The scheduled expiration of the Fed’s Municipal Liquidity Facility (MLF) at the end of 2020 could … [+]
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As Senate Republicans continue blocking state and city budget aid in a new stimulus package, progressive advocates want the Federal Reserve to be a much more active municipal lender. But the immediate risk to the municipal finance market—and thus to state and city budgets— is the scheduled expiration of the Municipal Liquidity Facility (MLF) at the end of 2020, which could threaten a repeat of this spring’s market liquidity crisis. So the MLF needs to be extended now.
Remember the MLF was created in response to spring’s sudden liquidity crisis in municipal finance. Investors pulled back from the muni market, forcing a selloff to cover their withdrawals. The cascading selloff in turn quickly drove up interest rates for billions of dollars in muni bonds approaching 10% in some cases, threatening a seizing-up of the entire market.
To restore liquidity, the Fed created the MLF under emergency powers granted to it during the Great Depression, and later used to fight the financial crisis of 2008. When the Covid recession caused financial market turmoil in addition to the collapse of businesses and jobs, the Fed revived some of those 2008 facilities and added new ones, including the MLF.
For the Fed, the MLF was always intended to backstop private markets, signaling that investors shouldn’t panic and that governments wouldn’t face excessively high interest rates, allowing markets to stabilize. Their website says “the immediate purpose of the MLF is to enhance the liquidity of the primary short-term municipal securities market.”
Markets did stabilize, and the Fed felt the MLF had done its job. The bank has never wanted to be a major direct lender to the tens of thousands of entities in the muni market, fearing they would be seen as picking winners and losers, and coming under political pressure to make substandard loans.
But as the recession continued and states and cities began facing now-ongoing budget crises due to rising costs and rapidly declining revenues, some advocates began to criticize the MLF for not doing more. To date, only two loans have been made through the MLF, to the state of Illinois and to New York’s Metropolitan Transit Authority.
To critics, the lack of loans means the Fed has been too tough—charging high interest rates and not letting enough smaller entities borrow directly from the facility. The Fed points to low interest rates for muni borrowers and record issuance volume in the private market as evidence they don’t need to make direct loans for the market to work effectively. They also note they’ve reduced the penalty interest rates the law requires for emergency borrowers, and opened the facility to smaller governments.
Advocates for more aggressive lending are being driven by the lack of fiscal aid to states and cities, blocked by Senate Republicans. Progressive economist Bob Kuttner says that with a “corona relief package off the table” at least until after the election, “it’s a crime that the Federal Reserve is not liberalizing the terms of municipal lending.”
In effect, advocates want increased lending to states and cities to replace the necessary and missing fiscal assistance. They want the MLF to go beyond its current short-term bond purchases (less than three years), and also want lower non-penalty interest rates. The latest version of the House’s HEROES Act calls for MLF lending up to ten years at the bedrock federal funds rate. Some advocates even say the Fed’s muni lending should not be based on emergency authority, but done through normal open market operations.
The Fed remains opposed to this type of MLF expansion. In September, the Fed official in charge of the MLF, Kent Hiteshew, testified to a Congressionally-mandated oversight panel that the facility is successfully meeting several objectives: helping states and cities “manage the extraordinary cash flow pressures associated with the pandemic,” “backstop private market capacity” to keep liquidity in the market, and “encourage private investors to reengage in the municipal securities market.”
The Democratic members of the oversight panel and several witnesses called for changes to the MLF, including allowing longer-term loans, cutting interest rates, allowing more entities to borrow directly, and establishing a secondary market facility for muni debt. Hiteshew, while sympathetic to the extreme budget woes facing states and cities, kept to the Fed’s position that “all of us would agree that while State and local governments cannot cut their way out of this recession, neither can they borrow their way out of it.”
But the hearing revealed a looming danger to the MLF and the muni market. It is scheduled to expire at the end of December, and Republicans seem willing to let it shut down. Senator Pat Toomey (R-PA), one of the oversight commissioners, stated that “liquidity in the municipal bond market has been restored and as such the MLF in my view should wind down.”
This has rattled private market players. Like many other market participants, Citigroup
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has called for the MLF to be extended “at least for another 12 months” because of “the uncertain economic and political environment” and because “the gaping budget deficits facing municipal issuers have yet to be addressed.”
But, by law, the MLF can only be extended if both the Federal Reserve and the Secretary of the Treasury agree. While it appears the Fed may favor an extension, there are fears the Trump Administration may walk away from the issue (and many others) if they lose the election.
There already are fears that Senate Republicans will reject a major lame-duck session stimulus bill that includes state and city aid. And a toxic combination of no fiscal aid and no MLF reauthorization could spark another muni liquidity meltdown. But the Republican price of any lame-duck extension would likely be dropping any attempt to liberalize the MLF.
A new Treasury Secretary under President Biden could re-establish the facility with the very likely agreement of the Fed, but that could still mean severe short-term disruption in the muni market. And as spring’s meltdown and the financial crash of 2008 both showed, contagion can spread quickly in financial markets (not just in public health), causing major economic harm. It is irresponsible to risk a muni meltdown and possibly a broader financial crisis by letting the MLF’s authority lapse.
In any case, fiscal aid remains the much better option than increased total debt for states and cities. That’s where advocates need to focus their pressure, as frustrating and cynical as Senate Republican opposition to aid has been And a Democratic electoral sweep could provide states and cities with substantial fiscal aid to buffer their budget problems. Then there will be time to carefully consider any possible historic changes to the Fed’s municipal finance role. But the MLF needs to be reauthorized now.