On June 2nd, 2021, the Fed announced that it will be selling off its Corporate Bond and Corporate Bond ETF Portfolio. If you recollect, in March 2020 at the start of the mayhem during the virus pandemic, the Fed had initiated a slew of market stabilizing measures – one of which was the SMCCF – or the Secondary Market Corporate Credit Facility. The SMCCF was established with the objective to support employers by providing liquidity to the secondary market for corporate bonds. The SMCCF provided liquidity by purchasing either corporate bonds of investment grade companies or corporate bond US listed ETFs.
A bit more on the mechanics – The way the transaction structure works is that the Treasury sets up an SPV and injects it with equity. In this case, the Treasury agreed to make a US$75bn equity injection. The US$75 was intended to be towards both the SMCCF as well as a Primary Market Corporate Credit Facility intended to buy investment grade corporate bonds in the primary market, directly from companies issuing those bonds. The Fed, through the Federal Reserve Bank of New York (“FRBNY”), then lends to this SPV at a leverage ratio of 10:1. The SPV thus has effectively buying power of $750bn. The loan provided by FRBNY to the SPV is collateralized with both, the assets purchased by the SPV as well as the equity injected by the Treasury into the SPV.
I was asked 2 questions recently. First, whether the sale announcement and the sale would have any impact on the corporate bond or corporate bond ETF market? Second, whether this announcement would be viewed negatively by the markets, generally, for risk assets?
The SMCCF was initiated on 22 Mar 2020 and began buying assets on 12 May 2020. The Fed stopped buying assets under this facility on 31 Dec 2020. The SPV has approx. $14billion in assets acquired during the period of operation. So, in summary, starting June 7th the Fed will start offloading these US$14bn of corporate bonds and ETFs in the secondary market. Just by way of comparison, the total corporate bond market size in the US is more than US$10Tn (Source: SIFMA as of 1Q 2021). Basically, the Fed’s corporate bond portfolio is a drop in the ocean. For fun sake, here is a graphical representation, drawn to size !
Second, while there are legitimate views or concerns on whether the Fed unwinding a pandemic response facility sends a tightening signal to the market, I find it hard to digest that any market participant can reasonably call this move tightening at a time when the Fed is still buying US$80bn of US Treasuries each month and US$40bn of Mortgage Backed Securities each month. With almost 2 weeks having passed since the Fed’s selling announcement, during which the corporate bond market has shown minimal ripples, this view seems to be vindicated. The facility was set up at a time of extreme market stress and with that stress having disappeared more or less, it is only appropriate that the Fed packs back this tool kit to be reopened selectively and judiciously only in extreme events which truly require the use of these unconventional tools.
More interesting though, is that fact that the Fed and consequently the Treasury (i.e. the tax payer), will likely make a net gain on the SMCCF overall. Markets and asset prices have recovered since the lows of March 2020.
This brings me to the story of a few similar transactions that were conducted in 2008, during the height of the Global Financial Crisis. Invariably, the wider public seems to only remember the fact that tax payer money was put to use to bail out institutions like AIG and Bear Stearns (to facilitate JPM’s purchase of Bear Stearns). But how many of us really followed the sequence of events right till the very end when these Fed support facilities were fully unwound and money paid back to the tax payer’s account at the Treasury. Here is a quick summary of three such transactions that were conducted at the height of the GFC.
The First Maiden Lane
Bear Stearns was in deep trouble in March 2008. JP Morgan eventually purchased Bear Stearns, but only after the Fed had agreed to buy $30bn of “toxic assets“ off the Bear Stearns portfolio. Maiden Lane LLC was created in March 2008 and was funded with a US$29bn loan from the FRBNY and a $1.15bn subordinated loan from JPM. Collectively, with US$30bn of funds, Maiden Lane LLC purchased a portfolio of Agency Mortgage Backed Securities, Commercial Real Estate Whole Loans, Non-Agency Mortgage Backed Securities and other such related assets including derivatives from Bear Stearns. JPM, then bought the rest of Bear Stearns at $10 a share. Maiden Lane LLC, progressively over the next few years sold these assets in the secondary markets. The Fed loan of US$29bn was repaid in June 2012. The last of the securities under Maiden Lane LLC were sold as recently as 2018. Cumulatively, the Fed realized a profit for the US tax payer of US$2.5bn including the interest FRBNY received on the loan to Maiden Lane LLC.
The Second Maiden Lane
Post Lehman’s collapse in Sep 2008, all hell broke loose. The next likely casualty on the block was AIG. Maiden Lane II LLC was the next SPV to be set up to facilitate the government’s financial support to AIG. Once again, the Fed through FRBNY, lent US$19.5bn to the SPV. Armed with a total of US$20.5Bn of funds, which included a deferred note from AIG, Maiden Lane II LLC purchased US$20.5bn of Residential Mortgage Backed Securities from several regulated insurance subsidiaries of AIG. The transaction was valued on 31st Oct 2008 and effectively Maiden Lane II LLC held a portfolio of RMBS securities that had a fair value of US$20.5bn and a par value of approx.. US$39bn. The SPV then sold these securities in the secondary markets through competitive sales processes. The last of these securities were sold in Feb 2012 and the American tax payer derived a net gain of US$2.8bn including the interest received by the FRBNY on the loan to the SPV.
The Third Maiden Lane
I had just begun my career on Wall Street, right when the 2008 financial crisis struck. It was both, enthralling and intimidating, in equal parts. There were just so many lessons to learn. One of the most fascinating stories was, of course, AIG. On one hand, the insurance subsidiaries of AIG were buying these Residential Mortgage Backed Securities which were offering tantalising yields. On the other hand, another arm of the AIG umbrella – AIG Financial Products – was merrily writing Credit Default Swaps for counterparties. For the uninitiated, in simple terms, Credit Default Swaps (“CDS”) are contracts through which AIGFP sells protection to counterparties in the event the housing market and the corresponding Mortgage Backed Securities and Collateralized Debt Obligations (“CDO”) took the trip down south. Basically, the two units of AIG were taking the same directional bet. So much for risk control! So, in November of 2008, the Fed created Maiden Lane III LLC to alleviate capital and liquidity pressures on AIG. Maiden Lane III LLC borrowed US$24.3bn from the FRBNY and, together with US$5Bn of equity interest from AIG, purchased a portfolio of CDOs from AIGFP’s counterparties. In return, the counterparties agreed to terminate the CDSs that AIGFP had written on this portfolio of CDOs. Subsequently, Maiden Lane III LLC started gradually disposing off the securities in this portfolio through competitive sales processes in the secondary markets. The last of the securities under this portfolio was sold around August of 2012 and the conclusion of this transaction resulted in a net gain to the US tax payer of approx. US$6.6bn, including interest paid on the FRBNY loan.
In aggregate, the 3 Maiden Lane transactions resulted in a net gain of more than US$12bn to the US tax payer. Of course, this is all hindsight. Needless to say, in times of severe crises, the Fed and the Treasury have a larger role to play in terms of maintaining financial stability and preventing an all-out catastrophe scenario where millions of livelihoods could be at stake. At the end though, a pretty decent outcome with a net gain of US$12bn by buying assets at a time when volatility and fear is at its peak and selling them when the storm has passed and the dust has settled. Did we hear anyone say “Buy when the World is Selling”? But then again, reminding you just for good measure, don’t confuse yourself with the Fed. You have no Section 13(3)…
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