A historic shift from private to public

| March 27, 2020

This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors. This material does not constitute research.

A historic share of US debt is about to shift from private to public hands with unprecedented speed. Between the Fed, the Treasury, the Small Business Administration and other parts of government, the federal balance sheet could end up taking risk on debt equivalent to more than half of US GDP. Most of the federal effort should flow into the market before the end of 2020. The scale and speed of the intervention is unprecedented. And lessons from federal interventions after the 2008 crisis point to powerful potential effects on spreads and liquidity in capital markets and banking.

A range of interventions dwarfed by the CARES Act

Within the last week, the Fed has already intervened in the capital markets in unprecedented scale. As Stephen Stanley points out elsewhere in this issue, for the week ending March 25, the Fed bought $355 billion in Treasury debt and MBS. Its 1-week purchases of more than $200 billion in MBS exceeded its 1-month record set in February 2009 of $167 billion.

The Fed pace almost has to slow. The central bank at this rate would quickly absorb most of the $16.7 trillion in publicly held Treasury debt and most of the $6.7 trillion in outstanding agency MBS. Brian Landy points out elsewhere in this issue that nominal MBS spreads have tightened within the last week from nearly 200 bp over the Treasury curve to nearly 100 bp over the curve. The Fed has also started buying agency CMBS, which Mary Beth Fisher points out elsewhere in in this issue has consequently tightened 90 bp.

The Fed also announced programs within the last week to buy commercial paper and newly issued and secondary market investment grade corporate debt, and to lend through a $100 billion Term Asset-Backed Securities Loan Facility.

The new Coronavirus Aid, Relief and Economic Security Act, or CARES Act, may end up dwarfing all of these efforts. The CARES Act, among other things, provides $349 billion in loans to small business, $150 billion to state and local governments and $500 billion to larger businesses. But the nominal support to larger businesses masks a powerful mechanism.

The large business allocation includes $450 billion that the Fed, with Treasury authorization, could use as equity for lending through special purposes vehicles. This is the approach now used with TALF. The Fed historically has made loans of $10 for every $1 of Treasury equity, potentially unleashing $4.5 trillion of lending to US businesses.

Tallying up the Fed’s current $5 trillion balance sheet, the potential for $4.5 trillion in additional lending, and the various programs for small and large business and state and local governments, the federal balance sheet could end up holding between $10 trillion and $12 trillion in debt exposure, equivalent to between 47% and 56% of last year’s GDP.

Lessons from the last crisis: lower rates, tighter spreads, steady liquidity

Since the last crisis, a raft of excellent work has outlined the impact of Fed QE on capital markets. Some of the key work has come from Arvind Krishnamurthy, now at Stanford, and Annette Vissing-Jorgenson, now at the University of California Berkeley. Other important work has come from Diana Hancock and Wayne Passmore of the Federal Reserve Board.

Expectations. This new round of QE likely signals the Fed will keep rates low for longer than a traditional Taylor rule might suggest. Rates could stay low well after a rebound in the economy might otherwise allow. The Fed is adding Treasury debt and agency MBS and CMBS, could add corporate debt and commercial paper and take risk on ABS. A sharp rise in rates would trigger losses for the Fed, signaling, along with forward guidance, a low path for policy. Earlier QE reduced rates on 5- to 10-year Treasury notes by an estimated 20 bp to 40 bp.

Safety. By taking a sizable share of safe assets out of the market, the Fed creates scarcity for portfolios that need safe assets and drives up demand for substitutes. The safety premium for remaining Treasury debt and MBS rises. Even though the Fed never bought corporate debt in earlier rounds of QE, its purchases of Treasury debt and MBS drove buyers into higher quality corporate names. Some work estimates that the safety premium on 10-year Treasury and agency debt occasionally hit 160 bp.

Inflation premiums. QE also raises the tail risk for inflation and tends to widen the gap between nominal and real rates. This could be especially true for a massive injection of liquidity into an economy going through a sudden stop. A sudden start could create inflation risk, although the obvious evidence of global economic damage so far likely means any start will be gradual.

Prepayment premiums. QE also reduced mortgage yields and spreads arguably by taking diversifying prepayment risk out of the market and forcing investor to pay a higher price for the remaining supply. When the Fed’s MBS holdings stood at 24% of the outstanding market during earlier QE, MBS spreads stood an estimated 55 bp tighter than otherwise.

Default premiums. Past QE also reduced market assumptions about corporate default risk. For example, 10-year CDS rates on Baa corporate names fell during QE1 by 40 bp. The market arguably viewed corporate debt as safer with a financial system brimming with liquidity. With the powerful liquidity likely to come into the system this time through the Small Business Administration as well as the Fed, reductions in default premiums could be even larger.

Other effects. QE also had some very specific impacts on MBS. Since the Fed bought TBA pass-throughs without regard to pool quality and rarely rolled contracts to other months, the Fed ended up taking in some of the cheapest-to-deliver pools and frequently keeping dollar roll financing special. The value of TBA improved substantially. This looks likely to happen again.

A good news-bad news impact on commercial banking

Commercial banks should read both good news and bad news into the federal efforts. The details of the $450 billion allocated to the Treasury for use by the Fed should come out within 10 days. If the Fed chooses to leverage that into $4.5 trillion of lending, it would likely compete with bank loans. The Fed loans can only go to US business without adequate funding available elsewhere, and rates and terms have to reflect market levels. But the Fed lending should attract businesses with good odds of rebounding. That could reduce future demand for bank loans, putting pressure on loan spreads and terms.

The $349 billion of lending coming through the Small Business Administration should give community and regional banks a powerful product to offer. The SBA will need to streamline parts of its current process. And it will need to assure that loans coming out of the new program are designed for sale in the secondary market. Otherwise, the volume of loans could quickly use up current bank funds and stall. A secondary market would replenish the cash.

The SBA lending program will also likely stabilize businesses where banks already have loans outstanding. This could save banks from the expensive and time-consuming job of restructuring loans or pursuing foreclosure.

On the margin, however, the SBA program could also crowd out bank lending. The new program will forgive the portion of the loan going toward payroll, mortgage payments, rents, utilities and the like for the first eight weeks. But borrowers may also take the opportunity to make capital improvements or increase marketing budgets. Any portion of the loan leftover converts into a 10-year government-guaranteed loan at 4%. That could force banks to compete.

Both Fed QE and lending as well as the SBA programs should generate a surge in deposits just as banks start to compete with federal lending programs. A market with low rates and a flat yield curve compounds the problem. The absolute cost of bank liabilities should rise, with interest income under pressure.

The remote risk of engaging the gears of the economy too soon

Finally, the speed of the coming rounds of intervention, along with the uncertainty about the economy’s ability to reengage its gears after COVID-19, creates unusual risk of inflation. Of course, the counter-argument points to past QE with steadily underwhelming inflation and the possible lingering economic damage from COVID-19 worldwide that would cut the money multiplier. But this is an intervention without precedent. And one good thing without precedent often deserves another.

* * *

The view in rates

The current 0.68% rate on 10-year Treasury debt implies an average real rate of -34 bp and inflation of 101 bp. With the press of QE, real rates have fallen and implied inflation has gone up. Futures now imply policy rates at zero-bound for at least the next year. Fed intervention is likely to reach historic levels with help from fiscal policy.  Given the tremendous monetary and fiscal stimulus working its way into the economy, a quick ebb in the coronavirus pandemic should threaten the rates market with visions of inflation and continue to sharply steepen the yield curve.

The view in spreads

Spreads markets with Fed or fiscal support should continue tightening, and impact of scarcity, broad liquidity, falling default and prepayment premia should tighten other debt sectors, too. As liquidity pressure ebbs, relative value should quickly become more important.

The view in credit

The immediate risk in credit is from companies with high fixed costs and a sharp drop in revenue from current efforts to avoid coronavirus infection. Companies with the highest leverage are first in line. Potential downgrades and defaults among leveraged lends should ramp up quickly. Until the arrival of pandemic, the consumer balance sheet has been extremely strong. The coming sharp rise in unemployment should change that, although the CARES Act should substantially cushion the blow.

john.killian@santander.us 1 (646) 776-7714

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