The Fed allows munis as collateral under mutual fund program
The Federal Reserve has added short-term municipal debt to a list of assets eligible to be used as collateral by financial institutions under a program announced earlier this week, a step that may act to calm the anxiety over the flight of money from tax-exempt money market funds.
Indeed, short-term rates were already falling on AAA benchmarks from early morning highs that had the one-year at over 3%, but they settled around 2.70% as of publication after the Fed news.
The Fed announced Friday that it had added to the Money Market Mutual Fund Liquidity Facility highly rated muni debt with maturities of 12 months or less. The program, initially announced Thursday, aims to “assist money market funds in meeting demands for redemptions by households and other investors, enhancing overall market functioning and credit provision to the broader economy.”
The move may provide some relief for tax-exempt funds, but some market professionals were quick to respond that the step is perhaps just a short-term relief to a longer-term problem and it would not be sufficient to soften the blows hammering the wider muni market.
"It's only money markets right now and that's not the real problem," a New York strategist said. "It's a workaround that isn't really going to work. Not for this market."
In very real terms, yes, the municipal market can use any help it can get at this point. But larger than that, the industry at the moment should not interpret this as a Fed buys munis.
Under the program the Boston Fed will lend money to financial institutions, secured by those institutions’ purchases of eligible assets from money market funds.
The munis that qualify must be rated no lower than SP1, MIG1, or F1 by at least two major rating agencies or, if rated by only one major rating agency, must be rated within the top rating category by that agency. If rated under long-term criteria, the eligible munis must be rated at least AA by two agencies or AAA by one.
Money market funds have seen a rush of redemptions in recent weeks as the full force of the COVID-19 virus financial panic has set in, and the Fed’s liquidity facility is an answer to that.
"What this does is shore up the very front end of the muni market. Money market funds have been forced to sell in a dramatic fashion and what the Fed is doing is giving the confidence to this segment of the market," Matt Fabian, partner at Municipal Market Analytics, said. "It creates a buyer where one mostly hasn’t existed, or if it did, was asking for a lot. It says that ‘yes, we going to loan you capital in a liquidity-deprived environment.’ Money market funds are essentially cash providers and they were hit very hard in this crisis. Short bonds have become long bonds for all intents and purposes."
The Bond Dealers of America weighed in. "Considering municipal market disruption and current economic uncertainty, the BDA believes the Federal Reserve should provide temporary, meaningful broad-based support to the municipal market during these unprecedented times, including to VRDNs and longer dated securities," the BDA said in a statement.
Does it mean that the Fed is buying munis tenfold? No, Fabian said. It means that on a short-term basis, money market funds that own municipals can now rely on a buyer of last resort — the Fed.
Does it mean that the Fed is going to be buying 30-year municipal bonds? No.
In the immediate term, though, it means that there is some relief for this market.
Meanwhile, that broader support could come from a bill introduced in the Senate Friday. The Municipal Bonds Emergency Relief Act, sponsored by Sen. Bob Menendez, D-N.J. would grant the Fed power to buy municipal debt under “unusual and exigent circumstances.”
Current law largely precludes the Fed from buying munis except those with maturities of under six months, and it has been historically hesitant to wade into the muni market as a buyer of last resort during difficult financial times. Then-Fed Chairman Ben Bernanke said in a 2008 letter to then-Rep. Paul Kanjorski, D-Pa.,that the Fed did not want new authority to lend to states and localities because such decisions were inherently politicial and jeopardized the freedom of localities from federal financial oversight.
“States and localities are on the front lines in the fight against COVID-19 and need assistance from the federal government to be able to finance the increasing costs of the response to this health emergency,” Menendez said. “The Municipal Bonds Emergency Relief Act would do that by allowing the Federal Reserve to provide support to state and local governments for this crisis and similar future emergencies.”
The concept of requiring the Fed to buy munis was also included in a memo circulated by House Financial Services Committee Chairwoman Maxine Waters, D-Calif. The totality of information suggests that Democrats at least support some imminent federal legislation to authorize the Fed to support state, territory, and local debt issuance in response to the coronavirus outbreak.
Lynne Funk contributed to this report.