.”

There will be time later for Fed Chair Jerome Powell and Treasury Secretary Steven Mnuchin, among others, to reflect upon their time leading crucial U.S. institutions through this period. Like their predecessors, they’ll probably note that some companies became dangerously overleveraged and couldn’t withstand the economic shock from the coronavirus outbreak. That conveniently skims over the conditions that encouraged the huge debt buildup in the first place.

But retrospection does the Fed little good in the moment. “Once it’s clear that a crisis is truly systemic, underreacting is much more dangerous that overreacting,” Bernanke, Geithner and Paulson concluded. The markets and the economy have reached that level of systemic risk. So Powell and his colleagues, learning from the lessons of 2008, stand ready to do near-infinite quantitative easing and whip up as many new facilities as needed across markets to restore stability. The time for worrying about doing too much passed the moment the central bank announced a 100-basis-point interest-rate cut less than three days before its scheduled decision.

Technically, $250 trillion of debt isn’t infinite. But it’s far more than the global financial system can handle when staring down an unknowable economic shock. The markets have always seen the Fed as having virtually unlimited power. In a world full of leverage, we’re witnessing the central bank deploy the heavy artillery like never before.

This column does not necessarily reflect the opinion of 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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