The legal scope of Fed purchases

This is a guest post by JP Koning:

Any central bank that wants to be Chuck Norris-like requires the legal authority to purchase a broad array and quantity of assets. Without the legal ability to conduct broad purchases, a central bank’s threat to enforce a new target will lack credibility. The Federal Reserve Act significantly limits the sorts of assets that the Federal Reserve is allowed to purchase and, given the politicization of all things Fed, is unlikely to be changed. Given the current scope of purchases allowed by the Federal Reserve Act, can the Fed be Chuck Norris?

Section 14 of the Federal Reserve Act sets out the rules governing Fed asset purchases. It currently limits the Fed’s purchases to gold (14.a) and US Federal government issued and guaranteed assets (14.b.1), including those of Federal agencies (14.b.2). Eligible government and agency securities include treasuries, agency debt, and agency-issued MBS. These purchases must be conducted in the open market, or secondary market. The open market stipulation prevents the Fed from purchasing Treasury or agency debt directly from the Federal government or its agencies. Such direct purchases would constitute monetary financing of the government.

The Fed is also permitted to purchase bankers acceptances and bills of exchange in the open market (14[para 1]).  These are privately issued assets. But both are legacy instruments. Few American institutions use them much anymore.

The Fed is also allowed to purchase state and municipal debt with a term not exceeding six months. (14.b.1)

Lastly, it can purchase foreign government issued and guaranteed assets, as well as those of their agencies. (14.b.1)

Note that Small and Clouse claim that both municipal and foreign purchases can be made directly, and not via the secondary market. This precludes the need for an already-existing market in these assets to be present before the Fed can participate in it.

There is also a not-so-well known legal route by which the Fed has purchased assets in the past. The restrictions set by Section 14 clearly prohibited the massive Fed purchases of all sorts of private assets during the 2008 crisis, including private label RMBS (much of it subprime), CDOs, CMOs, ABS, swaps, whole commercial mortgage loans, and asset-backed and unsecured commercial paper. Furthermore, in many cases these purchases were often not made in the open market, but directly from distressed banks. (Bear Stearns and AIG)

In announcing its purchasing programs in 2008, the legal route taken by the Fed invariably drew on section 13.3 of the Federal Reserve Act. But oddly, Section 13 sets out the rules and regulations regarding Fed loans, not purchases.  Section 13.3 is an incredibly open ended passage, allowing the Fed to lend to any individual, partnership, or corporation upon any collateral the Fed deems satisfactory.

Over the course of the crisis, the Fed mobilized 13.3’s lending powers so as to justify purchases by creating five separate Delaware limited liability companies: Maiden Lane LLCs I, II, and III, Commercial Paper Funding Facility LLC (CPFF), and Term Auction Lending Facility LLC (TALF). It lent to these corporations under the authority of Section 13.3. These LLCs proceeded to use these funds to purchase assets not specifically authorized by the Federal Reserve Act.

In short, the Federal Reserve attempted to get around the limitations concerning asset purchases found in Section 14 by lending under the much broader Section 13.3 to the five recently created LLCs it controlled, and ordering these LLCs to purchase whatever assets it deemed necessary. Presumably as long as the LLCs were doing the purchasing, and not the Federal Reserve itself, Fed lawyers felt that Section 14 was not being violated.

Dubious? It would take a court of law to determine how legal the entire range of transaction conducted though these LLCs was. Certainly it seems to have violated the spirit of the law, though perhaps not the letter. Nevertheless, there exists some sort of precedent, wholly legal or not, for large scale purchasing program of private assets.

So could the Fed incorporate, say, “NGDP Targeting LLC” or “QE3 LLC” and lend it an unlimited amount of dollars under Section 13.3 of the Federal Reserve Act?  A stumbling point is that Section 13.3 only allows loans under unusual and exigent circumstances. Since targeting and quantitative easing are more than just emergency programs, but ways of conducting monetary policy on an ongoing basis, getting either through Section 13.3 sounds akin to passing an elephant through the eye of a pin. In sum, it seems unlikely that the Fed could ever purchase private label MBS, CDOs, stocks or corporate bonds on a regular basis.

Despite the difficulty of invoking 13.3 loans to fund “NGDP Targeting LLC” or “QE3 LLC”, purchases allowed under Section 14 are still significant. They amount to approximately:

Federal government debt: ~ $7.5 T

Agency debt: ~ $3 T

Agency guaranteed debt total:  ~ $1.5 T?

Bankers acceptances: ~ minimal

Gold: ~ $10 T

Short term state/municipal debt and foreign government debt: theoretically infinite

While the existing market for acceptances is tiny, a Fed decision to enter the market as a large purchaser would lead to immediate growth in the acceptance market. Acceptances are short term credit instruments that in many ways serve the same purpose as commercial paper. 

A short term municipal and/or state debt purchase program would also lead to a significant surge in the size of short term municipal/state debt markets. The fact that these securities can be purchased directly from municipalities/states rather than in the secondary market dramatically increases the scope for purchases, as a pre-existing stock of muni/state short term debt isn't necessary for the Fed to participate.

The gold market is a market in which the Fed could exercise significant purchasing power.

Lastly, the largest market through which purchases might be conducted is via foreign government debt markets. As in the case with states and municipalities, it would not be necessary to confine purchases to open market paper, since it seems that the Fed is allowed to directly negotiate with foreign governments to buy their paper.

If the Federal Reserve wants to become a credible Chuck Norris, it’s worth considering some of the costs involved in a decision to either re-enter the acceptance market or establish itself as a major player in municipal and foreign government finance.  It would surely shape patterns of investment and liquidity in a very significant way, probably displacing existing financial instruments and market participants. Secondly, there is potential for abuse of the Fed’s power to purchase debt directly from municipalities/states and foreign governments. The traditional requirement to confine central bank purchases of government debt to the open market forces central banks to pay market rates rather than rates that might subsidize governments. Monetary financing of governments is not an accepted task of a central bank.

The above is by JP Koning.

Comments

[Min]

"The Fed is also allowed to purchase state and municipal debt with a term not exceeding six months. (14.b.1)"

How much has the Fed purchased? States and cities are hurting.

"Section 13.3 is an incredibly open ended passage, allowing the Fed to lend to any individual, partnership, or corporation upon any collateral the Fed deems satisfactory."

If commercial banks are not lending, shouldn't the Fed? Here is a direct and broad route to stimulating the economy. No?

[Dan Kervick]

With states and cities, do the debt purchases work the same way as with the Federal government? The Fed returns the interest?

[Steve Waldman]

This is a good piece, and I'm glad JP Koning didn't emphasize circumventing the law by setting up asset-purchasing LLCs and lending to them. In any case, and for good reason, this Sec 13.3 power has been curtailed by Dodd-Frank (now requires by-in from outside the Fed, cannot be directed to the benefit of specific firms).

Dan — The Fed remits its profits (above a small percentage of its formal capital) to the US Treasury. If the Fed issued reserves to buy municipal debt, the spread between the interest it earns from municipalities and the interest it pays on reserves would go the the Federal government. However, if the Fed became a large buyer, it might bid down municipal rates, in which case the operation would still be something of a subsidy to municipalities by reducing their interest burden.

[bill woolsey]

If the Fed has purchased all of the usual things, and still nominal GDP is below target, I think the situation qualifies as an emergency.

If you think about it, why would doing these things be necessary except in a crisis type situation?

[Alex R.]

The basic idea of the Chuck Norris principle is that Chuck rarely, if ever, needs to actually beat anybody up. Indeed, we might think of those situations where he _does_ need to beat someone up to maintain his credibility as being "unusual and exigent" circumstances...

With regards to the Dodd-Frank restrictions mentioned by Steve Waldman, what constitutes "buy-in"? Credibility maintaining purchases wouldn't be for the benefit
of a particular firm, so I don't think that part of the restriction is serious...

[JKH]

The LLC structure does not "justify purchases".

It enables secured lending.

That's what an LLR function is supposed to do.

E.g. Maiden lane structure:

http://newyorkfed.org/markets/maidenlane.html

[JP Koning]

I'll give a shot at addressing technical and legal related questions and points.

Min: "How much has the Fed purchased? States and cities are hurting."

The Fed to my knowledge hasn't exercised this power since the 1910s.

Dan: "With states and cities, do the debt purchases work the same way as with the Federal government? The Fed returns the interest?"

The earnings would get paid to the Federal government.

Steve: "Sec 13.3 power has been curtailed by Dodd-Frank."

Yes, 13.3 used to run just one paragraph. Sections B, C, D, and E have now been added to it, dramatically reducing the Fed's ability to make section 13.3 loans.

Bill: "If the Fed has purchased all of the usual things, and still nominal GDP is below target, I think the situation qualifies as an emergency."

That may be the case, but 13(3)(b)(iv) says that "The Board may not establish any program or facility under this paragraph without the prior approval of the Secretary of the Treasury." So the task of qualifying something as an emergency is no longer in the hands of the Fed but is now a political decision. I think that would make instituting such a program much more difficult than in the past.

JKH: "The LLC structure does not "justify purchases". It enables secured lending. That's what an LLR function is supposed to do."

Sure, but if the point was to engage in secured lending, the Fed could have lent directly to AIG and Bear on a secured basis via 13.3 but didn't.

[JP Koning]

Alex: "With regards to the Dodd-Frank restrictions mentioned by Steve Waldman, what constitutes "buy-in" Credibility maintaining purchases wouldn't be for the benefit of a particular firm, so I don't think that part of the restriction is serious"

The point I made to Bill points out what 'buy in' might mean. Give Section 13.3 a read, it's got some interesting stipulations attached to it.

[David Pearson]

JP Koning,

Woosley says, "If you think about it, why would doing these things be necessary except in a crisis type situation?"

The intent of the limits on Fed purchases is to allow for Treasury OMO's and the Fed's LOLR function. The reason for this is clear (as is the reason for limitations on ECB asset purchases): the Treasury -- and through it the taxpayer -- ultimately bears any losses incurred by the Fed.

Congress willingly gave up part of its power of the purse to enable the Fed to engage in monetary policy. When the Fed's actions cross the line into fiscal policy, it should not be surprised if Congress reacts by protecting its constitutionally-mandated turf.

[David Pearson]

That should have read "to allow ONLY for Treasury OMO's and...LOLR". In other words, risk-asset purchases are fiscal policy, as they create a contingent tax liability without, necessarily, addressing a systemic liquidity crisis.

[Tim]

Why have bankers acceptances become a "legacy" instrument in the US. In Canada BA's are frequently used and are the basis of the short term money market rate setting mechanism hence the three month Canadian Bankers Acceptance rate. Is this just another example of the "inferior" US financial system compared to Canada. I know one difference is that under that under Canada's constitution BA's and Bills of Exchange are governed by federal law and not provincial law whereas in the US they are part of the UCC governed by state law.

[JP Koning]

Tim: "Why have bankers acceptances become a "legacy" instrument in the US?"

The Fed ceased buying BAs back in the early 1980s and thus the market lost a major backstop. My guess is that commercial paper markets in the US have taken up the slack vacated by BAs.

[Nick Rowe]

What is a "bankers acceptance"? Presumably an IOU of some kind, but what precise kind? Just like a 90 day Tbill, only signed by a bank rather than the government? And these are marketable liquid assets too, presumably?

[dlr]

Nick yes, a banker's acceptance is a commercial payable (usually from an import/export business) that has been guaranteed by a bank. It is thus exactly like commercial paper guaranteed by a bank, and they in theory can be resold in the secondary market and would trade like short term bank debt. It's an interesting point that this could be a very powerful monetary policy instrument (because although the market is essentially dead now such a policy would create incentives to invigorate it), but also that it could create very strange distortions in the market as banks reinsert themselves as intermediaries in corporate borrowing markets. Meanwhile, the right to purchase foreign obligations (noted by JP), doesn't get a lot of attention but brings a ton of Section 14 credibility to Chuck's stare.

I agree completely with JKH and disagree with all the critics (and JP) who characterize Maiden Lane I-III as stealth purchases. They are only stealth purchases to the extent that any loan on risky enough collateral or with a small enough haircut is a stealth purchase. But the Fed had the right to make such risky loans, and the SPV vehicle was simply a legal simplification (due to a ton of complications with regard to corporate structure, regulation and various stakeholders) -- certainly not some way to communicate a new Fed reaction function via a risk section 14 version of QE.

[Nick Rowe]

dlr: thanks. IIRC, one of the unsung methods the Canadian government used during the height of the financial crisis was a big expansion in the size of Export Development Canada, which is a government entity that does export (and I think import) finance.

[vjk]

dlr:

You wrote:

"But the Fed had the right to make such risky loans"

As I commented about two weeks ago, the feds most likely overstepped their statutory boundaries as defined by 13.3. In simple words, the SPV concoction was probably illegal. Here's a nice analysis of the 13.3 related issues with which I largely agree:

http://www.law.upenn.edu/journals/jbl/articles/volume13/issue1/Mehra13U.Pa.J.Bus.L.221%282010%29.pdf

As Steve Waldman correctly noticed, the feds power with regard to 13.3 application is currently limited to a substantial degree by Frank/Dodd (see. http://www.skadden.com/Cimages/siteFile/Skadden_Insights_Special_Edition_Dodd-Frank_Act1.pdf, Page 15.) which makes the Maiden Lane abominations much less likely to occur in the future.

Of course, any interpretation will have to be resolved in court.

[JP Koning]

dlr, although I’m fond of the Maiden Lane-as-loophole-around-FR-Act theory, I’m willing to be dissuaded.

The Maiden Lanes purchased assets outright, they didn’t lend, but maybe you already know that. So the Maiden Lanes weren’t conducting an LOLR function, since the purchased assets were removed from the balance sheets of AIG and Bear Stearns for good.

Why did the Fed feel it was necessary to purchase assets from rather than lend to AIG/BS? Well, in BS’s case we know that the JPM would only go through with the purchase of BS if *someone* bought the most toxic assets RMBS, ABS, swaps etc. Enter the Fed.

Section 14 prevented the Fed from buying those particular assets outright. Lending to BS and accepting those toxic assets as collateral via 13.3 loans – a perfectly legal route in an emergency - would not have performed the vital role of completely removing said assets from BS’s balance sheet and allowing the transaction to go forward.

So create Maiden Lane LLC, lend to that via 13.3, and purchase the BS assets.

They must have felt that the AIG meltdown required the same treatment.

So that’s why I see the creation of these LLCs as more than mere simplification. They were surely not loans.

[JP Koning]

vjk, thanks for the link to the Mehra article. I hadn't realized someone had published on this issue. I just read through it... it is very well written.

[vjk]

JP:

"it is very well written"

It is indeed. Very rarely do lawyers have such good command of English ;)

[JFL]

A quick question to JP or to anyone else with knowledge in this area:

After the Fed sets up the Maiden Lane's, etc., what assets do they have to pledge as collateral to initiate the secured lending with the Fed? And was it the Fed that initially capitalized them?

-JFL

[JKH]

I don’t understand your point.

The LLC’s were not loans – that’s obvious. It’s not the LLC’s that are the LLR function.

They were structured to enable Fed secured lending.

That included first loss protection in front of the Fed’s position.

Look at the capital structure of the LLC’s.

[Jon]

Unfortunately, I am on the road, so I'm not going to give you the citations but this article is seriously wrong. The board of governors has broad legal authority to define what assets the fed may purchase. These provisions were adopted by congress in the late 90s when it was seriously contemplated that the entire federal debt might be retired by 2010.

Most of the federal reserve act is deadletter and hasn't had meaning or purpose since the 20s and 30s.

[studentee]

"Unfortunately, I am on the road, so I'm not going to give you the citations but this article is seriously wrong."

awesome

[Too Much Fed]

David Pearson said: "The intent of the limits on Fed purchases is to allow for Treasury OMO's and the Fed's LOLR function. The reason for this is clear (as is the reason for limitations on ECB asset purchases): the Treasury -- and through it the taxpayer -- ultimately bears any losses incurred by the Fed."

Does bear any losses mean issue more gov't debt and give it to the fed?

[JP Koning]

JKH, I'd say the Maiden Lane LLCs were first and foremost structured to avoid section 14 limitations on purchases, and since the risk involved in outright purchases of those particular assets was so high (much higher than collateralized lending) first loss protection was added to cover the Fed.

If the primary purpose of the Fed's LLCs was to add first loss protection, then why did CPFF LLC not have any first loss protection? (the five major LLCs that recieved 13.3 loans were the Maiden Lanes, CPFF LLC, and TALF LLC). As far as I can see, they had to create CPFF LLC because Section 14 doesn't allow for purchases of commercial paper.

[JP Koning]

JFL: "And was it the Fed that initially capitalized them?"

It was the Federal Reserve Bank of New York. 1 share, $10 par value.

---

I probably shouldn't have put so much stress on the 13.3 stuff, which is proving interesting but maybe a touch distracting, and just focused on Section 14. Going forward, what makes the Fed a Chuck Norris or not are the Section 14 bits. I personally found the size of potential Section 14 purchases surprising, and am curious if those who support NGDP targeting see this as sufficient or not.

[JKH]

"If the primary purpose of the Fed's LLCs was to add first loss protection, then why did CPFF LLC not have any first loss protection?"

Because first loss protection was already provided by the issuers of the commercial paper - in their own capital structures, where paper ranked before equity. That was not the case with Maiden lane assets.

I said the primary purpose of the LLCs was to enable secured lending.

First loss protection engineering was then a function of the particular LLC and its assets.

[JKH]

First loss protection structuring was a function of asset risk and coverage otherwise:

"The commercial paper that was eligible for purchase was HIGHLY RATED, U.S. dollar-denominated, unsecured and asset-backed commercial paper with a three-month maturity. To manage its risk, the Federal Reserve required issuers whose commercial paper was purchased by the CPFF LLC to pay FEES at the time of each purchase. Additionally, at the time of the initial registration, each issuer was required to pay a facility fee equal to 10 basis points of the maximum amount of commercial paper that it could issue to the CPFF LLC. A total of $849 million in fees were collected by the CPFF LLC."

[JP Koning]

Since the Fed could have easily lent directly (without the intermediation of an SPV) to commercial paper issuers on a secured basis via section 13.3 loans and included all the same fees you mention above, setting up a CPFF LLC middleman to enable secured lending was redundant. There has to be some other reason for the structure.

The reason for creating CPFF LLC was not for secured lending, but to enable outright purchases of commercial paper. A rebuttal to this is that there's no economic difference between a purchase of a firm's commercial paper and a direct secured loan to that same firm. But in commercial law, there is a very big difference between a loan and a purchase (the loan/asset-purchase distinction, as Mehra calls it), and the FR Act simply doesn't allow for purchases of commercial paper. So CPFF LLC was a way to create a way to get around this. Secured lending was already in the Fed's toolbox prior to CPFF LLC.

[vjk]

JP:

"But in commercial law, there is a very big difference between a loan and a purchase"

Quite right. The main, if not the sole purpose, of the ML scheme was to make possible buying what was not possible to buy due to the FRA limitations as you pointed out in the old thread (in that thread I erroneously thought that no actal buying occurred, only 13.3 lending took place, but you put me straight in this regard).

Funny, in the early 2009 when I tried to analyze the MLs structure and purpose, I came to the same tentative conclusion that there were actual purchases taking place, through SPVs, but later dissuaded myself by being convinced of illegality of such purchases no matter the actual set up might be.

[JKH]

You're making my point for me.

The Fed needed to lend secured. It can't do that by purchasing commercial paper. It can by lending against commercial paper collateral.

The LLC's were designed to accommodate secured lending. The Fed didn't want to buy anything. It wanted to lend secured.

[vjk]

Maiden Lane I/II bought RMBS. Maiden Lane III bought CDOs.

Not commercial paper, toxic assets.

[JKH]

I was responding to the point on CPFF LLC.

[JP Koning]

So we should be able to agree that the Fed can't legally lend against an issuing firm's own commercial paper as collateral. Lending against a firm's own paper is not secured lending. The Fed can only lend directly to firms via 13.3 by taking third-party securities from the firm as collateral, like government bonds or other firms' commercial paper. Or a firm can pledge some un-hypothecated asset like its real estate as security. But it can't offer its own unsecured notes.

That leaves the Fed with only one legal route by which it can directly interact with commercial paper issuers and their unsecured notes - as a purchaser. But Section 14, which governs purchases, doesn't allow commercial paper to be purchased.

So set up CPFF LLC to conduct the transactions. Then the Fed can deny it is contravening the Act. Invoke 13.3 to fund CPFF LLC, which abides by the letter of 13.3 because the CPFF is borrowing from the Fed by submitting third-party paper as collateral.

The fact nevertheless remains that the ultimate purpose for the LLC was to get around the limitations of the Federal Reserve Act. The ultimate purpose was not to facilitate secured lending, since the Fed could have lent directly via 13.3 to commercial paper issuers on a secured basis by accepting third party assets, real estate, etc as collateral. Your point stands though that CPFF LLC does enable secured lending from the Fed to the CPFF.

Which leads back to the thrust of the article about the scope of Federal Reserve purchases, since an LLC unchecked would be capable of unlimited purchases. But luckily it is no longer unchecked.