What is the Policy Response to the Coronavirus Crisis?

Quantitative easing refers to the central bank expanding the money supply by buying assets, typically longer-dated government securities. It is the most common form of unconventional monetary policy, and is typically only resorted to once interest rates have reached the zero lower bound. By purchasing long-dated assets, the Fed is in a sense increasing demand for such securities and, in turn, driving up their price.

This process has two effects. First, through a credit channel, there is more liquidity in the financial system. Increased liquidity makes it easier for banks and other financial intermediaries to make loans. Second, there is a portfolio rebalancing channel. By lowering the yield on safe, long-dated securities, investors may tilt their portfolio towards riskier assets, such as corporate securities, which would tend to ease financial constraints faced by the corporate sector. For more details on these two channels, see Krishnamurthy and Vissing-Jorgensen (2011).

By the end of October 2014, the Fed was no longer buying new assets and was trying to shrink its balance sheet. The size of the balance sheet began falling in late-2017 as assets began to "roll off" its balance sheet. In other words, the Fed was letting them mature without reinvesting the proceeds. In September 2019, following disruptions in the repo market, the Fed began investing a portion of the principal repayments into treasury securities and agency debt.

On March 15, 2020, in the FOMC statement the Fed announced purchases of at least $500 billion in treasury securities and $200 billion in agency mortgage-backed securities over the next few months. On March 23, 2020, they included agency commercial mortgage-backed securities in its expected purchases.

What is the Historical Precedent?

Quantitative easing was first used in Japan in 2001. It was mostly a Japanese phenomenon until the Great Recession, when policy rates for central banks around the world hit zero. In the United States, there were many rounds of Quantitative Easing, or Large Scale Asset Purchases, during the Great Recession. All told, the Fed's balance sheet increased from around $800 billion to over $4 trillion. This increase was due to purchases of agency MBS (mostly held by Fannie Mae, Freddie Mac, and Ginnie Mae) and long-term treasury securities

What is the Academic Evidence?

The academic evidence on the effectiveness of QE grew substantially following the Great Recession. Krishnamurthy and Vissing-Jorgensen (2011) find that yields fell in response to QE announcements. They highlight that QE works thorugh narrow channels that depend crucially on the types of assets purchased and the prevailing economic conditions. Di Maggio, Kermani, and Palmer (2019) find evidence of a refinancing channel, whereby households refinanced their mortgages and thus faced lower interest rates. Rodnyansky and Darmouni (2017) find evidence of banks increasing lending following announcements of QE during the Great Recession.

What Market is Under Stress?

A repurchase agreement (repo) is a short-term, secured loan where one party sells a security to another party with the intention of buying it back shortly thereafter (i.e., a simultaneous sale of a security and purchase of a forward contract). The traded security is therefore the collateral for the loan, in much the same way a home is collateral for a mortgage loan. The majority of repos are overnight loans but longer term agreements also occur, as can clearly be seen in the figure below (see next paragraph and figure following).

The largest repo market is the US Treasury repo market, with between $2-4 trillion worth of repo's traded daily. A reverse repurchase agreement is simply the opposite transaction, whereby one party buys a security from another party with the intention of selling it back shortely thereafter. The Federal Reserve uses the US Treasury repo market to conduct monetary policy. They buy and sell government securities in the repo market using reserves.

What is the Policy Response to the Coronavirus Crisis?

Before the Coronavirus epidemic, the Fed was offering $100 billion and $20 billion in overnight and two-week repo operations, respectively. Overnight operations were conducted daily, and two-week repo operations were conducted multiple times per week. These repo operations were announced approximately one month in advance on the New York Fed's repo calendar.

On March 12, 2020, the New York Fed announced that they would immediately conduct a $500 billion three-month repo operation. They also announced a $500 billion operation for both three-month and one-month repos on March 13, 2020. This $1.5 trillion repo operation announcement garnered a lot of press, both for its immediacy and its scale (for comparison, the estimated size of the CARES Act is estimated to be approximately $2 trillion). While the scale of these offerings is quite large, it is worth reminding the reader that repo operations are loans that, absent default of the counterparty, will be paid back; moreover, these repo agreements are collateralized by safe securities, which the Fed retains on its balance sheet in the case of default.

These $500 billion three-month and one-month operations are planned to be offered weekly for the foreseeable future. These additional repo operations were added to the pre-existing $175 billion and $45 billion in overnight and two-week repo operations. On March 17, 2020, the Fed increased the amount for daily overnight repo operations to $500 billion, at least through April 13, 2020.

The interest rate on these repo operations is determined by an auction mechanism. First, the Federal Reserve sets a minimum interest rate (i.e., a reserve price), typically equal to the federal funds rate, with additional basis points added depending on the maturity of the repo operation. If the minimum bid for a repo operation is above this level, then the interest rate will rise to reflect this minimum bid.

What have been the Results?

The total results of each repo operation is available daily. While the Fed has offered half a trillion dollars in three-month and one-month repo operations, the actual takeup of these amounts has been small. The daily amounts submitted and accepted for any individual one-month or three-month operation have never gone over $80 billion. In total, the largest day for repo operations in March has been March 12th, when total accepted repos went over $250 billion.

What is the Historical Precedent?

During the Great Recession, the repo market also experienced some strain. This was problematic, as repo markets were the primary means by which the Federal Reserve set the Federal Funds Rate. During the height of the crisis in late 2008, repo operations rose to over $50 billion. By the end of 2008, due to a combination of new lending programs and interest on excess reserves, repo operations were no longer used.

The Federal Reserve also encountered problems within the repo market in September 2019. During this time period, overnight repo rates skyrocketed to 10%, five times as high as the federal funds rate at the time. Two factors contributed to the surge in interest rates. First, corporate tax payments for large companies came due, increasing demand for repo's by the banks that were financing the tax payments. Second, the Federal Reserve had been running down its balance sheet, which reduced the supply of repos by removing eligible collateral from financial markets. In response, the Fed rebooted its Great Recession repo operations.

What is the Academic Evidence?

The repo market was the subject of a handful of academic papers following the Great Recession. An influential paper by Gorton and Metrick (2012) argues that the Great Recession had its roots in the repo market. Essentially, the repo market experienced the modern equivalent of an old-fashioned bank run. Krishnamurthy, Nagel, and Orlov (2014) argue that the collapse of the repo market mattered because key institutions, in particular dealer banks, relied heavily on the repo market for funding.

What Market is Under Stress?

Primary dealers are among the most fundamental players in the financial system. Primary dealers are financial institutions that trade directly with the Federal Reserve. They interact directly with the Federal Reserve in the implementation of monetary policy (for example, managing the federal funds rate), and are in many cases subsidiaries of Globally Systemically Important Banks (GSIBs). Additionally, they provide the Federal Reserve with important information about financial markets on a daily basis. Problems at these institutions can therefore be damaging to the proper conduct of monetary policy.

There are currently twenty-four primary dealers active in the United States. Primary dealers rely heavily on repos for funding, as they typically making up at least 50% of their liabilities. Problems in the repo market can therefore directly affect primary dealers. Primary dealers are typically not traditional, commercial banking institutions, which means they do not have access to the discount window for emergency loans during periods of financial distress. Thus, these institutions can see their funding dry up in a financial crisis if the repo market turns illiquid.

What is the Policy Response to the Coronavirus Crisis?

The Federal Reserve created the Primary Dealer Credit Facility (PDCF) on March 17, 2020. Through the PDCF, primary dealers are able to borrow directly from the Federal Reserve. To access such loans, primary dealers must pledge some form of collateral, which can be a wide variety of USD-denominated securities including treasuries securities, corporate debt, commercial paper, and some equity securities. Loans are available for up to 90 days and are offered at terms equal to the New York Fed's primary credit rate (discount rate). This interest rate is currently set at 0.25 percent. The facility will come into operation on March 20, 2020.

Why the PDCF if we have Repo Operations?

The workings of the PDCF may seem very similar to the new repo operations conducted by the Federal Reserve. Both involve long-term loans on high-quality collateral, and both are designed to help primary dealers. There are two key differences between the two policies. First and foremost, the interest rate on repo operations is determined through an auction. The interest rate may therefore be higher or lower than what primary dealers may expect, depending on the bids submitted. In contrast, the PDCF has a fixed interest rate (equal to the prime lending rate), with no uncertainty involved.

Second, the set of eligible collateral for the PDCF is larger than in the repo market. In particular, high-quality corporate debt, municipal debt, and asset-backed securities can be used to secure a PDCF loan.

What is the Historical Precedent?

A PDCF was also enacted in 2008 during the Great Recession. It was viewed similarly today, specifically as an alternative for primary dealers who, by nature of not being commercial banks, lacked access to the discount window. The facility had closed in February 2010. One key differences between the PDCF during the Great Recession and the PDCF today are that the maturity of loans offered have been lengthened (from overnight to 90 days).

What is the Academic Evidence?

Adrian, Burke, and McAndrews (2009) find that credit default swap spreads for primary dealers with access to facility fell in the three months following its creation in 2008. Krishnamurthy, Nagel, and Orlov (2014) find that the PDCF was not used as extensively as it might have been during the Great Recession due to the potential stigma felt by banks, similar to the discount window.

What Market is Under Stress?

Commercial paper is short-term, typically unsecured debt issued by firms, banks, and other financial firms. Firms issuing such debt do so typically to finance working capital, which are funds used for daily operations. Because it is unsecured, commercial paper is typically issued in large amounts and by large corporations (both financial and non-financial) with low default risk. The CP market in the United States contains approximately $1.2 trillion outstanding as of March 16. Of this amount, approximately 50% is for financial firms, with 25% each for non-financial firms and asset-backed.

Buyers of commercial paper include mutual funds, banks, and institutional investors. The advantages for investors of using the CP market are that, under certain restrictions, the transaction does not have to be registered with the SEC.

What is the Policy Response to the Coronavirus Crisis?

On March 17, 2020 the Federal Reserve introduced the Commercial Paper Funding Facility (CPFF). The CPFF is designed to backstop the commercial paper market by providing liquidity to the commercial paper market. Specifically, the CPFF will purchase CP through its primary dealers. The CPFF will only purchase three-month US-dollar denominated debt from US issuers (including US subsidiaries of foreign parents) rated at least A1/P1 (referring to prime or high grade) through primary dealers. The total size of the program is based on the amount of previous issuances. The maximum amount that the SPV may own at any time for a given issuer is the maximum outstanding value of issuances over the past year (March 16, 2019 through March 16, 2020). Interestingly, high-quality commercial paper backed by tax-exempt state and municipal securities is also eligible.

Pricing is at the 3-month OIS rate plus 200bp. The 3-month OIS is essentially the market expectation of the effective fed funds rate, compounded daily. The SPV is scheduled to stop lending on March 17, 2021. There is also a 10bp fee for registration based on the maximum amount of CP that can be owned.

Operationally, the CPFF will be a special purpose vehicle (SPV) that purchases CP via lending directly from the New York Fed. For additional credit protection, the US Treasury Department is providing an additional $10 billion through the Exchange Stabilization Fund.

What is the Historical Precedent?

A commercial paper facility was opened during the Great Recession, but was closed in 2010. During the Great Recession, the average spread in the commercial paper market nearly hit 300bp. Spreads for A2-rated commercial paper rose to 400bp, while spreads for AA-rated commercial paper rose to around 150bp. AA-rated commercial paper spreads declined much more rapidly than A2-rated commercial paper spreads.

The results of CPFF operations during the Great Recession were released in 2011, and summarized by Adrian and Schaumberg (2012). The CPFF at its peak accounted for approximately one-fifth of total commercial paper outstanding, corresponding to around $350 billion. While the bulk of CPFF operations were for commercial paper issued by banks, non-bank financial institutions and corporate issuers accounted for a substantial share as well.

What have been the Results?

The impact of the CPFF can be readily seen in the spread between commercial paper (for various qualities) and the federal funds rate. Spreads in the AA-rated market, which represents high-quality commercial paper have returned to normal following a brief period of widened spreads. However, spreads for A2-rated commercial paper, which is not covered by the CPFF, rose to over 300bp on March 18, 2020. Spreads in the A2 market have stopped rising, however they remain elevated compared with the earlier period.

Notably, this figure also highlights again the importance of the repo market. During the September repo market calamity, spreads in the commercial paper market also rose substantially. Unlike the Coronavirus crisis, these spreads largely returned to normal following intervention by the Federal Reserve in the repo market during that time period.

What Market is Under Stress?

Money market mutual funds are investment vehicles that specialize in short-term, low-credit risk investments. There are two ways to slice the MMF market, either by their assets or their liabilities. First, there are the assets the MMF invests in. These are typically repos collateralized by US government, prime (high-quality private sector debt), or municipal debt. Second, there are the types of investors that use the MMF, which are either retail investors or institutional investors. For the purposes of the policy response, it is sufficient to focus only on the MMFs as a lender in the repo market.

During this crisis, investors have been withdrawing money from MMFs, forcing the MMFs to sell securities in order to pay out. For example, they hold over $1 trillion in repo assets. This puts all the corresponding asset markets under stress, including the repo market.

Another market under stress is the municipal debt market representing borrowing by state and local governments. A core component of this market is reliance on variable-rate demand notes (VRDNs). The interest rate for these notes is based on the municipal swap rate, published weekly by SIFMA. This rate rose from around 1 percentage point to 5 percentage points within a week in mid-March. The principal investor in these notes are municipal MMFs. To the extent that MMFs come under pressure to liquidate their asset holdings, this could increase interest payments by local governments.

What is the Policy Response to the Coronavirus Crisis?

On March 18, 2020 it was announced that the Federal Reserve Bank of Boston will provide loans to depository institutions that concurrently extend credit to money market mutual funds. As collateral, assets invested in by the MMFs can be offered. These loans will help MMFs meet demand for redemptions, or withdrawals, from investors in their funds.

On March 20, 2020, the eligible collateral was expanded to include US municipal debt. This was accomplished by expanding the set of funds to include certain municipal MMFs. This was later expanded on March 23, 2020 to include VRDNs.

What have been the Results

The SIFMA swap index is the variable rate index that VRDNs issued by municipal governments is tied to. When it rises, interest payments by municipal governments also rises. The index spiked in mid-March to almost 500 basis points, and has remained elevated since.

What is the Policy Response to the Coronavirus Crisis?

The PMCCF is designed to alleviate stress in the corporate bond market. An SPV will be set up with the authority to purchase bonds directly from eligible issuers and provide loans to eligible issuers. Eligible issuers are U.S. companies with material operations in the United States. Eligible assets must be rated at least BBB-/Baa3 or higher, with the maximum amount allowed to be borrowed rising with the credit rating (up to 140 percent for AAA/Aaa rated assets). Finally, assets must have a maturity of four years or less.

The SMCCF is identical to the PMCCF with at least two notable exceptions. First, the remaining maturity must be five years or less. Second, the facility may also purchase ETF's that focus on investment grade corporate bonds.

What Have Been the Results?

One way to see the effect of the SMCCF and PMCCF is to compare the value of investing in either an index fund or an Exchange Traded Fund (ETF) that specializes in short-term corporate bonds. If holders of shares in an ETF decide to sell their holdings en masse, this may lead to a fall in the share price even if the underlying assets comprising the ETF are sound. Thus, to the extent that the ETF markets experienced distress via lower prices relative to index funds, the opening of the SMCCF should have, in some ways, reduced this gap.

Before proceeding, it is useful to define some terms. An index fund is a form of passive investing, whereby a financial institution invests money to match a specific portfolio. In this case, the specific portfolio corresponds to the group of high-quality, short-term bond debt securities, with each corporate bond receiving investment relative to its size in the market. Investors give money directly to the financial institution (typically required to be above some non-trivial minimum value), with the ability to withdraw that money on demand (paying taxes when necessary). In addition, investors receive the interest income from the underlying bonds, minus any operational fees by the financial institution. In practice, financial institutions create shares, and the price of the share is simply the total value of the index fund divided by the number of outstanding shares.

An ETF, on the other hand, is a traded security. Rather than saving money through a financial institution, who then manages the portfolio of corporate bonds, an investor can purchase a share in an ETF directly on an exchange. The minimum required is simply the cost of each share, and, via dividends, the investor still receives the proceeds from the underlying interest payments (again net of any operational fees). However, rather than withdraw the investment from the financial institution, the investor must sell their ETF on the exchange to another investor.

This difference in the ability to withdraw the investment (either by requesting from the index fund or selling the ETF share on the exchange) creates additional risk for ETFs relative to index funds. If there are no willing buyers for the ETF share at the current price, the price must fall, perhaps considerably, in order to induce new buyers. In normal times, this typically does not happen, as the ETF shares are valued based on the underlying bond investments. However, when financial markets seize up due to increased global risk, such as in the current coronavirus pandemic, the desire to sell ETF shares may be unrelated to the value of the underlying corporate bond investments---at least relative to the corresponding index fund---leading the price of the ETF to deviate substantially from the index fund value.

Such a problem occurred very quickly in the ETF markets as the coronavirus outbreak swelled. Consider comparing the price of Vanguard’s short-term corporate bond ETF (Ticker: VCSH) with Vanguard’s short-term corporate bond index fund (Ticker: VSCSX). The price of the ETF represents its value in the market, whereas the price of the corporate bond index represents the value of one share of the index fund.

We normalize the two series such that the value at any point in time represents its value relative to February 21, 2020. First, notice that the relative price of the ETF and the index fund tracked each other very closely prior to the Coronavirus crisis. (On average, the average absolute relative price difference of the series was roughly 0.2% prior to February 21, 2020; the standard deviation was also 0.2%) However, shortly after the onset of the crisis in March, the two series diverged. In particular, the ETF fell substantially relative to the index fund. At the close of business on March 20, 2020, the ETF was below the index fund by nearly 7% (35 standard deviations lower than usual). Following the introduction of the SMCCF on March 23, 2020, the ETF series recovered relative to the bond index fund. The two series have tracked each other a bit more closely since.

What Market is Under Stress?

Asset-backed securities (ABS) are issued securities that are collateralized by a pool of assets, typically loans or other debt. These loans are typically small and cannot be sold individually, rendering them illiquid. ABS allows these small loans to be securitized. By packaging many small loans into a pool of loans, financial markets can sell securities which represent a portion of the value of the pool of loans, with returns subject to the assets' cash flow.

The ABS market contains over $1 trillion in assets, with the majority being mortgage-backed securities (MBS).

What is the Policy Response to the Coronavirus Crisis?

On March 23, 2020 the Federal Reserve created the TALF to improve credit conditions in the ABS market. The TALF will lend up to $100 billion US companies with eligible collateral. Eligible collateral include highly-rated, dollar-denominated assets where the underlying credit exposure represents a variety of business and personal loans, such as auto loans, student loans, and small business loans. The maturity of each loan will be three years, with pricing equal to 100 basis points over the LIBOR swap rate.

Which Market is Under Stress?

State and local governments, often referred to as municipalities, play an important role in the provision of government services. Public education, transportation, and hospital services are just a small part of the operational responsibilities of municipal authorities. Such services are funded mainly by tax revenue. Unlike the federal government, income, corporate, and social security taxes do not play a large role. According to the US Census Bureau, sales and property taxes make up around ten to twenty percent of total expenditures each. Local governments rely on sales taxes for approximately one-tenth of revenues, while state government rely on sales taxes for over one-third of revenues.

The outbreak of coronavirus has had at least two effects on local economies. First, due to rising unemployment, lower consumer expectations, and shelter-at-home policies, consumption and production of goods and services has fallen dramatically. Lower consumption levels will reduce current and future sales tax revenue. Second, low demand for housing and construction has already led to a fall in new mortgage applications. To the extent that this low demand lowers real estate values, future revenues from property taxes will also fall.

Facing revenue shortfalls, state and local governments may turn to the bond market to sustain public services—some of which are crucially important in the public health fight against the coronavirus pandemic. However, the potential collapse in state and local government revenue has at the same time raised the risk of lending to municipal governments.

What is the Policy?

On April 9, 2020, the Federal Reserve announced the creation of the Municipal Liquidity Facility (MLF). The MLF is a special purpose vehicle (SPV) with the authority to purchase up to $500 billion in eligible short-term municipal debt. Not all municipal debt is eligible. Only debt with maturities of less than two years is eligible to be purchased. In addition, only “anticipation notes” (specifically, tax anticipation notes TANs, tax and revenue anticipation notes TRANs, and bond anticipation notes BANs) are eligible. Anticipation notes are issued with the expectation of receiving revenues soon. The facility will last until September 30, 2020.

Pricing of the facility has not yet fully been announced.

The MLF is partially backstopped by the US Treasury, which provided $35 billion from the Exchange Stabilization Fund under the Coronavirus Aid, Relief, and Economic Security (CARES) Act .

How important is short term debt? As a share of outstanding debt, not that important. Using the 2017 vintage of the Annual Survey of State and Local Government Finances, conducted by the Census, most municipalities have only around 5% of total debt in short-term issuances, although we note that “short-term” here refers to one year or less rather than up to 24 months.

There are at least two reasons. First, many state and local governments have instituted policies to delay income tax revenue in line with the federal government. The fact that only anticipation notes are covered can therefore be partially explained by the fact that municipalities expect some portion of income taxes to be delayed. Second, by focusing on short-term debt, the Federal Reserve is trying to maintain liquidity in the municipal bond market, rather than simply provide aid to insolvent governments.

More specifically, due to the coronavirus increasing risk, borrowing rates for municipalities have risen substantially. Such high interest rates increase the debt burden for municipal governments, resulting in additional fiscal sustainability issues as a larger share of expenditures goes towards paying interest. Essential services can suffer under this additional strain. Reducing the effect of high interest payments is therefore crucial. To prevent such issues, the Federal Reserve has stepped in to purchase debt directly from municipalities to keeping borrowing rates low. The focus on short-term debt allows the Fed to exit the market in a short period of time when conditions return to normal.

On April 9, 2020, the Federal Reserve announced the creation of two new facilities under the umbrella of the Main Street Lending Program. The Main Street Lending Program was designed to assist small and medium sized businesses with obtaining credit due to the credit supply restrictions caused by coronavirus. Specifically, qualified lenders would extend loans to small and medium sized businesses (defined as having less than 10,000 employees or less than $2.5 billion in 2019 annual revenue), and then sell 95% of the loan to a special purpose vehicle (SPV) set up by the Federal Reserve.

The two facilities differed mainly in whether or not the loans purchased by the SPV were extended before or after the announcement on April 9th. New loans (after April 9th) were restricted to be much smaller than loans extended before the announcement. Loans were relatively short-term, with four-year maturities, and deferred amortization and principal for one year. Lending rates were at SOFR (secured overnight funding rate) plus a margin between 250 and 400 basis points.

The combined size of the two programs is $600 billion. There is also a $75 billion equity injection from the Treasury via the CARES act.

On April 9th, 2020, the Federal Reserve announced terms related to the creation of the PPPLF (after announcing it a few days prior on April 6th, 2020). The PPPLF was designed to facilitate the flow of credit to small businesses that were seeking loans through the Paycheck Protection Program (PPP) established by the CARES Act. The PPPLF is lending to banks that offer PPP loans as collateral.

What is Total Loss Absorbing Capacity (TLAC)?

Total Loss Absorbing Capacity (TLAC) refers to long-term debt and high-quality capital that a bank must hold as a buffer in the event of adverse economic conditions. If for any reason the financial sector becomes distressed, as in 2008, the bank (by law) will have high-quality, liquid assets that it can use to meet liabilities. The rule specifying the size of TLAC had been finalized in December 2016, and it had targetted the largest and most systemic banks operating in the US. The rule change as a result of the Coronavirus pandemic allows banks to lend more when their long-term debt and high-quality capital falls below the TLAC buffer requirements. Specifically, the "eligible retained income" that can be lent out has been broadened in scope. The goal of this policy is to permit financial institutions to maintain lending to firms and households even if risky asset prices decline.

Are Small Financial Institutions Getting Relief?

The Federal Reserve, along with the Federal Financial Institutions Examination Council (FFIEC), have allowed small financial institutions to file their financial statements late and without penalty. Both the Fed and the FFIEC require financial institutions to periodically report their balance sheets and income in order to monitor the financial sector. Such a policy eases regulatory burdens on smaller financial institutions and permits them to meet local credit demand, especially by small firms that usually rely on regional banks for financing.