Despite its limited use, the Municipal Liquidity Facility bolstered eligible local governments by reducing the likelihood of credit downgrades, raising the price on trades in the secondary market and saving local government jobs.
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“We find that while the announcement of the liquidity option improved overall municipal bond market functioning across the board, low-rated issuers additionally benefited from direct access: low-rated government bonds traded at higher prices and were issued more frequently on private markets with facility access,” the authors wrote.
Using data from the Municipal Securities Rulemaking Board, Bloomberg and Census Bureau files, the authors said eligible governments for the MLF fared well. They found that yields on bonds issued by lower-rated, i.e. A and BBB cities and counties with populations just above the MLF thresholds of 250,000 or more and 500,000 or more respectively, exhibited yields 72 basis points lower than equivalent issuers that narrowly missed the cutoff. According to the study’s data, 43 unique issuers were within that cutoff.
“We interpret these results as suggestive of a setting in which pre-existing uncertainty in the pricing environment for low-rated municipal issuers (those with more bonds on the margin of default) may have been amplified by the pandemic,” the authors said. “This credit risk seems to have been priced differentially by investors, depending on whether issuers had the ability to borrow from the Federal sector as a last resort lender.”
The Fed created the MLF in April 2020 and it ended at the end of 2020. It was open to counties with populations of 500,000 or more and cities of 250,000 or more. In June, the central bank allowed U.S. states to be able to have at least two cities or counties eligible to directly issue notes regardless of population. Governors of each state were also able to designate two issuers whose revenues are derived from activities such as public transit and tolls.
Illinois and the New York Metropolitan Transportation Authority were the only issuers to use the MLF, garnering criticism that it wasn’t open to enough issuers.
Eligible issuers were also less likely to face downgrades, indicating that access to the MLF decreased their riskiness as borrowers. Ineligible issuers’ chance of being downgraded increased, the authors said.
The number of MLF-ineligible issuer bond downgrades rose from roughly 100 to 600 by November of 2020, whereas downgrades were rarer for issuers that had MLF optionality, the authors found. Low-rated MLF-eligible bonds also appeared to recover fully to pre-March levels, mimicking the behavior of high-rated bonds, the authors said.
Because of the MLF, local governments were able to keep 23% more employees, the economists said. Eligible issuers under the MLF retained about 405 more local government employees or 23% compared to last spring.
“The results imply municipal debt markets and employment outcomes would likely have been more distressed absent the MLF, and are consistent with the view that large government furloughs might have over-weighted the worst possible outcomes based on past experience,” the authors said.
Secondary market yields and primary market issuance mostly returned to normal market functioning as a result of Federal intervention and low-rated investment-grade bonds were relatively distressed.
Democratic lawmakers argued in the last Congress that harsh terms and penalty rates for the MLF made it unusable. However, sources reiterated that the Fed’s role was to act as a backstop.
“The evidence is that the MLF did serve its purpose,” said Brian Battle, director of trading at Performance Trust Capital Partners LLC. “It did help highly distressed issuers, but it’s hard statistically to prove a negative. I’m not surprised by the result of the report.”
The MLF also helped non-eligible issuers as a sort of shadow effect as many issuers thought as the Fed expanded eligibility after the program was created, they may be included.
“More marginal buyers felt confident that they would be eligible, that this program would reach them eventually if it got bad enough,” Battle said.
When asked if the Fed will act in the future when markets next go volatile, Battle said they shouldn't.
“I believe that the Federal Reserve should stay out of it, it’s not in their job description, but when Congress tells them to do it, this is how they should do it,” Battle said.
