Unsanitized: The Fed Is Overpaying Banks and Hedge Funds for Corporate Bonds

Plus, the Problem Solvers step up with a dead-on-arrival bill. This is The COVID-19 Daily Report for September 16, 2020.

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First Response

You know the old joke about the guy who gets asked in a job interview about his greatest weakness, and he says, “I’m a perfectionist?” That was essentially Neil Irwin’s column about the Federal Reserve and the pandemic. The Fed did too good a job inflating financial markets and asset prices, you see, and now Congress has no urgency to engage in further relief for the public because everyone like them—wealthy people with stocks—is doing well.

There’s some truth in this, but only if you see the Fed as perfectly virtuous and perfectly hamstrung, only able to prop up the investor class. Congress gave it tools to engage in small business and municipal lending that it’s barely used. The Main Street Lending Program for smaller businesses has left 99.8 percent of its funding untapped. There are numerous creative ways for the Fed to prevent state and local austerity through long-dated, rolled-over lending, but they’ve made a grand total of two shorter-term loans. The choice has been not to do so, and yet to buy corporate bonds steadily because the Fed must “keep its promise” to the market. Asset inflation, in other words, was a choice. The K-shaped recovery was a choice.

Part of this, as my colleague Bob Kuttner points out, is that the Treasury Department is a silent partner in the Congressionally approved programs, and Treasury has fashioned onerous terms for smaller businesses and government bonds. (I should note here that the Fed has the power to use Section 14 loan terms for muni lending that would have nothing to do with Treasury.) In addition, the Main Street program is run through banks that must take on a sliver of the risk, which they’re reluctant to do.

Bob’s right that we need a Reconstruction Finance Corporation-type setup that could inject direct funds into failing companies, as well as grants to the states. But letting the Fed off the hook for its favoritism to financial elites would be a mistake. In fact, the Fed’s own data proves that it does engage in direct cash infusions, by overpaying for corporate bonds.

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Americans for Financial Reform ferreted this out in a criminally under-discussed revelation. The Fed reports its corporate bond purchases and loans under the CARES Act to Congress; the most recent one came out September 8. If you go to the trade-level data for bond purchases, you see this very clearly. There’s a par value, a market rate for the bond purchases the Fed is making. It’s paying more than par with virtually every purchase. It bought Altria (the Marlboro and Juul people) bonds at 109.9 percent. It bought Columbia Pipeline group at 116.7 percent. It bought Principal Financial Group at 112 percent. All but a very few of hundreds of purchases totaling tens of billions of dollars are made above par. On average, the price is 107 percent.

Critically, the Fed isn’t buying these bonds directly, but on the secondary market. So when they overpay, they’re lining the pockets of the investors in corporate bonds—like hedge funds and institutional investors like Pimco. Big banks, who handle transactions as the primary dealers in corporate bonds, also make out. BlackRock, the asset manager giant that manages these purchases on the Fed’s behalf, is likely also getting a taste. Essentially everyone on Wall Street is getting rich from the Fed overpaying for bonds.

Don’t take my word for it, check out the words of the head of credit trading at a large Wall Street bank: “We like it when the Fed asks for a price—they tell you exactly what they need [ie size and direction]. Never a problem.”

Of course it’s not a problem. The Fed has more power than any other market participant to set a price; that’s what the money printer is for. They cannot be outbid; there is no “market price” when it comes to the Fed. Their policy decisions set the price, and the data tells you they’ve decided to stuff money into the hands of some of the richest people on Earth, in the middle of a pandemic that is swelling the Medicaid rolls and causing mass food insecurity. It’s abominable.

The Fed’s steady, practically automated bond purchases tell everyone in the purchasing chain that they will get bought off above par eventually. Of course the markets are up! Of course Wall Street is happy! It’s just a mass payday.   

If you want to say that the Fed’s actions are limited, and we need a fiscal deal to forestall economic catastrophe, then OK. But even the apologists would agree that there are areas where the Fed has unquestioned power. And here’s what they’re doing with it: giving bad terms to smaller businesses and municipalities to make their assistance effectively useless, while inflating asset prices and giving hedge funds and banks a giant tip for their efforts. That’s the ugly choice the central bank is making.

Problem Solvers, Solving Problems

The bipartisan group of House moderates known as the Problem Solvers has weighed in with a compromise proposal for a relief package that appears to take everything House Democrats put on the table and cut it in half. Did this negotiation take five minutes or ten? Democratic leaders immediately rejected it and Republican leaders didn’t really have to.

Speaker Pelosi is keeping the House in session through the election, which will delight members in difficult races, who will probably ignore the request and campaign anyway. I don’t know that there’s a lot more to say here. It’s been 142 days since Pelosi told everyone to “just calm down” about the lack of state and local government support. New York City is breaking 100 years of precedent and not guaranteeing schooling five days a week due to budget cuts. I’m not calm.

Days Without a Bailout Oversight Chair

174.

Today I Learned

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