A $500 billion amended MLF is not as simple as it seems. Creating a series of smaller, more specialized lending facilities within the framework would be a lot more practical and effective, economically and politically. A sub-facility for refinancing municipal infrastructure assets is an example.
An amended MLF as lender-of-actual-loans sure looks compelling when the federal revenue impact is included. Just change two digits — term and rate — and it’s aux armes, right? Not quite. There are serious practical problems with the minimalist amended MLF outlined in a prior post. The purpose of that thought experiment was only to show that the FCRA cost of state & local loans is low, relative to the likely tax revenue loss of the alternative. Cool your jets citoyens — implementing a MLF as lender-of-actual-loans is a very different matter.
Policy, Economics — and Politics
Notwithstanding the intent of the CARES Act and the Fed’s mandate, federal credit programs that actually make direct loans are governed by OMB Circular 129. This guidance is pretty clear that credit programs aren’t supposed to replace functioning debt markets. Rather, they should be designed “with the objective that private lending is displaced to the smallest degree possible by agency programs”.
I don’t know whether OMB 129 would be applicable or (if so) could be overruled in this case in light of Covid-19 emergency objectives. But the general principle — don’t mess with working markets — seems valid. Especially in this case. The purpose of the original MLF lender-of-last-resort was to ensure a functioning market. Now that that job is done, presumably an amended MLF should be designed with an eye towards keeping it that way — or least not carelessly degrading its functionality.
And a simple amended MLF might do just that. It’s a scale issue — $500 billion is a big chunk of the relatively small and specialized muni market. Annual total muni issuance was only about $425 billion in 2019. Assuming amended MLF take-down over three years, about 40% of annual issuance may be displaced — yeah, that’ll leave a mark.
It would be temporary, and if it helps state & local governments recover from the unprecedented economic fall-out of Covid-19, arguably the market will make it up in the long run. Terminal fiscal stress isn’t exactly helpful to issuance or credit quality either.
But markets aren’t an adjustable machine that can be dialed up or down. They are fundamentally organic. Several years of major disruption in issuance volume will certainly damage the muni market — the investor base atrophies, intermediaries seek other jobs or are laid off, research and innovation is cut, etc. There’ll be cost and delay in restoring it — borne inevitably by the same state & local governments that an amended MLF is seeking to help.
And it’s not as if muni market stakeholders are going to passively accept such a possibility. Not a chance. Federal tax-exemption subsidies notwithstanding, it’s a private-sector financial market that should be expected to aggressively protect its own interests. The prospect of a gigantic amended MLF emerging to smash 40% of their market — a federal loan Godzilla — won’t be taken lightly, regardless of its intentions for the greater good. Since unleashing a loan Godzilla is fundamentally a political decision, the muni market will wage a political defense, with all that that entails in the real world. Aux armes indeed. And they’re good at it.
We Can Be Nice
There’s sometimes a lot of virtue in a large and simple response to an economic emergency regardless of near-term consequences. On some occasions, it’s necessary not to be ‘over-nice’, as the BoE official quoted in Lombard Street said with cool understatement. The $500 billion size of the original MLF was primarily needed to demonstrate a willingness to do (as said with much less cool by a modern central bank official) ‘whatever it takes’ to keep the market functioning. If Covid-19 had taken a Black Death turn and conditions had deteriorated to the extent that the original MLF was extensively utilized — by desperate state & locals willing to pay the penalty rate — we’d be in a meltdown situation where OMB rules and muni market volume were the least of our problems.
Fortunately, all that didn’t happen. But we’re not out of the Covid-19 woods yet by any means. The economic impact of extended shut-downs — on top of all the other economic, social and demographic challenges state & locals were facing anyway — will certainly persist for several years. Echoing the onset of the Covid-19 virus itself, the extent and severity is at this point unknown. Reasonable people can disagree. Some say that it will be mild and recovery has already started, others that it will be catastrophic and is imminent. That debate will — and should — continue.
Given the uncertainty, repurposing the MLF framework to get ready for worse is simply prudent. Hasn’t 2020 taught us that? But also given that the worse has not yet arrived, and macroeconomic effects (unlike market meltdowns) are slow in coming and persistent, the repurposing can be deliberate, precise and innovative. There’s no need to fight to unleash a federal loan Godzilla that might wreak unintended consequences and trigger more political fighting. Instead, as Bagehot’s contemporaries might have put it, on this occasion we can be ‘nice’.
Some MLF Repurposing Principles
A few principles can guide the repurposing:
1) Break it up: The $500 billion amount is an artefact of the original MLF’s bazooka-like purpose to send a strong signal to a freezing-up market. It’s not related to state & locals’ as-yet-unknown need for federal credit, and if that need arises, it’ll be multi-faceted, not monolithic. By all means, keep the full $500 billion framework and especially the $35 billion loss reserve in place (passed legislation is not easy to come by these days). But think of that framework as supporting a series of smaller, sub-facilities that are specialized to lend for specific needs of the state & locals (newly sub-investment grade governments, emergency liquidity, etc.) and for specific federal policy objectives (safety & health services, mitigating disproportionate impact on low-income communities, environmental — and infrastructure of course). Each sub-facility can have its own lending criteria and terms, and initially sized for expected need. And each will have its own well-informed and motivated advocates and stakeholders. $500 billion in the aggregate will cover a lot of ground.
2) Design around federal credit strengths: Believe it or not, the federal government as a lender is more efficient (in economic terms) in a few aspects than any lender in the private sector , due to economies of scale, long time horizon, ability to self-insure for liquidity, etc. Once the basic need and policy objectives of a sub-facility are defined, the design of precise loan terms should emphasize whatever federal strengths might be applicable. Apart from an efficient use of resources, this has the advantage of differentiating amended MLF and market loans and potentially minimizing market displacement — it’ll make OMB happy.
3) Co-lend with the muni market wherever possible: Don’t go it alone unless that’s absolutely, positively needed. The vast majority of state & local governments are credit-worthy on some level, even if they’re seriously stressed and lost their investment grade rating. There’s no need for a sub-facility to be a sole lender when the borrower is investment grade. It’s a really bad idea for the federal government to do that when they’re not. Share the good volume to minimize market disruption. Share the risky volume to get market discipline involved. Different sub-facilities can be designed with different co-lending requirements. Yes, co-lending with the muni market will reduce the potential gain in federal revenues if the sub-facility did it all. But maximizing federal revenues per se is not at all the point here, right? Keep the bigger picture and longer term in mind — we’ve got enough extremes going on already.
Municipal Infrastructure Refinancing Facility
To illustrate this practical path, I’ll briefly sketch out an example of a possible amended MLF sub-facility, based on my own specialty, federal infrastructure loan programs. The various parts are mostly on the successful precedent shelf, which is always the best way to start designing something new. That also means that I can do the sketch for now by referring to prior posts and articles.
The basic idea is a sub-facility, the Municipal Infrastructure Refinancing Facility, or MIRF, that lets state & local governments refinance their existing (leveraged or unleveraged) infrastructure assets with federal loans that amortize beyond the muni market norm of 30 years, a federal strength. I’m thinking $50 billion in size just to underscore the sub-facility point — in reality, may be larger or smaller.
The basic refinancing feature exists in the TIFIA loan program and I’ve suggested it be added to WIFIA specifically as a Covid-19 response. The MIRF would follow the same model, but more expansive about eligible assets, as long as they have useful lives in excess of the final maturity. Some strings should be attached to how any net proceeds are used — ideally, spent on other pandemic-stalled infrastructure projects capex or O&M and not simply to displace existing debt.
Sorry — this sub-facility is for solid investment grade state & locals only, since by definition the term is very long. This is not about monetizing public assets. They’re are good security to make sure that public borrowers pay by raising taxes or rates as necessary. But in a full meltdown, public assets rarely have independent value as a source of repayment — if the community’s own elected officials couldn’t squeeze enough money out of the locals to pay debt service, a new owner’s chances are dubious. Sub-investment grade state & locals need a different sub-facility.
The real benefit is in fine-tuning cash flow management — longer amortization means lower debt service so taxes and rates can be kept a little lower during Covid-19 recovery. But the benefit of doing that is easily obviated if the interest rate on the long maturities is high. Hence, a 40 or 50-year loan (expensive in the muni market) priced at a US Treasury rate preserves cash but keeps a commitment to repayment on track.
The MIRF sub-facility is clearly a case where co-lending with the muni market makes sense on many levels. A 50/50 mix would allow both types of lender to play to their respective strengths. Since the loans would be large scale, investment grade, and the muni tranche basically market standard, displacement would be minimized, especially if net proceeds are required to be recycled into infrastructure.
Finally, for the MIRF in particular, actively encouraging muni market stakeholders to be involved in the design stage would be both a practical and mutually beneficial move. Other sub-facilities might have much less room to avoid displacement (liquidity loans) or not relevant to cooperation (very difficult credits). From what I’ve seen of the WIFIA Program, there’s a lot of potential synergies between federal credit programs and the muni market — an amended MLF should encourage that (and not just tax revenue impact) wherever possible.