The Doom-Loop Redux: The Corporate Bond-Purchase Program and the Political Economy of the Fed’s Pandemic Response

2.1. Shadow banking and the 2008 financial crisis

The collapse of Lehman Brothers in 2008 focused attention on the special purpose entities that flourished in shadows of the big banks (Pozsar et al. 2010). Shadow banking, which has been defined as “money-market funding for capital lending” (Mehrling et al. 2013: 2), eclipsed traditional banking based on loans and deposits so that both borrowing and lending were increasingly mediated by the market. The repo-market, where cash is acquired against the collateral of safe securities, served as the primary private channel for short-term borrowing and liquidity management (Mehrling 2010). Unlike the sale of a security, the repo of a security allows the investor to reuse this pledged collateral for a variety of purposes, amplifying the financial ripple effects on liquidity and credit (Gabor and Vestergaard 2016). Securitization served to transform illiquid risky assets like subprime mortgages into tradable assets, magnifying the scale of lending through the capital markets, even as derivatives provided new ways of credit enhancements and hedging of risks (Minsky 2008). When the breakdown of these shadow, market-based channels of credit and liquidity precipitated the financial crisis in 2008, the US Fed stepped in as lender and dealer of resort and extended its backstop to include this market-based shadow banking system that had precipitated the global financial crisis. It did so by setting up new lending facilities in 2008–9.

These included the Primary Dealer Credit Facility (PDCF), to provide daily access to funding for primary dealers, the Term Auction Fund (TAF) for longer-term funding, and the Term Securities Lending Facility (TSLF) to lend US treasuries to primary dealers against other eligible collateral. It also launched facilities to lend to financial institutions against eligible assets of money market funds (Money Market Mutual Fund Liquidity Facility [MMLF]), to purchase commercial paper (the Commercial Paper Funding Facility [CPFF]), and asset-backed securities (the Term Asset-Backed Securities Loan Facility [TALF]) directly bypassing the banking system. By extending its back-stop to a wider range of assets, and by directly buying up the toxic assets that could not find a price or a market, the Fed had taken on the mantle of the dealer of last resort for the shadow banking system (Mehrling 2010; Mehrling et al. 2013).

These interventions also marked a break from the practice established after the Great Depression. In the financial boom through the 1920s, the Fed had helped support the nascent market for banker acceptances by direct purchases (Eichengreen and Flandreau 2012). When the financial markets unraveled after 1929, and the Great Depression unfolded, the Fed reduced its holdings of banker acceptances in favor of buying US treasuries, which were a significant part of bank balance sheets to revive credit. The Fed’s holdings of US treasuries grew through the launch of the New Deal and the World War II, and US treasuries—a public security—displaced private banker acceptances on the Fed’s balance sheet and also as the pivot of the money market (Mehrling 2010).

At the same time, the Glass-Steagall Act of 1933 sought to erect a firewall between commercial banks and investment banks in order to protect the savings of households and small businesses from the riskier speculative pursuits of broker dealers and investment banks. This firewall had been breached much before the meltdown of 2008, as the shadow banking system proliferated and capital markets (where securities are traded) came to overshadow loans and deposits as the main mechanism by which the business of banking was conducted. The shadow banking system was creating liquidity and credit outside the regulatory control of the Fed. ² The interbank federal funds market was eclipsed by the euro-dollar markets and the shadow repo channels of private liquidity. The mechanisms of collateralization and securitization—the twin pillars of the market-based financial system—helped engineer private substitutes to the US treasury bill in the money markets (Mehrling 2010; Pozsar 2014; Gabor and Vestergard 2016). The tool kit the Fed had developed after the Great Depression to calibrate liquidity and stabilize financial markets were inadequate in responding to this new context.

The unconventional policies and the massive expansion of the Fed’s balance sheet embodied the Fed’s efforts to absorb the risks of these private “shadow” channels of liquidity creation and financial intermediation. The range of assets the Fed could purchase was no longer limited to treasuries and securities guaranteed by the federal government, and the scope of Federal Reserve backstop was also extended beyond banks to include nonbanks and the shadow banking system. These interventions proved extraordinarily effective in restoring the credit machinery, while bringing the market-based credit system out of the shadows, reinforcing its role as the essential plumbing of the credit machinery. Four big banks—Citibank, Bank of America, J.P. Morgan Chase, and Goldman Sachs—came to dominate the banking sector that had become even more highly concentrated in the wake of the financial crisis. The structural drivers—growing inequality, the concentration of wealth and income, and the squeeze of workers’ incomes—that had been ascribed a key role in the fueling of shadow banking (Pozsar 2014) also remained intact.

This is the sense in which the Fed’s interventions in 2008 manifested the doom-loop and paved the way for the reemergence of fragilities and fostered a further accentuation of the complexity and interconnectedness of the financial system Three trends in the changing financial landscape that are of particular significance for this article are the rise of asset managers, the eclipse of active investment strategies by passive investment strategies, and the rapid growth of corporate debt.

2.2. The Rise of Asset Management

Regulations put in place, in line with the Basel III standards and the Dodd-Frank Act, imposed a heavier regulatory requirement of capital reserves and high-quality liquid assets with the supplementary leverage ratio (SLR) and liquidity coverage ratio (LCR). But finance continually innovates and seeks ways of breaching the regulatory framework in search of returns. Most significantly, asset management funds, which are exempt from the regulatory requirements of capital and liquidity buffers, prospered in this period, adding another layer to the concentrated hierarchy of finance.

Asset management funds, which include hedge funds, private equity funds, mutual funds, index funds, and exchange-traded funds (ETFs), manage financial assets on behalf of investors. Unlike banks, such funds do not hold deposits or engage in trading on their own behalf. While some asset management funds are controlled by the big banks, independent asset management firms have emerged as big players in their own right, overshadowing US banks in the sphere of asset management.

The sphere of asset management is itself highly concentrated, with three asset management groups—BlackRock, Vanguard, and State Street—controlling the major share of the assets managed by this sector globally and in the United States (Fichtner, Heemskerk, and Garcia-Bernardo 2017). These big asset management groups leverage the scale and scope of their operations to lower fees and costs and capture an increasing share of funds flowing into this sector (Azar, Schmalz, and Tecu 2018). They deployed their reputation, connections, and expertise to attract investors, reinforcing their dominance. The extended web of control exercised by big banks over nonfinancial corporations through shareholdings and board membership has been penetrated by fund managers. There is also significant cross-ownership between the major banks and the major asset management funds (Azar, Schmalz, and Tecu 2018). Banks and asset management funds are also interconnected through direct lending and borrowing linkages (Epstein 2020).

The big asset management groups have thus come to enjoy a place in the inner sanctum of the power brokers of finance, alongside the big banks. So much so that the period after the global financial crisis has been christened the age of asset management (Haldane 2014). Common ownership and concentration of holdings among the big asset managers, who hold shares across firms within an industry, give these asset management groups the power to recast the rules and norms of an industry (Fichtner, Heemskerk, and Garcia-Bernardo 2017). The big asset managers also have considerable clout in determining the executive boards and in shaping company policies and corporate governance (Fichtner, Heemskerk, and Garcia-Bernardo 2017).

The rise of asset management is, however, entwined in the same processes that have fueled the concentration of wealth and the pervasive spread of market-based shadow finance since the nineties (Pozsar 2014; Epstein 2020). Shadow banking channels intermediate between risk-averse pension funds and money market institutions flush with funds seeking safety and hedge funds and other asset management funds with an appetite for risk and returns (Pozsar 2014). The quest for yield, unconstrained by the burden of losses, has propelled riskier strategies, especially in the low-interest regime that has prevailed since the 2008. These include investment strategies like momentum trades, carry trades, and relative-value trades. This postcrisis period has also seen the growing prominence of passive investment strategies with the rise of index funds and ETFs.

2.3. The Rise of Passive Investment Funds

Active investment strategies, which involve picking and choosing winners and losers in order to beat the market, lost some of their sheen in wake of the losses incurred in the 2008 financial crisis. Since then, passive investment strategies that track a composite of bonds or equities, usually a financial index like the S&P 500 index curated by index providers, have come to overshadow active investment strategies. August 2019 marked a turning point, when flows into passive funds eclipsed that into active funds (Gittleson 2019). The promise of lower volatility, and low fees and transaction costs, makes passive funds particularly attractive.

Passive funds include index funds and ETFs. Both funds seek to mirror the performance of a specific benchmark market index, but the shares of ETFs are traded throughout the day like stocks, while the index fund, like regular mutual funds, only trades once a day at the close of the market. The promise of immediate liquidity at their current trading price makes ETF shares attractive to high-turnover investors pursuing short-term investment strategies (Sushko and Turner 2018). Funds invested in ETFs have grown rapidly since the 2008 financial crisis. Global ETF asset holdings rose from about $800 billion in 2007, to more than $5 trillion mid-2019 (Aramonte and Avalos 2020a).

ETF share values, which fluctuate through the day, are supposed to create greater transparency and help the discovery of prices for assets like bonds or equity that may be more thinly traded. Key to this process are the actions of select broker-dealers (big banks like J.P. Morgan Citibank, Bank of America, and Goldman Sachs)—called authorized participants—whose operations ensure that prices in the ETF markets reflect the value of the underlying assets. When the ETF begins to trade at a discount to the value of the Net Asset Value (NAV), authorized participants redeem shares by buying cheaper ETF shares in the market and returning these to the ETF in exchange for the more expensive underlying asset, and when they trade at a premium to the value of the underlying assets, dealers create ETF shares by buying the cheaper asset in the market and turning them over to the ETF in exchange for ETF shares. The creation and redemption of ETF shares brings the value of ETF shares back in line with the value of underlying assets, helping to make the market. The dealers corner profits from any small drift of ETF shares from the value of the underlying assets. The possibility of profiting from such price differentials drives flows to ETF funds, and these flows can become quite volatile, especially when driven by high-frequency and algorithmic trading strategies that milk returns from small differentials through large trade volumes. Dealers also lend ETF shares (in what is termed “create to lend” transactions), even before they own them, when they create ETF shares for the specific purpose of enabling short selling by the investor, another form of speculative lending.

The flows into and out of ETFs and other passive funds have a significant impact on the prices of the underlying assets comprising the index that is being tracked by the funds, as the entire basket of assets that make up the benchmark index is traded in response to fund flows (Sushko and Turner 2018). Synchronized strategies of the fund managers propel co-movements in asset prices. As the correlation among securities in an index increases, they become less reflective of individual security prices (Sushko and Turner 2018). Passive investment strategies also lead to crowding of investors and common exposure to risks (OFR 2013).

The concentration of control and the interconnectedness with the rest of the financial system, given the large market and industry-wide stakes of the big asset management funds, also imply that distress in passive investment funds (including ETFs) would spill over through the financial markets, amplifying the repercussions of any market disruption (OFR 2013). The exit of investors trying to redeem their assets in times of turbulence exacerbates market stress, as falling asset prices and illiquid asset markets make it harder for fund managers to meet cash calls (OFR 2013). This risk, which can be compared to a run on a bank—is particularly acute in passive investment funds that pool funds of widely dispersed investors and face greater hurdles in unwinding (Sushko and Turner 2018). These risks, which inhere in passive investment strategies, are even more pronounced in ETFs, which are particularly vulnerable to sudden selloffs triggered by the liquidity mismatch between the ETF shares and the underlying assets that the ETF tracks. Flows into and out of ETFs that trade through the day can become extremely volatile (Sushko and Turner 2018).

The rise of asset management funds and financial innovations, including ETFs, has transformed the financial landscape after the global financial crisis. Remarkably, despite their size and potential for generating systemic risks, asset management funds have successfully evaded the regulatory oversight that the label of being a systemically important financial institution would have entailed. But the Minskyian processes of the endogenous buildup of fragility have continued unabated in the recovery from the 2008 crisis. Specifically, vulnerabilities have built up on the balance sheets of nonfinancial corporations, which had been able to boost bond issuance in the favorable environment that ETFs created for the growth of the corporate bond market.

2.4. The Growth of Corporate Debt

The prevalence of low interest rates and the growth of asset management funds chasing yield provided a fertile ground for the growth of corporate debt (BIS 2019; IMF 2019). Passive investment strategies and the emergence of ETFs allowed a wider range of investors to enter the relatively thinner market for corporate debt (Aramonte and Avalos 2020a, 2020b).

Nonfinancial corporate debt in the United States, which was $6.7 trillion in September 2008 (44.5 percent of GDP), has grown since the recovery after 2010, crossing $10 trillion (47 percent of GDP) in 2019, and marketable corporate debt (bonds and other securities) had risen from $3.4 trillion in September 2008 (25 percent of GDP) to $6.5 trillion (30 percent of GDP) in 2019 and over $7 trillion (40 percent of GDP) at the end of March 2020 (figure 1). From being around 50 percent of total debt of the nonfinancial corporate sector in 2008, the share of bonds and other debt securities had risen to about 64 percent at the end of 2019. Issuance of lower-grade corporate debt has grown, buoyed by growing demand from ETFs, mutual funds, and other institutional investors—its share in total issues rising from 29 percent in 2010 to 36 percent in 2019 (BIS 2019). The share of lower-grade BBB bonds in corporate bond mutual fund portfolios more than doubled from 19 percent in 2010 to 45 percent in 2019 (BIS 2019), raising the risk that any downgrades of low investment-grade bonds to junk status would trigger a fire-sale of bonds as funds offload their holdings of these downgraded assets.

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Figure 1.

Debt of US nonfinancial corporate sector (percentage of GDP).

The growing role of nonbanks and asset management funds in corporate financing reflects the process of financialization that embeds nonfinancial firms in market-based financial channels of accumulation (Crotty 2003; Lapavitsas 2013). A key feature of this process is the increasing recourse by nonfinancial corporations to market channels (commercial paper and bond markets) for their liquidity and funding needs. In terms of investment too, nonfinancial corporations are increasingly embedded in capital markets and the accumulation of financial assets. At the same time, growing corporate cash pools, which are typically placed in money markets rather than being deposited in banks, have further fueled the growth of the shadow banking (Pozsar 2014).

Despite the rising importance of market-based finance and nonbank lending (typically by asset managers) to corporations, it should be noted that banks continue to play a critical role in funding nonfinancial corporations in the United States, including in the growing market for leveraged loans targeting highly indebted companies with below investment-grade credit (FSB 2019). By 2018, the scale of leveraged loans, at above $1 trillion, was comparable to the size of the high-yield junk bond market. While the bulk of exposures to leveraged loans is concentrated among a few banks, nonbanks and private equity firms have a growing imprint in underwriting leveraged loans and there has been a decline in the share of the big banks (McCauley 2020). Securitization through the issuance of collateralized loan obligations (CLOs) helped fuel the rapid growth of these loans, which can be viewed as the corporate analogue of subprime mortgages. The amount of CLOs outstanding in the United States grew apace with the growth of leveraged loans, doubling from around $300 billion to $600 billion at the end of 2018 (FSB 2019).

There is thus an increasing risk associated with the rapid growth of corporate debt. Highly indebted firms are vulnerable to tightening of credit conditions, which are exacerbated by fire sales by investors in response to mark-to-market losses triggered by credit downgrades. Further, the bulk of this high-risk debt (whether through junk bonds or leveraged loans) has been deployed toward financial accumulation—including payouts to shareholders, stock buybacks, and mergers and acquisitions including leveraged buyouts—rather than to building productive capacity (IMF 2019). Both the BIS (2019) and the IMF (2019) had raised an alarm on the vulnerability of nonfinancial corporate sector even before the outbreak of COVID-19. One indicator of this financial fragility is the rise in the ratio of corporate debt to earnings, a measure of gross leverage, which crossed its previous peak of 3.13 from 2002, in 2015 when it reached 3.36 (BIS 2019).

Papadimitriou, Nikiforos, and Zezza (2020) have pointed to the buildup in the US economy of the Minskyian processes of the overvaluation in the asset markets alongside the gradual weakening of corporate balance sheets on the eve of the pandemic. The impact of pandemic shock has thus unfolded in a context where fragility was already evident in corporate balance sheets (Nikiforos 2020).

The three trends highlighted above—the growing role and reach of asset management funds, the growth of passive investment strategies, and the surge of riskier corporate debt—are the context in which the Fed’s extraordinary response to the market meltdown in March can be understood. They signal the increasing complexity and interconnectedness of the financial system, fueled by the resurgence of the collateralized market-based channels of shadow banking in the wake of the Fed’s interventions in 2008. Market liquidity based on collateralization hinges on the market-making capacity of dealer banks, but with increasing strains to their balance sheets, this capacity was undermined. With the declaration by the World Health Organization of a global pandemic and the initiation of lockdown and closures, the financial fragility that had been building up erupted (BIS 2020).

3.1. The March meltdown

In early March, the bond and stock markets collapsed. Following a period of rapid growth, corporate debt issuance stalled, and debt-laden, leveraged nonfinancial companies were faced with significant losses on their debt, as the outbreak spread (Aramonte and Avalos 2020b). There was a spike in corporate-bond spreads and ratings downgrades, particularly in energy, retail, and entertainment sectors and borrowing costs rose (Aramonte and Avalos 2020a). Unusually strong default-risk correlations were seen in in the investment-grade and high-yield bond markets. Comovement between short- and long-term credit rose to unprecedented levels (Aramonte and Avalos 2020b). Bond issuance also contracted sharply in late February (Aramonte and Avalaos 2020b). Funds focused on high-yield bonds faced outflows as selling pressure from fund redemptions was compounded by constrained dealer activity in the face of rising uncertainty and balance sheet pressures.

The strains in corporate credit markets became apparent in the growing wedge between NAV values and share values of ETFs (Aramonte and Avalos 2020a). When the market for corporate bonds stalled, the fact that ETF shares are traded throughout the day, and that ETFs are exempt from any capital requirements, allowed them to unwind their positions at a more rapid rate, aggravating the problem in the bond market. The trades of ETFs amplified the shocks to the bond market. The largest ETFs in both the investment-grade and high-yield segments began to trade at discounts of 6 percent below their NAV. Market volatility had a significant impact on ETFs, which trade much more frequently than the relatively illiquid underlying corporate bonds. The liquidity mismatch that arose from limited liquidity in the bond market and the heavy trading in ETFs exacerbated the market stress. The authorized participants who in normal times stepped in to bring share values in line with the NAV pulled back from their role as private dealer and market maker in the face of rising risk perceptions.

A deflationary spiral was set off as falling asset values fueled a search for liquidity, and fire sales reinforced the collapse of asset values (BIS 2020; FSB 2020). The interconnectedness of the financial markets constituting the financial system became evident as turbulence engulfed the market for US treasuries, and there was an atypical plunge in US treasuries together with that of the stock and bond market as investors made a dash for cash (FSB 2020).

3.2. The Fed breaks new ground

As the financial markets unraveled, the Fed initially slashed interest rates to near zero and stepped-up lending in repo-markets. When this proved inadequate to restore the private shadow channels of credit and liquidity, and volatility spiked in the US treasury market, the Fed launched a multipronged operation including the emergency purchase of $700 billion in Treasuries (and federally guaranteed mortgage-backed securities) on March 15. Drawing on the playbook that it had deployed so effectively in 2008–9, the Fed also launched new versions of the PDCF, CPFF, MMLF, and TALF (see section 2.1). ³

The PDCF would inject liquidity into the balance sheets of the primary dealers when the Fed’s repo operations failed to restore the capacity of primary dealers to act as market makers. Unlike 2008, the new PDCF can lend against a broader range of eligible collateral (including municipal bonds, corporate bonds, and equity) for up to 90 days and not just overnight. The direct purchase of securities out of the inventories of dealer institutions was meant to stabilize the money markets. The CPFF, a special entity set up to buy commercial paper, which is the staple of short-term funding for a range of financial and nonfinancial corporations, was relaunched to provide a liquidity backstop to this short-term market. The MMLF, set up for lending to financial institutions against the collateral of high-quality assets purchased from prime money-market mutual funds, was a new version of the MMLF of 2008. Eligibility as collateral was not restricted to asset-backed commercial paper and was even extended to municipal paper. TALF, a special purpose vehicle for lending against the collateral of asset-backed securities, was reintroduced to revive the machinery of securitization that dominated credit creation and enable the issuance of asset-backed securities. These included securities backed by student loans, auto loans, credit card loans, commercial mortgages, and loans guaranteed by the Small Business Administration.

Together, these facilities sought to restore the critical market for treasuries, which is the anchor of the collateralized mechanism of liquidity generation (Gabor and Vestergaard 2016), and prop up the markets for other liquid short-term assets like commercial paper, money markets, mutual funds, and a broad range of securitized assets. These can be seen as responses geared to providing a backstop to the shadow banking system. However, the scale of these credit facilities, which crossed $23 billion in October 2020, remains much below the peak of $900 billion in December 2008.

Alongside the relaunch of the credit facilities it had deployed in 2008, the Fed also announced the revocation of the previous limit on purchases of treasuries at $700 billion—a move that has been called unlimited quantitative easing. With this measure, the outright purchase of these securities would come to play a much more significant role in the unprecedented expansion of the Fed’s balance sheet in response to the COVID-19 pandemic, when compared to 2008–9. In the two years from September 2008 to September 2010, the Fed added about $1.5 trillion to its outright purchases of securities. In ten months, from March to October 2020, the Fed had already added about $2.6 trillion to its outright purchases of securities.

The expansion of the assets on the Fed’s balance sheet in response to the financial crisis of 2008 and the pandemic are compared in figure 2. Emergency liquidity facilities (including central bank liquidity swap-lines), which provide a liquidity backstop in times of market volatility, played a relatively smaller role in the current conjuncture, constituting only around 6 percent of the total assets in March and April compared to 65 percent at the peak of the Fed’s response after the collapse of Lehman Brothers, in December 2008. Purchases of US treasuries played a more significant role in the current response (above 83 percent in March and April 2020) compared to 2008–9 (22 percent at the December 2008 peak), reflecting the imperatives of stabilizing the market for US treasuries. Market channels for liquidity generation cannot be restored simply by injecting funds into the financial system. The market value of treasuries has to be revived and outright purchases, which alter the supply of the asset in the market, have a more direct impact on asset valuations.

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Figure 2.

The Fed’s assets (in million US dollars). (A) Response to 2008 financial crisis. (B) Response to the pandemic.

But the Fed went beyond providing a backstop and injecting liquidity into the banking and shadow banking system through the outright purchase of treasuries and its liquidity facilities. It launched a set of unprecedented measures, designed to directly support nonfinancial enterprises and the market-based channels that funded nonfinancial corporations. ⁴

The Paycheck Protection Program Liquidity Facility was set up to support the Paycheck Protection Program to provide forgivable loans to small businesses to enable them to keep workers on the payroll by supplying liquidity against the collateral of these loans. Under the Main Street Lending Program (MLP) the Fed set up loan facilities to support, solvent midsized businesses with up to ten thousand employees and less than $2.5 billion in revenues by buying 95 percent of the value of loans off the banks making these loans. While the MLP was directly administered by the Fed through a special entity set up with seed equity of $75 billion from the US Treasury to support up to $600 billion in loans, the PPP was run by the Small Business Administration and was allocated around $670 billion under the CARES Act.

The extension of direct support to the last-mile end users of credit can be viewed as a response to the specific challenges posed by the pandemic, which triggered lockdown measures that stalled the real economy, before spilling over to the financial markets (Cavallino and De Fiore 2020). Collapsing revenues, illiquid inventories, and frozen trade credit led to cash-flow disruptions, and as firms drew down on their credit lines, rollover of expiring credit lines also became harder (Banerjee et al. 2020). Credit risk plays a significant role determining nonfinancial firms access to liquidity (Acharya and Steffen 2020), so that the dislocation of normal economic activity accentuated the nonfinancial sector’s need for financing at precisely the time when credit had tightened.

The choice of using such funding-for-lending programs instead of direct stimulus to protect jobs is itself noteworthy, especially when compared to the employment-protection policies in Europe and Britain. The Fed did not, however, stop at these funding-for-lending programs. The pervasive penetration of market-based finance fueled by the rise of asset managers, ETFs in particular, had led to financial fragilities emerging in this new corner of the financial landscape. The deviations of share values of ETFs from the underlying NAV had continued to widen as the Fed launched its initial emergency liquidity operations. In fact, the launch of the MMLF triggered flows of investor funds away from ETFs to money market mutual funds, exacerbating the NAV discounts (Aramonte and Avalos 2020a). As spreads and borrowing costs rose, the corporate-bond market also collapsed.

The Fed had already included corporate bonds in the assets eligible for use as collateral by primary dealers through the PDCF to alleviate balance sheet constraints and encourage a restoration of their market-making activities. It went even further and launched two special facilities that directly targeted the market for corporate debt by supporting corporate bond purchases of up to $750 billion. As the authorized participants that in the normal course acted as market makers by creating and redeeming ETF shares pulled away from these trades, the Fed stepped in to fill the breach as the authorized participant of last resort in this market.

The Primary Market Corporate Credit Facility (PMCCF) was meant to provide a funding backstop for corporate debt issued by eligible nonfinancial companies by purchasing qualifying bonds as the sole investor in a bond issuance, or purchasing portions of syndicated loans or bonds at issuance. The Secondary Market Corporate Credit Facility (SMCCF) was launched to support the market for corporate debt by purchasing investment-grade corporate bonds and ETFs in the secondary market. The SMCCF would also mimic passive investment fund strategies in its purchase of bonds by matching the composition of its purchases to track a broad market index developed for this facility.

Set up with Treasury equity injections of $75 billion, these facilities were quite significant. The corporate credit facilities constituted about 22 percent of the total liquidity and credit facilities (excluding central bank swap-lines) of the Fed since May. Figure 3 presents the net portfolio holdings of the Corporate Credit facilities and Main Street facilities. If we include the Main Street Loan facilities, about 45 percent of the Fed’s liquidity and credit facilities targeted lending to the nonfinancial corporate sector. ⁵ The mere announcement of the corporate bond buying facilities helped restore trading liquidity, raise the price of corporate bonds, and spur corporate bond issuance. The discounts on NAV were also reversed as ETF share values revived with the resurgence of trading liquidity and investor flows (McCauley 2020).

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Figure 3.

The Fed’s liquidity and credit facilities (million US dollars).

Turning to the funding of the Fed’s interventions, figure 4 compares the liabilities side of the expansion of the Fed’s balance sheet in 2008–9 and in the current pandemic. While the massive extension of the Fed’s balance sheet was funded largely by the growth of reserve balances, and the expansion of nonreserve deposits (including Treasury account balances) as in 2008, a distinctive feature of the Fed’s response to the pandemic is the key role of Treasury guarantees to these new programs—the Treasury contribution to credit facilities. In 2008, the Treasury’s Supplementary Financing Program, set up to support the Fed’s interventions, placed the proceeds of newly issued treasury bills with the Fed in order to offset the expansion of the balances of depository institutions with the Fed, while bypassing the negotiations and constraints of the debt ceiling (Tymoigne 2014). In contrast, this time, $484 billion (about 2 percent of the GDP) was allocated under the CARES Act to the US Treasury to seed the Fed’s emergency facilities.

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Figure 4.

Feds Liabilities ($ million). (A) Funding the response to the 2008 crisis. (B) Funding the response to the pandemic.

In using the provisions of Section 13(3) of the Federal Reserve Act to create special entities to engage in underwriting and purchasing assets that were not federally guaranteed public assets, the Fed extended its backstop beyond traditional commercial banking system to nonbanks and the end-users of credit, but at a one-step remove. The risks were, however, still being absorbed on the Fed’s balance sheet. The seed equity from the Treasury served as a buffer of public capital that the Fed could leverage to support up to as much as ten times that amount of private asset purchases and lending. The emergency authority under Section 13(3), along with the protective buffer of capital injections from the Treasury, have thus been deployed by the Fed to venture further afield, in order to support new and riskier segments of the financial market. Fiscal authority is, thus, being harnessed to restore the smooth functioning and continued resilience of the system of market-based finance, while direct stimulus to households facing the brutal impact of the pandemic faced greater constraints. ⁶ The extraordinary interventions in the corporate debt market (compared even to the weaker support to the municipal bond market) underscore these constraints.

Borio and Disyatat (2009), while distinguishing between interest-rate policies and balance sheet policies, argue that the balance sheet policies of central banks need to be viewed as part of the government’s consolidated balance sheet, since these actions could in principle be replicated by the fiscal authority. ⁷ Thus, the massive expansion of the Fed’s purchase of treasuries reflects the use of the Fed’s balance sheet to implement debt management policy traditionally undertaken by the Treasury, signaling a blurring of boundaries between monetary and fiscal policy. ⁸ This blurring also reflects the significant role of private liquidity mechanisms undergirded by the use of treasuries as collateral in the financial system (Gabor and Vestergaard 2016).

The special credit facilities launched in response to the 2008 crisis and the pandemic deploy the Fed’s balance sheet to support different segments of the financial market—commercial paper, asset-backed securities, and corporate bonds and bond ETFs. Such support to the market for private financial assets involves the Fed using its balance sheet policies to substitute a public claim for private claims on private-sector balance sheets through its funding facilities. In the process, the Fed also absorbs the financial risks created by the operations of dominant financial institutions and of nonfinancial corporations enmeshed in financial markets, onto its own, or more appropriately the consolidated Fed-Treasury balance sheet. Rather than deploying this consolidated balance sheet to support direct fiscal stimulus targeting households facing the worst impacts of the pandemic, unconventional balance sheet interventions target the weak links of the financial system. Even if the Fed has the capacity to absorb this risk, placing the huge power of the Fed’s consolidated balance sheet in the service of supporting the spread of finance into new and riskier terrain and atypical markets for private financial assets, instead of providing direct fiscal stimulus, poses critical questions.

With corporate finance becoming dominated by market-based finance and asset management funds becoming important sources of corporate funding, traditional tools designed for bank-dominated corporate funding no longer serve the purpose. With the corporate bond-buying program the Fed could potentially use its balance sheet to exert its influence not just over borrowing costs, but also over long-term corporate debt held by the ETFs (McCauley 2020). But in the absence of effective regulatory control and checks on the power of finance, Fed’s wider backstop would also entrench the dominance of market-based finance and asset-management funds.

This dominance can be seen in the appointment by the Fed of the financial advisory arm of BlackRock—the largest asset management group and a key player in the bond ETF sphere—as investment manager of the corporate bond buying facilities without any open contest or debate. Its experience and pervasive presence in the market for corporate debt and its control over the crucial data and technology that drives investment portfolios have now enshrined BlackRock’s position as the Fed’s partner, as it seeks to restore funding to corporate bond and ETF markets.

By stepping in as the public dealer of last resort (or authorized participant of last resort) when the private dealer system collapsed, the Fed is using its balance sheet to influence prices and conditions in different financial markets and calibrate the price of the collateral assets that anchor money market funding (Mehrling 2010, 2016). These policies could provide a potential source of direct leverage over other asset prices (Mehrling 2016). But in order to control asset prices, the Fed also has to be in a position to exercise a greater degree of control over the supply of these assets, which are created in a highly concentrated, rapidly evolving, market-based financial system dominated by a few big banks and asset managers, unlike state-controlled treasury securities.

While the restoration of channels of liquidity and credit may be seen as an indispensable public good (Mehrling 2016), in the absence of the development of regulatory capacity to rein in the dominance of big financial institutions and contain the spread of market-based finance to new corners of the economy, new sources of fragility will emerge, necessitating further expansion of the Fed’s backstop and balance sheet policy interventions—a growing doom-loop.

The April 9 decision to include recently downgraded and riskier high-yield junk bonds and debt of highly leveraged firms owned by private equity fund in the Fed’s bond purchases, undermines regulatory efforts to contain such lending by banks and exacerbates pro-cyclical financial dynamics (McCauley 2020). The deeper issue is the persistent challenge that the proliferation of market-based finance and the concentrated, interconnected structure of finance continues to pose as new sources of financial fragility inevitably emerge.