This is an explanation why the Feds recent actions are illegal. Its from John Hussman’s new post which also talks about the spread of SARS-COV-2 and stock market valuations and internals.
Both the Federal Reserve Act and the recent CARES Act places very clear restrictions on the types of assets that the Federal Reserve can purchase, and the conditions that must be satisfied in order to purchase them. Congress went so far as to include a section in CARES to emphasize these requirements “for the avoidance of doubt.”
Put simply, Fed purchases under the Federal Reserve Act are restricted to assets that are explicitly guaranteed as to interest and principal by the U.S. government, or that has a claim to sufficient collateral to avoid losses to the public.
The securities that the Federal Reserve is legally allowed to purchase are:
a) Section 14 open market purchases of securities that are fully guaranteed as to interest and principal by the U.S. government or a foreign government;
b) Section 14 purchases of “commercial bills of exchange” arising out of commercial transactions. What are those? See the definition in Section 13(2), which defines commercial bills of exchange exactly as they’re commonly understood: arising out of commercial transactions, secured by agricultural products, goods, or merchandise, with a maturity of less than 90 days, and specifically prohibited from “covering merely investments, or issued or drawn for the purpose of carrying or trading stocks, bonds, or other investment securities, except bonds and notes of the government of the United States.”
c) Section 13(2) discounting (i.e. prepayment) of commercial, agricultural, and industrial paper (again, bills of exchange);
d) Section 13(3) emergency lending to individuals, partnerships, and corporations, restricted to discounting notes, drafts and bills of exchange, and contingent on collateral (“security”). Section 13(3) also requires that these activities must be for “the purpose of providing liquidity to the financial system, and not to aid a failing financial company, and that the security for emergency loans is sufficient to protect taxpayers from losses.”
e) Section 13(4) and 13(6) lending for payment of sight drafts for agricultural transactions, and bankers acceptances which typically arise out of merchandise transactions.
That’s it. The menu is very specific: either government securities, or those that are backed by a pledge of collateral “sufficient to protect taxpayers from losses.” This principle is consistent with the U.S. Constitution: only Congress has fiscal authority. The Federal Reserve does not. If this is not taken seriously, the Fed could purchase whatever security it wished, at whatever valuation it might choose, and the American public would be on the hook for any losses.
On April 9, the Federal Reserve announced the creation of the “Secondary Market Corporate Credit Facility” (SMCCF), that would leverage $75 billion of CARES funding from the U.S. Treasury to buy as much as $750 billion of corporate debt and ETFs.
The initial allocation from the Treasury covers $50 billion for “primary” lending (directly to companies), and $25 billion for “secondary market purchases” of outstanding corporate bonds from investors. That Treasury funding is fine. Congress allocated the $75 billion in Treasury funds as part of the CARES Act. Every dollar provided by the Treasury acts as a Federal guarantee for the equivalent amount of corporate obligations that the Federal Reserve purchases.
The problem is that the Fed intends to leverage these funds 10-to-1 without taking actual collateral pledges from the underlying companies. This exposes the public to outright losses in the event that declining market prices or corporate defaults reduce the value of these bonds by even 10%.
As a result, the newly created SMCCF is either a Ponzi scheme at public expense (if the Fed plans to allow portfolio losses to exceed 10%) or a 1987-style portfolio insurance scheme (if the Fed plans to liquidate securities into a falling market in order to cap its losses at 10%). Section 13(3) requires updates every 30 days on the “value of collateral” – that’s going to be an interesting dance if we break the March lows. In any event, even here, the SMCCF is already illegal.
Uncollateralized junk bonds are being treated as their own collateral.
What makes this so brazen is that when Congress approved the CARES Act, it wrote the terms and conditions section like a children’s book, “for the avoidance of doubt” – to prevent exactly this sort of abuse of public funds. Specifically, here is section 4003(c)(3)(B), which limits how the $500 billion of 4003(b)(4) funding provided for businesses, states, and municipalities may be used:
4003(c)(3)(B) FEDERAL RESERVE ACT TAXPAYER PROTECTIONS AND OTHER REQUIREMENTS APPLY. – For the avoidance of doubt, any applicable requirements under section 13(3) of the Federal Reserve Act, including requirements relating to loan collateralization, taxpayer protection, and borrower solvency, shall apply with respect to any program or facility described in subsection (b)(4).
CARES Act Section 4003 and Federal Reserve restrictions (violated)
Has the Federal Reserve taken collateral pledges from the companies underlying these “loans”? Has the Federal Reserve ensured that “the security for emergency loans is sufficient to protect taxpayers from losses”? Nope.
Instead, what’s going on here is that the Fed is treating the SMCCF as if it is a “business” in itself. It is then treating the corporate bonds and ETFs purchased by that vehicle as if those unsecured bonds are the “collateral.”
Yes, that’s right. Uncollateralized junk bonds are being treated as their own collateral.
Of course, that’s also why Section 13(2) of the Federal Reserve Act was written to prevent this sort of thing, prohibiting discounting of corporate securities “covering merely investments, or issued or drawn for the purpose of carrying or trading stocks, bonds, or other investment securities, except bonds and notes of the government of the United States.”
The whole operation is a hand-waving attempt to the purchase of assets that are wholly rejected by the provisions of 13(3), and may ultimately be impossible to close without a loss to the Fed, which is a loss to the public, which is fiscal policy, which belongs to Congress, not the Fed.
Again, it’s fine for the Federal Reserve to use the $75 billion of Treasury funding as “collateral“ that confers a federal guarantee on $75 billion of corporate loans and security purchases. Those funds are part of the amount that Congress, in its singular constitutional role, has allocated for public support for corporate lending.
In contrast, additional purchases to “leverage” that funding are neither secured by non-financial collateral, nor have security sufficient to protect taxpayers from losses. They are illegal, both under Section 13(3) of the Federal Reserve Act, and under Section 4003(c)(3)(B) of the CARES act, which “for the avoidance of doubt” specifically invokes 13(3) “requirements relating to loan collateralization, taxpayer protection, and borrower solvency.”
The newly created SMCCF is either a Ponzi scheme at public expense (if the Fed plans to allow potential portfolio losses to exceed 10%) or a 1987-style portfolio insurance scheme (if the Fed plans to liquidate securities into a falling market in order to cap its losses at 10%).