Fed's muni program works in current market conditions
Despite lawmakers’ calls to expand the program, there is strong indication the Federal Reserve’s short-term note purchase program is working as intended and does not need to be changed so long as the municipal market stays stable.
A group of more than 50 members from the Congressional Progressive Caucus, a liberal faction of Democratic House members, recently wrote a letter to Fed Chair Jerome Powell urging him to expand the $500 billion Municipal Liquidity Facility to make more municipalities eligible, extend the maturity period for those bonds and change the bond rates to be more favorable.
“At present, the harsh terms and penalty rates for the MLF make it functionally unusable for the vast majority of the state and local governments that are technically eligible, which severely undermines the program’s intent to help states and cities struggling from unprecedented financial hardship,” the lawmakers wrote. “The unusually harsh penalty rate on users of the MLF, coupled with an arbitrarily set and short three-year time limit on the lending, makes it unusable to a majority of potential local government participants.”
That letter was led by Reps. Mark Pocan, D- Wis., Pramila Jayapal, D-Wash., as well as Rashida Tlaib, D- Mich., and Joe Neguse, D- Colo. It's been endorsed by organizations such as the Americans for Financial Reform.
The lawmakers noted that very little of the program has been used and will likely ever be used if it stays as is. Illinois has been the only municipality to use it since it was created this spring.
But many muni market participants disagree, saying the MLF is working exactly as intended. While the progressive lawmakers argued that the MLF is infrequently used, Brian Battle, director of trading at Performance Trust Capital Partners, said that’s the way it was intended.
“The Fed was empowered during the crisis to make sure the markets had clearing levels and that there was liquidity and by that definition, the MLF is doing exactly what it’s supposed to,” Battle said. “Right now, we’ve had weeks and weeks and weeks of inflows.”
The MLF is open to counties with populations of 500,000 or more and cities of 250,000 or more. Population parameters were two million for counties and one million for cities when the program was announced in April. In June, the central bank allowed U.S. states to be able to have at least two cities or counties eligible to directly issue notes regardless of population. Governors of each state are also now able to designate two issuers whose revenues are derived from activities such as public transit and tolls.
House Democrats’ HEROES Act would extend the MLF expiration date from December 31, 2020 to December 31, 2021, extend the maturity period to 10 years from three years and adjust rates to the Federal Funds rate in effect lowering it.
The Fed charges issuers a premium — a baseline 150 basis points for triple-A issuers to 590 basis points for below investment-grade-rated issuers.
“What Congress is advocating for is that the Federal Reserve support the muni market as a subsidy,” Battle said. “By lowering the rate, the federal government would be subsidizing municipal issuers, meaning they would be getting a lower rate than the market would deliver. That is a huge policy change, definitionally different than the way the MLF was intended.”
In the end, the Fed will do what Congress tells them, with some resistance, but Battle said using the MLF as a stimulus is “an inappropriate application of the MLF” since the Fed is supposed to be the buyer of last resort. The program is supposed to be used infrequently and the rates are supposed to be high, he added.
If the Fed were to expand the program more, it would come with “political danger,” Battle said.
“Those are political decisions and that’s not the Fed’s job,” he said.
If the market does take a downturn like it did in March with heightened volatility, the Fed’s rates still shouldn’t move Battle said.
“The idea or possibility that the Fed could be involved tightened the market,” Battle said. “They didn’t have to buy any bonds when the market got tighter. Just the possibility of them being involved put a backstop in the market.”
Illinois used the MLF in June for its $1.2 billion one-year, general obligation backed notes at a rate of 3.82% based on its ratings. At the time of its use, Illinois’ one year bond was set by Municipal Market Data at 345 basis points to the AAA benchmark.
Two weeks before the state decided to use the MLF, Illinois’ bonds were trading at peak spread penalties of 400 basis points and 425 basis points to the one-year and 10-year MMD AAA benchmarks.
Illinois was able to borrow at a rate of 3.82%, which historically, Battle said is a fair rate, referencing municipal rates for three-year general obligation bonds pre-2008 recession were closer to 7%.
Illinois’ required competitive bidding process on such borrowing which is allowed under state law due to a failure of revenues was a sticking point. In May, the Fed expanded the program to allow issuers to use it even after a competitive sale process but ahead of the sale, state lawmakers approved late amendments to the short-term borrowing act to forgo the competitive sale requirement.
Illinois is likely planning to use the MLF more, said Richard Ciccarone, President & CEO of Merritt Research Services, LLC. Illinois’ situation at the beginnings of the pandemic was uncertain.
“Illinois was reaching a rampant COVID problem like New York, and therefore with its weak credit backdrop, it made it uncertain of what kind of rate the market would bring them, especially on such a large deal, Ciccarone said. “They thought this deal was as good as they could get in the marketplace so therefore they used it.”
Interest rates are remarkably low. As of Friday the Bond Buyer Index 20 year maturity for general obligation bonds was 2.02%. Between 1943 and 1947 the index average was 1.70%, hitting a low of 1.29% in 1946. That pattern reemerged in 1950 and 1951 when the index yield fell below 2% again. Today, the 30-year AAA municipal on most curves sits at 1.28%-1.30%. The U.S. Treasury 30-year is at 1.24%.
“With such low-interest rates what more could the window (MLF) do for the investment-grade credit?” Ciccarone said.
It is favorable to go into the market place now, even as a low-rated issuer, he said.
The Fed specifically said it would arrange to submit a bid in a competitive sale process only in cases where an issuer is required by law to sell notes through a competitive sale process and does not have the authority to sell notes to the MLF’s special purpose vehicle following a competitive sale process.
The Fed also specified that participants must obtain evidence that they were unable to secure adequate credit accommodations from other banking institutions. However lack of adequate credit does not mean that no credit is available, they said.
Illinois used the program because market rates were higher than what the Fed offered at the time, so they had a good reason to use it, said Yingchen Li, municipal research strategist at Bank of America.
In late May, BofA predicted that about $90 billion of the MLF’s $500 billion would be used — an 18% rate. BofA expects that number to be a bit higher following the program's acceptance of revenue bond issuers into the program in June.
Ian Rogow, municipal research strategist at BofA said it was unlikely for the Fed to change the costs to use the MLF, as lawmakers have asked unless state and local governments don’t get direct aid from Congress.
Over the weekend, President Donald Trump signed a handful of executive orders following an inability to pass a COVID-19 relief bill on Friday. Those include extending unemployment benefits at $400, down from the $600 temprarily enacted in the last COVID relief bill. House Democrats had called for the full $600, while Senate Republicans were aiming for a lower amount.
States now have to contribute as much as 25% for each person to get to that $400 amount.
On Friday, the White House agreed to offer $200 billion in direct aid to municipalities. The HEROES Act tunes in closer to $915 billion.
Lawmakers come back from August recess in September, creating a small window to pass a relief bill if they can come to an agreement. If they don’t, Rogow said it becomes more likely that the Fed will expand the MLF terms.
“We expect the Fed to act to keep the market functioning at normal or near normal levels,” Rogow said.
Li emphasized that the Fed is there to direct the market, which it did in March in bringing rates down following the announcement of the MLF.
“The low utilization rate is saying the market is working really well,” he said.
Cities haven’t taken advantage of the MLF yet, showing that it might not be working well for cities or offering them what they need, said Michael Gleeson, legislative manager at the National League of Cities. Although, Gleeson said the MLF is supposed to be a last resort.
“Anecdotally, you can say that just from them not using it, they’re probably finding something else out in the market if they need it,” Gleeson said.
The MLF is not what cities need right now, and the challenge has been revenue shortfalls, for which they need direct aid. If they don’t get direct aid from Congress, then the MLF becomes a more important piece of the puzzle, Gleeson said.
Bank lending, capital market financing for short-term and long-term bonds are functioning well right now, said Michael Decker, senior vice president of policy and research at Bond Dealers of America.
“There is generally liquidity available to investment grade issuers from banks and the capital markets,” Decker said. “As long as those conditions prevail, a lot of issuers will just seek financing through traditional channels, which is what the Fed intended.”