On April 9, amidst plunging economic conditions, the Federal Reserve announced a set of lending policy initiatives that included a new “Municipal Liquidity Facility” for state and local governments. For legal authority, the Fed cited the emergency lending provisions in section 13(3) of the Federal Reserve Act.
Normally, a central bank lends to banks, but emergency provisions have historically been used by the Fed to justify direct lending to “individuals, partnerships and corporations” in “unusual and exigent circumstances.” Section 13(3) is titled “Discounts for individuals, partnerships, and corporations,” raising questions whether the Municipal Liquidity Facility is actually authorized under Section 13(3).
The new facility is unprecedented. It is available to cities and counties meeting population requirements, and all 50 states. Smaller cities and counties may be supported by state borrowing through the facility. The lending facility is operated by the Federal Reserve Bank of New York. The facility may lend as much as $500 billion.
The State of Illinois became the first entity to use the facility, under a transaction that closed last Friday.
To qualify as an “eligible issuer,” states, cities and counties must meet thresholds for credit quality as determined by credit ratings set by “Nationally Recognized Statistical Rating Organizations.” This provides a depressing reminder of lessons unlearned from the financial crisis of 2007-2009, with implications for the State of Illinois. Kind, benevolent, and well-paid credit rating agencies can issue ratings above thresholds for Municipal Lending Facility access, even for places like Illinois that may have debt trading with yields more characteristic of “junk” credit.
The facility’s term sheet published by the Fed includes criteria to make issuers eligible, but does not mention another factor central to lender of last resort activity, and required by federal law. Section 13(3) of the Federal Reserve Act, as amended, includes provisions purportedly designed to check the discretion and scope of Fed crisis lending. After the Fed’s widespread and massive lending amidst the financial crisis of 2007-2009, the Dodd-Frank Act included qualifiers forbidding lending to “borrowers that are insolvent.”
To implement this directive, the Federal Reserve Board is directed to develop procedures that may call for the borrower’s CEO or another authorized officer to certify that the borrower is not insolvent. Yet for the purpose of that provision, Section 13(3) defines “insolvent” to be one of three cases – the borrower is in bankruptcy, under resolution procedures in Title II of Dodd-Frank, or “any other Federal or state insolvency proceeding.”
Municipal governments aren’t banks, but it is difficult to escape the conclusion that the City of Chicago, Cook County, and the State of Illinois are all balance-sheet insolvent. Their assets are swamped by their liabilities. All three entities sport massively negative unrestricted net positions, the product of decades of spending beyond their means on an accrual basis despite advertised “balanced budgets.” But none of them are currently in bankruptcy or the other forms of resolution procedures called for in Section 13(3).
Federal statutes are not the only sources of authority for Fed emergency lending, however, with one implication for identifying responsibility (and discretion) at the Federal Reserve. The Fed issues its own regulations, under law, including Regulation A – Extensions of Credit by Federal Reserve Banks. Regulation A provides other criteria for determining whether a borrower is insolvent. They include whether the Fed finds that the entity “is generally not paying its undisputed debts as they become due,” and whether “the Board or Federal Reserve Bank otherwise determines that the person or entity is insolvent,” with the latter determination resting in part on a review of audited financial statements.
The State of Illinois is arguably not an “individual, partnership or corporation,” so how can it be the object of loans asserted to be authorized by a statute titled “Discounts for individuals, partnerships and corporations?” The State of Illinois has a $5.7 billion bill backlog, yet the Federal Reserve seemingly did not find Illinois “is generally not paying its undisputed debts as they become due.” The Fed apparently did not “otherwise determine that the person or entity is insolvent,” even as the State of Illinois’ latest annual balance sheet reported $267 billion in liabilities, “backed” by only $85 billion in assets – leading to a reported unrestricted net position of (negative) $214 billion. And the interest rate on the loan closed last Friday assertably lies well below what the market would have charged Illinois, despite the fact that Regulation A calls for a "penalty rate" for emergency loans.
The State of Illinois recently passed budget legislation that relied in part on billions of dollars in anticipated borrowing proceeds from the Federal Reserve’s Municipal Liquidity Facility. That lending has reportedly been expected to be repaid with uncertain proceeds from Federal aid from other places. So the value of the credit – and the risk to the Fed – appear to be conditioned with political risk.
Those concerned about the risks of politicizing monetary policy frequently stress that politicized lending decisions should not be undertaken by a monetary authority, but by fiscal authorities closer to the whip of accountable elections.
Traditional lender-of-last-resort theory cautions that central banks should restrict their lending to illiquid but solvent institutions. The City of Chicago and State of Illinois may not strictly be in bankruptcy or related resolution arenas yet, but they have been headed in that direction, and more than a few parties believe those proceedings can and/or should arrive down the road.
In banking, history cautions that failing institutions backed by a public safety net should be resolved sooner than later, under principles for what has become known as “prompt corrective action.” Absent timely intervention, which may take the form of forced mergers or even liquidation, insolvent failed firms can have incentives to gamble on the public purse, privatizing any gains while socializing losses.
So it may also go for many state and local governments and their massively underfunded pension funds. The Fed’s new Municipal Liquidity Facility can prop up failed enterprises with public resources, and through a vehicle fueled with a combustible mix of fiscal and monetary policy.