Is the Coronacrisis Giving the Fed Cover to Hold Corporate Debt?
Two weeks ago, Fed chair Jay Powell declared the “fundamentals of the U.S. economy strong,” while simultaneously announcing the largest interest rate cut since 2008 in the face of global pressures stemming from the coronavirus.
Last week, the Fed escalated its repo operations in a desperate attempt to boost short-term liquidity for large financial institutions.
But this past weekend, the Federal Reserve made its most radical moves since 2008. The headlines focused on cutting the federal funds rate back to 0–0.25 percent and a major $700 billion reboot of quantitative easing. The Fed also cut reserve requirements, maintained paying interest on excess reserves (0.1 percent), and cut its discount window down to 0.25 percent from 1.75 percent.
The discount window cut may be the biggest deal.
As Bob Murphy explained in his Money Mechanics chapter on post-2008 monetary policy, the discount window is an alternative to standard open market operations that allows banks to borrow directly from the Fed by posting collateral. Since 2008, banks have largely abandoned the discount window, opting instead to sit on excess reserves, in part to avoid the appearance of being stressed.
The Fed is now actively trying to reverse this trend. The cut brings the discount window rates down to the closest they’ve been to the federal funds rate since the 2008 crisis. In case that was too subtle, Chairman Powell also explicitly emphasized the opportunity banks have to utilize the discount window.
Discount Rate vs. Effective Fed Funds Rate, 2002–February 2020
Note: Discount rate last updated December 2019.
This may end up being the most important piece of yesterday’s historic announcement, because it may serve not only as a lifeline to banks, but as a means to prop up a dangerous corporate debt bubble.
During his press conference following yesterday’s announcement, Powell emphasized that the Fed is statutorily limited to purchases of US Treasurys and mortgage-backed securities for its balance sheets. These limits, however, do not apply to discount window loans.
According to the Fed’s website, assets that can be used for discount window collateral include:
- US Treasury obligations
- Obligations of US government agencies and government-sponsored enterprises
- Obligations of states or other US political subdivisions
- Collateralized mortgage obligations
- Asset-backed securities
- Corporate bonds
- Money market instruments
- Residential and commercial real estate loans
- Commercial, industrial, or agricultural loans
- Consumer loans
Perhaps most important here are corporate bonds.
One of the most significant challenges that the coronavirus has posed to global markets are major supply shocks to industries, as well as a significant decrease in oil prices as demand has dropped. Although lower oil prices can reduce costs for transportation-heavy industries, they are a major problem for American energy companies reliant upon shale oil. Although fracking has unleashed a massive oil boom in the US, it is not on an even playing field with oil operations in a country like Saudi Arabia. According to oilprice.com, only five shale drillers are profitable at $31 oil.
As a result, the drop in oil prices has caused significant dangers for banks heavily invested in energy markets—particularly regional banks.
As Vipal Monga noted in today in the Wall Street Journal:
Especially vulnerable are regional banks with big energy-lending portfolios. Larger banks also are on the hook for billions of dollars in loans to the energy industry, but they are relatively less exposed because their balance sheets are much bigger and their lending businesses more diversified. Energy accounts for 3.2% of Citigroup Inc.’s loan portfolio and 2.1% of JPMorgan Chase & Co.’s loan book, according to Goldman Sachs analysts.
But a shakeout among regional banks’ borrowers could dent their earnings this year between an average of 15% to 60%, depending on the extent of loan losses, said Keefe, Bruyette & Woods analyst Brady Gailey.
“It is a big deal for these oil-exposed banks,” he said.
Of course, the energy sector isn’t the only industry in which banks may want to offload corporate bond holdings.
A decade of global easy money policies has created a world flush with corporate debt, both due to the ease with which corporations have been able to access credit lines and to a demand for yield. This has resulted in the rise of “zombie companies,” which James Grant defines as companies “failing to generate cash flow to cover interest expense for three consecutive years.” Such firms made up almost 14 percent of S&P 1500 companies last year.
For years there have been warning signs that a recession could light the fuse on a massive corporate debt bomb, and it’s possible that the coronavirus may be the match. By explicitly pushing the use of the discount window, the Fed may be signaling acknowledgment of this problem and giving American banks the ability to borrow off their bad loans.
Although this may provide short-term relief, it’s another example of the real disease that has infected global financial markets—central banks engaging in extraordinary monetary policy without any end game in place.
After all, we have seen that central banks have been unable to unwind their 2008 interventions in financial markets. In the US, minor rate hikes and a slow balance sheet roll-off sparked dangers that forced it to reverse course within a year. It has resulted in an overleveraged global economy, full of wildly mispriced debt. This has not only created significant bubbles throughout the financial system, but also an economy that is even more reliant on these volatile markets as conservative investments have been repressed in our low-interest environment.
So, although discount window operations are meant to be short-term loans to financial institutions, we’ve seen the Fed's ability to make the temporary permanent. The coronavirus has helped accelerate a global crisis, but it is having the impact it has because the economy was already sick.
Now governments want us to believe that the ones who infected it are equipped to save it.