Building on recent actions of the Federal Reserve to help stabilize and add liquidity to the country’s financial system, including the market for municipal securities, on March 27, 2020, President Trump signed the $2 trillion Coronavirus Aid, Relief, and Economic Security (CARES) Act, that includes the Coronavirus Economic Stabilization Act of 2020 (the “Act”).
Among other things, the Act authorizes the US Treasury to make up to $500 billion in loans, loan guarantees, and other investments in support of eligible US businesses and state and local government borrowers. Of this amount, $46 billion is earmarked for direct corporate loans and loan guarantees to certain US corporate borrowers (US airlines, air cargo, and critical national security businesses), and the remaining $454 billion is “available to make loans and loan guarantees to, and other investments in” programs or facilities established by the Board of Governors of the Federal Reserve System (the “Federal Reserve” or the “Fed”) to provide “liquidity to the financial system that supports lending to” both States and localities (collectively, “government borrowers”1) and eligible US businesses. It also directs the Secretary of the Treasury to “endeavor to seek” to implement such a program or facility that supports lending to government borrowers.
In the days leading up to the passage of the Act, the Fed had (a) expanded its money market liquidity programs to authorize non-recourse, short-term loans to qualified financial institutions backed by purchases of highly rated short-term and demand securities issued by government borrowers and purchased from money market mutual funds after March 17, 2020, (b) authorized funding to a special purpose vehicle (“SPV”) to facilitate the purchase of highly-rated commercial paper issued by government borrowers, among others, and (c) authorized primary dealers in US Treasury securities to pledge investment grade securities issued by government borrowers, among others, as collateral in their borrowings from the Fed. Read our prior client alert on these actions, US Federal Reserve acts to provide liquidity for municipal short-term securities.
The Act continues a major shift in the focus of the Federal Reserve to provide liquidity assistance to the municipal securities market – a focus the Fed has historically avoided because of a desire to keep its transactional actions out of the political arena. The Act puts an exclamation point on the message to the debt markets that the political branch of the US Government, along with the Federal Reserve, will act to keep those markets functioning, a message that, if the recent reduction in market interest rates and spreads for municipal securities holds, has been heard by that sector. It remains to be seen, however, whether and, if so, when the Act will result in direct federal lending to government borrowers, or whether it will add only liquidity (albeit the potential for significant liquidity) to the secondary market for their securities. Below we summarize the Act’s provisions related to the municipal securities market.
Municipal market liquidity
The Act authorizes up to $500 billion in (1) direct US Treasury loans and loan guaranties for eligible US corporate borrowers and (2) loans and loan guaranties for, and other investments in, programs or facilities established by the Federal Reserve to provide liquidity to the financial system that supports lending to eligible US corporate borrowers and government borrowers, by (a) purchasing debt obligations directly from eligible issuers or in the secondary market or (b) making loans (both secured and unsecured). The liquidity providing Fed programs currently include the Commercial Paper Funding Facility, the Money Market Mutual Fund Liquidity Facility and the Primary Dealer Credit Facility, all of which were also utilized by the Fed in varying degrees during the Great Recession of 2008-2010.
The Act’s text in regards to the loans referenced in (2)(b) in the preceding paragraph leaves open the mechanism by which these loans will be made and by whom. The Fed’s limited term, municipal market support actions that recently preceded the Act’s passage include lending to financial institutions and a secured loan to an SPV to enable them to purchase eligible municipal securities that would be contained within the collateral packages securing those loans. The Treasury agreed to make a $10 billion equity contribution to this SPV to leverage its purchasing power. If this approach is a guide, the Treasury’s equity investment to the existing or any newly created SPV could be many multiples of this previous contribution, given the almost $500 billion in assistance that Congress has appropriated to the Treasury under the Act. This has the potential of providing far more leverage to inject liquidity into the credit markets, including the municipal securities market. At the same time, however, because of the breadth of potential US business recipients eligible for support from this up to $500 billion allotment and the historical reluctance of the Fed to target its financial aid to state and local governments, it remains to be seen how much actual financial assistance will be made available to the municipal debt market despite the exhortations in favor of those borrowers in the Act, or whether the express authorization in the Act for the Fed to provide assistance, even without more, will continue to bolster the recovery and ongoing functioning of the municipal debt market.
The Act does not address whether any loan guarantees and other federal assistance to provide liquidity for state and municipal debt through the Fed will be deemed a guaranty of municipal securities and run afoul of Internal Revenue Code Section 149(b), which bars even indirect federal guarantees of tax-exempt debt. If not clarified, application of Section 149(b) might further suppress the anticipated impact of the financial assistance for government borrowers, depending possibly on how liquidity is structured.
Terms and conditions of assistance
The Treasury Secretary will determine the appropriate terms and conditions of its transactions, and the rate on any loans will be based on their risk profile and the current average yield on comparable maturities of marketable direct US obligations. Loan forgiveness will not be permitted for any obligation issued by a beneficiary of the above programs, including any government borrower. The Act does not specify the maximum term of any loan or loan guarantee related to the Secretary’s actions in respect of the Fed programs or facilities to provide liquidity to the municipal securities market. This is in contrast to the five-year maturity limitation on direct loans and loan guarantees to eligible US businesses under the Act. As we noted in our earlier client alert, the liquidity assistance previously provided for the municipal market was generally limited to SPV purchases of three-month, high quality, unsecured, discount commercial paper and other short-term municipal debt (including variable rate demand obligations) with a maturity (or optional tender (or put) period) of not more than 12 months. The Primary Dealer Credit Facility can be used (but only by the Fed’s limited number of primary dealers) to provide liquidity for secondary market purchases by primary dealers of longer dated municipal securities, which they can then pledge as collateral for Fed loans, but it remains to be seen how this facility will be utilized under the Act and what impact these or any new facilities will have on fixed income investor sentiment.
The Act requires any Federal Reserve liquidity facilities or programs (including any new ones) authorized by the Act to comply with the “loan collateralization, taxpayer protection and borrower solvency” requirements under Section 13(3) of the Federal Reserve Act. That subsection authorizes the Fed, “in unusual and exigent circumstances,” to discount notes and similar loan instruments of solvent borrowers “unable to secure adequate credit accommodations from other banking institutions,” but conditioned on security designed to “protect taxpayers from losses.” These requirements apply to all of its broad-based, Treasury-approved eligibility programs, such as those noted above, which currently terminate within a year and in some cases sooner (in compliance with Sections 13(3)’s requirement that such programs sunset “in a timely and orderly fashion”). The effect of these provisions in the past has effectively constrained the Fed’s credit market liquidity assistance to the purchase of higher rated debt instruments. It remains to be seen how the Fed will navigate through these requisites in putting the Treasury’s money to work when the credit rating agencies have placed many municipal credits, intended by the Congress to be beneficiaries of the assistance provided by the Act, on “credit watch” for possible downgrades on account of the financial impact of COVID-19.
The Act requires the Treasury Secretary to publish, within 10 days of the Act’s passage, procedures for application and minimum requirements for direct loans to eligible US businesses that the Act authorizes. There is, however, no timeline given for the Fed to provide similar materials in respect of its credit market purchase and liquidity programs/facilities. Further, while the Act provides that the Secretary “shall endeavor to seek the implementation of a [Fed] program or facility…that provides liquidity to the financial system that supports lending to” government borrowers, it is unclear whether this is in addition to the programs and facilities that the Fed recently established and expanded to cover certain aspects of the municipal debt market and the US credit markets generally. As a result, it remains to be seen whether the Fed will provide additional liquidity for longer-dated municipal securities beyond the existing Primary Dealer Credit Facility or will keep its focus on the shorter end of the municipal securities maturity range.
Reporting and oversight
The Act requires (1) detailed Federal Reserve reporting to the Senate and House committees with jurisdiction over the Fed regarding, among other things, the amount, material terms, justification and taxpayer cost of the financial assistance provided (whether under new or existing programs/facilities), (2) publication of these reports on the Fed’s website, (3) quarterly testimony by the Treasury and the Fed to those Congressional committees regarding their transactions entered into under the Act, and (4) US Comptroller General Congressional reporting as well.
The Act establishes within the Treasury the Office of the Special Inspector General for Pandemic Recovery (the “Inspector”), to be appointed by the President and confirmed by the Senate, to (a) collect necessary information and “conduct, supervise, and coordinate audits and investigations regarding the loans, loan guarantees and other investments made by the Secretary [of the Treasury] … under any program established” by the Act and the Secretary’s management thereof and (b) report quarterly to the Congress summarizing its activities.
The Act also creates a five-member Congressional Oversight Commission appointed by the leaders of both Houses of the Congress (the “Commission”) to review implementation of the transactions by the Treasury, the Fed and the US Government and to report to the Congress monthly on, among other things, the efficacy thereof “on the financial well-being of the people of the United States and the United States economy, financial markets and financial institutions…and minimizing long-term costs to…and maximizing the benefits for taxpayers.” The Commission will also have the power to hold hearings and take sworn testimony in carrying out its duties. The Inspector and Commission functions will terminate during 2025.
The authority to make new loans, loan guarantees and investments under the Act terminates on December 31, 2020, but transactions still outstanding after that date “may be modified, restructured or otherwise amended” (but not, as noted above, “forgiven”). It seems that this latter provision applies to direct Treasury loans to eligible US businesses, but the language does not expressly limit that power to those loans.
Other provisions of the CARES Act
The CARES Act authorizes $10 billion in grants (without any state match requirement) for US airport operators (including, where applicable, government borrowers). To receive funds, an airport must retain at least 90 percent of its March 27, 2020 employment through the end of this year (with certain exceptions for non-hub and non-primary airports or for a showing of economic hardship). Just under three-quarters of this grant funding, $7.4 billion, will be made available to operators of airports that receive scheduled passenger aircraft service with at least 2,500 annual passenger boardings for any lawful purpose for which their airport revenues may be used (although not specified, presumably including debt service on obligations issued for capital projects at those airports). This grant will be allocated based on each airport’s relative share compared to the total for all such airports in 2018 of (1) passenger enplanements, (2) debt service and (3) unrestricted reserves to debt service ratios.
In addition to the provisions discussed above, the CARES Act also provides additional funding to states for small business activities, educational stabilization and unemployment relief. Additionally, the CARES Act creates a new Coronavirus Relief Fund in order to provide no less than $1.25 billion to each state for COVID-19-related costs incurred in 2020.
If you have further questions regarding the operation or impact of the Act on the municipal securities market, or would like advice concerning possible government borrower action to take advantage of the above programs/facilities, including any eligible private activity conduit borrowers, please reach out to your Norton Rose Fulbright lawyer.