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  1. Why doesn't the Federal Reserve appear to worry Moral Hazard?

  2. How bad's the Moral Hazard? The Fed is creating money to transfer to the balance sheets of corporations that invest in securities like junk bonds, hoping that these corporations will wake up, see credit risk and roll the cash into the stock market. Is the Fed propping the junk underlying corporations from failing even if they should? Banks, institutional investors, and the rich will buy up ownership in these companies, because they'll benefit from rising stock prices propped up by the Fed.

On June 15 2020, the Federal Reserve Board's Secondary Market Corporate Credit Facility (SMCCF) will begin buying a broad and diversified portfolio of corporate bonds to support market liquidity and the availability of credit for large employers.

I think the disconnect that you are seeing in most comments elsewhere on Reddit is that many individuals will try and apply their knowledge of equities to fixed income. Corporate bonds are in normal times a fairly illiquid market, an issue from even a large cap may only trade once a week or so. So when we have an unprecedented drop in economic activity this means far fewer dollars are flowing in to credit markets than would otherwise be doing so, at that same time there is significant and growing demand for dollars across the entire globe. While buying ETFs is a way to broadly inject liquidity in to an entire market, buying specific issues allows the Fed to target specific pockets of illiquidity without needing to over-buy others.

Just to put this out there, because I have seen many comments elsewhere on reddit written with this assumption: The Fed buying a corporation's debt poses no benefit to that corporation at that time. Liquidity helps for corporations performing capital raises but the implicit assumption seen elsewhere is that liquidity drying up is the result of fundamental concerns with respect to the underlying corporations - I don't believe that to be the case nor have I seen any major commentary discussing broad weakness in corp balance sheets.

So the question is "should the Federal Reserve "prop up" bad businesses. No, that is not their role. And there is really no reason to believe that is occurring today. Should they ensure that credit markets function properly so that businesses can borrow? Yes, for some historic perspective the Federal Reserve was created to fulfill the needs for a credit backstop in the economy during times of economic panic - the dual mandate was a secondary and over time expanding portion of their responsibilities but from day one making sure credit markets work has been squarely the responsibility of the Fed.

On May 29 2020, WSJ reported Federal Reserve Discloses Holdings of $1.3 Billion in Exchange-Traded Funds.

As part of the backstops, the Fed on May 12 began purchasing exchange-traded funds that provide broad exposure to U.S. corporate bond markets. The Fed said the “preponderance” of those holdings would be in funds whose primary investment objective was in the market for debts with investment-grade ratings, but officials said they would allow for some purchases of ETFs with exposure to junk bonds.

The decision to invest in junk debt has been controversial. Some investors have argued that the central bank risked a deeper credit freeze that would lead to higher unemployment if the central bank shunned riskier assets, while others warned that doing so would reward firms and their investors that were already vulnerable to an economic downturn before the crisis due to heavy debt burdens.

The disclosures of 158 transactions cover purchases made between May 12 and 18. Of the Fed’s $1.3 billion in ETF holdings as of May 19, around 17% were in funds that invest primarily in junk debt. The funds the Fed invested in have appreciated 2.7% on average since purchases began on May 12, according to Roberto Perli of Cornerstone Macro, a research firm.

The Fed owned \$100 million in iShares iBoxx High Yield Corporate Bond ETF, which as of Thursday included small holdings of bonds issued by rental car company Hertz Global Holdings Inc., which filed for bankruptcy protection on May 22. It also included small holdings of retailers J.C. Penney Co. and Neiman Marcus Group Inc. and oil-shale driller Whiting Petroleum Corp., all of which filed for bankruptcy in recent weeks.

I cite evidence for moral hazard. On Apr 28 2020, Bloomberg published America’s Credit Whale Is Already Bailing Out Levered Companies

Long before the coronavirus pandemic would bring business to a standstill all across America, Surgery Partners Inc., a sprawling network of outpatient clinics, already had its share of financial problems.

This was no secret on Wall Street. Surgery Partners’s majority owner, the buyout firm Bain Capital, had loaded so much debt onto the company’s books that when it went to the market last year to refinance maturing bonds, investors demanded a 10% interest rate to compensate them for the risk. The debt was rated CCC -- eight levels below investment grade.

Even a moderate downturn, it was understood, was going to raise existential questions about the company. So by late March, with the economic effects of the outbreak in full force, frantic investors braced for default, pushing the price of those bonds below 55 cents on the dollar.

But then the Federal Reserve did something it had never done before. It pledged to buy risky corporate debt as part of its emergency financing package for the economy. The move was so aggressive and sparked a rally that was so powerful and broad-based that today those bonds are all the way back up near par value, and Surgery Partners was able to raise another $120 million from loan investors earlier this month.

It all has worked out so fortuitously for the creditors and equity holders of Surgery Partners -- and those of scores of other companies with similarly shaky balance sheets -- that the Fed’s actions carry a grave risk: that investors, rather than being chastened, will be emboldened to take greater chances and seek fatter returns in the future, believing that policy makers will be there to bail them out if they get in trouble.

Economists refer to this phenomenon as moral hazard, and it hasn’t been this big a concern in a long time, perhaps not even during the 2008 financial crisis.

I skip some paragraphs.

“It’s as if they believe the banking system no longer works,” said Paul Tucker, former Deputy Governor of the Bank of England and chair of the Systemic Risk Council, a think tank of former regulators.

What’s worse, according to Tucker, is that the Fed might have altered investor incentives for years to come, creating even more instability in the next downturn.

“Once you start fixing prices, the information content is lost and they no longer tell us anything about risk and reward to help allocate resources,” said Peter Fisher, a professor at Dartmouth College’s Tuck School of Business and former head of fixed income at BlackRock, which is managing some of the Fed lending facilities.

Even more troublesome is that the Fed had been warning for more than a year about corporate leverage buildups amid the record economic expansion.

In a financial stability report published last year, the central bank noted that the share of new loans to large corporations with debt-to-earnings ratios above 6 times had increased past peak levels previously seen in 2007 and 2014 when underwriting quality was poor.

Distorting Incentives

Srinivas Dhulipala, a former prop trader at Bank of America Corp., said he shuttered his hedge fund last year after falling behind rivals partly because he was unwilling to take outsized risks on his credit bets. He believes the Fed is distorting incentives in the marketplace.

“The Fed is saying if you were willing enough to take too much risk, then don’t worry, we will bail you out,” he said in an interview. “Of course the virus was a big hit,” he added, but the market “was trading with absolutely no cushion for any type of a shock.”

Matthew Mish, a strategist at UBS Group AG who has often highlighted risks building in corporate debt, has a more generous assessment of Powell’s actions so far. He argues the central bank needed to prevent an economic crisis from turning into a financial one and that the benefits filtering through to the riskiest borrowers have so far been minimal.

“What I am concerned about is if the Fed ultimately has to expand the credit box, because the next time they expand it is going to be bailing out highly levered, private-equity owned companies,” Mish said. “That would be the definition of moral hazard.”

For some, that bridge has already been crossed.

“If they now provide a significant amount of support to get those firms that were heavily leveraged through this, everybody will assume that they will do it next time,” said William English, the former director of the Division of Monetary Affairs at the Fed Board who is now a professor at the Yale School of Management. “They will have to be clear that they are only doing this with gritted teeth.”

On Apr 9 2020, Bloomberg reported Fed to Buy Junk Bonds, Lend to States in Fresh Virus Support.

Moral Hazard

“Many of the programs we are undertaking to support the flow of credit rely on emergency lending powers that are available only in very unusual circumstances,” he said in his speech. “I would stress that these are lending powers, not spending powers. The Fed is not authorized to grant money to particular beneficiaries.”

”That does present some moral hazard but a lot will depend on how these programs are executed and how they’re unwound,” said Stephen Stanley, chief economist at Amherst Pierpont Securities. “Are they executed in a way that doesn’t unduly benefit people? If the programs are devised effectively, hopefully that won’t be the case.”

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Why doesn't the Federal Reserve appear to worry about moral hazard?

In the current environment, central banks face a trade-off between macro- and micro-prudential regulations.

In deciding which firms have access to Fed/Treasury facilities directly or whose corporate debt gets purchased by the Fed, the Fed adverse-selects as well as faces a moral hazard problem. From the micro-prudential perspective, ideally one would only provide facility to otherwise viable firms which require temporary assistance and let the others fail, as well as having a mechanism ensuring funds are used efficiently by the firm.

On the other hand, from the macro-prudential perspective, the central bank's priority is to act in a timely manner to prevent a liquidity/credit crisis that would exacerbate the impact of the demand shock to the economy.

The potential cost (in time) of addressing adverse-selection and moral hazard by screening firms for eligibility for assistance/restricting purchases to investment grade bonds/etc may (and, in practice, does) conflict with the macro-prudential objective.

The actions of various central banks show that they have decided that micro-prudential considerations are second-order for the moment. The priority is to provide liquidity, at the expense of artificial inflation of asset prices---which leads to moral hazard.

How bad's the moral hazard?

Frivolous nonsensical question that cannot be answered.

To quantify the extent of moral hazard by comparing, say, some first and second-bests does not seem like a sensible question, as the second-best (ideal micro-prudential policy, whatever it may be) incurs cost along other economic and public health dimensions.

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    $\begingroup$ +1 because I think most of your answer is spot on but I would disagree on that "how bad's the moral hazard? " cannot be answered - at least not in principle. There are lot of studies that try to estimate potential moral hazard that this or that policy can create. On macroeconomic scale estimating moral hazard is extremely difficult, and perhaps argument could be made that we cant do it in any completely satisfactory way now, but the question itself is not non-answerable or nonsensical at least not in principle as the design policy can create stronger or weaker incentives $\endgroup$ – 1muflon1 Jun 3 at 11:13
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    $\begingroup$ for risky behavior where others bear risk $\endgroup$ – 1muflon1 Jun 3 at 11:13
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    $\begingroup$ @1muflon1 I would claim that quantifying moral hazard in the sense of comparison with a first best ("how bad is it") is a frivolous question, in this particular context, especially taking into account intertwined public health and economic impacts. Improvement of existing measures along micro-prudential lines---yes, of course, that is a valid issue. But, practically speaking, the bureaucratic structure and processes required to address this seem simply beyond reach at the moment, unfortunately. $\endgroup$ – Michael Jun 3 at 12:45
  • $\begingroup$ how do you recommend rewriting "How bad's the moral hazard?" "Frivolous nonsensical question" doesn't sound very nice at all. $\endgroup$ – Nai Jun 6 at 21:08

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