On Thursday, the Fed took a dramatic step to try to stabilize the financial system, offering banks trillions of dollars in new short-term loans. The loans would last for up to three months. Banks could only access the money if they turned over super-safe assets—mainly US Treasury bonds—whose value was equal to the loan amount.
The basic idea was as old as central banking itself. In times of financial stress, people want to hold more cash. That puts pressure on banks, who don’t have as much cash as people want, which can lead to a financial panic. To stave off panic, the central bank creates additional cash and lends it to the banks, allowing banks to meet customer demands and stave off a meltdown.
Unfortunately, the large dollar amounts and the convoluted process the Fed uses to distribute the money has led to confusion and misguided criticism. Rep. Alexandria Ocasio-Cortez, for example, griped that the $1.5 trillion the Fed is offering to banks this week could cover “all student loan debt in the US.” A number of people complained that it was a bailout for banks. These folks seem not to know, or care, that the banks will have to pay back ever penny, with interest, within three months. That’s not a bailout.
In this post I’ll try to dispel some of the confusion surrounding the Fed’s actions. First I’ll use a simple example to illustrate exactly what the Fed is doing. Then I’ll explain why actions like this are in everyone’s interest.
The Amazon card loan
Let’s say you’ve got a friend who owes $475 in rent tomorrow, but he’s broke and his $1,000 paycheck doesn’t come until next week. You notice that he has a $500 Amazon gift card, so you make him an offer. You’ll lend him $500, and you’ll hold on to the gift card. Next week, after his paycheck comes, he’ll pay you $500 and you’ll give the card back. If he doesn’t pay, you keep the card.
The risk to you is very low. You’re a regular Amazon shopper, so it wouldn’t be much hassle to load the $500 into your Amazon account and use it for future purchases. One way or another you’ll get your money back.
The Fed’s new loan program works essentially the same way, except that the Fed doesn’t take Amazon gift cards as collateral. To get a loan, banks have to put up US Treasury bonds or a few other forms of US government debt.
To take out a loan, a bank electronically sends the Fed (say) $1 billion in Treasury bonds. The Fed creates $1 billion in new new money and sends it to the bank. Then after a specified time period—which can range from overnight to three months—the bank returns the Fed its $1 billion in cash and the Fed gives the bank its $1 billion in Treasury bonds. (The bank also pays the Fed some interest but I’m gonna be a lazy blogger and not figure out the exact mechanics of that).
In the very unlikely event that a bank fails to repay a loan, the Fed keeps the Treasury bonds, whose value will be very close to the amount originally lent out. So the risk being taken by the Fed is tiny.
To be clear, this isn’t a new type of loan program. The Fed has been offering to make loans like this to banks for years. What’s new is the scale of the program. In the past, this type of loan offering was often capped at $100 billion or less across all banks. In normal times, that was more than enough to meet bank demand—banks typically didn’t even use the full amount offered. But now the Fed has drastically increased its limits, offering three different $500 billion loan programs just this week—with more to come.
OK, so that’s what the Fed announced it was doing on Thursday. The more important thing to understand is why.
“Highly unusual disruptions in Treasury financing markets”
Most people expect the Coronavirus to be economically disruptive. So if you’re a Chief Financial Officer at an American company, one of the first things you’re going to want to do is get more cash on your balance sheet. Suppose your company got a $100 million line of credit from a bank last year and you’ve only used $50 million of it. So you decide to take the extra $50 million now.
That might be a smart move for you, but now the bank has a problem. Every CFO is having the same though at around the same time. The bank set the credit limits on these accounts based on assumption that most customers wouldn’t use the full amount. As more and more companies borrow more and more money, the bank’s cash reserves are dwindling.
This isn’t to say the bank is about to go bankrupt. This particular bank has billions of dollars invested in safe assets like US Treasury securities—more than enough to cover all of its liabilities.
But the bank doesn’t want to disappoint a customer—and possibly set off a panic—by refusing to honor an existing credit line. And you, the business customer, need $50 million in cash. You can’t pay your workers with Treasury bonds.
Can’t the bank just sell some of its Treasuries and use that cash to meet its customers’ cash needs? In normal times, that’s easy. There’s always someone willing to buy US Treasury bonds. But these are not normal times.
In its Thursday statement announcing the new loan program, the Fed wrote that it was aiming to “address highly unusual disruptions in Treasury financing markets associated with the coronavirus outbreak.” That’s cryptic Fed-speak, but a Bloomberg story offers some details on what the Fed might have been seeing.
Yields in the world’s largest debt market have been on a mind-bending, three-week roller-coaster ride. At one point, the entire U.S. yield curve was below 1% for the first time ever. But this week rates have jumped from Monday’s all-time lows even though fear of the virus has intensified… This volatility is happening as trading-platform order books thin out to a degree last seen during the 2008 financial crisis, making it harder to use Treasuries as a gauge of investor anxiety.
I’ll admit I don’t fully understand this. But the basic issue is that what’s supposed to be the world’s most liquid asset—an asset you can always, always sell quickly and for a predictable price—has become less liquid and less stable recently.
Any one person or company can use Treasuries as a ready substitute for cash and everything will work fine. But if a lot of people start to use them that way—and they all start to exhibit herd behavior, with a lot of panic buying and panic selling—it can lead to sudden swings in bond values, or even to moments when it’s hard to find a buyer for every seller, or vice versa.
So one way to look at the Fed’s actions Thursday was that they were just trying to calm down Treasury markets. Now a bank that is trying to sell Treasury bonds for short-term liquidity needs doesn’t actually needs to sell the bond at all—it can use the bond as collateral for a loan. By guaranteeing that this kind of loan will always be available, the Fed hoped to calm down the markets and limits wild swings in the market.
You might think that volatility in bond markets aren’t of any concern to the average American, but I think the experience of 2008 suggests otherwise. Nobody cared very much about mortgage-backed securities in mid-2008, but chaos in that market sparked panic in other markets, ultimately bringing the entire financial system to the brink of collapse. I can’t predict exactly how a dysfunctional market for US Treasuries would create bad consequences elsewhere. But I’m glad the Fed didn’t wait to find out.
Why liquidity is crucial
Here’s a broader way of looking at it that I think makes the stakes for the average American clearer.
Fundamentally, what happened on Thursday was that a lot of people—not just banks, but their millions of individual and business customers—wanted to increase their cash holdings to help them ride out the Coronavirus pandemic and any economic dislocation that comes with it. And fundamentally what the Fed did was create an orderly way for that to happen.
That was important because my hypothetical about businesses stockpiling cash wasn’t just a hypothetical. On Wednesday evening, Bloomberg reported there was a “dash for cash” in corporate America.
“Behind the scenes, some CEOs and their finance chiefs are calling bankers this week to ask for liquidity,” Bloomberg’s Sridhar Natarajan and Yalman Onaran wrote. “And throughout the day Wednesday, word leaked out on company after company pulling from existing facilities.”
“There is fear in the market that liquidity might dry up, so business owners want more cash in hand to weather a host of uncertainties,” the president of an online lending platform told CNBC.
It’s in everyone’s interest to make sure that corporate America can get the cash they need—assuming there’s a bank willing to lend to them. If there’s an economic downturn later this year, extra cash on corporate balance sheets could make the difference between big layoffs and small layoffs—or no layoffs at all.
So that’s what the Fed did: it made sure that banks could access all the cash they needed to serve their customers. It would have been a self-inflicted wound for the Fed to allow a panic to intensify because banks were having cashflow problems and couldn’t make loans to creditworthy borrowers. Even if that hadn’t sparked an immediate crisis—which it very well could have—it would have left corporate America, and the American economy more broadly, less well-prepared for the difficult months ahead.