COVID-19: The Federal Reserve’s Municipal Liquidity Facility

COVID-19: The Federal Reserve’s Municipal Liquidity Facility

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August 14, 2020
COVID-19: The Federal Reserve’s Municipal Liquidity Facility
State and local (municipal) governments issue debt (often
year municipal revenue bonds of 2.51% for the week of
called bonds) for a variety of purposes, including
July 30, down from 3.10% in the first week of 2020. Lower
infrastructure construction. In April 2020, the Federal
yields reduce the interest costs to municipal governments
Reserve (Fed) announced the creation of the Municipal
when issuing debt. Over the same period, 30-year (federal)
Liquidity Facility (MLF) to ease pressures in municipal
Treasury yields declined from 2.32% to 1.20%.
debt markets caused by Coronavirus Disease 2019
(COVID-19). Pressures eased around the time the MLF was
Despite relatively normal conditions for new debt
announced. One municipality has used the MLF to date.
issuances, there are still concerns about municipalities’
abilities to make existing debt payments in the coming
Recent Activity and Outlook
months. State and local governments are statutorily required
State and local governments faced two financing problems
to balance their operating budgets, and COVID-19 has both
early in the pandemic. First, they faced budgetary pressures
decreased state and local revenues and increased spending
caused by COVID-19’s effects on revenues and spending.
demands on health, education, and other services. Such a
Second, they faced a disruption in municipal bond markets
situation increases the risk that municipal governments may
at the onset of the COVID-19 crisis, which hindered their
default on existing obligations if those budgetary gaps are
ability to issue debt. This disruption was triggered by a
not addressed elsewhere. Late or missed payments would
decline in investor demand caused by uncertainty about
then likely lead to a drop in municipal credit ratings, which
COVID-19’s effects on municipal bond markets and the
could hamper future municipal borrowing efforts.
economy more generally.
Municipal Liquidity Facility
Beginning in April, municipal debt market activity has
The Fed acts as a lender of last resort, traditionally to
rebounded as investor fears have subsided. Table 1 shows
banks, to provide liquidity directly to ensure continued
the volume of new municipal issuances in 2020 in nominal
access to needed funding. The Fed has set up a series of
terms and as a reflection of 2019 activity. Following a 31%
emergency facilities , including the MLF, in response to
year-over-year decline in March 2020 issuance volume,
COVID-19, expanding its lender of last resort role to other
new issuances returned to roughly 2019 levels in April and
sectors of the economy. This marked the first time the Fed
May, before increasing in June and July. The year to date
has purchased municipal debt since the 1930s.
2020 issuance volume through July is 19% larger than 2019
levels over the same period.
The MLF was announced as a $500 billion program. It
purchases newly issued debt from eligible issuers, which is
Table 1. New Municipal Issuance Volume, 2020
backed by anticipated taxes , bonds, or revenues and
matures within three years. All states and the District of
New Issuance
Columbia are eligible to use the facility, but a limited
Volume (in
Change from
number of cities and counties are eligible. To be eligible, a
Month
billions)
2019
city must have at least 250,000 residents, and a county must
January 2020
32.9
+16%
have at least 500,000 residents. For states that do not have a
combination of at least two cities or counties meeting that
February 2020
41.7
+55%
size threshold, the state may designate two of its largest
March 2020
19.5
-31%
cities or counties to participate. Figure 1 shows the eligible
issuers. Issuers also had to have an investment grade credit
April 2020
28.7
-4%
rating before April 8 to be eligible. The interest rate on the
debt is based on the issuer’s credit rating, with lower rated
May 2020
30.0
-1%
issuers paying a higher interest rate. There is also a limit on
June 2020
60.6
+34%
how much debt any issuer may sell to the Fed.
July 2020
52.9
+54%
The Fed created the MLF under its emergency authority,
Year to Date 2020
266.3
+19%
found in Section 13(3) of the Federal Reserve Act (12
U.S.C. 343). (The Fed’s ability to purchase municipal debt
Source: Municipal Securities Rulemaking Board.
under its normal authority is far more limited.) Under this
authority, actions must be temporary and approved by the
Some of the recent rebound in activity may be a reflection
Treasury Secretary. The interest rate must be higher than
of broader improvement in market conditions. General
normal market rates. Actions also must provide security
interest rates, which were already low by historical
(e.g., collateral) that is sufficient to protect the taxpayer and
standards before the crisis, declined further in the past few
be based on sound risk management practices. To absorb
months. The Bond Buyer reported an average yield on 25-
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COVID-19: The Federal Reserve’s Municipal Liquidity Facility
potential losses, Treasury has pledged $35 billion in
Fed had already created several other facilities addressing
CARES Act (P.L. 116-136) funding—protecting the Fed,
other parts of the financial system. Thus, extending its
but still exposing taxpayers to future losses. Likewise, any
purchases to the municipal bond market may have made the
profits from the facility ultimately accrue to taxpayers.
Fed’s overall actions more credit neutral.
Among other requirements, the CARES Act does not
permit debt forgiveness.
The decline in yields on highly rated debt since the MLF
was announced—and before it was operational—suggests
Figure 1. MLF Designees by State and Locality
that municipal bond markets are no longer stressed for
creditworthy borrowers. Some of the improvement, which
predated the announcement, may be attributable to other
actions by the Fed and Congress (such as aid to states and
localities in the CARES Act). The MLF might see greater
use if market conditions were to deteriorate again.
For those hoping the Fed would offer a widely used lifeline
to struggling municipalities, the MLF so far has not done
so. Nevertheless, the facility may be successful despite its
limited use, given the decline in private borrowing costs. As
the term implies, a lender of last resort is intended to be
used when there is no private sector alternative. If issuers
find the Fed’s rates too high compared with private sector
alternatives, then the Fed has succeeded in charging above
market rates to discourage its use. These rates would be
problematic if market rates were also prohibitively high, but
this does not seem to be the case.
Some may be concerned that the facility has been

underused because not enough municipalities are eligible.
Source: CRS, based on information from the Federal Reserve.
Eligibility could be extended to more municipalities by
The MLF became operational on May 26. The Fed has
lowering the minimum size or credit rating or by including
publicly disclosed users on a monthly basis. In its first two
other types of issuers, such as U.S. territories or issuers of
months of operation, one issuer (Illinois) used the facility.
private activity bonds (such as utilities). The Fed allows
The MLF is currently scheduled to stop purchasing debt at
states to borrow through the MLF and lend the proceeds to
the end of 2020.
some of these ineligible issuers, with the states bearing the
Policy Issues
default risk. But states may be unwilling to do so and,
according to an April 23 Wells Fargo newsletter,
The Fed cited two policy rationales for creating the MLF: to
“Unfortunately, most states do not have an established
ensure that municipal bond markets function smoothly, and
mechanism for this and some are legally barred from doing
to ease funding pressures on municipal governments.
so.” If eligibility criteria were relaxed, it might increase the
likelihood of losses—particularly if minimum credit ratings
As discussed above, municipalities faced two sources of
were reduced. This highlights the tradeoff between risk to
fiscal pressure in the spring—higher interest rates and
taxpayers and the program’s aim to ease funding pressures
heightened borrowing needs. The MLF can help
on municipalities.
municipalities with the former problem, not the latter. The
MLF ensures that municipalities will have a willing buyer
How much risk is the MLF taking on? Reporting to
of their debt at a predetermined interest rate, but it does not
Congress, the Fed said it did not expect losses to the Fed
alleviate the fiscal challenges that states face, including
from the MLF. Typically, municipal default rates are very
rising spending, falling revenues, and balanced budget
low. The Municipal Securities Rulemaking Board reported
requirements. In the words of California’s deputy state
a municipal default rate of 0.19% in 2019, well below the
treasurer, “You can’t borrow your way out of debt.”
corporate default rate of 1.74%. But COVID-19 is placing
unprecedented strains on state and local governments,
Helping ensure that municipalities can borrow
which could make historical default rates a poor predictor.
inexpensively is not part of the Fed’s statutory mandate. At
best, one could try to connect municipal bond market
CRS Resources
stability with the Fed’s broader financial stability remit—
CRS Report R46411, The Federal Reserve’s Response to
although the municipal bond market has never caused
COVID-19: Policy Issues, by Marc Labonte
broader financial instability. Justification for the MLF is
probably best understood through a wider lens of the Fed’s
CRS In Focus IF11502, State and Local Government Debt
actions. COVID-19 was an unprecedented emergency, and
and COVID-19, by Grant A. Driessen
the Fed threw “everything but the kitchen sink” at
ameliorating its economic effects. The Fed generally tries to
maintain a neutral effect on the allocation of credit, which
Grant A. Driessen, Analyst in Public Finance
might seem to rule out a facility dedicated to buying one
Marc Labonte, Specialist in Macroeconomic Policy
type of debt. But by the time the MLF was announced, the
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COVID-19: The Federal Reserve’s Municipal Liquidity Facility

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