By Julia-Ambra Verlaine and Nick Timiraos
Reviving the market for bonds sold by state and local
governments is shaping up as one of the stiffest tests in the
Federal Reserve's campaign to restore financial normalcy.
The Fed has committed trillions of dollars to keep money flowing
through markets vital to economic growth, including huge purchases
of government and mortgage securities and new programs to backstop
money-market funds and corporate-debt markets.
Those efforts have helped to fuel the markets' partial recovery,
say investors and portfolio managers, with the Dow Jones Industrial
Average up 22% from its March 23 low.
But the central bank is limited in its efforts to revive the $4
trillion market for municipal securities, which back everything
from school facilities to stadiums and highways. The Fed has so far
intervened in only a few corners of the market, which is fraught
with idiosyncrasies that make it difficult to categorize debt as
investment-grade or risky, the line in the sand drawn by the Fed to
ascertain what it backstops during a crisis.
The constraints stem in part from the coronavirus's decimation
of state and local finances, which could make the risks even harder
to judge, and the Fed's traditional deference to Congress in
handling local government financing decisions.
"The Fed doesn't want to be in a position to say you have to
raise taxes or cut pay to policemen or firemen" to secure or repay
a loan from the central bank, said Scott Alvarez, who was the Fed's
general counsel from 2004 to 2017.
Fed and Treasury Department officials are working on a program
to backstop some financing for states, according to people familiar
with the matter, but the devil of any program will be in the
details.
While the Fed has the authority to purchase municipal debt with
maturities of six months or less, it hasn't exercised that
authority. A more likely route would be to establish an
emergency-lending program to backstop longer-dated muni debt.
The $2 trillion rescue package that Washington approved last
month includes $454 billion that the Treasury can use to absorb
losses on any Fed lending facilities. That bill provided $200
billion in direct funding for states and cities, but they are
likely to need another $300 billion to $600 billion, said Tom
Kozlik, head of municipal credit at Hilltop Securities.
The aid to cities and states in the recent rescue package "will
not be enough to offset the cost many states and municipalities are
encountering," said Boston Fed President Eric Rosengren. The Fed
can help with financial markets, but those efforts will be less
effective without more direct aid, he said.
Officials are trying to avoid a rerun of state and
local-government layoffs after the 2007-09 recession, which
contributed to an underwhelming economic recovery despite
unprecedented Fed stimulus.
The Fed typically seeks to steer clear of concerns about the
potential loss of taxpayer funds by focusing on purchases of assets
such as highly rated bonds whose default is widely judged to be
minimal. Such judgments are harder to come by in the market for
municipal bonds, where even the strongest borrowers have been
hammered by the challenges arising from an unprecedented shutdown
of business and commerce around the country.
States face not just the burden of boosting spending on
public-health responses, but also a drop in revenue from sharp
declines in sales-tax collections.
"In almost every way, states are at the front lines of fighting
this," said Joe Torsella, Pennsylvania's state treasurer.
Fears that state and local finances will be permanently damaged
are evident in the investor flight from this market, which until
recently has ranked among the most resilient.
In March, investors pulled $32.8 billion from municipal-bond
mutual and exchange-traded funds, according to Refinitiv, the
largest monthly outflows since data collection began in 1992. State
and local governments canceled billions of dollars of planned
borrowing. The S&P Municipal Bond Index gave up more than a
year's worth of gains.
The Fed has long resisted lending to states and companies,
having spurned requests from lawmakers in 2008 to aid ailing U.S.
auto makers and ruled out a muni-debt backstop.
The central bank has already broken some taboos during the
current crisis. It is in the process of unveiling lending
facilities for large and midsize companies, and it has dipped a toe
into muni-debt markets by expanding a money-market lending backstop
to include certain types of municipal debt -- and by purchasing
some highly rated municipal debt in a facility backing the market
for very-short-term commercial debt.
Analysts and state officials said the Fed could provide support
by buying a broad-based muni index, avoiding the prospect of
picking winners and losers outright.
Among the issues the Fed must weigh is who ultimately benefits.
The yields on bonds issued by Montgomery County, Md., an affluent
suburb of Washington, D.C., and Cook County, Ill., home to Chicago
and where more than 700,000 people live in poverty, both jumped
more than 2 percentage points over a week in March, indicating
lower prices.
Yields on the Montgomery County bonds have since declined more
than those on the Cook County bonds -- indicating that while the
market views the Montgomery County bonds as a better risk, the Cook
County securities are potentially the ones more in need of support.
Those sorts of regional and distributional issues carry significant
risk for the Fed, investors said.
"It would be very problematic for the institution and its
credibility to decide between New York and Montana," said Mark
Spindel, a Washington-based investment manager who co-wrote a
history of the Fed.
The prospect of increased lending to businesses and local
governments, often in consultation with the Treasury Department,
could reshape the Fed's longstanding autonomy from the executive
branch.
During and after World War II, the central bank pegged Treasury
yields to finance war spending and the recovery. A bruising fight
with the Truman administration, which resulted in the resignation
of the Fed chairman, ultimately led to a formal agreement in 1951
to end the Fed's policy of fixing Treasury yields.
"I think it is possible that we will have a central bank when
this is all over that has sacrificed a piece of its independence,"
said Jeremy Stein, a former Fed governor who now teaches at
Harvard.
Fears about the loss of central-bank independence are overstated
given the gravity of the current crisis, said Mr. Torsella.
While political and constitutional tensions loom, "smart,
well-intentioned people can figure out how to do this in a way"
that "simply restores functioning of this market," said Mr.
Torsella. "I want to make sure we have a fighting chance of getting
back to those more normal times."
Write to Julia-Ambra Verlaine at Julia.Verlaine@wsj.com and Nick
Timiraos at nick.timiraos@wsj.com
(END) Dow Jones Newswires
April 08, 2020 05:44 ET (09:44 GMT)
Copyright (c) 2020 Dow Jones & Company, Inc.