Federal Reserve

Error message

Deprecated function: The each() function is deprecated. This message will be suppressed on further calls in _menu_load_objects() (line 579 of /var/www/drupal-7.x/includes/menu.inc).

Why International Financial Regulation Still Falls Short

Financial regulators still don't like to tame bubbles even after seeing how costly it is when they go boom. Shame, that.

Immaculate Deception, Fed Style

The Fed knows it it is up to no good as far as ordinary citizens are concerned, witness its propaganda efforts.

MBS Market Dysfunctions in the Time of COVID-19

Published by Anonymous (not verified) on Fri, 17/07/2020 - 9:00pm in

Jiakai Chen, Haoyang Liu, David Rubio, Asani Sarkar, and Zhaogang Song

MBS Market Dysfunctions in the Time of COVID-19

The COVID-19 pandemic elevated financial market illiquidity and volatility, especially in March 2020. The mortgage-backed securities (MBS) market, which plays a critical role in the housing market by funding the vast majority of U.S. residential mortgages, also suffered a period of dysfunction. In this post, we study a particular aspect of MBS market disruptions by showing how a long-standing relationship between cash and forward markets broke down, in spite of MBS dealers increasing the provision of liquidity. (See our related staff report for greater detail.) We also highlight an innovative response by the Federal Reserve that seemed to have helped to normalize market functioning.

The Parallel Trading of Agency MBS

Most agency MBS are issued as securities in which interest (subtracting the credit guarantee and mortgage service fees) and principal payments on the underlying mortgages pass through pro rata to MBS investors. All agency MBS are effectively default-free with credit guarantees provided by Fannie Mae (FNMA), Freddie Mac, or Ginnie Mae. They are, however, subject to uncertainty as to the timing of cash flows, known as prepayment risk. There is substantial heterogeneity in prepayment risk across individual MBS because of the vastly different characteristics of the mortgage loans and borrowers behind the MBS.

Related to this heterogeneity in the risks of different mortgage pools, the agency MBS market has a unique organization that utilizes two parallel trading mechanisms. One is the specified pool (SP) market in which individual MBS are traded using specific contracts while the other is the to-be-announced (TBA) market in which similar MBS are traded together using standardized contracts. A seller with TBA-eligible MBS can freely choose to sell through either the SP or the TBA market.

The parallel market structure gives rise to three major differences in the characteristics of the SP and TBA contracts. First, a single price is set for a TBA contract that accepts any MBS satisfying certain eligibility requirements—for example, the delivered MBS is guaranteed by Fannie Mae or Freddie Mac, contains thirty-year fixed-rate mortgages, and pays a coupon of 4 percent. In consequence, sellers have incentives to deliver the cheapest eligible MBS, and buyers pay a cheapest-to-deliver (CTD) price. This CTD discount is absent for SP contracts since they are priced individually. Second, SP trading incurs higher transaction costs than TBA trading, with the difference being about 30-60 basis points on average. Third, TBA trading occurs through a forward contract that settles once every month, while the SP trading is through a spot contract that often settles close to TBA settlement days. Hence, a seller can collect cash sooner through SP trading.

SP Payup before and during the COVID-19 Market Disruptions

In this Liberty Street Economics post, we use “payup” to denote the weighted-average SP minus the weighted-average TBA price on a particular day. The prices of SP contracts are typically higher than those of TBA contracts. In particular, higher-quality MBS (that is, those with lower prepayment risk) tend to be sold in SP markets where the CTD discount is absent, whereas lower-quality MBS are generally sold in TBA markets to take advantage of lower trading costs. The chart below shows that, before the COVID-19 crisis, the price of the FNMA thirty-year MBS contract with a 3.5 percent coupon, one of the most liquid agency-coupon combinations, was typically higher in the SP market than in the TBA market.

We note that market practitioners may use the term “payup” differently. For example, practitioners may use an adjusted measure of the SP‑to‑TBA price difference to account for a variety of factors such as the different settlement dates of the SP and TBA contracts or the loan balances of the underlying mortgages.

Amid the market turmoil in March, the SP payup diminished substantially. Specifically, as shown in the chart above, since March 9 when stock market trading was halted due to extreme volatility, the payup, as defined above, totally disappeared and, strikingly, even turned into a discount, according to our methodology. The payup reappeared only after the Fed’s aggressive actions on March 23 “to increase the System Open Market Account holdings of Treasury securities and agency … MBS in the amounts needed to support the smooth functioning of markets for Treasury securities and agency MBS.” Yet, even today, the payup continues to be lower than before the COVID-19 pandemic.

In addition to the diminished payup, the number of trades in the SP market with prices below TBA prices increased markedly in March 2020. Since mid-March, around 75 percent of SP trades have been below the daily average TBA prices for the FNMA thirty-year 3.5 percent coupon cohort (see chart below). In contrast, the share of SP trades below the average TBA price was typically less than 40 percent in January 2020, according to our methodology. Thus, normal price relations in the MBS market were distorted during the pandemic crisis.

MBS Market Dysfunctions in the Time of COVID-19

Diminished SP Payup, Cash-Forward Arbitrage, and Dealers’ Liquidity Provision

The liquidity shock in the MBS markets caused customers to quickly liquidate their holdings for cash rather than wait for up to thirty days in the TBA market. For example, a TBA trade on March 16 would be settled on April 15. Thus, sellers could not liquidate (that is, receive cash from the sale) before April 15, creating a disincentive to sell in the TBA market. Instead, sellers turned to the SP market to raise cash, pushing down SP prices relative to TBA prices.

The diminished SP payup—especially when it turned into an SP discount— indicates market price dislocations. In our paper, we show that this reversal from an SP payup to an SP discount is robust to accounting for changing characteristics of bonds traded in the SP market. This implies that, relative to the pre-COVID period, MBS with similar fundamental values were traded at a lower price in the SP market than the TBA market. Dealers could potentially buy the MBS in the SP market and simultaneously sell a TBA contract. Provided the cost of funding this strategy was below its returns, dealers could reap a positive expected profit at the TBA settlement. This strategy is known as cash-forward arbitrage in practice, similar to the cash-futures arbitrage in the Treasury market.

As important intermediaries in the MBS market, broker-dealers are the natural liquidity providers and arbitrageurs. Indeed, as the next chart shows, dealers were on net buying from customers in the SP market and selling to customers in the TBA market and, in so doing, provide liquidity to the market. This participation stands in contrast to the 2013 fixed‑income sell-off , when dealers reduced their net positions in agency MBS. However, the continuing reduction in the payup implies that dealers’ cost of deploying capital was too high to restore the payup to its pre-pandemic levels immediately.

MBS Market Dysfunctions in the Time of COVID-19

The Fed's Innovative Response to MBS Market Disruptions

To ensure a properly functioning secondary MBS market, the Federal Open Market Committee announced an increase in agency MBS holdings by at least $200 billion on March 15 and further purchases of agency MBS on March 23. The next chart shows how the Fed boosted purchases of uniform MBS since March 16. A unique feature of the Fed’s recent MBS purchases is that, from March 19 to March 27, most of the transactions followed an unconventional TBA settlement date that allowed primary dealers to receive the sales proceedings within two to three trading days, much sooner than the nearest SIFMA settlement date of April 15. These unconventional TBA trades reduced the short-term selling pressure on the TBA market, so that after April 1, the pre-pandemic SP payup started to emerge again. This resumption of more normal MBS market pricing suggests that the Fed’s unconventional TBA trades provided the “fast‑moving capital” that the market needed.

MBS Market Dysfunctions in the Time of COVID-19

Summing Up

We describe a breakdown in normal relations between spot and forward MBS markets during the pandemic. The market failure occurred in spite of continued liquidity provision by primary dealers, which speaks to the magnitude of forced selling that occurred during this stressful period in the markets. The return of the typical payup between cash and forward MBS markets after the Fed started purchasing agency MBS suggests that the Fed’s actions, and its use of an unconventional TBA settlement procedure in particular, were effective at restoring market conditions to a more normal state.

Jiakai Chen is an assistant professor at the Shidler College of Business, University of Hawaii.

Haoyang Liu

Haoyang Liu is an economist in the Federal Reserve Bank of New York’s Research and Statistics Group.

David Rubio

David Rubio is a senior research analyst in the Bank’s Research and Statistics Group.

Asani Sarkar

Asani Sarkar is an assistant vice president in the Bank’s Research and Statistics Group.

Zhaogang Song is an associate professor at the Johns Hopkins Carey Business School.

Related Reading:

Chen, J., H. Liu, A. Sarkar, and Z. Song. 2020. “Cash-Forward Arbitrage and Dealer Capital in MBS Markets: COVID-19 and Beyond,” Federal Reserve Bank of New York Staff Reports, no. 933 July.

How to cite this post:

Jiakai Chen, Haoyang Liu, David Rubio, Asani Sarkar, and Zhaogang Song, “MBS Market Dysfunctions in the Time of COVID-19,” Federal Reserve Bank of New York Liberty Street Economics, July 17, 2020, https://libertystreeteconomics.newyorkfed.org/2020/07/mbs-market-dysfunc....




Disclaimer

The views expressed in this post are those of the authors and do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System. Any errors or omissions are the responsibility of the authors.

Federal Reserve Agency CMBS Purchases

Published by Anonymous (not verified) on Thu, 16/07/2020 - 11:38pm in

Woojung Park, Julia Gouny, and Haoyang Liu

Federal Reserve Agency CMBS Purchases

On March 23, the Open Market Trading Desk (the Desk) at the Federal Reserve Bank of New York initiated plans to purchase agency commercial mortgage-backed securities (agency CMBS) at the direction of the FOMC in order to support smooth market functioning of the markets for these securities. This post describes the deterioration in market conditions that led to agency CMBS purchases, how the Desk conducts these operations, and how market functioning has improved since the start of the purchase operations.

The Agency CMBS Market

Agency CMBS are primarily securitizations of multifamily residential properties, typically apartment buildings or complexes with five or more rental units. The multifamily real estate market accounts for a significant portion of households in the United States, providing housing to about one-half of the nation’s 44 million rental households. As opposed to single-family houses that are often occupied by homeowners, multifamily properties are typically owned by individuals or companies as investments. Multifamily property owners often borrow to purchase the properties or refinance existing mortgages, and rely on tenant rent payments and associated fees to service the mortgage payments.

Similar to the much-larger agency MBS market that supports financing to homeowners in the single-family housing market, the agency CMBS market facilitates multifamily mortgage lending by allowing lenders to sell mortgage loans to the agencies (Fannie Mae, Freddie Mac, and Ginnie Mae). At a high level, these agencies package the mortgages into securities and guarantee principal and interest payments of those securities. Broker dealers facilitate selling the securities to investors, such as banks and asset managers.

Agency CMBS outstanding total around $750 billion, and account for 47 percent of the $1.6 trillion in total multifamily mortgage debt outstanding. (The remainder is financed through the non-agency CMBS market and non-securitized loans from financial institutions.) The agency CMBS market has grown rapidly in the last decade, from about $130 billion in 2010, along with the growth of the agency multifamily lending programs. Major agency multifamily CMBS securitization programs include Fannie Mae’s Delegated Underwriting and Servicing (DUS), Freddie Mac’s K-Series, and Ginnie Mae’s Project Loans.

Deterioration of Market Functioning

In March, conditions in the agency CMBS market became severely disrupted amidst extraordinary financial market stress related to the outbreak of COVID-19. Uncertainty about the potential economic impact of the pandemic led to rapid selling of risk assets and a deterioration in market liquidity. The yield spreads of agency CMBS to the swap curve widened significantly as shown in the chart below, with average agency CMBS spreads widening from about 55 basis points in mid-February to about 120 basis points on March 20. Rapid spread widening in agency CMBS resulted in the need for leveraged investors to liquidate positions, worsening liquidity conditions. In this environment, broker dealers, the main intermediaries of agency CMBS, sought to reduce their risk and worsened the terms at which they would provide liquidity. New issuance of agency CMBS stalled, threatening to reduce credit availability in the multifamily housing sector.

Federal Reserve Agency CMBS Purchases

Fed Purchases

The Desk purchases, which began on March 27, are authorized under the terms of Section 14 of the Federal Reserve Act, which allows for purchases of securities that are fully guaranteed by agencies of the United States. Operations have targeted three main sectors of the market, Fannie Mae DUS, Freddie Mac 10-year K Series, and Ginnie Mae Project Loans, with a focus on key benchmark security types within those sectors. This approach was designed to improve liquidity in critical market segments, and that these improvements could then spill over more broadly in the agency CMBS market. Operations are scheduled regularly and solicit competitive offers from a range of primary dealer counterparties. Offers are assessed relative to a measure of estimated fair value. Program Terms and Conditions and FAQs are available on the public website.

Federal Reserve Agency CMBS Purchases

The chart above shows that as of July 14, the Desk has purchased $9.3 billion of agency CMBS across 24 operations, and that purchases have slowed in recent weeks. Desk purchases to date are a small percentage, about 1 percent, of the overall agency CMBS market. The Federal Reserve’s current agency CMBS holdings, are concentrated in the areas where the market experienced relatively more stress. The current holdings are roughly 70 percent in Fannie Mae DUS securities, followed by 20 percent in Ginnie Mae Project Loans and the remaining 10 percent in Freddie Mac K-Series securities. By contrast, the composition of the overall agency CMBS market is estimated to be about 45 percent in Fannie Mae, 40 percent in Freddie Mac, and 15 percent in Ginnie Mae securities.

Assessing Agency CMBS Market Functioning

Market functioning drives the pace of agency CMBS purchases. A range of metrics used to assess market functioning indicate that overall agency CMBS conditions have improved significantly since March. During the height of market stress, the Desk purchases of agency CMBS were relatively large, but as market functioning recovered Desk purchases declined.

First, spreads of agency CMBS have tightened substantially since the start of the Desk operations, as shown in the first chart. Average spreads of agency CMBS tightened from about 120 basis points in mid-March to about 60 basis points in mid-July. In addition, spreads on recently-issued deals suggest robust demand for these securities.

Second, the next chart shows that market liquidity as measured by bid-ask spreads has improved substantially. A sample of bid-ask spreads collected from selected dealers indicate that they have returned to the February levels for both Fannie Mae and Freddie Mac securities.

Federal Reserve Agency CMBS Purchases

Third, new issuance of agency CMBS resumed in April, allowing for the resumption of credit flow to the multifamily housing sector, although year-to-date issuance volumes for Fannie Mae and Freddie Mac are still lower than over the same period in 2019.

Finally, results from Desk operations indicate that the selling pressures in CMBS have subsided substantially. Over the course of the purchase operations, the total amount of offers submitted and the share of competitively priced offers have declined, leading to lower total purchase amounts, as shown in the last chart below. In the first of several operations, the total amount of offers submitted far exceeded the maximum purchase amount, particularly for the Fannie Mae and Ginnie Mae operations. In addition, the offers were competitive relative to fair market value, suggesting significant interest to sell securities. Recent purchase amounts have been declining as the competitiveness of the submitted offers has declined. Despite the small size of current purchases, market participants have suggested that the presence of these operations have provided assurance against the potential for future shocks.

Federal Reserve Agency CMBS Purchases

Conclusion

The agency CMBS market was significantly disrupted in March. Both market-based measures and Desk operations indicate notably improved market functioning since then. The frequency and the size of the Desk operations have declined over recent months as a result, although the presence of these operations continues to sustain market functioning in the market for CMBS.

Woojung Park
Woojung Park is a senior associate in the Federal Reserve Bank of New York’s Markets Group.

Julia Gouny
Julia Gouny is an officer in the Bank’s Markets Group.

Haoyang Liu
Haoyang Liu is an economist in the Bank’s Research and Statistics Group.

How to cite this post:

Woojung Park, Julia Gouny, and Haoyang Liu, “Federal Reserve Agency CMBS Purchases,” Federal Reserve Bank of New York Liberty Street Economics, July 16, 2020, https://libertystreeteconomics.newyorkfed.org/2020/07/federal-reserve-ag....




Disclaimer

The views expressed in this post are those of the authors and do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System. Any errors or omissions are the responsibility of the authors.

A New Reserves Regime? COVID-19 and the Federal Reserve Balance Sheet

Published by Anonymous (not verified) on Tue, 07/07/2020 - 9:00pm in

Gara Afonso, Marco Cipriani, Gabriele La Spada, and Will Riordan

Aggregate reserves declined from nearly $3 trillion in August 2014 to $1.4 trillion in mid-September 2019, as the Federal Reserve normalized its balance sheet. This decline came to a halt in September 2019 when the Federal Reserve responded to turmoil in short-term money markets, with reserves fluctuating around $1.6 trillion in the early months of 2020. Then, in response to the COVID-19 pandemic, the Federal Reserve dramatically expanded its balance sheet, both directly, through outright purchases and repurchase agreements, and indirectly, as a consequence of the facilities to support market functioning and the flow of credit to the real economy. In this post, we characterize the increase in reserves between March and June 2020, describing changes to the distribution and concentration of reserves.

The Expansion of the Federal Reserve Balance Sheet

The Federal Reserve balance sheet has increased dramatically since the onset of the COVID-19 pandemic, as shown in the chart below. In response to the pandemic, the Federal Reserve expanded its holdings of Treasury securities and agency mortgage-backed securities (MBS) to support the smooth functioning of these markets, established several new lending facilities to support the flow of credit to the real economy, and expanded swap lines with other central banks to ease strains in global U.S. dollar funding markets. Assets held by the Federal Reserve increased from $4.3 trillion in March to $7.2 trillion in June. More than 70 percent of this increase comes from an expansion of the Federal Reserve’s portfolio of Treasury securities (56 percent) and agency securities (16 percent), and around 20 percent comes from the facilities put in place. The central bank swap lines account for the vast majority of the balance sheet increase arising from the facilities. As the Federal Reserve expanded its asset holdings, reserves increased.

1Artboard 1@2x

Who Holds Reserves?

As the chart below shows, since mid-March, reserves increased by $1.5 trillion, reaching $3.2 trillion on June 10, almost half a trillion above the prior peak in August 2014. This increase was much more abrupt than the one observed in 2008, when the Federal Reserve expanded its balance sheet in response to the 2008-09 financial crisis; at that time, it took thirty-two months for reserves to increase by an amount similar to that of the last three months.

2Artboard 2@2x

During the 2008-09 financial crisis, the increase in reserves was largely absorbed by U.S. global systemically important banks (GSIBs) and branches of foreign banking organizations (FBOs), while non-GSIB domestic institutions, especially the smaller ones, increased their holdings at a much slower pace. As a result, the share of reserves held by non-GSIB domestic institutions dropped significantly; for example, domestic institutions with less than $50 billion in assets went from being the largest holders of reserves in 2007 (35 percent) to being the smallest holders in 2008 (10 percent).

In the first two years after the crisis, the share of reserves held by GSIBs dropped, as these institutions held a relatively constant level of reserves while aggregate reserves were increasing. The share of reserves held by GSIBs then slowly rebounded over 2012-18. In contrast, branches of FBOs almost tripled their reserve balances during 2009-12 and, as the chart below shows, their share of reserves continued to increase in the aftermath of the 2008-09 financial crisis, reaching 50 percent in 2011. As the Federal Reserve began normalizing its balance sheet in 2014, GSIBs and especially branches of FBOs absorbed the bulk of the decline in reserves. In contrast, non-GSIB large domestic institutions increased their reserve balances while aggregate reserves were decreasing, thereby almost doubling their share of reserves.

3Artboard 1@2x

The Federal Reserve increased its balance sheet again in response to the COVID-19 pandemic. As they had in 2008-09, GSIBs and branches of FBOs absorbed the majority of the increase in reserves during the initial stages of the balance sheet expansion. In contrast to the earlier episode, however, GSIBs continued to expand their reserve holdings until June, while branches of FBOs began reducing their balances in May (which led to a decline in the share of reserves held by branches of FBOs, as shown in the right panel of the chart). Moreover, unlike during the 2008-09 financial crisis, non-GSIB large domestic institutions also significantly expanded their reserve holdings, increasing their share of reserves from 13 percent to 20 percent over the last four months.

How Concentrated Are Reserves?

More than 5,000 institutions have accounts at the Federal Reserve. An intuitive way to look at the concentration of reserves is by calculating the share of reserves held by the largest reserve holders. Concentration increases as the share held by the largest entities rises.

The chart below shows the share of reserves held by the top reserve holders. In 2007, the five largest reserve holders in the United States held around 20 percent of reserves. This share increased substantially in the second half of 2008, when the Federal Reserve started expanding its balance sheet in response to the 2008-09 financial crisis, and fell back to just over 20 percent in 2012, as the proportion of reserves held by GSIBs declined and the share held by branches of FBOs increased. Then, as reserves shifted from branches of FBOs to GSIBs, concentration again rose between 2013 and 2018. We have observed a similar pattern since the COVID-19 outbreak, with the share of reserves held by the five largest reserve holders increasing by almost 10 percentage points since mid-March and now exceeding 35 percent.

4Artboard 1@2x

Conclusions

In response to the COVID-19 pandemic, the Federal Reserve has aggressively used its tools to keep markets functioning and credit flowing to the real economy. These actions have been supported by an expansion of the Federal Reserve’s balance sheet, leading to an increase in reserve balances. The increase has been absorbed mainly by GSIBs and to a lesser extent by non-GSIB large domestic institutions and branches of FBOs. As GSIBs have absorbed a larger share of the increase in reserves, the concentration of reserves has also increased.

Afonso_garaGara Afonso is an assistant vice president in the Federal Reserve Bank of New York’s Research and Statistics Group.

Cipriani_marcoMarco Cipriani is an assistant vice president in the Research and Statistics Group.

Laspada_gabrieleGabriele La Spada is a senior economist in the Research and Statistics Group.

Will-RiordanWill Riordan is an assistant vice president in the Federal Reserve Bank of New York’s Markets Group.

How to cite this post:

Gara Afonso, Marco Cipriani, Gabriele La Spada, and Will Riordan, “A New Reserves Regime? COVID-19 and the Federal Reserve Balance Sheet,” Federal Reserve Bank of New York Liberty Street Economics, July 7, 2020, https://libertystreeteconomics.newyorkfed.org/2020/07/a-new-reserves-reg....




Disclaimer

The views expressed in this post are those of the authors and do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System. Any errors or omissions are the responsibility of the authors.

Three Strikes against the Fed

Published by Anonymous (not verified) on Sun, 05/07/2020 - 8:45pm in

Until the results of new stress tests are known, the uncertainty principle calls for extreme caution in the regulator’s approach to the capital adequacy of systemically important banks (and indeed of banks in general).

The Federal Government Always Money-Finances Its Spending: A Restatement

Published by Anonymous (not verified) on Wed, 01/07/2020 - 5:30pm in

An explanation of the mechanics of Federal spending, with emphasis on the role of the Fed and Treasury.

Leverage Ratio Arbitrage All Over Again

Published by Anonymous (not verified) on Tue, 30/06/2020 - 9:00pm in

Donald P. Morgan, Dong Beom Choi, and Michael R. Holcomb

Leverage limits as a form of capital regulation have a well-known, potential bug: If banks can’t lever returns as desired, they can boost returns on equity by shifting toward riskier, higher yielding assets. That reach for yield is the leverage rule “arbitrage.” But would banks do that? In a previous post, we discussed evidence from our working paper that banks did do just that in response to the new leverage rule that took effect in 2018. This post discusses new findings in our revised paper on when and how banks arbitraged.

When They Arbitraged

The new leverage rule, like other post-crisis reforms, had a long gestation period:

Leverage Ratio Arbitrage All Over Again

U.S. regulators first proposed the supplementary leverage ratio (SLR) rule in January 2012. The motivation for the rule was to have a simple, unweighted capital requirement as backup in case the risk-weighted requirement did not capture true asset risk at the very large banks using internal, model-based risk estimates. Several years of refinement followed, particularly concerning which assets would count in the denominator of the SLR (“total leverage exposure”). Banks argued for excluding certain “safe” assets, which would tend to make the leverage ratio less binding. The denominator was finalized in September 2014 and the leverage rule wound up as the more binding requirement for most covered banks. Banks were required to disclose their SLR to investors in 2015, but had until January 2018, six years to the month after the rule was first proposed, to comply—in other words, to bring their leverage capital ratios to the required minimum.

If banks intended to arbitrage the new rule by shifting toward riskier assets, when along that time line would one expect them to do so? Our original paper focused on the third quarter of 2014, when the SLR denominator was finalized, on the grounds that only then did banks know how binding the rule would be. While we found evidence of risk shifting starting then, our data ended before the compliance date in 2018. Did we miss part of the story?

Evidently not. We extend the sample in our revised paper but find no additional risk shifting after the compliance date. To illustrate, the chart below plots the mean ratio of risk-weighted securities to total securities at the fifteen banks covered by the SLR and a control group comprising the eighteen next largest banks (with assets between $50 and $250 billion). The control banks are similarly regulated, save for the new leverage rule. The SLR banks increased their risk-weighted securities ratio—indicating riskier holdings—just as the SLR denominator was finalized in 2014 (the light gray vertical line), but there was no additional risk shifting when it took effect in 2018 (the dark gray vertical line). While it might be surprising that banks did not postpone any shift until absolutely necessary, we show that among SLR banks, those most constrained by the rule began increasing their leverage ratios around the disclosure date in 2015. The timing of this “forced” deleveraging, rather than the official compliance date, may have determined when to reach for yield. More generally, this finding illustrates the perils of identifying regulatory effects when the regulations under study have such long gestation periods and ambiguous “treatment” dates; had we naively compared before and after the compliance date, we might have rejected the arbitrage hypothesis.

Risk Shifting Evident After SLR Denominator Is Finalized but Not at Compliance Date

How They Arbitraged

While we find evidence of reach for yield via securities, we find no evidence of a shift toward riskier loans (see chart below). The ratio of risk‑weighted loans to total loans was essentially flat and parallel for SLR banks and control banks. That’s potentially surprising since loans are banks’ signature assets. While it might be that the risk shifting is simply not detectable in risk-weighted loans, we look at alternative credit risk measures (provisions and nonperforming loans) in our revised paper and find no evidence of a differential change in either. While evidence may yet be found, we conclude that effecting a discrete increase in risk might be cheaper and more predictable via the securities books than by forging new loan relationships.

Leverage Ratio Arbitrage All Over Again

Takeaways

The main takeaway in our revised paper is unchanged: Banks can be expected to arbitrage simple leverage rules by shifting toward riskier, higher yielding assets. Our revised paper shows that arbitrage was effected well before the compliance date for the new leverage rule, and not in the loan book, where one might most have expected it.

Related Reading

Choi, D. B., Holcomb, M. R., and Morgan, D. P. “Bank Leverage Limits and Regulatory Arbitrage: Old Question, New Evidence.” Federal Reserve Bank of New York Staff Reports, no. 856, revised December 2019.

Choi, D. B., Holcomb, M. R., and Morgan, D. P. “Leverage Rule Arbitrage.” Federal Reserve Bank of New York Liberty Street Economics, October 12, 2018.

<br />
Donald P. Morgan

Donald P. Morgan is an assistant vice president in the Federal Reserve Bank of New York’s Research and Statistics Group.

Dong Beom Choi is an assistant professor of finance at Seoul National University. He previously was an economist in the Bank’s Research and Statistics Group.

Michael R. Holcomb is a Ph.D. student at Harvard’s Kennedy School of Government. He previously was a senior research analyst in the Bank’s Research and Statistics Group.

How to cite this post:

Donald P. Morgan, Dong Beom Choi, and Michael R. Holcomb, “Leverage Ratio Arbitrage All Over Again,” Federal Reserve Bank of New York Liberty Street Economics, June 30, 2020, https://libertystreeteconomics.newyorkfed.org/2020/06/leverage-ratio-arb....




Disclaimer

The views expressed in this post are those of the authors and do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System. Any errors or omissions are the responsibility of the authors.

Municipal Debt Markets and the COVID-19 Pandemic

Published by Anonymous (not verified) on Tue, 30/06/2020 - 12:02am in

Marco Cipriani, Andrew Haughwout, Ben Hyman, Anna Kovner, Gabriele La Spada, Matthew Lieber, and Shawn Nee

In March, with the outbreak of the COVID-19 pandemic in the United States, the market for municipal securities was severely stressed: mutual fund redemptions sparked unprecedented selling of municipal securities, yields increased sharply, and issuance dried up. In this post, we describe the evolution of municipal bond market conditions since the onset of the COVID-19 crisis. We show that conditions in municipal markets have improved significantly, in part a result of the announcement and implementation of several Federal Reserve facilities. Yields have decreased substantially, mutual funds have received significant inflows, and issuance has rebounded. These improvements in municipal market conditions help ensure that state and local governments have better access to funding for critical capital investments.

Many Federal Reserve Facilities Include Municipal Securities

On March 23, partly as a response to the strains in the municipal markets, the Federal Reserve extended asset eligibility for the Money Market Mutual Fund Liquidity Facility (MMLF) and for the Commercial Paper Funding Facility (CPFF) to include certain short-term municipal securities. Then, on April 9, the Federal Reserve announced the establishment of the Municipal Liquidity Facility (MLF), which purchases short-term notes directly from municipal authorities. The MLF was designed not only to address the liquidity needs of municipal authorities but also with the explicit goal of supporting market functioning. In early June, Illinois became the first MLF borrower when it sold $1.2 billion of short term notes to the facility at a rate more than 1 percentage point below the rate at which it was previously able to access private markets in May. In addition, the Coronavirus Relief Fund, established through the CARES Act, provided $150 billion in federal fiscal support for state and local governments.

Secondary Market Conditions Have Stabilized

The chart below shows the yields on 30-year municipal bonds by credit rating. While Federal Reserve facilities focus on shorter-duration municipal securities, the 30-year yield is a common benchmark. Across all credit ratings, yields spiked up in mid-March: between March 2 and March 23, the yield on AAA securities jumped 1.8 percentage points.

Municipal Debt Markets and the COVID-19 Pandemic

For AAA and AA securities, yields have returned to their pre-pandemic levels and are now near all-time lows. Yields on lower-rated securities (BBB and to a lesser extent A) are still somewhat higher than pre-pandemic levels, though they have been steadily declining. As a result, the spread between lower-rated (A and BBB) and higher-rated (AAA and AA) municipal securities is still higher than it was in the first two months of the year, suggesting that investors have become more discriminating.

The path of yields shows the combined effects of two policy actions: changes in the level of interest rates and the impact of Federal Reserve facilities and other government interventions. To control for changes in the level of interest rates, we show the ratios of the yields on 10- and 30-year AAA muni bonds over the yields on Treasury bonds with the same tenor (see chart below). Until March 2020, these ratios hovered below 100 percent, which is typical as most municipal securities are tax-exempt. The yield ratios spiked in March, reaching peaks of 365 percent and 252 percent on March 23, reflecting the avalanche of selling by mutual funds triggered by sell-offs of risky assets in response to mounting COVID-19 concerns.

Municipal Debt Markets and the COVID-19 Pandemic

Yield ratios have now returned to close to their historical norms. Changes in secondary market yields are important because prices in the primary market are closely related to them. Facilities that support liquidity in money markets

(MMLF and CPFF) and the availability of a backstop facility (MLF) have all contributed to the improvements in market functioning, as has the general improvement in risk sentiment. However, it is hard to parse the effects that each facility has had in bringing about the improvement in market functioning, especially since changes in the terms of the facilities were also made after they were announced.

It is important to note, however, that yield ratios remain above 100 percent, reflecting both the historically low level of Treasury yields and the deterioration of municipal borrowers’ financial condition since the beginning of the year.




Outflows from Municipal Bond Mutual Funds Have Reversed

Mutual fund holdings of municipal securities account for almost a third of municipal securities outstanding; mutual funds are the largest buyers of long-dated municipal paper, which constitutes more than half of the market. Importantly, among the owners of municipal bonds, investors in mutual funds are the most sensitive to changes in market conditions. The chart below shows inflows (positive bars) and outflows (negative bars) for municipal bond mutual funds since January 2019. In the first two months of 2020, mutual funds investing in municipal securities received inflows totaling $22 billion. This continued a trend of record inflows experienced throughout 2019, when total inflows leapt to $90 billion, more than the combined inflows from the preceding four years. Inflows reversed suddenly in March, with municipal bond mutual funds experiencing outflows of $43 billion.

Municipal Debt Markets and the COVID-19 Pandemic

When funds experience outflows, fund managers must sell securities in order to have enough liquidity to meet redemptions. As a result, there was almost no demand for new issuance at the peak of the market disruption.
Outflows slowed down markedly in April, and municipal bond mutual funds have received net inflows each week since the first week of May. The behavior of municipal bond mutual funds is similar to that of municipal money market funds, which saw heavy redemptions in March that subsided after the expansion of the MMLF to include certain short-term municipal securities.

Issuance of Municipal Securities Has Picked Up

The chart below shows weekly issuance of municipal securities in 2020 (solid line) and the range of weekly issuance for the same weeks between 2014 and 2019 (shaded area). Ordinarily, municipal issuance builds through March before taxes are due in April. In 2020, issuance began close to the top of its historical range but dropped precipitously by the end of March, remaining low through much of April.

Municipal Debt Markets and the COVID-19 Pandemic

Issuance picked up again in May and June as financial market conditions improved; indeed, by the fourth week of May, cumulative issuance for the year to date exceeded (and still exceeds) its 2014-19 average. However, as the table below shows, although issuance of AAA and AA securities had recovered by May, issuance of securities rated A and below (a small fraction of overall issuance) was still below the 2014-19 average.

Municipal Debt Markets and the COVID-19 Pandemic

The pickup in issuance does not necessarily mean that spending by state and local authorities is at the socially efficient level. Unlike corporations, municipal governments typically operate under balanced budget requirements, which constrain or even prohibit the financing of deficits across fiscal years. Debt financing is almost exclusively reserved for capital infrastructure investments. Thus, improvements in muni debt markets are not necessarily sufficient to induce willingness to spend at the local level.

Historically, state and local governments respond to recessions by drawing down rainy day reserves, cutting expenses, and temporarily raising revenues, including taxes, rather than borrowing. While collectively these steps are contractionary from a macroeconomic perspective, individually they reflect sound fiscal policies and are one of the principal reasons for the very high credit quality of the municipal sector.

Recognizing these fiscal constraints, the federal government often responds with significant fiscal support for state and local governments, as Congress has previously done during the current crisis. Most state and local governments are currently developing their 2021 budgets with the expectation of additional federal fiscal support that would limit the extent of budgetary retrenchment and deficit borrowing.

Summing Up

Both the primary and secondary markets for municipal securities underwent considerable stress during the early stages of the COVID-19 pandemic in the United States. Market conditions for municipal securities have improved significantly since then: yields for most issuers have receded to below pre-pandemic levels, outflows from municipal bond mutual funds have turned into inflows, and issuance has picked up. However, conditions remain strained relative to the start of the year, especially given the uncertainty about the path of the COVID-19 pandemic, its impact on economic recovery, and the degree of fiscal support from the federal government following the significant revenue losses experienced by state and local governments. Remaining market strains are concentrated in the riskiest segments of the municipal debt market.

Marco Cipriani

Marco Cipriani is an assistant vice president in the Federal Reserve Bank of New York’s Research and Statistics Group.

Andrew Haughwout


Andrew Haughwout
is a senior vice president in the Bank’s Research and Statistics Group.

Ben Hyman

Ben Hyman is an economist in the Bank’s Research and Statistics Group.

Anna Kovner

Anna Kovner
is a vice president in the Bank’s Research and Statistics Group.

Gabriele La Spada

Gabriele La Spada is a senior economist in the Bank’s Research and Statistics Group.

Matthew Lieber

Matthew Lieber is a vice president in the Bank’s Markets Group.

Shawn Nee

Shawn Nee is a senior analyst in the Bank’s Markets Group.

How to cite this post:

Marco Cipriani, Andrew Haughwout, Ben Hyman, Anna Kovner, Gabriele La Spada, Matthew Lieber, and Shawn Nee, “Municipal Debt Markets and the COVID-19 Pandemic,” Federal Reserve Bank of New York Liberty Street Economics, June 29, 2020, https://libertystreeteconomics.newyorkfed.org/2020/06/municipal-debt-mar....




Disclaimer

The views expressed in this post are those of the authors and do not necessarily reflect the position of the Federal Reserve Bank of New York or the Federal Reserve System. Any errors or omissions are the responsibility of the authors.

Pages