Federal Reserve: Picking Winners and Losers?

Division: The Fed will only lend to large localities


Policy: Municipal Facility

Why it matters: Municipal Bond market functionality. States face major shortfalls in their budgets.

Potential Impact: Acceleration of Urbanization. Political tension across communities.

Facility: The Municipal Liquidity Facility (“Facility”), which has been authorized under Section 13(3) of the Federal Reserve Act, will support lending to U.S. states and the District of Columbia (together, “States”), U.S. cities with a population exceeding one million residents 2 (“Cities”), and U.S. counties with a population exceeding two million residents3 (“Counties”). Under the Facility, a Federal Reserve Bank (“Reserve Bank”) will commit to lend to a special purpose vehicle (“SPV”) on a recourse basis. The SPV will purchase Eligible Notes directly from Eligible Issuers at the time of issuance. The Reserve Bank will be secured by all the assets of the SPV. The Department of the Treasury, using funds appropriated to the Exchange Stabilization Fund under section 4027 of the Coronavirus Aid, Relief, and Economic Security Act, will make an initial equity investment of $35 billion in the SPV in connection with the Facility. The SPV will have the ability to purchase up to $500 billion of Eligible Notes

Eligible Notes: Eligible Notes are tax anticipation notes (TANs), tax and revenue anticipation notes (TRANs), bond anticipation notes (BANs), and other similar short-term notes issued by Eligible Issuers, provided that such notes mature no later than 24 months from the date of issuance. In each case, a note’s eligibility is subject to review by the Federal Reserve. Relevant legal opinions and disclosures will be required as determined by the Federal Reserve prior to purchase

Call Right: Eligible Notes purchased by the SPV are callable by the Eligible Issuer at any time at par.

Eligible Use of Proceeds: An Eligible Issuer may use the proceeds of Eligible Notes purchased by the SPV to help manage the cash flow impact of income tax deferrals resulting from an extension of an income tax filing deadline; potential reductions of tax and other revenues or increases in expenses related to or resulting from the COVID-19 pandemic; and requirements for the payment of principal and interest on obligations of the relevant State, City, or County. An Eligible Issuer may use the proceeds of the notes purchased by the SPV to purchase similar notes issued by, or otherwise to assist, political subdivisions and instrumentalities of the relevant State, City, or County for the purposes enumerated in the prior sentence.

Termination Date: The SPV will cease purchasing Eligible Notes on September 30, 2020, unless the Board and the Treasury Department extend the Facility. The Reserve Bank will continue to fund the SPV after such date until the SPV’s underlying assets mature or are sold

The Fed’s action cleaved in two the $4tn municipal bond market, where governments and public organizations raise funds. Just 16 counties and 10 cities are eligible for the direct purchases, according to data from Bank of America. That means, with just over 2m residents, the county of San Bernardino outside Los Angeles can partake in the program, while Nassau county in the suburbs of New York, with a population of 1.4m, will not be included.

“It is a very short-sighted, short-term measure,” said Vikram Rai, head of municipal strategy at Citigroup. “It will not help states and local governments with long-term funding problems, where they will need to have a stable buyer to help in times in volatility.”

Investors believe the new facility will at least help to quell the volatility that has erupted in the typically sedate muni bond market. Triple A-rated munis maturing in 10 years now yield less than 1.5 per cent, according to indices from Bloomberg and IHS Markit. In mid-March these bonds yielded more than 2.5 per cent. Yields on lower-rated bonds have also come down from the worst days in March, indicating investors have returned and that the market is functioning more normally. Credit: FT

Chart: Debt to GDP