Alphabet soup

It's that time of the economic cycle. Financial writers are flocking to the phrase alphabet soup again. This was a phrase we all adopted in 2008 to describe the hodge podge of credit facilities created by the Federal Reserve to deal with the credit crisis. Twelve years later, alphabet soup applies just as well to the Fed's response to the coronavirus crisis.

As in 2008 the Fed is currently trying to get funding into as many nooks & crannies of the credit system as it can. The easiest way to do this would be for the central bank to create a slew of new deposits and either lend them directly to corporations (and other counterparties like municipalities) or buy up already-issued corporate bonds and other debt instruments.

But things aren't that easy. The Fed's money is taking a somewhat tortuous route into credit markets.

Like 2008, the Fed has reacted to the crisis by incorporating a bunch of special purpose vehicles, or SPVs. An SPV is a subsidiary or corporation that is legally distinct from the Fed, but controlled by it. The Fed has then been lending fresh money to the SPV. And then the SPV on-lends this money to corporations, or buys up their bonds and other debt instruments.

To illustrate, take the Fed's newly unveiled Primary Market Corporate Credit Facility (PMCCF). The Fed is using this facility to lend to an SPV, this SPV in turn purchasing bonds directly from corporate issuers, like Walmart. The hope is that by providing Walmart with direct access to Fed credit, the retailer will be better able to maintain business operations during the pandemic.

Why doesn't the Fed just directly purchase Walmart bonds?

About all the Federal Reserve can legally buy are Treasury bills and other safe government securities. The Federal Reserve Act prohibits the central bank from purchasing Walmart bonds or any other type of corporate debt.

But a Fed-created SPV isn't really subject to the same set of rules as the Fed, right? If it is legally remote enough from the Fed, an SPV can "lawfully" buy all the Walmart bonds that the Fed can't, no? That's basically the strategy that the Fed took in 2008, and it is taking it again.

But that SPV still needs to be funded. Luckily for the Fed, Section 13(3) of the Federal Reserve Act allows it to exercise broad lending powers in an emergency. So the Fed invokes 13(3), lends funds to the SPV, and then has the SPV buy Walmart debt. Voila, the Fed has purchased Walmart bonds without actually buying Walmart bonds. All the legal i's have been dotted, the t's crossed.

The SPV structure isn't just a legal hack. It also allows the Fed to protect itself.

Each of the five or six SPVs that have been created over the last two weeks is backed up by the U.S. government. This means that if the SPV's loans or bond portfolio falls in value, the central bank needn't worry. The Federal government will promise to make it whole.

Take the aforementioned Primary Market Corporate Credit Facility, or PMCCF. The Treasury has currently invested $10 billion in the SPV to which the PMCCF will lend. So if the Fed buys $10 billion in Walmart bonds via the SPV, and Walmart goes bankrupt and its bonds become worthless, the Fed still gets $10 billion back. It's the Treasury that loses its investment, not the Fed. The SPV structure is a tidy way to formalize the Treasury's support.

To get more context about this protection, let's compare the PMCCF to another facility created by the Fed, the Primary Dealer Credit Facility, or PDCF. The goal of the PDCF is to get funds to primary dealers, large financial institutions that make markets in all sorts of assets including the all-important US government securities market.

To create the PDCF, the Fed has also invoked Section 13(3) of the Federal Reserve Act. The Fed's interactions with primary dealers are limited by law to buying and selling government-issued assets. The central bank can't lend to dealers, certainly not on the basis of exotic sorts of collateral. But the emergency powers embedded in Section 13(3) allow the Fed it to open a broad lending channel to primary dealers.

Unlike the rest of the alphabet soup of facilities that invoke Section 13(3), the Primary Dealer Credit Facility is not set up as an SPV, nor does it enjoy $10 billion in protection from the U.S. Treasury. I have it on good authority that the Fed doesn't believe that a firewall is necessary. A strict process is already in place to vet primary dealers. Furthermore, the Fed has an ongoing relationship with dealers because they mediate all central bank purchases and sales of government securities.

But the Fed knows very little about the counterparties that it will lend to under the other facilities it has created, like the PMCCF. To make up for this extra risk, it wants to get some protection from the Treasury should those counterparties fail.

And in a nutshell, that's why the Fed has taken such a circuitous route to get funds into the credit system.

The bigger picture is that you've got a very old set of laws embodied in the Federal Reserve Act. Many of these rules were designed back in 1913 when America was still mostly a farming economy. Debts were almost always short-term back then, usually in the form of a bill of exchange, a debt instrument that doesn't really exist anymore. Heck, a whole section of the Act is about discounting "agricultural paper". That section probably hasn't been invoked in fifty years.

Meanwhile, a massively complex financial system has evolved over the last century. All sorts of new exotic credit instruments have emerged, say like asset-backed commercial paper. Farming, once a dominant sector, now accounts for a tiny part of the US economy. In a modern crisis like the one we are in, Federal officials believe that they need to be able to deal in these new types of securities. And reach new industries. Because the Act is mostly designed for a previous era, Fed lawyers have had to drill a strange new path to the credit markets via Section 13(3), SPVs, and Treasury support.   

I'm going to leave off now. Readers will obviously have a lot of unanswered questions.  

• Should the Fed be lending such a massive amount of money to such a wide variety of borrowers? (I don't have a good answer).
• Why is the Money Market Mutual Fund Liquidity Facility called the MMLF and not the MMMFLF? (Nathan Tankus deals with this and much more in his two part overview of what the Fed has done up till now).
• Aren't the Treasury backstops a waste of ammo? (George Selgin has a good explanation about why they exist, and I am inclined to agree with him. They're not a gimmick.)
• Aren't the SMCCF and PMCCF unprecedented? (Yes, they are. These facilities fund SPVs that either lend directly to corporations or buy corporate bonds in secondary markets. The Fed never went this far in 2008). Are they a good idea? (In a recent blog post, Stephen Cecchetti  & Kermit Schoenholtz argue that they aren't.)
• Shouldn't the Fed limit its support to buying bonds in the secondary market rather than lending directly to corporations? (Narayana Kocherlakota says no. He is opposed to the PMCCF, but likes the SMCCF. George Selgin and I don't see much difference between the SMCCF and PMCCF.)

Would Bernanke accept a trillion dollar platinum coin?

The idea behind the trillion dollar platinum coin goes something like this. According to law, President Obama is permitted to take an ounce of platinum, which is worth around $1,500 in the market, and mint it into a collector's coin that says $1 trillion on its face. Obama then heads off to the Federal Reserve and deposits the coin at face value, his $1,500 worth of platinum having been exchanged for $1 trillion worth of fresh Fed deposits.

What is being exploited here is the difference between a collector coin's intrinsic value and its legal tender face value. Anyone who has collected American Eagle's will be aware of this difference. On its face, an Eagle is worth $50. But the coin's intrinsic value due to its gold content is well over $1600.

Do Eagle's pass at their face value or at intrinsic value? Head on over to the US Mint and you'll see that the Mint is selling $50 Eagles at their intrinsic price of $1,900 or so. Coin dealer American Gold Exchange is hocking 1 oz Eagles for $1750.  Aren't the Mint and and American Gold Exchange breaking the law in selling coins so far from face value? Not really. Legal tender laws stipulate the sorts of payment media required in the discharge of debt obligations. In selling collectors coins in retail spot transactions, the Mint isn't engaged in the activity of discharging debts. Nor is American Gold Exchange.

Think about the implications of requiring coin dealers and the US Mint to sell Eagles at face value to all comers. Both would be providing the world with the a great risk-free arbitrage opportunity—and destroying their balance sheet in the process.

Here's another interesting anecdote about collector's coins circulating (or not) at face value. From 1997 to 2003 Robert Kahre, a resident of Las Vegas and owner of 6 construction companies, ran a scheme in which he paid wages with gold eagles at their legal tender face value. Rather than hiring someone for say $50,000 a year payable by check, Kahre paid with 45 ounces of  Eagles with a total face value of $2,250 or so. Their declared income of $2,250 was so low that Kahre's workers didn't have to report their income to the IRS. At the same time, Kahre saved on payroll tax. Win-win. Except for the IRS. In May 2003, Kahre's businesses were raided by the tax authorities. Kahre was at first acquitted in 2007, but in 2009 he was found guilty of tax evasion and sent to prison.

The implications of the Kahre case are that despite what's said on their face, collectors coins pass at intrinsic value in the US.

The ability, indeed requirement, to ignore a collector coin's face value when engaging in transactions with these coins is a matter of common-sense self-preservation. If private coin shops like American Gold Exchange, the US Mint, or the IRS were required to let eagles pass at face value they would all suffer tremendous losses. Likewise, if the market price of an ounce of gold fell to $2, those obliged to accept Eagles at their $50 face value would quickly go bankrupt. Face value on collectors coins is merely symbolic, not obligatory.

With the rest of the US already passing collector coins at their intrinsic value, why would Ben Bernanke be expected to accept a platinum collector coin worth $1,500 at its face value of $1 trillion? He has no obligation to do so. As I pointed out, legal tender refers to the types of media that can be used to discharge debts, and Bernanke is not indebted to Obama in any way. All he does is administer the Treasury's account at the Fed.

Nor can Bernanke choose to forgo self-preservation. Section 16.2 of the Federal Reserve Act obligates him to protect the Fed's balance sheet by stipulating the rules concerning Federal Reserve note collateralization. The Act requires that all notes must be backed by

collateral in amount equal to the sum of the Federal Reserve notes thus applied for and issued pursuant to such application... In no event shall such collateral security be less than the amount of Federal Reserve notes applied for.

This means that notes cannot be backed by an insufficient amount of collateral security. There is a long history behind section 16.2. I've discussed it before here and here. 16.2 has been liberalized over the decades. In the old days, only a small range of assets could stand as collateral, but now almost any asset can back the note issue. Nevertheless, the 16.2 requirement for sufficient quantity of security remains. If a collector coin's market value is only $1,500, then Section 16.2 presumably prevents Bernanke from depositing the coin in exchange for anything over $1,500 in Fed notes and deposits. Any larger amount of notes and deposits applied for and the coin fails the collateral test.

The case could be made that Bernanke would accept the trillion dollar coin if it were to represent a binding debt of the government to repay the $1 trillion loan. But in this form the coin is no more than a bond or promissory note. Instead of being written on paper, the promise is embossed on platinum. Bernanke can't directly accept government debt, no matter if its inscribed on platinum, paper, or a mere digital entry. He can only bring government debt onto his balance sheet after the market has already purchased it. These limits can be found in sections 13 and 14 of the act. Section 13, which governs the Fed's lending powers, does not give the Fed power to lend to the government, while section 14, which governs open market purchases, only allows the Fed to purchase government bonds on the open market.

Of course, we can speculate about the possibility of Bernanke accepting the trillion dollar coin until we turn blue. We only really know what he'd do when the time actually comes. Bernanke might accept the trillion dollar coin at face value, but he'd surely have both tradition and law on his side in questioning his obligation to do so. However, laws and conventions often bend and morph when circumstances dictate. The Bear Stearns transaction via Maiden Lane I and the AIG bailout via Maiden Lane II and III somehow went through, despite what would seem to be explicit warnings against such actions in the Federal Reserve Act. Until it gets minted, I've got to hand it to the Beowulf, the originator of the trillion dollar coin idea, in having created what seems to be the econ blogosphere's most influential idea of the New Year.

[Update: In the comments with Bill W., I mentioned another bit of legalese indicating that the Fed needn't accept coin from either the government or a member bank. See section 13.1 of the Federal Reserve Act: “Any Federal reserve bank may receive from any of its member banks, or other depository institutions, and from the United States, deposits of current funds in lawful money, national-bank notes, Federal reserve notes, or checks.”  More evidence that Bernanke can say no to a government deposit request. May≠must.]