The Fed’s $1.5 trillion loan injection, explained

It’s not a “stimulus” — it’s $1.5 trillion in loans that have to be paid back, fast.

On Thursday, March 12, the Federal Reserve Bank of New York announced that it would offer $1.5 trillion in short-term loans to banks to “address highly unusual disruptions in Treasury financing markets associated with the coronavirus outbreak”: $500 billion on Thursday, March 12; $1 trillion, in two batches, on Friday, March 13; and another $500 billion each week for the rest of the month.

One-and-a-half trillion is a lot of money and could pay for a lot of things. And perhaps because everyone’s on high alert due to coronavirus worries, and maybe because $1.5 trillion is an eye-poppingly big number, and maybe because congressional debates over fiscal stimulus packages are in the news already, several lefty politicians seized on the announcement and argued that $1.5 trillion should be spent on other priorities, like student debt relief or universal health care.

This is not a very good comparison to make. The Fed did not “spend” $1.5 trillion; it loaned the money to banks, which rely on these kinds of short-term loans as a way to get cash when most of their resources are tied up in assets like bonds. What’s more, the Fed’s loans are collateralized, meaning they are backed up by bonds worth even more than the money the Fed lent. If the banks should for some reason default on the loan, the Fed gets to keep the bonds and makes a sizable profit. If the loans are paid back, the Fed still makes a profit because it charges a modest amount of interest for the loan.

Now, you could argue, as Vanderbilt Law School professor Morgan Ricks has, that the availability of these cheap loans amounts to a subsidy to firms taking them out. But it’s just not a good comparison to equate this with spending $1.5 trillion on, say, Medicare-for-all.

The “repo” market, briefly explained

The Fed’s action was taken with an eye toward stabilizing the market for repurchase agreements, or the “repo” market for short. The repo market is the main mechanism by which financial institutions on Wall Street get cash, leveraging the huge amount they have invested in stocks, bonds, and other assets.

The details are called “repurchase agreements” because of how they’re structured. “You’re selling something and promising to buy it back,” Joseph Gagnon, a senior fellow at the Peterson Institute for International Economics who spent over two decades as an economist for the Fed, explained. “The financial institution has some high-quality bonds and it says, ‘I’m going to sell these bonds to you, Federal Reserve, and you give me cash, and at a certain date, I will buy those bonds back from you at a fixed price. You purchase them, and I will repurchase them.’”

That essentially amounts to a loan. The Federal Reserve is giving money to the financial institutions in exchange for a promise to pay it back (with interest) at some point later on. In the March 12 announcement, the terms laid out were one month and three months. Like home mortgages, the loan is “secured,” which means there’s an underlying asset that the borrower has to give up if they don’t repay. In the case of a home mortgage, that means your house. If you don’t pay, the bank can foreclose on you and take your house.

In the case of repos, the collateral is a Treasury bond. If banks don’t pay the Fed back, it can keep the Treasury bonds it bought as part of the repo deal, bonds whose value exceeds that of the money it lent. So it’s really not in the banks’ interests to renege on the deal.

The repo market is gigantic. The most common kind of repo — a tri-party repo, where the buyer and seller use an intermediary —has an average daily volume in the $1 trillion to $3 trillion range; on February 11, for instance, it was nearly $2.5 trillion. So $1.5 trillion over two days is a very significant intervention by the Fed, but it’s an intervention into an already very large market.

In part due to its size, a breakdown in the repo market can have much bigger, and graver, repercussions. As Slate’s Jordan Weissmann notes, a run on the repo market was one of the instigating factors in the 2008 financial crisis. There are good arguments to be made that it’s bad for Wall Street firms to rely so heavily on the repo market for its access to cash, but for the time being they do, and so destabilizing the repo market could have dire consequences.

A destabilization of the repo market could also disrupt the whole market for Treasury securities. Since repo deals often use Treasury bonds as collateral, a large share of the total volume of Treasury bond deals involve repo agreements. A shock to the repo market could thus shock Treasury interest rates, which are the baseline against which rates on everything from mortgages to credit cards to small businesses are set. That could have unpredictable and harmful effects if not stabilized.

Gagnon emphasizes that these deals are profitable for the Fed. “The Fed does not make loans in which there’s any risk they won’t be paid back,” he says. “Certainly in the last 30-40 years, the Fed has not lost a penny on any money they loaned.”

A subtler question is whether the Fed charged below-market rates such that it earned less profit than it could have earned charging market rates. It did, and that’s exactly the point: It’s a lender of last resort that steps in when it decides the rest of the market isn’t up to the task.

But it remains the case that the Fed didn’t create money out of thin air and spend it. It offered a public option for loans to banks that needed it.

Why this isn’t like student loan forgiveness

It should be fairly obvious that a repo market intervention isn’t like, say, printing $1.5 trillion to pay for an expansion of health care. If the Fed funded Medicare-for-all that way, it would not get $1.5 trillion back plus interest. It would just spend a whole lot of money on doctor’s and nurse’s salaries, MRI equipment, hospital mortgages, etc., and never get it back.

But what about student loans? That’s a comparison Rep. Alexandria Ocasio-Cortez (D-NY) made and it’s a comparison that benefits from referring to another loan market. Students are borrowing money with the intent of paying it back, just like the banks. So why don’t they get below-market loan rates?

Well, for one thing, they do. As part of Obamacare, the Education Department nationalized most of the student loan industry: Subsidized as well as unsubsidized Stafford loans and PLUS loans are issued directly by the federal government. And even in “unsubsidized” form, these loans are generally offered at rates below what private lenders can offer due to the inherent stability of the federal government. President Trump has further said he will suspend interest payments on federal student loans as part of his coronavirus response, though it’s unclear if he needs congressional approval to go through with that.

All of which is to say the federal government is already offering below-market rates on student loans, and it probably should if we want to encourage people to go to college and deter them from predatory private loans.

There’s an important difference between the student loan market and the repo market, though. The repo market features loans that are basically risk-free; they are essentially always paid back, and they’re collateralized, so in the event they aren’t paid back, the lender still makes money by keeping the bonds offered as collateral. Student loans are not only sometimes defaulted upon, but they’re not collateralized. There’s no bond or house or whatever that students have to give up if they default on their student loans.

Now, the federal government does have the power to garnish wages, and it has decided that student loans aren’t dischargeable in bankruptcy, which both serve to lower the risk of default compared to, say, an unsecured credit card loan. If I fall behind on my credit card payments, Chase can’t garnish my wages and I can discharge my debts in bankruptcy, both of which make Chase’s decision to offer me a line of credit riskier, in some respects, than a federal student loan.

But student loans are still far, far riskier than repo loans of the kind the Fed is making.

So the comparison between a $1.5 trillion loan package and a hypothetical $1.5 trillion spending package for health care or student loan forgiveness is flawed, to say the least. There are definitely valid critiques to be made of how the repo market works and how the Fed props it up — Ricks has a great book on just that. But I worry that these comparisons confuse more than they clarify.