The Three Theories of Banking: An Overview

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I have already published a few posts regarding the Federal Reserve and the credit facilities it has developed in an attempt to mitigate the financial crisis resulting from the COVID-19 pandemic. However, I thought it would be beneficial to take a step back and explore a more fundamental topic – how does banking work? This is a topic that I’ve been interested in discussing for a while and I think now is a great time to explore it. The answer to the question of how banking works is more complicated than many realize. Moreover, it is still a topic that remains open to debate within the realm of economics.

One of the most compelling arguments that I’ve come across stems from the work of German economist Richard Werner. He provides three mutually exclusive theories of banking, ultimately making the case that one in particular is the empirically correct way to understand how banking works in practice. The three theories put forward by Dr. Werner are the financial intermediation theory, the fractional reserve theory and the credit creation theory.  It is important to grapple with these theories because the way banking is conceived of and carried out in practice will ultimately have profound implications for how banking policies, monetary policies, and bank regulations are implemented. For the purposes of this post, I will be focusing on the three theories of banking presented above and how they are unique from each other.

Financial Intermediation Theory

This is the presently dominant theory of banking. It holds that banks are merely financial intermediaries, undiscernible from other non-bank financial institutions: they gather deposits from clients and use them to make loans. Put another way, banks are “borrowing” money from their depositors in the short term and using that money to make long term loans to borrowers. This theory of banking is publicized by highly ranked economics journal and has also been lauded by well known economists such as Keynes and Mises, with Mises being one of its earliest proponents. The more recent views of this theory, as put forth by the likes of Ben Bernanke, double down on the notion that banks are simply financial intermediaries, one among many, with the power to create credit or money. The key distinction here is that banks and other financial intermediaries do not create money, they can only repurpose existing funds – effectively swapping one asset for another.

Fractional Reserve Theory of Banking

This theory of banking also makes the case that each bank serves as a financial intermediary, but it takes a more nuanced approach than the former. For example, this theory disagrees with the collective notion that banks are solely financial intermediaries, indistinguishable from others, incapable of creating money. Rather, it argues that “together” the banking system does create money through the process of depository expansion. This process is also referred to as the “money multiplier” process. While each bank serves as a financial intermediary, the banking system as a whole is capable of creating new money. Fractional reserve banking effectively means that banks can lend in excess of their reserves, while the total amount outstanding must remain equal to total deposits. Typically, banks are only required to hold 8-10% of their outstanding loan balances in reserves. An important caveat here is that, just like in the financial intermediation theory, banks cannot make loans without having depositors. The nuanced part of this is that banks are only required to allocate a small percentage of their deposits to reserves, while lending out the rest. These new loans become inevitably create multiple new deposits throughout the financial system, which has the aggregate effect of creating new money.

Credit Creation Theory

The third theory of banking is at odds with the other two theories presented above. Unlike financial intermediation and fractional reserve approaches, the credit creation theory asserts that banks are not financial intermediaries in any sense. Rather, each bank is said to be capable of creating credit and money out of nothing whenever it executes a bank loan contract or purchases an asset. From this perspective, banks are not required to gather deposits or allocate reserves in order to lend. This theory posits the opposite – that banks create deposits whenever they originate a loan. The argument being made here actually has less to do with finance and more to do with the law. When a bank originates a loan, what takes place legally is the execution of a legal document. This legal document is a “debt instrument” that the bank is technically purchasing from the borrower under a particular set of conditions (i.e. the sum being purchased by the bank now, will be repaid in the future with interest). Through this purchase, the bank creates a deposit and records it as such on its books. Therefore, at the end of the transaction, money has been created that did not exist prior.

Conclusion

This concludes my brief overview of the theories of banking. Most are probably familiar with the financial intermediation and fractional reserve theories, especially if they have taken contemporary courses in finance, economics, or business. What I found the most interesting in Werner’s work was the notion of credit creation, as it was, for me, a novel concept with some interesting implications. In future blogs I will focus more on this topic and expand on more on the credit creation theory. As always, if you found this information valuable please like, share, and subscribe to my content.

Main Street Lending Program – What Businesses Should Know

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On April 9th, 2020 the Federal Reserve announced the creation of the Main Street Lending Program – a novel pair of credit facilities that will provide credit to eligible businesses with a maximum of 10,000 employees or a maximum of $2.5 billion in annual revenues. The Program will achieve this by purchasing up to $600 billion in loans.

The Program’s facilities are designed to support lending to both investment-grade and below investment-grade borrowers. Moreover, these facilities are separate from the other mid-sized business loan program contemplated in the CARES Act. Since I dedicated last week to expanding on the programs designed for large firms, I wanted to take some time this week to dive into the Fed’s solution for medium-sized businesses. I’ll start by providing an overview of the two facilities that comprise the Main Street Loan Program and then wrap up the post by identifying potential risks businesses should be aware of before applying for relief under this program.

Overview

The Program is comprised of two facilities: first, the Main Street New Loan Facility (MSNLF) applies to eligible unsecured new terms loans originated on or after April 8th, 2020. Second, the Main Street Expanded Loan Facility (MSELF) applies to eligible “upsized tranches” (sometimes referred to as debt accordions) to existing secured or unsecured loans originated before April 8th, 2020 (provided the upsize occurs on or before April 8th, 2020). The primary differences between the terms of the two facilities relate to maximum loan amounts and collateral requirements (see table below).

Similar to the other Fed facilities explored on this blog, the Main Street Lending Program will utilize an SPV to facilitate transactions. Specifically, the SPV will purchase a 95% stake in each of the loans made to borrowers under the program and eligible lenders will retain the remaining 5%. The SPV will be seeded by $75 billion from the Treasury and will utilize leverage to meet the $600 billion obligation discussed above. Eligible lenders are U.S. insured depository institutions, U.S. bank holding companies, and U.S. savings and loan holding companies. Non-bank lenders are currently ineligible.

Table 1 – Differences Between MSNLF and MSELF:

Source: Miller Canfield

Risks for Businesses

First, unlike the PPP loan program, loans made under the Main Street Program need to be repaid in full. There are no provisions for loan forgiveness under this program. As shown above, the loans are underwritten to 4 year terms with variable interest rates. Repayment can be deferred for up to 1 year, but this is only grace period allowed.

Second, despite being called the Main Street Lending Program, the minimum loan amounts for both credit facilities are $1,000,000 – a far larger sum than is normal and customary for small-to-medium sized business loans. Typically, a commercial bank will lend up to 2-3 times a borrower’s earnings before interest, taxes, depreciation and amortization (EBITDA) and require some form of collateral. For many small businesses, 2-3 times EBITDA still falls well below $1,000,000. Under the Main Street Program facilities, many small businesses would be required to leverage themselves 4-6 times above EBITDA (depending on whether or not they are accepting a new loan, or adding on to an existing loan). Banks tend to be hesitant about providing excess leverage, as the likelihood of default increases when repayment capacity is diminished or all together inadequate. Conversely, there are few incentives for a small-to-medium sized business to take on excessive leverage given the 4 year expiry and variable rate.

Finally, it is also important to consider the fact that some lenders may not be interested in originating these loans. As currently written, the Fed’s term sheet implies that loans made under the Main Street Program will be senior to any other existing notes. Moreover, the Main Street Program facilities cannot be utilized to refinance existing debt. While it is still unclear to what degree these loans will be made senior over others, the ambiguity in the existing term sheet doesn’t help much in terms of establishing buy-in from eligible lenders. Ultimately, it appears that significant deterrents exist on both sides of the equation. While the impact of the Main Street Lending Program remains to be seen, I believe the overall result will unfortunately be underwhelming.

As always, thank you for taking the time to read my thoughts. If you found this information valuable, please be sure to like, subscribe and share with others.

Secondary Market Corporate Credit Facility: Analysis and Consequences

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Earlier this week I wrote about the Primary Market Corporate Credit Facility (PMCCF). Today, I will follow up with an analysis of its counterpart – the Secondary Market Corporate Credit Facility (SMCCF). The SMCCF and PMCCF both aim to support the flow of credit to large firms. The key difference between the two is that the SMCCF supports liquidity in existing markets, while the PMCCF is designed to support new bond and loan issuances. Similar to the PMCCF, the SMCCF will take the form of an SPV that will purchase existing individual corporate bonds as well as corporate bond portfolios in the secondary market.

The facility works like this – the Federal Reserve Bank of New York (FRBNY) will lend to the aforementioned SPV on a recourse basis and the FRBNY’s loans will be fully secured by the entirety of the assets held by the SPV. Finally, the Treasury will seed the SPV with $10 billion using the Exchange Stabilization Fund, the FRBNY will in turn leverage the $10 billion investment to purchase existing bonds and bond portfolios in the secondary markets. I will highlight what I consider to be the most important aspects of the SMCCF and discuss potential consequences of the facility below.

Key Aspects

The SMCCF will mirror the guidelines of the PMCCF when it comes to the purchase of individual corporate bonds – they must be BBB or better by a major NRSRO. Specific to SMCCF is that the bond being purchased must have a remaining maturity of five years or less to be eligible. Moreover, the SMCCF will be purchasing eligible bonds at fair market value in the secondary market. The rationale here is that the FRBNY will, through the SPV, mitigate existing volatility and provide stability in the credit markets by insuring there remains a buyer for existing corporate debt.

In addition to individual corporate bonds, the SMCCF will purchase corporate bond portfolios which (for now) are only limited to exchange traded funds (ETFs). This is, in my opinion, the most profound point of departure we’ve seen the Fed take over the course of the pandemic and it is certainly unprecedented. The investment objective here is to provide broad exposure to the market for U.S. investment-grade corporate bonds. The specifics are presented below:

  • The SMCCF can purchase up to 10% of an issuer’s maximum bonds outstanding at any time between March 22, 2019 and March 22, 2020.
  • The SMCCF can purchase up to 20% of the assets of any one ETF as of March 22, 2020.
  • Finally, and this is a key provision, the SMCCF will not purchase shares of ETFs at a price that materially exceeds the estimated net asset value of the ETF’s underlying portfolio. This is supposed to mitigate substantial losses, should the portfolios buckle.

Both eligible purchases under the SMCCF will have tangible impacts in the secondary markets, but my primary focus for this piece will be to drill down on the former. As stated previously, the Fed making direct investments in the corporate bond portfolios is certainly a new frontier that is sure to result in a slew of consequences, both intended and unintended.

Consequences of the SMCCF

In my opinion, the most interesting consequence has been the market’s reaction to the announcement of the new facility. Companies have started issuing massive sums of corporate debt in anticipation of the SMCCF and the HYG Fund (a corporate bond ETF) experienced its most significant single day spike in value since 2009 late last week (depicted below).

Source – ETF.com segment: Fixed Income: U.S. – Corporate, Broad-based High Yield

Again, keep in mind that this spike was wholly attributed to the Fed’s announcement. The facility has yet to be implemented and therefore no bonds or shares of bond ETFs have been acquired by the Fed through the SMCCF. In my post about the PMCCF, I expressed concern that it was effectively a bailout for imprudent firms, that it sent the message that bad behavior is acceptable. The same is true of the SMCCF, as it will provide liquidity for existing corporate bonds that would otherwise collapse. However, the speculation that it will drive in bond portfolios such as the HYG Fund is far more concerning.

Facilitating artificial growth in the corporate bond markets is dangerous because these credit facilities are effectively propping up what can be objectively considered poor investments in overleveraged firms. In doing so, they are overriding a fundamental truth – firms that egregiously mismanage money are ultimately supposed to fail. This is no longer the case, so long as a firm is large enough to issue corporate debt they will be empowered to do so. This will maintain a status quo that routinely punishes other firms and investors for making prudent financial decisions.

Conclusion

Finally, I think it is important to mention that all of this is occurring in the midst of record high unemployment filings. Each week the numbered of unemployed expands, demonstrating profound strife in the real economy. However, this inconvenient truth appears to have no bearing on the stock market as stocks once again begin to rise in the midst of these new Fed credit facilities. I mentioned above that the HYG Fund experienced it’s largest single one day valuation spike since 2009 last week – this occurred after unemployment filings were recorded in excess of 6 million. The most recent filings, adding an additional 5.2 million to initial jobless claims, are presented below.

Source – YCharts: US Initial Jobless Claims

Unfortunately, these figures once again coincide with an uptick in equity futures. Below is a graph chronicling activity within the NASDAQ Composite index over the course of today, signaling an ever-expanding chasm between Wall Street and Main Street.

Source – Yahoo Finance: NASDAQ GIDS Real Time Price

As always, thank you for taking the time to read my thoughts. If you found this information valuable, please be sure to like, subscribe and share with others. Additionally, please feel free to weigh in on these topics, I’d love to see what others are thinking!

Primary Market Corporate Credit Facility: How it Works and Where it Falls Short

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As promised, this post will expand more on the Primary Market Corporate Credit Facility (PMCCF) and address potential shortcomings. In my overview post, I outlined the mechanics of the PMCF, but didn’t provide any color on key points. In this post I will isolate what I consider the most important aspects of this facility to explain how it will work in practice. Once we have an understanding of the “fine print” we can move into a discussion about who will reap the most benefits from its implementation and address what I consider to be legitimate shortfalls with this facility.

The Fine Print

The term sheet provided for the PMCCF is relatively straight forward regarding eligibility, loan maximums, and fees. However, it takes some digging to understand an important relationship between the CARES Act and this facility. The CARES Act prohibits the payment of dividends and share buybacks, while also placing restrictions on executive level compensation until 12 months after a loan has been repaid. These are arguably the most lauded provisions of the Act as they are intended to reign in the behavior of large firms to ensure they allocate relief funding in a way that is beneficial to the employees.

Unfortunately, this provision does not apply to the PMCCF as the SPV established by the Fed to orchestrate this facility will only be purchasing bonds and syndicated, which are not direct loans pursuant to the CARES Act. The direct implication of this is that eligible issuers will be allowed to issue additional debt to a captive audience, without any prohibitions on how proceeds will be spent. Therefore, the PMCCF is more or less incentivizing the behavior that lead to a myriad of firms facing liquidity and solvency issues in the wake of the pandemic.

Now that the CARES Act loophole has been addressed, it’s important to understand how the debt limits associated with this facility are calculated. The PMCCF limits the amount of total outstanding bonds or loans for an eligible issuer participating in the facility to 130 percent of the eligible issuer’s maximum outstanding bonds and loans on any day between March 22, 2019 and March 22, 2020. For example, let’s say company A’s maximum outstanding bond and loan obligations for the period described is $2 billion. Under the PMCCF, Company A is allowed to issue an additional $600 million of bonds or loans directly to the PMCCF SPV.

Finally, let’s expand more on the notion of eligibility. Eligible issuers must have an investment-grade of at least BBB as of March 22, 2020 by a major NRSRO, which is essentially the lowest rating a bond can have while still being considered “adequate.” A BBB rating indicates medium quality, which is generous considering anything below a BBB rating is categorized as “junk” due to their highly speculative and risky nature. So, what’s the problem? The Fed has drawn the line at BBB, effectively mitigating the risk of highly speculative purchases, right? Wrong. There is an important caveat to this eligibility requirement – if the issuer was rated at least BBB as of March 22, 2020, but was subsequently downgraded, it must be rated at least BB at the time the PMCCF SPV makes a purchase. This effectively opens the floodgates to a slew of eligible junk rated bonds that will be picked up by the Fed, no questions asked.

Conclusion

The direct lending program under the PMCCF is truly an unprecedented effort by the federal government and Federal Reserve to provide liquidity directly to investment-grade corporate borrowers. In the past, the Fed would coordinate with banks to facilitate access to capital. Given the present circumstances, there are concerns that banks will be limited in their ability to provide credit to such borrowers due to existing leverage and regulatory capital requirements. Having cut the middle man out of the equation, the Fed’s new program will likely be an effective tool for investment-grade borrowers in need of refinancing or other immediate funding needs.

Ultimately, however, a strong case can be made that the PMCCF is essentially a bailout for reckless companies. Given the fact that the CARES Act prohibitions will not apply to participants in this facility, there is really no incentive to improve the behavior which placed many of the investment-grade borrowers in this position to begin with. As a result, the Fed has sent the following message – “there are no consequences for bad behavior, in fact it gets rewarded.”

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TALF: A Looming Deficit

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Last week I published a blog post that outlined the credit facilities introduced by the Federal Reserve to address the impact Coronavirus has had on the financial markets and real economy. My introduction to that post did not shy away from the fact that I had some reservations and misgivings about the decisions made by the Fed. I stated that I would expand on these misgivings in more detail in future posts, so this week I will follow through on that statement. I am going to discuss issues I have with three credit facilities in particular in separate posts: Term Asset-Backed Securities Loan Facility, Primary Market Corporate Credit Facility, and Secondary Market Corporate Credit Facility. I will begin with TALF.

The Missing Market

I’d like to start off by stating that I understand the impetus for TALF and believe it will provide stability to lenders and allow them to support borrowers through the crisis. The rationale is essentially that this will allow lenders to continue extending credit since the Fed will step in and maintain the market for asset backed securities. However, as American Banker has pointed out, the 2020 version is ill equipped to fully address the existing market for these loans. This credit facility neglects a significant aspect of the contemporary market – the prominence of unsecured consumer loans.

According to Kroll Bond Rating Agency (KBRA), approximately $10 billion of consumer loan backed ABS was originated in 2019. These loans were primarily originated by nonbank lenders, also known as “fintechs” (financial technology companies). These loans are typically considered investment-grade (i.e. they have a higher interest rate associated with them in lieu of collateral and therefore provide a higher yield to investors willing to purchase them). The problem here is that these tranches of ABS loans are not eligible under the existing TALF provisions, hence excluding a significant portion of originators from relief. It is likely that this will in turn lead to restricted credit access for millions of consumers.

Demand for unsecured consumer installment loans has expanded rapidly over the last 10 years, with volume more than doubling. The St. Louis Fed published an article stating that approximately 78% of consumers have utilized these loans in one form or another, most often for the purpose of refinancing existing debt. These loans also play a significant role in small business lending – which I can speak to anecdotally. Small business owners will often front initial start-up costs with personal loans from companies such as Prosper or Kabbage. Once they become “bankable” (i.e. they have a more stable track record operating as a business) they will seek to refinance these installment loans with a commercial loan at a lower rate.

Many fintechs fund their lending operations through the capital markets. They originate the aforementioned installment loans and then package them as investment-grade ABS products for sale to investors. As a result of the uncertainty stemming from the pandemic, the market for these riskier, higher yield ABS products has started to dry up. Since many of these fintech companies rely on the capital markets to fund their operations, the absence of prospective buyers for these tranches will force them to rely on their balance sheets to originate new loans, or halt lending for an undetermined period. Given the business model associated with most fintechs, the latter appears to be the more likely outcome. This will of course lead to a large swath of consumers being cut off from much needed credit.

Conclusion

Without access to reasonably priced credit, many consumers will be left without viable credit options. The alternative for many will be to accept credit on more expensive terms at a time when they will likely be unable to afford it. Unfortunately, given the dynamics of the pandemic, it is difficult to think of a viable solution to the aforementioned that wouldn’t have to come from TALF. This is especially true, in my opinion, given the issues we’ve seen with the roll out of PPP lending and individual stimulus checks.

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Federal Reserve Credit Facilities: An Overview

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Two weeks ago the Federal Reserve announced a set of measures that largely mirrored the response to the 2008 financial crisis. Though nuanced in some respects, the credit facilities introduced by the Fed were generally in alignment with previous practices – albeit more aggressive than in crises past. Today all of that changed. The Fed announced an additional $2.3 trillion in loans and purchases in an attempt to stabilize a volatile and languishing economy. What makes today’s measures truly unprecedented, however, is that this is the first time in their 107 year history that the Fed agreed to purchase investment grade corporate bonds – effectively nationalizing the bond market.

With the blessing of the Treasury, the Fed has officially exhausted every conceivable measure at their disposal by extending credit to the most vulnerable verticals of the bond market – junk bonds, municipal bonds, and collateralized loan obligations (CLOs) are officially fair game. At this point, the only thing missing from the Fed’s “toolkit” is the extension of credit to purchase equities outright (but never say never). Though my opinion is clearly starting to bleed through, I will save my thoughts on the Fed’s response to the pandemic for another day. The objective of this post is to provide an overview of each credit facility that has been introduced by the Fed as of today. Considering the breadth of the existing measures, I consider it unlikely that the Fed will follow up with another announcement. For the time being, what’s presented below is an exhaustive summary of the Fed credit facilities. Highlights were taken directly from the Fed’s website.

Main Street Lending Program

  • The Fed will purchase 95% of the loan and the lender will retain 5% on its books – this is a full recourse loan with a tenor of 4 years.
  • Eligible Borrowers: businesses with up to 10,000 employees or up to $2.5 billion in 2019 annual revenues. Each eligible borrower must be a business that is created or organized in the United States with significant operations in and a majority of its employees based in the United States.
  • Loan Specifics:
    • 4 year maturity;
    • Amortization of principal and interest deferred for one year;
    • Adjustable rate of Secured Overnight Financing Rate (SOFR) +250-400 basis points;
    • Minimum loan size of $1 million;
    • Maximum loan size that is the lesser of (i) $150 million, (ii) 30% of the Eligible Borrower’s existing outstanding and committed but undrawn bank debt, or (iii) an amount that, when added to the Eligible Borrower’s existing outstanding and committed but undrawn debt, does not exceed six times the Eligible Borrower’s 2019 earnings before interest, taxes, depreciation, and amortization (“EBITDA”); and
    • Prepayment permitted without penalty.
  • There are a number of attestations that the Borrower must make to receive loan funds, but the crux of them focus on not utilizing funds to repay other loan balances. The Borrower must also make “reasonable” efforts to maintain its payroll/employees and agree to limits on compensation and stock buybacks.
  • Total Allocation: $600 billion and it will be seeded by $75 billion from the Treasury.
  • The program has not been finalized and the Fed will be receiving comments until April 16th. Details to come.

Municipal Liquidity Facility

  • The Fed will establish a Special Purpose Vehicle (SPV) to purchase municipal notes directly from eligible issuers.
  • Eligible Issuers:
    • U.S. states and the District of Columbia
    • U.S. cities with population over 1 million
    • U.S. counties with population over 2 million
  • Eligible Collateral:
    • Tax Anticipation Notes (TANs)
    • Tax and Revenue Anticipation Notes (TRANs)
    • Bond Anticipation Notes (BANs)
    • *All notes must mature in less than 2 years
  • Maximum Amount: the SPV can purchase is capped at 20% of the issuer’s fiscal year 2017 general revenue and utility revenue.
  • Pricing: will be based on the issuer’s bond rating (details forthcoming) and an origination fee of 10 basis points must be paid to participate in the facility.
  • Total Allocation: The SPV can purchase up to $500 billion in municipal notes and will be seeded with $35 billion from the Treasury. As it stands, the facility will sunset on September 30th, 2020.

Paycheck Protection Program Lending Facility

  • This facility exists to facilitate additional lending to small businesses under the PPP provision of the CARES Act. The Fed will take the PPP note as collateral, with no recourse to the borrower.
  • Eligible Borrowers: Depository institutions that are approved to originate PPP loans. The program will likely expand to include non-depository institutions participating in the program.
  • Rate and Fees: Extension of credit under the facility will be made at a rate of 35 basis points; there are no fees associated with this facility.
  • Collateral Valuation: PPP loans pledged as collateral to secure extensions of credit under the facility will be valued at the principal amount of the PPP loan.
  • Maturity Date: Credit extended by the Fed will have a maturity date equal to the PPP loan, but the maturity rate will be accelerated if the underlying asset goes into default and the eligible borrower sells the underlying asset to the SBA to realize the 100% SBA guarantee.
  • Regulatory Capital Requirements: The PPP loan will be assigned a risk weighting of 0% and PPP loans financed by this facility can be neutralized by banking organizations for leverage capital ratio requirements.

Term Asset-Backed Securities Loan Facility

  • The Term Asset-Backed Securities Loan Facility (TALF) is intended to help meet the credit needs of consumers and businesses by facilitating the issuance of asset-backed securities (ABS).
  • Under TALF, the Federal Reserve Bank of New York will commit to lend to an SPV on a recourse basis.
  • Eligible Borrowers: All U.S. companies that own eligible collateral and maintain an account relationship with a primary dealer are eligible to borrow under TALF.
  • Eligible Collateral: Must be an ABS where the underlying credit exposures are one of the following:
    • Auto loans and leases;
    • Student loans;
    • Credit card receivables (both consumer and corporate);
    • Equipment loans and leases;
    • Floorplan loans;
    • Insurance premium finance loans;
    • Certain small business loans that are guaranteed by the SBA;
    • Leveraged loans; or
    • Commercial Mortgages
    • *Eligible collateral will not include ABS that bear interest payments that step up or down to predetermined levels on specific dates. In addition, the underlying credit exposures of eligible collateral must not include exposures that are themselves cash ABS or synthetic ABS.
  • Term: Three years; non-recourse to borrower.
  • Pricing:
    • For CLOs, the interest rate will be 150 basis points over the SOFR;
    • For SBA Pool Certificates (7(a) Loans), the interest rate will be the top of the federal funds target range plus 75 basis points
    • For SBA Development Company Participation Certificates (504 Loans) the interest rate will be 75 basis points over the 3-year fed funds overnight index swap (OIS) rate.
    • For all other eligible ABS with underlying credit exposures that do not have a government guarantee, the interest rate will be 125 basis points over the 2-year OIS rate for securities with a weighted average life less than two years, or 125 basis points over the 3-year OIS rate for securities with a weighted average life of two years or greater. The pricing for other eligible ABS will be set forth in the detailed terms and conditions.
  • Fees: The SPV will assess an administrative fee equal to 10 basis points of the loan amount on the settlement date for collateral.
  • Total Allocation: The TALF SPV will initially make $100 billion of loans available and will be seeded with $10 billion from the Treasury.

Primary Market Corporate Credit Facility

  • This facility will serve as a funding backstop for corporate debt issued by eligible users. Under the facility, the Federal Reserve Bank of New York will commit to lend to an SPV on a recourse basis.
  • The SPV will purchase:
    • Qualifying bonds as the sole investor in a bond issuance;
    • Purchase portions of syndicated loans or bonds at issuance.
  • Collateral: The Reserve Bank will be secured by all assets of the SPV.
  • Eligible Assets:
    • Eligible corporate bonds as sole investor. Eligible corporate bonds must: be issued by an eligible issuer and have a maturity of 4 years or less.
    • Eligible syndicated loans and bonds purchased at issuance. Eligible syndicated loans and bonds must: be issued by an eligible issuer and have a maturity of 4 years or less. The facility may purchase no more than 25 percent of any loan syndication or bond issuance.
  • Eligible Issuers:
    • Must be a business that is created or organized in the U.S. or under the laws of the U.S.
    • Must be rated at least BBB-/Baa3 as of March 22, 2020 by a major nationally recognized statistical rating organization (NRSRO).
      • Issuers that were rated at least BBB-/Baa3 as of March 22, 2020, but are subsequently downgraded, must be rated at least BB-/Ba3 at the time the Facility makes a purchase.
    • The Issuer is not an insured depository institution or depository institution holding company.
    • The Issuer must satisfy conflicts-of-interest requirements as set forth by the CARES Act.
  • Leverage: Corporate bonds & loans can be levered 10:1, other assets can be levered 7:1.
  • Pricing:
    • Eligible corporate bonds: Pricing will be issuer specific, pursuant to market conditions, plus a 100 basis point facility fee.
    • Eligible syndicated loans and bonds: The facility will receive the same pricing as other syndicate members, plus a 100 basis point fee on the facility’s share of the syndication.
  • Total Allocation: Not to exceed $750 billion, seeded by $75 billion in Treasury funding.

Secondary Market Corporate Credit Facility

  • This program is very similar to the primary market corporate credit facility. The main difference here is that this facility will be used to purchase corporate bonds as well corporate bond portfolios issued on the secondary market.
  • Key differences are eligible asset classes, eligible sellers, and pricing. All other requisites remain the same as above.
  • Eligible Assets:
    • Eligible Individual Corporate Bonds: Must purchase bonds that were issued by an eligible issuers; have a maturity of 5 years or less; were sold to the facility by an eligible seller.
    • Eligible ETFs: The Facility also may purchase U.S.-listed ETFs whose investment objective is to provide broad exposure to the market for U.S. corporate bonds. The preponderance of ETF holdings will be of ETFs whose primary investment objective is exposure to U.S. investment-grade corporate bonds, and the remainder will be in ETFs whose primary investment objective is exposure to U.S. high-yield corporate bonds.
  • Eligible Seller: Each institution from which the facility purchases securities must be a business that is created or organized in the United States or under the laws of the United States with significant U.S. operations and a majority of U.S.-based employees. The institution also must satisfy the conflicts-of-interest requirements of section 4019 of the CARES Act.
  • Pricing: The facility will purchase eligible corporate bonds at fair market value in the secondary market. The facility will avoid purchasing shares of eligible ETFs when they trade at prices that materially exceed the estimated net asset value of the underlying portfolio.

Conclusion

This was a longer post than usual and certainly dense, but I hope you were able to find this information useful. These are the tools that will be utilized to stabilize credit markets in the U.S. and (hopefully) divert a deep recession as we navigate the coronavirus pandemic. As always, if you found this informative please like, subscribe, and share with your network.

Monetary Policy: Key Takeaways

This picture was sourced from Pepi Stojanovski on Unsplash

The Covid-19 pandemic has introduced an era of profound strife and uncertainty. In the simplest terms, this pandemic has created two huge problems in the areas of public health and economics. To make matters worse, these public policy domains are, generally speaking, at odds with one another. This post will focus on the economic dimensions of this crisis at a high level.

When a national economy experiences macro level shocks there are two primary policy tools at the disposal of government and quasi-government actors – Monetary Policy and Fiscal Policy. The former is focused on addressing interest rates and the supply of money in circulation, it is generally managed by a central bank (such as the Federal Reserve). The latter addresses taxation and government spending, it is generally determined by legislation. Specifically, this post will proved an overview of monetary policy and explain how it is utilized by the Federal Reserve to promote certain outcomes within the national economy.

Monetary Policy

Monetary policy is typically carried out by Central Banking authorities, in the United States it is carried out by the Federal Reserve – often referred to as “The Fed.” Monetary policy involves two primary actions:

  • Establishing base interest rates.
  • Influencing the supply of money (most often carried out through policies of “quantitative easing” which increase the supply of money in the nation.

The Fed has typically used monetary policy to stimulate the economy or check its growth. When the Fed cuts interest rates, it’s sending a signal to individuals and businesses that they should borrow money and spend it in the economy. Conversely, when the Fed increases interest rates the aim is to encourage saving, rather than spending. This acts as a brake on inflation and other issues associated with rapid growth.

More specifically, the Fed has looked to three primary policy levers when influencing rates and borrowing activities – Open market operations, changing reserve requirements for other banks, and setting the discount rate.

Open market operations refer to measures carried out on a daily basis. These operations occur when the Fed buys or sells U.S. government bonds, thereby injecting or withdrawing money out of the national economy.

The second, changing reserve requirements, relates to the percentage of deposits that banks are required to keep in reserve (i.e. cash on hand at any given time). The key takeaway here is that through it’s control over reserve requirements, the Fed is able to directly influence the amount of money created when banks make loans to individuals and businesses. This is important to keep in mind in the present, as reserve requirements have become relatively lax.

Finally, the Fed has dominion over the discount rate. The discount rate is the interest rate the Fed charges on loans it makes directly to financial institutions. The key takeaway here is that the discount rate has an overarching impact on short-term interest rates across the entire national economy.

Conclusion

Ultimately, monetary policy is more of a high level tool. It’s focus lies on expanding and contracting the money supply while influencing borrowing and saving behaviors, however it has less of an impact on the real economy. The key takeaway with monetary policy is that it exists to dictate banking behaviors in the national economy through its control of interest rates and the money supply.

In normal times, the Fed’s focus will be placed on contractionary or expansionary measures. In times of crisis, however, their focus shifts to providing enough liquidity in the financial system to maintain solvency. This, in large part, helps explain the measures taken by the Fed over the last couple of weeks.

If you made it this far, thank you for taking the time to read this! I will be following up on this post with a post that provides a similar overview of fiscal policy. If you found this information valuable, please like and share it with others.

Sea of Red: Interview with a Stockbroker

This picture was sourced from Aditya Vyas on Unsplash

One of my close friends from college currently works as a stockbroker with a large financial services company. He is responsible for executing trades via the firm’s proprietary trading platform and his area of expertise lies with the firm’s specialty trading products. Given his experience on what many would consider the “front lines” of the market, I thought his insight would be quite valuable. I’m grateful he was kind enough to set aside time for a brief interview.

He requested that his name and firm remain anonymous, but was open to sharing information about his day to day experience and how that differed from what he has experienced during a truly historic week. He also provided some candid feedback on key market signifiers, the Presidential Address, and the Federal Reserve’s $1.5 trillion injection.

  1. What is your title and job description at your brokerage?

    I’m a client services agent. I work with our trading desk, primarily for our discretionary trading platform for the firm’s financial advisors. Secondarily, I focus on our specialty trading products – primarily fixed income and options products.

  2. What is a typical day like and how is that different from this week?

    A typical day on my team involves assisting advisors with the discretionary trading platform, serving as a middle man between the equity and bond desks, and executing trades related to our specialty products. I also review trade corrections for the discretionary platform. Occasionally, I’ll be tasked with back-office projects related to operations.

    This week, our call volume, in general, is through the roof. It’s very difficult to execute bond trades, and I’ve had to review about ten times as many trade corrections as usual. Very hectic, very busy days from market open to market close.

  3. What are some of the most common trading activities you’ve noticed this week?

    Recently I’ve been noticing a lot of clients liquidating their discretionary trading accounts or reallocating their positions into more conservative models. Additionally, I’ve noticed a lot of clients liquidating their fixed asset accounts and re-allocating funds into the equity markets. When reviewing trades placed on our website by clients, I’ve noticed several high dollar accounts placing large positions into the equity market – i.e. the people with a significant amount of capital do not appear to be panicking.

  4. From your perspective, what is the driving force behind this week’s historic losses and why were they so devastating?

    Generally speaking, I think we were due for a correction, or at least a small recession. When you look at market signifiers, such as the inverted bond yield curve, this has been anticipated and overdue. This viral outbreak is simply accelerating it.

  5. Expand on the notion of market signifiers – what are some of the patterns you’re observing as a broker and why are they relevant?

    The inverted yield curve is the biggest sign. I’d say overall, the growth of our economy has been questionable in the last few years. A big event in my eyes was General Electric falling off of the DJIA in mid-2018. It says a lot that the DJ is the yardstick we use to measure the health of our economy and essentially every company on the list is partially to completely reliant on Chinese production. This virus dropped their output significantly the last several weeks and it is reflecting in investors’ perception of the market. The big tech companies on the Dow (Microsoft, Cisco, Apple, Intel) have all of their hardware made in China or other overseas markets. The industrial conglomerates like 3M and United Technologies are much the same. The retail giants rely on cheap Chinese goods flowing in to stock their shelves. You can see how this is a problem.

    Beyond this, I’d say the oil situation may actually be more impactful on the markets after China returns to full capacity. There will definitely be at least a brief recession due to the virus, which in a way is good, because it is forcing the market to un-inflate and correct. But the games going on between Russia and OPEC will have a lasting effect. Oil is one of the only things we have been producing domestically. The price of oil has declined gradually from a peak at over $100/barrel during the Obama administration to around $45 before this pricing skirmish began. Now it will likely be around $30 for the foreseeable future. This is very good from a consumer’s perspective though: cheaper travel, cheaper produced goods, cheaper gas. But it is going to hit one of the few functioning American industries pretty hard. I suspect some kind of tariff will need to be applied to combat this issue.

  6. How would you explain the relationship between novel coronavirus and the financial markets?

    I observe a few dimensions of it.

    As I alluded to above, the virtual shutdown of the Chinese economy, caused by this virus, has shown that our own economy is de-facto dependent on Chinese Industry. This is a huge problem for the future, that is not being fixed. Trump has paid lip service to the necessity to “bring back industrial jobs”, yet essentially zero progress has been made toward this end so far. It is something that will actually have to be addressed soon, before the US is completely un-industrialized, which will cause an even more severe and long-term decline in investor confidence.

    Second, Travel and Tourism industries have also been shut down. You can see this reflected in the prices of Airline Stock, Royal Caribbean and Carnival & other Cruiseliners, Vegas Resort Companies, etc. There is not much that can be done for this until the need to quarantine on a mass scale diminishes.

    Third, there is extreme emotion and hysteria involved in a lot of these sell offs by retail investors, or public-conscious institutional investors (like pension funds, endowments, etc). It is a very, VERY good opportunity to buy in if you can see past this. There will only be a few times in a lifetime to invest at such a discount. The wisest thing is to take advantage of it. In 2008 you could buy major companies for literally less than a dollar a share while people were panicking. If you bought Bank of America at its lowest and sold and its peak before this crash, you would have multiplied your money nearly 30-fold.

    This isn’t to say that it isn’t being pushed by the institutional investors either though. Earlier in February, Bezos himself sold off billions of dollars of his own AMZN stock. I have heard the same of executives of a lot of companies. I’ve read published rumors of the same for my own firm, where the stock has dropped by half.

  7. In last night’s Presidential Address Trump outlined three primary responses to the crisis – restricting travel from Europe for 30 days, instructing the IRS to push back the tax deadline, and calling for low-interest loans for small businesses in tandem with a payroll tax cut. Why, in your opinion, did his address fail to quell the markets?

    The travel ban basically instigated the biggest drop we’ve seen in a decade. I’m sure there are logistical reasons for it, it definitely seems like something should have been done sooner, but it is difficult to expect the other financial plans to actually remedy the situation. I suppose the tax extension is convenient, but the tax cuts and loans are not going to have an effect until the virus is gone. I think the Fed’s rate cuts are the most significant thing happening right now, but they will need to maintain it for a while, and probably drop rates lower after the pandemic dies down, in order to get us out of the bear market.

    Trump is clearly trying to give himself talking points for re-election debates, to point to the things that he did to say he did them. They may end up as good things done to overcome the forthcoming recession, but Corona-hysteria will ignore them in the meantime.

  8. What do you think of the Federal Reserve’s decision to add an additional $1.5 trillion to the system? Will a stimulus package have any significant or long-lasting effects in this situation?

    Will this be necessary? I suppose the answer is yes. I think doing so at this point is completely irrelevant. Dropping rates and expanding the monetary supply doesn’t make a difference if huge portions of huge industries are inoperable due to a viral pandemic. Maybe they are doing such now with the prediction its impacts will begin when things actually start to pick back up.

  9. Finally, based on your understanding of financial markets, what do you think would be the best approach or set of approaches to stabilize the financial markets?

    Wait.

    I don’t think we are out of the woods yet, there will be more panic selling, and the market will zig-zag up and down as it has been, until corona virus isn’t striking fear into the global economy. It is going to be hectic and rough, especially for those working in the industry or people reliant on income from their investments. I think we will see the DJIA decline below 20k, I wouldn’t be surprised to see it bottom out lower than that.

    Then it will begin to rise, and stabilize on an upward trend.

    You just have to hold fast, keep buying in and you won’t regret it.

    Ride the Tiger.

If you made it this far, I certainly hope you enjoyed this interview. It was an absolute pleasure for me to facilitate this conversation. If you found this content interesting, please be sure to subscribe and share it!

Covid-19 & Financial Markets

This picture was sourced from CDC on Unsplash

As Covid-19 (Novel Coronavirus) continues to spread through the global system, and increasingly through U.S. metros, the financial markets have certainly taken notice. Volatility is on the rise and major indices have dropped as much as 11% over the course of this week. Many practitioners, government officials, and pundits have attempted to downplay the Covid-19 outbreak – arguing that the volatility of the market is the result of an overzealous media. The Federal Reserve, in typical fashion, cut interest rates in an attempt to stimulate the economy. It didn’t work.

So, why is the market reacting with such profound volatility? Because this is about more than finance. Contrary to popular belief, investors are not guided by the notion of lower rates being equivalent to higher market caps. As Sina Kian puts it in his recent Politico article Coronavirus: The Real Reason the Markets are Worried – “They’re worried about the human and economic costs of the virus itself. “

It’s Not About Monetary Stimulus

A phrase that is often thrown around in finance is confidence and what we’re seeing from investors in the financial markets is a lack of it. Confidence is not solely tied to stock performance in the literal sense, confidence also relates to the ability of public and private sector leaders to manage a particular set of circumstances. Up to this point, confidence in Washington has been shaken. The market (in aggregate) is looking for signs that the crisis can be addressed in a competent manner. There is nothing artificial stimuli, such as rate cuts and quantitative easing, can do to prevent the spread of a virus and that’s why these schemas have failed thus far.

The market, vis-a-vis it’s participants, is seeking tangible solutions to tangible problems. How will the government contain the outbreak and address existing cases? What is to be done about disruptions in global supply chains? How should reductions in revenue streams in key industries and in key companies be addressed in the midst of a black swan event? These are complex questions that cheap access to capital cannot comprehensively address.

Conclusion

This is a rare instance when public and private sector interests are in alignment and one in which public policy decisions will have a profound impact. Ultimately, the focus should lie on addressing the dynamics of the virus itself. This will begin to restore confidence in the financial markets and help bolster economic considerations moving forward.