The Fed’s Muni Bond Purchases Won’t Rescue State And Local Budgets

The Fed’s historic $500 billion intervention will help stabilize the muni market. But it won’t solve the plummeting state and local budgets caused by the pandemic recession.

Among the extraordinary policy steps taken in response to the pandemic is the Federal Reserve’s creation of a new $500 billion “Municipal Liquidity Facility” (MLF) to directly purchase state and local debt.  But this historic action, which has helped stabilize the municipal bond market, won’t solve looming state and local budget declines caused by the pandemic recession.  Congress needs to authorize direct massive direct aid to those governments; the Fed can’t solve that problem.

The Fed has long resisted this unprecedented step.  In mid-March, bondholders sold billions in municipal debt, driving up yields and forcing even more sales to pay for bond redemptions.  The municipal market began to seize up, in an uncomfortable echo of the impending financial market collapse at the start of 2008’s Great Recession.

To prevent this implosion, the Fed directly entered the short-term muni market for the first time, calming the market by providing liquidity.  The policy is now formalized through the MLF, expanded recently to cover smaller cities and county governments but (as of now) staying capped at $500 billion.

But liquidity isn’t the only problem facing the muni market, or state and local governments.  The deepening pandemic recession is hammering government budgets, as tax revenues from every source—sales and income taxes, severance payments from oil and other resources, gas taxes and highway tolls—are falling sharply.  

Some politicians blame economically troubled states for bad management.  Senator Majority Leader Mitch McConnell (R-KY) suggested states be allowed to go bankrupt (something currently not allowed under federal law and practice) in order to avoid “blue state bailouts.”

But revenue losses are bipartisan, hitting blue and red states alike.  Most states end their 2020 fiscal year on June 30, and are trying to forecast revenues for the 2021 fiscal year starting on July 1.  No state in the country—blue or red or purple— expects revenues to stabilize or grow.  Blue state New York projects a 14 % revenue drop in the next fiscal year, while red state Missouri estimates a 10% fall.  Even Senator McConnell’s home state of Kentucky estimates a minimum revenue drop of 11% for the first half of its new budget period.

These revenue losses will drag down the economy even more.  Before the pandemic, state and local workers made up 13 percent of the nation’s employed, and state and local revenues also support many profit making contractors and non-profit organizations, and their workforces.  Many of these workers—police, fire, health care, garbage collection, senior care—will lose their jobs if the revenue holes aren’t plugged.

But isn’t the Fed coming to the rescue?  Won’t the new $500 billion of debt purchases infuse a lot of cash into state budgets?  No—that’s not the intention of the Fed’s action.

The Fed will buy “short-term” debt (defined as maturities of three years or less) while capping the amount from each state.  Short-term debt, such as Tax or Revenue Anticipation Notes (TANs or RANs), traditionally are used to cover timing gaps between expenditures and delayed revenues.  They are not the main source of borrowing for states and localities, and make up a small share of the total muni market.  In 2019, only 10.1% of new issues were short-term. 

States and localities could issue a lot more short-term debt to generate revenue and hope the Fed would buy it.  But that will be limited by the MLF’s state caps.  The Fed limits MLF purchases of state and local debt to 20 percent of estimated own-source revenues.  Any state flooding the market with new issues would face higher interest rates and debt service. 

The Fed also requires that any debt it purchases be rated as investment grade (although the lowest level).   Those ratings are dominated by Fitch, Moody’s

MCO
and S&P Global, and states and localities cannot risk dropping below investment grade, as that would bar them from the MLF altogether.

So the Fed’s actions aren’t trying to solve state and local revenue shortfalls, except to keep those shortfalls from freezing the muni credit market.  In essence, the Fed is acting as if these governments face a short-term revenue problem, with the muni market needing liquidity while state and local revenues adjust, hopefully as the economy rebounds.

But that economic rebound doesn’t look likely. Instead, we are entering a deep recession which could drag state and local revenues down for years.  The Congressional Budget Office (CBO) estimates a drop of 5.6% in this year’s GDP, turning up by 2.8% in 2021.  But CBO also predicts an unemployment rate of 10.1% for next year, higher than the Great Recession’s peak monthly rate of 10 percent in October 2009.  With last week’s new unemployment claims coming in at over 3.1 million, we have lost at least 33.5 million jobs in five weeks, 10.5 million more jobs than all of the 23 million created in the decade since the end of the Great Recession.

So the Fed may hope the muni market only needs short-term assistance.  Their intervention may be deep, but the design seems to assume a quick return to economic normalcy, followed by increased state and local revenues.  (In this way, the MLF is similar to the small business lending program, or extended unemployment insurance, or the one-time checks to households, all of which seem to be implicitly based on a quick economic rebound.)

But the economic data are signaling a much deeper and longer recession.  The Fed’s actions are necessary to stabilize the muni bond market.  But they are not designed to solve the  cratering of state and local revenues, driven by the economic collapse.  Instead, Congress must help state and local governments by authorizing more spending.  The Fed can stabilize the muni market, but it can’t do Congress’ job.