Global markets are bleeding, including the U.S. The Fed has already taken several measures to prevent the economy from going into recession due to coronavirus. It has already slashed the interest rate to near zero, re-established the Commercial Paper Funding Facility (CPFF) and reinstated the Primary Deal Credit Facility (PDCF) as well. However, it is believed that the Fed will need to come up with more measures in the weeks ahead to lower the strain on the financial markets due to the coronavirus outbreak.
Q4 2019 hedge fund letters, conferences and more
Fed implements CPFF and PDCF
On Tuesday, the Federal Reserve announced establishing a commercial paper funding facility to “support families, businesses and jobs across the economy." Specifically, the Fed has created a special purpose vehicle to buy the unsecured and asset-backed commercial paper from qualifying companies.
In a rare interview with Harvard Business School that was published online earlier this month, (it has since been taken down) value investor Seth Klarman spoke at length about his investment process, philosophy and the changes value investors have had to overcome during the past decade. Klarman’s hedge fund, the Boston-based Baupost has one of Read More
The Treasury has assured $10 billion credit protection to the Fed through the Exchange Stabilization Fund (ESF). This facility (CPFF) was last used during the 2008 financial crisis.
Additionally, the Federal Reserve has made use of its emergency powers to establish the credit facility for the primary dealers. The Fed, in a recent press release, said the PDCF would allow primary dealers to support smooth market functioning and facilitate the “availability of credit to businesses and households." This new facility will be available starting on March 20.
The PDCF facility will only be available to the primary dealers of the Federal Reserve Bank of New York. The loans under PDCF will be for a period of up to 90 days and the interest rate will be the same as the primary credit rate at the New York Fed.
Under the program, lending will be made against several securities, including investment grade corporate debt securities, municipal securities, commercial paper, mortgage-backed securities, equity securities, collateral in open market operations, asset-backed securities and international agency securities.
Presently, foreign currency-denominated securities have not been included for pledge under PDCF. For now, the plan is to carry with the PDCF for six months, but Treasury Secretary Steven Mnuchin suggested it could be extended if needed.
What measures can the Fed take?
Though the above measures have proven effective previously, it is possible that the Fed may need to come up with more measures in the days or weeks ahead to fight coronavirus fears. However, under 13(3) the Fed can only resort to lending if there is a high degree of credit protection. It must be noted that the Fed is not allowed to take material credit risk in a 13(3) program.
As per a report from Nomura (dated March 17), the Fed can meet the requirement of no material credit risk in two ways:
First, the agency may go ahead with lending without any extra support, if the amount of credit provided is well below the fundamental value of the assets, which are given as collateral.
“This is essentially about the size of the 'haircut' the Fed gets for its lending,” the Nomura report says.
Also, the Fed may go for financing asset purchases under 13(3) without needing any extra credit protection if the prices of assets “are sufficiently depressed.” As per the Nomura analysts, lending on such terms is effective only if the “asset prices are extremely depressed.”
Second, Nomura analysts say it would be relatively easier for the Fed to lend under 13(3) if it has enough credit protection. Meaning, there is another entity to absorb the loss first. This would help lower the risk for the Fed. For the CPFF facility, the Treasury has already provided the first loss protection of $10 billion via the Exchange Stabilization Fund.
During the 2008 financial crisis, the Fed made use of the Treasury’s Troubled Asset Relief Program (TARP) to offer credit protection for several programs under 13(3).
More measures to fight recession
There have also been suggestions that the Fed will use its authority to extend credit to affected households and businesses. Nomura analysts, however, believe that such plans may prove challenging when it comes to implementation.
Such programs require assessing the credit risk on loans to businesses and individuals. Considering the high standards that the Fed has to follow under the 13(3) program, such a measure may prove ineffective.
“Given the rigorous standards the Fed has to adhere to it is not obvious that the best to support such credit is through a 13(3) program,” the report says.
Also, Nomura analysts expect Congress to eventually add more options to what the Fed can buy through the traditional asset purchase program. There have been talks about giving authority to buy assets, including corporate debt and equities.
Additionally, the Nomura analysts also talked of a possibility of Congress making changes to Chapter 14 of the Federal Reserve Act to allow the agency to purchase risky assets without any fiscal support. “But we think this is unlikely to occur at this time,” the report noted.