Fed creates muni facility to buy short-term debt
Muni market advocates are broadly supportive of the Federal Reserve's Thursday announcement of a program to directly purchase short-term muni debt, though the parameters set by the central bank drew sharp criticism from some.
The Fed's new Municipal Liquidity Facility will purchase up to $500 billion of short-term notes, with the Treasury providing $35 billion of credit protection to the Fed using funds appropriated in the $2 trillion Coronavirus Aid, Relief, and Economic Security Act signed into law on March 28. But the program will directly aid only the largest issuers, at least for now, relying on those issuers to provide support to smaller localities.
“Our country's highest priority must be to address this public health crisis, providing care for the ill and limiting the further spread of the virus," said Jerome Powell, Federal Reserve board chair. "The Fed's role is to provide as much relief and stability as we can during this period of constrained economic activity, and our actions today will help ensure that the eventual recovery is as vigorous as possible."
The Fed will buy notes directly from states, counties with a population of at least two million residents, and cities with a population of at least one million residents. Only one issuer per state, city or county is eligible, the Fed said. State-level issuers can use the proceeds to support additional counties and cities.
Under the new facility, the Fed will lend to a sp,ecial purpose vehicle, which will then purchase notes from issuers at the time of issuance. The SPV will stop purchasing on Sept. 30, 2020, unless the facility is extended. The Fed will continue to fund the SPV until the SPV’s underlying assets mature or are sold.
Notes eligible under the program are tax anticipation notes, tax and revenue anticipation notes, bond anticipation notes and other similar short-term notes as long as the notes don’t have a maturity of more than two years.
Each issuer that participates in the facility must pay an origination fee equal to 10 basis points of the principal amount of the notes purchased by the SPV, the Fed said. The origination fee may be paid from the proceeds of the issuance.
An issuer can use the proceeds from selling notes to help manage cash flow impacted by delays income tax revenue and reductions in tax and other revenues and expenses related to the pandemic. The issuer can also use the proceeds for the payment of principal and interest on obligations relevant to their municipality and use the proceeds of the notes to buy similar notes issued by “political subdivisions and instrumentalities of the relevant state, city or county.”
The SPV can buy the notes issued by municipalities in one or more issuances of up to an aggregate amount of 20% of the general revenues from the municipalities’ own sources and utility revenue for fiscal year 2017. Notes bought by the SPV are callable at any time at par.
Powell said in a televised statement that the Fed has now announced nine emergency credit facilities that have been set up with permission from Treasury Secretary Steven Mnuchin.
Powell emphasized the facilities are “lending powers” that involve only “solvent entities.”
“Our emergency measures are reserved for truly rare circumstances,” Powell said.
The eligibility rules have been made broad and could be changed.
“We are going to be watching and are very much willing to adapt,” Powell said.
“The Fed and Treasury decided to focus initially on state and larger local governments, apparently not including nonprofit hospitals and universities, while recognizing a broader program and more action may be necessary in the future,” said Chuck Samuels of Mintz Levin, counsel to the National Association of Health & Educational Facilities Finance Authorities. “Market participants will review the details of the program, monitor its implementation and undoubtedly propose revisions and further action.”
Mnuchin, appearing on the CNBC show "Squawk on the Street," emphasized that the Fed facilities are loans that will be paid back. Mnuchin said Congress has authorized over $450 billion for the new Fed programs and rolled the programs out to new asset classes.
“I really want to thank the Fed,” Mnuchin said. "They have done an extraordinary job rolling out all these new facilities and for all different types of asset classes from Main Street to municipalities, states and cities, now know they will have liquidity. This is an unprecedented move.”
Most market groups reacted with general positivity.
“SIFMA applauds the Federal Reserve’s latest actions to provide liquidity support to state and local governments and non-profits," said Ken Bentsen, president and chief executive officer of the Securities Industry and Financial Markets Association. "The Municipal Liquidity Facility is an important first step to help state and local governments to deliver critical services during the pandemic. We appreciate the focus on this important sector of the economy, and we look forward to continuing to work with them on support programs during this volatile time.”
Mike Nicholas, CEO of Bond Dealers of America, welcomed the program but expressed some concern and called for more action.
"We are looking particularly at how smaller issuers will access the facility," Nicholas said. "BDA looks forward to working with the Fed and others to ensure that any extraordinary help for the market is applied as effectively as possible. We also urge the Fed to use its CARES Act authority to provide support as needed for the secondary market for municipal bonds — providing much needed liquidity, benefiting the overall market."
Matthew Chase, CEO of the National Association of Counties, is waiting to see what the facility does for smaller municipalities. Right now, 3,054 counties have populations below two million and would not qualify under the facility. Only 15 counties are above two million people, Chase said.
National Association of Bond Lawyers President Richard Moore, a tax partner at Orrick in San Francisco, said his group “generally applauds the Fed for taking this unprecedented step so quickly.”
NABL is “still analyzing the terms under which the Fed will buy munis,” Moore said.
The American Securities Association blasted the Fed's decision to target larger issuers for the direct support.
“While today’s action helps the largest cities, it completely misses the mark for those cities, towns, and counties across our country that fall under the population minimums,” said ASA CEO Chris Iacovella. “These areas represent the heartbeat of America and for some reason the Fed and Treasury have chosen to exclude them while backstopping the largest cities, which doesn’t make any sense. We expect Members of Congress on both sides of the aisle who represent these Main Street districts to work together and join us to remedy this situation immediately.”
The Fed has been historically hesitant to become a direct participant in the municipal market, and Powell's remarks make it clear his preference is to intervene for as short a time as practical while making sure the economy permits it.
When the economy recovers, "We will put our emergency tools away,” Powell said, expressing his confidence that the recovery “can be robust.”
Powell said the Fed will “be in no hurry to pull back” and wants “the economy on a solid footing again” before it does so. As was the case in the wake of the 2008 financial crisis, Powell said the Fed “will telegraph” in advance any pullback.
Updated at 12:40 with additional reaction and analysis from municipal market participants.