July 2, 2020
The Federal Reserve (Fed) is waging war on a recession with Jerome Power as commander in chief. Its main weapon of choice are open market interventions in the corporate debt market. While the Fed is purchasing debt of U.S. companies with the support of the federal government, there are few critics who sound the moral hazard alarm bell.
Purchase of Corporate Bonds
Initially, when the Fed had announced its plan to purchase debt of American corporations in March 2020, few details were known to the public. At the time, the practice of purchasing U.S. corporate debt in the secondary market through exchange-traded funds (ETFs) was already well established as a broad tool of purchasing corporate debt and supporting the economy.
On Monday, June 15, the Fed announced additional details regarding its corporate debt purchasing program. It will extend its purchase of U.S. corporate debt to individual companies, in addition to its existing ETF purchases. In doing so, the Fed plans to spend $750 billion to purchase U.S. corporate bonds. For this purpose, the Treasury Department has generously provided $75 billion of taxpayer funds to offset any losses that occur from these purchases.
Effects of Intervention
There are positive effects associated with the Fed open market intervention, otherwise it would not engage in such measures. By purchasing bonds of U.S. corporations, the Fed effectively lowers the interest rate at which all U.S. corporations can borrow new debt. In this way, companies are more likely to survive, the economy is stabilized, and a looming recession is fought back.
However, every market intervention also comes with downsides. The most obvious downside concerns investors who prefer safe and stable investment classes such as government, municipal or corporate bonds. As the Fed steps in to support struggling corporations by lowering the interest rate for corporate bonds, it also lowers the return investors can expect to earn on these bonds. This affects people like us directly.
The second downside is that taxpayer are funding the Fed’s open market operation with $75 billion. Compared to the aid package worth $2.2 trillion passed earlier this year by congress, this may be considered pocket change, but it is still more than the annual budget of NASA.
The third downside is the purchase of corporate debt continues to blow up the Fed’s balance sheet. The Fed's balance sheet has expanded and contracted over time. During the 2007-08 financial crisis and subsequent recession, total assets increased significantly from $870 billion in August 2007 to $4.5 trillion in early 2015. Then, reflecting the Fed’s balance sheet normalization program, which took place between October 2017 and August 2019, total assets declined slightly to under $3.8 trillion. Beginning in September 2019, total assets started to increase again only to hit $7.2 trillion in June of 2020. See chart “Total Assets of Federal Reserve 2007 - 2020” for details.
This represents nearly a 10-fold increase in the Fed’s balance sheet over a period of 13 years, which should lead us to ask the question how far the Fed can balloon its balance sheet before it runs out of ammunition to battle another recession.
The fourth downside is moral hazard. The concept behind moral hazard is rewarding corporations for bad decisions. The more technical explanation used by economists is the existence of bad incentives that are created when people or companies know they will be rescued from their mistakes.
The kind of mistake companies typically make is overleveraging. They plain and simply do not put any money aside to sustain a recession on their own. In addition, they borrow more money than they should, putting these companies at more risk during downturns. This can be the case for corporations owned by private equity firms, which generally use lots of debt for a hostile takeover, and companies which are not very productive. In a normal interest rate environment, without the interventions of the Fed, these companies would have to face the consequences of their imprudent actions – possible bankruptcy. However, due to the Fed’s interventions they are able to borrow additional funds at low rates to stay afloat and remain part of the economy. In essence, these two types of firms get bailed out, even though they may not deserve it.
The number of companies which will receive an unwarranted bailout is unknown. However, the Fed publishes data on the outstanding corporate debt of nonfinancial businesses. This data reveals a stark picture, because U.S. corporations have been loading up on debt for years, not just during the crisis. At the end of March in 2005, total U.S. corporate debt had amounted to $7.7 trillion. This amount peaked during the financial crisis of 2007-08 at $10.7 trillion only to rise sharply to $16.8 at the end of March in 2020. See chart “U.S. Nonfinancial Corporate Debt 2005 – 2020” for details.
By looking at the chart above, it becomes obvious why the Fed has such a strong interest in purchasing corporate debt without any regard to moral hazard. The Fed’s interest lies in fighting off a recession. Making judgements about which firms are worthy to benefit from its open market interventions and which are not would jeopardize this goal. As Machiavelli said – the end justifies the means.
Hopefully, this newsletter gave you a better understanding of the events that shape our economy today. In times like this, we would like to offer you a form of investing that focuses on the safety of your principal as well as constant cash flows at a high rate of return. Thus, we encourage you to take a look at the concept of First Deed Lending, which provides you with the advantages of renting, without the hassle of being a landlord. This is your opportunity to earn a stable stream of income during unstable times.
